Pricing

Defining Price

• When you ask about the cost of a good or service, you're really asking how much you will have to give up in order to get it.
• For the business to increase value, it can either increase the perceived benefits or reduce the perceived costs. Both of these elements should be considered elements of price.
• Viewing price from the customer's perspective helps define value -- the most important basis for creating a competitive advantage.
• There are two different ways to look at the role price plays in a society; rational man and irrational man.

Terms Used to Describe Price

• From a customer's point of view, value is the sole justification for price.
• The price of an item is also called the price point, especially when it refers to stores that set a limited number of price points. The words charge and fee are often used to refer to the price of services.
• The transportation industry charges a fare for its services.

The Importance of Price to Marketers

• Price is important to marketers because it represents marketers' assessment of the value customers see in the product or service and are willing to pay for a product or service.
• Adjusting the price has a profound impact on the marketing strategy, and depending on the price elasticity of the product, it will often affect the demand and sales as well.
• Pricing contributes to how customers perceive a product or a service.

Value and Relative Value

• Value is the worth of goods and services as determined by markets.
• Something is only worth what someone is willing to pay for it.
• The utility for the seller is not as an object of usage, but as a source of income.
• In term of pricing, prices of valued items undergo questionable fluctuations.

Competitive Dynamics and Pricing

• Price Competition
• Nonprice Competition

Price Competition

• Price is a very important decision criteria that customers use to compare alternatives. It also contributes to the company's position.
• The pricing process normally begins with a decision about the company's pricing approach to the market.
• In general, a business can price itself to match its competition, price higher, or price lower.

Nonprice Competition

• Non-price competition can be contrasted with price competition, which is where a company tries to distinguish its product or service from competing products on the basis of a low price.
• Firms will engage in non-price competition, in spite of the additional costs involved, because it is usually more profitable than selling for a lower price and avoids the risk of a price war.
• Although any company can use a non-price competition strategy, it is most common among oligopolies and monopolistic competition, because these firms can be extremely competitive.
  

Demand Analysis

• The Demand Curve
• The Influence of Supply and Demand on Price
• Elasticity of Demand
• Yield Management Systems

The Demand Curve

• Demand does not only have to do with the need to have a product or a service, but it also involves the willingness and ability to buy it at the price charged for it.
• The demand curve for all consumers together follows from the demand curve of every individual consumer. The individual demands at each price are added together.
• The negative slope of the demand curve is often referred to as the "law of demand," which means people will buy more of a service, product, or resource as its price falls.

Figure 2

The Influence of Supply and Demand on Price

• There are four basic laws of supply and demand.
• Since determinants of supply and demand other than the price of the good in question are not explicitly represented in the supply-demand diagram, changes in the values of these variables are represented by moving the supply and demand curves (often described as "shifts" in the curves).
• Responses to changes in the price of the good are represented as movements along unchanged supply and demand curves. 

Supply and Demand

Elasticity of Demand

• Price elasticities are almost always negative; only goods which do not conform to the law of demand, such as a Veblen good and a Giffen good, have a positive PED.
• In general, the demand for a good is said to be inelastic (or relatively inelastic) when changes in price have a relatively small effect on the quantity of the good demanded.
• The demand for a good is said to be elastic (or relatively elastic) when changes in price have a relatively large effect on the quantity of a good demanded.
• A number of factors can thus affect the elasticity of demand for a good. Equation

$e_{\langle R\rangle}=\frac{\mathrm{d} Q / Q}{\mathrm{~d} P / P}$

Yield Management Systems

• Yield management is the process of understanding, anticipating, and influencing consumer behavior to maximize yield or profits from a fixed, perishable resource (such as airline seats or hotel room reservations).
• Yield management is particularly suitable when selling perishable products, which are goods that become unsellable at a point in time (for example, airline tickets just after a flight takes off).
• While yield management systems tend to generate higher revenues, the revenue streams tend to arrive later in the booking horizon as more capacity is held for late sale at premium prices.
  

Inputs to Pricing Decisions

• Marginal Analysis
• Fixed Costs
• Break-Even Analysis
• Organizational Objectives
• Other Inputs to Pricing Decisions

Marginal Analysis

• Firms tend to accomplish their objective of profit maximization by increasing their production until marginal revenue equals marginal cost.
• At the output level at which marginal revenue equals marginal cost, marginal profit is zero and this quantity is the one that maximizes profit.
• In some cases, a firm's demand and cost conditions are such that marginal profits are greater than zero for all levels of production up to a certain maximum; thus, output should be produced at the maximum level.

Marginal Profit Maximization

Fixed Costs

• The distinction between fixed and variable costs is crucial in forecasting the earnings generated by various changes in unit sales and thus the financial impact of proposed marketing campaigns.
• Fixed costs are not permanently fixed - they will change over time - but are fixed in relation to the quantity of production for the relevant period.
• Average fixed cost (AFC) is an economic term that refers to fixed costs of production (FC) divided by the quantity (Q) of output produced.

Fixed Costs and Variable Costs

Break - Even Analysis

• In the linear Cost-Volume-Profit Analysis model, the break-even unit of sales can be directly computed in terms of total revenue and total costs.
• Unit contribution margin is the marginal profit per unit, or alternatively the portion of each sale that contributes to fixed costs.
• Break-even analysis is a simple and useful analytical tool, yet has a number of limitations as well.

Break-Even Analysis Using Contribution Margin

Organizational Objectives

• A business can cut its costs, it can sell more, or it can find more profit with a better pricing strategy.
• When costs are already at their lowest and sales are hard to find, adopting a better pricing strategy is a key option to stay viable.
• A pivotal factor in determining a price is how consumers will perceive it. 

Other Inputs to Pricing Decisions

• Economic Value to Customers (EVC) is based on the insight that a customer will buy a product only if its value to them outweighs the value of the closest alternative.
• To sell a product, a firm needs to price at or below its competitor's price plus the value advantage its product has to the customer over the rival product.
• Price controls are governmental restrictions on the prices that can be charged for goods and services in a market.

Price Controls

Pricing Objectives

• Survival
• Profit
• Return on Investment
• Market Share/Sales
• Cash Flow
• Status Quo
• Product Quality

Survival

• New and improved products may hold the key to a firm's survival and ultimate success.
• All business enterprises must earn a long term profit in order to survive in the long run.
• Just as survival requires a long term profit for a business enterprise, profit requires sales. Sales patterns should be altered to ensure success.
• Management of all firms, large and small, are concerned with maintaining an adequate share of the market so their sales volume will enable the firm to survive and prosper. Prices must be set to attract the appropriate market segment in 

McDonald's Surviving the Recession

Profit

• In launching new products or considering the pricing of current products, managers often start with an idea of the dollar profit they desire and ask what level of sales will be needed to reach it. This can be done through profit-based sales targets.
• Profit is equal to total revenue (TR) minus total cost (TC). The profit maximizing output is the one at which this difference reaches its maximum. The corresponding price will depend on whether the firm is a perfect competitor. This is the TR-TC method.
• Marginal profit (Mπ) equals marginal revenue (MR) minus marginal cost (MC). If Total Profit Maximization MR is greater than MC at some level of output, marginal profit is positive and thus a greater quantity should be produced. When MR = MC, Mπ is zero and this quantity is the one that maximizes profit.

Total Profit Maximization

Return on Investment

• Return on investment is one way of considering profits in relation to capital invested.
• Marketing not only influences net profits but also can affect investment levels, too. New plants and equipment, inventories, and accounts receivable are three of the main categories of investments that can be affected by marketing decisions.
• ROI provides a snapshot of profitability adjusted for the size of the investment assets tied up in the enterprise.

Chart showing ROI

Market Share/Sales

• Marketers need to be able to translate sales targets into market share because this will determine whether forecasts are to be attained by growing with the market or by capturing share from competitors.
• Market share is a key indicator of market competitiveness - that is, how well a firm is doing compared to its competitors. It enables them to judge not only total market growth or decline but also trends in customers' selections among competitors.
• Losses in market share can signal serious long-term problems that require strategic adjustments. Firms with market shares below a certain level may not be viable.

Cash Flow

• Some companies will set prices so that they can recover cash flow as quickly as possible. This strategy could be due to the company spending too much of its resources on developing products.
• One way to get cash flow quickly is through seasonal discounts. Seasonal discounts are price reductions given on out-of-season merchandise.
• Another option is cash discounts. Cash discounts are reductions on the base price given to customers for paying cash or within some short time period.

Status Quo

• A small firm can avoid a price war by setting prices in line with its competition. It is best to respond to changes as quickly as possible or else it could signal to competitors that you are ready to engage in a price war.
• Charging what the competition is charging can be quite popular where costs are difficult to measure or where the response of competitors is uncertain.
• The major advantage of setting prices to maintain the status quo is that is requires little planning. It's pretty much a passive policy.

Product Quality

• Some of these consequences of poor quality include loss of business, liability, decreased productivity, and increased costs.
• Good quality has its own costs, including prevention, appraisal, and failure.
• Successful management of quality requires that managers have insights on various aspects of quality such as understanding the costs and benefits of quality and recognizing the consequences of poor quality.
• Understanding the determants of quality, such as design of the product and the "ease of use" of the product, will help managers price the products accordingly.

General Pricing Strategies

• Cost-Based Pricing
• Demand-Based Pricing
• Competitor-Based Pricing
• Markup Pricing
• Profit-Maximization Pricing

Cost-Based Pricing

• Implementation of cost-based pricing presents problems in practice.
• A company must know its costs to implement cost-based pricing.
• Costs are a function of sales, which are in turn a function of prices; therefore, the calculation of these values is circular.
• Cost-based pricing is misplaced in industries where there are high fixed costs and near-zero marginal costs.

Demand-Based Pricing

• Price skimming is a pricing strategy in which a marketer sets a relatively high price for a product or service at first, then lowers the price over time.
• Price discrimination exists when sales of identical goods or services are transacted at different prices from the same provider.
• Psychological pricing is a marketing practice based on the theory that certain prices have a psychological impact.
• Bundle pricing is a marketing strategy that involves offering several products for sale as one combined product.
• Penetration pricing is the pricing technique of setting a relatively low initial entry price, often lower than the eventual market price, to attract new customers.
• Value-based pricing sets prices primarily on the value, perceived or estimated, to the customer rather than on the cost of the product or historical prices.

Price Skimming

Competitor-Based Pricing

• Sometimes this simply takes the form of a firm copying their competitor's pricing and not conducting their own pricing research.
• Sometimes such pricing can take the form of a firm setting a market share objective and discounting their price relative to their competitor until they attain it.
• Its main advantage is ease of use. Extensive marketing research and statistical analysis are not required.
• Instead of setting market share objectives, firms should focus on identifying the most profitable segments to serve, and finding ways of profitably serving them while protecting themselves from price wars. 

Competitor Analysis

Markup Pricing

• Markup pricing is used primarily because it is easy to calculate and requires little information.
• The first step to determine markup price involves calculation of the cost of production, and the second step is to determine the markup over costs.
• In markup pricing, we use quantity to calculate price, but price is the determinant of quantity. To avoid this problem, the quantity is assumed.

Cost-Plus Price Equation

Profit-Maximization Pricing

• Fixed costs, which occur only in the short run, are incurred by the business at any level of output, including zero output.
• Variable costs change with the level of output, increasing as more product is generated.
• The profit-maximizing output is the one at which the difference between total cost and total revenue reaches its maximum.
• If a firm is not a perfect competitor in the output market, the price to sell the product at can be read off the demand curve at the firm's optimal quantity of output. 

Total Profit Maximization

Specific Pricing Strategies

• New Product Pricing
• Product Line Pricing
• Psychological Pricing
• Pricing During Difficult Economic Times
• Everyday Low Pricing
• High/Low Pricing
• Other Pricing Strategies

New Product Pricing

• Penetration pricing is the pricing technique of setting a relatively low initial entry price, often lower than the eventual market price, to attract new customers. The strategy works on the expectation that customers will switch to the new brand because of the lower price.
• Skimming involves goods being sold at higher prices so that fewer sales are needed to break even. By selling a product at a high price, sacrificing high sales to gain a high profit is therefore "skimming" the market.
• The decision of best strategy to use depends on a number of factors. A penetration strategy would generally be supported by the opportunity to keep costs low, and the anticipation of quick market entry by competitors. A skimming strategy is most appropriate when the opposite conditions exist.

Product Line Pricing

• Line pricing is beneficial to customers because they want and expect a wide assortment of goods, particularly shopping goods. Many small price differences for a given item can be confusing.
• From the seller's point of view, line pricing is simpler and more efficient to use. The product and service mix can then be tailored to select price points.
• Line pricing suffers during inflationary periods, where such a strategy can be inflexible.

Psychological Pricing

• Products and services frequently have customary prices in the minds of consumers. A customary price is one that customers identify with particular items.
• Odd prices appear to represent bargains or savings and therefore encourage buying. Thus, marketers often use odd prices that end in figures such as 5, 7, 8, or 9.
• A somewhat related pricing strategy is combination pricing, such as two-for-one or buy-one-get-one-free. Consumers tend to react very positively to these pricing techniques.

Pricing During Difficult Economic Times

• Many companies are tempted to slash prices during a recession, but this strategy should be carefully considered.
• Cutting prices can degrade the value of the brand, lead to a price war, and also lead customers to put off buying when times are good in expectation of price cuts when times are bad.
• Unlike traditional brands that are designed with target consumers in mind, fighter brands are created specifically to combat a competitor that is threatening to take market share away from a company's main brand.
• When the strategy works, a fighter brand not only defeats a low-priced competitor, but also opens up a new market.

Everyday Low Pricing

• Every day low pricing saves retail stores the effort and expense needed to mark down prices in the store during sale events, as well as to market these events.
• One 1994 study of an 86-store supermarket grocery chain in the United States concluded that a 10% EDLP price decrease in a category increased sales volume by 3%, while a 10% Hi-Low price increase led to a 3% sales decrease.
• Trader Joe's is an example of successful EDLP. It is unique because it does not market itself like other grocery stores do, nor are customers required to obtain membership to enjoy its low prices - at Trader Joe's, its everyday low prices are available to everyone.

High/Low Pricing

• The lower promotional prices are designed to bring customers to the organization where the customer is offered the promotional product as well as the regular higher priced products.
• The basic type of customers for the firms adopting high-low price do not have a clear idea about what a product's price would typically be or have a strong belief that "discount sales = low price".
• The way competition prevails in the shoe and fashion industry is through high-low price strategies.

High-Low Pricing Strategies

Other Pricing Strategies

• Cost-plus pricing is the simplest pricing method. The firm calculates the cost of producing the product and adds on a percentage (profit) to that price to give the selling price.
• Dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customer's willingness to pay. The airline industry is often cited as a success story. Most of the passengers on any given airplane have paid different ticket prices for the same flight.
• Non-price competition means that organizations use strategies other than price to attract customers. Advertising,credit, delivery, displays, private brands, and convenience are all examples of tools used in non-price competition.

Airlines and Dynamic Pricing

Pricing Tactics

• Discounting
• Value-Based Pricing
• Geographic Pricing
• Transfer Pricing
• Consumer Penalties

Discounting

• Seasonal discounts are price reductions given for out-of-season merchandise.
• Cash discounts are reductions on base price given to customers for paying cash or within some short time period.
• Senior discounts are discounts offered to customers who are above a certain age, typically a round number such as 50, 55, 60, 65, 70, and 75.
• Educational or student discounts are price reductions given to members of educational institutions, usually students but possibly also to educators and to other institution staff.
• Quantity discounts are reductions in base price given as the result of a buyer purchasing some predetermined quantity of merchandise. A noncumulative quantity discount applies to each purchase and is intended to encourage buyers  to make larger purchases.

Value-Based Pricing

• Value-based pricing is most successful when products are sold based on emotions (fashion), in niche markets, in shortages (e.g., drinks at open air festival at a hot summer day), or for indispensable add-ons (e.g., printer cartridges, headsets for cell phones).
• Although it would be nice to assume that a business has the freedom to set any price it chooses, this is not always the case. Firms are limited by constraints such as government restrictions.
• Value-based pricing is predicated upon an understanding of customer value. In many settings, gaining this understanding requires primary research through interviews with customers and various surveys. The results of such surveys often depict a customer's willingness to pay.

Geographic Pricing

• Zone pricing is a pricing tactic where prices increase as shipping distances increase. This is sometimes done by drawing concentric circles on a map with the plant or warehouse at the center and each circle defining the boundary of a price zone.
• FOB origin (Free on Board origin) is a pricing tactic where the shipping cost from the factory or warehouse is paid by the purchaser. Ownership of the goods is transferred to the buyer as soon as it leaves the point of origin.
• Freight-absorption pricing is where the seller absorbs all or part of the cost of transportation. This amounts to a price discount and is used as a promotional tactic.

Transfer Pricing

• Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges of goods and services within a multi-divisional organization, particularly in regard to cross-border transactions.
• Intra-company transactions across borders are growing rapidly and are becoming much more complex. Compliance with the differing requirements of multiple overlapping tax jurisdictions is a complicated and time-consuming task.
• Division managers are provided incentives to maximize their own division's profits. The firm must set the optimal transfer prices to maximize company profits or each division will try to maximize their own profits leading to lower overall profits for the firm.

Optimal Transfer Pricing Diagram

Consumer Penalties

• Most organizations reserve the right to restrict a user's access to the service if they violate the terms in the agreement.
• Other forms of penalties can exist as fees. An early-termination fee is charged by a company when a customer wants or needs to be released from a contract before it expires.
• Early payment penalties and fees also exist when people pay off a loan earlier than expected, making a firm lose out on interest fees. The fees typically negate this advantage at least in part.

Mobile phones

Pricing Legal Concerns

• Unfair Trade Practices
• Illegal Price Advertising
• Predatory Pricing
• Price Discrimination
• Price Fixing

Unfair Trade Practices

• Unfair business acts are generally prohibited by law, so committing them may force a company to provide for the award of compensatory damages, punitive damages, and payment of the plaintiff's legal fees.
• Two major forms of unfair trade practice are fraud and misrepresentation.
• Unfair trade practices not only affect consumers, but may affect other stakeholders as well, such as competitors and investors.

Illegal Price Advertising

• While deceptive price advertising is usually illegal, in practice, it can be difficult to stop or difficult to enforce any law relating to it.
• False and deceptive advertising methods include hidden fees and surcharges, "going out of business" sales, manipulation of measurement units, fillers, oversized packaging, bait and switch, etc.
• Advertising need not be proven to be deceptive for it to be illegal. What matters is the potential to deceive, which happens when consumers see the advertising to be stating to them, explicitly or implicitly, a claim that they may not realize is false and material. 

Listerine advertisement, 1932

Predatory Pricing

• After the weaker competitors are driven out, the surviving business can raise prices to supra competitive levels. The predator hopes to generate revenues and profits in the future that will more than offset the losses it incurred during the predatory pricing period.
• While predatory pricing is illegal in many countries, it is very difficult to prove that a company has undertaken a strategy of predatory pricing rather than competitive pricing.
• Critics argue that the prey know that the predator cannot sustain low prices forever, so it is essentially a game of chicken: if they can ride it out, they will survive.

Oil refinery

Price Discrimination

• In theoretical markets there exists perfect information, no transaction costs, and perfect substitutes, and in these cases price discrimination can only exist in monopolistic or oligopolistic markets.
• For price discrimination to take place, companies must be able to identify market segments by their price elasticity of demand, and they must be able to enforce the scheme.
• There are four degrees of price discrimination (including reverse price discrimination), that all occur under slightly different circumstances, depending on the market structure and the company's ability to discriminate.

Third degree price discrimination

Price Fixing

• Price fixing is inefficient, transferring some of the consumer surplus to producers and results in a deadweight loss.
• Price fixing is illegal in most developed countries. In the US, price fixing can be prosecuted as a criminal federal offense. However, price fixing is perfectly legal in many countries.
• When sovereign nations rather than individual firms come together to control prices, the cartel may be protected from lawsuits and criminal antitrust prosecution.

Source: Boundless
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