BUS 620 Week 4 Discussion 1& 2 plus Week 4 Assignment

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Chapter 10

Pricing Strategies and Tactics

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Learning Outcomes

By the end of this chapter, you should:

Understand the different approaches to price se�ng, based on costs, customers, and compe�tors, that can be used to meet organiza�onal objec�ves. Recognize how alterna�ve pricing goals and objec�ves can shape pricing policies. Appreciate the significance of price elas�city of demand product as a measure of how consumers respond to changes in product pricing. Develop a prac�cal understanding of promo�onal pricing as a set of alterna�ve tac�cs for s�mula�ng near-term product sales. Understand the far-reaching impact of product pricing decisions on brand management and product strategy.

Pricing is the judgment that translates poten�al business into reality—yet it is s�ll the least ra�onal of all business decisions. (A. Walker, Harvard Business Review)

Pricing policy is the last stronghold of medievalism in modern management—largely intui�ve and even mys�cal. (J. Dean, American Marke�ng Associa�on)

Price se�ng in this country is approached like Russian roule�e—to be engaged in only by those contempla�ng professional suicide. (David Aaker, author and consultant)

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Ch. 10 Introduction Pricing is one of the most important, yet least understood, dimensions of marke�ng strategy. Despite the growing role of nonprice factors in the marke�ng process, there is no escaping the direct cause-and-effect rela�onship between pricing decisions and profitability. As increased compe��on from interna�onal compe�tors and the growing sophis�ca�on of buyers have pushed market prices down for many goods and services, marke�ng managers have had to become more knowledgeable in both the art and science of se�ng prices.

* * *

It should be evident from the quota�ons at the start of this chapter that many business professionals have trouble fully comprehending pricing strategy and concepts. Marke�ng management can be a complex process, and o�en the interrela�onships among price, opportunity cost, and value in a given situa�on can evade our understanding for a �me. Consumers, however, some�mes understand these complexi�es 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 �ght and he was reluctant to take on another mouth to feed at this �me. He also worried that the responsibili�es 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 �me 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 mee�ng his mortgage payments twice that first year and lost some sleep because of it. He opted to put off ge�ng the pair of new glasses for himself that he needed . . . at least for a li�le 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 percep�on 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 have a great �me on the annual trip to the beach. Gumby has always been there at those �mes 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 �me?

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The pricing tasks that confront marke�ng managers require an assessment of alterna�ve strategies that are constrained by product-related costs, compe�tors' strategies, and customer percep�ons. Each of these is a cri�cal element of the pricing environment that must be evaluated.

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 cri�cal to the firm's achieving its overall financial goals. Consequently, the process of se�ng prices must be based on a fundamental understanding of what the organiza�on is trying to accomplish with its pricing strategy.

As illustrated in Figure 10.1, marketers o�en think of the alterna�ve pricing op�ons available to them as bounded or constrained by three Cs: costs, customers, and compe�tors. Pricing products below cost cannot be sustained in the long run. Pricing beyond customers' willingness to pay will not be successful. Se�ng prices that fail to deliver a compe��ve value will lead to a brand's demise in compe��ve 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 op�ons

Cost-Based Pricing

Cost-based pricing decisions rely on an understanding of produc�on- and marke�ng-related costs as the key elements in determining a product's ini�al or standard price. It uses the product's break-even point to iden�fy a price floor, the minimum selling price that will cover the product's variable and fixed costs at a given level of produc�on. 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 conserva�ve approach to se�ng 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 ini�al product cost to arrive at a retail price. By u�lizing a common fixed percentage for all of the brands within a category (e.g., small kitchen appliances), the retail price is a direct reflec�on 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 distribu�on. This is an important considera�on 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 commonly used throughout the service sector of the economy where �me- and labor-related costs are o�en 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 �me plus materials. Since the type of fan is unlikely to impact the �me or labor required to install it, the es�mate for the job will o�en be stated as a fixed fee to cover the cost of his or her �me plus the cost of materials to be used. The buyer is made aware from the outset that devia�ons in the price of the job will depend on any changes in material costs and that labor costs will remain constant.

For many types of sellers, the simplicity and conserva�ve features of cost-based pricing make it an a�rac�ve 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 poten�al if underpriced. An alterna�ve pricing methodology that corrects this fundamental limita�on of cost-based pricing is customer-based pricing.

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Cost-plus pricing is o�en used by electricians and other skilled tradespeople, because �me- and labor-related costs are o�en independent of material costs.

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Customer-Based Pricing

Customer-based pricing is also some�mes referred to as demand-driven or value-based pricing since prices are derived from buyers' percep�ons of value rather than the seller's cost. This approach to se�ng prices includes two specific pricing policies for new and emerging products that are addressed later in the chapter: price skimming and penetra�on pricing.

Among the most widely adopted variants of value-based pricing strategies is Economic Value Es�ma�on (EVE). The fundamental principles of EVE are straigh�orward: "A product's total economic value is the price of the customer's best alterna�ve (the reference value) plus the economic value of whatever differen�ates the offering from the alterna�ve (the differen�a�on value). Differen�a�on value may have both posi�ve and nega�ve elements" (Nagle et al., 2011). An illustra�on of this technique is provided in the following feature.

Economic Value Es�ma�on

Is using EVE complicated? Not really. For the sake of illustra�on, let's do the analysis on a product innova�on for light- and heavy-duty commercial trucks. The TRIM brand fluid cooler is an a�er-market device designed to cool transmission fluid to prevent excess heat buildup in the transmission case, which leads to early transmission failure. 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 plas�c 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 transmission fluid, it uses direct air flow. This design creates a wider temperature differen�al 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 conven�onal 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 configura�on. Currently, original equipment suppliers to the major automakers charge $.82 per inch for the metal tubing used in this applica�on.

As shown in Table 10.1, TRIM brand managers have iden�fied four dis�nct sources of differen�a�on value for their product rela�ve to its compe�tors:

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 applica�on 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 es�mated at $.08 per inch for the larger applica�ons and about $.03 per inch for the smaller applica�ons.

3. Weight Reduc�on: Due to the reduced radiator size described above and the resul�ng reduc�on in size of the front end of the vehicle for the engine cooling module, the overall weight reduc�on 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 reduc�on in the opera�ng temperature of a transmission system can double the life of the equipment. Though difficult to evaluate, the economic value related to the cooler opera�ng temperatures achieved by the TRIM product is es�mated at $.02 per vehicle.

Table 10.1: Economic value es�ma�on

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 Reduc�on .01 .01

Extended Transmission Life .02 .02

Value Es�mate Price per Inch $.92 per inch $1.02 per inch

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Make sense? Does a dollar or so per applica�on seem like it would make much difference? The market poten�al for this applica�on is more than 8 million vehicles annually. The average tube length for this type of applica�on exceeds 30 inches. Do the math: What price per inch should TRIM brand managers quote to the major automakers for this innova�ve 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" be�er brands with higher prices and discounts inferior quality brands.

Economic Value Es�ma�on is a very useful tool for developing profitable pricing strategies for many types of goods and services. Consider a brand that is well posi�oned and superior to compe�tors' alterna�ves for a given segment of the market. The price of the buyer's next-best alterna�ve 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 differen�a�on value (or value added) plus the reference value price of the closest compe�tor's brand. Consequently, this new price should approximate the maximum price that buyers will be willing to pay for the be�er brand.

An important implica�on of EVE is that success does not depend on having the best brand. Instead, the objec�ve is to price the product in line with customers' expecta�ons and understanding of the value your brand represents rela�ve to alterna�ves. Consequently, nega�ve differen�a�on values are just as much a valid considera�on in pricing as posi�ve ones. Aside from brand-specific differences, nega�ve 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 buying 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 exis�ng parts inventory obsolete? Each of these is a poten�al basis for nega�ve differen�a�on that needs to be accounted for in establishing prices that are consistent with buyers' expecta�ons of value.

In every purchase situa�on, 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 jus�fy taking a risk on a new brand or supplier.

The primary advantage to customer-based pricing strategies is that they explicitly recognize and account for differences between compe�ng brands and consumers' responses to superior product value. Objec�vely assessing and measuring the mo�va�ons for buying and the product values that mo�vate customers also promotes a more prac�cal apprecia�on of product posi�oning and market segments based on how each cluster of buyers 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 compe�tors' ac�ons is more appropriate.

Competition-Based Pricing

Compe��on-based pricing decisions are made by organiza�ons in response to the prices charged by compe�tors. Several types of company objec�ves are consistent with this approach. For example, firms may be pursuing compe��ve advantage by se�ng prices below their nearest compe�tors' prices. Alterna�vely, they may set a price higher than their closest compe�tors' prices as a means of posi�oning their product as a premium brand.

It is reasonable to expect compe�tors to react to changes in each other's pricing strategies. In fact, many brands o�en rely on compe�tors' price behavior to provide indicators of where prices should be set. Monitoring market prices is a rela�vely inexpensive form of market research that is essen�al to maintaining a viable compe��ve 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' specifica�ons and nego�ated prices in some B2B markets make the gathering of data and the process of making meaningful comparisons difficult.

Most marke�ng mix decisions, including pricing, should include a review and assessment of compe�tors' behavior. In the case of pricing strategy, the value of this informa�on is in direct rela�onship to how price-compe��ve the product market is. By defini�on, price compe��on has a more direct and substan�al influence on sales in price-compe��ve markets. However, the posi�oning and market share of compe�ng brands may either accentuate or mi�gate the role of pricing for each firm.

Brands that dominate markets and are recognized as market leaders will generally be less influenced by compe�tor pricing. They are, in fact, more likely to be exercising their market power to set baseline or standard prices in accord with their own marke�ng strategy. They act as price leaders in this regard. In highly compe��ve situa�ons where a dis�nct market leader may not exist, each brand needs to be more cognizant of how its nearest compe�tors price their brands. Knowing how compe�tors will respond to any change in pricing strategy is just as important as knowing prevailing price levels. To use compe�tors' prices as standards against which to make brand management decisions, marketers also need to be aware of how aggressively and how rapidly compe�tors will respond to price changes.

Although there are no absolute rules for how to use compe�tor prices as a basis for shaping a brand's pricing strategy, companies tend to be consistent in responding to their direct compe�tors in one of three ways:

Below-Compe��on Pricing: Companies that are pursuing market share growth will o�en respond to changes in prevailing market prices by keeping their prices below those of their closest compe�tors.

Above-Compe��on Pricing: Brands that have achieved quality leadership and highly specialized niche brands will o�en maintain their prices above those of compe�tors in support of their brand image. The generally posi�ve rela�onship between perceived product quality and price o�en requires high-end brands to increase their price rela�ve to compe�tors to reinforce their posi�oning strategy.

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

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Parity Pricing: Brands seeking to compete on a basis other than head-to-head price compe��on o�en simply match changes in their nearest rivals' prices. Parity pricing to match the price by similarly posi�oned brands also provides a simple method for se�ng the ini�al price of new brands in compe��ve markets.

It is important to note that pricing changes should rarely be made exclusively in response to compe�tors' ac�ons. By the same basic logic, marketers need to recognize that establishing a new price is not the only type of response that can be made to compe�tors' pricing changes. Customers are responding to product value, which is a func�on of both price and quality. Isolated changes in compe�tors' prices may afford marke�ng managers with opportuni�es to consider more significant revisions to the marke�ng mix. Rather than simply reac�ng 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 distribu�on channels to improve availability, or providing greater convenience through changes in product packaging.

Think About It

A�racted by a seemingly lucra�ve market for premium fresh-brewed coffee, 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 tradi�onally been perceived as the quality leader within this market, these compe�tors are making substan�al inroads.

What do consumers want? Taste and value.

Who offers the best blend?

Based on your percep�on of how these brands compete, which one(s) could ini�ate 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 follows the price leader?

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 objec�ves and goals direc�ng the management of the brand is a hazardous prac�ce. Any decision to revise pricing policies should be though�ully considered and subject to thorough analysis before proceeding. Though price changes are easily executed, the financial and strategic consequences are o�en substan�al and enduring. In light of this, it is essen�al that all pricing decisions be made with the organiza�on's pricing objec�ves in mind.

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10.2 Pricing Objectives As part of the market planning process, companies have great la�tude in deciding how a brand's price should contribute to its posi�oning and the overall strategy for the product. The primary goal of any given pricing strategy will typically be focused on achieving one of four major objec�ves: profit maximiza�on, market share maximiza�on, price skimming, or quality leadership.

Profit Maximization

The pricing objec�ve for many brands is to maximize current profits based on projec�ons of the rela�onship among price levels, associated product costs, and corresponding levels of consumer demand. This is a common objec�ve for established brands since the firm has had �me to develop a reliable understanding of both price–demand and price–cost func�ons. It also tends to be a more appropriate goal for brands in the maturity stage of the PLC, since market-related dynamics and vola�lity have stabilized.

Profit maximiza�on may be an objec�ve that is poorly suited to new and emerging brands since the nature of the rela�onships among price, demand, and product costs are less understood. Similarly, market dynamics tend to be more vola�le, and finding the right price may be a ma�er of chasing a moving target. Placing too much emphasis on near-term measures of profitability can adversely impact the long-term performance of emerging brands if other growth-related goals are ignored.

Market Share Maximization

A market share maximiza�on pricing objec�ve may be of par�cularly great importance for firms trying to secure a substan�al posi�on within a new or emerging market. It is a goal that is also consistent with market penetra�on strategies where the intended effect of higher sales volume is to reduce unit costs of produc�on and distribu�on. This penetra�on pricing strategy is some�mes observed in the marke�ng plan for new products where ini�al prices are set ar�ficially low to build sales volume and market share. A�er securing customer acceptance and a foothold in the market, prices are subsequently increased to capture higher levels of profitability.

Although the primary aim of penetra�on pricing strategy is to maximize the quan�ty sold by offering buyers a low price, it also affords brands with a measure of protec�on and defense against the threats posed by impending compe��on. By reducing the short-term profitability incen�ve to enter the market, firms pursuing this op�on o�en enhance their long-run financial prospects. This is par�cularly true in circumstances where large decreases in unit cost result from cumula�ve volume increases.

Price Skimming

An alterna�ve to penetra�on pricing is a technique referred to as price skimming. In the ini�al 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 compe�tors enter. This price skimming strategy enables the product innovators to recover development and preliminary marke�ng costs before the arrival of compe�ng brands drives prices lower. The sustainability of this strategy over �me 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 �me are illustrated in Figure 10.2.

Figure 10.2: Price skimming graph

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

Several prerequisite market condi�ons must be met for price skimming strategies to be successful. To jus�fy the strategy on a revenue basis, a sufficient number of buyers in the cri�cal PDC innovator category must be willing to pay the rela�vely high price of being the first to own this innova�ve new product. Similarly, the higher unit costs associated with limited produc�on cannot be so high that they negate the addi�onal margins associated with the higher price. From a posi�oning perspec�ve, it is also essen�al 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 objec�ve based on the u�liza�on of higher prices to signal superior product quality to both compe�tors and consumers. As discussed previously, consumers o�en rely on price as an indicator of quality, par�cularly when they are unfamiliar with a product category. The intent behind establishing quality leadership as a goal is to promote and reinforce a brand's posi�oning strategy as a quality leader within the category.

The appropriateness of this goal depends largely on the category context. In mature markets, it is o�en difficult to successfully challenge entrenched brands that occupy the "high quality" posi�ons in buyers' percep�ons. And it can be even more difficult to carve out a space for mul�ple co-leaders on the dimension of product quality. Changes in the character of consumer preferences, however, some�mes create opportuni�es. 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 posi�on for consumers who a�ach the greatest priority to energy efficiency or environmental friendliness. That is, a clear "green quality" leader hasn't emerged for many home appliance categories.

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The price itself takes into considera�on what customers will pay. What are the factors that companies must consider in order to price their products for their target customers?

10.3 Price-Related Factors Influencing Consumer Demand A number of factors inside and outside the organiza�on impact consumer demand for products. The firm's goals and strategic plan for the product represent the most obvious and prescrip�ve of the internal factors. Internal constraints that can limit demand in the short run include unan�cipated spikes in product-related costs and limited produc�on 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 se�ng insofar as these are influences beyond the organiza�on's direct control. However, understanding and responding to these factors is an essen�al part of the price se�ng 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 subjec�ve influences on percep�ons of price throughout his career (1973, 2002). These included the role of reference prices and the posi�ve rela�onship between a brand's price and buyer percep�ons of quality.

In this sec�on we briefly examine two addi�onal sets of factors and their impact on consumer demand. We consider the factors that drive price elas�city of demand and how this measure serves as an indicator of consumer response to changes in product pricing. In the next sec�on, we will inves�gate the role of promo�onal pricing strategies as the organiza�on's best short-run pricing alterna�ve for directly impac�ng product sales.

Pricing Strategies

Price Elasticity of Demand

Price elas�city of demand (PED) is an economic measure of the responsiveness of the quan�ty of a good demanded to a change in its price. It is expressed as the percentage change in quan�ty demanded in response to a 1 percent change in price. The mathema�cal formula for the coefficient of price elas�city of demand is:

PED = % change in quan�ty demanded

= ΔQd/Qd

% change in price ΔP/P

The mathema�cal value of the PED ra�o is almost invariably nega�ve in normal product markets, since an increase in price will typically produce a decline in the quan�ty demanded by buyers. By conven�on, the nega�ve sign is usually disregarded and the value of the equa�on is simply expressed according to its absolute value.

The demand for a good is regarded as being rela�vely inelas�c when the PED is less than 1.0 in absolute value. This indicates that a change in price will have a dispropor�onately small effect on the quan�ty of the good demanded. In this scenario, the percentage change in quan�ty demanded is smaller than the percentage change in price. Consequently, if the price is raised, total revenue increases.

Demand is regarded as rela�vely elas�c when its PED is greater than 1.0 in absolute value. In this condi�on, changes in price have a dispropor�onately large effect on the quan�ty demanded. Under these condi�ons, the percentage change in quan�ty demanded is greater than the percentage change in price. Therefore, if the price is raised, total revenue will decrease.

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Companies such as Adidas strive to differen�ate their brands and execute posi�oning strategies designed to build brand loyalty and reduce their customers' willingness to switch to subs�tute goods.

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When the percentage change in quan�ty 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 elas�city is valid.

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

Availability of subs�tute goods: PED will be higher when more close product subs�tutes are available. The availability of subs�tutes allows buyers to switch to less expensive alterna�ves or be�er product values when the price of their usual brand increases. The rela�ve willingness of buyers to switch to other goods in the face of higher prices is called the subs�tu�on effect.

Percentage of income: The higher the percentage of the buyer's income that is needed to acquire the products, the higher the elas�city tends to be. In general, consumers are simply more price sensi�ve 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 discon�nue buying the product in response to a price increase. This effect is evident in the sale of both over-the-counter and prescrip�on drugs.

Dura�on: If a price increase persists over �me or buyers believe that it will remain in effect for the foreseeable future, they will be more inclined to seek out alterna�ve, subs�tute goods. Consequently, the PED will increase over �me. An increasing number of car-bound commuters faced with the prospect of higher gas prices, for example, will seek alterna�ve forms of transporta�on over �me.

Brand Loyalty: Buyers' commitment or a�achment to specific brands will reduce their sensi�vity to price increases, resul�ng in more inelas�c demand.

For marke�ng managers, price elas�city of demand for a given brand can be applied to es�mate the an�cipated change in quan�ty demanded for a proposed price. It is a useful tool for analyzing

alterna�ve 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 informa�on used in the analysis and the realism of the underlying assump�ons.

PED-based projec�ons of how price changes will impact demand and revenue are based on the assump�on that no other relevant market changes will occur at the same �me. This includes an assump�on that compe�tors will not respond to a price change in kind. However, the likelihood of nothing else changing in the market but the price of a single product is, in reality, quite small. Measures of elas�city are also of limited u�lity insofar as they are only valid for a given point in �me. The shi�ing �de of consumer preference and underlying market dynamics necessarily invalidate their reliability over �me.

It is reasonable to conclude that the price elas�city of demand provides a sta�s�cally sound basis for assessing the general consequences of price changes on demand and total revenue. Market dynamics and the sensi�vity of markets to factors other than price, however, limit the predic�ve reliability of the methodology. Despite its prac�cal limita�ons, PED can be a valuable tool for projec�ng the general direc�on of market responses to a brand's change in price. As such, it can provide important insight into the development of effec�ve product pricing strategies.

A Closer Look at PED

Since their first encounter with the concept of price elas�city of demand is typically in an economics class, marke�ng managers some�mes mistakenly believe that the PED concept is simply too abstract to be of much prac�cal use. But what could be more prac�cal and poten�ally valuable than knowing the most likely change in quan�ty demanded or total revenue that will result from a change in price? PED market tests and analysis can be applied to determine the op�mal pricing strategy for many types of products.

Consider the challenge of se�ng the retail price for an innova�ve new frozen Greek entree: spanakopita, or spinach pie in bu�ered filo dough. Although products like frozen shepherd's pie and Cornish pasty meat pies are somewhat comparable, they only provide vague guidelines and loose constraints for price se�ng. Field pricing tests in matched markets throughout the United States could be used to ascertain the price elas�city of demand for the product. Data on the quan�ty response to alterna�ve retail price points could be compiled to es�mate the PED over the range of prices tested. These data could be used to iden�fy the rela�ve elas�city of demand to price changes from one point to the next. This, in turn, could provide the marke�ng manager with the informa�on required to determine the op�mal price point in terms of maximizing revenue and profitability.

You might be inclined to guess that the PED for spanakopita will be elas�c 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 inelas�c over some range of relevant price op�ons. Since it is an inexpensive purchase and has few close subs�tutes, consumers may be rela�vely insensi�ve to the product's price. It is precisely these types of uncertain�es that make doing PED field tests so valuable.

It is cri�cal to note, however, that PEDs will shi� over �me in response to compe��ve behavior, changing economic condi�ons, and the evolu�on of consumer tastes and preferences. It is also essen�al to remember that se�ng the product's price is o�en intended to accomplish objec�ves beyond simply maximizing total revenue. Building brand awareness and market share, for example, may dictate se�ng lower introductory prices than the analysis of the PED alone would indicate.

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This chapter ini�ally iden�fied three approaches to se�ng prices that differed based on their orienta�on to product costs, customer preferences, and compe��ve pricing. Understanding price elas�city can make posi�ve contribu�ons to the development of pricing strategy under all of these general frameworks. The same can be said of understanding the essen�als of promo�onal pricing.

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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?

Associated Press

10.4 Promotional Pricing Price changes in response to compe�tors' behavior tend to be fairly permanent revisions or long-term adjustments to brand strategy. They reflect an enduring shi� in the overall marke�ng 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 promo�onal pricing effort.

Promo�onal pricing is a term used to describe a diverse collec�on of price-reduc�on tac�cs intended to s�mulate the demand for a specific brand. It is frequently employed when new products are ini�ally introduced to the market and throughout the Product Life Cycle as a temporary s�mulus when sales are lagging below expecta�ons. It is a strategy that targets prospec�ve buyers who are generally price sensi�ve as well as those an�cipa�ng price reduc�ons as opportuni�es to purchase. However, the overuse of short-term price incen�ves to s�mulate 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 skep�cism about the true value or significance of discounts.

Think About It

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

How can you explain this?

When used appropriately, promo�onal pricing can be a very effec�ve tool for increasing brand sales in the short run. It also holds the poten�al to create brand- loyal customers if first-�me buyers are favorably impressed by the quality of the product and value they receive from the purchase. There are five general categories of promo�onal pricing alterna�ves: markdowns, loss-leader pricing, product bundling, dynamic pricing, and sales promo�ons.

Markdowns, or "sale prices," represent the most familiar form of promo�onal pricing. They encompass a wide array of promo�ons that feature products selling below their usual or customary price. Seasonal and holiday sales events are commonly used to promote sales at specific �mes of the year. These events may be run countercyclically to build sales during tradi�onal off-peak periods (e.g., Christmas in July) or procyclically to build volume and capture market share during natural sales peaks (e.g., discoun�ng snowblowers in December). Special event pricing (e.g., back-to-school sales) is also included in this category.

Loss-leader pricing is used primarily by tradi�onal store retailers. This tac�c consists of featuring one or more popular brands for sale at prices below the seller's cost of goods. The expecta�on is that these featured values will build customer traffic for the store and result in purchasers of addi�onal regular-priced products as well. Convenience stores, for example, o�en feature fresh-brewed coffee priced below cost to a�ract customers with the expecta�on that they will also purchase higher- margin products.

Product bundling is most o�en 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. Consider the promo�ons frequently featured by electronics retailers. Desktop computers are typically bundled with a monitor, so�ware, and a printer/scanner for a price significantly below the cost of the individual components purchased separately.

An advantage to the marketer is that prices can o�en be reduced on product bundles without adversely impac�ng consumers' percep�ons of brand quality. That is, buyers are likely to view a lower cost on the computer package as represen�ng a "be�er value" rather than raising ques�ons about the quality of any par�cular component.

Dynamic pricing is a form of retail promo�onal pricing that has grown in popularity with Internet retailers. The central element of this technique is that price adjustments are made at the point of sale, specific to the purchase history and behavior of the buyer. In some respects, it resembles the nego�ated pricing model that is typical of B2B transac�ons. Dynamic pricing methodologies combine known customer data with preprogrammed pricing algorithms to create price offers uniquely suited to each specific transac�on and buyer.

Airline pricing, for example, may rely on customer characteris�cs such as preferred dates of travel, prior purchase pa�erns, 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-�me 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. Informa�on stored on the prospec�ve buyer's computer may also provide useful data about other sites visited, the user's interests, and general buying tendencies.

Sales promo�ons, as with the other categories, work to build sales volume by lowering the price paid by the buyer. This set of short-term price incen�ves, however, requires coordina�on with a suppor�ng communica�ons plan to be effec�ve. Addi�onally, it o�en involves more ini�a�ve on the part of the buyer to gain the price reduc�on. The methods used in this category include rebates, coupons, special financing, trade-in plans, and loyalty programs. These types of promo�on are discussed in greater detail in the next chapter.

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Think About It

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

Do certain types of sales promo�ons seem to go with certain types of products?

Does the online use of this pricing tac�c differ much from how it is prac�ced by tradi�onal retailers?

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

Bloomberg/Ge�y Images

10.5 Understanding the Role of Product Pricing Marketers need to recognize the cri�cal roles that pricing decisions play in product management. The price component of the marke�ng 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, effec�ve product posi�oning is dependent on cul�va�ng a brand image that resonates with the target market. Pricing strategy is a cri�cal part of this process. However, it is a par�cularly impac�ul part of the process at the earliest stages of the brand's life cycle. Customers' first impressions are typically las�ng impressions, and their percep�on of a brand is o�en formed when they first learn the price. If buyers do not see substan�al product value at this first encounter, it is unlikely that they will pursue the evalua�on of this brand any further.

Flexibility: Price is the most flexible and easily modified of the marke�ng mix variables. In contrast to product, promo�on, and distribu�on decisions, pricing strategy can be changed quickly without incurring significant direct expenses. This feature provides an important tool for responding to compe��ve threats and for s�mula�ng demand.

Demand Management: Price adjustments can be used effec�vely to s�mulate near-term sales or slow the rate of sales growth if capacity constraints limit product produc�on in the short run. Price-driven sales promo�ons can also grow demand by securing new distribu�on channels for the product and expanding the overall distribu�on network.

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Ch. 10 Conclusion Pricing is always a pivotal decision for marke�ng managers. It is a prime determinant of both sales revenue and profitability. It is an essen�al component of how consumers assess product value. It must be planned rela�ve to the needs and preferences of the target market. And it needs to be coordinated with the other elements of the marke�ng mix for successful execu�on of the marke�ng plan. Elements of pricing strategy and tac�cs are o�en used to complement the promo�onal features of the marke�ng mix to refine the brand's posi�oning rela�ve to its compe�tors and drive product sales. In the next chapter, we'll inves�gate the poten�al applica�ons of specific op�ons in the promo�ons mix.

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Ch. 10 Learning Resources

Key Ideas

Cri�cal Thinking Ques�ons

1. Some�mes brand mangers find the issues surrounding pricing strategy very simple and straigh�oward. At other �mes, pricing strategy is the most challenging of the marke�ng mix variables to manage. What market-related circumstances or product-specific issues are likely to have a direct influence on the level of difficulty that managers encounter when se�ng prices?

2. Do buyers understand the economic benefits and gains offered by individual brands the same way that marke�ng managers see them? Do they perceive the significance of price differen�a�on between brands the same way? Do they really think about whether higher prices for some brands are jus�fied by product quality and value? Does it depend on the product? Do you think that certain segments 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 rela�on to how consumers value the product being sold. Another category of pricing strategies looks like it is oriented to just keeping up with whatever compe�tors are doing. Is one of these views more consistent with the marke�ng concept than the others?

4. What poten�al ethical problems might arise from the aggressive applica�on 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 rela�ve to another? Why? 6. What is the rela�onship between consumers' level of involvement with a purchase decision and their sensi�vity to pricing differences between brands? 7. Iden�fy several examples from the B2B environment where a company charges premium prices over its compe�tors' rates. On what basis is it able to be successful

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. Iden�fy examples of pricing prac�ces that you find unfair or decep�ve. In each instance, iden�fy what you believe to be the seller's mo�va�on in using these

techniques. Are they effec�ve? Legal? 10. Has the Internet made product pricing more compe��ve in some industries? Less in others? Provide examples to support your posi�on. 11. It has been argued that the availability of independent and objec�ve online sources of compara�ve product informa�on is improving buyers' ability to make

informed decisions about the brands they purchase. Do you agree? Cite examples. Can you iden�fy a product market where the availability of online informa�on has lowered prices?

Key Terms

compe��on-based pricing (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

The process of making pricing decisions in response to the prices charged by compe�tors. Several types of company objec�ves are consistent with this approach.

cost-based pricing (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

The reliance on an understanding of produc�on- and marke�ng-related costs as the key elements in determining a product's ini�al or standard price.

cost-plus pricing (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

Se�ng an ini�al price by adding a fixed monetary or dollar amount above the product's ini�al cost. This approach is commonly used throughout the service sector of the economy where �me- and labor-related costs are o�en independent of material costs.

customer-based pricing (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

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Some�mes referred to as demand-driven or value-based pricing. It is a set of price-se�ng techniques that derive product prices from buyers' percep�ons of value rather than the seller's cost. This approach includes price skimming and penetra�on pricing.

differen�a�on value (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

The economic value of whatever differen�ates the brand being priced from the best alterna�ve. Differen�a�on value may have both posi�ve and nega�ve elements.

dynamic pricing (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

A form of retail promo�onal pricing, popular with Internet retailers, that takes advantage of the opportunity to adjust prices at the point-of-sale based on specific informa�on about the buyer and purchase situa�on. It enables sellers to create price offers uniquely suited to each specific transac�on and buyer.

Economic Value Es�ma�on (EVE) (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

A customer-based method that sets prices according to the valua�on of the reference value of alterna�ves and differen�a�on value of the brand being priced.

loss-leader pricing (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

Consists of featuring one or more popular brands for sale at prices below the seller's cost of goods. The expecta�on is that these featured values will build customer traffic for the store and result in purchasers of addi�onal regular-priced products as well.

markdowns (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

O�en referred to as "sale prices," these are the most familiar form of promo�onal pricing. They encompass a diverse array of promo�ons that feature products selling below their usual or customary price.

markup pricing (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

Se�ng an ini�al or standard price by adding a fixed percentage increase above the product's ini�al cost. This is a method favored by many large retailers.

penetra�on pricing (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

A pricing technique that consists of establishing rela�vely low ini�al prices to a�ract new customers and build sales volume. A�er securing customer acceptance and a foothold in the market, prices are subsequently increased to capture higher levels of profitability.

price elas�city of demand (PED) (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

An economic measure of the responsiveness of the quan�ty of a good demanded to a change in its price. It is expressed as the percentage change in quan�ty demanded in response to a 1 percent change in price. Its value can be influenced by many factors, including brand loyalty, the availability of subs�tute goods (the subs�tu�on effect), percentage of income being spent to acquire a product, the perceived necessity of the purchase, and the an�cipated dura�on of the price change.

price skimming (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

A pricing technique that ini�ally sets new product prices rela�vely high to maximize per-unit profits. This approach enables the organiza�on to recover development and preliminary marke�ng costs before the arrival of compe�ng brands drives prices lower. The sustainability of this strategy over �me hinges on several factors related to the dynamics of the market including barriers to entry.

pricing objec�ves (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

An alterna�ve pricing goal typically set in response to the posi�oning 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 objec�ves: profit maximiza�on, market share maximiza�on, market skimming, or quality leadership.

product bundling (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

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 product individually.

promo�onal pricing (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

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An array of price-reduc�on tac�cs intended to s�mulate the demand for specific brand. They are frequently employed when new products are ini�ally introduced to the market and throughout the Product Life Cycle as a temporary s�mulus when sales are lagging below expecta�ons. There are five general categories of promo�onal pricing alterna�ves: markdowns, loss-leader pricing, product bundling, dynamic pricing, and sales promo�ons.

reference value (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

The price of the customer's best alterna�ve rela�ve to the brand being priced.

sales promo�ons (h�p://content.thuzelearning.com/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12.1/sec�ons/front_ma�er/books/AUBUS620.12

Short-term incen�ves intended to build sales volume by lowering the price paid by the buyer. The methods used in this category include rebates, coupons, special financing, trade-in plans, and loyalty programs.

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 effec�ve price management. h�p://www.pricingsociety.com (h�p://www.pricingsociety.com)

An award-winning site dedicated to providing resources to both students and teachers of economics. Marke�ng managers would find the sec�ons on pricing and elas�city of demand par�cularly useful. h�p://www.welkerswikinomics.wetpaint.com (h�p://www.welkerswikinomics.wetpaint.com)

Site hosted by LeveragePoint so�ware that provides a video demonstra�on of how value modeling so�ware programs can be used to execute EVE analysis. Though it exclusively features LeveragePoint brand so�ware solu�ons, the basic principles are applicable to all forms of EVE analysis. h�p://www.leveragepoint.com/solu�ons/so�ware/eve/ (h�p://www.leveragepoint.com/solu�ons/so�ware/eve/)