A Brief Introduction to Price Discrimination
Price discrimination is the idea that you can charge one price to one set of customers and a different price to another set of customers for a similar product or service. Many people first learn this concept in an entry-level microeconomics class, where it is taught that perfect price discrimination (charging each customer exactly what they're willing to pay for your product) is the key to maximizing the profit of a monopoly. However, that lesson doesn't exactly translate to the world of new business owners and entrepreneurs; for them, price discrimination is often used differently. Instead of using price discrimination to squeeze every dollar out of an existing customer base, new business owners will use it to secure new customers, retain old customers, and run a more productive business operation.
The concept of charging different customers different prices for similar services sounds dishonest when you first hear about it. However, there are two common circumstances where this practice is generally accepted for the modern business:
Special pricing terms for new or underrepresented customer groups, and
Payment and service timing incentives.
Special Pricing for New or Underrepresented Customers
Offering a promotional rate to new customers to get them to sign up is a very common practice for many companies today. This different rate is used to get the customer on the service with hopes that they stay long term and end up paying a higher price later. This strategy is particularly effective because customers who don't understand the value of your services of products might not be willing to pay as much until they've tried it for themselves. Allowing them to come in at a lower rate will help introduce them to your company and see the value that you were offering when they otherwise wouldn't have tried.
Another common example of offering different customers different rates is providing a seniors, veterans, or children's discount. This happens frequently at places like movie theaters, zoos, and restaurants. The goal of these discounts is to get underrepresented customer groups to frequent your business more often. For them, it's inherently rewarding to get a discount and for the business owner, it's rewarding to have more customers. It's very important to understand that every business will be different regards to the appropriateness of these discounts and what groups would qualify for them. When done right, adding a $2 discount to an admission ticket will make the difference between someone choosing that activity or not. When done wrong, the PR backlash from offering special rates to specific groups can really harm your business. So be careful!
Payment and Service Timing Incentives
Businesses will charge some customers lower rates if it allows them to have more favorable payment terms or more efficiently use their capacity.
Favorable Payment Terms
Many service-based businesses will allow customers to prepay their bill 3 months, 6 months or even years in advance and earn a discount for doing so. From the business' perspective, being able to lock in a customer for a certain amount of time and getting cash up front is very valuable, even if it means charging less money. For businesses that are more product oriented, the same concept applies to bulk purchasing. Generally, when a bulk purchase is made, the unit price per item is lower to reward the customer for buying more of your product (which is why many people like shopping at Costco). By securing payment sooner, the business is more likely to meet its operating obligations in a timely manner and less likely to need debt financing like a line of credit, which can carry a whole different set of costs.
Supporting Capacity Constraints
If you have ever worked for business and thought "this would be so much easier if everyone didn't show up all at the same time," then you understand how businesses can be affected by the timing of customer demands for products or services. I'm a CPA, and the number of jobs that I need to do in the first few months of the year is overwhelming. I am constantly busy because some of my clients have very important deadlines to meet and I need to get them all done by those deadlines. If I had a client come up to me and ask for my time during those months, I might want to charge them a little more for the trouble. Alternatively, if I had a client offer to push their deadline back into the summer, I would be more than happy to provide them a slight discount because it gives me some breathing room to complete the engagement without being rushed. This same concept can be seen in restaurants that offer special happy hour and early bird discounts to get customers in at a time where there isn't usually too many. By exercising price discrimination and incentivizing some customers to work with you when you aren’t’ as busy, you can fill the excess capacity and ultimately serve more customers.
Why Does it Matter?
Every business, every person, and every businessperson will have some sort of limiting factors that can impact their ability to grow. Among many things, these limiting factors can be capacity, cash flow, and the customer base. By taking the time to understand your limiting factors, you may be able to alleviate some problems by working with your customers through the strategies noted above. When you use price discrimination to support your overall business objectives, the cost of providing the discounts can be significantly outweighed by the benefits of having more customers and smoother operations.