Chapter 6: The Logic of Price Segmentation

 One aspect of price structure concerns the different prices that a company may charge for the
same product.
 A second aspect of a company’s price structure concerns the array of prices charged for the
different products sold by the company. Because there are often interrelationships between a
seller’s various products, the pricing of these products should take such relationships into account.

MARKET SEGMENTS AND PRICING

Formally, a market is defined as all customers and potential customers for a product. Potential customers
would be those who have needs or desires for a product and have the ability to purchase the product if
they so choose.

Most markets are not homogeneous—in other words, they are not made up of customers who are all
similar. Rather, most markets consist of individuals or organizations who have widely varying
characteristics. Of course, some of these diverse individuals and organizations are going to be similar to
each other. These are known as market segments—groups of buyers and potential buyers within a
market who have similar characteristics.

It is important for our subsequent discussion to note that dividing a market into segments does not
necessarily involve placing an individual or organization into only a single category. A particular individual
or organization may be in one market segment when in one purchase situation and in another market
segment when in a different purchase situation.

Factors Causing Pricing Differences Between Market Segments

The best price for a product often differs between market segments.

A product’s best price is likely to differ between market segments because three factors that determine
the best price often differ between market segments. As we have seen in our discussion of price setting, a
product’s best price is determined by (1) the product’s value to the customer (VTC), (2) the costs
to the seller of providing the product, and (3) the customers’ price sensitivity or
responsiveness to price changes. Any or all of these three factors may differ between market
segments.

Price Segmentation

The Problem of Three Market Segments with Different Best Prices

 In a market where the best prices differ between segments, it is important to find an alternative to
charging only a single price for the product.
 This alternative is price segmentation—the practice of a seller charging different market
segments different prices for the same product.
 If price segmentation can be accomplished, it relieves the need for a seller to charge a single price
in the market and creates the opportunity to gain increased profits from most market segments.
The importance of price segmentation for profitable pricing cannot be overemphasized.
 Chapter 6: The Logic of Price Segmentation
The Price-Segmentation Solution to the Problem of Three Market Segments with Different Best Prices

ACCOMPLISHING PRICE SEGMENTATION

There are at least two difficulties in accomplishing price segmentation.

1. The first difficulty is that one cannot expect customers to voluntarily identify themselves as willing
pay prices that are higher than those paid by other customers.

2. The second difficulty in accomplishing price segmentation is the possibility of arbitrage. This is the
practice of buying a product at a low price in order to sell it to others at a higher price. Those in the
segments receiving a low price could make money by reselling the product to those in the
segments being charged the higher price. In fact, in some markets, customers would buy products
for other customers just as a favor.

To deal with these difficulties in accomplishing price segmentation, it is necessary to establish “fences” to
keep the customers in a market segment that pays a higher price separate from those in a market
segment that pays a lower price. A price-segmentation fence is a criterion that customers must meet to
qualify for a lower price. This criterion could be a characteristic of the customer, such as the customer’s
age.

A seller who wants to maximize the benefits of price segmentation should be careful—and creative—in
establishing price-segmentation fences. It is important to keep in mind the two goals of a price-
segmentation fence.

1. The first is that the fence divides the market so that those customers for whom a high price is
appropriate are on one side of the fence and those customers for whom a low price is appropriate
are on the other.
2. The second goal is to minimize the degree to which the fence can be crossed, say by customers
who belong on the high-price side of the fence or by arbitragers who attempt to defeat the fence
by buying an item on the low- price side of the fence and reselling it on the high-price side.

Effective management of price segmentation requires a familiarity with the diversity of methods available
to accomplish it. We discuss the following six Major Types Of Price-Segmentation Fences:

1. Price Segmentation By Customer Characteristics

When a product’s price differs depending on an observable characteristic of a customer, then this
characteristic is being used as a price-segmentation fence. Age is probably the customer characteristic
most commonly used for price segmentation. Whether or not a customer is a child is easily observable,
and many businesses offer lower prices to children. Seniors also often receive discounts. If their age is not
readily apparent, they can document it by showing a driver’s license or the membership card for a senior
citizen’s organization.

The status of being a student is another customer characteristic often used for price segmentation. Upon
showing their school ID card, students are able to get discounts for numerous entertainments, travel, and
merchandise products. It makes sense for businesses to use student status rather than age as a price-
segmentation fence because it is only the young adults who are in school that are likely to have the higher
price sensitivity coming from having limited spending money. Customers who are of college age but who
are working full-time are likely to have considerably more discretionary income than students and
therefore not be especially price-sensitive.

Constraints on the Use of Customer Characteristics

If price-segmentation fences could consist solely of customer characteristics, then there would be
only limited opportunities to practice price segmentation. The reason for this is that the use of
customer characteristics to determine who can pay lower prices is likely to create questions of price
fairness. Customers often perceive a price to be unfair if they observe that other customers are
paying a lower price for the same item.

A perception of unfairness is particularly likely when it is perceived that other customers are paying
a lower price not because of something these customers choose to do but simply because of who
they are. Economists have traditionally referred to price segmentation as “price discrimination.” It
is indeed discrimination in the sense that sellers make distinctions between customers in setting
prices. But when the fence, or criterion that determines who pays what, is an immutable customer
characteristic, then price segmentation can also feel like discrimination in the sense of being
“discriminated against” or being slighted in favor of other people.

Clearly, the use of a customer characteristic as a price-segmentation fence must be done with care.
Use of a characteristic such as gender, race, religion, or ethnic group is very likely to violate
 Chapter 6: The Logic of Price Segmentation
customer sensitivities and should generally be avoided. On the other hand, customer
characteristics such as age, student status, and commercial status seem to be considered generally
acceptable. For other possible customer characteristic fences, it may depend on the specifics of the
situation. For example, colleges and universities routinely consider the income of a student’s family
when setting the price of that student’s education. Offering scholarships to accepted students who
provide information that they are of limited financial means does this. This may be considered
acceptable because of the recognition of the mission of colleges and universities—that it is
beneficial to society for higher education to be widely accessible. One can wonder if the use of the
customer’s income level to set prices would be as acceptable if practiced by, say, a consumer
electronics retailer or a dinner restaurant.

Price Segmentation in Negotiation

As was discussed in Chapter 1, there are many occasions when prices are not fixed but rather are
negotiated through a direct interaction between the seller and the customer. When prices are set
through negotiation, the seller has a greater ability to use customer characteristics as price-
segmentation fences because it is difficult for customers to recognize that this is being done. For
example, a salesperson in business selling may quietly allow some price concessions only to
businesses whose public financial data indicate that they are less prosperous than others.

When consumer prices are determined through negotiation, it is often part of a salesperson’s job to
determine customer characteristics that may be relevant to price segmentation.

Price Segmentation By Purchase Quantity

Because of the fairness issues involved in using observable customer characteristics as price-segmentation
fences, it is important to be familiar with an alternative approach to accomplishing price segmentation.
This alternative approach involves using a characteristic of the purchase situation rather than a
characteristic of the customer as the price-segmentation fence. Having the criterion for a low price
involving a purchase-situation characteristic gives customers at least some degree of choice concerning
whether or not they obtain the low price. Because of people’s greater control over what they choose to do
than over what they are, purchase situation characteristics tend to be more emotionally acceptable than
customer characteristics as price- segmentation fences.

One purchase-situation characteristic that is widely used as a price-segmentation fence is the quantity
that the customer purchases. The best price for those customers who buy larger quantities of a product is
often lower than that for those customers who buy smaller quantities of the product. When this is so, it
makes sense for the seller to offer a lower per-unit price to the customers who buy larger quantities. This
lower per-unit price is often termed a quantity discount. When quantity discounts are used for price
segmentation, it is the quantity of the product purchased that becomes the fence that enables charging
different customers different prices for the same product.

There are a number of ways to offer lower prices to those customers who buy larger quantities of a
product. These are among those most commonly used:

An order-size discount gives customers who purchase larger amounts at one time a lower per-unit
price than those making smaller orders.
A cumulative-purchase discount gives customers who have made many purchases from the seller a
lower price for new purchases than customers who have done less business with that seller.
Cumulative- purchase discounts often take the form a frequent-user program, such as when
collecting enough frequent-flyer miles from traveling on a particular airline entitles the customer to a
free trip on that airline.
Fixed-charge pricing gives open access to a product to customers who pay a single price, such as
paying one price for a meal in a buffet restaurant or an annual fee to belong to a health club. The
effect of this is that customers who make more use of the product pay a lower per-portion or per-use
price than those who make less use of the product.
Two-part pricing involves both a fixed charge and a per-unit charge, such as paying a fixed amount
to rent a car plus an additional amount for each mile driven. These two charges are often set so that
customers who buy more units of a product pay less per unit than those who buy fewer units.

Why Purchasers of Larger Quantities Might Warrant Lower Per-Unit Prices

Cost differences may also play a role in making a quantity discount appropriate. Large orders often involve
lower per-unit costs for assembling and shipping the product. This is one reason why order-size discounts
are particularly common in the selling of products whose transportation costs are substantial, such as
industrial chemicals and machinery.

It is important to keep in mind that lower costs do not by themselves mean that prices should be dropped
accordingly. Rather, lower costs are associated with lower prices because they increase the likelihood that
a price decrease will be profitable.
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Customer price sensitivity contributes to the profitability of quantity discounts because buyers who
purchase larger quantities are likely to be more price-sensitive. One reason for this is that, with larger
purchases, more money is involved. This gives the buyer more incentive to switch from a higher-priced
seller to a lower-priced one.

Another reason for greater price sensitivity among large-quantity buyers is that larger purchases often
involve alternative opportunities that are less available or less practical to smaller-quantity purchasers.

Constraints on Use of Price Segmentation by Purchase Quantity

For a quantity discount to be effective as a price-segmentation fence, it needs to be structured to prevent

it from being defeated by arbitragers. Particularly if a product is easily stored and transported, it is
necessary to keep quantity discounts modest enough so that it would not be profitable for an entrepreneur
to buy large quantities of the product for the purpose of reselling the product to small-quantity buyers.

A quantity discount also needs to be structured to discourage purchasing alliances, or associations

between groups of buyers of a product.

A different type of constraint on quantity discounts involves the issue of legality.The law was designed to
protect mom-and-pop stores from large retail chains, and small retailers to try to block the deep discounts
manufacturers give to high-volume customers have most recently used it.

Because the intent of the law is to support business competition, it applies only to differing prices given to
business customers, not to consumers. It also applies only to the pricing of goods, not services. Further,
there are two important exceptions to the Robinson– Patman Act’s restrictions. Charging one business
customer less than another for the same good is acceptable (1) if it reflects differences in the costs of
serving the twocustomers or (2) if it is done in specifically order to meet the low price of a competitor.
Clearly, the limited reach of this law enables most sellers to retain considerable freedom in using purchase
quantity as a price- segmentation fence.

PRICE SEGMENTATION BY PRODUCT FEATURES

A second purchase-situation characteristic that can be used as a price-segmentation fence is the

customer’s choice regarding the product’s features.

When product features are used for price segmentation, it is the choice of the feature that becomes the
fence enabling the seller to charge different customers different prices for the same basic product. In that
case, the buyers of the luxury feature could be said to be paying a feature-dependent premium for the
basic product, because the higher price they pay for the basic product is caused by their choice of the
luxury feature.

Product-Enhancing Features

When the price-segmentation goal is to charge a higher price for the basic product to a segment that has
a higher valuation of that product, then it would be appropriate to consider using as a price-segmentation
fence a feature that enhances the product.

Product-Diminishing Features

When the price-segmentation goal is to charge a lower price for the basic product to a segment that has a
lower valuation of that product, then it would be appropriate to consider using as a price-segmentation
fence a feature that diminishes the product. In this case, the buyers of the product with the feature that
diminishes it could be said to be receiving a feature-dependent discount.

To be effective in price segmentation, a product-diminishing feature should make the product less than
fully acceptable to the customers in the market segment that pays the high price.

Combining Price-Segmentation Features

In some situations, it may be appropriate to consider using both product-enhancing and product-
diminishing features for price segmentation.

PRICE SEGMENTATION BY DESIGN OF PRODUCT BUNDLES

A third purchase-situation characteristic that can be used as a price-segmentation fence is how a seller’s
offerings are combined into product bundles. A bundle is any set of products that are offered together as
 Chapter 6: The Logic of Price Segmentation
a package. The careful design of product bundles can accomplish price segmentation in a way that is
slightly different than that of the previous two types of price-segmentation fences. Quantity discounts
(which are sometimes considered a type of product bundle) accomplish price segmentation because some
customers choose to buy the higher quantities and others do not. Feature-dependent premiums and
discounts accomplish price segmentation because some customers choose the product enhancing or
product-diminishing features and others do not. However, the design of bundles can accomplish price
segmentation even if all customers choose to purchase the product bundle.

The key to designing a product bundle to accomplish price segmentation is to identify a set of products
that show a VTC “crossover” between at least two important market segments.

CHOOSING A PRICE-SEGMENTATION FENCE

Because of issues regarding customer judgments of price fairness, it is important to be familiar with price-
segmentation fences that do not involve a customer’s characteristics. Purchase-situation characteristics
such as the quantity purchased or choice of product features or bundles can serve very effectively as
price- segmentation fences. If designed carefully, quantity discounts, feature-dependent premiums or
discounts, and product bundles can create the conditions where different groups of customers pay
different prices for essentially the same product.

It should also be noted that a company’s price structure might well involve the use of more than one
price- segmentation fence. For example, a men’s clothing retailer could offer discounts to customers
showing proof of being over sixty-five and discounts for high-quantity purchases. The retailer could also
charge feature- dependent premiums for services such as monogramming and could offer carefully
designed bundles of suits, shirts, and accessories. At times, a seller may need to use more than one fence
to effectively separate two segments, as in the symphony orchestra that both offers students discounts for
showing an ID card as well as offering feature-dependent discounts for the theater’s less desirable seats.

It is a rare company that cannot benefit from price segmentation. An understanding of the possible means
for effectively carrying out this important pricing technique is one of the keys to successfully using price to
maximize a firm’s profits.