TABLE OF CONTENTS
Introduction____________________________________________________________ 1
Internal Factors
Relevant to Pricing Decisions_______________________________ 1
Pricing Objectives______________________________________________________ 1
Cost Relationships and
Pricing____________________________________________ 3
External Factors
Relevant to Pricing Decisions_______________________________ 4
Product Market and
Demand_____________________________________________ 4
Competitor price and
product attributes____________________________________ 6
Government Regulations________________________________________________ 7
General Pricing
Approaches_______________________________________________ 9
Cost-Based Pricing_____________________________________________________ 9
Value-Based Pricing___________________________________________________ 10
Competitive-Based
Pricing______________________________________________ 10
Pricing Strategies______________________________________________________ 11
Differential Pricing
Strategies____________________________________________ 11
Competitive Pricing
Strategies___________________________________________ 13
Product Line Pricing
Strategies__________________________________________ 15
Psychological Pricing___________________________________________________ 17
Pricing Innovations_____________________________________________________ 17
Conclusion____________________________________________________________ 18
References____________________________________________________________ 19
Price is the value consumers exchange for the benefit of goods or services. Historically, prices were determined through bargaining or negotiations between buyers and sellers. Different prices were agreed upon based upon buyer needs and bargaining skill. The establishment of one price for every customer is a relatively new phenomenon that came about with the rise of large retailers. Although diminishing in importance, price remains a major factor in affecting consumer-buying decisions. In addition, it is the most flexible of those components. The ability of price to affect consumer decisions and its flexibility makes pricing strategies important in meeting company objectives in a competitive environment. This discussion will cover internal and external factors pertinent to pricing decisions, general pricing approaches, pricing strategies, and new developments in pricing strategies and policies (Armstrong & Kotler, 1996, p. 340).
Pricing decisions are not made in isolation. The pricing decision process should be approached with company objectives firmly in mind. Larger objectives such as the target market and product positioning strategy should be determined first. By focusing on the desired target market and positioning, it becomes easier to develop an appropriate marketing mix. Within this marketing mix, the appropriate product or service price can assist in pursuing one of four pricing objectives. These objectives include: survival, maximum current profit, market share leadership, or product-quality leadership. It is important to note that non-profit and public organizations can have alternative objectives largely dependent upon their overall objectives, purposes, and environments (Kotler, 1997, p. 496).
Survival. Survival is a relatively
short-term objective. The over riding
concern of the company is no longer profits, but rather, simply turnover that
will cover a portion of their variable and fixed costs. Common market or environmental conditions
associated with such a strategy include: over capacity, intense competition, or
changing consumer demand (Kotler, 1997, p.496).
Maximum current profits. Maximizing profits requires
balancing the relationship between demand, price, and costs. The metrics
commonly used to evaluate pricing decisions with these objectives are total
current profit, cash flows, or return on investment. This approach neglects
long-run competitive viability, competitor reactions, legal restraints, and the
effect of other marketing mix variables.
Perhaps the most serious challenge to this pricing objective is the
ability to accurately forecast demand and a product's cost function is far from
precise. Resulting inaccuracies can
result in serious complications (Kotler, 1997, p.496).
Market share leadership. Focusing on revenues
indirectly focuses on market share.
This approach believes that large market share will result in long-run
profitability. Profitability is
believed to be achieved by reducing unit costs through economies of scale. By reducing costs, more revenue is retained
as profits. This approach also requires knowledge of the demand curve (Kotler,
1997, p.497).
Product-quality leadership. This pricing objective
circumvents conventional price competition by differentiating products and
services. This strategy typically
provides higher quality to individuals who value that product attribute. Price can indirectly signal or reflect
product quality (Kotler, 1997, p.497).
Production costs at different levels of
output. The
total cost function defines the minimum possible cost of producing each output
level. Total production costs in the
short-run are equal to the sum of fixed and variable costs. Variable costs are costs that change with
different levels of output. Fixed costs
do not change with the levels of output and are inflexible in short time
frames. These costs include rent,
overhead, and other set costs. As
production increases, one finds that the fixed portion of the cost structure is
absorbed by a greater number of units.
Therefore, the average cost of a unit produced decreases as output
increases. It is these factors that
motivate many firms to pursue market-share dominance objectives. Just as costs associated with overhead and
facilities are inflexible in the short-run, so to is the capacity of those
facilities. After an optimal level of
output, other costs and inefficiencies associated with producing over optimal
capacity increases the average cost per unit.
When average cost per unit is decreased by additional output, economies
of scale are said to exist. However,
when additional production results in increasing average costs, diseconomies of
scale are said to exist. In the long run, capacity, and therefore, fixed costs
are flexible. A producer’s long-run
average cost curve is defined by the aggregate of all short-run average cost
curves associated with facilities of different optimal capacities and the
demand for the product within the market (Baye, 2000, p. 177).
Relationship between costs and production
experience.
While reducing costs per unit can be attributed to increasing output, the
actual relationship between cost and production can also be altered by
increasing employee knowledge and experience.
With each unit produced, the labor force increases its efficiency. This results in decreased variable cost per
unit and decreased fixed cost per unit.
This relationship can be expressed by an experience or learning curve. It is a downward sloping curve with unit
cost on the vertical axis and accumulated production on the horizontal
axis. The amount of labor force
learning or experience is directly related to the accumulated production
experience. Therefore, this places
pressure upon firms to increase market share in order to exploit cost
reductions associated with increased production (Armstrong & Kotler, 1996,
p. 346).
Effect of market structure on pricing
policies. The market structure of a product largely
determines a firm’s freedom in pricing.
Product markets are classified into four categories: pure competition,
monopolistic competition, oligopolistic competition, and pure monopolies. These market structures and their effect on
prices are largely determined by characteristics such as barriers to entry,
number of buyers and sellers, and product differentiation (Armstrong &
Kotler, 1996, p. 347-348).
Many buyers and sellers, no barriers to
entry, and uniform products characterize pure competition markets. The large numbers of market participants and
low barriers to market entry encourages competition. Furthermore, the commodity nature of the product ensures that
competition is based primarily upon price considerations. Under these characteristics, firms often
have little control over product pricing.
In fact, these firms can be said to be price takers, meaning that the
firms must accept the market price (Armstrong & Kotler, 1996, p. 347-348).
Monopolistic competition markets have large
numbers of buyers and sellers, no barriers to entry, but differentiated
products. The different product
attributes allow firms to compete based upon factors other than price. These factors may include quality, style,
and other features. The end result is
pricing freedom within a market-determined range of prices (Armstrong &
Kotler, 1996, p. 347-348).
Oligopolistic competition markets typically
have either differentiated or uniform products and few sellers resulting from
barriers to entry. While these
conditions typically result in economic profits, there is still relatively low
price flexibility. Price decreases are
usually matched by competitors. In
addition, it is uncertain how much volume such tactics gains. Furthermore, there is little certainty that
competitors will follow price increases, which could result in loss of market
share (Armstrong & Kotler, 1996, p. 347-348).
Pure monopoly market structures are mainly
distinguished by having only one seller.
The selling firm has complete control over price levels within these
markets. However, the threat of entry,
production volume considerations, and potential government interference limits
prices to some degree (Armstrong & Kotler, 1996, p. 347-348).
Relationships among consumers, price, and
demand.
Michael Baye (2000, p. 34) states that a fundamental principle of economics is
the law of demand, which declares that price and quantity demanded are
inversely related. This relationship is
derived from the individual consumer’s perception of value. In transactions, consumers exchange a store
of value (money) in substitute for the benefits or value of a product or
service. Each individual values the
product differently. Therefore, as
price increases consumers become increasingly unwilling or unable to purchase
the product. The purchasing decisions
of individual consumers can be aggregated into a demand cure. This curve indicates the total quantity of a
good all consumers are willing and able to purchase at each possible price,
holding other factors constant. When
other factors (income, advertising, price of substitutes, consumer tastes or
expectations, etc.) change, the entire demand curve may shift because all
consumers are affected at every price.
However, when price changes, the quantity changes are represented by
shifts along the demand curve. The
extent of the shift and its affects on quantity demanded are determined by
price elasticity of demand.
“Price elasticity is a measure of the
sensitivity of demand to changes in price (Armstrong & Kotler, 1996, p.
350).” Inelastic demand denotes that
the quantity demanded will change by a smaller percentage than the price. Whereas, elastic demand means that the
quantity demanded will change by a greater percentage amount than price. The extent of a product’s elasticity can be
determined by factors such as: product differentiation, scarcity, absence of
viable substitutes, and the proportion of a consumer’s income such a purchase
represents.
Almost no product or transaction is conducted
in isolation. Competitors and
substitutes must be considered relative to a firm’s own product. The product’s value to price ratio must be
comparable to the other options available to consumers for long-term
competitive viability. In this context,
benchmarking becomes important. Competition
among products is often a zero sum game (especially in mature markets). Therefore, quality and price are important
relative to competitor and substitute products (Armstrong & Kotler, 1996,
p. 351).
Government regulations can have a profound
effect upon pricing strategies and terms.
This discussion focuses on U.S. federal business legislation. The overall purpose of this legislation is
to protect the consumer from market conditions that limit consumer
surplus. This broadly equates to the
preservation of competition within product markets.
Sherman Act. Section 1 of the Sherman act
prohibits contracts, combinations, and conspiracies that restrain trade. U.S. courts have established two standards
of proof for potential violations of this legislation. The rule of reason test requires the courts
to determine whether a practice unreasonably restricts competition considering
factors such as relevant industry attributes, the defendant’s position within
that industry, the competition’s ability to respond, and the defendant’s
purpose of adopting the policy in question.
However, some categories of trade restraints have been deemed to be
illegal per se, or unreasonable by their very nature. Therefore, plaintiffs merely need to show the existence of such
practices (Mann & Roberts, 1997, p. 1034-1038).
Price fixing is the primary and most serious
of illegal per se violations of the Sherman Act. Price fixing is an agreement with the purpose or effect of
inhibiting price competition. These
agreements may attempt to raise, depress, fix, peg, or stabilize prices. Both horizontal and vertical price fixing is
illegal per se. Horizontal price fixing
involves agreements with competitors or other sellers. Vertical price fixing covers arrangements
with retailers or other purchasers that require a certain resale price level
(Mann & Roberts, 1997, p. 1034-1038).
A second illegal per se violation of the
Sherman Act that involves pricing decisions and structure is tying
arrangements. A tying arrangement
occurs when the seller of a product or service conditions the sale on the
buyer’s purchase of a second product.
These arrangements are illegal per se when the seller has substantial
economic power in the tying product and involves significant interstate
commerce (Mann & Roberts, 1997, p. 1034-1038).
Clayton Act. The Clayton Act supplements the Sherman Act and is intended to
stop trade practices before they become restraints of trade. Section 3 of the Clayton Act primarily deals
with tying arrangements and exclusive dealing, selling, or leasing arrangements
that prevent the purchaser from dealing with the seller’s competitors. The exclusive dealing clause is a violation
if the arrangement tends to create a monopoly or may substantially lessen competition. While the Clayton Act provides only for
civil action, the legislation allows for treble damages, as does the Sherman
Act (Mann & Roberts, 1997, p. 1040).
Robinson-Patman Act. The Robinson-Patman Act primarily limits price discrimination
practices involving commodities of same grade and quality. Violations of this act must either tend to
create monopolies or substantially lessen competition. Differences in prices to different customers
are allowed on two basis. The first is
a cost savings resulting from the attributes of a particular buyer. These attributes may include distribution
expenses or volume discounts. The other
basis of price discrimination among consumers is a good faith effort to meet
competition (Mann & Roberts, 1997, p. 1043).
The voluntary nature of transactions dictates
that any transaction price will fall between a price floor where no profit is
achieved and a price ceiling where no demand exists. These two boundaries are represented by the supply curve (price
floor) and the demand curve (price ceiling).
Determining the relative distribution of consumer and producer surplus
of value is dependent upon market, product, and environmental attributes. Several approaches have been used to
determine an offer price.
This approach utilizes the cost structure of
producing a product. The pricing
strategy is product driven rather than customer driven. The benefit of this approach is that the
chance of loss is low. Purchasing
decisions, however, are based upon the customer’s perceived value of the
good. Therefore, volume may be lost if
costs are over estimated or profits may be lost if costs under estimate product
value (Libresco, 1997, p. 10).
Mark-up pricing. This cost-based pricing approach involves adding a standard
markup to the product’s cost. The
amount of the markup is typically higher on goods that are demand inelastic,
seasonal, slower moving, specialty items, or have high storage and handling
costs. This method seldom results in the optimal price because it disregards
customer perceived value, demand, and competition. It does, however, simplify the pricing process and results in
similar prices if the industry utilizes the method (Kotler, 1997, p.503).
Target profit pricing. Rather than add a standard markup to the product’s cost, this
method adds a premium equal to the return the project requires. This method ignores price elasticity of
demand and competitor policies and their effects on sales volume and
profits. A tool called a break-even
analysis aids in evaluating the pricing policy's margin of error. This tool determines the volume of sales
necessary for the firm to cover all fixed costs. This manner of pricing products greatly encourages production
cost reductions in order to lower the break-even sales volume (Armstrong &
Kotler, 1996, p. 354).
Perceived value pricing. Value pricing sets its target price based upon customer
perception of product value. Therefore,
the pricing is customer and value driven.
From a perceived value, the price is determined. From the price, the product is designed at a
certain cost to ensure profits of a desired level. In this manner, firm’s attempt to claim greater portions of the
value created by every transaction. In
essence, they seek to claim portions of consumer surplus as producer
surplus. Problem arises in estimating
consumer perceptions of value (Armstrong & Kotler, 1996, p. 355).
Going Rate. This
approach to pricing products relies mainly on the prices that leading
competitors quote. Firms that employ
this method price their product relative to market leaders. This approach is popular in pure competition
or oligopolistic competitive market structures (Armstrong & Kotler, 1996,
p. 356).
Sealed Bid. This
pricing method relies on pricing services or products based on the expected
prices of other competitors. Long-run
operations often quote bids on an expected profit basis. Both the probability of customer acceptance
and profit margin are combined to determine the highest expected return. Utilizing these two variables will result in
the maximum profit over the long-run as more opportunities present themselves. Determining the probability of project
acceptance, however, is a difficult task (Armstrong & Kotler, 1996, p.
356).
“Pricing strategy is a reasoned choice from a
set of alternative prices (or price schedules) that aim at profit maximization
within a planning period in response to a given scenario (Tellis, 1986, p.
147).” In his article, “Beyond the Many
Faces of Price: An Integration of Pricing Strategies,” Gerard Tellis states
that pricing strategies can be classified by two dimensions: a firm’s pricing
objective, and consumer characteristics.
Possible pricing objectives include: differential pricing, competitive
pricing, and product line pricing. The
relevant consumer characteristics include: search costs, price sensitivity, and
transactions costs. These two
dimensions and their three options create a nine box matrix demonstrating which
are the necessary conditions for each pricing strategy.
Due to consumer differences, the same product
is sold to consumers under a variety of prices. Consumer differences refer to search costs (allowing random
discounting), price sensitivity (allowing periodic discounting), and
transaction costs (allowing second market discounting) (Tellis, 1986, p.
148).
Random discounting strategies. Random discounting strategies or promotional pricing strategies
involves decreasing the price of certain items on a random and unpredictable
basis in order to increase short-run sales of individuals with low search
costs. Those with low search costs will
look for and purchase items discounted because their opportunity costs are
lower. Whereas individuals with high
opportunity or search costs will maintain their purchasing decisions regardless
of discounts. Therefore, a random
discounting strategy is appropriate when the profits from attracting those with
low search costs exceed the costs of individuals with high search costs
inadvertently purchasing discounted items (Tellis, 1986, p. 146). The High-Low Pricing Method is a prime
example of random discounts among retailers.
This approach involves charging higher prices on an everyday basis, but
running frequent promotions that lower prices in an attempt to lure price
sensitive consumers (Dreze, Hoch, & Prurk, 1994, p. 16).
Periodic discounting. Periodic discounting
(market-skimming pricing) involves setting different prices for
different portions of the market in order to set higher prices for individuals
with less price sensitivity. Higher
prices are charged to those portions of consumers with less price sensitivity. As this portion of the market matures,
prices are lowered to attract new consumers.
This strategy requires a wide diversity of demand at different
prices. This diversity of consumer
perceived value may require high quality products to support higher consumer
valuations. Seasonal discounts for
fashion, automobiles, travel, and technology are common examples of this
pricing strategy (Tellis, 1986, p. 149).
Second market discounting. Second market discounting
(segmented pricing) is the sale of a product or service at two or more prices.
These prices are not based on product cost or attribute differences. The main
thrust of this strategy is to penetrate other market segments while maintaining
both the profit margin and position within the branded product segment. The main prerequisites of this strategy are
firm over capacity and high consumer transaction costs. These transaction costs prevent arbitrage
between the two markets. Transaction
costs may result from traveling costs, investment risk, the cost of money, or
switching costs. Generic products are an example of this differentiation
strategy strategy (Tellis, 1986, p. 149).
These strategies are employed with the firm's
competitive position in mind. Specific
pricing strategies include penetration pricing, experience curve pricing,
predatory pricing (although illegal), price signaling, and geographic pricing.
Penetration pricing. Penetration strategies (market-penetration pricing) involve
setting low prices in order to increase market share so that economies of scale
are achieved. Market characteristics
such as consumer price sensitivity, falling production and distribution costs
associated with increased volume, and the threat of competitive entry increases
the attractiveness of such a pricing strategy.
A similar pricing strategy that can be employed is limit pricing. This
approach seeks to set prices at the maximum level that still discourages market
entry (Armstrong & Kotler, 1996, p. 366).
Another form of market penetration pricing is
value pricing strategies. Value pricing
focuses on providing customers with prices that provide high value offers. Quite simply, these firms provide low costs
while maintaining product quality. This
process requires more commitment than simply lowering prices. In order to remain competitively viable, the
firm must reduce its operating expenses in order to become a low cost producer
throughout the organization (Kotler, 1997, p. 507-508).
One example of value pricing within the
retail industry is a practice called Everyday Low Pricing (EDLP). An EDLP policy attempts to charge a constant
low price without temporary price discounts.
Many contend that EDLP is an effective manner of communicating to
consumers a pricing strategy and credibility when random discount strategies
have eroded credibility. In addition,
it has cost reductions associated with reduced service, inventory, handling,
and labor expenses (Dreze, Hoch, & Prurk, 1994, p. 16).
Price signaling pricing. Using price as a false indication of quality, price signaling
seeks to sell lower quality goods to consumers with high search costs. Individuals with high opportunity costs find
it overly expensive to determine product quality. Three conditions are necessary for such a pricing strategy to be
successful. First, information on price
must be easier to attain than information on product quality. Secondly, consumers must value quality so
highly that they will risk purchasing over priced goods. Finally, a sufficiently large portion of the
market must both be able to distinguish product quality and be willing to pay
for it. This final condition allows the
price quantity relationship to be maintained as an indication of product
attributes (Tellis, 1986, p. 153).
Geographic pricing. Geographic pricing strategies determine the manner in which
differing distribution expenses are spread among customers. A free on board (FOB-origin pricing)
strategy allows individual customers to pay for their own distribution. While this approach may result in true
individual costs, competitive viability among distant customers is
reduced. Another method, uniform
delivered pricing, charges the same distribution expense to all customers
regardless of location. Some consumers
pay for product distribution of other consumers. Zone pricing is a hybrid of the FOB-origin pricing and the
Uniform delivered pricing approaches.
It involves designating geographic territories or zones with certain
distribution expenses. While prices
more accurately reflect true costs, subsidization of distribution costs still
occurs with in the zones. Basing point
pricing is another strategy which selects a city or reference point and then
charges customers based on their location relative to that point. This transfers distribution expenses from those
in distant locations to those close to the factory. Finally, freight absorption pricing simply charges distribution
expenses to the seller thereby allowing market penetration or retention of
market share in an increasingly competitive environment (Armstrong &
Kotler, 1996, p. 373-375).
Product line pricing is applicable when a
firm has a set of related products. The
firm seeks to maximize profit by pricing its products to match consumer
demand. Product line pricing strategies
include price bundling, premium pricing, image pricing, and complementary
pricing strategies (Tellis, 1986, p. 154).
Price bundling. Combining two or several firm products at a reduced price is
product-bundle pricing. This strategy
is typically employed when non-substitutable perishable goods are being sold in
a heterogeneous market. Examples of
this tactic are season tickets, software packages, and hotel packages (Tellis,
1986, p. 155).
Premium pricing. Premium pricing (product
line pricing) is setting the price steps between various products in a product
line based on cost differences, customer evaluations of different product
features, and competitors' prices (Armstrong & Kotler, 1996, p. 368). These product lines are typically
differentiated only by additional product features. Therefore, economies of scale result from producing different
product models on the same facilities.
In addition, heterogeneous demand is exploited to charge different
prices for the different product lines (Tellis, 1986, p. 156).
Image pricing. This pricing tactic
involves introducing an identical existing product, but with a different name
and a higher price. Image pricing is a cross between price signaling and
premium pricing. The firm uses the
higher price to imply higher quality to uniformed consumers. The higher profits on the higher priced
version are then used to subsidize the lower priced version. It is a different product only in name and
price. This pricing method can be seen
in the variance of prices in soaps, wines, fashion, and cosmetics (Tellis,
1986, p. 156).
Complementary pricing. Two strategies are included within this category. The first of these categories is called
captive pricing. Captive pricing is the
setting of a premium price on a good that is used along with a main
product. The main limiting factor on
supplementary goods is that there are seldom dual product economies of
scale. Without these cost reductions,
there are little barriers to entry to those that would provide the secondary
good. Therefore, the premium charged is
limited (Tellis, 1986, p. 157).
Retailers have similar pricing strategy known
as loss leadership. Store traffic is
generated through the reduction of price on major brand items. With increased traffic, retailers hope to
generate offsetting profits from the items that consumers purchase in addition
to the discounted items. Consumers have
incentive to purchase other items in order to limit their transaction cost. Manufacturers disapprove of these tactics
mainly because it erodes the brand value and causes conflicts with other
retailers (Tellis, 1986, p. 157).
This approach to pricing considers the
psychological nature of prices rather than economic factors. Price is a reflection of product
quality. The importance of price as a
measure of quality increases, as determining product quality through other
means becomes more difficult. Consumers
have prices to compare product prices and their attributes to called reference
prices. Even the visual aspect of
prices and its price range are considered when setting prices (Armstrong & Kotler, 1996, p. 371).
Technology remains the biggest innovation in
determining pricing policies and strategies.
Technology allows instantaneous transfer of information from a register
at Wal-Mart to the central office. This
information in turn can be turned into data points on the demand curve of
products. Perhaps the biggest change
has been the use of the Internet and web-based auction sites. "Technology is enabling us to gain
information about the prices of products and services quickly and inexpensively
(Krauss, 1998, p. 9)." These
transactions are recorded, compiled, and provide valuable pricing information
due to its large volume of transactions.
"One of the most important added benefits to adding auction
technology to a corporate web site is the simple fact that it can generate
traffic (Briody, 1999, p. 31)."
The effects of more accurate and timely estimates of demand curves could
be felt in the general pricing approaches and strategies that companies pursue.
Pricing can arguably be described as the most
important component of a marketing mix.
It is the negotiation between a consumer and a firm for the transfer of
a product and the benefits associated with it.
Internal factors, external factors, pricing objectives, and pricing
strategies combine to dictate a product's or service's price. One must remember, however, that price is
not in isolation from other product attributes and marketing decisions. These all combine so that competition is
based upon consumer perceived product attributes and value relative the price
that is charged.
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