Advantages and Disadvantages of Differential Pricing
Now, let’s get to the meat of the matter…you know, where the rubber meets the road. Many have been paid lots of money to perform studies concerning the upside and downside of differential pricing. After reading parts 1 and 2 and this 3rd and final installment on differential pricing, you will be well equipped to be the judge and make up your own mind. Hey, it’s a free country!
The Upside
Varian (1996, p.13) says, “It is easy to construct examples where consumers will not be served unless differential pricing is permitted.” Varian uses the example of the telecommunications industry to illustrate price discrimination’s beneficial nature. Consider a firm that serves two consumers. Consumer A will pay 20 dollars for service. Consumer B will pay five dollars. Assume the marginal cost is zero. If the telecommunications firm has the ability to charge a uniform price, the company would find it most profitable to sell only to Consumer A. If the firm is allowed to use price discrimination, it is profitable to serve both consumer markets. The firm would sell to the high-value user, Consumer A at a price of 20 dollars, and the low-value user, Consumer B at a price of five dollars. The service is then available to Consumer B, if differential pricing were not used; Consumer B would never be able to acquire the good or service. On the same token, niche markets may never be able to be served without the implementation of price discrimination by various firms. In this way of thinking the consumer surplus, as well as the producer surplus, are maximized. Both parties seem to benefit.
The Downside
I pointed out one of the disadvantages in part 1 where I discussed the legal aspects. If factors other than price discrimination are employed, such as collusion and price fixing, then consumers as well as competitors literally pay the price.
As a refresher…collusion and price fixing are BAD!
Here’s another “dark-side”. Park (2000, p. 1) reports two reasons why third-degree price discrimination affects welfare.
1. Different groups of buyers are charged different prices that lead to a misallocation of output. More product may be priced and distributed for the “high-ticket” market segment
2. Total output under price discrimination may differ from total output under uniform pricing. In layman’s terms, a manufacturer may deliberately price and distribute more of the company’s product(s) when demand is high for a “high-ticket” market segment.
Okay, here’s another broad-sweeping negative affect of price discrimination. Nielsen (2000, p. 1) reports that price discrimination can have negative repercussions on firms. We saw this example in the McCormick and Company case. Customers may discover that different consumers are paying different prices. Those consumers paying higher rates may rebel or not return to the business. The exact consumers that would have become loyal customers, and willing to pay the most in the long run, may be the consumers most likely to choose a permanent alternative.
Another negative aspect is that in some cases, if the consumer is able to do so, the consumer may simply hold off on a purchase and wait for a price reduction. This is obviously a tenuous situation for any firm. Could your business handle the repercussions of a scenario such as this one?
Conclusion
Price discrimination is a significant and influential practice on the market in the modern economic world. This pricing strategy assists a company’s profit maximization goal. Likewise, price discrimination allows certain consumers with more scarce resources the opportunity to purchase goods and services that would otherwise not be available. Price discrimination also aids firms in balancing what amount of a good or service is or is not sold.
Differential pricing is an effective means of enabling a company to sell a higher quantity of goods. Firms are provided the opportunity to acquire a higher profit margin on the goods the company produces. Why you may ask? Well, because a segment, or segments, of the product line have higher pricing levels. Differential pricing also assists companies to build a broader consumer base. The building of the consumer base is due to differing price elasticity of demand for given goods and services. On the most simplistic of terms, more people are able to purchase a companies product(s). Price discrimination has the benefit of equalizing price and value for both consumers and companies. This factor creates an ideal situation for consumers and businesses in terms of preference and opportunity. Care must be taken by a firm such as McCormick and Company, when marketing the company’s product line to retail grocers. Managers must do their level best to not use differential pricing at the risk of putting the firm in the position of being accused of unfair trade practices.
When not used to exclude competition from the market, differential pricing has the potential to be beneficial to ALL players in the market, from producers of products and services to the people that use those products and services.
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