notes

# Pricing Strategy

Price can be defined as the overall sacrifice a customer is willing to make to acquire a product.

# Five Cs of Pricing

# Company Objectives

A firm's pricing strategy should align with their overall objectives. A firm can be characterized as one of four types based on their strategic goal.

  • Profit orientated: Implement three pricing strategies revolving around profits
    • Target profit pricing -> Set price to reach a specific profit goal
    • Maximize profit -> Use economic theory to find price that maximizes profits
    • Target return pricing -> Set price that maximizes return on investment
  • Sales oriented: Sets prices to maximize sales (unit sales/dollar sales, etc)
    • Sometimes as part of an overall goal to gain market share
    • Lowest priced product not always most dominant
    • Some firms utilize premium pricing -> attract customers who care most about quality and/or money is not a problem
  • Competitor oriented: Sets prices relative to competition only
    • Competitive parity -> Set price similar to competition
    • Status quo pricing -> Change price in response to competitor price changes
  • Customer oriented: Sets prices to maximize customer value

# Customers

Price directly affects customers' perecption of value.

  • For regular products, increase in price -> decrease in demand
  • For prestige products, increase in price -> increase in demand (up to a certain point)
    • Customers value the increase in prestige > increase in price

Price Elasticity

  • Measures how much demand changes as prices change
    • Market is said to be elastic if its PED is < -1; relatively small changes in price will lead to large increases in demand
    • Inelastic if PED is > -1 -> firms can freely increase price without much changes in demand

Some customers are more sensitive to price than others.

  • Firms respond to this through dynamic pricing -> a strategy to charge different customers different prices.

Factors Affecting Price Elasticity

  • Income effect: Change in demand of a product as consumer incomes change.
    • Generally higher incomes -> trend towards more expensive products.
  • Substitution effect: Availability of substitute products.
    • More substitute products -> higher elasticity of the product demand
  • Cross-price elasticity: Change in demand of a product in response to a change in price of another product
    • If an increase in price of one product -> increase in demand of another, then the two products are substitutes.
    • If an increase in price of one product -> decrease in demand of another, then the two products are complementary.

# Costs

  • Variable costs -> costs that vary with production volume
  • Fixed costs -> costs that don't vary with production volume
  • Total cost -> variable + fixed costs

Break-Even Analysis

Find break-even point -> point where total revenue = total costs.

  • Break-even point defined as fixed cost / contribution per unit
    • Contribution per unit is unit price - variable costs

# Competition

There are four levels of competition: monopoly, oligopolistic competition, monopolistic competition, and pure competition.

  • Monopoly
    • Market dominated by one firm
    • No price competition; price usually regulated by government or government breaks down monopoly to allow competition
  • Oligopolistic competition
    • Market dominated by few firms
    • Firms usually change prices in response to price changes of competitors -> may lead to price wars
    • May introduce predatory pricing -> deliberately set low prices to drive competition out of business
  • Monopolistic competition
    • Many competing firms with differentiated products
    • Customers perceive value not only on price but also product differences
    • Allows creation of unique value propositions
  • Pure competition
    • Many competing firms with substitutable products
    • Price set based on market forces (supply and demand)
    • Firms may move out of pure competition by providing a point of difference in their products

# Channel Members

Channel members refer to parties involved in distribution: manufacturers, wholesalers, retailers.

  • If members have different price orientations, conflicts may occur
  • Rise of gray markets: Legal but irregular channels of distribution to sell goods at lower prices than market
  • Manufacturers require signed agreements before retailers are allowed to be authorized

# Pricing Terms

  • Retail selling price (RSP)
  • Manufacturer selling price (MSP)
  • Gross margin = manufacture price - variable costs
  • Contribution margin = sales revenue - variable costs
  • Markup = RSP - MSP / MSP
  • Margin = RSP - MSP / RSP
  • Profit = gross margin - unit fixed cost

# Example

Feathers and Foam Ltd sells its duvet covers for $100 to Ed's Linens. The variable cost per duvet cover is $40. Ed's Linens prices it at $120 in its retail stores.

  • What is F&F's gross margin %? (100-40)/100 = 60%
  • What is Ed's markup? 120-100 = 20 / 100 = 20%
  • With a markup of 30%, what margin would Ed generate?
    • RSP = 1.3 * 100 = 130
    • Margin = 130 - 100 / 130 = 23%
  • If F&F sells 500 covers to Ed's, what is the total dollar contribution?
    • Total revenue = 500 * 100 = $50000
    • Total variable cost = 500 * 40 = $20000
    • Total dollar contribution = 50,000 - 20,000 = $30,000
  • If F&F were considering a price decrease of 5%, what number of units would they need to sell in order to generate the same dollar contribution?
    • New price = $95
    • Required revenue = $50,000
    • Quantity = 50,000/95 = 527 units

# Pricing Strategies

# Everyday Low Pricing (EDLP)

  • Set prices somewhere between market price and sale prices
  • On average prices will be lower than competitors

# High/Low Pricing

  • Provide sales where prices are temporarily lower
  • Attracts two segments: price insensitive individuals who are willing to pay the "high" price and price sensitive individuals looking to pay the "low" price
  • Uses reference price to compare sale prices
    • Increases perceived value as consumers see how much they are saving

# New Product Strategies

New products have their own pricing strategies because it is more difficult to determine the customer's perception of their value.

  • Market penetration pricing -> Set initially low prices to gain market share and build sales.
    • Experience curve effect -> Drop in unit costs as sales volume increases
    • Discourages competitors from entering market because of low margins
    • Late entrants would see higher unit costs unless they can quickly build volume
    • Drawbacks:
      • Firm must have capacity to keep up with rapid sales
      • Low prices may signal low quality
      • Not suitable for markets where individuals are willing to pay higher prices
  • Price skimming -> Set high initial price to attract innovators and early adopters, then slowly reduce prices
    • Product has to be innovative in some way
    • Reasons firms use price skimming:
      • Signal high quality to market
      • Test demand elasticity for the product (easy to lower price, hard to raise price)
      • Quickly earn back high R&D costs
    • Drawbacks:
      • Does not work if low barriers of entry -> competitors can simply charge lower prices
      • High unit costs associated with low sales volume -> tradeoff between high price and high production costs
      • Must eventually lower prices -> margins go down and initial buyers may be irritated at price drops

# Pricing Tactics

  • Promotional pricing -> markdowns/discounts/coupons/rebates
  • Bundling -> Packaging basket of products together at one price
  • Addons -> Base price for main product + any extras for complementary goods

# Deceptive or Illegal Price Advertising

  • Deceptive reference prices
    • Reference prices must be "bona fide" and not fictious
    • Difficult to determine what makes a reference price "bona fide"
  • Loss leader pricing -> pricing items at a loss to generate store traffic
    • Illegal in some states
  • Bait-and-switch -> lure customers with very low prices with the intent of not selling the low price item
    • Hard to prove because sellers would want customers to buy a higher-priced item instead
  • Predatory pricing -> set low prices with the intention of driving competitors out of business
  • Price discrimination -> sell same product to different resellers at different prices.
    • Ok if targeted to end consumers (e.g. seniors and students often get discounts)
  • Price fixing -> colluding with other firms to control prices
    • Horizontal -> firms that produce competing goods collude to control prices
    • Vertical -> parties at different levels of the same marketing channel (e.g. manufacturers, retailers) agree to fix price for end consumer

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