The Strategy of Setting Price for Products and Services
Pricing is a basic and interesting topic in the business. This paper will be described the strategy of setting prices for products and services; especially it will focus on one specific strategy called price discrimination, which is to charge different prices to different customers for the same or similar product and service. Price discrimination is one of the most effective strategy to maximize a company’s profits when compared with a single pricing. However, it represents a transfer of value from consumers to companies and people may argue it benefits less to customers than to companies. In the following, three types of price discrimination will be described, and real examples will be used to illustrate them. The advantages and disadvantages of price discrimination as well as its benefit to consumers and society will be discussed.
The first type of price discrimination
The first type of price discrimination is based on two concepts: reservation price and consumer surplus. For a product and service, the reservation price is defined as the maximum price that a customer is willing to pay (Pindyck & Rubinfeld, 2001, p.371), and the consumer surplus is difference between the reservation price and the price the consumer actually pays (Hubbard & O’Brien, 2012, p.98). The goal of the first type of price discrimination is to capture the consumer surplus and turn it into its profit for a company.
For example, a tea shop sells a good brand of tea. For a cup of the tea, the competitive price (offered by many competitive suppliers) and the monopoly price (offered by few dominant suppliers) are $3.50 and $4 respectively. It is supposed that there are three customers to buy the tea, and the reservation price of these three customers are $6, $5 and $3.5 respectively. Based on the competitive market price ($3.5), their consumer surplus would be $2.5, $1.5 and $0 respectively. By using the first type of discrimination, the tea shop can ask different prices to these three customers which is $6, $5 and $3.5. By doing so the shop will sell three cups of the tea, and all consumer surplus ($4) would be captured. However, if the shop sets a single price $4, then it can only sell two cups of tea, and the third customer would be eliminated from service. Therefore, not only the profit is reduced but also the number of customers served is reduced as well.
Although it sounds great that a company can increase their profits and the quantity of products sold as well as the number of customers serviced, in practice it is hard to conduct. There are two reasons: first, it is difficult to know each customer’s reservation price; second, in order to know customer’s reservation price, companies need a lot of efforts in marketing research and investigation, which adds extra cost to the product and then reduces the product’s profit. Therefore, it is more suitable for some professional people such as dentists, lawyers and accountants, as they know their customers relatively well. For example, a lawyer may offer a reduced service fee to low-income client, but may charge a higher service fee to upper-income clients as they have the ability to pay. The possible problem is some customers who pay higher price may object price discrimination and argue that it represents a transfer of consumer surplus from customers to companies, which benefits less to customers than to companies such resulting an unfairness to rich people.
The second type of price discrimination
A company can discriminate prices according to the quantity purchased. The practice of setting different prices per unit for different quantities is called the second type of price discrimination or “block” pricing (Pindyck & Rubinfeld, 2001, p.374).
There are many companies who use this type of price discrimination such as grocery stores, suppliers of electricity, water and natural gas. For example, for electric power, consumers are charged different price per kilowatt depending on the quantity consumed. It’s usual, as an instance, the first 100 kilowatts of electricity consumed are charged at a higher rate, and after the first 100 kilowatts, consumers are charged at a lower rate per kilowatt.
This price strategy allows a company to convert part of consumer surplus into producer’s profit, and at mean time it increases the product’s quantities sold and the number of consumers served. Even though it has greater benefit to the company, it cannot be widely used in some business regions or areas. For examples, in China, it has huge population but limited water and power resources, so single pricing for power and water would be more suitable than price discrimination. The price discrimination may encourage people to use more power and water; such may result in resources shortage and air pollution, and eventually may damage the environment. Therefore, price discrimination should be applied under conditions, and only if it is used correctly, then it would create positive impact on the environment and society.
The third type of price discrimination
Third-degree price discrimination is based on two steps: dividing consumers into two or more groups and charging different prices to each group (Pindyck & Rubinfeld, 2001, p.376). One group may have the ability to pay a higher price such as upper-income customers; another group may only be able to pay a lower price such as students and seniors. Companies also would charge customers a higher price if the customers’ demand for it is inelastic such as a service is urgent and it must be done immediately, and charge other customers a lower price if their demand for the service is elastic. This strategy may cause price competition among suppliers to offer discount to different groups, such competition may result in lower price for products. If it is used by few suppliers in some period of time, then it may encourage consumers to buy more products. However, if it is used from wide range of suppliers over long period of time, then it may make the product permanently reduce price, and some companies may have difficulty to get profits.
To practice this type of price discrimination companies often set prices based on the consumers’ occupation, age, income, preference, time of use. Some of them will be discussed in the following:
(a) Based on occupation and income: Hubbard and O’Brien (2012) noted, “In mid-2009, Apple was selling an iMac desktop with a 24-inch display …for $1,499” to general public, “but university students and faculty members could buy the same computer from Apple for $1,399” (p.498). In this example, apple assumed the manufacturing cost of a computer is $400, so selling one iMac to university user would get profit $999, and selling one iMac to general user would get profit $1,099. In that period Apple sold 20,000 iMac to university users and 30,500 computers to general public users. The total profit from these sales is $53,499,500 ($999*20,000 + $1,099*30,500). However, if Apple used a single pricing, and if it also charged $1,399 in the general public market, it would sell 32,500 iMac (Hubbard & O’Brien, 2012, p.499), and then the profit from these sales would become $52,447,500 ($999*20,000 + $999*32,500). The difference of the profit made between using price discrimination and setting single pricing is $1,052,000 ($53,499,500 – $52,447,500). This example shows this strategy increased Apple’s profit. However, from another point of view that the total iMacsold was reduced from 52,500 (single price) to 50,500 (price discrimination), price discrimination reduced the number of products made/sold, and in turn it may influence the number of people employed and also may generate negative effect on the society.
(b) Based on preference and time: one example is that early adopters of new products would pay a higher price, such as new type cell phones, new books, new released music DVDs. Airlines usually charge ticket differently according to time. During the holiday such as Christmas and New Year, the tickets price is normally higher than other times. Customers sometimes are argue that the airline gets extra profit by exaction of customer’s surplus and leaves very little to customers.
This paper provides analysis on three types of price discrimination. Price discrimination is one of the most effective strategy to maximize a company’s profit when it is compared with a single pricing for the products and services. All three types of price discrimination raise a company’s profit, and they all have both positive and negative effect on the society. I personally think that price discrimination is a reality and it is acceptable to many customers in most situations. It exists in our daily life, and it is used widely in various industries.