final paper man econ

9

New Product Pricing and Pricing in New Markets

Learning Objectives

After reading this chapter, you should be able to:

• Explain how new products might be quality- and price-positioned in existing markets.

• Distinguish between new-to-the-market products and new-to-the-world products and the pricing implications of each.

• Explain why the extent of product differentiation is critically important for price making.

• Recognize how barriers to entry are important to retain excess profitability.

• Identify that even where entry barriers are not insurmountable, the firm has a profit incentive to introduce innovative new products.

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CHAPTER 9Introduction

Introduction

New products 1 are introduced on an almost

daily basis as existing firms strive to reju- venate their product lines to maintain

their competitiveness and market share. New products are also introduced by entrepreneurs who start new firms to commercialize new tech- nologies. Because new products are new to the market, managers must decide what price will be appropriate for their new product, and will make this decision after considering the prices of existing products in the market and the novelty of their new product relative to other products. The lack of prior production and market experi- ence with their new product means managers will not have much, if any, information on which to base their estimation of demand and cost curves for these products.

We shall distinguish between products that are new to the market and those that are new to the world. By new to the market we mean a new brand in an existing market where the new prod- uct is simply a new variant in an existing product category, such as a new brand of dish detergent that claims enhanced cleaning power. These have been called creative imitations and are “new” to the extent that they offer the market a new combina- tion of product attributes (see Chapter 3)—that is, the new product is differentiated from what has previously been offered to the market by the other brands. New to the world means the product offers a new way to serve customers’ needs, such as the Segway Personal Trans- porter, which was introduced to the market for personal transportation in 2002.2 New- to-the-world products are typically the outcome of disruptive innovation, which creates a new technological platform, as distinct from sustaining technology innovation, which allows improvements on an existing technology platform providing enhancements to products that serve to differentiate them from other products already available in the market (Bower & Christensen, 1995).

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Entrepreneurs such as Michael Dell, the founder and CEO of Dell Inc., introduce new products and services through startup business ventures with the aim to commercialize new ideas and earn a profit.

1. Just a reminder that we use the term “products” to mean the output of the production process, so product could mean either a physical product or an intangible service, or some combination of products and services. This saves having to say “products and services” every time “product” is mentioned.

2. In case you have not seen one, see www.segway.com. The Segway is a battery-powered two- wheeled, single-passenger vehicle that goes in the direction that you lean it, utilizing gyroscopes to balance the rider. It is quite unlike any other form of personal transportation, such as bicycles, motorbikes, scooters, or horses, yet it serves the same basic need, that is, to transport a person from one location to another.

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CHAPTER 9Section 9.1 Pricing New-to-the-Market Products

This chapter is organized on the basis of the new-to-the-market versus new-to-the-world dichotomy. In the next section, we will examine the pricing decision in the context of introducing new product variants into existing markets and, thus, consider topics such as price skimming, penetration pricing, price positioning, and product-line pricing. In the third section, we will be concerned with pricing new-to-the-world products and examine the “diffusion curve” phenomenon, which causes the adoption rate of new products to be slow at first and then progressively faster up to a point, after which the rate of cus- tomer adoption becomes progressively slower until the firm’s maximal market share is attained, other things being equal. The diffusion curve phenomenon means that the quan- tity demanded at any particular price increases from one production period to the next, and thus, causes shifts of the demand curve from one period to the next, and this in turn has implications for the profit-maximizing price in each period. We also consider the case of geographic expansion of an existing product, where the product is at first an unknown new product in the new geographic area, such as an Indian-made car entering the U.S. automobile market under a new brand name (e.g., Tata).

9.1 Pricing New-to-the-Market Products

Marketing textbooks tend to advocate either price skimming or penetration pricing for new products. To skim means to take something off the top, such as skim-ming the cream off the top of milk. Price skimming means to set a very high price that allows relatively high profit outcomes for the firm. Penetration pricing, on the other hand, means to set a relatively low price that causes more units of the product to be sold and, thus, achieve greater penetration into the market. Both of these approaches may result in profit maximization—skimming is intended to maximize profits in the short term whereas penetration pricing is intended to maximize profits over the longer term. We shall consider these in turn.

Price Skimming Price skimming is intended to gain as much profit for the firm as pos- sible in each production period. As such, the skimming price must be the same as the short-run profit- maximizing price, since there is no point setting a price higher or lower than that if the intention is to gain as much profit as possible. By now you are very familiar with the marginalist pricing rule for profit maximization (i.e., set MC 5 MR), which would be used after consideration of the estimated demand and cost curves, if reli- able estimates of this data can be obtained at reasonable search

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Tide laundry detergent pods are an example of a new-to- the-market product. Offering a new combination of product attributes, new-to-the-market products are an innovative variation on an existing product category.

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CHAPTER 9Section 9.1 Pricing New-to-the-Market Products

cost. But herein lies the problem: With a new product, there is no prior history of customer demand or production costs that is exactly applicable to this product. Thus, we must extrapolate (i.e., go outside the limits of the available data) from data relating to similar but differentiated products already available in the same product category. Obviously, the more closely substitutable the new product is for one or more of the other products in the category, the more reliable our estimates will be, with the extreme case being the identical- products case (i.e., pure competition) where the information derived from observation of an existing product is fully applicable to the new product entering the market (and, thus, the new product simply accepts the prevailing market price).

In differentiated-product markets, however, there will be a range of prices chosen by the firms that reflect differences in the qualitative attributes of the competing products. In a world of full information (i.e., zero search costs) with firms that want to maximize short- run profit, these different prices will reflect different locations of the MC curves (due to cost differences required to produce the different qualities) and different locations of the MR curves (due to demand differences for particular products due to the differences among customers’ preferences for the various attributes of the products). This gives rise to an observable relevant range of prices, which is the range of prices from the most expensive to the least expensive of the products in the same product category. Associated with the relevant range of prices will be a relevant range of quality; that is, the competing products would probably offer mostly the same core product attributes with each product potentially offering more or less of each of these attributes and additionally offering one or more quality attributes that rivals do not offer (e.g., their location, brand name, and reputation, if not additional tangible characteristics). If the firm’s new product offers the core quality attributes that characterize the product category and some or most of the product attributes that are offered by others in the relevant product category, then the new product’s price should be expected to fall somewhere within the relevant range of prices.3

How does the manager proceed to set the actual price for the new product? If search costs are not zero but are indeed significant, the manager should first consider adopt- ing a markup pricing rule. The manager will have estimated the projected average vari- able costs (AVC) of the new product but any estimate of average fixed cost (AFC) must await an estimate of the quantity demanded (volume sold) of the new product and that will depend on the price chosen and will be revealed only later when the market reacts to the introduction of the new product. So what markup over AVC should the manager choose? To be competitive with rival products the new product’s price must be carefully positioned such that it offers a competitive value proposition to customers in that market.

3. Note that the relevant product category may need to be limited to a subset of what might seem to belong in that category. For example, the broad product category “passenger automobiles” cov- ers a wide range, from the very inexpensive Tata Nano CX (under $3,000) to the very expensive Bugatti Veyron (over $1.5 million). Obviously, the manager must choose a more limited subset of rival products that are more closely substitutable with the new product, such as luxury, compact, five-passenger cars and observe the price range across this relevant range of quality to find the relevant range of prices.

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CHAPTER 9Section 9.1 Pricing New-to-the-Market Products

Price Positioning for a Competitive Value Proposition

Price positioning is the selection of price within the relevant range of prices for rival products such that the chosen price offers a competitive value proposition to prospective customers. As you know, the value proposition can be defined as a measure of perceived quality divided by a measure of price. To illustrate using a simple example, consider Fig- ure 9.1 where product quality and price are shown as one-dimensional (e.g., simply larger or smaller volume of a particular beverage in different sized containers, and price is in dollars per container with no other costs of purchasing). We depict four products, labeled A, B, C, and D, that have different qualities (left-hand axis) and different prices (right- hand axis). As we saw in Chapter 8, particular customers will perceive these differing size containers of beverage as having higher or lower value propositions due to the differing reservation prices they place on each of the product offerings.

Figure 9.1: Competitive value propositions, bargains, and rip-offs

Quality Price

A B

C D

A

B C

D

Because value is equal to quality over price, Product A and Product C are perceived by this particular customer to be equal (i.e., competitive) value propositions since they have the same ratio of quality to price, such that lines AA and CC have the same slope. Although Product A is more expensive than product C, it is of commensurately higher quality (i.e., larger, in this simple one-dimensional example of quality) so is seen (by this particular customer) to represent an equal value proposition. Product B, however, is a bargain, with its price positioning being lower than its quality positioning. It offers more quality per dollar, or “bang for the buck” as some would say. Product D, on the other hand, is a rip- off, because its price positioning is set higher than its quality positioning. Faced with this choice among products, this particular customer will therefore choose Product B since its value proposition is highest.

In terms of customer behaviors examined in Chapter 3, this customer will choose among products to maximize utility. The choice of the highest value proposition is consistent with utility maximization because it includes the customer’s perception of quality (and hence marginal and total utility from the product) relative to the price level. Note also that in Chapter 8 we argued that the customer would have a reservation price that is the maxi- mum he or she would pay for an item. Viewed from the value-proposition perspective,

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CHAPTER 9Section 9.1 Pricing New-to-the-Market Products

the reservation price is the price that pushes the product’s value proposition to be just equal to the value proposition of the best alternative (prod- uct’s) value proposition—any higher price would cause it not to be purchased. In the case depicted in Figure 9.1, it may be that the customer’s res- ervation prices are above the seller’s prices for all four products, in which case he or she would buy none, but the bargain product (B) will be the one purchased if its reservation price is above the seller’s price, unless the customer has a very low income and must choose C (an inferior good, as we saw in Chapter 3) because the customer is unable to afford the higher priced bargain.

In this simple example, we have depicted quality and price as each being one-dimensional. In real- ity, of course, both quality and price are multidi- mensional. The perception of quality includes a variety of quality attributes including size, shape, weight, color, design elements, purchase loca- tion, warranty, and so on, as we saw in Chapter 3. Similarly, price includes not only the ticket price but also other costs associated with the purchase, such as search costs, opportunity costs, pick-up or delivery costs, product maintenance cost, and so on, also known as product lifetime price, which is the purchase price plus all other costs incurred

by the consumer over the product’s lifetime (such as delivery, repairs, and maintenance costs) suitably discounted back to present value terms.4 In Figure 9.2, we again show price on one of the vertical axes but this time let us regard price as the product lifetime cost to the consumer. In reality, this might change the ranking of the four products compared to their ranking in Figure 9.1, since some products may have higher delivery costs, higher maintenance costs, and so on. But, for expositional purposes here, we shall assume these product lifetime costs are constant across products so no change in relative price is intro- duced at this point. Instead, let us add a second quality attribute—let’s call this “sweet- ness”—into the measure of quality shown on the other vertical axes in Figure 9.2. The customer may believe the four products taste more or less sweet and has a preference for either greater or lesser sweetness in the beverages under discussion.

©altrendo images/Thinkstock

Bargains occur when a product’s price positioning is lower than its quality positioning, offering more quality per dollar.

4. Most products have both immediate and future explicit (monetary) costs associated with their purchase and subsequent use, and these are likely to differ across competing products. For example, some new cars have a service interval of 5,000 miles compared to 10,000 miles, so even if the monetary cost of the service is the same the present value of the latter is lower. Similarly, some cars have more expensive spare parts, are more likely to break down, and have differing salvage value (i.e., resale value as a proportion of new car price).

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CHAPTER 9Section 9.1 Pricing New-to-the-Market Products

Figure 9.2: Price positioning with multidimensional quality and price

Quality= Quantity plus sweetness

Price= Purchase price

plus lifetime costs

A

B

E

C

D

A

B,E

C

D

Ignoring the new Product E for the moment, we see in Figure 9.2 that considering size and sweetness, the target customer now ranks the quality of the products in the order B, A, C, D. By comparing this ranking with that in Figure 9.1 (which showed quality simply in terms of beverage quantity), we can deduce that Product B must be substantially sweeter than Product A, since the smaller container of B is now ranked above the larger container of A. Further, Products C and D must be about equally sweet, since neither their ranking nor the quality interval between them has changed significantly. The slopes of the lines now indicate that Product D is still viewed as a rip-off and that Product A is now also viewed as a rip-off due to the inclusion of the customer’s preference for sweetness (and because A apparently offers relatively low sweetness at its relatively high price). Similarly, under this broader view of product quality, Products B and C are viewed as bargains and Product B is seen as the better bargain, having the higher quality/price ratio, and so will be preferred by this particular customer.

Now, suppose this particular customer is the average customer and is, thus, representa- tive of the market5 for this product category, such that Figure 9.2 is relevant for the price positioning of the new product to be introduced by Firm E. The manager of Firm E must evaluate the quality (size and sweetness) of Product E against the other product offerings and price it accordingly. So, suppose for the sake of illustration that the quality position- ing of Product E is chosen to be superior to Product B. To sell into this market, the price positioning of Product E will need to be quite close to the price of Product B in order to offer a superior value proposition (that is, the price–quality line EE needs to be steeper than the line BB).

5. Alternatively, we could suppose this customer to be representative of a particular market niche, or segment of the market—in this case those people who value only quantity and sweetness in their beverages.

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CHAPTER 9Section 9.1 Pricing New-to-the-Market Products

You may be wondering why wouldn’t every cus- tomer now switch to Product E and abandon all the other product offerings. If (a) they had full information, and (b) the only quality attributes they want in the product are size and sweetness, and (c) they all have identical tastes across degrees of sweetness and volume of beverage, then indeed they would all switch to Product E since it offers them the better value proposition (or utility- maximizing choice). But other customers, in addi- tion to volume and sweetness of beverage, will seek additional attributes in the product (such as color, nutrient, electrolytes, lower carbohydrates, and so on) and may find a better value proposi- tion in the products A, B, C, D or other products if these products offer these attributes in such quan- tum within their product that they become a bar- gain (or at least a competitive value proposition) for individual consumers. So, different custom- ers (almost certainly having different preferences and different levels of information about prod- ucts) will prefer different product offerings, such that each firm’s product will appeal to groups of customers who have similar tastes, and such mar- ket segments within a market are called a niche market. Within each niche market we expect to find rival firms that offer products that are relatively close substitutes for each other in terms of their quality and price (i.e., their value proposition).

Thus, the price that should be set to enter an existing market (or market niche) with a new product must be selected by the manager with a view to the relative price and qual- ity offerings of other firms. The markup rate over AVC is then deduced from the ratio of the price selected to the AVC level. For example, if AVC 5 $6 and the price chosen is $10, the markup over AVC is 4/6 5 67%. Subsequently, when demand and cost conditions change (causing the unobserved demand, marginal revenue, and marginal cost curves to shift) the firm may continue to use a 67% markup rate to cause its price to move in con- scious parallelism with those of its rival firms (as we saw in Chapter 7), assuming they all want to maintain or increase profits as well. For example, suppose a new firm enters the beverage market with a new product, such as a soft drink with lower carbohydrates. Suppose that the prices of the existing products range from $2 to $2.50 per can, and that the management of the new firm determines that the new low-carb product would offer an attractive value proposition to many customers at a premium price of $2.75. If the new firm’s AVC 5 MC is, say $1.50, the $2.75 price represents a markup of 83% (or $1.25) above AVC. Later, if production costs rise for all firms and they all want to increase their prices to pass on the cost to consumers, they would maintain their relative prices by each using the same markup rates as before, applied to their new levels of AVC.

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Different customers prefer different products. Certified organic foods appeal to a market segment of consumers who want produce grown without chemicals or pesticides. This is an example of a niche market.

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CHAPTER 9Section 9.1 Pricing New-to-the-Market Products

Product Line Pricing and Product Proliferation

There is often a profit incentive for the firm to increase the breadth of its product line— to offer additional variants of its product within an existing product category. Examples include a beverage company offering containers in several sizes, or a detergent company offering a new soap powder product with lemon scent, or optimized for cold water wash- ing, and so on. Toyota reportedly had 43 models of cars and light trucks at the time of this writing. These different products offered by the same firm are known collectively as its product line.

We can show the profit incentive to increase the product line with a very simplistic exam- ple. Suppose there are three firms competing in a market, each offering one product, and their products are (for simplicity) what we call symmetrically differentiated, which sim- ply means that the market splits equally among the products offered to the market when their prices are equal. The market share of each firm is thus 1/n, where n is the number of competing products, so in this case it is 33.3% for each firm. Now, suppose one firm introduces a second symmetrically differentiated product, making a total of four products in the market. That firm’s market share would rise from 33% to 50% since it now gains revenue from two of the four products in the market. If it introduced a third product its share would increase from 2/4 to 3/5 5 60%, and so on. Eventually, rival firms would catch on and start expanding their product line to avoid their market share shrinking as others add new products to their product lines. Soon a point would be reached where the shrinking sales for each of the individual products causes the firm’s total costs to rise more than their total revenues have risen, so the process of product proliferation would then stop. It is reported that Procter and Gamble in the 1980s expanded its line of detergents to 22 (slightly differentiated) products before determining that the introduction of an addi- tional product would be uneconomical.

It is difficult to find an example of a market that is exactly symmetrically differentiated, but in many markets consumer demand does split relatively evenly across the available prod- ucts. Thus, adding an additional product to the firm’s product line might be expected to gain sales by “stealing” some customers from the nearest substitute products both within the firm’s product line (known as cannibalizing sales) and from the products of other firms also contesting the market. We saw in Chapter 7 that firms in monopolistic competi- tion compete with many other firms with slightly differentiated products, and that addi- tional firms will enter the market until the excess profit earned by any firm is competed away by another firm offering a similar product, so finally all firms will earn only normal profit, which we know is equal to the best they could earn by investing their resources elsewhere. Now transfer that logic to existing firms adding additional products into their product lines—they will continue to add new products while there is excess profit to be earned by doing so. If a particular firm does not add new products that compete with its existing products, then another firm will, so each firm has an incentive to add additional products to increase the share of the overall market accruing to that firm (rather than to another firm) until any further product proliferation would cause all firms (or product lines) to take losses until some firms (or product lines) exit the market. All firms would then earn a quantum of profit equal to the normal profit from each product multiplied by the number of products they have in their product line. Thus, moving quickly to add new products, before others fill the market (i.e., squeeze out the excess profit) with their new products, serves to increase the magnitude of the firm’s total profits earned, notwithstand- ing that its profit rate will remain at the normal level.

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CHAPTER 9Section 9.1 Pricing New-to-the-Market Products

So the question for the manager is, “Where in the product line should I put an additional product?” That is, what should the quality and price positioning be for the new product? The answer will be found in the profitability of the existing products in the firm’s prod- uct line and in other firms’ product lines. The manager should position the new product such that it steals sales from existing products that are currently earning excess profits, whether these be within the firm’s own product line or within another firm’s product line. Although it may seem counterproductive for a firm to cannibalize profits from within its own product line, if it doesn’t do it, another firm will! Other firms have a profit incentive to design new products that compete with your most profitable products; it is better that you do it first and gain two shares of normal profit rather than only one.

The proliferation of franchises. The expansion of fast-food fran- chises in a densely populated area illustrates the same issue. If McDonald’s adds more and more stores into a particular area, it will increase its aggre- gate market share even though the sales of each individual franchise is shrinking, because the total demand for fast food is then being shared across more and more fast-food stores in the area. If McDonald’s owned all its stores, it might pursue this to an optimal point of many rela- tively small stores earning only normal profit causing maxi- mum total profits to the parent firm, but since most of its stores are operated by franchisees, who

would be very upset by shrinking sales and profit, the franchise agreement is likely to include a clause guaranteeing the franchisee a minimum distance from another franchi- see, or at least a minimum annual revenue before additional franchises might be issued in close proximity. Even with this constraint imposed by the need to retain good franchisees, McDonald’s might gain sales from other franchise chains (e.g., KFC) if those other chains do not expand their store numbers as quickly, and from independent operators who can- not afford to open additional retail outlets.6

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In densely populated areas with many differentiated sellers, new franchises will continue to enter the market until profits in each firm are reduced to normal profits.

6. The sales of individual franchisees would not necessarily shrink in monetary terms, as the demand for a product in a region typically expands with population growth and with franchisor advertising, for example. Individual franchise sales might grow over time but grow at a lesser rate than the total sales grow, or grow in monetary terms rather than in real (adjusted for infla- tion) terms.

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CHAPTER 9Section 9.1 Pricing New-to-the-Market Products

In a densely populated region with many sellers, this situation approximates monopolistic competition, which we examined in Chapter 7. There will be entry of new firms (or new franchises of multifranchise firms) until profits in each firm are reduced to normal profits. As we saw in Chapter 7, each store will be operating at a plant size that is smaller than the optimal size of plant (i.e., their short-run average cost (SAC) will not be at the minimum point on their long-run average cost (LAC) curve). In a market that initially promises excess profits, there will be a rush to enter that market and the franchiser that moves more quickly to set up the most franchises before the market is filled will earn a larger volume of profit than the franchiser who is slow to set up franchises. As an example, we see the rapid expansion in the number of U.S. fast-food franchises in emerging Asian markets where the citizens are becoming wealthier and more able to afford these products.7

Penetration Pricing Penetration pricing is the practice of setting a relatively low price to induce greater adop- tion by consumers and, thus, gain greater market share. Whereas price skimming is effec- tively short-run profit-maximizing (i.e., where short run MC 5 MR), penetration pricing is probably more akin to long-run-profit-maximizing prices (i.e., where long-run marginal cost [LMC] equals marginal revenue [MR]). By setting a lower price and gaining greater market share in the short run, the firm hopes to gain a number of marketing and cost advantages that will enhance its profitability over the longer term. Let us briefly enumer- ate the reasons why a penetration price might be profit-maximizing over the longer term.

First, setting a lower price will inhibit entry of rival firms, since new entrants typically have higher costs of production costs (per unit of output) than pre-existing firms because the pioneer firm and early followers will have already begun to move down their learning curves (see Chapter 5) to reduce unit costs. If the focal firm is able to set a relatively low price that is below the average cost level of potential entrants, these other firms will fore- see losses and will not want to enter this market unless they can foresee a rapid movement down their own learning curve so that the initial period of losses will be relatively short.

Second, a lower price allows the focal firm to produce and sell more volume and thus learn faster about the most efficient ways to produce and sell its product, which allows it to move further down its learning curve, and, thus, it can continue to inhibit entry of new rivals (by exhibiting a lower cost structure) as well as enjoy an increasing gross margin.

Third, the larger production volumes (made possible by a lower price) can allow the firm to take advantage of economies in production, such as economies of plant size (reduced average cost per unit); purchasing economies (buying materials in bulk at lower unit prices); and economies of scope (spreading total fixed costs across a broader product line)

7. To the extent that firms have strategic resources (such as a strong brand name) their profits will exceed the normal level, as we will see in Chapter 12 when we consider how the firm achieves sustainable competitive advantage by the initial possession or development of hard-to-copy and nonsubstitutable resources.

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CHAPTER 9Section 9.1 Pricing New-to-the-Market Products

as discussed in Chapter 5. Again, this serves to reduce AVC and MC and to allow price reductions that further inhibit entry of new rivals and/or the firm can enjoy an increased gross margin on sales.

Fourth, in markets where different technological platforms underlie competing products, and where these competing products must interact with a related product (such as mem- ory systems for laptop computers), there will evolve a race for the industry standard, which is the race to be adopted by the market as the superior solution to the customer’s problem. For example, compact disk (CD) and “flash memory” are alternative technolo- gies for data storage within and between laptop computers. The higher the functionality (quality) and the lower the price of laptops offered by the computer manufacturer, the better will be the value proposition perceived by customers. Accordingly, the design of the related product (in this case the laptop) will evolve to favor the memory solution that is cheaper and more functional. So, rather than offering an interface with both competing memory storage technologies, for cost and size reasons, the laptop manufacturer will limit its interface to the memory device that the market has adopted as the industry standard. Thus, we saw laptops stop offering CD drives in favor of USB ports for flash-memory devices, and, in turn, we may see these disappear in favor a new technology (such as stor- age “in the cloud”).

Fifth, there are future-period marketing advantages of lower prices in the current period. If the product is one that is subject to repeat purchases by customers, more sales in the current period will lead to greater sales in future periods as satisfied customers come back to repurchase the firm’s product. If consumer ignorance about product quality, price, or availability is high and can be reduced by “word-of-mouth” advertising by satisfied users, more users in the present period will mean more new adopters in the subsequent periods.

Sixth, the natural reluctance of potential customers to try a new product offering, due to their quality risk aversion, is offset to some degree by a lower price and serves to induce potential customers (who would not have purchased at a higher price) to step up and try the product.

But, while there are six good reasons to utilize penetration pricing rather than skimming pricing, the manager of the firm introducing a new product to an existing product cat- egory will need to be conscious of the general price level (i.e., the relative range of rival’s prices) and will want to position the new product’s price appropriately within that range. If the other firms are attempting to maximize their profits in the short run, the general price level will be higher than the penetration price. Setting the penetration price might provoke retaliatory price cutting (risking a price war) by rival firms. Whether or not this happens will depend on the market structure—that is, whether the rival firms offering differentiated products are operating in monopolistic or oligopolistic competition. In monopolistic competition, as we saw in Chapter 7, there are many rivals and each one can act independently of the others. In this case, it makes no sense to set any price lower than the short-run profit-maximizing price since the inevitable entry of new firms means the price is destined to fall to the long-run profit-maximizing price and output equilibrium levels (where MR 5 LMC 5 SMC and SAC 5 LAC 5 AR [where LMC signifies long- run marginal costs and AR signifies average revenue, or price]). Thus, the monopolistic competitor might as well set the short-run maximizing price to make greater profits (com- pared to a lower penetration price) in the short run while awaiting the inevitable entry of

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CHAPTER 9Section 9.2 Pricing New Products in New Markets

new firms that will cause price to be pushed down to the long-run equilibrium level soon enough.

In oligopoly, however, where barriers to entry prevent the emergence of new firms, and where mutual dependence will be recognized, firms will set prices relative to each other’s prices, so the focal firm must carefully decide where to position its price. If the focal firm does not want to compete on the basis of a lower price, preferring to compete on the basis of its product differentiation, it will offer a competitive value proposition (positioned within the relative range of prices) so as not to provoke a damaging price war. For exam- ple, the passenger car companies revitalize their models periodically in an attempt to offer a new value proposition rather than getting drawn into price wars based on their existing models. On the other hand, if the focal firm strongly prefers the longer term advantages of the penetration price, it can assume the role of the low-cost price leader (see Chapter 7) and set the penetration price and expect the other firms to shift their prices downward to protect their market shares until a new relative range of prices is established at a lower level where the other firms’ positioning within the relative range depends on their relative quality positioning. Walmart stores are an excellent example of a low-cost price leader. Its bulk purchases and other buying strategies allow it to keep prices relatively low and thereby force other retailers to keep their prices relatively low to offer a competitive value proposition. Note that this does not mean that rivals have to match Walmart’s prices— these firms can charge higher prices if they offer higher-quality products, including better service, free delivery, familiar brand names, and so on.8

9.2 Pricing New Products in New Markets

New-to-the-world products and services might emanate from existing firms that currently produce other products that are perhaps related or unrelated to the new product being introduced. Alternatively, they might emanate from entrepreneur- ial new firms that are set up to commercialize a new technology and exploit the market opportunities that the new technology offers. An example of a new-to-the-world product is the Segway personal transporter, a two-wheeled battery-operated vehicle that moves in the direction towards which the rider leans. This new method of transporting oneself from point A to B essentially opened a new product category on a new technological platform and created a new market in which Segway was initially the only supplier. Subsequently, rivals, including Toyota and Honda, have displayed prototypes of similar personal trans- portation machines. More broadly, Segway effectively competes with a wide variety of transportation methods, including scooters, skates, bicycles, motorbikes, cars, buses,

8. It is important to appreciate that either skimming pricing or penetration pricing may be profit- maximizing for the firm. First note that profit maximization over a time horizon that lies beyond the present period requires that profits be measured in expected net present value (ENPV) terms, as we saw in Chapter 2. If the product life cycle is short, and rivals are unable to quickly respond with competitive offerings, the price that maximizes the firm’s ENPV is most likely the skim- ming price. Conversely, if the product life cycle is relatively long, and particularly if consumers engage in repeat purchases, and if the opportunity discount rate is relatively low, the penetration price is likely to be the profit-maximizing price over the firm’s decision horizon.

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CHAPTER 9Section 9.2 Pricing New Products in New Markets

and trains, not to mention just plain walking! Because it was not closely related to any exist- ing product category, Segway effectively faced a new mar- ket demand curve and did not expect mutual dependence to be recognized by any other manufacturer of transportation devices, and could at least ini- tially act like a monopoly sup- plier of the only product offering in that particular market.

Other examples of new-to-the- world products include RFID (radio frequency identifica- tion) chips, Apple’s iPad, USB- memory sticks, Hotmail, Google, and Facebook. Although some of these brands were not actu- ally the pioneer firm who first introduced the new product or service genre, they were among the early entrants to new markets created by the application of new technology or a combination of technologies and therefore tend to be credited with “creating” those markets (Tellis & Golder, 1996).9

Innovative-New-Product Pricing So how should a pioneer firm with a new-to-the-world product set its price? Although there is a demand curve for the new product or service (as a collective of the willingness to pay for the product in the minds of thousands or millions of prospective customers), this demand curve will not be visible or available to the pioneer firm without survey- ing the population of prospective buyers. And, of course, therein lies a major problem: The new-to-the-world product will be as yet unknown to many customers who will later buy it when they become aware of it, and, thus, the initial period demand curve will be relatively small and will shift outwards in subsequent periods as customer awareness increases. As we know from Chapter 7, shifting demand curves mean shifting MR curves and that, in turn, means the profit-maximizing price of the monopolist would be set at a relatively low level initially and, subsequently, would be raised as the demand curve continues to shift outward. Customers, particularly repeat customers, are likely to view increasing prices as exploitative behavior on the part of the monopolist and may harbor a grudge that will cause them to switch to a rival supplier as soon as one or more other firms enter the market and price competition in the (by then) oligopoly market causes the price level to fall, as we saw when the telecommunication monopolies were first subject

©Sean De Burca/Corbis

The Segway personal transporter is an example of a new-to-the- world product, which is a product offering a new way to serve customers’ needs.

9. For a historical account of many new-to-the-world products and how the public’s memory of who actually pioneered the new product is biased in favor of the follower firms who later became the market leaders in those markets.

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CHAPTER 9Section 9.2 Pricing New Products in New Markets

to rivalry from new entrants. Thus, we need to better understand the sequence of shifts in the demand curve experienced by pioneer firms before we can prescribe a pricing policy to deal with this special situation of increasing market demand and the risk that rivals will soon enter (if they can) and compete on the basis of price. In fact, the shifts of the demand curve for new products are quite predictable, due to the diffusion curve phenomenon.

The Diffusion Curve

Rogers (1962) found that new technologies diffuse into the production functions of firms in an industry in a quite predictable manner, with only a small proportion of firms willing to adopt the new technology at first. He found that the adoption rate progressively increases, up to the midpoint of the adoption process, after which the rate of adoption progressively decreases. Rogers categorized the new technology adopters as innovators, early adopt- ers, early majority, late majority, and laggards according to how soon they adopted the new technology into their production processes. In a variety of studies, he found that the adoption pattern of a new technology tends to approximate a cumulative normal distribu- tion.10 Marketing scholars (Bass, 1969; Mahajan & Muller, 1979) then extended the diffu- sion model to the behavior of customers who are faced with a new-to-the-world product or service, arguing that the “innovativeness” of customers is approximately normally dis- tributed and, thus, there is similarly an approximately normal distribution around the mean time to adoption. A wide variety of new products have diffused through their mar- kets in this fashion (Mahajan, Muller, & Bass, 1990) and this pattern is an artifact of the behavior of human beings in aggregate, with some being more willing (or able) to try new products than are others. The diffusion curve varies dramatically across products, being more than 100 years for automobiles and less than 10 years for email, for example.

In Figure 9.3, we show an approximately normal distribution of the time to adoption of new products, with the innovators adopting more than 2 standard deviations (SDs) before the mean time to adoption, the early adopters adopting between 1–2 SDs before the mean; the early majority adopting between 0–1 SDs before the mean, and the late majority and the laggards adopting subsequently. In Figure 9.4 we show the cumulative normal dis- tribution, adding up the adopters as time shifts from 3 SDs before to 3 SDs after the mean time to adoption. You will note that the cumulative normal distribution, also called a cumulative density function, necessarily takes a “lazy-S” shape, as customers are initially slow to adopt and then adopt at increasingly faster rates until the mean time to adoption, after which point the rate of adoption (i.e., the number of adopters per period) slows as the product or service continues to diffuse through the market.

10. As you probably know, a normal distribution is characterized by 68% of the observations being within plus or minus 1 standard deviation (SD) from the mean of that distribution; 95% within 1/2 2 SDs of the mean; and 99.7% within 1/2 3 SDs of the mean. A cumulative normal distri- bution thus means that about 2.5% of the adopters adopt more than 2 SDs before the mean time to adoption; 16% adopt more than 1 SD before the mean time to adoption; 50% adopt before the mean time to adoption; 84% adopt before the passage of time that is 1 SD after the mean time to adoption; and the remainder adopt after more than 1 SD beyond the mean time to adoption.

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CHAPTER 9Section 9.2 Pricing New Products in New Markets

Figure 9.3: The normal distribution of time to adoption of new products

Relative frequency

Standard deviations from

mean time to adoption–3 –2

2.5% 13.5% 34% 34% 13.5% 2.5% Percentage of adopters

–1 1 2 3Mean

Figure 9.4: The diffusion curve for a new product

–3 –2 –1 1 2 3Mean

Total adoptions

of the product

Standard deviations from the mean time to adoption of

the product

Diffusion curve

Laggards

Late majority

Early majority

Early adopters

Innovators

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CHAPTER 9Section 9.2 Pricing New Products in New Markets

There are good economic rea- sons for the approximately normal distribution of time to adoption. Douglas (2012) has argued that the normal distri- bution of customer adoption is actually due to six component factors that each serves to inhibit customer adoption of a new product. He argues that each of these factors should be expected to exhibit a bell-shaped prob- ability distribution with respect to time, and that when these six probability distributions are added together (vertically) the result is a probability distribu- tion that is approximately nor- mally distributed around the mean time to adoption. The first factor is customer awareness of

the new product and its benefits—some potential customers will be highly aware of the new product while others will be not at all aware of it, with most people having some degree of awareness in between. Second, the appreciation for the quality attributes of the new product, or the amount of utility the customer expects from the new product, is also likely to be distributed around a mean value with some gaining very high utility and some gaining very low utility, but with most people nearer the mean utility expected from the new product. Third, the quality risk aversion of customers is likely to vary across a spectrum with most people located in the middle; at one extreme some will be only slightly quality risk-averse and at the other extreme others will be highly risk-averse. Fourth, the distribution of switching costs (related to discontinuing the existing alterna- tives to the new product) are likely to vary across a spectrum with a central tendency such that most people are within plus or minus one standard deviation from the mean and others fall to each side of the mean switching costs. Fifth, it is expected that there will be a distribution of customer accessibility to the supplier of the new product—there will be a mean distance from the supplier (or other measure of purchase inconvenience) with some potential customers finding access highly convenient while, on the other side of the distribution, others will find access highly inconvenient. Finally, there is affordability of the new product: Some customers will easily afford to buy the product while others will need to save up for several periods, such that affordability is also likely to have a roughly bell-shaped distribution.

It is argued that these six factors impose a series of barriers to purchase a new product that must be overcome, one by one, before the customer can purchase the new product. But note that each barrier to purchase will decline as time passes. Awareness should be expected to spread as the firm ramps up its promotional campaign, as news reports are made, as word-of-mouth is more widely generated, and as communication takes place between those who have already adopted the product and those who have not yet adopted it. The appreciation for the new product is likely to grow for those whose initial appreciation was not high as more information about the new product is learned by potential customers

©Jupiterimages/Thinkstock

As consumers earn and save more money, affordability increases. Following a standard distribution, some customers will easily afford to buy a product while others will need to save for several periods.

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CHAPTER 9Section 9.2 Pricing New Products in New Markets

and as those who have tried the product endorse and recommend it to others. Quality risk aversion associated with the new product declines as new information about the quality of the new product is generated and disseminated. The appeal of alternatives (that satisfy the same customer need) declines as the switching costs are reduced over time as cus- tomers use up their personal inventories of the old way to satisfy the need and learn by observation of others how to best use the new product. Accessibility increases as potential customers schedule travel to the place of sale and as the seller expands its distribution network to serve more distant places (including Internet sales). And finally, affordability increases as people save up money to buy the product, and as the price of the product is reduced in line with the cost savings due to the learning curve effect. As each of these inhibitors to purchase declines, their combined effect is to induce the potential customer to move closer to the decision to adopt the new product, and given the approximately normal distribution of the six main inhibitors in total, the rate at which people reach this decision point increases at first and decreases later.

Thus, the demand curve faced by the firm introducing a new product should be expected to be quite close to the price axis at first, and then shift outward progressively over time in subsequent periods, with the extent of the demand shift per period increasing at first and later decreasing, as we depict in Figure 9.5. As discussed in Chapter 7, if the firm were to set the profit-maximizing price, where MC 5 MR, this pricing rule would cause price to rise substantially over time if the demand curve is shifting outward, and this rising price would be likely to attract new firms into the industry (not to mention upsetting custom- ers). Customers are accustomed to seeing prices fall over time (at least in real terms 11) as the firm benefits from learning curve effects and as it tries to expand its sales and market share as new rivals emerge. But, as we know, the cost of information to derive the demand curves in multiple periods into the future is likely to far exceed the increased profit that could be earned, so the firm is likely to adopt a pricing rule that economizes on search costs and hopefully returns higher profit as a result. In Figure 9.5 we have assumed that the firm knows demand will increase over time and sets a regular price (shown as P) that seems to offer an attractive value proposition given the quality positioning of the new product relative to other products that serve the same needs. The firm then sets the introductory price, P” by allowing a relatively large discount (e.g., 50%) off the regular price, and subsequently reduces the discount (e.g., to 25%) from the regular price by set- ting price P’, as the demand curve continues to move outwards until the regular price is offered without any discounts as the product moves towards the maturity stage of the diffusion process.12

11. Real prices, as we saw in Chapter 8, are the nominal or “ticket” prices divided by a price index that adjusts for the declining purchasing power of the dollar due to inflation.

12. You may be aware of the “product life cycle” concept from a marketing class. This concept is related to the diffusion curve and assumes that sales of a new product will grow in the same “cumulative normal distribution” pattern but will later fall as it is made obsolete by newer ver- sions of the product genre that include improvements due to newer technologies. Figure 9.5 assumes that the new product, once adopted, will be repetitively purchased by all customers (such as for a new teeth-whitening product). If the product is a once-only purchase (such as braces for the teeth) the demand curve would shift outward at first and later shift back as the product moves through the product life cycle. Discounts from the regular price would apply at first, and discounts would be applied again later in the product life cycle to induce the late adopters and laggards to purchase the product.

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CHAPTER 9Section 9.2 Pricing New Products in New Markets

Figure 9.5: Setting a “mature-market price” for the new product with discounts initially

Price

P

Q

P'

P''

Q' Q'' Q''' Q'''' Q'''''

D D' D'' D''' D'''' D''''' Quantity/ period

Price positioning for a competitive value proposition—i.e., based on quality positioning

Thus, the price is set at P” in the first period, P’ in the second period, and reverts to the regular price P in the third period. Notice that these time periods coincide with 2–3, 1–2, and 0–1 standard deviations before the mean time to adoption, respectively. Whether the regular price remains at the level P in later periods is a matter for empirical observation, since many things can change to upset the firm’s plans—in any case, the prices P”, P’, and P, are mostly for planning purposes initially and might well be revised significantly if the actual sales outcomes are different from projections.

Entering New Geographic Markets

When a firm enters a new geographic market it is likely to also experience a similar dif- fusion curve in that new market largely because the locals are not aware of the product and need to learn about it. Earlier in this chapter we mentioned the Tata Nano CX, a car made in India and introduced to the U.S. market in the very-small-car category. We should expect the sales of this vehicle to follow a path approximated by a cumulative normal probability distribution as it approaches its equilibrium market share, all things staying equal.13 Potential customers will have varying degrees of awareness, attraction, quality risk aversion, switching costs (from alternatives), accessibility, and affordability, for the Tata Nano CX that will cause them to delay adoption until these issues have been settled in their minds. Thus, Tata should expect to see the sales of its Nano car start slowly in the cities and regions of the U.S. market and gradually pick up speed as the impediments to customer adoption are progressively removed in those markets.

13. Equilibrium only happens if nothing further changes, but of course there will likely be smaller models of other cars made available and changes in customer tastes and preferences are also likely. So the equilibrium market share is only notional in practice, based on a particular set of assumptions and expectations.

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CHAPTER 9Summary

Conversely, exporters of U.S. products to overseas markets must expect their sales to start slowly if all six inhibitors are strong. In some cases, fortu- nately, some of the inhibitors will be relatively weak and may not deter sales much at all. For example, overseas mar- kets might be highly aware of a firm’s product, due to news reports they have seen, and highly appreciative of the prod- uct because it fulfills a long-felt need. It may be quite inexpen- sive, such that affordability is not a strong inhibitor, and qual- ity risk aversion might be very low since they know that the product has been tested and well-received in the home mar- ket. If it serves a long-felt need that was not previously served, then switching costs from alternative products would be minimal. And finally, exporting the product into their market solves the problem of accessibility.

More broadly, these six inhibitors will slow the adoption of any new product into any market if they are significant. Even established firms offering a new-to-the-market prod- uct line extension have to keep in mind that one or more of these six impediments to adoption are likely to impede the initial sales of their new product. In established product markets, switching costs and quality risk aversion are likely to be the greatest inhibitors and, thus, the firm should consider entering the market at a bargain price to offset the potential customers’ reluctance to try the new product. Particularly if the new product is an experience good, meaning the quality characteristics are not easily and inexpensively observed, the firm may need to offer free trial usage of the product, or deep introduc- tory discounts, to allow the quality risk-averse potential customer to gain information about the product at minimal cost to the customer. Obviously, advertising and promo- tional efforts, including detailed information on the firm’s website, are also important to reduce customer reluctance to adopt the new product. On the other hand, search goods, for which the quality characteristics are easily and inexpensively observed, may not need these particular marketing tactics to induce trial purchase and consumption.

Summary

In this chapter, we have examined the pricing of new products, first in the context of new-to-the-market variants of an existing product category and later in the context of a new-to-the-world product that effectively initiates a new product category. In line with marketing parlance, we considered price skimming and penetration pricing, which

©Reuters/Corbis

If foreign consumers are highly aware of a product or appreciative of the unmet need it fulfills, some of the inhibitors to expanding into overseas markets will be relatively weak. For example, when the first McDonald’s opened in Moscow, hundreds of patrons lined up outside to get a taste of America.

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CHAPTER 9Summary

effectively correspond to short-run and long-run profit maximization, respectively. We noted that the firm’s product, if differentiated from those of rivals, would be priced accord- ing to its relative quality, and thus the prior decisions about quality positioning of the new product effectively determine its price positioning. Differentiated products may be sold into either monopolistic competition or oligopoly markets, where mutual dependence is not recognized and is recognized, respectively. In monopolistic competition, where the absence of entry barriers means that new firms and new product variants are inevitable if the existing firms are making excess profits, new product variants will constantly arise because firms have a profit incentive to proliferate their products because, although each product will only earn normal profits, the firm will make more profit if it has more prod- ucts each making normal profits.

In oligopolistic markets the firm should recognize its mutual dependence with rival firms and should expect rivals to react to the quality and price decisions embodied in its new product offering. The presence of barriers to entry in oligopoly markets generally allow firms to earn excess profits, but, unless there are barriers to the introduction of new prod- uct variants by existing firms, these rival firms may be able to copy the firm’s best-selling products and augment their profits in the same way as monopolistic competitors who broaden or deepen their product lines to earn profits on more, rather than fewer, product offerings.

In making the choice between price skimming and penetration pricing, we noted that short-run profit-maximizing potentially allows the firm to recoup its product develop- ment expenses sooner but also potentially attracts the entry of new rivals (if barriers to entry are not insurmountable). In Chapter 12, when we examine the resource-based view of competitive strategy, we will see that although entry of new firms to an industry may not be preventable, entry of new firms to specific markets or market niches might be prevented because the firm owns or controls specific strategic resources that cannot be acquired or accessed by rival firms. We noted several reasons why penetration pricing might be con- sidered profit-maximizing over the longer term, including that it serves to inhibit entry of new firms, facilitate word-of-mouth promotion by customers, deliver economies in pro- duction, capture the industry standard, increase repeat purchases, and offset switching costs and quality risk aversion.

Subsequently, we examined the diffusion curve of new product adoption and considered the six main impediments to new product adoption that cause the sales of new products to be relatively slow at first and then increase at an increasing rate until the median cus- tomer has adopted the product, after which the rate of increase of demand for the product declines progressively. This means that the demand curve for the firm must be shifting out to the right as time passes, so it is not optimal to set a single price for the new product that would remain unchanged during the entire diffusion process. But since information on the location of the demand curve will be relatively hard to get, it is most likely profit- maximizing for the firm to avoid search costs and instead proceed on the basis of the managers’ judgment of the appropriate quality and price positioning of the new product. We argued that the firm should estimate a mid-product-life price relating to the adoption of the product by the early majority of customers, call this the regular price, and discount heavily from that price in the initial period. The discount from the regular price would be reduced when sales expand as the mean time to adoption is approached.

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CHAPTER 9Decision Problems

Finally, we considered the applicability of the six main impediments to new product adoption, namely, awareness, attraction, (quality risk) aversion, (switching costs of) alter- natives, accessibility, and affordability, of the quality positioning of the new product. We argued that each potential customer must overcome these impediments to new product adoption before choosing to adopt the new product. Managers are expected to introduce strategies and tactics to increase awareness, accessibility, affordability, and appreciation of the new product while decreasing switching costs and quality risk aversion. It was noted that these factors inhibiting the diffusion of new products through markets might be especially prevalent in international markets, but also apply to varying degrees with any introduction of a new product variant into a market category.

Questions for Review and Discussion

1. Under what circumstances is the penetration price the best price for the firm wishing to maximize the expected net present value of profits over its planning horizon?

2. Under what circumstances is the skimming price the best price for the firm wishing to maximize the expected net present value of profits over its planning horizon?

3. Explain the diffusion curve phenomenon in terms of the six impediments to cus- tomer adoption of a new product.

4. Why is a new-to-the-market product also subject to the diffusion curve phenomenon? 5. Explain the relationship between the customer’s perceived value proposition and the

firm’s price positioning for its new product. 6. Why is product proliferation, even involving cannibalizing its own sales, profit maxi-

mizing for the monopolistic competitor? 7. Why does the entry of new firms in monopolistic competition squeeze out all the

pure profit whereas the entry of new firms in oligopoly may not reduce the focal firm’s demand back to the point where only normal profits are attainable?

8. Firms expanding globally with a product that is well-known and in high demand in their home market, will nonetheless expect to encounter resistance to adoption of that product in international markets. Please explain.

9. Explain, in terms of the customers’ utility-maximizing choice of alternative products, why switching costs delay the adoption of a new product.

10. Explain why the barriers to the adoption of new products decay over time, causing more and more potential customers to become actual customers.

Decision Problems

1. The Forever-Young Health Foods Company has a wide range of multivitamins, nutrition and dietary supplements that compete with dozens of other firms who also provide a range of similar products. These products are all slightly differenti- ated from each other and compete on the basis of brand name and the ingredients included in each product. Forever-Young is considering broadening its product range, since it can see a profit opportunity in a particular area of cold and flu preven- tion multivitamin combinations. It considers that it can make pure profits in the mar- ket for cold and flu multivitamin supplements with a new product that contains a new combination of vitamins and trace elements (such as zinc) at a price that would position it as a very competitive value proposition.

a. Advise Forever-Young how it should proceed to position its new product in the market for cold and flu prevention multivitamin supplements.

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CHAPTER 9Decision Problems

b. In what way(s) should Forever-Young expect rivals to react to its new product initiative, and when?

c. Suppose Forever-Young is currently making normal profits on most of the prod- ucts in its product line, but is making pure profits on some of its newer products. What should Forever-Young do to increase profits?

2. Eastman Paint Company manufactures a range of slightly differentiated paint prod- ucts for the do-it-yourself homeowner. Its product line includes products that are combinations of (either) gloss, semi-gloss, low-sheen, and matte finishes, with either a water or oil base. All paints can be tinted to any color at the point of sale. East- man competes with three other large paint companies, who have each spent a lot of money on advertising to build a reputation for higher quality. Most of Eastman’s products are sold at prices that just cover its economic cost of production such that the firm makes only normal profits on those products. On three of the products in its product line, however, Eastman is making pure profit with a comfortable margin of price above short-run average cost (SAC) (see table below). Eastman has examined the products and prices of rival firms and notes that there are three other products it could produce and gain relatively high prices compared to its economic cost of production.

More profitable product variants for Eastman Paints

Eastman’s economic profit per gallon

Rival X’s economic profit per gallon

Rival Y’s economic profit per gallon

Rival Z’s economic profit per gallon

1. High-gloss, oil-based $1 — $3 $2

2. Semi-gloss, water-based $4 $6 — $4

3. Semi-gloss, oil-based $3 $5 $5 —

4. Low-sheen, water-based $5* $6 $3 $2

5. Low-sheen, oil-based $3* $5 $4 $5

6. Matte finish, water-based $5* $8 $6 $4

Profit per gallon of the product variants marked with an asterisk (*) indicates East- man’s expected profit if it is to offer a product in that subcategory (it currently does not). The horizontal dash (—) indicates that the rival does not currently offer that particular product variant, although it could. Note that there are no barriers to entry preventing any of these firms from introducing new product variants, or copy-cat products, that are the same technical specification as rivals’ products except for their different brand names.

a. Based on this limited information, and making assumptions as necessary, advise Eastman what it should do to maximize its profit.

b. What should Eastman expect its rival firms to do? c. What do you expect the eventual equilibrium situation in this market to be?

3. Chuck Branson won a gold medal at the 2012 Olympics and has decided to start his own business as a personal trainer. He thinks he could make a lot of money since he

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CHAPTER 9Decision Problems

is now well-known and admired by many fitness-oriented people and thus, should be able to attract a large clientele of people who want to lose weight and build mus- cle tone. He has made an arrangement with a fitness center to meet clients there and use its facilities for a reasonable fee and plans to do a letter-box drop of pamphlets to homes and apartments in the surrounding suburbs. He is aware that there are many other personal trainers, all slightly differentiated from each other in terms of their personalities, methods, locations, and personal sporting achievements.

a. Advise Chuck whether he should charge a skimming price or a penetration price, with supporting reasoning for and against each pricing alternative.

b. Is Chuck likely to make pure profits initially? Can he continue to make pure prof- its in the longer term? Why or why not?

c. What advice would you give to Chuck to help him make more profit in the lon- ger term?

4. Alicia Montezuma is ready to launch a new business venture with an innovative new cosmetic product. Alicia knows that there will initially be relatively little market awareness of her product; that most potential customers will have significant quality risk aversion and switching costs; and that many customers will not have immedi- ate access to or affordability for this product. However, Alicia is quite sure that the product will be attractive to customers once they become aware and fully under- stand it. Alicia has estimated that she will sell about 32,500 units of the product over the first 24-month period. Sales per month are expected to follow a diffusion curve pattern, starting slowly with the rate of sales growth peaking in the 12th month and falling thereafter. Total sales per month are expected to grow to about 2,500 units per month by the 24th month and to remain at that level thereafter. Experimenting with a spreadsheet model, Alicia has found the parameters of the diffusion curve that conforms to her sales growth assumptions, as follows: Q 5 40.45T 1 9.12T2 2 0.27T3 where Q is the monthly sales level and T is the month number after the launch of the new product. Alicia has estimated that the demand curve will be P 5 2,764.28 2 1.9Q at the midpoint of the diffusion curve. Alicia expects that the price elasticity of demand will be relatively high, about e 5 23, since there are many substitutes and it seems that cosmetic products need to be relatively expensive to convince custom- ers that they are effective. Accordingly, Alicia expects to apply a 50% markup to her average variable costs of $155 per container to set the regular price that would be profit-maximizing when the early majority customers have fully entered the market.

a. What introductory price do you recommend Alicia set for the innovators in the market, and why? (Be explicit about any assumptions you need to make.)

b. What price should she set for the early adopter customers? (Again, state the assumptions underlying your recommendation.)

c. What is your advice for Alicia concerning revisiting her assumptions about the shape of the diffusion curve and the profit-maximizing markup rate, after her new product gains some months of experience in the market?

5. Maxim Motronics A.G. has been marketing a new product in Europe that has achieved notable market success and it now plans to introduce this product into the United States market. The product is an electronic device that is mounted in the rear window of passenger cars and allows the driver of one vehicle to have a spoken mes- sage converted to text and scrolled across the display panel to be read by occupants

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CHAPTER 9Key Terms

of a following vehicle. This new product can utilize the hands-free telephone micro- phone already installed in many new vehicles, or provides this as free accessory. Maxim expects that demand will be slow at first but will pick up quickly as automo- bile accessory stores begin to stock the product and as word-of-mouth promotion spreads awareness. Maxim also plans to produce a humorous video for posting to YouTube and to utilize social media marketing to spread awareness and enthusiasm for the new product. Market demand estimates provided by Maxim are that the firm expects to sell about 125,000 units into the U.S. market within 24 months, and that sales per month will start slowly and increase monthly in the expected diffusion pattern until they stabilize at about 10,000 per month after month 24. The diffusion curve parameters that fit these assumptions are shown in the equation Q 5 75.4T 1 46.11T2 2 1.352T3, where Q is sales per month and T is the number of months after the launch into the U.S. market. Maxim’s average variable cost (AVC) is constant at $62 per unit and expects to set the profit-maximizing price by applying a 167% markup to arrive at a regular price of $165, since it estimates the demand curve to be P 5 270 2 0.02Q.

a. What introductory price do you recommend Maxim sets for the launch of the product into the U.S. market, and why? (State any assumptions you need to make.)

b. How might Maxim further adjust the price before raising it to the regular level envisioned? (Again, state any assumptions you need to make.)

c. What is your advice for Maxim concerning the confirmation of prior projections of demand, the shape of the diffusion curve, and the profit-maximizing price after this new product gains some months of experience in the U.S. market?

Key Terms experience good A product for which search costs to ascertain product qual- ity are relatively high, since its quality attributes are not easily or inexpensively observed; thus, it must be experienced to ascertain the quality attributes.

inhibit entry A blocking action that prevents rival firms from entering a given market, such as setting a low price that new rivals could not match without mak- ing losses, because they have higher costs or advertising that your product contains desirable attributes that no other firm can provide.

niche market A market segment within a larger market that includes customers with similar tastes for whom sellers offer similar but differentiated products or services.

penetration pricing A new product pric- ing approach that sets price lower than the short-run profit-maximizing price in an attempt to maximize profit over a longer period of time.

price positioning The process of selecting a price within the relevant range of prices for rival products so that the chosen price offers a competitive value proposition to prospective customers.

price skimming A new product pricing approach that sets price at the short-run profit-maximizing price in an attempt to recoup developmental costs as quickly as possible.

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CHAPTER 9Key Terms

product lifetime price The purchase price plus all other costs incurred by the consumer over the product’s lifetime (e.g., including delivery, repairs, and maintenance costs) minus salvage value, expressed in net present value terms.

product line The collective of different products that a firm produces or sells, such as the range of cosmetics produced by L’Oreal or the vehicles produced by Ford.

quality risk aversion The natural reluc- tance of potential customers to try a new product offering, due to their fear that the quality of the new product may not live up to the claims made by the seller.

relevant range of prices The range of prices from the most expensive to the least expensive of the products in the same product category or niche market.

relevant range of quality The range of product quality from the highest quality to the lowest quality of the products in the same product category or niche market.

search goods Items for which the quality characteristics are easily and inexpen- sively observed; that is, for which the search costs to ascertain product quality are relatively low.

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