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Two identical calculators. Different looks, different prices.
Same calculator, different prices.

Product differentiation

Price discrimination, when not based on objective consumer differences (e.g. children, students, elderly people…), often relies on product differentiation, so that consumers can select the product they prefer (whether it is a good or service).

Slight differences in products are used very frequently to help companies offer a wide range of prices. In this respect, product differentiation is only price discrimination in disguise. This leads us to our most precise definition of price discrimination:

There is price discrimination if the differences in the prices paid by two customers are not justified by the cost differences of supplying ‘similar’ services or goods, that is, goods or services that are close substitutes to one another.

This type of price discrimination (which we called ‘second-degree price discrimination’) is the most powerful and efficient from the point of view of the producer. It is also generally well accepted by consumers because they benefit from a large choice of goods and services to choose from. Note that the choice should not be too large to avoid confusing the consumers. Airlines tend to be walking a fine line here, sometimes falling on the side of offering too many confusing prices, as also seems to be the case for mobile phones manufacturers.

This product differentiation can be a variation in the composition of the good or service, or a variation in its quality, or both. In the following graph, there are four variations of a good (different sizes or colours, for example) and for type A, there are two different quality levels.

Variations on a good

There can be an incentive for companies to lower the quality of their product in order to offer a low quality/low price product that will not appeal to the same consumers as a high quality/high price product. This was remarked on a long time ago by a French economist, Jules Dupuit, in 1849, when writing about train companies, he commented:

“What the company is trying to do is prevent the passengers who can pay the second-class ticket fare from traveling third-class; it harms the poor, not because it wants to hurt them but to frighten the rich”.

Note that this may be very easy and cost-free to do in the case of services. Think about tickets which are cheaper when bought in advance: they are of a lesser quality because they imply a strict constraint on the date of purchase, but they actually relate to the same service and the cost of providing it may be exactly the same. This type of ticket might even come with a bonus to the producers because they will collect the revenue earlier. Conversely, it is often the case that higher quality products, for example, refundable tickets, cost more: the producers may have to reimburse the customer and, in the case of a capacity constraint, they may end up with an empty seat.

To sum up: for a producer, the most efficient price discrimination scheme (second-degree price discrimination) is based on product differentiation and self-selection by customers according to their tastes. Slight differences in the product will help the company offer a wide range of prices. For the consumers, it leads to a wider range of products, so it is often viewed positively, although in reality, it sometimes leads to a worsening in the quality of the lower price type of product.

Real-life examples

There are many examples of product differentiation and these may lead to price discrimination, unless there is a high level of competition on the market. It is up to consumers individually to judge if they are ‘victims’ of price discrimination, and if they want to play along or not (which they probably will if they get the lower price!).

Join the discussion

What do you think of the following cases? They are all examples of product differentiation, and may (or may not) lead to price discrimination.

  • diet cola vs regular cola
  • rental cars of different sizes or brands
  • takeaway vs eating in restaurants
  • pink razors for women vs regular razors
  • man haircut vs woman haircut
  • weekend discounts in trains/planes/hotels vs prices during the week
  • happy hours in bars

Take one of these examples and argue whether or not the customer is faced with price discrimination, then comment on other discussions.

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This article is from the free online course:

Manage Your Prices: an Introduction to Pricing Strategy and Revenue Management

École Nationale de l'Aviation Civile

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