BUS 640 Week 5 Discussion 1& 2 and Week 5 Assignment

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New Product Pricing and Pricing in New Markets

Learning Objectives

A�er reading this chapter, you should be able to:

Explain how new products might be quality- and price-posi�oned in exis�ng markets. Dis�nguish between new-to-the-market products and new-to-the-world products and the pricing implica�ons of each. Explain why the extent of product differen�a�on is cri�cally important for price making. Recognize how barriers to entry are important to retain excess profitability. Iden�fy that even where entry barriers are not insurmountable, the firm has a profit incen�ve to introduce innova�ve new products.

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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.

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Introduction

New products1 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/ch09introduc�on#footernote1) are introduced on an almost daily basis as exis�ng firms strive to rejuvenate their product lines to maintain their compe��veness and market share. New products are also introduced by entrepreneurs who start new firms to commercialize new technologies. 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 a�er considering the prices of exis�ng products in the market and the novelty of their new product rela�ve to other products. The lack of prior produc�on and market experience with their new product means managers will not have much, if any, informa�on on which to base their es�ma�on of demand and cost curves for these products.

We shall dis�nguish 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 exis�ng market where the new product is simply a new variant in an exis�ng product category, such as a new brand of dish detergent that claims enhanced cleaning power. These have been called crea�ve imita�ons and are "new" to the extent that they offer the market a new combina�on of product a�ributes (see Chapter 3)—that is, the new product is differen�ated 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 Transporter, which was introduced to the market for personal transporta�on in

2002.2 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/ch09introduc�on#footernote2) New-to-the-world products are typically the outcome of disrup�ve innova�on, which creates a new technological pla�orm, as dis�nct from sustaining technology innova�on, which allows improvements on an exis�ng technology pla�orm providing enhancements to products that serve to differen�ate them from other products already available in the market (Bower & Christensen, 1995).

This chapter is organized on the basis of the new-to-the-market versus new-to-the-world dichotomy. In the next sec�on, we will examine the pricing decision in the context of introducing new product variants into exis�ng markets and, thus, consider topics such as price skimming, penetra�on pricing, price posi�oning, and product-line pricing. In the third sec�on, we will be concerned with pricing new-to-the-world products and examine the "diffusion curve" phenomenon, which causes the adop�on rate of new products to be slow at first and then progressively faster up to a point, a�er which the rate of customer adop�on becomes progressively slower un�l the firm’s maximal market share is a�ained, other things being equal. The diffusion curve phenomenon means that the quan�ty demanded at any par�cular price increases from one produc�on period to the next, and thus, causes shi�s of the demand curve from one period to the next, and this in turn has implica�ons for the profit-maximizing price in each period. We also consider the case of geographic expansion of an exis�ng 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).

1. Just a reminder that we use the term "products" to mean the output of the produc�on process, so product could mean either a physical product or an intangible service, or some combina�on of products and services. This saves having to say "products and services" every �me "product" is men�oned. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/ch09introduc�on#return1) ]

2. In case you have not seen one, see www.segway.com (h�p://www.segway.com) . The Segway is a ba�ery-powered two-wheeled, single-passenger vehicle that goes in the direc�on that you lean it, u�lizing gyroscopes to balance the rider. It is quite unlike any other form of personal transporta�on, such as bicycles, motorbikes, scooters, or horses, yet it serves the same basic need, that is, to transport a person from one loca�on to another. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/ch09introduc�on#return2) ]

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Tide laundry detergent pods are an example of a new-to-the- market product. Offering a new combina�on of product a�ributes, new-to-the-market products are an innova�ve varia�on on an exis�ng product category.

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9.1 Pricing New-to-the-Market Products

Marke�ng textbooks tend to advocate either price skimming or penetra�on pricing for new products. To skim means to take something off the top, such as skimming the cream off the top of milk. Price skimming means to set a very high price that allows rela�vely high profit outcomes for the firm. Penetra�on pricing, on the other hand, means to set a rela�vely low price that causes more units of the product to be sold and, thus, achieve greater penetra�on into the market. Both of these approaches may result in profit maximiza�on—skimming is intended to maximize profits in the short term whereas penetra�on 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 possible in each produc�on period. As such, the skimming price must be the same as the short-run profit-maximizing price, since there is no point se�ng a price higher or lower than that if the inten�on is to gain as much profit as possible. By now you are very familiar with the marginalist pricing rule for profit maximiza�on (i.e., set MC = MR), which would be used a�er considera�on of the es�mated demand and cost curves, if reliable es�mates of this data can be obtained at reasonable search cost. But herein lies the problem: With a new product, there is no prior history of customer demand or produc�on costs that is exactly applicable to this product. Thus, we must extrapolate (i.e., go outside the limits of the available data) from data rela�ng to similar but differen�ated products already available in the same product category. Obviously, the more closely subs�tutable the new product is for one or more of the other products in the category, the more reliable our es�mates will be, with the extreme case being the iden�cal-products case (i.e., pure compe��on) where the informa�on derived from observa�on of an exis�ng product is fully applicable to the new product entering the market (and, thus, the new product simply accepts the prevailing market price).

In differen�ated-product markets, however, there will be a range of prices chosen by the firms that reflect differences in the qualita�ve a�ributes of the compe�ng products. In a world of full informa�on (i.e., zero search costs) with firms that want to maximize short- run profit, these different prices will reflect different loca�ons of the MC curves (due to cost differences required to produce the different quali�es) and different loca�ons of the MR curves (due to demand differences for par�cular products due to the differences among customers’ preferences for the various a�ributes 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 compe�ng products would probably offer mostly the same core product a�ributes with each product poten�ally offering more or less of each of these a�ributes and addi�onally offering one or more quality a�ributes that rivals do not offer (e.g., their loca�on, brand name, and reputa�on, if not addi�onal tangible characteris�cs). If the firm’s new product offers the core quality a�ributes that characterize the product category and some or most of the product a�ributes 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 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#footernote3)

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 adop�ng a markup pricing rule. The manager will have es�mated the projected average variable costs (AVC) of the new product but any es�mate of average fixed cost (AFC) must await an es�mate of the quan�ty 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 introduc�on of the new product. So what markup over AVC should the manager choose? To be compe��ve with rival products the new product’s price must be carefully posi�oned such that it offers a compe��ve value proposi�on to customers in that market.

Price Posi�oning for a Compe��ve Value Proposi�on

Price posi�oning is the selec�on of price within the relevant range of prices for rival products such that the chosen price offers a compe��ve value proposi�on to prospec�ve customers. As you know, the value proposi�on can be defined as a measure of perceived quality divided by a measure of price. To illustrate using a simple example, consider Figure 9.1 where product quality and price are shown as one-dimensional (e.g., simply larger or smaller volume of a par�cular 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 quali�es (le�-hand axis) and different prices (right-hand axis). As we saw in Chapter 8, par�cular customers will perceive these differing size containers of beverage as having higher or lower value proposi�ons due to the differing reserva�on prices they place on each of the product offerings.

Figure 9.1: Compe��ve value proposi�ons, bargains, and rip-offs

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

© altrendo images/Thinkstock

Because value is equal to quality over price, Product A and Product C are perceived by this par�cular customer to be equal (i.e., compe��ve) value proposi�ons since they have the same ra�o 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 par�cular customer) to represent an equal value proposi�on. Product B, however, is a bargain, with its price posi�oning being lower than its quality posi�oning. 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 posi�oning is set higher than its quality posi�oning. Faced with this choice among products, this par�cular customer will therefore choose Product B since its value proposi�on is highest.

In terms of customer behaviors examined in Chapter 3, this customer will choose among products to maximize u�lity. The choice of the highest value proposi�on is consistent with u�lity maximiza�on because it includes the customer’s percep�on of quality (and hence marginal and total u�lity from the product) rela�ve to the price level. Note also that in Chapter 8 we argued that the customer would have a reserva�on price that is the maximum he or she would pay for an item. Viewed from the value-proposi�on perspec�ve, the reserva�on price is the price that pushes the product’s value proposi�on to be just equal to the value proposi�on of the best alterna�ve (product’s) value proposi�on—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 reserva�on 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 reserva�on 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 reality, of course, both quality and price are mul�dimensional. The percep�on of quality includes a variety of quality a�ributes including size, shape, weight, color, design elements, purchase loca�on, warranty, and so on, as we saw in Chapter 3. Similarly, price includes not only the �cket 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 the product life�me price, which is the purchase price plus all other costs incurred by the consumer over the product’s life�me

(such as delivery, repairs, and maintenance costs) suitably discounted back to present value terms.4

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#footernote4) In Figure 9.2, we again show price on one of the ver�cal axes but this �me let us regard price as the product life�me 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 exposi�onal purposes here, we shall assume these product life�me costs are constant across products so no change in rela�ve price is introduced at this point. Instead, let us add a second quality a�ribute—let’s call this "sweetness"—into the measure of quality shown on the other ver�cal 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.

Figure 9.2: Price posi�oning with mul�dimensional quality and price

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 quan�ty), we can

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Different customers prefer different products. Cer�fied organic foods appeal to a market segment of consumers who want produce grown without chemicals or pes�cides. This is an example of a niche market.

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deduce that Product B must be substan�ally 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 s�ll 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 rela�vely low sweetness at its rela�vely 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 be�er bargain, having the higher quality/price ra�o, and so will be preferred by this par�cular customer.

Now, suppose this par�cular customer is the average customer and is, thus, representa�ve of the market5

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#footernote5) for this product category, such that Figure 9.2 is relevant for the price posi�oning 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 illustra�on that the quality posi�oning of Product E is chosen to be superior to Product B. To sell into this market, the price posi�oning of Product E will need to be quite close to the price of Product B in order to offer a superior value proposi�on (that is, the price–quality line EE needs to be steeper than the line BB).

You may be wondering why wouldn’t every customer now switch to Product E and abandon all the other product offerings. If (a) they had full informa�on, and (b) the only quality a�ributes they want in the product are size and sweetness, and (c) they all have iden�cal tastes across degrees of sweetness and volume of beverage, then indeed they would all switch to Product E since it offers them the be�er value proposi�on (or u�lity-maximizing choice). But other customers, in addi�on to volume and sweetness of beverage, will seek addi�onal a�ributes in the product (such as color, nutrient, electrolytes, lower carbohydrates, and so on) and may find a be�er value proposi�on in the products A, B, C, D or other products if these products offer these a�ributes in such quantum within their product that they become a bargain (or at least a compe��ve value proposi�on) for individual consumers. So, different customers (almost certainly having different preferences and different levels of informa�on about products) will prefer different product offerings, such that each firm’s product will appeal to groups of customers who have similar tastes, and such market segments within a market are called a niche market. Within each niche market we expect to find rival firms that offer products that are rela�vely close subs�tutes for each other in terms of their quality and price (i.e., their value proposi�on).

Thus, the price that should be set to enter an exis�ng market (or market niche) with a new product must be selected by the manager with a view to the rela�ve price and quality offerings of other firms. The markup rate over AVC is then deduced from the ra�o of the price selected to the AVC level. For example, if AVC = $6 and the price chosen is $10, the markup over AVC is 4/6 = 67%. Subsequently, when demand and cost condi�ons change (causing the unobserved demand, marginal revenue, and marginal cost curves to shi�) the firm may con�nue to use a 67% markup rate to cause its price to move in conscious 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 so� drink with lower carbohydrates. Suppose that the prices of the exis�ng 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 a�rac�ve value proposi�on to many customers at a premium price of $2.75. If the new firm’s AVC = MC is, say $1.50, the $2.75 price represents a markup of 50% (or $1.25) above AVC. Later, if produc�on costs rise for all firms and they all want to increase their prices to pass on the cost to consumers, they would maintain their rela�ve prices by each using the same markup rates as before, applied to their new levels of AVC.

Product Line Pricing and Product Prolifera�on

There is o�en a profit incen�ve for the firm to increase the breadth of its product line—to offer addi�onal variants of its product within an exis�ng 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 op�mized for cold water washing, and so on. Toyota reportedly had 43 models of cars and light trucks at the �me of this wri�ng. These different products offered by the same firm are known collec�vely as its product line.

We can show the profit incen�ve to increase the product line with a very simplis�c example. Suppose there are three firms compe�ng in a market, each offering one product, and their products are (for simplicity) what we call symmetrically differen�ated, which simply 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 compe�ng products, so in this case it is 33.3% for each firm. Now, suppose one firm introduces a second symmetrically differen�ated 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 = 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 prolifera�on would then stop. It is reported that Procter and Gamble in the 1980s expanded its line of detergents to 22 (slightly differen�ated) products before determining that the introduc�on of an addi�onal product would be uneconomical.

It is difficult to find an example of a market that is exactly symmetrically differen�ated, but in many markets consumer demand does split rela�vely evenly across the available products. Thus, adding an addi�onal product to the firm’s product line might be expected to gain sales by "stealing" some customers from the nearest subs�tute products both within the firm’s product line (known as cannibalizing sales) and from the products of other firms also contes�ng the market. We saw in Chapter 7 that firms in monopolis�c compe��on compete with many other firms with slightly differen�ated products, and that

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In densely populated areas with many differen�ated sellers, new franchises will con�nue to enter the market un�l profits in each firm are reduced to normal profits.

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addi�onal firms will enter the market un�l 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 inves�ng their resources elsewhere. Now transfer that logic to exis�ng firms adding addi�onal products into their product lines—they will con�nue to add new products while there is excess profit to be earned by doing so. If a par�cular firm does not add new products that compete with its exis�ng products, then another firm will, so each firm has an incen�ve to add addi�onal products to increase the share of the overall market accruing to that firm (rather than to another firm) un�l any further product prolifera�on would cause all firms (or product lines) to take losses un�l 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 mul�plied 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, notwithstanding that its profit rate will remain at the normal level.

So the ques�on for the manager is, "Where in the product line should I put an addi�onal product?" That is, what should the quality and price posi�oning be for the new product? The answer will be found in the profitability of the exis�ng products in the firm’s product line and in other firms’ product lines. The manager should posi�on the new product such that it steals sales from exis�ng 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 counterproduc�ve 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 incen�ve to design new products that compete with your most profitable products; it is be�er that you do it first and gain two shares of normal profit rather than only one.

The prolifera�on of franchises. The expansion of fast-food franchises in a densely populated area illustrates the same issue. If McDonald’s adds more and more stores into a par�cular area, it will increase its aggregate 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 op�mal point of many rela�vely small stores earning only normal profit causing maximum 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 franchisee, or at least a minimum annual revenue before addi�onal 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 cannot

afford to open addi�onal retail outlets.6

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#footernote6)

In a densely populated region with many sellers, this situa�on approximates monopolis�c compe��on, which we examined in Chapter 7. There will be entry of new firms (or new franchises of mul�franchise firms) un�l profits in each firm are reduced to normal profits. As we saw in Chapter 7, each store will be opera�ng at a plant size that is smaller than the op�mal 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 ini�ally 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 ci�zens are becoming wealthier and more able to afford these products.7

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#footernote7)

Penetration Pricing

Penetra�on pricing is the prac�ce of se�ng a rela�vely low price to induce greater adop�on by consumers and, thus, gain greater market share. Whereas price skimming is effec�vely short-run profit-maximizing (i.e., where short run MC = MR), penetra�on pricing is probably more akin to long-run-profit- maximizing prices (i.e., where long-run marginal cost [LMC] equals marginal revenue [MR]. By se�ng a lower price and gaining greater market share in the short run, the firm hopes to gain a number of marke�ng and cost advantages that will enhance its profitability over the longer term. Let us briefly enumerate the reasons why a penetra�on price might be profit-maximizing over the longer term.

First, se�ng a lower price will inhibit entry of rival firms, since new entrants typically have higher costs of produc�on costs (per unit of output) than pre- exis�ng 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 rela�vely low price that is below the average cost level of poten�al entrants, these other firms will foresee losses and will not want to enter this market unless they can foresee a rapid movement down their own learning curve so that the ini�al period of losses will be rela�vely 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 con�nue to inhibit entry of new rivals (by exhibi�ng a lower cost structure) as well as enjoy an increasing gross margin.

Third, the larger produc�on volumes (made possible by a lower price) can allow the firm to take advantage of economies in produc�on, 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

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fixed costs across a broader product line) as discussed in Chapter 5. Again, this serves to reduce AVC and MC and to allow price reduc�ons 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 pla�orms underlie compe�ng products, and where these compe�ng products must interact with a related product (such as memory 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 solu�on to the customer’s problem. For example, compact disk (CD) and "flash memory" are alterna�ve technologies for data storage within and between laptop computers. The higher the func�onality (quality) and the lower the price of laptops offered by the computer manufacturer, the be�er will be the value proposi�on perceived by customers. Accordingly, the design of the related product (in this case the laptop) will evolve to favor the memory solu�on that is cheaper and more func�onal. So, rather than offering an interface with both compe�ng 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 storage "in the cloud").

Fi�h, there are future-period marke�ng 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 sa�sfied 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" adver�sing by sa�sfied users, more users in the present period will mean more new adopters in the subsequent periods.

Sixth, the natural reluctance of poten�al 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 poten�al 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 u�lize penetra�on pricing rather than skimming pricing, the manager of the firm introducing a new product to an exis�ng product category will need to be conscious of the general price level (i.e., the rela�ve range of rival’s prices) and will want to posi�on the new product’s price appropriately within that range. If the other firms are a�emp�ng to maximize their profits in the short run, the general price level will be higher than the penetra�on price. Se�ng the penetra�on price might provoke retaliatory price cu�ng (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 differen�ated products are opera�ng in monopolis�c or oligopolis�c compe��on. In monopolis�c compe��on, 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 des�ned to fall to the long-run profit-maximizing price and output equilibrium levels (where MR = LMC = SMC and SAC = LAC = AR [where LMC signifies long-run marginal costs and AR signifies average revenue, or price]). Thus, the monopolis�c compe�tor might as well set the short-run maximizing price to make greater profits (compared to a lower penetra�on price) in the short run while awai�ng the inevitable entry of 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 rela�ve to each other’s prices, so the focal firm must carefully decide where to posi�on 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 differen�a�on, it will offer a compe��ve value proposi�on (posi�oned within the rela�ve range of prices) so as not to provoke a damaging price war. For example, the passenger car companies revitalize their models periodically in an a�empt to offer a new value proposi�on rather than ge�ng drawn into price wars based on their exis�ng models. On the other hand, if the focal firm strongly prefers the longer term advantages of the penetra�on price, it can assume the role of the low-cost price leader (see Chapter 7) and set the penetra�on price and expect the other firms to shi� their prices downward to protect their market shares un�l a new rela�ve range of prices is established at a lower level where the other firms’ posi�oning within the rela�ve range depends on their rela�ve quality posi�oning. Walmart stores are an excellent example of a low-cost price leader. Its bulk purchases and other buying strategies allow it to keep prices rela�vely low and thereby force other retailers to keep their prices rela�vely low to offer a compe��ve value proposi�on. 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 be�er service, free delivery, familiar brand names, and so on.8

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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" covers a wide range, from the very inexpensive Tata Nano CX (under $3,000) to the very expensive Buga� Veyron (over $1.5 million). Obviously, the manager must choose a more limited subset of rival products that are more closely subs�tutable 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. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#return3) ]

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 compe�ng 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 la�er 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 propor�on of new car price). [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#return4) ]

5. Alterna�vely, we could suppose this customer to be representa�ve of a par�cular market niche, or segment of the market—in this case those people who value only quan�ty and sweetness in their beverages. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#return5) ]

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 popula�on growth and with franchisor adver�sing, for example. Individual franchise sales might grow over �me but grow at a lesser rate than the total sales grow, or grow in monetary terms rather than in real (adjusted for infla�on) terms. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#return6) ]

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 compe��ve advantage by the ini�al possession or development of hard-to-copy and nonsubs�tutable resources. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#return7) ]

8. It is important to appreciate that either skimming pricing or penetra�on pricing may be profit-maximizing for the firm. First note that profit maximiza�on over a �me 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

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quickly respond with compe��ve offerings, the price that maximizes the firm’s ENPV is most likely the skimming price. Conversely, if the product life cycle is rela�vely long, and par�cularly if consumers engage in repeat purchases, and if the opportunity discount rate is rela�vely low, the penetra�on price is likely to be the profit-maximizing price over the firm’s decision horizon. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#return8) ]

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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.

© Sean De Burca/Corbis

9.2 Pricing New Products in New Markets

New-to-the-world products and services might emanate from exis�ng firms that currently produce other products that are perhaps related or unrelated to the new product being introduced. Alterna�vely, they might emanate from entrepreneurial new firms that are set up to commercialize a new technology and exploit the market opportuni�es that the new technology offers. An example of a new-to-the-world product is the Segway personal transporter, a two-wheeled ba�ery-operated vehicle that moves in the direc�on towards which the rider leans. This new method of transpor�ng oneself from point A to B essen�ally opened a new product category on a new technological pla�orm and created a new market in which Segway was ini�ally the only supplier. Subsequently, rivals, including Toyota and Honda, have displayed prototypes of similar personal transporta�on machines. More broadly, Segway effec�vely competes with a wide variety of transporta�on methods, including scooters, skates, bicycles, motorbikes, cars, buses, and trains, not to men�on just plain walking! Because it was not closely related to any exis�ng product category, Segway effec�vely faced a new market demand curve and did not expect mutual dependence to be recognized by any other manufacturer of transporta�on devices, and could at least ini�ally act like a monopoly supplier of the only product offering in that par�cular market.

Other examples of new-to-the-world products include RFID (radio frequency iden�fica�on) chips, Apple’s iPad, USB-memory s�cks, Hotmail, Google, and Facebook. Although some of these brands were not actually the pioneer firm who first introduced the new product or service genre, they were among the early entrants to new markets created by the applica�on of new technology or a combina�on of technologies and therefore tend to be credited with

"crea�ng" those markets (Tellis & Golder, 1996).9 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.2#footernote9)

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 collec�ve of the willingness to pay for the product in the minds of thousands or millions of prospec�ve customers), this demand curve will not be visible or available to the pioneer firm without surveying the popula�on of prospec�ve 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 ini�al period demand curve will be rela�vely small and will shi� outwards in subsequent periods as customer awareness increases. As we know from Chapter 7, shi�ing demand curves mean shi�ing MR curves and that, in turn, means the profit-maximizing price of the monopolist would be set at a rela�vely low level ini�ally and, subsequently, would be raised as the demand curve con�nues to shi� outward. Customers, par�cularly repeat customers, are likely to view increasing prices as exploita�ve 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 compe��on in the (by then) oligopoly market causes the price level to fall, as we saw when the telecommunica�on monopolies were first subject to rivalry from new entrants. Thus, we need to be�er understand the sequence of shi�s in the demand curve experienced by pioneer firms before we can prescribe a pricing policy to deal with this special situa�on 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 shi�s 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 produc�on func�ons of firms in an industry in a quite predictable manner, with only a small propor�on of firms willing to adopt the new technology at first. He found that the adop�on rate progressively increases, up to the midpoint of the adop�on process, a�er which the rate of adop�on progressively decreases. Rogers categorized the new technology adopters as innovators, early adopters, early majority, late majority, and laggards according to how soon they adopted the new technology into their produc�on processes. In a variety of studies, he

found that the adop�on pa�ern of a new technology tends to approximate a cumula�ve normal distribu�on.10

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.2#footernote10) Marke�ng scholars (Bass, 1969; Mahajan & Muller, 1979) then extended the diffusion model to the behavior of customers who are faced with a new-to-the-world product or service, arguing that the "innova�veness" of customers is approximately normally distributed and, thus, there is similarly an approximately normal distribu�on around the mean �me to adop�on. A wide variety of new products have diffused through their markets in this fashion (Mahajan, Muller, & Bass, 1990) and this pa�ern is an ar�fact 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 drama�cally 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 distribu�on of the �me to adop�on of new products, with the innovators adop�ng more than 2 standard devia�ons (SDs) before the mean �me to adop�on, the early adopters adop�ng between 1–2 SDs before the mean; the early majority adop�ng between 0– 1 SDs before the mean, and the late majority and the laggards adop�ng subsequently. In Figure 9.4 we show the cumula�ve normal distribu�on, adding up the adopters as �me shi�s from 3 SDs before to 3 SDs a�er the mean �me to adop�on. You will note that the cumula�ve normal distribu�on, also called a cumula�ve density func�on, necessarily takes a "lazy-S" shape, as customers are ini�ally slow to adopt and then adopt at increasingly faster rates un�l the mean �me to adop�on, a�er which point the rate of adop�on (i.e., the number of adopters per period) slows as the product or service con�nues to diffuse through the market.

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

© Jupiterimages/Thinkstock

Figure 9.3: The normal distribu�on of �me to adop�on of new products

Figure 9.4: The diffusion curve for a new product

There are good economic reasons for the approximately normal distribu�on of �me to adop�on. Douglas (2012) has argued that the normal distribu�on of customer adop�on is actually due to six component factors that each serves to inhibit customer adop�on of a new product. He argues that each of these factors should be expected to exhibit a bell-shaped probability distribu�on with respect to �me, and that when these six probability distribu�ons are added together (ver�cally) the result is a probability distribu�on that is approximately normally distributed around the mean �me to adop�on. The first factor is customer awareness of the new product and its benefits—some poten�al 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 apprecia�on for the quality a�ributes of the new product, or the amount of u�lity the customer expects from the new product, is also likely to be distributed around a mean value with some gaining very high u�lity and some gaining very low u�lity, but with most people nearer the mean u�lity 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 distribu�on of switching costs (related to discon�nuing the exis�ng alterna�ves 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 devia�on from the mean and others fall to each side of the mean switching costs. Fi�h, it is expected that there will be a distribu�on 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 poten�al customers finding access highly convenient while, on the other side of the distribu�on, 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 distribu�on.

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 �me passes. Awareness should be expected to spread as the firm ramps up its promo�onal campaign, as news reports are made, as word-of-mouth is more widely generated, and as communica�on takes place between those who have already adopted the product and those who have not yet adopted it. The apprecia�on for the new product is likely to grow for those whose ini�al apprecia�on was not high as more informa�on about the new product is learned by poten�al customers and as those who have tried the product endorse

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and recommend it to others. Quality risk aversion associated with the new product declines as new informa�on about the quality of the new product is generated and disseminated. The appeal of alterna�ves (that sa�sfy the same customer need) declines as the switching costs are reduced over �me as customers use up their personal inventories of the old way to sa�sfy the need and learn by observa�on of others how to best use the new product. Accessibility increases as poten�al customers schedule travel to the place of sale and as the seller expands its distribu�on 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 poten�al customer to move closer to the decision to adopt the new product, and given the approximately normal distribu�on 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 shi� outward progressively over �me in subsequent periods, with the extent of the demand shi� 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 = MR, this pricing rule would cause price to rise substan�ally over �me if the demand curve is shi�ing outward, and this rising price would be likely to a�ract new firms into the industry (not to men�on upse�ng

customers). Customers are accustomed to seeing prices fall over �me (at least in real terms 11

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.2#footernote11) ) 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 informa�on to derive the demand curves in mul�ple 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 �me and sets a regular price (shown as P) that seems to offer an a�rac�ve value proposi�on given the quality posi�oning of the new product rela�ve to other products that serve the same needs. The firm then sets the introductory price, Pʺ by allowing a rela�vely large discount (e.g., 50%) off the regular price, and subsequently reduces the discount (e.g., to 25%) from the regular price by se�ng price Pʹ, as the demand curve con�nues to move outwards un�l the regular price is offered without any discounts as the

product moves towards the maturity stage of the diffusion process.12 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.2#footernote12)

Figure 9.5: Se�ng a "mature-market price" for the new product with discounts ini�ally

Thus, the price is set at Pʺ in the first period, Pʹ in the second period, and reverts to the regular price P in the third period. No�ce that these �me periods coincide with 2–3, 1–2, and 0–1 standard devia�ons before the mean �me to adop�on, respec�vely. Whether the regular price remains at the level P in later periods is a ma�er for empirical observa�on, since many things can change to upset the firm’s plans—in any case, the prices Pʺ, Pʹ, and P, are mostly for planning purposes ini�ally and might well be revised significantly if the actual sales outcomes are different from projec�ons.

Entering New Geographic Markets

When a firm enters a new geographic market it is likely to also experience a similar diffusion 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 men�oned 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 cumula�ve normal probability

distribu�on as it approaches its equilibrium market share, all things staying equal.13 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.2#footernote13) Poten�al customers will have varying degrees of awareness, a�rac�on, quality risk aversion, switching costs (from alterna�ves), accessibility, and affordability, for the Tata Nano CX that will cause them to delay adop�on un�l these issues have been se�led in their minds. Thus, Tata should expect to see the sales of its Nano car start slowly in the ci�es and regions of the U.S. market and gradually pick up speed as the impediments to customer adop�on are progressively removed in those markets.

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, fortunately, some of the inhibitors will be rela�vely weak and may not deter sales much at all. For example, overseas markets might be highly aware of a firm’s product, due to news reports they have seen, and highly apprecia�ve of the product because it fulfills a long-felt need. It may be quite inexpensive, such that affordability is not a strong inhibitor, and quality risk aversion might be very low since they know that the product has been tested and well-received in the home market. If it serves a long-felt need that was not previously served, then switching costs from alterna�ve products would be minimal. And finally, expor�ng the product into their market, solves the problem of accessibility.

More broadly, these six inhibitors will slow the adop�on of any new product into any market if they are significant. Even established firms offering a new-to- the-market product line extension have to keep in mind that one or more of these six impediments to adop�on are likely to impede the ini�al sales of their

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

© Corbis/CORBIS

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 poten�al customers’ reluctance to try the new product. Par�cularly if the new product is an experience good, meaning the quality characteris�cs are not easily and inexpensively observed, the firm may need to offer free trial usage of the product, or deep introductory discounts, to allow the quality risk-averse poten�al customer to gain informa�on about the product at minimal cost to the customer. Obviously, adver�sing and promo�onal efforts, including detailed informa�on 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 characteris�cs are easily and inexpensively observed, may not need these par�cular marke�ng tac�cs to induce trial purchase and consump�on.

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. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.2#return9) ]

10. As you probably know, a normal distribu�on is characterized by 68% of the observa�ons being within plus or minus 1 standard devia�on (SD) from the mean of that distribu�on; 95% within +/− 2 SDs of the mean; and

99.7% within +/− 3 SDs of the mean. A cumula�ve normal distribu�on thus means that about 2.5% of the adopters adopt more than 2 SDs before the mean �me to adop�on; 16% adopt more than 1 SD before the mean �me to adop�on; 50% adopt before the mean �me to adop�on; 84% adopt before the passage of �me that is 1 SD a�er the mean �me to adop�on; and the remainder adopt a�er more than 1 SD beyond the mean �me to adop�on. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.2#return10) ]

11. Real prices, as we saw in Chapter 8, are the nominal or "�cket" prices divided by a price index that adjusts for the declining purchasing power of the dollar due to infla�on. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.2#return11) ]

12. You may be aware of the "product life cycle" concept from a marke�ng class. This concept is related to the diffusion curve and assumes that sales of a new product will grow in the same "cumula�ve normal distribu�on" pa�ern but will later fall as it is made obsolete by newer versions of the product genre that include improvements due to newer technologies. Figure 9.5 assumes that the new product, once adopted, will be repe��vely 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 shi� outward at first and later shi� 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. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.2#return11) ]

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 no�onal in prac�ce, based on a par�cular set of assump�ons and expecta�ons. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.2#return13) ]

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Summary

In this chapter, we have examined the pricing of new products, first in the context of new-to-the-market variants of an exis�ng product category and later in the context of a new-to-the-world product that effec�vely ini�ates a new product category. In line with marke�ng parlance, we considered price skimming and penetra�on pricing, which effec�vely correspond to short-run and long-run profit maximiza�on, respec�vely. We noted that the firm’s product, if differen�ated from those of rivals, would be priced according to its rela�ve quality, and thus the prior decisions about quality posi�oning of the new product effec�vely determine its price posi�oning. Differen�ated products may be sold into either monopolis�c compe��on or oligopoly markets, where mutual dependence is not recognized and is recognized, respec�vely. In monopolis�c compe��on, where the absence of entry barriers means that new firms and new product variants are inevitable if the exis�ng firms are making excess profits, new product variants will constantly arise because firms have a profit incen�ve to proliferate their products because, although each product will only earn normal profits, the firm will make more profit if it has more products each making normal profits.

In oligopolis�c 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 introduc�on of new product variants by exis�ng firms, these rival firms may be able to copy the firm’s best-selling products and augment their profits in the same way as monopolis�c compe�tors 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 penetra�on pricing, we noted that short-run profit-maximizing poten�ally allows the firm to recoup its product development expenses sooner but also poten�ally a�racts the entry of new rivals (if barriers to entry are not insurmountable). In Chapter 12, when we examine the resource-based view of compe��ve 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 penetra�on pricing might be considered profit-maximizing over the longer term, including that it serves to inhibit entry of new firms, facilitate word-of-mouth promo�on by customers, deliver economies in produc�on, capture the industry standard, increase repeat purchases, and offset switching costs and quality risk aversion.

Subsequently, we examined the diffusion curve of new product adop�on and considered the six main impediments to new product adop�on that cause the sales of new products to be rela�vely slow at first and then increase at an increasing rate un�l the median customer has adopted the product, a�er which the rate of increase of demand for the product declines progressively. This means that the demand curve for the firm must be shi�ing out to the right as �me passes, so it is not op�mal to set a single price for the new product that would remain unchanged during the en�re diffusion process. But since informa�on on the loca�on of the demand curve will be rela�vely 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 posi�oning of the new product. We argued that the firm should es�mate a mid-product-life price rela�ng to the adop�on of the product by the early majority of customers, call this the regular price, and discount heavily from that price in the ini�al period. The discount from the regular price would be reduced when sales expand as the mean �me to adop�on is approached.

Finally, we considered the applicability of the six main impediments to new product adop�on, namely, awareness, a�rac�on, (quality risk) aversion, (switching costs of) alterna�ves, accessibility, and affordability, of the quality posi�oning of the new product. We argued that each poten�al customer must overcome these impediments to new product adop�on before choosing to adopt the new product. Managers are expected to introduce strategies and tac�cs to increase awareness, accessibility, affordability, and apprecia�on of the new product while decreasing switching costs and quality risk aversion. It was noted that these factors inhibi�ng the diffusion of new products through markets might be especially prevalent in interna�onal markets, but also apply to varying degrees with any introduc�on of a new product variant into a market category.

Ques�ons for Review and Discussion

Click on each ques�on to reveal the answer.

1. Under what circumstances is the penetra�on price the best price for the firm wishing to maximize the expected net present value of profits over its planning horizon? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

The penetra�on price might maximize the ENPV of the firm's profits over the longer term because (i) it serves to inhibit entry of new rivals; (ii) it allows the firm to reduce costs down its learning curve faster for ini�al cost advantages over early followers; (iii) it induces larger sales volumes and thus gains earlier access to economies of scale and scope; (iv) larger volumes also help the firm to have its product adopted as the industry standard, for future sales advantages; (v) greater ini�al sales mean more people will become repeat purchasers sooner, further boos�ng later demand; (vi) it allows a wider base of ini�al customers to later spread word-of-mouth promo�on; and (vii) the lower price makes it easier for customers to overcome their quality risk aversion and their switching costs.

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? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

The skimming price might be profit maximizing when the barriers to entry can be overcome, if at all, only a�er a rela�vely long period during which the firm could make larger profits; when the demand for the product is short-lived (such as for a fad product or fashion items); where there are not significant economies of scale or other cost advantages that are associated with larger volumes available; and similar reasons.

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3. Explain the diffusion curve phenomenon in terms of the six impediments to customer adop�on of a new product. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Poten�al customers adopt new products with different �me lags a�er the product is first introduced to the market. The innova�ve customers adopt earliest because they tend to be more aware, more apprecia�ve, less averse to quality risk, less a�ached to other alterna�ves (including lesser switching costs), more able to afford the new product, and have greater access to the places of sale of the new product. Next to adopt, in order, are the early adopters, the early majority, the late majority, and the laggards, as they progressively overcome the six barriers to new product adop�on.

4. Why is a new-to-the-market product also subject to the diffusion curve phenomenon? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

New-to-the-market products (i.e., new brands) entering an exis�ng product category must first overcome the lack of awareness of consumers who do not know about the availability of the new product, its price and quality, how it should be used, where it can be bought, etc. The same six impediments to adop�on should be expected to be overcome by poten�al consumers, slowly at first, then at faster and faster rates per period, un�l a�er the median customer when the rate of adop�on should be expected to slow progressively as the late majority and the laggards gradually overcome the barriers to their adop�on of the product.

5. Explain the rela�onship between the customer’s perceived value proposi�on and the firm’s price posi�oning for its new product. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Different consumers value different a�ributes to different degrees, so the firm must design the a�ribute content of its product to appeal to a dis�nct segment of the market and offer that target market the best value proposi�on, or the best quality-per-dollar compared with the value proposi�ons offered by other firms. The firm should first consider the quality posi�oning of its product in terms of the a�ributes offered rela�ve to other firm's offerings, and then posi�on its price such that if offers slightly more quality per dollar.

6. Why is product prolifera�on, even involving cannibalizing its own sales, profit maximizing for the monopolis�c compe�tor? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Since there are no barriers to entry in monopolis�c compe��on, the products of any firm that earn excess profit will be copied un�l the profit from that group of similar products (or a�ribute combina�ons) is reduced to the normal profit level. If the firm fails to introduce slightly differen�ated similar products itself, other firms will do so and capture excess profits at first and later normal profits associated with the a�ribute combina�ons that are desired by the market. Although seemingly cannibalizing its excess profit from one product variant, by prolifera�ng its products the firm can earn two or more �mes normal profit on two or more differen�ated versions of the product.

7. Why does the entry of new firms in monopolis�c compe��on 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 a�ainable? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Since there are no barriers to entry into monopolis�c compe��on, entrants can copy whichever a�ribute combina�on that customers are willing to pay for. Where the price allows pure profit, firms will introduce variants that capture part of this pure profit un�l it is all competed away and the firms all make only normal profit. In oligopolies there are barriers to entry that effec�vely prevent firms from copying the a�ribute content of exis�ng firms' products (such as their brand name and reputa�on, and intellectual property protec�on of product innova�ons including new technology and designs) allowing the oligopolists to retain pure profits from their products since these cannot be perfectly copied by rival firms.

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 adop�on of that product in interna�onal markets. Please explain. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

When entering foreign markets firms must expect to gain sales slowly at first and then at an increasing rate following the diffusion curve pa�ern of new product adop�on, since the six inhibitors to new product adop�on also apply to new brand adop�on. The new brand will face lack of awareness; lack of apprecia�on of the dis�nc�ve a�ributes of the product; quality risk aversion; consumer preference for known alterna�ves; lack of affordability; and lack of accessibility. These must be overcome via promo�onal efforts to inform and persuade prospec�ve consumers that the new brand offers a dis�nc�ve combina�on of a�ributes that represents an a�rac�ve value proposi�on.

9. Explain, in terms of the customers’ u�lity-maximizing choice of alterna�ve products, why switching costs delay the adop�on of a new product. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Switching costs delay the adop�on of a new product because in effect they add to the price of the new product, thus reducing the value proposi�on of the new product. Switching costs usually decline as �me passes, and also the consumer's apprecia�on of the quality of the new product will grow over �me. If these trends con�nue, the value proposi�on of the new product will increase and the rate of consumer adop�on will increase progressively.

10. Explain why the barriers to the adop�on of new products decay over �me, causing more and more poten�al customers to become actual customers. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

The barriers to consumer adop�on each decay over �me as (i) awareness spreads due to adver�sing and word-of-mouth informa�on transmission; (ii) apprecia�on grows due to be�er informa�on about the product a�ributes; (iii) aversion declines as consumers see that the product performs to expecta�ons; (iv) alterna�ves recede in a�rac�veness as switching costs decline; (v) affordability increases as the price typically comes down and/or as the consumer saves up to purchase the new product; and (vi) as accessibility to the new product improves due to the opening of more sales and service outlets, including online sales.

Decision Problems

1. The Forever-Young Health Foods Company has a wide range of mul�vitamins, nutri�on and dietary supplements that compete with dozens of other firms who also provide a range of similar products. These products are all slightly differen�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 par�cular area of

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cold and flu preven�on mul�vitamin combina�ons. It considers that it can make pure profits in the market for cold and flu mul�vitamin supplements with a new product that contains a new combina�on of vitamins and trace elements (such as zinc) at a price that would posi�on it as a very compe��ve value proposi�on.

a. Advise Forever-Young how it should proceed to posi�on its new product in the market for cold and flu preven�on mul�vitamin supplements. b. In what way(s) should Forever-Young expect rivals to react to its new product ini�a�ve, and when? c. Suppose Forever-Young is currently making normal profits on most of the products 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 differen�ated paint products for the do-it-yourself homeowner. Its product line includes products

that are combina�ons of (either) gloss, semi-gloss, low-sheen, and ma�e finishes, with either a water or oil base. All paints can be �nted to any color at the point of sale. Eastman competes with three other large paint companies, who have each spent a lot of money on adver�sing to build a reputa�on for higher quality. Most of Eastman’s products are sold at prices that just cover its economic cost of produc�on 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 rela�vely high prices compared to its economic cost of produc�on.

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. Ma�e finish, water-based $5* $8 $6 $4

Profit per gallon of the product variants marked with an asterisk (*) indicates Eastman’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 par�cular product variant, although it could. Note that there are no barriers to entry preven�ng any of these firms from introducing new product variants, or copy-cat products, that are the same technical specifica�on as rivals’ products except for their different brand names.

a. Based on this limited informa�on, and making assump�ons 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 situa�on 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 is now well-known and admired by many fitness-oriented people and thus, should be able to a�ract a large clientele of people who want to lose weight and build muscle tone. He has made an arrangement with a fitness center to meet clients there and use its facili�es for a reasonable fee and plans to do a le�er-box drop of pamphlets to homes and apartments in the surrounding suburbs. He is aware that there are many other personal trainers, all slightly differen�ated from each other in terms of their personali�es, methods, loca�ons, and personal spor�ng achievements.

a. Advise Chuck whether he should charge a skimming price or a penetra�on price, with suppor�ng reasoning for and against each pricing alterna�ve. b. Is Chuck likely to make pure profits ini�ally? Can he con�nue to make pure profits in the longer term? Why or why not? c. What advice would you give to Chuck to help him make more profit in the longer term?

4. Alicia Montezuma is ready to launch a new business venture with an innova�ve new cosme�c product. Alicia knows that there will ini�ally be rela�vely li�le market awareness of her product; that most poten�al customers will have significant quality risk aversion and switching costs; and that many customers will not have immediate access to or affordability for this product. However, Alicia is quite sure that the product will be a�rac�ve to customers once they become aware and fully understand it. Alicia has es�mated 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 pa�ern, star�ng slowly with the rate of sales growth peaking in the 12th month and falling therea�er. 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 therea�er. Experimen�ng with a

spreadsheet model, Alicia has found the parameters of the diffusion curve that conforms to her sales growth assump�ons, as follows: Q = 40.45T + 9.12T2 −

0.27T3 where Q is the monthly sales level and T is the month number a�er the launch of the new product. Alicia has es�mated that the demand curve will be P = 2,764.28 − 1.9Q at the midpoint of the diffusion curve. Alicia expects that the price elas�city of demand will be rela�vely high, about ε = −3, since there are many subs�tutes and it seems that cosme�c products need to be rela�vely expensive to convince customers that they are effec�ve. 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 assump�ons you need to make.)

b. What price should she set for the early adopter customers? (Again, state the assump�ons underlying your recommenda�on.) c. What is your advice for Alicia concerning revisi�ng her assump�ons about the shape of the diffusion curve and the profit-maximizing markup rate, a�er

her new product gains some months of experience in the market?

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5. Maxim Motronics A.G. has been marke�ng 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 message converted to text and scrolled across the display panel to be read by occupants of a following vehicle. This new product can u�lize the hands-free telephone microphone 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 automobile accessory stores begin to stock the product and as word-of-mouth promo�on spreads awareness. Maxim also plans to produce a humorous video for pos�ng to YouTube and to u�lize social media marke�ng to spread awareness and enthusiasm for the new product. Market demand es�mates 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 pa�ern un�l they stabilize at about 10,000 per month a�er month 24. The diffusion

curve parameters that fit these assump�ons are shown in the equa�on Q = 75.4T + 46.11T2 − 1.352T3, where Q is sales per month and T is the number of months a�er 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 es�mates the demand curve to be P = 270 − 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 assump�ons you need to make.)

b. How might Maxim further adjust the price before raising it to the regular level envisioned? (Again, state any assump�ons you need to make.) c. What is your advice for Maxim concerning the confirma�on of prior projec�ons of demand, the shape of the diffusion curve, and the profit-maximizing

price a�er this new product gains some months of experience in the U.S. market?

Key Terms

Click on each key term to see the defini�on.

experience good (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A product for which search costs to ascertain product quality are rela�vely high, since its quality a�ributes are not easily or inexpensively observed; thus, it must be experienced to ascertain the quality a�ributes.

inhibit entry (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A blocking ac�on that prevents rival firms from entering a given market, such as se�ng a low price that new rivals could not match without making losses, because they have higher costs or adver�sing that your product contains desirable a�ributes that no other firm can provide.

niche market (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

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

penetra�on pricing (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A new product pricing approach that sets price lower than the short-run profit-maximizing price in an a�empt to maximize profit over a longer period of �me.

price posi�oning (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The process of selec�ng a price within the relevant range of prices for rival products so that the chosen price offers a compe��ve value proposi�on to prospec�ve customers.

price skimming (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

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

product life�me price (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

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

product line (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The collec�ve of different products that a firm produces or sells, such as the range of cosme�cs produced by L’Oreal or the vehicles produced by Ford.

quality risk aversion (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

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The natural reluctance of poten�al 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 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

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 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

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 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

Items for which the quality characteris�cs are easily and inexpensively observed; that is, for which the search costs to ascertain product quality are rela�vely low.