12 Price Determinationand Pricing Strategies
Learning Objectives • After studying this chapter, you should be able to: • Discuss the interrelationships among price, demand, demand elasticity, and revenue. • Understand methods for determining price. • Recognize the different pricing strategies and the conditions that best suit the choice of a strategy. • Recognize the importance of adapting prices under shifting economic and competitive situations. • Understand the ethical considerations involved in setting and communicating prices.
eBay • Founded in 1995, eBay continues to be among the most consistently profitable Internet companies; it is used by millions of consumers worldwide. The site offers online trading opportunities in which consumers can bid on products and sellers can auction items for sale. Of particular importance, and unlike traditional exchange relationships in the marketplace, buyers have significant input into the determination of prices.
Price Determination: An Overview Exhibit 12-1
Price Determination: An Overview • The relationship between price and demand is expressed in the traditional market demand curve labeled D below. Under normal conditions, customers buy more as prices drop; they buy less when prices rise. Exhibit 12-2
% Change in quantity demanded Price Elasticity of Demand = % Change in Price Price Elasticity of Demand • Price elasticity of demand is a basic business concept. The relationship between price and quantity demanded varies; as one increases, the other decreases. Price elasticity of demand is computed as follows: • Elastic demand exists when small price changes result in large changes in demand. When demand is elastic, a small decrease in price increases total revenues. Elastic demand prevails in the motor vehicles, engineering products, furniture, and professional services industries.
Demand Exhibit 12-3 • Inelastic demand exists when price changes do not result in significant changes in demand. • Cross elasticity of demand relates the percentage change in quantity demanded for one product to percentage price changes for other products.
TC = (VC X Q) + FC Total Costs • Fixed costs (FC) such as plant and large equipment investments, interest paid on loans, and the costs of production facilities, cannot be changed in the short run and do not vary with the quantity produced. • Variable costs (VC) such as wages and raw materials change with the level of output. • Total costs (TC) are the sum of variable costs (VC) and fixed costs (FC). Variable costs are made up of the variable cost per unit times the number or quantity of units manufactured (Q):
Total Revenue (TR) = Price X Quantity Total Revenue • Marginal costs (MC) are incurred in producing one additional unit of output. • Marginal revenue (MR) is the additional revenue the firm will receive if one more unit of product is sold. This amount typically represents the price of the product. • Total revenue (TR) is total sales, or price times the quantity sold:
Profits = Total Revenue (TR) – Total Costs Profits • To determine the price that maximizes profits, the firm combines cost information with demand or revenue information: • This difference is greatest at the point where profits are maximized, where the firm’s marginal revenue (MR) equals marginal cost (MC). When marginal revenue exceeds marginal cost, additional profits can be made by producing and selling more product.
Markup Markup as a % of selling price = Selling Price Markup Markup as a % of cost = Cost Markup Pricing • Retailers typically use some form of markup pricing, where markup is the difference between the cost of an item and the retail price, expressed as a percentage. A product’s price is determined by adding a set percentage to the cost of the product.
Break-Even Analysis Exhibit 12-4 • Break-even analysis is a useful guide for pricing decisions. It involves calculating the number of units that must be sold at a certain price for the firm to cover costs and, hence, break even. • The break-even point(BEP) is determined by the intersection of the total revenue line (TR = P X Q) and the total cost line (TC = FC + VC X Q). The area between the two lines and to the right of the intersection represents profits. To make a profit, the quantity sold must exceed the BEP.
(Desired return X Invested capital) Price = Unit Cost + Expected unit sales Target-Return Pricing • Target-return pricing is a cost-oriented approach that sets prices to achieve some desired rate of return. Cost and profit estimates are based on some expected volume or sales level. The price is determined using this equation: Target-return pricing forecasts a fair or needed rate of return.
Role of Cost in Pricing Exhibit 12-5 • Some Japanese firms use an approach to pricing that recognizes the effects of price on demand and the role of costs in determining demand. • The Japanese specify a target cost based on the price they believe the market is most likely to accept. Designers and engineers then meet target costs.
Prices and Customer Value Exhibit 12-6
Pricing Strategies Differential Prices Second-market discounting Periodic discounting Product Line PricingBundlingPremium pricingPartitional pricing Competitive PricingPenetration pricingPrice signaling Going-rate pricing Psychological PricingOdd-even pricingCustomary pricing One-sided claims
Price Decreases • Price reductions are risky. Competitive retaliation to price decreases is particularly important. Firms may encounter three traps in reducing prices: • Low-quality trap—Buyers may question the quality of low-priced products. • Fragile market share trap—Price-sensitive buyers may switch to the next lower-priced product that comes along. • Shallow pockets trap—Higher-priced competitors that reduce prices also may have longer staying power due to higher margins.
Price Changes • Considerable research has been conducted regarding the effects of price changes. These studies have involved experiments in which price levels were systematically varied and analyses of scanner data were collected in-store. A review of these studies yielded the following conclusions: • Temporary retail price reductions substantially increase store traffic and sales. • Large-market-share brands are hurt less by price changes from smaller competitors. • Frequent price dealing lowers consumers’ reference prices, which may hurt brand equity. • Price changes for high-quality brands affect weaker brands and private-label brands disproportionately.
Price Discounts and Allowances Cash Discounts Marketers offer cash discountsfor prompt payment by retailers. Terms of payment may be “3/10, net 30” Trade Sales Promotion Allowances Trade sales promotion allowancesare concessions a manufacturer pays or allocates to wholesalers or retailers to promote its products. Quantity Discounts Marketers give quantity discountswhen the customer buys large quantities of a product.
Geographic Pricing FOB Origin Pricing FOBstands for “free on board,” meaning the goods are placed on a carrier and shipped to the customer. Uniform Delivered Price Using a uniform delivered price, the company charges each customer an average freight amount. Zone Pricing Zone pricing is an approach between the previous two. Customers within an area are charged a common price. Freight Absorption Pricing Freight absorption pricing is a form of geographical pricing. The seller absorbs freight costs to attract more business.
Competitive Pricing • In the United States, retail prices for most consumer goods normally are not negotiable. However, outside the United States, price negotiations for consumer goods occur regularly. Likewise, almost all business-to-business purchases are negotiated to some extent. Sealed-bid Pricing Sealed-bid pricing is unique in that the buyer determines the pricing approach and the eventual price. Reverse Auctions Reverse auctions, in which sellers bid instead of buyers and prices fall instead of rise, enable buyers to negotiate lower prices from multiple suppliers.
Ethical Issues Bait and Switch A bait and switch occurs when the retailer advertises but does not actually offer a reasonable amount of the promoted product. Predatory Pricing In some instances, companies charge very low prices to drive competition from the market. This practice is called predatory pricing. Unit Pricing Unit pricing presents price information on a per-unit weight or volume basis to facilitate price comparisons across brands and across package sizes within brands.
Summary • After studying this chapter, you should be able to: • Discuss the interrelationships among price, demand, demand elasticity, and revenue. • Understand methods for determining price. • Recognize the different pricing strategies and the conditions that best suit the choice of a strategy. • Recognize the importance of adapting prices under shifting economic and competitive situations. • Understand the ethical considerations involved in setting and communicating prices.