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Chapter 14 Pricing Techniques

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Title: Chapter 14 Pricing Techniques


1
Chapter 14 Pricing Techniques


1
1
3
2
The Marketing Mix and Pricing
  • Product, promotion, place, positioning and pace
    are the five marketing mix elements constitute
    the firms instruments to create value in the
    marketplace
  • Price is the element of the marketing mix that
    differs essentially from the other five elements
    in that it is the firms instrument to capture
    this value in the profit it earns

3
Pricing - The Harvest of Your Profit Potential
  • If product development, promotion, distribution,
    positioning and speed of entry sow the seeds of
    business success, effective pricing is the
    harvest
  • Effective pricing cannot compensate for poor
    execution on the five elements, but ineffective
    pricing can prevent those efforts from resulting
    in financial success

4
Strategic Pricing Questions
  • The failure to integrate value-creating
    activities with pricing decisions leads to
    ineffective pricing and business mediocrity
  • To achieve superior, sustainanble profitability,
    pricing must become an integral part of strategy,
    not an afterthought
  • Strategic pricers ask the right questions in
  • Customers-gtValue-gtPrice-gtCost-gtProduct

5
Strategic Pricing Questions (cont.)
  • What costs can we afford to incur, given the
    prices achievable in the market, and still earn a
    profit?
  • What is our product worth to this customer and
    how can we better communicate this value, thus
    justifying our price?
  • What level of sales or market share can we most
    profitably achieve?

6
The Imperatives of Strategic Pricing
  • Strategic pricing requires anticipating price
    levels before product development
  • Strategic pricing requires a new relationship
    between marketing and finance - it is actually
    the interface between the two
  • Value is best understood by marketing and sales
    while the constraining financial objectives are
    best understood by finance

7
Pricing techniques
  • Cost-plus pricing
  • Multiproduct firm pricing
  • Price discrimination
  • Transfer pricing

8
Cost-plus Pricing
  • Two steps
  • The firm estimates the cost per unit of output of
    the product
  • The firm adds a markup to the estimated average
    cost
  • Markup (Price - Cost) / Cost

9
Target Return Figure
  • P L M K F/Q (PA)/Q
  • where P is price
  • L is unit labor cost
  • M is unit material cost
  • K is unit marketing cost
  • F is fixed cost
  • Q is units of output
  • A is total gross operating assets
  • P is desired profit rate on assets

10
The Cost-Plus Delusion
  • Financial prudence, by this view, is achieved by
    pricing every product/service to yield a fair
    return over all costs
  • The Fundamental Problem is In most industries,
    it is impossible to determine a products unit
    cost before determining its price because unit
    costs change with volume - due to fixed costs
    depending on volume

11
The Cost-Plus Delusion (cont.)
  • A price increase to cover higher fixed costs
    reduces sales further and causes unit cost to
    rise even higher -gt reducing profits
  • A price cut causes sales to increase, spreading
    fixed costs over more units, making unit costs
    decline-gtincreasing profit
  • Instead of pricing reactively to cover costs and
    profit objectives, price proactively

12
The Cost-Plus Delusion (cont.)
  • Cost-driven pricing leads to overpricing in weak
    markets and underpricing in strong ones - the
    opposite of strategic pricing
  • The only way to ensure profitable pricing is to
    let anticipated pricing determine the costs
    incurred rather than the other way around
  • Value-based pricing must begin before investments
    are made

13
Role of Pricing in Product Development
  • The nature of Cost-based Pricing
  • Product-gtCost-gtPrice-gtValue-gtCustomers
  • The nature of Value-based Pricing
  • Customers-gtValue-gtPrice-gtCost-gtProduct

14
The Customer-Driven Pricing Fallacy
  • The purpose of customer-driven pricing is to
    create satisfied customers
  • While this seems laudable, customer satisfaction
    can usually be bought by discounting
    sufficiently, but this may be at the cost of
    financial success
  • The purpose of strategic pricing is to price
    profitably by capturing more value, not
    necessarily by making more sales

15
Problems with Customer-Driven Pricing
  • Problem 1 Sophisticated buyers are rarely honest
    about how much they are actually willing to pay
    for a product
  • Problem 2 The job of sales and marketing is not
    simply to process orders at whatever price
    customers are willing to pay - it is to raise
    customers willingness to pay a price that better
    reflects the products true value

16
Pitfalls of Competition-Driven Pricing
  • In this view, pricing is a tool to achieve sales
    objectives such as increasing market share
  • Market-share goals usually produce greater
    profit. Priorities are confused, however, when
    managers reduce the profitability of prices to
    achieve the market-share goal. Price cuts are
    matched and LT profits suffer

17
Pitfalls of Competition-Driven Pricing (cont.)
  • The goal of strategic pricing is to find the
    combination of margin and market share that
    maximizes profitability over the long term. Often
    the most profitable price is one that
    substantially restricts market share relative to
    the competition (e.g. Godiva, BMW, Peterbilt
    Trucks, Snap-On Tools)
  • Goal of strategic pricing is to capture a
    substantial value-created share for the firm

18
Planning for Effective Pricing
  • Like most marketing decisions, pricing is an art,
    based on good judgment calculations
  • An effective pricing strategy requires that
  • Manager must understand how costs, customers and
    competition determine the p-environment
  • Strategic price formulation then begins with
    setting strategic objectives
  • Set concrete and deadline-bound goals
  • Decide tactics as specific actions for strategy

19
Basic Pricing Strategies
  • Basic Pricing Rule for Price Takers
  • Under Pure Competition, firms are Price Takers.
    Consequently, the manager has no control over
    market price. The only feasible strategy is the
    Least Cost Strategy where the manager tries to
    minimize the costs of manufacture and sale or
    tries to create differentiation on some
    dimension, if at all possible.

20
Basic Pricing Strategies (cont.)
  • Basic Pricing Rule for Price Searchers There is
    a trade-off between selling many units at a low
    price and selling only a few units at a high
    price
  • Manager of a firm with market power balances off
    these two forces by
  • choosing output where MRMC
  • the profit-maximizing price is the maximum price
    consumers will pay for this output

21
Simple Pricing Rule for Price Searchers
  • Marginal Revenue for a Price Searcher is
    MR P(1EF)/EF
  • where EF is the own price elasticity of demand
    for firms product P is the price
  • Since MR MC, then P(1EF)/EF MC or,
    alternatively, P EF/(1EF) MC
  • that is, P (K) MC where K EF/(1EF) and
    is the profit-max markup factor

22
Simple Pricing Rule Observations
  • Given EF, the manager can calculate P
  • The more elastic the demand for the firms
    product, the lower the profit-maximizing markup
    and hence price. In the case of perfect
    elasticity, P MC
  • The higher the marginal cost, the higher the
    profit-maximizing price

23
Other Pricing Strategies
  • Pricing Strategies for Extracting Consumer
    Surplus from Consumers
  • Price discrimination
  • Two-part pricing
  • Block pricing
  • Commodity bundling
  • Pricing Strategies for Special Cost/Demand
  • Peak-Load Pricing
  • Cross subsidization

24
Other Pricing Strategies (cont)
  • Price Strategies in Markets with Intense
    Competition
  • Price Matching
  • Inducing Brand Loyalty
  • Randomized Pricing
  • Multiple Product Pricing
  • Joint Product Pricing
  • Transfer Pricing

25
Price Discrimination
  • Price discrimination is when a seller charges
    different consumers different prices for the same
    good or service.
  • Price discrimination can occur when a price
    searcher is able to
  • identify groups of customers with different price
    elasticities of demand
  • prevent customers from re-trading the product.

26
Price Discrimination
  • Sellers may gain from price discrimination by
    charging
  • higher prices to groups with more inelastic
    demand
  • lower prices to groups with more elastic demand
  • Price discrimination generally leads to more
    output and additional gains from trade

27
Price discrimination
  • Occurs when the same product is sold for more
    than one price


P2
MC
P1
D2
G
R2
D1
R1
Output
Q2
Q
Q1
28
The Economics of Price Discrimination
  • Consider the market for airline travel where the
    MC per traveler is 100.
  • If the airline charges all customers the same
    price, profits will be maximized where MC MR
    (P 400 and q 100). Net Operating Revenue is
    equal to TR (40,000) - operating costs
    (10,000).
  • If the airline charges different prices (price
    discrimination), it will be able to increase
    net revenues. If the firm charges a higher price
    (600) to business travelers (who have a
    highly inelastic demand) and a lower price (300)
    to other travelers (who have a more elastic
    demand), it is able to increase Net Operating
    Revenue to 42,000.
  • If sellers can segment their market, they can
    gain by charging higher prices to consumers
    with a less elastic demand and offering discounts
    to those with a more elastic demand.

100
60
120
29
Price Discrimination
  • Price Discrimination involves charging different
    consumers different prices
  • Conditions for Price Discrimination
  • Consumers are partitioned into two or more types,
    each with different elasticities of demand
  • the firm has some means of identifying who
    belongs to which type
  • there is no possibility of resale between groups
  • General Rule Price so that MR1MR2MC

30
Price Discrimination (cont.)
  • Price Discrimination Rule To maximize profits, a
    price-discriminating firm with market power
    produces the output at which the marginal revenue
    to each group equals marginal cost
  • MR1 P1(1E1)/E1 MC
  • and MR2 P2(1E2)/E2 MC

31
Types of price discrimination
  • First-degree the firm is aware of each buyers
    demand curve
  • Second-degree the firm charges a different
    price, depending on the quantity each buyer
    purchases
  • Third-degree the firm breaks buyers into groups
    based upon their price elasticity of demand

32
Two-Part Pricing
  • With Two-Part Pricing, a firm charges a fixed fee
    for the right to purchase its goods, plus a
    per-unit charge for each unit purchased (athletic
    clubs, golf clubs, etc.)
  • Two-Part Pricing Rule Charge a per-unit price
    that equals marginal cost, plus a fixed fee equal
    to the consumer surplus each consumer receives at
    this per unit price

33
Block Pricing
  • Block Pricing involves the firm packaging units
    of a product and selling them as one package so
    as to earn an amount larger than that obtained
    from a simple per-unit price (six-packs,
    warehouse store prices, etc.)
  • The profit-maximizing price under block pricing
    is the total value the consumer receives for the
    package, including consumer surplus

34
Commodity Bundling
  • Commodity Bundling is the practice of bundling
    two or more products together and selling them at
    a single bundle price (e.g. travel company
    package deals, cars, computers, etc.)

35
Peak-Load Pricing
  • Peak-load Pricing involves the firm charging
    higher prices during periods of high demand and
    lower prices during periods of off-peak demand
  • Peak-load Pricing Rule Charge a higher price
    during peak times than is charged during off-peak
    times so that MRMC during each period

36
Cross Subsidies
  • A firm that engages in Cross-Subsidization uses
    profits made with one product to subsidize sales
    of another product
  • It is relevant in situations where a firm has
    cost complementarities and the demand by
    consumers for a group of products is
    interdependent

37
Price Matching
  • Price Matching is a strategy in which the firm
    advertises a price and promises to match any
    lower price offered by a competitor
  • Firm need not monitor the prices charged by
    rivals
  • Prevention device for consumers claiming to have
    found a lower price when they did not
  • Not feasible if one firm has lower costs

38
Inducing Brand Loyalty
  • By inducing Brand Loyalty a firm reduces the
    number of switchers
  • Several Methods
  • Comparative advertising
  • Frequent user programs
  • Club membership

39
Randomized Pricing
  • With a Randomized Pricing Strategy, a firm varies
    its price from hour to hour or day to day basis,
    consequently
  • consumers cannot learn from experience which firm
    charges the lower price thus reducing shopping
    for the best price
  • it reduces the ability of rival firms to undercut
    a firms price

40
The Multiple-product firm
  • TR TRX TRY
  • MRX dTR/dQX dTRX/dQX dTRY/dQX
  • MRY dTR/dQY dTRX/dQY dTRY/dQY

41
Optimal pricing for joint products fixed
proportions

Total MR
MC
PA
DemandA
PB
MRA
DemandB
MRB
Output
Q
42
Optimal pricing for joint products fixed
proportions
43
Tying
  • Occurs when a firm sells a product, the use of
    which requires the consumption of a complementary
    product
  • The consumer is required to buy the complementary
    product from the firm selling the product itself

44
Transfer Pricing
  • Occurs in large firms when one division sells
    product to another division
  • The transfer price is the price at which the
    transfer of product takes place within a firm
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