Price differentiation – that is, setting different prices for different customers – is typically positioned as one of the silver bullets in the arsenal of the pricing manager. In this blog, we will outline the justification for price differentiation. Moreover, we will show that there is a catch; if price differentiation is not done correctly, it will immediately hurt the bottom line. It turns out that price differentiation is like blowfish sushi – great if prepared correctly, but deadly otherwise – and most of the time.
Why differentiate prices?
Price differentiation is generally justified by some version of the following example. You sell a single product with unit costs of $50. Demand is linear with a maximum demand of 3,000 (at a price of $0), a price elasticity of -2 at a price of $100, and a maximum willingness-to-pay of $150.
If you sell to all your customers at a single price point (Graph A), then the profit optimum is at a price of $100 with a margin of 50% (on price elasticity and pricing see here). Then, your profit is 1,000*($100-$50) = $50,000.