Pricing Policy

Key Terms: pure competition, target costing, demand curve, price elasticity of demand, elastic, inelastic, segmented (segmentation) pricing, peak-user pricing, cost-based pricing, target profit pricing, value-based pricing, competition-based pricing, going rate pricing, EDLP, price lining, psychological pricing, price-quality relationships, odd pricing, cost transparency, smart pricing, "tragedy of the commons," shrouding.

One of the conditions of pure competition is homogeneous product, i.e., all brands are perceived as being exactly the same. Marketers do not want their product seen as a "commodity" and attempt to differentiate their product. Notice how Perdue differentiated its chickens and convinced the public that they were fresher. Airlines also do not want to be seen as a "commodity" and try to stress what makes them different. Some examples of products that seem like "commodities" but have been differentiated via good marketing: cigarettes, vodka, gasoline, toothbrushes, Sunkist oranges, Idaho potatoes, and aspirin. If you want to be able to raise the price of your brand above that of the competition, you have to differentiate your brand. This means that you have to convince the public that your brand is different and better.

Target costing
Start with an ideal price -- a price customers are willing to pay-- and then do everything possible to keep costs low enough to make  a profit.

Price elasticity of demand measures the percentage change in quantity demanded divided by the percentage change in price.

Ed = percentage change in quantity demanded / percentage change in price

If this ratio in absolute value (i.e., ignore the negative sign) is less than 1, elasticity of demand is inelastic. If the price elasticity ratio is greater than 1, then demand is elastic. If it is exactly 1, then it is unitary elastic.  Demand is inelastic when a product is a necessity (or needed very badly) and there are few good substitutes (e.g., gasoline, tobacco, alcohol, mass transit)

Suppose the price of gasoline is raised by 50% and the quantity demanded drops by 10%, price elasticity is .20 (-10% / +50%), i.e., inelastic demand.

Suppose you sell 20,000 sweaters at $10 each. Your Total Revenue (TR) is $200,000. You decide to raise the price of each sweater to $20 and sell 15,000 sweaters at the higher price; your TR is $300,000. What happened? Demand was inelastic: Price was raised 100% and quantity demanded dropped 25% (elasticity is .25). This is why TR rose.

If tuition went from $100 per credit at a public college to $140 per credit (a 40% increase), what would happen to enrollment? My guess is that it might drop 10% which means that demand is inelastic (.25). Thus, TR would go up.

Suppose you sell 10,000 shirts at $20 each. Your Total Revenue (TR) is $200,000. You decide to raise the price of each shirt to $30 and you sell 2,000 shirts at the higher price, your TR is $60,000. What happened? Demand was elastic: Price was raised 50% and quantity demanded dropped 80% (-80% / 50% = 1.6).  This is why TR dropped.

Suppose an airline sells 100,000 tickets to Ft. Lauderdale at $200. TR is $20,000,000. The price of a ticket is raised by 30% to $260. At the new price, 50,000 tickets are sold. TR is $13,000,000. TR dropped because demand is elastic. Price rose by 30% and quantity demanded dropped by 50%. Price elasticity is 1.67 (-50%/+30%)

Elasticity of Gasoline and Electricity:

The price of energy has gone through the roof.  Economists have studied the elasticity of electricity and gasoline.  They have found that when the price of electricity goes up 10%, quantity demanded drops by about 3% (this means that the elasticity is .3 -- inelastic).  When the price of  gasoline rises by 10%, quantity demanded falls by 2% (.2 -- inelastic). 

Segmented (or Segmentation) Pricing:

You might find that you have two types of customers: one has inelastic demand and the other has elastic demand. What do you do? This is the problem the airlines have. The business traveler tends to be inelastic. S/he must get to, say, Seattle on Wednesday to close a $5 billion business deal and it does not matter much whether the ticket costs $300 or $700. A non-business traveler (e.g., vacationer) is much more elastic. If the price of a ticket to, say, Miami is too high, you change your plans and go to the Poconos. What airlines do is charge different prices depending on when you buy the ticket and whether your stay includes a Friday or Saturday night. The same seat might cost one person twice as much as another person. In fact, it is not unlikely that every person on the plane paid a different price for a seat.

The rule of segmentation pricing is:  charge the inelastic user more and the elastic user less.

Some colleges charge degree students the full tuition and, after degree students register, senior citizens are allowed to take courses for a small fee. Why? Generally, senior citizens are more elastic since they do not need a degree. This is why they are charged less.

Peak-User Pricing:

In general, it costs more to supply peak users than off-peak users. More equipment is needed to satisfy the peak users. For instance, many more people use buses during rush hour than during non-rush hours. The Transit Authority has to buy enough buses to satisfy peak demand even if these buses will not be used for much of the day. What are the effects of charging peak users more? One effect is that the peaks will not be so pronounced since some people will shift from peak periods to off-peak periods. Secondly, TR should increase since most peak users have inelastic demand and will not be able to find substitutes. They will have to pay the higher price.

Consider a two-fare bus system: $3.00 during rush hours and $2.00 during non-rush hours. Some people will purposely avoid the rush hours so that it will then be less crowded during the rush hours. Most will have no choice and will still travel during rush hours. Revenues will go up and the need for buses will drop somewhat.

The same holds for bridges and tunnels. When tunnels, highways, and bridges are built extra lanes are added to satisfy peak demands. Who should pay for the extra lanes? The peak user who makes them necessary. Consider what would happen if there were two different tolls for using a bridge or tunnel: $10.00 during peak periods and $6.00 during off-peak periods. What effects would this have?

Breakeven Analysis

Total Cost (TC) = Fixed Cost + Total Variable Cost

Total Revenue (TR) = Price per unit x Quantity (P x Q)

At the Break-even point, TC = TR and profits are 0.

The break-even quantity, Q* = Fixed Cost / (Price per unit – Variable Cost per unit)

Example 1:

The fixed cost of making a music CD is $50,000. The variable cost per unit is $4 and the selling price is $9. Calculate the break-even quantity.

Q* = $50,000/ ($9 - $4) = 10,000 CDs
If you sell 10,000 CD’s at $9:
Total Fixed Cost = $50,000
Total Variable Cost = $40,000 ($4 x 10,000)
Total Cost = $90,000 ($50,000 + $40,000)
Total Revenue = $90,000 ($9 x 10,000)
Total Profit = 0

Note that you make $5 on each CD you sell after the break-even point.

Example 2:

The fixed cost of publishing a book is $30,000. The variable cost per book is $8 and the selling price is $18. Calculate the break-even quantity.

Q* = $30,000/ ($18 - $8) = 3,000 books

Example 3:

The fixed cost of running a weekend seminar for executives is $10,000. The variable cost per student is $500 and the tuition is $1,500. Calculate the break-even quantity.

Q* = $10,000/ ($1500 - $500) = 10 students

Example 4:

The fixed cost of some computer software is $60,000. The variable cost per unit is $3 and the selling price is $23. Calculate the break-even quantity.

Q* = $60,000/ ($23 - $3) = 3000 units

To learn more about breakeven analysis, go to this site:
http://www.innovationworks.org/resources/library/be.html

Pricing methods are based on an organization's overall mission and purpose. Not every firm has maximization of profits as their objective. Certainly, non-profit organizations (e.g., CUNY) do not have the maximization of profits as their objective. In a classic study, one researcher found that most firms had a target return objective, i.e., they wanted to achieve a 20% return before taxes. Some common pricing objectives include maximization of profits, sales volume objectives (usually expressed in terms of market share), social and ethical considerations, maintaining the status quo, prestige goals.

Profit Objective -- Economists usually claim that the objective of firms is to maximize profits. Actually, as noted above, firms that are concerned with profits are usually more likely to use price to achieve a certain target return.

Sales Volume Objective --many firms use price to attain a certain market share. For instance, a company might use price to achieve a market share high enough for it to be the largest firm in the industry.

Social and Ethical Consideration--Some firms might want to keep their price low because they feel that the product or service is important for society (e.g., education, medicines)

Maintaining the Status Quo -- In some industries competition may be so fierce that the big fear is a price war. If this is the case, firms in the industry might not want to compete on the basis of price because of the fear of starting a price war. The key pricing objective might then be to keep things quiet and not start anything by lowering prices. You might have noticed how some industries (cigarettes, cereals) rarely compete on the basis of price. Indeed, in the past, the FTC was concerned about the lack of price competition in the cereal industry.

Prestige Objective -- Some firms purposely keep prices high to maintain a prestige product image. It is doubtful that Rolls Royce, Mont Blanc, Rolex, etc. would want to offer their products at discount prices. The attraction of these products is due to the high price. Thus, the objective of pricing is to give the product a mystique and make it a status product.

Pricing Methods:

(1) Cost-based pricing -- this includes cost-plus pricing, rate-of-return pricing, and markup pricing.

Most retailers use markup pricing. Suppose a clothing store uses a 50% markup on cost on all dresses. If a dress costs the retailer $80, the selling price for the dress will be?

[$80 + $40 = $120]. Actually, in fancy clothing stores, markups are more like 100% and even 200% for designer labels.

Rate of Return Pricing: Suppose a firm manufactures 800,000 sweaters at a cost of $10,000,000. The firm desires a 20% return on investment (ROI) before taxes.  What price should they charge?

Answer: They need total revenues of $12,000,000 [ $10,000,000 + 20% ($10,000,000)]

Price = desired TR / Q They need $12,000,000 in total revenues and have 800,000 sweaters to sell. This means they will have to sell each sweater for $15 ($12,000,000 / 800,000).

(Example 2) Suppose a firm imports 100,000 telephones at a cost of $2,000,000. The firm desires a 50% return on investment (ROI) before taxes.   What price should they charge?

Answer: They want total revenues of $3,000,000 [ $2,000,000 + 50% ($2,000,000)] for 100,000 telephones, so they should sell the phones for $30 each.

(Example 3)   A coat manufacturer uses target return pricing.  It expects to sell 20,000 coats.  Fixed costs for manufacturing the coats = $600,000; and variable cost = $20 per coat.  (a) If the manufacturer wishes to earn a 20% return on the fixed cost investment (note the target return is only on the fixed cost), what price should be charged?  (b) What is the breakeven at this price?

Answer:   Desired Total Revenue for the 20,000 coats is =  $600,000 (fixed costs) + $120,000 (desired return-- 20% of $600,000) + $400,000 (variable costs -- $20 per coat x 20,000 coats).  Thus, desired total revenue is $1,120,000.  Price = $1,120,000 /  20,000 = $56 per coat.   
(b) Breakeven quantity at this price is $600,000 / ($56 - $20) = $600,000 / $36  = 16,667 coats.

3. Buyer-based pricing – Some firms (lawyers, consultants) consider the benefit provided in determining the price. For instance, many lawyers use contingency fees of 33 and 1/3 percent in product liability (or automobile accident) cases. This means that they get one-third of what they win for their client. Some doctors consider one's ability to pay in determining the fee to charge. This is also buyer-based.

3. Competition-based pricing – Some firms follow the price leader, i.e., they copy the price of the firm that is the price leader in the industry. Going rate pricing, where a firm charges what the competition charges, is competition-based pricing.

4. Demand-based pricing – In some industries, firms will actually try to construct the demand curve. This is not easy when a firm manufactures a product in many different sizes and packages. However, a firm should consider demand when pricing products. When demand is heavy (e.g., peak usage periods) you should consider charging more for a product or service.  Thus, if you own a condominium in Florida you might charge a higher rent during the winter than the summer.   Airlines charge more for a ticket to Florida during the winter than autumn.  Cell phone rates are cheaper late at night than during the daytime.

Currently, airlines pay airports the same price (it is based on the weight of the plane) whether they fly a plane during peak periods or off-peak periods.  What effect does this have?  Is this a good idea?  

The effect of this is to cause a great deal of congestion during peak periods.  There is no incentive for airlines to fly larger planes during peak periods.  Also, there is no disincentive for people to avoid flying small, private planes during peak periods. What this causes is huge congestion during the peak flying periods (Thanksgiving is a very popular time to fly).  A simple solution is to allow airports to charge airlines more during peak periods.  Or, to auction the rights to land planes and takeoff during peak periods at certain busy airports (JFK, LAG, and Newark would be the main ones). For more information about this solution, see Op-Ed article by Mary Peters, Secretary of Transportation, in the July 22, 2008, New York Times; "End Gridlock on the Runway."   By the way, according to Ms. Peters, congestion in NYC airports is responsible for 75% of all airport delays nationally.  One thing you should realize is that there are no free lunches. If prices are too low, we end up paying somewhere else.  

Psychological Aspects of Pricing:

Odd pricing: Psychologically, a price ending in 99 or 95 seems cheaper than an even price. The evidence is not conclusive, but this is one way for a retailer to project the image of a bargain store. Consumers feel that a price ending in .99 is cheaper than one ending in .00 -- Compare $5.99 with $6.00 or $99.95 with $100.  This may be the logic behind the 99 cent stores.   Steven Jobs of Apples priced music at iTunes for .99 a song and was extremely successful.  Prices have gone up at iTunes and songs will be priced at 69 cents and  $1.29  depending on the popularity of the song.  

Price-Quality Relationships: There is a great deal of evidence that consumers will use price to make attributions about quality when the brand name provides no information as to quality. They will assume that the more expensive brand is the higher quality brand. In fact, you may sell more of a product at a high price than at a price that is too low. Pricing too low might convince consumers that the product is of very inferior quality. Would you buy a hammer with the brand name Quarko sold for .99 in an outlet store?

Price Lining:
Some retailers feel that it makes more sense to offer merchandise at a limited number of prices, say, three or four different prices, rather than pricing merchandise at dozens of different prices. For instance, a tie store may sell ties at only three prices: $3, $10, and $25. This is called price lining. One advantage of this practice is that it makes it easier for consumers to shop.

Cost Transparency:
The Web has given consumers the ability to determine the seller’s actual cost. For instance, you can find out the actual price that the dealer has paid for a new car. Many consumers now come to an automobile dealership with printouts listing the dealer’s actual costs. This will exert a downward pressure on prices.

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This excerpt from a paper by Bhattacharya and Friedman ("Using ‘Smart’ Pricing to Increase Profits and Maximize Customer Satisfaction" appeared in the National Public Accountant) dealing with "smart" pricing will help you understand how pricing can be used by a company to increase profits:

Selecting the right price for a product or service is both an art and a science.  It is a major decision and can have a significant impact on the bottom line.  McKinsey & Co., in a study of 1,000 firms, found that a 1% increase in price – with constant sales – resulted in an average increase in profitability of 7.4%.   The McKinsey study also showed that the effect of pricing on profitability was even stronger than that of increasing sales volume or reducing costs.  An understanding of the fixed and variable costs associated with a product is critical in selecting an optimal price.  However, pricing should not only reflect costs but also take into consideration the value customers place on the product or service.

Shapiro and Varian (1998) note that since the marginal cost of information (e.g., software) is extremely low, traditional approaches to selling will not work on the Web.  Pricing approaches such as matching the competition or cost-based pricing are recipes for disaster.  They recommend that firms that sell information on the Web “set prices according to the value a customer places on the information.”

Smart pricing is a value-based strategy requiring that firms have accurate information about market demand and profit margins on each item sold.  Smart pricing is dynamic pricing and means that a firm will not use a fixed price but will adjust prices, even on a daily basis, as market conditions, consumer demand, and product valuations change.  Smart prices take into account differences in the costs of serving different segments and also the different valuations of one’s product by different segments.  After all, it is highly unlikely that all customers value a product/service exactly the same way.  Airlines are the ultimate users of smart pricing.  Two hundred people might be on the same flight and each individual might have paid a different fare. Airlines, in order to ensure maximum profits, adjust prices constantly and take into account such things as the sensitivity of business and non-business travelers to price, fares of the competition, and booking activities. 

Smart pricing is becoming extremely crucial for firms as consumers use the Internet not only to make price comparisons but also to determine the seller’s actual costs.  The Internet provides consumers with a huge quantity of easily accessible information, much of which is available at no cost.  Today, consumers enter automobile dealerships armed with downloaded printouts detailing the dealer’s cost.  This problem, referred to as cost transparency, makes it very difficult for sellers to obtain high profit margins.

Businesses too can search the entire world to find the best price for a raw material or component.  The days of consumers and businesses paying full prices may be coming to an end.  In fact, much business-to-business (B2B) trading is being conducted via Internet exchanges.  These electronic exchanges are online marketplaces where buyers and sellers “meet” to buy, sell, and/or exchange goods and services.  The appearance of an electronic exchange in one’s industry can totally change the way companies price products. 

One scholar claims that some ways of dealing with the problems of cost transparency are smart pricing and bundling the product with other products and services.  These approaches make it more difficult for customers to determine the true price of the basic product.  In other words, it is important to make sure that the product or service you sell is not perceived as a “commodity,” i.e., essentially the same as that sold by numerous other competing firms. The Internet will most likely reduce prices for standard commodities, but not for products that are perceived as being different and of providing a great deal of value to a particular target market.

Different Approaches to Smart Pricing


The approaches to smart pricing that follow are ways firms can sell their products or services at two or more prices.  The different prices will not necessarily be based on differences in cost.  Products, of course, have to be priced in a way so that customers feel that they are receiving great value for their money. 

Premium Product Pricing
 

Suppose a firm sells a basic computer for $1500.  It might do some research and find that customers would find certain added features extremely desirable and useful.   These additional features might only cost the firm an additional $200, but it might very well be able to sell the premium model for $2500.  The addition of features that only cost $200 might enable the firm to charge an extra $1,000.  This is not unlike what automobile makers do when pricing the luxury cars.  The price difference between, say, a Cadillac and an Oldsmobile, reflects much more than the cost difference.  The same can be said for the difference in price between first class and coach seats in an airline or the difference between a high-quality wine or scotch and a regular brand.  Hotels offer fancy suites at much higher prices than “standard” rooms.  Customers decide what level of quality they desire in a hotel room.  Some scholars recommend that firms produce different versions of the same information product (e.g., software) in order to increase profits.  They refer to their system as “versioning.”

In some states, consumers are given a choice of two types of electricity:  (1) electricity generated from polluting fossil fuels and nuclear energy or (2) Green-e.  Green-e, i.e., green electricity is mainly generated from renewable resources such as sun, water, wind, and geothermal and is environmentally friendly.  Green-e is more expensive than regular electricity but a significant number of consumers are willing to pay the premium since they are aware of the benefits and value to society of using electricity from sources that do not harm the environment (see http://www.green-e.org/ for more information about green-e).  Green power is now available in most of Connecticut for about $5 to $6 more per month than regular electricity.

 It should be noted that the profit margins on premium products are almost always significantly higher than on the no-frills version. Consider that a cup of Starbuck’s coffee costs three to four times as much as a cup of coffee at a diner and much, much more than a cup you brew for yourself.  Does the Starbuck’s coffee actually taste three times as good?  What is the profit margin on a cup of Starbuck’s coffee, a product that is essentially 98% water?  The way to improve profits is to offer customers who demand the extra quality this option but at a significantly higher price.

A bookseller could use this approach to improve profits. Suppose an order comes in for a book selling for $10.  The order taker can offer a special leather-bound, monogrammed edition for $18.  Of course, the cost of the additional features is only $3.  Charging an additional $8 for something that costs only $3 can help dramatically improve profits.  Enhancing the product or service by offering additional features is an easy way to improve profits and increase customer satisfaction. In industries where products are becoming commodities and are all perceived as being very much alike, the addition of interesting features and/or exemplary service can make one brand stand out. 

Most consumers would agree that eggs are a standard commodity and it is therefore hard to charge more for a particular brand of eggs.  Interestingly, some specialized brands of eggs – omega-3 enriched eggs and organic eggs – cost more than three times as much as other brands.  These eggs appeal to specific target markets, are perceived as being unique and providing great value, and therefore command much higher prices.  The Web may lower prices for commodities, but could actually raise prices for unique products that are perceived as providing value and that are targeted to specific market segments.

 

Prime Location Pricing

Virtually no theater or stadium charges one price for all seats.  Since customers are willing to pay more for seats at a better location, e.g., orchestra seats, theater owners charge more for these seats.  In fact, uniform pricing would result in lower profits than a dynamic pricing approach. One researcher describes how one opera company studied demand patterns for different types of seats, and discovered that it was almost always turning customers away for Friday and Saturday night performances, especially for the best seats.  Meanwhile, midweek seats went unsold.  Management checked the quality of every single seat in terms of view and acoustics and went from five different prices to nine prices.  The price of certain seats were raised by as much as 50%.  These changes resulted in a 9% increase in revenues.

Enhanced Warranty Pricing

Improving the length of a warranty can result in additional profits for a firm and can also increase customer satisfaction.  Suppose the standard warranty for a heavy-duty laser printer is 2 years and the firm’s research indicates that only 3% of printers will fail between year 2 and year 7. If the cost of replacing the printer is $5,000, then the expected value of the cost of an additional five years of warranty is $150 ($5,000 times .03).  If the firm offers an extended warranty for five additional years for a price of $100 per year, it can expect to make a profit of $350 per warranty sold.  Indeed, the profit margin on the extended warranty may be higher than on the printer.  Charging a total of $500 for something that costs the company $150 produces a very healthy profit.  Moreover, it allows customers high in perceived risk an option for lowering their risk by providing them an optional long-term warranty and thereby increase their satisfaction.      
 

Priority Service Pricing

The same idea could be used with regard to speed of service.  Not all individuals feel the same way about having to wait for a service.  In fact, some customers might be willing to pay more for faster service than others.  These individuals might simply be impatient and hate waiting for anything or the opportunity cost of their time may be high.  For instance, a computer consultant who earns $500 per hour as a troubleshooter might be willing to pay considerably more than a retiree for priority service that means not having to wait in a queue.  Organizations that charge customers for the privilege of immediate service can increase their earnings while at the same time improving customer satisfaction.  Time is an extremely valuable commodity to customers and they are often willing to pay to save time.

Some computer companies provide two different technical support help lines for customers:  one help line is free but may require a long wait for a technician; another help line provides almost immediate access to technical support for a fee.  A company whose computer system has crashed is more willing to pay for super-fast service than an individual consumer whose system has crashed.  The cost to the company might be in the millions of dollars so it would certainly be willing to pay for immediate service.  Uniform pricing would not make sense for a computer repair firm and it should have a two-price system, one price for super-fast service and a lower price for normal service. Federal Express built an incredibly successful business by offering overnight delivery of packages.  Customers can either drop off their packages or have their package picked up by Federal Express for a slightly higher fee.  
         

Off-Peak Pricing

The approach of charging peak users more and off-peak users less to pricing (discussed above) not only helps flatten the peaks, but also may decrease a firm’s costs by reducing the need for extra equipment.  Satisfying the peaks often means that a great deal of equipment (e.g., extra buses for rush hours) is needed to satisfy peak demand.  Airlines charge lower fares to various destinations during slow periods (e.g., Florida during the summer) and charge considerably more during peak vacation periods (e.g., Florida during the winter).  Similarly, many transportation companies charge higher fares for rides during rush hours and lower fares during non-rush hours; cellular phone users often pay less for telephone service during off-peak periods.  Some restaurants offer special reduced prices for patrons willing to eat dinner early before the peak periods. A system of charging peak users more and off-peak users less can increase a firm’s profits and result in more efficient use of resources.
 

Several utilities are finding that satisfying demand for electricity during peak demand periods can be extremely costly. The cost of generating electricity during regular demand periods is usually about 2 cents per kilowatt-hour and rarely higher than 12 cents.  Since electricity is sold to customers at prices of about 5 to 10 cents per kilowatt-hour, utilities can expect to make a reasonable profit. The price of electricity in the unregulated open market during peak demand periods, however, can be as high as $6 per kilowatt-hour.  This is due to the fact that the cost is bid up by numerous utilities trying to purchase the limited quantity of electricity available for sale. This can have a serious impact on profits.  Some utilities are trying to solve the problem by paying customers – especially large manufacturers that use a great deal of electricity – to shut down for short periods during heavy demand periods.  Some utilities are installing radio-controlled switches which allow the utilities to turn off their customers’ central air conditioners and swimming pool pumps.  Customers are paid for providing the utility with the ability to shut off their air conditioners during peak periods.  Some utilities pay customers to allow them to install devices that enables them to raise the thermostat settings.

All of the above methods are alternatives to the ideal method which would involve the installation of special meters in customers’ homes and businesses that allow the implementation of time-of-day pricing.  These relatively expensive meters not only record how much electricity is being used but also when it is being used.  A system of pricing electricity according to time of day and season makes more sense than a one-price policy since the cost of electricity does indeed fluctuate from hour to hour.  If consumers were aware that the cost of electricity between 3 p.m. and 6 p.m. during the summer was 50% higher than during other time periods, many would avoid using their air conditioners and vacuum cleaners during that time. Time-of-day pricing may not be practical yet for small residential homes, but is certainly reasonable for large firms.

Drastic solutions may be necessary since several states are on the verge of breakdowns in their power supply and blackouts have occurred.

Customer-Segment Pricing



With certain products and services, a firm might note that not all customers have the same sensitivity towards price (what economists refer to as price elasticity of demand).  Business travelers, for instance, are usually less sensitive to the price of the airline ticket than vacationers.  For instance, a business traveler who needs to get to Rome to consummate a deal worth several million dollars will not be concerned as to whether the ticket costs $400 or $900.  A vacationing couple, on the other hand, might go elsewhere on vacation if the ticket is too expensive.  This is why airlines charge considerably more for a ticket if one wishes to leave and return during the week (something mainly done by business travelers) than if one plans to stay over a weekend.

Senior citizens and students are also usually quite sensitive to prices and are offered discounts to movies and theaters.  Some universities offer senior citizens discounts on tuition for courses.   Of course, the senior citizens (typically non-degree students) register last and the only courses available to them are the ones that have available seats.  Degree-candidate students are less sensitive to prices than senior citizens because a college degree means substantially higher lifetime earnings. Senior citizens, on the other hand, are retired or near retirement and are quite sensitive to price and may therefore not register for courses if they have to pay the full tuition.

A tie store that only sells forty-dollar ties might only reach one market segment. Mainly wealthy individuals and customers considering the ties as a gift will purchase the $40 ties.  To reach several customer segments it might be more logical to sell ties at various prices, say,  $3, $10, and $40.  Software companies that sell inexpensive student versions of their products are also making use of this pricing approach.  The student market is much more sensitive to price and cannot afford to pay several hundred dollars for computer software.

 It should be noted that electronic commerce makes it very easy to use “dynamic” pricing and charge each customer a unique price based on his or her price sensitivity.  Using data-mining and analysis software, electronic retailers such as Amazon.com can amass a great deal of information about their customers.  When a customer enters the Amazon.com Web site, the company not only knows about past purchases and the kind of music and books this individual likes, it can just as easily determine what is the maximum price the customer would be willing to pay for a certain product.  This is much more sophisticated than the current system of price segmentation used in the book-publishing business today in which books are first sold as hardcover for a high price.  After those that are willing to pay the high price of the hardcover editions have been milked, books are sold as paperbacks at a much lower price.  The much lower price of the paperback is only partially due to the lower cost of publishing a paperback and is mainly due to the different price sensitivities of the two segments.

Conclusion


This article demonstrates how price can be used as a tool to increase both profits and customer satisfaction.  More importantly, it demonstrates that a one-price policy and/or cost-based prices may not always be the optimal way to price products and services, especially in these days of transparent costs.  Of course, firms that desire to use a multiple pricing approach must be careful not to confuse their customers.  A uniform  price is less likely to bewilder customers than a differential pricing approach. In addition, firms must not employ multiple prices if it will cause resentment among customers.  You do not want customers to feel that they have been cheated.  Increasing profits may be an important goal but not if it comes at the expense of customer satisfaction. 

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Pricing for Nonprofit Organizations and the "Tragedy of the Commons"

One important purpose of price is to maximize profits or at least achieve a target return. Not-for-profit organizations might find that price has another important purpose. Individuals running not-for-profit organizations should have a basic understanding of what is known as the "tragedy of the commons." This expression, first coined in a paper by Garrett Hardin (Hardin, Garrett (1968), "The Tragedy of the Commons," Science, v. 162, pp. 1243-1248) refers to the observation that whenever a resource is held in common by a group of individuals, it will always be in the interest of each individual to exploit the resource. The tragedy is that eventually the resource will be completely depleted.

For instance, if a forest is community property, everyone in town will keep logging it until the forest has been totally consumed. This will not be the case if the forest is owned by one individual. The owner might hire individuals to mill the forest but will only hire enough loggers to produce sufficient profit for the enterprise. Thus, if lumberjacks are paid, say, $18 per hour, the owner will hire lumberjacks as long as their output will be worth more than $18 per hour. No additional workers will be hired once the number of trees is so reduced that the output is worth less than $18 per hour per worker. Thus, the forest is far less likely to be exhausted. Furthermore, it is in the owner's interest not to allow the forest to be depleted because the forest is a long term asset that must produce a profit in future years as well.

The Internet is also an example of a common, i.e., an electric common, and it is being spammed and filled with so much commercial information that there is no way for capacity to keep up with the flow of so much valuable, and so much useless, information.

Some solutions to the "tragedy of the commons" are to: (1) sell the common and make it private property, (2) keep it as a common but charge for the right to use it, or (3) allow a limited number of individuals to use the commons on a first-come, first-served basis and force everyone to wait in a long queue. Note that price is a way of keeping a resource from being overexploited. At one time, some communist countries kept the price of bread extremely low since they wanted to ensure that every one would be able to afford it. What happened was that the demand for bread increased dramatically since farmers were feeding it to their livestock. Obviously, it makes more sense for farmers to feed their cattle grain rather than bread, since bread requires much more work (kneading, baking, etc.) to produce than grain.

If a country were to keep the price of milk very low (say, as low as or lower than the price of water), people would fill their swimming pools with milk, wash their cars with milk, and take baths in milk. Prices serve as signals to indicate what should be produced and what should be consumed.

Thus, those advising not-for-profit organizations regarding price should bear in mind that a very low price or a price of $0.00 might result in overexploitation of a resource. Countries that make medical care completely free have found that people run to doctors far too often. Individuals will visit doctors for every sniffle or slight ache. This means that more doctors will be needed and more of society’s resources will be shifted to the medical area resulting in the overuse of doctors. Even not-for-profit organizations might have to consider pricing at a high enough level to discourage overexploitation of a resource.

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Shrouding -- Is it ethical?

"Shrouding" is a term coined by Prof. David Laibson of Harvard University. It is a strategy used by businesses who charge customers additional fees that the customer might not want to pay but hide them deep in the fine print.  Of course, they  attract the consumer to the product or service by promoting low prices.  For example, some hotels run ads touting very low prices (e.g., only $90 per night). What you are not told is that you will have to pay a fee for parking the car, using the pool, using the Internet, room service, using the safe, etc.  The one night stay in the "cheap" hotel ends up costing you $150.  You might be better off in a luxury hotel.  Companies that sell printers also do this.  The printer may be very inexpensive but the cost of a toner cartridge that only makes, say, 1,000 copies, could be double that of a more expensive printer with cheaper cartridges that make 5,000 copies.  Banks also hide many of their add-on fees from customers in the fine print (e.g., use of ATM fees, fees for bouncing a check, fees to stop a check, etc.).  Is this good marketing?  Is it ethical?

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                                                                                                                                                                    "Making 5 for $5 More Tempting than one for $1" 
[Source:  Stephanie Clifford, New York Times, July 18, 2011, pp. A1, B8]

Retailers are looking for ways to improve profits by getting customers to buy more of a product. They try to find the multiple that encourages customers to buy larger quantities.  By studying purchasing patterns from scanner data, they try to come up with the best multiple.  Of course, if the advertisement indicates, say, "5 bottles of Coke for $5," this does not mean you have to buy all five bottles; you can purchase one bottle and still get the discount.  Psychologically, however, if consumers see "5 for $5" they tend to purchase the five bottles. People tend to purchase the amount that is advertised even if they do not need that quantity.  Of course, there is a limit to how much people will buy so you do not want to go overboard with this and promote, say, "100 bottles of Coke for $100" or an amount that is unrealistic. Some stores test different multiples to see which works best.  One study compared "1 for $1" with "5 for $5" and "10 for $10" and found that the "10 for $10" resulted in the most items being sold.  Note that Yoplait yogurt is sold in multiples of 10. 

Another approach used by retailers is to use "build-a-meal deals."  In order to encourage customers to buy more items, the retailer will combine various items that make up an entire meal (e.g., cold cuts, bottle of soda, potato salad, and cole slaw for $15). 

Studies show that 84% of consumers use a shopping list.  This is why retailers have to come up with strategies to get people to buy more of a product or items that are not on the list. 

 


(c) 2011 H.H. Friedman