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Small Business Owners: Learn to Discriminate!

Posted By Scott Shane On April 7, 2014 @ 8:00 am In Economy | 2 Comments

Price discriminate, that is.

Many small business owners fail to appreciate the value of this economic concept. That’s a shame because all small business owners can use price discrimination to boost revenues.

“Price discrimination” is an economic term that describes a strategy of making different buyers pay different amounts for the same good or service.

Let’s start with why you want to price discriminate. All of your customers have a reservation price – the maximum amount they are willing to pay for your product or service. You want your customers to pay their reservation price. Sell to them for anything less and you are giving up revenue.

You can’t charge all your customers the same amount because they don’t have the same reservation price. People who really want your product would be willing pay more than those who are mostly disinterested. So if you don’t charge the eager customers a premium, you’ve lost revenues. And if you don’t give the largely disinterested ones a discount, they won’t buy. In short, you will bring in more revenue if you charge eager customers a premium and offer reluctant customers a discount than if everyone pays the same amount.

Unfortunately, your customers don’t walk around with their reservation prices tattooed on their foreheads. So the price discrimination process is more complicated than just looking at your customers.

Economists generally describe the price discrimination process by reference to degrees: First, second, and third. First degree price discrimination refers to tactics that identify the maximum price that each customer is willing to pay. Consider the purchase of a used car. Rather than charging you a “sticker price,” the dealer is going to negotiate with you to figure out what you are willing to spend.

First degree price discrimination is tough to pull off because you need to negotiate with each and every customer to figure out his or her reservation price. But it still happens.

Perhaps the best first degree price discriminator I ever met was a rug shop owner a Turkish bazaar. Over several hours and numerous cups of apple tea, he asked me and my wife seemingly innocuous questions that helped him figure out our reservation price for a handmade Turkish rug. Once he had figured that out, he “miraculously” discovered that the rug we loved was available for our reservation price.

Second degree price discrimination refers to tactics that get customers to meet certain conditions to get a lower price. For example, volume discounts, premium packages, loyalty card programs, and early booking discounts are all examples of second degree price discrimination.

Consider the example of airline fares. Airlines sell tickets booked well in advance more cheaply than walk-up fares. They know that vacation travelers won’t pay as much as business travelers on expense account. Because vacation travelers will book further ahead, the air carriers can price discriminate by setting advance ticket prices at the maximum price vacation travelers will pay, while keeping walk-up fares at the maximum price that business travelers will pay.

Third degree price discrimination refers to tactics that lower prices for groups of people who wouldn’t otherwise buy because their reservation price is below the product’s list price. Consider movie theaters that offer senior citizens a discount. Because seniors tend to have less income than younger adults, the theaters can attract the seniors at the price they are willing to pay without having to lower the price that they charge other adults.

Basic economics offers small business owners a lot of lessons to increase revenues, lower cost, and boost profits. One of those is to learn to (price) discriminate.


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