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Pricing Concepts for Establishing Value

McGraw-Hill/Irwin

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© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

CHAPTER

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© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 14 – Pricing Concepts for Establishing Value

List the four pricing orientations.

Explain the relationship between price and quantity sold.

Explain price elasticity.

Describe how to calculate a product’s break-even point.

Indicate the four types of price competitive levels.

Pricing Concepts for Establishing Value

LO1

LO2

LO3

LO4

LO5

LEARNING OBJECTIVES

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These are the learning objectives for this chapter.

Price and Value

What’s the most you will pay for your favorite drink?

©The McGraw-Hill Companies, Inc./Jill Braaten, photographer.

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Ask students why they will pay the prices they mention? It really comes down to the benefits and value they place on their favorite drinks.

Price

Benefits

Sacrifice

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Remind students that price refers not just to money but also other costs such as time.

Bottled vs. Tap Water

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Note: Please make sure that the video file is located in the same folder as the PowerPoint slides.

Price is a Signal

Prices can be both too high and too low

Price set too low may signal poor quality

Price set too high might signal low value

PriceGrabber.com Website

“What does this signal?

©Alex Segre/Alamy.

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Consumers recognize price as a signal. If a marketer sets a price too high or too low, the wrong message gets sent to the market.

This web link is for pricegrabber.com. There are many online comparison shopping sites for general goods as well as hotels and airlines. Ask students if they use these types of sites and why?

The Role of Price in the Marketing Mix

Price is the only marketing mix element that generates revenue

Price is usually ranked as one of the most important factors in purchase decisions

Chad Baker/Ryan McVay/Getty Images

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Ask students to provide an example of a purchase where they did not consider price. They will probably be hard-pressed to come up with anything, thus making the point.

The 5 C’s of Pricing

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The following slides discuss each C in detail; alternatively, you can use this graph as a basis for a shortened discussion.

1st C: Company Objectives

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Each firm has a specific orientation in the marketplace that dominates its pricing strategy. Profit-oriented firms do not use value as a consideration but rather focus on generating a set level of profit from each sale.

Profit Orientation

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Ask students: What are the issues with a profit orientation?

Answer: The key issue is that it does not take into consideration the value customers have for the product. This may lead to prices being set below and optimal level.

Profit

Orientation

Target

return

pricing

Target

profit

pricing

Maximizing

profits

Sales Orientation

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Firms that want to attain market leadership set prices at less profitable levels to gain market share.

Ask Students: Why would firms adopt this orientation? Many first adopt this orientation to establish a position in the market by getting the most price sensitive consumers to change brands.

Focus on increasing sales

More concerned with overall market share

Does not always imply setting low prices

Competitor Orientation

Competitive parity

Status quo pricing

Value is not part of this pricing strategy

Roz Woodward/Getty Images

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This strategy is particularly common among smaller firms that lack knowledge or experience in setting prices. Non-market leader firms also use it to signal they are similar to the market leader.

Ask students: What are the benefits of a competitor strategy? For example, can a new hotel chain indicate its level of service through price? The answer is yes. In many instances new brands will set price equal to the competitors they wish to be compared with knowing that consumers use reference prices to indicate quality

Focus on customer expectations by matching prices to customer expectations

automotive.com Website

Customer Orientation

C Borland/PhotoLink/Getty Images

Don Farrall/Getty Images

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A recent study indicates that a variety of retailers sell one-carat diamonds, but consumers pay vastly different prices at Costco versus Tiffany’s. The diamonds are a commodity; they must meet the same standards and are rated the same. Ask students: Why would a consumer spend thousands more to buy a stone at Tiffany’s?

This web link is to automotive.com website where consumer’s can shop for the lowest gas price around. With prices at over $3 a gallon at some times, many consumer’s are price sensitive enough to search for cheaper gas.

What are they trying to accomplish with this ad?

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Consumer’s have an expectation of a rental car costing a lot of money. They don’t realize they can rent the car for under $10 an hour. Because Zipcar is a new product, they need to set customer’s expectations. To help consumer’s relate to the price, they compare it to a purchase very familiar to the consumer.

2nd C: Customers

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The following slides address different parts of this graph; this slide serves as an introduction to the topic of demand curves.

Demand Curves and Pricing

Knowing demand curve enables to see relationship between price and demand

Photo by Simon Frederick/Getty Images

E-book Prices

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This information should be a review from students’ micro-economics coursework, so they should be familiar with the concept, but this discussion applies it in a slightly different way.

Video: “E-Book Readers Face Sticker Shock”

Ask students as a consumer, how readily to you buy e-books versus hard cover books?

Ask students to discuss the potential collusion that could have occurred between the book publishers.

Demand Curves

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Ask students to name a prestige product. Why do they think people are willing to pay a higher price. For example, why will someone pay a higher price for a BMW than a Saturn. They will mention product quality but also branding issues including the esteem offered to the owner from the BMW.

Not all are downward sloping

Prestigious products or services have upward sloping curves

Price Elasticity of Demand

©PhotoLink/Getty Images

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For pricing, elasticity is a crucial concept.

Elastic (price sensitive)

Inelastic (price insensitive)

Consumers are less sensitive to price increases for necessities

Price Elasticity of Demand

©Dennis MacDonald/PhotoEdit, Inc.

©Bill Aron/PhotoEdit, Inc.

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Ask students: In what circumstances will raising the price NOT result in an increase in revenue? In what circumstances will raising the price result in an increase in revenue?

In elastic markets, depending on the level of elasticity, a price increase can increase revenues, but if the increase drives consumers out of the market, demand falls, and a loss of revenue may result. In contrast, in inelastic markets, a price increase almost always increases revenues, because the relationship between price and demand is weak. Pharmaceuticals provide a good example; even if the price of a cancer drug increases, consumers still demand it, so the firm generates more revenue.

Factors Influencing Price Elasticity of Demand

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In this YouTube ad (always check link before class) Wal-Mart stresses good service in the holiday season, but as always, ends their ad with messaging related to their low price offerings AND the importance of low price (live better).

YouTube link: http://www.youtube.com/watch?v=H3TZ-8rhpVQ

Income

effect

Substitution

effect

Cross-

price

elasticity

Income Effect & Substitution Effect

Meet Pete, college student on a budget:

Old Spice Sport Deodorant user

At the store he notices that Old Spice is more expensive

Pete decides to give another brand a try and save money

BananaStock/JupiterImages

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Discuss the case of Pete and how the income and substitution effects alter his buying behavior. As a college student, he prefers a less expensive substitute deodorant, because it demands less of his total income. Ask students: When Pete graduates and gets a high-paying job, will he worry as much about the cost of deodorant? Do you expect him to switch back to Old Spice? Why or why not?

Cross-Price Elasticity

Meet Kendra, self-supporting college student:

Buys a new printer on sale for a great price

Learns it requires special ink cartridges that cost more than the printer

Getty Images/Digital Vision

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Just like Kendra, many people buy products without considering the price of necessary peripherals. Kendra is caught in a cross-elasticity trap, because her demand for one product generated demand for the other.

Group activity: Brainstorm a list of other products that exhibit cross-price elasticity.

3rd C: Costs

Variable Costs

Vary with production volume

Fixed Costs

Unaffected by production volume

Total Cost

Sum of variable and fixed costs

Michael Rosenfeld/Stone/Getty Images

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No discussion of price would be complete without a discussion of cost. The price must at least cover the cost of the item. However, as students may have learned in their finance courses, understanding costs is rarely easy.

Break Even Analysis and Decision Making

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Students might have discussed break-even in previous classes – ask them what it is. In many cases it is hard for students to define.

Break Even Analysis

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Although profit, which represents the difference between the total cost and the total revenue (total revenue or sales = selling price of each unit sold number of units sold), can indicate how much money the firm is making or losing at a single period of time, it cannot tell managers how many units a firm must produce and sell before it stops losing money and at least breaks even.

4th C: Competition

Less Price Competition

More Price Competition

Fewer

Firms

Many

Firms

Oligopoly

A handful of firms control the market

Ingram Publishing/SuperStock.

Monopoly

One firm controls the market

©Brand X Pictures/PunchStock.

Monopolistic Comp.

Many firms selling differentiated products at different prices

Steve Cole/Getty Images.

Pure Competition

Many firms selling commodities for the same prices

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Group activity: List a product or service market that demonstrates each type of competition.

Monopoly: Microsoft software products.

Oligopolistic: Cable TV firms.

Pure: Most frequently purchased consumer goods such as soft drinks.

5th C: Channel Members

Manufacturers, wholesalers and retailers can have different perspectives on pricing strategies

Manufactures must protect against gray market transactions

Courtesy Apple, Inc.

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Ask students: have you ever bought books marked “Instructor Copy: Not for Resale,” or “International Student Edition”? Is the bookstore engaging in unethical behavior? Whom does this gray market benefit? Whom does it hurt?

Answer: The purchase of gray market textbooks hurt the publisher and authors. These books do not help recover the costs of all the ancillary packages that are provided to instructors.

CHECK YOURSELF

What are the five Cs of pricing?

Identify the four types of company objectives.

What is the difference between elastic versus inelastic demand?

How does one calculate the break-even point in units?

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1. Company Objectives, customers, costs, competition, channel members

Profit orientation, sales oriented, customer oriented, competitor oriented

In general, the market for a product or service is price sensitive (or elastic ) when the price elasticity is less than –1, that is, when a 1 percent decrease in price produces more than a 1 percent increase in the quantity sold. In an elastic scenario, relatively small changes in price will generate fairly large changes in the quantity demanded. The market for a product is generally viewed as price insensitive (or inelastic ) when its price elasticity is greater than –1, that is, when a 1 percent decrease in price results in less than a 1 percent increase in quantity sold. Generally, if a firm must raise prices, it is helpful to do so with inelastic products or services because in such a market, fewer customers will stop buying or reduce their purchases.

Divide the fixed costs by the contribution per unit (price per unit minus variable cost per unit)

Macro Influences on Pricing

The Internet

Increased price sensitivity

Growth of online auctions

Ryan McVay/Getty Images

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Ask students: How has online shopping affected firms’ pricing strategies?

Answers: Internet shopping has provided people with more information so they have become more sensitive to prices, alternative product options and retailers

Economic Factors

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Firms and consumers alike should constantly monitor the economic environment, because economic conditions have a direct impact on pricing.

Ask students: How many people cross-shop? Do you believe this practice has influenced the way some firms price their merchandise?

Answer: it has made prestige products more expensive and more moderately priced merchandise even less expensive.

Local economic conditions

Increasing disposable income

Cross- shopping

Increasing status consciousness

Increasing globalization

How have the Internet and economic factors affected the way people react to prices?

CHECK YOURSELF

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Because it is so easy to get information on the Internet, people generally have become more aware of and sensitive to price. This trend has forced both manufacturers and retailers to become more price competitive. Some consumers even know more about the relative value of different products than the firms from which they are buying. Online auctions like eBay not only provide consumers with the relative value of millions of products but also enhance their value by establishing a global market for products that would have been geographically limited in the past.

Break-even analysis enables managers to examine the relationships among cost, price, revenue, and profit over different levels of production and sales.

Glossary

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Break-even analysis enables managers to examine the relationships among cost, price, revenue, and profit over different levels of production and sales.

Cross-price elasticity is the percentage change in the quantity of Product A demanded compared with the percentage change in price in Product B.

Glossary

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Cross-price elasticity is the percentage change in the quantity of Product A demanded compared with the percentage change in price in Product B.

Fixed costs are those costs that remain essentially at the same level, regardless of any changes in the volume of production.

Glossary

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Fixed costs are those costs that remain essentially at the same level, regardless of any changes in the volume of production.

Income effect is the change in the quantity of a product demanded by consumers due to a change in their income.

Glossary

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Income effect is the change in the quantity of a product demanded by consumers due to a change in their income.

The maximizing profits strategy assumes that if a firm can accurately specify a mathematical model that captures all the factors required to explain and predict sales and profits, it should be able to identify the price at which its profits are maximized.

Glossary

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Price is the overall sacrifice a consumer is willing to make to acquire a specific product or service.

Glossary

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Price is the overall sacrifice a consumer is willing to make to acquire a specific product or service.

The substitution effect refers to consumers’ ability to substitute other products for the focal brand.

Glossary

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The substitution effect refers to consumers’ ability to substitute other products for the focal brand.

Target profit pricing is implemented by firms to meet a targeted profit objective. The firms use price to stimulate a certain level of sales at a certain profit per unit.

Glossary

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Target profit pricing is implemented by firms to meet a targeted profit objective. The firms use price to stimulate a certain level of sales at a certain profit per unit.

Target return pricing occurs when firms employ pricing strategies designed to produce a specific return on their investment, usually expressed as a percentage of sales.

Glossary

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Target return pricing occurs when firms employ pricing strategies designed to produce a specific return on their investment, usually expressed as a percentage of sales.

The total cost is the sum of the variable and fixed costs.

Glossary

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The total cost is the sum of the variable and fixed costs.

Variable costs are the costs that vary with production value.

Glossary

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Variable costs are the costs that vary with production value.

Total Variable Cost

Variable Cost per unit X Quantity

Total Cost

Fixed Cost + Total Variable Cost

Total Revenue

Price X Quantity

Fixed Costs

Contribution per unit

Break-Even Point (units)