lecture 9 pricing programs

8/13/2019 Lecture 9 Pricing Programs

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Pricing Programs

Chapter 9


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Topic Outline

Establish the pricing objectives Analyze the price-elasticity of demand Identify key factors acting on price

competition Examine the relationship between pricechanges and volume, cost, and profitchanges

Basic types of pricing programs Impact of the planned pricing program on any

product line, substitute or complements


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Pricing Program

A pricing Program is the firms selection ofgeneral level of pricing for a given productrelative to the level of pricing being charged bythe competitors

The general type of pricing programs1. Penetration pricing

2. Parity pricing

3. Premium pricing Pricing program should be supportive ofmarketing strategy


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Pricing Objectives

The primary role of pricing decisions is to help

management implement its chosen marketing strategy. Pricing is central thrust of marketing strategy

Price will play a minor role in buying process, When:

Buyers are concerned about other attributes and benefits

The differences in price among competitors are minimal Pricing can be supportive of primary demand oriented

strategy if lower price can:

Increase the number of users

Increase the rate of use or repurchase within the productform or class


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Pricing Objectives In early stages of PLC, an important goal is to generate

new users. A lower price may:

Reduce the risk of trail Enhance the value of a new product relative to old one

The use of pricing programs to support primary demandstrategies is limited

Market demand must be price elastic for such strategiesto be successful ( early stages of life cycle)

Industry prices tend to decline over life cycle , leavingless margins available for future price cuts

The effectiveness of price in selective demand strategydepends on:


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Pricing Objectives the importance customers attach to price in making choices within

product form or product class Nature of demand interrelationship within the product line- Firms seeking to expand their served market through line extensions

must consider the pricing of a new product in the context of existingproducts

- Too low a price on an extension targeted to price sensitive segmentcan enhance the probability of cannibalization on existing productsale

- If the extension is a high end quality oriented addition, the higherprice may signal high quality

If the firms strategy is retention of existing customers, the role ofprice is to meet the price charged by the competitors

Price can used to sell complimentary products to customers through

tactics like Price leaders and bundling Price may be a critical factor in acquiring competitors customerseither by

Becoming the low price leader


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Pricing Objectives High price to underscore a quality based differentiation In most price categories price differences among competitors

decline overtime as: Consumers become more knowledgeable about products Quality differences are harder to maintain Pursuit of competitive advantage through pricing programs requires

a very thorough understanding of competitive forces

The ability to successfully use price to implement a given marketstrategy will be limited by: The price elasticity of the market and company demand Competitors actions and reactions Cost and profitability consequences Product line consideration


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Marketing Strategies and possible pricing objectives

Marketing Strategies Pricing Objectives

Primary Demand StrategiesIncrease number of users Reduce economic Risk of trail

Offer better value thancompeting product/ classes

Increase Rate of Purchase Enhance frequency of purchase

Enable use in more situationsSelective Demand StrategyExpand Served market Serve price oriented segment

Offer high end versions ofproduct

Acquire Competitors customers Undercut competitors on priceUse price to signal high quality

Retain/Expand current customers Eliminate competitors priceadvantageExpand sales of Complimentary

Products


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Considerations Involved in the success of Pricing Program

Pricing

ProgramsPenetration

ParityPremium

Contributionto achievingMarketingStrategy

Competitors Actions

Cross ElasticitySubstitutes

Compliments

Elasticity ofDemand

Cost andProfitability


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Price Elasticity Of Demand Unlike other productivity relationships, a change in price

has two fold effect on the firms sales revenue

A change in the units soldA change in revenue per unit

Managers should not be concerned merely:

With price sensitivity of the market

Must also be concerned with the change on total dollarvolume

Price elasticity is not simply another way to expresssensitivity

If a change in price causes a change in units sold ,demand is somewhat price sensitive

When using the term price elasticity, the impact of pricechange on total revenue should be examined


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Specifically Price-elasticity of demand ismeasured by the percentage change inquantity divided by percentage change in

in price

Given an initial price P1and an initialquantity Q1, the elasticity of change in in

price from P1 to P2is calculated by:e = Q2Q1 / 1 ( Q2+ Q1)

2

(P2P1) / 1 (P2+ P1)2


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Effects Of Different Types of Elasticity

Value of e Type of Elasticity

Effect On Total Revenue Of

Price increase PriceDecrease

e>-1 inelastic increase decrease

e = - 1 unitary elastic no change no change

e < -1 elastic decrease increase

The important number to keep in mind is - 1

If elasticity is -1 0r smaller (-2 or -3) then demand is very sensitiveto price and the change in revenue change will be in oppositedirection (increase or decrease) of the price changeIf elasticity is greater than -1 such as -1/2 or +1/2, then demand is

not very price sensitive and an increase (or decrease) in price willresult in an increase decrease in revenue


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Price Elasticity Of Demand

In practice it is difficult for managers to developa precise, reliable estimate of elasticity

By simply determining e is greater than1 or

less than -1 will enable managers to understandthe impact of a change in price or revenue

In making estimates of elasticity, managers needto distinguish between elasticity of market

demand and elasticity of company (or brand)demand and to recognize that differences inelasticity may exist across segment within amarket


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Market Segments, and CompanyElasticity

Market elasticity indicates how total primary demandresponds to a change in the average prices of allcompetitors

Company elasticity indicates the willingness ofcustomers to shift brands or suppliers (or new customersto choose a supplier) on the basis of price

Example table salt: the market demand for table salt isinelastic: people cannot consume much more if pricesare lowered

If one producer lowers its price, that producers is likely togain market share

Although market demand may be inelastic, companydemand at the same time can be elastic because buyersmay be very sensitive to competitive price differences


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Market and Market Segment Demand Schedule

Weekly Market Sales

Weekly TripUndiscountedRate

Units TotalRevenue

$350 40,000 $ 14.0 mill.$325 45,000 $ 14. 625 mill

$300 51,000 $15.3 mill.

Weekly TripUndiscounted

Rate

Weekly SalesBusiness Class

Weekly SalesEconomy Class

Units Revenue Unit Revenue

$ 350 24,000 $8.4 mill. 16,000 $ 5.6 mill.$ 325 25000 $ 8.125 mill 20,000 $ 6.5 mill.$ 300 26,000 $ 7.8 mill. 25,000 $ 7.5 mill


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Airlines which target business segment need not useaggressive pricing as the basis for marketing strategy

Whether a firms individual marketing strategy is effective

will depend on company elasticity of demand Even if the industry prices declines in the price elasticsegment, a firm might conceivably experience inelasticdemand if it could clearly differentiate its products/services in terms of some other determinant attribute

If so that firm could continue to charge prices higher thancompetitors without reducing profitability If the pricing objective reflect primary demand strategies

(increasing rate of purchase for the product form, orincrease in demand among users) then managersshould be concerned about market demand elasticity

If pricing objective reflect selective demand strategies (retention or acquisition of customers) then managersshould be concerned about elasticity of companydemand


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It is not necessary that demand be elastic in order to achieve a pricingobjective

Managers may be very committed to retaining or acquiring new customerswhen the objective is to maintain share or increase market share

This commitment may be so strong that manager will be willing to risk somereduction in total revenue in order to maintain or establish a strong position inthe market

Price Demand Total Revenue

$ 2.00 500,000 $ 1,000,000

$ 1.50 600,000 $ 900,000$ 1.00 750,000 $ 750,000

Demand is inelastic, as total revenue decrease as price is reducedBuyers are still sensitive to price. If the impact of higher volume on totalrevenue and profit is acceptable, then a manager will decide to lower the price,sacrificing some degree of profitability for market share and sales volume


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Factors underlying Elasticity of Demand

Factors Suggesting Elastic Market demand

1. Many alternative forms or classes exist for which product couldbe substituted2. Only a small percentage of potential buyers currently purchaseor own the product because of the high price and because theproduct represent a discretionary purchase3. The rate of purchase or the rate of replacement can beincreased through lower price

Factors Suggesting Elastic Company Demand1. Buyers are knowledgeable about a large number of alternatives2. Quality differences do not exist or are not perceived3. The supplier or brand can be changed easily and with minimalefforts or costs


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Estimating Price Elasticity1. Historical Ratios: When using this approach, managers must have historical data

of : Company sales and its prices Industry sales and competitive prices To estimate market elasticity must determine the historical

relationship between industry sales and some average ofindustry prices

Both pieces of information are also needed to estimatecompanys elasticity of demand

The effect of a companys price on selective demand willdepend on how much companys price differs from competitors

- If, in the past a firm has consistently raised its price without anyloss in sales, management cannot necessarily infer thatcompany demand is inelastic. Why?

- Competitors may also have been raising prices


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Estimates of companys elasticity cannot bemade without considering changes in industry

sales Increase in companys sales may result inincrease in market share or an increase inindustry sales

Accordingly managers should examine thehistorical relationship between a companysrelative price (relative to competitors prices) andmarket share when attempting to accesscompanys elasticity

Historical ratios will only reveal price elasticity ifno changes in other important variable orenvironmental variables have occurred


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Estimating Price Elasticity2. Field experiments:

Price experiments are conducted using scannerpanel experiments

Stores in particular regions are selected

In control stores price of the product remainsame through out

In experimental stores sales levels are recordedat different price levels

The impact of price on sales is calculated toform opinion about price elasticity

Limitation Time consuming


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Estimating Price Elasticity3. Controlled Choice experiments: Prediction of what consumer might do in store

environment can be made by surveys or choiceexperiments conducted in controlled setting The most widely used approach is the conjoint analysis

method This method analyses how buyers trade-off attributes in

making choices The biggest trade-offs consumers make are usuallybetween various levels of benefits and price

This method is relevant in: Understanding price sensitivity

Designing and pricing new products because it allowsmanagement to consider the contribution of price andnon price attributes in market acceptance


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Competitive Factors Whether the concern is market or company

elasticity, competitors reaction to price change

must be considered If change in price is met by all competitors, then

no change in market share should result

In such case price will have no impact on

selective demand Managers should attempt to determine what

competitors pricing reaction will be

It will be useful to examine historical patterns ofcompetitive of competitive behavior in projectingprice reactions


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Competitive Factors Some competitors may price their products on

the basis of cost. These firms often do not shift

their pricing policies over time. Instead:They either price very competitively( if they aretrying to take advantage of experience curves oreconomies of scale)

Attempt to maintain consistent contributionmargins and avoid direct price competition

By analyzing competitors historical pricingbehavior, insights regarding the customersreaction to price change may be obtained

If an industry has historically been characterizedby extensive price cutting buyers will more likelyto be price sensitive

C


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Competitive Factors Competitors response can also be analyzed by knowing

their strengths and weaknesses and the degree ofintensity of competition

Even when the price is decision issue at hand managersshould assess both the non price reaction as well asdirect price reaction in a market because competitorsnon-price reactions may influence price elasticity

Research has drawn the following conclusions1. An increase in price-oriented advertising in the market

leads to greater price sensitivity among consumers

2. An increase in non-price advertising in a market leads to

lower price sensitivity among consumers


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Cost Factors Many firms use cost plus approach to pricing

Price is determined by taking the cost per unit and then

adding a dollar or percentage- target contribution margin

An illustration of Cost plus Pricing for a liquid Dishwashing

Detergent

Variable cost per case ( materials, packaging) $ 6.80Plus allocated share of manufacturing overhead 1.70

Plus allocated share of advertising 6.50

Total unit cost $ 15. 00plus target profit per case $ 2.00

Manufacturers selling price to retailer $ 17.00

C t F t


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Cost Factors In order to estimate the fixed cost per case, the company

must have some estimate of the number of cases that will besold because

Fixed cost per case = Total Fixed cost/ number of cases A key issue in using cost plus method is determining the true

unit cost In many cases some costs are fixed arbitrarily Fixed cost will include direct fixed cost plus some contribution

to company overhead Since the amount of fixed cost must be based on some

estimate of the number of units sold, the company is implicitlyassuming demand will not vary dramatically with any changein the factory price

In the above example assume that total annual advertisingand selling expenses are expected to $26million.

In order to determine the share of these costs to assign toeach case sold a manager must have some estimate ofexpected sales volume, even though the total cost( and thusthe final price) has yet to be determined

$ 6.50 allocation per unit must mean sales are expected tobe 4 million cases


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$ 6.50 = $ 26 million / 4 million cases The above example is the use of full cost

approach in which all cost are included in setting

the minimum price Alternative approach is variable cost pricing

approach If a firm is operating in a price elastic market at

less than full capacity it may be able to improvetotal profitability through pricing below theaverage unit cost

As long as the company is pricing the productabove variable cost each unit sold makes somecontribution to fixed cost

If managers assume that demand is inelastic thevariable cost pricing option is not used

f


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Types of Pricing Programs Pricing program is selected after:

Establishing pricing objective Assessed price elasticity

Assessed competitive and cost situation

Three basic types of programs1. Penetration pricing

2. Parity pricing

3. Premium pricing

1 P t ti P i i


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1. Penetration Pricing Designed to use low price as the major basis for

stimulating demand

Firms are attempting to increase their degree ofpenetration in the market by either: Stimulating primary demand Increasing the market share ( acquiring new customers)

on price

The success of penetration pricing requires that eithermarket( primary) demand or company (selective)demand be elastic

If market demand is elastic the market demand and totalindustry revenue will grow with reduction in industry

prices Even if competitors match the price cut, the increase inmarket demand will make all competitors better off

1 P t ti P i i


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1. Penetration Pricing If economies of scale exist or the product has many

complements, the benefits of increased volume are even

greater If market demand is inelastic, then penetration pricing

can make sense only if selective demand is elastic

If competitors cannot or will not match lower prices

The failure of competitors to match the lower pricescould reflect:

a lack of competitiveness on cost

Willingness to concede market share in exchange forhigher profits

Low price appeals to minor segment of the market


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Conditions Favoring a penetration pricing program

1. Market demand is elastic

2. Company demand is elastic, and competitors cannot matchprice because of cost disadvantage

3. The firm also sells higher-margin complementary products

4. A large number of potential competitors exist5. Excessive economies of scale exist, so variable cost approach

can be used to set premium price

6. The pricing objective is to accomplish either of the following:

Build primary demand

Acquire new customers by undercutting competition


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2. Parity Pricing Setting price at or near competitive levels

Attempt to downplay the role of pricing Other marketing programs are primarily

responsible for implementing marketing strategy

This approach will be selected when companydemand is elastic industry demand is inelastic

Most competitors are willing and able to marchany price cut

In such situations managers should avoidpenetration pricing because:


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2. Parity PricingAny cuts will be offset by competitive retaliationResulting in lower industry prices

Without significant gain in industry salesTotal revenues and profit margin will decline Parity pricing is comparable with cost plus

pricing In many industries cost structures will be similar

for various competitors ( similar labor contracts,raw materials, technologies and distributionchannels)

The potential gains for any economies of scalewould go unrealized, meaning variablecostfloor price is impractical


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Conditions favoring a parity pricing program

1.Market demand is inelastic company demand is elastic

2.The company has no cost advantage over competitors

3.There are no expected gains from economies of scaleto the price floor

4.The pricing objective is to meet the customer


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Premium Pricing

Setting pricing levels above competitive levels This approach will be successful if a firm is able to

differentiate its products in terms of: Higher quality

Superior features or special services Establishing an inelastic demand curve Firms that successfully implement this approach will: Generate higher contribution margin Insulate them from price competition

Advantage that allows a firm to set a premium price maynot last for ever

These programs must be reviewed regularly


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Conditions Favoring Premium Pricing Program

1.Company demand is inelastic

2.The firm has no excess capacity

3.There are very strong barriers to entry

4.Gains from economies of scale are relatively minor.So full cost method is used to determine theminimum price

5.The pricing objective is to attract new customers onquality


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Product Line Pricing Pricing decision for one product can influence

sales of other products Price cross elasticities are the relationship that

exist when a change in in the price of oneproduct influence the sales volume of a second

product Price elasticity are of two types:

1. Substitute Products:

When an increase (decrease) in price of oneproduct result in increase (decrease) in sales ofsecond product

2. Compliment products:


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Product Line Pricing If the price increase (decrease) in price of one

product results decrease (increase) in sales ofsecond product

Product line extension can be of two types:Vertical or horizontal

In vertical product line extensions differentofferings provide similar benefits at differentprice and quality levels

In horizontal extensions each offering has

distinctive non price benefits In both cases cannibalization is the potential

problem.


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Product Line Pricing In vertical line extension cannibalization due to

price difference is much greater In horizontal line extensions cannibalization that

results from price difference is not verysignificant. Why?

Differentiation among offering s in the line isrelated specialized benefits, usage situations, orpreferences that will override price in the choiceprocess

In such cases consumers would have arelatively wide range of acceptable pricesrelative to their reference price


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Product Line PricingA reference price is a psychological standard

againstwhich observed prices are compared tojudge their reasonableness

When products in the same broad category areevaluated , the reference price range is likely tobe wide because the range of actual prices theconsumer is aware of is also wide

In vertical extensions, products within the line

are likely to be similar, different only on one ortwo dimensions other than price


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Product Line Pricing In this case an important principle is anchoring

Anchoring is the effect a price stimulus has onthe reference price buyers use to assess price

When two or more products offer similar type

types of benefits, buyers evaluate a price in thecontext of the overall range in which they areconfronted

Adding a new price at the higher or low end of

the range will change the standards by whichcustomers evaluate each item

Pricing Complements


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Pricing Complements Leader pricing:

If the demand for product is elastic, and if the product

has number of complements that either enhance itsvalue or can be purchased more conveniently by buyingfrom the same source, that product may be used asleader

The expectation is that sales of complements to new

customer will increase more than enough to offset thereduced profit on the leader

In selecting a leader, one must avoid:

Products that customers are likely to stock up during

special prices When strong substitution effect will lead to simple shifts

in sales from high-margin to low margin products

Ch t i ti f d i l d


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Characteristics of a good price leader1. The product is widely used by individual

buyers in the target market

2. The products prevailing market price is wellknown

3. The product has a high degree of priceelasticity

4. The product has many complements whichenhance the value of the leader or areconvenient to purchase when buying theleader

5. The product has few or no substitutes6. The product is not usually bought in large

quantities and stored

Price Bundling


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Price Bundling Two or more products or services are bundled

together for a special price

Most firms employ mixed bundling Buyers are given choice of buying two products

in a package or buying the products individually Buyers who place a low value on one of the two

products will avoid the bundle The economic incentive of a lower price on oneitem will lead to additional sales of bothproducts to some buyers who otherwise will buyonly one

When complementary relationships are verystrong, the effects of special prices are evengreater

Price Bundling


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Price Bundling Mixed price bundling can be

accomplished through two approaches

1. Mixed leader form:

The price of a lead product is discountedon the condition that the second product

will be purchased2. Mixed joint bundling:

Two or more products or services are

offered for a single packaged deal

Ch t i ti f S f l


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Characteristics of SuccessfulMixed Price Bundling

Mixed Leader Programs1. Demand for lead product should be price elastic2. Complementarity is based on the leader being enhanced by other

product(s) or on convenience3. If the objective is to cross-sell complements to regular customers; The leader is the lower margin product (so that the lost profit from price

reduction is minimized) Sales volume for the leader exceeds that of other products Mixed Joint Programs1. Demand for the total package is price-elastic2. Complementarity is bi directional (each product in the bundle enhances the

value of the others) or is based on convenience

3. If the objective is to cross sell complements to regular customers, thevarious products the bundle are approximately equal in volume and profitmargins so that sales gains from regular purchasers of any product areabout equal

lecture 9 pricing programs

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