2 business discussions - due in 16 hours

Learning Outcomes

By the end of this chapter, you should:

• Understand the different approaches to price setting, based on costs, customers, and competitors, that can be used to meet organizational objectives.

• Recognize how alternative pricing goals and objectives can shape pricing policies.

• Appreciate the significance of price elasticity of demand product as a measure of how consumers respond to changes in product pricing.

• Develop a practical understanding of promotional pricing as a set of alternative tactics for stimulating near-term product sales.

• Understand the far-reaching impact of product pricing decisions on brand management and product strategy.

10

Pricing Strategies and Tactics

Sung-Il Kim/Corbis

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CHAPTER 10Introduction

Pricing is the judgment that translates potential business into reality—yet it is still the least ratio- nal of all business decisions. (A. Walker, Harvard Business Review)

Pricing policy is the last stronghold of medievalism in modern management—largely intuitive and even mystical. (J. Dean, American Marketing Association)

Price setting in this country is approached like Russian roulette—to be engaged in only by those contemplating professional suicide. (David Aaker, author and consultant)

Introduction

Pricing is one of the most important, yet least understood, dimensions of market-ing strategy. Despite the growing role of nonprice factors in the marketing process, there is no escaping the direct cause-and-effect relationship between pricing deci- sions and profitability. As increased competition from international competitors and the growing sophistication of buyers have pushed market prices down for many goods and services, marketing managers have had to become more knowledgeable in both the art and science of setting prices.

* * *

It should be evident from the quotations at the start of this chapter that many business professionals have trouble fully comprehending pricing strategy and concepts. Marketing management can be a complex process, and often the interrelationships among price, opportunity cost, and value in a given situation can evade our understanding for a time. Consumers, however, sometimes understand these complexities quite well.

Clint’s son Ryan had been pestering him for weeks to get a puppy. As the holidays drew nearer, the 6-year-old’s appeals grew more persistent and intense. Clint wanted to get his son a dog, but the household finances were tight and he was reluctant to take on another mouth to feed at this time. He also worried that the responsibilities of caring for a dog might be too much for an only child in a single-parent household. Yet despite his concerns, Clint brought home a Basenji puppy named Gumby on Christmas Eve.

What can we say about pricing? Clint felt fortunate to pay only $65 to adopt the dog from the local humane society. However, he had to pay $578 in customary and necessary veterinary bills over the first three months of the dog’s time with the family. Another $55 for an annual license. An average of $14 per week for food, treats, and dog toys. The price of owning and caring for Gumby easily exceeded $1,500 before the end of the first year.

What of opportunity costs? Clint had trouble meeting his mortgage payments twice that first year and lost some sleep because of it. He opted to put off getting the pair of new glasses for himself that he needed . . . at least for a little while. The $1,500 down payment he needed for a new bass boat just wasn’t there that year or the next.

And value? Value is always determined by the perception and experiences of the consumer. Gumby is 11 years old today; Ryan is 17. Gumby remains a boundless source of happiness for the family. He’s been to lots of family picnics in the park, enjoys playing Frisbee, and helps everyone

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CHAPTER 10Pre-Test

have a great time on the annual trip to the beach. Gumby has always been there at those times when Ryan was home alone due to the demands of Clint’s job, and he generally keeps an eye on the place when no one else is there.

Maybe the purchase of Gumby was a poor decision at the outset. Maybe both the price and opportunity cost exceeded the value for a brief period, but what do you think of the return on this investment over time?

Pre-Test

1. Above-competition pricing a. necessarily leads to reduced profits. b. is usually pursued by a highly regarded brand. c. is the best way for a new market entrant to increase market share. d. sets prices as a fixed percentage above total costs.

2. A well-established brand has the best chance of profit maximization in the _________ stage of the Product Life Cycle.

a. market introduction b. market growth c. market maturity d. sales decline

3. Price elasticity of demand a. assumes that competitors are also changing their prices for competing

products. b. allows accurate predictions of price, demand, and marketplace change. c. is only affected by two variables: availability of substitute goods and necessity

of the product. d. is typically valid only for a particular time.

4. Of the following, which is a potential danger of using promotional pricing? a. Promotional pricing may teach buyers to wait for good deals. b. Promotional pricing tends to entice price-sensitive buyers. c. Promotional pricing often provides only a temporary stimulus to sales. d. Promotional pricing often leads to jumps in product demand.

5. Which part of the marketing mix is the easiest and quickest to modify? a. product b. place c. promotion d. price

Answers 1. b. Is usually pursued by a highly regarded brand. The answer can be found in Section 10.1. 2. c. Market maturity. The answer can be found in Section 10.2. 3. d. Is typically valid only for a particular time. The answer can be found in Section 10.3. 4. a. Promotional pricing may teach buyers to wait for good deals. The answer can be found in Section 10.4. 5. d. Price. The answer can be found in Section 10.5.

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CHAPTER 10Section 10.1 Approaches to Price Setting

10.1 Approaches to Price Setting

A product’s price is simply the payment given by a buyer to a seller in exchange for goods or services. Buyers seek to minimize the payment required to obtain goods as a basis for maximizing the value they receive. Sellers generally endeavor to secure higher prices to increase the revenue from each sale; pricing decisions are always critical to the firm’s achieving its overall financial goals. Consequently, the process of set- ting prices must be based on a fundamental understanding of what the organization is trying to accomplish with its pricing strategy.

As illustrated in Figure 10.1, marketers often think of the alternative pricing options avail- able to them as bounded or constrained by three Cs: costs, customers, and competitors. Pricing products below cost cannot be sustained in the long run. Pricing beyond custom- ers’ willingness to pay will not be successful. Setting prices that fail to deliver a competitive value will lead to a brand’s demise in competitive markets. In general, there are three approaches to making pricing decisions, and each uniquely reflects the priority of one of these three Cs.

Figure 10.1: The constraints on pricing options

Customers Competitors

Costs

Viable Pricing Options

The pricing tasks that confront marketing managers require an assessment of alternative strategies that are constrained by product-related costs, competitors’ strategies, and customer perceptions. Each of these is a critical element of the pricing environment that must be evaluated.

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Cost-Based Pricing

Cost-based pricing decisions rely on an understanding of production- and marketing- related costs as the key elements in determining a product’s initial or standard price. It uses the product’s break-even point to identify a price floor, the minimum selling price that will cover the product’s variable and fixed costs at a given level of production. Any prices set above this floor will provide the seller with a profit margin on each unit sold. Cost-based pricing techniques consist of simply adding a fixed percentage or monetary (dollar) value profit margin to the established price floor.

This approach is easy to use and logically infallible as long as actual costs are known. It is regarded by some managers as a conservative approach to setting prices since the price floor represents a break-even point where unit revenues match unit costs and all product-associated costs are recovered. In this sense, the cost-recovery or break-even price is recognized as the minimum unit price for the product being sold. Markup pricing and cost-plus pricing are two of the most commonly used methods for making cost-based pricing decisions.

Markup pricing is a pricing method favored by many large retailers. The price for any given category of products is set by establishing a fixed percentage increase or markup on top of the initial product cost to arrive at a retail price. By utilizing a common fixed percentage for all of the brands within a category (e.g., small kitchen appliances), the retail price is a direct reflection of wholesale price paid for the merchandise. Consequently, the ranking of brands according to price remains the same as the products move through the channel of distribution. This is an important consideration in many categories where brand price is intended to provide consumers with cues about product quality and value.

Cost-plus pricing is similar to markup pricing. Instead of using a fixed percentage markup to arrive at a final price, however, cost-plus pricing simply adds a fixed monetary amount. This approach is com- monly used throughout the service sector of the economy where time- and labor-related costs are often independent of material costs. An electrician who is hired to install a new ceiling fan will determine a total price for the job based on time plus materials. Since the type of fan is unlikely to impact the time or labor required to install it, the estimate for the job will often be stated as a fixed fee to cover the cost of his or her time plus the cost of materials to be used. The buyer is made aware from the outset that deviations in the price of the job will depend on any changes in material costs and that labor costs will remain constant.

Ralph Clevenger/Corbis

Cost-plus pricing is often used by electricians and other skilled tradespeople, because time- and labor-related costs are often independent of material costs.

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For many types of sellers, the simplicity and conservative features of cost-based pricing make it an attractive pricing policy. However, these approaches do not reflect consumer preferences or product demand in any meaningful way. Consequently, products may be priced either higher or lower than what the market will bear. This can result in the loss of sales if the product is overpriced and missed profit potential if underpriced. An alterna- tive pricing methodology that corrects this fundamental limitation of cost-based pricing is customer-based pricing.

Customer-Based Pricing

Customer-based pricing is also sometimes referred to as demand-driven or value-based pric- ing since prices are derived from buyers’ perceptions of value rather than the seller’s cost. This approach to setting prices includes two specific pricing policies for new and emerging products that are addressed later in the chapter: price skimming and penetra- tion pricing.

Among the most widely adopted variants of value-based pricing strategies is Economic Value Estimation (EVE). The fundamental principles of EVE are straightforward: “A product’s total economic value is the price of the customer ’s best alternative (the reference value) plus the economic value of whatever differentiates the offering from the alterna- tive (the differentiation value). Differentiation value may have both positive and nega- tive elements” (Nagle et al., 2011). An illustration of this technique is provided in the following feature.

Economic Value Estimation

Is using EVE complicated? Not really. For the sake of illus- tration, let’s do the analysis on a product innovation for light- and heavy-duty commercial trucks. The TRIM brand fluid cooler is an after-market device designed to cool transmission fluid to prevent excess heat buildup in the transmission case, which leads to early transmission fail- ure. The original factory-installed fluid cooling equipment in most commercial vehicles is simply a stack of flat, long, oval loops of tubes located inside the plastic tank-top of the radiator. Hot transmission fluid is pumped into one end of the cooler and is cooled by the radiator fluid surrounding the tubes. In contrast to this design, TRIM’s cooler is a set

of coiled tubes mounted in front of the radiator. Instead of relying on radiator coolant to cool transmis- sion fluid, it uses direct air flow. This design creates a wider temperature differential between the transmission fluid and the cooling medium than the standard equipment can, thereby increasing the amount of heat that can be pulled from the transmission fluid versus the standard equipment.

TRIM would like to sell this product to truck manufacturers. Prices for the conventional fluid cooling equipment are based on the length of tubing required to make each product model, since each type of truck requires a slightly different configuration. Currently, original equipment suppliers to the major automakers charge $.82 per inch for the metal tubing used in this application. (continued)

Car Culture/Corbis

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Economic Value Estimation is a very useful tool for developing profitable pricing strate- gies for many types of goods and services. Consider a brand that is well positioned and superior to competitors’ alternatives for a given segment of the market. The price of the buyer’s next-best alternative is the buyer’s reference value or basis for comparison. The EVE approach emphasizes capturing the value added by the preferred product based on the greater economic value of the brand. In principle, the price for the superior brand should reflect the differentiation value (or value added) plus the reference value price of the closest competitor’s brand. Consequently, this new price should approximate the maximum price that buyers will be willing to pay for the better brand.

Economic Value Estimation (continued)

As shown in Table 10.1, TRIM brand managers have identified four distinct sources of differentiation value for their product relative to its competitors:

1. Tube Length: Higher rates of heat transfer due to using air as the cooling medium will reduce the number of coils and the length of tube required for each application by $.04 per inch for light-duty and $.09 per inch for heavy-duty trucks based on laboratory performance tests.

2. Radiator Performance: Due to the reduced size of the fluid cooler, the improved air flow to the radiator improves the cooling capacity of the radiator, allowing for a smaller radiator. This impact is estimated at $.08 per inch for the larger applications and about $.03 per inch for the smaller applications.

3. Weight Reduction: Due to the reduced radiator size described above and the resulting reduction in size of the front end of the vehicle for the engine cooling module, the overall weight reduction improves fuel efficiency, which adds to the value of the vehicle to the customer. Economic value equals about $.01 per inch for both classes of trucks.

4. Extended Transmission Life: Every year more than 14 million transmissions fail. A 20-degree reduction in the operating temperature of a transmission system can double the life of the equipment. Though difficult to evaluate, the economic value related to the cooler operating temperatures achieved by the TRIM product is estimated at $.02 per vehicle.

Table 10.1: Economic value estimation

Light-Duty Trucks Heavy-Duty Trucks

Reference Price $.82 per inch $.82 per inch

Reduced Tube Length .04 .09

Enhanced Radiator Performance .03 .08

Weight Reduction .01 .01

Extended Transmission Life .02 .02

Value Estimate Price per Inch $.92 per inch $1.02 per inch

Make sense? Does a dollar or so per application seem like it would make much difference? The market potential for this application is more than 8 million vehicles annually. The average tube length for this type of application exceeds 30 inches. Do the math: What price per inch should TRIM brand managers quote to the major automakers for this innovative product? Why?

Apply this process to brands in a category that you are very familiar with. Be sure that you recognize how the process “rewards” better brands with higher prices and discounts inferior quality brands.

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An important implication of EVE is that success does not depend on having the best brand. Instead, the objective is to price the product in line with customers’ expectations and understanding of the value your brand represents relative to alternatives. Conse- quently, negative differentiation values are just as much a valid consideration in pricing as positive ones. Aside from brand-specific differences, negative values can also stem from costs incurred by the buyer, especially in business-to-business sales contexts.

Consider the purchase of new machine tools for a product assembly facility. Would buy- ing a new brand of equipment in place of the current brand result in having to retrain employees? Would it mean changing inventory requirements? Could it make some of the buyer’s existing parts inventory obsolete? Each of these is a potential basis for negative differentiation that needs to be accounted for in establishing prices that are consistent with buyers’ expectations of value.

In every purchase situation, buyers also confront an element of risk and uncertainty when making a change of any kind. Consequently, purchasing agents or other people in charge of making buying decisions for a company may require extraordinary improvements in product performance or quality to justify taking a risk on a new brand or supplier.

The primary advantage to customer-based pricing strategies is that they explicitly recog- nize and account for differences between competing brands and consumers’ responses to superior product value. Objectively assessing and measuring the motivations for buying and the product values that motivate customers also promotes a more practical appre- ciation of product positioning and market segments based on how each cluster of buy- ers evaluates economic value in the brands it buys. This is a compelling argument for applying EVE to making pricing decisions. However, it cannot be meaningfully applied in every instance. In some circumstances, making pricing decisions based on competitors’ actions is more appropriate.

Competition-Based Pricing

Competition-based pricing decisions are made by organizations in response to the prices charged by competitors. Several types of company objectives are consistent with this approach. For example, firms may be pursuing competitive advantage by setting prices below their nearest competitors’ prices. Alternatively, they may set a price higher than their closest competitors’ prices as a means of positioning their product as a premium brand.

It is reasonable to expect competitors to react to changes in each other ’s pricing strategies. In fact, many brands often rely on competitors’ price behavior to provide indicators of where prices should be set. Monitoring market prices is a relatively inexpensive form of market research that is essential to maintaining a viable competitive strategy in most B2C markets. The task of tracking prices, however, is generally more difficult in many B2B markets. The sale of products custom built to buyers’ specifications and negotiated prices in some B2B markets make the gathering of data and the process of making meaningful comparisons difficult.

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Most marketing mix decisions, including pricing, should include a review and assessment of competitors’ behavior. In the case of pricing strategy, the value of this information is in direct relationship to how price-competitive the product market is. By definition, price competition has a more direct and substantial influence on sales in price-competitive mar- kets. However, the positioning and market share of competing brands may either accentu- ate or mitigate the role of pricing for each firm.

Brands that dominate markets and are recognized as market leaders will generally be less influenced by competitor pricing. They are, in fact, more likely to be exercising their mar- ket power to set baseline or standard prices in accord with their own marketing strategy. They act as price leaders in this regard. In highly competitive situations where a distinct market leader may not exist, each brand needs to be more cognizant of how its nearest competitors price their brands. Knowing how competitors will respond to any change in pricing strategy is just as important as knowing prevailing price levels. To use competi- tors’ prices as standards against which to make brand management decisions, marketers also need to be aware of how aggressively and how rapidly competitors will respond to price changes.

Although there are no absolute rules for how to use competitor prices as a basis for shap- ing a brand’s pricing strategy, companies tend to be consistent in responding to their direct competitors in one of three ways:

Below-Competition Pricing: Companies that are pursuing market share growth will often respond to changes in prevailing market prices by keeping their prices below those of their closest competitors.

Above-Competition Pricing: Brands that have achieved quality leader- ship and highly specialized niche brands will often maintain their prices above those of competitors in support of their brand image. The generally positive relationship between perceived product qual- ity and price often requires high- end brands to increase their price relative to competitors to reinforce their positioning strategy.

Parity Pricing: Brands seeking to compete on a basis other than head-to-head price competition often simply match changes in their nearest rivals’ prices. Parity pricing to match the price by simi- larly positioned brands also pro- vides a simple method for setting the initial price of new brands in competitive markets.

age fotostock/SuperStock

Family Dollar stores compete for customers and sales by pursuing a clearly defined below-competition pricing strategy.

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CHAPTER 10Section 10.2 Pricing Objectives

It is important to note that pricing changes should rarely be made exclusively in response to competitors’ actions. By the same basic logic, marketers need to recognize that estab- lishing a new price is not the only type of response that can be made to competitors’ pric- ing changes. Customers are responding to product value, which is a function of both price and quality. Isolated changes in competitors’ prices may afford marketing managers with opportunities to consider more significant revisions to the marketing mix. Rather than simply reacting to price changes or mimicking them, marketers may have the opportunity to reshape the whole product offering or bundle of benefits that the product represents. Superior product value may rest in adding new features, improving levels of core product quality, revising distribution channels to improve availability, or providing greater conve- nience through changes in product packaging.

Think About It

Attracted by a seemingly lucrative market for premium fresh-brewed cof- fee, Dunkin’ Donuts and McDonald’s have expanded their product lines in recent years to offer an increasing variety of premium coffee blends, cappuccino, and espresso drinks. Though Starbucks has traditionally been perceived as the quality leader within this market, these competitors are making substantial inroads.

What do consumers want? Taste and value.

Who offers the best blend?

Based on your perception of how these brands compete, which one(s) could initiate an across-the-board price increase on the price of the products and expect the others to follow suit? Why?

What is the net impact on product unit sales and revenue if everyone goes along? If only one fol- lows the price leader?

iStockphoto/Thinkstock

Simply following a market leader’s price moves may seem like the easiest pricing path and the one least likely to get a company into trouble. However, making pricing changes without regard for the objectives and goals directing the management of the brand is a hazardous practice. Any decision to revise pricing policies should be thoughtfully consid- ered and subject to thorough analysis before proceeding. Though price changes are easily executed, the financial and strategic consequences are often substantial and enduring. In light of this, it is essential that all pricing decisions be made with the organization’s pric- ing objectives in mind.

10.2 Pricing Objectives

As part of the market planning process, companies have great latitude in decid-ing how a brand’s price should contribute to its positioning and the overall strat-egy for the product. The primary goal of any given pricing strategy will typically be focused on achieving one of four major objectives: profit maximization, market share maximization, price skimming, or quality leadership.

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Profit Maximization

The pricing objective for many brands is to maximize current profits based on projections of the relationship among price levels, associated product costs, and corresponding levels of consumer demand. This is a common objective for established brands since the firm has had time to develop a reliable understanding of both price–demand and price–cost functions. It also tends to be a more appropriate goal for brands in the maturity stage of the PLC, since market-related dynamics and volatility have stabilized.

Profit maximization may be an objective that is poorly suited to new and emerging brands since the nature of the relationships among price, demand, and product costs are less understood. Similarly, market dynamics tend to be more volatile, and finding the right price may be a matter of chasing a moving target. Placing too much emphasis on near- term measures of profitability can adversely impact the long-term performance of emerg- ing brands if other growth-related goals are ignored.

Market Share Maximization

A market share maximization pricing objective may be of particularly great importance for firms trying to secure a substantial position within a new or emerging market. It is a goal that is also consistent with market penetration strategies where the intended effect of higher sales volume is to reduce unit costs of production and distribution. This penetra- tion pricing strategy is sometimes observed in the marketing plan for new products where initial prices are set artificially low to build sales volume and market share. After securing customer acceptance and a foothold in the market, prices are subsequently increased to capture higher levels of profitability.

Although the primary aim of penetration pricing strategy is to maximize the quantity sold by offering buyers a low price, it also affords brands with a measure of protection and defense against the threats posed by impending competition. By reducing the short- term profitability incentive to enter the market, firms pursuing this option often enhance their long-run financial prospects. This is particularly true in circumstances where large decreases in unit cost result from cumulative volume increases.

Price Skimming

An alternative to penetration pricing is a technique referred to as price skimming. In the initial stages of category growth and development, the first brands to pioneer the market may choose to set prices at a level that is much higher than can be sustained once competi- tors enter. This price skimming strategy enables the product innovators to recover devel- opment and preliminary marketing costs before the arrival of competing brands drives prices lower. The sustainability of this strategy over time hinges on several factors related to the dynamics of the market, including barriers to entry. The effects of applying the price skimming methodology to gradually lower the price of a product over time are illustrated in Figure 10.2.

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Figure 10.2: Price skimming graph

Several prerequisite market conditions must be met for price skimming strategies to be successful. To justify the strategy on a revenue basis, a sufficient number of buyers in the critical PDC innovator category must be willing to pay the relatively high price of being the first to own this innovative new product. Similarly, the higher unit costs associated with limited production cannot be so high that they negate the additional margins asso- ciated with the higher price. From a positioning perspective, it is also essential that the skimming price be consistent with and convey a brand image of high quality and high customer value.

Quality Leadership

Quality leadership is a pricing objective based on the utilization of higher prices to signal superior product quality to both competitors and consumers. As discussed previously, consumers often rely on price as an indicator of quality, particularly when they are unfa- miliar with a product category. The intent behind establishing quality leadership as a goal is to promote and reinforce a brand’s positioning strategy as a quality leader within the category.

Demand t1

Demand t2

Demand t3

Quantity demanded

P ri

ce

Q1 Q2 Q3

P1

P2

P3

Customer surplus captured

This graph illustrates the consequences of lowering product prices gradually over time. At each successively lower price point, additional levels of revenue and profitability are captured.

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The appropriateness of this goal depends largely on the category context. In mature mar- kets, it is often difficult to successfully challenge entrenched brands that occupy the “high quality” positions in buyers’ perceptions. And it can be even more difficult to carve out a space for multiple co-leaders on the dimension of product quality. Changes in the character of consumer preferences, however, sometimes create opportunities. Although there are a small number of quality leaders in different sectors of the home appliance market (e.g., Maytag, Whirlpool), none yet dominates that highest-quality market position for consum- ers who attach the greatest priority to energy efficiency or environmental friendliness. That is, a clear “green quality” leader hasn’t emerged for many home appliance categories.

10.3 Price-Related Factors Influencing Consumer Demand

A number of factors inside and outside the organization impact consumer demand for products. The firm’s goals and strategic plan for the product represent the most obvious and prescriptive of the internal factors. Internal constraints that can limit demand in the short run include unanticipated spikes in product-related costs and limited production capacity. Though the influence of each can be profound and complex, these factors are generally under the direct control and management of the company in the long run.

External influences on consumer demand pose a more difficult challenge for price setting insofar as these are influences beyond the organization’s direct control. However, under- standing and responding to these factors is an essential part of the price setting process. In previous chapters we have addressed many of the psychological factors that impact consumers’ demand for products as well as specific brands. Kent Monroe explored many of these subjective influences on perceptions of price throughout his career (1973, 2002). These included the role of reference prices and the positive relationship between a brand’s price and buyer perceptions of quality.

In this section we briefly examine two additional sets of factors and their impact on con- sumer demand. We consider the factors that drive price elasticity of demand and how this measure serves as an indicator of consumer response to changes in product pricing. In the next section, we will investigate the role of promotional pricing strategies as the organiza- tion’s best short-run pricing alternative for directly impacting product sales.

Price Elasticity of Demand

Price elasticity of demand (PED) is an economic measure of the responsiveness of the quantity of a good demanded to a change in its price. It is expressed as the percentage change in quantity demanded in response to a 1 percent change in price. The mathemati- cal formula for the coefficient of price elasticity of demand is:

PED = % change in quantity demanded = ∆Qd/Qd % change in price ∆P/P

The mathematical value of the PED ratio is almost invariably negative in normal prod- uct markets, since an increase in price will typically produce a decline in the quantity demanded by buyers. By convention, the negative sign is usually disregarded and the value of the equation is simply expressed according to its absolute value.

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The demand for a good is regarded as being relatively inelastic when the PED is less than 1.0 in absolute value. This indicates that a change in price will have a disproportionately small effect on the quantity of the good demanded. In this scenario, the percentage change in quantity demanded is smaller than the percentage change in price. Consequently, if the price is raised, total revenue increases.

Demand is regarded as relatively elastic when its PED is greater than 1.0 in absolute value. In this condition, changes in price have a disproportionately large effect on the quan- tity demanded. Under these conditions, the percentage change in quantity demanded is greater than the percentage change in price. Therefore, if the price is raised, total revenue will decrease.

When the percentage change in quantity is equal to the percentage change in price, the value of PED will be 1. This is referred to as unit or unitary PED. In this circumstance, price changes will not affect total revenue over the range of prices where this assessment of elasticity is valid.

The PED for a product can be influenced by many factors:

Availability of substitute goods: PED will be higher when more close product substitutes are available. The availability of substitutes allows buyers to switch to less expensive alterna- tives or better product values when the price of their usual brand increases. The relative willingness of buyers to switch to other goods in the face of higher prices is called the substitution effect.

Percentage of income: The higher the percentage of the buyer ’s income that is needed to acquire the products, the higher the elasticity tends to be. In general, consumers are simply more price sensitive to products that are more expensive.

Necessity: The more necessary the consumer believes a good to be, the lower the PED will be. That is, consumers are much less likely to discontinue buying the product in response to a price increase. This effect is evident in the sale of both over-the-counter and prescription drugs.

Duration: If a price increase persists over time or buyers believe that it will remain in effect for the foreseeable future, they will be more inclined to seek out alternative, substitute goods. Consequently, the PED will increase over time. An increasing number of car-bound commuters faced with the prospect of higher gas prices, for example, will seek alternative forms of transportation over time.

Brand Loyalty: Buyers’ commitment or attachment to specific brands will reduce their sen- sitivity to price increases, resulting in more inelastic demand.

For marketing managers, price elasticity of demand for a given brand can be applied to estimate the anticipated change in quantity demanded for a proposed price. It is a useful tool for analyzing alternative strategy scenarios on a what-if basis. In general, however, the value of the results from these types of conceptual experiments is limited by the reliability of the information used in the analysis and the realism of the underlying assumptions.

PED-based projections of how price changes will impact demand and revenue are based on the assumption that no other relevant market changes will occur at the same time. This

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includes an assumption that com- petitors will not respond to a price change in kind. However, the like- lihood of nothing else changing in the market but the price of a single product is, in reality, quite small. Measures of elasticity are also of limited utility insofar as they are only valid for a given point in time. The shifting tide of consumer preference and underlying market dynamics necessarily invalidate their reliability over time.

It is reasonable to conclude that the price elasticity of demand pro- vides a statistically sound basis for assessing the general consequences of price changes on demand and total revenue. Market dynamics and the sensitivity of markets to factors other than price, however, limit the predictive reliability of the methodology. Despite its practical limitations, PED can be a valuable tool for project- ing the general direction of market responses to a brand’s change in price. As such, it can provide important insight into the development of effective product pricing strategies.

A Closer Look at PED

Since their first encounter with the concept of price elasticity of demand is typically in an economics class, marketing managers sometimes mistakenly believe that the PED concept is simply too abstract to be of much practical use. But what could be more practical and potentially valuable than knowing the most likely change in quantity demanded or total revenue that will result from a change in price? PED market tests and analysis can be applied to determine the optimal pricing strategy for many types of products.

Consider the challenge of setting the retail price for an innovative new frozen Greek entree: spanakopita, or spinach pie in buttered filo dough. Although products like frozen shepherd’s pie and Cornish pasty meat pies are somewhat comparable, they only provide vague guide- lines and loose constraints for price setting. Field pricing tests in matched markets throughout the United States could be used to ascertain the price elasticity of demand for the product. Data on the quantity response to alterna- tive retail price points could be compiled to estimate the PED over the range of prices tested. These

iStockphoto/Thinkstock (continued)

Getty Images Entertainment/Getty Images

Companies such as Adidas strive to differentiate their brands and execute positioning strategies designed to build brand loyalty and reduce their customers’ willingness to switch to substitute goods.

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CHAPTER 10Section 10.4 Promotional Pricing

This chapter initially identified three approaches to setting prices that differed based on their orientation to product costs, customer preferences, and competitive pricing. Under- standing price elasticity can make positive contributions to the development of pricing strategy under all of these general frameworks. The same can be said of understanding the essentials of promotional pricing.

10.4 Promotional Pricing

Price changes in response to competitors’ behavior tend to be fairly permanent revi-sions or long-term adjustments to brand strategy. They reflect an enduring shift in the overall marketing plan for the product. However, product prices can also be adjusted for shorter intervals on a temporary basis. This is most frequently done as part of a promotional pricing effort.

Promotional pricing is a term used to describe a diverse collection of price-reduction tactics intended to stimulate the demand for a specific brand. It is frequently employed when new products are initially introduced to the market and throughout the Product Life Cycle as a temporary stimulus when sales are lagging below expectations. It is a strategy that targets prospective buyers who are generally price sensitive as well as those anticipating price reductions as opportunities to purchase. However, the overuse of short- term price incentives to stimulate sales in specific product or geographic retail markets can create deal-prone buyers who will only purchase in response to discounted prices. Similarly, frequent price changes and aggressively promoted sale prices can create skepti- cism about the true value or significance of discounts.

A Closer Look at PED (continued)

data could be used to identify the relative elasticity of demand to price changes from one point to the next. This, in turn, could provide the marketing manager with the information required to determine the optimal price point in terms of maximizing revenue and profitability.

You might be inclined to guess that the PED for spanakopita will be elastic over the relevant range of prices tested. This could be inferred from some of the factors listed above. The product is not, for example, a necessity. However, other factors would support the belief that PED may be inelastic over some range of relevant price options. Since it is an inexpensive purchase and has few close sub- stitutes, consumers may be relatively insensitive to the product’s price. It is precisely these types of uncertainties that make doing PED field tests so valuable.

It is critical to note, however, that PEDs will shift over time in response to competitive behavior, changing economic conditions, and the evolution of consumer tastes and preferences. It is also essen- tial to remember that setting the product’s price is often intended to accomplish objectives beyond simply maximizing total revenue. Building brand awareness and market share, for example, may dic- tate setting lower introductory prices than the analysis of the PED alone would indicate.

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CHAPTER 10Section 10.4 Promotional Pricing

When used appropriately, promotional pricing can be a very effective tool for increasing brand sales in the short run. It also holds the potential to create brand-loyal customers if first-time buyers are favorably impressed by the quality of the product and value they receive from the purchase. There are five general categories of promotional pricing alternatives: markdowns, loss-leader pricing, product bundling, dynamic pricing, and sales promotions.

Markdowns, or “sale prices,” rep- resent the most familiar form of promotional pricing. They encom- pass a wide array of promotions that feature products selling below their usual or customary price. Seasonal and holiday sales events are commonly used to promote sales at specific times of the year. These events may be run coun- tercyclically to build sales during traditional off-peak periods (e.g., Christmas in July) or procyclically to build volume and capture mar- ket share during natural sales peaks (e.g., discounting snowblowers in December). Special event pricing (e.g., back-to-school sales) is also included in this category.

Loss-leader pricing is used pri- marily by traditional store retail- ers. This tactic consists of featuring one or more popular brands for sale at prices below the seller ’s cost of goods. The expectation is that these featured values will build cus- tomer traffic for the store and result in purchasers of additional regular-priced prod- ucts as well. Convenience stores, for example, often feature fresh-brewed coffee priced below cost to attract customers with the expectation that they will also purchase higher- margin products.

Product bundling is most often used in reference to the sale of complementary products together at a special combined or bundled price. For buyers, the overall cost of purchasing the set or bundle is less when compared to purchasing each product individually. Con- sider the promotions frequently featured by electronics retailers. Desktop computers are typically bundled with a monitor, software, and a printer/scanner for a price significantly below the cost of the individual components purchased separately.

Associated Press

Many parents take advantage of the back-to-school sales that fall under the special event pricing category of markdowns. What markdowns do you regularly look for when shopping?

Think About It

Most towns seem to have one: that furniture, flooring, or clothing store that advertises a “going-out- of-business” sale several times a year. The strategy must be working to some extent since, ironically, the store never closes up for good.

How can you explain this?

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CHAPTER 10Section 10.5 Understanding the Role of Product Pricing

An advantage to the marketer is that prices can often be reduced on product bundles without adversely impacting consumers’ perceptions of brand quality. That is, buyers are likely to view a lower cost on the computer package as representing a “better value” rather than raising questions about the quality of any particular component.

Dynamic pricing is a form of retail promotional pricing that has grown in popular- ity with Internet retailers. The central element of this technique is that price adjust- ments are made at the point of sale, specific to the purchase history and behavior of the buyer. In some respects, it resembles the negotiated pricing model that is typical of B2B transactions. Dynamic pricing methodologies combine known customer data with pre- programmed pricing algorithms to create price offers uniquely suited to each specific transaction and buyer.

Airline pricing, for example, may rely on customer characteristics such as preferred dates of travel, prior purchase patterns, travel frequency, and whether the trip is for business or leisure to determine the best offer available to any given prospect. If the inquiry is made online, first-time visitors to the site may receive a more favorable price. If the “cookies” on the customer’s computer indicate that they have been to the site on many occasions without purchasing anything, deeper discounts may be in order. Information stored on the prospective buyer’s computer may also provide useful data about other sites visited, the user’s interests, and general buying tendencies.

Sales promotions, as with the other categories, work to build sales volume by lowering the price paid by the buyer. This set of short-term price incentives, however, requires coordination with a supporting communications plan to be effective. Additionally, it often involves more initiative on the part of the buyer to gain the price reduction. The methods used in this category include rebates, coupons, special financing, trade-in plans, and loy- alty programs. These types of promotion are discussed in greater detail in the next chapter.

Think About It

Sales promotions have become an integral part of retail strategy. Visit several stores online. Be sure to include Best Buy, Sears, Amazon, and L.L.Bean. Identify as many types of sales promotions as you can.

Do certain types of sales promotions seem to go with certain types of products?

Does the online use of this pricing tactic differ much from how it is practiced by traditional retailers?

10.5 Understanding the Role of Product Pricing

Marketers need to recognize the critical roles that pricing decisions play in product management. The price component of the marketing mix impacts the way in which brands compete for sales in three ways, including brand image, flexibility, and demand management.

Brand Image: As discussed at several points throughout this text, effective product posi- tioning is dependent on cultivating a brand image that resonates with the target market. Pricing strategy is a critical part of this process. However, it is a particularly impactful part of the process at the earliest stages of the brand’s life cycle. Customers’ first impressions are typically lasting impressions, and their perception of a brand is often formed when

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CHAPTER 10Post-Test

they first learn the price. If buyers do not see substantial product value at this first encoun- ter, it is unlikely that they will pursue the evaluation of this brand any further.

Flexibility: Price is the most flexible and easily modified of the market- ing mix variables. In contrast to product, promotion, and distribu- tion decisions, pricing strategy can be changed quickly without incur- ring significant direct expenses. This feature provides an impor- tant tool for responding to com- petitive threats and for stimulating demand.

Demand Management: Price adjust- ments can be used effectively to stimulate near-term sales or slow the rate of sales growth if capacity constraints limit product produc- tion in the short run. Price-driven sales promotions can also grow demand by securing new distri- bution channels for the product and expanding the overall distri- bution network.

Conclusion

Pricing is always a pivotal decision for marketing managers. It is a prime determinant of both sales revenue and profitability. It is an essential component of how consum-ers assess product value. It must be planned relative to the needs and preferences of the target market. And it needs to be coordinated with the other elements of the market- ing mix for successful execution of the marketing plan. Elements of pricing strategy and tactics are often used to complement the promotional features of the marketing mix to refine the brand’s positioning relative to its competitors and drive product sales. In the next chapter, we’ll investigate the potential applications of specific options in the promo- tions mix.

Post-Test

1. Cost-plus pricing is especially common in a. the retail sector. b. the service sector. c. the sale of raw materials in the B2B market. d. high-tech sectors.

Bloomberg/Getty Images

Pricing plays a significant role in consumer perceptions of brand image. Some Aston Martin models retail for over $300,000. What conclusions would you make about the brand from that price?

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CHAPTER 10Key Ideas

2. Overall, the greatest range of pricing strategies, from penetration pricing to price skimming to profit maximization, is primarily the prerogative of

a. market followers. b. the market leader. c. a market challenger. d. a medium-sized company pursing a diversification strategy.

3. If the PED for a good is below 1.0, then a. any change in price will not affect overall revenue. b. demand is relatively elastic. c. a company can likely increase profits by raising prices. d. there must be a large number of quality substitute goods available.

4. Which of the following types of promotional pricing typically requires the MOST effort on the part of the customer?

a. markdowns b. dynamic pricing c. product bundling d. sales promotions

5. Establishing brand image in relation to price and value is MOST crucial a. when a customer first encounters the brand. b. when a customer has encountered a brand several times and compared it with

others. c. when a product is in the market growth phase. d. when a product is in the market maturity phase.

Answers 1. b. The service sector. The answer can be found in Section 10.1. 2. b. The market leader. The answer can be found in Section 10.2. 3. c. A company can likely increase profits by raising prices. The answer can be found in Section 10.3. 4. d. Sales promotions. The answer can be found in Section 10.4. 5. a. When a customer first encounters the brand. The answer can be found in Section 10.5.

Key Ideas

• Alternative pricing strategies are constrained by three Cs: costs, customers, and competitors. Pricing products below cost cannot be sustained in the long run. Pricing beyond customers’ willingness to pay will not be successful. Setting prices that fail to deliver a competitive value will lead to a brand’s demise in competitive markets.

• Cost-based pricing decisions begin with understanding production and marketing- related costs as the key elements in determining standard price, relying on the break-even point to identify a price floor.

• Cost-based pricing decisions are commonly used in retailing. This approach is easy to use and logically infallible as long as actual costs are known. It is regarded by some managers as a conservative approach to setting prices since the price floor represents a break-even point where unit revenues match unit costs and all product-associated costs are recovered.

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CHAPTER 10Critical Thinking Questions

• Markup pricing is a pricing method favored by many large retailers. The price for any given category of products is set by establishing a fixed percentage increase, or markup, on top of the initial product cost to arrive at an retail price. Cost-plus pricing adds a fixed monetary or dollar amount to arrive at the final price. It is the logic used when contractors bid for jobs on a time-plus-materials basis.

• Customer-based or value-based pricing sets prices based on perceptions of value rather than the seller’s cost. This approach to setting prices includes EVE analy- sis, price skimming, and penetration pricing.

• Competition-based pricing decisions are made by organizations in response to the prices charged by competitors. Several types of company objectives are con- sistent with this approach, including profit maximization, market share maximi- zation, and price leadership.

• Price elasticity of demand (PED) is an economic measure of the responsiveness of the quantity of a good demanded to a change in its price. It is calculated as the percentage change in quantity demanded in response to a 1 percent change in price. Its value can be influenced by many factors, including brand loyalty, the availability of substitute goods (the substitution effect), percentage of income being spent to acquire a product, the perceived necessity of the purchase, and the anticipated duration of the price change.

• Promotional pricing includes an array of pricing tactics intended to stimulate the near-term demand for specific brand. It is frequently employed when new prod- ucts are initially introduced to the market and throughout the Product Life Cycle as a temporary stimulus when sales are lagging below expectations. The five basic categories of promotional pricing alternatives are markdowns, loss-leader pricing, product bundling, dynamic pricing, and sales promotions.

• Pricing strategy impacts how brands compete for sales in three ways. It has a powerful impact on brand image, it is a flexible tactical tool that can respond rap- idly to shifting market dynamics, and it can be used to directly influence short- run product demand through the use of sales promotions.

Critical Thinking Questions

1. Sometimes brand mangers find the issues surrounding pricing strategy very sim- ple and straightfoward. At other times, pricing strategy is the most challenging of the marketing mix variables to manage. What market-related circumstances or product-specific issues are likely to have a direct influence on the level of diffi- culty that managers encounter when setting prices?

2. Do buyers understand the economic benefits and gains offered by individual brands the same way that marketing managers see them? Do they perceive the significance of price differentiation between brands the same way? Do they really think about whether higher prices for some brands are justified by product qual- ity and value? Does it depend on the product? Do you think that certain seg- ments of the market are more likely to “get it” while others don’t? Why?

3. Some pricing strategies seem to be focused on “how much money should we charge above our costs?” Others seem oriented toward pricing in relation to how consumers value the product being sold. Another category of pricing strategies looks like it is oriented to just keeping up with whatever competitors are doing. Is one of these views more consistent with the marketing concept than the others?

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CHAPTER 10Key Terms

4. What potential ethical problems might arise from the aggressive application of dynamic pricing?

5. Consider three of the largest purchases you have made during the past month. How important was the product’s price in your choice of brands for each? Was there a significant difference in the impact of price in one category relative to another? Why?

6. What is the relationship between consumers’ level of involvement with a pur- chase decision and their sensitivity to pricing differences between brands?

7. Identify several examples from the B2B environment where a company charges premium prices over its competitors’ rates. On what basis is it able to be success- ful with this strategy? Are there service-related features that enhance the value of the product?

8. Under what circumstances can paying more for a product make it a less risky purchase for the buyer? Consider both B2C and B2B market examples.

9. Identify examples of pricing practices that you find unfair or deceptive. In each instance, identify what you believe to be the seller’s motivation in using these techniques. Are they effective? Legal?

10. Has the Internet made product pricing more competitive in some industries? Less in others? Provide examples to support your position.

11. It has been argued that the availability of independent and objective online sources of comparative product information is improving buyers’ ability to make informed decisions about the brands they purchase. Do you agree? Cite examples. Can you identify a product market where the availability of online information has lowered prices?

Key Terms

competition-based pricing The process of making pricing decisions in response to the prices charged by competitors. Several types of company objectives are consistent with this approach.

cost-based pricing The reliance on an understanding of production- and marketing-related costs as the key ele- ments in determining a product’s initial or standard price.

cost-plus pricing Setting an initial price by adding a fixed monetary or dollar amount above the product’s initial cost. This approach is commonly used through- out the service sector of the economy where time- and labor-related costs are often independent of material costs.

customer-based pricing Sometimes referred to as demand-driven or value- based pricing. It is a set of price-setting techniques that derive product prices from buyers’ perceptions of value rather than the seller’s cost. This approach includes price skimming and penetration pricing.

differentiation value The economic value of whatever differentiates the brand being priced from the best alternative. Differen- tiation value may have both positive and negative elements.

dynamic pricing A form of retail promo- tional pricing, popular with Internet retail- ers, that takes advantage of the opportunity to adjust prices at the point-of-sale based on specific information about the buyer and purchase situation. It enables sellers to create price offers uniquely suited to each specific transaction and buyer.

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CHAPTER 10Key Terms

Economic Value Estimation (EVE) A cus- tomer-based method that sets prices accord- ing to the valuation of the reference value of alternatives and differentiation value of the brand being priced.

loss-leader pricing Consists of featuring one or more popular brands for sale at prices below the seller’s cost of goods. The expectation is that these featured values will build customer traffic for the store and result in purchasers of additional regular- priced products as well.

markdowns Often referred to as “sale prices,” these are the most familiar form of promotional pricing. They encompass a diverse array of promotions that feature products selling below their usual or cus- tomary price.

markup pricing Setting an initial or stan- dard price by adding a fixed percentage increase above the product’s initial cost. This is a method favored by many large retailers.

penetration pricing A pricing technique that consists of establishing relatively low initial prices to attract new customers and build sales volume. After securing cus- tomer acceptance and a foothold in the market, prices are subsequently increased to capture higher levels of profitability.

price elasticity of demand (PED) An economic measure of the responsiveness of the quantity of a good demanded to a change in its price. It is expressed as the percentage change in quantity demanded in response to a 1 percent change in price. Its value can be influenced by many fac- tors, including brand loyalty, the avail- ability of substitute goods (the substitution effect), percentage of income being spent to acquire a product, the perceived neces- sity of the purchase, and the anticipated duration of the price change.

price skimming A pricing technique that initially sets new product prices rela- tively high to maximize per-unit profits. This approach enables the organization to recover development and preliminary marketing costs before the arrival of com- peting brands drives prices lower. The sus- tainability of this strategy over time hinges on several factors related to the dynamics of the market including barriers to entry.

pricing objectives An alternative pricing goal typically set in response to the posi- tioning and the overall brand strategy for the product. The primary goal of any given pricing strategy will typically be focused on achieving one of four major objectives: profit maximization, market share maximization, market skimming, or quality leadership.

product bundling Selling complementary products together at a special combined or bundled price. For buyers, the overall cost of purchasing the set or bundle is less when compared to purchasing each prod- uct individually.

promotional pricing An array of price- reduction tactics intended to stimulate the demand for specific brand. They are frequently employed when new products are initially introduced to the market and throughout the Product Life Cycle as a temporary stimulus when sales are lagging below expectations. There are five general categories of promotional pricing alterna- tives: markdowns, loss-leader pricing, product bundling, dynamic pricing, and sales promotions.

reference value The price of the custom- er’s best alternative relative to the brand being priced.

sales promotions Short-term incentives intended to build sales volume by lower- ing the price paid by the buyer. The meth- ods used in this category include rebates, coupons, special financing, trade-in plans, and loyalty programs.

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CHAPTER 10Web Resources

Web Resources

The home page for the Professional Pricing Society. The site includes a number of useful references and white papers for business professionals concerned with making pricing decisions and effective price management. http://www.pricingsociety.com

An award-winning site dedicated to providing resources to both students and teachers of economics. Marketing managers would find the sections on pricing and elasticity of demand particularly useful. http://www.welkerswikinomics.wetpaint.com

Site hosted by LeveragePoint software that provides a video demonstration of how value modeling software programs can be used to execute EVE analysis. Though it exclusively features LeveragePoint brand software solutions, the basic principles are applicable to all forms of EVE analysis. http://www.leveragepoint.com/solutions/software/eve/

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