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Pricing Theory and Practices
The Nature of the Pricing
Process
Pricing is the process of determining what a company will receive in exchange for its
products. Pricing factors are manufacturing cost, market place, competition, market
condition, and quality of product. Pricing is also a key variable in microeconomic price
allocation theory. Pricing is a fundamental aspect of financial modelingand is one of the four
Psof themarketing mix. The other three aspects are product, promotion, andplace. Price is
the only revenue generating element amongst the four Ps, the rest being cost centers.
Price means the monetary sacrifice to purchase the value of the product. In ordinary usage
price is the quantity of payment or compensation given by one party to another in return of
goods or services.
In all modern economics, the overwhelming majority of prices are quoted in and the
transactions involve! units of some form of currency. "lthough in theory, prices could bequoted as quantities of other goods or services this sort of barter exchange is rarely seen.
In terms of cost:
Price is a monetary expression which covers all kinds of costs related to producing those
kinds of product plus a return on investment.
In terms of customer viewpoint:
1 | P a g e
Denition of Price
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Price is a monetary expression of the value for dimensions of quality and features or benefits
for a given product or service as compared with the competitors product or service.
The relationship can be viewed as Price # $uality% &alue
In terms of psychological viewpoint:
Price represents a quantitative estimate and subjective image of the benefits from a selective
group of product features for a good or service on the basis of psychological patterns of
consumers.
Theory of price asserts that the market price reflects interaction between two opposing
considerations. 'n one side are demand considerations on marginal utility, while on the other
side are supply considerations based on marginal cost.
The price of the product determines the products contributions to profitability. The motivation
in setting a high price is that it creates bigger margins, which is turn lead to increased profits.
(ith low prices the opposite happens) margins are reduced and there is less contribution from
that particular product. The critical factors considered in pricing decision are given below)
Eective cost information:
*arketing management needs to look carefully at the cost involved in the allocation of
resources to create and define the product. This means not only manufacturing and
distribution costs, but special marketing and technological costs.
Customer valuation:
+ather than compete on price alone, marketers must think in terms of total value as perceived
by the customers, or the combination of features and experiences that create a total customer
perception of value. (hen a customer will pay for the product or service does not relate
solely to physical features or performance. +ather it is the total package including
complementary features such as installation, delivery, technical support and after sale service.
ar!et targets:
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Critical "actors in Pricing
Decisions
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The total market for a product or service package can be segmented because of the
differences groups of customers. These differences may allow for product and pricing
differentials whereby no market segment is buying the same product or paying the same price
as another.
Competitive dynamics:
ompetitor-s reactions have a significant impact on pricing to the extent they may keep as
firm from making a price adjustment. The most common example is when a firm cuts the
price of a product and competitors follow suit precipitating a price war. "t the end of other
spectrum, the marketer considering a price increase needs to know whether the competitors
will follow low suit and raise their price or hold their price, thereby creating a competitive
differentials.
Pricing strategies:
Price as an integral part of marketing mix will contribute to the attainment of marketing
objectives, which in turn are derived from objectives set forth for the firm as a whole.
ocusing on gaining a competitive advantage, marketing management analyses the situation,
sets specific functional objectives and formulates strategies or ways of achieving these
objectives.
/evelopment of rules such as following can be of help in formulating specific pricing
strategies)
0cale) is the si1e of purchase
onsumer knowledge) is the customer ability to evaluate the value of a product in
terms of monetary consideration. /emand) price play an important role in consumer pricing decision
Information) through Information marketer can accurately determine price%value
evaluation and level of demand
ompetitive substitute) is the other products in the category that provide relatively
close substitutes against which price can be compared. Patronage) Is the customer-s favorability for non price reasons compared with the
competitors.
3 | P a g ePrice #tructure
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" price structure is defined as a series of price levels that represent how a product will be
priced. These price levels allow flexibility in pricing by providing variations in price
depending on product features, customer differences and purchasing behavior.
2enefits from the use of a pricing structure include greater flexibility in pricing, rapid
adjustment to competitive trends in the marketplace, and enhancement of market
segmentation strategies through objective distinctions between customer types. Price
structures are used by different firms in varying market conditions. The benefits of price
structure as opposed to a single price do not always carry over to the customer.
'ne of the primary reasons in adopting of a pricing structure is to provide a ready response to
competitive threats or market opportunities. "nother reason in setting up a pricing strategy is
to install customer incentives that are cost effective from the seller-s perspective. " pricing
structure that recogni1es the differences between customer segments will also allow for
different customer evaluation of a product or service and different perception of value.
Constraints of Pricing Practices:
"lthough market valuations and costs of product are major pricing determinants
Industry membership
0tructure of marketplace
3eneral economic condition
4egal constraints
Place constraints
ompetitions
"re the major constraints of pricing practices of a firm.
The more the competitive the industry, the easier is the pricing decisions. The major
competitors are not the same, nor the products, the way the product are sold, or to whom theyare marketed. It is difficult to resist increasing prices during the times of prosperity and when
consumer confidence is up or lowering the prices during the period of recession. In
developing pricing strategies those responsible for decisions must work within what seems at
times a baffling legal framework such as foreign trade, public policy and national interest.
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Ethics in Pricing
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The process of setting a price for a product may produce a conflict with social values. The
reason is that in setting a price the marketer wants to achieve the best possible outcome over
the long run. This may result in a higher or lower price than market forces dictate at a
particular time. (hile high price will provoke more comment than low price, the motives of
the seller will be questioned with both. 5igh prices suggest excess profit and the seller
making more money than he or she should on a reasonable basis. 4ow prices on the other
hand suggest less value to the customer and a seller who may be trying to put something over
on a customer.
0ome of the instances where pricing may be questioned are)
The incremental price in a product line does not seem justified in terms of value
increases.
The price of branded merchandise is considerably higher than generic merchandise.
There is disproportionately high part for replacement parts.
The price for new product is greater than the value of the change incorporated in the
product.
$uestion arises about price when it is used as a false reference or appeal to increase sales.
'ne answer to the question of ethical pricing is a statement of principles.
'ne of the four major elements of the marketing mix is price. Pricing is an important
strategic issue because it is related to product positioning. urthermore pricing affects other
marketing mix elements such as product features, channel decisions, and promotion.
(hile there is no single recipe to determine pricing, the following is a general sequence of
steps that might be followed for developing the pricing of a new product.
/evelop marketing strategy) perform marketing analysis, segmentation, targeting and
positioning. *ake marketing mix decisions) define the product, distribution, and promotional
tactics. 6stimate the demand curve) understand how quantity demanded varies with price.
alculate cost) include fixed and variable cost associated with the cost.
7nderstand environmental factors) evaluate likely competitor-s actions, understand
legal constraints, etc.
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Pricing #trategy
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0et pricing objectives) profit maximi1ation, revenue maximi1ation, or price
stabili1ation. /etermine pricing) using information collected in the above steps, select a pricing
method, develop the pricing structure and define discount.
These steps are interrelated and are not necessarily performed in the above order.
8onetheless, the above list serves to present a starting framework.
The firms pricing objectives must be identified in order to determine the optimal pricing.
ommon objective include the following)
Current prot ma$imi%ation:seeks to maximi1e current profit, taking into
account revenue and cost. urrent profit maximi1ation may not be the best objectives
if it results in lower long term profit. Current revenue ma$imi%ation:seeks to maximi1e current revenue with
no regard to profit margins. The underlying objectives often are to maximi1e longterm profits by increasing market share and lowering costs.
a$imi%e &uantity:seeks to maximi1e the number of units sold or the number
of customer served in order to decrease long term cost as predicted by the experience
curve. a$imi%e prot margin: attempts to maximi1e the unit profit margin,
recogni1ing that quantities will be low. 'uality leadership( use the price to signal high quality in an attempt to
position the product as a quality leader. Partial cost recovery:an organi1ation that has other revenue sources may
seek only partial cost recovery. #urvival:in situation such as market decline and overcapacity, the goal may be to
select a price that will cover cost and permit the firm to remain in the market. In this
case, survival may take a priority over profits, so this objective is considered
temporary. #tatus &uo: the firm seeks price stabili1ation in order to avoid price wars and
maintain a moderate but stable level of profit.
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Pricing )*+ectives
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or new product the pricing objectives often is either to maximi1e profit margin or to
maximi1e quantity market share!.
ar!et Interpretation of Price
The price is the amount a customer pays for the product. The price is very important as it
determines the company9s profit and hence, survival.
Price as an element of marketing mix generates revenue of the firm. In contrast the other
element of the marketing mix: product, promotion, place: involves expenditure. Pricing
below the competition represents a loss of potential profit from the sale of an item.
ompetition forces firms to focus on and serve customer better than competitors through
product offering, more services, as well as more effective pricing scheme. 6ffectiveness inpricing is viewed in terms of product positioning and total profitability over the product life
cycle. 6ffective combination of price and quality can produce a favorable strategic position
and in turn higher profit.
*arketing management must weigh the behavioral aspect of price and then juggle all the
elements of the marketing mix including price. In using the marketing mix it is important to
emphasi1e on the relationship of the elements with one another as they impact the total
marketing programme. These interrelationships can be thought in terms of consistency,
integration and leverage.
The price of a product or service is subjected to different interpretations and utili1ation by
consumer in making purchase decisions. The psychological aspects of price may be used in
several ways by the customer. 'ne is the use of price to signal characteristics of a product or
7 | P a g e
Price as a Part of ar!eting i$
Price as Purchasing Information
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service such as quality, value and personal status. The makers of 2*( cares believe that the
luxury performance market is shifting from cares representing what he or she has to % what he
or she is. That is the brand of car, instead of signaling positional status or prestige now
provides information as to how astute the buyer is in getting the most value of the money.
The formula helps in visuali1ing this)
eatures% 2enefits ; Price # &alue
'bviously the greater the value, the more likely is the consumer to purchase of product in
question.
(hether or not price provides information to the purchaser depends upon the inferred
relationship between price and the product or service and also the reliability of that relation.
3enerally positional product will have higher prices.
Price along with various forms of promotion, act to stimulate consumer response in terms of
sales. The expected pattern is an increase in sales, with a cut in price or the introduction of a
new product or brand at a lower price. " major competitive tool in many industries is
promotional pricing, involving short term price cuts, cash:back deals or rebates, value
pricing, or merchandising incentives that may include premium or contests.
+esponse to marketing stimuli such as price cuts is an approach used by marketers in
identifying consumers and segmenting markets. /efining markets by those characteristics
that identify price sensitive consumers ties segmentation strategy with a profit measure. Profit
maximi1ation through plan segmentation can be achieved by allocating resources based on
incremental response to the marketing stimulus, in this case price cuts. The take:home sales
market for soft drinks is an example of market that appears to be price sensitive. 'ff price
retailers have focused their marketing efforts on price sensitive consumers.
(hile many companies made significant inroads and some say, changed their respective
industries by offering drastically discounted, no:frills service, competition was able to
counter their low:price advantages by packaging price with other important product aspects,
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Price as ar!eting #timulus
Customer interpretation of price
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principally quality and customer service. onsumers perceive differences in competitive
offerings in terms of several important characteristics, of which lower price is but one.
Time implications:
"s a general rule, individual and industrial customers alike consider delays in getting the
product a time cost. "s a consequence, products that are readily available will often command
a premium price as a trade:off with time costs. Time cost is equal to the time between giving
order and getting the product.
Psychological implications:
onsumers tend to relay on price in differentiating between products and forming
impressions of product quality. The result is that successful quality product must have higher
prices than their counterparts with less quality. (hile the customer will tend to pay more for
higher quality, others pay more to avoid the perceived less desirable consequences of
purchasing a lower:priced brand that may be unsatisfactory. The assumption is that the lower:
priced brand lacks certain quality, features, or customer service.
onsumers should use a product9s price to determine if the product is affordable. 5owever,
consumers also appear to use a product9s price as a measure of the product9s quality. *any
empirical studies have shown that when consumers have some uncertainty concerning a
product9s quality, the consumer often assumes that a higher product price indicates a higher
level of quality.
0ome of the consumers in this market are not concerned with this quality of the product.
These consumers are very price sensitive. They will buy the lowest priced product regardless
of the level of the quality. These price:sensitive consumers depress the price and, because
they place no value on quality, they also depress quality levels
(ith more and more products to choose from, and a constant flow of new and more complex
products, the job of judging which of the alternatives to purchase have become exceedingly
complicated and made shopping much more difficult. omparing models of a product or
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Price 'uality ,elationship
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brands of a product at differing price levels is all the more difficult because the customer
lacks the complete information relative to difference in quality. If it is possible to measure
quality, than the difference can be compared to price differences. omparative value can be
determined using the following formula):
v
(here v is the comparative value or the relative difference in value between a higher:priced
product 5! and a lower:priced product 4!, $5 is the quality dimensionof 5, $4is the quality
dimension of 4, P5is the price of 5, and P4the price of 4.
"ll consumers who were concerned with the quality of the product were also able to identify
that quality. 0ome consumers, however, may want the quality but these consumers may be
unable to determine whether or not the quality is present.
5owever, product quality may be multidimensional. 0ome consumers may be interested in
one quality of the product while other consumers may be interested in another quality of the
product. or example, some consumers may judge the quality of an automobile in terms of its
luxuriousness while other consumers may judge the quality of the automobile in terms of its
need for repairs.
rom the preceding sections, we come to the following conclusions.
Prices reflect levels of quality even with limited competition.
The quality:price relationship is non:linear.
Prices reflect levels of quality even when some consumers do not behave in a rational
economic manner.
onsumers using price as a surrogate measure of quality encourage companies to
raise the level of product quality.
ompetition does not destroy the relationship between price and quality.
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ompanies with high quality products spend more on advertising than companies
offering lower quality products.
(hen different qualities of the product are important, price can only be used as a
measure of the quality desired by the market. In other words, a consumer can only use
price as a measure of quality if the consumer9s values are reflected by other
consumers in the market.
"nother psychological dimensions of price as related to products and sometimes brands is its
use by consumers to set price levels for products to sort products into price ranges. Price
levels refers to the amount of money one would expect to pay for a level of quality in a
particular product type, in other words , the minimum one must pay to obtain value in a type
of product. Prices below this minimum will indicate a sacrifice in value for the product.
Price +ange) 7pper and lower limit of price, as the perception of value in a product to
a series of prices with an upper and lower boundary.
Price 4evel) +efers to the amount of money one would expect to pay for a level of
quality in a particular product type.
"n acceptable price range extends the perception of value in a product to a series of prices
with an upper and a lower boundary. (illingness to buy a product is higher with in the range
than above or below the range. (hile the acceptable price range tends to narrow the price
differentials available in a product, it simplifies the purchasing process for the customer.
"cceptable price ranges are usually found with convenience and shopping goods
classifications rather than with specialty or luxury types of product.
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-ccepta*le Price level and ,anges
Price .ine
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" variation of acceptable price levels or ranges is what is called price lining. (ith price
lining, price levels or price ranges are set up for a product type and individual brands
accordingly.2y offering products at more than one price line, the seller can appeal to more
segments of the market. *ore than one price offer the potential for trading up from one price
line to the next higher. The risk is the possible lack of consistency caused by different prices
and resulting damage to the product image.
(ith acceptable prices and price ranges, seller, in setting a price, are dealing with product
valuation as perceived by consumers. 'bviously, consumers will have different evaluation,
yet are presented with one price in most situations at the retail level. In industrial and other
organi1ational buying situations, it is far more common for the consumer to be presented
several different prices as a result of negotiation. Typically, multiple prices are effective when
differing consumer valuation can be determined by a particular characteristic of the
purchasing process.
2eing comparative is a natural human instinct. *ost rational shopper wants to buy a product
or a service if its price first matches his or her perceived value. Then the rational buyers
might compare its price that this store offers relatively to other stores. The buyers might also
have a set price in mind. 0ometimes buyers do not have all of the relevant information to
know how much a certain product or a service is worth, and this is where marketers can come
in and assist or trick if you have a negative view on marketing! and help buyers make buying
decisions. *arketers can convince the buyers to purchase their product or service by
implementing reference pricing strategy, most prominently used in discount stores. +eference
prices are prices that buyers carry in their minds and refer to when looking at a given product.
+eference price is one component of psychological pricing, in which the sellers consider the
psychology of prices and not simply the economics.
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,eference Prices
)dd/Even Pricing
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'dd:even pricing assumes that prices ending in an odd number increases consumer
sensitivity, in that consumers react to those prices as indicating bargains. 'ne reason is that
consumers perceive odd prices as being substantially lower than even:priced items< even
through the real difference is perceptually very well.
Psychological pricing or price ending is a marketingpractice based on the theory that certain
prices have a psychologicalimpact. Theretailprices are often expressed as =odd prices=) a
little less than a round number, e.g. >?@.@@ or AB.@C. The theory is this drives demand greater
than would be expected if consumers were perfectly rational. Psychological pricing is one
cause ofprice points.
Pricing from the #tandpoint of
Economic Theory
The constant state of flux experienced in any given market is a result of heterogeneity to be
found in both buyer demand and seller supply. 2uyers demand changes heterogeneously
owing to):
0ome buyers are being faster learners than others
3reater product interest in usage variance< and
0ome buyers having more discretionary income
The heterogeneous changes of supply arise from):
0ome sellers learning faster
0ome having more resources
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Dynamics of the ar!etplace
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0ome prepared to take more risk
0upply and demand is an economic modelof price determinationin a market. It concludes
that in a competitive market,the unit pricefor a particular good will vary until it settles at a
point where the quantity demanded by consumers at current price! will equal the quantity
supplied by producers at current price!, resulting in an economic equilibriumof price and
quantity.
The four basic laws of supply and demand are)
If demand increases and supply remains unchanged, then it leads to higher
equilibrium price and higher quantity.
If demand decreases and supply remains unchanged, then it leads to lower equilibrium
price and lower quantity.
If supply increases and demand remains unchanged, then it leads to lower equilibrium
price and higher quantity.
If supply decreases and demand remains unchanged, then it leads to higher
equilibrium price and lower quantity.
/emand is the amountof a particular economicgood orservicethat a consumeror group of
consumers will want topurchaseat a givenprice. /emand is the relationship between the
quantities of a product that will be purchased and the possible alternative prices for that
product at a given time. This relationship is shown by the demand curve. The demand curve
is usually downward sloping, since consumers will want tobuymore aspricedecreases
The demand curveis usually downward sloping, since consumers will want tobuymore as
pricedecreases. /emand for a good or serviceis determined by many different factorsother
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The Concept of Demand
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than price, such as the price of substitute goodsand complementary goods. In extreme cases,
demand may be completely unrelated to price, or nearly infinite at a given price. "long with
supply, demand is one of the two keydeterminants of the market price.
/emand curve is based on the following three assumptions):
The market is composed of those who are both desirous of the product in question and
able to buy.
The general pattern of demand is an inverse relationship between quantities demanded
and price changes.
/emand pertains is to a given period of time.
The determinants of demand follow)
Income
Tastes and preferences
Prices of related goods and services
onsumers9 expectations about future prices and incomes
8umber of potential consumers
" demand schedule, depicted graphically as the demand curve, represents the amount of
some good that buyers are willing and able to purchase at various prices, assuming all
determinants of demand other than the price of the good in question, such as income, tastes
and preferences, the price of substitute goods, and the price of complementary goods, remain
the same. ollowing the law of demand, the demand curve is almost always represented as
downward:sloping, meaning that as price decreases, consumers will buy more of the good.
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Elasticity of Demand
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Price elasticity of demand P6/ or 6d! is a measure used in economics to show the
responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its
price. *ore precisely, it gives the percentage change in quantity demanded in response to a
one percent change in price holding constant all the other determinants of demand, such as
income!. It was devised by "lfred *arshall.
Definition
P6/ is a measure of responsiveness of the quantity of a good or service demanded to changes
in its price. The formula for the coefficient of price elasticity of demand for a good is)
The above formula usually yields a negative value, due to the inverse nature of the
relationship between price and quantity demanded, as described by the =law of demand=.
(hen the price elasticity of demand for a good is relatively inelastic 6d D ?!, the percentage
change in quantity demanded is smaller than that in price. 5ence, when the price is raised, the
total revenue rises, and vice versa.
(hen the price elasticity of demand for a good is unit elastic 6d #?!, the percentage change
in quantity is equal to that in price, so a change in price will not affect total revenue.
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(hen the price elasticity of demand for a good is elastic 6d D?!, the percentage change in
quantity demanded is greater than that in price. 5ence, when the price is raised, the total
revenue falls, and vice versa.
Determinants
The overriding factor in determining P6/ is the willingness and ability of consumers after a
price change to postpone immediate consumption decisions concerning the good and to
search for substitutes =wait and look=!. " number of factors can thus affect the elasticity of
demand for a good)
"vailability of substitute goods) the more and closer the substitutes available, the
higher the elasticity is likely to be, as people can easily switch from one good to
another if an even minor price change is made