Price Discrimination and Internet Advertising
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
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
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.