FORETHOUGHT

Are Your Prices Too Low?

by Joel E. Urbany

Reprint f0109d
FORETHOUGHT

idea

Are Your
Prices
Too Low?
T h e a n sw e r m ay w e l l
b e y e s. H e r es w h y.

by Joel E. Urbany

Your company sells sunglasses for

$10. The unit cost is $7. Youre thinking
about cutting the price by 50 cents.
According to the best sales estimates,
if you hold the price, youll have a
100% chance of selling 1,000 units. If
you cut the price to $9.50, youll have
an 80% chance of selling 1,250 units,
and a 20% chance of selling only 1,000.
What should you do?
Statistically speaking, options A and
B are identical: Each produces a $3,000
prot. And since Option A is risk-free,
it might seem like the logical choice.
Yet when 60 managers responsible for
pricing decisions were asked this ques-
tion, most opted to reduce the price.
When they were told that competi-
tors were likely to match the cut, most
still chose the cheaper price point.
Even when they were informed that a
new demand forecast showed that the
cut would actually lead to lower prof-
its, the majority still wanted to reduce
the price.
This and many other studies indi-
cate that pricing managers routinely
set prices too low, sapping their com-
panies prots. What would explain
such counterproductive pricing deci-
sions? I believe there are two psycho-
logical forces at work.
First is managers reliance on what
marketing scholars call hysteresis
a type of market evolution pattern in
which buying market share through
aggressive short-term pricing leads to

2 Copyright 2001 Harvard Business School Publishing Corporation. All rights reserved.
 FORETHOUGHT

permanent increases in prof-

itability. Although only one
ILLUSTRATION: BRANT DAY

of several possible patterns of

market evolution, hysteresis
has a unique hold on the imag-
ination thanks to certain high-
ly memorable instances when
price cuts did lead to enduring
share gains. More often than
not, however, price cuts are quickly ing decisions based on current costs, pro- in market share. As Leonard Lodish, a
matched by competitors. Any gain in jected short-term share gains, or current professor at Wharton, has written, top
market share is short-lived, and overall competitor prices rather than on long- executives need to create an environ-
industry prots end up falling. term protability. ment that encourages pricing managers
The second and more important force The problems can be tackled from to make vaguely right decisions in
is managers natural tendency to want two directions, quantitatively and psy- other words, decisions that take into
to make decisions that can be justied chologically. By linking information account likely market responses, which
objectively. What could be wrong with about price, cost, and demand within cant be encapsulated in concrete data.
that? The problem is that companies the same decision-support system, ex- Pricing managers need to be encour-
tend to lack hard data on the complex ecutives can get the hard data they need aged to conduct pricing experiments
and to speculate about competitors fu-
ture moves and countermoves over the
Managers tend to make pricing decisions near and long terms.
Yes, its hard to estimate sales, costs,
based on current costs, projected short-term and prots at alternative price points.
share gains, or current competitor prices And its hard to predict competitors re-
rather than on long-term protability. actions well into the future. But if you
ignore the complexities and ambiguities
of pricing, you may end up leaving sig-
determinants of protability, such as the to calculate the effects of pricing deci- nicant sums of money on the table.
relationship between price changes and sions on protability. Between 1995 and
sales volumes, the link between demand 1999, for instance, decision makers at Joel E. Urbany is the associate dean of
levels and costs, and the likely responses Ford adopted a new pricing strategy by graduate programs and a professor of mar-
of competitors to price changes. In con- studying the demand at different price keting at the Mendoza College of Business
trast, companies usually have rich, un- points as well as consumer perception of at the University of Notre Dame in South
ambiguous information on costs, sales, value-added features. In part by raising Bend, Indiana.
market share, and competitors prices. prices, Ford reported record earnings
As a result, managers tend to make pric- in 1999, even though it lost two points Reprint f0109d

october 2001 3