Price Quotes and Pricing Decisions Applied Problems

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New Product Pricing and Pricing in New Markets

Learning Objectives

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

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

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

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Introduction

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

We shall dis�nguish between products that are new to the market and those that are new to the world. By new to the market we mean a new brand in an exis�ng market where the new product is simply a new variant in an exis�ng product category, such as a new brand of dish detergent that claims enhanced cleaning power. These have been called crea�ve imita�ons and are "new" to the extent that they offer the market a new combina�on of product a�ributes (see Chapter 3)—that is, the new product is differen�ated from what has previously been offered to the market by the other brands. New to the world means the product offers a new way to serve customers’ needs, such as the Segway Personal Transporter, which was introduced to the market for personal transporta�on in

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

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

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

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

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

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9.1 Pricing New-to-the-Market Products

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

Price Skimming

Price skimming is intended to gain as much profit for the firm as possible in each produc�on period. As such, the skimming price must be the same as the short-run profit-maximizing price, since there is no point se�ng a price higher or lower than that if the inten�on is to gain as much profit as possible. By now you are very familiar with the marginalist pricing rule for profit maximiza�on (i.e., set MC = MR), which would be used a�er considera�on of the es�mated demand and cost curves, if reliable es�mates of this data can be obtained at reasonable search cost. But herein lies the problem: With a new product, there is no prior history of customer demand or produc�on costs that is exactly applicable to this product. Thus, we must extrapolate (i.e., go outside the limits of the available data) from data rela�ng to similar but differen�ated products already available in the same product category. Obviously, the more closely subs�tutable the new product is for one or more of the other products in the category, the more reliable our es�mates will be, with the extreme case being the iden�cal-products case (i.e., pure compe��on) where the informa�on derived from observa�on of an exis�ng product is fully applicable to the new product entering the market (and, thus, the new product simply accepts the prevailing market price).

In differen�ated-product markets, however, there will be a range of prices chosen by the firms that reflect differences in the qualita�ve a�ributes of the compe�ng products. In a world of full informa�on (i.e., zero search costs) with firms that want to maximize short- run profit, these different prices will reflect different loca�ons of the MC curves (due to cost differences required to produce the different quali�es) and different loca�ons of the MR curves (due to demand differences for par�cular products due to the differences among customers’ preferences for the various a�ributes of the products). This gives rise to an observable relevant range of prices, which is the range of prices from the most expensive to the least expensive of the products in the same product category. Associated with the relevant range of prices will be a relevant range of quality; that is, the compe�ng products would probably offer mostly the same core product a�ributes with each product poten�ally offering more or less of each of these a�ributes and addi�onally offering one or more quality a�ributes that rivals do not offer (e.g., their loca�on, brand name, and reputa�on, if not addi�onal tangible characteris�cs). If the firm’s new product offers the core quality a�ributes that characterize the product category and some or most of the product a�ributes that are offered by others in the relevant product category, then the new product’s price should be expected to fall

somewhere within the relevant range of prices.3 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#footernote3)

How does the manager proceed to set the actual price for the new product? If search costs are not zero but are indeed significant, the manager should first consider adop�ng a markup pricing rule. The manager will have es�mated the projected average variable costs (AVC) of the new product but any es�mate of average fixed cost (AFC) must await an es�mate of the quan�ty demanded (volume sold) of the new product and that will depend on the price chosen and will be revealed only later when the market reacts to the introduc�on of the new product. So what markup over AVC should the manager choose? To be compe��ve with rival products the new product’s price must be carefully posi�oned such that it offers a compe��ve value proposi�on to customers in that market.

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

Price posi�oning is the selec�on of price within the relevant range of prices for rival products such that the chosen price offers a compe��ve value proposi�on to prospec�ve customers. As you know, the value proposi�on can be defined as a measure of perceived quality divided by a measure of price. To illustrate using a simple example, consider Figure 9.1 where product quality and price are shown as one-dimensional (e.g., simply larger or smaller volume of a par�cular beverage in different sized containers, and price is in dollars per container with no other costs of purchasing). We depict four products, labeled A, B, C, and D, that have different quali�es (le�-hand axis) and different prices (right-hand axis). As we saw in Chapter 8, par�cular customers will perceive these differing size containers of beverage as having higher or lower value proposi�ons due to the differing reserva�on prices they place on each of the product offerings.

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

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

© altrendo images/Thinkstock

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

In terms of customer behaviors examined in Chapter 3, this customer will choose among products to maximize u�lity. The choice of the highest value proposi�on is consistent with u�lity maximiza�on because it includes the customer’s percep�on of quality (and hence marginal and total u�lity from the product) rela�ve to the price level. Note also that in Chapter 8 we argued that the customer would have a reserva�on price that is the maximum he or she would pay for an item. Viewed from the value-proposi�on perspec�ve, the reserva�on price is the price that pushes the product’s value proposi�on to be just equal to the value proposi�on of the best alterna�ve (product’s) value proposi�on—any higher price would cause it not to be purchased. In the case depicted in Figure 9.1, it may be that the customer’s reserva�on prices are above the seller’s prices for all four products, in which case he or she would buy none, but the bargain product (B) will be the one purchased if its reserva�on price is above the seller’s price, unless the customer has a very low income and must choose C (an inferior good, as we saw in Chapter 3) because the customer is unable to afford the higher priced bargain.

In this simple example, we have depicted quality and price as each being one-dimensional. In reality, of course, both quality and price are mul�dimensional. The percep�on of quality includes a variety of quality a�ributes including size, shape, weight, color, design elements, purchase loca�on, warranty, and so on, as we saw in Chapter 3. Similarly, price includes not only the �cket price but also other costs associated with the purchase, such as search costs, opportunity costs, pick-up or delivery costs, product maintenance cost, and so on, also known as the product life�me price, which is the purchase price plus all other costs incurred by the consumer over the product’s life�me

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

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#footernote4) In Figure 9.2, we again show price on one of the ver�cal axes but this �me let us regard price as the product life�me cost to the consumer. In reality, this might change the ranking of the four products compared to their ranking in Figure 9.1, since some products may have higher delivery costs, higher maintenance costs, and so on. But, for exposi�onal purposes here, we shall assume these product life�me costs are constant across products so no change in rela�ve price is introduced at this point. Instead, let us add a second quality a�ribute—let’s call this "sweetness"—into the measure of quality shown on the other ver�cal axes in Figure 9.2. The customer may believe the four products taste more or less sweet and has a preference for either greater or lesser sweetness in the beverages under discussion.

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

Ignoring the new Product E for the moment, we see in Figure 9.2 that considering size and sweetness, the target customer now ranks the quality of the products in the order B, A, C, D. By comparing this ranking with that in Figure 9.1 (which showed quality simply in terms of beverage quan�ty), we can

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

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deduce that Product B must be substan�ally sweeter than Product A, since the smaller container of B is now ranked above the larger container of A. Further, Products C and D must be about equally sweet, since neither their ranking nor the quality interval between them has changed significantly. The slopes of the lines now indicate that Product D is s�ll viewed as a rip-off and that Product A is now also viewed as a rip-off due to the inclusion of the customer’s preference for sweetness (and because A apparently offers rela�vely low sweetness at its rela�vely high price). Similarly, under this broader view of product quality, Products B and C are viewed as bargains and Product B is seen as the be�er bargain, having the higher quality/price ra�o, and so will be preferred by this par�cular customer.

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

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#footernote5) for this product category, such that Figure 9.2 is relevant for the price posi�oning of the new product to be introduced by Firm E. The manager of Firm E must evaluate the quality (size and sweetness) of Product E against the other product offerings and price it accordingly. So, suppose for the sake of illustra�on that the quality posi�oning of Product E is chosen to be superior to Product B. To sell into this market, the price posi�oning of Product E will need to be quite close to the price of Product B in order to offer a superior value proposi�on (that is, the price–quality line EE needs to be steeper than the line BB).

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

Thus, the price that should be set to enter an exis�ng market (or market niche) with a new product must be selected by the manager with a view to the rela�ve price and quality offerings of other firms. The markup rate over AVC is then deduced from the ra�o of the price selected to the AVC level. For example, if AVC = $6 and the price chosen is $10, the markup over AVC is 4/6 = 67%. Subsequently, when demand and cost condi�ons change (causing the unobserved demand, marginal revenue, and marginal cost curves to shi�) the firm may con�nue to use a 67% markup rate to cause its price to move in conscious parallelism with those of its rival firms (as we saw

in Chapter 7), assuming they all want to maintain or increase profits as well. For example, suppose a new firm enters the beverage market with a new product, such as a so� drink with lower carbohydrates. Suppose that the prices of the exis�ng products range from $2 to $2.50 per can, and that the management of the new firm determines that the new low-carb product would offer an a�rac�ve value proposi�on to many customers at a premium price of $2.75. If the new firm’s AVC = MC is, say $1.50, the $2.75 price represents a markup of 50% (or $1.25) above AVC. Later, if produc�on costs rise for all firms and they all want to increase their prices to pass on the cost to consumers, they would maintain their rela�ve prices by each using the same markup rates as before, applied to their new levels of AVC.

Product Line Pricing and Product Prolifera�on

There is o�en a profit incen�ve for the firm to increase the breadth of its product line—to offer addi�onal variants of its product within an exis�ng product category. Examples include a beverage company offering containers in several sizes, or a detergent company offering a new soap powder product with lemon scent, or op�mized for cold water washing, and so on. Toyota reportedly had 43 models of cars and light trucks at the �me of this wri�ng. These different products offered by the same firm are known collec�vely as its product line.

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

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

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

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addi�onal firms will enter the market un�l the excess profit earned by any firm is competed away by another firm offering a similar product, so finally all firms will earn only normal profit, which we know is equal to the best they could earn by inves�ng their resources elsewhere. Now transfer that logic to exis�ng firms adding addi�onal products into their product lines—they will con�nue to add new products while there is excess profit to be earned by doing so. If a par�cular firm does not add new products that compete with its exis�ng products, then another firm will, so each firm has an incen�ve to add addi�onal products to increase the share of the overall market accruing to that firm (rather than to another firm) un�l any further product prolifera�on would cause all firms (or product lines) to take losses un�l some firms (or product lines) exit the market. All firms would then earn a quantum of profit equal to the normal profit from each product mul�plied by the number of products they have in their product line. Thus, moving quickly to add new products, before others fill the market (i.e., squeeze out the excess profit) with their new products, serves to increase the magnitude of the firm’s total profits earned, notwithstanding that its profit rate will remain at the normal level.

So the ques�on for the manager is, "Where in the product line should I put an addi�onal product?" That is, what should the quality and price posi�oning be for the new product? The answer will be found in the profitability of the exis�ng products in the firm’s product line and in other firms’ product lines. The manager should posi�on the new product such that it steals sales from exis�ng products that are currently earning excess profits, whether these be within the firm’s own product line or within another firm’s product line. Although it may seem counterproduc�ve for a firm to cannibalize profits from within its own product line, if it doesn’t do it, another firm will! Other firms have a profit incen�ve to design new products that compete with your most profitable products; it is be�er that you do it first and gain two shares of normal profit rather than only one.

The prolifera�on of franchises. The expansion of fast-food franchises in a densely populated area illustrates the same issue. If McDonald’s adds more and more stores into a par�cular area, it will increase its aggregate market share even though the sales of each individual franchise is shrinking, because the total demand for fast food is then being shared across more and more fast-food stores in the area. If McDonald’s owned all its stores, it might pursue this to an op�mal point of many rela�vely small stores earning only normal profit causing maximum total profits to the parent firm, but since most of its stores are operated by franchisees, who would be very upset by shrinking sales and profit, the franchise agreement is likely to include a clause guaranteeing the franchisee a minimum distance from another franchisee, or at least a minimum annual revenue before addi�onal franchises might be issued in close proximity. Even with this constraint imposed by the need to retain good franchisees, McDonald’s might gain sales from other franchise chains (e.g., KFC) if those other chains do not expand their store numbers as quickly, and from independent operators who cannot

afford to open addi�onal retail outlets.6

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

In a densely populated region with many sellers, this situa�on approximates monopolis�c compe��on, which we examined in Chapter 7. There will be entry of new firms (or new franchises of mul�franchise firms) un�l profits in each firm are reduced to normal profits. As we saw in Chapter 7, each store will be opera�ng at a plant size that is smaller than the op�mal size of plant (i.e., their short- run average cost (SAC) will not be at the minimum point on their long-run average cost (LAC) curve). In a market that ini�ally promises excess profits, there will be a rush to enter that market and the franchiser that moves more quickly to set up the most franchises before the market is filled will earn a larger volume of profit than the franchiser who is slow to set up franchises. As an example, we see the rapid expansion in the number of U.S. fast-food franchises

in emerging Asian markets where the ci�zens are becoming wealthier and more able to afford these products.7

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

Penetration Pricing

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

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

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

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

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fixed costs across a broader product line) as discussed in Chapter 5. Again, this serves to reduce AVC and MC and to allow price reduc�ons that further inhibit entry of new rivals and/or the firm can enjoy an increased gross margin on sales.

Fourth, in markets where different technological pla�orms underlie compe�ng products, and where these compe�ng products must interact with a related product (such as memory systems for laptop computers), there will evolve a race for the industry standard, which is the race to be adopted by the market as the superior solu�on to the customer’s problem. For example, compact disk (CD) and "flash memory" are alterna�ve technologies for data storage within and between laptop computers. The higher the func�onality (quality) and the lower the price of laptops offered by the computer manufacturer, the be�er will be the value proposi�on perceived by customers. Accordingly, the design of the related product (in this case the laptop) will evolve to favor the memory solu�on that is cheaper and more func�onal. So, rather than offering an interface with both compe�ng memory storage technologies, for cost and size reasons, the laptop manufacturer will limit its interface to the memory device that the market has adopted as the industry standard. Thus, we saw laptops stop offering CD drives in favor of USB ports for flash-memory devices, and, in turn, we may see these disappear in favor a new technology (such as storage "in the cloud").

Fi�h, there are future-period marke�ng advantages of lower prices in the current period. If the product is one that is subject to repeat purchases by customers, more sales in the current period will lead to greater sales in future periods as sa�sfied customers come back to repurchase the firm’s product. If consumer ignorance about product quality, price, or availability is high and can be reduced by "word-of-mouth" adver�sing by sa�sfied users, more users in the present period will mean more new adopters in the subsequent periods.

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

But, while there are six good reasons to u�lize penetra�on pricing rather than skimming pricing, the manager of the firm introducing a new product to an exis�ng product category will need to be conscious of the general price level (i.e., the rela�ve range of rival’s prices) and will want to posi�on the new product’s price appropriately within that range. If the other firms are a�emp�ng to maximize their profits in the short run, the general price level will be higher than the penetra�on price. Se�ng the penetra�on price might provoke retaliatory price cu�ng (risking a price war) by rival firms. Whether or not this happens will depend on the market structure—that is, whether the rival firms offering differen�ated products are opera�ng in monopolis�c or oligopolis�c compe��on. In monopolis�c compe��on, as we saw in Chapter 7, there are many rivals and each one can act independently of the others. In this case, it makes no sense to set any price lower than the short-run profit-maximizing price since the inevitable entry of new firms means the price is des�ned to fall to the long-run profit-maximizing price and output equilibrium levels (where MR = LMC = SMC and SAC = LAC = AR [where LMC signifies long-run marginal costs and AR signifies average revenue, or price]). Thus, the monopolis�c compe�tor might as well set the short-run maximizing price to make greater profits (compared to a lower penetra�on price) in the short run while awai�ng the inevitable entry of new firms that will cause price to be pushed down to the long-run equilibrium level soon enough.

In oligopoly, however, where barriers to entry prevent the emergence of new firms, and where mutual dependence will be recognized, firms will set prices rela�ve to each other’s prices, so the focal firm must carefully decide where to posi�on its price. If the focal firm does not want to compete on the basis of a lower price, preferring to compete on the basis of its product differen�a�on, it will offer a compe��ve value proposi�on (posi�oned within the rela�ve range of prices) so as not to provoke a damaging price war. For example, the passenger car companies revitalize their models periodically in an a�empt to offer a new value proposi�on rather than ge�ng drawn into price wars based on their exis�ng models. On the other hand, if the focal firm strongly prefers the longer term advantages of the penetra�on price, it can assume the role of the low-cost price leader (see Chapter 7) and set the penetra�on price and expect the other firms to shi� their prices downward to protect their market shares un�l a new rela�ve range of prices is established at a lower level where the other firms’ posi�oning within the rela�ve range depends on their rela�ve quality posi�oning. Walmart stores are an excellent example of a low-cost price leader. Its bulk purchases and other buying strategies allow it to keep prices rela�vely low and thereby force other retailers to keep their prices rela�vely low to offer a compe��ve value proposi�on. Note that this does not mean that rivals have to match Walmart’s prices—these firms can charge

higher prices if they offer higher-quality products, including be�er service, free delivery, familiar brand names, and so on.8

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3. Note that the relevant product category may need to be limited to a subset of what might seem to belong in that category. For example, the broad product category "passenger automobiles" covers a wide range, from the very inexpensive Tata Nano CX (under $3,000) to the very expensive Buga� Veyron (over $1.5 million). Obviously, the manager must choose a more limited subset of rival products that are more closely subs�tutable with the new product, such as luxury, compact, five-passenger cars and observe the price range across this relevant range of quality to find the relevant range of prices. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#return3) ]

4. Most products have both immediate and future explicit (monetary) costs associated with their purchase and subsequent use, and these are likely to differ across compe�ng products. For example, some new cars have a service interval of 5,000 miles compared to 10,000 miles, so even if the monetary cost of the service is the same the present value of the la�er is lower. Similarly, some cars have more expensive spare parts, are more likely to break down, and have differing salvage value (i.e., resale value as a propor�on of new car price). [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#return4) ]

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

6. The sales of individual franchisees would not necessarily shrink in monetary terms, as the demand for a product in a region typically expands with popula�on growth and with franchisor adver�sing, for example. Individual franchise sales might grow over �me but grow at a lesser rate than the total sales grow, or grow in monetary terms rather than in real (adjusted for infla�on) terms. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#return6) ]

7. To the extent that firms have strategic resources (such as a strong brand name) their profits will exceed the normal level, as we will see in Chapter 12 when we consider how the firm achieves sustainable compe��ve advantage by the ini�al possession or development of hard-to-copy and nonsubs�tutable resources. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.1#return7) ]

8. It is important to appreciate that either skimming pricing or penetra�on pricing may be profit-maximizing for the firm. First note that profit maximiza�on over a �me horizon that lies beyond the present period requires that profits be measured in expected net present value (ENPV) terms, as we saw in Chapter 2. If the product life cycle is short, and rivals are unable to

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

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

© Sean De Burca/Corbis

9.2 Pricing New Products in New Markets

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

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

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

Innovative-New-Product Pricing

So how should a pioneer firm with a new-to-the-world product set its price? Although there is a demand curve for the new product or service (as a collec�ve of the willingness to pay for the product in the minds of thousands or millions of prospec�ve customers), this demand curve will not be visible or available to the pioneer firm without surveying the popula�on of prospec�ve buyers. And, of course, therein lies a major problem: The new-to-the-world product will be as yet unknown to many customers who will later buy it when they become aware of it, and, thus, the ini�al period demand curve will be rela�vely small and will shi� outwards in subsequent periods as customer awareness increases. As we know from Chapter 7, shi�ing demand curves mean shi�ing MR curves and that, in turn, means the profit-maximizing price of the monopolist would be set at a rela�vely low level ini�ally and, subsequently, would be raised as the demand curve con�nues to shi� outward. Customers, par�cularly repeat customers, are likely to view increasing prices as exploita�ve behavior on the part of the monopolist and may harbor a grudge that will cause them to switch to a rival supplier as soon as one or more other firms enter the market and price compe��on in the (by then) oligopoly market causes the price level to fall, as we saw when the telecommunica�on monopolies were first subject to rivalry from new entrants. Thus, we need to be�er understand the sequence of shi�s in the demand curve experienced by pioneer firms before we can prescribe a pricing policy to deal with this special situa�on of increasing market demand and the risk that rivals will soon enter (if they can) and compete on the basis of price. In fact, the shi�s of the demand curve for new products are quite predictable, due to the diffusion curve phenomenon.

The Diffusion Curve

Rogers (1962) found that new technologies diffuse into the produc�on func�ons of firms in an industry in a quite predictable manner, with only a small propor�on of firms willing to adopt the new technology at first. He found that the adop�on rate progressively increases, up to the midpoint of the adop�on process, a�er which the rate of adop�on progressively decreases. Rogers categorized the new technology adopters as innovators, early adopters, early majority, late majority, and laggards according to how soon they adopted the new technology into their produc�on processes. In a variety of studies, he

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

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.2#footernote10) Marke�ng scholars (Bass, 1969; Mahajan & Muller, 1979) then extended the diffusion model to the behavior of customers who are faced with a new-to-the-world product or service, arguing that the "innova�veness" of customers is approximately normally distributed and, thus, there is similarly an approximately normal distribu�on around the mean �me to adop�on. A wide variety of new products have diffused through their markets in this fashion (Mahajan, Muller, & Bass, 1990) and this pa�ern is an ar�fact of the behavior of human beings in aggregate, with some being more willing (or able) to try new products than are others. The diffusion curve varies drama�cally across products, being more than 100 years for automobiles and less than 10 years for email, for example.

In Figure 9.3, we show an approximately normal distribu�on of the �me to adop�on of new products, with the innovators adop�ng more than 2 standard devia�ons (SDs) before the mean �me to adop�on, the early adopters adop�ng between 1–2 SDs before the mean; the early majority adop�ng between 0– 1 SDs before the mean, and the late majority and the laggards adop�ng subsequently. In Figure 9.4 we show the cumula�ve normal distribu�on, adding up the adopters as �me shi�s from 3 SDs before to 3 SDs a�er the mean �me to adop�on. You will note that the cumula�ve normal distribu�on, also called a cumula�ve density func�on, necessarily takes a "lazy-S" shape, as customers are ini�ally slow to adopt and then adopt at increasingly faster rates un�l the mean �me to adop�on, a�er which point the rate of adop�on (i.e., the number of adopters per period) slows as the product or service con�nues to diffuse through the market.

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

© Jupiterimages/Thinkstock

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

Figure 9.4: The diffusion curve for a new product

There are good economic reasons for the approximately normal distribu�on of �me to adop�on. Douglas (2012) has argued that the normal distribu�on of customer adop�on is actually due to six component factors that each serves to inhibit customer adop�on of a new product. He argues that each of these factors should be expected to exhibit a bell-shaped probability distribu�on with respect to �me, and that when these six probability distribu�ons are added together (ver�cally) the result is a probability distribu�on that is approximately normally distributed around the mean �me to adop�on. The first factor is customer awareness of the new product and its benefits—some poten�al customers will be highly aware of the new product while others will be not at all aware of it, with most people having some degree of awareness in between. Second, the apprecia�on for the quality a�ributes of the new product, or the amount of u�lity the customer expects from the new product, is also likely to be distributed around a mean value with some gaining very high u�lity and some gaining very low u�lity, but with most people nearer the mean u�lity expected from the new product. Third, the quality risk aversion of customers is likely to vary across a spectrum with most people located in the middle; at one extreme some will be only slightly quality risk- averse and at the other extreme others will be highly risk-averse. Fourth, the distribu�on of switching costs (related to discon�nuing the exis�ng alterna�ves to the new product) are likely to vary across a spectrum with a central tendency such that most people are within plus or minus one standard devia�on from the mean and others fall to each side of the mean switching costs. Fi�h, it is expected that there will be a distribu�on of customer accessibility to the supplier of the new product—there will be a mean distance from the supplier (or other measure of purchase inconvenience) with some poten�al customers finding access highly convenient while, on the other side of the distribu�on, others will find access highly inconvenient. Finally, there is affordability of the new product: Some customers will easily afford to buy the product while others will need to save up for several periods, such that affordability is also likely to have a roughly bell-shaped distribu�on.

It is argued that these six factors impose a series of barriers to purchase a new product that must be overcome, one by one, before the customer can purchase the new product. But note that each barrier to purchase will decline as �me passes. Awareness should be expected to spread as the firm ramps up its promo�onal campaign, as news reports are made, as word-of-mouth is more widely generated, and as communica�on takes place between those who have already adopted the product and those who have not yet adopted it. The apprecia�on for the new product is likely to grow for those whose ini�al apprecia�on was not high as more informa�on about the new product is learned by poten�al customers and as those who have tried the product endorse

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and recommend it to others. Quality risk aversion associated with the new product declines as new informa�on about the quality of the new product is generated and disseminated. The appeal of alterna�ves (that sa�sfy the same customer need) declines as the switching costs are reduced over �me as customers use up their personal inventories of the old way to sa�sfy the need and learn by observa�on of others how to best use the new product. Accessibility increases as poten�al customers schedule travel to the place of sale and as the seller expands its distribu�on network to serve more distant places (including Internet sales). And finally, affordability increases as people save up money to buy the product, and as the price of the product is reduced in line with the cost savings due to the learning curve effect. As each of these inhibitors to purchase declines, their combined effect is to induce the poten�al customer to move closer to the decision to adopt the new product, and given the approximately normal distribu�on of the six main inhibitors in total, the rate at which people reach this decision point increases at first and decreases later.

Thus, the demand curve faced by the firm introducing a new product should be expected to be quite close to the price axis at first, and then shi� outward progressively over �me in subsequent periods, with the extent of the demand shi� per period increasing at first and later decreasing, as we depict in Figure 9.5. As discussed in Chapter 7, if the firm were to set the profit-maximizing price, where MC = MR, this pricing rule would cause price to rise substan�ally over �me if the demand curve is shi�ing outward, and this rising price would be likely to a�ract new firms into the industry (not to men�on upse�ng

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

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.2#footernote11) ) as the firm benefits from learning curve effects and as it tries to expand its sales and market share as new rivals emerge. But, as we know, the cost of informa�on to derive the demand curves in mul�ple periods into the future is likely to far exceed the increased profit that could be earned, so the firm is likely to adopt a pricing rule that economizes on search costs and hopefully returns higher profit as a result. In Figure 9.5 we have assumed that the firm knows demand will increase over �me and sets a regular price (shown as P) that seems to offer an a�rac�ve value proposi�on given the quality posi�oning of the new product rela�ve to other products that serve the same needs. The firm then sets the introductory price, Pʺ by allowing a rela�vely large discount (e.g., 50%) off the regular price, and subsequently reduces the discount (e.g., to 25%) from the regular price by se�ng price Pʹ, as the demand curve con�nues to move outwards un�l the regular price is offered without any discounts as the

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

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

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

Entering New Geographic Markets

When a firm enters a new geographic market it is likely to also experience a similar diffusion curve in that new market largely because the locals are not aware of the product and need to learn about it. Earlier in this chapter we men�oned the Tata Nano CX, a car made in India and introduced to the U.S. market in the very-small-car category. We should expect the sales of this vehicle to follow a path approximated by a cumula�ve normal probability

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

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

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

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

© Corbis/CORBIS

new product. In established product markets, switching costs and quality risk aversion are likely to be the greatest inhibitors and, thus, the firm should consider entering the market at a bargain price to offset the poten�al customers’ reluctance to try the new product. Par�cularly if the new product is an experience good, meaning the quality characteris�cs are not easily and inexpensively observed, the firm may need to offer free trial usage of the product, or deep introductory discounts, to allow the quality risk-averse poten�al customer to gain informa�on about the product at minimal cost to the customer. Obviously, adver�sing and promo�onal efforts, including detailed informa�on on the firm’s website, are also important to reduce customer reluctance to adopt the new product. On the other hand, search goods, for which the quality characteris�cs are easily and inexpensively observed, may not need these par�cular marke�ng tac�cs to induce trial purchase and consump�on.

9. For a historical account of many new-to-the-world products and how the public’s memory of who actually pioneered the new product is biased in favor of the follower firms who later became the market leaders in those markets. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.2#return9) ]

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

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

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

12. You may be aware of the "product life cycle" concept from a marke�ng class. This concept is related to the diffusion curve and assumes that sales of a new product will grow in the same "cumula�ve normal distribu�on" pa�ern but will later fall as it is made obsolete by newer versions of the product genre that include improvements due to newer technologies. Figure 9.5 assumes that the new product, once adopted, will be repe��vely purchased by all customers (such as for a new teeth-whitening product). If the product is a once-only purchase (such as braces for the teeth) the demand curve would shi� outward at first and later shi� back as the product moves through the product life cycle. Discounts from the regular price would apply at first, and discounts would be applied again later in the product life cycle to induce the late adopters and laggards to purchase the product. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.2#return11) ]

13. Equilibrium only happens if nothing further changes, but of course there will likely be smaller models of other cars made available and changes in customer tastes and preferences are also likely. So the equilibrium market share is only no�onal in prac�ce, based on a par�cular set of assump�ons and expecta�ons. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec9.2#return13) ]

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Summary

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

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

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

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

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

Ques�ons for Review and Discussion

Click on each ques�on to reveal the answer.

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

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

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

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

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

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

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

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

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

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

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

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

7. Why does the entry of new firms in monopolis�c compe��on squeeze out all the pure profit whereas the entry of new firms in oligopoly may not reduce the focal firm’s demand back to the point where only normal profits are a�ainable? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

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

8. Firms expanding globally with a product that is well-known and in high demand in their home market, will nonetheless expect to encounter resistance to adop�on of that product in interna�onal markets. Please explain. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

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

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

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

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

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

Decision Problems

1. The Forever-Young Health Foods Company has a wide range of mul�vitamins, nutri�on and dietary supplements that compete with dozens of other firms who also provide a range of similar products. These products are all slightly differen�ated from each other and compete on the basis of brand name and the ingredients included in each product. Forever-Young is considering broadening its product range, since it can see a profit opportunity in a par�cular area of

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

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

products. What should Forever-Young do to increase profits? 2. Eastman Paint Company manufactures a range of slightly differen�ated paint products for the do-it-yourself homeowner. Its product line includes products

that are combina�ons of (either) gloss, semi-gloss, low-sheen, and ma�e finishes, with either a water or oil base. All paints can be �nted to any color at the point of sale. Eastman competes with three other large paint companies, who have each spent a lot of money on adver�sing to build a reputa�on for higher quality. Most of Eastman’s products are sold at prices that just cover its economic cost of produc�on such that the firm makes only normal profits on those products. On three of the products in its product line, however, Eastman is making pure profit with a comfortable margin of price above short-run average cost (SAC) (see table below). Eastman has examined the products and prices of rival firms and notes that there are three other products it could produce and gain rela�vely high prices compared to its economic cost of produc�on.

More profitable product variants for Eastman Paints

Eastman’s economic profit per gallon

Rival X’s economic profit per gallon

Rival Y’s economic profit per gallon

Rival Z’s economic profit per gallon

1. High-gloss, oil-based $1 — $3 $2

2. Semi-gloss, water-based $4 $6 — $4

3. Semi-gloss, oil-based $3 $5 $5 —

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

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

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

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

a. Based on this limited informa�on, and making assump�ons as necessary, advise Eastman what it should do to maximize its profit. b. What should Eastman expect its rival firms to do? c. What do you expect the eventual equilibrium situa�on in this market to be?

3. Chuck Branson won a gold medal at the 2012 Olympics and has decided to start his own business as a personal trainer. He thinks he could make a lot of money since he is now well-known and admired by many fitness-oriented people and thus, should be able to a�ract a large clientele of people who want to lose weight and build muscle tone. He has made an arrangement with a fitness center to meet clients there and use its facili�es for a reasonable fee and plans to do a le�er-box drop of pamphlets to homes and apartments in the surrounding suburbs. He is aware that there are many other personal trainers, all slightly differen�ated from each other in terms of their personali�es, methods, loca�ons, and personal spor�ng achievements.

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

4. Alicia Montezuma is ready to launch a new business venture with an innova�ve new cosme�c product. Alicia knows that there will ini�ally be rela�vely li�le market awareness of her product; that most poten�al customers will have significant quality risk aversion and switching costs; and that many customers will not have immediate access to or affordability for this product. However, Alicia is quite sure that the product will be a�rac�ve to customers once they become aware and fully understand it. Alicia has es�mated that she will sell about 32,500 units of the product over the first 24-month period. Sales per month are expected to follow a diffusion curve pa�ern, star�ng slowly with the rate of sales growth peaking in the 12th month and falling therea�er. Total sales per month are expected to grow to about 2,500 units per month by the 24th month and to remain at that level therea�er. Experimen�ng with a

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

0.27T3 where Q is the monthly sales level and T is the month number a�er the launch of the new product. Alicia has es�mated that the demand curve will be P = 2,764.28 − 1.9Q at the midpoint of the diffusion curve. Alicia expects that the price elas�city of demand will be rela�vely high, about ε = −3, since there are many subs�tutes and it seems that cosme�c products need to be rela�vely expensive to convince customers that they are effec�ve. Accordingly, Alicia expects to apply a 50% markup to her average variable costs of $155 per container to set the regular price that would be profit-maximizing when the early majority customers have fully entered the market.

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

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

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

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5. Maxim Motronics A.G. has been marke�ng a new product in Europe that has achieved notable market success and it now plans to introduce this product into the United States market. The product is an electronic device that is mounted in the rear window of passenger cars and allows the driver of one vehicle to have a spoken message converted to text and scrolled across the display panel to be read by occupants of a following vehicle. This new product can u�lize the hands-free telephone microphone already installed in many new vehicles, or provides this as free accessory. Maxim expects that demand will be slow at first but will pick up quickly as automobile accessory stores begin to stock the product and as word-of-mouth promo�on spreads awareness. Maxim also plans to produce a humorous video for pos�ng to YouTube and to u�lize social media marke�ng to spread awareness and enthusiasm for the new product. Market demand es�mates provided by Maxim are that the firm expects to sell about 125,000 units into the U.S. market within 24 months, and that sales per month will start slowly and increase monthly in the expected diffusion pa�ern un�l they stabilize at about 10,000 per month a�er month 24. The diffusion

curve parameters that fit these assump�ons are shown in the equa�on Q = 75.4T + 46.11T2 − 1.352T3, where Q is sales per month and T is the number of months a�er the launch into the U.S. market. Maxim’s average variable cost (AVC) is constant at $62 per unit and expects to set the profit-maximizing price by applying a 167% markup to arrive at a regular price of $165, since it es�mates the demand curve to be P = 270 − 0.02Q.

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

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

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

Key Terms

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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The natural reluctance of poten�al customers to try a new product offering, due to their fear that the quality of the new product may not live up to the claims made by the seller.

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

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

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

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

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

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

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10

© Apostrophe Produc�ons/Ge�y Images

Competitive Bids and Price Quotes

Learning Objectives

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

Discuss the nature of price se�ng where a buyer calls for compe��ve bids or tenders to supply goods and/or services that are not available "off-the-shelf." Dis�nguish between three different modes of compe��ve bidding: fixed-price, cost-plus-fee, and incen�ve (risk-sharing) bid pricing. Apply the logic of incremental costs and revenues, and thus contribu�on analysis, to the compe��ve bid pricing problem, incorpora�ng into the analysis any opportunity and future costs and revenues. Demonstrate that high search costs induce firms to set compe��ve bid prices using a standard markup over a standard cost base, with varia�ons for nonmonetary considera�ons including aesthe�cs, poli�cs, and risk a�tudes of the buyer and seller. Explain how the firm can adjust its standard cost base and/or its standard markup rate to raise its success probability, capacity u�liza�on rate, or profit rate, when these are below the levels that best serve the firm's objec�ves.

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When quo�ng a price, sellers take a gamble. They must operate on the mentality of "win some and lose some" but sellers must win o�en enough to cover overhead costs and realize a profit.

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Introduction

This is the fourth chapter concerned with the pricing decision of the business firm or other organiza�on. In this chapter, we will look into compe��ve bidding, a different type of pricing decision problem that is quite commonly found in business-to-consumer (B2C), business-to-business (B2B), and business- to-government (B2G) transac�ons. Compe��ve bidding occurs in any market where a single buyer calls for a price quote (or tender) from one or more sellers. It is a single buyer situa�on in the sense that the buyer wants a special package of goods and services that is not stock standard and, thus, cannot simply or easily be purchased "off-the-shelf" from a supplier. Instead, the buyer calls for compe��ve bids from one or more poten�al suppliers and then compares the value proposi�on offered by each responding bidder. Consumers effec�vely call for compe��ve bids every �me they want their car fixed, their teeth braced, their house painted, or any other kind of repair work or service that is specific to their par�cular preferences or requirements. Firms call for compe��ve tenders for sta�onery supplies, new vehicles or machines, component parts, consul�ng advice, new buildings, and so on, both to economize on their �me and to induce lower prices from suppliers who are most keen to get their business. Governments wan�ng roads and dams built, military hardware, fleets of cars supplied, and so on, similarly call for compe��ve bids from poten�al suppliers. In many cases, some, or even all, of the products required by the buyer are indeed available off-the-shelf, but when the buyer wants a complex combina�on of products and services it is more efficient if the supplier quotes on the whole package rather than have the buyer separately go around finding out prices and buying them individually (thus avoiding search costs and transac�ons costs). Quo�ng on the whole package also allows the supplier to reduce its profit margin on individual items in favor of winning a rela�vely large contract with an acceptable profit margin.

Each seller should expect that the buyer will ask for a compe��ve bid from other suppliers as well; although, in prac�ce, buyers o�en ask for a single quote and if that seems fair they will accept that price without seeking addi�onal quotes. Seller will realize that if their price quote is too high the business will go elsewhere. Conversely, if their price is too low they will get the job but may end up losing money on the job—this la�er situa�on is known as the

winner's curse.1 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/ch10introduc�on#ch10txt1) The pricing problem in compe��ve bid markets is that the seller must select a price that is high enough to provide a sufficient contribu�on to overheads and profit, yet low enough to ensure that it wins enough jobs to maintain a sufficient volume of work to ensure its survival. Sellers cannot expect to win every job they tender for. Since there is only one buyer and several poten�al sellers, sellers must operate on the basis of "win some and lose some," but win enough to survive and hopefully prosper.

In addi�on to the uncertainty the seller faces concerning the bids of other poten�al sellers, there is uncertainty surrounding the cost of comple�ng the job as specified. Unless the job is completely specified down to the last nut and bolt, and is otherwise straigh�orward, there will be uncertainty about exactly what repairs, services, parts, and labor will be required. Also, since the price is specified ini�ally and the work is done later, weather and other uncontrollable disturbances may add unexpected costs to the project. Thus, compe��ve bidding is a complex pricing prac�ce faced by many firms in the economy and is especially applicable to business-to-business (B2B) transac�ons.

1. The winner's curse applies to a range of situa�ons where the costs of comple�ng the contract are uncertain. If poten�al suppliers each make es�mates of their costs to complete, and one buyer inadvertently underes�mates these costs and subsequently bids at a lower level, it is likely to win the contract, but later find out that its actual costs exceed the price tendered and it is forced to take a loss on the contract. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/ch10introduc�on#return1) ]

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10.1 Types of Competitive Bids and Price Quotes

There are two main types of compe��ve bids plus an intermediate (or combina�on) type. First, there is the fixed-price bid where the seller quotes a price and undertakes to complete the job for exactly that price regardless of unexpected varia�ons in the costs of comple�ng the project. In this case, the seller faces the en�re risk of cost variability. That is, if actual costs are higher than expected costs, the seller will make reduced profit (or even take a loss) on the project. The second main type is the cost-plus-fee bid, where the par�es agree that the ul�mate price will be the actual costs plus a predetermined profit margin for the seller, and in this case the buyer bears the en�re risk of cost variability. In this case, the buyer may end up paying more than it ini�ally expected the final price to be. In most B2B and B2G situa�ons the buyer retains the right to an audit of the seller's costs, but in B2C situa�ons it is more commonly a "take it or leave it" tender, or the price is subject to renego�a�on if the buyer thinks all the bids are too high. In this case, the buyer might receive the bids and then go back to one or more bidders and ask for varia�ons, inclusions, or exclusions before choosing the winning tender.

Fixed-price bids are more common where the items to be purchased can be priced separately, such as building materials, and where labor costs are more predictable. Alterna�vely, cost-plus bids are more common where the degree of uncertainty regarding costs is high. Repair work to automobiles, houses, and industrial plant and equipment typically proceeds on the la�er basis because the actual labor �me and parts required only become known as the repair work progresses and a�er the item to be repaired has been at least par�ally disassembled. The buyer's problem with cost-plus bids is that the seller has li�le incen�ve to work fast and efficiently and thus minimize costs. Given that an audit of the seller's costs will be �me consuming and imperfect, due to the asymmetry of informa�on, the final price to the buyer most likely will be higher than if the seller had a strong incen�ve to keep costs to the minimum.

In Table 10.1, we show the circumstances under which one of these bid types is likely to be preferred over the other. If costs are rela�vely easy to control, then the buyer will probably demand fixed-price bids and the sellers will need to bid in this mode to be considered by the buyer. Conversely, if costs are harder to control or are subject to unexpected increases, sellers will strongly prefer the cost-plus-fee mode and buyers will generally have to bid in this mode. Of course the bidding mode also depends on the rela�ve bargaining power of the buyer. In some B2B and B2G situa�ons a large and important customer might simply announce that it will only accept fixed-price bids.

Next, we consider the degree of risk aversion of the buyer and seller. If the seller is highly risk-averse, it will prefer not to bid in the fixed-price mode; and oppositely, if the buyer is highly risk-averse it will prefer not to receive cost-plus-fee bids. As we noted in Chapter 2, however, even risk-averse people can afford to be risk-neutral with regard to the next decision if they have a por�olio of risky assets. So, if the seller bids on many tenders over the year, it can afford to be risk-neutral with respect to any one tender, expec�ng that cost over-runs on one project tender might be offset by cost under-runs on other projects. The same applies from the buyer's perspec�ve: If the buyer rou�nely calls for tenders for similar jobs, such as a taxi cab company repairing its cabs, it can afford to be risk-neutral with respect to any one cab repair. This is because some repairs will cost more and others will cost less, and on balance the jobs that cost less than expected will tend to offset the jobs that cost more than expected.

Table 10.1: Factors influencing choice of fixed-price versus cost-plus bids Factor Fixed-price bids Cost-plus-fee bids

Degree of cost uncertainty (and/or uncontrollability)

If costs are rela�vely easy to control, buyers will insist on this mode, and seller must tolerate the risk of cost variability.

If cost uncertainty is high, sellers will strongly prefer this mode, and buyers must tolerate the risk of cost variability.

Seller's a�tude to risk

If highly risk-averse, the seller will not want to bid in this mode, unless required to (unless the seller can be risk-neutral due to many concurrent bids, in which case, the seller will tolerate these).

Whatever the degree of risk aversion (unless the seller is risk-neutral) the seller will prefer cost-plus bids since these push all the cost variability risk to the buyer.

Buyer's a�tude to risk

If highly risk-averse, the buyer will strongly prefer this mode. If highly risk-tolerant, the buyer will accept these, and indeed sellers will only want to bid in this mode if cost uncertainty is high.

Many trials of the same risk

If the seller rou�nely and repe��vely bids on similar contracts, it can act as if it is risk-neutral (and submit fixed-price bids), since high-cost jobs will tend to be balanced by low-cost jobs.

If the buyer rou�nely and repe��vely calls for similar tenders, it can act as if it is risk-neutral (and submit cost- plus-fee bids), since high-cost jobs will tend to be balanced by low-cost jobs.

Any request for tender (RFT) by a buyer will have an implicit or explicit quality expecta�on built into the specifica�ons of the work to be done. For example, if you ask for a quote for new �res on your car, or to fix your transmission, you expect the job to be completed to a par�cular level of quality. You want new �res that comply with road safety regula�ons, or you want your transmission to work properly again. The buyer will typically be happy enough to bear a legi�mate cost over-run that is necessary to achieve that expected level of quality, even if the extra cost is unexpected. The problem is the asymmetry of informa�on between the buyer and the seller: The buyer may not be sure that the extra costs charged by the seller are, in fact, necessary to achieve the desired level of quality. Where observa�on and monitoring of the project by the buyer is unsafe (as in the workshop) or would be expensive (in terms of incurred costs and opportunity costs) there needs to be a mechanism to ensure that the seller does indeed deliver the specified quality without leveraging

the asymmetry of informa�on to raise its profit at the expense of the buyer.2 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.1#ch10txt2)

The third type of compe��ve bid provides one such mechanism. It is known as incen�ve bid pricing, and involves the buyer and seller agreeing on the bid price ini�ally, but also agreeing to share any devia�on from the expected cost in an agreed propor�on. The variance of actual costs from the expected costs

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Project management of a compe��ve bid transac�on involves the efficient management of costs, quality, and the �me it takes to complete the project.

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is a cost over-run (if posi�ve) or a cost under-run (if nega�ve). For example, the share of the cost variance might be agreed to be 50% to each party, or in another case 70:30, with one party taking the larger propor�on. In these situa�ons, the seller has a substan�al incen�ve to control costs, since it will have to pay a propor�on of any cost over-run and this will reduce its profit from the job. Conversely, any cost under-run will also add to its profit because the seller will receive an agreed por�on of that cost saving. The buyer's incen�ve to pay more, to cover unexpected cost increases, is to achieve the desired level of quality associated with the job. On the other hand, if the repair is not as extensive as an�cipated, or if weather and other uncontrollable factors play nicely, both the buyer and the seller benefit from the unexpected cost savings.

Apart from price and quality, the third major issue with compe��ve tenders is �me to comple�on. Project management of a compe��ve bid transac�on involves the efficient management of costs, quality, and the �me it takes to complete the project. The buyer will typically want to set a deadline by which �me the job is to be completed, and this deadline will usually be part of the tender specifica�ons. Especially when the project is considered to be urgent, such as comple�ng major road works, bridges, and other public infrastructure (for B2G contracts); comple�ng the manufacture and installa�on of new capital equipment to allow a business to get back in business (for B2B contracts); or comple�ng a car repair or house renova�on (for B2C contracts), the tender specifica�ons might include a clause rela�ng to penal�es for late comple�on, and, conversely, for bonuses if the project is completed before the deadline. Note that such agreements are effec�vely risk sharing agreements as well, since produc�on delays might be caused by both controllable factors (such as poor management by the seller) and uncontrollable factors such as bad weather and unavoidable delays in receiving materials. If the seller beats the deadline it receives a bonus for early comple�on, and indeed it may have put in place an incen�ve contract with its own managers and employees to share this bonus with them if the contract is completed prior to the deadline. The buyer will be happy to

pay this bonus because it will allow early access to the completed project and the bonus will be less than the opportunity cost associated with wai�ng for the job to be completed. On the other hand, if comple�on of the project is delayed beyond the planned delivery date, the seller's profit will be reduced to the extent of the penal�es imposed and the buyer's opportunity costs will be offset to some degree.

2. By seeking mul�ple quotes, and more detail from each poten�al seller, the buyer is likely to reduce the informa�on asymmetry by gaining more informa�on about the produc�on side of the job, including what the job is most likely to involve and what is likely to be the costs of labor, materials, parts, and so on. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.1#return2) ]

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10.2 Incremental Costs and Revenues and the Optimal Bid Price

From the informa�on above, we can deduce that it is very important that the prospec�ve seller carefully calculates the incremental costs that are expected to be associated with comple�ng any contract that it wins through a compe��ve tender process. We saw in Chapter 6 that there are three main categories of incremental costs and revenues, namely present-period explicit costs and revenues, opportunity costs and revenues, and future-period costs and revenues. Let us now consider these in the compe��ve bid pricing problem.

The Incremental Costs of the Contract

The incremental costs of the contract are all those costs, expressed in present value terms, that are incurred as a result of winning and comple�ng the contract. Costs that have been incurred already (sunk costs) and costs that will be incurred whether this contract is won or lost (unavoidable costs) are not incremental costs for the purposes of the pricing decision to be made.

Present-Period Explicit Costs

These include the direct and explicit costs associated with undertaking and comple�ng the project. Included are such cost categories as direct materials, direct labor, and variable overheads that are due to the project under considera�on. These may be es�mated on the basis of the firm's experience with comple�ng similar contracts previously, modified to reflect present materials and labor prices, plus a trend factor if comple�on of the project will take several months or years. In addi�on, the contract may require the firm to purchase and deliver to the buyer capital equipment that needs to be purchased by the seller at current prices.

In some cases, the comple�on of the contract will necessitate the seller purchasing special machines, tools, or other items of capital equipment that are needed to complete the job but which remain the property of the seller a�er the contract is completed. If these items have a useful life remaining, it seems unfair to the buyer to charge the en�re cost against the current contract. The appropriate way to deal with this is indeed to charge the en�re cost of the item as an incremental cost to the buyer, but to also take account of possible future income or cost savings that are likely to be obtained subsequently. These should be counted as incremental revenues to reduce the incremental cost by an amount represen�ng the net present value of the future revenues and the future costs avoided (which we call "opportunity revenues").

Another considera�on is the capacity u�liza�on rate of the firm. When the firm is at or near to its full capacity rate of output, it must consider the addi�onal incremental costs that will be incurred if it wins the contract, such as over�me labor rates, outside contrac�ng expenses, penalty charges associated with delays on other exis�ng contracts, and new capital equipment that must be purchased to enable the contract to be undertaken and completed.

Opportunity Costs

As we know, opportunity costs are the value of resources in their next-most-valuable use. Hence, if plant and equipment are lying idle, they have zero

opportunity cost if they are used in the contract under considera�on.3 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.2#ch10txt3) On the other hand, if they are currently employed in a project that must be set aside, delayed, or cancelled to accommodate the contract under considera�on, then the contribu�on to overheads and profits that these resources could have made must be counted as an opportunity cost for the project under considera�on. For example, a firm producing rela�vely low-value items to build up its inventories for supply to wholesale and retail customers may decide to bid on a tender and if successful would stop producing these items, u�lizing its resources more profitably on the contract under considera�on. The contribu�on foregone is an opportunity cost of the contract under considera�on. If the alterna�ve produc�on is simply delayed and this simply causes revenues from the sale of those items to be delayed, the opportunity cost is simply the interest income foregone on the revenues involved.

Future Costs

Future incremental costs may include the effects of customer ill will, deteriora�ng labor rela�ons or supplier rela�ons, and legal recourse by dissa�sfied buyers or government prosecutors. Ill will (or ill feeling) toward the seller may manifest itself in the expected present value of contribu�on (EPVC) of future contracts that are lost if this current contract is undertaken. For example, undertaking a difficult or poli�cally conten�ous contract today might come back to haunt the firm if it upsets employees, suppliers, or government regulators. To the extent that such future costs are envisioned, the firm should allow for them in the current calcula�on of incremental costs. For example, a trucking company that wins a contract to move the city's garbage during a garbage- workers' strike may well expect to lose business in the future from people and organiza�ons who are sympathe�c to labor unions.

In prac�ce, it is not likely to be worth the search costs required to carefully es�mate every single opportunity and future incremental costs associated with a par�cular compe��ve tender, nor is the bidding firm likely to have the �me required for this informa�on search ac�vity, since RFTs are typically issued with only a short �me for poten�al sellers to respond. More realis�cally the bidding firm will simply add a "cushion" (or safety margin) to its explicit incremental costs to reflect its recogni�on that there are opportunity and future incremental costs involved.

Bid Prepara�on Costs

Even when it avoids the search costs of es�ma�ng opportunity and future costs, the bidding firm will incur significant bid prepara�on costs, which are costs associated with studying the tender specifica�ons and subsequently es�ma�ng the costs of undertaking and comple�ng the project to the required level of quality and within the required �meframe. It may take one or more employees several days to work up an es�mate and to submit the formal tender

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Opportunity revenues are costs that are avoided as the result of a management decision.

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documents, and they may need to buy-in informa�on and exper�se in order to complete and submit their tender. Note that these bid prepara�on costs are incurred before the bid price is submi�ed and are incurred regardless of whether the contract is later won or lost. They are therefore sunk costs as far as the incremental costs of the contract are concerned.

Thus, bid prepara�on costs must be treated as part of the firm's overhead costs that are (hopefully) covered by the contribu�ons to overheads made by the contracts that the firm actually wins. As noted earlier, the firm that engages in compe��ve bidding cannot expect to win every contract it bids on and must con�nue bidding on many contracts in order to win enough to avoid bankruptcy and hopefully also to be profitable. In the following sec�ons, we shall see how the firm plays the probabili�es game in choosing its compe��ve bid price to win enough bids to stay alive and make enough profit on those that it does win to stay profitable.

Incremental Revenues of the Contract

The incremental revenues of the contract are all those revenues (expressed in net present value terms) that are expected to be received as a result of winning and comple�ng the contract. As discussed earlier, they include present-period explicit revenues, opportunity revenues, and future revenues.

Present-Period Explicit Revenues

If the contract is to be awarded, completed, and paid for within the present period, then there will be present-period explicit revenues that accrue to the seller—these are the actual cash inflows to the selling firm within the current produc�on period. Par�cularly in B2B and B2G situa�ons, the job to be completed may extend beyond the present period, with large projects being completed years later. In such cases there will typically be progress payments at intervals within the contract dura�on, and at least one of these is likely to occur in the present period. Other progress payments and the final payment that are to be received in future periods should be discounted using the opportunity discount rate to bring them back to present-value terms and allow them to be addi�ve with present period cash flows.

Opportunity Revenues

Opportunity revenues are costs that are avoided as the result of a management decision. In this case, if costs can be avoided by winning a compe��ve bid contract, the magnitudes of the costs avoided (discounted if avoided in future periods) are included as opportunity revenues. For example, if the firm wins the contract it might avoid severance costs associated with laying off workers and the later costs of recrui�ng and training new workers.

It might also avoid the cost of having to apply special treatments to idle plant and equipment to avoid deteriora�on of those capital assets—for example, machinery might need to be sprayed with oil or otherwise sealed to prevent rus�ng. In such cases, the equipment will need to be cleaned and serviced before it can be brought back into produc�on again, so the avoidance of these costs would also represent opportunity revenue. Another possible opportunity revenue is the equipment and research and development (R&D) costs that can be avoided if the firm wins the present contract. Managers might know that they need to upgrade their equipment and conduct R&D to keep up to date in the industry, and that winning the current contract would allow them to do this within the context of that contract, and thus save the expense of doing it separately. By trea�ng this expense as an opportunity revenue the firm can bid at a lower price and be more likely to win the contract and, thus, upgrade its equipment and exper�se while also gaining work for the employees and a posi�ve contribu�on to overheads and profits for the firm.

Future Revenues

Winning and comple�ng the present contract may allow the firm to gain exper�se and reputa�on that will lead to other contracts in the future that will generate future profit. Accordingly, the firm can afford to count the EPVC of the future contracts as incremental revenue of the contract under review and, thus, will be able to bid at a lower explicit revenue price and be more likely to win the current contract. In prac�ce of course, the search costs of es�ma�ng the future revenues are likely to be prohibi�ve and, instead, the bidding firm will "take a bit off" its bid price in recogni�on that winning the contract will not only generate revenues in the current and subsequent periods but also facilitate the firm poten�ally winning other contracts in the future.

In the previous discussion, I explained that a lower bid price will make it more likely that the bidding firm will win the bid. It is now �me to look at how the probability of winning the bid increases as the bid price is reduced, and how the firm considers the expected value of the contract at each of several bid prices to choose the bid price that maximizes the expected value of profit.

The Optimal Bid Price

If the firm's objec�ve is to maximize its net present worth, the op�mal bid price will be the price that maximizes the expected present value of contribu�on (EPVC) to overheads and profits. The "expected" in this term implies that we have to mul�ply the present value of the contribu�on at each price by the probability of winning the contract at that price, as we do in Table 10.2. The higher the bid price the lower will be the success probability, which is the

probability that the firm will submit the lowest bid price and be selected by the buyer.4 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.2#ch10txt4) In Table 10.2, we show the data for a par�cular compe��ve bid situa�on. Suppose the firm has become aware of an RFT and wants to submit a tender. A�er scru�ny of the tender specifica�ons, the managers have determined that the incremental costs, minus the incremental revenues (other than the bid price),

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all expressed in present value terms, are $500,000. In column 2, we show a range of bid prices with the consequent contribu�on levels in column 3. In column 4, we show the es�mated success probabili�es at each of the indicated bid price levels. As you can see, the success probability is 90% when price is set equal to the net incremental costs (meaning there is a 10% chance that at least one other firm might bid lower than that) and then falls progressively as the probability increases that at least one other firm will bid lower than that price. The data in column 5 is the EPVC, which is the contribu�on at each bid price level mul�plied by the success probability at that price level. As you can see the EPVC seems to be maximized at $100,000 when the bid price is $700,000.

Table 10.2: Expected present value of contribu�on analysis of the bid price Net EPV of incremental costs $000s Possible bid price $000s Contribu�on if winning bid $000s Success probability EPVC $000s

500 500 500 500 500 500

500 600 700 800 900 1000

0 100 200 300 400 500

0.90 0.70 0.50 0.30 0.15 0.05

0 70 100 90 60 25

But, note that the possible bid prices were arbitrarily spaced out at $100,000 intervals, and the bid price that maximizes EPVC might be somewhere in between these arbitrary bid levels. It is a simple ma�er to plot the EPVC data against the bid price and interpolate between these data points—that is, to sketch in the apparent intermediate values of the EPVC between the known data points. We do this in Figure 10.1 and see that the EPVC appears to be maximized at about $101,500 when the bid price is set at about $725,000.

Figure 10.1: Interpola�on of the EPVC to find the op�mal bid price

In this case, the firm should bid at $725,000 which appears to maximize its EPVC. Subsequently it may or may not win this contract, since the success probability is only about 45% (found by interpola�ng between the success probabili�es in Table 10.2). But, if a firm bids for a large number of contracts and always bids at the price that maximizes EPVC, it may win some and lose some, but it should expect to maximize its net present worth over an extended period of �me. Indeed the firm will need to bid on many contracts if the success probability of this project (about 45%) is typical—it will need to bid on more than two contracts in order to win one contract, on average.

Aesthe�c, Poli�cal, and Risk Considera�ons

Several nonmonetary considera�ons may also enter the compe��ve bid pricing process. Aesthe�c considera�ons, such as design aspects that generate psychic sa�sfac�on for the bidding firm, might induce the firm to bid higher or lower than the EPVC-maximizing price. If the project is aesthe�cally appealing, delivering psychic sa�sfac�on to the firm's top managers, for example, they might lower the bid price to increase the chances of winning the contract. Conversely, if comple�ng the project is expected to deliver disu�lity to the managers or employees of the firm, because it is dirty, uncomfortable, or inconvenient in some way, the managers might decide to raise the bid price somewhat to compensate for that disu�lity in the event that they do win the contract.

Poli�cal (i.e., self-serving) behavior by the firm's managers may also cause the bid price to vary from the EPVC-maximizing level. If the pricing manager wants to impress his or her superiors, the bid price might be lower than the EPVC-maximizing level to increase the chances of winning the contract. Similarly, if the pricing manager wants to do a favor for a friend who is seeking a price quote, the price quoted may be set at a lower level to recognize (or promote) the friendship between the person buying and the person selling. Similarly, buying firms may wish to build up goodwill with their suppliers to ensure they will receive supplies in the future when the supplier is really busy.

Concerning risk considera�ons, note that the risk of not winning the contract is about 55% in the case examined above. If this contract is representa�ve of all other contracts for which this firm tenders, this would mean that the firm would win about 45% of the projects it tenders for. But, if the firm needs income soon to avoid running out of cash, not winning this par�cular contract would put the firm at extreme risk of insolvency. In this case, the managers

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Poli�cal behavior can influence a firm's bid price. For instance, the pricing manager might decide to do a favor for a friend who is seeking a price quote by quo�ng a lower price to recognize the friendship between the person buying and the person selling.

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might not be willing to gamble on a 45% chance of success on this par�cular occasion and will prefer to trade off some contribu�on for a be�er chance of winning the contract, by se�ng a lower bid price. We have already considered the opportunity revenues that would accrue if the firm can avoid the costs of laying off workers and dormant equipment, but here we are concerned with the risk aversion of the firm's managers (or their shareholders) and their willingness to avoid the risk of insolvency by reducing their bid price even further to increase their chances of success. Thus, we see firms bid at lower bid prices if their managers or shareholders are more risk-averse and strongly want to avoid the psychic disu�lity associated with going through the process of bankruptcy.

Cost-Plus-Fee Bids to Avoid the Risk of Cost Varia�on

As men�oned earlier, in addi�on to the risk of not winning the contract, there is the risk that (if the contract is won) the actual costs of comple�ng the contract will exceed the expected or projected costs (i.e., the winner's curse). And, as indicated earlier, the greater the risk aversion of sellers the greater will be their desire for cost-plus-fee bids rather than fixed-price bids. The bidding firm usually has a choice of bidding mode—it

may bid either a fixed price (bearing all the risk of cost varia�on), a cost-plus-fee bid (transferring all the risk to the buyer), or an incen�ve bid that shares the risk of cost varia�on between the buyer and the seller in some agreed propor�ons. Unless the supplier is risk-neutral (which it might be if it bids on many similar bids) it will want to set a higher bid price if tendering a fixed-price bid than it would if (for the same es�mate of costs) tendering a cost-plus- fee bid price.

In Figure 10.2, we show an indifference curve linking the fixed-price bid and the cost-plus-fee bid that would provide the same expected u�lity for a par�cular bidder. This figure depicts a quite risk-averse seller who would be equally sa�sfied with a $725,000 fixed-price bid, a $650,000 incen�ve bid (with 50:50 risk sharing), and a $600,000 cost-plus-fee bid. It presumably also depicts a situa�on in which the poten�al cost varia�on is apparently quite high, since the seller is willing to give up about $125,000 to totally avoid the risk of cost varia�on.

Figure 10.2: The risk–return trade-off for different bidding modes

Note that in Figure 10.2 we have selected the 50:50 risk sharing propor�ons quite arbitrarily. The actual propor�ons are a ma�er for nego�a�on between the buyer and the seller and could occur anywhere along the indifference curve. That is, anywhere between 0% and 100% of the cost-varia�on risk could be borne by the seller with the complementary propor�on being borne by the buyer. You can imagine that if the buyer is highly risk-averse it will prefer to bear no risk of cost varia�on and pay the $725,000 fixed price, whereas if the buyer is highly risk-tolerant it will prefer to pay the substan�ally lower cost-plus-fee price of $600,000 and bear all of the risk of cost varia�on. If the buyer's degree of risk tolerance is somewhere in between, it will prefer an incen�ve (risk- sharing) bid price somewhere in between these extremes and this might then be nego�ated with the seller.

As an example, suppose the state government issues an RFT that calls for the construc�on of a mul�story parking garage. The es�mated cost for construc�on of this parking garage is quite straigh�orward except for the fact that in digging the holes for the concrete foo�ngs, the construc�on firm might encounter rock. If rock is found, it will require blas�ng with dynamite, which will increase the cost significantly. XYZ Co. is highly familiar with this kind of work, and plans to submit a tender. Its managers reason that some�mes they find rock and have lower than expected profit (because of the extra blas�ng costs) and other �mes they find no rock and have higher profit because blas�ng costs are avoided. Whether XYZ Co. bids in fixed-price mode or cost-plus mode may depend on which mode the buyer asks for. In this case, let us suppose that the buyer has asked for bids in both modes and will choose the price and mode that is most suitable, poten�ally asking for agreement on a risk-sharing arrangement.

If bidding in the cost-plus-fee mode, XYZ Co. can ignore the blas�ng costs, since it will simply pass them along to the buyer. Excluding the possible blas�ng cost, XYZ Co. calculates that the construc�on cost of the parking garage will be $1.5 million, including the firm's es�ma�on of opportunity and future costs

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and revenues, and we will assume that this incremental cost is not subject to uncertainty since XYZ Co. is very familiar with this kind of construc�on project. In Table 10.3 we show the EPVC for several bid price levels.

Table 10.3: Expected present value of contribu�on analysis of the bid price Net EPV of incremental costs* $000s Possible bid price $000s Contribu�on if the winning bid* $000s Success probability EPVC* $000s

1,500 1,500 1,500 1,500 1,500 1,500

1,500 1,600 1,700 1,800 1,900 2,000

0 100 200 300 400 500

1.00 0.80 0.60 0.40 0.20 0.10

0 80 120 120 80 50

*Excluding possible blas�ng costs

By interpola�ng between the bid prices in Table 10.3 we would find that the EPVC is maximized (at about $125,000) when the bid price is $1,750,000, allowing a contribu�on from the winning bid of $250,000. Accordingly, to bid in the cost-plus-fee mode, XYZ Co. simply says its price will be the actual cost (as audited by the seller) plus a fee of $250,000.

Now suppose that XYZ Co. has es�mated the probability distribu�on of blas�ng costs to be as shown in Table 10.4, where you can see that blas�ng costs might be somewhere between $0 and $500,000 with an expected value of $180,000. If the contract is awarded on a fixed-price basis, the actual blas�ng costs will be borne by the seller, XYZ Co.

Table 10.4: Expected costs of blas�ng if rock is encountered Expected cost of blas�ng ($000s)

Probability (%)

EV of blas�ng cost ($000s)

0 100 200 300 400 500

20 30 20 15 10 5

0 30 40 45 40 25 180

To find the fixed-price bid, which transfers all the risk of finding rock to the seller, we need to recalculate the EPVC at each bid price level, since incremental costs will now be $180,000 higher, now totaling $1,680,000 in expected value terms. We show this in Table 10.5.

Table 10.5: Expected present value of contribu�on analysis of the fixed-price bid Net EPV of incremental costs $000s Possible bid price $000s Contribu�on if winning bid $000s Success probability EPVC $000s

1,680 1,680 1,680 1,680 1,680 1,680

1,500 1,600 1,700 1,800 1,900 2,000

−180 −80 20 120 220 320

1.00 0.80 0.60 0.40 0.20 0.10

−180 −64 12 40 45 32

Interpola�ng between the rows in Table 10.5, you can see that the EPVC-maximizing fixed-price bid appears to be somewhere close to $1,900,000. Since XYZ Co. bids frequently on jobs like this, it can afford to be risk-neutral about these possible blas�ng costs, and tender a fixed-price bid of $1.9 million. The buyer will then consider its own degree of risk aversion and might choose the cost-plus-fee bid (if it is risk-neutral) or the fixed-price bid (if it is highly risk-

averse) or a bid price and a risk share somewhere in between (if its degree of risk aversion is somewhere in between the two extremes).5

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.2#ch10txt5)

3. Idle plant and equipment may provide a back-up plan if the breakage of similar equipment would cause a delay in comple�on of a contract and a�ract penalty charges. Also, idle plant capacity (known as excess capacity) allows a firm to increase its produc�on level quickly without wai�ng for new plant and equipment to be installed. This may serve to deter the entry of new firms that might have entered to supply unmet demand if the exis�ng firm(s) did not have any extra produc�ve capacity. In these cases idle equipment does have an opportunity cost. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.2#return3) ]

4. Or more generally, in cases where the bidders submit differen�ated tenders with different bid prices, the lower the likelihood that the firm's bid price will be considered the best value proposi�on from the buyer's perspec�ve and consequently selected by the buyer. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.2#return4) ]

5. Note that if the seller were risk-averse, rather than risk-neutral as in this example, it would want its fixed-bid price to be higher than $1.9 million, since the actual costs of blas�ng might be considerably higher than the EV of the blas�ng costs. The higher its degree of risk aversion, the higher it will want its fixed-price bid to be above $1.9 million. On the other side of the transac�on, the buyer's degree of risk aversion will determine how much of the cost-varia�on risk it is prepared to take on. The op�mal risk-sharing agreement will be nego�ated between the two par�es taking into account their rela�ve degrees of risk aversion. We will not show the theore�cal solu�on to this nego�a�on problem here as it is rather complex and in any case assumes that informa�on on the par�es' risk preferences is easily found with zero search costs. For those interested in the theore�cal solu�on, see Douglas, E.J. (1989). "The simple analy�cs of the principle-agent incen�ve contract." The Journal of Economic Educa�on, 20 (Winter): pp. 39–51, for an analogous argument. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.2#return5) ]

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10.3 Markup Bid Pricing When Information Is Costly

In earlier chapters, we learned that when informa�on is costly the firm is likely to avoid informa�on search costs and simply apply a markup percentage to its cost base to arrive at its pricing decision. It is completely possible that the firm can arrive at the same bid price using a simple markup pricing procedure. For example, if foreseeable costs had been $1,583,333 and the firm had applied a 20% markup rate, the result would be a bid price of $1,900,000.

Essen�ally, the firm will adjust its markup rate to ensure that it wins enough contracts to stay in business and hopefully also make sa�sfactory profits. If it does not win enough contracts, it should reduce its markup rate and, thus, increase its probability of success. If it wins too many contracts and cannot handle the volume of business that it wins, it will raise its markup rate to reduce its success rate, at least for a while un�l it has excess produc�ve capacity again. You will see that these adjustments are compa�ble with what we said earlier about adjus�ng the bid price to take account of the opportunity costs and revenues and the future costs and revenues that are likely to be hard to measure.

Reconciling the EPVC and Markup Approaches

In Figure 10.3, we show a flow chart of the two alterna�ve approaches to compe��ve bid pricing. The first step is to decide whether to make a bid. If the project is within the firm's competency; if the firm is not already opera�ng at full capacity (or expects to fall below full capacity by �me the contract would be undertaken); or if the firm thinks it has a reasonable chance of success, it would typically decide to bid on the contract. It must then decide what search costs it wishes to incur. To implement the full EPVC cost and subsequent expected profit calcula�ons, the firm must es�mate what its incurred addi�onal search costs would be. If not excessive, due to readily available cost data and condi�ons that ensure rela�vely low cost variability, the firm might choose the EPVC route. Alterna�vely, in par�cular when the RFT has a rela�vely short deadline, the firm might decide to u�lize the markup pricing procedure. Figure 10.3 serves as a useful review of the steps in the bid-pricing process in the two alterna�ve modes. Not stated in Figure 10.3 is the op�on to bid in a different mode—that is, either cost-plus-fee mode or incen�ve (risksharing) mode—if the risk of cost variability is high and one of these other modes would be�er suit the risk preferences of the buyer or the seller.

Figure 10.3: The EPVC model contrasted with the markup bid-pricing model

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Bid Pricing for the Satisficing Firm

O�en we observe that the prac�cing compe��ve bidder appears to exhibit the four basic features of a sa�sficing firm, which is a firm that is content to earn sa�sfactory profits rather than strive to exactly maximize profits (Cyert & March, 1963; Simon, 1979). The first basic feature of sa�sficing firms is that they exhibit bounded ra�onality, or pu�ng boundaries on the informa�on that they will seek due to the search cost of informa�on, and then ac�ng ra�onally (i.e., trying to maximize profit by se�ng MC = MR, or by choosing the markup rate based on es�mated price elas�city) within the boundaries of the informa�on that is available to them. Thus, the sa�sficing compe��ve bidder might calculate only its es�mated incremental costs and decline to search for future costs and probability distribu�ons. Second, the sa�sficing firm prac�ces selec�vity by confining its a�en�on to profit-making opportuni�es that are near at hand and that seem worthwhile to pursue. Thus, the sa�sficing firm will not bid on all RFTs offered, but confines its a�en�on to those that it is most likely to win and for which it has the technology and produc�ve capacity. Third, the sa�sficing firm establishes decision rules, like standard-cost bases and markup rates, to facilitate and expedite its decision-making processes, as we saw above. Fourth, sa�sficing firms establish targets, or sa�sfactory levels for their output and profit rates, and use feedback informa�on from their experience in the market to adjust these targets and decision rules when such ac�on becomes necessary or desirable.

In Figure 10.4 we see a flowchart of the decision-making process for the sa�sficing firm in the context of compe��ve bidding. You can see that it is essen�ally a varia�on of the markup pricing procedure with several ques�ons explicitly posed to help the decision maker decide whether to bid and, if so, at what price to bid.

Figure 10.4: Bid-pricing decision sequence for the sa�sficing firm

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The Value Proposi�on From the Buyer's Perspec�ve

As in most pricing situa�ons, the seller's inten�on is (usually) to offer the best value proposi�on to the poten�al buyer. Thus, a supplier's bid may be accepted even if it is more expensive to the buyer if it is simultaneously a be�er value proposi�on due to its qualita�ve aspects. So sellers might offer above-specifica�on quality at a slightly higher price and might win the tender if this is a superior value proposi�on for the buyer. Similarly, where the seller contributes design quality to the project, the design of one seller might be considered superior and chosen even though that firm's bid price is higher. Conversely, if the tender is completely specified such that there is no room for design or other qualita�ve varia�on, the best value proposi�on will be the one with the lowest bid price, assuming they all meet the quality specifica�ons.

Although most pricing situa�ons involve the supplier firm feeling compelled to bid and maintain a rela�onship with the buyer, this may not always be the case. If the supplier is opera�ng above full capacity, or sees nega�ve aesthe�c, poli�cal, or risk issues with the contract, the supplier may not really want to win the contract and should accordingly set a somewhat higher price that will make it worthwhile if the contract is indeed won. This higher price may cause the tender to not be the best value proposi�on facing the buyer, of course.

Illegal Bidding Practices

In the foregoing we have assumed that firms bidding for a par�cular contract do so without the benefit of any interac�on or informa�on flow between the compe�ng suppliers. Doing so would likely cons�tute collusive pricing, which is illegal under federal legisla�on and would result in financial penal�es for the firms and poten�ally jail terms for the managers concerned. Collusive bidding is where two or more firms conspire to set their bid prices to the detriment of the buyer or society in general. Colluding firms might agree to set their prices at a rela�vely high level such that the lowest bid price is higher than would have happened if they had competed independently for the business. They might not agree to the actual prices to be set but simply exchange or provide informa�on that results in, or could reasonably be construed to result in, a higher price to the buyer. Be sure to avoid any contact or informa�on flow between your firm (and its managers) and rival bidders (and their managers) that might be construed, even circumstan�ally, as collusive bidding. Because

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this is o�en a "gray area" of the law, it is useful to take a brief look at the kinds of prac�ces that are likely to a�ract the a�en�on of the compe��on regulators.

Compe�ng suppliers might conspire to submit iden�cal bids, which are exactly the same bid price on a par�cular contract. These firms might ra�onalize that they will set iden�cal bids to avoid the situa�on where one firm might place a low bid to win a fully specified contract on the basis of price, and to force the seller to choose the winner on some other basis, which might be the above-specifica�on qualita�ve aspects of the tender or on other aesthe�c, poli�cal, or risk considera�ons. Of course, iden�cal bids might be en�rely coincidental, par�cularly where the component materials and services are rela�vely standard and there is a general expecta�on that a par�cular markup or profit rate is standard in that industry. But a prac�ce of se�ng iden�cal bids is likely to a�ract the a�en�on of the regulators, especially if the poten�al buyer feels that the iden�cal bid price is unreasonably high and brings the situa�on to the a�en�on of the regulators.

Another illegal bidding prac�ce is bid rota�on, where the firms conspire to take turns to submit the lowest bid in a situa�on where they bid repeatedly against each other. Thus, it is illegal for firms to "take turns" to be the lowest bidder, by submi�ng bids that are too high to win except when it is their turn to be the lowest bidder. Or similarly, a firm might make it obvious that it would really like to win a par�cular contract and the other firms acquiesce to that by either not bidding on that contract or by submi�ng higher bids than they normally would.

Bid disclosure is the prac�ce of making public the prices at which one or more firms have tendered. Even if there is no collusive agreement, if the suppliers regularly disclose their bid prices a�er the winner is announced, this informa�on may allow suppliers to predict the bidding behavior of rivals in subsequent tenders and also to confirm whether the other firms did in fact bid according to their prior expecta�ons, and this will likely lead to higher bid prices for the buyer in the future. From the buyer's point of view, it is therefore likely to be counterproduc�ve to release any informa�on other than who was the successful bidder; although in B2G situa�ons, the public will want to be assured that the bidding process is sufficiently transparent.

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Summary

In this chapter, we have applied the contribu�on approach to the pricing situa�on where firms must make compe��ve tenders for sales to buyers. The relevant cost concept is the incremental cost associated with undertaking and comple�ng the contract, and as long as the bid price exceeds the incremental cost of the project, some contribu�on will be made to overhead costs and profits. Note that incremental costs and incremental revenues include opportunity costs and revenues and future costs and revenues, and that winning each bid is probabilis�c, such that the appropriate calcula�on is the expected present value of the contribu�on, or EPVC. We noted that varia�ons from this purely monetary figure may be jus�fied on the basis of aesthe�c, poli�cal, or risk considera�ons.

In prac�ce, most firms use markup pricing over easily obtainable cost measures as a search-cost-avoiding method to arrive at hopefully a similar profit outcome. Not only does markup pricing save search costs, but it also saves �me in a pricing situa�on where the tender deadline may be quite soon, and in many B2C situa�ons may be almost immediate. The markup rate u�lized by the firm should be scru�nized periodically to ensure that it is keeping the firm at the desired levels of capacity u�liza�on and profitability.

Both the EPVC approach and the markup approach require an explicit or implicit es�mate of the probability of winning the contract at each possible bid price level. The major factors involved in es�ma�ng these success probabili�es are the probability that compe�tors will bid at a lower level, and the apprecia�on that the buyer will have for qualita�ve differences that the firms might be able to insert into their tender proposals, such that their bid is seen as the superior value proposi�on from the buyer's perspec�ve.

When firms repeatedly engage in compe��ve bidding, and par�cularly when the �me to prepare the bid is short, they will gravitate towards a pricing process that is based on a standard markup over costs calculated using a standard cos�ng formula. By repeatedly using this standard cost base and markup rate the firm wins some and loses some, and if winning too few contracts will adjust its markup rate downwards, and if winning too many it will use a higher markup rate or include a larger contribu�on to overheads in its standard cos�ng formula. We noted that firms in compe��ve bidding markets may adopt a sa�sficing approach by prac�cing bounded ra�onality or selec�vity, using simple decision rules, and se�ng targets for capacity u�liza�on and profitability levels.

Ques�ons for Review and Discussion

Click on each ques�on to reveal the answer.

1. Outline one or more situa�ons in which you have been the buyer in a compe��ve bidding or price quote situa�on. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Perhaps you have asked for a price quote for a repair to your bicycle or car; or to paint a fence or a house; or to fix a broken string in a tennis racket; or to mow your lawn; or to tutor your child in math, and so on. In a business context, perhaps your firm called for tenders to purchase several vehicles; to refurbish the office space; or to install storage space and par��ons in the factory.

2. Make a list of those items that you would expect to enter into the incremental cost calcula�on for a contract to remove the seagulls from the vicinity of a major coastal airport. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Incremental costs might include the costs associated with the capture and reloca�on and/or of culling and disposing of the seagulls; the costs of appeasing animal rights groups; the costs of promo�on and publicity generated to cast your firm in a favorable light; and the costs of future contribu�ons lost due to bad publicity over killing or removing birds from their habitat.

3. In calcula�ng the incremental cost of a par�cular project, how would you treat the possible future costs of a lawsuit that may occur as a result of this project, where the cost of the lawsuit might range from $10,000 to $500,000 with an associated probability distribu�on? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

The incremental cost of a possible future lawsuit should be es�mated in ENPV terms by first es�ma�ng a probability distribu�on of legal costs in each year for, say, the next five years. From this data you would calculate the EV of legal costs in each future year. Any future revenues including costs that will be avoided as a result of the lawsuit would also be expressed in EV terms and ne�ed against the EVs of legal costs in each year. These values would then be discounted back to ENPV terms by mul�plying each one by the appropriate discount factor and finally summing the products.

4. How would you value the goodwill (i.e., expected future business) that is expected to be generated as a result of undertaking a par�cular contract? If there is expected goodwill, would you be prepared to bid lower than otherwise? Why? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

The expected future business an�cipated to be generated from winning a contract in the current period might be valued in ENPV terms by se�ng out a list of the contribu�on levels (to overheads and profit) that are expected to result from this contract, in each year for several years into the future. A�er es�ma�ng probabili�es for each of these outcomes in each period into the future you would calculate the EV of the future business in each year. By mul�plying each of these by the appropriate discount factor and summing the products you would derive the ENPV of the future business that is expected to flow from winning the present contract.

5. Explain why the strategy of choosing the bid price with the highest expected value is likely to generate the greatest contribu�on to overheads and profit over a large number of successful and unsuccessful bids. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

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Over many trials of a gamble, the best strategy is to con�nually choose the alterna�ve with the highest ENPV. Although you will win some contracts and lose some contracts, you can expect to win the propor�on of bids indicated by the probability of success. Any other bid pa�ern is likely to cause you to win some contracts but lose money due to bidding too low, and lose other contracts by bidding too high when you might have won them at a lower but s�ll profitable bid price.

6. Outline the different modes of bid pricing. Why choose one mode of bidding over the others? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

The fixed-price bidding mode offers a fixed price to comple�on regardless of any cost over-runs or under-runs. The bidder (supplier) thus bears all risk of cost varia�on. The cost-plus fee mode offers a fixed fee on top of actual (audited) costs, and thus transfers all the risk of cost varia�on to the buyer. The incen�ve bidding mode shares the risk of cost varia�on between the buyer and the supplier in an agreed propor�on. The mode chosen will depend on the inherent risk involved in the project, and the rela�ve risk aversions of the buyer and the seller.

7. Explain how the strategy of marking up incremental costs by a standard percentage (and subsequently winning some contracts and losing some contracts) may over a period of �me give equivalent results as compared to selec�ng the bid price with the maximum expected value of contribu�on. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

A standard mark-up pricing procedure may give equivalent profit results over �me (to the ENPV approach) because it avoids extensive search costs and the mark-up rate can be adjusted or fine-tuned to take into account any recognized factors that are likely to increase or decrease the probability of success in any specific bid pricing situa�on.

8. Outline the factors that would cause you to use a lower markup rate on incremental costs (as compared with your usual markup rate) in a par�cular bidding situa�on. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

You would reduce the mark-up rate if (i) capacity u�liza�on was currently very low; (ii) if the job promised extraordinary future net benefits; and (iii) if the job promises extraordinary aesthe�c outcomes, poli�cal rewards, or risk reduc�on.

9. Explain how value analysis enters the bid pricing process when buyers call for tenders that poten�ally vary in their qualita�ve aspects, such as a company asking for bids to design and build a new corporate headquarters building. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Value is equal to quality over price and some contracts call for the bidder to suggest design features that result in higher or lower quality being perceived by the buyer. Thus the best value proposi�on is not necessarily the tender with the lowest bid price. In such bid markets the bidder's first priority is to create a compelling design which, if preferred by the buyer, can be used to secure a more-profitable bid price.

10. Why is collusive bidding illegal? Who does it hurt? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Collusive bidding is illegal because it causes a lack of compe��on in the market, and this in turn tends to cause the buyer to pay higher prices and to receive lower quality than it would if the firms competed independently on the basis of their prices and quali�es. It reflects an abuse of market power, to the financial detriment of not only the buyers and their shareholders but also the downstream customers of the buyer who will, as a consequence, have to pay higher prices for lower quality goods and services.

Decision Problems

1. The Billings Prin�ng Company is preparing to bid on a contract to supply half a million leaflets for a mailbox drop by a major pizza restaurant. Billings has calculated its incremental costs to be $50,000. Past experience with this kind of contract has resulted in the following schedule, which shows the number of contracts tendered and won at each of several markup rates over incremental costs during the past three years.

Markup rate (%)

Contracts tendered at this rate

Contracts won at this rate

10 20 30 40 50

53 180 624 110 63

50 130 283 20 4

a. Calculate the expected value of the contribu�on at each of the bid prices implied by the above markup rates. b. Interpolate between these rates to iden�fy the markup rate, and the bid price, that would maximize expected contribu�on from the contract. c. What assump�ons and qualifica�ons underlie your analysis?

2. Your company, Bright Paints, is one of a dozen companies manufacturing a special reflec�ve paint used for traffic signs. The State Department of Transporta�on has called for tenders to supply 10,000 gallons of blue reflec�ve paint to be delivered within two months. You can foresee fi�ng in a produc�on run of the blue paint and have decided to bid on the job. You calculate your incremental costs for this job to be $76,200. This par�cular contract is standard, similar in all respects to hundreds of contracts you have bid on over the past few years. Your pricing policy has been to apply a markup rate to incremental costs to arrive at the bid price. Your markup rate has been higher when you had plenty of orders and lower when you had few or no orders to fulfill. You have assembled data rela�ng the markup rate used and the percentage of contracts won at each markup rate, as follows:

Markup rate (%) Percentage of contracts won at that rate (%)

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0 10 15 20 25 30 35

95.9 84.8 65.4 41.3 15.7 3.0 0.2

a. Why would your company have bid with a 0% markup on some past tenders? Why didn't it win all of those contracts? b. What is the bid price that maximizes the expected contribu�on of the contract? c. Why, or why not, is the fixed-price mode of bidding likely to be the best one to use for this contract?

3. Stenson Steel Fabricators is preparing a bid for a steel watergate to be installed in an irriga�on canal. Its prac�ce has been to charge each contract with bid prepara�on costs of $2,000, which is actually about three �mes the actual value of �me and office supplies spent on each bid, but it is costed this way because Stenson wins only about 33% of tenders it submits, on average. Its bidding policy has always been to add a 15% margin to the incremental and allocated costs, and hence the pricing manager insists that the appropriate bid price for this contract is $138,230 as shown in the following table.

Cost category $

Bid prepara�on costs Direct materials Direct labor Allocated variable overheads Allocated fixed overheads Profit margin

Suggested bid price

2,000 18,600 33,200 14,400 52,000 18,030 138,230

You have recently joined Stenson Steel and are worried that business condi�ons in the industry have deteriorated recently. You are aware that some of your compe�tors have been opera�ng well below capacity, and you suspect that demand for steel fabricated products is likely to be depressed for the coming 12 months.

a. What is the absolute minimum price you would bid on this contract? Please explain and defend your answer. b. On the basis of the informa�on given, what bid price would you recommend? c. What factors would you want to inves�gate and evaluate before choosing the actual bid price to submit?

4. You operate your own small building company and have decided to bid on a government contract to build a pedestrian walkway in a na�onal park during the coming winter. The walkway is to be of standard government design and should involve no unexpected costs. Your present capacity u�liza�on rate is moderate and allows sufficient scope to undertake this contract, if you win it. You calculate your incremental costs to be $268,000 and your fully allocated costs to be $440,000. Your usual prac�ce is to add between 60% and 80% to your incremental costs, depending on capacity u�liza�on rate and other factors. You expect three other firms to also bid on this contract, and you have assembled the following compe�tor intelligence about those companies:

Issue Rival A Rival B Rival C

Capacity u�liza�on

At full capacity Moderate Very low

Goodwill considera�ons

Very concerned Moderately concerned Not concerned

Produc�on facili�es

Small and inefficient plant Medium sized and efficient plant

Large and very efficient plant

Previous bidding pa�ern

Incremental cost plus 35–50% Full cost plus 8–12% Full cost plus 10–15%

Cost structure Incremental costs exceed yours by about 10%

Similar cost structure to yours Incremental costs 20% lower but full costs are similar to yours

Aesthe�c factors Does not like winter jobs or dirty jobs

Does not like messy or inconvenient jobs

Likes projects where it can show its crea�vity

Poli�cal factors Decision maker is a rela�ve of the buyer

Decision maker is seeking a new job

Decision maker is looking for a promo�on

a. What price would you bid if you must win the contract? b. What price would you bid if you want to maximize the expected value of the contribu�on from this contract? c. Defend your answers with discussion, making any assump�ons you feel are reasonable or are supported by the informa�on provided.

5. A request for tender (RFT) has been issued by Milford Hydroelectric Power Sta�on to repair a turbine generator. Your company's engineers have examined the broken generator and in conjunc�on with your company accountant have established the following costs associated with repairing the generator.

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Cost category $

Bid prepara�on costs Direct materials Direct labor Specialized equipment required Variable overheads Allocated fixed overheads

750 115,000 252,000 27,500 42,000 86,750

The specialized equipment required will not be purchased unless the contract is won. If purchased it would be available at no incremental cost for similar repair contracts in the future, if such contracts should be forthcoming. You are aware of three other companies that are likely to bid on this contract—relevant details are as follows:

Detail Company A Company B Company C

Cost structure Similar to yours 10% higher 10% lower

Previous bidding pa�ern Incremental costs plus 60% Full costs plus 15% Full costs plus 40%

Capacity u�liza�on Moderate Very low Near full

Your current capacity u�liza�on is moderate, leaving sufficient capacity to handle this project. Your previous bidding pa�ern is to add 25% to your full costs. a. What is the absolute minimum that you would bid on this contract? b. What would be your actual bid price on the basis of the informa�on given? c. What other factors would you want to consider before submi�ng your tender?

Key Terms

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

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

The prac�ce of making public the prices at which compe�ng suppliers have tendered.

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

The costs that a bidding firm will incur due to studying the tender specifica�ons and es�ma�ng the economic costs of comple�ng the project to the required level of quality within the required �meframe.

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

An illegal bidding prac�ce, where the firms conspire to take turns to submit the lowest bid and otherwise bid at rela�vely high prices such that they do not expect to win the contract.

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

Rather than consider all possible decision alterna�ves, the decision maker limits the decision alterna�ves under considera�on to those on which it can obtain sufficient informa�on at reasonable cost, and for which it has the required resources. In choosing among this limited set, the firm avoids extreme informa�on search costs and addi�onal produc�on costs and may be content to make a sa�sfactory profit (see sa�sficing) rather than maximize its profit.

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

A system where two or more firms conspire to set their bid prices at a rela�vely high level such that the lowest bid price chosen by the buyer is higher than would have happened if sellers had competed independently for the business.

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

A price-determina�on system whereby the price paid by the buyer is determined by the lowest bid price tendered by compe�ng sellers, or in the case of differen�ated bids (i.e., incompletely specified quality aspects) where prices bid may differ, the buyer selects the bid that offers the best value proposi�on (considering both quality and price differences).

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

A type of compe��ve bidding where the buyer and seller agree that the ul�mate price (upon comple�on) will be the actual costs of comple�on plus a predetermined profit margin for the seller, such that the buyer bears the en�re risk of cost variability.

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

A bidding process where the seller quotes a fixed price and undertakes to complete the project for exactly that price regardless of unexpected varia�ons in the costs of comple�ng the project.

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

Compe�ng suppliers submit exactly the same bid prices on a par�cular contract. Although this could happen by chance, or if costs are the same for all suppliers and they all tend to use the same markup percentage, iden�cal bids or nearly-iden�cal bids are likely to draw the a�en�on of the An�-Combines "watchdogs."

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

A form of bid pricing that involves the buyer and seller agreeing on the bid price but also agreeing to share any cost over-run or under-run (varia�on from the expected cost) in an agreed propor�on. Thus, the par�es agree to share the risk of cost varia�on.

incremental costs of the contract (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

All those costs, expressed in present value terms, that are incurred as a result of winning and comple�ng the contract.

incremental revenues of the contract (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The sum of all revenues (expressed in net present value terms) that are expected to be received as a result of winning and comple�ng the contract. These include present-period explicit revenues, opportunity revenues, and future revenues.

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

Costs that are avoided as the result of a management decision. For example, if costs can be avoided by winning a compe��ve bid contract, the magnitudes of the costs avoided (suitably discounted if extending beyond the current produc�on period) are included as opportunity revenues.

present-period explicit revenues (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The actual cash inflows to the selling firm within the current produc�on period.

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

The prepara�on and implementa�on work involved in managing people and other resources to bring a project from incep�on to comple�on.

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

A philosophy of firms or their managers under which they are content to earn sa�sfactory profits, rather than striving to maximize their profits.