pricingpractices

Thatendangerpropits

How do buyers perceive

and respond to pricing?

By Kent B. Monroe and Jennifer L. Cox

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Pricing decisions can be complex anddifficult, but they're also some of

the most important marketing decision variables a man-ager faces. Companies that make profitable pricing deci-sions take what may be called a proactive pricingapproach. By considering how pricing decisions affectthe way buyers perceive prices and develop perceptionsof value, these companies manage to leave less moneyon the table and successfully raise or reduce prices.

Eight Pricing FallaciesMany companies continue to develop their pricing

strategies and tactics naively and, consequently, don'tget the results they expect. Tradition-bound solutionsand outdated practices have helped perpetuate a num-ber of pricing misconceptions that can cause problemsfor companies. We outline eight of the most commonones here.

1. Most companies have a serious pricing strategybased on serious pricing research. On the contrary. Arecent study found that only about 8% of the companiessurveyed could be classified as conducting serious pric-ing research to support developing an effective pricingstrategy. In fact, 88% of them did little or no serious pric-ing research. McKinsey & Company's PricingBenchmark Survey estimated that only about 15% ofcompanies do serious pricing research. A 1997 Coopers& Lybrand study found that, in the previous year, 87% ofthe surveyed companies had changed prices. However,only 13% of the price changes came after a scheduledreview of pricing strategy.

These numbers indicate that strategic pricing deci-sions tend to be made without an understanding of thelikely buyer or competitive response. Further, it showsthat managers often make tactical pricing decisions with-out reviewing how they may fit into the firm's overallpricing or marketing strategy. The data suggest thatmany companies make pricing decisions and changeswithout an existing process for managing the pricingactivity. As a result, many of them do not have a seriouspricing strategy and do not conduct pricing research todevelop their strategy.

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EXECUTIVE b r i e f i n gSome companies are starting to embrace a proactive pricing strategy, but many still cling to old misconceptions about markets and

the entire pricing process. Understanding and overcoming the pricing fallacies that continually plague managers, the pricing process,

and price perceptions among buyers requires a truly proactive pricing approach. Once managers understand these problems, they can

better develop and implement a product and market strategy for the current economic and competitive environment.

2. Prices can be set annually, typically during the budget-ing exercise, and don't require continuous managerial atten-tion between annual reviews. To understand a firm's approachto price management, first consider how it sets its pricing objec-tives; gathers, processes, and analyzes relevant information;provides for an orderly decision process; and establishes proce-dures for anticipating and responding to customer, market, andcompetitor changes. Although managers consistently identifypricing as a major pressure point or marketing headache,organizations have been slow to develop a proactive approachto pricing. This state of affairs exists partly because managershave misconceived price management as setting prices per serather than as a process.

By not considering pricing as a process, companies fail todistinguish between pricing strategy and pricing tactics; to coor-dinate pricing decisions across departments; and to have anorganizational unit responsible for regularly monitoring priceadjustments and price policies. For example, a survey of the 20largest pharmaceutical companies revealed that companies withan organized pricing function approached pricing as an ongoingprocess. Those without a permanently assigned pricing respon-sibility, however, treated pricing decisions episodically, with lit-tle or no continuity.

3. Buyers compute price differences easily and unambigu-ously. This misconception leads to a host of strategic pricingerrors. Failing to consider the complex underlying psychologyof how people encode, perceive, learn, and retrieve numbers(i.e., prices) when making buying decisions can lead to severalerrors. What follows are some important psychological conceptsas well as problems that occur when pricing managers don'tunderstand these concepts.

Reference Prices4. Buyers don't evaluate prices comparatively. Not quite.

In fact, behavioral pricing research provides explanations ofhow people form value judgments and make decisions whenthey don't have perfect information about alternatives. Why arebuyers more sensitive to price increases than to price decreases?How do buyers respond to comparative price advertisements{i.e., regular price $65, sale price $49), coupons, rebates, andother special price promotions? The common response is thatbuyers judge prices comparatively through the anchoring effectsof reference prices.

The reference price for a specific product category is a func-tion of tbe frequency of different prices for that category (i.e., thedistribution of prices). Further, tbe reference price is a functionof the relative magnitude of tbe prices, tbe range of prices, and

the dispersion of prices from tbe average price. A buyer's refer-ence price is influenced by practice and past experience and bythe sequence in which the buyer observes tbe prices for the cate-gory. A reference price may be an external price in an advertise-ment or the sbelf price of another product. It may also be aninternal price the buyer remembers from a previous purchase,an expected price, or some belief about the price of a product inthe same market area.

Tbe concept of reference price supports tbe notion that buy-ers judge or evaluate prices comparatively. Managers who ignorethis point make tbe mistake of not distinguishing between pric-ing strategies and pricing tactics. The marketing group managerof Frito-Lay Inc. told the story of a local tortilla chip producer inthe Phoenix market that did not understand this relationship.The local tortilla chip enjoyed a competitive advantage untilFrito-Lay upgraded its Tostitos chip. Instead of raising its mone-tary price to continue to reflect a perceived quality/value rela-tionship similar to Tostitos, the local producer reduced its qualityand costs, but maintained tbe monetary price to protect its mar-gin. Customers soon recognized that the local chip was now aninferior product and shifted their purchases to FHto-Lay. In tbiscase, tbe local tortilla producer tactically maintained price to becompetitive on price with Frito-Lay but ignored the importantstrategic issue of competing on perceived value.

Absolute Price Tiiresiioids5. There is just one acceptable price for a product or serv-

ice. The truth is that buyers typically have lower and upperprice thresholds, or a range of acceptable prices for a purcbase.The upper and lower price limits are not constant and shift asbuyers obtain more information about tbe actual price range inthe market or about tbe range of prices in a specific product line.Plus, a lower price threshold implies that positive prices greaterthan $0 exist and are unacceptable because they are consideredto be too low, perhaps because buyers are suspicious of theproduct's quality at prices below the lower price threshold.

A number of factors influence the varying levels and widthsof buyers' acceptable price ranges. For a specific product catego-ry the upper price threshold will be lower if buyers recognizethe availability of similar alternative offerings. However, if cus-tomer satisfaction increases or buyers become more loyal, theupper tbresbold tends to increase. Conversely, if customer satis-faction declines, leading to lower buyer loyalty, then buyers'upper price thresholds decrease.

When buyers are relatively uncertain about prices for aproduct category, tbeir acceptable price ranges tend to be rela-tively narrow and their lower and upper acceptable price limitstend to be lower than those of more knowledgeable buyers.

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Perceived Value vs. Price (Mickey Goofed!)

Buyers who infer quality on the basis of price usually havehigher acceptable price levels, higher upper acceptable pricelimits, and wider acceptable price ranges. On the other hand,price-conscious buyers typically tend to have lower acceptableprice levels, lower upper acceptable price limits, and narroweracceptable price ranges. The sidebar on this page illustrates thepricing error made when French buyers were unwilling to paymore than a specific amount to enter Disneyland Paris.

Differential Price ThresholdsUsually a buyer selects from among alternative choices avail-

able for a contemplated purchase. The prices of these alternativechoices may provide cues (or information) to facilitate the decisionprocess. However, even if the numerical prices are different, wecan't assume prices are perceived to be different. Hence, the prob-lem becomes one of determining how perceived price differencesaffect buyer choice. The two most relevant concepts when consid-ering this are price elasticity and cross-price elasticity of demand.

6. Absolute price is more important than relative price.The experience of a major snack food producer illustrates theerror of not recognizing the difference between absolute and rel-ative price. Several years ago, a specific size of this brand's pota-to chips was priced at $1.59 while a comparable size of the localbrand was $1.29, a difference of 30 cents. Over time, the price ofthe national brand increased several times until it was beingretailed at $1.89. In like manner, the local brand's price increasedto $1.59. However, while the local brand was maintaining a 30-cent price differential, the national brand obtained a significantgain in market share. The problem was that buyers perceived a30-cent price difference relative to $1.89 as less than a 30-centprice difference relative to $1.59.

As this example shows, relative price is a more importantconcept than absolute price. The concept of price elasficity ofdemand indicates the sensitivity of buyers to a price change fora particular product. Thus, if buyers perceive the product's priceas different from the last time they purchased it, then the issue iswhether this perceived price difference alters their purchasingbehavior. For example, a price reduction from $1.30 to $1.25 maynot be sufficient to induce buyers to buy more of the product,whereas reducing the price to $1.15 might lead to increasedemand. Conversely, a price increase from $1.30 to $1.35 mightnot deter some buyers from purchasing it, but an increase to$1.40 might lead to noticeably decreased demand.

7. The way price information is communicated can'tchange buyers' preferences between products. The differentialprice issue examines how the price of one product is perceived todiffer from the price of another alternative offering. These alter-native products could be sold by different competitors or theycould be mtxlel variations sold by a single seller. For example,Kodak cameras compete with Minolta, Polaroid, and otherbrands as well as with different models within the Kodak cameraline. From a managerial perspective, it's important to know how

Disneyland Paris, formerly itnown as Euro Disney, openedin Aprii 1992 on the eastern outskirts of Paris, However,this new venture didn't lare well at first. In tad, it got sobad Ihat by 1994. losses were averaging $1 million a day.Prior to the April 1995 opening, a market research surveydiscovered that French consumers were unwilling tospend more ttian 200ff (Frencti francs) for a single adultto enter the park. So Disneyland Paris set the 1995admission price for a single adult at 195 francs. Thenumber of visitors increased by approximately 23% in1995 and by 33% by the end of the 1996 season.Importantly, by 1996, 40% of the visitors wereFrench, hall of them from the Pafis area. In 1995.the park operated at a profit for the first time.

So what's the lesson here? Apparently, man-agers at Disney did not immediately understandthat the relationship between price, perceivedquality, and perceived value has limits orabsolute thresholds. Disney initially failed lo recognize the important linkbetween perceptions of quality and perceptions of value,

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to price the different cameras within the product line as well ashow to price the cameras relative to the competitors' cameras.Perhaps the most important strategic aspect of a pricing manag-er's job is to team how to manage the price differentials within aproduct line as well as relafive to competitors' products.

Take a look at the sidebar on page 46. Can you figure outwhy sales of B increased after a compefitor introduced a muchhigher-priced version? First consider how buyers would evaluateB relative to A when they were the only two products in this cate-gory available for purchase. On a subjective scale, B would bejudged as expensive, or perhaps high-priced. However, after thecompetitor had introduced C, then B would be judged as notexpensive, or perhaps moderately priced. Second, the $16 pricedifference between C and B made the $4 price difference betweenA and B perceptually smaller than it was before. The competitor'spricing caused a product that had been perceived as expensive tobe perceived as not expensive. Third, it's well-known that peopleusually don't choose extremes when there is a middle option.Indeed, we found that when buyers have multiple choices, theirpreferences tend to gravitate toward the "middle-priced" brands.Thus, for these three reasons, consumers who had previously pre-ferred A now purchased B. This example clearly indicates thatwhen buyers cannot evaluate quality, the strategic use of priceinformation can infiuence preferences and choices.

Decomposing Price Elasticity8. Price elasticities are constant. In reality, price elasticiHes

vary according to the direction of a price change, a brand's priceposifion, and the magnitude of the price change. Buyers, in gen-eral, are more sensitive to perceived price increases than to per-ceived price decreases. !n practical terms, this difference in rela-five price elasticity between price increases and price decreasesmeans it's easier to lose sales from current buyers by increasingprice than it is to gain sales from new buyers by reducing price.

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For example, price elasticity for local telephone calls following aprice decrease was estimated to be -0.022, while tbe price elastic-ity following a price increase was -0.215. In tbis case, the ratio ofprice increase elasticity to price decrease elasticity was 9.77.Other researchers have estimated this ratio to vary between 1.3and 4.0 for different products.

Research also confirms that price elasticity of demandvaries over brands within tbe same product category. In oneproduct category, elasticity varied from -0.84 to -4.56. However,price elasticity is not independent of the relative price level. Tbefurther a brand's price is from tbe product category's averageprice, in either direction, the lower its price elasticity will be, If abrand's price is already at the extreme end of the price-marketrange, then a more substantial price change will be needed toproduce a perceived price change. And extreme prices, high ortow, will become more price-elastic as the prices are changedtoward the market average or as competitors' pricing moves thebrand's price toward the market average. Further, price elasticitywill be relatively higher for offerings positioned in the middle ofa category because such a position makes it more difficult toestablish either a low price or high-quality image.

How price-elastic or inelastic the demand for a product orbrand is depends on its cross-price elasticity relative to compet-ing products. Moreover, a brand's price-quality positioning rela-tive to its competitors influences its price elasticity. These com-petitive effects not only are asymmetric relative to price increas-es or decreases, but also are relative to the price-quality posi-tions of the competing products. That is, price promotions by ahigher-priced brand affect the market share of a lower-pricedbrand more than the reverse. Also, brands closer to each other inprice have larger cross-price effects than brands that are pricedfurther apart.

In summary, price elasticities are not constant and they canbe managed over products, brand, and time to a greater extentthan previously recognized. Managers need to pay attention tothe nature and duration of a price change and to bow extensive-ly the price change will be communicated or promoted to themarket. Unfortunately, most companies do not make sufficientefforts to track the sensitivity of demand from their products toprice changes and to price differences over time.

Becoming Proactive PricersThe pricing misconceptions we've discussed here can pre-

vent managers from becoming proactive pricers. Too often, com-panies fail to conduct proper research to guide tbeir pricingstrategy. They base price setting on annual budgeting exercisesand misunderstand how buyers compute price differences andform value judgments.

To overcome these hurdles, managers need to understandthe realm of pricing, including their customers' perceptions ofprices, price changes, and price differences. To become proac-tive pricers, managers should take certain steps. First, research

A Competitor Lends a Helping Hand

A producer of a consumer packaged good developedand marketed two versions of a product, A and B.The two versions were quite similar except that thelabel used for B and the packaging gave it an imageof being a better product. Initially A and B were the

oniy two products in the market, and the firm priced them as follows:A B

$14.95 $18.95

As would be expected, the lower-priced version. A, was the firm's best-sellingproduct in this line. However, after a time, a competitor inlroduced its versionof the product, C, positioning it as a high-price, high-quality product. Nowthe prices of the three products were:

A B C$14.95 $18.95 $34,95

In a very short time, version B became the first firm's best-selling product inthis product category! The product manager was mystified and sought help iofigure out what had happened.

your pricing environment to understand the factors that influ-ence tbe dynamics of supply and demand. Next, recognize thatstrategic pricing decisions define an organization's value imagein the eyes of customers and competitors. In fact, one of themost important statements a firm can make about a product orservice is its price. Finally, understand that tactical pricing deci-sions concern tbe day-to-day management of tbe pricingprocess and must be made within tbe firm's overall pricingstrategy By mastering these three principles, management canleave behind reactive or stagnant pricing practices and fullyembrace a new era of proactive pricing. •

Additional Reading

Monroe, Kent B. and Angela Y. Lee (1999), "Remembering Versus

Knowing: Issues in Buyers' Processing of Price Infonnation,"

journal of the Academy of Marketing Science, 27(2), 207-225.

Sivakumar, K. (2000), "Price-Tier Competition: An Integrative

Review," fourtial of Producf & Brand Managcmetil Featuring

Pricing Strategi/ & Practice, 9(5), 276-290.

Urhany, Joel E. (2001), "Justifying Profitable Pricing," Journal of

Product & Mmmgetnent Featuring Pricing Strategy & Practice,

10(3), 141-157.

About the AuthorsKent B. Monroe is tbe J. M. Jones professor of marketing, depart-

ment of business administration, University of Illinois, Champaign,

111. He may be reached at k-monroe@uiuc.edu.

Jennifer L. Cox is a marketing specialist with John Deere,

Worldwide Commercial & Consumer Equipment Division, Raleigh,

NC. She may be contacted at JCoxUl@aol.coni.

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