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Chapter Objectives

After studying this chapter, you should be able to:

1. Outline the traditional role of price in the marketing mix.

2. Describe the impact of pricing objectives, consumer price

sensitivity, and environmental factors on pricing decisions.

3. Outline common pricing strategies and techniques.

4. Explain the use of price to segment consumer markets.

5. Outline the role of price in revenue management.

6. Discuss legal and ethical issues surrounding pricing practices.

Pricing Strategy

Chapter Outline

Industry Profile

Introduction

Factors that Affect Pricing Decisions Pricing Objectives

Consumer Price Sensitivity

Environmental Factors

Broad Pricing Strategies Skim Pricing

Penetration Pricing

Neutral Pricing

Pricing Techniques and Procedures Cost-Oriented Pricing

Demand-Oriented Pricing

Competitive Pricing

Segmented Pricing Segmenting by Buyer Identification

Segmenting by Purchase Location

Segmenting by Time of Purchase

Segmenting by Purchase Volume

Segmenting by Product Design

Segmenting by Product Bundling

(continues)

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EBSCO Publishing : eBook Academic Collection (EBSCOhost) - printed on 7/23/2018 3:14 AM via LOUISIANA STATE UNIV AT SHREVEPORT AN: 492766 ; Reid, Robert D., Bojanic, David C..; Hospitality Marketing Management Account: s3563253

Revenue Management Establishing a Pricing Structure

Yield Management

Selective Discounting

Historical Booking Analysis

Yield Management Equation

Pricing Law and Ethics Legal Issues in Pricing

Ethical Issues in Pricing

Summary of Chapter Objectives

Key Terms and Concepts

Questions for Review and Discussion

Case Study: The Pasta Shack

Chapter Outline (continued)

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industry profile 551 in d u stry p

ro file

Ashish Khullar Director of Revenue Management Park Central Hotel • New York, New York

1. What are the major components or duties associated with your current position?

a. Pricing

b. Inventory and channel management

c. Competitive analysis

d. Budgeting, forecasting, and reporting

e. Training, communication, and team management

2. What are the components of your position that bring you the most satisfaction? What about your position causes you frustration?

Pricing, inventory, and channel management involve a lot of creative thinking

and analysis and hence bring me the most satisfaction. Training, communica-

tion, and team management are components that one can never stop learning

from and never claim to be a master of, at least in my case, and those cause me

the most frustration. In essence, there is a symbiotic relationship between each

component; one cannot be ignored over the other for my overall performance

and success.

3. What are the most challenging aspects that you face? The dynamic nature of the market, the industry, and my role are probably the

most challenging aspects of my job, but that is what keeps it interesting.

4. What major trends do you see for your segment of the hospitality and tourism industry?

a. E-commerce and Web 2.0

b. Direct Distribution—lower costs and higher conversion

c. Globalization—technology, brands, resources, services, and people

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5. What role does marketing play within your company? Marketing is the key performer in the success of our company. We follow the

marketing mix (product, price, place, and promotion) seriously, and our suc-

cess on every scorecard and financial measure can be attributed to our pas-

sion for following the basic principles of marketing.

6. If you could offer one piece of advice to an individual preparing for a career in the hospitality and tourism industry, what would you suggest?

Networking!

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INTRODUCTION

Price is a component of the marketing mix and the vehicle used in free enter-

prise to allocate limited resources. The other three components of the mar-

keting mix—promotion, product, and distribution—create value and appear

on the firm’s income statement as expenses. Conversely, price is the firm’s tool

for capturing value, and it affects the revenue section of the income statement.

Price is the easiest of the marketing mix components to change, and it directly

affects revenue. Therefore, firms should put a great deal of effort into for-

mulating their pricing strategies. Price can be defined as the value given to a

product or service by consumers.

Various names are associated with price, such as fee, tuition, and premium.

The important thing to remember is the concept of exchange. In other words,

the buyer and the seller have to be mutually satisfied for an exchange to take

place, and this exchange does not have to include a monetary unit. The early

system of exchange was referred to as bartering, where individuals or orga-

nizations exchanged goods and services with one another. Even nonprofit

organizations are in the business of selling a sense of goodwill or charity in

exchange for donors’ contributions.

Pricing strategy integrates marketing and finance in an attempt to create

an atmosphere of mutual satisfaction. The product or service attributes are

combined with price to provide enough value to satisfy customers, while

enabling the firm to cover costs and make an adequate profit. The rest of this

chapter covers the process of strategic pricing, including the factors that influ-

ence pricing decisions.

FACTORS THAT AFFECT PRICING DECISIONS

The pricing decision remains a critical component of the marketing mix and

the positioning of a product or service. Pricing is a continual process that

requires a firm understanding of the market and its environments. The

dynamic nature of the market and its environments creates a formidable chal-

lenge for even the most experienced managers. Therefore, it is best to take a

systematic approach to pricing that includes establishing pricing objectives

consistent with the overall objectives of the firm, assessing consumer price

sensitivity, and monitoring the external environment.

factors that affect pricing decisions 553

Bartering

Individuals or organizations exchange goods and services with one another without the use of money.

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Pricing Objectives

Most of the possible pricing objectives can be grouped into four major cate-

gories based on goals related to financial performance, volume, competition,

and image. These objectives are consistent with the organizational objectives

discussed in Chapter 5 and must be considered when setting prices. A brief

summary of the categories follows:

• Financial performance objectives focus on areas such as the firm’s level of

profitability, rates of return on sales and equity, and cash flow. Most large

companies continually monitor these performance measures and find it

easy to use these measures as benchmarks or objectives. It becomes rela-

tively easy to see the role of price in these measures of firm performance.

• Volume objectives focus on sales and market share. These measures can

be based either on the number of units sold or on the dollar amount of units

sold. The sales measure looks at the firm individually, while the market

share measure views the firm relative to the competition. Volume objec-

tives are particularly common in the early stages of the product life cycle,

when firms are willing to forgo profits in exchange for building long-term

sales and market share. In addition, price competition stays strong in the

maturity stage in an attempt to hold market share.

• Competition objectives focus on the nature of the competitive environment.

A firm may want to maintain competitive parity with the market leader,

widen the gap between itself and market followers, or simply survive. There

is a good deal of head-to-head competition in the hospitality and tourism

industry. For example, airline companies match each other’s price changes

so closely that the industry is often under investigation for price collusion.

• Image objectives focus on the firm’s overall positioning strategy. A firm’s

position in the market is a direct result of its price–quality relationship as

perceived by consumers. The hotel market can be segmented by price into

economy, midmarket, and premium categories. Also, airline companies

offer bereavement fares for emergency travel, and hotels offer discounts

for guests with family members in the hospital. These discounts enhance

the image of the firm.

Consumer Price Sensitivity

An important factor in setting price is consumer price sensitivity, or how con-

sumers react to changes in price. Many situational factors affect a consumer’s

554 chapter 15 pricing strategy

Pricing objectives

Pricing objectives can be grouped into four major categories based on goals related to financial performance, volume, competition, and image.

Consumer price sensitivity

Consumer price sensitivity reflects how consumers react to changes in price.

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price sensitivity, and these factors can actually vary from one purchase deci-

sion to another. For example, a married couple may be less price-sensitive

when choosing a restaurant for a special occasion than they would be if they

were having a normal meal after work. The following summarizes the most

common effects on consumer price sensitivity.1

PRICE–QUALITY EFFECT. In many situations, consumers use price as an indi- cator of a product’s quality, especially when they do not have much experi-

ence with the product category. In this case, consumers will be less sensitive

to a product’s price to the extent that they believe higher prices signify higher

quality. For example, overseas travelers often use price as a gauge of quality

because they lack familiarity with the travel products in foreign countries.

This pertains to all components of the travel product, such as hotels, restau-

rants, car rentals, and tourist attractions. This lack of information is one of

the main reasons that consumers would use price as a signal of quality, along

with the perceived risk of making a bad choice and the belief that quality dif-

ferences exist between brands.

UNIQUE VALUE EFFECT. Consumers will be less price-sensitive when a prod- uct stays unique and does not have close substitutes. If a firm successfully

differentiates its product from those of its competitors, it can charge a higher

price. Consumers must remain aware of the differentiation and convinced of

its value in order to pay the higher price. In essence, the firm’s strategy is to

reduce the effect of substitutes, thereby eliminating the consumer’s reference

value for the product. Resorts and health spas use this strategy by marketing

themselves as one-of-a-kind properties. Similarly, many fine-dining restau-

rants use this approach and differentiate themselves on attributes such as the

chef, the atmosphere, and/or the menu. Airline and car rental companies

would have a more difficult time using this strategy because of the homo-

geneity of the products.

PERCEIVED-SUBSTITUTES EFFECT. Consumers become more price-sensitive when comparing a product’s higher price with the lower prices of perceived

substitutes for the product. Consumers must be aware of the other products

and actually perceive them as substitutes. The prices for the substitutes help

consumers form a reference price, or a reasonable price range, for the product.

There are many perceived substitutes for products such as fast food, airline

travel, car rentals, and hotel rooms. When there are a number of substitutes

that consumers are aware of, there tends to be a downward pressure on

price, resulting in a relatively narrow acceptable range for prices. For

example, there are no significant price differences between products in

fast-food restaurants or airline tickets for a popular route (e.g., New York

to Chicago).

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DIFFICULT-COMPARISON EFFECT. This effect is closely related to the per- ceived-substitutes effect. Consumers may be aware of substitutes for a prod-

uct, but they will tend to become less price-sensitive as it becomes more

difficult to compare brands. Therefore, many firms try to differentiate them-

selves from the competition on certain attributes that are difficult to compare.

For example, bars may serve drinks in different quantities, or resorts may

package products in an attempt to make direct comparisons more difficult.

However, rather than spend the time and effort to make comparisons, many

consumers are content to simply choose a brand that they perceive as satis-

factory. Franchises benefit from this phenomenon because they focus on

providing consistent products and services under a recognizable brand name.

Even though they have not made direct comparisons or familiarized them-

selves with all of the alternatives, consumers will feel safe in choosing one of

these well-known brands.

SHARED-COST EFFECT. Consumers will be less sensitive to price if another organization or individual is sharing in the cost of a product. The smaller the

portion of the price paid by the consumer, the less sensitive the individual is

to price. This sharing could be in the form of a tax deduction, a business

reimbursement, or some type of sales promotion (e.g., coupon or rebate). When

business travelers stay in hotels, eat at restaurants, or rent cars, they tend to

be less sensitive to price because their firms normally pay for most of their

travel expenses. Hospitality and tourism firms that target business travelers

often charge higher relative prices for their products. One exception is hotels,

where business travelers usually pay lower prices than individual travelers,

due to the overall volume of the business segment.

TOTAL EXPENDITURE EFFECT. Consumers will tend to be more price- sensitive the larger the amount of the total expenditure. This amount can be

measured either in absolute terms or as a percentage of income. For example,

a consumer booking a cruise at a price of $5,000 will be more sensitive to price

than if he or she were eating a meal in a restaurant. The cost of the cruise is

a relatively large travel expenditure, whereas the cost of a meal pales in com-

parison. However, a consumer with an income of $500,000 a year would

normally not be as price-sensitive regarding the cruise as one with an income

of $50,000 a year. Also, consumers with higher incomes place a greater value

on their time and may decide to accept higher prices without evaluating alter-

native products.

END-BENEFIT EFFECT. A product may represent only one component of the purchases necessary to attain a desired benefit. The end-benefit effect con-

sists of two parts: derived demand and the share of total cost. Derived

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factors that affect pricing decisions 557

To many, a hotel spa provides a unique experience. Gaylord Opryland Resort & Convention Center, Nashville, TN.

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demand refers to the relationship between the desired end benefit and the

consumer’s price sensitivity for something that contributes to that end benefit.

This is most popular in industrial markets where firms purchase products

to resell to other consumers. The more price-sensitive the firm’s consumers

are, the more price-sensitive the firm will be in purchasing components of

the end benefit. For example, tour operators determine the type of hotel or

car rental to be included in a package based on the price sensitivity of the

target segment.

In the retail market, consumers tend to be more price-sensitive when the

price of a component represents a larger portion of the total cost. Consumers

would be less sensitive to beverage or dessert prices at an upscale restaurant

where dinner for two can cost $100 or more. Similarly, a consumer may not

be as price-sensitive to hotel parking rates when spending $300 a night in a

downtown hotel. The use of packages, or bundles, by resorts and tourist attrac-

tions attempts to extract as much consumer surplus as possible by “backing

in” to the consumer’s value for the end benefit.

Environmental Factors

As discussed in depth in Chapter 1, management must keep abreast of the

developments in the external environment. Even though these developments

cannot be controlled, they can affect pricing decisions because they affect a

firm’s costs, the demand for its products, and the competition. The compo-

nents of the external environment include the economic environment, the

social environment, the political environment, the technological environment,

and the competitive environment.

ECONOMIC ENVIRONMENT. Constant changes occur in the state of the econ- omy as measured by indicators such as business growth, inflation, consumer

spending, unemployment rates, and interest rates. If firms are to compete and

earn an acceptable profit, their pricing strategies should reflect changes in the

economy. Firms that compete in international markets must consider the state

of the economy in the foreign markets as well as the domestic market. Foreign

exchange rates can affect a firm’s income statement drastically and influence

the future of the firm. Prices alter in accordance with changes in income and

consumer spending, as well as with variations in a firm’s costs resulting from

changes in the economy.

SOCIAL ENVIRONMENT. Consumers’ tastes often change over time, and firms that do not adapt go out of business. Changes in cultures and subcultures

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throughout the world are affecting many societies. Different cultures have

different spending patterns and saving practices. For example, many Asians

tend to save more of their incomes than other nationalities do, but they also

tend to purchase name brands that are associated with high quality. There-

fore, the Asian market is less price-sensitive than some of its counterparts. As

cultures mesh, they influence each other’s eating habits. For example, con-

sumers in the United States are eating more sushi and drinking more tea than

in the past.

POLITICAL ENVIRONMENT. All levels of government have a tremendous impact on the operation of hospitality and tourism firms throughout the

country. Changes in minimum-wage laws affect the costs of restaurants,

while changes in tax laws related to business expenses affect the demand

in restaurants. Managers must consider both of these areas when setting

menu prices. Similarly, hotels must consider the impact of hotel taxes on

consumers when setting their prices. For example, hotels in New York City

were very concerned about the impact on group and convention business

when local hotel taxes were raised. At one point, the total taxes on guest

rooms added up to over 21 percent. In response, the city lowered hotel taxes

to make New York City a more attractive destination for group business.

In addition, governments impose many fees on businesses, and firms

operating in international markets must contend with additional fees and

tariffs.

TECHNOLOGICAL ENVIRONMENT. Another area of concern for managers is keeping up with advances in technology. Many of the new technologies in the

hospitality and tourism industry are intended to improve the efficiency of

firms, thereby reducing costs. For example, when food servers use handheld

terminals to place orders, they no longer have to enter the kitchen or move

to a stationary terminal in another location. These new point-of-sale (POS)

systems also enable firms to track costs and demand for particular food items.

This information is invaluable in setting prices. Similarly, hotels and airlines

use sophisticated systems to capture costs and demand that help them maxi-

mize revenues through price setting.

COMPETITIVE ENVIRONMENT. Finally, managers must know what occurs in the competitive environment. New firms entering the market will change

overall supply, thereby changing the market structure and putting downward

pressure on prices. Competitors also engage in promotional campaigns offer-

ing price discounts or free merchandise that will affect consumers’ percep-

tions of value. For example, the airline industry is notorious for its short-term

price wars in a battle for market share.

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BROAD PRICING STRATEGIES

Once a firm’s pricing objectives are set, managers must identify the role that

price will serve in the product’s overall marketing strategy. Prices can be set

high to restrict the firm’s market to a limited segment of buyers, as in luxury

hotels and fine dining restaurants (skim pricing); set low to attract buyers, as

in economy hotels and fast-food restaurants (penetration pricing); or kept

neutral to emphasize other aspects of marketing, as in midscale hotels and

theme restaurants (neutral pricing).2 Table 15.1 illustrates these strategies

based on the relationship between price and economic value for the mid-

dle market of consumers. Economic value can be defined as the sum of a

product’s reference value, or the cost of the competing product that the

consumer perceives as the closest substitute, and a product’s differentiation

value, or the value to the consumer (both positive and negative) of any dif-

ferences between a firm’s offering and the reference product.

Skim Pricing

A skim pricing strategy involves setting high prices in relation to the prod-

uct or service’s economic value to most potential consumers. This strategy is

designed to capture high profit margins from an exclusive segment of con-

sumers who place a high value on a product’s differentiating attributes. Skim

pricing is a preferred strategy when selling to the exclusive, price-insensitive

market, and it results in higher profits than selling to the mass market at a

lower price. For example, luxury hotels and resorts market hotel rooms with

many amenities such as valet parking, laundry service, and golf. Most con-

sumers are not willing to pay the higher prices associated with this level of

service, but there is a smaller segment of consumers that places a high value

on the additional amenities and will pay the higher prices. Similarly, upscale

and fine-dining restaurants charge higher prices based on the menu, the

560 chapter 15 pricing strategy

Economic value

Economic value equals the sum of a product’s reference value and a product’s differentiation value.

Reference value

The cost of the competing product that the consumer perceives as the closest substitute.

Differentiation value

The value to the consumer (both positive and negative) of any differences between a firm’s offering and the reference product.

Skim pricing

This strategy involves setting high prices in relation to the product or service’s economic value to most potential consumers. This strategy is designed to capture high profit margins from an exclusive segment of consumers that places a high value on a product’s differentiating attributes.

relative price

perceived economic value Low High

Low Neutral Skim Pricing

High Penetration Pricing Neutral

table 15.1 • Strategies Based on Price and Economic Value.

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ambience, the location, and the restaurant’s reputation. In addition, many of

the restaurants in this market segment offer valet parking.

Many service firms have limited capacity, and it may be necessary to max-

imize profits by managing supply and demand through higher prices. Skim

pricing also tends to be used by firms whose variable costs represent a large

portion of total costs and the product’s price. There is little incentive to

decrease cost per unit by increasing volume under this cost structure. From a

competitive standpoint, skim pricing works best when a firm’s product

remains unique or is superior to competitive products in perceived quality.

Once again, restaurants with good reputations, exclusive resorts, and airlines

with limited business and first-class seating (especially on international flights)

practice skim pricing.

Penetration Pricing

Penetration pricing involves setting low prices in relation to the firm’s economic

value to most potential consumers. This strategy works best on price-sensitive

consumers who are willing to change product or service providers to obtain a

better price. Firms using this strategy choose to have lower profit margins in

an attempt to gain high sales volumes and market shares. Penetration pricing

broad pricing strategies 561

Luxury hotels and resorts add value to their offerings with amenities, such as golf. Courtesy Mobile Bay CVB.

Penetration pricing

This strategy involves setting low prices in relation to the firm’s economic value to most potential consumers.

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stays common among economy hotels that market to consumers who view the

product as merely a place to sleep and have no need for additional amenities.

However, firms must have the necessary capacity to accommodate the large

volume in order to use this pricing strategy.

Most of the costs of providing the rooms in economy hotels are fixed.

Normally, an economy hotel does not have a restaurant with room service or

a concierge to help guests with travel plans. Similarly, quick-service restau-

rants do not have chefs, and food costs are relatively low. In both cases, the

furniture and décor are fairly basic. The higher volume generated by the lower

prices is expected to result in economies of scale and a lower cost per unit of

providing the service. From a competitive standpoint, penetration pricing

works best when a firm has a significant cost advantage over its competitors

or when the firm is small and not considered a threat by its competitors.

Charter airlines and small commuter airlines are examples of firms that can

adopt a penetration pricing strategy and are not considered a threat by larger

airline companies.

Neutral Pricing

A neutral pricing strategy involves setting prices at a moderate level in rela-

tion to the economic value to most potential consumers. In other words, the

firm makes a strategic decision to use attributes other than price to gain a

competitive advantage (i.e., attributes related to product, promotion, and/or

distribution). Another reason firms use this strategy is to maintain a product

line that includes product offerings at different price levels. For example,

many hotel chains have brands across all price categories such as budget/

economy, mid-priced, upscale, and luxury. Therefore, one or more of their

offerings will occupy the average price range with the basic amenities (i.e.,

low economic value) for full-service hotels. Franchising and the proliferation

of chains in the hospitality industry often lead to homogeneous offerings with

little differentiation and standard pricing across competitors in the same

market segment.

A neutral strategy can be used by default, when a firm cannot use skim

pricing or penetration pricing because of its cost structure or the market con-

ditions. However, this strategy has become more popular with the growth in

the value segment of consumers. In the hotel industry, many consumers do

not want to pay high prices, but they do want some amenities such as restau-

rants and pools. Also, the Internet has simplified the information search

process for consumers and it allows them to make quick price comparisons.

For example, online travel agents obtain inventory from various companies

562 chapter 15 pricing strategy

Neutral pricing

This strategy involves setting prices at a moderate level in relation to the economic value to most potential consumers.

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and manage it based on the overall supply and demand for the product cate-

gory and the market. Finally, a high price can actually be a neutral price when

product value justifies the price to most potential consumers.

PRICING TECHNIQUES AND PROCEDURES

When management establishes prices, three approaches can be used, either

individually or in combination with one another: cost-oriented pricing,

demand-oriented pricing, and competitive pricing.

Cost-Oriented Pricing

As the name implies, cost-oriented pricing uses a firm’s cost to provide a prod-

uct or service as a basis for pricing. In general, firms want to set a price high

enough to cover costs and make a profit. Two types of costs can be consid-

ered: fixed costs and variable costs. Fixed costs are those incurred by a company

to remain in business, and they do not vary with changes in sales volume. For

example, restaurants must invest in a building, kitchen equipment, and tables

before they begin to serve customers. Variable costs are the costs associated

with doing business, and they vary with changes in sales volume. For exam-

ple, restaurants incur costs for food, labor, and cleaning that are directly related

to the level of sales.

Break-even analysis can be used to examine the relationships between

costs, sales, and profits. The break-even point (BEP) is the point where total

revenue and total cost are equal. In other words, the BEP in units would be

the number of units that must be sold at a given contribution margin (price-

variable cost) to cover the firm’s total fixed costs:

Total fixed costs BEPunits �

(Selling price � Variable cost)

The break-even point in dollars can be calculated by multiplying the

break-even point in units by the selling price per unit. Break-even analysis is

a seemingly easy method for analyzing potential pricing strategies, but one

must be careful to use only costs that are relevant to the decision so that the

results are accurate.

pricing techniques and procedures 563

Cost-oriented pricing

Cost-oriented pricing uses a firm’s cost to provide a product or service as a basis for pricing.

Break-even analysis

Break-even analysis can be used to examine the relationships between costs, sales, and profits. The break-even point (BEP) is the point where total revenue and total cost are equal.

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Figure 15.1 illustrates the relationships between costs, sales, and profits. As

mentioned before, fixed costs are incurred regardless of sales. Therefore, they

remain constant with changes in sales volume and are represented by a hori-

zontal line. The total costs line intersects the fixed costs line where it begins

on the vertical axis and increases with volume to account for variable costs.

The total revenue line begins at the origin and increases with volume. The

break-even point in units is the point where the total revenue line intersects

the total costs line. When firms operate at volumes less than the break-even

point, losses are incurred because total revenue is not enough to cover the total

cost of producing and marketing the product. When volume exceeds the break-

even point, firms will make a profit because total revenue exceeds total cost.

For example, suppose a family purchases a large home and renovates it for

use as a bed-and-breakfast. The total fixed costs would be the $300,000 pur-

chase price plus the $100,000 spent on renovations, or a total of $400,000. The

owners estimate the variable costs to clean the rooms, restock supplies, and feed

the guests at approximately $25 per day. If the owners were to charge guests

$75 per night to stay at the bed-and-breakfast, the break-even point in units

would be 8,000 room nights [400,000 / (75 � 25)]. If there were a total of 20 rooms

and they obtained an average occupancy of 50 percent throughout the year, it

would take 800 nights (a little over two years) to recoup their original invest-

ment. However, it is more likely that the purchase was financed over time, and

the owners receive tax credits on the interest, expenses, and depreciation. There-

fore, assuming the owners did not take salaries or hire additional workers, it is

more likely that the yearly fixed costs are in the neighborhood of $30,000. The

new break-even point would be 600 room nights [30,000 / (75 � 25)], which

would represent 60 days at an average occupancy rate of 50 percent.

564 chapter 15 pricing strategy

Total revenue

Total costs

Profits Losses

Dollars

Fixed costs

VolumeBEPunits

figure 15.1 • Break-even analysis.

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This example illustrates the benefit of using break-even analysis for set-

ting the prices for new products. However, break-even analysis does not

account for the price sensitivity of consumers or the competition. In addition,

it is very important that the costs used in the analysis are accurate. Any changes

in the contribution margin or fixed costs can have a significant impact on the

break-even point. For instance, if the owners overestimated the price, and con-

sumers are only willing to pay $50 a night, then the break-even point would

change to 1,200 nights, or double the original estimate. Finally, the break-

even formula can be easily adjusted to account for a desired amount of profit.

The desired amount of profit would be added to the numerator (total fixed

costs) and would represent the additional number of units that would need

to be sold at the current contribution margin to cover the desired amount.

Cost-plus pricing is the most widely used approach to pricing in the indus-

try. The price for a product or service is determined by adding a desired

markup to the cost of producing and marketing the item. The markup is in

the form of a percentage, and the price is set using the following equation:

Price � ATC � m(ATC)

where:

ATC � the average total cost per unit and

m � the markup percentage / 100%.

The average total cost per unit is calculated by adding the variable cost

per unit to the fixed cost per unit. The fixed cost per unit is simply the total

fixed costs divided by the number of units sold. For example, suppose a hotel

has an ATC of $35 for turning a room and would like to have a 200 percent

markup, which is reasonable for a full-service hotel. The selling price, or room

rate, would be calculated as follows:

Price � $35 � [(200 / 100) � $35] � $105

This approach is popular because it is simple and focuses on covering costs

and making a profit. However, management must have a good understand-

ing of the firm’s costs in order to price effectively. Some costs are truly fixed,

but other costs may be semifixed. Semifixed costs are fixed over a certain range

of sales but vary when sales go outside that range. In addition to the problem

of determining the relevant costs, the cost-plus approach ignores consumer

demand and the competition. This may cause a firm to charge too much or

too little.

Target-return pricing is another form of cost-oriented pricing that sets

the price to yield a target rate of return on a firm’s investment. This approach

is more sophisticated than the cost-plus approach because it focuses on an

pricing techniques and procedures 565

Cost-plus pricing

Determining the price for a product or service by adding a desired markup to the cost of producing and marketing the item.

Target-return pricing

Setting a price to yield a target rate of return on a firm’s investment.

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overall rate of return for the business rather than a desired profit per unit.

The target-return price can be calculated using the following equation:

Price � ATC � (desired dollar return / unit sales)

The average total cost per unit is determined the same way as in the cost-

plus approach, and it is increased by the dollar return per unit necessary to

provide the target rate of return. This approach is also relatively simple, but

it still ignores competitors’ prices and consumer demand. For example, sup-

pose someone wants to sell souvenir T-shirts in a tourist area of a popular

destination such as the French Quarter in New Orleans. If he wants to make

$30,000 a year, assuming the average total cost is $6.00 (cost per unit of

T-shirts, cart rental, and license/permit) and he sells an average of 20 shirts

per day, the price would be calculated as follows:

Price � $6.00 � [$30,000 / (20 � 365)]

� $6.00 � ($30,000 / 7,300)

� $6.00 � $4.11 � $10.11, or approximately $10.00

The 20 shirts per day is an average, assuming some seasonality and varia-

tions due to weather. However, it is important to have accurate estimates for

costs and sales in order to price effectively. In addition, the price should be com-

pared with the competitors’ prices in the area to make sure it is reasonable.

Demand-Oriented Pricing

Demand-oriented pricing approaches use consumer perceptions of value as a

basis for setting prices. The goal of this pricing approach is to set prices to

capture more value, not to maximize volume. A price is charged that will

allow the firm to extract the most consumer surplus from the market based

on the reservation price, or the maximum price that a consumer is willing to

pay for a product or service. This price can be difficult to determine unless

management has a firm grasp of the price sensitivity of consumers. Econo-

mists measure price sensitivity using the price elasticity of demand, or the per-

centage change in quantity demanded divided by the percentage change in

price. Assuming an initial price of P1 and an initial quantity of Q1, the price

elasticity of demand (�p) for a change in price from P1 to P2 can be calculated

by:

(Q2 _ Q1) / Q1

�p � (P2

_ P1) / P1

566 chapter 15 pricing strategy

Demand-oriented pricing

The demand-oriented approaches to pricing use consumer perceptions of value as a basis for setting prices. The goal of this pricing approach is to set prices to capture more value, not to maximize volume.

Reservation price

The maximum price that a consumer is willing to pay for a product or service.

Price elasticity of demand

A measure of the percentage change in demand for a product resulting from a percentage change in price.

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The price elasticity of demand is usually negative because price increases

tend to result in decreases in quantity demanded. This inverse relationship

between price and quantity demanded, referred to as the law of demand, is

representative of most products and services. However, the demand for prod-

ucts and services can demonstrate varying degrees of elasticity (see Figure 15.2).

The demand for products is said to be elastic (�p � 1) if a percentage change

in price results in a greater percentage change in quantity demanded. Con-

versely, the demand for products is said to be inelastic (�p � 1) if a percentage

change in price results in a smaller percentage change in quantity demanded.

Unitary elasticity (�p � 1) occurs when a percentage change in price results in

an equal percentage change in quantity demanded. The absolute value of the

price elasticity of demand is used to determine the type of demand.

In a market with elastic demand, consumers are price-sensitive, and any

changes in price will cause total revenue to change in the opposite direction.

Therefore, firms tend to focus on ways to decrease price in an attempt to

increase the quantity demanded and total revenue. In a market with inelas-

tic demand, consumers are not sensitive to price changes, and total revenue

will change in the same direction. In this situation, firms tend to focus on rais-

ing prices and total revenues, even with a decrease in quantity demanded. In

markets with unitary demand, price changes have no effect on total revenue

and firms should base pricing decisions on other factors, such as cost. For

example, suppose a theme park decreases its price of admission from $50 to

$45 in an attempt to increase the number of visitors. After initiating the price

change, the park observes an increase in the average daily attendance at the

park from 10,000 to 12,500 people. The price elasticity of demand for this

example would be calculated as follows:

(12,500 � 10,000) / 10,000 .25 �p � � � 1.5

(45 � 50) / 50 .10

pricing techniques and procedures 567

Law of demand

The inverse relationship between price and quantity demanded is representative of most products and services.

Price

P2 P1

a. Elastic Demand b. Inelastic Demand c. Unitary Demand

P2 P1

Q2 Q1

Q2 Q1 Quantity

figure 15.2 • Price elasticity of demand.

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This indicates that the demand for theme park visitation is elastic. In other

words, theme park visitors are price-sensitive and the percentage change in

quantity demanded exceeds the percentage change in price. The total revenue

before the price change was $500,000 and after the change $562,500, repre-

senting an increase of $62,500.

Some popular demand-oriented pricing approaches are based on con-

sumer perceptions of value. These psychological pricing practices have been

proven to be successful based on their ability to influence consumer percep-

tions of price. Prestige pricing is used by firms that have products with strong

price-quality relationships in markets with inelastic demand. These firms set

high prices and try to build value through other quality-related attributes such

as service and atmosphere. This approach is common among five-star hotels

and fine-dining restaurants. Odd/even pricing involves setting prices just

below even dollar amounts to give the perception that the product is less expen-

sive. For example, car rental agencies set prices such as $79.95 rather than $80,

and hotels use prices such as $99 instead of $100. Also, many menu items are

priced with odd endings such as $5.99 or $10.95. Theory has it that people

read and process prices from left to right, rounding to the lower number.

Price lining refers to the practice of having a limited number of products

available at different price levels based on quality. Demand at each price point

is assumed to be elastic, whereas demand between price points is assumed to

be inelastic. The products at each price level are targeting a different market

segment. For example, rental car companies have economy, midsize, full-size,

and luxury categories.

Competitive Pricing

As the name implies, competitive pricing places emphasis on price in relation

to direct competition. Some firms allow others to establish prices and then posi-

tion themselves accordingly, either at, below, or above the competition. This

method ensures that the price charged for products and services will be within

the same range as prices for competitive products. This method, however, has

several drawbacks. First, consider the case of two similar firms. One is new

and the other has been operating for several years. On the one hand, the new

establishment is likely to have higher fixed costs such as a mortgage with a

high interest rate that must be paid each month. On the other hand, the estab-

lished firm might have a much lower mortgage payment each month and fewer

costs. Because of these differences, the established firm would have lower fixed

operating expenses and could charge lower prices, even if all other expenses

were equal. Second, other expenses might also vary among different firms.

568 chapter 15 pricing strategy

Psychological pricing

Setting prices based on consumer perceptions of value.

Odd/even pricing

Odd/even pricing involves setting prices just below even dollar amounts to give the perception that the product is less expensive (e.g., car rental agencies set prices like $79.95 rather than $80, and hotels use prices like $99 instead of $100).

Price lining

Price lining refers to the practice of having a limited number of products available at different price levels based on quality.

Competitive pricing

Competitive pricing places emphasis on price in relation to direct competition. This method assures that the price charged for products and services will be within the same range as prices for competitive products in the immediate geographic area.

Prestige pricing

Prestige pricing is used by firms that have products with strong price-quality relationships in markets with inelastic demand. These firms set high prices and try to build value through other quality-related attributes such as service and atmosphere.

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Labor costs might be higher or lower depending on the skill level of the per-

sonnel, their length of service in the operation, and numerous other factors that

may come into play. For this reason, it is extremely risky for managers to rely

on the prices of a direct competitor when setting their own prices. Each oper-

ation is unique and has its own unique cost and profit structure. Although

management does need to monitor the competition, prices should never be

based solely on prices charged by a competitor.

SEGMENTED PRICING

The importance of price varies among consumers, and firms often use

segmented pricing as a means for segmenting markets. Then a firm can choose

to target one or more of these markets with specific marketing strategies (e.g.,

discounts) tailored to each market segment. The appropriate strategy depends

on the firm’s costs, consumers’ price sensitivities, and the competition. Several

tactics can be used to segment markets on the basis of price.3 Table 15.2 provides

a summary of segmented pricing examples across the major segments of the

hospitality and travel industry.

Segmenting by Buyer Identification

One method that can be used to segment by price is to base the price on some

form of buyer identification. That is, in order to obtain a discounted price, con-

sumers must belong to a group of people that share similar characteristics. For

example, hotels and motels have many discounted rates available for consumers

belonging to groups such as the American Automobile Association (AAA) or

the American Association of Retired Persons (AARP). Another variation is for

consumers to save coupons that can be presented at a later date for a discount.

Many restaurants put coupons in newspapers or direct-mail pieces that must

be saved and brought to the establishment to get a discount within a certain

time period. However, only a particular type of price-sensitive consumer will

take the time to save, file, and redeem coupons for price discounts.

Segmenting by Purchase Location

It is possible to segment consumers based on where they purchase a product or

service. Some restaurant chains will vary their prices in different geographic

segmented pricing 569

Segmented pricing

The importance of price varies among consumers, and firms often use this variation as a means for segmenting markets. Then, a firm can choose to target one or more of these markets with specific marketing strategies tailored to each market segment.

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570 chapter 15 pricing strategy

segmentation

strategy lodging food service travel leisure

Buyer

Identification

Purchase

Location

Time of Purchase

Purchase Volume

Product Design

Product Bundling

Business vs.

leisure

City, suburban,

airport, resort

Weekend vs.

weekday

Meetings and

corporate

contracts vs.

transient

Concierge or

business level

Overnight stay

with champagne

brunch and/or

theater tickets

Seniors and

children

Mall, airport,

corporate dining

Peak hours vs.

early-bird (before

6 P.M.)

Banquets vs.

restaurants in

hotels

Corporate dining

facilities often

have fine dining

and cafeterias

“Value” meals or

combos (e.g., meal

deal at Subway)

Seniors, students

Online vs. calling

or using a travel

agent

Peak business

travel vs. leisure

Airlines and

rental car

companies that

offer corporate

rates

Southwest

Airlines “business

select” and airline

first class seats

Cruise lines offer

airline tickets and

online travel

agents package

hotels, airlines,

and rental cars

Golf memberships

for ladies,

children, seniors

Theme parks on-

site vs. off-site

Theme parks and

golf courses with

twilight discounts

Golf course

discounts for

tournaments

Country clubs

offer social

memberships and

full memberships

Grouping

museum

admissions (e.g.,

Ripley’s Believe It

Or Not and

Guinness World

Records)

table 15.2 • Segmented Pricing Examples across Industry Segments.

locations to account for differences in purchasing power and standard of living.

For example, fast-food restaurants often charge more for menu items in large

cities, food courts, and major highway locations than in suburban and rural

locations. Also, hotel, restaurant, and car rental chains charge different prices

in international markets based on a country’s standard of living. Finally, a gen-

eral practice by theme parks is to charge more for tickets purchased at the gate

and less for tickets purchased at nearby locations (e.g., hotels and supermarkets)

or through various organizations (e.g., government agencies and AAA).

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segmented pricing 571

Some hotels and motels offer discounted rates to consumers belonging to groups, such as the American Automobile Association. Courtesy of Wyndham Worldwide.

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Segmenting by Time of Purchase

Service firms tend to notice certain purchasing patterns based on the time

of day, week, month, or year. Unfortunately, it is not always possible to

meet the demand during these peak periods. One way to smooth the

demand is to offer discounted prices at off-peak times. Restaurants offer

early-bird specials for patrons who are willing to eat earlier in the evening,

airlines offer supersaver rates for consumers who are willing to travel at

off-peak times, and hotels offer lower rates for weekends and slower sea-

sons throughout the year. This results in a shift in demand from peak times

to off-peak times by the most price-sensitive consumers. Yield management

programs are used by airlines and hotels to set prices that will maximize

revenue, based on the costs of providing services and the price sensitivities

of the consumers.

Segmenting by Purchase Volume

One of the most common forms of price segmentation is to vary price based

on the quantity purchased, offering discounts for larger orders. The major-

ity of firms, both small and large, will negotiate price discounts for larger

volume orders. Hospitality and tourism firms will normally start dis-

counting prices for groups of ten or more people. In particular, hotel

salespeople are responsible for filling the hotel with groups by offering

discounts that tend to increase with the size of the group. Hotels and restau-

rants use the same tactics to sell catering functions such as weddings and

banquets.

Segmenting by Product Design

Another form of price segmentation is based on the actual product or service.

It may be possible to segment consumers by offering simple variations of a

firm’s product or service that appeal to the different segments. For example,

airlines found that they could charge substantially more for first-class seating

by widening the seats slightly and providing a little more service. Similarly,

hotels offer suites and concierge floors that are slightly larger and/or provide

some additional services. None of these variations by airlines or hotels has a

significant impact on the cost of providing the service, but the firms are able

to charge significantly higher prices to a small segment of the market that

values the additional amenities and services.

572 chapter 15 pricing strategy

Yield management

Yield management programs are used to set prices that will maximize revenue, based on the costs of providing services and the price sensitivities of the consumers.

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Segmenting by Product Bundling

The last form of price segmentation involves packaging products and services

into price bundles. Firms offer several products to consumers at a packaged

price that is lower than the cost of purchasing the products separately. Fast-

food restaurants offer bundled meals that include a sandwich, an order of

french fries, and a soft drink. They also allow consumers to increase the size

of the components for a small amount more. An alternative form of product

bundling is to offer premiums, or free merchandise, with the purchase. Fast-

food restaurants put free game pieces and pull-tabs on their packaging, and

they give children free toys with a child’s meal.

These are some of the basic tactics that can be used to segment markets on

the basis of price. The various tactics can be used alone or in combination with

one another to achieve a firm’s desired goals. Today’s consumers can obtain

information about competitive products and services very easily, resulting in a

large, value-conscious market. Firms will need to find ways to segment the

price-sensitive consumers from the quality-oriented consumers so that they can

extract the most consumer surplus and revenue from the marketplace.

REVENUE MANAGEMENT

Revenue management involves combining people and systems in an attempt

to maximize revenue by coordinating the processes of pricing and inventory

management. Pricing is the process of determining the value of products and

services that will result in the maximum total revenue for the firm. In real-

ity, hospitality and tourism firms offer many different products and must

determine the appropriate price points based on customer demand and com-

petition. Inventory management is the process of determining how much of

a product or service should be offered at each price point. For example, hotels

allocate a certain number of guest rooms for groups and try to fill the quota

by setting a price that will extract the most revenue from the market.

One of the challenges of revenue management is that price sensitivity

varies from customer to customer. Market segmentation allows hospitality and

tourism firms to group customers into market segments that share certain

characteristics such as price sensitivity. In a perfect world, a firm would max-

imize its revenue by selling its products and services to customers at the high-

est price each customer is willing to pay for the product or service. Therefore,

the goal of revenue management is to “sell the right product to the right

customer at the right time for the right price.”

revenue management 573

Revenue management

Revenue management involves combining people and systems in an attempt to maximize revenue by coordinating the processes of pricing and inventory management.

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This concept of revenue management is particularly important in service

industries because of the intangible nature of the product. Hospitality and

tourism firms such as hotels and airlines have limited capacities and resources.

This situation, combined with the fact that the product is perishable and rev-

enue cannot be inventoried, leaves firms in a difficult position. Unused capacity

for service firms is lost forever. For example, airlines cannot recoup the revenue

lost by having unoccupied seats on a flight, hotels cannot make up for unsold

rooms, and car rental companies cannot compensate for cars sitting on the lot.

This phenomenon often leads to overbooking by hotels and airlines, since

the firms do not want to have unused capacity because of cancellations or

no-shows. In some cases, revenue can be recouped through requiring deposits

or charging penalties, but there are limits to the effectiveness of these prac-

tices. For example, charging a group a penalty for not picking up its entire

room block could cause the group to discontinue using your hotel or brand

in the future.

Establishing a Pricing Structure

Revenue per available room (REVPAR) provides a better indication of a

hotel’s capacity utilization than average daily rate (ADR). ADR is calculated

using total revenue, occupancy rate, and the number of available rooms.

Total revenue � Sum of (room � price) for all rooms sold

Number of rooms sold � Occupancy rate � Available rooms

Average daily rate � Total revenue / Number of rooms sold

ADR and average occupancy rate can be used to estimate long-term rev-

enues (monthly, quarterly, or annually) for hotels and other lodging facilities.

Airlines perform the same type of analysis using revenue per available seat

and average fare based on the number of seats sold. However, there are many

factors such as seasonality, business cycles, and economic trends that can affect

future performance. This makes it difficult to get accurate estimates for use

in strategic pricing, but firms need to determine how much inventory to make

available at each price point in an effort to maximize revenue.

The following is a simplified example to illustrate the decision facing an

airline trying to maximize revenue. Only two possible prices exist: a discounted

fare and the full fare. The airline must decide whether to sell a seat at the dis-

counted fare ($200) or take the chance that the seat can be sold at a later date

at full fare ($500). The decision tree that appears in Figure 15.3 outlines the

options facing the airline.

574 chapter 15 pricing strategy

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If the airline sells now at the discounted fare, there is guaranteed revenue

of $200. If the airline decides not to sell at the discounted fare, the two possi-

ble outcomes are to sell at the full fare or to have the seat remain empty. If

the seat does not get sold, there is zero revenue. Therefore, the final decision

is based on the expected value of each option based on the probability that the

seat will be sold at a later date for full fare. If there is a 50 percent chance of

selling the seat for full fare, the expected value of waiting would be:

.50 ($500) � .50 ($0) � $250

Since the expected value of waiting ($250) exceeds the expected value of

selling at the discounted fare (1.0 � $200 � $200), then the airline should

wait. In this case, as long as the probability of selling at a later date for full

fare is greater than 40 percent (200 / 500), the airline is better off waiting. The

estimated probability is based on past experience. In reality, this decision is

much more complicated.

A firm’s pricing structure gets established based on a careful analysis of

customers, the firm’s business, and the market for its products and services.

First, the customer analysis should include an examination of customer mar-

ket segments and their shared characteristics. It is important to know what

attributes are used by the customers to make decisions (e.g., rate/price, location,

convenience, service quality). In addition, it is useful to know the price

sensitivity of the market segment and what distribution channels are used to

buy the firm’s services. Second, the firm should take an objective look at the

quality of its product-service mix, its marketing programs, and the results of

past pricing actions. Finally, the firm should examine the demand for its

product and its competitive position (i.e., strengths and weaknesses relative to

the competition).

Yield Management

Yield management refers to a technique used to maximize the revenue, or

yield, obtained from a service operation, given limited capacity and uneven

demand. This technique was first used by airline companies and then adopted

by lodging and cruise firms. Within the hospitality and tourism industry, yield

revenue management 575

Sell at Discounted Fare

Decision

Do Not Sell at Discount

Sell at Full Fare

Leave Seat Empty

figure 15.3 • Decision tree for airline revenue.

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management has come into more widespread use with the expansion of

computerized property management systems. In its most basic form, yield

management uses a firm’s historical data to predict the demand for future

reservations, with the goal of setting prices that will maximize the firm’s

revenue and profit.

Yield management is widely used within the hospitality and tourism

industry for several reasons:

• Perishable inventory. As discussed in Chapter 2, hospitality and tourism

services are highly perishable. If a hotel room is not occupied one evening

or an airline flies with empty seats, the potential revenue for those ser-

vices cannot be captured at a later date. In other words, there are no inven-

tories for services.

• Fluctuating demand. Most hospitality and tourism firms experience

demand that rises and falls within a day, week, month, or year. During

high-demand periods, services are sold at or near full price. During the

low-demand or nonpeak periods, capacity remains unused.

• Ability to segment customers. Firms must segment customers based on

price, as discussed earlier in this chapter, and offer a discounted price to

a selective group of customers.

• Low variable costs. Hospitality and tourism firms often have a large ratio

of fixed to variable costs, which would favor a high-volume strategy. The

marginal cost of serving an additional customer is minimal as long as there

is excess capacity.

Selective Discounting

One of the cornerstones of yield management is the ability to offer discounts

to only a selected group of customers. Rather than offer one price for a given

time period, either peak or nonpeak, firms can distinguish between con-

sumers. This minimizes the effect of lost revenue resulting from consumers

who are willing to pay full price being able to pay the discounted price. To

accomplish this, service firms normally place restrictions on the discounted

price so that consumers must sacrifice something in return for the discount.

For example, airline companies require passengers to book in advance (up to

21 days), stay over Saturday night, and accept a no-cancellation policy to obtain

the discounted fare. Similarly, hotels require guests to stay over weekends,

during nonpeak seasons, or for a minimum number of nights.

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Historical Booking Analysis

One of the major problems facing service firms using yield management

systems is the determination of the amount of capacity to make available at

the discounted rate. As mentioned earlier, yield management makes use of

historical data in predicting future trends. A curve is constructed using data

from the same period the previous year, and adjusting for recent trends seen

in the most recent periods. Figure 15.4 illustrates a typical pattern for a large

conference hotel. The solid line represents the historical pattern for room sales

prior to the date in question. In general, the hotel would determine a com-

fort zone or construct a confidence interval around the actual occupancy rate.

If prior sales are within this interval, then the hotel continues to use its current

discounting policy. If the occupancy rate exceeds the upper level, then the

hotel will temporarily reduce the number of discounted rooms and rates. If

the occupancy rate falls below the lower level, then the hotel will offer more

discounted rooms and rates until the occupancy rate is brought back within

the predicted interval.

Yield Management Equation

As stated earlier, the goal of yield management is to maximize the revenue,

or yield, from a service operation. The following equation is a simplified ver-

sion of the calculation used in actual programs.

revenue management 577

increase discounts

reduce discounts

25%

10 20

Weeks Prior to Date

30 40

50%

75%

100%

% of Rooms Sold

figure 15.4 • Booking pattern curve for a conference hotel.

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[ ] Actual revenue

Maximize Potential revenue

The potential revenue for a hotel would be the number of total rooms

available for sale multiplied by the rack rate for those rooms. For instance, if

a hotel had 200 rooms that all had a rack rate of $100, the potential room rev-

enue for that hotel would be $20,000 per night. However, if the hotel had an

occupancy rate of 70 percent and an average room rate of $80, then the actual

revenue would be $11,200 [(0.7 � 200) � 80]. The yield in this case would

be .56 (11,200 / 20,000). The goal is to maximize this figure or to get it as

close to 1.0 as possible. What if this hotel offered more discounts and had

an occupancy rate of 80 percent and an average room rate of $75? The

actual revenue would have been $12,000 [(0.8 � 200) � 75], or a yield of

0.6 (12,000/20,000). As you can see, the potential revenue remains the same,

but the actual revenue will change, depending on the level of discounts and

the price sensitivity of consumers.

This example is simplified to demonstrate the basic use of yield manage-

ment. In reality, hotels have different rooms with different rack rates, and

many different market segments, including business, pleasure, or transient,

and various group markets. Each of these major segments can be divided

into smaller subsets. For instance, the group market can be segmented into

578 chapter 15 pricing strategy

Hotels earn additional revenue through various on-site services, including the bar. Courtesy of Foxwoods Resort Casino.

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association, corporate, and incentive travel. Hotels have created positions and,

in some cases, departments that are responsible for revenue management.

These individuals perform historical booking analysis and confer with the

hotel’s executive committee to determine discounting policies.

Another area that needs to be considered in determining a hotel’s dis-

counting policy is the additional revenue, other than room revenue, that is

generated from guests. For example, hotels can earn additional revenue from

the restaurant, bar, fitness center, parking, laundry services, room service,

corporate services such as faxing and shipping, and catering for groups. Rather

than analyze each guest, hotels look at the major market segments and cal-

culate a multiplier that can be used to adjust room revenue for additional

revenue potential. This is important because hotels must maximize the rev-

enue they receive from all sources. For instance, it would be a mistake to sell

the room to a transient guest who paid $10 more a night than a business trav-

eler if the business traveler is likely to spend more than $10 a day for addi-

tional services. Similarly, turning down a group because of high demand

among transient customers may result in a loss of revenue from catering ser-

vices that would have been purchased by the group. However, in peak demand

seasons, such as fall in New England, hotels can charge considerably more to

transient customers than to groups, and it would be a mistake to book a group

well in advance and forgo this additional revenue.

Yield management has had a major impact on the hospitality and tourism

industry. Advances in computer technology have improved the ability to esti-

mate demand and revenue. In addition, it has become easier to segment mar-

kets and employ selective discounting through vehicles such as the Internet.

In the future, yield management programs will become more affordable for

smaller operations. In fact, yield management systems can be developed using

ordinary spreadsheet software. Finally, companies are working on resource

management models that will analyze the revenue contribution from all

sources in the hotel, rather than focusing only on guest rooms.

PRICING LAW AND ETHICS

Pricing practices are normally illegal if they are found to be anticompetitive

or if they take unfair advantage of consumers. However, ethical standards are

not as clear as legal standards developed through case law. Many people feel

that although it is legal to maximize profits through pricing, it may not always

be ethical. First, we will discuss the legal issues surrounding pricing decisions,

and then we will present a typology that can be used for considering the ethical

constraints on pricing.

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Legal Issues in Pricing

The federal government has sought to ensure fair price competition since it

passed the Sherman Act in 1890, followed by the Clayton Act in 1914. These

two pieces of antitrust legislation were enacted in response to growing

concerns for small businesses with the advent of large corporations compet-

ing on a national level. Most of the laws are open to interpretation and often

difficult to enforce, especially in regard to services. The Robinson-Patman

Act, passed in 1936 to strengthen the Clayton Act, targeted unfair pricing

practices. Most laws focus on goods or commodities, for which grade and qual-

ity can be easily determined, whereas services vary greatly. Therefore, the

government has devoted most of its resources to monitoring the pricing of

tangible products. Pricing practices that are potentially illegal fall into four

groups: explicit agreements, nonexplicit agreements, price discrimination, and

tie-in sales.4

EXPLICIT AGREEMENTS. Explicit agreements are formal agreements among firms to set the same prices or to use the same formula in setting

prices. This practice of price fixing is generally regarded as illegal and will

be enforced. It is illegal for competitive hotels to discuss prices, even if they

are accommodating guests for the same conference. For example, a Marriott

and a Sheraton have formed a hotel “connection” in Springfield, Massa-

chusetts, to compete for meetings requiring more rooms than either hotel

contains. The two hotels are physically connected, and they operate as two

wings of one hotel for larger conferences. Guests can charge meals and other

services from either hotel to their rooms. However, each hotel must nego-

tiate price separately with the meeting planner without any contact, or it

would be illegal.

NONEXPLICIT AGREEMENTS. Nonexplicit agreements take the form of con- certed actions by competitors that are not formal but represent some level of

collusion. The courts look for a pattern of uniform business conduct, or

conscious parallelism. It is not enough for competitive firms to exhibit parallel

behavior; they must also be found guilty of making a conscious effort to engage

in that behavior. Airline companies have been investigated, and prosecuted,

for this behavior in the past. Even today, it is not uncommon to be quoted

identical fares on competitive airlines for the same routes. As with explicit

agreements, it is unlawful for firms to exchange price information if it is

intended to affect prices or if it identifies specific customers. Convention and

visitors bureaus are able to provide aggregate price information on hotel rates

in their regions, as long as they do not identify the rates for specific customers,

including groups for meetings and conventions.

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PRICE DISCRIMINATION LAWS. Under price discrimination laws, firms are forbidden from charging purchasers different prices for commodities of like

grade and quality in an attempt to substantially lessen competition. Two legal

defenses exist for discriminatory prices: cost justification and meeting com-

petition. The cost justification defense allows firms to charge different prices

when the costs of providing the product differ between purchasers, and the

meeting competition defense allows firms to charge different prices to meet the

lower price of a competitor. As mentioned earlier, it is difficult to use these

criteria to evaluate the pricing practices of service firms. Every service expe-

rience is different and, with the consumer being part of the production pro-

cess, firms could argue that the cost of providing the service differs between

purchasers. There is a fine line when it comes to the price segmentation tech-

niques applied in the yield management programs used by hotels and airline

companies, but services have remained largely untouched by the price dis-

crimination laws, as stated in the Robinson-Patman Act.

TIE-IN SALES. This is the practice of sellers requiring that, as a condition of purchasing one product, customers must buy other products exclusively

from the seller. Tying arrangements were deemed unlawful according to

the Clayton Act if the arrangements were meant to substantially lessen com-

petition. The courts have been lenient in allowing tying arrangements that

are voluntary or result in pro-competitive benefits. For instance, courts

have allowed franchisors, such as McDonald’s, to require franchisees to

purchase products from them that are necessary to maintain standards of

performance and a consistent image.

Ethical Issues in Pricing

Ethical standards are much more difficult to evaluate and uphold than legal

standards in the area of pricing. People’s views regarding ethics can be as

diverse as their cultural or socioeconomic backgrounds. At one end of the con-

tinuum, there is a view that as long as a practice is legal, it is ethical to charge

a price that will result in maximal profit. At the other end, there is a view that

individuals and firms should not exploit one another for personal gain and

that societal benefits should be stressed over those of any one entity. Table 15.3

illustrates the levels constituting the continuum, from the legal perspective to

the societal perspective.

Level one assumes that all exchanges are voluntary and it is the responsi-

bility of the buyer to obtain as much information as necessary to make a good

decision. The legal principle of caveat emptor, or let the buyer beware, is the

pricing law and ethics 581

Price discrimination laws

Price discrimination laws forbid firms from charging purchasers different prices for commodities of like grade and quality in an attempt to substantially lessen competition.

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cornerstone of a capitalist economy. This principle enables firms to compete

and results in a larger variety of products offered at lower prices. However,

services cannot be physically held or evaluated until after they are purchased

and consumed. This, along with the high level of variability associated with

services, provides a high degree of risk and uncertainty for consumers in pur-

chasing hospitality and tourism products.

Level two suggests that consumers should not be exposed to making pur-

chases under conditions of asymmetric information. That is, the seller should

be required to disclose pertinent information to buyers so that they are not at

a disadvantage. For example, airline companies are required to disclose any

restrictions placed on tickets for air travel, such as the fact that supersaver

rates are nonrefundable. Similarly, hotels must disclose room cancellation poli-

cies to would-be guests.

Level three imposes an additional restriction that sellers cannot earn exces-

sive profits by charging artificially high prices for essential products. The best

example of this practice would be when pharmaceutical companies charge

high prices for life-saving drugs that are unaffordable for those without insur-

ance or people with lower incomes. For example, airline companies and hotels

offer discounted prices for certain consumers who must travel and find lodg-

ing away from home because of emergencies (e.g., funerals, family illnesses,

accidents).

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level of ethical restraint

pricing policy Low High

1 2 3 4 5

Price is paid voluntarily X X X X X

Price is based on equal information X X X X

Price is not exploiting buyers’ X X X

essential needs

Price is justified by costs X X

Price provides equal access to goods X

regardless of one’s ability to

cover costs

table 15.3 • Pricing ethics.

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Level four condemns the practice of segmented pricing even when the

product is nonessential. It states that prices should not be segmented based on

value, and firms should not take advantage of consumers during periods

where there are shortages, even for nonessential products. Hotels engage in

questionable practices when they charge higher than normal rates during peri-

ods of high demand such as college graduations and special events. They often

require minimum stays and charge a price above the published rate (rack rate).

Additionally, some restaurants use different menus with higher prices for

holidays and other special events.

Level five would seem extreme to most people because it is not consistent

with free markets in a capitalist economy. Instead, this ethical restraint resem-

bles a standard that one would find in a socialist society. It suggests that every

member of the community or society should share with others to ensure a

minimum standard of living. This standard would be more applicable to

underdeveloped countries or to communities where the members are com-

mitted to a societal goal (such as religious communities). This ethical restraint

would normally result in less variety of products and services of lower qual-

ity. For example, institutional food service operations in K–12 schools often

offer subsidies for children from lower income families.

In closing, one’s approach to the world would certainly affect one’s belief

about the appropriate level of ethical restraint. Obviously, a trade-off exists

between what is best for an individual and what is best for society. The more

levels of restraint imposed, the smaller the gap between the higher and lower

incomes in a society. There is not as much incentive for people to invest, result-

ing in a lower overall standard of living. Therefore, the correct level of

restraint is probably somewhere between levels one and five as determined by

the respective society.

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Summary of Chapter Objectives

Price remains an important component of the marketing mix because it directly

affects the revenue of a firm. Price is also a critical element in segmenting mar-

kets and positioning a firm’s products and services. As such, firms must consider

all of the factors that affect price, such as the objectives of the firm, consumers’

price sensitivity, and the external environment. Government regulations, trends

in demographics and purchasing patterns, economic conditions, technological

advances, and changes in the competitive environment all impact prices.

Consumers’ perceptions of value are the basis for making pricing decisions.

After all, price must be an accurate representation of the value that a consumer

places on a product or service, or an exchange would not occur. The three

broad pricing strategies—price skimming, price penetration, and neutral

pricing—are based on the relationship between price and economic value.

Firms attempt to differentiate their products from one another, and then focus

on those segments of the population that value their product–service mixes.

Price segmentation should concentrate on those attributes that are valued

differently by various segments of the population.

The most common pricing techniques are the cost-oriented, demand-

oriented, and competitive pricing approaches. Cost-oriented approaches base

pricing decisions on the cost of providing the product, starting with the break-

even point and then adding a markup or target return. Demand-oriented

approaches focus on consumer price sensitivity and market demand, includ-

ing certain psychological tactics. Competitive pricing involves setting prices

in relation to a firm’s competition. The firm must choose to price at, below,

or above the competition.

Finally, legal and ethical issues surround product pricing. Laws exist to

protect consumers and ensure fair competition. Firms cannot collude to fix

prices and take advantage of consumers and other competitors. In addition to

the legal standards, firms must often deal with ethical standards imposed by

society. These standards will vary somewhere between “let the buyer beware”

in a pure capitalist economy and a socialist economy, which restricts profits

for personal gain.

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w Key Terms and Concepts

Bartering

Break-even analysis

Competitive pricing

Consumer price sensitivity

Cost-oriented pricing

Demand-oriented pricing

Differentiation value

Economic value

Law of demand

Neutral pricing

Odd/even pricing

Penetration pricing

Prestige pricing

Price discrimination laws

Price elasticity of demand

Price lining

Pricing objectives

Psychological pricing

Reference value

Reservation price

Revenue management

Segmented pricing

Skim pricing

Target-return pricing

Yield management

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Questions for Review and Discussion

1. What is price? What are some of the major factors that affect pricing decisions?

2. What are the major pricing objectives discussed in the chapter?

3. What are the most common effects on consumer price sensitivity?

4. What are the three broad pricing strategies? When is it appropriate to use each strategy?

5. What are the advantages and disadvantages of using break-even analysis?

6. What is economic value? Give an example of how you would determine the economic value for a particular hospitality service.

7. Discuss some of the price segmentation strategies that can be used by hospitality and tourism firms.

8. What are the three major pricing techniques? Can you use more than one? Explain.

9. What is revenue management? How are yield management and revenue management related?

10. What are some of the legal and ethical issues surrounding pricing decisions?

11. Internet exercise: Online travel agents normally have access to the same hotel and airline rates. The purpose of this exercise is to compare the

prices between two online travel agents for the same products, and

determine if there is a discount relative to purchasing the products

directly from the suppliers.

a. Go to Expedia.com and Travelocity.com and compare the rates for a trip from your airport to Orlando. Look at the same hotel and airline,

both separately (hotel only and flight only) for a five-night trip that is

approximately six months away (use the same dates for both online

travel agents). Is there a difference in the prices?

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chapter review 587 ch a p te

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w b. Go to the individual suppliers (e.g., Sheraton Hotels and Delta Airlines)

and get the prices for the same dates. Is there a difference between

the online travel agents and the suppliers?

c. Compare the package price (Flight � Hotel) for the same trip between the online travel agents. Is there a difference? Is the savings signifi-

cant compared to purchasing the products separately from the travel

agent or the suppliers?

d. What concepts in the chapter can be used to describe the pricing strategies for the online travel agents?

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Notes 1 Thomas T. Nagle and Reed K. Holden, The Strategy and Tactics of Pricing: A Guide to Profitable Decision

Making, 3d ed. (Englewood Cliffs, NJ: Prentice-Hall, 1995), pp. 77–94.

2 Ibid., pp. 152–61.

3 Thomas T. Nagle, “Economic Foundations for Pricing,” Journal of Business 57, 1, Part 2 (1984): S3–S26.

4 Nagle and Holden, pp. 366–381.

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Case Study The Pasta Shack

T he Pasta Shack is an Italian restaurant in Orlando, Florida, near the

major tourist attractions that has noticed a recent decline in sales.

The owner and his managers decided to have a meeting to come up

with some strategies to reverse this trend. One of the managers used to work

for an independent restaurant in a suburban neighborhood in Chicago and

suggested a strategy used successfully by his former restaurant: offering an

early-bird menu to customers who order before 6:00 P.M. The idea is to provide

a limited number of entrées at a discounted price.

The original price of the entrées placed on the early-bird menu was $10.95

and included a salad. The new price for the specials would be $8.95. After the

first two weeks of offering the specials, the daily average number of covers

increased from 50 to 58 during the 4 to 6 P.M. time period. However, the daily

average number of covers after 6 P.M. decreased from 75 to 70, due to some

cannibalization of current customers. Assume that $8.95 is the average price

per person from 4 to 6 P.M. and $10.95 is the average price per person after

6 P.M. when answering the following questions.

Case Study Questions and Issues

1. What was the effect of the price change on total revenues during the early-bird time period?

2. Using the concepts presented in the chapter, how would you explain this change?

3. Is the new strategy successful? Explain your answer.

4. What could be the cause for the initial decline in sales?

5. Are there any additional costs associated with the new strategy?

6. How could you increase the profitability associated with the early-bird strategy?

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Courtesy of Corbis Digital Stock.

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