How Customer Differences Can Lead to Price Differences Price Segmentation Chapter 6

Agenda What is price segmentation? When does price segmentation work? Is price segmentation a good or bad? How do segmentation hedges enable a firm to price-segment the market? How should an executive design a price segmentation policy?

Price Segmentation Pricing the same or similar products differently for different customer segments. Different customers value products differently This diversity is a form of market heterogeneity. When we are describing differences between individuals in their willingness to pay, we are describing a form of heterogeneity in demand.

Goal of Price Segmentation Align prices to demand heterogeneity in an effort to extract a greater portion of the consumer surplus from the market in the form of profits. Align prices to factors that drive (or undermine) value for customers can be used to create a price segmentation policy in that the firm automatically charges more (or less) when and where the product delivers more (or less) utility. Align prices to cost factors to discourage profit-destructive behaviors.

Results of Price Segmentation Quantity Price Demand Revenue P* Q* Profit Contribution Variable Costs It can improve the firm’s profits. It can improve the number of customers served by actually lowering the market entry price for some customers. Quantity Price Demand PL QL Profit Contributions Variable Costs PH QH

Segmentation Hedges Segment hedges are barriers that prevent customers who are willing to pay a higher price from paying a lower price If the segmentation hedge acts as a sieve rather than a barrier, it can actually damage profits

Segmentation Hedges The key to price segmentation is the ability to separate customers who are willing to pay more from those who are not. If the segmentation hedge is perfect, all the customers who are willing to pay more will purchase at the higher price, whereas any customer willing to pay lower price are allowed to purchase at the lower price. If the segmentation hedge is imperfect, no products would be sold at the higher price In other words, with poor segmentation hedges, all customers, both with a high willingness to pay and a low willingness to pay, will purchase at the lowest price.

Limited Transferability Price Segmentation requires limited transferability of the product or service Once sold to a customer, that customer should find it difficult to resell it to another customer.

Segmentation classifications First, Second and Third degree price discrimination Complete, Direct and Indirect Price segmentation Strategic or tactical price segmentation

1st, 2nd,& 3rd Degree Price Discrimination Perfect price discrimination, or first-degree price discrimination, is charging every customer at the price that matches their willingness to pay. Second-degree price discrimination is charging different customers different prices according to the quantity purchased. Third-degree price discrimination is charging different markets or market segments different prices.

Complete, Direct, and Indirect Price Segmentation Complete price discrimination requires complete information of all customers’ willingness to pay in all situations. Direct segmentation defines price variances based upon specific attributes of the customer, such as age, gender, or location Indirect segmentation defines price variances based upon a proxy that correlates to customer’s willingness to pay

Strategic or Tactical Tactical price segmentation approaches are those that are used to capture marginal and sometimes even specific customers in unique situations Strategic price segmentation approaches are those in which the definition of the price structure itself enables different customers to pay different price

Segmentation Hedges Segment hedges are barriers that prevent customers who are willing to pay a higher price from paying a lower price If the segmentation hedge acts as a sieve rather than a barrier, it can actually damage profits Requirements Correlate with customers’ perception of value Minimal information needed for implementation, Enforceability, Cultural acceptability.

Common price segmentation hedges Age Gender Income Time of purchase Purchase location Buyer self identification Quantity of purchase Negotiation

Summary Price segmentation is charging different prices to different customers or groups of customers. Willingness to pay varies between individual customers. This heterogeneity in willingness to pay creates the opportunity for firms to improve profitability through price segmentation. In addition to heterogeneity in willingness to pay, price segmentation strategies require that products sold to one segment of the market have limited transferability to another segment in the market. Price segmentation improves profits by enabling the firm to capture a higher price from those customers who value the product higher and capture higher volumes at a lower price to customers with a lower willingness to pay. Segmentation hedges are used to separate customers who must pay more from those who will pay less. Good price segmentation hedges should be highly correlated with customers’ perception of value, require minimal information from customers, be enforceable based on objective criteria, and be culturally acceptable. 16