MANAGERIAL ECONOMICS NOTES

Pricing Strategies: Pricing Models

PRICING ANALYSIS AND DECISION

Price is the amount of money paid for a unit or quantity of the good or service under consideration. A “package” of other services goes with the physical commodity and include time and place of delivery, time payment is expected by the seller, cash and quantity discounts, guarantees that go with the product, or any rights of return of goods. If changes occur in any of these things, even though money paid per unit remains unaltered, the true price has changed. The quoted and list prices may be no guide to the price actually paid, as concessions may be given to particular groups of individuals. Price is the only element in the marketing mix that creates sales revenues, other elements are costs.

The setting of prices involves three areas of information- costs, competition and consumer demand. Costs information is derived from internal sources whereas information on competition and consumer demand involves the external environment. In any business a great deal of information is potentially available about its external environment from the operations of its own staff. Reports from salesmen in the field will convey information about the strategy of competitors, the emergence of new competition and reaction of customers. This can be very effective if salesmen are given guidance on what to look for, and reporting should be restricted to statement of observable fact.

PRICING STRATEGY

This is the task of defining the initial price range and planned price movement through time that the company will use to achieve its marketing objectives in the target market.

1. COST ORIENTED PRICING STRATEGIES

(a) Mark up pricing or cost plus pricing- also called Average Cost pricing or full cost pricing. It is the most common method of pricing a product by manufacturing firms. The term cost plus is often used to describe the pricing of jobs that are non-routine and difficult to “cost” in advance, such as construction and military weapon development. Under the cost plus pricing, the firm calculates or estimates its AVC , and then sets its price by adding on a percentage mark-up that includes a contribution towards the firm’s fixed costs, and a profit margin. The general practice under the mark-up pricing method is to add a fair percentage of profit margin to the AVC. The price is set as:

P= AVC+ x% (of AVC) where x is the mark-up percentage chosen. Or

P=AVC + AVC x (m) = (1+m)AVC or (1+m)C where m is the mark-up percentage fixed so as to cover AFC and net profit margin. The size of mark up depends on the willingness of consumers to pay the maximizing and this level varies inversely with the value of price elasticity. Products with higher price elasticities of demand should be expected to have relatively lower percentage mark ups in order to make the maximum total contribution to overheads and profits. Firms find their “best” mark up by trial and error or by adopting the same mark up that is applied by other firms or by the price leader in the industry.

Firms usually apply higher mark-ups to products facing less elastic demand than to products with more elastic demand. It can also be shown that cost-plus pricing leads to approximately the profit –maximising price. If we take where Ep is the price elasticity of demand. Solving for P we get .Since profits are maximised where MR=MC, we can substitute MC for MR in the above equation and get . If the firm’s MC is constant and equal to C we can get . We can then set P =(1+m)C or 1+m. Thus we get . From this if Ep=-1.5, m=2, or 200%; if Ep=-2, m=1 or 100%. It can then be concluded that the optimal mark-up is lower the greater is the price elasticity of demand of the product. Firms in practice have been found to apply a higher mark-up to products with inelastic demand than to products with elastic demand, and when increased competition has increased the price elasticity of demand, they have been found to reduce their mark-up. It can thus be concluded that cost-plus pricing does lead to approximately profit-maximizing prices. In a world of inadequate and imprecise data on demand and costs, firms may simply utilize cost-plus pricing as the rule-of-thumb method for determining the profit-maximising prices.

The advantages of mark-up pricing are:

(i)by pinning the price to unit costs, sellers simplify their own pricing task considerably and they do not have to make frequent adjustments as demand conditions change.

(ii)There is also generally less uncertainty about costs than about demand.

(iii)It requires less information and less precise data than in MC=MR case.

(iv)It results in stable prices when costs do not vary much.

(v)It provides a justification for price increases when costs rise.

(vi)It is easy and simple to use (may be misleading since difficulty of projecting TVCs and overheads allocation).

Limitations

(i)Assumes firm’s resources are optimally allocated and the standard cost of production is comparable with the average for the industry.

(ii)Uses historical cost rather than current cost data- this may lead to underpricing under increasing cost conditions and to overpricing under decreasing cost conditions.

(iii)If VC fluctuates frequently and significantly, cost plus pricing may not be an appropriate method of pricing.

(iv)It is “alleged” that cost plus pricing ignores the demand side of the market and is solely based on supply conditions (“alleged” because firms determine the markup on the basis of what the market can bear.).

(b) Marginalist Pricing .There are three main ways of practicing marginalist pricing under uncertainty:

(i) Given estimated demand and MC curves. MR has the same intercept value and twice the slope value as compared with the demand curve and thus we can quickly derive an estimate of MR. Setting the expression for MR equal to that of MC, we can solve for the quantity level that preserves the equality. This method of price determination involves inserting the result back into the demand curve to give us the price that will maximize contribution and hence profit.

(ii) Given estimated price elasticity and MC- involves using the elasticity value and the current price and output levels to find an expression for the demand curve and then proceed to equate estimated marginal revenue and marginal cost.

(iii) Given estimates of incremental costs and revenues- is a marginalist approach since it is concerned with changes in both total revenues and total costs. Where demand contains indivisibilities or discontinuities we cannot construct the marginal revenue function, since the total revenue curve is not continuous and therefore is not differentiable. Instead we must compare the incremental costs and incremental revenue at each price level and choose the price that allows the maximum contribution to be made.

(c) Target Pricing- also cost oriented pricing approach in which the firm, tries to determine the price that would give it a specified target rate of return on its total costs at an estimated standard volume e.g. pricing of good X so as to achieve an average rate of return of 15 to 20% on a firm’s investment. The breakeven chart can be used to illustrate target pricing. The total cost curve (TC) and total revenue (TR) curve have to be worked out. Target pricing has a major conceptual flaw- the company uses an estimate of sales volume to derive the price but price is a factor that influences the sales volume.

2. DEMAND ORIENTED PRICING STRATEGIES

This calls for setting a price based on consumer perceptions and demand intensity rather than on cost.

(a) Perceived value pricing or prestige pricing-deliberately setting high prices to attract prestige-oriented consumers (goods have a snob appeal. An increasing number of companies are basing their price on the product’s perceived value. They see the buyers’ perception of value as the key to pricing. Price is set to capture the perceived value. A company develops a product for a particular target market with a particular market positioning in mind with respect to price, quality and service. Market research has to be carried out to establish the market’s perceptions.

(b)Demand Differential pricing- is another of demand oriented pricing. It is also called price discrimination. It takes many forms (i) Customer basis- different customers pay different amounts for same product/service. (ii) Product form basis- different versions of the product are priced differently but not proportionately to their respective marginal costs. (iii) Place basis- different locations are priced differently although there is no difference in MC. (iv) Time basis- different prices charged seasonally by the day, by the hour, etc. For effectiveness the market must be segmentable and have different demand elasticities, no resale to segment paying the higher price. The cost of segmenting and policing the market should not exceed the extra revenue derived from price discrimination the practice should not breed customer resentment and turning away.

Price discrimination types

There are three types

First degree Discrimination – involves charging the maximum possible price for each unit of output. It involves making the price per unit of output depend on the identity of the purchaser and on the number of units purchased. Thus the consumer who attaches the greatest value to the product is identified and charged a price of P1 (this being individual 1’s reservation price) Similarly, the consumers willing to pay P2 for the second unit (this being individual 2’s reservation price) and P3 for the third are identified and required to pay P2 and P3 respectively.each customer is being charged different prices. Each unit of product is charged separately. All consumer surplus is extracted.

First degree Second Degree

P1---- P1

P2 ------P2

P3------

Pc MC=AC P3

D

Q1 Q2 Q3 QD O Q1 Q2 Q3

With first degree price discrimination , the profit maximising output rate is where the MC and Demand curves intersect. Any sale in excess of QD would reduce profits because price would have been less than MC. First degree Price discrimination is uncommon because it requires that the seller have complete knowledge of the market demand curve and also of willingness of individuals to pay for the product, In addition the market must be segmentable and also that resale is not possible.

Second degree price discrimination- this involves pricing based on the quantities of output purchased by individual consumers.. That is it involves making the price per unit of output depend on the number of units purchased. The monopolist designs a menu of prices and quantities (or use rates of quantities purchased) such that each consumer chooses a price –quantity combination that allows the monopolist to discriminate profitably between consumers. The price does not depend on the identity of the purchaser. It involves charging uniform prices per unit for a specific quantity or block of the product sold to each customer, a lower price per unit for an additional batch or block of the product and so on.. This is easy where there are meters as in electricity and water. Another version is discriminating among groups of buyers on a time or urgency basis. This probably applies to new products. For example first 10 units at 15cents, next 20 units at10cents and all additional at 5cents each. In other words blocks are charged at different prices. Examples include the charging of electricity, whereby there is a two-part tariff, requiring the payment of a fixed fee if the consumer wishes to make any purchases at all, plus an additional uniform price per unit purchased.It also involves charging different prices in two or more different markets at the same point in time (until MR of the last unit of product sold in each market equals the MC of producing the product). This implies that MR1=MR2=MC. The market is segmentable e.g. student versus nonstudent.

Third Degree price discrimination - most common. The price per unit depends on the identity of the purchaser. The price does not depend on the number of units purchased. Involves separating consumers or markets in terms of their price elasticity of demand. The monopolist charges a relatively high price to consumers whose demand is price inelastic, and a relatively low price to consumers whose demand is price elastic. Segmentation can be based on several factorse.g. geographical location (selling of books outside US at lower prices), telephone users may be residential or commercial (nature of use), usage of electricity ( industrial or residential) or during certain times), can be according to age (personal characteristics).

Forms of price discrimination used in practice

These include:

  • Intertemporal price discrimination, whereby the supplier segments the market by the point in time at which the product is purchased.
  • Branding, whereby different prices are charged for similar or identical goods differentiated solely by a brand label.
  • Loyalty discounts for regular customers.
  • Coupons that provide price discounts discriminate between consumers on the basis of willingness to make the effort to claim the discount.
  • Stock clearance sales involving successive price reductions are a form of intertermporal price discrimination.
  • Free-on-board pricing involving the producer or distributor absorbing transport costs, and representing a form of price discrimination favouring buyers in locations where transport costs are higher.

3. COMPETITION ORIENTED PRICING

This is when a company sets its price chiefly on the basis of what its competitors are charging. It is not necessary to charge the same price as the competition. The firm may seek to keep its prices lower or higher than the competition by a certain percentage. The distinguishing characteristic is that it does not seek to maintain a rigid relation between its price and its own costs or demand. Conversely the same firm will change its price when competitors change theirs, even if its costs or demand have remained constant.

Going rate pricing- the firm tries to keep its price at the average level charged by the industry. The pricing primarily characterizes pricing practice in homogeneous product markets, although the market structure itself may vary from pure competition to pure oligopoly.

Sealed Bid pricing- also called competitive tendering or competitive bidding. In this there is only one buyer in the market whose requirements are individual to himself. In other words a number of sellers compete for the business of a single buyer. Confronting him is a number of suppliers each of whom is capable of doing the work e.g. building a ship, an office block, or building a nuclear power station. The buyer, wishing to secure the benefits of competition, puts his contract up for tender. It may be open to all comers or may be restricted to a select group which the buyer judges to have the competence and resources to undertake the work successfully. Normally the contract will go to the bidder quoting the lowest price but, with a view to protecting his own interest, the buyer will usually reserve the right to accept any tender – or none. Competitive bids may also occur where Services of a product may not be identical hence combination of price and quality also matter. Examples are in the service sector.

Normally buyer has budgeted expenditure whilst bidders do not know of it. Too low a price leads to loss or loss of tender. Too high a price may be rejected. A firm can win a tender but may incur losses due to rising costs- the ‘winner’s curse’.

Types of Bids

There are three types of bids

(1)Fixed price bids.

(2)Cost plus fee bids.

(3)Incentive bids.

Fixed Price Bids

This is when suppliers tender for a price bid regardless of variation of costs. Supplier tenders a bid price or price quote and undertakes to complete the job for that price regardless of any variation of costs from expected levels.

where is the bid price; is target profit and is supplier’s target cost. The actual profit=+ () where is actual cost. (NB. If Ct > Ca falls)

Cost Plus Fee Bids

In these the entire risk is borne by the buyer who agrees to meet the actual cost plus what supplier stated was their profit.

where is the bid price. (NB. is the fee)The buyer expects to audit the costs. The contract is unfair to the buyer because of the problems of conducting the audit.

Incentive Bids-

These are also called risk sharing bids. The buyer and seller (supplier) agree before hand on a bid price but agree to share any deviation from expected costs level in a given way.

More formally mathematically if = supplier’s share of cost variation where 0<<1 then

For the buyer

is the bid price , is supplier’s target cost, is target profit.

For the Seller =+ ().