Chapter 14 Pricing Techniques

Chapter 14Pricing Techniques + = 1 1 3

The Marketing Mix and Pricing • Product, promotion, place, positioning and pace are the five marketing mix elements constitute the firm’s instruments to create value in the marketplace • Price is the element of the marketing mix that differs essentially from the other five elements in that it is the firm’s instrument to capture this value in the profit it earns

Pricing - The Harvest of Your Profit Potential • If product development, promotion, distribution, positioning and speed of entry sow the seeds of business success, effective pricing is the harvest • Effective pricing cannot compensate for poor execution on the five elements, but ineffective pricing can prevent those efforts from resulting in financial success

Strategic Pricing Questions • The failure to integrate value-creating activities with pricing decisions leads to ineffective pricing and business mediocrity • To achieve superior, sustainanble profitability, pricing must become an integral part of strategy, not an afterthought • Strategic pricers ask the right questions in: Customers->Value->Price->Cost->Product

Strategic Pricing Questions (cont.) • “What costs can we afford to incur, given the prices achievable in the market, and still earn a profit?” • “What is our product worth to this customer and how can we better communicate this value, thus justifying our price?” • “What level of sales or market share can we most profitably achieve?”

The Imperatives of Strategic Pricing • Strategic pricing requires anticipating price levels before product development • Strategic pricing requires a new relationship between marketing and finance - it is actually the interface between the two • Value is best understood by marketing and sales while the constraining financial objectives are best understood by finance

Pricing techniques • Cost-plus pricing • Multiproduct firm pricing • Price discrimination • Transfer pricing

Cost-plus Pricing Two steps: • The firm estimates the cost per unit of output of the product • The firm adds a markup to the estimated average cost Markup = (Price - Cost) / Cost

Target Return Figure P = L + M + K + F/Q + (PA)/Q where: P is price L is unit labor cost M is unit material cost K is unit marketing cost F is fixed cost Q is units of output A is total gross operating assets Pis desired profit rate on assets

The Cost-Plus Delusion • Financial prudence, by this view, is achieved by pricing every product/service to yield a fair return over all costs • The Fundamental Problem is: In most industries, it is impossible to determine a product’s unit cost before determining its price because unit costs change with volume - due to “fixed” costs depending on volume

The Cost-Plus Delusion (cont.) • A price increase to “cover” higher fixed costs reduces sales further and causes unit cost to rise even higher -> reducing profits • A price cut causes sales to increase, spreading fixed costs over more units, making unit costs decline->increasing profit • Instead of pricing reactively to cover costs and profit objectives, price proactively

The Cost-Plus Delusion (cont.) • Cost-driven pricing leads to overpricing in weak markets and underpricing in strong ones - the opposite of strategic pricing • The only way to ensure profitable pricing is to let anticipated pricing determine the costs incurred rather than the other way around • Value-based pricing must begin before investments are made

Role of Pricing in Product Development • The nature of Cost-based Pricing: Product->Cost->Price->Value->Customers • The nature of Value-based Pricing: Customers->Value->Price->Cost->Product

The Customer-Driven Pricing Fallacy • The purpose of customer-driven pricing is to create satisfied customers • While this seems laudable, customer satisfaction can usually be bought by discounting sufficiently, but this may be at the cost of financial success • The purpose of strategic pricing is to price profitably by capturing more value, not necessarily by making more sales

Problems with Customer-Driven Pricing • Problem 1: Sophisticated buyers are rarely honest about how much they are actually willing to pay for a product • Problem 2: The job of sales and marketing is not simply to process orders at whatever price customers are willing to pay - it is to raise customers’ willingness to pay a price that better reflects the product’s true value

Pitfalls of Competition-Driven Pricing • In this view, pricing is a tool to achieve sales objectives such as increasing market share • Market-share goals usually produce greater profit. Priorities are confused, however, when managers reduce the profitability of prices to achieve the market-share goal. Price cuts are matched and LT profits suffer

Pitfalls of Competition-Driven Pricing (cont.) • The goal of strategic pricing is to find the combination of margin and market share that maximizes profitability over the long term. Often the most profitable price is one that substantially restricts market share relative to the competition (e.g. Godiva, BMW, Peterbilt Trucks, Snap-On Tools) • Goal of strategic pricing is to capture a substantial value-created share for the firm

Planning for Effective Pricing • Like most marketing decisions, pricing is an art, based on good judgment & calculations • An effective pricing strategy requires that: • Manager must understand how costs, customers and competition determine the p-environment • Strategic price formulation then begins with setting strategic objectives • Set concrete and deadline-bound goals • Decide tactics as specific actions for strategy

Basic Pricing Strategies • Basic Pricing Rule for Price Takers: Under Pure Competition, firms are Price Takers. Consequently, the manager has no control over market price. The only feasible strategy is the Least Cost Strategy where the manager tries to minimize the costs of manufacture and sale or tries to create differentiation on some dimension, if at all possible.

Basic Pricing Strategies (cont.) • Basic Pricing Rule for Price Searchers: There is a trade-off between selling many units at a low price and selling only a few units at a high price • Manager of a firm with market power balances off these two forces by • choosing output where MR=MC • the profit-maximizing price is the maximum price consumers will pay for this output

Simple Pricing Rule for Price Searchers • Marginal Revenue for a Price Searcher is: MR = P[(1+EF)/EF] where EF is the own price elasticity of demand for firm’s product & P is the price • Since MR = MC, then P[(1+EF)/EF] = MC or, alternatively, P = [EF/(1+EF)] MC that is, P = (K) MC where K = [EF/(1+EF)] and is the profit-max markup factor

Simple Pricing Rule: Observations • Given EF, the manager can calculate P • The more elastic the demand for the firm’s product, the lower the profit-maximizing markup and hence price. In the case of perfect elasticity, P = MC • The higher the marginal cost, the higher the profit-maximizing price

Other Pricing Strategies • Pricing Strategies for Extracting Consumer Surplus from Consumers • Price discrimination • Two-part pricing • Block pricing • Commodity bundling • Pricing Strategies for Special Cost/Demand • Peak-Load Pricing • Cross subsidization

Other Pricing Strategies (cont) • Price Strategies in Markets with Intense Competition • Price Matching • Inducing Brand Loyalty • Randomized Pricing • Multiple Product Pricing • Joint Product Pricing • Transfer Pricing

Price Discrimination • Price discrimination is when a seller charges different consumers different prices for the same good or service. • Price discrimination can occur when a price searcher is able to: • identify groups of customers with different price elasticities of demand • prevent customers from re-trading the product.

Price Discrimination • Sellers may gain from price discrimination by charging: • higher prices to groups with more inelastic demand • lower prices to groups with more elastic demand • Price discrimination generally leads to more output and additional gains from trade

Price discrimination Occurs when the same product is sold for more than one price $ P2 MC P1 D2 G R2 D1 R1 Output Q1 Q2 Q

Price Price Net Operating Revenuefrom Business Travelers ($500*60) = $30,000 Net Operating Revenue($300*100) = $30,000 $700 $700 Net Operating Revenue from Others ($200*60) = $12,000 $600 $600 $500 $500 $400 $400 $300 $300 $200 $200 $100 $100 MC MC D MR D Quantity /Time Quantity /Time PriceDiscrimination SinglePrice The Economics of Price Discrimination • Consider the market for airline travel where the MC per traveler is $100. • If the airline charges all customers the same price, profits will be maximized where MC = MR (P = $400 and q = 100). Net Operating Revenue is equal to TR ($40,000) - operating costs ($10,000). • If the airline charges different prices (price discrimination), it will be able to increase net revenues. If the firm charges a higher price ($600) to business travelers (who have a highly inelastic demand) and a lower price ($300) to other travelers (who have a more elastic demand), it is able to increase Net Operating Revenue to $42,000. • If sellers can segment their market, they can gain by charging higher prices to consumers with a less elastic demand and offering discounts to those with a more elastic demand. 100 60 120

Price Discrimination • Price Discrimination involves charging different consumers different prices • Conditions for Price Discrimination: • Consumers are partitioned into two or more types, each with different elasticities of demand • the firm has some means of identifying who belongs to which type • there is no possibility of resale between groups • General Rule: Price so that MR1=MR2=MC

Price Discrimination (cont.) • Price Discrimination Rule: To maximize profits, a price-discriminating firm with market power produces the output at which the marginal revenue to each group equals marginal cost: MR1 = P1[(1+E1)/E1] = MC and MR2 = P2[(1+E2)/E2] = MC

Types of price discrimination • First-degree: the firm is aware of each buyer’s demand curve • Second-degree: the firm charges a different price, depending on the quantity each buyer purchases • Third-degree: the firm breaks buyers into groups based upon their price elasticity of demand

Two-Part Pricing • With Two-Part Pricing, a firm charges a fixed fee for the right to purchase its goods, plus a per-unit charge for each unit purchased (athletic clubs, golf clubs, etc.) • Two-Part Pricing Rule: Charge a per-unit price that equals marginal cost, plus a fixed fee equal to the consumer surplus each consumer receives at this per unit price

Block Pricing • Block Pricing involves the firm packaging units of a product and selling them as one package so as to earn an amount larger than that obtained from a simple per-unit price (“six-packs”, warehouse store prices, etc.) • The profit-maximizing price under block pricing is the total value the consumer receives for the package, including consumer surplus

Commodity Bundling • Commodity Bundling is the practice of bundling two or more products together and selling them at a single “bundle price” (e.g. travel company package deals, cars, computers, etc.)

Peak-Load Pricing • Peak-load Pricing involves the firm charging higher prices during periods of high demand and lower prices during periods of off-peak demand • Peak-load Pricing Rule: Charge a higher price during peak times than is charged during off-peak times so that MR=MC during each period

Cross Subsidies • A firm that engages in Cross-Subsidization uses profits made with one product to subsidize sales of another product • It is relevant in situations where a firm has cost complementarities and the demand by consumers for a group of products is interdependent

Price Matching • Price Matching is a strategy in which the firm advertises a price and promises to match any lower price offered by a competitor • Firm need not monitor the prices charged by rivals • Prevention device for consumers claiming to have found a lower price when they did not • Not feasible if one firm has lower costs

Inducing Brand Loyalty • By inducing Brand Loyalty a firm reduces the number of “switchers” • Several Methods: • Comparative advertising • Frequent user programs • Club membership

Randomized Pricing • With a Randomized Pricing Strategy, a firm varies its price from hour to hour or day to day basis, consequently • consumers cannot learn from experience which firm charges the lower price thus reducing “shopping” for the best price • it reduces the ability of rival firms to undercut a firm’s price

The Multiple-product firm TR = TRX + TRY MRX =dTR/dQX = dTRX/dQX+ dTRY/dQX MRY=dTR/dQY = dTRX/dQY+ dTRY/dQY

Optimal pricing for joint products: fixed proportions $$ Total MR MC PA DemandA PB MRA DemandB MRB Output Q

$$ Total MR MC PA DemandA PB MRA DemandB MRB Output Q0 Q1 Optimal pricing for joint products: fixed proportions

Tying • Occurs when a firm sells a product, the use of which requires the consumption of a complementary product • The consumer is required to buy the complementary product from the firm selling the product itself

Transfer Pricing • Occurs in large firms when one division sells product to another division • The transfer price is the price at which the transfer of product takes place within a firm

Chapter 14 Pricing Techniques