What is price discrimination? (Plus definition and examples)

By Indeed Editorial Team

Published 4 May 2022

Money-making entities use price discrimination strategies to make the most money possible for their business in their product or service offering. You can use multiple different degrees of price discrimination depending on your business goals and financial situation. If you're interested in learning how to increase profit margins within a business environment, understanding the price discrimination strategy may be helpful. In this article, we discuss what price discrimination is, who uses it, how it functions, what the degrees of this discrimination type are and what its limitations are.

What is price discrimination?

When a corporation sells the same product to various buyers at different prices, they use price discrimination. Price discrimination occurs when a seller determines how much a customer is willing to pay for its product or service and based its prices on this information. This pricing method has various degrees, each with its own unique set of characteristics. In its purest form, sellers sell customers a product or service for the maximum amount the customer is willing to pay.

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Who uses a price discrimination strategy?

Businesses in different industries can utilise price discrimination within their business strategy to give them a competitive advantage. Here are some of the companies that may use a price discrimination strategy:

  • Supermarkets and grocery shops: It's common for grocery shops and supermarkets to offer customers different coupons or vouchers on various food items or offer deals like buy one get one free.

  • Retailers: retailers often use price discrimination to encourage loyalty from their customers through customer loyalty programmes and deals on specific clothing lines and designers.

  • Fast-food restaurants: some fast-food restaurants may offer customers specific deals if they're under a certain age or purchase food at a particular time.

  • Manufacturing companies: it's common for suppliers and manufacturing companies to offer their customers deals or a certain amount of money off their order if they purchase from the supplier in bulk.

  • Cinemas: you may pay different prices for cinema tickets depending on your age. For example, you may receive a discount if you're under a specific age or an older individual.

  • Transportation service companies: within the transportation sector, many service providers like airlines, taxis, train and bus companies and ride-share services offer older individuals discounts.

How does price discrimination function?

Price discrimination functions on assumptions companies make about their customers. Companies determine what prices they'll set their products or services based on what they believe their customers can and are willing to spend. Companies use data to determine what demographics align with their target market and what value their customers derive from the company's product or services. Based on their knowledge of their target market, companies may group their potential customers into different segments based on financial-related demographics and price.

Price discrimination works if the value companies gain from different market segments outweighs the value they gain from having one market segment. Vital economic terms like elasticity and demand directly impact price discrimination. As it relates to economics, elasticity refers to the variability of change in one variable compared to a change in another. For example, elasticity explains a shift in demand and, therefore, quantity due to a price difference. Demand refers to the willingness someone has to purchase a product or service and the amount of money they're willing to invest in purchasing.

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Price discrimination degrees

Within price discrimination, you can implement first-degree, second-degree or third-degree pricing. Here are the three types to consider:

First-degree or personalised pricing

This price discrimination approach, also known as perfect price discrimination, occurs when a corporation charges the highest amount of money that customers may pay for each unit of a product or service consumed. As determining the optimal price point for items or services can be complex and costly for a corporation, this sort of price discrimination is the least common. This pricing approach may yield minimal earnings, depending on how much research the corporation undertakes on certain target markets and price points.

Example: After extensive market research, a speciality pastry company determines that their customers pay the maximum amount a customer is willing to pay for a pastry is €7. As a result, the pastry company increases its prices to €7 for half of its offerings to test its success. The company found its customers were still just as willing to purchase its pastries despite the price increase.

Second-degree or product versioning

When a corporation uses a second-degree pricing discrimination technique, it offers varying prices depending on the quantity purchased. This happens when a corporation, for example, provides a buy one get one free (BOGO) alternative for items at supermarkets or grocery shops. Retailers and manufacturers use this sort of price discrimination to increase the number of goods their customers purchase, ultimately increasing their profits.

Example: A popular retailer is transitioning from its fall and winter clothing line to its spring collection. To increase sales and generate interest from its customers, the retailer offers customers a 25% off deal on all fall and winter clothing. As a result, the retailer saw a distinct increase in sales from the additional incentive and price reduction.

Third-degree or group pricing

As the most common form of price discrimination, companies use third-degree price discrimination to maximise profits. Companies use their customer's location, age, gender, economic status or other attributes to determine the price they offer to that specific customer segment. Generally, companies conduct extensive research and experimentation to define each particular price from each market segment. Through investigation, companies can discern whether the prices they offer customers generate enough demand to increase profits.

Example: A popular coffee seller generates a significant amount of business from middle-aged patrons. To increase interest in its product offering, the company offers students and senior citizens discounts. After conducting research, the company arrives at unique offerings to two segments. For students, the coffee seller provides a 20% discount. For senior citizens, the company offers a 15% discount.

Related: Buyer vs purchaser (the differences and key skills required)

Price discrimination strategy limitations

Although the price discrimination strategy is an effective way for businesses to increase their profit margins, some limitations apply. Here are the main limitations to this discrimination type:

Customer numbers

When a business utilises price discrimination, they effectively determine that most of its customers are willing to pay a specific price for a product or service. Sometimes, a subset of customers may be unwilling to pay the new price. As a result, the company may see a decrease in purchases from one segment of customers and an increase in purchases from another. Ultimately, the company can determine whether the change brought about a net profit.

Administration costs

To effectively implement price discrimination, it's necessary to conduct research. Conducting research can cause additional expenses like outsourcing the research to a market research company or spending time and money developing a survey in-house. If the resulting price discrimination strategy is successful, the administrative costs cannot outweigh the profits generated.

Limitation for demand

It's necessary that companies have a strong understanding of the market and the economy before changing their prices. To understand the market, a company may conduct research and determine that demand is low for a certain product. Therefore, a company may wait before increasing its product price to accommodate the market trend.

Variability

Consumers can decide that they do not wish to pay the utmost amount possible for a product or service. This can result in a loss of profit, a loss of customers and an increase in a company's manufacturing fees due to an increase in production quantity. Understanding your customers and potential markets can help you make wise business choices regarding price increases or reductions.

Example of price discrimination

Here is an example of price discrimination in practice:

Steel Manufacturing Limited offers customers three different order quantities when purchasing products. The packages include:

  • First package: customers can buy 20 items for €400, paying €20 per unit.

  • Second package: customers can buy 40 products for €700, paying €17.50 per unit.

  • Third package: customers can purchase 100 products for €1,600, paying €16 per unit.

As a result of its price discrimination strategy, Steel Manufacturing saw an increase in sales as most customers purchased the third package offering.