Store cards, price discrimination and price skimming

Wiki does its usual excellent summaries of price discrimination and price skimming, which like most things in economics are blindingly obvious, but nonetheless it's nice to put names to them.

Simply put, price discrimination and price skimming are when a supplier charges different prices for the same product based on a consumer's willingness or ability to pay, to illustrate the examples which Wiki gives:

* First degree price discrimination - I have no idea what they mean.

* Second degree price discrimination - where a supplier gives bulk discounts to wholesalers, because, for example, the supplier's fixed selling costs per unit are lower with bulk orders and because the wholesaler bears more of the risk that the final retail price of the goods or services will fall. This does not just happen with physical goods, the same can be observed with media buying companies who block book advertising space in newspapers or on telly weeks or months in advance and then try to sell it on to the end customer at a price that is higher than what they paid but lower than the media outlet's current quoted retail price.

* Third degree price discrimination - where the supplier has all the infrastructure in place and significant fixed costs; low marginal costs; and demand which fluctuates strongly over time. So the supplier demands lower prices at certain times of day, week or year. This works best with services or goods consumed at point of sale such as bus companies or cinemas offering cheaper tickets outside the rush hour or in the daytime, restaurants which offer cheaper meals on Monday and Tuesday evenings; or package holiday companies which demand lower prices out-of-season or during school time.

[As an aside, there is little degree of price differentiation between different geographical areas where easily transportable physical goods are concerned (e.g. dresses in Primark on High Street, Anytown cost the same as dresses in Primark on Oxford Street, London - see footnote) but there can be huge differences where you pay for things consumed at point of use - a cup of coffee at Leicester Square or Trafalgar Square costs £3 because you are paying for the view, not just the coffee, but a cup of coffee in a back street somewhere might be only £1.50. Let's not even get started on the price of housing, which by definition has to be consumed exactly where it is.]

* Price skimming - where new products are sold for a high price when first introduced, and the price then falls steadily. This is particularly noticeable with high technology, such as DVD players or CD burners, which cost hundreds of pounds each a few years ago but you can now buy them for £15, or even get them installed 'for free' when you buy a new computer. The same applies to clothing - the unit cost of buying a dress is minimal, say £10, but retailers never know whether they have ordered something that will be in fashion when it hits the racks, so they start by selling them for £100 and then keep dropping the price until you can pick them up for a mere £5 in the end-of-season sale.

So where do credit cards offered by high street shops, which can only be used to buy goods from the issuing shop, fit in?

1. We notice that most shops which offer store cards are clothes and eletronics retailers, who face a price curve which declines over time; they'd rather shift a dress for £100 now while it's in fashion than for £5 in the end-of-season sale. They'd rather sell the newest computer now for £1,000 than for £500 in a year's time.

2. It's in their interests to shift as much stuff as possible as quickly as possible while it's in fashion. Seeing as the additional value of a new dress or a new computer is rather ephemeral and subjective, one way of doing it would be to somehow work out how wealthy their customers are and to charge the wealthier people £100 for the dress and poorer people £50 (which is what doctors used to do in pre-NHS days), but this fails for impracticality.

3. The other way of doing it is store cards. We know that some people get a bit carried away with store cards and run up tens of thousands of pounds of debt on them, half of which ends up being quietly written off, but from the point of view of the retailers, the write-offs don't particularly matter:

4. They could:

a) Stick to cash-only selling and sell 500 dresses for £100 and 500 for £5 in the end-of-season sale, total revenues £52,500 (we can ignore fixed costs in this example), or

b) Introduce store cards, sell 500 dresses for £100 for cash, and an additional 250 for £100 to people using store cards when they are in fashion; and then only end up selling 250 for £5 in the end of season sale, total revenues £76,250.

So by introducing store cards, the retailer has boosted his gross revenues by £25,000, and ends the season with £25,000 outstanding on store cards (although if you look at the small print, these credit cards are usually issued/underwritten by an existing credit card company).

5. Of course, the retailer would like to collect as much as possible of that £25,000 (quite how the losses are split between the retailer and the actual credit card company is an unknown), but even if half of it ends up being written off, the retailer is still ahead of the game, and the fairly savage interest rates they charge (usually over 20% a year) soften the blow to the retailer.

6. Quite how they decide whose debts are written off and not pursued is also an unknown, but by and large we expect that it will be lower income people who simply have no assets and are thus not worth pursuing. Thus by a very indirect route, what they are actually doing is demanding higher prices from wealthier people (who pay cash up-front or actually repay their store card debts) and demanding lower prices from lower income people (who are more likely to pay by store card and more likely to have their store card debts cancelled) - which is alluded to in para 2. above.

7. Also worth noting is the psychology of the retail industry, which is to focus on 'sales growth' and 'market share' as much as net profits, which also encourages retailers to issue store cards, even if this is at the expense of the bottom line.

Here endeth today's lesson.

Footnote re Primark - although they charge the same prices in their flagship Oxford Street store as in their branch on High Street, Anytown, they can shift ten times as many units per square foot of retail space in Oxford Street, so they can make ten times as much in gross profits so the total rent they pay for their Oxford Street store is ten times as high as the rent for a unit on High Street, Anytown. This is subtly different to the price of a cup of coffee; it's £2.50 on Oxford Street but only £1.50 on High Street, Anytown where the 'rental' element of the price is immediately obvious to the consumer.