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For some years now, the Internet has been changing the way buyers and sellers interact. On this slide is a short list of how the Internet allows sellers to discriminate between buyers and buyers to discriminate between sellers.

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Pricing practices have changed significantly, thanks in part to a severe recession in 2008–2009, a slow recovery, and rapid technological advances. But the new millennial generation also brings new attitudes and values to consumption. Renting, borrowing, and sharing are valid options to many.

Some say these new behaviors are creating a sharing economy in which consumers share bikes, cars, clothes, couches, apartments, tools, and skills and extracting more value from what they already own.

Bartering, one of the oldest ways of acquiring goods, is making a comeback through transactions estimated to total $12 billion annually in the United States. Trade exchange companies like Florida Barter and Web sites like www.swap.com connect people and businesses seeking win-win solutions. The sector of the new sharing economy that is really exploding is rentals.

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In small companies, the boss often sets prices. In large companies, division and product line managers do. Even here, top management sets general pricing objectives and policies and often approves lower management’s proposals.

Many companies do not handle pricing well and fall back on “strategies” such as: “We calculate our costs and add our industry’s traditional margins.” Other common mistakes are not revising price often enough to capitalize on market changes; setting price independently of the rest of the marketing program rather than as an intrinsic element of market-positioning strategy; and not varying price enough for different product items, market segments, distribution channels, and purchase occasions.

For any organization, effectively designing and implementing pricing strategies requires a thorough understanding of consumer pricing psychology and a systematic approach to setting, adapting, and changing prices.

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Purchase decisions are based on how consumers perceive prices and what they consider the current actual price to be—not on the marketer’s stated price. Customers may have a lower price threshold, below which prices signal inferior or unacceptable quality, and an upper price threshold, above which prices are prohibitive and the product appears not worth the money. Different people interpret prices in different ways.

Reference Prices Although consumers may have fairly good knowledge of price ranges, surprisingly few can accurately recall specific prices. When examining products, however, they often employ reference prices, comparing an observed price to an internal reference price they remember or an external frame of reference such as a posted “regular retail price.” When consumers evoke one or more of these frames of reference, their perceived price can vary from the stated

price.

Price-Quality Inferences Many consumers use price as an indicator of quality. Image pricing is especially effective with ego-sensitive products such as perfumes, expensive cars, and designer clothing.

Price Endings Many sellers believe prices should end in an odd number. Customers perceive an item priced at $299 to be in the $200 rather than the $300 range; they tend to process prices “left to right” rather than by rounding.24 Price encoding in this fashion is important if there is a mental price break at the higher, rounded price. Another explanation for the popularity of “9” endings is that they suggest a discount or bargain, so if a company wants a high-price image, it should probably avoid the odd-ending tactic.

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All types of reference prices are possible (see Table 16.1), and sellers often attempt to manipulate them. For example, a seller can situate its product among expensive competitors to imply that it belongs in the same class. Department stores will display women’s apparel in separate departments differentiated by price; dresses in the more expensive department are assumed to be of better quality. Marketers also encourage reference-price thinking by stating a high manufacturer’s suggested price, indicating that the price was much higher originally, or by pointing to a competitor’s high price.

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A firm must set a price for the first time when it develops a new product, when it introduces its regular product into a new distribution channel or geographical area, and when it enters bids on new contract work. The firm must decide where to position its product on quality and price. Most markets have three to five price points or tiers. Firms devise their branding strategies to help convey the price-quality tiers of their products or services to consumers.

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The company first decides where it wants to position its market offering. The clearer a firm’s objectives, the easier it is to set price. Five major objectives are: survival, maximum current profit, maximum market share, maximum market skimming, and product-quality leadership.

Survival Companies pursue survival as their major objective if they are plagued with overcapacity, intense competition, or changing consumer wants. As long as prices cover variable costs and some fixed costs, the company stays in business.

Maximum Current Profit Many companies try to set a price that will maximize current profits. They estimate the demand and costs associated with alternative prices and choose the price that produces maximum current profit, cash flow, or rate of return on investment.

Maximum Market Share Some companies want to maximize their market share. They believe a higher sales volume will lead to lower unit costs and higher long-run profit, so they set the lowest price, assuming the market is price sensitive. Texas Instruments famously practiced this market-penetration pricing for years. The company would build a large plant, set its price as low as possible, win a large market share, experience falling costs, and cut its price further as costs fell.

Maximum Market Skimming Companies unveiling a new technology favor setting high prices to maximize market skimming. Sony has been a frequent practitioner of market-skimming pricing, in which prices start high and slowly drop over time.

Product-Quality Leadership A company might aim to be the product-quality leader in the market. Many brands strive to be “affordable luxuries”—products or services characterized by high levels of perceived quality, taste, and status with a price just high enough not to be out of consumers’ reach.

Other Objectives Nonprofit and public organizations may have other pricing objectives. A university aims for partial cost recovery, knowing that it must rely on private gifts and public grants to cover its remaining costs. A nonprofit hospital may aim for full cost recovery in its pricing. A nonprofit theater company may price its productions to fill the maximum number of seats. A social service agency may set a service price geared to client income.

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Price Sensitivity The demand curve shows the market’s probable purchase quantity at alternative prices, summing the reactions of many individuals with different price sensitivities. The first step in estimating demand is to understand what affects price sensitivity. Generally speaking, customers are less price sensitive to low-cost items or items they buy infrequently. They are also less price sensitive when (1) there are few or no substitutes or competitors; (2) they do not readily notice the higher price; (3) they are slow to change their buying habits; (4) they think the higher prices are justified; and (5) price is only a small part of the total cost of obtaining, operating, and servicing the product over its lifetime.

Estimating Demand Curves Most companies attempt to measure their demand curves using several different methods.

Surveys can explore how many units consumers would buy at different proposed prices. Price experiments can vary the prices of different products in a store or of the same product in similar territories to see how the change affects sales. Statistical analysis of past prices, quantities sold, and other factors can reveal their relationships.

Price Elasticity of Demand Marketers need to know how responsive, or elastic, demand is to a change in price.

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Each price will lead to a different level of demand and have a different impact on a company’s marketing objectives. The normally inverse relationship between price and demand is captured in a demand curve (see Figure 16.1): The higher the price, the lower the demand. For prestige goods, the demand curve sometimes slopes upward. Some consumers take the higher price to signify a better product. However, if the price is too high, demand may fall.

Consider the two demand curves in Figure 16.1. In demand curve (a), a price increase from $10 to $15 leads to a relatively small decline in demand from 105 to 100. In demand curve (b), the same price increase leads to a substantial drop in demand from 150 to 50. If demand hardly changes with a small change in price, we say it is inelastic. If demand changes considerably, it is elastic.

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Companies prefer customers who are less price-sensitive. Table 16.3 lists some characteristics associated with decreased price sensitivity.

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Demand sets a ceiling on the price the company can charge for its product. Costs set the floor. The company wants to charge a price that covers its cost of producing, distributing, and selling the product, including a fair return for its effort and risk.

A company’s costs take two forms, fixed and variable. Fixed costs, also known as overhead, are costs that do not vary with production level or sales revenue. A company must pay bills each month for rent, heat, interest, salaries, and so on, regardless of output. Variable costs vary directly with the level of production. For example, each tablet computer produced by Samsung incurs the cost of plastic and glass, microprocessor chips and other electronics, and packaging.

Total costs consist of the sum of the fixed and variable costs for any given level of production. Average cost is the cost per unit at that level of production; it equals total costs divided by production. Management wants to charge a price that will at least cover the total production costs at a given level of production.

To price intelligently, management needs to know how its costs vary with different levels of production. Take the case in which a company such as Samsung has built a fixed-size plant to produce 1,000 tablet computers a day. The cost per unit is high if few units are produced per day. As production approaches 1,000 units per day, the average cost falls because the fixed costs are spread over more units. Short-run average cost increases after 1,000 units, however, because the plant becomes inefficient: Workers must line up for machines, getting in each other’s way, and machines break down more often [see Figure 16.2(a)].

If Samsung believes it can sell 2,000 units per day, it should consider building a larger plant. The plant will use more efficient machinery and work arrangements, and the unit cost of producing 2,000 tablets per day will be lower than the unit cost of producing 1,000 per day. This is shown in the long-run average cost curve (LRAC) in Figure 16.2(b). In fact, a 3,000-capacity plant would be even more efficient according to Figure 16.2(b), but a 4,000-daily production plant would be less so because of increasing diseconomies of scale: There are too many workers to manage, and paperwork slows things down. Figure 16.2(b) indicates that a 3,000-daily production plant is the optimal size if demand is strong enough to support this level of production.

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Suppose Samsung runs a plant that produces 3,000 tablet computers per day. As the company gains experience producing tablets, its methods improve. Workers learn shortcuts, materials flow more smoothly, and procurement costs fall. The result, as Figure 16.3 shows, is that average cost falls with accumulated production experience. Thus the average cost of producing the first 100,000 tablets is $100 per tablet. When the company has produced the first 200,000 tablets, the average cost has fallen to $90. After its accumulated production experience doubles again to 400,000, the average cost is $80. This decline in the average cost with accumulated production experience is called the experience curve or learning curve.

Now suppose three firms compete in this particular tablet market, Samsung, A, and B. Samsung is the lowest-cost

producer at $80, having produced 400,000 units in the past. If all three firms sell the tablet for $100, Samsung makes $20 profit per unit, A makes $10 per unit, and B breaks even. The smart move for Samsung would be to lower its price to $90. This will drive B out of the market, and even A may consider leaving. Samsung will pick up the business that would have gone to B (and possibly A). Furthermore, price-sensitive customers will enter the market at the lower price. As production increases beyond 400,000 units, Samsung’s costs will drop still further and faster, more than restoring its profits, even at a price of $90.

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Costs change with production scale and experience. They can also change as a result of a concentrated effort by designers, engineers, and purchasing agents to reduce them through target costing. Market research establishes a new product’s desired functions and the price at which it will sell, given its appeal and competitors’ prices. This price less desired profit margin leaves the target cost the marketer must achieve.

The firm must examine each cost element—design, engineering, manufacturing, sales—and bring down costs so the final cost projections are in the target range. Cost cutting cannot go so deep as to compromise the brand promise and value delivered. Despite the early success of the PT Cruiser, Chrysler chose to squeeze out more profit by avoiding certain redesigns and cutting costs with cheaper radios and inferior materials. Once a best-selling car, the PT Cruiser was eventually discontinued.

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If the firm’s offer contains features not offered by the nearest competitor, it should evaluate their worth to the customer and add that value to the competitor’s price. If the competitor’s offer contains some features not offered by the firm, the firm should subtract their value from its own price. Now the firm can decide whether it can charge more, the same, or less than the competitor.

Value-priced competitors Companies offering the powerful combination of low price and high quality are capturing the hearts and wallets of consumers all over the world. Value players, such as Aldi, E*TRADE Financial, JetBlue Airways, Southwest Airlines, Target, and Walmart, are transforming the way consumers of nearly every age and income level purchase groceries, apparel, airline tickets, financial services, and other goods and services.

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Given the customers’ demand schedule, the cost function, and competitors’ prices, the company is now ready to select a price. Companies select a pricing method that includes one or more of these three considerations. We will examine seven price-setting methods: markup pricing, target-return pricing, perceived-value pricing, value pricing, EDLP, going-rate pricing, and auction-type pricing.

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The most elementary pricing method is to add a standard markup to the product’s cost. Construction companies submit job bids by estimating the total project cost and adding a standard markup for profit. Lawyers and accountants typically price by adding a standard markup on their time and costs.

Assume the manufacturer wants to earn a 20 percent markup on sales. The manufacturer will charge dealers $20 per toaster and make a profit of $4 per unit. If dealers want to earn 50 percent on their selling price, they will mark up the toaster 100 percent to $40.

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In target-return pricing, the firm determines the price that yields its target rate of return on investment. Public utilities, which need to make a fair return on investment, often use this method. Suppose the toaster manufacturer has invested $1 million in the business and wants to set a price to earn a 20 percent ROI, specifically $200,000. The target-return price of $20 is calculated by the formula on this slide.

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The manufacturer can prepare a break-even chart to learn what would happen at other sales levels (see Figure 16.5). Fixed costs are $300,000 regardless of sales volume. Variable costs, not shown in the figure, rise with volume. Total costs equal the sum of fixed and variable costs. The total revenue curve starts at zero and rises with each unit sold. The total revenue and total cost curves cross at 30,000 units. This is the break-even volume.

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An increasing number of companies now base their price on the customer’s perceived value. Companies must deliver the value promised by their value proposition, and the customer must perceive this value. Firms use the other marketing program elements, such as advertising, sales force, and the Internet, to communicate and enhance perceived value in buyers’ minds. Ensuring that customers appreciate the total value of a product or service offering is crucial. The key to perceived-value pricing is to deliver more unique value than competitors and to demonstrate this to prospective buyers. The company can try to determine the value of its offering in several ways: managerial judgments within the company, value of similar products, focus groups, surveys, experimentation, analysis of historical data, and conjoint analysis.

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Value Pricing Companies that adopt value pricing win loyal customers by charging a fairly low price for a high-quality offering. Value pricing is thus not a matter of simply setting lower prices; it is a matter of reengineering the company’s operations to become a low-cost producer without sacrificing quality to attract a large number of value-conscious customers.

EDLP A retailer using everyday low pricing (EDLP) charges a constant low price with little or no price promotion or special sales. Constant prices eliminate week-to-week price uncertainty and the high-low pricing of promotion-oriented competitors. In high-low pricing, the retailer charges higher prices on an everyday basis but runs frequent promotions with prices temporarily lower than the EDLP level.

Going-Rate Pricing In going-rate pricing, the firm bases its price largely on competitors’ prices. Going-rate pricing is quite popular. Where costs are difficult to measure or competitive response is uncertain, firms feel it is a good solution because they believe it reflects the industry’s collective wisdom.

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Auction-type pricing is growing more popular, especially with scores of electronic marketplaces selling everything from pigs to used cars as firms dispose of excess inventories or used goods. These are the three major types of auctions and their separate pricing procedures:

English auctions (ascending bids) have one seller and many buyers. On sites such as eBay and Amazon.com, the seller puts up an item and bidders raise their offer prices until the top price is reached.

Dutch auctions (descending bids) feature one seller and many buyers or one buyer and many sellers. In the first kind, an auctioneer announces a high price for a product and then slowly decreases the price until a bidder accepts. In the other, the buyer announces something he or she wants to buy, and potential sellers compete to offer the lowest price.

Sealed-bid auctions let would-be suppliers submit only one bid; they cannot know the other bids. The U.S. and other governments often use this method to procure supplies or to grant licenses.

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Pricing methods narrow the range from which the company must select its final price.

Impact of Other Marketing Activities The final price must take into account the brand’s quality and advertising relative to the competition.

Company Pricing Policies The price must be consistent with company pricing policies. Yet companies are not averse to establishing pricing penalties under certain circumstances.

Gain-and-Risk-Sharing Pricing Buyers may resist accepting a seller’s proposal because they perceive a high level of risk, such as in a big computer hardware purchase or a company health plan. The seller then has the option of offering to absorb part or all the risk if it does not deliver the full promised value.

Impact of Price on Other Parties How will distributors and dealers feel about the contemplated price? If they don’t make enough profit, they may choose not to bring the product to market. Will the sales force be willing to sell at that price? How will competitors react? Will suppliers raise their prices when they see the company’s price? Will the government intervene and prevent this price from being charged?

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Companies usually do not set a single price but rather develop a pricing structure that reflects variations in geographical demand and costs, market-segment requirements, purchase timing, order levels, delivery frequency, guarantees, service contracts, and other factors. As a result of discounts, allowances, and promotional support, a company rarely realizes the same profit from each unit of a product that it sells.

In geographical pricing, the company decides how to price its products to different customers in different locations and countries. Countertrade may account for 15 percent to 20 percent of world trade and takes several forms:

• Barter. The buyer and seller directly exchange goods, with no money and no third party involved.

• Compensation deal. The seller receives some percentage of the payment in cash and the rest in products.

• Buyback arrangement. The seller sells a plant, equipment, or technology to a company in another country and agrees to accept as partial payment products manufactured with the supplied equipment.

• Offset. The seller receives full payment in cash for a sale overseas but agrees to spend a substantial amount of the money in that country within a stated time period. In the Gorbachev era, PepsiCo sold its cola syrup to the government of the Soviet Union for rubles and agreed to buy Russian vodka at a certain rate for sale in the United States.

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Most companies will adjust their list price and give discounts and allowances for early payment, volume purchases, and off-season buying (see Table 16.4). Companies must do this carefully or find their profits much lower than planned. Discount pricing has become the modus operandi of a surprising number of companies offering both products and services.

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Companies can use several pricing techniques to stimulate early purchase:

Loss-leader pricing. Supermarkets and department stores often drop the price on well-known brands to stimulate additional store traffic. This pays if the revenue on the additional sales compensates for the lower margins on the loss-leader items.

Special event pricing. Sellers will establish special prices in certain seasons to draw in more customers. Every August, there are back-to-school sales.

Special customer pricing. Sellers will offer special prices exclusively to certain customers.

Cash rebates. Auto companies and other consumer-goods companies offer cash rebates to encourage purchase of the manufacturers’ products within a specified time period.

Low-interest financing. Instead of cutting its price, the company can offer low-interest financing.

Longer payment terms. Sellers, especially mortgage banks and auto companies, stretch loans over longer periods and thus lower the monthly payments.

Warranties and service contracts. Companies can promote sales by adding a free or low-cost warranty or service contract.

Psychological discounting. This strategy sets an artificially high price and then offers the product at substantial savings; for example, “Was $359, now $299.”

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Price discrimination occurs when a company sells a product or service at two or more prices that do not reflect a proportional difference in costs. In first-degree price discrimination, the seller charges a separate price to each customer depending on the intensity of his or her demand. In second-degree price discrimination, the seller charges less to buyers of larger volumes. In third-degree price discrimination, the seller charges different amounts to different classes of buyers, as in the following cases

• Customer-segment pricing. Different customer groups pay different prices for the same product or service. For example, museums often charge a lower admission fee to students and senior citizens.

• Product-form pricing. Different versions of the product are priced differently, but not in proportion to their costs. Evian prices a 2-liter bottle of its mineral water as low as $1 but 5 ounces of the same water in a moisturizer spray for as much as $12.

• Image pricing. Some companies price the same product at two different levels based on image differences. A perfume manufacturer can put a scent in one bottle, give it a name and image, and price it at $10 an ounce. The same scent in another bottle with a different name and image can sell for $30 an ounce.

• Channel pricing. Coca-Cola carries a different price depending on whether the consumer purchases it from a fine restaurant, a fast-food restaurant, or a vending machine.

• Location pricing. The same product is priced differently at different locations even though the cost of offering

it at each location is the same. A theater varies its seat prices according to audience preferences for different locations.

• Time pricing. Prices vary by season, day, or hour. Restaurants charge less to “early bird” customers, and some hotels charge less on weekends. Retail prices for roses increase by as much as 200 percent in the lead-up to Valentine’s Day.

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The airline and hospitality industries use yield management systems and yield pricing, by which they offer discounted but limited early purchases, higher-priced late purchases, and the lowest rates on unsold inventory just before it expires.

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Several circumstances might lead a firm to cut prices. One is excess plant capacity: The firm needs additional business and cannot generate it through increased sales effort, product improvement, or other measures. Companies sometimes initiate price cuts in a drive to dominate the market through lower costs. Either the company starts with lower costs than its competitors, or it initiates price cuts in the hope of gaining market share and lower costs.

Cutting prices to keep customers or beat competitors often encourages customers to demand price concessions, however, and trains salespeople to offer them. A price-cutting strategy can lead to other possible traps:

• Low-quality trap. Consumers assume quality is low.

• Fragile-market-share trap. A low price buys market share but not market loyalty. The same customers will shift to any lower-priced firm that comes along.

• Shallow-pockets trap. Higher-priced competitors match the lower prices but have longer staying power because of deeper cash reserves.

• Price-war trap. Competitors respond by lowering their prices even more, triggering a price war.

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A successful price increase can raise profits considerably. A major circumstance provoking price increases is cost inflation. Rising costs unmatched by productivity gains squeeze profit margins and lead companies to regular rounds of price increases. Companies often raise their prices by more than the cost increase, in anticipation of further inflation or government price controls, in a practice called anticipatory pricing. Another factor leading to price increases is overdemand. When a company cannot supply all its customers, it can raise its prices, ration supplies, or both. It can increase price in the following ways, each of which has a different impact on buyers.

Delayed quotation pricing. The company does not set a final price until the product is finished or delivered. This pricing is prevalent in industries with long production lead times, such as industrial construction and heavy equipment.

• Escalator clauses. The company requires the customer to pay today’s price plus all or part of any inflation increase that takes place before delivery. Escalator clauses base price increases on some specified price index. They are found in contracts for major industrial projects, such as aircraft construction and bridge building.

• Unbundling. The company maintains its price but removes or prices separately one or more elements that were formerly part of the offer, such as delivery or installation. Car companies sometimes add higher-end audio entertainment systems or GPS navigation systems to their vehicles as separately priced extras.

• Reduction of discounts. The company instructs its sales force not to offer its normal cash and quantity discounts.

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If the company’s profit margin is 3 percent of sales, a 1 percent price increase will increase profits by 33 percent if sales volume is unaffected. This situation is illustrated in Table 16.5. The assumption is that a company charged $10 and sold 100 units and had costs of $970, leaving a profit of $30, or 3 percent on sales. By raising its price by 10 cents (a 1 percent price increase), it boosted its profits by 33 percent, assuming the same sales volume.

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The introduction or change of any price can provoke a response from customers, competitors, distributors, suppliers, and even government. Competitors are most likely to react when the number of firms is few, the product is homogeneous, and buyers are highly informed. How can a firm anticipate a competitor’s reactions? One way is to assume the competitor reacts in the standard way to a price being set or changed. Another is to assume the competitor treats each price difference or change as a fresh challenge and reacts according to self-interest at the time.

How should a firm respond to a competitor’s price cut? It depends on the situation. The company must consider the product’s stage in the life cycle, its importance in the company’s portfolio, the competitor’s intentions and resources, the market’s price and quality sensitivity, the behavior of costs with volume, and the company’s alternative opportunities.

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