Management Accounting Performance Evaluation: Not All Customers Will Pay the Same for the Same Product, So How Can a Seller Set Prices to Maximise Revenue? by Using "Price Discrimination"

By Scarlett, Bob | Financial Management (UK), November 2005 | Go to article overview

Management Accounting Performance Evaluation: Not All Customers Will Pay the Same for the Same Product, So How Can a Seller Set Prices to Maximise Revenue? by Using "Price Discrimination"


Scarlett, Bob, Financial Management (UK)


The question "what price should be charged for the product?" is one of the most critical that businesses must consider. Most aspects of the process of bringing a product to market take time to change or develop. Modifying the cost structure of a business or altering its strategic direction can take years, but a change in product price can usually be made instantly.

The logic behind price discrimination is illustrated by the graph. Imagine we're running a firm that sells units at one price. Each potential customer will buy only one unit. At 10 [pounds sterling] per unit there are no buyers, but sales rise by 2,000 units for every 1 [pounds sterling] the unit price is reduced below 10 [pounds sterling]. So, when the price is zero, 20,000 units can be "sold". The line on the graph represents possible combinations of price and unit sales. It shows that, if one price is charged, revenue will be maximised at a unit price of 5 [pounds sterling], giving sales of 10,000 units and a revenue of 50,000 [pounds sterling]. But adopting a uniform unit price of 5 [pounds sterling] means two things:

* Almost all the customers actually buying units would have been prepared to pay more.

* There are 10,000 potential customers who do not buy units because they are not prepared to pay more than 5 [pounds sterling].

How can we refine our pricing structure to improve upon our existing 50,000 [pounds sterling] revenue? If we abandon the idea of a single uniform unit price, various possibilities emerge. Let's say that we can identify our 2,000 keenest customers and devise some way of charging them the 9 [pounds sterling] per unit that they're prepared to pay while holding the other 8,000 units at 5 [pounds sterling]. This would boost our revenues to 58,000 [pounds sterling]--ie, (2,000 x 9 [pounds sterling]) + (8,000 x 5 [pounds sterling]).

Let's say that we can also identify the 5,000 potential customers who are prepared to pay 2.50 [pounds sterling] per unit, but not 5 [pounds sterling]. If we could devise some way of selling our product to them without disturbing our existing unit sales, it would be possible to boost our revenue to 70,500 [pounds sterling]--ie, 58,000 [pounds sterling] + (5,000 x 2.50 [pounds sterling]).

If you are willing and able to play this game, known as price discrimination, it's possible to obtain a lot more revenue from a given market, in this case it's mathematically possible to extract 100,000 [pounds sterling] if you can a find a way of charging each customer the exact price they are prepared to pay.

There is a dear theoretical case for price discrimination, but charging different customers different prices can cause practical difficulties. So how can it be done effectively? There are generally considered to be three degrees of price discrimination.

First-degree price discrimination

The public auction is the classic price discrimination method in which potential buyers reveal their keenness to buy items via their bids. Products commonly sold through auctions include artworks, used cars, houses and livestock. Where similar items are being auctioned over a day, prices commonly decline as time goes on. The keenest buyers make their purchases early to ensure that they get what they want. By the end of the day, only the least-keen buyers are left and prices tend to sag. If you are a seller, it is usually wise to get your products into the auction as early as possible, while the keenest buyers are still there.

Advances in IT have allowed the auction principle to be extended into new areas. For example, goods can be auctioned on the web (eg, eBay) or on television (eg, bid tv). The normal TV auction method is to display an item--a watch, say--on screen and state that 100 are available and that the "guide shop price" is 80 [pounds sterling]. Viewers are then invited to phone in with their bids (and credit card details). …

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