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Corporate Nov 22, 2012

Games companies play: Why you pay more while he pays less for the same product

By Vivek Kaul

Indian Railways can even spring up positive surprises, now and then.

Recently, while travelling from Delhi to Mumbai, this writer was pleasantly surprised to have been upgraded from third AC to second AC. And this, of course, meant traveling more comfortably.

On entering the coupe in the second AC bogie I found an elderly lady already sitting there who somehow figured out that I had been upgraded.

"How can they upgrade you? You haven't paid as much as I have!" she said.

And she was right about it. I was travelling second AC while having paid for a third AC fare.

Nevertheless, this sort of "price-discrimination" has now become a quintessential part of our lives. Airlines are an obvious example. You could have paid many times more than the guy sitting next to you because you booked the ticket two hours before takeoff and he had it all planned out three months back.Yours might be a business trip wherein you need to be at a particular place on a particular day at a particular point of time. The person sitting next to you might be simply travelling for pleasure and could have thus planned it all in advance.

When books are first launched they are typically launched in hardback form. A few months later a cheaper paperback is launched. The hardback is targeted at the avid book reader who just can't wait to get his hands on the book, and so is ready to pay more.When the best-sellingShantaramfirst came out in India it retailed for around Rs 1,200 in hardback. Prices finally fell to around Rs 400 for the paperback, which was 66 percent lower.

But these, as I said a little earlier, are the obvious examples. Companies have also started using the discriminatory pricing strategy when it comes to electronic products. This has started to happen primarily because being spotted with the latest cell phone (be it an Apple iPhone 5 or a Samsung Galaxy S3) or a tablet (the Apple iPad) gives so much meaning to the lives of people these days. Till a decade back a man's worth was decided by what he wore. Now it's decided by the brand of cell phone that he carries.

What was once a luxury became a comfort and is now almost a necessity for a large number of individuals. When such products are first launched they are targeted at the "geeks," or early adopters, who find a lot of meaning in their lives by being the first to use the latest iPad/iPhone and hence are willing to pay more for it.

Companies tend to exploit this human need by charging more for freshly launched electronic products. Of course, once companies have skimmed higher prices off these early adopters, they cut prices so that you, I and everybody else, can start buying the product.

Companies practice price discrimination in the hope of raising their average price per unit of sale.This, of course, works if the core business model of the industry is strong. Reuters

In the apparel industry, fresh stocks go for higher rates towards the beginning of a season, whereas, as the season ends, the same set of clothes is sold at a discount.

The logic behind price discrimination is to divide consumers into various categories and get them to pay what they are willing to pay. As Seth Godin says inAll Marketers are Liars, "Ralph Lauren generates a huge portion of its sales from seconds... There are so many of these stores that many of the items aren't seconds at all."

So those who are price-sensitive buy the "so-called" seconds, while those who are not buy the "so-called" originals. Companies try and cash in on this price sensitivity of consumers through price discrimination.Anyone living in Mumbai can go to Parel and buy all kinds of things from the so-called seconds shops that swarm the area and get a good discount doing so.

As Jagmohan Raju, a professor at Wharton Business School, says in an article published byKnowledge@Wharton: "Companies...charge people different prices depending on the buyer's desire or ability to pay...They reap wide profit margins from those willing to pay a premium price. In addition, they benefit from high volume, even at a lower per unit price, by building a wider customer base for the product later."

But this logic doesn't always work. Consumers may not mind discounts for senior citizens or lower prices for early morning cinema shows, but they can be touchy about discriminatory pricing.

In the late 1990s, Coca Cola developed a vending machine which charged the consumer a higher price on warm days. As Eduardo Porter writes inThe Price of Everything, "When Coke chief executive Doug Ivester revealed the project in an interview...a storm of protest erupted." Coca Cola had to ultimately drop the idea.

In September 2000, it was revealed thatwww.Amazon.comwas charging different prices for the same DVDs to different customers. The company denied segregating customers on the basis of their ability to pay, something they could easily figure out from their shopping histories.

The early adopters of Apple iPhone were an unhappy lot when, in 2007, the company decided to cut prices of the 8GB model from $599 to $399 within two months of launching it. The company had to placate this lot of customers by offering them a $100 store credit.

However, there are no easy ways of ensuring that your customers do not feel cheated. One way is to differentiate the offering in some way. "Companies have to sell products that are at least slightly different from each other," writes Tim Harford inThe Undercover Economist. "So they offer products in different quantities (a large cappuccino instead of a small one, or an offer of three for the price of two) or with different features (with whipped cream or white chocolate)," he adds.The products are marginally different, but it gives the company a reliable excuse to charge "significantly" higher prices.

The next time you go to a coffee shop try this little experiment by just try saying no to everything extra that the Barista or CCD tries to offer you and see by what proportion your bill comes down.

Book publishers tend to launch a book in hardback form.The cost of production of a hardback is slightly higher, but the price difference between a hardback and a paperback is significantly different (as we saw in the case ofShantaramearlier).The hardback is just a way of telling the early buyer that the book firm is offering him something more.

Frequent flyer programmes work in a similar way, where the frequent flyer may get a cheaper rate because he is a frequent flyer and thus other flyers do not feel cheated.

Companies practice price discrimination in the hope of raising their average price per unit of sale.This, of course, works if the core business model of the industry is strong.But even price discrimination cannot rescue a flawed business model.

A great example is the newspaper/magazine industry worldwide. It started putting news and analysis free online while expecting those buying the newspaper/magazine in their physical form to pay a price for it. Of course, consumers will take what is free and shun what they have to pay for, especially if it's the same product.

No wonder, worldwide the industry is in trouble. While it was easy to put news/analysis free online and get the so called "eyeballs", nobody bothered to figure out how would they go about earning money doing the same?

The other example of an industry which has seen disaster despite all the price discrimination is the airline industry. As Porter points out, "For all their efforts at price management, competition has pushed airfares down by about half since 1978, to about 4.16 cents per passenger mile, before taxes...In terms of operating profits, the industry as a whole spent half the decade from 2000 to 2009 in the red."

At times companies end up in trouble because of price discrimination practiced by someone else. A spate of websites which sell books at a discount of as high as 40 percent have been launched in India over the last few years and this has led to bookstores getting into serious trouble. People now use bookstores to browse and check out what are the latest titles to have come out and then go home and order the books online at a discount.

Price discrimination is a new game in town and impacts consumers and companies in both good and bad ways. Hence it's important, at least, for consumers to be aware when and where are they being price-discriminated. Or else, they are likely to react like the old lady who travelled with me from Delhi to Mumbai.

Vivek Kaul is a writer. He can be reached at vivek.kaul@gmail.com

by Vivek Kaul

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