Price Discrimination

Price Discrimination is the business practice of selling the same product or service to different buyers at different prices. It’s a strategy companies use to move beyond a one-size-fits-all price tag and instead charge each customer, or group of customers, as close as possible to the maximum amount they are willing to pay. Think of airline tickets: the person in seat 14A might have paid €500 by booking last minute for a business trip, while the vacationer in 14B paid just €150 by booking months in advance. Same flight, same cramped legroom, vastly different prices. The airline isn't being random; it’s systematically trying to capture the most Revenue from every single seat. This practice works because the cost of providing the service to each customer is roughly the same, but the customers' willingness (or desperation) to pay is not. A successful strategy requires the company to identify different customer groups, prevent low-price buyers from reselling to high-price buyers, and, most importantly, possess some degree of Pricing Power.

Economists generally classify price discrimination into three categories, moving from a theoretical ideal to what we commonly see in the marketplace.

Also known as perfect price discrimination, this is the company's ultimate fantasy. It involves charging every single customer the absolute maximum price they are willing to pay. It’s like a mind-reading salesperson who knows your exact budget and won't let you leave with a cent to spare. In the real world, this is incredibly rare because it's nearly impossible to know every individual's true willingness to pay. However, you might see approximations of it in places like:

• A high-stakes art auction where bidders compete up to their personal limits.
• A car dealership haggling over the final price of a vehicle.

This is pricing based on the quantity consumed. The more you buy, the cheaper the price per unit becomes. It’s a way for companies to entice heavy users to spend more while still capturing sales from more casual customers. You encounter this all the time:

• Bulk Discounts: The giant “family size” box of cereal is cheaper per ounce than the small one.
• Tiered Pricing: Cloud storage services might offer 100GB for $2.99/month but 2TB for $9.99/month—a much lower price per gigabyte for the bigger plan.
• Utilities: Your electricity provider might charge a higher rate for the first 500 kWh of usage and a lower rate for everything after that.

This is the most common and recognizable form. The seller divides its customers into distinct groups and sets a different price for each group. The key is to segment the market based on observable characteristics that correlate with willingness to pay. Classic examples include:

• Student and Senior Discounts: Movie theaters and museums assume students and retirees have less disposable income and are more price-sensitive.
• Geographic Pricing: A software subscription or a new video game might cost more in the United States than in India, reflecting differences in average income.
• Time of Purchase: As seen with airline tickets, prices are often lower when booked far in advance and higher for last-minute purchases.

For a Value Investing practitioner, spotting effective price discrimination is like finding a clue that points to a hidden treasure. It reveals crucial information about a company's underlying strength and profitability.

The ability to consistently and successfully practice price discrimination is a powerful indicator of a durable Competitive Advantage, or what Warren Buffett calls an economic Moat. A company in a cutthroat, commodity-like industry can't pull this off; if it tries to charge one group more, those customers will simply flee to a competitor. To make different prices stick, a business needs:

• A strong brand that commands loyalty.
• A unique product or service with few direct substitutes.
• High Switching Costs that make it painful for customers to leave.

In short, price discrimination is the result of pricing power, which itself is the result of a strong moat.

By tailoring prices, a company can dramatically increase both its revenue and Profit Margin. A single price inevitably leaves money on the table—either by charging too little to those who would have paid more or by pricing out those who would have bought at a lower price. Price discrimination allows a company to capture both. This leads to higher profitability and a better Return on Invested Capital (ROIC), which are core ingredients of a long-term compounder.

Price discrimination isn't just a clever marketing trick; it's a window into the economic soul of a business. When you see a company executing it skillfully—like a software giant with tiered enterprise plans or a consumer brand with premium and budget versions of the same core product—don't just see different prices. See the signs of a powerful, profitable business that has carved out a defensible space in the market. That's a business worth investigating further.