In many markets, it makes sense to charge different prices for very similar services and products. This so called price discrimination captures more value from a less price-sensitive segment and more sales volume from a more price-sensitive segment. We see price discrimination everywhere. A student or senior citizen discount is a price discrimination. A loyalty card discount is a price discrimination.
- In the last video, we saw that an airline can maximize it's profit by analyzing the demand curve into variable costs. In that example, we learned that at 550 Franks, the airline would sell 135 tickets. In this video we'll go one step further and calculate how much profit the firm can generate by charging different prices for basically the same service. This tactic is called Price Discrimination, and works well if, and when, different customers show a different willingness to pay.
In this chart, you can see that we have calculated the best solution for setting one price. But the chart indicates some problems with charging a flat rate. According to the demand curve, there are passengers who are willing to pay more than 550 Franks, and others will only pay less. In other words, the area A is a potential profit the airline does not capture at the price of 550 Franks. Since only 135 tickets can be sold at the price of 550 Franks, most seats remain empty.
So we need to find a way to sell those seats. Area B shows that many potential passengers are willing to pay more than the variable costs of 100 Franks, but are not willing to pay 550 Franks. In other words, for A we are too cheap, for B we are too expensive. The reason is that passengers have very different levels of willingness to pay. A business traveler, or a rich person, does not mind to pay a high ticket price. While a student, or a family or four, need to manage a tight budget.
What the airline can do, actually what the airlines do all the time, is to charge different prices for different customers, depending on their booking behavior and ticket restrictions. Of course, as passengers, we don't like that. However, we like the fact that flying has become so much cheaper over the last 50 years. Because airlines have learned to capture as much value and ensure that the occupancy rate remains high. Going back to our example.
One possibility would be for the airline to have two tickets type, a flexible ticket for 700 Franks and a restricted ticket, with a minimum stay of three days, for 400 Franks. With this pricing model, and the given demand curve, we would have 90 passengers paying 700 Franks, and 90 passengers paying 400 Franks. A total of 180 passengers which results in a total profit of 50 thousand Franks.
In contrast, if you only set one price, the optimal price of 550 Franks, the gross profit is 60,750 Franks, minus the fixed costs, leads to a net profit of 29,750 Franks. In other words, by charging two different prices we can increase the profit by 69%. Keep in mind that we have not changed our offerings, nor do we have different customers. All we did was capturing a given demand with price discrimination.
We see price discrimination everywhere. A student of senior citizen discount is a price discrimination. A loyalty card discount is a price discrimination. If you pay more for a Coke in a vending machine then in the store next to the vending machine, that's also form of price discrimination. If you get a volume discount that can also be considered price discrimination. While you need to understand the logic of price discrimination, be careful when you want to implement it in your business. Sometimes price discrimination is illegal.
And in many cases it upsets your customers. In those instances you cannot charge different prices for the same product or service. What you do is to create different offerings or offer a lower price to anybody under a certain condition. For example, a mailing coupon is a way to offer different prices for the same product. But only a few customers will eventually send in the coupon. To sum this up, whenever your demand is shaped by customers with a different level of willingness to pay, you need to consider charging different prices through price discrimination.
- What are customers buying? (demand theory)
- What should we produce? (production theory)
- Which costs do I need to worry about now? (cost theory)
- What market am I in? (competition theory)
- What should we charge for it? (pricing theory)
To understand what managerial economics looks like in practice, Stefan explains how Google's auction-based advertising system employs the principles of game theory and how understanding this can help decision makers to outmaneuver their competitors.
- Using economics to solve business problems
- Understanding price elasticity
- Demand curve shifts
- Economics of scale vs. scope
- Break-even and what-if analysis
- Profit maximization
- Economics in action