Sunday, 27 February 2011

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.


Deniro said...

Retail is counter intuative to people who have not studied it . For example if a shops loses 10% of its customers its profits do not go down by 10%. They could go down by 100% if 90 percent of customers pay for the fixed costs. Even people in retail get mixed up, I watched an Interview with Adam Crozier when he was head of the post office. Paraphrasing, The interview went something like this,

Interviewer "Mr Crozier, surley the 100% increase in profits you are claiming credit for, are simply due to price rise in stamps this year"

Crozier "Of course they are not, our profits are up 100% and the stamp price is only up 15%"


Ian B said...

I don't understand the point of this post Mark. Are you objecting to "price discrimination" and "price skimming"? If so, on what basis?

James Higham said...

Yes but why price "skimming"? why "skimming"?

john b said...

Mark - 99% sure that retailers don't take the credit risk on store cards, they're offered by The Bank Of Somewhere So Dodgy You'd Be Reluctant To Take Out Even A Credit Card With Them, and serviced accordingly. Yes, obviously retailers pay a cut which is *theoretically* equivalent to the default risk, but we all know that banks underprice default risks because everyone who works for a bank has an incentive to do so.

Deniro - That's not cos Crozier's an idiot, it's because he's lying. If you're the Post Office or BT or British Gas, you make all your money by ripping off people who're too old/confused/daft to realise that you can get a better deal from almost anyone else; if you're in charge of such a company, your job is to try and stop people who're old/confused/daft from realising this.

(in the Post Office there's a special rule, which is that the difference between "decently paid boss" and "has your own Caribbean island" is all about a massive share price rise after the government privatise it and give you shares, so there's a massive incentive to inflate costs and understate profits in the meantime.

That explains the PO's decisions that would otherwise be incomprehensible (e.g. agreeing a bulk mail rate with OFCOM based on stated costs which means that the PO loses money on all bulk mail it carries for other firms. Private PO > hire McKinsey to do a fair analysis of costs > jack up bulk mail prices by 50% > share price rises massively). The risk is, like Crozier, you get 'asked to leave' before anyone has the balls to do the IPO...

formertory said...

John B's right on the credit risk issue; store cards are operated by finance house subsidiaries of banks, generally speaking. The retailer doesn't carry the risk of default and of course gets the benefit of additional turnover. The finance house prices the default risk in to the interest rate. Exception: interest-free promotions when interest is billed back in one way or another to the retailer.

Interesting when the schemes are set up (or used to be, back in the day....); you do an exercise with the retailer to determine what their customer profile looks like and then model the acceptance rate on card applications (from your accumulated credit scoring data) against it. Then you tell the retailer what % of appns will be accepted, and can model from that purchases, profit and so on. Some retailers may be aghast at how lousy the profile is (having convinced themselves that they're just the dog's doobries) and so they want a higher % of appns accepted; so up goes the risk, up goes the interest rate (or up goes the subsidy the retailer puts in).

It's all negotiable.....

Steven_L said...

I get the impression all the bad debt gets sold on.

It takes a while before they know it is bad debt because consumers can sustain quite a few cards making the minimum payments before they have to default.

Old BE said...

I find interesting the technique which has become more and more widespread of discount vouchers or unadvertised deals. This is when Pizza Express, for example, offers a few pounds off to those who can be bothered to print off a voucher from their web site. The person who rocks up unplanned pays a little bit of a premium and doesn't care because he doesn't have to wait or plan in advance. The person who chooses a restaurant on price remains a customer because he feels like he's got a good deal.

Likewise Starbucks et al. have drinks which aren't on the big board behind the counter. You can ask for a filter coffee, for example, which costs a third of the price of an americano. But you can only get the deal if you can be bothered to know about it. So the people who like the idea of paying through the nose for smart coffee get their expensive branded coffee and those who just want a cup of coffee aren't put off by the high prices.

Mark Wadsworth said...

Den, another excellent point. See also JB's lengthier explanation.

Ian B, why would I object to it? I'm old fashioned and don't use store cards myself, but if I were a clothes or computer retailer, I would seriously consider offering them.

JH, I suppose you have to imagine consumer demand like an ice cream, with the valuable sprinkles at the top; so by initially charging a high price, they 'skim' off the valuable sprinkles?

JB, as I said, I don't know how credit risk/losses are shared between retailer and actual credit company. Maybe the retailer just accepts 90% of the face value of the debts?

FT, that's the daft bit. I did once save up £1,000 to buy a three piece suite, and found one that exactly fitted the bill. The counter lady flatly refused to accept the proffered debit card and insisted I sign up for 3 years' interest free credit, so in the end I caved in and repaid it interest-free over three years. Of course, a lot of people in my position would have tried to haggle them down to £950 for immediate payment but i couldn't be bothered.

Sl, that's the unknown (see what JB and FT say). There's only so much 'selling on' that you can do, somebody somewhere has to take the losses.

BE, that's another very good example of both price discrimination and price skimming. Also known as 'discounts for regular customers' which Starbucks et al try to replicate or depersonalise using 'customer loyalty cards', so they gamble that people who bother with them drink e.g. 50% more coffee at a 10% lower price.

Lola said...

...(quite how the losses are split between the retailer and the actual credit card company is an unknown),... and the taxman/taxpayer?

Mark Wadsworth said...

L, HMRC collect one-sixth of the nominal amount paid for that new dress, hi fi, whatever, as VAT and make it nigh impossible for retailer or credit card company to get anything back if the debt goes bad.

If the customer actually pays, then HMRC helps itself to another 28% or so as corporation tax.

formertory said...

....insisted I sign up for 3 years' interest free credit, so in the end I caved in and repaid it interest-free over three years

That's where it gets interesting and different priorities start to emerge because of different incentives.

The finance house and the retailer will cooperate on a sales incentive to boost account numbers because it can be demonstrated that once on the hook with a card, people'll come back and (at least in principle) can be marketed to; you "sold" your demographic details in return for "zero interest" (which in reality is priced in, or course) or for "convenience" - a card.

The counter lady was quite happy for you to be just another refusee of their furniture. It doesn't matter to her that you didn't buy it; someone will.

She wasn't happy not to meet her personal target of [n] store cards / interest-free agreements sold. Presumably the bonus was bigger or more immediate for that than for the furniture sale. Or the penalty for not hitting target, worse.

Now pleeeeeaase just don't get me going on High Street bank branches and targeting of personal loan, credit card and other FS sales.

Mark Wadsworth said...

FT, I paid off the loan and never heard from them again. I'd be interested to know what you think about High Street bank branches and targeting of personal loan, credit card and other FS sales...

Derek said...

First degree price discrimination -- here's my take on it.

Imagine a village out in the middle of nowhere. Everyone in the village knows each other inside out including each other's financial positions. Everyone in the village has an old car but doesn't know how to maintain them. Except for one man who is the only car mechanic for 100 miles around.

Because the car mechanic knows everyone else's net worth to the penny, knows that they can't resell what he sells them and has them all over a barrel he can charge each of his customers exactly as much they are willing and able to pay, for, say, changing the tyres. His only regard for his own costs is that they are at least covered. Other than that he can, and does, charge as much as the individual user "wants" to pay. That mechanic is indulging in first degree price discrimination.

It's a bit of a theoretical concept because the conditions under which it is possible rarely arise. As far as I can see, you need a monopolist/cartel, a good which can't be resold, and perfect knowledge of the demand level for each and every buyer.

Mark Wadsworth said...

D, aha, that's what I alluded to in para number 2 about what doctors did in pre-NHS days.

Anonymous said...

The OFT report on store cards in 2005 said:

The OFT asked retailers to provide financial data relating to merchant fees and commission payments for the past three years. It appears that the net payments
(the average per active card of the difference between commission received and merchant fee paid from retailer to provider) can be positive for some retailers
but negative for others. The net payments from retailers to card providers per active card in circulation range from + £5.00 to - £2.50 per year, but if no
commission had been paid to the retailer the payment to the provider could be in excess of £6.00 per active card.
Retailers receiving a positive net payment often have a large customer base of active cards.

Basically, big retailers actually make a profit from the cards themselves as well as from the extra sales that result.

Mark Wadsworth said...

AC, that's good background, but those payments are relatively tiny, nothing compared to the hundreds or thousands of pounds that people are supposed to spend on store cards.

More interesting is how the bad debts are shared between retailer and card issuer.