Mind Your Business: Price Targeting - 26 March 2007
The News
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What does this article cover? See our mind map for details. |
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Imagine the situation: you run a business which, fortunately, has customers. You know every customer in person and also know a great deal about their personal circumstances - so much so that you have inside access to their individual demand schedules. Why might such knowledge be useful to a business? Let us take an example. In the area where this author lives, there is a chain of local builder's merchants. In the local area, there are at least four depots that I could phone to place an order. Let us assume that I want 100 bricks, two bags of cement, two dumpy bags of soft sand and a bag of lime. I phone depot 1 and they give me a price - £75. I then phone depot 2 for the same order and they also give me a price, but this time it is £65. I phone depot 3 to find that their price is £69. What is going on? This is the same company and the same order but three different prices. Maybe it is because they have different costs - possibly. There might also be another explanation, however. 
Different depots charging different prices for the same materials - what is going on? Copyright: Lotus Head, from stock.xchng. 
Customers on a train - how many are paying the same price for the same journey? Copyright: Horacio Apresto, from stock.xchng. How many people would phone three depots from the same chain? I might phone a different builder's merchants altogether, but I am unlikely to expect one firm to have different prices. The scenario of different people paying different prices for the same product or service, though, is not that unusual. Some firms are able to do this but others are not. The principle behind this is called Price Targeting. In many textbooks, it might be referred to as price discrimination. The extent to which price discrimination occurs is significant. There are many examples of cases where different people pay different prices for essentially the same thing. Transport is one such example. There are plenty of cases where rail and airline users pay a range of different prices for their journey. Ultimately, the journey is one between point A and point B but in many cases, there are a wide range of prices that could be paid by the customer for that journey. Next time you are on a train, for example, ask the people around you to compare prices - see how many different ones there are. There's a piece of coursework in that one!
How much does it cost to froth up some milk and shake some chocolate onto a cappuccino? Is the extra effort worth the additional price you have to pay or does it say something about how the business might view your willingness to pay for their product? Copyright: Stanley Leung, from stock.xchng. Part of the reason for these different prices will, of course, be due to the fact that there are slight differences in the quality of the product or service involved, or even the cost of production. The question might be whether the difference in the price is reflective of the additional cost involved in providing that good or service - is a cup of coffee with frothy milk and some chocolate sprinkled on the top really that much different compared to one without? Does it warrant the extra price we might have to pay? In many cases it might not, but whilst the market is sufficiently ignorant of the costs involved and, to a large extent, the market itself, businesses will continue to charge different prices for the same product or service. That is not meant to be an insult to consumers; how many of us have a true understanding of the way in which the gas or electricity market works? How many of us truly understand the range of prices and packages that are on offer from telephone companies and mobile phone service providers?  Electricity - different prices for different customers, same product. Why is this? Copyright: Josep Altarriba, from stock.xchng.  Is it right to charge different people different prices for the same product such as a DVD? Amazon's 'price test' did just this but after many complaints, they stopped the test. Were they right to do so? Is this just a case of using valuable market information appropriately? Copyright: Lynne Lancaster, from stock.xchng. Many businesses might long to be in a position where they could set a price according to the willingness of their customers to pay. In any market, there are customers each willing to pay different amounts to acquire the same good. I might be prepared to pay £50 to acquire a certain CD of my favourite band, whereas you might only be prepared to pay £1. If the actual market price is £12.99, then the business loses your custom, but it also loses the possibility of gaining £37.99 in revenue from me. That's a combined total of £38.99 worth of lost potential revenue from the two of us. In e-commerce, many companies use technology and the online environment to gather useful information about those who use their business. Take supermarkets, for example: Tesco have their Clubcard. Is it about a genuine desire to give you money back from your loyalty to the store, or is it more a case of gathering very useful information about your spending patterns that can be used to target the price you are willing to pay for different products? If you shop online, how do you know that the prices you are being offered are the same as those being offered to other customers looking at the same goods? The use of registrations, cookies and other information-gathering techniques might be very useful for a company in planning its future pricing strategies. Perhaps the most interesting example of this practice came from Amazon, the online retailer. In September 2000, the company faced a volley of discontent from users who accused the company of using the information it had gathered to develop a targeted pricing scheme. Amazon had a policy of using the data it collected on customers in any way it saw fit. The complaints centred on the suggestion that Amazon was using this data to profile customers and charge different people different prices for the same product. The premise was that new customers might be persuaded to use the site if they found cheaper prices, whereas established customers would most likely pay more. Amazon said that it was conducting a 'price test' but abandoned the test, saying that it would not do anything like it again. |
Theory
This theory section will look at the background to price targeting and price discrimination.
Price Targeting:
The theory here rests on the shape of the demand curve. The demand curve shows the relationship between price and quantity demanded.
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Demand is the amount consumers are willing and able to buy at various alternative prices. This assumes that consumers have the means to be able to buy the goods and services they would like - so-called effective demand. |
The demand curve tells us that at higher prices there are fewer consumers willing to purchase a product than at lower prices. There is an inverse relationship between price and quantity demanded. For producers, the demand curve is important as it tells them something about the possible revenues they might get from sales. Revenue is calculated by multiplying the price of the product by the number sold.
When we look at the market demand curve, it shows us the combinations of price and quantity demanded for all the individuals in that market. The market can consist of many hundreds, thousands or even millions of people. Each individual within that market will have a unique demand schedule. What we have, therefore, is akin to a map of the prices that individuals within that market would be prepared to pay to acquire different quantities.
Let us take a simple example to highlight the point. Assume we are looking at the market for a CD by the band Coldplay. In this market, there are just 10 individuals. The market demand curve is represented in the diagram below
Note that 1 person would be prepared to pay £50 to acquire the Coldplay CD. If the price were reduced to £45, then a second person would be prepared to pay that amount. If the price was set at £30, a third person would be prepared to pay that price, and so on. This would be a typical position for any product and whilst they cannot control demand, producers will have some idea about this relationship.
For the producer, therefore, the question is: what price do they charge for this CD? If they charge £45, the market would only consist of 2 people - they would price the remaining 8 people out of the market. The margin they would be making at this price might be quite high (the margin being the difference between the price charged and the cost of production).
On the other hand, they could charge a price of £5 for the CD. At this price, they would sell all 10 CDs, but the margin would now be very small and possibly even negative. The problem facing producers, therefore, is knowing what price to charge.
If we assume that the CD price is set somewhere between the two extremes, we might have a market price of £20. At £20, the demand curve tells us that 7 people would buy the CD. If we assume that all 7 are sold, then the producer's revenue is 7 x £20 = £140.
Let us now assume that the producer has more information about each of the ten people in the market. This information tells them about the maximum price that each person is willing to pay to buy the CD. Each person is in a position where they do not know what the other is being charged; this situation is shown in the diagram below. Person 1 is charged a price of £50. Person 2 is charged £45, person 3, £30 and so on. The revenue to the firm from each of these transactions is shown by the bars in the diagram. The firm now receives a total revenue of 50 + 45 + 40 + 35 + 30 + 25 + 20 + 15 + 10 + 5 = £270.
In this situation, the firm is able to increase its revenue considerably. What is vital in this situation is that each individual consumer is not able to find out what the others are being charged.
In many markets, firms do have such price tactics, although not quite as obvious as this. In many cases, firms are able to split the market into different users, each of whom might have different price elasticities of demand. This is most obviously the case in the market for railways. People who use the train to get to work might have little choice as to when they are able to get the train. They might have to catch a train sometime between 6.30am and 9.00am in the morning and 4.00pm and 6.30pm in the evening. The demand for rail journeys at this time tends to be relatively price inelastic.
Rail firms know that they can charge a higher price at these times of the day compared to off-peak periods. Let us assume a return rail ticket from Birmingham to London was £90 in the peak period. People who travel from Birmingham to London to work might have little choice other than to accept this price: they have to get in at a certain time and so have to use the railway at this time of the day. For other users, paying £90 might be considered too high a price to pay and they might decide to use an alternative form of transport, or not bother making the journey at all. If the price were reduced to £40 for a return ticket, then they might just then be persuaded to make that journey.
The situation is represented in the diagram below.
Notice that in the diagram above, if the rail firm charged a price of £90 in the off-peak times, demand would be non-existent!
What the rail firm needs to ensure is that passengers travelling during peak hours are not able to use off-peak tickets for the journey. If they buy a fare from the ticket office at 7.00 in the morning for a 7.15 train, the member of staff would not sell them a ticket for less than £90. Even if someone got on the 7.15am train with a £40 ticket the guard would make them pay the difference.
The railways are just one example where price discrimination is practiced. Consumers know there is a gap between prices but they cannot access the different markets - if they could, prices would be driven down. Firms must ensure that the leakage between markets is sealed off. Copyright: Stephen Tainton, from stock.xchng.
To make price discrimination work, therefore, there must be some mechanism whereby either the consumer does not know what prices are being charged to other consumers, or the consumer is prevented in some way from accessing the market with the different pricing structure. In some cases, it can be a combination of the two.
Questions:
- In some cases, price discrimination might appear to be operating but there might be very good reasons why prices for similar base products or services might be different. For example, the difference between first and second class travel on the railways. Find out what the passenger who buys a first class ticket is paying extra for - is the higher price they are paying justified?
- Can you conceive of a situation where price discrimination is of benefit to the consumer?
- Consider the view that price targeting is a perfectly acceptable method of pricing if the firm has sufficient knowledge of its market.
- What is the difference (if any) between a theme park offering a price discount to a group who pre-book and Amazon charging its customers different prices for the same DVD?
Extension work:
Please read this article. (http://knowledge.wharton.upenn.edu/article.cfm?articleid=739&CFID=5623064&CFTOKEN=41765519)
- Discuss the issues facing a business in considering whether to implement a targeted pricing policy as part of its marketing strategy.
Mark Scheme:
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In some cases, price discrimination might appear to be operating, but there might be very good reasons why prices for similar base products or services might be different. For example, the difference between first and second class travel on the railways. Find out what the passenger who buys a first class ticket is paying extra for - is the higher price they are paying justified?
- In considering this answer, you will have to focus on the costs involved in the provision of the extra service. In the case of a first class rail journey, what are the extra benefits that a passenger might be paying for? How much extra are they paying for that service and does the extra money they are paying reflect the cost of providing that extra service? In some cases, such as electricity generation, it could be argued that peak demand is associated with higher costs - plant maintenance, capacity constraints and so on. In such cases, is the additional price charged to customers at that time justified by the higher costs involved?
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Can you conceive of a situation where price discrimination is of benefit to the consumer?
- For this answer, you will need to think of a situation where there might be a loss-making monopoly. If the monopolist has to charge a single price for their product then they may well incur losses. It follows that such a good or service might not be produced. The ability to charge different prices for the same product or service might lead to the monopolist making some profits. In such cases, society might be better off given that the product or service will now be provided. (Think about the Post Office, for example)
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Consider the view that price targeting is a perfectly acceptable method of pricing if the firm has sufficient knowledge of its market.
- The argument in this answer will be based around the principles explained around the demand curve in the theory section above. If a person is willing to pay £50 for a CD then what is the problem with them being charged that price? Presumably they would get at least £50 worth of utility out of the consumption of that product? For those at the other end of the demand curve, they either cannot afford the product or do not consider the music of Coldplay to warrant the opportunity cost of what they are being asked to pay for the CD. The question does specify some constraint - 'if the firm has sufficient knowledge of the market'. This implies that they must know enough about the market to be able to charge different prices. In reality this is not very easy but with the development of e-commerce and the Internet, firms are able to track their consumers with greater accuracy and gain more knowledge of them. This works both ways, however, and consumers can find out more about the firms. This can lead to a situation where the consumer feels betrayed by a firm if it finds out it is charging a lower price to someone else. If this is the case, the firm might risk losing valued custom.
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What is the difference (if any) between a theme park offering a price discount to a group who pre-book and Amazon charging its customers different prices for the same DVD?
- You will need to think about who these groups might be and the relative frequency with which they might be expected to attend such parks. There might also be links to the relative price elasticities of these different consumers. The cost of processing a group booking might be less than that of a similar number of individuals coming through the gates. The basis of the answer will be around your ability to develop an argument related to the question. You will need to make some form of judgement and explore some of the issues outlined above.