The Art of Price Discrimination – can Ayn Rand teach us a lesson in pricing?
In traditional sense “discrimination” is a word with a negative connotation. However, in the pricing context, by discrimination I mean that I will make some customers pay more and some customers pay less for the same product. However that is pure discrimination and by no means an art. Discrimination becomes an art only when all the subjects concerned accept the price they pay without a grudge.
To demonstrate with let me resort to one of the earlier mentions of value-based pricing in popular literature – Atlas Shrugged by Ayn Rand:
“I’ve thought of a new Rearden Metal bridge, I’ve had my engineers give me an estimate.”
“What did they tell you?”
“Two million dollars.”
“What would you say?”
“Eight hundred thousand.”
She looked at him. She knew that he never spoke idly. She asked, trying to sound calm, “How?”
He showed her his notebook. She saw the disjoined notations he had made, a great many figures, a few rough sketches. She understood his scheme before he had finished explaining it. The bridge was to be a single twelve-hundred-foot truss span. He had devised a new type of truss. It had never been made before and could not be made except with members that had the strength and the lightness of Rearden Metal.
The lightness coupled with strength made Rearden Metal a better alternative than steel for the application.
Two important notes can be derived from the above example –
1. If used in the same method as steel – Rearden Metal would be a more “expensive” option.
2. The advantage is applicable only when the design makes use of the strength and lightness, the differential benefits provided by this particular material.
What if another application, say a golf club, wanted to use Rearden Metal instead of steel? There may not be any value derivable at all – as strength and lightness are not required for the application.
So should the selling strategy of Rearden metal be the same when the customer wants to build a bridge as when he wants to make a golf club?
Such questions become more pertinent when a single product has multiple applications. Each application makes use of one or more features of the product, be it an innovative metal or an innovative microchip.
For illustrative purpose let’s consider again the Product A featured in last month’s article with Features X, Y and Z is used in multiple applications: App 1 , App 2 … App 5:
|App 1||App 2||App 3||App 4||App 5|
*Number in Cells denotes number of products (suppliers) offering the feature
From the diagram it is evident that App 2 and App 5 are the applications that see most value in Product-A – because they use Feature Z (which in turn is offered by a single supplier).
On the other hand for App1, App3 and App5; product A is more of a commodity as features X and Y (required features) are provided by multiple suppliers (alternatives).
In such a situation as value-based pricing practitioners we have the following options:
1. Concentrate on App2 and App5 – for the rest of the applications we don’t sell (Customer Segmentation)
2. Sell for all applications but derive different products for App 1, App3, and App4 (Product Segmentation)
Both the above pointers can be critical business strategies.
1. Market (Customer) Segmentation –
This form of segmentation is more outward-looking as you are modifying your offering based on the application requirements. It is also an important task to complete while planning a new product.
Going back to the example above, if we are targeting only App2 and App5, our positioning would be pivoted around benefit ‘Z’, targeting the customer groups associated with App2 and App 5. Moreover, while planning new products, if we realize that the market size of App 2 and App 5 is too small to justify the new product, we may abstain from launching.
In absence of the above knowledge a firm tends to plunge in with a product with an inefficient approximation of market size, consequentially adding a commodity in the basket.
2. Product Segmentation –
In the above case there may be another way of attacking the problem. What if the segmentation is such that we come out with two versions of same product A: One with Z (A1) and one without Z (A2)? Now given Z is a feature that is valuable, we can price A1 higher than A2. (Consequentially selling the same product at discriminated prices without making any party feel discriminated against.)
We see this a lot with respect to service industries (e.g. airlines) where it is easy to unbundle the opportunity.
Benefit-based segmentation does make the task easier but sometimes it is impossible to execute as the features (benefits) are closely coupled with each other. Moreover the task of value selling would get even more challenging if the applications that see value (App2 and App5) are too small to justify ROI. In such a situation value-based pricing is dependent on lack of information flow (about pricing) in the buyer world. Sometimes flow of information can be blocked strategically. An example would be making the customer (definitely a low priced one) sign a price NDA. Sometimes it also makes sense to create different names for the same product and sell at two different prices (e.g. by differentiating the package).
In conclusion I would like to remind the reader, that the role of a value-based seller is not blocking revenue for want of a good price. He is more of an advocate for the true worth of a product. Through all the methods described above we are trying to arrive at a price that is neither low nor high – but fair. We discriminate to be fair.