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Price Discrimination and Internet Advertising

Walshaw.com
Published: May 7 2005

Discrimination to most people is a dirty word. It conjures up images of social discrimination and the problems that go with it. However, price discrimination is a coveted feature of firm pricing structures, because it results in greater profits for firms. Price discrimination in simplest terms is the act of charging different prices to different customers for the same product. The customer who is more willing to pay is charged more than the customer who doesn't value the product as highly. Everyone has been exposed to price discrimination in their life. For example, seniors, students, and children pay less for movie tickets. These three groups are less willing to pay for a ticket, and charging them less increases their attendance, which boosts theatre profits. Another example is a mail in rebate. Have you ever seen a product like shampoo with a $1 mail in rebate attached? Only those who are less willing to pay for the product will bother to get the $1 back, and are hence effectively charged less than others who don't care as much. The same principal works for supermarket coupons. Wealthier people don't bother with the hassle of using them, and are effectively charged more for the same product than someone who redeems the coupon.

The purpose of this article is to introduce price discrimination in the context of Internet advertising. The various forms of discrimination will be introduced, followed by the ways in which you can implement them to get more revenue out of your existing advertising space. This is an important concept to understand because as any online publishers will tell you, advertisers' willingness to pay vary dramatically depending upon, among other things, the profitability of their own sites. For example, a web hosting provider will be willing to pay more for a visitor than an information based site because they can potentially make more money off that same visitor.

First Degree Price Discrimination

In an ideal world, you would want to charge each advertiser the maximum amount they are willing to pay for an ad space. This is known as first degree price discrimination, where each and every consumer is charged a unique price, which equals the maximum amount they are willing to pay for the product. A simple example with numbers can illustrate the value of doing this. Say you have three sponsored text link spots on your site. Now pretend there are five people who are interested in advertising on your site. Person one is willing to pay $100 per month, person two is willing to pay $90 per month, and people three, four, and five are willing to pay $60, $40, and $20 per month, respectively. If you set one price for the three spots, you would be best off charging $60. In this case, people 1, 2, and 3 would be willing to pay, and you would make $60 x 3 = $180. Now pretend that you practice first degree price discrimination and charge each person their maximum willingness to pay. Your profit would be $100 + $90 + $60 = $250. this represents an increase in profit of $70!

In the real world, this is very difficult to implement, because consumers are unwilling to convey to companies how much they're willing to pay for a product. The best way to practice this, however, is to follow the lead of search engines and auction off advertising positions, typically on a pay-per-click (PPC) basis. Auctions are a great way to entice advertisers into conveying how much they're willing to pay, and they are as close as you can get to first degree price discrimination. Of course, pay per click auctions like Google Adwords aren't perfect in terms of discrimination because they charge each advertiser a fraction above the maximum amount their closest rival is willing to pay. Using the numbers above, with increments of $1.00, Google would make $91 + $61 + $41 = $193. This is a lower than $240, but the results will vary depending on the numbers used. The important thing to see is that auctions enable webmasters to extract more revenue from the same set of advertisers.

Second Degree Price Discrimination

Second degree price discrimination is also referred to as bulk discounts. Most people have experienced this in a store where it says, "buy three, get one free!" Someone who is willing to buy three units is charged less per unit than someone who is only willing to buy one or two.

This is very easy to implement in terms of structuring advertising prices. Simply price a banner at $4.00 for 1,000 impressions or $30.00 for 10,000 impressions. Buying in bulk means the advertiser is charged $3 instead of $4 per 1,000 impressions, thus enticing them to purchase a larger quantity. An advertiser who is trying hard to find the best value will buy in bulk, while an advertiser with a higher willingness to pay will purchase the $4 package to have the option of not paying for more later if the ad performance isn't as good as they had hoped.

The benefits to publishers for this type of advertising are three-fold. First, it reduces paperwork involved with signing up a new advertisers, as most will opt for the longer term package. Second, it provides a larger sum of money today, as opposed to receiving $4 periodically. The level of the bulk discount will depend on how much you value receiving a large amount now, compared to a smaller amounts later. Third, it enables you to distinguish between advertisers who vary in willingness to pay.

Similarly, you can offer bulk packages that include a combination of advertising spaces at a discount compared to buying the ad positions separately. Advertisers who are looking for value will buy the combination of links while other advertisers will purchase positions individually.

Third Degree Price Discrimination

Third degree price discrimination is the act of charging two or more groups of people different prices. This in effect is a watered down form of first degree discrimination, in which every individual is charged a different price. The movie ticket example earlier is a classic example of third degree discrimination. The theatre can distinguish between different groups of consumers by requiring a student or pensioner's ID in order to receive the discounted price.

In terms of Internet advertising, it is harder for publishers to separated advertisers into groups and charge different prices. However, it is feasible, and a few examples can illustrate this.

The first way to third degree discriminate is to charge different prices for different pages of your site. Say you run a link directory, and two categories are credit cards and free tutorials. You could set a higher advertising price for the credit cards page because credit card companies make more money per visitor than the owner of a free tutorial.

A second way to discriminate if you sell site wide advertising is to not disclose your advertising rates publicly. Create two or more pricing structures, where one is more expensive than the other. When a potential advertiser makes an enquiry regarding rates, you offer prices depending on the nature of their site. Because the advertising prices aren't publicly known, each advertiser doesn't know what the others are being charged. Now you may notice that this method could be used on a case by case basis to replicate first-degree discrimination, however remember that it is very difficult to figure out the exact willingness to pay for each advertiser. Instead, it is more feasible to create a finite number of packages, with prices that are conservatively set below the willingness to pay of the most profitable sites in each category, as to ensure the sale of ad space to advertisers.

Conclusions

Three forms of price discrimination have been discussed, including how they can be used by publishers to earn greater revenue from their existing advertising space. First degree discrimination involves charging each individual advertiser their maximum willingness to pay. On the Internet, the best way to implement this is to run an auction for advertising positions. Second degree discrimination involves offering bulk discounts. This can be achieved by offering lower per-unit prices for longer term advertising campaigns, or for combination packages. Finally, third degree price discrimination involves separating consumers into two or more groups, and charging each group a different price. With Internet advertising, this can be achieved by charging varying prices for different sections of the web site, or by not publishing prices, and offering different price packages to different advertisers, depending on the nature of their site.

By understanding and utilizing the various forms of price discrimination, webmasters can extract greater revenue from the same number of advertising spaces. Through being able to distinguish between different types of advertisers and charge different prices accordingly, you can extract more revenue from those who have a greater willingness to pay. Putting the theory into practice is not easy, but hopefully this article will give you some ideas as to how to implement it.

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