Market Segmentation

Successful Segmentation (Lancaster, 1966)

Suggested that goods / services should be viewed as consisting of a ‘bundle’ of characteristics:

• Each characteristic can satisfy different consumer preferences.

Benefits of market segmentation

• Increased revenue

• Reduces space for competitors

• Enhance brand reputation

• Monopoly power

  • Earn positive economic profits

Non-uniform pricing

Consumers are charged different prices for the same good.

• Can be quantity-based

Conditions for price discrimination

• Must have a degree of market power

• Customers have varying willingness to pay

• Know valuation of good

• Separate markets

Arbitage

The practice of a customer in a low-price market to sell on to customers in a high-priced market.

Mechanisms to avoid arbitage

• Void warranty agreements for resold goods

• High transaction costs

• Binding mechanisms

• Poisoning of goods

First degree / ‘Perfect’ price discrimination

Involves selling at a different price to each customer.

• In this case the firm can successfully extract all consumer surplus.

• Demand = marginal revenue

Second degree price discrimination

Involves the firm selling at different prices depending on how much of the good the customer buys or the version chosen.

Quantity discount

Occurs when small levels of consumption are charged at relatively higher rates and increasingly high levels are charged at lower rates.

Third degree price discrimination

Involves the firm identifying groups of customers with different sensitivities to the variations in the price of a good.

Whole market in third degree price discrimination

• Arbitrage may cause a kinked demand curve

• Arbitrage may cause a discontinuous MR curve

• Price 1 > Price* > Price 2

  • The firm has higher profits by charging 2 prices

Total welfare & price discrimination

Total welfare is higher with price discrimination than with monopoly pricing.

Firm welfare & price discrimination

Firm welfare is higher as firms generate greater economic profit.

Consumer welfare & price discrimination

Consumer welfare is lower as firms extract all consumer surplus as profit.

• Equity issues

• More customers are served

Product Differentiation Strategy / Versioning

When firms sell different versions of the good/service to consumers who can self-select the product they desire.

Purpose of Versioning

• Set themself apart from competitors

• Offer different versions of goods/services

Horizontal product differentiation

Products differ but their physical attributes are quite similar.

Vertical product differentiation

Products’ real physical attributes differ in quality.

Advertising & Competition

The intensity of advertising depends upon the degree of competition in the market (market concentration).

Durability

Low advertising:

Consumers tend not to rely on advertising for significant purchases, which are often durable goods.

Brand proliferation

High advertising:

Brands that value loyalty will need to entice customers from rivals and maintain brand awareness.

• Brand loyalty causes a relatively inelastic demand curve

Successful advertising

Increases sales and causes the demand curve to shift to the right.

Deadweight welfare loss & advertising

Advertising does not increase the quality of number of goods in the economy.

Irrational consumers

"If the firm can afford to spend a lot on advertising it must be good. Therefore, they trust the good to offer a minimum standard of service."

Benefits of advertising

• Increases information

• Builds consumer trust

• Creates jobs

• Vital source of revenue

• Mutually beneficial during sponsorships

• Improves retail efficiency & productivity

Drawbacks of advertising

• Invasive to consumers

• Adverts for demerit goods

• Cost of advertising does not improve product

• Exploitative advertising

• Barriers to entry

• Requires regulation

• Opportunity cost of R&D

Advertising and low prices

In some areas prices tend to fall when advertising is used, because there is better information and greater competition.

Advertising and high prices

In some areas prices tend to rise when advertising is used because of persuasion and lack of information.

Information View and advertising

Informing customers about products and prices.

• Elastic demand curve

Signal of Quality (Milgrom & Roberts, 1986)

If consumers cannot distinguish between high quality (Gh) and low quality (Ql) all firms receive the same market price.

Signal of Quality: Burning money

Firms selling high quality (Gh) goods will spend more on advertising to secure a higher price and repurchases.

Benefits of information advertising

• Welfare improving

• Widens consumer choice

• Lower barriers to entry

• Lower prices

• Lower search

Persuasive View and advertising

Switches market demand from one product to another.

• Less elastic demand curve

• Creates deadweight welfare loss

Entry Deterrent (Sutton, 1992)

Persuasive advertising creates high barriers to entry via brand loyalty and the sunk cost nature of advertising.

Complementary View and advertising

The advertisement adds additional value to the product and the world of wider media.

Search good

When a consumer can establish a product’s quality by inspection before purchase.

Experience good

When the consumer must consume the product to determine its quality.

Credence good

When a consumer cannot determine the quality even after consumption.

Traditional Theory of Information

• Consumers have complete (perfect) information

• Price reflects quality

Asymmetrical Information

One or more agent hold better information sets (bargaining advantages) over the other agents in the market.

Adverse selection

When one party has better information than the other before a transaction.

Moral hazard

One party takes more risk because it does not bear the full consequences of that risk.

Opportunism

Occurs when one agent takes actions that the principle cannot observe.

Cost of quaulity

If information about quality is costly to obtain, then it is no longer possible that buyers and sellers have the same information.

Gresham’s Law (1558)

Circulating currency consisting of both ‘good’ and ‘bad’ money, where both forms are required to be accepted at equal value under legal tender law quickly becomes dominated by the ‘bad’ money.

The Market for ‘lemons’ (Akerlof, 1970)

When buyers have incomplete information about the quality of a product, sellers have an incentive to pass off lower quality goods.

Measures to solve the Lemon Problem

• Guarantees

• Warranties

• Brand names

• Licensing

• Credit scores

• Evidence of no-claims bonus

Signalling Theory (Spence, 1973)

Evaluates a situation between two parties where one actor holds more information than the other.

Role of education

• Improving human capital

• Signal higher productivity

Education and wages

Firms cannot observe productivity levels of workers before hiring them, but they can observe educational attainment.

• High level education = high wages

• Low level education = low wages

Pooling equilibrium and education

• Nobody will undertake education because the cost is too high relative to the rewards.

• Everybody will undertake education if the cost is too low relative to the rewards

Separating Equilibrium and education

Highly productive individuals might find it cheaper to undertake education compared to low productive individuals.

• High productive individuals = high wages

• Low productive individuals = low wages