Lesson 5 - Price Discrimination, Product Differentiation, and Elasticity

Price setting is a critical function in running a business. Given other factors remain constant, the law of demand states that quantity demanded will be determined by the price level.

Due to the fact that customers are sensitive to price, entrepreneurs can use price discrimination strategy to maximize sales by selling the same product to different groups of customers for different prices.

For example, hard cover books or special editions are usually sold at a higher price to book lovers and libraries for collection purpose. They are usually released before the paperback edition to give preferential treatment to the premium customers. In terms of the content, both versions are the same. Sometimes, special content may be added to the work to create a perception of product differentiation to increase the value of ownership. For example, some movie DVD may be packaged as a special director cut edition with film sequences not available in the standard version.

Product differentiation allows variation in the offering in terms of functionality and appearance to target different customer segment so that the differentiated products can be sold at different price levels. Air flights with first, business, and economy classes are good examples of how a product, in this case “air flight”, can be offered to address different customer segments at different price levels.

Entrepreneurs should experiment with various price discrimination and product differentiation strategies to maximize revenue. The concept of elasticity furthers allows the entrepreneurs to develop pricing strategy in response to changes in income and price.

Income elasticity can be either positive or negative, depending on the nature of the good being sold. The good can be normal, luxury, or inferior. There is a positive change to income elasticity, causing an outward shift of the demand curve, when the goods sold are either normal or luxurious. For luxury good, the demand rises more than proportionate to the change in income. For inferior good, there is a negative change to demand, causing a shift of the demand curve inward, as less will be consumed at each price point. For instance, if the increase in income of your customers does not affect the quantity sold of your product, which means your product is a normal good to your customers. On the other hand, if you experience a more than proportionate increase. You may have found a potential high-end customer segment that worths your attention. Find out more about the segment and discover what additional products can be sold to them.

Price elasticity measures the change in quantity sold as a result to price change when all other factors held constant. Knowing the factors affecting the price elasticity of demand will allow an entrepreneur to see the value of the offering among substitutes, priorities of the buyer’s budget, degree of necessity and urgency, and finally different price points. For instance, if a change of price does not cause any change in quantity sold. This is a sign that there is room for price increase. However, the entrepreneur should spend the time to find out what may have caused that. Is it because the product is so unique that there is no direct substitute? Or the previous price was set way below market?

The key factors affecting elasticity of supply include resources availability, mobility of resources, storage of finished goods, capacity, and complexity and duration of the production cycle. The more versatile and agile the entrepreneur is, the more adaptive and competitive one would be. Any disruption to the production function can be restored with ease by the entrepreneur means that the system is already in place. Good job!

Major points to recap

a. The law of demand states that quantity demanded will be determined by the price level
b. Due to the fact that customers are sensitive to price, companies can use price discrimination strategy to maximize sales by selling the same product to different groups of customers for different prices.
c. Product differentiation allows variation in the offering in terms of functionality and appearance to target different customer segment so that the differentiated products can be sold at different price levels.
d. Entrepreneurs should experiment with various price discrimination and product differentiation strategies to maximize revenue.
e. Price elasticity measures the change in quantity sold as a result to price change when all other factors held constant. Knowing the factors affecting the price elasticity of demand will allow an entrepreneur to see the value of the offering among substitutes, priorities of the buyer’s budget, degree of necessity and urgency, and finally different price points.
f. The key factors affecting elasticity of supply include resources availability, mobility of resources, storage of finished goods, capacity, and complexity and duration of the production cycle.

Questions:
a. “Freemium” is a strategy used by many app developers to encourage mass adoption of their products. For example, some software are free but the software vendor requires the users to watch an ad before using the software. To remove the ad, the users have to pay a fee. Functionally speaking, it is the same software but there is a difference in price (free vs. fee) because the two groups have different preferences toward the ad. What economic principle has been used here?