The primary reason for engaging in product differentiation is to avoid some of the ruinous effects of price competition. 1 Producers are involved in a never-ending process of introducing new products and services and then observing economic behavior. By having several products, producers can experiment and watch economic behavior as consumers will focus on the features and products that are most desirable. The benefits of being a monopolist via differentiation are short-lived, however. Just as cattle are attracted to water, producers are attracted to excess profits. 2 As long as profit potential makes it feasible, competitors will enter the market and begin to drive profits to zero. 3
In this chapter, we have illustrated that there are three approaches to price discrimination and product differentiation. Each pricing strategy is employed under various contexts in practice. The key takeaways include the following:
- First-degree price discrimination, also called personalized pricing, involves charging different prices to different customers for the same product.
- It is difficult to implement first-degree price discrimination because of the difficulty in measuring each consumer’s willingness-to-pay, because some consumers may be irritated when they find out they paid more for the same good, because of arbitrage issues and finally because of the potential legal issues.
- Second-degree price discrimination is referred to as product versioning and bundling.
- Versioning involves offering a high-end product for nonprice-sensitive consumers, and a low-end product for price-sensitive consumers.
- Bundling is a special form of versioning in which two or more products are offered as a package at a single price.
- According to Goldilocks pricing, three versions may be just right. The key is to make the versions different enough so that consumer groups can be segmented.
- Third-degree price discrimination involves setting different prices for different groups of consumers such as seniors and students and other groups. It is often based on the price sensitivities of the groups.
- In some instances, price discrimination can be illegal. If there is any doubt that a business practice is in violation of laws, legal counsel should be sought.