An economist must be “mathematician, historian, statesman, philosopher, in some degree……as aloof and incorruptible as an artist, yet sometimes as near the earth as a politician.”
John Maynard Keynes
What is Price?
This seems a rather inane question, as we have grown up in a world where everything that we required for subsistence was bought for a price. However, micro and macroeconomists have spent a lifetime trying to nail down a suitable answer for this simple question. Out of the millions of answers on the net, The Business Dictionary defines Price as ‘Market value, or agreed exchange value that will purchase a definite quantity, weight, or other measure of a good or service.’ Knowthis.com takes it further: “In general terms price is a component of an exchange or transaction that takes place between two parties and refers to what must be given up by one party (i.e., buyer) in order to obtain something offered by another party (i.e., seller).” This view provides a somewhat limited explanation of what price means to participants in the transaction. In fact, price means different things to different participants in an exchange:
· Buyers’ View – “For those making a purchase, such as final customers, price refers to what must be given up to obtain benefits. In most cases what is given up is financial consideration (e.g., money) in exchange for acquiring access to a good or service. But financial consideration is not always what the buyer gives up. Sometimes in a barter situation a buyer may acquire a product by giving up their own product. For instance, farmers may exchange cattle for crops. Also, buyers may also give up other things to acquire the benefits of a product that are not direct financial payments (e.g., time to learn to use the product).”
· Sellers’ View – “To sellers in a transaction, price reflects the revenue generated for each product sold and, thus, is an important factor in determining profit. For marketing organizations price also serves as a marketing tool and is a key element in marketing promotions. For example, most retailers highlight product pricing in their advertising campaigns.”
Price is commonly confused with the notion of cost. “Technically, though, these are different concepts. Price is what a buyer pays to acquire products from a seller. Cost concerns the seller’s investment (e.g., manufacturing expense) in the product being exchanged with a buyer. For marketing organizations seeking to make a profit, the hope is that price will exceed cost so the organization can see financial gain from the transaction.
We need to understand one more term: Market. I will use a definition that is extracted from what has been said so far. A market consists of the buyers and sellers of a ‘good’ or ‘service.’ Dr. Anindya Sen, Faculty at Indian Institute of Management, Kolkata, says, “In a market, the
interaction between buyers and sellers determines the prices that are established and the quantities that are transacted. The two sides of a market are represented through the forces of demand and supply.” Before going any further, I will first explain the general process in use as pricing strategy to determine market price. It will be required slightly later in this paper.
The Market Demand Curve
The market demand schedule shows the amounts of the commodity that buyers are prepared to pay for at different prices. When the relationship between price and quantity is plotted as a graph, we get a market demand curve. A demand curve thus shows graphically the quantity demanded at each price, or, alternatively, represents the maximum price buyers are willing to pay for each quantity. In the graph below, Quantity ‘Q’ is shown on the X axis and Price ‘P’ on the ‘Y’ axis. I will also take the demand curve (DD′) to be linear, for ease of further explanation. Usually, the line joining D, which shows the highest price willing to be paid, and D′, which shows maximum quantity willing to be bought, i.e. DD′ is a curve.
The slope of the line DD′ is downwards, or negative. The quantity demanded decreases as the price increases. The line DD′ is the aggregate of all demand curves. The shape of DD′ will depend on the ‘Parameters’ D and D′ and not on P and Q, which are ‘Variables.’
The Market Supply Curve
The market supply schedule shows the amounts of the commodity the suppliers are prepared to sell at differing prices. The market supply function expresses this relationship between the quantities supplied and prices and when this relationship is plotted as a graph, we get the market supply curve. A supply curve therefore represents graphically the quantity supplied at each price. It may also be thought of as representing the minimum price that sellers want for supplying each quantity. Though this curve does tend to have a slight curve, I will take it as linear. Variations in P and Q will obviously affect supply. If advancements in technology reduce production cost, the curve will shift downwards to the right. If input prices increase, the exact reverse will happen.
What will be the actual price in the market and the actual quantity transacted? Market
Equilibrium occurs when the prevailing price equates quantity demanded to quantity supplied. The ‘Equilibrium’ refers to the pairing of price/quantity at which this takes place. At such a price, buyers find that they are able to buy exactly the amount they want at the prevailing price and suppliers find that they are able to meet the buyers’ demands exactly, at the prevailing price. There is no incentive for either party to change their behavior. These points may be annotated as
P* and Q*.
Market Equilibrium occurs for only one set of parameters at any one time. If P rises, i.e. P>P*, supply will exceed demand. Conversely, if P drops, i.e. P<P*, then there will be a shortage in supply to the market. Market behavior is unpredictable. If there is excess supply, either the retailer will cut prices to sell off stock-which is what happens in sales in the U.S., or store it for later─ like firecrackers for festivals in Asia─ or send it back to the wholesaler. This way, an artificial equilibrium is created. If there is shortage in supply, either there will be a stock-out or unethical traders will jack up prices. There is also the probability that wholesalers will be able to produce extra stock, which will try to restore the old status quo, which is when market forces may fight against the wholesaler and keep prices high artificially.
This discussion makes it clear that one must be careful to interpret the demand and supply schedules. The demand schedule, for example, is the result of a hypothetical experiment: it is as if we had taken a list of prices and gone around asking buyers how much they would be prepared to buy at each price. Then, we totaled the quantities given by the different buyers at each price and came up with the demand schedule. But what about the actual quantities that are bought and sold in the market? If we go to a market, observe different prices at different times, and then add up the actual quantities sold at these prices, then (a) things other than price affecting demand might have changed so that the different price--quantity pairs might represent different demand curves, and (b) the actual quantities are the equilibrium quantities reflecting both demand and supply conditions. The same observations remain valid for supply curves. To emphasize the point once again, the actual transactions in the market are the result of both demand and supply forces and cannot normally be used to derive either the demand or the supply schedule.
Markets also operate at different levels. Most consumers go to the local grocery store to make their purchases, i.e deal with retailers. The retail seller, in turn, buys from the wholesale trader. Wholesale prices are responsive to many things. When the government tries to impose a service tax and affected agencies go on strike, the effect is first felt at the wholesale level, but retail level prices may take some time to change. Prices are not often changed at the retail level because there is a cost for changing prices. If, for example, a demand change is temporary, the retailer does not want to run the risk of alienating customers by marking up prices.
Some prices may also be set by bargaining. The seller quotes a price, but buyers recognize that counter-offers may be made and prices brought down from the opening level. When there are many buyers and sellers in the market, there is less scope for bargaining if agents are more or less well informed about prices. A seller’s price is benchmarked against that of others. Both buyers and sellers have the option of dealing with others at ‘standardized’ prices. However, in situations where a smaller number of agents are involved, bargaining takes place, because no price acts as a standard. The extent of bargaining also depends on the opportunity, cost of time and money spent. A retired person is not pressed for time, and he can afford to spend a longer time bargaining.
It is evident that the quantity demanded will, generally, depend on:
· Own price
· Tastes and preferences
· Prices of related commodities
In simple functional notation, Qd= f (I, T, Pr, E, P), where Qd= Quantity demanded, I=Incomes, T= Tastes/preferences, Pr= Prices of related commodities and E=Expectations. The equation becomes valid only if the other factors do not change. A parametric change leads to a shift in the curve, as the position of P and/or Q would change. If any of the factors above change, the entire demand curve would change. For standardization purposes, we express all variations as changes in quantity demanded. Therefore:
· If I (income) increases, we expect a greater demand at the same price.
· If T changes, as it will certainly do, what with changes in fashion and lifestyles, we expect a greater demand at the same price.
· If the price of a substitute rises, we expect an increase in demand. For example, if the price of diesel oil rises, the demand curve for petrol will move up and right.
· If the price of a complement falls, we expect demand to fall. If the price of sugar rises, the curve for tea/coffee/pastries will move down and left.
· If the OPEC price of a barrel of crude rises, the demand curve for fuel strains at the leash to move up and right.
This is the basic theory behind determining the price to be set for a product. Most companies follow this procedure blindly. Unfortunately, this is not the most efficient way of doing so. Some factors have been left out in the price determining process, which, as we shall see later, have a marked influence on the final price.
At this stage, we may study a factor that will crop up later when we approach types of pricing, particularly Competitive Pricing. This factor is ‘Elasticity of Demand’. Elasticity is evaluated under the assumption that no other changes are being made, or ceteris paribus, (i.e., “all things being equal”) and only price is adjusted. The logic is to see how price by itself will affect overall demand. Obviously, the chance of nothing else changing in the market but the price of one product, is unrealistic, yet the analysis must be made. Returning to knowthis.com, Elasticity deals with three types of demand scenarios:
· Elastic Demand: “Products are considered to exist in a market that exhibits elastic demand when a certain percentage change in price results in a larger and opposite percentage change in demand. For example, if the price of a product increases (decreases) by X%, the demand for the product is likely to decline (rise) by greater than X%.”
· Inelastic Demand – “Products are considered to exist in an inelastic market when a certain percentage change in price results in a smaller and opposite percentage change in demand. For example, if the price of a product increases (decreases) by X%, the demand for the product is likely to decline (rise) by less than X%.”
· Unitary Demand – “This demand occurs when a percentage change in price results in an equal and opposite percentage change in demand. For example, if the price of a product increases (decreases) by X%, the demand for the product is likely to decline (rise) by X%.”
Marketers need to understand this issue to assess how it impacts company revenue. Usually, the following scenarios apply to making price changes for a given type of market demand:
Value for Both Customer and Marketer - Value refers to the perception of benefits received for what someone must give up. Going back to knowthis.com, we can say, “For customers, value is most often measured by how much benefit they feel they are getting for their money, though the value one customer feels may differ from what another customer feels even though they purchase the same product. On the other side of the transaction, the marketer for a for-profit organization may measure value in terms of how much profit they make for the marketing efforts and resources expended. For a successful marketing effort to take place both the customer and the marketer must feel they are receiving something worth while in return for their efforts. Without a strong perception of value it is unlikely a strong relationship can be built.”
For most customers price by itself is not the key factor behind a purchase. They compare the entire marketing offering and delay their purchase decision till they evaluate several variables when they mentally assess a product’s overall value. Price is considered at this stage.
As just said, “value refers to the perception of benefits received for what someone must give up. Since price reflects an important part of what someone gives up, a customer’s perceived value of a product will be affected by a marketer’s pricing decision. Any easy way to see this is to view value as a calculation:
Value = Perceived Benefits Received
Perceived Price Paid
For the buyer, value of a product will change as perceived price paid and/or perceived benefits received change. But the price paid in a transaction is not only financial; it can also involve other things that a buyer may be giving up. For example, in addition to paying money a customer may have to spend time learning to use a product, pay to have an old product removed, shut down current operations while a product is installed or incur other expenses.”
Profit Maximisation: Profit maximization is a process that companies undergo to determine the best output and price levels in order to maximize its return. The company will usually adjust influential factors such as production costs, sale prices, and output levels as a way of reaching its profit goal. Radical leadership management.com sees it as “the process whereby companies focus on maximizing profit or getting the best possible profit in their particular kind of business.”
Profit maximization techniques include cost minimization, waste reduction, lean manufacture, flat organization structure, labor reduction through investment in appropriate technology, labor cost reduction, reduction of organizational fat by focusing on the company's core business,
product profit margin increase through value optimization, developing new markets and
product line extension.”
There are two main profit maximization methods used, and they are Total Cost-Total Revenue Method and Marginal Cost-Marginal Revenue Method. Profit maximization is good for a company, but can be adverse to consumer interests if the company starts to use cheaper products or decides to raise prices.
(a)Total Cost-Total Revenue Method: Gross profit is equal to total revenue less total cost. If we make a table of costs and revenues for each quantity, in fixed incremental values, we can derive equations or create a graph. The profit-maximizing output is the output at which profit scales its maximum. This is where our study of the demand-supply curves pays its dividend. Computing the price at which to sell the product requires knowledge of the firm's demand curve. The price at which quantity demanded equals profit-maximizing output is the optimum price to sell the product.
(b)Marginal Cost-Marginal Revenue Method: The Encyclopedia Brittanica explains this rather confusing phenomenon as, “If total revenue and total cost figures are difficult to procure, this method may also be used. For each unit sold, marginal profit equals marginal revenue minus marginal cost. Then, if marginal revenue is greater than marginal cost, marginal profit is positive, and if marginal revenue is less than marginal cost, marginal profit is negative. When marginal revenue equals marginal cost, marginal profit is zero. Since total profit increases when marginal profit is positive and total profit decreases when marginal profit is negative, it must reach a maximum where marginal profit is zero - or where marginal cost equals marginal revenue. If the industry is competitive (as is assumed), the firm faces a marginal revenue curve that is identical to its demand curve.”
Price Versus Perspective: Rafi Mohammed opines that “value, an influencer of perspective, is highly subjective and intensely personal.” It can be astonishing how a relook at something you have just seen can alter your opinion dramatically. Let me give you a personal experience. I am a one-shop man and bought my apparel only from this shop in my hometown. I happened to go to another city on official business and, with time on my hand, I was bullied into a boutique by a friend, telling me that I’d get a great bargain during their ongoing festival sale. I was impressed by the wares on offer and the low prices, so I casually asked the owner what he would do with the shop-soiled goods. To my horror, he replied that he had a captive customer, none other than my select shop in my hometown, who would clean the item, hike the price by up to 100% and then offer it at as a new product at a discount. Talk about quality-consciousness and ethics!
Thomas C. Taylor, writing on ‘An Introduction to Austrian Economics’ says, “The explanation of all economic activity that takes place in the market economy ultimately rests on the subjective theory of value. The value of various consumer goods and services does not reside objectively and intrinsically in the things themselves, apart from the individual who is making an evaluation. His valuation is a subjective matter that even he cannot reduce to objective terms or measurement. Valuation consists in preferring a particular increment of a thing over increments of alternative things available; the outcome of valuation is the ranking of definite quantities of various goods and services with which the individual is concerned for purposes of decision and action. Theory resorts to the hypothetical concept of the scale of values in seeking to explain and understand the nature of human valuations. The ranking of alternative ends is determined by the person's expectations of satisfaction from each specific choice faced by him at any moment of decision. He will invariably select the alternative that he believes will yield him the greatest satisfaction.
The subjectiveness of valuation rests in the nature of satisfaction--satisfaction is subjective and not open to numerical measurement. The extent to which a thing gives satisfaction is always personal. People derive satisfaction from different goods and services; that is, all people are not alike in terms of the types of things that please them. Experience also demonstrates that a person's preferences vary from time to time. His ranking of alternative choices may undergo a reshuffling at any given moment. His scale of values may also be altered by deletions or additions.”
The three factors discussed have a direct bearing on pricing. Pricing is such a subject that economists have gone to sea describing it. Consider the various types of pricing:
1. Premium Pricing: Use a high price where there is a uniqueness about the product or service. This approach is used where a substantial competitive advantage exists. Such high prices are charge for luxuries such as Cunard Cruises, Rolls Royces and Space Shuttle flights.
2. Penetration Pricing: The price charged for products and services is set artificially low in order to gain market share. Once this is achieved, the price is increased. This approach was used by Sky TV.
3. Economy Pricing: This is a no frills low price. The cost of marketing and manufacture are kept at a minimum. Supermarkets often have economy brands for soups, spaghetti, etc.
The product is an item that sells in mass quantities, day in and day out.
4. Price Skimming: Charge a high price because you have a substantial competitive
advantage. However, the advantage is not sustainable. The high price tends to attract new competitors into the market, and the price inevitably falls due to increased supply. Manufacturers of calculators and digital watches used a skimming approach in the 1970s, followed by the VCR, Laptops, DVD, etc. Once other manufacturers are tempted into the market and the products are produced at a lower unit cost, other marketing strategies and pricing approaches are implemented.
Essentially, just these four concepts in pricing policies/strategies were considered sufficient to evolve pricing policies/strategies, according to marketingteacher.com, which derived a matrix using the four. However, there are many other important approaches to pricing, some being:
1. Cost-plus pricing: Cost-plus pricing is the simplest pricing method. Calculate the cost of producing the product and add on a percentage (profit) to that price to get the selling price. This simple method has two flaws; it takes no account of demand and there is no way of determining if potential customers will purchase the product at the calculated price. Price = Cost of Production + Margin of Profit.
2. Psychological Pricing: This approach is used when the marketer wants the consumer to respond on an emotional, rather than rational basis. For example 'price point perspective' $4.99 cents, or, less than five dollars.
3. Competitive pricing: Setting the price based upon prices of similar competitor products.
Competitive pricing is based on three types of competitive product:
* Products have lasting distinctiveness from competitor's product. Here we can assume
Ø The product has low price elasticity.
Ø The demand of the product will rise.
* Products have perishable distinctiveness from competitor's product, assuming the product features are of medium distinctiveness.
* Products have little distinctiveness from competitor's product. assuming that:
Ø The product has high price elasticity.
Ø No expectation that demand of the product will rise.
4. Optional Product Pricing: Companies will attempt to increase the amount customer spend once they start to buy. Optional 'extras' increase the overall price of the product or service. For example, VCR and microwave makers charged for optional extras such as automatic switching off of the system once it was no longer required.
5. Captive Product Pricing: Where products have complements, companies will charge a premium price where the consumer is captured. For example, Gillette charges a low price for its triple-blade razor and recoups its margin (and more) from the sale of the only design of blades which fitted the razor.
6. Product Bundle Pricing: Here sellers combine several products in the same package. This also serves to move old stock. Videos and CDs are often sold using the bundle approach.
7. Promotional Pricing: Pricing to promote a product is a very common application. There are many examples of promotional pricing including approaches such as Buy One Get One Free.
8. Limit pricing: A limit price is the price set by a monopolist to discourage economic entry into a market. The limit price is the price that the entrant would face upon entering as long as the incumbent firm did not decrease output. The limit price is often lower than the average cost of production or just low enough to make entering not profitable. Firms that export the good at this low price to increase volume are hit by anti-dumping laws.
9. Loss leader: A market leader sells below cost as part of its overall strategy. The idea may appear to be in the public interest and is not often challenged. Only when the leader pushes up prices does it becomes suspicious.
10. Penetration pricing: The price is deliberately set at low level to gain customer's interest and establishing a foot-hold in the market.
11. Dynamic pricing: Online adjustment of prices of identical goods to correspond to a customer’s willingness to pay, the classic example being today’s airline ticket costs. The aim is to sell at the right time, at the right price.
12. Value pricing: This approach is used where external factors such as recession or increased competition force companies to provide 'value' products and services to retain sales e.g. value meals at McDonalds.
That should be enough, though there are another twenty odd pricing schemes.
Where Companies Go Wrong and Preclusive Tactics
Despite the number of pricing policies outlined and taught in business schools, many decision makers in companies go wrong when it comes to attaching the price tag. I‘ll give you an example that I took maximum benefit of. The price of gaily caparisoned beach umbrellas on the Côte d’Azur was 495 French francs throughout summer. The first rain and the hint of cold air moving in saw Carrefour drop their beach umbrella price to FF 249. Leclerc, a competitor, reacted a bit late, but they quoted FF 199. Within a week, prices reached the FF99 mark, and in a close-out sale at Carrefour, I bought 4 beach umbrellas at FF25 each, with a demonstration model thrown in gratis. I had 5 beach umbrellas for next year!
Most companies think that discounts are the best way to sell, citing volume buy theories. This may work well with close-outs, but can cost quite a bit if tried out on a good seller. Tesco’s sold a particular brand of Ice cream which was highly popular. Their supermarket at Martin’s Heron, England was just outside the railway station and most commuters would drop in and pick up a pack at £6.95. A similar ice cream pack, costing £5.95 was not selling. As their primary tactic, they cut that price down to £4.45. At the end of the week, they found that they had sold only 20 packs extra, i.e. 90, as against the weekly average of 70. They lost £16 in that venture, no earthshaking amount, but just a revelation of actuals.
The problem lies partly in communication. Shop-floor supervisors must be taught how to steer paying customers into upper segment sections of merchandise. Another great example can be cited here. Noramix is a popular leather product seller and exporter in Sri Lanka, selling even in the duty free outlet at Colombo Airport. Most travelers would head into the duty free shop for perfumes and liquor. A well dressed young lady would invariably come up to you in the perfume store and say, “Sir, have you tried our liquor sales gifts yet? No? May I show you, please?” In the large alcohol segment, she would say, “Sir, buy two bottles of this Premium scotch and get a third free.” That, in itself was a great bargain. She would then add, “Buy four and get six. We’ll pack them in a Noramix leather bag for you.” Sales were phenomenal at Colombo.
Your customer must have faith in your product, a primary tenet of Brand Retention. Give him that something extra in your product to justify his faith. Send him a leaflet stating that for loyal customers such as him, he was entitled to a X% discount for some fixed period, but add the punch-line that he would specially be given the discount anytime he chose to accept it. And equally, loyal customers can be cross-sold or up-sold into premium products which generate more profits for your company. Again quoting Rafi Mohammed, “Creating a culture centered on maximizing profitability is a challenge. You have to be careful to use the right metrics to measure your success. Pursuing greater market share is meaningless…” as the Tesco example proved.
Make the most of opportunities. Souvenir makers capitalize on major events like the World Cup series or the Olympics. Closer home, I know of an enterprising young lad of 12 or so, who buys standard sized flimsy plastic bags at 1000 to the dollar. He would then slit one side fully, so that it could be converted into make-shift headgear. And when it rained, he would sell them at 10 to the dollar to pedestrians- a 10,000% profit.
Add value to your service. Customize goods for your buyer. If you deal in apparel, use the magic mirror to locate the minor fitment flaws and rectify them as your customer has a soda or coffee or whatever, gratis. When I drove into my gas station and had my car filled up, an employee sprayed a layer of fine foam on my windscreen. As soon as I had tanked up, he said, “Sir, just use your windscreen wiper once.” I did so and found my windscreen crystal clear. I heard him say, “Courtesy Paul’s Garage, sir.” The number of people who now get their car filled up at his service station has doubled.
Add guarantees. When I bought my Honda City sedan, I had a series of questions to ask. Whenever I started, “Now, if this fails……”I would not be allowed to complete my query. The response was always the same, “Sir, this is a Honda!” Imagine how much an average person’s morale would be boosted!
Follow up. A sales rep from Honda would ring me up every month and ask how my car was behaving. He was unhappy with the mileage I was getting, so one Sunday, I was asked if I was free, which I was. Two minutes later, a Honda servicing team was ringing my doorbell. They had called me from just outside my house! They carried out a quick check and told me, “Sir, your car is in perfect shape. We will change your wheels clockwise and use the spare. When you drive above 100 kph, do please flick your side-view mirrors in. That should save you some gas.”
As stated earlier, value is highly subjective and intensely personal. “In simple terms, that means different people are always willing to pay markedly different prices for the same
product or service. Value is truly in the eye of the beholder rather than set by any external metrics,” avers Rafi Mohammed. “To relate the matter of valuation to the individual person is not to suggest that each individual is concerned only with the satisfaction of his own appetites and needs. A person may find satisfaction or relief in helping another person. Satisfaction can be and often is derived from the attainment of altruistic as well as ‘selmarketersh’ motives. But the point remains that regardless of the form the satisfaction is to take, each choice arises from subjective valuation on the part of the particular person who is doing the choosing,” quoting Taylor again.
The Principle of Marginal Utility is a principle of perspective. Taylor adds, “Each additional unit of a particular good is devoted to a use that is less important and urgent than the use to which the preceding unit was applied. Valuation is always directed toward a definite quantity of a particular good or service. The principle that a person will always apply a given unit of a good or service to the most pressing desire or need to which it relates is inherent in the concept of purposive action.”
“There are three ways that a specific quantity of money can be put to immediate use; (i) to acquire another good or service to be used for consumption purposes,(ii) it can be spent for another good or service that is to be used in the productive process of effecting or fabricating a new good and (iii) to add the money to one's cash balance to help pay for future exchange transactions. The fact that a person holds a certain amount of money at a given moment indicates that he values the money more than those things that he could obtain in exchange for it. Yet holding an amount of money at a given moment does not alter the fact that money is valued for its exchangeability. It merely shows that being prepared for later exchanges is valued more highly than making exchanges now. The satisfaction arising from an increased cash supply is often manifested in a perspective of greater security.”
To be sure, for every product in the world, customers will have different valuations. Price carries an enormous amount of clout with customers. Prices regulate demand, in inverse fashion. High price meant low demand and low prices meant high demand. As an example, car prices were prohibitive in India till 1979, mainly due to various taxes. The government decided to reduce car prices, when they decided to set up a joint venture with Suzuki, Japan. There was no way that this new hi-tech car could be cheaper than the existing Fiats and Ambassador, the latter based on the British Morris Oxford III. But they pulled a rabbit out of a hat. Since the new Suzuki was a small car based on a successful model, it had an engine of 800 cc displacement as against the 1089 cc Fiat and the 1498 cc Ambassador. The government passed an order that cars below 1000 cc displacement would be given close to 50% discount in taxes. The new car was an instant hit, despite minor flaws. But the Fiat came back with a new carburetor and a shorter piston and cylinder that reduced displacement to 996 cc, surviving the onslaught of the Suzuki.
The Next Step
We had seen earlier that Qd= f (I, T, Pr, E, P), where Qd= Quantity demanded, I=Incomes, T= Tastes/preferences, Pr= Prices of related commodities and E=Expectations. I had explained this equation by saying that If I (income) increases, we expect a greater demand at the same price; If T changes, we expect a greater demand at the same price; If the price of a substitute rises, we expect an increase in demand. If the price of a complement falls, we expect demand to fall. If the price of sugar rises, the curve for tea/coffee/pastries will move down and left and
if the OPEC raised the price of a barrel of crude, the demand curve would move up and right.
If we converted the equation to a matrix, it would appear as projected below,
One factor was not considered, that of uncertainty, which would include a host of factors like market sentiment, our product’s longevity, effect by the arrival of a fad, information, technology or other external events beyond our control. We can club all these into a sixth factor and term it ‘Environment’. Another factor was considered only partially, where we looked at related commodities in isolation, not as part of Competition.
Direct Competitor Pricing: Knowthis.com explains that “almost all marketing decisions, including pricing, will include an evaluation of competitors’ offerings. The impact of this information on the actual setting of price will depend on the competitive nature of the market. In markets where a clear leader does not exist, the pricing of competitive products will be carefully considered. Marketers must not only research competitive prices but must also pay close attention to how these companies will respond to the marketer’s pricing decisions. For instance, in highly competitive industries, such as gasoline or airline travel, competitors may respond quickly to competitors’ price adjustments thus reducing the effect of such changes.
By analyzing these factors, you can come up with a price recommendation for your own product or service. Most of these factors are determined by market forces out of your control. Your product’s value will vary in tune with variations in these external factors, which are determined subjectively by each individual customer.” I must reiterate that different people will always have differing personal judgments about the value of things, which is why the value of the same product is seen differently from one person to the next. Hence, you cannot set a single price point for your product or service, as you would then stand to lose untapped profits which are there, but which you haven't visualized.
The Pricing Strategy
Having studied all background factors, it is time to move towards the actual pricing of your product. To do so, we need to understand a new set of parameters called “The Marketing Mix.”
The marketing mix is probably the most famous marketing term. First coined by Neil H. Borden in his article ‘The Concept of the Marketing Mix’ in 1965, its elements are the basic, tactical components of a marketing plan. Also known as the Four P's, the marketing mix elements are Price, Place, Product and Promotion.
The concept is simple. Think about another common mix - a cup of tea. All teacups contain teabags or loose tealeaves, milk, water and sugar. However, you can alter the final cuppa by altering the amounts of mix elements contained in it. So for a sweet tea, just add more sugar! Marketingteacher.com says, “In a marketing mix, the offer you make to you customer can be altered by varying the mix elements. So for a high profile brand, increase the focus on promotion and desensitize the weight given to price.”
In a hill station, focus on the body warmth maintaining component of your apparel item. In a rainy area, focus on nanotechnology used in your products. In a snowbound area, talk about products like Elekson’s phase change material jackets or smart fabrics with integrated Ipods.
As marketingteacher continues:
· Price: There are many ways to price a product.
· Place: Place is also known as channel, distribution, or intermediary. It is the mechanism through which goods and/or services are moved from the manufacturer/ service provider to the user or consumer.
· Product. For many a product is simply the tangible, physical entity that they may be buying or selling.
· Promotion: This covers all tools available to the marketer for 'marketing communication'.
Importance of Price: According to knowthis.com, some reasons pricing is important include:
“Most Flexible Marketing Mix Variable – For marketers price is the most adjustable of all marketing decisions. Unlike product and distribution decisions, which can take months or years to change, price can be changed very rapidly. The flexibility of pricing decisions is particularly important in times when the marketer seeks to quickly stimulate demand or respond to competitor price actions. Decisions can be made by phone.
Setting the Right Price – Pricing decisions made hastily without sufficient research, analysis, and strategic evaluation can lead to the marketing organization losing revenue. Prices set too low create a direct loss. Attempts to raise an initially low priced product to a higher price will have adverse results. Prices set too high will hurt sales. Setting the right price level takes considerable market knowledge and, especially with new products, testing of different pricing options.
Trigger of First Impressions - Often times customers’ perception of a product is formed as soon as they learn the price, such as when a product is first seen when walking down the aisle of a store.
Important Part of Sales Promotion – Many times price adjustments are part of sales promotions that lower price for a short term to stimulate interest in the product. However, marketers must guard against the temptation to adjust prices too frequently since continually increasing and decreasing price can lead customers to be conditioned to anticipate price reductions and, consequently, withhold purchase until the price reduction occurs again.
Marketing Objectives – like (a) Return on Investment (ROI) – A firm may set as a marketing objective the requirement that all products attain a certain percentage return on the organization’s spending on marketing the product. This level of return along with an estimate of sales will help determine appropriate pricing levels needed to meet the ROI objective; (b) Cash Flow – Firms may seek to set prices at a level that will insure that sales revenue will at least cover product production and marketing costs; (c) Market Share and the tactics to be employed to hit the goal and (d) Maximize Profits.
Customer Expectations − Possibly the most obvious external factors that influence price setting are the expectations of customers. As discussed, when it comes to making a purchase decision customers assess the overall “value” of a product much more than they assess the price.
Related Product Pricing - Products that offer new ways for solving customer needs may look to pricing of products that customers are currently using even though these other products may not appear to be direct competitors.
Primary Product Pricing - Marketers may sell products viewed as complementary to a primary product. For example, Bluetooth headsets are considered complementary to the primary product cell-phones. The fact is that the cell-phone price includes the cost of the headset!
Now that we are fully aware of the process, its pitfalls and twists, we can start setting our product price. Settling at one price is not the most advantageous. So we need a set of strategies that will enable you to benefit from each customer’s unique valuation of your product.
· Differential Pricing: As price sensitivity increases, customers are looking to reduce spend, and they have become more aware of any changes in cost. At the same time, customer demands for better pricing present an opportunity for marketers to increase retention and grow organically through the implementation of attractive pricing structures. For this, marketers must be able to quickly roll out new products to their customers; pricing has become crucial to maintaining customer loyalty, preserving current business and growing where opportunities still exist. Marketers need to be more careful in deciding their pricing strategy. They may have to look at various ‘differential pricing strategies’ based on the customer’s price sensitivity. Some differential pricing techniques are:
1. Pricing based on the Transaction Attributes - Marketers can decide to vary the price of the transaction based on various transaction attributes, such as channel of initiation, whether transaction is straight-through or requires manual intervention, time of the transaction, location origination, etc.
2. Cross-Product Pricing - Transactions of a product are priced based on the transaction attributes of some other product or products.
3. Performance-Based Pricing - Marketers can link pricing of their product to the performance of the customer. Attributes to measure customer performance could be balances maintained by the customer, transaction volumes, total revenue earned from the customer or incremental balances / revenues earned from the customer.
4. Loyalty-Based Pricing - Pricing based on customer loyalty, computed based on various parameters, such as length of the relationship, number of products subscribed, transaction value / volume, subscription to new products, etc.
5. Profitability-Based Pricing - Futuristic technique of pricing, which considers all factors affecting customer profitability. This technique is more comprehensive than performance-based pricing or loyalty-based pricing because it looks at profitability of the customer, instead of just business volumes or longevity of relationship.
Pricingforprofit.com lists seven more differential pricing techniques (http://www.
Properties: Different prices based on characteristics like age, organization affiliation, and gender. For example, govt. employees often receive special “government rates.”
6. Obstacles: Different prices based on obstacles such as sales, club membership, size, and other conscious actions. For example, at annual customer appreciation sales, price conscious customers start lining up at 6 AM to purchase the best sale items.
7. Timing: Discounting a product over time capitalizes on customers willing to pay premiums to have the product immediately as well as those with lower valuations that are willing to wait for discounted prices. For example, at the beginning of the season, summer clothes are sold at full price but are gradually discounted as the season progresses.
8. Volume: lower prices can be used as an incentive for customers to purchase larger quantities. At one time or another, haven’t most of us succumbed to the temptation of buying a larger size because of its better value?
9. Locale: Different prices can be charged based on where customers make purchases. For example, prices can be higher at Gucci’s Beverly Hills, California store on Rodeo Drive and lower in its Secaucus, New Jersey outlet store.
10. Discounted Bundling: Selling products both individually and in discounted bundles can enable you to charge different prices to different customers. For example, McDonald’s implicitly sells its Big Mac at a lower price to customers that purchase it as part of a Value Meal compared to those that individually purchase a Big Mac.
11. Negotiation: Individually negotiating with customers can lead to charging different prices for the same product. For example, car sales people often enquire about where you live, your profession, what other cars you are looking at, and how quickly you need the car. These questions are more than friendly chit chat. On the contrary, these experienced sales people are trying to determine this highest price you are willing to pay.
· Versioning: Versioning has been explained as offering a variety of options to your base product (e.g., good, better, and best products) to allow customers to self-select and pay their true valuation for your product. It is also seen as a form of second-degree price discrimination based on product quality, and is especially useful if degrading one's information good to create one or more lower quality versions is not expensive. In versioning, firms typically offer a list of different prices to consumers, allowing the consumers to self-select. In versioning pricing strategies, companies sell variations of a product or service at different prices to different groups of customers. Ideally, companies want to charge what consumers are willing to pay thereby maximizing company revenues. But it is difficult to know precisely how much each person is willing to pay. Companies therefore create versions of a product to appeal to different types of buyers. Customers then choose the version that best meets their needs. Businesses often distribute a physically identical product under different brand names, charging lower prices for the less known brand name. For example, the Gap Company sells its products with the Gap label at its own stores as well as under other labels at other retail stores.
Movie studios sometimes release special editions of movies. For instance, the DVD version of ‘Shakespeare in Love’ includes additional features such as director and actor interviews, deleted scenes, a wide-screen edition, and closed captioning for US$32.99, whereas the VHS version has no bonus materials and costs $14.99. Intuit, a software company, offers TurboTax for US$29.95 and TurboTax Deluxe, which includes additional features including "more money saving advice" and Internal Revenue Service publications for $39.95. Health clubs often charge less for memberships with restricted hours. People who agree to use the club during off-peak hours or on certain days of the week pay less than those with full memberships who can visit the club whenever they wish.
Long-distance telephone companies charge more for calling plans that allow low-rate calls during the day and less for plans that only offer low rates on weekends or late in the evening. Internet companies and photography studios sell different versions of their products by offering varying levels of resolution. PhotoDisk, an online photo- graphy library, charges users according to the resolution level of the images accessed. A 600 kilobyte version goes for $19.95, whereas a 10 megabytes version costs $49.95. Professional users who need a reproducible image for commercial publications are willing to pay for higher resolutions, whereas casual users prefer the cheaper images.
Versioning is a fairly successful strategy, according to Rafi, because “it allows you to capitalize on the different valuations your customers have; addition of attributes to your basic product may attract a new lot customers and open up new vistas; it has been found to be cost-effective.” Pricingforprofit.com opens up the various Versioning Pricing Tactics:
1. Options: Can you offer customers a menu of options for them to version your product? For example, in addition to selling a basic wash, car washes offer a variety of a la carte options including: different waxes, undercarriage wash, wheel cleaning, and rust inhibitor.
2. More is Better: Can you offer products with “more” (e.g., higher quality, support, or experience)? For example, international airlines offer first, business, and coach class seating.
3. Discounts Attract: Can you offer “less” (e.g., lower quality, brand, service, or experience) to attract new (usually value-conscious) customers. For example, major grocery chains sell discount private label products.
4. Flexibility: Can you change your product’s attributes in a manner that will attract new customers? For example, Williams- Sonoma often asks product manufacturers to create color options that are exclusively sold at Williams-Sonoma like Sonoma Green or Cobalt Blue.
5. Speeded Service: Can you provide faster service to your customers? For example, Federal Express offers 8:30 AM, 10:30 AM, and 3:30 PM same day delivery.
6. Valuation of Time: Can you offer options that allow customers to go to the head of the line? For example, Universal Studios Hollywood theme park offers $59 regular admission tickets as well as a $89.95 ticket version that allows purchasers to go to the head of the line at any theme park attraction.
7. Forward Selling: Can different levels of uncertainty (i.e., reducing consumer or your risk) be used to version your product? For example, to mitigate all of the uncertainty of oil costs, many home heating oil companies are offering their customers the option to lock in their prices for the winter season.
· Dr. Tim Smith, an expert in pricing, has another perspective to consider: Add-ons.
“An add-on strategy, as defined here and as used by others, starts with a base product with which different customers can choose additional products, modules, or features in order to customize the overall product to their demand. Examples abound. Automakers offer a base level vehicle model to which customers can select exterior paint, interior trim, audio system, seat-covers, wheel styles, interior color, and other features. Mobile handset makers offer base level handsets to which customers can add car kits, wireless headsets, audio adaptors, computer connectivity adaptors, and other chargers, adaptors, and features. Enterprise software providers such as Loadstar of Oracle offer a base Energy Information Platform to which utility customers can add rating engines, contract management, billing systems, trading, settlements, distribution planning, and much more.
Add-on pricing strategies fundamentally take the approach of not aggregating customer demands and not segmenting the market. An add-on strategy assumes that each additional product, module, or feature is a unique product which compliments the base product, and the decision to purchase one add-on vs. another is an independent decision. A market researcher might express this as the demand for one add-on feature being weakly or uncorrelated to the demand for another.”
So which one should be chosen, noting that there is a lot in common between Versioning and Add-ons? Dr. Smith adds, “While cost structure, competitive, consumer psychology and other issues influence the decision, one of the most basic influencing factors is the issue of aggregating customer demands into segments.
Add-on pricing strategies take the approach of not aggregating customer demands and not segmenting the market. An add-on strategy assumes that each additional product, module, or feature is a unique product which compliments the base product, and the decision to purchase one add-on vs. another is an independent decision.
In contrast, versioning strategies segment customer demands along a single dimension. Marketers often talk of versioning as segmenting customers into those that just need an entry level product to perform a function; those that want a slightly better, but not too expensive, product; and those who enjoy flaunting their conspicuous consumption and demand nothing but the best, in the good-better-best syndrome. Pricing strategists often discuss the establishment of segmentation fences to prevent what otherwise might be a higher value customer from downgrading into a lower priced product version.”
· Segment Based Pricing: Activate Dormant Customers with New Pricing Strategies
To attract new customers, some vacation homebuilders offer interval ownership timeshares which typically divide a condominium’s usage into fifty-two week segments. Customers purchase ownership for a week or two, good for the life of the condominium. This new pricing strategy has made the American dream of owning a vacation house a reality for many new customers, resulting in growth for the resort home-building industry, according to pricingforprofit.com, which gives us “Ten Segment-Based Pricing Tactics:
1. Split Ownership by Time: Can you attract new customers by subdividing your product into smaller increments? For example, interval ownership has been the catalyst to growth in the private jet industry.
2. Feature Bundling: Can bundling be used to grow your customer base by promoting convenience or inducing customers to buy products that they would not otherwise purchase? For example, many land line phone companies offer discounted bundles that include options that customers would not normally purchase (e.g., three-way calling, speed dialing).
3. Leasing: Can the “trading up to a better product for the same monthly payment” benefit, convenience, and financing attributes of leasing draw new customers to your product? For example, leasing is a key selling strategy for automobile companies.
4. Prepaid: Can the features of prepaid pricing (e.g., impose discipline, easier to purchase, provide flexibility) attract new customers to your product? For example, many wireless companies are focusing on selling “prepaid” cell phone plans as an avenue to growth.
5. Renting Out: Can you use rentals to serve new customers who want to use your product for a short period of time? For example, billionaire Warren Buffett owns Cort Furniture, a company that focuses on renting furniture to homes, businesses and trade shows.
6. Two-Part Pricing: Can two-part pricing be used to attract new customers by stimulating purchases and serving those with different valuations? For example, Costco uses a two part pricing strategy. After paying a membership fee ranging from $50 - $100, members can buy products that are generally priced 15% below rival retailers’ prices.
7. Obstacles: Can hurdles draw in new clients who use and value your service differently than your current customers do? For example, apart from offering hourly rates, downtown parking garages target commuters with discounted rates to drivers that are “in by 9, out by 6.”
8. Part Payment Plans: Can payment plans that better match customers’ cash flows draw in new clients? For example, the Home Shopping Network (HSN) phrases its prices as $1,648 or a flex-payment option of making 5 monthly payments of $329.60. HSN is not charging interest for its monthly plan. Instead, the flex-payment plan is being used to attract customers who would not otherwise purchase from HSN.
9. Individual Focused Pricing: Can you use customized pricing to attract new customers? For example, Progressive Auto Insurance has become the third largest auto insurer in the U.S. in great part because it offers customized rates to its customers.
10. Open Plate Buffets: Can the convenience and peace of mind provided by all-you-can-eat pricing attract new customers? For example, one benefit of Netflix is the ability to watch as many movies as you wish for one fixed monthly price.”
As discussed above, market segmentation is one of the fundamental determinants between versioning vs. add-on strategies. If the market exhibits no meaningful segments or segment aggregation variables, add-on strategies enable a firm to efficiently offer customized value propositions to individual consumers. In doing so, the company is able to create incremental value for different customers and capture incremental revenue and profit proportional to the level of demand for independent features and benefits.
If, however, the market has meaningful segments that can be correlated with an increasingly valuable bundle of goods and services, then a versioning strategy in which different versions are defined by their ability to fence more valuable segments from the lower value segments is in order. Importantly, add-ons vs. versions isn’t an either/or proposition. Companies execute both add-on and versioning strategies concurrently. Hyundai sells more than the i-10 magna car and add-on features, they also offer the i-12 version with a summer roof and two ABS, and the latter comes in different versions defined by engine size, the i-12 kappa being its nippy sports model with a larger engine.
The Role of Market Conditions
Popescu and Wu have postulated that consumers have memory and are prone to human decision making biases and cognitive limitations. As the firm manipulates prices, we have seen that consumers form a reference price that adjusts as an anchoring standard based on price perceptions. “Purchase decisions are made by assessing prices as discounts or surcharges relative to the reference price. Optimal pricing policies induce a perception of monotonic prices (a function which preserves the given order), whereby consumers always perceive a discount, relative to their expectations. The effect is that of a skimming or penetration strategy. The firm's optimal pricing path is monotonic on the long run, but not necessarily at the introductory stage. If consumers are loss averse, optimal prices converge to a constant steady state price; otherwise the optimal policy cycles. The range of steady states is wider the more loss averse consumers are. Steady state prices decrease with the strength of the reference effect, and with customers' memory, all else equal.
Therefore, the marketer must think about dropping prices.
· Low prices can create invaluable publicity and awareness of your product.
· Low prices promote repeat business, which is the cornerstone of success.
· Lower prices can position your product where it will have the broadest appeal.
Traditional economic, marketing and operational models view the consumer as a rational agent who makes decisions based on current prices, income and market conditions. Prices above the reference price appear to be high, whereas prices below the reference price are perceived as low. The latter effect stimulates short term demand and provides incentives for retailers to run price promotions as a mechanism to increase short-term profits. On the other hand, price promotions decrease consumers' price expectations, and hence their willingness to buy the product at higher prices in the future. For the firm, this means that high profits today may come at the expense of a loss in future demand, and hence less profit in the future. Therefore, a profit maximizing firm must consider the long term implications of its pricing strategy. This implies that lowering prices for any period of time is a decision based on market study and competitive pricing is called for.
We know that customers respond to the current price of a product by comparing it to the reference price. While other reference price models exist, an empirical comparison conducted in 1997 shows that the best model is one that is based on the brand's own price history", i.e. an internal reference price mechanism. Accordingly, consumers perceive prices as gains (discounts) or losses (surcharges) relatively to a reference price, and there is an inherent asymmetry in perception, in that losses loom larger than gains of the same magnitude (loss aversion). In addition, there is diminishing sensitivity to both gains and losses.
The value of the steady state price decreases with customers' loyalty (memory effects) and with their sensitivity to past prices (reference effects), all else equal. Also, the range of steady state prices is wider the more loss averse consumers are. If customers are heterogeneous in terms of their shopping frequency (and nothing else), retailers should offer discounts to loyal customers, and higher prices to occasional buyers (relatively to the unique price charged in a non-segmented market). While such strategies are consistent with current practices by retailers in consumer goods industries, they are not necessarily optimal if occasional buyers are more responsive to price changes than loyal ones.
The steady state price is bounded between the profit maximizing price charged to consumers
who don't form reference effects, and the steady state price charged by a firm to reference-sensitive consumers. Firms who ignore the long term impact of reference price effects, will myopically but systematically under-price. If consumers' reference price is initially high, they will be lead to perceive a gain in each period, as the firm will consistently price below the reference price. This perception of monotonic prices has the effect of a skimming strategy. Similarly, a low reference price leads to a penetration type strategy. While high-low prices may be observed at the introductory stage, in the long run prices are eventually monotonic in the same direction as reference prices.
Many people would be happy to spend half an hour on the internet for a 50 Euro discount on a 100 Euro airplane ticket, but not on a 2000 Euro one. In both cases, however, costs (30 minutes) and benefits (50 Euro) are identical, so from a purely rational view point the trade-off is the same. This example indicates that consumers are less responsive to a given price change when the status quo price is higher. Moreover, the marginal impact of a gain/loss on demand decreases with the reference value.
To utilize market conditions described above, the company must use the buyer’s mindset to maximize gain. Some important techniques are:
· Keep the reference price of high-value prestige items high, like Rolex does.
· Advertise prestige products for snob value.
· Neaten up your price tag. If your product is mid-range, avoid the ‘psychological pricing’ technique.
· If your product is of utility value, use the ‘psychological pricing’ technique.
· In a ten-pack, gift wrap two more as a giveaway, prominently displayed. Use this ploy in preference to discounts, but do not preclude discounting as a sales ploy.
· Do not under-price your product when offering a discount.
· Give loyal customers payment options.
· Add unadvertised surprise gifts to your bundles.
· Add a well advertised high value gift at random, but at low ratios, i.e. one in a thousand.
· Adopt the one-day bargain sale technique.
Refer to the table below as a guide: