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YOU DECIDE: Why do we often pay different prices?

May 04, 2007

By Dr. Mike Walden
North Carolina Cooperative Extension Service

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

Dr. Mike Walden
Media representatives: For a black-and-white or color copy of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.
What do all these price comparisons have in common?

A weekend flight to Miami costs less than a weekday flight. A senior citizen like me can rent a hotel room at a lower rate than one of my 20-year-old students. A construction company buying hundreds of 2x4s gets them at a cheaper unit price than the weekend handyman purchasing a few.

These are a few examples of how different buyers might purchase the same thing (a flight to Miami, a hotel room, 2x4s) for different prices, due to a common business technique called "market segmentation."

Here's how market segmentation works. Companies selling a product look for ways to separate -- or segment -- buyers into groups based on their sensitivity to the price of the product. For example, a builder needing many 2x4s will pay more attention to the price of each board than I would when I need only one, because paying a few pennies less per 2x4 could mean big savings when buying hundreds of 2x4s.

Likewise, a family considering flying to Miami for a vacation may decide to change plans if the ticket is too pricey. In contrast, a businessperson who must be in Miami to meet a client one day, then in Dallas the next day for another meeting will have no choice but to fly, even if the ticket price is high.

In each case, the company could choose to sell the product (2x4s, airline ticket to Miami) to both types of buyers at the same price. But businesses have found they can increase their revenues by selling the products to the different customers at different prices. In other words, segment the market.

Who gets the better deal when this happens?

It's the more price-sensitive customer. In our two examples, this means the price-conscious vacation traveler gets the best deal on airline tickets, as does the bulk buyer of 2x4s.

Companies can use market segmentation only when certain conditions are met.

First, there must be genuine differences in the price sensitivity of their customers.

Second, it must be impossible, or at least very difficult, for customers to trade the product among themselves. (For example, reselling airline tickets is illegal.) Finally, companies must find a way to easily separate buyers in a manner that is not obvious and that buyers will accept.

It is the last requirement that produces some interesting results. If airlines simply asked flyers if they were traveling for business or for pleasure, all travelers would eventually answer "pleasure" if they knew that got them the lower price.

So airlines had to invent another technique to separate business and pleasure travelers, and eventually hit upon the Saturday night stay. They found that most business travelers wanted to be home for the weekend, whereas pleasure travelers often stayed over a weekend. So simply separating travelers by whether they stayed over a Saturday night let airlines segment business travelers (higher ticket price) from pleasure travelers (lower ticket price).

Market segmentation explains many kinds of observed pricing practices. Retired buyers receive a senior citizen discount, not because sellers necessarily want to be kind to them, but because with more time to shop, they are more price-sensitive. New books are initially sold in hardcover at higher prices to avid readers and later in paperback at lower prices to more price-conscious readers. Universities charge full tuition to students from higher-income and less price-sensitive families and give aid to lower-income students for whom cost is a greater factor in determining their attendance.

Is market segmentation unfair? Shouldn't everyone pay the same price for the same product?

That's certainly one viewpoint, but notice what market segmentation does. Buyers who are less concerned about price pay more, while buyers who are more focused on the price pay less.

But whether you decide market segmentation is good or bad, it's a big part of the business world, so beware!

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Related audio files are at http://www.ces.ncsu.edu/depts/agcomm/writing/walden/index.html

Posted by Dave at May 4, 2007 08:44 AM