Pricing Theory and Practice jhu.doc

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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:

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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

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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

Pricing Theory and Practice jhu.doc

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