Chapter 1

Boundaries of a Good
Price
Using Exchange Value Models
to
Understand Price Competition
and Define Your Value Add

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website, in whole or in part.

Agenda

Who is involved in pricing decisions?

Why is pricing so important to the health of the firm?
Can firms influence their pricing power?
What is the nature of a good price?
How relevant are marginal costs and consumer surplus
in setting a good price?
How should the comparable alternatives on the market
influence the pricing of a product?
How can exchange value models be used to set prices?
Stretch Question: How are exchange value models
related to market segments?

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website, in whole or in part.

Pricing Errors Are Costly

Too high
Lost profits from lack of volume
The price is eventually dropped and the company must fight
for market interest and perception repositioning
Potential allegations of price gouging and unfairness, leading
to public relations and regulatory ramifications

Too low
Forgone profit in an attempt to gain volume which may not
come
Incorrectly set expectations for the product category, making
future price increases being driven against a headwind of
customer expectations

Ultimately, lost profits, revenues, and a shrinking/irrelevant

firm
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Pricing Decisions are Stakeholder

Decisions (Cross Functional Decisions)

CFO

Customers

Sales & Marketing

CEO
Shareholders

Executives

Responsible for developing new products

that customers value
Technical individuals often are challenged to
understand commercial aspects

Production

Responsible for promotion, product

strategy, and placement, along with pricing
Almost always involved in pricing decisions
from a value positioning perspective
General bias towards discounting and
market share

Research & Development

Responsible for measuring and reporting

performance
Almost always involved in pricing decisions
from a quantitative analysis / forecasting
perspective
General bias towards higher contribution
margins

Responsible for quality, throughput, and

capacity utilization
General bias towards volume to reduce
overhead allocation

CEO

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Arbitrator
between competing stakeholders
website, in wholeor in
part.

The Needs for Pricing

Professionals
Understand Customer (Perception and
Willingness to pay)
Grip the issue of COST
Market alert
Able to measure the demand
(elasticity)
Need Strong analytical skills
meaningful decisions
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website, in whole or in part.

Value Exchange and Profit Capture

Price is the value that the firm captures in a mutually beneficial
exchange with its customers

Firms reason for existence is to produce value for customers, value

which they exchange for cash
Customers purchase because they gain value from the product in
excess of the price they pay

Profit
Profit = Quantity X (Price Variable Costs) Fixed Costs
= Q (P V) F
Variable Costs (V)
Fixed Costs (F)
Volume or Quantity Sold (hence the Q)
Price (P)
Profit ()
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website, in whole or in part.

Marginal Improvement Price Has

Impact

Fixed Cost Reduction

Consider a firm that

improves one of the levers
in the profit equation by
1%, holding all else
constant

New Fixed Cost =

$321,750
New Profit = $78,250
Improvement of 4%

New Variable Cost = $2.97

New Profit = $81,000
Improvement of 5%

Example:

P = $5.00
Q = 200,000
V = $3.00
F = $325,000
Improve either P, Q, V, or
F by 1%
How does this affect
profit?

Initial Profitability

Quantity Sold Increase

New Quantity = 202,000
New Profit = $79,000
Improvement of 4%

Variable Cost Reduction

Price Increase
New Price = $5.05
New Profit = $85,000
Improvement of 13%

= 200,000 ($5.00-$3.00) $325,00

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Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
=Cengage
$75,000
website, in whole or in part.

Quantitative & Qualitative

Careful selection of model

Careful treatment of data
(cleansing)
Careful market segmentation

Marketing Sales

Price

Finance

Economics

Quantitative Modeling and Price

Optimization

Qualitative Modeling
Potential methods of influencing
willingness to pay
Relationship to corporate strategy
and industry dynamics
Customer acceptance to approach
of price discrimination

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website, in whole or in part.

What is the right Price?

Is about a range of potential points
that benefit customer and firms
In Proportion to the value that customer
perceive
Setting Prices with
Exchange Value Models

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website, in whole or in part.

Boundaries of Price

There is a range of right prices

Range implies boundaries, upper and lower

Extremes from standard economics:

Marginal Cost is the Extreme Lower Boundary
Consumer Utility is the Extreme Upper Boundary

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Marginal Cost = Extreme Lower

Bound

Marginal costs are the sellers bottom line.

Any price below marginal costs leave the seller worse off
then they would be without the transaction.
Any price above it leaves the seller better off.
Thus, marginal costs is the extreme lower boundary of
the right price.

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website, in whole or in part.

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website, in whole or in part.

Consumer Utility = Extreme Upper

Bound

Consumer utility are the buyers bottom line.

The customer would be worse off if they paid more

for a product than they gained in utility
Any price below consumer utility would be leave the
customer better off than going without

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website, in whole or in part.

Marginal Costs and Consumer

Utility
Extreme Boundaries
From this example, we know
only two extreme boundaries,

Consumer Utility
$500,000

Bottom boundary of marginal

cost generously estimated $325
Upper boundary of consumer
utility frugally estimated at
$500,000

Clearly, $325 and $500,000 is a

wide range, with the upper
bound a factor of 1000 above
the lower bound.

Range of
Potential Prices
lies between the
Extreme
Boundaries

$400
$4,000
$40,000
$400,000

Managers need a tighter bound

than this for decision making.

Blunt force economics of

producer cost and consumer
utility alone is insufficient.

Price Floor
$325
Marginal
Costs

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Competing Alternative and Differential Value

Narrow Boundaries
Marketing Strategy
Products are valued because they enable a customer to do
something, accomplish a goal, from that product.
Utility is derived from Goal accomplishment
Prior to the existence of the product, most consumers
found an alternative means of accomplishing the same
goal
What are those alternatives?
How much better can they achieve that goal, and perhaps others
simultaneously, from the product?

Narrower band is defined by the competing

alternatives and differential value
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Competing Alternatives /
Substitutes

Competing offers are often readably identifiable, and form a

reference price.
Reference Price = Price of nearest comparable offer

Substitutes are sometimes more challenging to identify, but

they always exists.
Substitutes: any alternative means of achieving a
similar set of benefits

When possible, use more direct competitors to consider

when modeling price decisions

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website, in whole or in part.

Differential Value

Differential value is the change in consumer utility that a product in

comparison to its comparable alternative

Exchange value is the price of the competing alternative adjusted for the
differential value

The drug eluting stent clearly delivers more benefits than standard stents.
Quantify it with a model.

The stent is a component in a larger process.

Implanting a stent is a roughly $12,000 operation, of which the standard stent is
only a $1050 component.

Operation cost = $10,950

Standard Stent Cost = $1050
Assume the procedure must be repeated 25% of the time due to restenosis
Total Maximum Expected Cost
($12,000) + ($12,000) 25% + ($0) 75% = $15,000
Repeat the Procedure
$12,000, 25%

Original Procedure
$12,000, 100%
Expectation Value = $15,000
$12,000(100%) + $12,000(25%) + $0(75%)

Dont Repeat the Procedure

$0, 75%

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Differential Value

The Drug Eluting Stent reduces restenosis to 5%

Repeat the Model, but this time let the price of the stent be unknown
and the expectation cost be held constant to that of the nearest
competing alternative

Solve for the unknown, using algebra.

Total Maximum Expected Cost

$15,000 = ($10,950 + X) + ($10,950 + X) 5% + ($0) 95%
X = [$15,000 ($10,950)1.05]/1.05
X = $3,340

Exchange Value of the new Drug Eluting Stent at $3,340

This price leave the patient economically equally well off as with the lower
price for the lower quality competing alternative
Ignores quality of life issues, the risk of a second failure, etc. It is a
conservative estimate
Repeat the Procedure
$ 10,950 + X, 5%

Expectation Value = $15,000

Original Procedure
$10,950 + X, 100%
Dont Repeat the Procedure
$0, 95%

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website, in whole or in part.

Exchange Value Model for

Drug Eluting Stent by Cordis
Exchange value = Price of
Alternative + Differential
Value

Consumer Surplus is the

difference between the
price paid and the total
consumer utility

Exchange
Value
$3,340
Differential Value
$2,290
Reference

Marginal
Costs

Consumer Surplus
$$$$$

Price of Comparable
Alternative

$3,340 = $1,050 + DV
Differential Value is a
whopping $2,290

Maximum
Potential Price

Consumer
Utility
$500,000

Value
$1050
Price Floor
$325

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website, in whole or in part.

Summary

Model your value add with Exchange Value Models to determine the
boundaries of a reasonable price

Consumer Utility
Marginal Cost
Price of Nearest Alternative
Differential Value
Exchange Value

Use Exchange Value Models to Identify a rational range for your price

Use Exchange Value Models to Communicate Pricing decisions with CFO /

Sales Team

Use Customer Utility Models to Communicate Value with Customers

Accept that different customers have different perspectives on value. Use

differences in valuation to drive price segmentation

2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.