The Dynamics of Optimal Product Pricing

When was the last time you traveled by plane? Or gotten a student discount on movie tickets? As many marketers will tell you, price discrimination is all around us. Price discrimination is the practice of selling products at often substantially different prices for the same or similar versions of a good or service for different customer groups. For example, a student may pay a lower price for a movie ticket than a non-student would.

While this is a more direct form of price discrimination, we often see ‘indirect’ discriminations in product variations, like smartphones with different memory capacities. This poses an interesting question for companies— is there a benefit to offering multiple versions of a product with varied pricing or is it preferable to only sell a single version at a fixed rate? When you don’t have access to data on how customers are different from each other, does discriminate pricing really matter? This is especially interesting when the varying features don’t correlate to varying costs on behalf of the company; in the case of smartphones, adding additional memory is not costly to the makers of the phones.

According to Yale SOM professor of marketing Soheil Ghili, the decision to price different ‘versions’ of product features hinges on identifying which customer segment values the feature more.

The topline boils down to this: If the more affluent segment cares more about the feature, versioning is optimal. If the price-sensitive segment cares more, it’s better to establish uniform pricing.

Using the smartphone example, if less affluent consumers are the segment that values more phone memory, the company would be wise to only put one version on the market, price it reasonably, and try to sell to everyone. The less affluent would buy because it has the feature they want, and the more affluent consumers wouldn’t care about the price or the memory in this scenario.

Conversely, we can rationalize that when extra memory is important to affluent customers, the company would benefit to version the product to be able to charge more to those willing to pay the extra cash. Those who are price-sensitive will not purchase the more expensive version because they do not care about smartphone memory as much, but the company will still capture this segment with the less expensive version.

Without versioning, Ghili says, “you will need to choose a ‘middle ground’ price level that is aimed at appealing to all your customer segments”. But if versioning is feasible, he adds, “you can tailor the price of each version of your product to the target customer segment it is meant for”. This broadens your reach to a wider customer base and improves your profitability.

Ghili believes that launching data analytics projects to understand consumer preferences is the first step to understanding how to design a pricing strategy. By estimating a model of consumer demand which captures the correlation between price sensitivity and product features, companies can make informed decisions on whether to engage in price discriminate product versioning for optimal results.

Discover more insights from Yale SOM’s renowned faculty here or reach out at ycci@som.yale.edu for other ways to collaborate.