Tuesday, July 24, 2012

Price Segmentation

"Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist."

- John Maynard Keynes

I suppose that when most people are presented with "price segmentation" as the stimulus, no synapses fire in the brain.  At best, a few people may have a vague recollection of some concept from a marketing course long forgotten.  This is an unfortunate state of affairs, and the purpose of this article is to show the importance of price segmentation to the average consumer.

Market Segmentation

Companies routinely divide the products and services they sell into different markets.  Usually the product or service is modified in some material way to appeal to different market segments.  Some products are segmented by geography (e.g. 4WD vehicles may have more appeal in colder areas) or by income (e.g. luxury goods versus utility goods).  Producers also routinely segment by age, gender, and other factors.  All of these ideas simply modify the product or service in some way that has greater appeal on average for that segment of the market.  This keeps consumers happier because there is usually some version of the product that is closer to what they want.  And it keeps producers happier because there is usually a slightly fatter profit margin for differentiated products.

However, there is one special kind of differentiation: segmentation by price.  Price segmentation is where essentially the same good or service is sold at different prices to different segments of the market.

Price Segmentation

You might wonder why a company would do this.  Why not just sell at one price?  And why not the higher price only?  You may also wonder how dual pricing is even possible.  If something is offered at two different prices, wouldn't everyone just buy at the lower price?

Let's think for a minute about pricing.  You probably know the laws of supply and demand.  At higher prices, fewer units are sold but at higher margins.  At lower prices, more units are sold but at lower margins.  Firms don't choose the highest or lowest price, but the place in the middle that maximizes total profits.  So far this is all Microeconomics 101.  But that is not the end of the story.

Clever people eventually realized that there is a lot of money being left on the table when things are priced in the middle.  First of all, there are some people who will pay more.  They may be happy to buy the item for $20, but they would still buy it at $30!  This is potential profit lost.  The problem with raising the price to $30 is that some of the other people who were happy to pay $20, now will not buy it at $30.  Losing those existing customers is more than the extra money you would have made on the people who would pay more.

Second, there are people who won't buy the item at $20, but who would buy it at $18 or $15.  If your costs are less than that, this is again potential money lost.  The problem with lowering the price to $15 is that while you will pick up some new customers, the profit is reduced on all the existing customers who were willing to pay $20.

For the producer, the solution to this dilemma is price segmentation.  Ideally, the producer could charge each consumer the highest price they were willing to pay.  Then profits would truly be maximized.  It is, however, completely impractical to have so many different prices.  But it is possible to have two or three, and often that is enough to capture most of the extra profits.  (A more formal way of stating this is that producers price to the aggregate demand curve, but there are many individual demand curves where they could do better, and this is what they want to exploit.)

Price Segmentation Examples

One of the very best examples of pure price segmentation is the old "Saturday night stay" that airlines used to require.  If your round-trip flight included a Saturday night stay in between, the rate was much lower.  Back when this practice was commonplace, I used to ask people why they thought the rates were so much better with a Saturday night stay.  Most people thought this had something to do with airline logistics - perhaps they were able to get the planes where they were needed over the weekend.  A few people thought perhaps the airlines got kick-backs from hotels for promoting weekend stays.  Almost nobody I talked to understood the real reason.

As it turns out, the requirement of a Saturday night stay almost perfectly segmented the airline market into business customers (who will usually pay more) and personal customers (who are much more price sensitive).  Here is an oversimplified example that contains the basic idea.

An airline has a flight with 200 seats available.  If they charge $400, they will only fill up 100 seats, for a total revenue of $40,000.  ($400 x 100 = $40,000)  If they charge $200, they will fill up the flight, but still only end up with $40,000 in revenue.  ($200 x 200 = $40,000)  With a Saturday night stay, however, they get to keep the 100 business customers who were willing to pay $400, while still filling up the rest of the seats with personal customers willing to pay $200.  The total revenue is now ($400 x 100) + ($200 x 100) = $60,000.

As you can see, this is an awesome idea if you are running an airline company.  If you are running a different kind of company, you will want to find a similar mechanism to achieve a reasonable level of price segmentation for your goods or services.


Coupons are another common mechanism for price segmentation.  For those unwilling to find, organize, and produce the coupons at the checkout counter, the higher price is paid.  For those willing to jump through the hoops, the lower price is available.

A lot of people think they are really outsmarting the manufacturers and the retailers with their use of coupons.  They assume that manufacturers are taking a loss at the coupon price, in an attempt to hook you into trying something new and then buying it later at full price.  People then feel that they are really sticking it to the producer by only purchasing the product with a coupon.  Occasionally companies use coupons as a loss leader, but usually it's just price segmentation.  I'm not saying you shouldn't clip coupons.  It's a reasonable way to save money in many cases.  However, don't think you are manipulating Proctor and Gamble; they are manipulating you.

Senior Discounts

I also hate to burst anyone's bubble, but senior specials and student specials are usually not done for altruistic reasons.  Students and seniors are unusually price sensitive for obvious reasons.  Hence, they are offered discounts.  There are many segments of the population that are price sensitive, but these particular groups are easy to identify (by driver's license or college id card) and it's socially acceptable to give them a discount.  Hence, the retailer makes a smaller profit on these people (still better than nothing), while maintaining a larger profit margin for everyone else.

New Products

Sometimes the segmenting process is enveloped in an elaborate ritual.  Books are a great example.  When many new books come out, they are published only in an expensive hardback edition at first.  Later, the cheaper paperback version is published.  What is going on here?  Does it really cost $15 more to put a hardcover on a book?  No.  This is price segmentation at work.  People do not like to wait for things, and they also like to participate in the buzz of something new.  Thus, many people will pay more for a new book if they can get it right away.  Others are willing to wait for the cheaper price.  For any given book, there may be a few who naturally prefer the hardcover edition and would be willing to pay for it.  But for most people, the hardcover/paperback choice is really all about paying more to have it now.

Consumer electronics also have major price segmentation, where early adopters are willing to pay more.  This can be confusing because there is also a long-term trend downward in prices because of technology improvements.  However, the sharp downward price trend over the first few months of a new technology is usually due more to price segmentation than anything else.  The people willing to pay $1,000 are first cleared out, then $900, then $800, and so forth.

The Element of Time

You may notice a common thread in many price segmentation schemes: time.  Do you have the time to find and use coupons?  Do you have a schedule that permits you to eat dinner at 4 PM, or go to the early bird shopping special at 6 AM?  Do you want the product now?  Can your travel schedule be inconvenienced by a weekend stay?  It is not surprising that various time strategies are used for price segmentation, as time is a universal constraint.

Advice for Producers

If you are selling goods or services, you might want to consider price segmentation.  Whatever your current price point, it's likely there are people who would pay more for what you are offering.  In some cases, there are a lot of people who would pay considerably more.

You'll notice that in nearly all cases, the pattern is to set the higher price as "normal" and then offer a discount for the price sensitive, often by requiring some inconvenience.  If you are willing to eat dinner out at 4 PM or on Tuesdays, then you get the discount.  Everyone loves a discount.  It makes them feel special to receive it, and quite frankly, there is a certain segment of the population that will buy a lot of things they don't even need as long as it's marketed as a discount.

It is very tricky to set a lower price as normal and then tack on a higher price for those who are willing to pay more.  While there are many things for which we would gladly pay more, we generally dislike surcharges intensely.  We would much rather the reference price be high, and then we can ignore the inconvenience associated with the discount.  So unless you are a marketing genius, I would suggest sticking with the conventional discount paradigm.

Advice for Consumers

The consumer should learn to differentiate between price segmentation and real differences in quality.  Baby back ribs for $11.99 on Tuesday aren't any different than those served for $17.99 on Saturday.  The difference is that people are usually paid on Friday and weekends have more social activity.  Hence, Saturday is one price segment; Tuesday is another.  On the other hand, a solid oak bookshelf is simply better than one made of particle board.  The cost of the materials is much different, and this drives the difference in the final product.

You may also want to contemplate your schedule.  There is a price to be paid for wanting the book now, wanting the new computer now, wanting to eat dinner out right now.  If you are able and willing to adjust your schedule, there are significant savings to be had in many areas.