Pricing Strategy: Components

Pricing Strategy

Units that you set the price for (value metrics)

Price structure

Pricing pattern over time

Pricing policy (the pricing process)

Marketing Management
Professor Dmitri Kuksov
UT Dallas

Company

Cost structure: fixed and marginal costs, capacity constraints

Overall goal of the price/product

Consumers

Demand curve (willingness to pay), change of demand over

time
psychological/signaling implications of price

Competition

Maximize profits from this product

Help company/brand image (to increase sales of other products)

Relative prices, product positioning

Expected competitive reaction (price war?)

Distribution

Total Fixed Costs (TFC): costs you pay regardless of how much

you produce (rent, salaries, capital, some utilities)

Variable Unit Cost: cost to produce and sell one unit (unit
production cost, sales commission, shipping costs)

Total Variable Costs (TVC):

Unit Contribution: profit increase from another unit sold:

Break-Even Volume: number of units the company has to sell to

(variable unit cost)*(number of units produced & sold)

(unit selling price)- (variable unit cost)

Break-Even Analysis

Total Revenue
Total Cost

Break-even quantity

E.g., Who sets the price (buyer or seller)? How (fixed,

negotiation/haggling, auction, etc.)?

Company: Cost Structure

Number of layers, profit margin for each layer, etc.

Break-even is the point at which Total Cost = Total Revenue

E.g., EDLP vs. Hi/Lo, Skimming vs. Penetration, etc.

Price point value(s) (or the exact rules of price setting)

Factors Affecting Pricing

e.g., Number of price points, quantity discounts or not, etc.

have zero (non-negative) profits

Note: variable unit cost may change with the number of units
produced; fixed costs may change too! More general way to
describe costs: cost curve

Example: Starting a business

A group of UTD students is considering an airport shuttle

from UTD campus to DFW. They can rent a car for $200
a week, the gas costs about $5 for the round trip to the
airport and some students are willing to drive somebody
to the airport for $20 a trip. Under what conditions does it
make sense to start this business?

Break-even volume, price, target ROI

ROI (return on investment) = Profit/Investment

Elasticity of demand

Consumers: Elasticity

Demand is called elastic if || is large (e.g., < 1, in

some definitions) and inelastic if it is small (e.g., > 1
in some definitions)

Price

= % change in q

% change in p

p2

Some products may have > 0, but this is unusual.

Examples?

Demand Curve

p1

q2

q1

If demand is more elastic, optimal price is lower than if

it is less elastic

Elasticity is a function of price

Quantity

How does optimal price depend on demand elasticity ()?

Common pricing methods

Elasticity: Example

Suppose a convinience store sells milk at $3.60 a gallon.

During one month, it decreased the price to $3.50 a
gallon and observed an increase of demand from 100 to
110 gallons of milk.

Markup pricing: set price at cost + target profit margin

Easy to set prices for a wide range of products, costs.

fair

Based on competition:

Below competition: steal consumers, but: poor quality signal,

possible competitive reaction (price war)
With competition: highlight differentiating features
Above competition: concentrate on better quality
Target break-even volume/price: determine price that
allows to recoup fixed and variable costs at a certain sales volume.
Attempt to ensure profitability

What is the demand elasticity?

Competitive Reaction

What Affects Willingness to Pay?

Reference Price

previous purchases, competitor or similar products

Disposable Income
Alternatives evaluation (competitor prices)
Future price expectations
Psychological issues:

Consumers process prices in a subjective way.

Implication: $7.99 is a better price for a bathroom slipper than 8!

Consumers are influenced by absolute and relative prices.

Implication: Bed priced at $699 with a reference price of $799 is
more attractive than a bed priced at $679!

Even price perception of quality, odd price perception of competitiveness/deal

Based on willingness to pay (value pricing)

Unlike other variables of the marketing mix, prices can be

changed (very) quickly

Competitive reaction is stronger/faster if:

Number of firms is small

Products are similar
Buyers are well informed about prices or have less uncertainty
about value

What can be used to decrease competitive response?

Differentiation
Committing to small size
Reputation (of quick retaliation) or preset response (e.g., price
matching policy)

Price Discrimination
Price Discrimination: charging different price to

Product Line Price Discrimination

different consumers according to their willingness to pay

(when price differences are not justified by costs). [also
called segmented pricing, customized pricing, or
consumer differential pricing]

Intel produced 486DX to sell at $1000. Then disabled math

co-processor (at a cost) to make 486SX to sell at $800.
Why incur cost to produce an inferior product???

How?

Geographic, Previous purchase history, Negotiation,

Observable consumer characteristics

example: student/senior discounts, coupons, location

Illustration: consider two segments, H and L, of equal size with

valuations as follows:

More examples:

Some direct price discrimination is not legal

Is it ethical? When?

Car: base model and extra options

Movie theater: movie and popcorn/drinks
Sat stayover for air tickets
Quantity discounts

More pricing strategies

Pre-conditions for Price Discrimination

Consumers must have different willingness to

pay (segments have different willingness to pay)
Arbitrage must not be possible/easy

1.

2.

E.g., Levys in China and Europe

E.g., price not reduced to cost by competition

Consumer demand changes over PLC:

Imitators/Innovators have higher willingness to pay

Less risk when buying proven good
Durables: Consumers who value more bought earlier
Network effects (e.g., what is the value of the first telephone?)
Competitive environment changes
Skimming strategy (decrease price over time) capitalizes on price
discrimination idea
Good for: durables, exclusivity status, capacity constraints
Penetration strategy (increase price over time) concentrates on
reducing consumer uncertainty (through use)
Pros: generates customer recognition, captures market fast (does
not invite competitors), good for: frequently purchased goods

Tie-in: requiring to buy other services from the same

company (e.g., if you want to buy gas from me, you also
have to buy electricity from me)

Similar to usage-based price discrimination

Bait and switch: attract consumer to a store with offer

known to be unavailable and try to sell other products
Not only unethical, but also illegal! (although not easy to prove)

similar to bundling
Illegal if you have monopoly power in one of the products

Existing customers revealed higher willingness to pay & may

have switching costs

Pricing over Product Life Cycle

Captive pricing: taking advantage of consumer prior

investment to sell accessories (this is legal)

Shares product cost, increases transaction cost and involves

moral hazard
But also: allows to price discriminate between heavy & light
users, and keep price high

New vs. old customer discounts

More pricing strategies (2)

Reduces transaction cost

Highlights benefits of joint purchase
But also: averages out consumer valuation heterogeneity

Renting (vs. selling):

E.g., Amazon.com attempt to customize prices

Company has market power

4.

Bundling:

Company does not antagonize consumers

3.

H values DX at $1100 and SX at $900

L values DX at $850 and SX at $800
Ignore costs. What is the best profit with one product? With two?