key term - Cream Skimming

Definition

Cream skimming is a business strategy where a company targets the most profitable customers or market segments, while neglecting the less profitable ones. This practice is often seen in industries with imperfect information and asymmetric information, where companies have an advantage in identifying and catering to the most lucrative customers.

5 Must Know Facts For Your Next Test

1. Cream skimming allows companies to maximize profits by focusing on the most lucrative customers, but it can lead to a lack of service or availability for less profitable market segments.
2. Imperfect information and information asymmetry enable cream skimming, as companies can leverage their superior knowledge to identify and target the most desirable customers.
3. Cream skimming can exacerbate adverse selection, as the less profitable customers are left without adequate service or options, further reinforcing the information asymmetry.
4. Market segmentation is a key strategy used in cream skimming, as companies divide the market into distinct groups and allocate resources to the most profitable segments.
5. Regulatory bodies may intervene to prevent cream skimming, as it can lead to market failures and a lack of access to essential goods or services for certain segments of the population.

Review Questions

• Explain how cream skimming is related to the problem of imperfect information.
  • Cream skimming is closely tied to the problem of imperfect information because it relies on companies having superior knowledge about the market and customer characteristics. With imperfect information, companies can leverage their advantage to identify and target the most profitable customers, neglecting the less lucrative segments. This information asymmetry allows companies to engage in cream skimming, maximizing their profits while potentially leaving certain customers underserved.
• Describe how cream skimming can exacerbate adverse selection in a market.
  • Cream skimming can worsen the problem of adverse selection by further concentrating the less desirable customers in the market. When companies focus their efforts on the most profitable segments, the remaining customers become even less attractive, leading to a vicious cycle where the less profitable customers have fewer options and are perceived as riskier. This reinforces the information asymmetry and makes it even more challenging for these customers to access the products or services they need, ultimately contributing to market failure.
• Evaluate the potential consequences of widespread cream skimming in a market and discuss potential regulatory interventions to address this issue.
  • Widespread cream skimming in a market can have significant negative consequences, such as a lack of access to essential goods or services for certain segments of the population, exacerbation of income inequality, and the potential for market failure. Regulatory bodies may intervene to prevent cream skimming and ensure that all customers, regardless of their profitability, have access to the necessary products or services. Possible interventions could include price controls, mandates for universal service, or the establishment of public or non-profit alternatives to provide coverage for the neglected market segments. Ultimately, the goal of such regulations would be to address the information asymmetry and adverse selection issues that enable cream skimming, promoting a more equitable and efficient market.

Related terms

Adverse Selection:

Adverse selection occurs when there is an information asymmetry between buyers and sellers, leading to a market failure where the wrong customers are attracted to a product or service.

Information Asymmetry:

Information asymmetry exists when one party in a transaction has more or better information than the other, leading to an imbalance of power in the relationship.

Market Segmentation:

Market segmentation is the process of dividing a market into distinct groups of customers with different needs, characteristics, or behaviors, who might require separate products or marketing mixes.