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Marketing Insight Course Reader

ICFAI University, Hyderabad


Summer 2008, Term II

Amiya K. Basu
Professor of Marketing, Syracuse University

May 31, 2008


Contents
1 Introduction 1
1.1 Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Alternative Marketing Management Philosophies . . . . . . . . . . . . . . . . . 2
1.3 Elements of Marketing Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.4 Appendix: Brand-Switching Matrix . . . . . . . . . . . . . . . . . . . . . . . . 9
1.5 Example: Mini-Survey on Cellular Telephone Service . . . . . . . . . . . . . . 11

2 Selected Topics on Consumer Decision Making and Business Marketing 20


2.1 Stages in Consumer Decision Making Process . . . . . . . . . . . . . . . . . . 20
2.2 Types of Consumer Decision Making . . . . . . . . . . . . . . . . . . . . . . . 21
2.3 Evaluation of Alternatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2.4 Maslow’s Hierarchy of Needs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
2.5 Business Customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
2.6 Nature of Business Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

3 Selected Topics on Market Segmentation and Targeting 35


3.1 Examples of Market Segmentation in Practice: Procter and Gamble . . . . . . 35
3.2 Meaning of Market Segmentation . . . . . . . . . . . . . . . . . . . . . . . . . 36
3.3 Evolution of the Concept of Market Segmentation . . . . . . . . . . . . . . . . 37
3.4 Possible Benefits of Market Segmentation . . . . . . . . . . . . . . . . . . . . . 38
3.5 Criteria for Successful Segmentation . . . . . . . . . . . . . . . . . . . . . . . . 38
3.6 Bases for Segmenting Consumer Markets . . . . . . . . . . . . . . . . . . . . . 39
3.7 Example of Psychographic Segmentation: VALS . . . . . . . . . . . . . . . . . 40
3.8 Strategies for Selecting Target Markets . . . . . . . . . . . . . . . . . . . . . . 42
3.9 Product Positioning Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
3.10 Example of Segmentation using student data . . . . . . . . . . . . . . . . . . . 47

4 Selected Topics on Marketing Research 51


4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
4.2 Basics of Sampling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
4.3 Non-Response in Mail Surveys . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
4.4 Example: Focus Group Outline . . . . . . . . . . . . . . . . . . . . . . . . . . 67

5 Conjoint Analysis 68
5.1 Idea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
5.2 Laptop Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
5.3 Evaluation of a New Product Concept using Linear Interpolation . . . . . . . . 70
5.4 Prediction of Market-Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
5.5 Example: Credit Card . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
5.6 Example: Personal Computer . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

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5.7 Optional Topics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
5.8 Additional Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
5.9 Appendix: Survey for Credit Card and PC . . . . . . . . . . . . . . . . . . . . 84

6 Selected Topics on Product Strategy 91


6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
6.2 Classification of Consumer Products . . . . . . . . . . . . . . . . . . . . . . . 91
6.3 Branding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
6.4 Product Life Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
6.5 Product features that affect rate of new product adoption . . . . . . . . . . . . 102
6.6 Strategic Planning and Boston Consulting Group (BCG) Market Growth/Market
Share Matrix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
6.7 Appendix: Practice Problem on BCG Market Growth/Market Share Matrix . 107
6.8 Appendix: Hypothetical Example of Experience Curve Effect . . . . . . . . . . 108

7 Selected Topics on Pricing Strategy 109


7.1 Introduction and Notations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
7.2 Demand and Own Price Elasticity of Demand . . . . . . . . . . . . . . . . . . 111
7.3 Factors That Affect Price Sensitivity . . . . . . . . . . . . . . . . . . . . . . . 117
7.4 Price Quality Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
7.5 Basic Methods of Setting Price . . . . . . . . . . . . . . . . . . . . . . . . . . 119
7.6 Competitive Bidding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
7.7 Psychological Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
7.8 Skim and Penetration Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
7.9 Spatial (Geographic) Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
7.10 Cross Price Elasticity of Demand and Pricing Related Products . . . . . . . . 128
7.11 Additional Topics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
7.12 Demand Functions used in Practice . . . . . . . . . . . . . . . . . . . . . . . . 133
7.13 Exercise Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
7.14 Additional Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

8 Selected Topics on Distribution Strategy 142


8.1 Rationale for Marketing Intermediaries (Middlemen) . . . . . . . . . . . . . . 142
8.2 Reasons for having intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . 143
8.3 Distribution Intensity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
8.4 Vertical and Horizontal Conflict . . . . . . . . . . . . . . . . . . . . . . . . . . 147
8.5 Alternative Channel Arrangements . . . . . . . . . . . . . . . . . . . . . . . . 149
8.6 Power in a Channel of Distribution . . . . . . . . . . . . . . . . . . . . . . . . 151
8.7 Some Legal Issues Related To Distribution Strategy . . . . . . . . . . . . . . . 152
8.8 Channel Coordination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
8.9 Additional Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

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9 Selected Topics on Promotion Strategy 158
9.1 Basic Ideas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
9.2 Selected Topics on Personal Selling . . . . . . . . . . . . . . . . . . . . . . . . 160
9.3 Publicity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
9.4 Selected Topics on Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
9.5 Sales Promotions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173

10 Estimation of Conjoint Model (Optional Material) 177


10.1 Dummy Variable Regression . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
10.2 Back to Conjoint Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
10.3 Estimation of Additive Part-Worth Model using Dummy Variable Regression . 184
10.4 Estimation of Conjoint Model for Credit Card Data in Section 5.5 . . . . . . . 185
10.5 Estimation of Conjoint Model for PC Data from Section 5.6 . . . . . . . . . . 187
10.6 Estimation of Ideal Point Model . . . . . . . . . . . . . . . . . . . . . . . . . . 189

11 Questionnaire Construction (Optional Material) 191


11.1 Basic Steps in Questionnaire Construction . . . . . . . . . . . . . . . . . . . . 191
11.2 Different Question Forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
11.3 Common Mistakes in Questionnaire Construction . . . . . . . . . . . . . . . . 195
11.4 Itemized Rating Scales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
11.5 Coding a Questionnaire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
11.6 Data Editing and Cleaning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
11.7 Example of Survey and Coding Scheme . . . . . . . . . . . . . . . . . . . . . . 206

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1 Introduction
1.1 Basics

Marketing: Marketing is the activity, set of institutions, and processes for creating, commu-
nicating, delivering, and exchanging offerings that have value for customers, clients, partners,
and society at large. (Adopted by the American Marketing Association in October, 2007)
More simply, Marketing is a process of exchange between two entities, a marketer who
produces a good, service or idea, and a customer.
Product: Anything that one can receive in an exchange.
Ideally, a product should be something that can satisfy a need or want. That may include
physical goods (e.g., an Apple iPOD), services (e.g., Apple iTunes music download service),
combination of goods and services (Apple iPOD with one year warranty), issues, and ideas.
Exchange: Process by which two or more parties give something of value to each other to
satisfy perceived needs.
An exchange requires the following conditions:

• At least two parties.

• Each party has something that might be of value to the other party.

• Each party is capable of communication and delivery.

• Each party is free to accept or reject the exchange offer.

• Each party feels it is appropriate or desirable to deal with the other party.

What is involved in marketing?

• Identification of customer needs.

• Design of goods and services to meet those needs.

• Promotion, that is, communication of information about those goods and services to
potential customers (key elements: advertising, personal selling, sales promotion, public
relations).

• Distribution of the product (time, place).

• Setting the price of the product.

• Service and follow up.

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1.2 Alternative Marketing Management Philosophies
1.2.1 The Production Concept: This philosophy focuses on the internal capabilities of
the firm in terms of how efficiently it can produce and distribute the product. The idea is
to streamline production and distribution to reduce cost. That allows the marketer to offer
a low price and hence generate a large demand. This, in turn, should give the marketer
economy of scale, and the process of cost reduction will be reinforced.
1.2.2 The Product Concept: Like the production orientation, the product orientation also
focuses on the internal capabilities of the firm. The objective now is to achieve a product of
high quality. The idea is that if product quality is high, customers would recognize that fact
and buy the product.
Potential Problems with Production and Product Concepts:

• The production and product concepts are incomplete because they do not consider what
the customer wants. You may have a great product and produce it efficiently, but nobody
may want it.

• While it is important to offer a quality product, it is also necessary to examine how


customers make trade-offs between price and quality. Otherwise, the product may be
too expensive to succeed in the marketplace.

1.2.3 The Selling Concept: This concept encourages the marketer to focus primarily on
promoting the product to customers and marketing intermediaries (resellers). Some methods
used are:
• Heavy advertising targeted at the end customer.

• Strong incentives to salespeople to sell the product. That may be done by using high
commission rates, bonuses for exceeding sales quotas, and sales contests.

• Promotional allowances (money to the reseller to promote the product), slotting al-
lowances (fixed fee paid to the reseller just to carry the product), and co-operative
advertising (partly reimburse the cost of local advertising) to the reseller.

Potential Problems with the Selling Concept:


1. The customer may not be interested in the product offered.
2. Heavy incentives encourage salespeople to hard-sell the product. This can generate ad-
ditional sales in the short runs, but customers may return the product later. Also, if the
customer is pressured to buy a product, they may develop a negative attitude about the
marketer.
1.2.4 The Marketing Concept: The idea is simple: The marketer should try to satisfy
the customers wants and needs while meeting the organization’s objectives. This includes the
following:

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• Customer wants and needs come first. The organization must focus of customer wants
and needs in order to distinguish its products from competitor’s offerings.

• This must be a company-wide orientation. The organization should integrate all its
activities (including production) to achieve the objective of satisfying customer wants
and needs.

• Achieve long term goals of the organization by satisfying customer wants and needs
legally and responsibly.

Issue: What happens when the product satisfies customer needs and wants legally, but the
product may be harmful to the customer or broader society in the long run?
1.2.5 The Societal Marketing Concept: Achieve a balance between what the customer
wants and what is good for the customer and society at large in the long run.
Issue: Usually more costly to implement than the marketing concept. It can only be imple-
mented if at least one of the following happens:

• There are government regulations or incentives that encourage societal marketing (e.g.,
tax break for buying a hybrid car).

• There is a substantial body of customers ready to pay extra for a product that is better
for society at large (e.g., Fair Trade coffee from plantation that give workers a living
wage).

• There is a vigilant body of consumer activists that will organize public opinion against
marketers who harm society in the long run.

• The industry regulates itself. This is often done to preempt government regulation or
consumer boycott.

1.3 Elements of Marketing Strategy

1.3.1 Basic Ideas:


Target Market: Group of people or organizations for which a marketer designs, implements,
and maintains a marketing mix. Objective: Satisfy their specific needs and wants, resulting
in mutually satisfactory exchanges.
Decision Variables of Marketer: Marketing Mix (also called the 4 P’s of Marketing)
1. Product
2. Price
3. Promotion: Advertising, personal selling, sales promotion, public relations

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4. Distribution (place, time)
Marketing Environment
Micro Environment
1. Internal environment

• Cost Structure

• Workforce

• Capabilities

• Resources available

2. Suppliers
3. Marketing intermediaries
4. Customers
5. Competitors
6. Publics: Any group of people that has an actual or potential interest in or impact on the
organization’s ability to achieve its goals. Clearly, the organization needs to communicate
with its publics effectively. Typically they include media, shareholders, employees, neighbors,
and regulators.
Macro Environment
1. Demographic
2. Economic (for example, inflation, recession, interest rate, currency exchange rates)
3. Technological
4. Natural
5. Political/legal
6. Social/cultural
1.3.2 Examples of changes in Demographic Environment
Example 1: Aging of baby-boomers
Example 2: Women in the work-force
Example 3: Rise of Generation Y. Born between 1979 and 1994, the Generation Y is a
technologically sophisticated and internationally connected group of customers. At least two
companies depended on Generation Y for success: Apple (iPod), and YouTube.
Discussion Problem: Identify a marketing opportunity created by each of the above changes.
1.3.3 Technological environment: Some factors

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1. Internet: The rise of the internet has had profound impact on may areas of marketing.
Some examples:

• It has allowed marketers serving a small and spatially dispersed group of customers to
survive. For example, a marketer who sells packaged Turkish sweets can directly serve
customers scattered over a large geographic area without depending on middlemen.

• It has created a platform for people to buy and sell products (eBay, Amazon).

• It allows marketers to distribute digital products (music, movie, online games, software)
without any distortion and at a very low marginal cost.

2. Modular products: For many product categories, the end product is a combination of
modules. For example, a personal computer offered by Dell is the combination of its mother-
board, hard drive, CD/DVD drives, RAM, monitor, and different software packages that come
with it. By changing the combination of modules, it is possible to customize a product at a
low cost. At the same time, since each module is mass produced, economy of scale is achieved.
3. Supermarket scanners that read the bar codes on packages. This allows better record keep-
ing and collecting information on consumer behavior through customer cards. Consequence:
This has shifted power in channels of distribution from the manufacturer to the retailer, as
retailers often have greater knowledge of demand than manufacturers. As a result, retailers
now charge promotional allowances, slotting allowances.
1.3.4 Political/Legal Environment
The political/legal environment affects many areas of business management. For example,
in the USA, the changes in the federal minimum wage affects company hiring, payroll, and
costs of production. The SarbanesOxley Act of 2002, passed in response to corporate and
accounting scandals such as Enron and Tyco, has had a major effect on accounting practices
and financial disclosure by companies. The areas listed below are only the areas of law that
affect marketing decisions in the USA.
Major Objectives of US Federal Laws Relating to Marketing:
(a) To maintain competition and prevent the formation of monopolies. Examples:

• Sherman Antitrust Act (1890): Makes trusts and conspiracies in restraint in trade illegal;
makes monopolies and attempts to monopolize a misdemeanor.

• Clayton Act (1914): Outlaws prices discrimination, tying agreements.

• Federal Trade Commission (FTC) Act (1914)

• Robinson-Patman Act (1936): Prohibits charging different prices to different buyers of


merchandize of similar grade and quantity; requires sellers to offer allowances to all
purchasers on proportionately equal basis. Applies only to situations where a marketer
in a state in the USA sells its products to other states in the USA.

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(b) To protect consumers from unfair business practices. These laws do not wish to prevent
marketers from doing business. The goal of these laws is limited to consumer protection.
Examples:

• Meat Inspection Act

• Automobile Information Disclosure Act

• Fair Packaging and Labeling Act (1966)

• Child Protection Act (1966): Bans sales of hazardous toys. Sets standards for child-
resistant packaging.

• Nutrition Labeling and Education Act (1990): Requires that food product labels provide
detailed nutritional information.

(c) Protect Interests of society from unrestrained business behavior. The goal of these laws is
to reduce or even eliminate certain marketing activities.
Examples:

• Federal Cigarette Labelling and Advertising Act (1967): Cigarette packages must include
the Surgeon General’s warning.

• Children’s Television Act (1990): Limits the number of commercials during children’s
programs.

(d) De-regulation. Examples: FTC Improvement Act, deregulation of the transportation


industry.
1.3.5 Competitive Environment
Key to understanding competitive environment:
(1) Identification of the need being satisfied. If two products can satisfy the same need, then
they are competing products.
(2) A clear idea of how the customer chooses a product. For example, if the choice follows a
series of steps, how is the choice made at each step?
Primary and Selective Demand: Primary demand is the demand for a product category.
Selective demand is the demand for a product within the category.
How to identify your competitor?
1. Frequently purchased brands: Look at purchase data over many purchase periods. One
method is examination of a “brand switching matrix” discussed later.
2. Durable products: Need to determine how close two objects are in the mind of a consumer
(“perceptual space”).

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3. Use a survey to find the “evoked set” of a customer.
Explanation of Terms:
1. Perceptual space: A consumer perceives a product in terms of the product’s features (also
called “attributes”). For example, a university may be perceived in terms of its tuition rate,
location, and academic reputation. Thus, each product alternative can be expressed as a point
in a multidimensional space in the mind of the customer. This space is called the perceptual
space.
2. Evoked Set: The evoked set of a consumer is the set of products (s)he considers before
making the choice. For example, Syracuse University might like to know which other schools
a student had applied to. This can be used to identify the competition for both durable and
frequently purchased products.

Example: Identifying competition using purchase history


You have data from 2000 consumers. Each customer in this sample bought exactly one tube of
toothpaste in April 2006, and one tube of toothpaste in May 2006. Each customer purchased
one of four brands: A, B, C, D. The data are presented as a cross-tab where the entry in the
i j-th cell is the number of consumers in your sample who purchased brand i in April and j in
May. For example, 200 out of this sample of 2000 purchased A in April, and B in May.
May 2006
April 2006 A B C D Row Totals
A 500 200 0 0 700
B 100 400 0 0 500
C 0 0 300 100 400
D 0 0 0 400 400
Column Totals 600 600 300 500 Total = 2000
Note: To understand what is going on, consider Row 1. The total of this row, i.e., 700, is how
many people purchased brand A in month 1. Out of these 700 people, 500 purchased A again
in month 2, 200 switched to B, and nobody switched to C or D.
Question 1: Which product is competing with which?
Question 2: Which product is in the greatest trouble?
Answers: There are two competitive groups: (1) brand A is competing with brand B (60% of
the overall market), and (2) brand C is competing with brand D (40% of the overall market).
The nature of competition is different in the two groups. Brand A seems to be an incumbent
product (such as Crest Fluoride), and B is a relative new comer (such as Colgate Fluoride).
Consumers seem to find the two products close substitutes as there is switching back and forth
between them. In the long run, both products will probably have equal shares of their portion
of the market (60% of the overall market). In contrast, brand D is drawing customers out of
C while C is not getting any customers from D, indicating that D is perceived as a superior
product. If this goes on, C may lose all its customers to D. Thus, while brands A and C are

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both losing customers, C is in much more serious trouble.
Important Note: The table given above is an example of a brand switching matrix.
Looking at a brand switching matrix, you can (1) identify who your competitors are, and (2)
learn how you are doing against your competitors. To construct a brand switching matrix, you
need record of purchases from the same set of customers over successive purchase occasions.
Such data can be obtained by (1) looking at shopping-card records if the customers always
goes to the same grocery-chain (such as Wegmans) and uses a card, or, (2) requiring the
customer keep a diary of purchases.

Effect of Competition on Marketing Decisions


1. Product Decisions

• Bench-marking: Attribute by attribute, determine how your offering compares with the
alternative that performs best on that attribute.

• Product Positioning: Creating a position of your product in the perceptual space of the
customer. This often requires comparing your product with competitor’s products.

• Product Differentiation: Make your product different from competing products on one
or more dimensions. Communicate these differences to the customer.

• Branding: Develop a brand name that tells the customer what to expect from your
product.

2. Pricing decisions: If the customer has more similar alternatives to choose from, she will be
more price sensitive. This has important impact on how the firm should set prices. Basically:

• Less competition allows you to set your price higher.

• If your product is perceived as unique, there will be a residual demand even when price is
high. On the other hand, if it is perceived as a commodity with many close substitutes,
demand will fall to zero if your price is much higher than the price charged by your
competitors.

3. Promotion decisions: A major focus of any promotion decision is to highlight your product
positioning. If your offering has unique features, usually your promotion tries to stress the
difference and charges a premium price (POD strategy). On the other hand, if your strength
is low cost, you may stress that you offer the same benefits as the expensive alternative at a
lower price (POP strategy).
4. Distribution decisions: You need to examine the distribution strategy of your competitor
to determine what threat or opportunity it presents. For example:

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• Are you ignoring the specific needs of some customers? For instance, are there many
students who wish to take evening MBA classes? Are there customers who wish to
do their grocery shopping on Sundays? Are there households who would like to have
groceries delivered at home?

• Is your competitor ignoring specific needs of some customers that you can fulfill?

1.4 Appendix: Brand-Switching Matrix

1.4.1 Cross-Tabulation
A cross-tabulation is used to summarize data obtained from a sample. This method deals
with two variables, each of which has a finite number of categories in the sample considered.
For example, for a sample of Syracuse University students, we may record (1) gender (male
or female) and (2) major (business, arts/science, engineering, other). We can place these
students into 2 × 4, that is, 8 categories: (1) male, business, (2) female, business, etc., and
count how many members of the sample belong to each of the 8 categories. The table we
get this way is called a cross-tabulation or cross-tab of these two variables. A hypothetical
cross-tabulation for these two variables is given below:
Gender
Major Male Female
Business 20 20
Arts/Science 15 25
Engineering 20 10
Other 18 22
For example, in the sample of size 150, 20 are male business majors, 25 are female
arts/science majors, etc. Cross-tabs can be used to understand the nature of the relationship
between two variables.

1.4.2 Brand-Switching Matrix: When you have data on what brand a customer selected
in two successive purchase occasions, you can prepare a brand-switching matrix. A brand-
switching matrix is a cross-tabulation of brand selected the first time against brand selected
the second time. By looking at this matrix, you can identify which brands are considered
substitutes of one another by customers.

Example to work with: Suppose you have a sample of 20 Syracuse University students
who went to campus area bars last Friday and Saturday. Each day, each of the students went
to exactly one bar, and they went to one of three bars: A, B, and C. You have the following
data on which bars were visited:

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Student # Friday Saturday Student # Friday Saturday
1 A A 11 C C
2 C C 12 B A
3 C C 13 A B
4 A B 14 A A
5 B A 15 B B
6 C C 16 A A
7 A A 17 C C
8 B B 18 A A
9 A A 19 A B
10 B B 20 A A
Prepare a cross-tab of bar visited Friday against bar visited Saturday. [Note that there
are 9 possible combinations here: AA (i.e., A Friday & A Saturday, AB (i.e., A Friday and B
Saturday), AC, BA, BB, BC, CA, CB, and CC.]
Proceed as follows. Note that in each purchase occasion, a customer selected one of three
bars (A, B, or C). Thus, the brand-switching matrix has three rows and three columns. Prepare
the template for the matrix as shown below.
Saturday
Friday A B C
A
B
C
Then, for each cell in the matrix, count how many times that combination has occurred in
the sample and enter that number in the cell. For example, the combination AA has happened
7 times in the sample (student # 1, 7, 9, 14, 16, 18, and 20). Thus, you enter 7 in the cell
AA. These are the students who went to bar A on Friday, and again on Saturday. Similarly,
you enter 3 in cell AB (students 4, 13, 19). Complete the table. This is the brand-switching
matrix.

10
1.5 Example: Mini-Survey on Cellular Telephone Service

1. Gender: Male Female

2. Place of residence (check one):


Dorm Fraternity/sorority South Campus

Rental apratment/house With parents Other


3. Do you drive a motor vehicle while in Syracuse?
Yes No
4. Do you subscribe to a land-line (not cellular) telephone service?
Yes No
5. Do you subscribe to cellular telephone service?
Yes (If yes, then continue with question 6.)
No (If no, then go to question 13.)
6. Approximately how much money do you spend each month on cellular telephone service?
(Check one)
$20 or less/month $21-$30/month $31-$40/month

$41-$50/month $51-$60/month $61-$70/month

$71-$80/month $81-$90/month $91 or more/month


7. How important are the following to you when you evaluate a cellular telephone service
provider? (Please circle)
Not important Very important
at all
(a) Monthly fee 1 2 3 4 5 6 7
(b) Price of handset 1 2 3 4 5 6 7
(c) Long distance rate 1 2 3 4 5 6 7
(d) Reliability of connection 1 2 3 4 5 6 7
(e) Features included 1 2 3 4 5 6 7
(e.g., text messaging)
8. In the space below, list the names of all the cellular telephone service providers you can
think of.

11
9. Which cellular telephone service provider do you subscribe to? (Check one. If more than
one, then check the one you use primarily.)
AT & T Cingular Cricket Nextel

Sprint PCS T Mobile Verizon Other


10. Overall, how satisfied are you with your current (primary) cellular telephone service
provider? (Please circle)
Very Dissatisfied Very Satisfied
1 2 3 4 5 6 7
11. If you had the option to either stay with the current provider or switch to a different
provider free of cost, which provider would you choose? (Check one)
AT & T Cingular Cricket Nextel

Sprint PCS T Mobile Verizon Other


12. How do you rate your current (primary) cellular telephone service provider on each of the
following? (Please circle)
Very Poor Excellent

(a) Monthly fee 1 2 3 4 5 6 7


(b) Price of handset 1 2 3 4 5 6 7
(c) Long distance rate 1 2 3 4 5 6 7
(d) Reliability of connection 1 2 3 4 5 6 7
(e) Features included 1 2 3 4 5 6 7
(e.g., text messaging)
13. During an average week, how many issues of the Daily Orange do you read? (Check one)
0 1 2 3 4 5
14. During Fall 2003 semester, how often did you attend an event at the Carrier Dome?
Never 1-2 times

3-4 times 5 or more times

**Thank You for Your Help**

12
Results (Data Collected 1/13/’04)

(A) Importance Weights

A.1 Mean Importance Weights of Attributes

Variable N Mean Std Dev Minimum Maximum


X7a 65 5.9539 1.1240 3.000 7.000
X7b 65 3.9692 1.6391 1.000 7.000
X7c 65 5.3385 1.7435 1.000 7.000
X7d 65 6.6000 0.7246 3.000 7.000
X7e 65 5.0000 1.2248 2.000 7.000

A.2 Frequencies of Importance Weights

Cumulative Cumulative
X7a Frequency Percent Frequency Percent
3 2 3.08 2 3.08
4 6 9.23 8 12.31
5 12 18.46 20 30.77
6 18 27.69 38 58.46
7 27 41.54 65 100.00

Cumulative Cumulative
X7b Frequency Percent Frequency Percent
1 5 7.69 5 7.69
2 9 13.85 14 21.54
3 9 13.85 23 35.38
4 18 27.69 41 63.08
5 13 20.00 54 83.08
6 6 9.23 60 92.31
7 5 7.69 65 100.00

Cumulative Cumulative
X7c Frequency Percent Frequency Percent
1 3 4.62 3 4.62
2 4 6.15 7 10.77
3 3 4.62 10 15.38
4 6 9.23 16 24.62
5 12 18.46 28 43.08
6 16 24.62 44 67.69
7 21 32.31 65 100.00

13
Cumulative Cumulative
X7d Frequency Percent Frequency Percent
3 1 1.54 1 1.54
5 3 4.62 4 6.15
6 16 24.62 20 30.77
7 45 69.23 65 100.00

Cumulative Cumulative
X7e Frequency Percent Frequency Percent
2 2 3.08 2 3.08
3 4 6.15 6 9.23
4 16 24.62 22 33.85
5 21 32.31 43 66.15
6 14 21.54 57 87.69
7 8 12.31 65 100.00

(B) Top of the Mind Awareness of Providers (List all you can think of)

AT&T Count Percent Cingular Count Percent Cricket Count Percent


0 13 20.00 0 12 18.46 0 46 70.77
1 52 80.00 1 53 81.54 1 19 29.23
N 65 N 65 N 65

Nextel Count Percent Sprint Count Percent TMobile Count Percent


0 30 46.15 0 9 13.85 0 14 21.54
1 35 53.85 1 56 86.15 1 51 78.46
N 65 N 65 N 65

Verizon Count Percent Other Count Percent


0 1 1.54 0 41 63.08
1 64 98.46 1 24 36.92
N 65 N 65

(C) Ratings of Current Provider on Attributes

Cumulative Cumulative
X12a Frequency Percent Frequency Percent
1 1 1.54 1 1.54
2 1 1.54 2 3.08
3 2 3.08 4 6.15
4 12 18.46 16 24.62
5 30 46.15 46 70.77
6 13 20.00 59 90.77
7 6 9.23 65 100.00

14
Cumulative Cumulative
X12b Frequency Percent Frequency Percent
1 3 4.62 3 4.62
2 1 1.54 4 6.15
3 8 12.31 12 18.46
4 18 27.69 30 46.15
5 15 23.08 45 69.23
6 14 21.54 59 90.77
7 6 9.23 65 100.00

Cumulative Cumulative
X12c Frequency Percent Frequency Percent
1 1 1.54 1 1.54
3 2 3.08 3 4.62
4 6 9.23 9 13.85
5 9 13.85 18 27.69
6 19 29.23 37 56.92
7 28 43.08 65 100.00

Cumulative Cumulative
X12d Frequency Percent Frequency Percent
1 2 3.08 2 3.08
3 3 4.62 5 7.69
4 4 6.15 9 13.85
5 12 18.46 21 32.31
6 15 23.08 36 55.38
7 29 44.62 65 100.00

Cumulative Cumulative
X12e Frequency Percent Frequency Percent
2 2 3.13 2 3.13
3 2 3.13 4 6.25
4 5 7.81 9 14.06
5 22 34.38 31 48.44
6 22 34.38 53 82.81
7 11 17.19 64 100.00
Frequency Missing = 1

(D) Attribute Ratings of Current Provider

D.1 Aggregate Attribute Ratings

15
Variable N Mean Std Dev Minimum Maximum
X12a 65 5.0308 1.1315 1.000 7.000
X12b 65 4.6462 1.4624 1.000 7.000
X12c 65 5.9385 1.2733 1.000 7.000
X12d 65 5.8462 1.4387 1.000 7.000
X12e 64 5.4531 1.1537 2.000 7.000
D.2 Ratings on Key Attributes (a and d)
Provider Number Mean of X12a Mean of X12d Mean of X10 (Satisfaction)
AT&T Wireless 1 5.00 6.00 5.00
Cingular 4 4.75 3.75 4.25
Nextel 3 4.00 5.67 6.00
Sprint PCS 5 4.60 4.60 5.00
T Mobile 3 4.67 3.00 4.00
Verizon Wireless 49 5.18 6.33 6.14
D.3 Ratings on Other Attributes (b, c, e)
Provider Number Mean of Mean of Mean of Mean of X10
X12b X12c X12e (Satisfaction)
AT&T Wireless 1 4.00 6.00 5.00
Cingular 4 3.50 4.50 4.75 4.25
Nextel 3 4.33 5.67 5.67 6.00
Sprint PCS 5 5.20 6.60 5.60 5.00
T Mobile 3 4.00 6.67 5.67 4.00
Verizon Wireless 49 4.76 5.96 5.47 6.14
Meaning of Attributes:
a Monthly fee b Price of handset c Long distance rate

d Reliability e Features included


(E) Satisfaction with Current Provider (X10 )
Frequencies of X10 for aggregate sample:
Cumulative Cumulative
X10 Frequency Percent Frequency Percent
1 1 1.54 1 1.54
2 2 3.08 3 4.62
3 1 1.54 4 6.15
4 1 1.54 5 7.69
5 13 20.00 18 27.69
6 28 43.08 46 70.77
7 19 29.23 65 100.00

16
Mean satisfaction for aggregate sample:

N Mean Std Dev Minimum Maximum


65 5.8153846 1.2486531 1.0000000 7.0000000
Mean Satisfaction for different providers

Provider N Mean Std Dev Minimum Maximum


X9 = 1 (AT&T) 1 5.00 5.00 5.00
X9 = 2 (Cingular) 4 4.25 1.5 2.00 5.00
X9 = 4 (Nextel) 3 6.00 0 6.00 6.00
X9 = 5 (Sprint PCS) 5 5.00 1.73 2.00 6.00
X9 = 6 (T Mobile) 3 4.00 2.65 1.00 6.00
X9 = 7 (Verizon) 49 6.14 0.89 3.00 7.00

(F) Market Shares of providers

F.1 Actual Shares:

X9 Frequency Percent
1 1 1.54
2 4 6.15
4 3 4.62
5 5 7.69
6 3 4.62
7 49 75.38

F.2 Wish Shares:

X11 Frequency Percent


1 3 4.62
2 3 4.62
3 1 1.54
4 10 15.38
5 6 9.23
6 2 3.08
7 40 61.54

Coding Scheme for X9 and X11 :

1 AT&T 2 Cingular 3 Cricket 4 Nextel


5 Sprint PCS 6 T Mobile 7 Verizon

F.3 Cross-tabulation: Current Provider by Provider They Wish to have

17
X11
X9 1 2 3 4 5 6 7 Row Totals
1 0 0 0 0 0 0 1 1
2 0 1 0 0 0 0 3 4
4 0 0 0 3 0 0 0 3
5 1 0 0 0 3 0 1 5
6 0 0 0 1 0 0 2 3
7 2 2 1 6 3 2 33 49
Columns Totals 3 3 1 10 6 2 40 Sample Size = 65

(G) Usage of Cellular Service

Results on $ spent (X6 : 1 if $20 or less, 2 if $21-$30, 3 if $31-$40, 4 if $41-$50, 5 if $51-$60, 6


if $61-$70, 7 if $71-$80, 8 if $81-$90, 9 if $91 or more)

Frequencies:

Cumulative Cumulative
X6 Frequency Percent Frequency Percent
1 1 1.54 1 1.54
2 2 3.08 3 4.62
3 11 16.92 14 21.54
4 13 20.00 27 41.54
5 24 36.92 51 78.46
6 5 7.69 56 86.15
7 2 3.08 58 89.23
8 1 1.54 59 90.77
9 6 9.23 65 100.00

Means and Standard Deviations of X6

Provider N Mean Std Dev


AT&T 1 5.00
Cingular 4 3.00 1.41
Nextel 3 5.00 1.00
Sprint PCS 5 5.60 2.07
T Mobile 3 7.00 2.00
Verizon 49 4.80 1.73
Aggregate Sample 65 4.86 1.80

(H) Media Habits: Attendance of Dome Events

H.1 Frequencies of X14 :

18
X14 Frequency
1 (Never) 7
2 (1-2 times/semester) 26
3 (3-4 times/semester) 7
4 (5 or more times/semester) 25
H.2 Cross-tabulation: Gender (X1) against Attendance of Dome events (X14):
X14
X1 1 (Never) 2 (1-2/semester) 3 (3-4/semester) (5 or more/semester) Row Totals
0 (Women) 4 19 5 7 35
1 (Men) 3 7 2 18 30
Column Totals 7 26 7 25 N=65
Discussion Questions:
1. Identify a company doing well, and a company not doing well. Compare them attribute by
attribute. What advice would you give to the company not doing well?
2. Consider the company with the dominant market share. Does it face any competitive
threat? Which competitor presents that threat? Why do you say so?

19
2 Selected Topics on Consumer Decision Making and
Business Marketing
2.1 Stages in Consumer Decision Making Process
In making a purchase, a consumer may go through the following five stages:
(1) Need Recognition: This may be something that develops over time, such as the need
to have an MBA degree to achieve your professional goals, or an impulse (no prior planning)
like seeing a box of candy at the supermarket and feeling hungry.
(2) Information Search: A consumer may search information to learn more about the
product category, and about the brands available. The search may be:

• Internal: Here, the customer is trying to retrieve information from her own memory.
For instance, when a person selects a vacation destination, he may remember places he
visited as a child and liked, and decide to go there again.

• External: These can be of two types:

– Marketing-Controlled: Sometimes, the customer obtains information from sources


controlled by the marketer. For example, a prospective MBA student may visit
the web-sites of different business schools to learn about their MBA programs.
Marketers generally try to show their own products favorably, and customers know
this fact.
– Non-marketing Controlled: Here, the customer is trying to obtain information from
sources she feels are not controlled by marketers. For instance, before applying to
a college, one may talk to friends and family members to learn more about alter-
native choices. Customers consider these information bias-free. Other examples of
non-marketing-controlled information sources include the Consumer Reports, and
www.tripadvisor.com.

The amount of external search conducted by a consumer depends on:

• The consumer’s interest in the product category.

• The consumer’s knowledge about the product category, and alternatives available.

• The consumer’s experience with the product category.

• The consumer’s confidence in making a decision.

After the information search, the consumer usually makes a short-list of alternatives to
choose from. This is called the evoked set (also called “consideration set”) of the consumer.

20
Note: Marketers sometimes plant paid endorsers among communities of prospective cus-
tomers. The P&G Tremor program is a major example of this trend.
(3) Evaluation of Alternatives: We discuss this in greater detail later (see Section 2.3 of
the Reader).
(4) Purchase
(5) Post-Purchase Behavior: During this stage, the consumer compares what she expected
to get, and what she actually received. Any imbalance between what she expected and what
she actually got after purchase is called cognitive dissonance.
Cognitive dissonance can only occur after a purchase is made. It is likely to increase if:

• The purchase is major.

• It is hard to reverse the purchase act.

• The rejected alternatives have desirable features the chosen alternative does not have.

A consumer may try to reduce cognitive dissonance by seeking favorable information about
the chosen alternative, and avoiding favorable information about alternatives not selected. If
she still feels dissatisfied, she may decide to switch to another product in the future.
Marketers recognize that cognitive dissonance is both a problem and an opportunity. The
incumbent marketer tries to reduce cognitive dissonance by allowing returns, offering after-
sales services, and sometimes running advertising campaigns trying to reassure the customer.
Competing marketers try to increase cognitive dissonance by planting doubts in the mind
of the customer about the purchase made. This is done through comparative advertising
focusing on some weakness of the competitor (e.g., commercials by Hertz car rental agency,
and the Capital One credit card).
Note: While the five-stage framework discussed above is comprehensive, a consumer may not
always go through all these stages. For example, during impulse purchase, a consumer may
go straight from need recognition (seeing a box of candy and feeling hungry) to purchase.

2.2 Types of Consumer Decision Making


To study consumer decision making, it is useful to categorize different types of consumer
decision making. There are two alternative ways we can do that.
Categorization 1: Consumer decision making may be placed in three categories based on
two dimensions: the consumer’s familiarity with the product category, and her familiarity
with the brands available to choose from. The categories are:
(1) Routine response behavior: Here, the consumer is familiar with both the product category,
and the brands available to choose from. In such cases, the consumer often selects the brand
she usually buys. For example, if you need laundry detergent, you probably buy the same
brand each time.

21
(2) Limited decision making: Here, the consumer is familiar with the product category, but
not familiar with the brands available. For example, if you are traveling in Europe and need
to buy laundry detergent, you may need to learn about the laundry detergents available there.
(3) Extensive decision making: Here, the consumer is unfamiliar with both the product cate-
gory and the brands available and needs to study both of these to make a choice.
Categorization 2: Alternatively, consumer decision making may be categorized based on
two dimensions:

• The consumer’s involvement with the purchase, which can be high or low.

• (2) Differences among the alternatives as perceived by the consumer, which can be high
or low.

There are four possibilities:


1. High involvement, high perceived difference: complex buying behavior. Here, the consumer
is highly involved with the purchase, and also is knowledgeable about the product category
and the alternatives available. The consumer is likely to develop evaluative criteria based on
the product attributes before making a final decision.
2. High involvement, low perceived difference: dissonance-reducing buying behavior. Here, the
consumer is highly involved with the purchase, but does not have the knowledge or confidence
to compare the product alternatives. In such cases, she is likely to play it safe and try to
make sure she is not sorry after the purchase. Thus, the consumer is trying avoid cognitive
dissonance.
In these cases, factors such as return policy, the length of warranty, expert opinion, and
prior experience with the product category are very important.
3. Low involvement, high perceived difference: variety-seeking behavior. Here, the consumer
is likely to try out different alternative products. For example, you may buy different flavors
of ice-cream on successive trips to the store.
4. Low involvement, low perceived difference: Habitual buying behavior. Here, the consumer
does not see any need to try out different alternatives (they are all the same to her) and
usually buys the same brand repeatedly.

2.3 Evaluation of Alternatives


Our discussion centers on limited or extensive decision making. (In routine response behavior,
the consumer typically buys the same brand without comparing alternatives.) We assume that
a consumer looks at each product alternative as a “profile” of its attribute values. For example,
suppose a prospective MBA student has received offers of admission from four MBA programs,
and she has rated each program in terms of the following attributes: reputation (X1 ), cost
(X2 ), location (X3 ), and campus life (X4 ). For simplicity, suppose she rates each program on

22
a given attribute such as reputation on a 1-7 scale, from “very poor” (1) to excellent (7), and
the rating scores are as follows:
Program Reputation Cost Location Campus Life
(X1 ) (X2 ) (X3 ) (X4 )
A 7 1 6 3
B 5 5 5 5
C 7 6 3 6
D 4 6 6 6
We can think of a four dimensional space, the four attributes being the coordinates, where
the decision makers perceives the four “products” (that is, MBA programs). This is the
“perceptual space” here. (It is easy to visualize a perceptual space in two or three dimensions.
Beyond three dimensions, it is harder to visualize a perceptual space, but the idea is the same
as for lower dimensions.)
Alternative Decision Rules: Once a consumer comes up with a perceptual space, she has
to choose one alternative. No one knows for sure how a consumer makes a choice. Five basic
rules which seem reasonable are described below. Note that in real life, a decision maker often
uses a combination of one or more “basic” rules.
Rule 1. Expectancy Value Rule: Here, we assume that when the consumer evaluates
product alternatives, she assigns an “expectancy value” to each alternative, and selects the
product with the highest expectancy value. She computes the expectancy values as follows:

1. She assigns an importance weight to every relevant attribute. For n attributes,


we denote the importance weights by W1 , W2 , . . . , Wn .

2) For product alternative i under consideration with attribute values X1i , X2i , . . . , Xni ,
she computes the expectancy value (EMi ) as the weighted sum:

EVi = W1 ∗ X1i + W2 ∗ X2i + . . . + Wn ∗ Xni .

This is repeated for every product alternative under consideration (W -s are same
for all products, but X-s change from alternative to alternative).

3) She selects the alternative with the highest expectancy value.


Note 1: The expectancy value rule is called a “compensatory” rule because a poor rating on
one attribute may be balanced out (compensated for) by a good rating on another attribute.
A poor rating on just one attribute may not necessarily imply that an alternative is rejected.
Note 2: The choice of importance weights for a consumer is not unique. If all the importance
weights (W -s) are multiplied by the same positive number K, all the expectancy values are
also multiplied by that number K, and the choice remains the same.

23
For example, suppose there are four attributes (n = 4), and the respondent considers each
attribute equally important. Then, for the purpose of selecting a product alternative, the
following two alternative sets of importance weights will give the same result:

• Alternative 1: W1 = 1, W2 = 1, W3 = 1, W4 = 1. Here, the expectancy value is the sum


of individual attribute ratings.

• Alternative 2: W1 = 0.25, W2 = 0.25, W3 = 0.25, W4 = 0.25

Example: Suppose the decision maker considers cost, location, and campus life equally
important, and reputation twice as important as any one of the other three attributes. We
can choose W1 = 2, W2 = 1, W3 = 1, and W4 = 1.
Program Expectancy Value
A (2 × 7) + (1 × 1) + (1 × 6) + (1 × 3) = 14 + 1 + 6 + 3 = 24
B (2 × 5) + (1 × 5) + (1 × 5) + (1 × 5) = 10 + 5 + 5 + 5 = 25
C (2 × 7) + (1 × 6) + (1 × 3) + (1 × 6) = 14 + 6 + 3 + 6 = 29
D (2 × 4) + (1 × 6) + (1 × 6) + (1 × 6) = 8 + 6 + 6 + 6 = 26
Choice: Alternative C, with the highest expectancy value of 29, will be chosen.
Note that if we multiplied by each W by the same positive number, choice would remain
the same. In the present case, suppose we chose W1 = 0.4, W2 = W3 = W4 = 0.2. Then:
Program Expectancy Value
A (0.4 × 7) + (0.2 × 1) + (0.2 × 6) + (0.2 × 3) = 2.8 + 0.2 + 1.2 + 0.6 = 4.8
B (0.4 × 5) + (0.2 × 5) + (0.2 × 5) + (0.2 × 5) = 2 + 1 + 1 + 1 = 5.0
C (0.4 × 7) + (0.2 × 6) + (0.2 × 3) + (0.2 × 6) = 2.8 + 1.2 + 0.6 + 1.2 = 5.8
D (0.4 × 4) + (0.2 × 6) + (0.2 × 6) + (0.2 × 6) = 1.6 + 1.2 + 1.2 + 1.2 = 5.2
Once again, the choice is Alternative C, with the highest expectancy value of 5.8.
Rule 2. Conjunctive Rule: This rule is often used by a consumer to make a short list of
alternatives for further consideration. According to this rule, the respondent sets minimum
acceptable levels on one or more attributes. A product is considered further only if it meets
all these criteria.
Example: Consider the prospective MBA student introduced earlier. Suppose she only
considers MBA programs that rate 6 or more on X1 , and 6 or more on X4 . Only MBA
program C meets both criteria and is selected.
Conjunctive rules often arise when a risk averse consumer is trying to make sure the
product meets minimum standards on one or more dimensions. That happens in dissonance
reducing buying behavior.
The Kotler/Keller text gives a special case of the conjunctive rule where the customer
selects the first product that satisfy all the criteria. More generally, a conjunctive rule is used
to make a short-list from which the consumer makes a final choice. We use the more general
definition in our class.

24
Rule 3. Disjunctive Rule: This rule is also used to prepare a short list of alternatives for
further consideration. Here, the respondent sets minimum acceptable levels on one or more
attributes. An alternative is considered further if it meets any one of these criteria.
Example: Consider the prospective MBA student introduced earlier. Suppose she considers
any MBA program that rates 6 or more on X1 , or 6 or more on X4 . MBA programs A, C,
and D all meet the condition that at least one of the two criteria is satisfied:

• A meets the first criterion.

• C meets both criteria.

• D meets the second criterion.

An MBA program is only removed from consideration if it fails to meet both criteria.
Disjunctive rules often arise in variety seeking buying behavior where the consumer is open
to trying many alternatives as long as they show promise on some dimension.
Rule 4. Lexicographic Rule: A consumer using this rule arranges the attributes from
most important to least important. She then compares the alternatives as follows:

1. Start with the most important attribute.

2. Compare all the alternatives on this attribute alone. If any alternative is worse
than any other on this attribute, it is eliminated from further consideration. If one
alternative is better than all others on this attribute, this alternative is selected,
and the search stops. If there is a tie on this attribute, keep only the set of
alternatives that are tied for highest score on this attribute, and proceed to the
next most important attribute.

3. Repeat step 2 until there is one alternative left.

Example: Consider again our prospective MBA student. Suppose she uses a lexicographic
decision rule where X1 is most important, X4 is second most important, X2 is third most
important, and X3 is fourth most important. Her choice process will proceed as follows:
Stage Attribute Alternatives Considered Eliminated
1 X1 A, B, C, D B, D
2 X4 A, C A
3 X2
4 X3
Here, MBA program C is selected in stage 2, and the choice process stops there.
Note: The name “lexicographic” comes from how the words in a dictionary (lexicon) are
arranged. The key aspect of the lexicographic rule is that if an alternative is even slightly

25
worse on a more important attribute, then it is selected even if it has much superior ratings
on less important attributes. Thus, the lexicographic rule is not “compensatory.” It should
be relatively rare when a decision maker uses a lexicographic rule. It may be reasonable, for
instance, when one is selecting a safety product such as baby car seat. Then, even when a
brand is just slightly more safe, it may be chosen regardless of price.

5. Elimination by Aspect (EBA): In contrast to the rules discussed so far, EBA is


a probabilistic decision rule. Here, the customer makes a list of desirable aspects a product
alternative may have, and assigns a value to each aspect. For instance, suppose the prospective
MBA student in our example has listed the following aspects and values:
Aspect Description Value
A1 6 or more on reputation 40
A2 6 or more on cost 40
A3 6 or more on location 20
The choice proceeds in stages. At each stage, the customer randomly chooses an aspect from
the aspects not already chosen. The probability that an aspect is selected is proportional to
the value of the aspect, that is, equal to the value of the aspect divided by the sum of the
values of all the aspects not selected in a previous stage.
After an aspect is chosen, two things can happen. If only one alternative possesses the
aspect, that alternative is chosen. If two or more alternatives possess the aspect, then only
the tied alternatives are considered further, and another aspect is chosen from the aspects not
selected in an earlier stage.

In the present example, the alternatives do or do not have aspects as shown below:
Alternative A1 A2 A3
A Yes No Yes
B No No No
C Yes Yes No
D No Yes Yes
We have the following possibilities:
Stage 1 Alternatives Eliminated Stage 2 Alternatives Eliminated Choice
A1 selected A, B, C, D B, D A2 selected A, C A C
A3 selected A, C C A
A2 selected A, B, C, D A, B A1 selected C, D D C
A3 selected C, D C D
A3 selected A, B, C, D B, C A1 selected A, D D A
A2 selected A, D A D
Program A: Program A may be selected in two ways:

(1) Aspect 1 is chosen in stage 1, and then Aspect 3 is selected in stage 2. The probability

26
that this happens is:

P (1 chosen in stage 1) ∗ P (3 chosen in stage 2|1 chosen in stage 1)


³ 40 ´ ³ 20 ´
= ∗ = 0.4 × 0.333 = 0.1332
40 + 40 + 20 40 + 20
(2) Aspect 3 is chosen in Stage 1, and then Aspect 1 in selected in Stage 2. The probability
that this happens is:

P (3 chosen in stage 1) ∗ P (1 chosen in stage 2|3 chosen in stage 1)


³ 20 ´ ³ 40 ´
= ∗ = 0.2 × 0.5 = 0.10
40 + 40 + 20 40 + 40
Thus, the probability that Program A is chosen is 0.1332 + 0.10 = 0.2332.
Program B: Program B has none of the three aspects and is never selected.
Program C: Program C may be selected in the following ways:
(1) Aspect 1 in selected in stage 1, and Aspect 2 is selected in stage 2. The probability that
this happens is:

P (1 chosen in stage 1) ∗ P (2 chosen in stage 2|1 chosen in stage 1)


³ 40 ´ ³ 40 ´
= ∗ = 0.4 × 0.667 = 0.2668
40 + 40 + 20 40 + 20
(2) Aspect 2 is selected in stage 1, and Aspect 1 is selected in stage 2. The probability that
this happens is:

P (2 chosen in stage 1) ∗ P (1 chosen in stage 2|2 chosen in stage 1)


³ 40 ´ ³ 40 ´
= ∗ = 0.4 × 0.667 = 0.2668
40 + 40 + 20 40 + 20
Thus, the probability Program C is chosen is 0.2668 + 0.2668 = 0.5336.
Program D: Program D may be chosen in the following ways:
(1) Aspect 2 is selected in stage 1, and Aspect 3 is selected in stage 2. The probability that
this happens is:

P (2 chosen in stage 1) ∗ P (3 chosen in stage 2|2 chosen in stage 1)


³ 40 ´ ³ 20 ´
= ∗ = 0.4 × 0.333 = 0.1332
40 + 40 + 20 40 + 20
(2) Aspect 3 is selected in stage 1, and Aspect 2 is selected in stage 2. The probability that
this happens is:

P (3 chosen in stage 1) ∗ P (2 chosen in stage 2|3 chosen in stage 1)

27
³ 20 ´ ³ 40 ´
= ∗ = 0.2 × 0.5 = 0.10
40 + 40 + 20 40 + 40
Thus, the probability D is chosen is 0.1332 + 0.10 = 0.2332
General Notes:

• If there is only a single cut-off point, then there is no difference between a conjunctive
and a disjunctive rule. The rules become different if there are two or more cut-off points.
Then, the conjunctive rule requires that all the cut-offs must be satisfied for the product
to be considered further, while the disjunctive rule only requires that any one of the
cut-offs be satisfied.

• The lexicographic, conjunctive, disjunctive and EBA rules are not compensatory rules
as a high level of one attribute may not be able to compensate for low levels on other
attributes. For example, a consumer who requires a minimum level of gas mileage may
not buy a car even though it offers excellent acceleration, handling and low price.

• The rules described above are basic decision rules. In reality, a decision maker may
use more than one of them to choose a product. For example, a consumer may make
his selection in two stages: first use a conjunctive or a disjunctive rule to obtain a
set of acceptable alternatives, and then use an expectancy value rule to make the final
choice. For example, you may have used a conjunctive rule to eliminate schools outside
the northeastern USA from further consideration, and then selected Syracuse from the
resulting smaller set of alternatives using an expectancy value rule.

• There is a simple extension of the expectancy value model where it is assumed that every
consumer has an “ideal product” she compares all alternatives with. The “ideal product”
occupies the “ideal point” in the “perceptual space” of the consumer, and she chooses
the product which has the smallest distance from the “ideal point” in the consumer’s
perceptual space. This model, called the “ideal point” model, is a compensatory model,
that is, a low rating on one attribute can be balanced by a high rating on another
attribute. We use this idea in Assignment 2.

• For each rule described above, we may have a tie among two or more alternatives. For
example, two MBA programs may have the same expectancy value. The rule itself does
not tell you how the tie is broken.

• For the conjunctive and disjunctive rules, it is possible that no alternative meets the
requirement for selection.

• For the elimination by aspect rule, it is possible that in a given stage, no alternative has
the aspect selected. If that happens, we will ignore that aspect and proceed to select an
aspect from the remaining aspects.

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2.4 Maslow’s Hierarchy of Needs
A marketer is always interested in learning how important different attributes are to a con-
sumer. However, attributes are product specific, and it is very difficult to determine what
attributes of a new product will even be relevant to a consumer. Maslow’s hierarchy of needs
is an attempt to understand what is more important to a consumer in general.
According to this hierarchy, a consumer has the following five levels of needs, ranging from
the lowest (1: physiological) to the highest (5: self actualization):
1. Physiological: Food, drink, shelter. Basically, survival.
2. Safety: security, protection, order. For example, you may buy a fire-wall to secure your
computer from identity theft.
3. Social: affection, acceptance, belonging to a group. For example, one may buy perfume to
be more attractive to others.
4. Esteem: respect, reputation, prestige, status. For example, one may purchase an expensive
car to show his status in society.
5. Self Actualization: self fulfillment. For example, one may come back to school after
retirement to get a graduate degree.
The basic idea of Maslow’s hierarchy is that a lower need is always more important than
a higher need, and a consumer tries to fulfill a higher need only when the lower needs are
largely fulfilled. If a marketer has a product that satisfies a higher need and a lower need,
Maslow’s hierarchy suggests that the product should be positioned by the lower need.

2.5 Business Customers

(a) Producers: They include

• Manufacturing

• Construction

• Transportation

• Services (legal, finance, food, security, health management)

• Farm

(b) Resellers: Buy finished goods and resell for profit. They include distributors (wholesalers
who resell to business customers), and retailers (who resell to final consumers).
(c) Governments: Federal, local, state, foreign
(d) Institutions: Hospitals, universities, etc. These tend to be non-profit organizations.

29
2.6 Nature of Business Markets

2.6.1 Differences from Consumer Markets:


1. Market structure: Fewer but generally larger buyers.
2. Demand: derived, inelastic, fluctuates more.
3. Nature of buying unit: More buyers involved, more professional purchasing.
4. Types of decisions and decision process: more complex decisions, more formal buying
process, long term relationship between buyer and seller possible.
5. Other: shorter channels, reciprocity, leasing more common.
In general, compared to the consumer market, decision making in the business market is
more complex and likely to involve more participants. Also, decision makers are usually more
informed customers than the typical consumer. Because each decision is time consuming,
purchase size is usually larger, and new purchase decisions are less frequent.
Seller’s perspective: Business buyers often demand more information than the consumer,
and the final product needs greater customization. As a result, business marketing involves
greater emphasis on personal selling than advertising. Also, because of the larger size of a
purchase order, there is less need for market intermediaries and channels of distribution are
shorter. Sellers sometimes use national account management where a sales team is dedicated
to one major client with divisions dispersed nationally.
2.6.2 Types of Business Products:
(1) Major Equipment (Installations): major items like buildings, aircraft, computer systems,
etc. Represents a major purchase, and is often customized to the needs of a specific customer.
(2) Accessory Equipment: smaller items like personal computers, cars, etc., essential for
running the business.
(3) Component parts (modules such as computer chip, hard drive, DVD ROM, muffler for
a car), processed materials (e.g., alloy steel, silicon wafer), and raw materials (e.g., corn to
make cereals from).
(4) Supplies: maintenance, repair, operating.
(5) Services: financial, legal, medical, delivery, transportation, security, etc.
2.6.3 Type of Business Markets:
(1) Vertical Market: Only a specialized set of customers buy your product. For example,
Intel Pentium chips are sold only to PC manufacturers, and airplane navigational equipments
are sold only manufacturers and repairing facilities of airplanes. Here, product knowledge
is often very important, and the sales volume to a given customer is often large. Thus,
channels of distribution tend to be shorter and there is much greater emphasis on personal
selling (which can be more precisely targeted and can convey more information) than on
advertising. (However, you do see TV commercials for Intel even though its customers are
business customers. Why?)

30
(2) Horizontal Market: A wide spectrum of customers in different types of organizations may
buy your product. Examples: markets for (i) personal computers, (ii) air conditioners, (iii)
copy machines, (iv) Hammermill paper. Compared to vertical markets, here the marketer
does more advertising and also do more selling through wholesalers, retailers, etc.

2.6.4 Characteristics of Demand in Business Markets:

1. Derived Demand: Demand for a business product is usually derived from demand in the
consumer market. For example, there is a demand for Intel Pentium chips because consumers
buy personal computers, that is, the demand for Pentium chips is derived from the demand
for PC’s in the consumer market.
Consequences of derived demand:
1(a). Inelastic demand: Quite often, a business product represents only a part of the final
consumer product. Therefore, if the price of the business product changes, that has very little
effect on the total price the consumer pays and thus does not change demand in the consumer
market. Thus the demand for the business product often does not change significantly with
price, that is, demand tends to be inelastic.
For example, suppose the final product is a notebook computer which sells at a retail
price of $1500. Consider a component of the computer, say, a graphics chip, which costs the
manufacturer $100/unit. If the price of the chip increases to $110 and the manufacturer passes
on the cost to the end customer, then the retail price of the notebook is $1510, less than a 1%
increase. That is unlikely to have a major impact on the demand of the notebook computer
and hence of the graphics chip.
1(b). Highly fluctuating demand: Consider, for example, demand for installations such as
factories. Businesses like to operate at or near full capacity. Thus, even if demand in the
consumer market drops slightly, factories are closed in order to consolidate production. On
the other hand, if demand in the consumer market increases slightly, new factories are opened.
Thus, slight changes in consumer demand can cause major changes in demand for business
products. (Exception: Farm products usually do not have highly fluctuating demand because
demand for food is stable.)
2. Joint demand: If two or more business products are all used to make the same consumer
product, they have joint demand. For example, computer chips, LCD screens, hard drives,
and DVD ROM’s are all used to make PC’s and hence their demands are joint. Consequently,
a change in demand for the consumer product affect demands for all these products the same
way. Thus, a change in demand at the consumer level can affect demand in a wide spectrum
of industries.

Example: Processor, LCD screen, and DVD ROM are all components of a note-book com-
puter. Thus, the demands for all these components are derived from the demand for note-
books. If the demand for any component rises or falls, the demands for the other components
do that also. The demands for the components are joint.

31
Joint Joint

Processor ¾Demand -
LCD Demand
¾ -
DVD
Screen ROM

@ ¡
@ ¡
@ ¡
@ Derived Demand ¡
@ ¡
@ ¡
@ ¡
@
R ? ª
¡
Notebook
Computer

Consumer

2.6.5 Classifying Business Buying Behavior:


In any business buying situation, a customer must decide what to buy and which vendor
(seller) to buy it from. Three types of buying situations are possible.
1. Straight Rebuy: In a straight rebuy situation, the buyer knows exactly what to buy and
who to buy it from. For example, when Syracuse University needs more toner cartridges for
its printers, it will automatically order new cartridges from HP. This ordering is typically done
by clerical staff rather than a high level decision maker.
Seller’s Perspective: In a straight rebuy situation, fast and reliable delivery is very impor-
tant. The products involved are often low-margin items, and the ability to distribute large
volumes of material efficiently is required for success.
2. New Task: In a new task situation, the customer is purchasing a new product for the first
time. For example, a company may be setting up a new athletic facility for its employees.
This is typically a lengthy process where committees are formed to decide exactly what the
product should be, and multiple vendors are asked to submit bids. There is typically lengthy
negotiations before the vendor is selected.
Seller’s Perspective: A “new task” situation provides the greatest opportunity to a new
vendor to enter the market. As the prospective customer requires a lot of information, the
selling team typically includes experts in different areas (product, finance). As negotiations
are involved, high level executives from the selling organization often participate in the selling
process. The process involves significant risk of failure from the vendor’s perspective. However,

32
if the vendor succeeds and the customer is satisfied with the product, long term relationships
are possible leading to modified rebuy in the future.
3. Modified Rebuy: Here, the customer requires small variations from an existing product.
For example, the company may like to open an athletic facility at a second office. In these
cases, the customer typically has a lot of knowledge about the product, and also has preferred
vendors.
Seller’s Perspective: Modified rebuy situations typically represent the greatest profit op-
portunity for the preferred vendor. First, as the customer is already knowledgeable about
the product and you as vendor, there is less need to engage experts to educate the customer.
Also, the products involved are typically not low-margin items as in straight rebuy situations.
2.6.6 Reason Why Leasing is Common in Business Markets
Compared to the consumer market, leasing is more common in business markets because
it offers benefits to both the customer and the company leasing the product out.
Customer’s Perspective:
1. Tax advantage: Rental payments are totally tax deductible and usually are larger than
corresponding depreciation charges on owned products.
2. Convenience: Leased products are often serviced by the party leasing the product out (that
is, “lessors”).
3. Less commitment: This has two dimensions:
(a) Finance: Your capital is not tied up in an expensive purchase.
(b) Technology: You are not tied to a technology that may become obsolete. This is particu-
larly relevant in rapidly evolving technologies.
4. Your demand may be seasonal. For example, a builder may need earth moving equipment
only for short stretches of time.
Perspective of firm leasing out Product:
1. Total net income is often higher if you lease out rather than sell. This happens because
you earn money by servicing the leased out product.
2. You can expand your market by including customers who cannot buy the equipment
outright.
3. You can induce trial of a new product by reducing customer commitment.
2.6.7 Organizational Decision Styles
Organizations can be placed in four main categories based on their decision styles:
1. Bureaucratic Decision Style. Government agencies usually follow this decision style.
Sometimes, institutions like health care organizations or universities also follow this pattern
of behavior. These organizations are regulated tightly, and the focus is on making sure all the
regulations have been met.

33
Major needs of Customer: The product must meet exact specifications. Proper paper work
is required. Low price is also required. (Typically, if the order is large, the sellers have to
make bids, and the lowest bid is accepted).
Seller’s Perspective: Know when needs arise, the exact specification of the product, and
what paper work is involved. Usually all this can be done by the clerical staff. Also, need
engineers and accountants to estimate costs are prepare bids. There is not much need for
personal selling.
2. Small Companies. For example, a Mom and Pop family diner needs an air conditioner.
Characteristics: Small order size. Repeat purchases rarely made. The product is needed im-
mediately. There are usually one or two decision makers who do not have technical knowledge
of the product.
Major needs of Customer: Fast delivery. Guarantee that the product will work. Service after
the sale to make sure the product works properly.
Seller’s Perspective: Reduce the customers’s risk. One method used by selling firms in sit-
uations like this is to use a regional salesperson or a sales representative to deal with the
small customers. It is not necessary for the salesperson (or sales representative) to have a
high degree of technical knowledge about the product category as long as she knows how this
particular equipment works.
3. Large companies with functional divisions
Example: Citicorp purchasing computer work stations for its New York offices.
Characteristics: Large orders. Long period of planning and comparing alternatives. Formal
buying center consisting of representatives from different divisions (technical, finance etc.).
Important: Long term relationships and repeat purchases are possible.
Major needs: Quality of product. Satisfaction of clearly defined needs. Depending on the
product category, ease of use and scope to expand and upgrade (e.g., computer network) may
be important.
Seller’s Perspective: Need to have a sales team consisting of technical experts to explain
the product’s features to the buyer’s technical people, financial experts to negotiate financial
arrangements, etc. The negotiations are likely to be lengthy, and typically the sales team will
need to make several presentations. A selling firm often uses a national accounts executive to
coordinate the selling activities.
4. Political Decision Style: These involve organizations where participants with political
power make purchase decisions. As political power comes from forming coalitions of people
with similar interests, purchase decisions also require the support of a group of influential
people in the organization. For example, the purchase of a new weapons system often involves
political decision style.
Seller’s Perspective: You need supporters within the organization to champion your product.
Retired government officials and politicians are often hired as lobbyists to build such support.

34
3 Selected Topics on Market Segmentation and Target-
ing
3.1 Examples of Market Segmentation in Practice: Procter and
Gamble

(A) P&G Laundry and Fabric Care:

• Bounce: Bounce Sheets can breathe a fresh scent into almost anything, from your favorite
sweatshirt to Dad’s old recliner. Bounce Sheets come in four great scents, and an
unscented variety.

• Cheer: Cheer helps protect against fading, color transfer and fabric wear in powder or
liquid, with or without bleach.

• Downy: Downy offers a line of advanced fabric care conditioning products that keep
clothes feeling soft and smelling fresh.

• Dreft: Dreft is a specially formulated detergent that rinses out thoroughly, leaving
clothes soft next to a baby’s skin. Dreft has been the No. 1 choice of pediatricians for
years.

• Era: Era is a powerful laundry detergent that is tough on stains.

• Febreze: Febreze is a fabric refresher and air freshener that utilizes a unique odor-
eliminating technology to clean away odors from household fabrics and the air.

• Gain: Gain laundry detergent and fabric softener provide excellent cleaning power and
a smell that says clean.

• Ivory: Mild cleansing benefits for a gentle, pure and simple clean.

• Tide: Fabric cleaning and care at its best

(B) P&G Body Wash and Soap (Personal Cleansing Products)

• Camay: A moisturizing bar soap enriched with perfumes of French inspiration that
leaves your skin feeling fresh, soft and sensual.

• Ivory: Mild cleansing benefits for a gentle, pure and simple clean.

• Noxzema: Facial cleansers (creams, astringent and pads) deep clean for healthy, natural-
looking skin.

• Olay: Olay offers an array of skin-care and personal cleansing products that provide
multiple benefits designed for women of all ages.

35
• Old Spice: At Old Spice, we’re dedicated to staying up-to-date on emerging technologies
that protect you from odor and wetness, and keep you smelling great. With our new
scents and constantly expanding line of products, it’s no surprise that Old Spice is a top
choice among guys.

• Safeguard: Safeguard is the No. 1 antibacterial soap worldwide; it is the only bar soap
registered with the FDA. Safeguard is designed to provide excellent germ protection for
the whole family.

• Zest: Zest is refreshingly different from ordinary soap. It rejuvenates you with a com-
bination of great, refreshing scent and clean-rinsing lather that won’t dry out your skin
like soap.

Note: You should note two facts about the marketing strategy used by P&G:
1. In a given product category, each P&G product offers a unique benefit. This is the strategy
generally used by P&G and is called benefit segmentation.
2. P&G often offers more than one product to the same market segment. For example, in
the laundry detergent market, Ivory and Dreft are both meant for cleaning baby clothes, but
offer slightly different benefits (Ivory: pure, Dreft: soft).

3.2 Meaning of Market Segmentation


Context: Do the customers all respond the same way to your marketing mix, or are there
differences in their response to one or more of the elements of the marketing mix?
Examples:
Do they have different product needs?
Do they respond differently to price changes?
Do they patronize different types of stores?
Do some customers know a lot about the product category, and others know very little?
Are they likely to consume the different amounts of the product?
If any of the above holds, market segmentation may be helpful.
Formal Definition of Market Segmentation: Market segmentation is the process of
dividing a market into meaningful, relatively similar, and identifiable segments or groups
based on differences in their response to the marketing mix.
Once the segments are identified, the management selects one or more segments as the
organization’s target market.
Examples of Market Segments:
1. Different Product Needs: Different customers may have different “Ideal Products” or “Ideal
Points.”

36
1.(a) Cars: You may describe cars in terms of the two dimensions: fuel economy and rugged-
ness. For example, Honda Civic hybrid and Toyota Prius rate high on fuel economy but low
on ruggedness. In contrast, Hummer and Land Rover rate low on fuel economy and high
on ruggedness. As different consumers assign different importance weights to these two at-
tributes, the ideal car for some consumers will be close to a Prius, and the ideal car for some
others will be close to a Hummer.
1.(b) Grocery Stores: Grocery stores can be described in terms of two dimensions: price, and
width of assortment. For example, Wegmans has moderately high price and wide assortment.
On the other hand, BJ’s Wholesale Club has low price and low assortment. Again, some
consumers may find Wegmans close to ideal while some others may find BJ’s close to ideal.
1.(c) Location of convenience stores: Generally speaking, a convenience store that is close to
where you live or work is preferred to one far away.
2. Different response to price: Are there segments that are more price sensitive than other
segments?
Some marketing actions: “Special Prices” for students. Coupons and “Sale” prices to attract
price conscious consumers.
3. Different response to distribution: A person who enjoys shopping around and visiting malls
usually prefer to buy clothes and linen from department stores like JC Penney. On the other
hand, someone who either does not enjoy shopping around or does not have time to spare
often buy the same items from catalog merchants like LL Bean or Fingerhut.
4. Different response to promotion: Some consumers get their information from the internet
while others like to talk to a salesperson.

3.3 Evolution of the Concept of Market Segmentation


The concept of market segmentation has been around for a long time, but it became prominent
relatively recently. The evolution occurred in the following three stages:
1. Mass Marketing: Mass produce, mass distribute and mass promote one product to all
buyers.
Logic: Low cost −→ low price −→ high demand −→ economy of scale
Example: Ford (standard black car for $500).
2. Product-variety Marketing: Offer multiple products which may differ on almost any con-
ceivable dimension. For example, Baskin Robbins sells 31 flavors of ice cream.
Objective: Offer variety to consumers. Hopefully, there will be customers for each variety
offered.
Problem: The market may not be interested in all the variations offered. (Would you like to
buy roast-beef flavored chewing gum?) Of course, in the long run, it is possible to eliminate
the varieties consumers do not want. Still, the process is wasteful. Also, since you are not
starting with the customer, you may overlook opportunities.

37
3. Target Marketing: Utilizes segmentation.
Steps involved in target marketing:
(a) Distinguish between market segments: Market Segmentation.
(b) Evaluate each segment and select one or more segments as your target(s): Market Target-
ing
(c) Formulate a competitive positioning for the product and develop a detailed marketing mix:
Market Positioning.

3.4 Possible Benefits of Market Segmentation


1. Satisfy Customers: You can meet the target customer’s needs more accurately. This can
increase demand for the product in the selected segment.
2. Reduce competitive Pressure: This happens in two ways.

(i) Being a smaller market, a segment is less attractive for a competitor to enter.

(ii) Customers are satisfied with your product and are less likely to switch.

3. Market segmentation may lead to a more efficient use of your marketing mix. For example,
if you are a breakfast cereals manufacturer and have selected children as your target segment,
you may advertise during cartoon shows instead of prime time news programs.

3.5 Criteria for Successful Segmentation


Segmentation is only effective if market segments rate favorably on five criteria:
1. Differentiable: Segmentation can be effective only when different parts of the market
actually respond differently to your marketing mix. (For example, do some people prefer
sweeter soft drinks compared to others?) If there is no such difference, segmentation is not
meaningful.
2. Substantial: It is meaningful to develop a marketing mix for a segment only if the segment
has large enough purchasing power. This requires commonality, that is, presence of cus-
tomers who respond similarly to your marketing mix. You can then aggregate the customers
into relatively homogeneous subgroups, that is, form segments. Objective: Each segment
should be large enough to give you economy of scale.
3. Identifiable and Measurable: Market segments should be measurable in terms of size and
purchasing power. It is also desirable to identify the members of the different segments, if
possible.
4. Accessible: The segments can be effectively reached and served.
5. Actionable: You, the marketer, must be capable of developing a marketing mix for the
targeted segment and reach the segment with the customized mix.

38
Basically, you, the marketer, have to decide if after you segmented a market, can you take
marketing actions based on it? For example, can you offer a product which a given segment
may want? Can you distribute to this segment? Can you promote your product to this
segment through personal selling or advertising? The answer to these questions depend on
your strengths and weaknesses, your competitive position, and the method used to segment
the market. Also, the number of segments targeted should match your marketing capabilities.

3.6 Bases for Segmenting Consumer Markets


Some bases for segmenting the consumer market are discussed next. In practice, marketers
often use combinations of these bases. For example, Geodemographic Segmentation combines
geographic, demographic, and lifestyle segmentation.
1. Geographic Segmentation: Consumers in different geographic locations may respond differ-
ently to your marketing mix. For example, they may have different product needs, or different
levels of price sensitivity.
Examples: (i) People in Texas have less need for snow-tires or home insulation than people
in upstate New York. (ii) Students in Syracuse have less need for Michigan Wolverine jackets
than students in Ann Arbor, Michigan. (iii) Maxwell House Coffee is distributed in different
flavors in different regions (stronger in the West). (iv) The grocery store Wegmans offers
different assortments of products in different areas.
Assessment of Geographic Segmentation: It is easy to measure the size of the population
in each geographic segment using Census data. It is also easy to target specific segments
with your promotional activities. However, you need to check if consumers in the different
geographic areas really differ in their response to your marketing mix.
2. Demographic Segmentation. Examples: Age, Income, Gender, Education, Occupation.
The marketer may use multiple variables. For example, the segment of interest may be males
between 25 and 40, with college degrees.
Assessment of Demographic Segmentation: It is easy to measure the size of the popula-
tion in each demographic segment using Census data. It is also possible to target specific seg-
ments with your promotional activities as different demographic groups often have somewhat
different media habits. However targeting a specific demographic segment with promotion is
generally more difficult than it is for geographic segmentation. Once again, segmentation will
be successful only if the segments respond differently to your marketing mix.
3. Psychographic and life style Segmentation.
For example, is a person authority seeking, or is he independent? If a person is authority
seeking, you may have to distribute medicine to him through drug stores, and promote your
product to doctors and pharmacists. If (s)he is independent, you can distribute the product
through department stores, and use television advertisements.
Assessment of Psychographic Segmentation: Unlike geographic and demographic seg-

39
mentation, you cannot measure the size of psychographic segments using Census data. You
have to either measure them using survey research, or purchase data from companies like SRI
Consulting Business Intelligence (see the discussion of VALS in Section 3.7 of the Reader).
4. Benefit Segmentation: Classify customers based on benefits they are seeking. A segment is
a group of customers seeking similar benefits. For example, you may customers with similar
attribute importance weights in the same segment.
5. Usage Rate Segmentation: This is discussed quite adequately in the text. The only
additional thing you need to note is that heavy users need to be treated differently from
the light users because heavy users are often more price sensitive than light users. That
can happen due to many reasons. For example, if you are a heavy user, you may pay more
attention to your expenses. It can also happen because the market for heavy users is more
competitive as it is targeted by more marketers. In recognition of the higher level of price
sensitivity, marketers often offer lower prices (through quantity discounts) or incentives (for
example, frequent flyer programs) to heavy users.

3.7 Example of Psychographic Segmentation: VALS


A company called the SRI Consulting Business Intelligence, a spin-off of Stanford Research
Institute (SRI), conducts an ongoing survey called the “Value and Life Styles (VALS)” survey
and segments the US market based on the results. There are different slight variations of the
segmentation scheme: I discuss one below.
One version of the VALS segmentation scheme: In this version, a person is rated on
two dimensions:
(1) Orientation:

• Principle Oriented: They believe in principles and some form of religion and/or ethical
code, and have a strong sense of community responsibility. They generally do not believe
in conspicuous consumption.

• Status Oriented: They like to achieve status and to demonstrate that status to others.
Visible symbols of success are important to these people.

• Action Oriented

(2) Resources available to the person (money, time, education, etc.): Low to high.
Based on the ratings, a person can belong one of eight segments:
1. Innovator (also called Actualizer): Innovators have enormous resources, and are often
not targets of mainstream marketers as they get custom made products.
2. Survivor (Struggler): Survivors have very little resources and are again not targets of
mainstream marketers.

40
3. Thinker: Principle oriented with high resources. (This group was called the “fulfilled”
in earlier versions of VALS.) They engage in philanthropic activities, donate to charities and
organizations, and are targets for fund-raising activities.

4. Believer: Principle oriented with low resources. They volunteer for church, community,
or political activities.

5. Achiever: Status oriented with high resource. They purchase more expensive symbols
of status like expensive homes, vacations, jewelry, and high-end automobiles. Engage in
conspicuous consumption.

6. Striver: Status oriented, with low resource. They purchase less expensive symbols of
status such as expensive clothes.

7. Experiencer: Action oriented with high resource. They participate in activities such
as scuba diving and mountain climbing, purchase performance sports cars, high end music
systems and cameras.

8. Maker: Action oriented with low resource. They remodel their own homes, make their
own furniture, and targets for do-it-yourself stores like Home Depot in the USA.

A marketer can purchase information such as the size and media habits of a particular
segment from SRI Consulting Business Intelligence.

Note:

1. The VALS segmentation scheme satisfies the condition of identifiability and measurability
because you can obtain such information from SRI Consulting.

2. You can visit the website sric-bi.com, fill up their survey, and know what is your own type.

41
¡@
¡
¡ @
¡ @
¡ Innovator @@
High Resource @ ¡
@ ¡
@ ¡
@ ¡

Principle Status Action
Oriented Oriented Oriented

Thinker Achiever Experiencer

Believer Striver Maker

¡@
¡ @
¡ @
Low Resource ¡ @
¡ Survivor @
@ ¡
¡
@ ¡
@ ¡
@ ¡
@

3.8 Strategies for Selecting Target Markets


1. Undifferentiated Marketing: Offer a single marketing mix to all customers. This is
sometimes called “Mass Marketing.”
Process: First analyze the market, then design a product and a marketing program to appeal
to the broadest number of buyers.
Idea: Mass market to the largest possible segment.
Example: Hershey used to follow the strategy: “One chocolate bar for every person.”
Problem: Hard to protect from competition.
2. Multi-Segment Targeting (Differentiated Marketing): Operate in several segments
and design a separate marketing mix for each.

42
Possible Advantages of Multi-Segment Targeting:

• Consumers will identify company with the product category, e.g., Hewlett Packard with
laser printers and Canon with cameras. As a result, a consumer will automatically think
of the company when a need for the product arises.

• By customizing your marketing mix to a particular segment, you have more satisfied
consumers. This leads to a greater chance of repeat purchase and more brand loyalty.
Hence you have greater sales volume and reduced competitive pressure.

Possible Disadvantages of Multi-Segment Targeting:

• Multi-segment targeting is more costly than undifferentiated targeting for various rea-
sons. For example, you may have to:

(1) Produce different versions of the product.

(2) Develop different promotional campaigns.

(3) Distribute the product through different types of channels.

• Cannibalization: Your own products may compete with one another for market share.

Important Note: Both sales revenue and costs go up when differentiated marketing is used.
Examples of Multi-Segment Targeting:

• Kellogg: Breakfast cereals

• P&G: Different categories of consumer packaged goods, such as laundry detergent

• GM: Automobiles

3. Concentrated Targeting (Single-Segment Concentration): Operate in only one


segment. This is sometimes called “niche” marketing. This strategy is meaningful when
company resources are limited.
Note that resources need not always be financial or technological. For example, the resource
of a company may be its “image.” Levi Strauss has the “casual” image which it has used
successfully to introduce its “Docker” products. That very same image would work against
Levi Strauss if it tried to launch an expensive line of formal clothing under the Levi name.
(This actually happened when Levi tried to introduce a “Tailored Classics” line in the early
1980’s and failed.)
Objective of Concentrated Targeting: Capture a large share of a small market.
Example: Porsche (High priced sports cars).

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3.9 Product Positioning Strategies
Position is “the place a product, brand, or group of products occupies in consumers’ minds
relative to competing offerings.” A product’s position is the consumer’s perception of a prod-
uct’s attributes, use, quality, advantages and disadvantages. More simply, a product’s position
refers to what kind of “image” the relevant customers have about the product.
A marketer has to actively try to create a position for her product in the mind of the
consumer. This is essential whenever a new product is introduced to the market. To posi-
tion a product, the marketer has to provide the customer a basis for judging the product.
This generally requires communication with the customer. Consequently, promotion is very
important for a successful positioning activity.
Examples of positioning:
(a) Cars: BMW has an image of a high priced car with superb engineering. Honda has a
image of a moderately priced car with a “good value for the money.”
(b) Universities: Harvard University, University of California at Berkeley, and Princeton Uni-
versity are all known as great academic schools.
We now describe positioning bases, i.e., the different ways a product may be positioned.
Positioning Bases:
1. Position by attribute-benefit: Usually, this is used if a product has a very high rating on
an attribute, or offers a unique benefit.
Examples: Dr.Pepper has a unique taste. Tums contains calcium. Tylenol does not have any
major side effects.
2. Position by price/quality:
(a) Quality of the material used to make a product is sometimes used to position a product.
Examples: Furniture made of solid oak (versus furniture made of plywood), gold watch.
(b) When consumers have very few clear features to compare products on, but have an overall
sense of quality, they use price as a measure of quality. Thus, a marketer may use a high price
to create a perception of quality.
Examples: Fashion by Bloomingdale’s, Swiss watches, French wine, Gucci shoes, perfume.
3. Positioning by use/application: Adidas, Nike, and Reebok are positioned as athletic shoes.
4. Positioning by product user: Create the correct image for a particular market segment.
Example: MTV is positioned as a teenager’s channel. Virginia Slims is aimed at women.
Example of repositioning: Marlboro for men (Marlboro was originally marketed as a women’s
cigarette).
5. Positioning by product class: This can be done in one of four ways.
(a) A product can be positioned as similar to a product class, e.g., many Margarine brands
were positioned as similar to butter.

44
This strategy, which is a “point of parity (POP)” strategy, is commonly used by companies
with efficient production or distribution capabilities who can offer a product at a lower price
than its competitors. The focus of the positioning is to offer the same benefits at a lower
price.
(b) A product can be positioned as being different from a product class: Aleve and Claritin
are both positioned as products that work much longer than their competitors. Lexus positions
its car based on the unique ability to parallel park itself.
This strategy, which is a “point of difference (POD)” strategy, is adopted by companies
with cutting edge research and development capability. The focus of the positioning is the
unique benefit offered by the product, and a premium price is charged.
(c) A product can be positioned as a supplement to a product class: e.g., VCR s were
positioned to be supplements to televisions.
(d) A product can be positioned as a replacement for a product class: e.g., Nutra-Sweet (as
a replacement for sugar).
6. Positioning by competition: This makes sense when you have a major, clearly defined
competitor, and your strategy depends on how consumers perceive your product relative to
the competition.
(a) A product can be positioned as being similar to a competitor. These are generally
“me-too products” that do not enjoy a superior image in the mind of the consumer. Thus,
the advertising campaign usually tries the convince the consumer that she can get the same
product benefits at a lower price. This strategy is routinely used by less expensive automobile
manufacturers such as Hyundai.
(b) A product can be positioned as being different from a given competitor. For example,
two politicians competing for the same votes generally try to position themselves as different
from each other. Wendy’s stresses that it uses real chicken meat unlike its competitors.
(c) A combination of these two strategies was used by Subaru to sell the “Subaru Legacy”:
integrated body design like Volvo, and a better braking system.
7. Positioning by combination of ways: use two or more of the first six methods together.
Repositioning: Sometimes, a marketer tries to create a new, more favorable position for
an existing product. That is called repositioning. There are many examples of successful
repositioning. The College of New Jersey was repositioned as Princeton University. Marlboro,
originally a women’s cigarette, was repositioned for men. Rogaine was repositioned as a
medicine for hair regeneration rather than blood pressure reduction.
Note: Positioning by product class or a specific competitor:
If the new product does not have unique features and/or the incumbent is considered
superior, the new product usually adopts the me-too strategy. Usually that involves claiming
that the new product is just as good as the old product, and that it costs less. For example,

45
Folger positioned itself as similar to expensive coffees purchased from specialty stores, and the
brand Natra-Sweet positioned itself as similar to “Equal.”
If the new product has unique features, and at least a segment of customers considers it
superior because of that, it can stress the difference and charge a higher price. Examples
Sanka stressed that it was “decaffeinated” and charged a higher price than regular coffee.
Similarly, Nutra Sweet is priced higher than sugar.

46
3.10 Example of Segmentation using student data
The following mini-survey was completed by a sample of 148 undergraduate students at Syra-
cuse University. (These questions are excerpted from the survey provided in Section 11.7.)

1. Gender Male Female


2. Are you a member of fraternity or sorority?
Yes No
3. How interested are you in the following activities in your spare time? (Please circle)
Not interested Very
at all interested

(a) Exercise 1 2 3 4 5 6 7

(b) Participate in sports 1 2 3 4 5 6 7

(c) Shop for clothes 1 2 3 4 5 6 7

(d) Go to bars 1 2 3 4 5 6 7

(e) Go to malls 1 2 3 4 5 6 7

(f) Watch movie 1 2 3 4 5 6 7

(g) Do volunteer work 1 2 3 4 5 6 7

(h) Study/read 1 2 3 4 5 6 7

(i) Listen to music 1 2 3 4 5 6 7

(j) Spend time with friends 1 2 3 4 5 6 7

(k) Watch sports on TV 1 2 3 4 5 6 7

(l) Watch sports at the Dome 1 2 3 4 5 6 7

47
4. If a combined lacrosse/football/basketball season ticket were available, how likely
would you be to purchase it at the following prices? (Please circle)
Very unlikely Very likely

(a) $50 1 2 3 4 5 6 7

(b) $75 1 2 3 4 5 6 7

(c) $100 1 2 3 4 5 6 7

(d) $125 1 2 3 4 5 6 7

(e) $150 1 2 3 4 5 6 7

(f) $175 1 2 3 4 5 6 7

(g) $200 1 2 3 4 5 6 7

**Thanks for Your Participation**

Psychographic Segmentation: The items in question 3 represent lifestyle variables (activ-


ities, interest, opinion) of the students. I now use these to do psychographic segmentation
using Minitab.
Step 1: First, I use a method called factor analysis to find the key underlying dimensions of
the items 3(a)-3(l). Four dimensions (factors) emerge. The correlations of these four factors
(Factor1-Factor4) with the original variables (X3a − X3l ) are given below.
Variable Factor1 Factor2 Factor3 Factor4
X3a 0.681 −0.059 −0.103 0.328
X3b 0.869 0.152 −0.070 −0.005
X3c −0.223 −0.811 0.178 0.075
X3d 0.130 −0.516 −0.519 0.088
X3e −0.167 −0.801 0.144 −0.027
X3f 0.172 −0.547 −0.060 −0.452
X3g 0.016 −0.121 0.811 −0.002
X3h 0.038 −0.135 0.691 0.254
X3i 0.073 −0.092 −0.150 −0.760
X3j −0.055 −0.565 0.006 −0.384
X3k 0.725 0.285 −0.057 −0.369
X3l 0.754 −0.008 0.248 −0.247
Variance 2.4469 2.3339 1.5643 1.3141

48
Each factor has mean zero and the variance given in the last line of the table. Together, they
explain 63.8% of the variance of the 12 original variables. To interpret the factors, only look
at correlations above 0.5 in magnitude. That way:
Factor 1: Interest in watching and participating in sports.
Factor 2: Aversion to shopping, bars, and malls.
Factor 3: Interest in studying and volunteer work, together with aversion to bars.
Factor 4: Aversion to music.
Step 2: I now use a method called K-Means clustering to create groups of respondents with
similar factor scores. There are four clusters. The average factor score of each cluster is given
below. The last row of the table gives the number of respondents in each cluster.
Factor Cluster1 Cluster2 Cluster3 Cluster4
Factor1 0.8194 −1.1010 −0.0304 0.0255
Factor2 −0.9285 −0.1413 0.0869 0.8627
Factor3 −0.3284 −0.0403 1.0193 −0.5520
Factor4 −0.0721 −1.0335 0.2517 0.5458
Size 39 (26.35%) 29 (19.59%) 37 (25%) 43 (29.05%)
The four cluster are four psychographic segments with the following characteristics:
(1) Cluster 1: Interested in sports, and not interested in shopping for clothes, visiting bars
and malls, studies, or volunteer work.
(2) Cluster 2: Not interested in sports, shopping, bars, or malls. Interested in music.
(3) Cluster 3: Interested in studies and volunteer work.
(4) Cluster 4: Averse to shopping, bars, and malls. Not interested in studies, volunteer work,
or music.
Once we have the segments, we can try to find who belongs to each cluster. For example, we
created the following cross tabulation of gender with cluster:
Cluster
Gender 1 2 3 4
Women 15 22 22 16
(20.00%) (29.33%) (29.33%) (21.33%)
Men 24 7 15 27
(32.88%) (9.59%) (20.55%) (36.99%)
We can also check if some behavior or purchase intentions differ from cluster to cluster.
Consider question 4(e), which is likelihood of purchasing the combined ticket for $150. Let
Interest = 1 if the respondent circled 5-7, and 0 if the respondent circled 1-4. The cross-
tabulation of Interest with Cluster is given below:

49
Interest
Cluster 0 1
1 27 12
(69.23%) (30.77%)
2 19 10
(65.52%) (34.48%)
3 16 20
(44.44%) (55.56%)
4 15 28
(34.88%) (65.12%)
Interesting, cluster 4, which is not interested in shopping, bars, malls, or participating in
sports, are most likely to buy the ticket for $150. (There is one missing case in Cluster 3.)
Demographic Segmentation: We can also try to relate demographics to usage or intentions.
For example, we got the following cross-tabulation of Gender and Interest (1 if X4e ≥ 5, 0 if
X4e ≤ 4):
Interest
Gender 0 1
Women 42 33
(56.00%) (44.00%)
Men 35 37
(48.61%) (51.39%)
Apparently, men are slightly more interested in the ticket than women. (There is one missing
case among men.)

50
4 Selected Topics on Marketing Research
4.1 Introduction

4.1.1 Definition of Marketing Research: Marketing research is the function that links
the consumer, customer, and public to the marketer through information–information used
to identify and define marketing opportunities and problems; generate, refine, and evaluate
marketing actions; monitor marketing performance; and improve understanding of marketing
as a process. Marketing research specifies the information required to address these issues,
designs the method for collecting information, manages and implements the data collection
process, analyzes the results, and communicates the findings and their implications. (Ameri-
can Marketing Association, October, 2007).
More simply, marketing research is the systematic gathering, recording, and analysis of
data with respect to a particular market. Basically, marketing research involves collecting data
about the marketing environment so that you can make better decisions about your marketing
mix. Information about the macro-environment generally comes from secondary data that has
already been collected by someone else. (This is so because many parties are interested in these
information, and organizations like the Government or large marketing research companies
supply these data). On the other hand, you usually have to collect information about your
micro-environment first hand; this is called primary data collection.
4.1.2 Steps in the Marketing Research Process:
1. Identify and formulate problem/opportunity:
(a) Problem recognition
(b) Exploratory research
(c) Problem formulation: develop specific research questions; identify source of your data.
2. Plan research design:
(a) Decide on the nature of the study (survey? experiment? focus group?)
(b) Select nature of data collection (ask questions? observe behavior without asking? combi-
nation of the two?)
3. Specify sampling procedure
4. Collect data
5. Analyze data
6. Write report
7. Follow up
4.1.3 Data typically collected from customers
The purpose of a marketing research study is usually to understand and predict customer
behavior. The data collected can be broadly divided into two categories:

51
• Non-Behavioral data, which are not on customer behavior itself, but which can help
understand customer behavior.

• Behavioral data: Data on some element of customer behavior.

A) Non-behavioral Data:
1. State of being variables:

• Demographics: Basic descriptors of the customer, such as gender, age, income, marital
status, and geographic location.

• Ownership status: Ownership of items that may influence customer behavior. For ex-
ample, if a student has a car, he may be more likely to visit bars and restaurants away
from campus.

2. State of the mind variables:

• Does the customer know about your brand? This is called awareness. Awareness can
be measured at two levels:

– Top of the mind awareness, where no brand name is provided. For example, the
question may be: “Name the first brand of laundry detergent you can think of.”
Suppose you wish to measure the top of the mind awareness of Cheer. If a respon-
dent names Cheer, she gets 1, and if a respondent does not name Surf Excel, she
gets zero. For the aggregate sample, you compute the fraction of the sample that
named Cheer.
Note that even within this narrow definition, a change in wording may give very
different results. For instance, if you asked the respondent to list all the brands
she can think of, the top of the mind awareness of any given brand will be higher
than is you asked “name the first brand you can think of.”
– Aided recall, where the respondent is given a brand name and then asked if she
had heard of that brand. It becomes 1/0 variable for a given respondent (1 if the
respondent has heard of the brand, 0 if not), and a fraction for the aggregate sample
(proportion of the sample that has heard of the product).

Generally, top of the mind awareness is used for well-known brands, and aided recall is
used for new of unfamiliar brands.

• How important are product attributes to a customer?

• How does the customer rate your brand on different attributes?

• How much does the customer like or dislike your brand?

52
Life style variables (activities, interests, opinions) of the customer may also be included as
non-behavioral variables if they have an effect on the customer behavior we are interested in.
B) Behavioral Data:
1. Usage behavior (past, present): Does the customer buy in the product category? How
much money does he spend? Where and when does he buy the product? Which brand or
brands does he buy? How brand-loyal is he? Does the customer buy your brand?
2. Behavioral intentions: Does the customer plan to buy your product in the future? Will he
recommend your product to a friend?
3. Media habits
Use of These Information
The focus of a marketing research study is usually some form of customer behavior, such
as how much money one spends on different brands of soft drink.

• By aggregating expenditure information from a sample of respondents, the researcher


can estimate the demand for the product category.

• By aggregating expenditure information from a sample of respondent, the researcher


can estimate demands for specific brands.

• By combining the above two, the researcher can estimate market shares of brands.

• By tracking sales over time, the researcher can determine if the sales are growing or
shrinking over time, and whether there is any seasonal variation.

• By tracking the purchase behavior of a given person over time, the researcher can de-
termine whether the person tends to buy the same brand again and again, or does (s)he
buy whatever is available on sale. Such information can be used to plan production and
set an appropriate pricing strategy. Thus, knowing just the usage pattern can be quite
useful to a marketer.

• By tracking the purchase behavior of a fixed sample (called panel) of persons or house-
holds over time, the researcher can construct a brand-switching matrix.

The knowledge of other variables measured helps the marketer refine its actions. For
example:

• A study of media habits helps the marketer determine where and when it should adver-
tise.

• By examining the relationship between demographic variables and usage behavior, the
marketer can determine exactly who buys its products and which demographic segments
represent the greatest untapped potential.

53
• A study of awareness tells the researcher how many people know of the product.

• A study of importance weights of attributes and ratings of brands on attributes tells the
marketer how his brand is performing on relevant attributes. From such a study, the
strengths and weaknesses of the brand can be determined, and directions for product
improvement or new product development identified.

Note that a piece of information should be collected only if it can be used to improve
marketing decision making. Otherwise, it is of no value to the researcher.
4.1.4 Sources of Secondary Data: Secondary data are data that have already been col-
lected, not specifically for your study. These can come from internal and external sources.
Internal Secondary Data: These are data already collected by your organization. Examples
include data on sales, costs, prices, and sales call reports.
External Secondary Data: These can be of three types:
1. Data from library and internet sources.
2. Government sources (e.g., census data). For example, data collected by the US Census
of the Population, conducted every ten years, provides city-block level data on number of
households, average income, education, ethnic composition, and nature of households. Re-
tailers routinely analyze these data to estimate the demand for different products in a given
geographic area.
A particularly important Government source is the data obtained by the US Census of
Retail Industries, conducted every 5 years. For example, you may visit the site
www.census.gov/econ/census02. This gives you, for every NAICS category, the number of
establishments, dollar revenue, payroll, and number of employees in the USA, and also region
by region. This information is used to make sales-force allocation decisions.
3. Syndicated services. These are large marketing research firms such as Nielsen and Infor-
mation Resources Incorporated (IRI) that provide data to paid clients. For example, Nielsen
publishes the market shares of television programs at different time slots for different demo-
graphic groups in the US population.

Exhibit: Examples of Syndicated Services

A. Retail Data: Suppose you are a company like Kellogg’s which sells products like breakfast
cereals to customers all over the USA and sometimes worldwide. Naturally, it would like to
know how much of each product offering it sells each month, and how the sales are affected
by marketing actions such as commercials, coupons, new package design, etc.
However, these tasks are complicated by the fact that companies like Kellogg typically do
not sell the products directly to the end customers. Rather, it sells the products to marketing
intermediaries who, in turn, sell them to other resellers or end customers. While Kellogg’s

54
can monitor when the product leaves its warehouses, it does not know exactly when the sales
to the end customers occurs or who purchases them.
There are several syndicated services which provide such information to companies like
Kellogg’s. However, even these services differ in terms of the unit of measurement, that is,
who the data are collected from. The term retial data is used when the unit of measurement
is a retail store, and data are collected on sales made by the store in a specified time period.
We now discuss retail data provided by the Nielsen Company.
The services offered by Nielsen have evolved and expanded with time. Instead of discussing
the range of those services which are easily available on the internet, I will describe how Nielsen
used to collect these data until the 1980’s. The method is very robust, and can be used in
both advanced and developing economies.
The Nielsen Company maintained a fixed panel 1 of retial stores from the USA and mea-
sures the sales of a wide variety of packaged goods including food (e.g., yogurt, coffee, ketchup)
and personal care items (e.g., toilet tissue, detergent). A disproportionate stratified sample
with 1600 supermarkets, 750 drug stores, and 150 mass merchandisers was used. Store audits
were conducted at two month intervals. During an audit, the auditor recorded the inventory
of each stock keeping unit (SKU) as well as how many units of the product were shipped in
since the last audit.
You can think of the data from a given store as a spreadsheet. Each row of the spreadsheet
are the data collected on a single audit. Two columns of data come from each SKU: (1) current
inventory, and (2) shipments since the previous inventory. Each audit adds a new row to the
spreadsheet. For a given SKU, sales in a given period is computed as:
Beginning Inventory + Shipments Received in Period − Ending Inventory
This is a well known formula in accounting, and a moment’s reflection shows how much easier
it is to use this formula instead of tracking day to day sales. By measuring the sales of a
given SKU (e.g., 64 oz Hunt’s tomato ketchup) in a specific time period from each store in the
sample, Nielsen estimated the total sales of the product in the US market in that time period.
Also, as the subscribing company got data about the sales of its competitors’ products, it could
determine the market shares of its products and track how these were changing over time. Also,
by combining sales data from Nielsen with its own internal secondary data on promotional
activities, a company could determine how sales depended on its marketing decision variables.
In addition to the above information, Nielsen also collected data on the shelf facing of each
SKU, and whether the retail store did any local advertising for the SKU in the time period
concerned. From this information, a company could determine how sales depended on shelf
facing and local advertising.
There is one limitation of the Nielsen Retail Audit method as described above. The
quantity measured by the retail audit formula includes actual sales plus items lost or stolen,
1
A fixed panel of stores means a sample of which remains same over time and are measured again and
again. Similarly, a fixed panel of households means a panel consisting of the same group of households that
are measured repeatedly. Note that maintaining a fixed panel is difficult as some members may drop out over
time.

55
which is called shrinkage by the retail industry. Thus, the retail audit formula provides
an over-estimate of sales. To correct this bias, we can measure sales by a more costly and
more expensive method such as day by day recording of sales, and determine the percent
overestimation in the retail audit formula. With this knowledge, it is possible to obtain
approximately correct sales from retail audit results.
Example: Suppose you have conducted monthly audits of a local grocery store where
you visit the store the first day of each month and, for each stock keeping unit (SKU) record:
(1) present inventory, and (2) shipments received since the last inventory. The records for
Kellogg’s Rice Krispies 19 oz packages for January 1, 2007 through June 1, 2007 follow:
Date Recorded Present Inventory Shipments Received Since
Last Inventory
January 1, 2007 400 units 500 units
February 1, 2007 600 units 400 units
March 1, 2007 600 units 300 units
April 1, 2007 500 units 500 units
May 1, 2007 300 units 400 units
June 1, 2007 400 units 500 units
From these data, we can determine the sales in months January, February, March, April,
and May. Consider for example the month of January, that is, the times period between
January 1 and February 1. On January 1, the inventory is 400 units. During January, 400
additional units were shipped in (shipments recorded on February 1). Thus, if there were no
sales, there would be 400 + 400, that is, 800 units in inventory on February 1. The difference
between this number (800) and the actual inventory on February 1 (600) is the number of
units sold in January, that is:

Sales in January = 400 + 400 − 600 = 200 units.

We can also get this result by the direct application of the retail audit formula.
B. Consumer Purchase data: Consumer data differs from retail data in that the unit of
measurement is a household rather than a store. Here, a fixed panel of household is tracked
for a long time, and purchases of a large number of packaged goods are recorded. Note that
in contrast with retial data, consumer data tracks a given household over time. These can,
for example, tell a company precisely who is buying its products, and whether customers are
brand loyal. We now provide three examples of consumer panel data, where example B.1 is a
traditional method, and examples B.2 and B.3 are new, improved versions of B.1.
B.1. National Purchase Diary Panel (NPD): The NPD used a fixed panel of 13000
households, selected to represent the US population on major demographic characteristics. A
member household keeps a detailed monthly diary of the purchase in 50 product categories
and records brands purchased, quantity purchased, store purchased from, price paid, whether
any coupon was used, and intended use of the products. The completed diaries were mailed

56
to NPD at the end of the month. From this information, NPD estimated the sales of different
brands in the USA every month.
One can easily see that a consumer may fail to record the purchases on a timely basis
and thus make errors as they try to complete the surveys from memory. Also, as the task is
tedious, omissions may occur. Further, as the consumer has to report prices paid, (s)he may
pay more attention to price and thus become more price sensitive over time. The following
two methods try to eliminate such errors.
B.2. IRI Scanner Panel Data: These data are provided by Information Resources Incorpo-
rated, known as IRI. IRI maintains fixed panels of households in several medium sized towns
such as Marion, Indiana. In each town, a panel of about 2000 households is maintained. The
towns selected are self contained communities where residents purchase all groceries within
the community. IRI issues cards to the households and makes arrangements with the grocery
stores to accept the cards. Each time a member household makes a grocery purchase, the card
is scanned at the check-out counter, and details of the purchase such as brand purchased, price
paid, coupon used, etc., are recorded automatically. This avoids errors of omission that can
occur in a purchase diary that the customer has to fill. Further, as the respondent is not
providing the information actively, her/his purchase behavior would not change with time.
B.3. New NPD Method: To compete with IRI, NPD introduced an a variant of its diary
panel where a panel member household is given a wand attached to a black-box. The consumer
is asked to draw the wand across the bar codes of the packages after each purchase. Details
of the purchase are automatically recorded. Note that this method can be used in all types
of communities, and is not restricted to small self contained communities like the IRI.
As these examples show you, marketing research is a very dynamic field, and you have to
upgrade your services constantly if you wish to survive.
C. Media habits. We will discuss only one example, the well known Nielsen TV ratings.
The Nielsen Company uses a panel of about 1000 US households, selected to represent the US
population in terms of ethnicity, income, age distribution, etc. Before 1988, the member house-
hold had a device called the Audimeter, attached to the television sets, that automatically
recorded when the TV was turned on and what channel was watched. From this information,
Nielsen determined and published the market shares of different TV programs at each time
slot of the day.
The Audimeter could not record who was watching the programs. Thus, since 1988,
Nielsen has used a modification of Audimeter called the Peoplemeter. Each viewing member
of a panel household is given an ID which (s)he is supposed to enter when watching the TV.
That way, Nielsen can report the market shares of programs for different age groups also. Do
you see any problems with this approach?

4.1.5 Types of Research Studies: Depending on your needs, you may conduct three types
of research studies: exploratory research, descriptive research, and experiment.

57
4.1.5.1 Exploratory Research: This is usually done when you are still formulating your
research questions and want to make sure you do miss anything of importance. This requires
a flexible research design. Three important methods of exploratory research are as follows:
(1) Analysis of Selected Cases: Two groups of cases that represent two extremes of outcome
are selected. The groups are then compared attribute by attribute to see where they differ.
These are the relevant attributes.
For example, in Section 1.5, Sprint and Verizon represent two extremes of outcome: low
market share and high market share. Sprint has higher ratings on three attributes: price of
handset (b), long distance rate (c), and features included (e). Verizon rates higher on monthly
fee (a) and reliability of connection (d). Clearly, (a) and (d) are more important than (b),
(c), and (e).
(2) Focus Groups:
• A group of people are brought together in a moderated session. The people may be
present or potential customers, or people who are not customers but can provide infor-
mation about the decision making process.

• A typical session runs for 1.5-2 hours and include 8-12 respondents. Student sessions
are usually shorter (about 1 hour) and smaller (about 5-6).

• The moderator starts the conversation and gets the group going. She has an outline
but not a fixed questionnaire. She initiates a topic, gets the conversation flowing, and
probes further if interesting issues come up. She has to avoid conflicts by changing the
topic if necessary. She also has to identify people who are not talking and get their
views. She does not take notes.

• Sessions are usually recorded. Professional focus groups are conducted in special rooms
with one-way mirrors. The recorders sit behind the one-way mirror.

• Focus groups are suitable for idea generation but not statistical analysis. Uses of focus
groups include:

– Identify what customers like or dislike about your product or company.


– Identify the attributes that matter to customers.
– Show customers new product concepts and get their reaction. These are particu-
larly useful in weeding out product ideas that are likely to fail.
– Show customers commercials in cartoon form and get their reactions.

(3) Study of secondary data.


4.1.5.2 Descriptive research: Here, you have a population of interest, and you want to
measure a pre-determined set of variables from this population. Descriptive studies have the
following basic features:

58
(1) The problem is well structured and variables of interest are known and defined.

(2) Since the variables are pre-determined, a standardized formal questionnaire can
be used. Cost/respondent is low, which allows you to collect large, representative
samples and perform statistical analysis.

Common examples of descriptive studies are:

• Survey research (examples: mail survey, telephone survey, online survey, household door-
to-door survey, and group setting).

• Panel data: A fixed set of respondents are measured repeatedly. Examples: purchase
diaries, shopping cards.

4.1.5.3 Experiment: The purpose of an experiment is to determine the effect of a change


in your marketing mix on outcome variables of interest.
Example: A major printer/copier company wanted to find out the following:

• Does adding color to business documents improve information retention?

• Does adding color to business documents result in greater recall of information?

• Do people respond better and/or faster to business documents with color (invoices, call
to action materials, etc.)?

Here, the change in the marketing mix is: Adding color to a document
You wish to measure changes in the following outcome variables:
(1) Information retention
(2) Recall of information
(3) Speed of Response
(4) Rate of Response
Other Examples:
1. Determine the effect of a price-cut on units sold.
2. Determine the effect of an advertising campaign on what percentage of the population
know about your product (awareness level).
3. Effect of an advertising campaign on the sales of a product.
Controlled Experiment: In conducting an experiment, a marketer must try to make sure
that the change in outcome (e.g., units sold) is happening due to the change in marketing mix
(e.g., price cut), and not some other factor (e.g., change in the weather or drop in interest

59
rate). To eliminate such other factors, marketers usually conduct controlled experiments
where two groups are compared:
(1) An experimental group where the marketing mix is changed.
(b) A control group where the marketing mix is not changed.
Example 1: To measure the effect of price cut on units sold, a chain of retail stores may
introduce the price cut in some stores (experimental group) and keep price unchanged in some
the other stores (control group). By comparing sales in the experimental and control groups,
the marketer can determine how much sales changed due to the price cut. In this context, a
basic experimental design can be expressed as follows:
(R) EG O1 X O2
(R) CG O3 O4
EG represents the experimental group consisting of a sample of stores where the price was
cut, and CG is the control group (the group of stores where price was not changed). X is
the exposure to the treatment, that is, the price cut. O1 and O2 are observations (average
sales/store) in the experimental group before and after the treatment. O3 and O4 are ob-
servations (average sales/store) in the control group before and after the time the treatment
is applied to the experimental group. (R) represents the fact that the stores were assigned
randomly to EG and CG. The effect of the treatment is measured by (O2 − O1 ) − (O4 − O3 ).
Example 2: To find if a respondent pays more quickly if she sees the utility bill in color
instead of black and white, a utility company may send the bill in color to one group of clients
(experimental group), and in black and white to another group of clients (control group). A
basic experimental design can be expressed as follows:
(R) EG X O1
(R) CG O2
Once again, EG is the group of clients exposed to the treatment (bill in color), and CG is the
control group (bill in black and white). (R) represents random assignment to groups. O1 and
O2 represent observations (average time to pay bill). The effect of the treatment is measured
by (O1 − O2 ).

4.2 Basics of Sampling

Important: Please ignore the discussion of probability samples and non-probability samples
in the text (bottom of page 237 to end of page 238).
4.2.1 Basic Idea: In sampling, our objective is to study a specific population. A sample is a
subset of the population that we study to determine what the entire population is like.
For example, suppose we plan to survey the Syracuse University undergraduate student
population (approximately 11,000 students). If we draw the names of 100 students from the

60
student directory and study them, then these 100 students would be our sample. Sampling
methods include non-probability and probability sampling techniques, as explained next.
4.2.2 Non-Probability Sampling
In non-probability sampling techniques, the probability that a given member of the pop-
ulation will be selected is unknown. I will discuss four specific non-probability sampling
techniques: convenience sampling, quota sampling, judgment sampling, and snowball sam-
pling.
4.2.2.1 Convenience Sampling: Here, the criterion of choosing the sample is convenience.
For example, I may collect data from this class because you happened to be there. Similarly,
we may collect data from shopping malls, friends, and class-rooms simply because they can
be accessed easily. However, it is not always a bad technique to use. Consider two examples:
(1) I am using your class to estimate what percentage of Syracuse University students own
Nike shoes.
(2) I am using your class to estimate what percentage of Syracuse University students read
the Wall Street Journal at least once a week.
Clearly the sample will give me reasonable results in case (1) but an over-estimate in case
2. The reason is as follows: You are convenient for me to access because you are interested
in business management. Consequently, you are more likely to read Wall Street Journal than
other Syracuse University students. Stated differently, the reason for convenience here is
correlated with interest in business and hence reading the Wall Street Journal. There is no
such correlation between being a business student and using Nike shoes.
Thus, using a convenience sample is reasonable as long as what you are measuring is not
correlated with what makes the sample convenient to access.
4.2.2.2 Quota Sampling: Here, the sample is selected to have the same composition as the
population in terms of one or more relevant characteristics. For example, to determine what
percentage of Syracuse University students read the Wall Street Journal, I could collect a
sample that has the same proportions of business students and others as the overall Syracuse
University student population.
Note that a characteristic is relevant only if it is correlated with what you are measuring.
If there was no correlation between reading the Wall Street Journal and being a business
student, then it would not matter if you draw your sample from business students or others.
4.2.2.3 Judgment Sampling: Use your judgment to get a representative sample. For exam-
ple, market researchers often conduct test markets of new products in Syracuse or Columbus,
Ohio because they feel these areas behave largely like the overall USA.
4.2.2.4 Snowball Sampling: This method is used to collect data from a small population
embedded within a large population, such as people who share a hobby, or belong to the same
ethnic group. This method works well when people within the small population know each
other. In this method, you first identify a member of the population and collect data from

61
her. Then you ask her to identify other members of that population. Thus, your sample
“snowballs.”
4.2.3 Probability Sampling
In probability sampling techniques, every member of the population has a known and
non-zero probability of being selected. The probability of selection may or may not be equal
for all members of the population. A researcher using probability sampling draws the sample
from a frame, which lists all members of the population either individually or in groups.
We discuss three categories of probability sampling techniques: simple random sampling,
stratified sampling, and cluster sampling. A special case of cluster sampling, called systematic
sampling, is discussed in detail.
4.2.3.1 Simple Random Sampling: In this method, the researcher obtains a complete
list of population members, and draws one member of the sample at a time. In each draw,
anybody who has not been selected yet is equally likely to be chosen. The sample chosen this
way has two properties:
1. Every member of the population has the same chance of being selected.
2. Every group of population members is as likely to be selected as every other group of the
same size.
Limitation: The second property of a simple random sample (every combination equally
likely) is not always desirable. As a specific example, suppose there are 10,000 grocery stores
in a state, out of which 2000 are large stores, and 8000 are small stores. You want to select
a sample of 100 stores to estimate the average annual sales of Coca Cola by a store in this
state.
If you select a simple random sample of 100 stores, this sample can be any combination of
100 stores, including all large stores and all small stores. Thus, your estimate will vary widely
depending on which 100 stores are chosen. If you only got a list of the 10,000 stores and do not
know which are small and which are large, you cannot do any better than the simple random
sample. However, if you have separate lists of small and large stores, stratified sampling
discussed next is better than simple random sampling.
4.2.3.2 Stratified Sampling: In this method, the population is first divided into sub-groups
called strata or layers. Then, a separate simple random sample is selected from each layer.
Formally, we proceed as follows:
1. Divide population into mutually exclusive and collectively exhaustive subgroups (strata).
2. Choose a separate simple random sample from each stratum.
3. Compute a weighted sum of the estimates from the different sub-groups. The estimate
from a subgroup gets a weight equal to the proportion of the population that belongs to the
subgroup.
Example 1: Suppose again there are 10,000 grocery stores in a state, of which 2000 are

62
large stores and 8000 are small stores. Suppose you have drawn two separate simple random
samples:
(1) 50 large stores. Average annual sales of Coca Cola is $30,000.
(2) 50 small stores. Average annual sales of Coca Cola is $4000.
The estimate of the average annual sales of Coca Cola for the entire population of stores
is:
2000 8000
× 30, 000 + × 4000 = (.2 × 30, 000) + (.8 × 4000) = 9200.
10, 000 10, 000

Example 2: 20% of Syracuse University undergraduates are business majors, and 80% are
non-business majors. You have conducted stratified sampling with business majors and non-
business majors as the two strata. Results:
(1) 100 students with business majors. Of these 100 students, 60 students read Wall Street
Journal every week.
(2) 100 students with non-business majors. Of these 100 students, 25 students read Wall
Street Journal every week.
Estimate of the fraction of Syracuse University undergraduate students who read Wall Street
Journal every week:

60 25
(0.2 × ) + (0.8 × ) = (0.2 × 0.6) + (0.8 × 0.25) = 0.32
100 100

Important: Stratified sampling gives a better estimate than simple random sampling only
when the different strata are different from one another in terms of the quantity of interest.
If all the strata are similar, then it does not matter which one you draw the sample from, and
there is no improvement over simple random sampling. Thus, when creating the strata, you
should try to make them as different as possible.
4.2.3.3 Cluster Sampling: Cluster sampling involves the following steps:
1. Divide population into mutually exclusive and collectively exhaustive blocks (clusters).
2. Randomly choose one or more clusters.
3. Restrict your attention to the clusters you have selected in step 2. Either include all
members of these clusters in your final sample (one-stage cluster sampling), or choose a random
sample from these clusters (multi-stage cluster sampling).
Important Note: In cluster sampling, the final sample comes only from the cluster or
clusters selected in step 2. Thus, this method works best if the clusters are similar to one
another and hence similar to the overall population in terms of the quantity of interest.
One-Stage Cluster Sampling: In one-stage cluster sampling, after you select the cluster
or clusters in step 2, you include every member of the selected cluster(s) in the final sample.

63
For example, suppose you want to study the population of SU students who live in dorms,
and have selected the dorms as the cluster. If you randomly choose one dorm and include
every student in that dorm in your sample, that would be one-stage cluster sampling.
Multi-Stage Cluster Sampling: In multi-stage cluster sampling, after you select the cluster
or clusters in step 2, you again randomly choose some members of these clusters.
For example, in a common method used by economists, a city is divided into blocks
(clusters). Some city blocks are selected randomly. Then, from each city block chosen, a
fixed percentage of households are chosen randomly. This is an example of two-stage cluster
sampling, and is called city-block sampling.
4.2.3.4 Systematic Sampling: Systematic sampling is an example of one-stage cluster
sampling. In this method, you first obtain a complete list of population members. For
example, suppose you got a list of the 11,000 undergraduate students at Syracuse University,
and want to draw a systematic sample of 100 students from it. Proceed as follows:
11, 000
1. Compute the ratio of population size to sample size: K = = 110. K represents
100
one in how many in the population you are selecting, and is called the skip interval. (More
generally, if you are selecting a sample of size n out of a population of size M , the skip interval
M
is .)
n
2. Randomly choose a number from {1, 2, . . . , K} such that each number is equally likely to
be chosen. Call this number R.
3. From the list of population members, pick the following as your sample: R, R + K, R + 2K,
R + 3K, . . ., R + (n − 1)K.
To see that this is one-stage cluster sampling, write the list of 11,000 students as follows:
1 2 3 ... 110

111 112 113 ... 220

221 222 223 ... 330

.. .. .. .. ..
. . . . .

10,891 10,892 10,893 . . . 11,000


Note that each column in the above table is a cluster, and each cluster is equally likely to
be selected. If a cluster is selected, then every member of the cluster is included in the final
sample, that is, this is one-stage cluster sampling.
Note:
1. In systematic sampling, every member of the population is equally likely to be selected.
For example, in the example given, every member of the population has the same probability,

64
1/110 of being selected because the cluster she belongs to has the same chance, 1/110, of being
selected as any other cluster. However, not all combinations are equally likely. For example,
members 1 and 2 in the list will never be selected in the same sample.
2. Systematic sampling gives much better results than simple random sampling if you can
create a list where the quantity of interest either goes up or down along the list.
For example, suppose instead of 11,000 students, you have a list of 11,000 grocery stores
sorted from the smallest store to the largest store by floor size. You will use the sample of
100 stores to estimate average annual sales of Coca Cola.
Here, a systematic sample is guaranteed to include stores of all sizes. (In contrast, a simple
random sample of 100 stores could potentially consist of all small or all large stores.) Clearly,
sales of Coca Cola will be larger for larger stores. Since the systematic sample includes stores
of all sizes, it gives a more reliable estimate of average sales of Coca Cola than a simple random
sample of the same size.

4.3 Non-Response in Mail Surveys


In one-time mail surveys, the typical response rate is only about 20%. This is a problem
if people who respond to the mail survey are systematically different from people who do
not respond. For example, suppose you are conducting a mail survey to determine what
percentage of Syracuse undergraduates are interested in taking a class to learn the statistical
package SAS. Clearly, students who are interested in learning SAS will be much more likely to
respond to your survey than students who are not interested in the class. Thus, there are two
types of students: the “responding types” who are more likely to be interested in the class,
and the “non-responding types” who are less likely to be interested in the class. Note that
you are only getting responses from the “responding types.” Clearly, if you use this sample
alone, you will overestimate the percentage of Syracuse undergraduates who are interested in
the class. In other words, non-response creates a “biased sample” here.
To address this problem, researchers use a two-step approach:
(1) Improve response rate: Personalized cover letter, stamped self addressed return envelope,
multiple mailings of questionnaire, incentives such as donation to charity.
(2) Correct for non-response: To do the correction, you have to draw a sample from the
non-respondents. This is done by using some other method, typically a telephone survey.
Basically, you randomly call about one-third of the original sample and ask them if they have
had a chance to return the survey. If they have, thank them and hang up. If not, ask them if
they could spare a few minutes answering the survey on the phone. At the end of the process,
you have two samples:
(1) The original sample obtained by mail. This is a sample of the “responding types.”
(b) A second sample drawn from people who did not respond by mail. This is a sample of the
“non-responding types.”

65
The results are combined as illustrated below.
Example 1: Suppose Syracuse University (SU) is trying to decide whether it should build a
parking garage exclusively for students. To do that, it must charge an additional fee to the
students. SU therefore wants to determine how much an SU student will be willing to pay in
additional fees/semester for this service.
Suppose 400 questionnaires were mailed out, and 100 came back. In this sample, students
were ready to pay a fee of $200/semester on the average. Clearly, the respondents would be
more likely to be interested in this service, and $200 would therefore be an overestimate of
how much an SU student would be willing to pay for the service on the average.
To correct for non-response, suppose you collected data from 50 of the non-respondents by
telephone. On the average, these students are willing to pay $50 a semester for the service.
You now have two samples:
Sample (1): 100 initial respondents. Average = $200.
Sample (2): 50 initial non-respondents. Average = $50.
Note that the initial response rate was 100 out of 400, that is, 25%. Therefore, it is reasonable
to believe that 25% of the students are willing to pay $200 a semester for the service.
Similarly, 75% of the original sample did not return your survey. Thus, it is reasonable
to believe that the other 75% of the students are ready to pay only $50 a semester for the
service.
Combining, on the average an SU student would be ready to pay:
0.25 ∗ 200 + 0.75 ∗ 50 = 87.5, i.e., $87.50 a semester for the service.
Example 2: A company is trying to determine what proportion of Syracuse University stu-
dents are interested in an online movie download service that charges $20/month for unlimited
downloads. It mailed surveys to a random sample of 400 students. 80 came back, and 40 out
of the 80 were interested. 100 out of 320 students who did not return the mail survey were
contacted by telephone, and 10 out of the 100 were interested.
You now have two samples:
40
Sample (1): 80 initial respondents. Sample proportion interested = = 0.5.
80
10
Sample (2): 100 initial non-respondents. Sample proportion interested = = 0.10.
100
80
The initial response rate is = 0.2. Thus, about 20% of the population are like the people
400
who responded to your survey, and 80% of the population are like the people who did not
respond to the survey.
Combining, an unbiased estimate of the proportion of SU students interested in the service
is:
(0.2 × 0.5) + (0.8 × 0.1) = 0.18
Generalization:

66
In general, let Pr be the response rate to the original mail survey. Thus, approximately the
fraction Pr of the population are “responding types,” and the remaining (1 − Pr ) fraction
are of “non-responding types.” In Example 1, Pr = .25, and (1 − Pr ) = .75. The corrected
estimate is:
Pr ∗ estimate from the initial respondents +
(1 − Pr )∗ estimate from the second sample drawn out of non-respondents.

4.4 Example: Focus Group Outline

Instructions to Moderator:
A. (5 minutes) Introduce yourself and ask their names. State that the focus group will discuss
their lifestyle and interests, but do not say this is about Fossil yet. Ask them to help themselves
to snacks and drinks.
B.(5 minutes) Personal background: major, residence on campus, home state and hometown,
age.
C.(5 minutes) How do they spend leisure time at SU: Hang around with friends? Go to malls?
Watch TV? Go to bars?
D.(5 minutes) Media habits: radio, TV, newspapers, magazines
E.(10 minutes)
Favorite TV commercials: humorous, slice of life, dramatic
Favorite magazine commercials: Invite them to discuss which ones they like and why
F.(10 minutes) Designer brands:
Do they own any? (First let them come up with their answers. If they do not, then suggest
product categories: clothes, watches, pens, etc. You may also suggest brand names such as
Tommy Hilfiger, Guess. Do not mention the Fossil name yet.).
If yes, then which brands do they own? Which brands do they like best? What are they
looking for when they buy designer products? Where do they buy them? Do they always buy
the same brands?
Reason for purchase: own use, gifts.
G.(10 minutes) State that the focus group is about Fossil products:
Do they know about Fossil products? Do they own any? Do they like them? Have they
seen any Fossil commercials? Where? Do they like them? Which products do they think
meet the Fossil brand image? Which other brand is most like the Fossil brand?
H.(5 minutes) Ask for suggestions about:
(1) What can Fossil do to make its products more attractive?
(2) How can Fossil reach them (that is, people like the focus group participants)?

67
5 Conjoint Analysis

5.1 Idea
Like the expectancy value model, conjoint analysis assumes that the evaluation of a product
alternative depends on the attribute profile of the alternative, (X1 , . . . , Xn ). The evaluation
score, or utility, is denoted by U (X1 , . . . , Xn ). We discuss the simplest form of this utility
function, called the additive part-worth utility model:

(5.1) U (X1 , X2 , . . . , Xn ) = U0 + U1 (X1 ) + U2 (X2 ) + . . . + Un (Xn ),

where U0 is a constant term, and U1 , U2 , etc., are functions of the different attributes. This
model assumes that the marginal effect of a change in an attribute (say X1 ) on utility does
not depend on the levels of the other attributes (i.e., X2 , X3 , etc.). Still, the conjoint model
is more general than the expectancy value model.
Conjoint analysis examines products that can be expressed in terms of attributes that are
easy to describe to respondents. In general, the attributes may be qualitative or quantitative.
For simplicity, we only discuss quantitative attributes. The analysis is done at the level of
an individual respondent who is asked to rate several hypothetical products on a given scale.
From the evaluation scores, the researcher can determine how the respondent’s evaluation
of the product depends on attribute levels. This information is used to guide new product
development and to assess the potential market shares of new product concepts.
Meaning of Part-Worths: The functions U1 (X1 ), U2 (X2 ), etc., are called the part-worth
scores of the different attributes. We consider a fixed range of each attribute, and use a
simple convention: At the lowest point of the range of an attribute, the part-worth score of
the attribute is zero. With this convention:

• U0 is the evaluation score of the product for which each attribute is at the lowest point
of its range.

• Ui (Xi ) is zero if Xi is at the lowest level of its range. Otherwise, Ui (Xi ) is the marginal
change in evaluation score if attribute Xi is higher than its lowest level.

Example: Consider a product with 2 attributes: a laptop computer with attributes weight
(X1 ) and hard drive size (X2 ). X1 can rage from 4 lb to 10 lb, and X2 can range from 80 GB
to 160 GB. The laptop is evaluated on a 0-100 (very poor to excellent) scale.
In this case, the additive part-worth model can be expressed as follows:

(5.2) U (X1 , X2 ) = U0 + U1 (X1 ) + U2 (X2 ),

where U (X1 , X2 ) is the evaluation score of a laptop with attribute levels (X1 , X2 ). By our
convention, we assume that:

68
• U1 (4) = 0

• U2 (80) = 0

Under these assumptions:

U (4, 80) = U0 + U1 (4) + U2 (80) = U0 + 0 + 0 = U0

Therefore:

• U0 is the evaluation score of the “basic” laptop computer with each attribute at the
lowest levels in the ranges considered, that is, X1 = 4 and X2 = 80.

• U1 (X1 ) is the marginal adjustment to evaluation score depending on the level of weight
(X1 ). If X1 = 4, then no adjustment is needed.

• U2 (X2 ) is the marginal adjustment to evaluation score depending on the level of hard
drive size (X2 ). If X2 = 80, then no adjustment is needed.

Estimation: To estimate the conjoint model, the researcher creates hypothetical products,
and asks the respondent to rate each hypothetical product on a given scale (e.g., a 0-100
rating scale). To develop the hypothetical products, a fixed number of levels of each attribute
is used. For a given attribute, the lowest and the highest point of its range are always used.
Once the respondent rates the hypothetical products, the ratings are used to estimate the
following:
(1) U0 , the evaluation score of the product with the lowest level of each attribute.
(2) For each attribute, the value of its part-worth function at each level used in the analysis.
Using these information, the evaluation score of any new product concept can be estimated
by interpolation. In Section 10, I show how a conjoint model is estimated using dummy
variable regression. In the remainder of this section, I show how to use conjoint analysis after
estimation is done.

5.2 Laptop Example


We now discuss the laptop example in more detail to show how conjoint analysis is used. In
the present case, the objective of conjoint analysis is to estimate:
(1) The evaluation score of the “basic” product, U0
(2) U1 (X1 ) at two or more levels in the range 4 − 10. The extreme levels 4 and 10 are always
included.
(3) U2 (X2 ) at two or more levels in the range 80 − 160. The extreme levels 80 and 160 are
always included.
Suppose we selected the following levels of the two attributes:

69
(1) Four levels of X1 : 4, 6, 8, and 10.

(2) Four levels of X2 : 80, 100, 120, and 160.

Several hypothetical laptop computers are created using different combinations of these at-
tribute levels, and the respondent provides evaluation scores for these hypothetical products.
For a given respondent, we obtain the following results:

• U0 = mean evaluation score of the “basic laptop” with X1 = 4 and X2 = 80.

• U1 (4) = 0 (by assumption)

• U1 (6)

• U1 (8)

• U1 (10)

• U2 (80) = 0 (by assumption)

• U2 (100)

• U2 (120)

• U2 (160)

5.3 Evaluation of a New Product Concept using Linear Interpola-


tion
New product concepts need not have attributes exactly at the levels used in conjoint esti-
mation. For such intermediate levels, we use linear approximation to estimate part-worth
utilities. We illustrate this with an example.
Example: Suppose, for a given individual, we have the following estimates:

• U0 = 60

• U1 (4) = 0

• U1 (6) = −10

• U1 (8) = −20

• U1 (10) = −40

• U2 (80) = 0

70
• U2 (100) = 20

• U2 (120) = 40

• U2 (160) = 50

We can express the part-worth functions graphically as follows:

U1 (X1 )
6
4 6 8 10 X1
0 -

−10

−20

−40

U2 (X2 )
6
50

40

20

0 -
80 100 120 160 X2

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Note that we know U1 (X1 ) only at X1 = 4, 6, 8, and 10, and U2 (X2 ) only at X2 = 80, 100,
120, and 160. To approximate the curves, we join successive points by straight lines. This is
called linear interpolation. We now get the following graphs:

U1 (X1 )
6
4 6 8 10 X1
0 HH -
HH
HH
HH
HH
−10 HH
HH
HH
HH
HH
−20
@
@
@
@
@
@
@
@
@
−40 @

U2 (X2 )
6
50 »»
»
»»»
»»»
»»»»»
40 »»
¡
¡
¡
¡
¡
¡
¡
20 ¡
¡
¡
¡
¡
¡
¡
¡
0 ¡ -
80 100 120 160 X2

With these graphs, we can estimate the evaluation score of any laptop with X1 in the range 4-
10, and X2 in the range 80-160. We should not use these results to evaluate product concepts
with attribute levels outside the ranges used to estimate the model.

72
Consider two new product concepts:
Concept 1: X1 = 5.5, X2 = 90
Concept 2: X1 = 9, X2 = 150
We can evaluate the two concepts as follows:
Concept 1 (X1 = 5.5, X2 = 90) Concept 2 (X1 = 9, X2 = 150)

U0 60 60

n 5.5 − 4 o n o n 9−8 o n o
U1 (X1 ) U1 (4) + + × U1 (6) − U1 (4) U1 (8) + × U1 (10) − U1 (8)
n 1.5 on
6−4 o
10 − 8
1
=0+ (−10) − 0 = −7.5 = −20 + × {(−40) − (−20)} = −30
2 2

U2 (X2 ) U2 (80) U2 (120)


n 90 − 80 o n 150 − 120 o
+ × {U2 (100) − U2 (80)} + × {U2 (160) − U2 (120)}
100 − 80 160 − 120
10 30
=0+ × (20 − 0) = 10 = 40 + × (50 − 40) = 47.5
20 40

U (X1 , X2 ) 60 − 7.5 + 10 = 62.5 60 − 30 + 47.5 = 77.5


Therefore, this person will prefer concept 2 to concept 1.
Note: You can compute the utilities graphically also:

• X1 = 5.5 is 1.5 above 4, that is, it is 3/4 th of the way from 4 to 6. Thus, U1 (5.5) is
three-fourths of the way from 0 to −10, that is, −7.5.

• X1 = 9 is half-way between 8 and 10. Thus, U1 (9) is half-way between −20 and −40,
that is, −30.

• X2 = 90 is half-way between 80 and 100. Thus, U2 (90) is half-way between 0 and 20,
that is, 10.

• X2 = 150 is three-fourths of the way from 120 to 160. Therefore, U2 (150) is three-fourths
of the way from 40 to 50, that is, 47.5.

When you have several new product concepts, you can proceed this way to identify the concept
this person would prefer.

73
5.4 Prediction of Market-Share

In practice, we have parameter estimates for a representative sample of respondents. For each
member of the sample, we can predict if a given new product concept will be preferred to
existing products in the market. By aggregating over the sample, we can predict the market
share of the new product concept.

5.5 Example: Credit Card


In Fall 2001, I conducted conjoint analysis for an MBA Marketing Management class (MAR
600) at Syracuse University. The conjoint survey, provided in the Appendix to this section,
included two conjoint questionnaires, one on credit cards, and the other on personal computers.
While the attribute levels for computers are out of date, those for credit cards are not. I discuss
the credit card survey and results here, and the personal computer survey and results in the
next section.
5.5.1 Model and analysis: Hypothetical credit cards were designed using 4 levels each of
three attributes:
(1) X1 (interest rate): 6, 9, 12, or 18 percent APR.
(2) X2 : (credit limit): 5, 10, 25, or 50 (unit=$1000).
(3) X3 (annual fee): 0, 10, 20, or 50.
We assumed that the utility for a product (X1 , X2 , X3 ) can be expressed as:

U (X1 , X2 , X3 ) = U0 + U1 (X1 ) + U2 (X2 ) + U3 (X3 ),

where:

• U0 = rating of credit card with X1 = 6, X2 = 5, and X3 = 0

• U1 (6) = 0

• U2 (5) = 0

• U3 (0) = 0

U1 (X1 ), U2 (X2 ) and U3 (X3 ) are marginal contributions of the three attributes to utility as
their levels increased from the lowest points. The respondents ranked 18 hypothetical credit
cards, given in the table below, from best (1) to worst (18).

74
Card # Interest Rate Credit Limit Annual Fee Rank
1 6% $5000 $0
2 12% $25,000 $10
3 6% $50,000 $0
4 12% $5000 $50
5 18% $50,000 $0
6 6% $25,000 $20
7 18% $5000 $10
8 12% $50,000 $20
9 18% $5000 $50
10 9% $10,000 $50
11 18% $10,000 $20
12 9% $50,000 $10
13 12% $10,000 $0
14 18% $25,000 $50
15 6% $10,000 $10
16 9% $5000 $20
17 6% $50,000 $50
18 9% $25,000 $0
Credit cards 3 (best on all attributes) and 9 (worst on all attributes) served as anchors. Every
respondent should have given card 3 a rank of 1, and card 9 a rank of 18.
5.5.2 Data and Estimation: Data from 66 respondents (MBA students) were analyzed.
For each respondent, data for cards 3 and 9, inserted as anchors, were dropped. The other
16 cards were re-ranked from 1 (best) to 16 (worst). Then, this rank was subtracted from 17
to get a score on a 1-16 scale (1: lowest, 16: highest). Using these scores, we obtained the
following from each respondent:

• U0 = the rating of the basic credit card with X1 = 6, X2 = 5, and X3 = 0 on a 1-16


scale. (Denoted by U 0)

• U1 (6) = 0 (Denoted by U 11)

• U1 (9): The marginal change in utility if X1 is 9 instead of 6. (Denoted by U 12)

• U1 (12): The marginal change in utility if X1 is 12 instead of 6. (Denoted by U 13)

• U1 (18): The marginal change in utility if X1 is 18 instead of 6. (Denoted by U 14)

• U2 (5) = 0 (Denoted by U 21)

• U2 (10): The marginal change in utility if X2 is 10 instead of 5. (Denoted by U 22)

• U2 (25): The marginal change in utility if X2 is 25 instead of 5. (Denoted by U 23)

• U2 (50): The marginal change in utility if X2 is 50 instead of 5. (Denoted by U 24)

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• U3 (0) = 0 (Denoted by U 31)

• U3 (10): The marginal change in utility if X3 is 10 instead of 0. (Denoted by U 32)

• U3 (20): The marginal change in utility if X3 is 20 instead of 0. (Denoted by U 33)

• U3 (50): The marginal change in utility if X3 is 50 instead of 0. (Denoted by U 34)

5.5.3 Evaluating a new product idea: For any given respondent, the utility of a product
concept with attribute values within the ranges used in estimation can be estimated as follows:
First get the components:
(1) U0
(2) U1 (X1 ): Compute it as follows:
X1 − 6
6 ≤ X1 < 9: U1 (X1 ) = U 12 ∗ ( ).
3
X1 − 9
9 ≤ X1 < 12: U1 (X1 ) = U 12 + (U 13 − U 12) ∗ ( ).
3
X1 − 12
12 ≤ X1 ≤ 18: U1 (X1 ) = U 13 + (U 14 − U 13) ∗ ( ).
6
(3) U2 (X2 ): Express X2 in units of $1000, e.g., use 15 if credit limit is $15,000. Compute
U2 (X2 ) as follows:
X2 − 5
5 ≤ X2 < 10: U2 (X2 ) = U 22 ∗ ( ).
5
X2 − 10
10 ≤ X2 < 25: U2 (X2 ) = U 22 + (U 23 − U 22) ∗ ( ).
15
X2 − 25
25 ≤ X2 ≤ 50: U2 (X2 ) = U 23 + (U 24 − U 23) ∗ ( ).
25
(4) U3 (X3 ): Compute this as follows:
X3
0 ≤ X3 < 10: U3 (X3 ) = U 32 ∗ ( ).
10
X3 − 10
10 ≤ X3 < 20: U3 (X3 ) = U 32 + (U 33 − U 32) ∗ ( ).
10
X3 − 20
20 ≤ X3 ≤ 50: U3 (X3 ) = U 33 + (U 34 − U 33) ∗ ( ).
30
Then add: U (X1 , X2 , X3 ) = U0 + U1 (X1 ) + U2 (X2 ) + U3 (X3 ).
When you compare multiple new product concepts, a given person will select the option
that yields the highest utility.
5.5.4 Benefit Segments using Cluster Analysis: I performed cluster analysis using SPSS.
Each of the 66 cases in the data set is expressed in terms of 16 coordinates: the scores of the
16 profiles used (that is, 17−rank), denoted by S1 , S2 , . . ., S16 . The program computes the
distances between pairs of cases in this sixteen-dimensional space and tries to create clusters
based on proximity. The user specifies the number of clusters to be used. I tried both a two-
cluster solution and a three-cluster solution. The three-cluster solution was almost the same
as the two-cluster solution with only 4 cases in the third cluster. Therefore, I only provide

76
the two-cluster results. For each cluster, the average values of U0 and the part-worth scores
are given below.
Cluster 1:
U0 = 15.3429
U1 (6) = 0 U1 (9) = −3.0071 U1 (12) = −6.1857 U1 (18) = −10.2643
U2 (5) = 0 U2 (10) = 0 U2 (25) = −0.6143 U2 (50) = −1.5571
U3 (0) = 0 U3 (10) = −1.1857 U3 (20) = −1.8071 U3 (50) = −2.7500
Cluster 2:
U0 = 12.7823
U1 (6) = 0 U1 (9) = −1.1048 U1 (12) = −2.0645 U1 (18) = −3.3145
U2 (5) = 0 U2 (10) = 1.4032 U2 (25) = 2.5323 U2 (50) = 2.9032
U3 (0) = 0 U3 (10) = −2.8629 U3 (20) = −5.5887 U3 (50) = −9.0323
Thus, it appears that Cluster 1 is largely concerned with interest rate, and Cluster 2 is largely
concerned with annual fee. I don’t have a clear explanation for the negative part-worths
of credit limit for Cluster 1. It may be simply random error, given that credit limit is not
important anyway. It may also be worry about identity theft or misuse of a high credit limit.
5.5.5 Output: If you are interested, you may work with the Excel output file creditf01.xls
posted as a Blackboard course document. For each of the 66 observations, you have the
following data:
Case number (1 through 66)
Gender: 1 if male, 0 if female
Age: 1-5 scale
NCARD: Number of credit cards owned
CLUS: Cluster membership, 1 if cluster 1 and 2 if cluster 2.
S1 − S16 : The scores of the sixteen credit cards used in the analysis.
Conjoint Estimates: U 0, U 11, U 12, U 13, U 14, U 21, U 22, U 23, U 24, U 31, U 32, U 33, U 34.

5.6 Example: Personal Computer


We used the data from the MBA class in Fall 2001 to do a second conjoint analysis on personal
computers. The survey is included in the Appendix to this section.
5.6.1 Model and analysis: The hypothetical products were designed using 4 levels each of
three attributes:
(1) X1 (warranty length): 1, 2, 3, or 4 years.
(2) X2 : (RAM): 1, 2, 3, or 4 (unit= 128 MB).
(3) X3 (hard drive size): 1, 2, 3, or 5 (unit = 20 GB).

77
We assumed that the utility for a product (X1 , X2 , X3 ) can be expressed as:

U (X1 , X2 , X3 ) = U0 + U1 (X1 ) + U2 (X2 ) + U3 (X3 ),

where:

• U0 = utility for personal computer with X1 = 1, X2 = 1, and X3 = 1

• U1 (1) = 0

• U2 (1) = 0

• U3 (1) = 0

U1 (X1 ), U2 (X2 ) and U3 (X3 ) are marginal contributions of the three attributes to utility as their
levels increased from the lowest. Each respondent rated 18 hypothetical personal computers
listed in the table below from 1 (best) to 18 (worst). Data from computers 1 and 6, inserted
as anchors, were dropped. The remaining 16 products were re-ranked from 1 to 16. Each PC
was then given a score of (17−rank), that is, the PC ranked 1 got a score of 16, the PC ranked
2 got a score of 15, so on.
Personal Warranty Random Access Hard Drive
Computer Memory (RAM) Size
# (in MB) (in GB) Rank
1 4 yr 512 100
2 1 yr 128 60
3 2 yr 256 20
4 3 yr 384 60
5 4 yr 512 20
6 1 yr 128 20
7 1 yr 256 100
8 2 yr 384 40
9 3 yr 512 100
10 4 yr 128 40
11 1 yr 384 20
12 2 yr 512 60
13 3 yr 128 20
14 4 yr 256 60
15 1 yr 512 40
16 2 yr 128 100
17 3 yr 256 40
18 4 yr 384 100
5.6.2 Data and Estimation: Data from 68 respondents (MBA students) were analyzed. For
each respondent, data for computers 1 and 6, inserted as anchors, were dropped. The other 16

78
computers were re-ranked from 1 (best) to 16 (worst). Then, this rank was subtracted from
17 to get a score on a 1-16 scale (1: lowest, 16: highest). Using these scores, we obtained the
following from each respondent:

• U0 = the rating of the basic PC with X1 = 1, X2 = 1, and X3 = 1 on a 1-16 scale.


(Denoted by U 0)

• U1 (1) = 0 (Denoted by U 11)

• U1 (2): The marginal change in utility if X1 is 2 instead of 1. (Denoted by U 12)

• U1 (3): The marginal change in utility if X1 is 3 instead of 1. (Denoted by U 13)

• U1 (4): The marginal change in utility if X1 is 4 instead of 1. (Denoted by U 14)

• U2 (1) = 0 (Denoted by U 21)

• U2 (2): The marginal change in utility if X2 is 2 instead of 1. (Denoted by U 22)

• U2 (3): The marginal change in utility if X2 is 3 instead of 1. (Denoted by U 23)

• U2 (4): The marginal change in utility if X2 is 4 instead of 1. (Denoted by U 24)

• U3 (1) = 0 (Denoted by U 31)

• U3 (2): The marginal change in utility if X3 is 2 instead of 1. (Denoted by U 32)

• U3 (3): The marginal change in utility if X3 is 3 instead of 1. (Denoted by U 33)

• U3 (5): The marginal change in utility if X3 is 5 instead of 1. (Denoted by U 34)

5.6.3 Evaluating a new product idea: For a given respondent, the utility of a product
concept with attribute values within the ranges used in estimation can be estimated as follows:
First obtain the components:
(1) U0
(2) U1 (X1 ): Express X1 in years. Compute U1 (X1 ) as follows:
1 ≤ X1 < 2: U1 (X1 ) = U 12 ∗ (X1 − 1).
2 ≤ X1 < 3: U1 (X1 ) = U 12 + (U 13 − U 12) ∗ (X1 − 2).
3 ≤ X1 ≤ 4: U1 (X1 ) = U 13 + (U 14 − U 13) ∗ (X1 − 3).
(3) U2 (X2 ): Express X2 in units of 128 MB, e.g., use 1.5 if RAM is 192 MB. Compute U2 (X2 )
as follows:
1 ≤ X2 < 2: U2 (X2 ) = U 22 ∗ (X2 − 1).
2 ≤ X2 < 3: U2 (X2 ) = U 22 + (U 23 − U 22) ∗ (X2 − 2).
3 ≤ X2 ≤ 4: U2 (X2 ) = U 23 + (U 24 − U 23) ∗ (X2 − 3).

79
(4) U3 (X3 ): Express X3 in units of 20 GB. For example, use 2.5 if hard drive size is 50 GB.
Compute U3 (X3 ) as follows:
1 ≤ X3 < 2: U3 (X3 ) = U 32 ∗ (X3 − 1).
2 ≤ X3 < 3: U3 (X3 ) = U 32 + (U 33 − U 32) ∗ (X3 − 2).
X3 − 3
3 ≤ X3 ≤ 5: U3 (X3 ) = U 33 + (U 34 − U 33) ∗ ( ).
2
Then add: U (X1 , X2 , X3 ) = U0 + U1 (X1 ) + U2 (X2 ) + U3 (X3 ).
When you compare multiple new product concepts, a given person will select the option
that yields the highest utility.
5.6.4 Benefit Segments using Cluster Analysis: I performed cluster analysis using SPSS.
Each of the 68 cases in the data set is expressed in terms of 16 coordinates: the scores of the
16 profiles used (computed as 17−rank) for the case, denoted by S1 , S2 , . . ., S16 . The program
computes the distances between pairs of cases in this sixteen-dimensional space and tries to
create clusters based on proximity. The user specifies the number of clusters to be used. In
this case (personal computers), three distinct clusters emerged. For each cluster, the averages
of U0 , U1 (1), . . . , U3 (5) are given below.
Cluster 1
U0 = −0.0875
U1 (1) = 0 U1 (2) = 4.10 U1 (3) = 8.2125 U1 (4) = 10.5375
U2 (1) = 0 U2 (2) = 1.4125 U2 (3) = 2.8625 U2 (4) = 3.3250
U3 (1) = 0 U3 (2) = 0.6375 U3 (3) = 1.5500 U3 (5) = 1.7125

Cluster 2
U0 = −0.09167
U1 (1) = 0 U1 (2) = 0.5500 U1 (3) = 1.4417 U1 (4) = 1.5417
U2 (1) = 0 U2 (2) = 2.5250 U2 (3) = 3.4833 U2 (4) = 4.0917
U3 (1) = 0 U3 (2) = 3.4250 U3 (3) = 7.1417 U3 (5) = 10.1667

Cluster 3
U0 = 0.4722
U1 (1) = 0 U1 (2) = 0.6250 U1 (3) = 1.4722 U1 (4) = 1.3472
U2 (1) = 0 U2 (2) = 4.2222 U2 (3) = 7.7917 U2 (4) = 11.0417
U3 (1) = 0 U3 (2) = 1.1250 U3 (3) = 1.5972 U3 (4) = 2.8889
5.6.5 Output: The results are presented as the Excel file: pcf01.xls. For each of the 68
observations, you have the following data:
Case number (1 through 68)
Gender: 1 if male, 0 if female
Age: 1-5 scale
NCARD: Number of credit cards owned
KNOW: self assessment of knowledge of PC (1-7 scale)

80
PPC: 1 if purchased PC in the last two years, 0 if not
OWNPC: 1 if owns PC, 0 if not
EMAIL, WORD, SURF, SPREAD, TAX, STORDAT, STAT, PROG, VIDEO, OTHER: each
1 if checked, 0 if not
CLUS: Cluster membership using three-cluster solution; 1 if cluster 1, 2 if cluster 2, 3 if cluster
3.
S1 − S16 : The scores of the sixteen personal computers used in the analysis.
Estimates of: U 0, U 11, U 12, U 13, U 14, U 21, U 22, U 23, U 24, U 31, U 32, U 33, and U 34.

5.7 Optional Topics

5.7.1 Qualitative Attributes: To simplify the discussions, I only considered quantitative


attributes such as interest rate and credit limit. However, everything we discussed applies
equally well to qualitative attributes. For example, we could have used four levels of the
color of an iPOD: red, blue, silver, and black. Qualitative attributes are used extensively in
marketing applications. For example, researchers have used brand name and country of origin
to find how these attributes affect customer evaluation.
5.7.2 Estimating Price Sensitivity: In conjoint analysis, price may be used as one of the
attributes. Using the results, the researchers can estimate how customers make trade offs
between an attribute level and its price. Also, for a given new product concept, it is possible
to estimate its demand at a given price level.
5.7.3 Ideal Point Model: In our discussions, we did not make any assumption about what
the part-worth functions U1 (X1 ), etc., look like. Also, when we estimate these functions using
dummy variable regression as discussed in Section 10, we do not make assumptions about
functional form. We now discuss one specific case of the additive part-worth model called the
ideal point model.
The ideal point model assumes that a given customer has an ideal point, (X1∗ , X2∗ , . . . , Xn∗ ),
and the customer’s evaluation score of a product decreases with distance from the ideal point.
The distance of a product (X1 , X2 , . . . , Xn ) from the ideal point is defined as follows:

D2 = W1 (X1 − X1∗ )2 + W2 (X2 − X2∗ )2 + . . . + (Xn − Xn∗ )2 ,

where W1 , W2 , . . ., Wn are all greater than zero and reflect the relative importance of the
different attributes. (In Assignment 2, we applied a special case of this distance where W1 =
W2 = . . . = 1.) The evaluation score of any product (X1 , X2 , . . . , Xn ) can be expressed as:
n
X
2
U (X1 , X2 , . . . , Xn ) = K − D = K − Wi (Xi − Xi∗ )2 ,
i=1

81
where K is a constant and equals the utility of the ideal product. Rewriting:

h n
X i n
X
U (X1 , X2 , . . . , Xn ) = K − Wi Xi∗ 2 + (2Wi Xi∗ Xi − Wi Xi2 )
i=1 i=1

If each Xi is expressed as the difference of the attribute level from the lowest level, then this
becomes our usual additive part-worth utility model where:
Pn
U0 = K − i=1 Wi x∗i 2
U1 (X1 ) = (2W1 X1∗ )X1 − W1 X12
..
.
Un (Xn ) = (2Wn Xn∗ ) − Wn Xn2
For any attribute Xi , the part-worth function is a parabola that reaches the highest point at
Xi∗ as shown below. In Section 10.6 we discuss how to estimate this model.

Ui (Xi )
6

-
Xi∗ Xi
5.7.4 Developing new product concepts: To use conjoint analysis, it is necessary to
develop hypothetical new product concepts. If you use commercial packages such as those from
www.sawtooth.com, then the software will generate hypothetical products for you. Otherwise,
you have to develop hypothetical products yourself.
Note that in Sections 5.5 and 5.6, I used 4 levels each of three attributes. Thus, in each case,
4 × 4 = 64 hypothetical products were possible. Instead, we used 16 hypothetical products
plus the two anchors. This was done using a method called Latin Square Design that can be
used for three attributes, each attribute with the same number of levels.
I now show how we can use the Latin Square design to get 16 hypothetical products when
there are three attributes with four levels each.
Step 1: First focus on attributes 1 and 2, and write the 4 × 4 = 16 combinations as a table:
Attribute 2
Attribute 1 1 2 3 4
1 (1,1) (1,2) (1,3) (1,4)
2 (2,1) (2,2) (2,3) (2,4)
3 (3,1) (3,2) (3,3) (3,4)
4 (4,1) (4,2) (4,3) (4,4)

82
Step 2: Start with row 1, and put the four levels of the third attribute sequentially. You
can use any starting point. For example, you can put them as (1, 2, 3, 4), or (2, 3, 4, 1), or
(3, 4, 1, 2), or, (4, 1, 2, 3). In row 2, shift them by one place to the left. For example, if you
have (1, 2, 3, 4) in row 1, then it should be (2, 3, 4, 1) in row 2. Again, shift them by 1 in row
3, and shift them by 1 in row 4. Thus, depending on what you chose in row 1, you may have
any of the following four Latin-Square designs:

Design 1 Attribute 2
Attribute 1 1 2 3 4
1 (1,1,1) (1,2,2) (1,3,3) (1,4,4)
2 (2,1,2) (2,2,3) (2,3,4) (2,4,1)
3 (3,1,3) (3,2,4) (3,3,1) (3,4,2)
4 (4,1,4) (4,2,1) (4,3,2) (4,4,3)

Design 2 Attribute 2
Attribute 1 1 2 3 4
1 (1,1,2) (1,2,3) (1,3,4) (1,4,1)
2 (2,1,3) (2,2,4) (2,3,1) (2,4,2)
3 (3,1,4) (3,2,1) (3,3,2) (3,4,3)
4 (4,1,1) (4,2,2) (4,3,3) (4,4,4)

Design 3 Attribute 2
Attribute 1 1 2 3 4
1 (1,1,3) (1,2,4) (1,3,1) (1,4,2)
2 (2,1,4) (2,2,1) (2,3,2) (2,4,3)
3 (3,1,1) (3,2,2) (3,3,3) (3,4,4)
4 (4,1,2) (4,2,3) (4,3,4) (4,4,1)

Design 4 Attribute 2
Attribute 1 1 2 3 4
1 (1,1,4) (1,2,1) (1,3,2) (1,4,3)
2 (2,1,1) (2,2,2) (2,3,3) (2,4,4)
3 (3,1,2) (3,2,3) (3,3,4) (3,4,1)
4 (4,1,3) (4,2,4) (4,3,1) (4,4,2)

For example, in Design 4, the first product in Row 1 has level 1 of attribute 1, level 1 of
attribute 2, and level 4 of attribute 4. All these designs have an important property: For
each level of a given attribute is combined with each level of another attribute exactly once.
Technically, the attributes have zero correlations in the design.

83
5.8 Additional Reading

1. Paul E. Green, and V. Srinivasan (1978), “Conjoint Analysis in Consumer Research: issues
and outlook,” Journal of Consumer Research, volume 5, pages 103-23.
2. and (1990), “Conjoint Analysis in Marketing: new developments with implications
for research and practice,” Journal of Marketing, volume 54, pages 3-19.
These are excellent review papers written by two of the leading authorities on the subject.
You may also visit www.sawtoothsoftware.com

5.9 Appendix: Survey for Credit Card and PC


Dear Participant:
We are conducting this survey to determine what is important to you when you select
credit cards and personal computers. Your response is very important to us. Any information
you provide will be held strictly confidential and will not be used for any commercial purpose.
Thanks for your help.
Students of MBC 600, School of Management

84
Part 1: Credit Card

18 hypothetical credit cards are described on page 3 of this questionnaire (Table 1). All
these credit cards are Visa cards issued by a major Midwestern bank and they all have the
following standard features:

• Collision and damage insurance on rental cars.

• Frequent flier mileage at one mile for one dollar of purchase using the card on an airline
of your choice.

• 30 day grace period on payments.

These cards are identical in every way except for the following:
1. Interest rate: The interest rate can be 6%, 9%, 12%, or 18% APR.
2. Credit limit: The credit limit can be $5000, $10,000, $25,000, or $50,000.
3. Annual fee: The annual fee can be $0, $10, $20, or $50.
Once again, the credit cards listed on the next page are identical in every way except for
the three features listed above. Assume that you are interested in getting a new credit card,
and your choice is restricted to the 18 credit cards described in Table 1. Identify the one credit
card in the list that best suits your personal tastes and preferences. Assign this card a rank
of 1. Then, identify the card you like second best, and assign it a rank of 2. Please continue
this way and rank all the 18 credit cards. Please answer carefully; your last few rankings are
as important as your first few. Enter the ranks in the rank column.

85
Table 1

Please rank the following credit cards in order of preference (from 1: best to 18: worst). All
these credit cards are identical in every way except for interest rate, credit limit, and
annual fee.
Card # Interest Rate Credit Limit Annual Fee Rank
1 6% $5000 $0
2 12% $25,000 $10
3 6% $50,000 $0
4 12% $5000 $50
5 18% $50,000 $0
6 6% $25,000 $20
7 18% $5000 $10
8 12% $50,000 $20
9 18% $5000 $50
10 9% $10,000 $50
11 18% $10,000 $20
12 9% $50,000 $10
13 12% $10,000 $0
14 18% $25,000 $50
15 6% $10,000 $10
16 9% $5000 $20
17 6% $50,000 $50
18 9% $25,000 $0

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Part 2: Personal Computer

18 hypothetical personal computers are described in Table 2 of this questionnaire. All


these personal computers are offered by companies with similar reputation at the same price,
$1500, and they all have the following standard features:

• 17” Sony Trinitron monitor

• 1.8 GHz Intel Pentium 4 Processor

• Ultra ATA hard drive, 7200 RPM

• 16x max DVD Rom

• 12x max CD-RW drive

• 3.5” floppy drive and 250 MB Zip drive

• Microsoft Windows XP Home edition with Microsoft Works Suite 2001

• 64 MB NVidia GeForce 2 MX graphics card

• Harmon Kardon HK695 surround sound speakers with subwoofer

• Sounblaster Pro 16 soundcard

• 56 K modem and 10/100 network card

• i.Link I-EEE 1394 interface

• HP 845C color printer

• free 12 month internet access by MSN

However, these personal computers differ on the following three features: hard drive size,
random access memory (RAM), and term of warranty, as described on the next page.

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The personal computers can differ on the following three features:
(1) Hard drive size:
The hard drive size can be 20 GB, 40 GB, 60 GB, or 100 GB.
(2) Random Access Memory (RAM): (133 MHz RDRAM)
The random access memory can be 128 MB, 256 MB, 384 MB, or 512 MB.
(3) Warranty: The warranty can be:

1 yr: One year limited warranty with next business day on-site service; one year
online help.

2 yr: Two year limited warranty with next business day on-site service; two year
online help.

3 yr: Three year limited warranty with next business day on-site service; lifetime
online help.

4 yr: Four year limited warranty with next business day on-site service; lifetime
online help.

Assume that you are interested in buying a personal computer for personal use, and your
choice is restricted to the 18 personal computers described in Table 2. Please rank these 18
personal computers in order of preference. Assign a rank of 1 to the personal computer that
best suits your personal tastes and preferences. Then find the next best personal computer
for yourself, and assign it a rank of 2. Proceed this way until you have ranked all 18 personal
computers. Please answer carefully; your last few rankings are as important as your first few.

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Table 2
Please rank the following personal computers in order of preference (from 1:best to 18: worst).
All personal computers have the same price ($1500), and are identical in every way except for
warranty, random access memory, and hard-drive size.
Personal Warranty Random Access Hard Drive
Computer Memory (RAM) Size
# (in MB) (in GB) Rank
1 4 yr 512 100
2 1 yr 128 60
3 2 yr 256 20
4 3 yr 384 60
5 4 yr 512 20
6 1 yr 128 20
7 1 yr 256 100
8 2 yr 384 40
9 3 yr 512 100
10 4 yr 128 40
11 1 yr 384 20
12 2 yr 512 60
13 3 yr 128 20
14 4 yr 256 60
15 1 yr 512 40
16 2 yr 128 100
17 3 yr 256 40
18 4 yr 384 100

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Part 3: background Information

1. Gender: Male Female


2. Age:
20 or below 21-25 26-40 41-60
over 60
3. How many credit cards do you have at present?
credit cards
4. Compared to an average person, how knowledgeable are you about personal computers?
(Please circle)
Much less Much more
knowledgeable knowledgeable
1 2 3 4 5 6 7

5. Did you purchase a personal computer within the last two years?
Yes No
6. Do you currently own a personal computer?
Yes No
7. If you do currently own a personal computer, what have you used it for during the last
three months? (Check all that apply. If you do not currently own a personal computer, please
skip the question.)
(a) send/receive email (b) word processing (c) surf the internet

(d) prepare spreadsheets (e) prepare tax forms (f) store data

(g) run statistical packages (h) do programming (i) play video games

(j) other

**Thank You for Your Participation**

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6 Selected Topics on Product Strategy
6.1 Introduction
A “product” is everything, favorable and unfavorable, that a person receives in an exchange.
A product is a very general term. It may be a pure good (e.g., a pair of blue jeans), a pure
service (e.g., an airplane ride to New Delhi), or a combination of both (e.g., a dinner at an
expensive restaurant, or a personal computer with on site service for one year). You may often
have a situation when the same need may be satisfied by a good and a service. For example,
your entertainment need may be satisfied by going to a movie theater (a service) or buying
a video tape (a good) and watching it at home. Similarly, one may decide to use disposable
diapers (a good) or a cloth diaper service.
It is useful to think of a product at three levels (the Kotler/Keller text adds two more
levels).
Core product: Basic benefit or service provided. For example, it may be the chemical
acetaminophen.
Actual Product: Core product plus brand name, packaging, features, style. With these,
acetaminophen becomes Tylenol, Panadol, or a store brand.
Augmented Product: Actual product + support (e.g., warranty, service, financing, delivery,
etc.) + price.
Example of augmented products: Singer, a manufacturer of sewing machines, provides sewing
lessons, the car manufacturer Acura provides 24 hour roadside service to its US customers.
Note: Even when the core product is the same, a marketer can differentiate the augmented
product through pricing, distribution, customer service, and even the effective use of promotion
to create the right image for the product. For example, Duracell has created an image of a
long lasting tough product. Marlboro has an image of rugged independence.

6.2 Classification of Consumer Products


Consumer products can be divided into four main categories, (1) convenience products, (2)
shopping products, (3) specialty products, and (4) unsought products. We will discuss them
separately.
6.2.1 Convenience products: These can be subdivided into three categories, staple prod-
ucts, emergency products and impulse products.
(a) Staple products: These are frequently purchased items, typically necessities of life, e.g.,
milk, bread, newspaper, car wash, dry cleaning etc., usually commodities with standard prices.
Key Feature: These are usually commodities, i.e., the consumer finds little difference in the
offerings of different manufacturers. If a particular brand is not available at a store, a consumer

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is unlikely to go from store to store to find it.
(b) Emergency products: These are products that consumers need immediately. Examples
include headache medicine, snow shovels, ambulance, the hospital emergency room, taxi to
get back home when the car breaks down, American Automobile Association (AAA) service
to tow your car.
Key feature: Once again, when the need arises, the consumer needs the product immediately
and is not able to shop around. For example, if your car is about to run out of gas on a lonely
highway, you would be unlikely to shop around for the best price.
(c) Impulse products: These are products one does not plan to purchase and decides to buy
only when she see them. Examples include magazines, candy, flowers, etc. Retailers usually
place many of these items near the check-out counter to increase the chance that they will
be noticed and hence purchased. The examples I have given so far are all goods, but impulse
purchase may include services also. For example, you may pass by a beauty salon and decide
to have your fingernails manicured, or see the phone in front of your seat during an airline
flight and proceed to call home.
Key feature: An impulse product is not purchased if the consumer does not notice it. Thus,
impulse products are packaged and placed to attract attention.
Common features of convenience products:
a) Consumers generally have adequate knowledge of the product category.
b) The consumer does not derive pleasure from the purchase activity itself, and does not
usually shop around. This makes product availability very important.
The marketer’s perspective:

• The product must be widely available. The manufacturer therefore has to distribute the
product through many retail outlets.

• The retailer usually does not advertise the product since that advertisement will benefit
all retailers and not just him. As a result, the manufacturer must bear the cost of
promoting the product to the ultimate consumer.

• Due to the size of the target audience, promotion is usually done through advertising and
the use of coupons. Companies like P & G and Johnson & Johnson, who market branded
products, do a lot of advertising about the specific brands they market. The marketers
of commodities often join together and advertise their common, generic, product in order
to generate primary demand; examples include the National Pork Producers sponsoring
pork commercials, and Florida citrus growers airing commercials about Florida orange
juice.

• The only time retailers promote a convenience product is when they group them together

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and promote them simultaneously (e.g., using coupons inserted in Sunday newspapers)
to attract customers to the store.

Note: Whether a product is a staple, an emergency product or an impulse product may


depend on the specific buying situation encountered by the consumer. For example, a staple
like gasoline may become an emergency product if you are stranded on a deserted highway.
Also, these days people have less time to spare and they expect to find everything they need
when they go to a supermarket. As a result, they often do not plan what they will purchase
when they go to grocery stores. Recent studies show that over 50 % of all supermarket
purchases are now “impulse” purchases, i.e., purchases without any prior planning. This
makes availability of product as well as attractive package design and shelf location (to attract
attention) very important.
6.2.2 Shopping products: Shopping products are characterized by the fact that consumers
perceive considerable difference in the augmented product and a purchase represents a greater
monetary or emotional investment compared to the purchase of convenience products. As a
result, the consumers shop around and compare price, quality, brands, etc., and many people
derive pleasure from the “shopping around” itself.
Note that a customer shops around only when she sees a benefit in doing so. While this
will occur for major purchases like that of a car or a house, it also occurs for purchases that
do not cost much but have important consequences. For example, a person may look around
to find a reliable day care provider. Also, if the product use is publicly observable (e.g., a
suit, an evening dress, a hair cut), the consumer is likely to be choosy.
When a consumer shops around, she may not necessarily buy a product right now. She
may simply be gathering information which she may use later. Even when she is ready to
make a purchase, she has usually made a decision about the product category, but not a
specific brand.
Categories of shopping products: Shopping products may be placed in two categories
based on the nature of the augmented product:
(i) Heterogeneous Shopping Products: Here, the actual product itself varies considerably, and
the consumer shops around until she finds one which she really likes. For example, when you
are trying to buy a jacket, you may have to look around until you find one which fits you
perfectly.
(ii) Homogeneous Shopping Products: Many products such as appliances (e.g., vacuum cleaner,
refrigerator, sewing machine, microwave oven) are standardized products, but the price (and
availability) may vary considerably from store to store. Here also the consumer is likely to
shop around for the best price.
Issues Regarding Shopping Products:
(a) The manufacturer’s point of view: The manufacturer usually limits distribution,
especially if the product has a high quality image (e.g., Sony TV or IBM personal computer).

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This has the following advantages:

1. The manufacturer is not hurt by limited distribution since the consumer will
look around.

2. The cost of distribution is lower as a smaller number of retail outlets need to


served.

3. As there are fewer retailers selling the product, there is a smaller chance that
they will engage in price competition. [Price competition among retailers lowers
the price the consumer pays, and it eventually lowers the profit of the manufacturer
as he must now sell the product at a lower price to all retailers.]

4. Limiting distribution allows the manufacturer to be selective. For example, a


marketer of a high quality product like Sony TV may like to avoid retailers who
will not provide adequate customer service or engage in loss leader pricing, i.e.,
selling the product at or below cost to attract customers to the store (this will
result in intense price competition among retailers and hurt the manufacturer).
For example, Compaq, a maker of high quality personal computers, at one time
only distributed its products through retailers who have salespeople with special
training about Compaq products.

5. If the manufacturer tries to get wider distribution, higher quality retailers may
drop the product.

(b) The importance of the retailer: When a shopping product is involved, a consumer
has usually made a decision about the product category but not the specific product. She is
therefore likely to choose retail outlets to visit where she thinks she will find the product she
wants. The manufacturer must therefore place its product at the right kind of outlet, and
store image becomes very important.
(c) The sharing of promotional costs: Due to limited distribution, the retailer directly
benefits from promotion. Thus, promotional costs are often shared between the manufacturer
and the retailer. This mechanism has a name: co-operative advertising (also called co-op
advertising).
(d) Formation of clusters of retailers: The retailer of shopping products (in particular
heterogeneous products) recognizes that it must provide the consumer enough choice. Some-
times small retailers accomplish that by forming a cluster where the consumer will find enough
variety. You observe this phenomenon in shopping malls where retailers of apparel are often
located next to one another. Here, the retailers forming the cluster are jointly offering a
prospective customer a reason to visit that location.
6.2.3 Specialty products: Examples include collectors’ items, products with unique features
etc.

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Key characteristic: The consumer thinks that the product is unique and therefore does not
consider a substitute acceptable. As a result, price and availability are not very important
and consumers will wait for a specific product. For example, a consumer who has made a
decision to attend a performance by the New York Metropolitan Opera is unlikely to go to
concert by Britney Spears instead.
Note: A specialty product does not always have to be costly. For example, a person may
drive a long distance to buy muffins from a bakery which she really likes.
6.2.4 Unsought products: These fall in two categories:
(a) New products that the consumer is not yet aware of. Most new products start out as
unsought products because the potential customers do not know the benefits of using the
product. For example, customers were slow to accept products like instant coffee and main
frame computers. In this case, the marketers must educate the potential customers about
potential benefits. IBM had to perform extensive personal selling to show businesses how a
main frame computer can improve business productivity.
(b) Products that consumers do not want to think about. Examples include funeral plots and
life insurance. As the selling task is difficult, businesses often have to work hard to motivate
their salespeople. For example, insurance companies sometimes pay up to a 60% commission
rate for the sales of whole life insurance policies.

6.3 Branding

6.3.1 Introduction: A brand is a name, term, symbol, design, or a combination that iden-
tifies a seller’s products and differentiates them from competitors’ products. The following
terms are useful.
Brand-name: This is the part of a brand that can be spoken, including letters, words, and
numbers. It identifies a product or a group of products and sometimes applies to a product
line, e.g., Honda Civic, Accord, Prelude.
Objective of Branding: Differentiate your product. Make it more than a commodity (e.g.,
Gold Medal flour, Morton salt, Weaver chicken).
Importance of branding:
1. Source of information for consumers: reduces information search by acting as surrogate for
detailed attribute information.
2. Makes it easy for consumers to identify goods or services.
3. Helps differentiate product from competitors’ products. This may reduce price sensitivity
of the consumer.
4. Branding can be helpful when introducing a new product as it reduces market development

95
costs by reducing the cost of promotion and distribution. For instance, that is extremely
useful for short lived products like designer clothes and toys.
Note: To use branding effectively, the marketer should be able to promote the brand and
also maintain a consistent quality of output. When these are not possible, branding may not
be used.
6.3.2 Family versus Individual Branding
A) Family Branding: Grouping many products under one brand name, e.g., Singer sewing
machines, Frigidaire appliances, Revlon beauty products, or Fisher Price toys. This is very
useful when the product line is constantly changing and any given product has a short life
span (e.g. designer clothes). Family branding may come at three levels:

(1) Same family name for all products offered by the company. Examples include
Fisher Price toys, Liz Claybourne fashion clothes, and Revlon cosmetics. What
do these products have in common?

(2) Family name plus an individual name, such as Toyota Camry and Honda Civic.
The family name conveys the shared properties of the brands (such as reliability)
while the individual name signifies specific aspects of a given brand (such as size).
This strategy is used extensively by car manufacturers.

(3) Groups of products, each with a different family name. For example, the US
retail giant SEARS uses the Kenmore name for its “white” appliances (refrigerator,
washing machine, etc.), and the Kraftsman name for its tools.

Possible benefits of family branding:

1. Advertising and promotion may help all products.


2. New product introduction is easier to accomplish.

Possible problems of family branding:

1. Any negative publicity (such as product failure) is also shared by all products
with the family name.

2. Need to make sure the family name has a consistent meaning. If you give the
same family name to two totally different products with nothing in common (such
as: perfume and chewing tobacco, or health food and cigarettes), the family name
will not convey any useful information to the customer.

3. If you market competing products, the customer may think they are close
substitutes. This may result in cannibalization, that is, your products eating up
each other’s market share.

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Usually, a new product is included in the “family” if any of the following holds:

1) The new product is a small variation of an old product, or, even if that is not
true, it is closely related to the family (e.g., GM auto parts are related to the GM
cars).

2) The introduction of the new product may enhance the image of the entire family.
For example, the introduction of the Athlon chip which performed better than
earlier versions of Intel Pentium chip has established AMD as a strong contender
in the chip market.

In addition, the new product is typically given the family name when there is little
risk of damaging the family name from doing that (e.g., when a new medicine
results in deaths).

B) Individual Branding: Using different brand names for different products. This is clearly
more costly than family branding as each product needs to be promoted individually. When
is that justified?
Some reasons to use it:

1. Avoid cannibalization: Less chance that consumers will think that the new
brand is a ‘new improved’ version of an old brand. Better chance that users of
competitors’ brands will switch to the new product. This is particularly relevant
when your company offers several products to the same market segment, and that
may be the reason why P & G uses individual branding exclusively.

2. To make sure the failure of one product will not harm other products.

3. The products are very different from one another or are aimed at very differ-
ent customer groups. Thus, no consistent image will be presented by using the
same brand name (e.g., if Skoal, the makers of chewing tobacco, decides to make
expensive perfumes). Parker, the makers of writing equipment, had this problem
as it marketed pens ranging from $2/unit “jotters” to fountain pens with price of
over $500. Thus, just the name Parker had little meaning to a consumer. Levi
Strauss, the makers of blue jeans, also markets a line of expensive formal clothing
called “Oxford.” It never promotes the fact that these products are marketed by
the same entity.

6.3.3 Brand Loyalty: You come across this term frequently when you read the marketing
literature. Brand loyalty is defined as a consistent preference for one brand over others.
Basically, it is the tendency of a customer to intentionally purchase a product repeatedly.
(Similar concepts: Store loyalty, product category loyalty).

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Some reasons why brand loyalty may exist:
1. Trying a new brand may involve risk. For example, people often do not like to switch
medicines they take for headaches or cold. Tylenol uses this fear as the basis of its ad theme:
“Recommended by physicians.”
2. Sunk investment plus alternatives are perceived to be similar. In this case, consumers see
little reason to make the effort needed to switch. For example, people rarely switch banks.
As a result, banks promote heavily to new arrivals in town (e.g., newly recruited professors
at SU) who have not yet attached themselves to particular banks.
3. Strong emotional involvement e.g., Coke, political party, school.
There is no universally accepted method to quantify brand loyalty. Some of the alternatives
marketers use to quantify brand loyalty are as follows:
1. Analyze pattern of purchases relative to competition. The objective here is to determine
the probability that a person will purchase a brand in the future. The probability is the
measure of brand loyalty. For example, if it equals 1, we know that the person will never
switch. A crude measure of this probability is the percentage of times the brand is purchased,
which can be computed easily from purchase data.
2. Ask a customer how much more money he would pay for a given brand compared an
alternative, or, equivalently, how much price cut by the competition would make him switch
(this is called the “dollar-metric”). This is particularly useful to a marketer as it tells him
how much of a price cut will be needed to induce a product switch.
Comparison: Method 1 uses data on past purchases alone and cannot measure underlying
likes/dislikes of a consumer. In contrast, method 2 directly questions respondents, and can
suffer from biased answers.
Note: Brand loyalty can be a basis for consumer segmentation as marketers often use sales,
coupons etc. to attract the switching segment.

6.4 Product Life Cycle

Terminology
Primary demand: demand for product category.
Selective demand: demand for a specific brand within the category.
The four stages of the life cycle listed below hold for a product class. We now consider the
transition of a new product through the four stages of its life cycle.
1. Introduction/Market Development
Characteristic: Most new products start out as unsought products as the consumers have not
yet grasped the nature of the benefit it will provide.

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−→ Consumer awareness is low. Competitors are waiting.
Pioneer’s objectives: Get consumers to try product and stores to carry it −→ Need to gen-
erate primary demand for the product. Need to promote the product to both consumers and
channels of distribution. Need to develop proper marketing mix with strategic goals.
Length of Stage: Depends on (i) complexity, (ii) perceived risk due to newness, (iii) ability to
satisfy consumer needs, and (iv) presence of substitutes and the level of consumers’ satisfaction
with the substitutes.
Some courses of action:

• A small number of innovators will try it first. It is crucial that they like it −→ The
marketer must make sure that the product is used properly. For example, if it is an
appliance, technical support should be provided. Any problems should be corrected
quickly. Strict quality control is needed, specially if the product is heavily promoted (a
big reason for the failure of Edsel was due to the fact that it was so heavily promoted
that its quality problems also received a lot of publicity).

• At this stage, heavy promotion is usually needed directed at both resellers and the ul-
timate customers of the product. Sometimes it makes sense to cooperate with other
organizations to develop the market (e.g., RCA shared its technology with other manu-
facturers to help develop the market for color television sets).

• Need to provide incentives to dealers to carry the product and promote it if necessary.
This strategy of providing incentives to marketing intermediaries (e.g., retailers) is called
a push strategy.

• The specific nature of promotion that should be adopted in the introductory stage
depends on the nature of the product. For products with a high unit price, personal
selling with a knowledgeable salesforce is appropriate. IBM used this method to educate
potential customers about the benefits of using a main frame computer. For medium
priced appliances, dealers are often offered incentives to promote the product to the
consumers. For low unit price consumer products, coupons and mass advertising are
effective mechanisms to induce trial.

Sales: During the introductory stage, sales are slow. If the product is successful, there is a
gradual rise of sales.
Profits: Usually negative due to heavy costs of research & development and promotion to
both consumers and channels of distribution. Lack of experience and inability to have economy
of scale drives up cost of production.
2. Growth

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Basic Characteristic: At this stage, many consumers are aware of the product, and as they
want the product, retailers carry it in self interest. In marketing terminology, we say that de-
mand now pulls the product. The product is now widely available. At this stage, competitors
are assured of the demand for the product category and enter the market. As a result, the
focus of promotion shifts to generating selective demand, i.e., the demand for your specific
product.
Pioneer’s problem: Get consumers to prefer product compared to what the competition offers
in order to reduce competitive pressure.
Usual Strategy of pioneer: Differentiate product. This reduces the need for price competition.
Note: While it is usually possible to avoid head on competition by differentiating product,
there are cases when you cannot avoid it even during growth. That happened in the market for
VCR’s where the format (VHS) with the larger market share became the industry standard.
Sales: Accelerates, i.e., the rate of increase itself increases. The experience curve phenomenon
and economy of scale (see Sections 6.6 and 6.8 of the Reader) jointly reduce the cost of
production and distribution.
Profit: Increases at first, then tends to be flat as prices come down to reflect the increase in
competition.
3. Maturity
Basic characteristics: High consumer awareness. Intense competition, including generic prod-
ucts. As a result, the margin of profit is low and marginal competitors drop out (the so called
“shake out” phenomenon).
Strategy : Product differentiation and heavy promotion to support it. Price competition can
no longer be avoided, and we observe a high degree of tactical price competition in the form
of temporary price cuts, coupons, etc.
Sales: Demand for product category is now at its highest point.
Costs: The marginal cost of production is at the lowest point.
Profit: Due to competition, prices drop close to the marginal cost of producing and selling
the product. Due to the lowered profit margins, profits gradually decline.
4. Decline
Basic Characteristics: Demand declines, usually due to the introduction of a superior substi-
tute. Intense price competition. More competitors drop out.
Some Strategies for the product line:

• Retrenchment: This is similar to concentrated marketing. The marketer drops some


products and focuses on specific markets.

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• Harvesting: The marketer does not reinvest in the product. The revenue generated is
invested in other businesses. This is a phased withdrawal strategy.

• Consolidate: This is adopted by the stronger competitors. The idea is to capture the
small market as competitors drop out.

Enlightened Strategy (during maturity or decline): Extend Product Life Cycle

• Find new users for product.

• Find new uses for product.

• Increase product usage by the existing customers.

• Modify product.

• Add new channels of distribution.

Examples: (i) Classic movies are sold in videotapes.


(ii) Arm & Hammer Baking Soda → (a) Baking agent, (b) antacid, (c) refrigerator deodorizer,
(d) carpet deodorizer, (e) toothpaste.
(iii) Selling cigarettes through vending machines and offering evening MBA programs.
Marketers also sometimes try to extend product life cycle by adopting short term survival
strategies such as pricing below the market and offering dramatic guarantees. However, these
tactics rarely work in the long run as competitors can copy them easily.
Some topics related to product life cycles:
1. Fashion, fad, and hype curve: When we discussed the product life cycle, we addressed
the case of regular products which replace an inferior substitute and are eventually replaced
by superior alternatives. There are three exceptions to the usual product life cycle called
fashion, fad, and hype curve (saddle).
Fashion: A fashion is a style (e.g., that of apparel, automobiles) that is popularly accepted
and purchased by people over a reasonably long period of time. After that, it slowly dies out
only to reappear after some time. Fashions (i.e., people’s preference for a given style) change
constantly but follow a cyclic pattern. We observe a fashion cycle in product categories where
a customer wants something different, but not too different from others. For example, for
cars, there is a cycle as the shape of the car oscillates between square and rounded.
Fad: A fad is a product with a novelty feature which enjoys meteoric success only to die out
quickly. Unlike fashions, fads have a one time life, and they do not follow a gradual life cycle
like regular products.
Hype Curve: The hype curve, also called a saddle, occurs when the demand for the product
first drops, but then the product gets a second life and a higher peak sales compared to the

101
first time. This may happen if there are two groups of customers, one group sensitive to
indirect network externality (availability of other products to use with this product), and the
other group is not. The insensitive customers buy immediately, giving the first peak. The
sensitive customers wait for the contingent products to arrive and produce the second peak.
2. Planned Obsolescence → Strategy of making your own product obsolete by replacing
it with another product marketed by you.
Types of planned obsolescence:
1. Technological obsolescence (also called Functional Obsolescence): Replace your old
product by a superior product. This is very common in high technology industries. It helps
establish the reputation of an organization as a leader in research and development and allows
it to charge a premium price. For example, Intel Pentium and Hewlett Packard LaserJet 4
were vastly superior to the previous generation of products offered by the same companies.
These products allowed Intel and HP to move far ahead of the “clones.” Other organizations
have also successfully adopted this strategy. Sun (manufacturer of computer work stations)
follows a principle of doubling the computing speed of its products every year.
2. Fashion Obsolescence: Make superficial changes to make the old product out of fashion.
This is used extensively by fashion designers, and to some extent by text book publishers. At
one time, American car manufacturers also followed that strategy; competition from foreign
cars has made that impossible now.
When the strategy of planned obsolescence is criticized, the target is usually fashion ob-
solescence since it does not provide any tangible benefit to the customer.

6.5 Product features that affect rate of new product adoption

The following are the major factors that determine whether a new product will be adopted at
all, and the speed of adoption if it is adopted:
1. Relative advantage
This has several important implications:

• If the advantage is in superiority in some aspect of functionality, then the marketer may
position the product as different from product class, or even replacement for product
class. Usually the product is offered at a premium price. This corresponds to the Point
of Difference (POD) strategy. Example: Claritin.

• If the advantage is in lower price, the similarity to product category is stressed. This
corresponds to the Point of Parity strategy.

• By making an itemized list of advantages and disadvantages relative to existing products


and asking customers how much value they assign to each item, the marketer can set

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an appropriate price for the new product. This is particularly important for a radically
new product. (Even when a product is radically new, something else is attempting to
fulfill the same customer needs and has a price. That price is the starting point.)

2. Compatibility
There can be different dimensions of compatibility. Examples include:

• Compatibility with beliefs (religious, political)

• Compatibility with way of life. This can be very basic. A keypad where letters are
arranged alphabetically was not accepted because consumers were not used to it. The
metric system was never accepted in the USA.

• Compatibility with products already owned. For example, a new software will be
adopted more quickly if it can be used with existing hardware.

3. Complexity: Clearly, customers are less likely to adopt a more complex product. To counter
this problem, the marketer has to educate the customer to use the product, and provide after
sales service.
4. Trialability: Can you try out the product in small quantities? Can you lease the product
for a limited time?
5. Observability: Is it easy to see the benefits of using the product? Is it easy to communicate
the benefits of using the product?

6.6 Strategic Planning and Boston Consulting Group (BCG) Mar-


ket Growth/Market Share Matrix

6.6.1 Introduction
Many organizations market a wide range of products which are not always closely related.
For example, the Altria group markets products ranging from cheese to tobacco. This phe-
nomenon has occurred due to large scale mergers and acquisitions of the 1980’s which took
place based on financial rather than marketing considerations. To manage a broad array of
products, it is useful to group your products into “strategic business units” or SBU-s.
A strategic business unit represents a grouping of one ore more related products or busi-
nesses within a multi-product firm with specific managers, resources, objectives and competi-
tors. It is formally defined as a unit of the company that has a separate mission and objectives
and that can be planned independently from other company businesses. An SBU can be a
company division, a product line within a division, or sometimes a single product or brand.
Dividing products into SBU-s provides better knowledge of the market and flexibility to
act when presented with threats or opportunities. Thus, any organization can be thought of

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as a portfolio of SBU-s. A given SBU may be a single product or a group of closely related
products in the same market. A popular approach to the management of SBU-s is the “market
growth/market share matrix” introduced by the Boston Consulting Group (commonly known
as BCG) in the 1970-s. This method categorizes SBU-s according to two criteria:

(1) The rate at which the market is growing. Typically, if this rate exceeds 10%
per year, then it is considered high. Otherwise it is called low. In my class, I will
use the 10% cut-off (over 10% is high, 10% or below is low.)

(2) The relative market share of the SBU in that market. This expresses the market
share of your SBU as a multiple of the market share of the largest competitor in
the market. For example, if your SBU has a 20% market share and the largest
20%
competitor has a 50% market share, then your relative market share is = 0.4.
50%
In contrast, if your SBU has the largest market share of 20% and your largest
20%
competitor has a market share of 10%, then your relative market share is = 2.
10%
Relative market share is considered high if it exceeds 1 (that is, you have a larger
market share than any competitor), and is considered low otherwise.

Based on this approach, SBU-s of a firm are placed in four categories:

1. Star: High market growth rate, high relative market share.

2. Question Mark: High market growth rate, low relative market share.

3. Cash Cow: Low market growth rate, high relative market share.

4. Dog: Low market growth rate, low relative market share.

The BCG recommends that firms should strive to achieve a portfolio consisting of both
stars (for success and even survival in the long run) and cash cows (for cash generation at
present). Dogs should be discarded. Regarding a “question mark,” the BCG recommends
careful evaluation regarding whether it can be converted into a star. If yes, then money
generated by cash cows should be used for that purpose; otherwise, it should be discarded.

6.6.2 Logic of the BCG Approach

The BCG approach selects the two dimensions of market growth rate and relative market
share for the following reasons:
Market Growth Rate: It is desirable to operate in a high growth market to ensure the
future success of the organization. In general, it is risky to rely only on SBU-s in low growth
markets because of the existence of the product life cycle phenomenon that product categories
pass through four distinct stages: introduction/market development, growth, maturity, and

104
decline. Low growth markets generally occur for mature product categories which only grow
at the rate of the population growth. While many mature product categories have existed for a
long time (e.g., vehicles with internal combustion engines, audio speakers, washing machines),
demand can decline sharply if a superior alternative is introduced to the market. For example,
record players were replaced rapidly by compact disc players.
Operating in a high growth market has two other advantages. First, during growth, there is
usually ample scope for product differentiation, and head to head competition can be avoided.
Also, as the market is growing, sales increase even when market share remains the same.
However, operating in a high growth market is often costly as an organization requires
resources to maintain or increase its market share. Typically, a market grows fast when new
customers start using a product, or new uses are found for an existing product. Either way,
marketers need to generate primary demand for the product category by educating potential
customers, which is an expensive proposition. Thus, a firm usually enters high growth markets
for the sake of future and not present profits.
Relative Market Share: In contrast to the desirability of high market growth rate
which comes from product life cycle considerations, the desirability of high relative market
share arises from two considerations: cost, and network externality.
Cost: This is driven by two factors:
(1) Economy of Scale: Economy of scale represents the fact that if you sell a larger quantity
of a product, the cost/unit usually drops. The simple accounting explanation is that a fixed
overhead is spread across a larger number of units produced, thereby reducing the average
cost of a unit produced. However, economy of scale may happen due to many other factors.
Some of them are as follows. First, if you are producing larger quantities of a product, the
process of production is usually more efficient, which reduces the average cost of producing a
unit of the product. Second, as you now need larger quantities of raw materials, you get better
prices from your suppliers. Finally, you can distribute the product at a lower cost when you
ship out larger quantities. For example, railroads charge you less per unit shipped if you make
shipments in “carload amounts” (c.l.) rather than in “less than carload” (l.c.l.) amounts.
While economy of scale effects are observed widely, there are cases where you may not
find it. An example is when to increase production, you need scarce resources, which may
include skilled labor. Then, a higher production rate leads to higher prices of such resources,
eliminating the economy of scale. Another example is when more production means you have
to pay overtime wages to the labor force, which is usually more expensive than regular wages.
(2) Experience Curve: This concept was popularized in the 1970’s by the BCG, and is based
on the proposition, supported by data from several industries (e.g., the electronics industry),
that the cost of producing a unit of a product drops by a fixed percentage every time the
cumulative volume of production doubles.
For example, suppose the cost of producing a unit of a computer chip drops by 10 % each
time cumulative production doubles, and the cost is $100/unit after 1000 units are produced.

105
Then, the cost/unit will be $90 after 2000 units are produced, $81 (i.e., 90% of $90) after
4000 units are produced, $72.90 (i.e., 90% of $81) after 8000 units are produced, etc.
While the experience curve phenomenon is a very important finding in business manage-
ment, we should be careful when we use it. Clearly, as you produce more units of a product,
you will identify sources of inefficiency in production and find ways to eliminate them. How-
ever, there are two reasons I feel the approach is somewhat simplistic. First, the experience
curve approach implies that cost goes down indefinitely as cumulative volume increases. That
would not happen if the cost of the raw materials used is significant. However, if you consider
only the production cost, it is more likely to occur. Second, the drop in cost of producing a
unit of a product should depend on “research and development” (R & D) expenditure, which
the BCG model does not consider.
Note that economy of scale deals with the rate of production, while experience curve
phenomenon deals with cumulative production.
To summarize, note that if an SBU has a relative market share greater than 1 (i.e., the
largest market share), it has a cost advantage over its competition due to economy of scale.
This advantage grows with time due to the experience curve phenomenon as the company
selling more also has higher cumulative production. An SBU with a high relative market
share therefore has a sustained cost advantage over the competition which it can use to either
increase its profits, or to squeeze out marginal competitors by reducing price.

Network Externality: In addition to cost considerations, high relative market share is some-
times desirable due to the presence of a phenomenon called network externality. Network
externality was first observed in network products such as telephone service and the internet,
and it takes two forms:

(1) Direct Network Externality: Sometimes, the value of a brand increases if more people use
the brand. For example, the value of the word processor Microsoft Word is greater because it
is used by more people. Thus, if you write a report on Word, you are fairly certain others can
read it also. Note that if a brand has greater market share, it has greater value due to direct
network externality.

(2) Indirect Network Externality: This refers to the availability of contingent products that can
be used with your brand. There are many products which are of value only if used with other
(contingent) products. For example, the value of a personal computer derives from the software
that can be used with it, and the value of a video game system (e.g., Playstation 3) depends
on the number of game titles developed for it. Different machines in a product category often
use different and incompatible formats (e.g., video game systems offered by Nintendo and
Sony). The developers of contingent products are naturally attracted to formats with larger
market shares as they represent greater demand potential. Thus, the formats with larger
market shares gain value through greater availability of contingent products, and formats
with smaller market shares often fail. Such failures include the technologically superior Beta
format video cassette recorders which were eliminated by the VHS format machines.

106
Overall BCG Recommendations: The BCG approach recommends that an organization
must balance the cash flow among its SBU’s and eliminate entities which do not help the
process. Specifically:

(1) Dogs should be discarded.

(2) Stars are needed for long term success of the organization. However, stars
require a large promotional effort to retain market share. This should be done by
using the cash generated by cash cows.

(3) Question marks should be evaluated closely. If they can be made into stars,
then the cash generated by cash cows should be used to do that. Otherwise, they
should be discarded.

6.6.3 Limitations of the BCG Approach

The BCG approach remains popular, partly due to the simplicity of its ideas. However, it
has some limitations:
1. It is not clear how a market is to be defined. Consequently, managers have been known to
define their markets in a such a way that the relative market share looks high, thus making a
case against the elimination of her/his brand.
2. The model ignores the possibility of the existence of synergy within a product line. A firm
may find it necessary to keep a “dog” even when it loses money on it. For example, beer
manufacturers often hold on to low- alcohol products simply to prove that they are socially
responsible marketer, thereby defending itself against possible attacks on the other products
they offer.

6.7 Appendix: Practice Problem on BCG Market Growth/Market


Share Matrix
Acme Company has four strategic business units: (1) lap top computers, (2) color printers,
(3) fax machines, and (4) digital cameras. The markets of the four strategic business units
are as follows:
(1) Lap top computer market: The market is growing 20% annually. Acme has a market share
of 30%. The market shares of its competitors are: Dell: 20%, HP: 15%, IBM: 15%. The other
competitors all have market shares less than 5%.
(2) Color printers: The market is growing 20% annually. Acme has a market share of 18%. The
market shares of its competitors are: HP: 30%, Canon: 20%, Epson: 10%. Other competitors
all have market shares less than 10%.

107
(3) Fax machines: The market is growing 2% annually. Acme has a market share of 15%.
The market shares of its competitors are: Sharp: 20%, HP: 15%. Other competitors all have
market shares less than 10%.
(4) Digital cameras: The market is growing 25% annually. Acme has a 15% market share.
The market shares of its competitors are: Olympus: 12%, Canon: 10%, Kodak: 10%, HP:
10%, Microsoft: 8%. Other competitors all have market shares less than 5%.
Questions:
(i) Using the BCG growth/share matrix approach, how would you categorize the four strategic
business units of Acme Company? (Show details of work)
(ii) Using the BCG approach, what action should Acme take for each SBU? Describe the logic
behind these recommendations.
(iii) Consider the portfolio Acme would get if it follows BCG recommendations. Is this port-
folio satisfactory? Clearly state yes or no and briefly discuss why you say so. If no, what type
of SBU should Acme try to add to its portfolio to balance it?

6.8 Appendix: Hypothetical Example of Experience Curve Effect


According to the experience curve effect, the marginal cost of producing one more unit of the
product drops by the same percentage whenever cumulative production doubles. Formally,
the marginal cost C of producing another unit of the product after a cumulative production
of Q units can be expressed as:
Q −η
C = C0 ∗ ( ) ,
Q0
where η is a fixed positive number, and C0 is the marginal cost after a cumulative production
of Q0 units. A larger η represents a sharper experience curve. Examples of how fast marginal
cost drops for different values of η are shown below, beginning with a marginal cost of $100
after a cumulative production of 1000 units.
Cumulative Production Marginal Cost Marginal Cost Marginal Cost
if η = 0.152 if η = 0.235 if η = 0.322
1000 $100.00 $100.00 $100.00
2000 $90.00 $85.00 $80.00
4000 $81.00 $72.25 $64.00
8000 $72.90 $61.41 $51.20
16,000 $65.61 $52.20 $40.96

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7 Selected Topics on Pricing Strategy

7.1 Introduction and Notations


In this section, we discuss the basic ideas and terms related to pricing. Here, we ignore any
price modifications such as discounts, and focus on the basic price of the product. We also
make simplifying assumptions about the costs of marketing.
7.1.1 Notations:
1. P = price/unit
2. Q = number of units sold
3. Revenue = P ∗ Q. This is the dollar sales.
4. Total Cost is given by:

(7.1) Total Cost = Total Fixed Cost + Total Variable Cost = F C + (V C ∗ Q),

where:

• F C = total fixed cost (does not depend on Q)

• V C = unit variable cost.

5. Unit gross margin = P − V C.


6. Contribution to profit = (P − V C) ∗ Q.
P −VC
7. Profit Volume Ratio (P V ratio, or simply P V ) = .
P
Note that
P −VC
Contribution to Profit = (P − V C) ∗ Q = ∗ (P ∗ Q) = P V ratio ∗ Revenue.
P
Thus, the P V ratio represents the fraction of revenue that becomes contribution to profit.
1
The inverse of the P V ratio, , gives the dollar sales required to generate one dollar of
PV
contribution to profit.
8. Profit, denoted by Π, is given by:

(6.2) Profit (Π) = Revenue − Total Cost = P ∗ Q − {F C + (V C ∗ Q)}

= (P − V C) ∗ Q − F C = Contribution to Profit − Total Fixed Cost.

Example: Suppose you are a retailer selling shirts. You buy shirts at $10/unit from a
manufacturer, and you sell them for $15/unit to the customer. You buy only as many shirts

109
as you sell. You pay $2000 as rent and utilities for your store. You have no other costs.
Currently you sell 1000 shirts.
In this case:

• P = 15, Q = 1000, F C = 2000, and V C = 10.

• Revenue is given by P ∗ Q = 15 × 1000 = $15,000.

• Unit gross margin is given by P − V C = 15 − 10 = $5.


15 − 10 5 1 1
• P V ratio = = = . Thus, for every dollar of sales revenue, dollars
15 15 3 3
1
become contribution to profit. Also, = 3, that is you need $3 of revenue to get $1
PV
of contribution to profit.

• Total Cost = F C + (V C ∗ Q) = 2000 + (10 × 1000) = $12,000.

• Contribution to Profit = (P − V C) ∗ Q = (15 − 10) ∗ 1000 = $5000.

• Profit = (P − V C) ∗ Q − F C = (15 − 10) × 1000 − 2000 = $3000.

7.1.2 Break-Even Analysis: Assume that price exceeds unit variable cost (P > V C). If
Q = 0, then profit = −F C. As Q increases from 0, profit increases from −F C. When the
contribution to profit is equal to F C, we achieve the “break-even point” where the profit is
zero, and the fixed cost has been exactly recovered. If sales exceed the break-even point,
additional sales generate positive profits at the rate of P V dollars for each dollar of additional
sales revenue.
We call the number of units sold at the break-even point the Break Even Quantity
(BEQ). This is given by:
FC
BEQ = .
(P − V C)
If Q exceeds BEQ, you have a positive profit. If Q is below the BEQ, you lose money. If
Q = BEQ, there is neither profit nor loss: you have broken even. The break-even point in
FC
dollars, that is, the revenue that you need to break-even is given by .
PV
Example: Suppose you sell shirts, your F C = 2000, V C = 10, and P = 15. In this case,
FC 2000
BEQ = = = 400,
P −VC 15 − 10
that is, you need to sell 400 shirts to achieve break-even.
7.1.3 Note:
1. Usually, the total fixed cost represents expenditure on machines needed for production,
advertising, etc, and the variable cost represents the expenditure on labor, raw material
purchase, supplies, etc. However, depending on the specific situation, these can change.

110
In a heavily unionized industry, labor costs may become fixed, regardless of the level of
production or sales. Similarly, as demand increases, a firm may need to rent additional
equipment to increase production, that is, equipment costs may change if production exceeds
current capacity.

2. Unless otherwise stated, we assume that the unit variable cost (V C) is constant for all
values of Q. That assumption is not always correct. For example, if the marketer receives
quantity discounts on the purchase of raw materials, V C is lower if Q is higher. The same
happens (V C lower if Q higher) if large-scale production corresponds the use of more efficient
technology. On the other hand, if large Qrequires second-shift production and overtime wages,
V C may be larger when Q is large.

7.2 Demand and Own Price Elasticity of Demand

7.2.1 Primary and Selective Demand: The demand for a product arises from the need
customers feel for a product. A customer makes the following decisions:

(1) Whether to buy a product from the product category at all? For example, should she
purchase an MP3 player? If the product is a necessity of life, a purchase is likely to occur.

(2) If a purchase is to be made, which one of the product alternatives to purchase? If the
customer feels that many products fulfill similar needs, she is less likely to stay with the same
product regardless of price.

(3) How many product units to purchase?

The demand for a product category (e.g., MP3 player) is called primary demand for
the product. The demand for a specific alternative within the product category (e.g., Apple
iPOD) is called selective demand for that product alternative.

7.2.2 Normal and Inverse Demand Curves: When a customer purchases a unit of a
product, she gains the product unit in exchange for the price of the unit. The gain from
the product unit depends on the attributes of the product. Clearly, the customer buys the
product only if the gain from owning the product unit exceeds the price of the unit.
Clearly, the demand for a product depends on the price of the product as well as its
attribute values as perceived by the consumer. For a given product, we denote its demand in
number of units by Q(P ) if the unit price is P . Demand can be either normal or inverse.

Normal Demand: Usually, if P increases, Q(P ) decreases. This is called normal demand.
For a normal demand curve, the plot of Q(P ) against P is a downward sloping line like that
shown in Figure 7.1.

111
Q(P )
6

-
P
Figure 7.1: Normal Demand

Inverse Demand: If a customer cannot evaluate product attributes directly, she often uses
price as an indicator of product quality. Then, if the price is set too low, she may assume that
product quality is unacceptably low and decide not buy the product. When many customers
behave this way, we have inverse demand where the demand is lower if price is lower and
higher if price is higher.
Inverse demand may be observed experimentally by offering the same product at different
price levels to different market areas. Inverse demand is more likely to happen for products
like perfumes, fashion apparel, and jewelry, where product attributes are difficult to judge.
Inverse demand does not occur if customers are sophisticated enough to evaluate product
quality.
Even when inverse demand occurs, it is only present when price is low. When price is high,
we have normal demand once again (see Figure 7.2). Experienced marketers do not encounter
inverse demand because they set price at a level the customer considers appropriate for the
product offering. Because of that, in the discussions to follow, we assume that demand is
normal unless stated otherwise.
Q(P )
6
Inverse ¾ - Normal
Demand Demand

-
P
Figure 7.2

112
7.2.3 Own Price Elasticity of Demand: This term captures how the demand (in units)
of a product depends on P , the unit price of the product and is defined by:

% change in demand
(7.3) ² = Price Elasticity of Demand = ,
% change in product’s price

where:

New Price − Old Price


• % change in price = × 100%.
Old Price
New Demand − Old Demand
• % change in demand = × 100%.
Old Demand

P dQ d ln Q
(More formally, using calculus notations: ² = = )
Q dP d ln P
Example: Suppose you are a retailer selling shirts. If price/unit is $20, the demand is 1000
units. If the price is changed to $21, the demand becomes 800 units.
(21−20)
In this case, the % change in price = 20
× 100% = 5%.
The corresponding % change in demand = (800−1000)
1000
× 100% = −20%.
− 20%
Therefore, the price elasticity of demand, ² = = −4.
5%
Note:
(1) For a normal demand curve, the price elasticity of demand is negative, that is, an increase
in price leads to lower demand.
(2) Short Run versus Long Run Demands: Usually, when we talk about price elasticity
of demand, we mean short run price elasticity of demand which is computed based on the
immediate change in demand in response to a price change. Sometimes, the short run elasticity
differs from the long run elasticity. Typically this is a result of sunk investment. For example,
when oil prices rose sharply in the early 70’s, American customers were stuck with the cars
they had, and the consumption of gasoline dropped only slightly in the short run. However,
in the long run, customers switched to more fuel efficient cars, and gasoline consumption
dropped significantly.
7.2.4 Price Sensitivity of Demand: We now restrict our attention to normal demand,
that is, demand decreases if price increases, and vice versa (² < 0). For normal demand, we
call |²|, the absolute value of price elasticity, the price sensitivity of demand, and denote it
by the symbol E. For example, if ² = −3, then E = 3. If E is greater, then demand falls
more sharply as price increases.
7.2.5 Relationship between Price Sensitivity and Revenue: We again assume normal
demand and that demand Q(P ) equals the number of units sold (Q), that is, there is no
unsatisfied demand. We now discuss how revenue (P ∗ Q) is affected by small changes in
price. Three cases are possible:

113
(1) If E < 1, a 1% increase in P leads to a less than 1% drop in Q. Similarly, a 1% drop in
P leads to a less than 1% increase in Q. Hence, revenue (P ∗ Q) increases if P increases, and
decreases if P decreases.
(2) If E = 1, a 1% increase in P is matched by a 1% drop in Q, and a 1% drop in P is matched
by a 1% rise in Q. Hence, the revenue (P ∗ Q) does not change if price varies slightly from
the current level.
(3) If E > 1, a 1% increase in P leads to a greater than 1% drop in Q, and 1% drop in P
leads to a greater than 1% rise in Q. Hence, revenue decreases in P increases, and increases
if P decreases.
Inelastic Demand: If E ≤ 1 (cases 1 and 2), revenue either remains the same or increases
if price increases. This is called inelastic demand.
Elastic Demand: If E > 1 (case 3), revenue decreases if price increases, and increases if
price decreases. This is called elastic demand.
Practice Problem: Suppose P = 100 and Q = 1000.
(a) Compute the revenue at the present price.
(b) Find the revenue if P = 101 for each of the following values of E:
(1) E = .5
(2) E = 1.0
(3) E = 2.0
(4) E = 4.0
7.2.6 Relationship between price sensitivity and profit: We again assume that demand
is normal and that there is no unsatisfied demand (Q(P ) = Q). From Section 1.1, Profit (Π)
is defined as:
Π = (P − V C) ∗ Q − F C.

In the expression for profit, only the term (P − V C) ∗ Q, is affected by changes in P . In this
term (contribution to profit), both the factors (P − V C) and Q are affected by price.
Effect of price change on (P − V C): It can be easily shown that for every 1% increase in
1
P , the unit gross margin (P − V C) increases by %.
PV
[Example. Suppose P = 20, and V C = 10, i.e., (P − V C) = 10. In this case, P V =
20 − 10 1
= .5, i.e., = 2. Suppose now P has increased to 21, i.e., there is a 5% increase
20 PV
11 − 10
in P . (P − V C) has increased to 11, i.e., there is a × 100%, i.e., 10% increase in
10
(P − V C). This is 2 times 5%, the percent increase in P .]
Effect of price change on Q: From the definition of price sensitivity, for every 1% increase
in P , the demand Q decreases by E %.

114
Combining, if P changes, the change in profit depends on which percentage change is
1
greater, , or E. Three cases are possible:
PV
1
Case 1. E < PV
: In this case, an increase in price increases profit and a decrease in price
reduces profit.

Explanation: Note that a 1% increase in price leads to a P1V % increase in (P − V C) and an


E% drop in Q. As the % increase in (P − V C) here is more than the % drop in Q, the term
(P − V C) ∗ Q and hence profit increases.

1
Case 2. E = PV
: In this case, profit does not change if price changes by a small amount.

Case 3. E > P1V : In this case, a price increase results in lower profit, and a price reduction
leads to greater profit.

P −VC Q
6 6
¢
¢
¢
¢
¢

¢
¢ t
¢
¢
¢
¢
- -
P P

(P − V C)Q (P − V C)Q
6 6 1
E>
PV
1
E< t
PV

- -
P P

115
(P − V C)Q
6

1
E=
PV
t

-
P

Figure 7.3

Practice Problem: Suppose V C = 10, Q = 1000, and E = 3. If you want to maximize


profit, what, if anything, should you do at the following levels of price?
(1) P = 11
(2) P = 12
(3) P = 15
(4) P = 20
(5) P = 30
1
7.2.7 Profit Maximizing Price: From Section 7.2.6, you can see that unless E = , you
PV
1
can change price to increase profit. For example, if E > , you can decrease price and raise
PV
1
profit, and if E < , you can increase price and increase profit. It can be shown that profit
PV
is maximized if and only if:
1
(7.4) E = .
PV
Two cases are possible:
P −VC 1
Case 1: E ≤ 1: Note that for any P > V C, P V = < 1, that is, > 1. Thus,
P PV
1
if E ≤ 1, you always have E < and can raise price to increase profit. This can happen
PV
when an essential product is in short supply and can lead to price gouging.
Case 2: E > 1: If E > 1, equation (7.4) can be rewritten as:

E VC
(7.5) P ∗ = VC ∗ = VC + ,
E−1 E−1
116
where P ∗ is the profit-maximizing price. Thus, the profit maximizing price is given by
unit variable cost plus a mark-up that depends on E. If E is greater, the mark-up is smaller.
3
For example, suppose V C = 10. If E = 3, the profit maximizing price is 10 × = 15
3−1
(a 50% mark-up on variable cost). On the other hand, if E = 5, the profit maximizing price
6
is 10 × = 12 (a 20% mark-up on variable cost).
6−1

7.3 Factors That Affect Price Sensitivity


A customer has to decide whether she should buy the product at all (primary demand) and if
yes, which alternative she should choose (selective demand). A related decision is how many
units to buy. If she has many alternatives she finds similar, she will clearly avoid the more
costly ones. This helps explain how price sensitivity depends on the different factors we now
identify.
1. Price Relative to Purchasing Power: Usually, the price sensitivity of demand depends
on the level of the price itself. In fact, E remains the same for all values of P only for the
constant elasticity demand function discussed in Section 7.12.1.
The reason why price sensitivity depends on price level can be seen by considering the
price relative to the purchasing power of the customer. For example, suppose Sony offered
its Vaio notebook computer with 1 GB RAM and 100 GB hard drive to SU students for
$100/unit. Clearly, almost all students can afford to buy the product at both $100 and $110,
and a 10% price increase from $100 would have no effect on demand. On the other hand, if
these same machines were sold for $1500 each, a 10% increase in price to $1650 would have a
large impact on demand as many students who would buy the product at $1500 would switch
to a competing product or buy nothing at all.
Example of change in elasticity with price level: Consider the linear demand function:

Q = 20, 000 − 100 P.

We will show that the price elasticity of demand is different for P = 100 and P = 150.
(1) At P = 100, Q = 20, 000 − (100 × 100) = 10, 000.
If P is increased by 1%, i.e., set at $101, new Q = 20, 000 − (100 × 101) = 9900, that is, Q
changes by −1%. Therefore, at P = 100, ² = −1.
(ii) At P = 150, Q = 20, 000 − (100 × 150) = 5000.
If P is increased by 1%, i.e., set at $151.5, new Q = 20, 000 − (100 × 151.5) = 4850, i.e., Q
(4850 − 5000)
changes by × 100% = −3%. Therefore, if P = 150, ² = −3.
5000
2. Whether the product is considered a necessity or a luxury item: By definition,
a consumer does not have a substitute for an item she considers a necessity, e.g., heating fuel
during winter, or a pain reliever when she has a toothache. Clearly, the demand for necessities
will be relatively inelastic in price as the consumer cannot do without them, while she does

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not really need the luxury items and can postpone or avoid the purchase of them. These
arguments hold for the demand of product categories (primary demand).
If you consider the demand for specific brands (selective demand), the effect of price on
demand is less clear. A staple product like bread is usually a commodity, and the consumer
is likely to switch from brand to brand without hesitation. Thus, while the demand for the
product category, bread, may be inelastic in price, the demand for a specific brand (e.g.,
Wonder Bread) is likely to drop sharply if its marketer raises price unilaterally.
In contrast, luxury products (e.g., perfume, chocolate, stereo equipment) often exhibit high
degrees of product differentiation. Thus, once the consumer has decided to buy the product,
she may be less sensitive to price changes of a specific brand.
3. Awareness and availability of substitutes: If the consumers have many alternatives
which satisfy their needs, they are more likely to switch in response to a price increase. The
consumer’s price sensitivity therefore increases with an increase in the number of substitutes
and the consumers’ awareness of them.
3.(a) If a product has unique values/features, the consumers are less likely to find a close
substitute. As a result, increased product differentiation reduces price sensitivity.
Example: Decaffeinated coffee, lactose-free milk, organic vegetables.
3.(b) Price quality association usually comes with reduced price sensitivity. One possible
reason is risk aversion. We discuss this factor in more detail in the next section.
3.(c) If the alternatives are more difficult to compare (e.g., different cold remedies), consumers
are less price sensitive.
Note that here, lower price sensitivity is very similar to higher brand loyalty.
4. The size of expenditure involved for consumer:
4.(a) Shared Cost Effect: If somebody else pays partly or fully for the product purchase, the
consumer is likely to be less price sensitive.
Example: Patients covered by comprehensive health insurance purchasing medicine, business
travelers purchasing airline tickets.
Marketer’s Perspective: Since customers are not price sensitive, it is difficult to attract cus-
tomers by offering price cuts.
Possible Strategy: Give non-price incentives to customers for trying out product. For example,
a frequent flyer plan may attract the attention of business travelers.
4.(b) Heavy users are usually more price sensitive than light users of a product.
Possible Reasons: (i) Greater knowledge of alternatives. (ii) More suppliers compete for the
heavy users, thereby increasing the number of alternatives.
4.(c) If the product purchase is part of a larger purchase/expenditure, price sensitivity de-
creases. For example, if restaurants in New York City charged a higher price for food, the
price increase would be more likely to reduce local demand than demand from people coming
from out of town to spend the day in New York City.

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5. Consumer’s ability to take advantage of a lower price.
5.(a) Inventory Effect: If the product can be stored for future use, price sensitivity is greater.
For example, a person with a large house can take advantage of a sale price on breakfast
cereals more easily than a student who lives in a dormitory.
5.(b) Sunk Investment Effect: Many purchases are used in conjunction with assets bought
previously, e.g., toner cartridges with printers, refills with pens, etc. To the extent that the
investments in the printers, pens, etc., are sunk, the price sensitivity for the products used
with them is reduced.
Example: When gas prices went up in the early 1970’s, consumers were stuck with large cars.
In the short run, demand for gas dropped only slightly. However, in the long run, consumers
purchased more fuel efficient cars, and demand for gas dropped sharply.

7.4 Price Quality Relationships


When a consumer cannot judge a product completely in terms of its attribute levels, she uses
the price of the product as an indicator of quality. This is often the case for new products.
Because of this phenomenon, a marketer has to be very careful about setting the price of a
new product. For example, she may successfully introduce a product at a low price to get
market share. However, this may create an image of low quality, and if she subsequently tries
to raise the price, demand may drop sharply. Japanese auto makers have avoided this problem
by continuing to modify and improve their product offerings.
Marketers often create an impression of quality with higher prices. For example, faced
with competition (from Wolfschmidt), Smirnoff Vodka actually raised its price to set it apart.
Some reasons why this works:
(i) Buyers justify higher expenditure by believing that quality is higher.
(ii) Snob appeal: The purchase of a higher priced product allows the purchaser to separate
himself from the masses.
Example: High fashion, wine, perfume, jewelry.
(iii) Risk aversion, as customers assume a low price indicates low quality and do not want
to take a chance. (Example: Michelin ran an advertising campaign with theme “So much is
riding on your tires” stressing that one’s child is safer with Michelin.)

7.5 Basic Methods of Setting Price


In practice, the marketer rarely knows the exact relationship between demand and price. This
is the main reason why we have many different methods of setting the price of a product.
7.5.1 Price Determination in Economic Theory: This is the hypothetical ideal case
when the marketer can exactly quantify how demand depends on price. Since the marketer
produces and sells the exact number of units the consumers demand, Q, the quantity sold, is

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equal to demand. Standard economic theory assumes that the marketer sets price to maximize
profit. This is achieved when the marginal cost of making another unit of product is equal
to marginal revenue (incremental revenue from selling that additional unit of product). The
profit maximizing price is given by equation (7.4).
7.5.2 A Simple Version of Economic Theory: In practice, it is virtually impossible for
a marketer to know the exact relationship between Q and P . Still, a sophisticated marketer
usually knows price sensitivity (E) around the current level of price. Using this knowledge, she
can apply the results of Section 2.6 to make small adjustments in price to improve profitability:

1
• If E < , she can increase profit by increasing price.
PV
1
• If E > , she can increase profit by reducing price.
PV
1
• If E = , she should not change price; profit is already maximized.
PV

Example: Suppose you are selling shirts at $15/unit, and the variable cost is $10/unit.
1
Here, P V = (15−10)
15
= , i.e., P1V = 3.
3
In this case, unless E ≥ 3, an increase in price increases profit.
Important Note: The following results hold for the profit maximizing price:

• The profit maximizing price maximizes contribution to profit also.

• The profit maximizing price does not depend on fixed cost.

7.5.3 Cost Oriented Pricing: Usually a firm can reasonably estimate its costs, but cannot
estimate demand with precision. In that case, a cost oriented method is commonly used. I
give two examples of cost based pricing.
(1) Fixed Percentage Mark-Up Method: Retailers use this method quite often.
By definition, selling price, P = V C + Mark Up.
In the fixed percentage mark-up method, the mark up is set equal to a pre-specified fraction of
V C.
Example: Suppose V C = 10. If we use a mark-up equal to 20% of the variable cost, the
selling price P = 10 + 0.2 × 10 = 12.
(2) Target Profit Method: In this method, the marketer decides up front how much profit it
wants to make if it sells a given quantity of the product (number of units), Q.
Let ΠT denote the target profit. Then, we must have,

ΠT = (P − V C) ∗ Q − F C −→ (P − V C) ∗ Q = (ΠT + F C).

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Rewriting,
(ΠT + F C)
P = VC + .
Q
Note that here, the mark-up is inversely related to Q.
Example: Suppose you sell shirts. V C = 10, F C = 2000, and you want to make a profit of
$1000 by selling 2500 shirts.
(1000 + 2000)
Using the target profit method, P = 10 + = 11.20.
2500
Advantages of Cost Oriented Pricing:
1) Usually, it is possible to estimate costs.
2) Helps determine what levels of sales are needed for profitability.
3) If price is predetermined, tells a firm what the costs should be.
Disadvantages of Cost Oriented Pricing:
1) Assumes that the consumer demand is not be lower than the quantity the firm intends to
sell. Does not actively incorporate consumer preferences, competitive action, etc.
2) Sometimes it is very difficult to measure the cost of producing a product. Some reasons: (i)
The firm uses the same manufacturing facilities to produce multiple products, and the total
costs have to be allocated among the products. (ii) Costs change with experience and/or scale
of production. (iii) The costs of labor, raw materials, etc., fluctuate rapidly.
7.5.4 Competition Oriented Pricing:
1) Pricing to meet competition (Status Quo Pricing). This strategy is appropriate when
customers are very price sensitive, a situation often observed in mature product categories.
When a competitor changes price, a firm usually follows that price change. In practice, this
method is often used when the firm does not know the exact price sensitivity of demand but
feels that it is large. This is often the case when salespeople have the authority to modify
price. Product differentiation reduces the need to match price changes by the competition.
Advantage: This is a safe strategy.
2) Pricing above the competitive level. This is often associated with a prestige objective.
3. Pricing below the competitive level. Typically, this is the pricing strategy of a generic
product.
7.5.4 Psychological Pricing: This is a class of pricing techniques which includes odd-even
pricing and customary pricing. I discus it separately in section 7.7 of the Reader.
7.5.5 Value-Based Pricing: Here, the price is based on the product’s perceived value to
the consumer, including both benefits and risks. The value is based on the features of the
augmented product rather than the core product, and a firm can use the non price variables
in its marketing mix (e.g., advertising, packaging) to build up perceived value in the buyers’
minds.
To apply this method, the marketer begins with the price of an alternative product as a
reference point, and makes an itemized list of advantages and disadvantages of his own offering

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compared to this alternative. Survey research is used to determine how much monetary value
the customer places on each item. Adding these price modifications to the price of the reference
product, the marketer determines what price he should charge.
Example.2 Caterpillar Tractors: Price of tractor is $24,000. Price of competitor’s tractor is
$20,000. (These were the prices in the late 1970’s.)
Justification:
$20,000 = Competitor’s Price.
$ 3,000 = Price premium for superior durability.
$ 2,000 = Price premium for superior reliability.
$ 2,000 = Price premium for superior service.
$ 1,000 = Price premium for longer warranty on parts.
$28,000 = total value of package relative to competition
$ 4,000 = discount
$24,000 = final price

7.6 Competitive Bidding

Basic Idea: Government agencies and non-profit organizations often ask the marketer to
submit a sealed bid. The marketer wins the contract if his bid price is lower than the com-
petitors’ bids. The product specifications and the quantity sold if the marketer wins the
bid are predetermined. We now discuss one method of selecting an optimal bid price, the
Expected Profit (EP) method. Expected profit is defined as follows:
Expected Profit = P(Win at Bid Price)∗(Bid Price − Cost), where:

• P(Win at Bid Price) = the probability of winning the bid at the bid price.

• Cost = estimated total cost.

Clearly, the probability of winning, increases if Bid Price is lower, but the profit if the
marketer wins, (Bid Price − Cost) decreases if the Bid Price is lower. The objective of the
marketer is to choose Bid Price to maximize Expected Profit, which is the product of P(Win
at Bid Price) and (Bid Price − Cost). The probability of winning at different bid prices is
determined from historical data.
Example: Suppose a school district has invited bids from local vendors to supply 1000 desks.
You are a vendor, and you estimate your cost of supplying the 1000 desks as specified to be
$80,000. You estimate the following probabilities of winning the bid at different bid prices:
2
Source: Thomas T. Nagle, The Strategy and Tactics of pricing, edition 1, Prentice Hall, 1987

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Bid Price Probability of Winning
$80,000 1.00
$90,000 0.80
$100,000 0.60
$110,000 0.30
$120,000 0.10
$130,000 0.00
Which of the bid prices listed above ($80,000, $90,000, $100,000, $110,000, $120,000, and
$130,000) will you choose?
Augmenting the table to add the profit if you win and the expected profit, we get:
Bid Price Probability of Winning Profit if win Expected Profit
(Bid Price − Cost)
$80,000 1.00 $0 $0
$90,000 0.80 $10,000 $8000
$100,000 0.60 $20,000 $12,000
$110,000 0.30 $30,000 $9000
$120,000 0.10 $40,000 $4000
$130,000 0.00 $50,000 $0
Hence, we choose a bid price of $100,000 to maximize expected profit.
Application and Refinement: Clearly, the key challenge in setting bid prices is to determine
the probability of winning at a given bid price. To determine these probabilities, you need to
get data on the product specifications and the winning bid prices from the past.
Method 1: The simple but crude method is to proceed as follows:

• For each bid in the data set, estimate your cost of providing the product as specified.
Call it C. Compute the “winning bid ratio” R∗ = P ∗ /C, where P ∗ is the winning bid
price.

• Consider a given bid ratio R = P/C, where P is the bid price. For this R, from the
historical data, find what percentage of cases where R∗ exceeds this R. This percentage
is an estimate of the probability of winning at this bid ratio. For instance, in the example
above, the probability of winning at a bid ratio 1.25 is 60%.

Method 2: If you can obtain not just the winning bid price, but all bid prices, you can refine
your estimation of probabilities. Proceed as follows:

• For each bid in the data set, estimate your cost, C. Compute the bid ratios for all the
bid prices. For instance, suppose the cost is $100,000, and the bid prices are $80,000,
$100,000, and $150,000. Then, the bid ratios are 0.8, 1.0, and 1.5.

123
• For any specific bid ratio R, find the fraction of bid ratios that exceed R. Call this
number P (R). This is the probability that any one given competitor will have a bid
ratio exceeding R.

• Suppose you have selected a bid ratio R, and there are N other bids made by your
competitors. You will win if all competing bids are higher. Assuming independence, the
probability of winning is P (win|R) = {P (R)}N .

• Compute P (R) and P (win|R) for all bid ratios under consideration.

Example: A government agency wishes to purchase 2000 laptop computers and has invited
sealed bids. You are a laptop computer vendor, and you estimate that your total cost to supply
the laptops as specified is $1,000,000. You are trying to choose one of the following five bid
prices: (1) $1,100,000, (2) $1,200,000, (3) $1,300,000, (4) $1,400,000, and (5) $1,500,000. You
have obtained 20 bid prices submitted by competing vendors in the past; the bid ratios for
these 20 bids are as follows:
Case Bid Ratio Case Bid Ratio Case Bid Ratio Case Bid Ratio
1 1.008 6 0.703 11 1.594 16 1.346
2 1.107 7 1.376 12 0.911 17 1.456
3 1.229 8 1.284 13 1.089 18 1.580
4 1.267 9 1.293 14 1.327 19 1.326
5 1.281 10 1.080 15 1.214 20 1.344
Suppose you know that other than you, two competing vendors will submit bids. Which of
the five bid prices will give you the highest expected profit?
Solution: You are considering five bid ratios, 1.1, 1.2, 1.3, 1.4, and 1.5. From the historical
data, you have the following results:
Bid Ratio (R) Fraction of bids with bid ratios higher than R (P (R))
15
1.1 = 0.75
20
14
1.2 = 0.70
20
8
1.3 = 0.40
20
3
1.4 = 0.15
20
2
1.5 = 0.10
20

For example, consider the bid ratio 1.2. Since you have two competing bids, you will win if
both competing bids have higher bid ratios than 1.2. The probability of that happening is

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P (1.2)2 = 0.72 = 0.49. Thus, we have the following results:
Bid Price Bid Ratio (R) P (R) P (win) Profit if Win Expected Profit
1,100,000 1.1 0.75 0.5625 100,000 56,250
1,200,000 1.2 0.70 0.49 200,000 98,000
1,300,000 1.3 0.40 0.16 300,000 48,000
1,400,000 1.4 0.15 0.0225 400,000 9000
1,500,000 1.5 0.1 0.01 500,000 5000
Therefore, out of the five bid prices considered, the bid price of $1,200,000 maximizes expected
profit.

7.7 Psychological Pricing


Consumers do not always behave as a traditional economist would believe. Here we discuss
two instances of “irrational” behavior, and offer possible explanations.
1. Odd-Even Pricing: It is commonly believed that buyers perceive odd-number prices to
be significantly lower than the slightly higher round numbers they approximate.
Examples: $1.99 vs $2.00, $19.95 vs $20.00, $5995 vs $6000.
Traditionally, odd prices have been used to indicate bargain values, and even prices to indicate
quality.
Two possible explanations for the present use of odd pricing (neither very satisfactory):
(a) Compare the two pairs: (i) $89 vs $78. (ii) $90 vs $79.
Which one is a better bargain?
The idea: When a consumer compares two prices quickly, he compares the digits from the
left to the right. For example, when comparing $89 vs $78, he will first compare 8 with 7.
When comparing $90 vs $79, he will first compare 9 with 7. This way, the second pair will
appear to represent the better bargain, even though the price difference is the same in both
cases, and the difference is a greater percentage of the price for the first pair.
(b) Odd pricing has been used for a long time. As a result, consumers have learnt to associate
odd prices with bargains. Thus, odd pricing has become a customary pricing method.
2) Customary Pricing: Due to custom and tradition, consumers expect what the price
should be for certain products, e.g., $1.00 for a candy bar at a vending machine, etc. In these
cases, a perceptible change in the price may lead to a sharp drop in demand.
Marketers counter this in different ways. One method commonly used for frequently pur-
chased packaged goods is to keep price/package the same, but reduce the amount of product
in a package. This practice has led consumer advocates to insist that supermarkets use unit
pricing in which all prices are stated in terms of some recognized unit of measurement or a
standard numerical count. Another method is to change the price in very small steps (e.g.,
price of postage stamps), so that the consumers do not notice the change.

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7.8 Skim and Penetration Pricing
Both skim and penetration pricing strategies can be explained by equation (7.5). From equa-
tion (7.5), the profit maximizing price depends on both E and V C. If E is larger, the price
is smaller. In contrast, if V C is larger, the price is larger. It can also be shown that if V C is
larger, profit is smaller.
Skim Pricing: Skim pricing is sequential price discrimination. The marketer divides the
market into groups based on price sensitivity. First, the price is set to maximize profit from
the least price sensitive customers (lowest E and hence highest P ∗ ). Once the potential of
this segment is exhausted, price is set to maximize profit from the next least price sensitive
customers.
Some issues related to skim pricing:
(1) Charging a high price attracts competitors to enter the market. Thus, skim pricing is ap-
propriate for unique products with good patent protection. Examples include pharmaceutical
products which are introduced at a high price (e.g., Cipro, Claritin, AZT).
(2) Profit maximizing price depends on V C also. As a higher price limits your demand,
you are giving up benefits from economy of scale and experience curve effects by using skim
pricing. Thus, skim pricing is appropriate if such effects are not strong.
(3) Skim pricing may be used during the introduction of a new product when you wish to
maintain product quality by limiting demand.
(4) If there is strong price quality association, skim pricing is appropriate as a high price
induces quality-conscious customers to buy the product and also serves as a barrier to com-
petitive entry.
Penetration Pricing: From equation (7.5), the profit maximizing price depends on V C and
is lower if V C is smaller. It can also be shown that if V C declines, profit (Π) is always higher.
Penetration pricing is used when a marketer feels that by offering a lower price now, V C can
drop fast from economy of scale and experience curve and thus generate more profits in the
future.
Issues related to penetration pricing:
(1) Here, the objective is to maximize long term profit instead of short term profit. This is
consistent with the BCG approach which focuses on having the largest market share.
(2) Penetration pricing can create a barrier to competitive entry if a strong experience curve
effect exists.
(3) Penetration pricing is appropriate for functional products where the customers can easily
assess product attributes. That way, customers do not automatically think that quality is
lower just because price is lower.
(4) You have adequate production capacity, and good quality control to ensure product quality
at a large production volume.
Examples: Texas Instruments used a penetration pricing strategy for its calculators. Japanese

126
automobile companies also used the penetration pricing strategy successfully.

7.9 Spatial (Geographic) Pricing


Note: This is quite different from “geographical pricing” discussed in the Kotler/Keller text.
A marketer sometimes serves different customers with different variable costs. For example,
suppose you are a pizza delivery store, and the variable cost of making a large pepperoni pizza
is $5. However, customers are scattered over a large area, and the cost of delivering the product
increases with distance from the store. In that case, your unit variable cost is the base unit
variable cost ($5) plus the cost of transportation. Even if your customers have the same
level of price sensitivity everywhere, equation (7.5) suggests that the optimal price should
be different at different locations due to variations in the cost of transportation. The study
of how prices should be modified due to spatial dispersion of customers is called geographic
pricing or spatial pricing. While it is possible to use equation (7.5) to determine the profit
maximizing prices for all customers, marketers use simple rules to set the prices for customers
at different distances. Four commonly used rules are discussed below. In these discussions,
the term delivered price is the unit price the customer pays after considering the cost of
transportation.
(1) Uniform Delivered Pricing Plan: Here, the marketer charges all customers the same de-
livered price. Note that the gross margin of the marketer decreases with increasing distance
from the source. Thus, a marketer using uniform delivered pricing typically serves customers
within a specified boundary. Also, customers located close to the marketer effectively subsidize
customers at a greater distance.
Examples: Pizza delivery services usually offer free delivery within a given boundary; the
US Postal Services charges the same fee of 41 cents for a standard letter for any destination
within the USA.
(2) Free on Board Origin (FOB origin) Pricing Plan: Here, the marketer charges the customer
a base price plus the exact cost of transportation. Thus, the unit gross margin is the same
for all customers, and thus the marketer does not have to limit its market served. However,
customers at a greater distance face a higher delivered price and thus may decide not to
patronize the store.
The FOB origin plan can be implemented simply by making the customer entirely respon-
sible for transporting the product from its source. For example, all grocery stores and eat-in
restaurants implement FOB origin pricing automatically.
(3) Zone Pricing Plan: This is a direct extension of the uniform delivered plan where the
marketer divides the market into zones and offered the same delivered price to each zones. By
increasing the number of zones, the marketer can increase contribution. However, the fixed
cost of implementation also increases with the number of zones used. As a result, marketers
using zone plan typically use a small number of zones.
(4) Freight Absorption Plan: Here, the marketer pays all or part of the transportation cost.

127
You can think of FOB origin pricing (no freight absorption) and uniform delivered pricing
(total freight absorption) as two extreme cases of the freight absorption method.

7.10 Cross Price Elasticity of Demand and Pricing Related Prod-


ucts
7.10.1 Cross price elasticity of demand: We now want to quantify how demand changes
if your price remains fixed, but the price of another product changes.
Definition: Let ²AB denote the cross elasticity of the demand of product A with respect to
the price of product B. Then:

% change in demand of product A P ∂QA


²AB = (In calculus notations: ²AB = B .)
% change in price of product B QA ∂PB

Example: Suppose you sell shirts, and the current demand for the shirts you sell is 2000
units. A competitor sells shirts at $20/unit. If you do not change price, but the competitor
increases his price to $21/unit, the demand for the shirts you are sell becomes 2150.
(21 − 20)
Here, change in the competing product’s price = × 100% = 5%.
20
(2150 − 2000)
The resulting change in the demand for your product = × 100% = 7.5%.
2000
Therefore, in this case, the cross price elasticity of demand for your product, relative to the
competitor’s price = (7.5%)/(5%) = 1.5.
Substitute products and Complementary products:
(1) If two products have positive cross elasticities of demand relative to each other’s prices,
they are substitute products, that is, a higher price of one product leads to switching to the
alternative product. Clearly, for substitute products, the cross elasticity of demand decreases
with increase in product differentiation.
(2) If product A has a negative cross price elasticity of demand relative to product B, then A
is a complement to B. In this case, a higher price for B leads to lower sales for B, which, in
turn, reduces sales for A.
Example: Toner cartridges are complementary products to printers.
Note on computing cross price elasticity of demand:
Demand at new price − Demand at old price
% change in demand = × 100%.
Demand at old price
New price − Old price
% change in price = × 100%.
Old price
7.10.2 Pricing related Products: So far, we discussed the pricing of a single product.
Here, instead of one product, we consider the simultaneous pricing of two or more related
products.

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Economic Issues (based on cross elasticities):
1) Pricing Substitute Products: Suppose you sell two substitute products A and B (e.g.,
regular unleaded and premium unleaded gasoline), and the price of product A is set at the
profit maximizing level given by equation (7.4). Suppose now you increased the price of
product A by 1%. As discussed in Section 7.2.6, the demand of product A will decrease by
1
E%, the gross margin/unit of product A will increase by %, and on balance contribution to
PV
profit from product A will not change. However, some customers who no longer buy product
A will buy the substitute, product B. Thus, the contribution to profit for product B will
increase. Combining, the total profit from products A and B will increase. To summarize, if
you sell two substitute products, the profit maximizing price of each product is higher than
the profit maximizing price if you consider the product in isolation.
2) Pricing Complementary Products: Suppose you are sell two complementary products A
and B (e.g., printers and toner cartridges). Suppose the price of product A is set at the profit
maximizing level given by equation (7.4). If you increase the price of A by 1%, the demand
1
for A drops by E%, the gross margin/unit increases by %, and on balance the profit from
PV
A does not change. However, the demand for B also drops, and your combined total profit
from A and B drops. In contrast, if you reduce the price of A, the total profit from A and B
combined increases. Thus, when you sell two complementary products, the profit maximizing
price of each product is lower than the profit maximizing price of the product considered in
isolation.
Example 1: Gillette sells its razors at a low price in order to attract customers who will
subsequently buy the razor blades (note the sunk investment effect here).
Example 2: Loss Leader Pricing. Sometimes a marketer sets the price of a product very
low (sometimes even lower than its variable cost) to attract customers to the other products
it offers. Supermarkets regularly take losses on advertised items (e.g., white bread for 39
cents, etc) to attract customers to the store. There are legal restrictions on the use of this
strategy. A retailer can sell a given product at or below cost for only a limited amount of
time. However, he can still offer “special prices” for different products during different time
periods.

7.11 Additional Topics

7.11.1 Price Discrimination: Contrary to common belief, a marketer can legally discrimi-
nate among ultimate consumers based on price. In fact, price based segmentation is another
name for price discrimination.
Basic Idea: Different segments have different levels of price sensitivity. Thus, the optimal
price will differ from one segment to another. Price discrimination is simply an attempt to
charge the less price sensitive customers a higher price and offer a lower price to a more price
sensitive customer.

129
Examples of Price Discrimination
Basis of discrimination Examples
Income, earning power Doctor’s fees. Professional association dues.
Tuition rate.
Age, gender, student status Hair-cut. Concert tickets.
Senior citizen fares.
Location of buyer Grocery prices differ between
inner city and suburbs.
Status of buyer New subscriber to a magazine.
Size of purchase Package size, number of units ordered.
Usage rate Long distance telephone rates.
Time of purchase Season/off-season, peak/off-peak.
Note: Price discrimination works well if “leakage” is not significant, i.e., if consumers who get
a lower price cannot undercut the prices of the original seller, and capture the price-insensitive
market. This is why we find widespread use of price discrimination in the marketing of
services where the service itself cannot often be separated from the service provider, thereby
eliminating the possibility of resale. A doctor can therefore charge different fees to patients
with or without an insurance coverage, and a bus line can give a lower fare to senior citizens.
7.11.2 Quantity Discount: This may be offered to resellers as well as final consumers.
Some reasons why a quantity discount may be offered:
1) Segmentation based on price sensitivity: Heavier users may be more price sensitive and a
lower price is therefore appropriate for them. Long distance telephone companies give lower
rates to heavier users. (This is an example of a cumulative quantity discount.)
2) Order discount: Sometimes, the cost for preparing an order is about the same for all order
sizes. In that case, the seller gives discounts for making larger orders.
Objective: Induce buyer to make one large order rather than several small ones. (This is an
example of non-cumulative quantity discount.)
3) Increase demand, which, in turn, reduces the cost of production by exploiting the economy
of scale, usage of inactive plant capacity, etc. This can also help clear inventory.
4) Coordination in a channel of distribution: A manufacturer may use a quantity discount to
affect the pricing strategy of a retailer and thereby coordinate activities of different levels of
the channel of distribution.
7.11.3 Robinson-Patman Act:
Excerpts: “It shall be unlawful for any person engaged in commerce . . . to discriminate in
price between purchasers of commodities of like grade and quality
− where either or any of the purchasers involved in such discrimination are in commerce,
− where the effect of such discrimination may be substantially to lessen competition or tend
to create a monopoly in any line of commerce, or to injure, destroy, or prevent competition

130
...

Important Points:

1. The objective of the Robinson-Patman Act is to maximize competition and prevent for-
mation of monopolies. For example, if a manufacturer sells two competing retailers the same
commodity at different prices, that hurts competition and is illegal. However, since a whole-
saler and a retailer usually do not compete directly, the manufacturer can offer different prices
to them.

2. The Robinson-Patman Act only applies when the competing buyers are business customers.

7.11.4 Buy-Response Curve


In general, it is very difficult to determine demand at every level of price. One method
which is crude but easy to implement is called the buy-response curve. This method uses a
survey of potential customers. A respondent is asked to consider a specific product and tell
how likely she is to purchase the product at different price levels. By aggregating data over a
sample of respondents, the researcher gets a crude idea of demand at every price level. The
data can also be fitted using the regression model to obtain an estimate of the price elasticity
of demand.
Examples of Buy-Response Curves

Example 1. Survey Question: Suppose the band Rolling Stones plans to offer a concert at
the Carrier Dome. Assuming that you have the time to attend the concert, please indicate
how likely would you be to buy a ticket for this concert at each of the following ticket prices
by circling your response. (1 → definitely not buy, 4 → 50/50 chance, 7 → definitely buy.)

Definitely Definitely
Price Not Buy Buy
$40 1 2 3 4 5 6 7
$45 1 2 3 4 5 6 7
$50 1 2 3 4 5 6 7
$55 1 2 3 4 5 6 7
$60 1 2 3 4 5 6 7
$65 1 2 3 4 5 6 7
$70 1 2 3 4 5 6 7
$75 1 2 3 4 5 6 7
$80 1 2 3 4 5 6 7
Data were collected from a sample of 44 MBA students. For each item, I recorded 1 if 5 or
more was circled, and 0 if not. Then, I counted how many respondents scored 1 and assumed
that those students would purchase the product at that price level. For example, in the table
below, 22 out of the 44 students will buy the ticket at a price of $40. The demands are as
follows:

131
Price (P ) 40 45 50 55 60 70 75
Demand (Q) 22 18 15 12 8 4 2

Clearly, we have a normal demand curve here.

Example 2. Survey Question: How interested are you in buying a ticket for an exhibition
basketball game between Denver Nuggets and Cleveland Cavaliers at the Carrier Dome at
each of the prices listed below? Please circle.

Not interested at all Very interested


$20 1 2 3 4 5 6 7
$25 1 2 3 4 5 6 7
$30 1 2 3 4 5 6 7
$35 1 2 3 4 5 6 7
$40 1 2 3 4 5 6 7
$45 1 2 3 4 5 6 7
$50 1 2 3 4 5 6 7
$55 1 2 3 4 5 6 7
$60 1 2 3 4 5 6 7

Data were collected from a sample of 71 Syracuse University undergraduate students. For
each item, I recorded 1 if 5 or more was circled, and 0 if not. Then, I counted how many
respondents scored 1 and assumed that those students would purchase the product at that
price level. The demands for men, women, and the whole sample are as follows:

Price (P ) 20 25 30 35 40 45 50 55 60
Men (40)
Demand (Qm ) 36 36 33 29 29 27 16 13 12
90.00% 90.00% 82.50% 72.50% 72.50% 67.50% 40.00% 32.50% 30.00%
Women (31)
Demand (Qw ) 21 18 16 16 12 9 3 2 1
67.74% 58.06% 51.61% 51.61% 38.71% 29.03% 9.68% 6.45% 3.23%
All (71)
Demand (Qall ) 57 54 49 45 41 36 19 15 13
80.28% 76.06% 69.01% 63.38% 57.75% 50.70% 26.76% 21.13% 18.31%

Example 3. Survey Question: If a combined lacrosse/football/basketball season ticket


were available, how likely would you be to purchase it at the following prices? (Please circle)

132
Very unlikely Very likely
$50 1 2 3 4 5 6 7
$75 1 2 3 4 5 6 7
$100 1 2 3 4 5 6 7
$125 1 2 3 4 5 6 7
$150 1 2 3 4 5 6 7
$175 1 2 3 4 5 6 7
$200 1 2 3 4 5 6 7
Data were collected from 148 Syracuse University Undergraduate students. Demand is ex-
pressed as percentage of population that circled 5, 6, or 7 at a given price.
P Q (overall) Q (Women) Q (Men)
50 87.07% 82.67% 91.66%
75 87.07% 81.33% 93.06%
100 76.19% 69.33% 83.33%
125 61.9% 57.34% 66.68%
150 47.62% 44% 51.38%
175 36.55% 28.38% 45.07%
200 28.08% 25.34% 31%

7.12 Demand Functions used in Practice

7.12.1 Two Commonly Used Demand Functions: While the normal demand curve
applies in typical pricing situations, there is no universal agreement about the functional form
of the demand curve. Two demand curves, the constant elasticity (also called Cobb-Douglas)
demand curve, and the linear demand curve, are used extensively in practice. These two
demand curves are illustrated graphically in Figure 7.4.

Q 6 Q 6
A
@
@
@
@
@
@
@
@
@
@
0 0 @
- @ -
0 P 0 A/B P
Constant Elasticity Demand Linear Demand

Figure 7.4

133
1. Constant Elasticity (Cobb-Douglas) Demand Curve: This curve assumes the fol-
lowing relationship between demand and price and is named after two U.S. Congressmen who
discovered it:
(7.6) Q = KP −E ,
where K and E are positive constants. It can be shown that E is equal to price sensitivity
for all levels of price. If this demand curve applies, then profit maximizing price can be
determined by using equation (7.5) if E > 1. If E ≤ 1, a profit maximizing marketer will
raise price as long as it is legally allowed.
Example: Suppose the demand function is 1000 × P −3 , and V C = 10. Here, K = 1000 and
3
E = 3. Hence, the profit maximizing price is 10 × = 10 × 1.5 = 15.
3−1
Note that if V C increases by $1 to $11, P ∗ increases to 11 × 1.5 = 16.5, that is, P ∗
increases by $1.5.
2. Linear Demand Function: This curve assumes that demand can be expressed as follows:
A A
(7.7) Q = A − B ∗ P if P ≤ B
, and Q = 0 if P > B
,

where A and B are positive constants. For the linear demand function, E depends on the
level of P , and equation (7.5) cannot be used directly to find the profit maximizing price. For
this demand curve, the profit maximizing price is given by:
1 A
(7.8) P ∗ = ( + V C),
2 B
that is, the profit maximizing price for the linear demand function is the average of (1) the
price point A/B where demand becomes zero, (2) the unit variable cost (V C) (see Figure
7.5).
Q
6

@
@
@
@
@
@
@
@
@
@
@
@
@
@
@ -
VC P∗ A/B P

Figure 7.5

134
Example: Suppose V C = 50, and demand is given by Q = 20, 000−100P , that is, A = 20, 000
A 20, 000
and B = 100. The price point where demand becomes zero is = = 200. The profit
B 100
1
maximizing price is (200 + 50) = 125.
2
1
Note that if V C increases by $1 to 51, P ∗ increases to (200 + 51) = 125.5, that is, P ∗
2
increases by $0.50.
Note 1: The constant elasticity demand curve and the linear demand curve both give good
fit to the data if you consider small variations in price from the current level, and you can use
either one to determine how a small change in price from the current price level will affect
price.
Note 2: The two demand functions imply very different demand conditions if you consider a
wide range of price variation. The constant elasticity demand function implies that there is a
residual demand even when price is very high. That only makes sense if some customers feel
they absolutely need the product and would not accept a substitute regardless of price. In
contrast, the linear demand function implies that the product has substitutes, and demand
becomes zero if price is too high.
Note 3: The two demand functions have different implications for profit maximizing price if
V C changes.

• If V C increases by $1, the profit maximizing price for a constant elasticity demand curve
E
with E > 1 increases by dollars, which is more than $1. (Meaning: The marketer
E−1
should pass along the increased variable cost plus charge a mark-up on it.)

• In contrast, if V C increases by $1, the profit maximizing price for the linear demand
curve increases by $0.50. (Meaning: The marketer should split the increased variable
cost with the customer.)

Note 4: The profit maximizing price P ∗ always satisfies equation (7.4). However, for the
linear demand function, we cannot use equation (7.4) directly to find P ∗ , because E itself
depends on price. Specifically, for the demand function Q = A − BP given by equation (7.7),
price elasticity of demand (²) and price sensitivity (E = |²|) are given by:

−P P
(7.9) ² = , that is, E = .
(A/B) − P (A/B) − P

Thus, E is close to zero if P is small, and very large if P is close to A/B. You can easily
verify the following:

A
• The linear demand function given by (7) is inelastic (E ≤ 1) if P ≤ , and elastic if
2B
A A
P > . At P = , E = 1.
2B 2B
135
1
• At P = P ∗ , E = .
PV

Note 5 (Double Marginalization): Consider a channel of distribution with multiple levels


where each level sets price to maximize its own profit independently. Since each level equates
its marginal cost with marginal revenue, there is a mark-up at each level. As a result, the end
customer pays a higher price if there are more levels to a channel of distribution compared to
the case the channel levels act as a single entity.
Double marginalization occurs for both constant elasticity and linear demand functions.
However, the specifics are different. Consider a simple two level channel of distribution (man-
ufacturer + retailer) where the manufacturer’s unit variable cost is V C, and the retailer’s
unit variable cost is the unit price the manufacturer charges the retailer. Let PM and PR
denote the unit price the manufacturer charges the retailer, and the retailer charges the end
customer, respectively. Then:

• Under the constant elasticity demand function given by equation (7.6):


³ E ´ h 1 i E ´2 h 1 i
(7.10) PM = V C ∗ = V C 1+ , PR = V C ∗ ( = PM 1 +
E−1 E−1 E−1 E−1
E
Note that the retailer’s unit margin is times the unit margin of the manufacturer.
E−1
• Under the linear demand function given by equation (7.7),

1 A 1 A 3A V C 1 A
(7.11) PM = ( + V C) = V C + ( − V C), PR = + = PM + ( − V C)
2 B 2 B 4B 4 4 B
Note that the retailer’s margin is half the margin of the manufacturer.

7.12.2 Estimation of Price Sensitivity from a Buy-Response Curve: The data shown
in Section 11.4 can be used to find the price sensitivity demand. I will discuss both examples.
Example 1: I fitted a constant elasticity demand function: K ∗ P E , where E is the price
sensitivity, with the data from Example 1 (Rolling Stone Concert). Taking logarithms:

ln Q = ln K − E ∗ ln P,

where ln is the natural logarithm. I then fitted this equation using regression analysis and
got:
ln Q = 18.92 − 4.20 ∗ ln P.

Hence, the estimated price sensitivity is 4.20.


Example 2: I fitted both the constant elasticity demand function and the linear demand
function.

136
Results for Constant Elasticity Demand Function: Here, the demand function can be
expressed as:
Q = KP −E , that is, ln Q = ln K − E ln P.
Using regression analysis, I got the following results:
Men ln Qmen = 6.95 − 1.04 ln P
Women ln Qwomen = 11.5 − 2.61 ln P
All ln Qall = 8.48 − 1.38 ln P
From these results, the demand for men is barely elastic (E = 1.04) while the demand for
women ia fairly elastic (E = 2.61). The demand for the combined market has an intermediate
level of price sensitivity (E = 1.38).
Results for Linear Demand Function: Here, the demand function is Q = A − BP . Using
regression analysis, I got the following three demand equations:
Men Qmen = 131 − 1.68P
Women Qwomen = 104 − 1.73P
All Qall = 119 − 1.70P
To help comparison, the demands are in percent form in all three equations. The price
sensitivity (E) for men, women, and the combined market (all) are given as follows:

P P
• Men: Emen = =
(131/1.68) − P 77.98 − P
P P
• Women: Ewomen = =
(104/1.73) − P 60.12 − P
P P
• All: Eall = =
(119/1.70) − P 70 − P

Thus, at any given level of price, women are more price sensitive than men, and the price
sensitivity of the combined market is intermediate to the price sensitivities of men and women.
For example, at P = $40, the price sensitivities are:

40
• Men: Emen = = 1.05
77.98 − 40
40
• Women: Ewomen = = 1.99
60.12 − 40
40
• All: Eall = = 1.33
70 − 40

The profit maximizing prices are also different for men and women. For example, suppose
V C = 10. Then, the optimal prices for men only, women only, and the combined market (all)
are given as follows:

137
∗ 1 h 131 i
Men Pmen = + 10 = 43.99
2 1.68

∗ 1 h 104 i
Women Pwomen = + 10 = 35.06
2 1.73

∗ 1 h 119 i
All Pall = + 10 = 40.00
2 1.70

Example 3: I fitted both the constant elasticity demand function and the linear demand
function with the data.
Results for Constant Elasticity Demand Function: Here, the demand function can be
expressed as:
Q = KP −E , that is, ln Q = ln K − E ln P.
Using regression analysis, I got the following results:
Men ln Qmen = 7.71 − 0.757 ln P
Women ln Qwomen = 8.18 − 0.899 ln P
All ln Qall = 7.91 − 0.821 ln P
From these results, all the three demand curves are inelastic.
Results for Linear Demand Function: Here, the demand function is Q = A − BP . Using
regression analysis, I got the following three demand equations:
Men Qmen = 121 − 0.443P
Women Qwomen = 110 − 0.433P
All Qall = 115 − 0.438P
To help comparison, the demands are in percent form in all three equations. The price
sensitivity (E) for men, women, and the combined market (all) are given as follows:

P P
• Men: Emen = =
(121/0.433) − P 273.14 − P
P P
• Women: Ewomen = =
(110/0.433) − P 254 − P
P P
• All: Eall = =
(115/0.438) − P 263 − P

Thus, at any given level of price, women are more price sensitive than men, and the price
sensitivity of the combined market is intermediate to the price sensitivities of men and women.
For example, at P = $150, the price sensitivities are:

150
• Men: Emen = = 1.22
273.14 − 150
138
150
• Women: Ewomen = = 1.44
254 − 150
150
• All: Eall = = 1.33
263 − 150

The profit maximizing prices are also different for men and women. For example, suppose
V C = 100. Then, the optimal prices for men only, women only, and the combined market
(all) are given as follows:
∗ 1 h 121 i
Men Pmen = + 100 = 186.57
2 0.443

∗ 1 h 110 i
Women Pwomen = + 100 = 177
2 0.433

∗ 1 h 115 i
All Pall = + 100 = 181.50
2 0.438

7.13 Exercise Problems

Scenario for Problems 1-3: Suppose you sell two products, A and B.
Product A: Price/unit = $10, variable cost/unit = $5, current demand = 10,000 units, fixed
cost = $20,000, (Own) price elasticity of demand = −2.5.
Product B: Price/unit = $20, variable cost/unit = $12, current demand = 8,000 units, fixed
cost = $30,000, (Own) price elasticity of demand = −2.
The cross price elasticity of demand of A with respect to price of B is 0.5.
The cross price elasticity of demand of B with respect to price of A is 1.0.
1) Are these two products substitute products or complementary products?
2) Compute each of the following:
(a) Profit from A.
(b) Profit from B.
(c) Profit from A and B combined.
3) Suppose you have increased unit price of A to $10.40, but kept the price of B unchanged.
Compute each of the following:
(a) Demand for A. (b) Profit from A.
(c) Demand for B. (d) Profit from B.
(e) Profit from A and B combined.

139
4. Scenario: Suppose you sell two products A and B. The current prices, current demands,
costs, and elasticities of demand are as follows:
Product A: Price/unit = $10, variable cost/unit = $5, current demand = 10,000 units, fixed
cost = $20,000, (Own) price elasticity of demand = −3.
Product B: Price/unit = $20, variable cost/unit = $12, current demand = 8,000 units, fixed
cost = $30,000, (Own) price elasticity of demand = −2.
The cross price elasticity of demand of A with respect to price of B is 1.5.
The cross price elasticity of demand of B with respect to price of A is 1.5.
4.(a) Compute (i) the profit from product A, (ii) the profit from product B, and (iii) the
combined profit from products A and B at the current prices.
4.(b) Suppose you increased the price of product A to $10.10/unit, but kept the price of
product B the same ($20/unit). At these new prices, compute:

• The new demand for product A.

• The new demand for product B.

• The profit from product A.

• The profit from product B.

• The combined profit from products A and B.

4.(c) Suppose you increased the price of product A to $9.90/unit, but kept the price of product
B the same ($20/unit). At these new prices, compute:

• The new demand for product A.

• The new demand for product B.

• The profit from product A.

• The profit from product B.

• The combined profit from products A and B.

4.(d) Keeping the price of product B unchanged at $20, which of these three prices of product
A ($10.00, $10.10, and $9.90) will you choose if you wanted to get the highest profit from
product A?
4.(e) Keeping the price of product B unchanged at $20, which of these three prices of product
A ($10.00, $10.10, and $9.90) will you choose if you wanted to get the highest combined profit
from products A and B?

140
5. Suppose you are organizing a rock concert at the Carrier Dome. Your total fixed cost
is $100,00, your variable cost per unit is $20, and the demand Q (number of tickets) is the
following linear function of price:

Q = 20, 000 − 250P

The relevant formulas for the linear demand function are given below. The profit maximizing
price here is:
1 ³ 20, 000 ´ 1
P∗ = + 20 = (80 + 20) = 50
2 250 2
5.(a) Compute the price sensitivity (E) at each of the following three levels of price: $40, $50,
$60. [To find E, the simple way is to increase P by 1%, compute the % change in Q, and
compute elasticity ² by dividing % change in Q by % change in P . E is the absolute value of
². You may also use the formula for E given by Equation (7.9).]
5.(b) Compute the PV ratio at each of the following three levels of price: $40, $50, $60.
1
5.(c) Suppose you wish to maximize profit. Comparing E and from 2(a) and 2(b), discuss
PV
how and whether price should be changed at each of the three price levels $40, $50, and $60.
[Should price be changed at all? If yes, then do you increase or reduce price in order to
increase profit?]

7.14 Additional Reading

Thomas T. Nagle and Reed K. Holden, Strategy and Tactics of Pricing: A Guide to Profitable
Decision Making, third edition, 2002, Prentice Hall.
The sections on competitive bidding and factors affecting price sensitivity in the Reader uses
concepts presented in this text.

141
8 Selected Topics on Distribution Strategy

8.1 Rationale for Marketing Intermediaries (Middlemen)


Marketing intermediaries (also called resellers, middlemen) exist when they can perform chan-
nel tasks more efficiently than the manufacturer.
8.1.1 Examples of Channel Tasks:
1. Research to determine nature and size of demand.
2. Promoting the product to target customers.
3. Contacting the customers.
4. Negotiating the terms of sale (price, delivery, financing, service).
5. Risk bearing: responsibility for unsold items; risk of bad credits.
6. Physical distribution.
7. Smooth discrepancy between needs of producers and consumers: Assortment, spatial,
temporal, quantity.
Typically, a manufacturer produces a limited number of products in large quantities in
order to achieve economy of scale at production facilities at a small number of locations. In
contrast, consumers are dispersed spatially and each consumer desires a limited quantity of a
variety of products. As a result, we have:

• Assortment discrepancy: The customer wants an assortment of different types of prod-


ucts. The manufacturer produces a limited number of products.

• Quantity discrepancy: The customer wants a small amount of each type of product. The
manufacturer wants to produced a large amount of a homogeneous product to achieve
economy of scale.

• Spatial discrepancy: The manufacturer produces the products in a small number of


locations. Customers are dispersed over a large area.

• Temporal discrepancy: This is the discrepancy between when the product is produced
and when it is consumed. For example, food products made with fruits or vegetables are
often produced seasonally but consumed throughout the year. In contrast, a garment
manufacturer may produce winter jackets throughout the year to maintain a stable labor
force, but sell its products only in fall and winter.

These discrepancies need to be removed.

142
8.2 Reasons for having intermediaries

Sometimes intermediaries can perform the channel tasks more efficiently than the manufac-
turers. For example:
1. Increased Contact Efficiency: The presence of intermediaries can significantly reduce
the number of transactions necessary in an economy of exchange.
For example, consider a market with three manufacturers who produce distinct products
(bread, cereal, and soft drink) and 3 customers who each buy all three products. If each
manufacturer had to interact with each customer directly, 3 × 3 = 9 transactions would
be necessary. On the other hand, if an intermediary purchased the products from all three
manufacturers and sold them to all three customers, only 3 + 3 = 6 transactions would be
necessary.
More generally, if there are C customers who each buy products from the same M man-
ufacturers, then M × C transactions are necessary if there is no intermediary. In contrast,
(M + C) transactions are necessary if there is an intermediary between the manufacturers and
the end customers.
Note that contact efficiency provided by an intermediary increases with fragmentation in
production and purchase. If one corporate entity produced all products (M = 1) or if only one
customer purchased all products (C = 1), there would be no gain in contact efficiency from
having a middleman. As M and C increase, the contact efficiency offered by the intermediary,
as measured by the difference between M × C and (M + C), increases.
While these examples are simplistic because we implicitly assumed that each transaction is
equally costly to the economy, the general idea is correct: whenever production and consump-
tion are fragmented, the presence of an intermediary makes the economy efficient by reducing
the number of contacts.
In addition to reducing the number of transactions necessary, the intermediaries can stan-
dardize transaction (e.g., by establishing a market price) and thus make distribution more
efficient.

M1 H - C1
*
©
@HH ©µ
¡
@ HH ©
©©¡
¡
@ HH ©
No Retailer Present
@ H©© ¡
@ ©© HH ¡
H
©@© ¡H M × C = 3 × 3 = 9 transactions
©©
HH
@ ¡
M2 © H-
©
H @¡ j
H
©©* C2
HH ¡@ ©
H ¡ @ ©©
HH¡H ©@©
¡ H © @
¡ ©© HH
©
H @
¡ ©© HH@
¡© HH@
M3 ©©
¡ R C3
-
j
H
@

143
M1 HH ©
C1
HH ©©
H
H
j ©© Retailer Present
¼
©

M + C = 3 + 3 = 6 transactions

M2 -
R ¾ C2

© ©©
* YH
H
HH
©© HH
M3 © C3

2 Reduction of Discrepancy. An intermediary can often smooth the discrepancy between


production and consumption more efficiently than the manufacturer. This increased efficiency
usually arises from economy of scale. For example, by carrying goods from several manufac-
turers in the same truck, an intermediary may be able to reduce the cost of transportation.
Note. The importance of the intermediary grows with the discrepancy between the offerings
of the manufacturers and the needs of the customers. For example, a large steel manufacturer
usually encourages its small volume customers, who typically need a wide variety of steel
products, to buy from wholesalers. In contrast, large volume buyers, who typically need
homogeneous supplies of steel in large lots, are urged to deal directly with manufacturer.
3 Market Knowledge. By specializing in local market conditions, the intermediary is in a
better position to estimate local demand, advertise in local media, offer credit to customers,
and provide after sales service.

8.3 Distribution Intensity


A producer has to decide how many sales outlets should carry its products in a given area.
Three basic choices are available.
8.2.1 Intensive Distribution. Under this strategy, the product or brand is placed in as many
outlets as possible. Convenience goods such as newspapers, candy, cigarettes, deodorants,
toothpaste, etc., are usually marketed this way. Marketers of products with a higher price have
also used this strategy successfully. For example, personal computer manufacturer Compaq
used this strategy to gain access to a large market.
Key Features
(a) Generally, this strategy is used for convenience products. Typically, the consumers know
about the product already and the nature of the sales outlet does not affect how a consumer
evaluates the product. Alternatively, purchasing the product represents a low involvement

144
choice from a class of products with low differentiation. Availability of the product is the key
to purchase. This is particularly relevant for impulse products like candy bars that are only
purchased if the customer sees them.
(b) The store itself does not promote the product as promotion is unlikely to benefit the
store directly. Also, the producer does not expect the store to provide information about the
product or demonstrate how to use it.
(c) If an intensive distribution strategy is used, competition among resellers would almost
certainly drive down the price of the product at the retail level. The retailers, in turn, would
demand the product at a lower price from the manufacturer. Thus, the gross margin/unit
would decrease, and the manufacturer would have to sell more units to break even or generate
a profit.
Advantage: Intensive distribution allows a consumer to make a purchase with the minimum
effort. This usually increases sales in the short run.
Disadvantages:
1. Costly: (i) More accounts have to be served. Often a manufacturer of a low priced item
like a candy bar uses wholesalers to reach small retailers rather than serve them directly. The
wholesaler achieves economy of scale by carrying the products of many manufacturers. (ii)
The manufacturer now has to bear the cost of promoting the product.
2. An intensive distribution strategy may not be suitable for a brand with a quality image
which enjoys a substantial profit margin at present. Sometimes, the image of quality arises
out of the exclusive nature of the product, and that image is hurt if the product is widely
available. For example, the image of Godiva chocolates will be diminished if it is sold at K
Mart.
Even when the reputation of the product is well established and does not depend on the
nature of the retail outlet, intensive distribution may still not be appropriate. For example,
suppose Denon, a maker of high quality stereo receivers, has expanded the number of its
outlets to include mass merchandisers, mail order stores, etc. An expansion like this usually
comes with a lack of control over the marketing of the product to the ultimate consumers,
which results in two major problems :
Problem 1: Increased competition among resellers. Some retailers would invariably reduce
the price of Denon to attract customers. This will force other outlets to reduce price as well,
leading to a general lowering of profit margins. The product will now be less attractive to
high end resellers who may drop the product.
Problem 2: Increased effort required from the manufacturer. This can occur in two ways:
(i) Competition reduces profit margin, and any advertising benefits all competing retailers.
The resellers are therefore less willing to promote the product. Consequently, the manufacturer
has to spend more money towards advertising the product.

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(ii) Some of the outlets will not have facilities to service the product after a sale is made. Since
warranty business is usually not very lucrative, major resellers who offer such service will be
reluctant to handle problems with equipment sold by other concerns. The manufacturer may
now have to either give more incentive to resellers to provide after sale service, or develop a
service network of its own (GE had to do that). Either option is costly.
In addition to the problems listed above, some resellers may find an intensively distributed
product to be inconsistent with the store image and hence drop the product. (For example, in
1982, Levi Strauss decided to sell its jeans through J.C. Penney and Sears. Macy responded
by dropping Levi Strauss jeans.)
Note: The above discussion demonstrates that an intensive distribution strategy is generally
suitable for a convenience product, but it may not be suitable for a shopping or a specialty
product.
8.2.2 Exclusive Distribution. Here, only one intermediary sells the product in a specific
area. For example, a car dealer may receive the exclusive right to sell a particular brand in a
given territory.
Key features
(i) The purchase represents high involvement decision making by the consumer. The consumer
is ready to travel to a specific outlet to examine the product.
(ii) The consumer usually requires information before she makes a purchase decision. Also,
she may require service (e.g., instruction, repair) after the purchase.
As a consequence, selling requires a high degree of involvement by the retailer. In exchange
for this effort, the retailer is spared competition from other retailers selling the same brand
and typically enjoys close cooperation from the producer/distributor.
In general, an exclusive distribution strategy is meaningful if a strong selling effort by the
intermediary is required. This is often used in the early stages of a product’s life cycle and/or
for the marketing of technically complex products.
Examples of exclusive distribution: (i) Imported automobiles (e.g., BMW). (ii) Higher priced
furniture. (iii) Construction and farm machinery.
8.2.3 Selective Distribution. This strategy is intermediate to intensive and exclusive
distribution strategies where a product or brand is placed in a limited number of outlets in
a defined geographic area. Typically, this is suitable for shopping goods which may require
some selling effort from intermediaries. Consequently, the producer/distributor protects the
retailer somewhat from competition, and provides a limited amount of support.
Examples: Medium priced electronics equipment like Sony, cosmetics such as Revlon and
Estee Lauder.
Note: The choice of distribution strategy depends on the nature of the product, the target
customers’ knowledge of the product and the buying habits of the target customers.

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8.4 Vertical and Horizontal Conflict
Each channel member plays a specific role in the channel and specializes in performing one
or more functions. Thus, each channel member depends on the others for success. Ideally,
the channel members should cooperate to serve the target market efficiently, and thereby
maximize profits for the entire channel. In real life, however, channel members rarely take
such a global view. Cooperating to achieve overall channel goals would often require members
to give up individual goals. Unwillingness to do that often leads to conflict. Note that conflict
may not necessarily indicate open hostility between the parties involved. For example, it may
simply refer to price competition leading to a reduction in profits of the entities in conflict.
Conflict in a channel of distribution usually arises from disagreement on what role each
member should play, and how each member should be compensated. Depending on the levels
of the channel of distribution the parties in conflict belong to, conflict may be horizontal or
vertical.
In our discussions, the term channel level refers to a layer of intermediaries that may exist
between the producer and the end customer. For example, wholesalers (who sell to businesses
including retailers) and retailers (who sell to consumers) represent different channel levels. If
there are no marketing intermediaries, we have a direct channel of distribution.
8.3.1 Horizontal Conflict. Horizontal conflict, which is conflict among members at the
same level of the channel of distribution, can usually be of two types:
(a) Price competition among resellers at the same level of the channel. For example, a Ford
dealer may try to steal sales from another Ford dealer through price reductions, or may
encroach on another dealer’s sales territory.
(b) When one member at a given level of the channel takes a “free ride” on the other members
at that level.
Example 1: A member of a fast food franchise may sell inferior product and thereby hurt the
reputation of all franchisees.
Example 2: Consider a product like a Seiko watch which sometimes requires servicing. As
servicing is usually not lucrative, some retail outlets do not want to service the product after
it is sold, and the burden falls on the remaining retailers, increasing their cost. This problem
is compounded by the fact that the retailers which do not service the product also tend to
offer the product at a lower price than retailers who do service the product.
8.3.2 Vertical Conflict. Vertical conflict refers to conflicts between different levels of the
same channel. For example, a manufacturer may feel that the wholesalers are demanding
unreasonably low prices and decide to start selling directly to retailers or ultimate customers.
Like horizontal conflict, vertical conflict can also arise in different ways. Some of the
common forms of vertical conflict are as follows:
(a) Competition for the same market. In a channel of distribution, members at different
levels of the channel often compete with each other for the same market. For example, a

147
manufacturer using a hybrid marketing system (that is, multiple channels of distribution)
may sell its products through wholesalers to the retailers, but also may sell them directly to
the retailers. Thus, there is now conflict between the manufacturer and the wholesalers as
they compete to serve the same market.
In a variant of the same problem, a change in distribution strategy may lead to vertical
conflict. For example, suppose a manufacturer of a high priced line of cosmetics currently uses
a selective distribution strategy and sells the product through upscale department stores like
Macy’s. The department stores have invested resources to have display booths and trained
personnel to sell this particular line of products. If the manufacturer now decides to switch
to an intensive distribution strategy, the department stores will no longer be protected from
intense competition, and their investment in resources will be wasted. This will definitely
lead to conflict between the manufacturer and the department stores that currently carry the
product.
(b) Disagreement about sharing of resources and duties to be performed: The success of a
channel depends on participation of all members of the channel and there is often disagreement
regarding who should be responsible for the various tasks. Some examples follow:
(i) Disagreement about who should bear the cost of promotion. For example, manufacturers
of small appliances often complain that large retailers like K Mart ask them for unreasonably
high promotional allowances.
(ii) Disagreement about the level of service to be provided to the customers before and after
a sale. This problem is compounded by the fact that some retailers offer service and others
do not, and this leads to horizontal conflict as well. Organizations like GE provide customer
service directly using toll free numbers. Some other organizations require retailers to commit
a significant amount of resources to selling the company’s products. For example, before it
adopted intensive distribution, Compaq used to sells its personal computers only through
retailers who have a staff trained about Compaq products and dedicated to selling them.
(iii) Disagreement about the price the manufacturer charges the middlemen. This may result
from a difference in the perception of reality as a manufacturer may underestimate the cost a
retailer incurs in selling the product.
(iv) Disagreement about who should be responsible for unsold merchandize.
(c) Incompatibility of goals. Quite often, members at different levels of a channel of distribu-
tion have conflicting goals. For examples, franchisees of fast food franchises like McDonald’s
and Burger King have to pay a royalty to the franchiser which is proportional to sales volume.
Thus, the franchiser is interested in maximizing sales volume. In contrast, the franchisees
themselves are interested in maximizing profit. As a larger sales volume is often associated
with a larger cost and does not necessarily result in a larger profit, this may lead to a conflict
between the goals of the franchiser and the franchisees. For example, when Pillsbury, the
franchiser of Burger King, wanted the outlets to add more lines to increase sales (and counter
a similar move by McDonald’s), the franchisees initially resisted as more lines represented a

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greater cost to the franchisees (cost of adding equipment and employing people to serve the
additional lines).
The case of soft drink bottlers like Coca Cola is also similar to the problem of fast food
franchisees. For example, Coca Cola sells its syrup to the franchisees (the bottlers), and is
therefore interested in maximizing sales volume. In contrast, the bottlers are interested in
profit, which depends on sales volume as well as costs.
Note: Some degree of conflict can actually be healthy for the channel. For example, fran-
chisees may monitor the performance of other franchisees and make sure that product quality
does not go down. Similarly, the threat that a manufacturer may bypass it may induce a
wholesaler not to keep a large margin of profit. In these cases, the conflict benefits the ul-
timate customers in the form of better product and lower price, respectively. However, too
much conflict hurts the performance of a channel of distribution. This makes coordinating
the activities of a channel of distribution important.

8.5 Alternative Channel Arrangements


We discuss two most common forms of channels of distribution, the conventional channel, and
the alternative to it, called a vertical marketing system (VMS).
8.4.1 Conventional Channels. A conventional channel consists of independent organiza-
tions. Each member of the channel is a separate business entity seeking to maximize its own
profit, even at the expense of maximizing profits for the system as a whole. This often results
in adversarial relationships between members of the channel. The vertical marketing systems
described next have evolved in response to these problems.
4.2 Vertical Marketing System (VMS). Here, members of the channel from different levels
(e.g., the producer, wholesaler(s) and retailer(s)) act as a unified system. The unification may
involve the entire channel or only a part of it. Usually, either one channel member owns the
others or franchises them, or has so much power that they all cooperate. Vertical marketing
systems can be classified into (1) corporate VMS, (2) contractual VMS, and (3) administered
VMS.
(1) Corporate VMS: In a corporate VMS, successive stages of production and distribution
are owned and operated by one organization. This is also called vertical integration.
Vertical integration can be forward, where a channel member closer to production acquires
all or part of the channel leading to the ultimate customer. For example, a manufacturer or
a retailer may decide to establish its own distribution outlets.
Example: Sherwin Williams (manufacturer of paint products).
Vertical integration can also be backward, where retailers or wholesalers assume ownership
of institutions that normally precede them in the marketing flow of goods and services.
Example: Sears obtains 50% of its throughput from manufacturing facilities which it partially
owns.

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(2) Contractual VMS: A contractual VMS consists of independent firms at different levels
of production and distribution integrating their programs on a contractual basis to improve
the efficiency of the channel. There are three categories of contractual VMS:
(a) Wholesaler-sponsored systems, called voluntary chains: Wholesalers may organize vol-
untary chains of independent retailers to help them compete with large chain organizations.
The wholesaler helps the retailers standardize their selling practices. This may include provid-
ing expertise in promotion, pricing, store location, store layout, merchandising, financing, and
inventory control. The wholesaler buys centrally in large quantities, and the entire channel
benefits from the savings that result from that.
Example: Independent Grocers Alliance (IGA)
(b) Retailer-sponsored systems called retailer cooperatives: Retailers may take the ini-
tiative and organize a new, jointly owned business entity to carry on wholesaling and even
production. The members buy through the cooperative, and plan their advertising jointly.
The profits are shared by members in proportion to their purchases. Non members are some-
times allowed to purchase through the co-op, but they do not share in the profits.
Example: True Value Hardware
(c) Franchise organizations: Franchising has grown rapidly in recent years. Sales of goods and
services by all franchised companies in the USA exceeded $700 billion in 1990 and is projected
to be $1.3 trillion in 2010. The reason for the growth of franchises is that a franchiser with a
good business idea can expand its business very fast through franchising. As the franchisees
typically pay to join the franchise and subsequently pay royalties, the franchiser does not
require a huge capital to start with. The potential benefits to the franchisee include a proven
business system, a well known name, promotional support, and market research information
provided by the franchiser. Franchising has been a major means for the growth of service
industries (e.g., Gymboree, the exercise centers for children).
A franchise is an agreement between the owner of a business system, the franchiser, and
another person or organization, the franchisee, that wishes to use the business system. The
franchisee has to agree to meet the operating requirements of the franchiser, and the agreement
takes the form of a legal contract. Franchise systems can be classified in two alternative ways:
(a) based on who sponsored the system, and (b) whether the franchise agreement deals with
the selling of a specific product. The text discussed the first classification. The second one is
discussed here. Based on whether a specific product is involved, there are two basic forms of
franchising:
(i) Product and trade name: Here, the focus is on what is sold. This is a distribution agreement
where a franchiser authorizes a franchisee to sell a product line, using the parent company’s
trade name for promotional purposes. The franchisee agrees to buy from the franchiser-
supplier and also abide by specified policies.
Examples: Automobile dealers (e.g., Ford, Honda), petroleum (Chevron, Texaco), soft drinks

150
(Coca Cola).
(ii) Business format: Here, the focus is on how a business is run. The franchisee receives a
proven business format from the franchiser and, in return, agrees to make payments (typically
royalties based on sales volume) to the franchiser and conform to policies and standards.
In a franchise agreement based on business format, the franchiser does not always supply
the franchisee with merchandize. For example, Little Professor Book Centers, Inc., does not
sell its books to the franchised stores (which buy the books from wholesalers). The franchiser
only provides management assistance. The 7-11 stores offer another example of a franchise
system based on business format. Here, the franchisees are free to buy the merchandize from
the franchiser (Southland Corporation) or any other vendor.
(3) Administered VMS. An administered VMS coordinates successive stages of production
and distribution, not through common ownership or contractual ties, but through the size and
power of one of the members, often the manufacturer. In an administered VMS, units may
exist with different goals, but a mechanism exists for informal collaboration on inclusive goals.
Decision making takes place though interaction of channel members.
Examples:
(a) Kraft has developed a program to administer the allocation of space in the dairy section of
supermarkets. Kraft’s power originates from the company’s 60% share of dairy case volume,
exclusive of milk, eggs and butter.
(b) Wrigley (the maker of chewing gum) controls the checkout merchandising programs in
virtually every major retail outlet in the USA. To accomplish this, Wrigley conducts extensive
research on the sales of checkout merchandise and serves as an objective source of such data,
which includes information on products marketed by Wrigley as well as products (e.g., Nestle
chocolates) which compete with Wrigley for checkout merchandise space. Wrigley also provides
retailers with superior fixtures to display their checkout merchandise. This is the reason the
layout of checkout merchandise looks virtually the same in every store.

8.6 Power in a Channel of Distribution


Channel members often have and sometimes exercise power over one another, both vertically
and horizontally. The major sources of power are the following.
1. Reward power: For example, a manufacturer may offer many different types of reward to
the retailer to induce the latter to take actions that benefit the manufacturer. Examples of
reward power are:
1(a) Protection from competition. For example, the retailer may be allowed to be the exclusive
dealer in a given area. In exchange, the manufacturer may require after-sales customer service,
share of promotional costs, or exclusive dealing agreement.
1(b) Greater margins

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1(c) Promotional expenditure in the territory
1(d) Generous return/refund policy
1(e) Employee training
1(f) Prompt delivery
2. Coercive power: This is the opposite side of reward power where one entity threatens
to remove rewards such as an exclusive territory. Both reward and coercive powers can be
exercised by large entities with adequate resources.
3. Expert power: Here, the power of one channel member over another comes from some form
of expertise.
Example 3(a) Wrigley Company does extensive research on how to improve the profitability
of checkout merchandizing. Most retailers simply follow the Wrigley recommendations when
they display their checkout merchandize.
3(b) Traditionally, national manufacturers had more detailed information on product demands
in different market areas. However, with the advent of supermarket scanner cards, retailers
have more accurate local demand information than manufacturers. This power allows the
retailer to demand more resources from the manufacturer. For example, a manufacturer may
have to pay a non-refundable “slotting allowance” of about $100,000 to a retial chain secure
shelf space for a new product offering.
4. Legitimate power: Here, the power arises from a binding legal contract. For example, in
all of types contractual vertical marketing systems, the parties enter contracts regarding how
the business will be run.
5. Referent power: Here, the reputation of a party makes it an attractive partner. Again, it can
work both ways. For example, many dealers would love to carry Lexus or BMW automobiles,
or Bose speakers. Similarly, most fashion designers would love to have the department store
Bloomingdale’s to carry its garments.

8.7 Some Legal Issues Related To Distribution Strategy


We will briefly review two distribution policies which sometimes violate the law: (1) exclusive
dealing, and (2) tying agreements. Each strategy is limited by the Clayton Antitrust Act,
Sherman Antitrust Act, or Federal Trade Commission Act. It is important to realize that
none of these three strategies is illegal by itself (legally speaking “per se”). Rather, it becomes
unlawful if it (i) substantially lessens competition, (ii) tends to create a monopoly, or (iii)
restrains trade.
1. Exclusive dealing agreement: When a manufacturer prohibits its middlemen from
carrying products of its competitors, it is engaging in exclusive dealing. This will occur, for
example, if GM prohibits one of its dealers from selling Honda products.

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Through the use of an exclusive dealing agreement, the manufacturer forces the reseller to
concentrate on selling its product. Such an arrangement clearly reduces the freedom of choice
of the middlemen and the competitors of the manufacturer now have fewer options to reach
the ultimate customers. Exclusive dealing is illegal if these problems are severe:
(a) When a manufacturer’s sales volume is a substantial portion of the total volume in a given
market, the use of exclusive dealing will exclude competitors from a major portion of the
market. In that case, exclusive dealing will be considered illegal.
(b) When the manufacturer is a large entity, and middlemen are small concerns, the manu-
facturer’s power is considered inherently coercive. In that case, the use of exclusive dealing
will be considered a restraint of trade and therefore illegal.
Exclusive dealing is legal in some situations. Court decisions have allowed exclusive dealing:
(a) When a manufacturer is trying to enter a market or its total market share is very small. In
a case like this, an exclusive dealing arrangement will force the middlemen to concentrate on
selling the manufacturer’s product, and this will in fact increase competition in the market.
However, when the same manufacturer establishes a firm foothold in the market, the use of
exclusive dealing may not be allowed by the law.
(b) When equivalent products are available in the market or when the manufacturer’s com-
petitors have access to equivalent dealers. In these cases, the presence of exclusive dealing
will not reduce competition and is therefore allowed.
In conclusion, it is important to note that exclusive dealing may not be entirely harmful to
consumers. For example, by focusing its efforts on selling the product of one manufacturer, a
retailer may acquire greater knowledge of that product and thus be able to serve the customer
better.
2. Tying agreement: If a manufacturer sells a product to a middleman only if the middle-
man also buys another (often unwanted) product from the manufacturer, we call that a tying
agreement. A tying agreement limits the ability of the reseller to buy the other product
(called tied product) from alternative sources. This may reduce the ability of the reseller to
compete, and limit the access the competing manufacturers have to the market.
Examples: (1) An appliance manufacturer may want the distributors to carry the entire line
of products it offers.
(2) A studio may let a theater show its hit movie only if also shows a less popular movie
released by the studio.
(3) A franchiser may insist that its franchisees buy all the supplies from him.
Note that unlike exclusive dealing, a tying agreement does not offer any tangible benefit
to a customer. As a result, courts rulings have rarely supported the use of tying agreements.
While tying agreements are illegal in most cases, there are some situations where they are
allowed:

153
(1) When a new company is trying to enter a market. In this case, the use of a tying agreement
benefits the fledgling company and therefore enhances competition. However, if the company
establishes itself and gains substantial market share, the tying agreement will no longer be
legal.
(2) When an exclusive dealer or distributor is required to carry the manufacturer’s full line of
products but is not prohibited from carrying competing products.
(3) When the second (tied) product is essential for the proper use of the first (tying) product.
In this case, the tying product and the tied product are effectively inseparable, and a tying
agreement is allowed by the law.
For example, consider franchise agreements. Here, the tying product is the trademark
itself, and the tied product may be supplies and equipment. ( For example, in a famous
lawsuit involving the ice cream franchise Baskin Robbins, some franchisees contended that
the supplies (the ice cream products sold by the franchiser) were unlawfully tied to the sale
of the Baskin Robbins trademark.) If the franchiser can establish that to run the business
properly, the franchisees need to obtain equipment and supplies only from him, then a tying
agreement is legal. The rationale is, sales of an inferior substitute under the trademark
will reduce value of the trademark. There are several cases involving franchises where the
courts allowed a tying agreement. For example, in a case involving the Chock Full O’Nuts
Corporations, the courts concluded that the franchiser had the right to supply its franchisees
with coffee and baked goods in order to ensure the quality of the product. However, in the
same decision, the courts allowed the franchisees to buy other products (e.g., French fries, soft
drink syrups, napkins, and glasses) from other vendors.

8.8 Channel Coordination


In Section 7.12, we discussed double marginalization in a channel with multiple levels, where
each level sets price to maximize its own profit independently. Since each level equates its
marginal cost with marginal revenue, there is a mark-up at each level. As a result, the end
customer pays a higher price if there are more levels in a channel of distribution compared to
an integrated channel where the channel levels act as a single entity. Because of the higher
end price, demand is lower, and the overall channel profit is less than it is for an integrated
channel.
If the channel is integrated, the end customer pays a lower price and the overall channel
profit is higher. Thus, marketers often develop mechanisms to make the different levels of the
channel act as a single entity. This is called channel coordination. Clearly, a corporate
vertical marketing system can achieve channel coordination. However, channel coordination
can also be achieved without having a corporate VMS. Two other mechanisms to achieve
channel coordination are as follows:
(1) Quantity Discount: The manufacturer/wholesaler offers the retailer a quantity discount if
demand exceeds a threshold.

154
(2) Two-part Tariff: The manufacturer/wholesaler offers the product to the retailer at marginal
cost, but charges a fixed fee.
Example: Consider a channel with one manufacturer and one retailer. The manufacturer
sells graphing calculators to the retailer at PM /unit, and the retailer sells the calculators to
the end customer at PR /unit. The manufacturer has zero fixed cost, and a unit variable cost
of $20. The retailer has no costs other than the PM /unit he pays the manufacturer. Demand
is given by:
Q(PR ) = 100 − PR if PR ≤ 100, and zero if PR > 100

Integrated Channel: Here, we have linear demand with A = 100 and B = 1, and V C = 20.
If the channel is integrated, the profit maximizing retail price is given by equation (7.8), that
is,
1 100
PR∗ = ( + 20) = 60
2 1
The demand is:
Q(PR ) = Q(60) = 100 − 60 = 40
Profit is:
Πintegrated = (60 − 20) × 40 − 0 = 1600

Q(PR )
6

100 H
HH
H
HH
H
HH
H
HH
HH
HH
HH
0 HH -

0 20 100 PR

Uncoordinated Channel with Independent Channel Members: Using equation (7.11),

1 A 1 1 A 1
PM = V C+ ( −V C) = 20+ (100−20) = 60, PR = PM + ( −V C) = 60+ (100−20) = 80
2 B 2 4 B 4
Therefore:
Q(PR ) = 100 − 80 = 20
Manufacturer’s Profit (ΠM ) = (60 − 20) × 20 = 800

155
Retailer’s Profit (ΠR ) = (80 − 60) × 20 = 400
Total Channel Profit is:

Πuncoordinated = ΠM + ΠR = 800 + 400 = 1200

This is 400 less than the profit for the integrated channel.
Channel Coordinated by Quantity Discount: Suppose the manufacturer offers a quan-
tity discount: PM = 60 if Q < 40, and PM = 45 if Q ≥ 40. The retailer has two choices:

• Ignore the quantity discount. Then, his unit variable cost is 60, price is 80, and the
profit is 400 as in the uncoordinated channel.

• Accept the quantity discount and charge PR = 60 to get Q = 40. Then, his profit is
(60 − 45) × 40 = 600.

Clearly, the retailer will accept the discount, set PR = 60, and get ΠR = 600.
The manufacturer’s profit is:

ΠM = (45 − 20) × 40 = 1000

Note that the total channel profit is

Πcoordinated = ΠM + ΠR = 1000 + 600 = 1600 = Πintegrated

Range of discount: Here, the discounted manufacturer price is PM = 45. Actually this
could have been any price in a range as long as both the manufacturer and the retailer have at
least the profit they get in an uncoordinated channel. Thus, in this example, the manufacturer
requires ΠM ≥ 800, that is,

(PM − 20) × 40 ≥ 800, that is, PM ≥ 40

The retailer requires ΠR ≥ 400, that is,

(60 − PM ) × 40 ≥ 400, that is, 60 − PM ≥ 10, that is, PM ≤ 50

Thus, we could have used any PM between 40 and 50. The exact number is obtained by
negotiation and depends on the relative powers of the manufacturer and the retailer.
Channel Coordinated by Two-part Tariff: Suppose the manufacturer charges PM = 20
and a fixed fee of $1000. Then, for the retailer, profit is maximized at PR = 60. Demand is
40, and

ΠR = (60 − 20) × 40 − 1000 = 600, ΠM = (20 − 20) × 40 + 1000 = 1000

156
Once again, the total profit of the coordinated channel is same as that of the integrated
channel.
Range of Fixed Fee: The manufacturer requires ΠM ≥ 800, that is, the fixed fee must be
at least 800. The retailer requires ΠR ≥ 400, that is,

(60 − 20) × 40 − Fixed Fee ≥ 400, that is, Fixed Fee ≤ 1600 − 400 = 1200

Thus, the fixed fee could be any number between 800 and 1200. The exact number is obtained
by negotiation and depends on the relative powers of the manufacturer and the retailer.

8.9 Additional Reading

1. Louis W. Stern, and Adel I. El-Ansary, Marketing Channels, fourth edition, Prentice Hall,
1992.
This is the standard text on channels of distribution. The concepts presented in this section
are largely drawn from this text.
2. Abel Jeuland, and Steven M. Shugan (1983), “Managing Channel Profits,” Marketing
Science, 2(3)
Shows how channels can be coordinated using quantity discounts.

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9 Selected Topics on Promotion Strategy

9.1 Basic Ideas


There are four forms of promotion.
9.1.1 Advertising. “Any paid form of non-personal presentation and promotion of ideas,
goods, or services by an identified sponsor.” Basic features of advertising:
1. Can reach a mass audience simultaneously.
2. Standardized: The same message reaches the entire audience.
3. Control: The sponsor directly controls the message which reaches the audience.
4. The message that can be delivered is limited in scope and cannot contain a large amount
of information. As a result, advertising is most suitable for generation of awareness.
5. The audience cannot provide feedback directly.
9.1.2 Personal Selling. “Presentation of a product to a prospective customer by a repre-
sentative of the selling organization.” Basic features:
1. Typically, it involves an oral presentation.
2. Compared to advertising, personal selling can be directed more easily at qualified customers.
3. The salesperson can customize message to satisfy the information needs of a specific
customer.
4. The salesperson directly interacts with the customer and receives immediate feedback. This
helps reduce noise in communication. In addition, the salesperson gets valuable insight into
the nature of the needs of the customer. This can help a company (i) identify competition, (ii)
determine if customers like the products it currently offers, (iii) get directions for improving
the products it offers, and (iv) get new product ideas.
5. By interacting directly with the customer, a salesperson would know whether to try to
close a sale or stop trying to sell the product.
6. A salesperson can build a long term relationship based on trust and/or mutual dependence
with a customer. This makes the selling task easier in the long run. This can happen only if
the salesperson keeps the customer’s interests at heart.
7. Personal selling is a company’s most expensive contact tool. In 1983, the average cost
of a sales call was $205. In 1981, American companies spent over $150 billion on personal
selling (compared to $61 billion on advertising in that year). This makes effective sales-force
management a priority for most companies.
8. Compared to advertising costs, the firm has a greater degree of control over personal selling
costs. First, in contrast to advertising space which has to be purchased in large blocks, the
size of the sales force can be changed by small amounts. Second, the firm has control over
the method of compensating the sales-force. For example, if a firm uses straight commissions

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to pay the sales-force, selling costs become variable rather than fixed and are incurred largely
after sales are made. That is desirable for a firm in a weak financial condition.

9.1.3 Sales Promotion. This is a name applied to a variety of techniques which include
coupons, contests, premiums, etc. A sales promotion can be directed at ultimate consumers
as well as at intermediaries in the channel of distribution.
Basic features of sales promotions:
1. Communication: They gain attention and usually provide information that may lead the
customer to the product (e.g., “At your participating GM dealers”).
2. Incentive: They often include something (e.g., price reduction) which is of value to the
party addressed.
3. Invitation: Usually, they include a distinct invitation to buy quickly. For example, if a
buyer for a department store may be offered a lower price if she places an order during a trade
show.
Examples: (i) 20% off all men’s shirts from October 20 - 22 at Sears. (ii) “. . . Prices this good
cannot last for ever, so buy now.”

9.1.4 Public Relations. The text discusses the general concept very well. I will now briefly
discuss publicity.
Publicity: “Securing editorial space in a medium which will reach the target audience.”
Unlike advertising, here the company usually has little control over the message that
reaches the public. If it is favorable, publicity has the following advantages over advertising:
1. High credibility: Since the information is published by independent media, the message is
more credible to the target audience.
2. Target audience may be caught off guard: Publicity can reach prospects who may con-
sciously avoid advertisements, salespeople, etc. For example, a person who does not look at
computer advertisements may read an article about a new chip by IBM published in the New
York Times.
3. Usually, publicity costs less than advertising (or personal selling). However, it is not entirely
cost free.
4. It can be conducted much faster than an advertising campaign.
5. More information can be released to the media than one can put in an ad campaign.
Of course, in order to get editorial space, the news media should consider the news worth
publishing.
However, publicity has two potential problems:
1. It is not possible to control what is published by the news media.
2. A given publicity item can usually be used only once as news has a very short shelf life.

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9.2 Selected Topics on Personal Selling

9.2.1 Introduction
Personal selling has two primary objectives, (1) convey product and company information
to the customer and receive feedback, and (2) persuade the customer to buy the product. In
addition, the salesperson, being close to the customer, can help the company determine the
customers’ needs and level of satisfaction with currently available products. The roles played
by the salesforce and the types of salespeople employed by a company are determined by these
objectives.
1. Roles played by the sales force. A sales force acts as an intermediary between the
firm and the customer and usually plays the following roles:
(i) Conveyer of information (including “missionary sales”). The sales force facilitates com-
munication between the firm and the customer. It conveys information about the company
and its product mix to the customer. It conveys information about the product mix sought
by the customer to the firm.
(ii) Catalyst for the selling process (creative selling). The sales force can create demand
by demonstrating how the product offered by the company can satisfy the customer’s needs.
This can take two forms:
(a) Developing primary demand for a new product category. For example, IBM’s salespeople
showed the target customers how a main frame computer would increase productivity. The
purchase will be a new task for the customer.
(b) Developing selective demand for the company’s product. Here, the sales force has to
compare the company’s product with the competitors’, and justify why the customer should
choose it. The purchase is likely to be a modified rebuy or a new task for the customer,
depending on what (s)he is using at present.
In her role as a catalyst for the selling process, a salesperson usually has some control
over the product mix she can offer a customer. Thus she can modify the mix to make it
more acceptable to a customer. For example, this may involve matching a price cut by a
competitor. Other common examples are offering a favorable trade in for an old product,
reducing the freight charge, or guaranteeing early delivery.
(iii) Service agent. The sales force sometimes performs service related tasks, some of which
are listed below:
(a) Order processing. (b) Delivering product. (c) Help arrange financing. (d) Service the
product after purchase (e.g., arrange repairs, supply parts). (e) Teaching the customer how
to use the product.
Note: I have often used the term sales force rather than salesperson in the discussions above.
This is because the selling may be done by a selling team rather than one salesperson. Also,
different salespeople might perform different tasks involved in personal selling.
2. Types of selling jobs. Salespeople may be categorized based on the functions they

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primarily perform for the company. The main categories are as follows.
(i) Order getters. Order getters specialize in new customers and their tasks include:
(a) Identifying prospects and their needs.
(b) Attracting attention and making the initial sale. This may include setting up displays,
giving product demonstrations, performing promotional work, making sales presentations, and
handling objections.
(c) After the sale, stimulating further demand for the product.
(ii) Order Takers. Here, the demand already exists. The salesperson’s tasks primarily
include: (a) Taking orders. (b) Providing delivery services. (c) Offering best deals. An order
taker can work inside(e.g., a salesperson working for a mail order PC company), or in the field
(outside) (e.g., a representative of an apparel manufacturer visiting the buyers of department
stores).
(iii) Sales Support Personnel.
(iii)(a) Missionary. The missionary salesperson is usually not expected or permitted to take
an order, and her primary task is to build goodwill or to educate the potential or current user.
The absence of selling pressure gives her greater access to potential customers. A missionary
salesperson can help the company identify the product mix sought by the customer and
determine whether these needs are satisfied by existing products. For example, representatives
of text-book publishers routinely visit professors and talk about new text offerings, supply
review copies, etc. They also take ideas about the competition and new texts back to the
publishers.
(iii)(b) Technical salespeople. The technical salespeople have specific technical knowledge
and generally come from functional areas such as production and finance. They usually do
not make actual sales unless the product is complex and new. A technical expert often has a
counterpart in the buying organization.
Examples:

Example 1. An engineering salesperson who is primarily a consultant to a client


company.

Example 2. A technical expert who prepares proposals for complex products that
will be purchased through bidding.

Example 3. A technical expert who assists an order getter handle objections during
a sales presentation.

Example 4. A financial expert who specializes in making complex deals.

In addition, sales support personnel also include people who make deliveries or
handle complaints.

9.2.2 Sales Force Organization (Structure).

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A firm should organize its salesforce to serve its market efficiently. There are four basic
structures: (1) geographical, (2) product, (3) customer and (4) function. Larger firms typically
use a complex structure, i.e., a combination of two or more basic structures.
The Basic Structures:
1. Territorial (Geographic) Structure. This is a very simple sales organization where
each salesperson is assigned a specific geographic territory, and she represents all the products
from the company in that area.
Advantages: (i) A salesperson’s duties are clearly defined. To the extent personal selling
makes a difference, the salesperson receives credit or blame for the sales in a territory.
(ii) The salesperson has a chance to develop local business and personal ties. This leads to
long term relationships with the customers and a better understanding of the local market
conditions. This is particularly meaningful when the customers are individual consumers or
small companies.
(iii) Travel costs are low. This is particularly meaningful when customers are scattered spa-
tially.
The geographical structure is the basic sales force structure. However, there are situations
where the geographic structure is not appropriate. If the company sells several unrelated
products and the selling of each product requires technical expertise, one sales representative
may not be able to function efficiently. In that situation, a product oriented sales force may
be used.
If the customers are heterogeneous, and different customers have different needs, one sales
representative may not be able to handle all of them efficiently. In that situation, the company
may use a customer-structured sales force.
Finally, sometimes personal selling may involve more tasks than generating immediate
sales. For example, it may be desirable to educate customers about potential benefits of the
product, provide service after a sale is made, train new recruits and try to identify and convert
new prospects rather than simply sell to existing customers. When tasks are diverse and need
different skills, a firm may structure its salesforce based on function.
2. Product Structure. Sometimes, when a company sells several unrelated, complex
products, a given salesperson specializes in selling certain products.
Advantages: (i) Each salesperson is more knowledgeable about what (s)he is selling, and can
answer customer questions and handle objections better.
(ii) If the company uses product management, a product oriented salesforce will be more
efficient, since a salesperson has to work with only one division in the company.
Potential Disadvantage: To begin with a product organization is more costly in terms of
travel expenses than a territorial organization. In addition, a company may have several
product divisions, each with its own salespeople, all selling products to the same customers.
For example, a hospital supply company may be selling many different products to the same
hospitals. In that case, the product-structured sales force may become inefficient due to the

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following reasons:
(i) If the salespeople responsible for the different products do not interact properly, they might
compete for the same buyer’s time.
(ii) The task of the buyer may become more complex as she now has to deal with several
salespeople (rather than one salesperson for a geographically structured salesforce).
3. Customer Structure. When customer needs and purchases vary widely, a company
may use a customer oriented sales force where different salespeople or sales teams specialize in
different groups of customers. For example, companies often structure their sales forces based
on customer type, e.g., major vs minor accounts, and regular vs new customers. The Digital
Equipment Corporation (DEC), for example, has a separate sales force for selling personal
computers to farmers. Note that a company using a customer oriented sales force is employing
market segmentation.
Advantage: A salesperson (or selling team) can be more knowledgeable about the needs of a
specific category of customers and can therefore sell more effectively to it.
Disadvantage: If the customers of a given category are scattered over a wide region, that may
lead to high costs of travelling.
A special case. Sometimes a customer is so large that the company assigns a salesperson
(or selling team) exclusively to that customer. The salesperson is usually responsible for
one account with one company for the entire country. This is called national account
organization.
4. Functional Structure. This organization is not discussed in the text. Here, the firm
organizes its salesforce based on function. For example, some salespeople may specialize in
prospecting, some salespeople may specialize in large customers, etc. Clearly, this method
makes sense if there are many functions involved and one salesperson or team may find it
difficult to master all of these functions.
Combination. So far we have discussed four simple salesforce structures. Sometimes a
company may use a combination of these structures as well. For example, a salesperson may
be responsible for selling a specific product only in a given territory (compare this with the
geographical structure where one salesperson sells all products).
To illustrate when a complex sales force structure may be useful to the selling company,
let us consider business market segmentation based on decision style. (For a more complete
description of the decision styles listed here, see Section 3 of the Reader.) Buying organizations
can be segmented as follows based on decision style:
(1) Bureaucratic Decision Style: Primarily government agencies. Many organizations with
trustees (e.g., hospitals, universities) also use this form of decision making.
Needs: Meet specifications. Proper paper work. Low prices.
Seller’s perspective: Assign clerical staff to learn when the need arises and what paper work
is required. May need technical salespeople to meet specifications, prepare bids and write
proposals. Usually, there is no need to make sales presentations.

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(2) Small Companies: These are typically characterized by (i) small order size, (ii) immediate
need, and (iii) a small number of decision makers without technical expertise.
Needs: Fast delivery. Guarantee that the product will work. After sale service.
Seller’s Perspective: A geographic (territorial) salesperson is most appropriate here. The
customer will feel comfortable dealing with somebody she can access easily after the product
is purchased.
(3) Large companies with functional divisions: These are typically characterized by large
orders and a long period of planning and comparing alternatives. As similar needs may recur,
the buying firm may wish to establish a long term relationship with the seller to avoid lengthy
decision making in the future.
Seller’s perspective: Need a selling team. Effective (and probably multiple) sales presentations
necessary. Need experts to negotiate with and handle objections from experts in the buying
team. This can be an ongoing process. If the customer is large, national account organization
may be necessary.
Team Selling. When the selling task is complex, a company may use a selling team instead of
a salesperson acting alone. A selling team may consist of an order getter, technical salespeople
to handle objections, support people to arrange deliveries, etc. Team selling makes sense if:
(i) The product is complex (e.g., a main frame computer), and the selling team needs experts
to answer questions raised by experts in the buying center.
(ii) The size of the order is very large. The selling team may require financial experts, experts
on the logistics of making deliveries etc. to negotiate the details of the purchase with the
buyer.
9.2.3 Salesforce Compensation
Selling is a physically demanding job. It is mentally demanding as well since uncertainty is
part of life. In addition, the salesperson often has an inferior status compared to the buyer, and
she has to confront aggressive, competing salespeople. Clearly, a salesperson needs recognition
and reinforcement to maintain a high level of motivation. An enlightened company would
provide individual attention to members of its salesforce, providing counselling and remedial
training to improve performance, and rewarding superior achievement.
Companies use financial as well non-financial incentives to motivate the salesforce. Non-
financial incentives include peer recognition, paid vacations, etc. The company often ties the
earnings of a salesperson to his performance to induce her to work harder. An examination
of the common methods of compensating salespeople illustrates that. We first describe three
basic methods of compensating a sales force and then discuss two ways to modify the basic
forms.
Basic Forms:
1. Straight salary. This is appropriate when the job of the salesperson includes primarily
non selling duties (e.g., missionary, technical salesperson).
Advantage: This provides the salesperson with a stable earning.

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Problems: (i) The earnings are not related to any performance measure. This method will be
effective only if the company can evaluate the quality of the salesperson’s performance and
use incentives like social recognition or possibility of promotion (or, threat of losing the job)
to motivate her.
(ii) A compensation structure based on salary represents a fixed cost for the firm. This may
not be appropriate for a firm in a weak financial situation.
2. Commissions. Under this plan, the salesperson is paid a predetermined percentage of
the revenue generated. Most companies use a straight commission plan where the sales-
person receives a fixed percentage of revenue regardless of the level of sales attained. Some
companies employ a sliding commission plan where the percentage depends on the level of
sales achieved. A plan based on commissions is appropriate when the amount of sales depends
largely on the initiative of the salesperson, e.g., on the number of accounts called.
Advantage: There is a clear incentive to work harder.
Some of the conditions when use of commissions is appropriate: (i) When the company has
a weak financial position. Commission is paid only if a sale is made, and is a variable rather
than fixed cost. (ii) When it is hard to monitor how hard a salesperson is working. (iii) When
the non selling part of the salesperson’s job is negligible.
Disadvantages: (a) The salesperson’s earnings are often unstable. Confronted with a high
level of uncertainty in income, salespeople may quit.
(b) The salesperson’s objective may be to earn a large amount quickly, and then leave the
salesforce. Such a salesperson will try to sell more in the short run at the expense of building
a long term relationship with the buyer. This can result in the loss of consumer goodwill for
the company. The company should be careful to prevent this. One solution may be to relate
the salesperson’s future earnings to the long term success of the firm, e.g., by giving her stocks
in the company.
3. Combination of salary and commission: These plans use a salary plus a commission.
The commission motivates the salesperson to work harder, and the salary provides a stable
income.
Modifications: These are used to modify basic forms such as a straight salary or a straight
commission plan.
1. Compensation based on sales quotas: Sometimes the incentive a salesperson receives
from the firm depends on the attainment of a pre-specified target, also called a quota. The
incentives are generally financial. For example, the salesperson may receive a bonus or a
higher commission rate if she reaches the target. In some cases, the incentive is non-financial.
For example, it may also be purely social recognition, e.g., the color of the uniform a Mary
Kay Cosmetics salesperson is allowed to wear.
The principal purpose of having a target is to motivate the salesperson to work hard. If
the quota is too low, that purpose is not served. If the quota is too high, that is not good
either as the salesperson may be discouraged even from trying to achieve it. Clearly, the

165
choice of the target is of central importance to the firm. An enlightened firm should recognize
that different salespeople cannot always be expected to generate equal revenues. For example,
they may be working in territories with unequal sales potentials, may have different levels of
training, etc. When the sales manager is qualified to recognize and evaluate such differences,
(s)he may use sales quotas to evaluate the performance of a salesperson. Usually, the sales
manager, together with each salesperson, decides on a target sales for a specified period.
There is a second reason why a firm may use a quota plan. By aggregating the quotas for
the different salespeople, the marketer can obtain an estimate of the total market demand.
This estimate can be used to plan production better.
In general, the success of a plan using quotas depends critically on the management’s
ability to predict sales for a given level of sales effort.
2. Drawing Account: To reduce the uncertainty in a salesperson’s earnings, firms sometimes
use drawing accounts where a salesperson can draw a moderate amount of money from the
firm to provide herself with a stable earning. For example, the firm may pay the salesperson
a fixed amount at regular intervals. Or, a salesperson may be able to draw limited amounts
until the outstanding balance reaches a predetermined limit.
Typically, a drawing account is used in combination with a compensation scheme based
on commissions, and the salesperson is expected to pay back the amount drawn when (s)he
makes the sales.
In addition to the compensation schemes listed above, firms use other financial incentives to
motivate their salespeople. For example, there are sales contests, and the winning salespeople
are rewarded.
9.2.4 Sales-force Size: Three methods commonly used to determine sales force size are
briefly described. For details, please see “Sales Force Management” by Churchill, Ford and
Walker, fifth edition, 1997, Irwin.
1. Breakdown Method: This is a simple approach where the firm estimates its forecasted
sales volume s, and the average sales generated by a salesperson p. The size of the sales force
is:
s
n =
p
For example, if the forecasted sales volume is $5,000,000, and the average productivity is
5, 000, 000
$250,000, you need = 20 salespeople.
250, 000
2. Workload Method: This is a more sophisticated method and has the following steps.

• Divide current and prospective accounts into categories. Some firms use the ABC mech-
anism which says that top 15% of accounts represent 65% of sales volume, the next 20%
accounts represent 20% of sales volume, and the last 65% accounts represent 15% sales
volume. Some other firms use the 80/20 rule which states that the top 20% of accounts
represent 80% of sales.

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• For each account category, determine the number of calls needed per year, and the length
of each call.

• For an average salesperson, determine the number of weeks he works in a year, the
number of hours he has available in a week, and the fraction of the available time he can
spend on his sales calls. From this, determine the average number of hours a salesperson
can spend on sales calls in a year.

• You can now determine the number of salespeople you need.

Example: Acme Company has the following accounts:


Account Number of accounts Frequency of calls Number of calls Length of
Category in Category needed needed in a year a call
A 200 once in a month 12 120 minutes
B 300 once in 3 months 4 60 minutes
C 1000 once a year 1 30 minutes
Thus, you need a total of
(200 × 12 × 120) + (300 × 4 × 60) + (1000 × 1 × 30) = 390, 000
390, 000
minutes a year, that is, = 6500 hours a year for sales calls.
60
Suppose now an average salesperson works 40 weeks a year, 45 hours a week, and can
spend 30% of this time on sales calls (the remainder is spent travelling, preparing reports,
arranging delivery, etc.) Thus, an average salesperson has 40 × 45 × 0.30 = 540 hours each
year he can spend on sales calls.
6500
Combining, the required size is ≈ 12.
540
3. Incremental Method: In this method, you estimate the revenue and costs as you increase
the size of your sales force. Keep on increasing the size as long as the marginal profit from one
more salesperson (before considering compensation and other costs related to having another
salesperson) exceeds the marginal cost of adding that salesperson.
Example: Suppose the marginal cost of adding another salesperson is $100,000, and you
have the following information:
Number of Revenue Cost unrelated to Gross Profit Marginal Profit Cost related Marginal
Salespeople to sales force to sales force Cost
($1000) ($1000) ($1000) ($1000) ($1000) ($1000)
0 0 0 0 0 0 0
1 300 120 180 180 100 100
2 580 270 310 130 200 100
3 850 420 430 120 300 100
4 1110 570 540 110 400 100
5 1350 720 630 90 500 100
6 1530 870 660 30 600 100

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Note that the marginal profit (column 5) from an additional salesperson exceeds the marginal
cost of having another salesperson (column 7) as long as the number of salespeople is 4 or
less. Clearly, the net profit after considering sales force related costs is maximized for a sales
force of size 4.

9.3 Publicity
Basic Idea: Publicity involves securing editorial space (as opposed to paid space) in media
watched, read or heard by the target audience.
Objective: The basic objective of publicity is to create a favorable image of the company which
will lead to improved performance (sales, investment, etc.) in the long run. Some specific
examples of publicity objectives are (i) handling adverse rumors and stories, (ii) building up a
good corporate citizen image for the company or industry, and (iii) enhancing the reputation
of the company as a pioneer in research and development.
In the rest of the section, we consider publicity through the news media only. However,
publicity can be conducted by other means also. For example, many nonprofit organizations
send newsletters to its target audience (e.g., universities to its alumni) which contain stories
about positive developments in the organizations. This method of transmission is a mixture
of advertising and publicity, and it is becoming more sophisticated with advances in desk-top
publishing.
The organization seeking the publicity does not control the message directly. Usually it
has to first sell the information to the news media. If that is successful, the media in turn
will communicate the information to the ultimate audience. Thus, this is an example of two
stage communication. The key to publicity is selling the information to the media. Many
organizations have public relations departments to do that effectively. Other organizations
hire public relations firms to do the job. One of the tasks of a public relations department is
to maintain a good relation with the press. This helps favorable news to get out quickly and
also control potential damage from unfavorable events. The public relations department also
advises corporate management about public issues and the company’s image.
Organizations often use the following two methods to generate publicity :
(1) Finding news. Most organizations have something important or interesting happening
within it. For example, a member of the research staff may have received a major scientific
award, or the organization has started a day care facility for children of the employees. De-
pending on the magnitude of the news, the organization can use a press conference or press
release, or it can submit an article to a magazine.
(2) Creating news. A university can host a major conference. A company can start a program
to benefit the homeless, etc. Nonprofit organizations generate considerable publicity through
events like auctions.
The news media usually publishes something only if a significant portion of its audience
can personally relate to it. Thus, the type of news an organization would try to get published

168
through a specific medium depends on the nature of the audience the organization intends
to reach through that medium. If the ultimate audience is technically sophisticated (e.g.,
buyers of main frame computers or advanced scientific equipment), news about a technological
development may be promoted. Otherwise, the stories often highlight the human element
involved. For example, during the early days of space exploration, stories addressed to the
popular media focused on the astronauts rather than the technological breakthroughs which
occurred at that time. The result was positive for NASA, −− it received the public support
and the funds it needed for success.
Examples of successful use of publicity:
(1) Cabbage Patch dolls: Caleco formally introduced the dolls in 1983 at a Boston press
conference where local school children participated in a mass adoption ceremony. The dolls
were promoted to child psychologists who publicly endorsed the product. Consequently, the
product was recommended by women’s magazines as a perfect Christmas gift, was featured
on the Today show, etc. The dolls were sold out by Thanksgiving, and the Cabbage Patch
Panic began.
(2) 9-Lives Cat Food: Star-Kist Food’s 9-Lives conducted a publicity campaign involving
Morris the cat. Among other things, the campaign used:
(i) A Morris look-alike contest in nine major markets. Morris made a personal appearance in
the shows. These shows generated several news stories.
(ii) Publication of “Morris, An Intimate Biography.”
(iii) Distribution of a booklet called “The Morris Method” of cat care.
The publicity generated by the campaign increased consumer awareness of 9-Lives Cat
Food and resulted in a 43% increase in sales.

9.4 Selected Topics on Advertising

9.4.1 Introduction
According to the American Marketing Association (AMA), advertising is defined as “Any
paid form of non-personal presentation and promotion of ideas, goods, or services by an
identified sponsor.”
Some numbers:
1) In 1983, U.S. companies spent $75.9 billion on advertising.
2) U.S.A., with 6% of the world’s population, accounts for 57% of world advertising.
3) By the time (s)he finishes school, a typical U.S. high school graduate spends 11,000 hours
in the classroom, and 25,000 hours watching T.V.. Before the advent of VCRs with remote
controls, an average U.S. high school graduate would have watched 6000 hours of T.V. adver-
tising.

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4) In the 1970’s, a typical U.S. family would be exposed to over 2000 commercial messages a
day.
9.4.2 Media Selection
A marketer can choose between many alternative media to reach its target audience. Some
criteria for selection are described below:
1. Audience Coverage: To begin with, the marketer has to decide what is the target audience,
that is, who are the people she would like to reach. This helps determine how to transmit
the message efficiently to them. For example, if you want to advertise a local restaurant, a
national advertisement during Olympics will probably reach a very large audience, but it will
not be efficient and will cost too much to reach each person in your target audience. The
efficiency of audience coverage depends on the following factors:

• Selectivity: How selectively can the media reach the target audience? A more selective
medium will have less wastage. For example, women’s magazines will be a more selective
medium for ads on baby lotions than the New York Times.

• Reach: The text defines it as the fraction of a target population that gets exposed to
the commercial in a specified time period (usually four weeks), multiplied by 100. For
example, suppose you have a target audience of 15 million people, and 6 million out of
these 15 million people are exposed to the commercial in a four week time period. Then,
6
reach is × 100 = 40.3
15
• Frequency: Within the specified time period (usually four weeks), how many times will
a receiver be reached by the advertisement if this medium is used?

Reach and the frequency are usually multiplied to form a single measure called the gross rating point
(GRP) of a commercial.
For example, suppose 6 million people within a target audience of 15 million are exposed
to the commercial within the specified period and these people are exposed to the commercial
6
five times on the average. Then, reach is 15 × 100 = 40, frequency is 5, and GRP of the
commercial is 40 × 5 = 200.
2. Flexibility: A medium is more flexible if an ad can be placed in it at a shorter notice. For
example, radio is more flexible than the television.
3. Cost: The marketer should consider the total cost as well as the cost per person reached.
In the context of print media, the Cost Per Thousand (CPM) is used to compare alternative
media outlets.
3
The idea of reach is simple, but the definition of reach varies from text to text. For example, some texts
define reach as the absolute number of people in the target audience that get exposed to the commercial, that
is, 6 million in the example above. Some other texts define it as the fraction of the target audience that gets
exposed to the commercial, that is, 0.4 in the example above. When you are given these numbers, you should
ask how reach is defined.

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Definition of CPM:
Cost of Commercial
CPM = × 1000
Number of target customers reached by commercial
For example, suppose the cost of placing the commercial in a given magazine is $20,000, and
the magazine is read by 500,000 men in the age group 35-49, which is your target audience.
Then,
20, 000
CPM = × 1000 = 40
500, 000

Note: For a given commercial in a given outlet, CPM varies with your target audience. For
example, if your target audience was men in age group 18-34, and 250,000 people in that age
20, 000
group read the magazine, the CPM would be × 1000 = 80
250, 000
4. The requirements of the message. This depends on the nature of the product and the
audience familiarity with the product. For example, the radio may not be the best vehicle for
ads about fashion clothing, for which it is desirable that the receiver can see what the product
looks like.
5. Editorial Environment.
We now evaluate some of the specific media used in advertising using the criteria described
above:
1. Television: The television is a relatively new but pervasive medium for advertising. An
advertiser would like to find the most efficient way to transmit the message to the target
audience. Thus, it is important to know the nature of the audience that watch the different
programs, and how many people watch them. This information is available from syndicated
sources, e.g., the A.C. Nielsen Company. Nielsen collects data from a panel of respondents
using a device attached to the TV which records which channels get turned on and when.
From this, Nielsen prepares ratings for TV programs and supplies them to the subscribers.
Advantages of TV advertising:

• It is a visual medium, suitable for mood advertising, demonstrations, etc.

• It can access a large and diverse audience at once.

Disadvantages of TV advertising:

• Very costly. Hard to transmit information selectively. The advent of cable has reduced
the problem. Some marketers are using self selection by receivers to reduce cost. For
example, some makers of cosmetics broadcast long (e.g., half hour) commercials using
infrequently used cable channels. This works only if the target audience knows where
to find the commercials.

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• Clutter. This problem is major for brands with low market shares as their commercials
get confused with those of the market leaders. This problem decreases with an increase
in product differentiation.

• Viewers often do not pay attention to the commercials, and even switch channels when
the commercials come on. In the past, before the days of the remote control, advertisers
tried to counter lack of attention from viewers by massive repetitions of the commercials.
Now, it is becoming more important to produce commercials that the viewers would like
to watch rather than be forced to watch. In general, television commercials should be
short and uncomplicated.

2. Radio. Comparison with television:


Advantages:

• Relatively inexpensive. A commercial can last longer.

• More selective: Can reach a local market more selectively. Also, specific radio stations
tend to be more specialized in terms of programs they carry. Thus, it is easier to reach
a certain type of audience more effectively.

• Sometimes the DJ acts as the spokesperson, and members of the audience can call back
and generate a dialogue about the product. This generates audience interest. This
method has elements of both advertising and publicity.

Disadvantage: Visual stimuli cannot be used.


3. Print Media
Advantages of print media:

• These can reach a specific audience effectively.

• Advertisements can provide more information. Visual stimuli can be used. Magazine
advertisements sometimes even have small samples or coupons attached to them.

• The receiver can retain the message itself rather than a memory of it. This reduces the
need for repetition.

• In rare cases, marketers have used smell in print media, such as perfume.

• By attaching numbered coupons to the print advertisements, the sales response to the
advertisement can be measured.

Disadvantage of print media: As the medium is static, commercials do not have the impact
of television commercials.
Types of Print Media:

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• Newspapers: These are geographically selective and flexible as advertisements can be
inserted at a short notice.

• Magazines: (i) Consumer Magazines. (ii) Trade Magazines (very selective).


Magazine advertising has the desirable feature that people often keep magazines for a
long time and pass them around among friends. As a result, reach and frequency both
increase.

Problem: Magazine advertising can be very costly and is not flexible like newspaper
advertising where you can insert an advertisement easily.

4. Outdoor advertising (Billboards): These advertisements are usually stationary and placed
where many people will see them. They are often placed next to busy highways.
Advantages:

• Relatively inexpensive.

• They can be placed near a distribution outlet and thus serve the same role as a point
of purchase display.

Disadvantages:

• Clutter. There are often many billboards near one another.

• The advertisement cannot contain much information. They are mostly suitable for
reminder advertising.

• Legal restrictions. In the USA, many communities impose restrictions on how many
billboards can be displayed in a given area.

• Not selective.

5. Internet: This is growing area and there is intense competition between organizations such
as google and Yahoo for advertising dollars. As this is a complex area with evolving pricing
strategies, we will not get into this topic in more detail.

9.5 Sales Promotions


9.5.1 Basic Idea
Sales promotions include those activities, other than personal selling, advertising, public
relations and publicity, that stimulate consumer purchasing and improve the marketing per-
formance of sellers, i.e., the term sales promotion is used to represent a variety of marketing
activities.

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General Comments:
1) Connection to communication: A sales promotion is a crude form of communication which
contains elements of advertising and pricing. The message development is usually simple. For
example, a coupon usually tells the receiver how much saving is involved, and how to redeem
it. Consequently, the decoding is also a simple process. Usually, the only feedback received
by the sponsor is the response to the promotion, e.g., number of trials generated.
2) Industry Practice: U.S. companies currently spend a massive amount of money on sales
promotion, and estimates range from $ 100 billion to $ 250 billion a year. This is partly a
result of reduced effectiveness (too many ads, legal restrictions) of advertising, and the fact
that managers now have competence in designing sales promotions. However, the increase
in trade promotions have resulted from another factor: the growing power of the resellers.
Typically, the manufacturer of consumer goods depend more on major retail chains than vice
versa, since the latter carry many types of products and has better knowledge of local market
conditions as well. This fact, coupled with increased competition, has forced manufacturers to
make concessions to retailers in order to get shelf space. As a result, for many of the packaged
food items, trade discounts are becoming the standard practice rather than anything special,
i.e., retailers are paying less for the items they carry.
9.5.2 Types of sales promotions and their objectives
A sales promotion may be directed at consumers, channel intermediaries, or the company’s
own salespeople. Usually, the objective of a sales promotion is to stimulate earlier or stronger
market response. In most cases, the effect of a sales promotion lasts for a short time. While a
given sales promotion usually lasts for a short time, a company often has a long term strategy
of using sales promotions.
Examples of Consumer promotions:
(1) Price Incentives (i.e., sale): These can be initiated by any member of the channel of
distribution, and they involve savings off the regular (i.e., list) price. Price incentives range
from cents-off deals for frequently purchased packaged goods to hundreds of dollars off the
prices of stereos, televisions, cars, etc.
Objective: Usually short term stimulation of sales and inventory clearance. It can also be a
form of price discrimination: it induces sales from the price sensitive segment which waits for
sale prices, and does not significantly reduce revenue from the price-insensitive segment which
would not wait.
(2) Coupons: Coupons are certificates which entitle the bearer to a stated saving on the
purchase of a specific product. Over 220 billion coupons were distributed in 1988, and about
7 billion were redeemed.
Method of distribution: Coupons may be mailed, inserted in a package, or inserted in print
advertisements.
Short Term Objectives: Coupons have been used to stimulate sales for mature products.
Long Term Objectives:

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(i) Coupons have been used to generate trial of frequently purchased goods in order to shorten
the introduction/market development phase. They have been used to induce reuse of fre-
quently purchased products (e.g., 50 cents off your next purchase of Folger’s Coffee), thereby
reducing search of alternatives.
(ii) The use of coupons is also a form of price discrimination : it induces sales from the price
sensitive segment who are ready to do the work required to redeem coupons.
(iii) To remind the consumer that the product exists.
(3) Bonus Packs: These offer a consumer an additional quantity of the product at no extra
cost (e.g., buy one, get one free). These are typically used to stimulate short term sales.
Bonus packs have been used by companies as entry barriers. For example, L’eggs dis-
tributed bonus packs of its panty hose to prolong the market development stage of No Non-
sense, a competing product.
(4) Premiums: A premium is merchandize offered free or at a low price to induce consumers to
buy a certain product. For example, breakfast cereal manufacturers often offer toys, t-shirts
etc as premiums (usually a consumer has to send in a proof of purchase, e.g., a box-top, to
collect the premium). Sometimes, the article given as premium is attached to the product
purchased (e.g., free matching slippers with purchase of a gown, etc.).
(5) Samples: Samples are small quantities of goods which a customer can try free of charge
or at a low cost.
Methods of Distribution: Samples may be delivered door-to-door or by mail, picked up at
stores, or found attached to other products.
Objective: Samples are commonly used to induce trial of a frequently purchased packaged
good. This can be very effective during introduction.
(6) Contests, sweepstakes, and games:
Contest → The participant submits an entry to be evaluated by a panel of judges.
Sweepstake → The participants submit their names for a drawing.
Game → Typically, a consumer gets something (a missing letter, etc) each time she makes a
purchase, which can potentially help her win prizes.
This form of sales promotion is very effective for every dollar spent by the company since
only a fraction of the participants will receive prizes. To participate, it is not always necessary
to make a purchase. Even then, increased consumer interest leads to more sales.
(7) Point of Purchase Advertising (Displays): These are used to grab a consumer’s attention
at the point of purchase. For example, there may be a five-foot cardboard display of the
Marlboro man placed above Marlboro cigarettes. The displays offer no price incentive to the
consumer. The retailers receive trade discounts for allowing the displays to take place.
Note: In methods (1) to (5), every participating consumer receives some benefit. That may
represent a major expenditure for a company.
Examples of promotions directed at channel intermediaries:

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(1) Trade Show: Over 5600 trade shows take place every year, drawing about 80 million
people. Channel members who place orders during a show receive premiums, discounts, etc.
(2) Push money: Manufacturers frequently give financial incentives to channel intermediaries
to induce them to push their products. Usually, this involves obtaining increased and/or more
prominent shelf space. (For example, a breakfast manufacturer may like to have the product
placed at the eye level of children). Push money is also used to induce channel intermediaries
to demonstrate the use of products to potential customers. This is most meaningful during
the introduction of medium priced appliances (e.g., a new carpet cleaning device).
(3) Trade allowances: These are bonuses (cash, extra merchandize, etc.) given to a channel
member who buys a certain volume of the product in a given time period.
Objective: These will induce the retailers to carry the product during introduction, or in a
highly competitive market. These are also used to clear inventory (similar to a sale).
Some texts list cooperative advertising as an example of sales promotion directed at the
middlemen.
Trade promotions are used widely by manufacturers of packaged goods. For example, in
recent years, retailers purchased 90% of the packaged food products they carried at a discount
from the manufacturers. In comparison, only 15% of the merchandise was sold at a discount
to the ultimate consumers. This indicates the power retailers have over manufacturers, and
that trade discounts are becoming the industry practice rather than something special. This
is probably a reason direct marketing, which bypasses the retailer, is becoming increasingly
attractive to manufacturers.

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10 Estimation of Conjoint Model (Optional Material)
Consider the additive part-worth conjoint model:

(10.1) U (X1 , X2 , . . . , Xn ) = U0 + U1 (X1 ) + U2 (X2 ) + . . . + Un (Xn ),

where U0 is the evaluation score where each attribute is at the lowest level of its range, and
each part-worth score is zero if the attribute is at the lowest level of its range. To estimate the
conjoint model, we assume that when asked to rate a hypothetical product, the respondent
reports the utility given by equation (10.1) plus a random error as the evaluation score Y ,
that is,
(10.2) Y = U (X1 , . . . , Xn ) + ² = U0 + U1 (X1 ) + . . . + Un (Xn ) + ²,

where ² is the random error. Equation (10.2) can be estimated using dummy variable regres-
sion analysis.

10.1 Dummy Variable Regression


We first discuss dummy variable regression. Our focus will be on the interpretation of the
coefficients of the dummy variable regression model. Then, we will apply the intuition devel-
oped to understand conjoint analysis. I will illustrate dummy variable regression using four
examples.
Example 1. One Categorical Independent Variable: Consider the population of stu-
dents in the USA who graduated from college with undergraduate business degrees in 2006
and received jobs. Let Y denote the annual starting salary of a student (unit = $1000). Sup-
pose we can classify the type of the job into one of four mutually exclusive and collectively
exhaustive categories:
(1) Accounting
(2) Finance
(3) Marketing
(4) Other
To represent the four job categories, we need (4 −1), that is, 3 dummy variables. For example,
we can use:
D1 = 1 if the type of job is Accounting, D1 = 0 if not Accounting
D2 = 1 if the type of job is Finance, D2 = 0 if not Finance,
D3 = 1 if the type of job is Marketing, D3 = 0 if not Marketing
If D1 = D2 = D3 = 0, then the type of job is “Other.”

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Consider the regression model:

(10.3) Y = β0 + β1 D1 + β2 D2 + β3 D3 + ²

This equation is simply a way to allow the mean of Y to be different for the four job categories.
From (1), Y can be expressed as follows for the four job categories:
(1) Accounting: D1 = 1, D2 = D3 = 0

Y = β0 + β1 + ²

(2) Finance: D1 = 0, D2 = 1, D3 = 0

Y = β0 + β2 + ²

(3) Marketing: D1 = D2 = 0, D3 = 1

Y = β0 + β3 + ²

(4) Other: D1 = D2 = D3 = 0
Y = β0 + ²

Thus, β0 is the mean of Y over the sub-population of students who received jobs in the “Other”
category.
β1 = Mean salary of Accounting jobs − Mean salary of “Other” jobs
β2 = Mean salary of Finance jobs − Mean salary of “Other” jobs
β3 = Mean salary of Marketing jobs − Mean salary of “Other” jobs
Example 2. Two Categorical Independent Variables: Let Y , D1 , D2 , and D3 be
as defined in Example 1. Suppose, in addition to job type, salary may also depend on the
region of the USA where the job is located. Suppose location has four categories: East, West,
Mid-West, and South, and is represented by (4 − 1) = 3 dummy variables:
D4 = 1 if East, and D4 = 0 if not East
D5 = 1 if West, and D5 = 0 if not West
D6 = 1 if Mid-West, and D6 = 0 if not Mid-West
If D4 = D5 = D6 = 0, then the location is South.
Consider the regression model:

(10.4) Y = β0 + (β1 D1 + β2 D2 + β3 D3 ) + (β4 D4 + β5 D5 + β6 D6 ) + ²

In this case, there are 4 × 4 = 16 combinations of type of job and location. From Equation
(9.4), the mean Y for these sixteen combinations are given as follows:

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Location
Type of Job East West Mid-West South
Accounting β0 + β1 + β4 β0 + β1 + β5 β0 + β1 + β6 β0 + β1
Finance β0 + β2 + β4 β0 + β2 + β5 β0 + β2 + β6 β0 + β2
Marketing β0 + β3 + β4 β0 + β3 + β5 β0 + β3 + β6 β0 + β3
Other β0 + β4 β0 + β5 β0 + β6 β0
Note that:

• β0 is the average salary of “Other” jobs in the South

• For any given location,

β1 = Average Accounting salary − Average “Other” salary

β2 = Average Finance salary − Average “Other” salary

β3 = Average Marketing salary − Average “Other” salary

• For any given job type,

β4 = Average Salary in East − Average Salary in South

β5 = Average Salary in West − Average Salary in South

β6 = Average Salary in Mid-West − Average Salary in South

In this example, the difference in the mean salaries of two job types is assumed to be same
in all locations. Similarly, the difference in mean salaries between two locations is assumed to
be same for all job types. In other words, we assume that there is no “interaction” between
the effects of the two categorical variables job type and location.
Example 3: Suppose now you are rating a wide variety of sandwiches on 0-100 scales (0:
strongly dislike, 100: strongly like). The sandwiches are all available at the same price and
are similar in quality. They differ on two attributes:
(1) Bread: White, Italian, whole wheat, rye
(2) Filling: Beef, turkey, ham-and-cheese, egg
To represent the four categories of bread, we define (4 − 1) = dummy variables:
D1 = 1 if the bread is white, D1 = 0 if not
D2 = 1 if the bread is Italian, D2 = 0 if not
D3 = 1 if the bread is whole wheat, D3 = 0 if not
If D1 = D2 = D3 = 0, then the bread is rye.
To represent the four categories of filling, we define (4 − 1) = 3 dummy variables:

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D4 = 1 if the filling is beef, D4 = 0 if not
D5 = 1 if the filling is turkey, D5 = 0 if not
D6 = 1 if the filling is ham-and-cheese, D6 = 0 if not
If D4 = D5 = D6 = 0, then the filling is egg.
Consider the regression model:

(10.5) Y = β0 + (β1 D1 + β2 D2 + β3 D3 ) + (β4 D4 + β5 D5 + β6 D6 ) + ²

In this case, there are 4 × 4 = 16 combinations of bread and filling. From Equation (39.5),
the mean Y for these sixteen combinations are given as follows:
Filling
Bread Beef Turkey Ham-and-Cheese Egg
White β0 + β1 + β4 β0 + β1 + β5 β0 + β1 + β6 β0 + β1
Italian β0 + β2 + β4 β0 + β2 + β5 β0 + β2 + β6 β0 + β2
Whole Wheat β0 + β3 + β4 β0 + β3 + β5 β0 + β3 + β6 β0 + β3
Rye β0 + β4 β0 + β5 β0 + β6 β0
Note:

• When you rate a particular sandwich, your evaluation score may randomly deviate from
the mean evaluation score for that sandwich. ² captures such deviations and is zero on
the average.

• β0 is the average rating of a sandwich of rye bread and egg filling.

• For any given filling,

β1 = Average Rating of White Bread − Average Rating of Rye

β2 = Average Rating of Italian Bread − Average Rating of Rye

β1 = Average Rating of Whole Wheat Bread − Average Rating of Rye

• For any given bread,

β4 = Average Rating of Beef − Average Rating of Egg

β5 = Average Rating of Turkey − Average Rating of Egg

β6 = Average Rating of Ham-and-Cheese − Average Rating of Egg

Once again, we have assumed that there is no interaction between the effects of bread and
filling.
Alternative Interpretation:

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• β0 is the mean evaluation score of a “basic” sandwich of rye bread and egg filling.

• The term (β1 D1 + β2 D2 + β3 D3 ) is the adjustment to the mean evaluation score for the
four levels of the attribute “bread.”

– If bread is “rye,” then (β1 D1 + β2 D2 + β3 D3 ) = 0, that is, no adjustment is needed.


– If bread is white, then (β1 D1 + β2 D2 + β3 D3 ) = β1 , that is, β1 is the marginal
adjustment if bread is white instead of rye.
– If bread is Italian, then (β1 D1 + β2 D2 + β3 D3 ) = β2 , that is, β2 is the marginal
adjustment if bread is Italian instead of rye.
– If bread is whole wheat, then (β1 D1 +β2 D2 +β3 D3 ) = β3 , that is, β3 is the marginal
adjustment if bread is whole wheat instead of rye.

• The term (β4 D4 + β5 D5 + β6 D6 ) is the adjustment to the mean evaluation score for the
four levels of the attribute “filling.”

– If filling is “egg,” then (β4 D4 + β5 D5 + β6 D6 ) = 0, that is, no adjustment is needed.


– If filling is beef, then (β4 D4 + β5 D5 + β6 D6 ) = β4 , that is, β4 is the marginal
adjustment if filling is beef instead of egg.
– If filling is turkey, then (β4 D4 + β5 D5 + β6 D6 ) = β5 , that is, β5 is the marginal
adjustment if filling is turkey instead of egg.
– If filling is ham-and-cheese, then (β4 D4 + β5 D5 + β6 D6 ) = β6 , that is, β6 is the
marginal adjustment if filling is ham-and-cheese instead of egg.

Example 4: Suppose instead of sandwiches, you are evaluating several hypothetical laptop
computers on 0-100 scales (very poor to excellent). These computers are identical in every
way except on two attributes:
(1) Weight (X1 ): It can be 4 lb, 6 lb, 8 lb, or 10 lb.
(2) Hard Drive Size (X2 ): It can be 80 GB, 100 GB, 120 GB, or 160 GB.
Even though these two attributes are quantitative, we can treat them as categorical variables
with four categories each and represent them with dummy variables.
Weight (X1 ): To represent the four levels, we define (4 − 1) = 3 dummy variables D1 , D2 , and
D3 as follows:

• D1 = 1 if X1 = 6, and D1 = 0 if X1 = 4, 8, or 10.

• D2 = 1 if X1 = 8, and D2 = 0 if X1 = 4, 6, or 10.

• D3 = 1 if X1 = 10, and D3 = 0 if X1 = 4, 6, or 8.

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Hard Drive Size (X2 ): To represent the four levels, we define (4 − 1) = 3 dummy variables
D4 , D5 , and D6 as follows:

• D4 = 1 if X2 = 100, and D4 = 0 if X2 = 80, 120, or 160.

• D5 = 1 if X2 = 120, and D5 = 0 if X2 = 80, 100, or 160.

• D6 = 1 if X2 = 160, and D6 = 0 if X2 = 60, 80, or 120.

Consider the regression model:

(10.6) Y = β0 + (β1 D1 + β2 D2 + β3 D3 ) + (β4 D4 + β5 D5 + β6 D6 ) + ²

In this case, there are 4 × 4 = 16 combinations of weight and hard drive size. From Equation
(4), the mean Y for these sixteen combinations are given as follows:
Hard Drive Size
Weight 80 GB 100 GB 120 GB 160 GB
4 lb β0 β0 + β4 β0 + β5 β0 + β6
6 lb β0 + β1 β0 + β1 + β4 β0 + β1 + β5 β0 + β1 + β6
8 lb β0 + β2 β0 + β2 + β4 β0 + β2 + β5 β0 + β2 + β6
10 lb β0 + β3 β0 + β3 + β4 β0 + β3 + β5 β0 + β3 + β6
This time:

• ² is the random error in the reported evaluation score of a hypothetical laptop computer.

• β0 is the mean evaluation score of the “basic laptop” computer with weight 4 lb, and
hard drive size 80 GB.

• (β1 D1 + β2 D2 + β3 D3 ) is the marginal adjustment in mean evaluation score depending


on which of the four levels weight (X1 ) is at.

– If X1 = 4, then (β1 D1 + β2 D2 + β3 D3 ) = 0, that is, no adjustment is needed.


– If X1 = 6, then (β1 D1 + β2 D2 + β3 D3 ) = β1 , that is, β1 is the marginal adjustment
if weight is 6 lb instead of 4 lb.
– If X1 = 8, then (β1 D1 + β2 D2 + β3 D3 ) = β2 , that is, β2 is the marginal adjustment
if weight is 8 lb instead of 4 lb.
– If X1 = 10, then (β1 D1 + β2 D2 + β3 D3 ) = β3 , that is, β3 is the marginal adjustment
if weight is 10 lb instead of 4 lb.

• (β4 D4 + β5 D5 + β6 D6 ) is the marginal adjustment in mean evaluation score depending


on which of the four levels hard drive size (X2 ) is at.

– If X2 = 80, then (β4 D4 + β5 D5 + β6 D6 ) = 0, that is, no adjustment is needed.

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– If X2 = 100, then (β4 D4 +β5 D5 +β6 D6 ) = β4 , that is, β4 is the marginal adjustment
if hard drive size is 100 GB instead of 80 GB.
– If X2 = 120, then (β4 D4 +β5 D5 +β6 D6 ) = β5 , that is, β5 is the marginal adjustment
if hard drive size is 120 GB instead of 80 GB.
– If X2 = 160, then (β4 D4 +β5 D5 +β6 D6 ) = β6 , that is, β6 is the marginal adjustment
if hard drive size is 160 GB instead of 80 GB.

10.2 Back to Conjoint Analysis


Consider a product with 2 attributes: The laptop computer as in Example 4 with attributes
weight (X1 ) and hard drive size (X2 ). Suppose we wish to examine how evaluation score
changes if X1 varies over the range 4 − 10 lb, and X2 varies over the range 80 GB to 160 GB.
Suppose also the evaluation is done on a 0-100 (very poor to excellent) scale.
In this case, the additive part-worth model can be expressed as follows:

(10.6) U (X1 , X2 ) = U0 + U1 (X1 ) + U2 (X2 ),

where U (X1 , X2 ) is the mean evaluation score of a laptop with attribute levels (X1 , X2 ).
Without loss of generality, we assume that:

• U1 (4) = 0

• U2 (80) = 0

Under these assumptions:

U (4, 80) = U0 + U1 (4) + U2 (80) = U0 + 0 + 0 = U0

Therefore:

• U0 is the mean evaluation score of the “basic” laptop computer with each attribute at
the lowest levels in the ranges considered, that is, X1 = 4 and X2 = 80.

• U1 (X1 ) is the marginal adjustment to mean evaluation score depending on the level of
weight (X1 ). If X1 = 4, then no adjustment is needed.

• U2 (X2 ) is the marginal adjustment to mean evaluation score depending on the level of
hard drive size (X2 ). If X2 = 80, then no adjustment is needed.

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10.3 Estimation of Additive Part-Worth Model using Dummy Vari-
able Regression
The objective of conjoint analysis is to estimate:
(1) The mean evaluation score of the “basic” product, U0
(2) U1 (X1 ) at three or more levels in the range 4 − 10. The extreme levels 4 and 10 are always
included.
(3) U2 (X2 ) at three or more levels in the range 80 − 160. The extreme levels 80 and 160 are
always included.
Suppose we selected the following levels of the two attributes:

(1) Four levels of X1 : 4, 6, 8, and 10.

(2) Four levels of X2 : 80, 100, 120, and 160.

Several hypothetical laptop computers are created using different combinations of these at-
tribute levels, and the respondent provides evaluation scores for these hypothetical products.
We assume that the evaluation score can be expressed as:

(6) Y = U0 + U1 (X1 ) + U2 (X2 ) + ².

During estimation, we focus on the four levels of X1 and the four levels of X2 only.
As in Example 4, we represent the four levels of X1 by three dummy variables D1 , D2 ,
and D3 , defined as follows:

• D1 = 1 if X1 = 6, D1 = 0 if X1 = 4, 8, or 10.

• D2 = 1 if X1 = 8, D2 = 0 if X1 = 4, 6, or 10.

• D3 = 1 if X1 = 10, D3 = 0 if X1 = 4, 6, or 8.
Again, as in Example 4, we represent the four levels of X2 by three dummy variables D4 ,
D5 , and D6 , defined as follows:

• D4 = 1 if X2 = 100, D4 = 0 if X2 = 80, 120, or 160.

• D5 = 1 if X2 = 120, D5 = 0 if X2 = 80, 100, or 160.

• D6 = 1 if X2 = 160, D6 = 0 if X2 = 80, 100, or 120.

Consider the regression model:

(10.8) Y = β0 + (β1 D1 + β2 D2 + β3 D3 ) + (β4 D4 + β5 D5 + β6 D6 ) + ².

Proceeding as in Example 4:

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• β0 = U0 = mean evaluation score of the “basic laptop” with X1 = 4 and X2 = 80.

• (β1 D1 + β2 D2 + β3 D3 ) is adjustment to mean evaluation score depending which of the


four levels (4, 6, 8, or 10) X1 is at. For these four levels, U1 (X1 ) = (β1 D1 +β2 D2 +β3 D3 ).
Thus:

– U1 (4) = 0 (by assumption)


– U1 (6) = β1
– U1 (8) = β2
– U1 (10) = β3

• (β4 D4 + β5 D5 + β6 D6 ) is adjustment to mean evaluation score depending which of the


four levels (80, 100, 120, or 160) X2 is at. For these four levels, U2 (X2 ) = (β4 D4 +
β5 D5 + β6 D6 ). Thus:

– U2 (80) = 0 (by assumption)


– U2 (100) = β4
– U2 (120) = β5
– U2 (160) = β6

When we regress Y against D1 , D2 , D3 , D4 , D5 , and D6 , we get estimates of β0 , β1 , . . ., β6 .


Denoting the estimates of β’s by b’s, we get, for a given respondent, the following:

• U0 ≈ b0

• U1 (4) = 0, U1 (6) ≈ b1 , U1 (8) ≈ b2 , U1 (10) ≈ b3

• U2 (80) = 0, U2 (100) ≈ b4 , U2 (120) ≈ b5 , U2 (160) ≈ b6

10.4 Estimation of Conjoint Model for Credit Card Data in Section


5.5
The hypothetical credit cards were designed using 4 levels each of three attributes:
(1) X1 (interest rate): 6, 9, 12, or 18 percent APR.
(2) X2 : (credit limit): 5, 10, 25, or 50 (unit=$1000).
(3) X3 (annual fee): 0, 10, 20, or 50.
We assumed that the utility for a product (X1 , X2 , X3 ) can be expressed as:

U (X1 , X2 , X3 ) = U0 + U1 (X1 ) + U2 (X2 ) + U3 (X3 ).

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U0 is the utility of the basic product with X1 = 6, X2 = 5 and X3 = 0. U1 (X1 ), U2 (X2 ) and
U3 (X3 ) are marginal contributions of the three attributes to utility as their levels increased
from the lowest. These are all zero at the basic levels, that is, U1 (6) = U2 (5) = U3 (0) = 0.
Each respondent rated 18 hypothetical credit cards, and data from cards 3 and 9, inserted as
anchors, were dropped. The remaining 16 cards were re-ranked from 1 to 16. Each card was
then given a score of 17−rank, that is, the card ranked 1 got a score of 16, the card ranked 2
got a score of 15, so on. The score of a hypothetical card is the dependent variable Y .
Estimation: We use the dummy variable model:
Y = β0 + (β1 D1 + β2 D2 + β3 D3 ) + (β4 D4 + β5 D5 + β6 D6 ) + (β7 D7 + β8 D8 + β9 D9 ) + ².
The D’s are only meaningful for the attribute levels used in the design, that is, X1 = 6, 9, 12,
18, X2 = 5, 10, 25, or 50, and X3 = 0, 10, 20, or 50. β0 is the utility of the basic product (6,
5, 0). The D’s and the remaining β’s may be interpreted as follows:
X1 D1 D2 D3 U1 (X1 ) = β1 D1 + β2 D2 + β3 D3
6 0 0 0 0
9 1 0 0 β1
12 0 1 0 β2
18 0 0 1 β3
X2 D4 D5 D6 U2 (X2 ) = β4 D4 + β5 D5 + β6 D6
5 0 0 0 0
10 1 0 0 β4
25 0 1 0 β5
50 0 0 1 β6
X3 D7 D8 D9 U3 (X3 ) = β7 D7 + β8 D8 + β9 D9
0 0 0 0 0
10 1 0 0 β7
20 0 1 0 β8
50 0 0 1 β9
Evaluating a new product idea: Let B0 , B1 , . . ., B9 represent the parameter estimates
for a given person. Then, for a product concept with attribute values within the ranges used
in estimation, utility can be estimated as follows:
First compute the components:
(1) U0 : Use B0 .
(2) U1 (X1 ): Compute it as follows:
X1 − 6
6 ≤ X1 < 9: U1 (X1 ) = B1 ∗ ( ).
3
X1 − 9
9 ≤ X1 < 12: U1 (X1 ) = B1 + (B2 − B1 ) ∗ ( ).
3
X1 − 12
12 ≤ X1 ≤ 18: U1 (X1 ) = B2 + (B3 − B2 ) ∗ ( ).
6
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(3) U2 (X2 ): Express X2 in units of $1000, e.g., use 15 if credit limit is $15,000. Compute
U2 (X2 ) as follows:
X2 − 5
5 ≤ X2 < 10: U2 (X2 ) = B4 ∗ ( ).
5
X2 − 10
10 ≤ X2 < 25: U2 (X2 ) = B4 + (B5 − B4 ) ∗ ( ).
15
X2 − 25
25 ≤ X2 ≤ 50: U2 (X2 ) = B5 + (B6 − B5 ) ∗ ( ).
25
(4) U3 (X3 ): Compute this as follows:
X3
0 ≤ X3 < 10: U3 (X3 ) = B7 ∗ ( ).
10
X3 − 10
10 ≤ X3 < 20: U3 (X3 ) = B7 + (B8 − B7 ) ∗ ( ).
10
X3 − 20
20 ≤ X3 ≤ 50: U3 (X3 ) = B8 + (B9 − B8 ) ∗ ( ).
30
Then add: U (X1 , X2 , X3 ) = U0 + U1 (X1 ) + U2 (X2 ) + U3 (X3 ).
When you compare multiple new product concepts, a given person will select the option
that yields the highest utility.

10.5 Estimation of Conjoint Model for PC Data from Section 5.6


The hypothetical personal computers were designed using 4 levels each of three attributes:
(1) X1 (warranty length): 1, 2, 3, or 4 years.
(2) X2 : (RAM): 1, 2, 3, or 4 (unit= 128 MB).
(3) X3 (hard drive size): 1, 2, 3, or 5 (unit = 20 GB).
We assumed that the utility for a product (X1 , X2 , X3 ) can be expressed as:

U (X1 , X2 , X3 ) = U0 + U1 (X1 ) + U2 (X2 ) + U3 (X3 ).

U0 is the utility of the basic product with X1 = 1, X2 = 1 and X3 = 1. U1 (X1 ), U2 (X2 ) and
U3 (X3 ) are marginal contributions of the three attributes to utility as their levels increased
from the lowest. These are all zero at the basic levels, that is, U1 (1) = U2 (1) = U3 (1) = 0.
Each respondent rated 18 hypothetical personal computers, and data from computers 1 and
6, inserted as anchors, were dropped. The remaining 16 products were re-ranked from 1 to
16. Each PC was then given a score of (17−rank), that is, the PC ranked 1 got a score of 16,
the PC ranked 2 got a score of 15, so on.
Two models were used to estimate the model: the basic (dummy variable) model, and the
ideal point model. These models are now described separately.
Estimation: We use the dummy variable regression model:

Y = β0 + (β1 D1 + β2 + β3 D3 ) + (β4 D4 + β5 D5 + β6 D6 ) + (β7 D7 + β8 D8 + β9 D9 ) + ².

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The D’s are only meaningful for the attribute levels used in the design, that is, X1 = 1, 2, 3,
4, X2 = 1, 2, 3, or 4, and X3 = 1, 2, 3, or 5. β0 is the utility of the basic product (1, 1, 1).
The D’s and the remaining β’s may be interpreted as follows:
X1 D1 D2 D3 U1 (X1 ) = β1 D1 + β2 D2 + β3 D3
1 0 0 0 0
2 1 0 0 β1
3 0 1 0 β2
4 0 0 1 β3

X2 D4 D5 D6 U2 (X2 ) = β4 D4 + β5 D6 + β6 D6
1 0 0 0 0
2 1 0 0 β4
3 0 1 0 β5
4 0 0 1 β6

X3 D7 D8 D9 U3 (X3 ) = β7 D7 + β8 D8 + β9 D9
1 0 0 0 0
2 1 0 0 β1
3 0 1 0 β2
5 0 0 1 β3
Evaluating a new product idea: Let B0 , B1 , . . ., B9 represent the parameter estimates
for a given person. Then, for a product concept with attribute values within the ranges used
in estimation, utility can be estimated as follows:
First compute the components:
(1) U0 : Use B0 .
(2) U1 (X1 ): Express X1 in years. Compute U1 (X1 ) as follows:
1 ≤ X1 < 2: U1 (X1 ) = B1 ∗ (X1 − 1).
2 ≤ X1 < 3: U1 (X1 ) = B1 + (B2 − B1 ) ∗ (X1 − 2).
3 ≤ X1 ≤ 4: U1 (X1 ) = B2 + (B3 − B2 ) ∗ (X1 − 3).
(3) U2 (X2 ): Express X2 in units of 128 MB, e.g., use 1.5 if RAM is 192 MB. Compute U2 (X2 )
as follows:
1 ≤ X2 < 2: U2 (X2 ) = B4 ∗ (X2 − 1).
2 ≤ X2 < 3: U2 (X2 ) = B4 + (B5 − B4 ) ∗ (X2 − 2).
3 ≤ X2 ≤ 4: U2 (X2 ) = B5 + (B6 − B5 ) ∗ (X2 − 3).
(4) U3 (X3 ): Express X3 in units of 20 GB. For example, use 2.5 if hard drive size is 50 GB.
Compute U3 (X3 ) as follows:
1 ≤ X3 < 2: U3 (X3 ) = B7 ∗ (X3 − 1).
2 ≤ X3 < 3: U3 (X3 ) = B7 + (B8 − B7 ) ∗ (X3 − 2).

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X3 − 3
3 ≤ X3 ≤ 5: U3 (X3 ) = B8 + (B9 − B8 ) ∗ ( ).
2
Then add: U (X1 , X2 , X3 ) = U0 + U1 (X1 ) + U2 (X2 ) + U3 (X3 ).
When you compare multiple new product concepts, a given person will select the option
that yields the highest utility.

10.6 Estimation of Ideal Point Model


As discussed in Section 5.7.3, the ideal point model is an additive part-worth utility model
and can therefore be estimated using dummy variable regression. However, it can also be
estimated more directly as discussed here.
From Section 5.7.3, the utility of (X1 , X2 , . . . , Xn ) can be expressed as:
h n
X i n
X
U (X1 , X2 , . . . , Xn ) = K − Wi Xi∗ 2 + (2Wi Xi∗ Xi − Wi Xi2 ),
i=1 i=1

where each Xi is expressed as the difference of the attribute level from the lowest level. Also,
as shown in Section 5.7.3:
Pn
U0 = K − i=1 Wi x∗i 2
U1 (X1 ) = (2W1 X1∗ )X1 − W1 X12
..
.
Un (Xn ) = (2Wn Xn∗ ) − Wn Xn2
Let Y be the rating score of the hypothetical product (X1 , X2 , . . . , Xn ). Assuming that the
respondent reports the utility plus a random error, we have:

Y = β0 + (β11 X1 + β12 X12 ) + . . . + (βn1 Xn + βn2 Xn2 ) + ²,

where:
Pn ∗2
β0 = K − i=1 Wi xi (Utility of product with each attribute at lowest level)
β11 = (2W1 X1∗ ), β12 = −W1
..
.
βn1 = (2Wn Xn∗ ), βn2 = −Wn
This regression model can be estimated by regressing Y with X1 , X12 , . . ., Xn , Xn2 .
Note: The regression model is actually more general than the ideal point model. Consider
any attribute Xi .

• If βi1 > 0 and βi2 < 0, we get the classic ideal point model where Wi = |βi2 |, and
2βi1
Xi∗ = .
|βi2 |
• If βi1 < 0 and βi2 < 0, then the attribute level should be set at the lowest point of the
range.

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• If βi1 > 0 and βi2 > 0, then the attribute level should be set at the highest point of the
range.

Estimation of Credit Card data: We estimate the regression model:

Y = C0 + C1 (X1 − 6) + C2 (X1 − 6)2 + C3 (X2 − 5) + C4 (X2 − 5)2 + C5 X3 + C6 X32 + ²,

where X1 , X2 , and X3 are same as in Section 5.5, and C0 is the rating of the card with X1 = 6,
X2 = 5, and X3 = 0 on a 0-16 scale. The results are provided in the Excel file “creditf01 ideal
point.xls” posted as a Blackboard course document.
Estimation of PC data: We estimate the regression model:

Y = C0 + C1 (X1 − 1) + C2 (X1 − 1)2 + C3 (X2 − 1) + C4 (X2 − 1)2 + C5 (X3 − 1) + C6 (X3 − 1)2 + ²,

where X1 , X2 , and X3 are same as in Section 5.6, and C0 is the rating of the PC with X1 = 1,
X2 = 1, and X3 = 1 on a 0-16 scale. The results are provided in the Excel file “pcf01 ideal
point.xls” posted as a Blackboard course document.

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11 Questionnaire Construction (Optional Material)

11.1 Basic Steps in Questionnaire Construction


Data collected from customers can be divided into the following blocks of information:

Non behavioral information:


(a) State of being (demographics, ownership status).
(b) State of the mind (awareness, attitude, satisfaction, etc.).
Behavioral information:
(a) Product usage, past and present. This is appropriate for frequently purchased products
as such information is then available.
(b) Media habits.
(c) Purchase intentions. This is appropriate for new product ideas, future purchase intentions,
and durable products for which data on past purchases are difficult or even impossible to
obtain.

To begin questionnaire construction, first determine precisely what information you need
to gather. Usually, the focus of a questionnaire is current or future usage behavior. The rest
of the information should be relevant to this usage behavior.
For example, suppose you wish to study a college student’s usage of cellular telephone
service. Then, the appropriate state of being variables are the ones that can possibly affect
cell phone usage behaviors. The media habits should focus on the media where the cellular
service providers broadcast their commercials.
Proceed as follows:
1. For each block of information, identify precisely what information you need to gather. It
is useful to first create an outline and build the questionnaire around the outline.
2. For each question, select the form of the question (open ended, multiple choice, or combi-
nation).
3. Determine question sequence:
(a) Start with easy, general, interesting questions.
(b) Make the questions gradually more specific. The earlier questions should not sensitize the
respondent to what comes later.
(c) Keep sensitive questions for the end. Note that what is sensitive varies from population
to population. For undergraduate students, age and income are usually not sensitive issues.
For working professionals, they often are.

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Example: Typical Question Sequence for Student Subjects:

1. Demographics: gender, class, place of residence, etc.

2. Ownership status: car, meal plan, etc.

3. Usage of product category: Does the respondent use product at all? If yes,
then how often, and how much each time?

4. Value system: How important are different product features to the respondent?

5. Specific product: awareness, usage, rating of the product on relevant attributes.

Note: If you may like to place awareness questions on a new page to avoid biasing
the respondent.

6. Media habits.

11.2 Different Question Forms


There are three alternative question forms, (1) open ended questions, (2) multiple choice
questions, and (3) combinations of open ended and multiple choice questions. We discuss
them separately.
11.2.1 Open Ended Questions: Open ended questions do not ask a respondent to select
from a list of possible responses. However, they do vary in terms of how much structure they
impose on the answers. Consider the following examples with progressively greater structure:
Example 1: Why did you join the MBA Program at Syracuse University?
Example 2: List below the reasons you joined the MBA Program at Syracuse University.
Example 3: What are the most important reasons you joined the MBA Program at Syracuse
University? (List up to three reasons.)
Reason 1:
Reason 2:
Reason 3:
Example 4: What is the one most important reason you joined the MBA Program at Syracuse
University?
Reason:
Example 5: Name the one MBA program that you most wanted to join when you applied to
MBA programs.
Name of Program:

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Note that with increased structure, it becomes easier to code and enter the data. However,
with increased structure, the question becomes less flexible.
Advantages of open ended questions: The respondents are not constrained by a pre-
determined set of answers. This flexibility makes open ended of questions appropriate for
exploratory studies.
Disadvantages:

• Depending on how much freedom we allow the respondent, recording the information
may be difficult. For example, if a telephone interview is used, the interviewer may
introduce errors while recording the answers.

• Coding the response may be difficult.

• More articulate respondents get recorded more often while less articulate respondents
tend to keep silent. This may introduce a non-response bias by over-representing the
views of the more articulate respondents.

11.2.2 Multiple Choice Questions: A multiple choice question provides the respondent a
list of categories, and asks her to choose one category from the list.
Multiple choice questions are commonly used in survey research because of the following
advantages:

1. The responses are easy to code and record.

2. It is easier to obtain cooperation from respondents because the task of respond-


ing is simpler.

Requirements of a multiple-choice question: The categories provided in a multiple


choice question must meet three stringent criteria:
1. The categories must be mutually exclusive, that is, exactly one category must apply to
a given respondent.
For example, the categories in the following question are not mutually exclusive.
How often do you go to grocery stores? (Check one)
0-2 times/week 3 or more times/week 5 or more times/week”
2. The categories must be collectively exhaustive, that is, cover all possible responses. You
may need to conduct an exploratory study (e.g., focus group) to determine an adequate set of
responses. Even then, we may need to include options like “other” in the question statement.
3. The categories must be appropriate, that is, all the respondents should not belong to the
same category.
For example, suppose we asked:
“How much money do you spend on food each month?

193
Less than $5 $5 to $10 More than $10”
Here, virtually everybody will check the category “ More than $10,” and the question will
not obtain any useful information.
To address this problem, we should first identify very high (but still possible) and a very
low (but still possible) value of the variable. These numbers define the two end categories.
Then, we divide the range into equal parts to obtain the other categories. For example,
suppose we determined that $100 is a very low monthly expenditure on food for a student,
and $400 is a very high monthly expenditure. We can then prepare an eight point scale as
follows:
Approximately how much money do you spend on food each month? (Check one)
$100 or less $101−$150 $151− $200
$201−$250 $251−$300 $301−$350
$351−$400 Over $400

Example 6.2: Examples of Multiple-Choice Questions:


1. During an average month, how often do you go out for dinner? (Check one)
0-1 times/month 2-3 times/month 4-6 times/month

7-10 times/month 11 or more times/month

2. Do you subscribe to an internet service provider?


Yes No
Note: This is a special case of the multiple-choice question with only two categories. It is
called a dichotomous question.
3. Which of the following movies have you seen? (Check all that apply)
Borat Shrek 2 Pirates of the Caribbean
Cars The Da Vinci Code
Note: This is not a single question, but a series of dichotomous questions. In effect, we
are asking separate dichotomous questions such as: “Have you seen Borat? Yes
No”

11.2.3 Combination of Multiple-Choice and Open-ended Questions:


When we do not have the prior knowledge to specify all the categories, we add an “other”
category to a multiple choice question. If we wish to know what “other” means, we ask the
respondent to specify “other.” This incorporates an element of an open ended question to a
multiple choice question. The following two are examples of such combination questions.
Example 1: Which state are you from? (Check one)

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California New York Pennsylvania

Florida Illinois Other(Specify:)


Example 2: Which newspapers have you read during the last month (check all that apply)?
New York Times Daily Orange
Wall Street Journal USA Today
Other(s) (Please list):

11.3 Common Mistakes in Questionnaire Construction

Basic Errors:
1. Does the question apply to the respondent? We need to address this issue in two ways.
1.(a) If the issue is confined to just one question, add a category that allows the respondent
to tell you that the question does not apply to her.
Example: What brand of beer do you like to drink most? (Check one)
Budweiser Coots Corona

Rabat Miller Sam Adams

I don’t drink beer

1.(b) If you are rating an object on several attributes, add a “don’t know” category to
each scale.
Example: Please rate the Wegmans grocery store on each of the following:
Very Poor Excellent Don’t Know
Store Hours 1 2 3 4 5 6 7 DK
Selection of items 1 2 3 4 5 6 7 DK
Price 1 2 3 4 5 6 7 DK
1.(c) If an entire block of question do not apply if the answer to a question is “no,” use a
screening question that allows the respondent to bypass this block of questions.
Example: “Do you smoke cigarettes?”
Yes (If yes, please continue with question 10.)
No (If no, please skip to question 20.)
2. The words used in the question may be unfamiliar to the respondent.
Whenever possible, we should use simple language and terms the respondent can under-
stand. Even apparently simple terms may be unclear depending on the context. For example,
it is doubtful if one can answer: “How many milligrams of salt do you like to have in a serving
of potato chips?”

195
3. In a multiple choice question, the categories may not be mutually exclusive and collectively
exhaustive. In addition, the categories may not be appropriately defined in that all the
responses fall in just one category.
4. Lack of specificity. This occurs when terms in a question may be interpreted differently by
different respondents.
Example 1: This may occur if we use terms like “often” and “regularly” without defining what
we mean. For example, instead of asking “Do you watch the CBS Evening News regularly?”,
we may like to ask:
“During an average week, how often do you watch the CBS Evening News?

0 times 1−2 times 3−4 times 5 or more times

Example 2: This happens when you do not label the end points of a scale. For example,
suppose you asked: “Please rate the Wegmans grocery store on each of the following:
Store Hours 1 2 3 4 5 6 7 DK
Selection of items 1 2 3 4 5 6 7 DK
Price 1 2 3 4 5 6 7 DK
Some respondents will interpret 1 as excellent, and others will interpret 7 as excellent.
Example 3: This happens when an object has multiple dimensions, and you ask someone to
rate the object without specifying the dimension. For example, suppose we asked: “Do you
like grapefruit juice?” It is possible that the respondent does not like the taste of grapefruit
juice, but likes the nutritive value of grapefruit juice.
5. Do not ask a question in a way that will require a respondent to do a complex estimation.
For example, if we ask somebody how much money he spends at bars in a month, he may
(a) think of how many times he goes to bars in a month, (b) how much he usually spends
each time, and (c) multiply the two numbers. In this case, it is better to ask two separate
questions: (i) How many times do you go to bars in a month? (ii) How much do you usually
spend each time you go to a bar?
6. Avoid double-barreled questions. Examples of double barreled question are:

(a) Do you like the taste and nutritive value of grapefruit juice?
Yes No

(b) Name the one store that has the best price and selection of DVD movies.

To correct a double barreled question, we should ask two separate questions.


More Complex Errors:
1. Biasing questions. Here, the question is such that the respondents think there is a preferred
answer and gives that answer even when it does not reflect his true feelings or behavior. This

196
problem is more likely to be present when a human contact is involved in data collection (e.g.,
telephone interview, household interview, etc.).
There are two specific cases where this problem is likely to exist. The first occurs when you
are trying to find out how many people are interested in a new product idea. Here, the respon-
dents often feel compelled say that they are interested in the new product because they think
that is the desired answer. The second relates to behavior which has either socially desirable
(e.g., donation to charities, exercise habits) or undesirable (e.g., smoking) connotations.
In order to reduce this problem, it is useful to show the respondent that it is okay to give a
socially undesirable answer. For example, before asking: “Have you donated blood during the
last one year,” we may add the statement: “Due to health and other concerns, many people
do not donate blood.” To make the statement even stronger, we may replace many people by
most people. The added statement is called a “counter-biasing” statement.
Even when the respondent is not deliberately giving you a biased response, the question
wording or sequence may generate a biased response. We now describe four cases where that
happens. The four factors discussed here are very similar and are likely to be significant only
if the respondent is not familiar with issues involved.
2. Order/position bias. For example, if we give a respondent a list of five alternative hypo-
thetical products and ask him which one he likes most, he will tend to choose the ones at the
beginning (primacy effect) or at the end (recency effect) of the list rather than the ones at
the middle.
This problem is greater if the alternatives are very similar from the perspective of the
respondent. Also, this problem is more likely to be present in a telephone survey compared
to a mail survey because in a telephone survey, the respondent does not have the alternatives
in front of him when he makes the choice and must rely on his memory.
3. Categories provided in a multiple choice question may create the response.
Consider the following two examples.
Example 1: What do you consider to be appropriate price for a 10 megapixel SLR digital
camera? (Check one)
$400 or less $401-$600 $601-$800

$801-$1000 $1001 or more

Here, a respondent unfamiliar with digital cameras will tend to check a middle category,
leading to a response created by the categories presented. This problem can be addressed by
using an open ended question along with a “don’t know” option.
Example 2: If you can get a gift coupon to dine at any restaurant in Syracuse, which restaurant
will you choose? (Check one)
Acropolis Olive Garden Panda West Pizzeria Uno
Other (specify:)

197
Unless the respondent has strong favorite, (s)he will be more likely to choose a restaurant
listed in the question than a restaurant not included in the list. Thus, it is appropriate not
to provide a list at all.
4. Leading question. Consider the following alternative ways of asking the same question:
(a) Do you support tax cuts which will lead to the closing of high schools in the New York
State?
versus
(b) Do you support a tax cut that will put money in the hand of the consumer and promote
growth?
If the respondent does not have a clear opinion beforehand, the two question formulations
will generate very different answers. Note that here the object concerned (that is, proposed
tax cut) has a favorable and an unfavorable aspects. By focusing on only one aspect of the
object, the question creates a biased response.
5. Unclear concept of the status quo. Consider the following wordings of the same question:
(a) If medical procedure X is used, 30% of the patients die. Do you support the use of
procedure X?
versus
(b) If medical procedure X is used, 70% of the patients survive. Do you support the use of
procedure X?
In version (a), the status quo is “the patient will live otherwise.”
In version (b), the status quo is “the patient will die otherwise.”
Unless the respondent is familiar with the topic, the question presentation will affect her
response.
6. Implicit alternatives. Consider the following alternative ways of asking the same question:
(a) Do you support a measure to repair highways and schools in New York state?
versus
(b) Do you support a measure which will raise state taxes by 5 % to repair highways and
schools in New York state?
Here, the alternatives are (i) tax and improvement, and (ii) no tax and no improvement.
In version (a), the alternatives are not clearly specified (i.e., they remain “implicit”), and
the respondent may think he can get something without making a sacrifice. In contrast, the
alternatives are clearly specified in version (b).

11.4 Itemized Rating Scales


Itemized rating scales are used extensively in survey research. An itemized rating scale is
a multiple choice question with a fixed number of categories where the categories represent

198
progressively higher or lower values of an attribute. I now give examples of a special case of
itemized rating scales called semantic differential scales where the two end points of the
scale are verbally described using words of opposite meaning.
Example 1: To rate an object on one or more attributes.
Please rate the Whitman School iMBA Program on each of the following by circling your
response.
Very Poor Excellent
Tuition Charged 1 2 3 4 5 6 7
Course Selection 1 2 3 4 5 6 7
Academic Reputation 1 2 3 4 5 6 7
Example 2: To rate importance weights of attributes.
How important were the following to you when you selected an MBA Program? (Please circle)
Not important at all Very Important
Tuition Charged 1 2 3 4 5 6 7
Course Selection 1 2 3 4 5 6 7
Academic Reputation 1 2 3 4 5 6 7
Example 3. Degree of agreement with a statement. (This is called a likert scale.)
Please indicate how strongly do you agree or disagree with the statement, “The Whitman
School iMBA Program gives me good value for my money,” by circling your response.
Strongly Disagree Strongly Agree
1 2 3 4 5 6 7
Example 4. Interest in a new product concept.
How interested are you in subscribing to a door-to-door grocery delivery service that charges
$5 for each delivery?
Not interested at all Very interested
1 2 3 4 5 6 7
Example 5. Customer satisfaction.
How satisfied with your current cellular telephone service provider?
Very Dissatisfied Very Satisfied
1 2 3 4 5 6 7
Example 6. Comparison of an object to a reference object on an attribute.
Compared to US Air, how much would you rate American Airlines on baggage handling?
Much worse Much better
1 2 3 4 5 6 7
In all these examples, I used seven-point scales which are the most common scales used.
However, 4-point, 5-point, and 10-point scales are also used quite often. You should always

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define the two ends of the scale.

11.5 Coding a Questionnaire


After you prepare a survey, you have to develop a “coding scheme” to convert responses into
numbers suitable for data analysis. You need to do the following:
1. Make a complete list of all the different variables you are measuring with the questionnaire.
2. For each variable we identified in step 1, make a complete list of different values it can
take. Assign a number to indicate each value the variable may take.
3. Give an ID number to each completed questionnaire.
4. Give a name to each variable. Standard statistical packages allow alphanumeric names of up
to eight characters as a variable name. This means the name has to start with a letter, followed
by any combination of letters or numbers. For example, X1 , V AR1 , GEN DER, are all valid
variable names. People select variable names based on personal taste. I choose variables
names based on which item in the questionnaire the variable comes from. For example, X1 is
the variable from Question 1, X2 is the variable from Question 2, etc. If Question 3 has three
parts (a), (b), and (c), then I use variable names X3a , X3b and X3b .
5. Preparing EXCEL Worksheet: Save the data as an EXCEL worksheet, which can then
be used with all major statistical packages. Prepare the worksheet as follows.

• The first line of the data should be ID, Variable Name 1, Variable Name 2, etc., in the
successive cells. For example, it may be: ID, X1 , X2 , X3a , X3b , X3c .

• Each of the following lines comes from one completed questionnaire. Please enter the
ID number followed by the numerical values of the successive variables in the successive
cells.

In the completed worksheet, the first column will be ID followed by the ID numbers of the
different questionnaires. Each of the following columns will have a variable name followed by
the numerical values of the variable for the different completed questionnaires.
6. Non-Response Code: If non-response occurs for a variable, you have two options:

• You may enter a period sign (.) in the cell. The period sign (.) is as a default non-
response code for the statistical packages Minitab and SAS.

• You may leave the cell blank. A blank cell serves as a default non-response code for
the statistical packages Minitab and SAS. Important Note: When you use Minitab,
leaving the cell blank is not a valid non-response code for the last line of data. Please
use a period sign to indicate non-response in the last line of data.

7. Pre and Post Coding: Sometimes, we have enough prior knowledge to develop a
complete coding scheme for a questionnaire before we collect any data. In that case, we only

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need to do pre-coding. In other cases, we may not be able to determine all the values a
variable may take beforehand. Sometimes we may not even be able to determine how many
variables are there before we look at the data. Then, we need post-coding.
The amount of post-coding we need to do depends on how much prior research we do.
A focus group held before questionnaire construction can significantly reduce the extent of
post-coding required and thereby save time needed to record the data. During coding, we
should try to avoid information loss as much as possible.
Examples of coding
1. Question:
Residence: Apartment Dorm
Fraternity/Sorority Other
Coding scheme: In this case, we are measuring only one thing: residence, that is, this question
represents only one variable. Let us call this X1 .
X1 is a nominal variable, and we can use any four different numbers to represent the different
possibilities. A simple coding scheme will be:
Apartment → X1 = 1, Dorm → X1 = 2,
Fraternity/Sorority → X1 = 3, Other → X1 = 4,
If non-response occurs, enter a period (.) sign.
No post coding is necessary here.
2. Consider now a variation of question 1:
Residence: Apartment Dorm
Fraternity/Sorority Other (specify)
Once again, this question involves the measurement of a single nominal variable, which we
may call X2 . In this case, however, the respondent fills in what “other” means. Thus, there
may be multiple categories of “other,” and we have to incorporate this fact into the coding
scheme. For example, we may use the following coding scheme:
Apartment → X2 = 1, Dorm → X2 = 2, Fraternity/Sorority → X2 = 3,
Share house → X2 = 4, Share mobile home → X2 = 5, Home with parents →
X2 = 6,
Non-response → period sign.
If we did not know all the possibilities about “other” before we studied the data, we would
need to do post coding here.
When we use a question like this, there may be many different responses under “other,”
and some responses may be present a very small number of times. We may then create a few
main categories of “other,” and lump the remainder into an “all others” category to make
coding convenient. In doing this, we need to make a decision about how much information we
can afford to lose in the process.
3. Question:

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Which of the following movies have you ever seen (check all that apply):
Borat Shrek 2 Cars
The Da Vinci Code Pirates of the Caribbean 2
Coding scheme: Here, we have five yes/no questions. Thus, we need five variables; let us call
them X3a , . . . , X3e . A possible coding scheme is:
If “Borat” is checked, then X3a = 1. Otherwise, X3a = 0.
If “Shrek 2” is checked, then X3b = 1. Otherwise, X3b = 0, etc.
In this case, we do not need post coding. Also, here, we cannot tell if non-response
is present since we cannot differentiate between whether the respondent is not answering a
question, or just has not seen the movie.
4. Question: “In the space below, list all the movies you have seen in the last month.”
Coding scheme:
(i) Make a list of all the movies mentioned by the entire sample of respondents.
(ii) Create a separate variable for each movie. For each movie in the list obtained from the
whole sample, a given respondent is telling us whether he has seen it or not in the last month.
Thus, he is effectively answering a series of yes/no questions.
(iii) Example of a possible coding scheme:
X4a = 1 if respondent has mentioned “Borat,” X4a = 0 if not.
X4b = 1 if the respondent has mentioned “Shrek 2,” X4b = 0 if not, etc.
Note:
(1) Here, we need post coding unless we have prepared, beforehand, a complete list of all
possible movies a respondent might see. The post coding here involves the creation of variables.
(2) There will be some movies listed which very few respondents have seen (e.g., one or two
respondents out of 200 have listed them). We may lump those responses into an “others”
variable.
(3) Here, we cannot identify if non-response is present. If no movie is listed, that may simply
mean that the respondent did not see any movie during the last month.
5. Question:
“(a) Do you ever listen to the radio?
Yes No (If no, please skip part (b))
(b) In the space below, list all the radio stations you listen to.”

Coding Scheme:
1. For Part (a), we are asking just one question and have one variable as a result. Let us call
it X5a . We can code X5a as follows :

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X5a = 1 if “YES,” X5a = 0 if “No,” and period sign if non-response.
Note that if a respondent forgets to answer part (a), but lists radio stations in part (b), we
can detect that fact and record X5a = 1.
2. For part (b), we need to make a list of radio stations from the entire sample, and create a
separate variable for each radio station listed. (If some stations are listed by very few people,
you may lump them into an “others” variable.)
For each radio station listed, a respondent is effectively answering a YES/NO question. A
possible coding scheme is:
X5b = 1 if respondent listens to 91.3 FM, X5b = 0 if not, and period sign if non-response.
X5c = 1 if respondent listens to 92.1 FM, X5b = 0 if not, and period sign if non-response, etc.
Note that non response occurs here in the following two cases:
(1) The respondent skips both part (a) and part (b).
(2) The respondent checks “YES” in part (a), but skips part (b).
6. Question: “Age (years)”
It is a single variable, and usually the number provided by the respondent is entered
without any change. As usual, a period sign is used for non-response.
7. Question: Example: Please rate the Wegmans grocery store on each of the following:
Very Poor Excellent Don’t Know
(a) Store Hours 1 2 3 4 5 6 7 DK
(b) Selection of items 1 2 3 4 5 6 7 DK
(c) Price 1 2 3 4 5 6 7 DK
You have three variables X7a , X7b , and X7c . For each one enter the number circled, or leave
the cell blank if the item is either skipped or DK is circled.

11.6 Data Editing and Cleaning


I now discuss some of the common errors in data entry and how to address them.
Step 1. Check if you interchanged rows and columns: Before you do anything else,
check if you mistakenly entered data as columns instead of rows, that is, entered ID followed
by the variables names in Column 1 instead of Row 1, and had a column of data from each
respondent. If you made this mistake, proceed to correct as follows:

(1) In the EXCEL worksheet, mark the data set. In the menu line, take the cursor
to Edit and click Copy.

(2) Mark a cell below your data set by clicking on it. Take the cursor to Edit and
click on “Paste Special.” A dialog box opens. Find “Transpose” at the bottom of
the dialog box. Click on “Transpose.” This will make each column a row and vice
versa.

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(3) Delete the original data set and keep the transposed data set.

Step 2. Prepare One-Way Tabulations for all Variables using Minitab:

(1) In the computer screen, double click on the Minitab icon to open Minitab.
(2) In the menu line at the top of the screen, click on “File” and then click on
“Open Worksheet.” A dialog box opens. In the dialog box, click on the bottom
line (“Files of type”) and click on EXCEL. Use the browser line at the top of the
dialog box to access and open your Excel worksheet. The Excel worksheet opens
as a Minitab worksheet.
(3) In the menu line at the top of the screen, click on “Stat” and drag the cursor
to “Tables.” Click on “Tally Individual Variables.”
(4) Select all the variables in the data set by marking their names in the dialog
box and clicking “Select.” Make sure at least “Count” is marked under “Display”
in the dialog box.
(5) Click “OK.”

Minitab now displays a one-way table for each variable in the data set.
Detecting Errors in Data Entry Using One-Way Tables: Examine each one-way tab-
ulation individually. For a given variable, the table gives you the different values it takes in
the sample, and the number of times it takes each value (“count”). If you find a number you
do not expect to see, a error has occurred in data entry. Usually, data entry errors occur in
three ways.

• For a given variable, a wrong code was used. For example, suppose you coded the
dichotomous variable gender as 1 for male and 0 for female. One of group members
entered 2 for female by mistake. Then, in the one-way table for gender, you will see 2 as
a value of the variable in addition to 0 and 1. Typically this error tends to be repeated
and can be detected easily.

• When entering a string of numbers, you skipped a number. For example, suppose your
variables are gender (coded 1/0) and interest in watching sports on TV (1-7 scale, coded
1 to 7). If you skip gender by mistake, you will have the value of the next variable in the
column for gender. Then, you may see any number from 2 to 7 in the table for gender
in addition to the valid numbers 0 and 1.

• Sometimes the number entered in simply wrong. When the entry is wildly wrong, it can
be detected. For example, suppose the variable is how much money a student spends on
cellular telephone service in a month. Suppose a respondent wrote $60 as response. If
you add a zero by mistake, the data entered will be 600 instead of 60. From the one-way
tables, you can detect numbers which do not look right.

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Step 3. Identifying and Correcting Errors: Once you detected errors using one-way
tabulations, you need to correct the errors.

• First, examine the EXCEL worksheet and find the places where the errors occurred.
Often the error is simple and can be fixed immediately. It is very helpful if you retain
the original completed surveys for reference. If you can correct the entries, no data are
wasted.

• Sometimes, when you suspect an error, it is difficult to determine what the correct
value is. This happens when the original data are not easy to access. Then, it becomes
necessary to declare the wrong data entries as “missing data.” One way to do that is
change the suspect cells in the EXCEL sheet to blank.

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11.7 Example of Survey and Coding Scheme

11.7.1 Carrier Dome Events Survey

Dear Participant:
We are conducting a survey to find out your opinions about the events held at the Carrier
Dome. We will be grateful if you take a few minutes of your time to complete the survey. Your
answers will be kept strictly confidential and will not be used for any commercial purpose.
Thank you very much for your help.
Students of Marketing Research, School of Management
(Note: To conserve paper, the survey is printed on both sides.)

Survey

A. Background Information
1. Gender Male Female
2. Year in School:
Freshman Sophomore Junior Senior
Other
3. Where do you live? (Check one)
Dorm Fraternity/Sorority South Campus

Rental apartment/house Other


4. Are you a member of fraternity or sorority?
Yes No
5. How do you come to campus? (Check all that apply)
Walk Bicycle Drive

Bus Other
6. How far do you live from the Carrier Dome? (Check one)
less than a mile
1−2 miles
more than 2 miles
Don’t Know
7. Which of the following are you a member of? (Check all that apply)
Fraternity Sorority Club Sport

Varsity Sport SU Athletic team

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B. Recreation Habits
8. How interested are you in the following activities in your spare time?
(Please circle)
Not interested Very
at all interested

(a) Exercise 1 2 3 4 5 6 7

(b) Participate in sports 1 2 3 4 5 6 7

(c) Shop for clothes 1 2 3 4 5 6 7

(d) Go to bars 1 2 3 4 5 6 7

(e) Go to malls 1 2 3 4 5 6 7

(f) Watch movie 1 2 3 4 5 6 7

(g) Do volunteer work 1 2 3 4 5 6 7

(h) Study/read 1 2 3 4 5 6 7

(i) Listen to music 1 2 3 4 5 6 7

(j) Spend time with friends 1 2 3 4 5 6 7

(k) Watch sports on TV 1 2 3 4 5 6 7

(l) Watch sports at the Dome 1 2 3 4 5 6 7

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C. Attendance of Carrier Dome Events
9. Have you ever been a season ticket holder for any of the following?
(Check all that apply)
SU Football

SU Lacrosse

SU Men’s Basketball
10. During the last one year, which of the following events have you
attended at the Carrier Dome? (Check all that apply)
SU Men’s Basketball game SU Football game

SU Lacrosse game High school sporting event

Empire State games Concert

Commencement address Telecast of SU Basketball game


11. During the current academic year (2002 − 2003), have you held
a season ticket for any of the following? (Check all that apply)
SU Football

SU Lacrosse

SU Men’s Basketball
12. How many people do you usually attend a Dome event with?
(Check one)
0 1 2−3 4 or more
Never attend a Dome event
13. Who do you usually attend a Dome event with?
(Check all that apply)
Parents Siblings Friends

Spouse/significant other Other Never attend Dome event

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14. How much money do you spend on concessions at an average
Dome event? (Check one)
Never attend a Dome event $0-$5 $6-$10 $11-$15

$16-$20 $21 or more


D. Opinion of Carrier Dome
15. Please rate the Carrier Dome on each of the following by circling your response:
Very Excellent Don’t
Poor Know

(a) Choice of events 1 2 3 4 5 6 7 DK

(b) Day/time of events 1 2 3 4 5 6 7 DK

(c) Quality of seating 1 2 3 4 5 6 7 DK

(d) Ticket price 1 2 3 4 5 6 7 DK

(e) Food choices 1 2 3 4 5 6 7 DK

(f) Food price 1 2 3 4 5 6 7 DK

(g) Drink choices 1 2 3 4 5 6 7 DK

(h) Drink price 1 2 3 4 5 6 7 DK

(i) Souvenir choice 1 2 3 4 5 6 7 DK

(j) Souvenir price 1 2 3 4 5 6 7 DK

(k) Cleanliness of 1 2 3 4 5 6 7 DK
restrooms
(l) Availability of 1 2 3 4 5 6 7 DK
restrooms
(m) Availability of parking 1 2 3 4 5 6 7 DK

(n) Safety 1 2 3 4 5 6 7 DK

(o) Overall value 1 2 3 4 5 6 7 DK


for the money
16. Has the threat of terrorism changed your Dome attendance habits
since 9/11/’01?
Yes No

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17. What should be done to improve safety at the Dome?
(Check all that apply)
More police presence Better screening at entrance
Metal detectors at gates
E. Interest in new Dome events
18. If a combined lacrosse/football/basketball season ticket were available, how likely
would you be to purchase it at the following prices? (Please circle)
Very unlikely Very likely

(a) $50 1 2 3 4 5 6 7

(b) $75 1 2 3 4 5 6 7

(c) $100 1 2 3 4 5 6 7

(d) $125 1 2 3 4 5 6 7

(e) $150 1 2 3 4 5 6 7

(f) $175 1 2 3 4 5 6 7

(g) $200 1 2 3 4 5 6 7
19. Consider the concept: “Allow all students free access to all games at the Carrier Dome
in exchange for a fixed increase in tuition fee.” How strongly do you agree/disagree with this
statement? (Please circle)
Strongly Disagree Strongly Agree
1 2 3 4 5 6 7
20. In the space below, please list any event(s) you would like to see at the Carrier Dome.

**Thank You for Your Participation**

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11.7.2 Coding Scheme and Instructions for Data Entry
Dome Events Questionnaire

The coding scheme for the Carrier Dome survey is provided. Please give each respondent in
the data your group collected an ID starting with 1. You have 76 variables:
ID, X1 , X2 , X3 , . . ., X15a − X15o , . . ., X19 .
Prepare an Excel sheet. The top line of the sheet lists the variables: ID in cell A, X1 in cell
B, . . ., X19 in cell BX. Then, enter a row of numbers from each respondent. For each person,
ID goes to cell A, X1 to cell B, , X19 to cell BX.
If there is non-response for a variable, leave the corresponding cell blank. Use the non-
response code also when a question does not apply. For example, consider question 13. If a
student never attends a Dome event, leave the five cells from question 13 blank.
If a question is either skipped or does not apply, then also leave the cell blank.

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Coding Scheme

A. Background Information
1. X1 Gender 1 Male 0 Female
2. X2 Year in School:
1 Freshman 2 Sophomore 3 Junior 4 Senior
5 Other
3. X3 Where do you live? (Check one)
1 Dorm 2 Fraternity/Sorority 3 South Campus

4 Rental apartment/house 5 Other


4. X4 Are you a member of fraternity or sorority?
1 Yes 0 No
5. How do you come to campus? (Check all that apply)
X5a : Walk X5b : Bicycle X5c : Drive

X5d : Bus X5e : Other


Variables X5a − X5e : For each variable, enter 1 if checked and 0 if not. Enter five period (.)
signs if question 5 is skipped.
6. X6 : How far do you live from the Carrier Dome? (Check one)
1 less than a mile
2 1−2 miles
3 more than 2 miles
Period (.) sign: Don’t Know
7. Which of the following are you a member of? (Check all that apply)
X7a : Fraternity X7b : Sorority X7c : Club Sport

X7d : Varsity Sport X7e : SU Athletic team


For each variable, enter 1 if checked and 0 if not. (There is no non-response for this question.)

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B. Recreation Habits
8. How interested are you in the following activities in your spare time?
(Please circle)
Not interested Very
at all interested

(a) Exercise 1 2 3 4 5 6 7

(b) Participate in sports 1 2 3 4 5 6 7

(c) Shop for clothes 1 2 3 4 5 6 7

(d) Go to bars 1 2 3 4 5 6 7

(e) Go to malls 1 2 3 4 5 6 7

(f) Watch movie 1 2 3 4 5 6 7

(g) Do volunteer work 1 2 3 4 5 6 7

(h) Study/read 1 2 3 4 5 6 7

(i) Listen to music 1 2 3 4 5 6 7

(j) Spend time with friends 1 2 3 4 5 6 7

(k) Watch sports on TV 1 2 3 4 5 6 7

(l) Watch sports at the Dome 1 2 3 4 5 6 7


Variables X8a − X8l . For each variable, enter either the number circled, or a period (.) sign if
the item is skipped.
C. Attendance of Carrier Dome Events
9. Have you ever been a season ticket holder for any of the following?
(Check all that apply)
X9a : SU Football

X9b : SU Lacrosse

X9c : SU Men’s Basketball


For each variable, enter 1 if checked and 0 if not. (There is no non-response for question 9.)

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10. During the last one year, which of the following events have you
attended at the Carrier Dome? (Check all that apply)
X10a : SU Men’s Basketball game X10b : SU Football game

X10c : SU Lacrosse game X10d : High school sporting event

X10e : Empire State games X10f : Concert

X10g : Commencement address X10h : Telecast of SU Basketball game


For each variable, enter 1 if checked and 0 if not. (There is no non-response for question 10.)
11. During the current academic year (2002 − 2003), have you held a season ticket for any of
the following? (Check all that apply)
X11a : SU Football

X11b : SU Lacrosse

X11c : SU Men’s Basketball


For each variable, enter 1 if checked and 0 if not. (There is no non-response for question 11.)
12. X12 : How many people do you usually attend a Dome event with?
(Check one)
10 21 3 2−3 4 4 or more
Period (.) sign: Never attend a Dome event
13. Who do you usually attend a Dome event with?
(Check all that apply)
X13a : Parents X13b : Siblings X13c : Friends

X13d : Spouse/significant other X13e : Other Never attend Dome event


For each variable, enter 1 if checked and 0 if not. Enter five period (.) signs if question 13 is
skipped or “never attend Dome event” is checked.

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14. X14 : How much money do you spend on concessions at an average Dome event? (Check
one)
Period (.) sign: Never attend a Dome event
1 $0-$5 2 $6-$10 3 $11-$15
4 $16-$20 5 $21 or more
D. Opinion of Carrier Dome
15. Please rate the Carrier Dome on each of the following by circling your response:
Very Excellent Don’t
Poor Know

(a) Choice of events 1 2 3 4 5 6 7 DK

(b) Day/time of events 1 2 3 4 5 6 7 DK

(c) Quality of seating 1 2 3 4 5 6 7 DK

(d) Ticket price 1 2 3 4 5 6 7 DK

(e) Food choices 1 2 3 4 5 6 7 DK

(f) Food price 1 2 3 4 5 6 7 DK

(g) Drink choices 1 2 3 4 5 6 7 DK

(h) Drink price 1 2 3 4 5 6 7 DK

(i) Souvenir choice 1 2 3 4 5 6 7 DK

(j) Souvenir price 1 2 3 4 5 6 7 DK

(k) Cleanliness of restrooms 1 2 3 4 5 6 7 DK


(l) Availability of restrooms 1 2 3 4 5 6 7 DK
(m) Availability of parking 1 2 3 4 5 6 7 DK

(n) Safety 1 2 3 4 5 6 7 DK

(o) Overall value 1 2 3 4 5 6 7 DK


for the money
Variables X15a − X15o : For each variable, enter either the number circled, or a period sign if
the item is skipped or DK is circled.
16. X16 : Has the threat of terrorism changed your Dome attendance habits
since 9/11/’01?
1 Yes 0 No

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17. What should be done to improve safety at the Dome?
(Check all that apply)
X17a : More police presence X17b : Better screening at entrance
X17c : Metal detectors at gates
For each variable, enter 1 if checked and 0 if not. (There is no non-response for question 17.)
E. Interest in new Dome events
18. If a combined lacrosse/football/basketball season ticket were
available, how likely would you be to purchase it at the following prices?
(Please circle)
Very unlikely Very likely

(a) $50 1 2 3 4 5 6 7

(b) $75 1 2 3 4 5 6 7

(c) $100 1 2 3 4 5 6 7

(d) $125 1 2 3 4 5 6 7

(e) $150 1 2 3 4 5 6 7

(f) $175 1 2 3 4 5 6 7

(g) $200 1 2 3 4 5 6 7
Variables X18a − X18g : For each variable, enter either the number circled, or a period (.) sign
if the item is skipped.
19. X19 : Consider the concept: “Allow all students free access to all games at the Carrier
Dome in exchange for a fixed increase in tuition fee.” How strongly do you agree/disagree
with this statement? (Please circle)
Strongly Disagree Strongly Agree
1 2 3 4 5 6 7
Enter either the number circled, or a period (.) sign if the item is skipped.
20. In the space below, please list any event(s) you would like to see at the Carrier Dome.
Coding: Do not enter anything from question 20 into the Excel sheet. On a separate page
list the new events and record how many times each event is recommended.

**Thank You for Your Participation**

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