8.1: Introduction to Price

8.1.1: Defining Price

Price is both the money someone charges for a good or service and what the consumer is willing to give up to receive a good or service.

Learning Objective

Define price and its relationship to cost

Key Points

When you ask about the cost of a good or service, you’re really asking how much you will have to give up in order to get it.
For the business to increase value, it can either increase the perceived benefits or reduce the perceived costs. Both of these elements should be considered elements of price.
Viewing price from the customer’s perspective helps define value — the most important basis for creating a competitive advantage.
There are two different ways to look at the role price plays in a society; rational man and irrational man.

Key Terms

bartering system: Barter is a medium of exchange by which goods or services are directly exchanged for other goods or services without using a medium of exchange, such as money.
benefit: an advantage, help or aid from something
value: a customer’s perception of relative price (the cost to own and use) and performance (quality)

Example

Perceived costs are the opposite of the perceived benefits. When finding a gas station that is selling its highest grade for USD 0.06 less per gallon, the customer must consider the 16 mile (25.75 kilometer) drive to get there, the long line, the fact that the middle grade is not available, and heavy traffic. Therefore, inconvenience, limited choice, and poor service are possible perceived costs.

What Is a Price?

Buying something means paying a price. But what exactly is “price? “

Price is the money charged for a good or service. For example, an item of clothing costs a certain amount of money. Or a computer specialist charges a certain fee for fixing your computer.
Price is also what a consumer must pay in order to receive a product or service. Price does not necessarily always mean money. Bartering is an exchange of goods or services in return for goods or services. For example, I teach you English in exchange for you teaching me about graphic design.
Price is the easiest marketing variable to change and also the easiest to copy.

Even though the question, “How much? ” could be phrased as “How much does it cost? ” price and cost are two different things. Whereas the price of a product is what you, the consumer must pay to obtain it, the cost is what the business pays to make it. When you ask about the cost of a good or service, you’re really asking how much will you have to give up to get it.

Price

The price is what a consumer pays for a good or service.

An electronic price display on a clothes stand at a retail store.

Different Perspectives on Price

The perception of price differs based on the perspective from which it is being viewed.

The Customer’s View

A customer can either be the ultimate user of the finished product or a business that purchases components of the finished product. It is the customer that seeks to satisfy a need or set of needs through the purchase of a particular product or set of products. Consequently, the customer uses several criteria to determine how much they are willing to expend, or the price they are willing to pay, in order to satisfy these needs. Ideally, the customer would like to pay as little as possible.

For the business to increase value, it can either increase the perceived benefits or reduce the perceived costs. Both of these elements should be considered elements of price.

To a certain extent, perceived benefits are the opposite of perceived costs. For example, paying a premium price is compensated for by having this exquisite work of art displayed in one’s home. Other possible perceived benefits directly related to the price-value equations are:

status
convenience
the deal
brand
quality
choice

Many of these benefits tend to overlap. For instance, a Mercedes Benz E750 is a very high-status brand name and possesses superb quality. This makes it worth the USD 100,000 price tag. Further, if one can negotiate a deal reducing the price by USD 15,000, that would be his incentive to purchase. Likewise, someone living in an isolated mountain community is willing to pay substantially more for groceries at a local store than drive 78 miles (25.53 kilometers) to the nearest Safeway. That person is also willing to sacrifice choice for greater convenience.

Increasing these perceived benefits are represented by a recently coined term, value-added. Providing value-added elements to the product has become a popular strategic alternative.

Perceived costs include the actual dollar amount printed on the product, plus a host of additional factors. As noted, perceived costs are the mirror-opposite of the benefits. When finding a gas station that is selling its highest grade for USD 0.06 less per gallon, the customer must consider the 16 mile (25.75 kilometer) drive to get there, the long line, the fact that the middle grade is not available, and heavy traffic. Therefore, inconvenience, limited choice, and poor service are possible perceived costs. Other common perceived costs include risk of making a mistake, related costs, lost opportunity, and unexpected consequences.

Ultimately, it is beneficial to view price from the customer’s perspective because it helps define value — the most important basis for creating a competitive advantage.

Society’s View

Price, at least in dollars and cents, has been the historical view of value. Derived from a bartering system (exchanging goods of equal value), the monetary system of each society provides a more convient way to purchase goods and accumulate wealth. Price has also become a variable society employs to control its economic health. Price can be inclusive or exclusive. In many countries, such as Russia, China, and South Africa, high prices for products such as food, health care, housing, and automobiles, means that most of the population is excluded from purchase. In contrast, countries such as Denmark, Germany, and Great Britain charge little for health care and consequently make it available to all.

There are two different ways to look at the role price plays in a society; rational man and irrational man. The former is the primary assumption underlying economic theory, and suggests that the results of price manipulation are predictable. The latter role for price acknowledges that man’s response to price is sometimes unpredictable and pretesting price manipulation is a necessary task.

8.1.2: Terms Used to Describe Price

Depending on whether they are describing a good or a service and the product’s industry, people may use terms other than the word price.

Learning Objective

Name the different terms used to reference pricing

Key Points

From a customer’s point of view, value is the sole justification for price.
The price of an item is also called the price point, especially when it refers to stores that set a limited number of price points. The words charge and fee are often used to refer to the price of services.
The transportation industry charges a fare for its services.

Key Terms

price point: The price of an item, especially seen as one of a number of pricing options.
price: The cost required to gain possession of something.

Example

Dollar General is a general store or “five and dime” store that sets price points only at even amounts, such as exactly one, two, three, five, or ten dollars (among others).

Introduction

We’ve been using the word “price” a lot. There are, however, other terms you may come across in your studies and daily life that serve as synonyms.

Price Point

The price of an item is also called the price point, especially where it refers to stores that set a limited number of price points.

For example, Dollar General is a general store or “five and dime” store that sets price points only at even amounts, such as exactly one, two, three, five, or ten dollars (among others). Other stores will have a policy of setting most of their prices ending in 99 cents or pence. Other stores (such as dollar stores, pound stores, euro stores, 100-yen stores, and so forth) only have a single price point ($1, £1, 1€, ¥100), though in some cases this price may purchase more than one of some very small items. Price is relatively less than the cost price.

Charge

When someone wants to know the price of a service, they may ask, “How much do you charge? ” In this context, the word “charge” is a synonym for price.

Value

From a customer’s point of view, value is the sole justification for price. Many times customers lack an understanding of the cost of materials and other costs that go into the making of a product. But those customers can understand what that product does for them in the way of providing value. It is on this basis that customers make decisions about the purchase of a product.

Fee

Service providers may present you with a fee list as opposed to a price tag if you ask for the price of their services.

Fare

You pay a price to fly, ride the bus and take the train. The price in these industries is expressed as a fare .

London Bus

A “fare” is the price to ride a bus.

A double-decker bus in London.

8.1.3: The Importance of Price to Marketers

Since pricing has a direct impact on a company’s revenue, and thus profit, setting the right price is essential to a company’s success.

Learning Objective

Discuss how pricing impacts marketing and business strategy

Key Points

Price is important to marketers because it represents marketers’ assessment of the value customers see in the product or service and are willing to pay for a product or service.
Adjusting the price has a profound impact on the marketing strategy, and depending on the price elasticity of the product, it will often affect the demand and sales as well.
Pricing contributes to how customers perceive a product or a service.

Key Terms

value: a customer’s perception of relative price (the cost to own and use) and performance (quality)
marketing mix: A business tool used in marketing products; often crucial when determining a product or brand’s unique selling point. Often synonymous with the four Ps: price, product, promotion, and place.

Example

A firm that wants to indicate that it offers products of the highest quality will charge a high price. A high price indicates high quality. The term luxury comes to mind. Louis Vuitton has continued to perform well in the midst of a financial crisis because it offers high quality products and its prices reflect this fact. If, however, a firms wants to position itself as a low-cost provider, it will charge low prices. Just as they do with high-end providers, consumers know what to expect when they see low prices. Someone who goes to a low-cost supermarket, such as Aldi, knows what to expect when he walks into the store.

Pricing and the Marketing Mix

Pricing might not be as glamorous as promotion, but it is the most important decision a marketer can make.

Price is important to marketers because it represents marketers’ assessment of the value customers see in the product or service and are willing to pay for a product or service. The other elements of the marketing mix (product, place and promotion) may seem to be more glamorous than price, and thus get more attention, but determining the price of a product or service is actually one of the most important management decisions. Here’s why.

While product, place and promotion affect costs, price is the only element that affects revenues, and thus, a business’s profits. Price can lead to a firm’s survival or demise.
Adjusting the price has a profound impact on the marketing strategy, and depending on the price elasticity of the product, it will often affect the demand and sales as well. Both a price that is too high and one that is too low can limit growth. The wrong price can also negatively influence sales and cash flow.
Problems occur if the marketer fails to set a price that complements the other elements of the marketing mix and the business objectives, as pricing contributes to how customers perceive a product or a service. A high price indicates high quality. The term luxury comes to mind. If, however, a firm wants to position itself as a low-cost provider, it will charge low prices. Just as they do with high-end providers, consumers know what to expect when they see low prices.

So, as you can see, it is important that a company sets the right price. A company’s success can depend on it. However, with so many factors to consider along with the lack of a crystal ball that will show the effect of a price change, It isn’t so easy to do.

8.1.4: Value and Relative Value

Value is the worth of goods, and relative value is attractiveness measured in terms of utility of one good relative to another.

Learning Objective

Discuss the different concepts of value and how it influences consumer buying decisions

Key Points

Value is the worth of goods and services as determined by markets.
Something is only worth what someone is willing to pay for it.
The utility for the seller is not as an object of usage, but as a source of income.
In term of pricing, prices of valued items undergo questionable fluctuations.

Key Terms

Surplus value: The part of the new value made by production that is taken by enterprises as generic gross profit.
marginal utility: The additional utility to a consumer from an additional unit of an economic good.
utility: The ability of a commodity to satisfy needs or wants; the satisfaction experienced by the consumer of that commodity.

Example

Even though housing provides the same utility to the individual over time, and supply and demand are relatively constant and stable, the relative price of housing fluctuates.

What is Value?

Value is the worth of goods and services as determined by markets. Thus, an important part of economics is the study of policies and activities for the generation and transfer of value within markets in the form of goods and services.

Often a measure for the worth of goods and services is units of currency such as the US Dollar. But, unlike the units of measurements in Physics such as seconds for time, there exists no absolute basis for standardizing the units for value.

One of the most complicated and most often misunderstood parts of economy is the concept of value. One of the big problems is the large number of different types of values that seem to exist, such as exchange value, surplus value, and use value.

The Buyer’s Utility

The discussion of values all start with one simple question: What is something worth?

Today’s most common answer is one of those answers that are so deceptively simple that it seems obvious when you know it. But then remember that it took economists more than a hundred years to figure it out: something is worth whatever you think it is worth.

This statement needs some explanation. Take as an example two companies that are thinking of buying a new copying machine. One company does not think they will use a copying machine that much, but the other knows it will copy a lot of papers. This second company will be prepared to pay more for a copying machine than the first one. They find a greater utility in the object.

The companies also have a choice of models. The first company knows that many of the papers will need to be copied on both sides. The second company knows that very few of the papers it copies will need double- sided copying. Of course, the second company will not pay much more for this feature, while the first company will. In this example, we see that a buyer will be prepared to pay more for the increase in utility compared to alternative products.

So we can summarize this with the statement that the economic value of an item is set by the increase in utility for customers. This increase in utility is called marginal utility, and this is all known as the marginal theory of value.

The Seller’s Utility

But how does the seller value things? Well, in pretty much the same way. Of course, most sellers today do not intend to use the object he sells himself. The utility for the seller is not as an object of usage, but as a source of income. And here again it is marginal utility that comes in. For what price can you sell the object? If you put in some more work, can you get a higher price?

Here we also get into the utility for resellers. Somebody who deals in trading will look at an object, and the utility for him is to be able to sell it again. How much work will it take, and what margins are possible?

Subjective Value

Not only do the two different buyers have a different value on an object, the salesman puts his value on it, and the original manufacturer may have put yet another value on it. The value depends on the person who does the valuation–it is subjective.

Relative Value and Pricing

Relative value in the marketing context is attractiveness measured in terms of utility of one product relative to another.

In term of pricing, prices of valued items undergo questionable fluctuations. For example, even though housing provides the same utility to the individual over time, and supply and demand are relatively constant and stable, the relative price of housing fluctuates, even more so than with stocks, oil, and gold.

This price volatility appears to occur in cycles and is caused by a myriad of factors. Figure 1 is an attempt to overlay the prices of housing, stocks, oil, and gold by normalizing the price streams. Normalizing is achieved by applying a discounting formula which converts a price to the price it would be at a certain date, given a certain discount rate. This would normally be used to cancel the effects of inflation, in which case the inflation rate would be used.

Value or Price

This chart shows that commonly valued items of constant utility tend to vary in price over time.

A chart shows that commonly valued items of constant utility tend to vary in price over time (house, stocks, rents, gold, crude oil, house trend, stocks trend, and rents trend).

8.2: Competitive Dynamics and Pricing

8.2.1: Price Competition

With competition pricing, a firm will base what they charge on what other firms are charging.

Learning Objective

Discuss price as a competitive strategy in marketing

Key Points

Price is a very important decision criteria that customers use to compare alternatives. It also contributes to the company’s position.
The pricing process normally begins with a decision about the company’s pricing approach to the market.
In general, a business can price itself to match its competition, price higher, or price lower.

Key Terms

competitor: A person or organization against whom one is competing.
strategy: a plan of action intended to accomplish a specific goal
price war: Price war is a term used in the economic sector to indicate a state of intense competitive rivalry accompanied by a multi-lateral series of price reductions. One competitor will lower its price, then others will lower their prices to match. If one of them reduces their price again, a new round of reductions starts.
off-price retailer: firms that purchase goods below wholesale cost and sell below normal retail price

Example

Many organizations attempt to establish prices that, on average, are the same as those set by their more important competitors. Automobiles of the same size that feature equivalent equipment tend to have similar prices.

Price Competition

Once a business decides to use price as a primary competitive strategy, there are many well-established tools and techniques that can be employed. The pricing process normally begins with a decision about the company’s pricing approach to the market.

Approaches to the Market

Price is a very important decision criteria that customers use to compare alternatives. It also contributes to the company’s position. In general, a business can price itself to match its competition, price higher, or price lower. Each has its pros and cons.

Pricing to Meet Competition

Many organizations attempt to establish prices that, on average, are the same as those set by their more important competitors. Automobiles of the same size that feature equivalent equipment tend to have similar prices. This strategy means that the organization uses price as an indicator or baseline. Quality in production, better service, creativity in advertising, or some other element of the marketing mix are used to attract customers who are interested in products in a particular price category.

The keys to implementing a strategy of meeting competitive prices are an accurate definition of competition and a knowledge of competitor’s prices. A maker of hand-crafted leather shoes is not in competition with mass producers. If this artisan attempts to compete with mass producers on price, higher production costs will make the business unprofitable. A more realistic definition of competition for this purpose would be other makers of hand-crafted leather shoes. After defining this competition, knowing their prices would allow the artisan to put this pricing strategy into effect. Banks shop with competitive banks every day to check their prices.

Pricing Above Competitors

Pricing above competitors can be rewarding to organizations, provided that the objectives of the policy are clearly understood. The marketing mix must also be used to develop a strategy that enables management to implement the policy successfully.

Pricing above competition generally requires a clear advantage on some nonprice element of the marketing mix. In some cases, it is possible due to a high price-quality association on the part of potential buyers. Such an assumption is increasingly dangerous in today’s information-rich environment. Consumer Reports and other similar publications make objective product comparisons much simpler for the consumer. There are also hundreds of dot.com companies that provide objective price comparisons. The key is to prove to customers that your product justifies a premium price.

Pricing Below Competitors

Such a strategy can be effective if a significant segment of the market is price-sensitive and or the organization’s cost structure is lower than competitors. Costs can be reduced by increased efficiency, economies of scale, or by reducing or eliminating such things as credit, delivery, and advertising. For example, if a firm could replace its sales force in the field with telemarketing or online access, this function might be performed at a lower cost. Such reductions often involve some loss in effectiveness, so the tradeoff must be considered carefully.

Historically, one of the worst outcomes that can result from pricing lower than a competitor is a price war. Price wars usually occur when a business believes that price-cutting produces increased market share, but does not have a true cost advantage. Price wars are often caused by companies misreading or misunderstanding competitors. Typically, price wars are overreactions to threats that either are not there at all or are not as big as they seem.

Another possible drawback when pricing below competition is the company’s inability to raise price or image. A retailer such as Kmart, known as a discount chain, found it impossible to reposition itself as a provider of designer women’s clothes. In keeping with this idea, can you imagine Swatch selling a 3,000 dollar watch?

Kmart

Kmart had a hard time selling upscale items because it’s known as a discount chain.

How can companies cope with the pressure created by reduced prices? Some are redesigning products for ease and speed of manufacturing or reducing costly features that their customers do not value. Other companies are reducing rebates and discounts in favor of stable, everyday low prices (ELP). In all cases, these companies are seeking shelter from pricing pressures that come from the discount mania that has been common in the US for the last two decades.

8.2.2: Nonprice Competition

Non-price competition involves firms distinguishing their products from competing products on the basis of attributes other than price.

Learning Objective

Differentiate price competition from non-price competition tactics

Key Points

Non-price competition can be contrasted with price competition, which is where a company tries to distinguish its product or service from competing products on the basis of a low price.
Firms will engage in non-price competition, in spite of the additional costs involved, because it is usually more profitable than selling for a lower price and avoids the risk of a price war.
Although any company can use a non-price competition strategy, it is most common among oligopolies and monopolistic competition, because these firms can be extremely competitive.

Key Terms

oligopolies: An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists). Because there are few sellers, each oligopolist is likely to be aware of the actions of the others.
generic: Not having a brand name.

Example

Common practices in the competition between firms (such as supermarkets and other stores) include the following: traditional advertising and marketing, store loyalty cards, banking and other services (including travel insurance), in-store chemists and post offices, home delivery systems, discounted petrol at hypermarkets, extension of opening hours (24 hour shopping), innovative use of technology for shoppers including self-scanning, and internet shopping services.

Introduction

Since price competition can only go so far, firms often engage in non-price competition. Non-price competition is a marketing strategy “in which one firm tries to distinguish its product or service from competing products on the basis of attributes like design and workmanship. “

The firm can also distinguish its product offering through quality of service, extensive distribution, customer focus, or any other sustainable competitive advantage other than price.

Non-price Competition

Amazon.com makes shopping and researching products, prices, and seller reliability quick and easy for its customers. Its prices are low, but not necessarily the lowest.

The idea is to try to convince consumers that they should buy these products, not just because they are cheaper, but because they are in some way better than those made by competitors.

It can be contrasted with price competition, which is where a company tries to distinguish its product or service from competing products on the basis of a low price.

The Benefits of Non-price Compeition

Non-price competition typically involves promotional expenditures (such as advertising, selling staff, the locations convenience, sales promotions, coupons, special orders, or free gifts), marketing research, new product development, and brand management costs.

Firms will engage in non-price competition, in spite of the additional costs involved, because it is usually more profitable than selling for a lower price and avoids the risk of a price war. For example, brand-name goods often sell more units than do their generic counterparts, despite usually being more expensive. Non-price competition may also promote innovation as firms try to distinguish their product.

Although any company can use a non-price competition strategy, it is most common among oligopolies and monopolistic competition, because these firms can be extremely competitive.

8.3: Demand Analysis

8.3.1: The Demand Curve

A demand curve is a graph showing the relationship between the price of a certain item and what consumers are willing to buy at the price.

Learning Objective

Define the demand curve

Key Points

Demand does not only have to do with the need to have a product or a service, but it also involves the willingness and ability to buy it at the price charged for it.
The demand curve for all consumers together follows from the demand curve of every individual consumer. The individual demands at each price are added together.
The negative slope of the demand curve is often referred to as the “law of demand,” which means people will buy more of a service, product, or resource as its price falls.

Key Terms

derived demand: when demand for a factor of production or intermediate good occurs as a result of the demand for another intermediate or final good
Giffen good: A good which people consume more of as the price rises; Having a positive price elasticity of demand. As price rises, more is consumed which increases demand.
Veblen good: A good for which people’s preference for buying them increases as a direct function of their price, as greater price confers greater status. As the price gets higher, demand rises.
straight rebuy: the repurchase of a good with no changes to the details of the order

Example

Demand is the willingness and ability of a consumer to purchase a good under the prevailing circumstances. Thus, any circumstance that affects the consumer’s willingness or ability to buy the good or service in question can be a non-price determinant of demand. For example, weather could effect the demand for beer at a baseball game.

Demand

When clients want a product and are willing to pay for it, we say that there is a demand for the specific product. There has to be a demand for a product before a manufacturer can sell it. Demand does not only have to do with the need to have a product or a service, but also with the willingness and ability to buy it at the price charged for it.

Example of Demand: Andrew’s Grape Jam

Andrew and his mother, Mrs. Jeffries, decided to earn extra money by selling grape jam at the local craft market. Mrs. Jeffries would buy the ingredients and make the jam. Andrew would help his mother seal it in jars and they planned to sell it at the market on Saturday mornings.

Before starting to boil the jam, they decided to test the market to see whether people would be interested in buying their product. Mrs. Jeffries therefore boiled a few jars of jam and asked their friends and family if they were interested in buying it and how much they would be willing to pay for it. Everyone was encouraged to taste some of the jam before making a decision.

The results Mrs. Jeffries received is are illustrated in the graph which indicates the demand at different prices.

Demand Curve

This graph shows the demand curve based on the number of jars and the price.

The line on the graph indicates the way in which the change in price brought about a change in demand. This is referred to as the demand curve. It specifies the amount of a product according to the demands for it at a specific price.

Demand Curve

In economics, the demand curve is the graph depicting the relationship between the price of a certain commodity (in this case Andrew’s jam) and the amount of it that consumers are willing and able to purchase at that given price. It is a graphic representation of a demand schedule.

The demand curve for all consumers together follows from the demand curve of every individual consumer: the individual demands at each price are added together.

Demand Curve Characteristics

According to convention, the demand curve is drawn with price on the vertical axis and quantity on the horizontal axis. The demand curve usually slopes downwards from left to right; that is, it has a negative association (two theoretical exceptions, Veblen good and Giffen good). The negative slope is often referred to as the “law of demand”, which means people will buy more of a service, product, or resource as its price falls.

Linear Demand Curve

The demand curve is often graphed as a straight line in the form Q = a – bP where “a” and “b” are parameters. The constant “a” “embodies” the effects of all factors, other than price, that affect demand.

If income were to change, for example, the effect of the change would be represented by a change in the value of “a” and be reflected graphically as a shift on the demand curve. The constant “b” is the slope of the demand curve and shows how the price of the good affects the quantity demanded.

The graph of the demand curve uses the inverse demand function in which price is expressed as a function of quantity. The standard form of the demand equation can be converted to the inverse equation by solving for P or P = a/b – Q/b.

Shift of a Demand Curve

The shift of a demand curve takes place when there is a change in any non-price determinant of demand, resulting in a new demand curve.

Non-price determinants of demand are those things that cause demand to change even if prices remain the same—in other words, changes that might cause a consumer to buy more or less of a good even if the good’s price remained unchanged.

Some of the more important factors are:

the prices of related goods (both substitutes and complements)
income
population
expectations

However, demand is the willingness and ability of a consumer to purchase a good under the prevailing circumstances. Thus, any circumstance that affects the consumer’s willingness or ability to buy the good or service in question can be a non-price determinant of demand. For example, weather could effect the demand for beer at a baseball game.

8.3.2: The Influence of Supply and Demand on Price

Changes in either supply or demand will move the market clearing point and change the market price for a good.

Learning Objective

Apply the basic laws of supply and demand to different economic scenarios

Key Points

There are four basic laws of supply and demand.
Since determinants of supply and demand other than the price of the good in question are not explicitly represented in the supply-demand diagram, changes in the values of these variables are represented by moving the supply and demand curves (often described as “shifts” in the curves).
Responses to changes in the price of the good are represented as movements along unchanged supply and demand curves.

Key Term

equilibrium price: The price of a commodity at which the quantity that buyers wish to buy equals the quantity that sellers wish to sell.

Example

Consider a certain commodity, such as gasoline. If there is a strong demand for gas, but there is less gasoline, then the price goes up. If conditions change and there is a smaller demand for gas, due to the presence of more electric cars for instance, then the price of the commodity decreases.

Introduction

The amount of a good in the market is the supply and the amount people want to buy is the demand. Consider a certain commodity, such as gasoline. If there is a strong demand for gas, but there is less gasoline, then the price goes up. If conditions change and there is a smaller demand for gas, due to the presence of more electric cars for instance, then the price of the commodity decreases.

The factors influencing supply include:

Price – As the price of a product rises, its supply rises because producers are more willing to manufacture the product because it’s more profitable.
Price of other commodities – There are two types: competitive supply (If a producer switches from producing A to producing B, the price of A will fall and hence the supply will fall because it’s less profitable to make A), and joint supply (A rise in one product may cause a rise in another. For instance, a rise in the price of wooden bedframes may cause a rise in the price of wooden desks and chairs. This means supply of wooden bedframes, chairs, and desks will rise because it’s more profitable. )
Costs of production – If production costs rise, supply will fall because the manufacture of the product in question will become less profitable.
Change in availability of resources – If wood becomes scarce, fewer wooden bedframes can be made, so supply will fall.

Factors influencing demand include:

Income
Tastes and preferences
Prices of related goods and services
Consumers’ expectations about future prices and incomes that can be checked
Number of potential consumers

Supply and Demand As an Economic Model

Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price). This results in an economic equilibrium of price and quantity.

The four basic laws of supply and demand are:

If demand increases and supply remains unchanged, then it leads to higher equilibrium price and higher quantity.
If demand decreases and supply remains unchanged, then it leads to lower equilibrium price and lower quantity.
If demand remains unchanged and supply increases, then it leads to lower equilibrium price and higher quantity.
If demand remains unchanged and supply decreases, then it leads to higher equilibrium price and lower quantity.

Graphical Representation of Supply and Demand

Although it is normal to regard the quantity demanded and the quantity supplied as functions of the price of the good, the standard graphical representation, usually attributed to Alfred Marshall, has price on the vertical axis and quantity on the horizontal axis, the opposite of the standard convention for the representation of a mathematical function.

Since determinants of supply and demand other than the price of the good in question are not explicitly represented in the supply-demand diagram, changes in the values of these variables are represented by moving the supply and demand curves (often described as “shifts” in the curves). By contrast, responses to changes in the price of the good are represented as movements along unchanged supply and demand curves.

Supply and Demand

The price P of a product is determined by a balance between production at each price (supply S) and the desires of those with purchasing power at each price (demand D).
The diagram shows a positive shift in demand from D1 to D2, resulting in an increase in price (P) and quantity sold (Q) of the product.

A graph the plots the supply and demand for a product based on the price, supply, demand, and quantity sold.

Equilibrium

Since the demand curve slopes down and the supply curve slopes up, when they are put on the same graph, they eventually cross one another. The point where the supply line and the demand line meet is called the equilibrium point.

In general, for any good, it is at this point that quantity supplied equals quantity demanded at a set price. If there are more buyers than there are sellers at a certain price, the price will go up until either some of the buyers decide they are not interested, or some people who were previously not considering selling decide that they want to sell their good. This process normally continues until there are sufficiently few buyers and sufficiently many sellers that the numbers balance out, which should happen at the equilibrium point.

8.3.3: Elasticity of Demand

Elasticity of demand is a measure used in economics to show the responsiveness of the quantity demanded of an item to a change in its price.

Learning Objective

Identify the key factors that determine the elasticity of demand for a good

Key Points

Price elasticities are almost always negative; only goods which do not conform to the law of demand, such as a Veblen good and a Giffen good, have a positive PED.
In general, the demand for a good is said to be inelastic (or relatively inelastic) when changes in price have a relatively small effect on the quantity of the good demanded.
The demand for a good is said to be elastic (or relatively elastic) when changes in price have a relatively large effect on the quantity of a good demanded.
A number of factors can thus affect the elasticity of demand for a good.

Key Terms

Giffen good: A good which people consume more of as the price rises; Having a positive price elasticity of demand. As price rises, more is consumed which increases demand.
conjoint analysis: Conjoint analysis is a statistical technique used in market research to determine how people value different features that make up an individual product or service.
Veblen good: A good for which people’s preference for buying them increases as a direct function of their price, as greater price confers greater status. As the price gets higher, demand rises.

Example

In general, the more substitues there are for a product, the more elastic it is. For instance, one can get their morning juice from products other than cranberry juice. So if the price of cranberry juice were to increase by $0.25 people would drink a substitute, like apple juice, instead. Cranberry juice, therefore, is an elastic good because a change in price will cause large decrease in demand.

Elasticity of Demand: an Overview

Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price.

More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price (holding constant all the other determinants of demand, such as income). It was devised by Alfred Marshall.

Elasticity of Demand

The price elasticity of demand equation shows how the demand for a good or service changes based on the price.

Price elasticities are almost always negative, although analysts tend to ignore the sign even though this can lead to ambiguity. Only goods which do not conform to the law of demand, such as a Veblen good and a Giffen good, have a positive PED.

In general, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a relatively small effect on the quantity of the good demanded.

The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one (in absolute value): that is, changes in price have a relatively large effect on the quantity of a good demanded.

Revenue is maximized when price is set so that the PED is exactly one. The PED of a good can also be used to predict the incidence (or “burden”) of a tax on that good. Various research methods are used to determine price elasticity, including test markets, analysis of historical sales data, and conjoint analysis.

Determinants

The overriding factor in determining PED is the willingness and ability of consumers after a price change to postpone immediate consumption decisions concerning the good and to search for substitutes (“wait and look”). A number of factors can thus affect the elasticity of demand for a good:

Availability of substitute goods: The more and closer the substitutes available, the higher the elasticity is likely to be, as people can easily switch from one good to another if an even minor price change is made. In other words, there is a strong substitution effect. If no close substitutes are available, the substitution of effect will be small and the demand inelastic.
Breadth of definition of a good: The broader the definition of a good (or service), the lower the elasticity. For example, Company X’s fish and chips would tend to have a relatively high elasticity of demand if a significant number of substitutes are available, whereas food in general would have an extremely low elasticity of demand because no substitutes exist.
Percentage of income: The higher the percentage of the consumer’s income that the product’s price represents, the higher the elasticity tends to be, as people will pay more attention when purchasing the good because of its cost. The income effect is thus substantial. When the goods represent only a negligible portion of the budget, the income effect will be insignificant and demand inelastic.
Necessity: The more necessary a good is, the lower the elasticity, as people will attempt to buy it no matter the price, such as in the case of insulin for those that need it.
Duration: For most goods, the longer a price change holds, the higher the elasticity is likely to be, as more and more consumers find they have the time and inclination to search for substitutes. When fuel prices increase suddenly, for instance, consumers may still fill up their empty tanks in the short run, but when prices remain high over several years, more consumers will reduce their demand for fuel by switching to carpooling or public transportation, investing in vehicles with greater fuel economy, or taking other measures. This does not hold for consumer durables such as the cars themselves, however; eventually, it may become necessary for consumers to replace their present cars, so one would expect demand to be less elastic.
Brand loyalty: An attachment to a certain brand—either out of tradition or because of proprietary barriers—can override sensitivity to price changes, resulting in more inelastic demand.
Who pays: Where the purchaser does not directly pay for the good they consume, such as with corporate expense accounts, demand is likely to be more inelastic.

8.3.4: Yield Management Systems

Yield management systems enable organizations to adapt pricing in real-time based on various factors impacting demand.

Learning Objective

Understand the purpose of projecting demand changes, and varying prices to capture opportunities

Key Points

Yield management systems are predicated on the idea that demand is not consistent over time for certain types of products and services. Predicting shifts in demand will therefore provide potential value to the organization.
By accurately predicting changes in demand over time or over consumer groups, organizations can produce a profit-maximizing pricing strategy through varying price points with demand.
Yield management is a multidisciplinary field, which requires buy in from financiers, accountants, marketers, strategists and often technical specialists in big data.
Knowing when to use yield management and when not to is an important strategic decision. Goods that are perishable, scarce, and which have a high fluctuation in willingness to pay are ideal for this model.
There are ethical concerns revolving around yield management however, as charging individuals based on their ability to pay and overall demand could be as exploitation.

Key Term

yield management: The marketing strategy of identifying variance in demand, and aligning pricing strategies to maximizing profits.

Estimating Demand

When an organization begins determining the price of a given product or service, the objective is to optimize profit through maximizing revenues and minimizing cost. To do so, projections of demand and fulfilling that projected demand with the appropriate supply to maintain the optimal price point is a central strategic endeavor for a marketer. Forecasting demand and understanding the elasticity of the demand for various types of goods is greatly empowered by systems built to manage yield.

Demand Shifts

Understanding fluctuations in demand is a critical component of yield management systems.

A graph that the plots the supply and demand for a product based on the price, supply, demand, and quantity sold.

Yield Management Systems

A yield management system is based on pricing models which are variable, which is to say that the price of a given product or service will change consistently over time. A good example of this, just as a frame of reference, would be a flight ticket. The prices for a flight from city A to city B will be different per day, per time, per airline and even per website in which you are finding that ticket. This variable pricing model is designed to maximize revenue through identifying supply, demand and optimal yield.

When To Manage Yield

Yield management is quite a complex endeavor, as it takes into account multidisciplinary considerations such as marketing, operations, financial management, statistics, and strategy to build an optimized approach to pricing which iterates and evolves over time. As a result, it is only worth building into practice when it will generate significant returns.

Yield management functions best when the following conditions are met:

There are a fixed amount of a given resource available (i.e. scarcity)
The resources are perishable, or time-sensitive in some way
There is a relatively high amount of fluctuation in regards to what consumers are willing to pay

Combining these three factors, we have scarce products which will likely expire and which are valued differently by different consumers. In these situations, managing yield through pricing properly based on timing and user can optimize profits.

Big Data

Effective yield management, like most intensive research projects, are best left to computers. Machine learning and the capacity to process large data streams (i.e. big data) can create highly reliable statistical models and segmentation of markets to enable an organization to target the appropriate consumer groups with the appropriate price at the appropriate time. This is generally accomplished through building forecasts utilizing huge data streams of past user behaviors.

For example, the price of a flight on a given day can take into account he day of the week, time of year, inflation, market conditions, competitive current pricing, and a wide variety of other data points in order to create a statistical spread of what the price should be set at.

Ethical Concerns

Yield management systems are very useful in specific industries, but are also somewhat controversial. The criticism of yield management is fairly intuitive. If companies can set prices based upon what type of consumer you are, and can identify demand with great accuracy, it is fairly easy for organizations to exploit consumers in specific situations.

For example, say you are stranded in a foreign country after flight cancellations, and need to get home to your two young children. You are there on business, and have an upper-middle class salary. A machine with all of that information can accurately predict that you are willing to pay a great deal more than someone else due to your dire situation. It would not be inaccurate to point out that this is somewhat predatory, and therefore potentially unethical behavior. You may pay thousands for the seat, while the person next to you paid less than 10% of what you paid.

8.4: Inputs to Pricing Decisions

8.4.1: Marginal Analysis

Pricing decisions tend to heavily involve analysis regarding marginal contributions to revenues and costs.

Learning Objective

Identify the characteristics of a marginal price analysis relative to pricing decision making

Key Points

Firms tend to accomplish their objective of profit maximization by increasing their production until marginal revenue equals marginal cost.
At the output level at which marginal revenue equals marginal cost, marginal profit is zero and this quantity is the one that maximizes profit.
In some cases, a firm’s demand and cost conditions are such that marginal profits are greater than zero for all levels of production up to a certain maximum; thus, output should be produced at the maximum level.

Key Terms

demand curve: The graph depicting the relationship between the price of a certain commodity and the amount of it that consumers are willing and able to purchase at that given price.
game theory: A branch of applied mathematics that studies strategic situations in which individuals or organizations choose various actions in an attempt to maximize their returns.

Marginal Analysis

Pricing decisions tend to heavily involve analysis regarding marginal contributions to revenues and costs. Specifically, firms tend to accomplish their objective of profit maximization by increasing their production until marginal revenue equals marginal cost, and then charging a price which is determined by the demand curve.

In business, the practice of setting the price of a product to equal the extra cost of producing an extra unit of output is known as marginal-cost pricing. Businesses often set prices close to marginal cost during periods of poor sales. If, for example, an item has a marginal cost of $1.00 and a normal selling price of $2.00 the firm selling the item might wish to lower the price to $1.10 if demand has waned. The business would choose this approach because the incremental profit of 10 cents from the transaction is better than no sale at all.

In the marginal analysis of pricing decisions, if marginal revenue is greater than marginal cost at some level of output, marginal profit is positive and thus a greater quantity should be produced. Alternatively, if marginal revenue is less than the marginal cost, marginal profit is negative and a lesser quantity should be produced. At the output level at which marginal revenue equals marginal cost, marginal profit is zero and this quantity is the one that maximizes profit.

Since total profit increases when marginal profit is positive and total profit decreases when marginal profit is negative, it must reach a maximum where marginal profit is zero.

The intersection of MR and MC is shown as point A. If the industry is perfectly competitive (as is assumed in the diagram), the firm faces a demand curve (D) that is identical to its marginal revenue curve (MR). Thus, this is a horizontal line at a price determined by industry supply and demand. If the firm is operating in a non-competitive market, changes would have to be made to the diagram.

Marginal Profit Maximization

This series of cost curves shows the implementation of profit maximization using marginal analysis.

A cost curve that shows how businesses set prices based on demand.

For example, the marginal revenue curve would have a negative gradient, due to the overall market demand curve. In a non-competitive environment, more complicated profit maximization solutions involve the use of game theory. In some cases, a firm’s demand and cost conditions are such that marginal profits are greater than zero for all levels of production up to a certain maximum. In this case, marginal profit plunges to zero immediately after that maximum is reached. Thus, output should be produced at the maximum level, which also happens to be the level that maximizes revenue. In other words, the profit maximizing quantity and price can be determined by setting marginal revenue equal to zero, which occurs at the maximal level of output.

8.4.2: Fixed Costs

Fixed costs are business expenses that are not dependent on the level of goods or services produced by the business.

Learning Objective

Describe the characteristics of fixed costs and they relate to pricing decisions

Key Points

The distinction between fixed and variable costs is crucial in forecasting the earnings generated by various changes in unit sales and thus the financial impact of proposed marketing campaigns.
Fixed costs are not permanently fixed – they will change over time – but are fixed in relation to the quantity of production for the relevant period.
Average fixed cost (AFC) is an economic term that refers to fixed costs of production (FC) divided by the quantity (Q) of output produced.

Key Terms

lease: A contract granting use or occupation of property during a specified period in exchange for a specified rent.
discretionary: Available at one’s discretion; able to be used as one chooses; left to or regulated by one’s own discretion or judgment.

Fixed Costs

Determining the cost of producing a product or service plays a vital role in most pricing decisions. Fixed costs are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as salaries or rents being paid per month. They and are often referred to as overhead costs. This is in contrast to variable costs, which are volume-related and are paid per quantity produced. In management accounting, fixed costs are defined as expenses that do not change as a function of the activity of a business, within the relevant period. For example, a retailer must pay rent and utility bills irrespective of sales. In marketing, it is necessary to know how costs divide between variable and fixed. This distinction is crucial in forecasting the earnings generated by various changes in unit sales and thus the financial impact of proposed marketing campaigns. In a survey of nearly 200 senior marketing managers, 60% responded that they found the “variable and fixed costs” metric very useful.

Fixed Costs and Variable Costs

The graph breaks down the difference between fixed costs and variable costs.

A graph that shows how fixed costs and variable costs impact total costs.

Fixed costs are not permanently fixed – they will change over time – but are fixed in relation to the quantity of production for the relevant period. For example, a company may have unexpected and unpredictable expenses unrelated to production. Warehouse costs and the like are fixed only over the time period of the lease. By definition, there are no fixed costs in the long run. Investments in facilities, equipment, and the basic organization that can’t be significantly reduced in a short period of time are referred to as committed fixed costs. Discretionary fixed costs usually arise from annual decisions by management to spend on certain fixed cost items. Examples of discretionary costs are advertising, machine maintenance, and research and development expenditures.

Average Fixed Costs

For pricing purposes, marketers generally take into account average fixed costs. Average fixed cost (AFC) is an economics term that refers to fixed costs of production (FC) divided by the quantity (Q) of output produced . Average fixed cost is a per-unit-of-output measure of fixed costs. As the total number of goods produced increases, the average fixed cost decreases because the same amount of fixed costs is being spread over a larger number of units of output.

8.4.3: Break-Even Analysis

The break-even point is the point at which costs and revenues are equal.

Learning Objective

Analyze the concept of break even points relative to pricing decisions

Key Points

In the linear Cost-Volume-Profit Analysis model, the break-even unit of sales can be directly computed in terms of total revenue and total costs.
Unit contribution margin is the marginal profit per unit, or alternatively the portion of each sale that contributes to fixed costs.
Break-even analysis is a simple and useful analytical tool, yet has a number of limitations as well.

Key Terms

break-even point: The point where total costs equal total revenue and the organization neither makes a profit nor suffers a loss.
Opportunity Costs: The costs of activities measured in terms of the value of the next best alternative forgone (that is not chosen).

Break-Even Analysis

In economics and business, specifically cost accounting, the break-even point is the point at which costs or expenses and revenue are equal – i.e., there is no net loss or gain, and one has “broken even.”

A profit or a loss has not been made, although opportunity costs have been “paid,” and capital has received the risk-adjusted, expected return. For example, if a business sells fewer than 200 tables each month, it will make a loss. If the business sells more, it will make a profit. With this information, the business managers will then need to see if they expect to be able to make and sell 200 tables per month. If they think they cannot sell that many, to ensure viability they could:

Try to reduce the fixed costs (by renegotiating rent for example, or keeping better control of telephone bills or other costs)
Try to reduce variable costs (the price it pays for the tables by finding a new supplier)
Increase the selling price of their tables

In the linear Cost-Volume-Profit Analysis model, the break-even point – in terms of Unit Sales (X) – can be directly computed in terms of Total Revenue (TR) and Total Costs (TC) as: where TFC is Total Fixed Costs, P is Unit Sale Price, and V is Unit Variable Cost. The quantity (P – V) is of interest in its own right, and is called the Unit Contribution Margin (C). It is the marginal profit per unit, or alternatively the portion of each sale that contributes to Fixed Costs. Thus the break-even point can be more simply computed as the point where Total Contribution = Total Fixed Cost:

Break-Even Analysis

A break-even quantity can also be found using contribution margin.

A break-even analysis where the total number of units equals the total fixed costs divided by the unit contribution.

Break-Even Calculation

We can derive the calculation for the break-even quantity from the relation of total revenue to total costs.

Break-Even and Pricing Decisions

The break-even point is one of the simplest analytical tools in management. It helps to provide a dynamic view of the relationships between sales, costs, and profits. A better understanding of break-even, for example, is expressing break-even sales as a percentage of actual sales. This can give managers a chance to understand when to expect to break even (by linking the percent to when in the week/month this percent of sales might occur). In terms of pricing decisions, break-even analysis can give a company a benchmark quantity of goods to be sold. This quantity can then be used to derive the average fixed and variable costs, the sum of which can be used as the basis for markup pricing, et cetera. Some limitations of break-even analysis include:

It is only a supply side (i.e. costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices.
It assumes that fixed costs (FC) are constant. Although this is true in the short run, an increase in the scale of production is likely to cause fixed costs to rise.
It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales (i.e. linearity).
It assumes that the quantity of goods produced is equal to the quantity of goods sold.
In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant).

8.4.4: Organizational Objectives

For the vast majority of business entities, the ultimate objective should be to increase profits, often through a better pricing strategy.

Learning Objective

Illustrate how an organization’s objectives impact its pricing decisions

Key Points

A business can cut its costs, it can sell more, or it can find more profit with a better pricing strategy.
When costs are already at their lowest and sales are hard to find, adopting a better pricing strategy is a key option to stay viable.
A pivotal factor in determining a price is how consumers will perceive it.

Key Term

viable: Able to be done, possible.

Organizational Objectives

For the vast majority of business entities, the ultimate objective should be to increase profits. Pricing strategies for products or services encompass three main ways to achieve this. A business can cut its costs, it can sell more, or it can find more profit with a better pricing strategy.

When costs are already at their lowest and sales are hard to find, adopting a better pricing strategy is a key option to stay viable. Merely raising prices is not always the answer, especially in a poor economy. Too many businesses have been lost because they priced themselves out of the marketplace. On the other hand, too many business and sales staff leave “money on the table. ” The objective is to adopt a pricing strategy and manage costs such that profit will be maximized.

One strategy does not fit all, so adopting a pricing strategy is a learning curve when studying the needs and behaviors of customers and clients.

Laws Of Price Sensitivity

A pivotal factor in determining a price is how consumers will perceive it. In their book,The Strategy and Tactics of Pricing, Thomas Nagle and Reed Holden outline nine “laws” that influence how a consumer perceives a given price and how price-sensitive they are likely to be with respect to different purchase decisions. They are:

Reference price effect – The buyer’s price sensitivity for a given product increases the higher the product’s price relative to perceived alternatives. Perceived alternatives can vary by buyer segment, by occasion, and other factors.
Difficult comparison effect – Buyers are less sensitive to the price of a known or more reputable product when they have difficulty comparing it to potential alternatives.
Switching costs effect – The higher the product-specific investment a buyer must make to switch suppliers, the less price sensitive that buyer is when choosing between alternatives.
Price-quality effect – Buyers are less sensitive to price the more that higher prices signal higher quality. Products for which this effect is particularly relevant include: image products, exclusive products, and products with minimal cues for quality.
Expenditure effect – Buyers are more price sensitive when the expense accounts for a large percentage of buyers’ available income or budget.
End-benefit effect – This effect refers to the relationship a given purchase has to a larger overall benefit and is divided into two parts. Derived demand: The more sensitive buyers are to the price of the end benefit, the more sensitive they will be to the prices of those products that contribute to that benefit. Price proportion cost: The price proportion cost refers to the percent of the total cost of the end benefit accounted for by a given component that helps to produce the end benefit, such as with computers. The smaller the given component’s share of the total cost of the end benefit, the less sensitive buyers will be to the component’s price.
Shared-cost effect – The smaller the portion of the purchase price buyers must pay for themselves, the less price sensitive they will be.
Fairness effect – Buyers are more sensitive to the price of a product when the price is outside the range they perceive as “fair” or “reasonable” given the purchase context.
The framing effect – Buyers are more price sensitive when they perceive the price as a loss rather than a forgone gain, and they have greater price sensitivity when the price is paid separately rather than as part of a bundle.

Oil Price Sensitivity

The graph shows the price fluctuation of oil after consumers have significant access to information regarding the commodity.

8.4.5: Other Inputs to Pricing Decisions

Pricing decisions can have a variety of inputs, such as value-added considerations, legal price requirements, competitive positioning, and discounting.

Learning Objective

List a few of the key considerations to pricing aside from simple expense-oriented break-even analyses

Key Points

Pricing is an important decision, as it impacts both profitability and competitive positioning.
One particularly important pricing consideration are the legal requirements in some industries (price floors and ceilings). For example, rent-controlled housing will have price limitations an organization will have to adhere to.
Functional value, social value, monetary value, and psychological value should all be taken into consideration when setting prices.
Differentiation and competitive positioning relative to other industry incumbents is another important pricing consideration. Differentiation can often lead to higher margins (though often lower volume).
For perishable goods or items which may go out of fashion (technology, clothing, etc.), discounting is a useful way to ensure that the organization gets some capital back for producing it (even if it sells at a loss on a per unit basis).

Key Term

perishable: Liable to perish, especially naturally subject to quick decomposition or decay.

Pricing Decisions

The pricing decision is an important one, both for profitability and competitive positioning. Organizations must take into account supply, demand, competition, expenses, profit margins, differentiation, quality, and legal concerns. The simplest methods of determining price include concepts such as break-even points, fixed/variable cost analysis, and marginal analysis. However, there are other concerns that need to be investigated when determining price.

Pricing Inputs

Looking at cost structures and determining break-even points is not always enough when it comes to effective pricing strategies. As a result, marketers should be familiar with the legalities of pricing (for certain commodities in particular), the value added to the consumer (willingness to pay), competitive positioning, and potential discounts.

Legal Concerns

For some products, governments will set firm price controls (i.e. price ceilings or price floors) to ensure ethical and/or accessible pricing for a given population. Just as the name implies, price floors and price ceilings will set minimum or maximum prices for some goods. This is particularly applicable to rent, real estate, banking, food and other core necessities. When operating in an industry with price ceilings or price floors, firms must adapt their pricing strategy to these legalities and ensure compliance.

Price Ceiling

When considering pricing decisions, understanding price floors and price ceilings is important.

A graph that shows the basic economic principles of supply and demand as they relate to the price.

Value-Added Pricing

In a perfectly practical and efficient market, the expenses would almost always lead to the appropriate price through competitive forces. However, we do not live in a world of perfect markets. As a result, there are a number of value-adds that consumers receive that are not easy or intuitive to measure from a strictly financial perspective. These include:

Functional Value: This is a typical example of demand, where the product is valued at how well it accomplishes a function (i.e. fulfills the need).
Monetary Value: This is another typical value example, where the cost of resources and production correlate cleanly with the price.
Social Value: The value a consumer receives can actually be social as well as economic. This is to say that some products provide intangible value to users. Fashion is a good example here, as some fashion items return margins that are enormous due to the social perception of a given fashion item (expensive bags, for example).
Psychological Value: Some items have value to an individual for personal reasons. A collector, for example, may pay far more than an item is worth due to a strong love for something. People who collect video game action figures, or deluxe editions, for example.

Competitive Positioning

Another input to pricing is the basic premise of differentiation to achieve higher value. This is not so much an exception to the above mentioned value-added pricing, but more of a facet of this. Branded items, for example, are often quite similar to generic versions of the same item. However, these brands add intangible value to the product above and beyond the cost of producing it. Buying brand name goods may be differentiated based upon celebrity sponsors, premium perception, social value or a wide variety of other differentiated factors. These can enable organizations to differentiate for a price premium (i.e. they can charge more for having a strong brand/position).

Discounting

There are also a number of reasons why an organization may offer discounts. Discounting is particularly useful when it comes to B2B transactions, in which a client might buy a few thousand of a given product and receive a wholesale price that is significantly lower than the price of buying each product individually. There are also situations in which a product may be sold at a price that is actually less than the cost of producing it. This is most often done when a perishable item will soon go bad anyway. In such a situation, selling at a loss is better than getting nothing at all (opportunity cost!).

Conclusion

All and all, pricing is a bit more complicated than simply understanding the expenses involve. Marketers must understand social value, legal considerations, branding, discounting, and the functional value of products and services in order to capture the full potential of a given item. Pricing can be a great opportunity to capture better margins than the competition, or could offer the ability to make a mistake and lose market share!

8.5: Pricing Objectives

8.5.1: Survival

Most executives pursue strategies that align pricing with revenue generation, enabling their organizations to survive and thrive long term.

Learning Objective

Name the different factors that impact a company’s success and survival

Key Points

New and improved products may hold the key to a firm’s survival and ultimate success.
All business enterprises must earn a long term profit in order to survive in the long run.
Just as survival requires a long term profit for a business enterprise, profit requires sales. Sales patterns should be altered to ensure success.
Management of all firms, large and small, are concerned with maintaining an adequate share of the market so their sales volume will enable the firm to survive and prosper. Prices must be set to attract the appropriate market segment in significant numbers.

Key Term

Market Share: The percentage of a market (defined in terms of either units or revenue) accounted for by a specific entity.

Example

Companies like McDonald’s and Starbucks were able to survive the recession by being smart about how they conducted business. The both closed down locations in less-favorable neighborhoods and added more products to their menus.

Survival

Firms rely on price to cover the costs of production, pay expenses, and provide the profit incentive necessary to continue to operate the business. These factors help an organization survive. Most managers pursue strategies that enable their organizations to continue in operation for the long term. Thus, survival is one major objective pursued by company executives. For a commercial firm, the price paid by the buyer generates the firm’s revenue. If revenue falls below cost for a long period of time, the firm cannot survive. Survival is closely linked to new product development, profit, sales, market share, and image.

New Products

For several decades, business has come increasingly to the realization that new and improved products may hold the key to their survival and ultimate success. Consequently, professional management has become an integral part of this process. As a result, many firms develop new products based on an orderly procedure, employing comprehensive and relevant data and intelligent decision-making.The continuing development of a successful new product looms as the most important factor in the survival of the firm.

Profit

Making a $500,000 profit during the next year might be a pricing objective for a firm. Anything less will ensure failure. All business enterprises must earn a long term profit. For many businesses, long term profitability also allows the business to satisfy company stakeholders such as investors, employees, customers, and suppliers. Lower-than-expected or no profits will drive down stock prices and may prove disastrous for the company.

Sales

Just as survival requires a long term profit for a business enterprise, profit requires sales. The task of marketing management relates to managing demand. Demand must be managed in order to regulate exchanges or sales. Thus, marketing management’s aim is to alter sales patterns in some desirable way.

Market Share

If the sales of Safeway Supermarkets in the Dallas-Fort Worth metropolitan area of Texas account for 30 percent of all food sales in that area, we say that Safeway has a 30 percent market share. Management of all firms, large and small, are concerned with maintaining an adequate share of the market so their sales volume will enable the firm to survive and prosper. Again, pricing strategy is one of the tools that is significant in creating and sustaining market share. Prices must be set to attract the appropriate market segment in significant numbers.

Image

Price policies play an important role in affecting a firm’s position of respect and esteem in its community. Price is a highly visible communicator. It must convey the message to the community that the firm offers good value, that it is fair in its dealings with the public, that it is a reliable place to patronize, and that it stands behind its products and services.

Surviving the Recession

Pricing plays a significant role in attracting and retaining market share during tough economic times.

A picture of a McDonald’s restaurant.

8.5.2: Profit

If the sole objective of a firm is to maximize profit, there are various profit maximizing pricing methods that can be used.

Learning Objective

Recall formulas for calculating profit maximizing output quantity and marginal profit

Key Points

In launching new products or considering the pricing of current products, managers often start with an idea of the dollar profit they desire and ask what level of sales will be needed to reach it. This can be done through profit-based sales targets.
Profit is equal to total revenue (TR) minus total cost (TC). The profit maximizing output is the one at which this difference reaches its maximum. The corresponding price will depend on whether the firm is a perfect competitor. This is the TR-TC method.
Marginal profit (Mπ) equals marginal revenue (MR) minus marginal cost (MC). If MR is greater than MC at some level of output, marginal profit is positive and thus a greater quantity should be produced. When MR = MC, Mπ is zero and this quantity is the one that maximizes profit.

Key Terms

Total cost: Total cost (TC) describes the total economic cost of production and is made up of variable costs, which vary according to the quantity of a good produced and include inputs such as labor and raw materials, plus fixed costs, which are independent of the quantity of a good produced and include inputs (capital) that cannot be varied in the short term, such as buildings and machinery.
Total Revenue: Total revenue is the total receipts of a firm from the sale of any given quantity of a product.
marginal revenue: Marginal revenue is the additional revenue that will be generated by increasing product sales by one unit.

Profit and Pricing Objectives

Some firms decide to set prices to maximize profits for either the short run or the long run. There are several methods to maximizing profits:

Profit-based Sales Targets

In launching new products or considering the pricing of current products, managers often start with an idea of the dollar profit they desire and ask what level of sales will be needed to reach it. Target volume (#) is the unit sales quantity needed to meet an earnings goal. Target revenue ($) is the corresponding figure for dollar sales. Increasingly, marketers are expected to generate volumes that meet the target profits of their firm. This will often require them to revise sales targets as prices and costs change.

The purpose of profit-based sales target metrics is to ensure that marketing and sales objectives mesh with profit targets. In target volume and target revenue calculations, managers go beyond break-even analysis (the point at which a company sells enough to cover its fixed costs) to determine the level of unit sales or revenues needed to cover a firm’s costs and attain its profit targets.

The Total Cost Method

To obtain the profit maximizing output quantity, you start by recognizing that profit is equal to total revenue (TR) minus total cost (TC). Given a table of costs and revenues at each quantity, we can either compute equations or plot the data directly on a graph. The profit maximizing output is the one at which this difference reaches its maximum. In , the linear total revenue curve represents the case in which the firm is a perfect competitor in the goods market, and thus cannot set its own selling price. The profit maximizing output level is represented as the one at which total revenue is the height of C and total cost is the height of B; the maximal profit is measured as CB. This output level is also the one at which the total profit curve is at its maximum. If, contrary to what is assumed in the graph, the firm is not a perfect competitor in the output market, the price to sell the product at can be read off the demand curve at the firm’s optimal quantity of output.

Total Profit Maximization

This linear total revenue curve represents the case in which the firm is a perfect competitor in the goods market. As a result, it cannot set its own selling price.

A revenue curve that shows total profit maximization based on total cost and total revenue.

The Marginal Cost Perspective

An alternative perspective relies on the relationship that, for each unit sold, marginal profit (Mπ) equals marginal revenue (MR) minus marginal cost (MC). Then, if marginal revenue is greater than marginal cost at some level of output, marginal profit is positive and thus a greater quantity should be produced, and if marginal revenue is less than marginal cost, marginal profit is negative and a lesser quantity should be produced. At the output level at which marginal revenue equals marginal cost, marginal profit is zero and this quantity is the one that maximizes profit. Since total profit increases when marginal profit is positive and total profit decreases when marginal profit is negative, it must reach a maximum where marginal profit is zero – or where marginal cost equals marginal revenue – and where lower or higher output levels give lower profit levels.

8.5.3: Return on Investment

Marketers should understand the position of their company and the returns expected when making adjustments in prices.

Learning Objective

Explain why pricing objectives focus on delivering a return on investment (ROI)

Key Points

Return on investment is one way of considering profits in relation to capital invested.
Marketing not only influences net profits but also can affect investment levels, too. New plants and equipment, inventories, and accounts receivable are three of the main categories of investments that can be affected by marketing decisions.
ROI provides a snapshot of profitability adjusted for the size of the investment assets tied up in the enterprise.

Key Terms

receivables: All the debts owed to a company by its debtors or customers.
accounts receivable: Accounts receivable refers to the money owed to a business by its clients (customers) and shown on its balance sheet as an asset.

Pricing objectives or goals give direction to the whole pricing process. Determining what your objectives are is the first step in pricing. When deciding on pricing objectives, you must consider:

1. The overall financial, marketing, and strategic objectives of the company

2. The objectives of your product or brand

3. Consumer price elasticity and price points

4. The resources you have available

One of the most common pricing objectives is obtaining a target rate of return on investment (ROI). Return on investment is one way of considering profits in relation to the capital invested. Marketing not only influences net profits but also can affect investment levels, too. New plants and equipment, inventories, and accounts receivable are three of the main categories of investments that can be affected by marketing decisions. Hence, it is important to keep all investments in mind when setting prices. It doesn’t pay to be narrow in focus.

The purpose of the return on investment metric is to measure per period rates of return on dollars invested in an economic entity. For example, this chart shows the rate of return on investments after training teachers. It provides a snapshot of profitability adjusted for the size of the investment assets tied up in the enterprise. Marketing decisions, such as setting prices, have obvious potential connection to the return on investment, but these same decisions often influence asset usage and capital requirements (for example, receivables and inventories). Marketers should understand the position of their company and the returns expected. Return on investment is often compared to expected (or required) rates of return on dollars invested.

Return on Investments

The chart shows the rate of return on investments after training teachers.

A chart that shows the return on equity per person over three years after training teachers. It looks at the cost, savings, quality gains, and marketing gains.

8.5.4: Market Share/Sales

Increasing market share is one of the most important objectives of business and pricing may offer a mechanism to increase share.

Learning Objective

Explain the relationship between market share and pricing strategies

Key Points

Marketers need to be able to translate sales targets into market share because this will determine whether forecasts are to be attained by growing with the market or by capturing share from competitors.
Market share is a key indicator of market competitiveness—that is, how well a firm is doing compared to its competitors. It enables them to judge not only total market growth or decline but also trends in customers’ selections among competitors.
Losses in market share can signal serious long-term problems that require strategic adjustments. Firms with market shares below a certain level may not be viable.

Key Term

Market Share: The percentage of a market (defined in terms of either units or revenue) accounted for by a specific entity.

Example

Netflix recently announced that they were going to offer, for the first time, their streaming video subscription service separately from their DVD-by-mail subscription service. Streaming-only will be the default for new customers, DVD-by-mail, shown here, is an optional add-on. Much of the discussion, verging on outrage, about this move centered on a price increase for the popular one-at-a-time DVD plus streaming option. Price increases are rare and this was a large one, at least on a percentage basis; the new price is nearly double the old one. By this pricing choice Netflix is positioning itself differently, a positioning that is part of its long term strategy. The pricing decision has to be seen in the context of a longer-term strategy. Pricing decisions are always serious because they flow almost directly to the bottom line, so Reed Hastings (Netflix CEO) must have concluded that the short-term loss of income from cancelled subscriptions will be outweighed by the longer term gain in new subscribers who do not take the DVD-by-mail option. This increase in new subscribers is an increase in sales. With so few on-line streaming opportunities it wouldn’t be difficult to obtain a large market share. Netflix is signalling to these customers that streaming is a better option.

Market share is a key indicator of market competitiveness—that is, how well a firm is doing compared to its competitors. It enables them to judge not only total market growth or decline but also trends in customers’ selections among competitors. Generally, sales growth resulting from primary demand (total market growth) is less costly and more profitable than that achieved by capturing share from competitors. Conversely, losses in market share can signal serious long-term problems that require strategic adjustments. Firms with market shares below a certain level may not be viable. Similarly, within a firm’s product line, market share trends for individual products are considered early indicators of future opportunities or problems.

Just as survival requires a long-term profit for a business enterprise, profit requires sales. The task of marketing management relates to managing demand. Demand must be managed in order to regulate exchanges or sales. Thus marketing management’s aim is to alter sales patterns in some desirable way. They are concerned with maintaining an adequate share of the market so that their sales volume will enable the firm to survive and prosper. Again, pricing strategy is one of the tools that is significant in creating and sustaining market share. Prices must be set to attract the appropriate market segment in significant numbers. Decreasing price may increase demand and lead to higher market share, though it could also provoke a competitive response.

Marketers need to be able to translate sales targets into market share because this will determine whether forecasts should be attained by growing with the market or by capturing share from competitors. The latter will almost always be more difficult to achieve. Market share is closely monitored for signs of change in the competitive landscape, and it frequently drives strategic or tactical decisions. Increasing market share is one of the most important objectives of business. The main advantage of using market share as a measure of business performance is that it is less dependent upon macro environmental variables such as the state of the economy or changes in tax policy.

Pricing Strategies

Changing the pricing strategy might be part of a longer-term strategy to increase market share in on-line video streaming.

A Netflix envelope and DVD.

8.5.5: Cash Flow

Cash flow is extremely important to firms as this is how they buy goods, pay employees, fund new investments, and pay dividends.

Learning Objective

Identify the different pricing strategies for generating cash flow in an organization

Key Points

Some companies will set prices so that they can recover cash flow as quickly as possible. This strategy could be due to the company spending too much of its resources on developing products.
One way to get cash flow quickly is through seasonal discounts. Seasonal discounts are price reductions given on out-of-season merchandise.
Another option is cash discounts. Cash discounts are reductions on the base price given to customers for paying cash or within some short time period.

Key Terms

cash flow: The movement of money into or out of a business.
seasonal discount: price reductions given when an order is placed in a slack period

Cash flow is the movement of money into or out of a business. The measurement of cash flow can be used for calculating other parameters that give information on a company’s value and situation. Some companies will set prices so that they can recover cash flow as quickly as possible. This strategy could be due to the company spending too much of its resources on developing products. This typically requires setting prices very high, which is a disadvantage since competitors can set prices lower and gain a larger market share.

Cash flow is extremely important to a firm. This is how they buy goods, pay employees, fund new investments, and pay dividends. It is necessary to determine the effects of pricing on cash flow to a firm.

One way to get cash flow quickly is through seasonal discounts . Seasonal discounts are price reductions given for out-of-season merchandise. An example would be a discount on snowmobiles during the summer. The intention of such discounts is to spread demand over the year. This can allow for the fuller use of production facilities and improved cash flow throughout the year.

Seasonal Sales

A quick way to generate cash flow is to offer seasonal discounts.

A picture of various sale price tags.

Another option is cash discounts. Cash discounts are reductions on the base price given to customers for paying cash or within some short time period. For example, a company can give a two percent discount on bills paid within 10 days. Another example is a gas station that gives discounts on gas prices to costumers who don’t pay with credit cards. The purpose is generally to accelerate the cash flow of the organization.

8.5.6: Status Quo

Status quo pricing is the concept that some goods within certain industries have an expected price for consumers, due to a relative norm within that market.

Learning Objective

Recognize that some product types have relative consistent pricing, and entering those markets often requires the ability to produce at that price or lower

Key Points

Many products and services have relatively normal expected prices, usually due to a balance of demand, competition, and economic factors.
In order to effectively compete in those markets, organizations must refine their process to produce at the status quo price point or lower in order to satisfy the needs of consumers in that market.
Status quo price points usually evolve organically as a byproduct of external and competitive forces.
It is important to differentiate price fixing and status quo pricing. Price fixing is an agreement among competitive firms to set prices at the same level in order to attain a monopoly. This is illegal under antitrust laws in most countries.

Key Terms

price fixing: An agreement between participants on the same side in a market to buy or sell a product, service, or commodity only at a fixed price, or maintain the market conditions such that the price is maintained at a given level by controlling supply and demand.
status quo: The state of things; the way things are, as opposed to the way they could be; the existing state of affairs.

When setting a price for a given product or service, there are countless objectives an organization may have that will impact how and why a price is determined. While there are too many objectives to provide a comprehensive list, some of the more common pricing objectives include:

Maximizing short-term or long-term profit
Increasing sales volume
Increasing market share and/or growth
Becoming a price leader
Differentiating for a niche segment
Social, ethical, or ideological objectives (e.g. making something available to consumers with lower incomes)
Attaining the competitive equilibrium

Many industries have key competitors that wield a great deal of power and influence within the industry. As a result, new entrants and smaller players are often forced to attain a similar efficiency in operations and become able to sell a given good at a specific price or lower. These larger, strong players often have scale economies, which slowly make the ‘status quo’ price of a given good lower than is obtainable by other incumbents.

Status Quo Pricing

As a result of this, some firms pursue status quo pricing as a pricing objective. In this situation, they assess the overall market to determine what the going prices are for the product or service they will sell. Once this price point is established, the organization will strive to build an operational mechanism that enables the organization to be profitable at the price point (or possibly lower). This objective is particularly useful when applied to mature industries with firmly set price points and a low variance in price elasticity in the consumer groups.

These status quo price points arise organically, based on consumer behavior, competitive factors, and the price of production. Status quo prices are often associated with homogeneous goods for which the price has been lowered significantly through competition.

Price Fixing

An extremely important ethical consideration of this pricing objective is avoidance of price fixing. Price fixing is the illegal practice of various competitive firms within an industry agreeing on a fixed price for goods within an industry. If all competitive firms agree on price, there is no real practical different for the consumer between this and a monopoly.

The purpose of price fixing is identifying the highest possible optimal price point that can be charged for a given good within a market, which will in turn benefit all of the providers of that good. This is a criminal offense in the United States and can be prosecuted under the Sherman Antitrust Act.

8.5.7: Product Quality

Quality refers to the ability of a product or service to consistently meet or exceed customer requirements or expectations.

Learning Objective

Identify the different aspects and determinants of product quality

Key Points

Some of these consequences of poor quality include loss of business, liability, decreased productivity, and increased costs.
Good quality has its own costs, including prevention, appraisal, and failure.
Successful management of quality requires that managers have insights on various aspects of quality such as understanding the costs and benefits of quality and recognizing the consequences of poor quality.
Understanding the determants of quality, such as design of the product and the “ease of use” of the product, will help managers price the products accordingly.

Key Terms

quality: The ability of a product or service to consistently meet or exceed customer requirements or expectations.
return on quality: An internal management approach that evaluates the financial return of investments in quality.

Example

The Mercedes-Benz SLR McLaren is a high quality car. People know that when they pay the price, they are getting an engine that is hand made and top of the line. Thus, Mercedes are able to charge a premium for this highly desired, high quality product.

Broadly defined, quality refers to the ability of a product or service to consistently meet or exceed customer requirements or expectations. Different customers will have different expectations, so a working definition of quality is customer-dependent. When discussing quality one must consider design, production, and service. In a culmination of efforts, it begins with careful assessment of what the customers want, then translating this information into technical specifications to which goods or services must conform. The specifications guide product and service design, process design, production of goods and delivery of services, and service after the sale or delivery.

Some of these consequences of poor quality include loss of business, liability, decreased productivity, and increased costs. However, good quality has its own costs, including prevention, appraisal, and failure. A recent and more effective approach is discovering ways to prevent problems, instead of trying to fix them once they occur. This will ultimately decrease the cost of good quality in the long run.

There are several costs associated with quality:

Appraisal costs – costs of activities designed to ensure quality or uncover defects
Prevention costs – costs of prevention defects from occurring
Failure costs – Costs caused by defective parts or products or by faulty services
Internal failures – failures discovered during production
External failures – failures discovered after delivery to the customer
Return on quality (ROQ) – an approach that evaluates the financial return of investments in quality

Successful management of quality requires that managers have insights on various aspects of quality. These include defining quality in operational terms, understanding the costs and benefits of quality, recognizing the consequences of poor quality and recognizing the need for ethical behavior. Understanding dimensions that customers use to judge the quality of a product or service helps organizations meet customer expectations.

Dimensions of Product Quality

Performance– main characteristics of the product
Aesthetics– appearance, feel, smell, taste
Special features– extra characteristics
Conformance– how well the product conforms to design specifications
Reliability– consistency of performance
Durability– the useful life of the product
Perceived quality– indirect evaluation of quality
Service-ability– handling of complaints or repairs

Determinants of Quality

Quality of Design – intention of designers to include or exclude features in a product or service. The starting point of producing quality in products begins in the “design phase”. Designing decisions may involve product or service size, shape and location. When making designs, designers must keep in mind customer wants, production or service capabilities, safety and liability, costs, and other similar considerations.
Quality of conformance – refers to the degree to which goods and services conform to the intent of the designer. Quality of conformance can easily be affected by factors like: capability of equipment used, skills, training, and motivation of workers, extent to which the design lends itself to production, the monitoring process to assess conformance, and the taking of corrective action.
Ease of use – refers to the ease of usage of the product or services for the customers. The term “ease of use” refers to user instructions. Designing a product with “ease of use” increases the chances that the product will be used in its intended design and it will continue to function properly and safely. Without ease of use, companies may lose customers, face sales returns, or legal problems from product injuries. Ease of use also applies to services. Manufacturers must make sure that directions for unpacking, assembling, using, maintaining, and adjusting the product are included. Directions for “What to do when something goes wrong” should also be included. Ease of use makes a consumer very happy and can help retain customers.

High-quality cars

The Mercedes-Benz SLR McLaren has a reputation for extremely high quality. Its handmade engine is a sign of the quality.

8.6: General Pricing Strategies

8.6.1: Cost-Based Pricing

Just as it sounds, cost-based pricing identifies the overall fixed, variable, and indirect costs of production and prices that product accordingly.

Learning Objective

Grasp the concept of pricing based on overall costs, and identify the various cost inputs involved

Key Points

When all operational fixed and variable costs are measured, and indirect costs are also compensated for, a price point can be determined based on overall price.
Often referred to as cost-plus pricing, some firms (excepting non-profits) will add a margin on top of the overall cost-based pricing to ensure profitability for stakeholders.
Differentiating between fixed, variable, and indirect costs is a central consideration for cost-based pricing strategies.
This model is best for organizations working to compete on price, and striving for optimal efficiency in the production process.

Key Term

cost-based pricing: This pricing strategy focuses on measuring all of the costs involved in producing a given product, and pricing that product according to those costs.

Pricing on Cost

Cost-based pricing is a fairly straight-forward concept, where the organization understands the operation costs of producing a given good and prices that good as close to this cost level as possible. It is often referred to as cost-plus pricing, as the firm (unless it is a non-profit organization) must retain some value or profit from the sale. This markup can be set at a fixed percentage, such as 5%. If a given good will cost $10 to develop, a perfect cost-based pricing would be to sell it at $10. A cost-plus pricing model at 5% would be to sell the product at $10.50.

Determining Cost

While the concept of cost-based pricing is quite simple, the accurate measurement of cost can sometimes be a bit complex. There are fixed costs, variable costs, and indirect costs that all must be factored into the overall calculation. Each of these costs are impacted differently by volume, and as a result, cost-based pricing may fluctuate over time. This creates some requirements for projecting volume, basing cost off of a certain volume and understanding the potential in variance.

Fixed Cost

Fixed cost changes over time, for the simple reason that each additional unit produced will lower the average cost per unit relative to fixed investments. Take, for example, an investment in a machine for $10,000. The machine can produce 10,000 units in a year. At maximum capacity, this machine will cost $1 per unit. However, the demand is not high enough to produce at this capacity. Instead, it is only producing 5,000 units a year. Now the cost per unit is $2.

Variable Cost

The variable cost is consistent for each new unit, and as a result is not sensitive to overall volume (in most cases). What this means is that producing 1 unit will cost $5, and producing 10 units will cost $50, 100 units $500.

Indeed, sensitivity to volume is often one of economy of scale, which is to say that purchasing inputs for production may even become cheaper the higher the quantity that is produced. As a result, variable costs and quantity have a very different relationship than fixed costs and quantity.

Quantity

The chart shows the relationship between fixed costs, variable costs, and total costs compared to the quantity produced and/or sold.

This simple chart underlines the relationship between fixed, variable and total cost compared to quantity produced and/or sold.

Indirect Cost

Complicating the concept of cost-based pricing is the indirect cost of doing business. Many aspects of an organization are not directly related to production, and are therefore somewhat difficult to factor into the overall equation. Salaries of corporate staff, administration costs, legal costs, office costs, utilities, electricity, and other supports must be accurately projected and built into the cost-based pricing model in order to ensure that the organization is properly pricing the product for profitability.

Conclusion

Overall, when a company decides to price goods based on cost, it is important that the internal mechanisms of measurement for fixed, variable, and indirect inputs are highly accurate and developed. This cost method is often considered a low-cost method, as the firm is attempting to forward as much value as possible to the consumer. This model is best for organizations working to compete on price, and striving for optimal efficiency in the production process.

8.6.2: Demand-Based Pricing

Demand-based pricing is any pricing method that uses consumer demand – based on perceived value – as the central element.

Learning Objective

Demonstrate the meaning of and the different types of demand-based pricing

Key Points

Price skimming is a pricing strategy in which a marketer sets a relatively high price for a product or service at first, then lowers the price over time.
Price discrimination exists when sales of identical goods or services are transacted at different prices from the same provider.
Psychological pricing is a marketing practice based on the theory that certain prices have a psychological impact.
Bundle pricing is a marketing strategy that involves offering several products for sale as one combined product.
Penetration pricing is the pricing technique of setting a relatively low initial entry price, often lower than the eventual market price, to attract new customers.
Value-based pricing sets prices primarily on the value, perceived or estimated, to the customer rather than on the cost of the product or historical prices.

Key Terms

psychological pricing: a marketing practice based on the theory that nominally different prices may be perceived differently
heterogeneity: This term describes the uniqueness of service offerings.

Demand-Based Pricing

Demand-based pricing, also known as customer-based pricing, is any pricing method that uses consumer demand – based on perceived value – as the central element. These include: price skimming, price discrimination, psychological pricing, bundle pricing, penetration pricing, and value-based pricing.

Pricing factors are manufacturing cost, market place, competition, market condition, and quality of the product.

Price Skimming

Price skimming is a pricing strategy in which a marketer sets a relatively high price for a product or service at first, then lowers the price over time. In other words, price skimming is when a firm charges the highest initial price that customers will pay. As the demand of the first customers is satisfied, the firm lowers the price to attract another, more price-sensitive segment.

The objective of a price skimming strategy is to capture the consumer surplus. It allows the firm to recover its sunk costs quickly before competition steps in and lowers the market price. If this is done successfully, then theoretically no customer will pay less for the product than the maximum they are willing to pay. In practice, it is almost impossible for a firm to capture all of this surplus .

Price Skimming

These are graphical representations of price skimming. Price skimming is sometimes referred to as riding down the demand curve.

Price Descrimination

Price discrimination exists when sales of identical goods or services are transacted at different prices from the same provider. Product heterogeneity, market frictions, or high fixed costs (which make marginal-cost pricing unsustainable in the long run) can allow for some degree of differential pricing to different consumers, even in fully competitive retail or industrial markets. Price discrimination also occurs when the same price is charged to customers that have different supply costs. Price discrimination requires market segmentation and some means to discourage discount customers from becoming resellers and, by extension, competitors. This usually entails using one or more means of preventing any resale, keeping the different price groups separate, making price comparisons difficult, or restricting pricing information.

Psychological Pricing

Psychological pricing is a marketing practice based on the theory that certain prices have a psychological impact. The retail prices are often expressed as “odd prices”: a little less than a round number, e.g. $19.99. The theory is this drives demand greater than would be expected if consumers were perfectly rational. Bundle pricing is a marketing strategy that involves offering several products for sale as one combined product. This strategy is very common in the software business, in the cable television industry, and in the fast food industry in which multiple items are combined into a complete meal. A bundle of products is sometimes referred to as a package deal, a compilation, or an anthology.

Penetration Pricing

Penetration pricing is the pricing technique of setting a relatively low initial entry price, often lower than the eventual market price, to attract new customers. The strategy works on the expectation that customers will switch to the new brand because of the lower price. Penetration pricing is most commonly associated with a marketing objective of increasing market share or sales volume, rather than to make profit in the short term. The main disadvantage with penetration pricing is that it establishes long term price expectations for the product as well as image preconceptions for the brand and company. This makes it difficult to eventually raise prices.

Value-based Pricing

Value-based pricing sets prices primarily, but not exclusively, on the value, perceived or estimated, to the customer rather than on the cost of the product or historical prices. Value-based-pricing is most successful when products are sold based on emotions (fashion), in niche markets, in shortages (e.g. drinks at open air festival at a hot summer day), or for indispensable add-ons (e.g. printer cartridges, headsets for cell phones). By definition, long term prices based on value-based pricing are always higher or equal to the prices derived from cost-based pricing.

8.6.3: Competitor-Based Pricing

Organizations that sell products or services may look at what price a product is generally being sold at and set that as a target for the sales price.

Learning Objective

Understand why matching the price of competitors is important, and how it can be misused (i.e. price fixing)

Key Points

Determining the price of a product or service can be approached many different ways, from consumer willingness to pay to pursuing the lowest possible cost for the consumer.
Competitor-based pricing is the strategic approach in which a company tries to match (or perhaps better) the price point set by key competitors within the industry.
Competitor-based pricing is particularly useful for new entrants, who are trying to achieve the efficiency and low price of more mature and established competitors.
Competitor-based pricing can be inappropriate in markets with limited competition, as it could essentially lead to price fixing.

Key Term

price fixing: An illegal agreement between participants on the same side in a market to buy or sell a product, service, or commodity only at a fixed price, or maintain the market conditions such that the price is maintained at a given level by controlling supply and demand.

Pricing Overview

Determining the optimal price for a given product or service can be approached in many different ways. Some organizations simply look at what it will cost (on average) to produce a product or service, and sell it at an acceptable profit margin above that expense rate. Other businesses may focus more on what the consumer is willing to pay, and try to capture as much of that potential as possible. Other organizations may be non-profit oriented, and will sell at the lowest possible price while remaining in business.

Pricing

Sellers price products in order to obtain a profit margin that is above the expense rate.

A fruit market in Israel.

Pricing on Competition

Organizations that sell products or services, usually in mature industries, may look at what price a product is generally being sold at and emulate that sales price. This can be done for a variety of reasons, and firms must be careful of ethical and legal concerns when considering this approach:

Customer Expectation – In some industries, competitor-based pricing is the best way to ensure customers pay what they expect to pay. A cup of coffee, for example, is very rarely priced too much differently from the competition. Customers don’t expect to pay $5 for a coffee, and therefore companies that sell at that price point will be quickly beaten by the competition.
Competitiveness – Along similar lines, remaining competitive (particularly for goods that are not easily differentiate) often requires matching or beating the price of the competition. Many companies will even match competitor prices as a policy, which is to say that if a consumer finds the same product somewhere else for cheaper, the organization will match that price in order to retain the customer. Competitor-based pricing ensures the organization can remain competitive.
Follow the leader – For newer entrants in an industry, keeping pace with the industry standard or industry leader is sometimes useful. This motivates the firm to match (or exceed) the more efficient and mature players in an industry, and sets a benchmark for what is feasibly accomplished in terms of efficiency and low-cost strategies.

Legal Concerns

While competitor-based pricing may be in pursuit of the cheapest possible price for consumers, this is unfortunately not always the case. Price fixing is a risk for organizations that pursue this pricing strategy, as it essentially would allow industries which are oligopolies (with a small number of providers) to remove the competitive aspect of capitalism through establishing a fixed price across all firms.

All this really means is that organizations within certain industries are NOT allowed to agree on a price that each competitor will stick to. If organizations were allowed to do this, competition on a key component of the marketing mix would be lost completely (i.e. price). Without this competitive force, organizations would gain pricing power over consumers through price fixing. As a result, competitor-based pricing is more appropriate for firms trying to grow more efficient and become more competitive, but not as appropriate for firms who are already established.

8.6.4: Markup Pricing

Markup pricing is a strategy in which a company first calculates the cost of the product, then adds a proportion of it as markup.

Learning Objective

Examine the rationale behind the use of markup pricing as a general pricing strategy

Key Points

Markup pricing is used primarily because it is easy to calculate and requires little information.
The first step to determine markup price involves calculation of the cost of production, and the second step is to determine the markup over costs.
In markup pricing, we use quantity to calculate price, but price is the determinant of quantity. To avoid this problem, the quantity is assumed.

Key Terms

marginal cost: The increase in cost that accompanies a unit increase in output; the partial derivative of the cost function with respect to output. The additional cost associated with producing one more unit of output.
discretion: The freedom to make one’s own judgements.

Markup Pricing

Several varieties of markup pricing – also known as cost-plus pricing – exist, but the common thread is that one first calculates the cost of the product, then adds a proportion of it as markup. The amount to be marked up is decided at the discretion of the company. Basically, this approach sets prices that cover the cost of production and provide enough profit margin to the firm to earn its target rate of return.

Cost-plus pricing is used primarily because it is easy to calculate and requires little information. Information on demand and costs is not easily available; however, this information is necessary to generate accurate estimates of marginal costs and revenues. Moreover, the process of obtaining this additional information is expensive. Therefore, cost-plus pricing is often considered a rational approach to maximizing profits. Cost-plus pricing is especially useful in the following cases:

Public utility pricing
Finding out the design of the product when the selling price is predetermined, which is also known as product tailoring
Pricing products that are designed to the specification of a single buyer
“Monopsony Buying” – buyers have enough knowledge about the costs of a supplier. Thus, they may make the product themselves if they do not comply with the offered prices. So the relevant cost would be the cost that a buying company would incur if it made the product itself.

Calculating a Markup Price

There are two steps which form this approach. The first step involves calculation of the cost of production, and the second step is to determine the markup over costs. The total cost has two components: total variable cost and total fixed cost. In both cases, costs are computed on an average basis . In cost-plus pricing, we use quantity to calculate price, but price is the determinant of quantity. To avoid this problem, the quantity is assumed. This rate of output is based on some percentage of the firm’s capacity. The objective of determining markup over costs is to set prices in a manner that a firm earns its targeted rate of return. This return can be considered R_sX, where R_s is the ratio of the respective share of total profit. Therefore, the markup over costs on each unit of output will be X/Q. Price will be calculated through the formula in.

Cost-Plus Price Equation

A cost-plus price is equal to the average variable costs plus average fixed costs plus markup per unit.

Total Average Cost Equation

The total average cost for a product is determined by dividing the total fixed costs (TFC) and total variable costs (TVC) by the quantity of the product produced and then adding them together.

Reasons For Widespread Use

The following points explain as to why this approach is widely used:

Even if a firm handles many products, this approach provides the means by which fair prices can be easily found.
This approach involves calculation of full cost. Prices based on full cost look factual and precise and may be more defensible on moral grounds than prices established by other means.
This approach reduces the cost of decision-making. Firms which prefer stability use cost-plus pricing as a guide to price products in an uncertain market where knowledge is incomplete.
Firms are never too sure about the shape of their demand curve; neither are they very sure about the probable response to any price change. It thus becomes risky for a firm to move away from cost-plus pricing.
The reaction of rivals to the set price is a major uncertainty. When products and production processes are similar, competitive stability is achieved by usage of cost-plus pricing. This competitive stability is achieved by setting a price that is likely to yield acceptable returns to other members of the industry.
Management tends to know more about product costs than any other factors which can be used to price a product.
Markup pricing ensures a seller against unpredictable or unexpected later costs.
Price increases can be justified in terms of cost increases.

Disadvantages Of Markup Pricing

Disadvantages of this strategy include:

Provides incentive for inefficiency
Tends to ignore the role of consumers
Tends to ignore the role of competitors
Uses historical rather than replacement value
Uses “normal” or “standard” output level to allocate fixed costs
Includes sunk costs rather than just using incremental costs
Ignores opportunity cost

8.6.5: Profit-Maximization Pricing

Profit maximization analysis is the process by which a firm determines the price and output level that returns the greatest profit.

Learning Objective

Describe profit maximization pricing relative to general pricing strategies

Key Points

Fixed costs, which occur only in the short run, are incurred by the business at any level of output, including zero output.
Variable costs change with the level of output, increasing as more product is generated.
The profit-maximizing output is the one at which the difference between total cost and total revenue reaches its maximum.
If a firm is not a perfect competitor in the output market, the price to sell the product at can be read off the demand curve at the firm’s optimal quantity of output.

Key Term

marginal cost: The increase in cost that accompanies a unit increase in output; the partial derivative of the cost function with respect to output. The additional cost associated with producing one more unit of output.

Profit Maximization Pricing

Profit maximization is the short run or long run process by which a firm determines the price and output level that returns the greatest profit. Any costs incurred by a firm may be classed into two groups: fixed costs and variable costs.

Fixed costs, which occur only in the short run, are incurred by the business at any level of output, including zero output. These may include equipment maintenance, rent, wages of employees whose numbers cannot be increased or decreased in the short run, and general upkeep.

Variable costs change with the level of output, increasing as more product is generated. Materials consumed during production often have the largest impact on this category, which also includes the wages of employees who can be hired and laid off in the span of time (long run or short run) under consideration.

Fixed cost and variable cost, combined, equal total cost. Revenue is the amount of money that a company receives from its normal business activities, usually from the sale of goods and services (as opposed to monies from security sales such as equity shares or debt issuances).To obtain the profit maximising output quantity, we start by recognizing that profit is equal to total revenue (TR) minus total cost (TC).

Given a table of costs and revenues at each quantity, we can either compute equations or plot the data directly on a graph.

Total Profit Maximization

This linear total revenue curve represents the case in which the firm is a perfect competitor in the goods market, and thus cannot set its own selling price.

The profit-maximizing output is the one at which this difference reaches its maximum. In the accompanying diagram, the linear total revenue curve represents the case in which the firm is a perfect competitor in the goods market and thus cannot set its own selling price. The profit-maximizing output level is represented as the one at which total revenue is the height of C and total cost is the height of B; the maximal profit is measured as CB. This output level is also the one at which the total profit curve is at its maximum.

If, contrary to what is assumed in the graph, the firm is not a perfect competitor in the output market, the price to sell the product at can be read off the demand curve at the firm’s optimal quantity of output. The above method takes the perspective of total revenue and total cost. A firm may also take the perspective of marginal revenue and marginal cost, which is based on the fact that total profit reaches its maximum point where marginal revenue equals marginal cost.

8.7: Specific Pricing Strategies

8.7.1: New Product Pricing

With a new product, competition does not exist or is minimal, hence the general pricing strategies depend on different factors.

Learning Objective

Compare and contrast penetration pricing and skimming pricing

Key Points

Penetration pricing is the pricing technique of setting a relatively low initial entry price, often lower than the eventual market price, to attract new customers. The strategy works on the expectation that customers will switch to the new brand because of the lower price.
Skimming involves goods being sold at higher prices so that fewer sales are needed to break even. By selling a product at a high price, sacrificing high sales to gain a high profit is therefore “skimming” the market.
The decision of best strategy to use depends on a number of factors. A penetration strategy would generally be supported by the opportunity to keep costs low, and the anticipation of quick market entry by competitors. A skimming strategy is most appropriate when the opposite conditions exist.

Key Terms

Market Share: The percentage of some market held by a company.
market penetration: having gained part of a market in which similar products already exist

With a totally new product, competition does not exist or is minimal. Two general strategies are most common for setting prices:

(1) Penetration pricing

In the introductory stage of a new product’s life cycle means accepting a lower profit margin and to price relatively low. Such a strategy should generate greater sales and establish the new product in the market more quickly. Penetration pricing is the pricing technique of setting a relatively low initial entry price, often lower than the eventual market price, to attract new customers. The strategy works on the expectation that customers will switch to the new brand because of the lower price. Penetration pricing is most commonly associated with a marketing objective of increasing market share or sales volume, rather than to make profit in the short term. The advantages of penetration pricing to the firm are as follows:

It can result in fast diffusion and adoption. This can achieve high market penetration rates quickly. This can take the competitors by surprise, not giving them time to react.
It can create goodwill among the early adopters segment. This can create more trade through word of mouth.
It creates cost control and cost reduction pressures from the start, leading to greater efficiency.
It discourages the entry of competitors. Low prices act as a barrier to entry.
It can create high stock turnover throughout the distribution channel. This can create critically important enthusiasm and support in the channel.
It can be based on marginal cost pricing, which is economically efficient.

A penetration strategy would generally be supported by the following conditions: price-sensitive consumers, opportunity to keep costs low, the anticipation of quick market entry by competitors, a high likelihood for rapid acceptance by potential buyers, and an adequate resource base for the firm to meet the new demand and sales.

Pricing

Companies and businesses set prices at certain levels in order to attract customers.

A gas station sign in Taiwan that shows prices.

(2) Skimming

Skimming involves goods being sold at higher prices so that fewer sales are needed to break even. Selling a product at a high price and sacrificing high sales to gain a high profit is therefore “skimming” the market. Skimming is usually employed to reimburse the cost of investment of the original research into the product. It is commonly used in electronic markets when a new range, such as DVD players, are firstly dispatched into the market at a high price. This strategy is often used to target “early adopters” of a product or service. Early adopters generally have a relatively lower price-sensitivity and this can be attributed to their need for the product outweighing their need to economize, a greater understanding of the product’s value, or simply having a higher disposable income.

This strategy is employed only for a limited duration to recover most of the investment made to build the product. To gain further market share, a seller must use other pricing tactics such as economy or penetration. This method can have some setbacks as it could leave the product at a high price against the competition. A skimming strategy would generally be supported by the following conditions:

Having a premium product. In this case, “Premium” does not just denote high cost of production and materials- it also suggests that the product may be rare or that the demand is unusually high. An example would be a USD 500 ticket for the World Series or an USD 80,000 price tag for a limited-production sports car such as this .
Having legal protection via a patent or copyright may also allow for an excessively high price. Intel and their Pentium chip possessed this advantage for a long period of time. In most cases, the initial high price is gradually reduced to match new competition and allow new customers access to the product.

8.7.2: Product Line Pricing

Line pricing is the use of a limited number of price points for all the product offerings of a vendor.

Learning Objective

Describe the characteristics of line pricing

Key Points

Line pricing is beneficial to customers because they want and expect a wide assortment of goods, particularly shopping goods. Many small price differences for a given item can be confusing.
From the seller’s point of view, line pricing is simpler and more efficient to use. The product and service mix can then be tailored to select price points.
Line pricing suffers during inflationary periods, where such a strategy can be inflexible.

Key Terms

shopping goods: Goods that require more thought and comparison than convenience goods. Consumers compare multiple attributes such as price, style, quality, and features.
product line pricing: the practice of charging different amount for goods or services that are variations on a base good or service
basing-point pricing: goods shipped from a designated city are charged the same amount
price point: Price points are prices at which demand for a given product is supposed to stay relatively high.

Line pricing is the use of a limited number of prices for all the product offerings of a vendor. This is a tradition started in the old five and dime stores in which everything cost either 5 cents or 10 cents . Its underlying rationale is that these amounts are seen as suitable price points for a whole range of products by prospective customers. It has the advantage of ease of administering, but the disadvantage of inflexibility, particularly in times of inflation or unstable prices.

Five and Dime Stores

Traditional five and dime stores followed a line pricing strategy. All of the goods were either $0.05 or $0.10. The dollar store is a modern equivalent.

Line pricing serves several purposes that benefit both buyers and sellers. Customers want and expect a wide assortment of goods, particularly shopping goods. Many small price differences for a given item can be confusing. If ties were priced at $15, $15.35, $15.75, and so on, selection would be more difficult. The customer would not be able to judge quality differences as reflected by such small increments in price. So having relatively few prices reduces this kind of confusion.

From the seller’s point of view, line pricing holds several benefits:

It is simpler and more efficient to use relatively fewer prices. The product and service mix can then be tailored to select price points.
It can result in a smaller inventory than would otherwise be the case. It might increase stock turnover and make inventory control simpler.
As costs change, the prices can remain the same, but the quality in the line can be changed. For example, you may have bought a $20 tie 15 years ago. You can buy a $20 tie today, but it is unlikely that today’s $20 tie is of the same fine quality as it was in the past.

8.7.3: Psychological Pricing

Psychological pricing is a marketing practice based on the theory that certain prices have meaning to many buyers.

Learning Objective

Explain the types of psychological pricing

Key Points

Products and services frequently have customary prices in the minds of consumers. A customary price is one that customers identify with particular items.
Odd prices appear to represent bargains or savings and therefore encourage buying. Thus, marketers often use odd prices that end in figures such as 5, 7, 8, or 9.
A somewhat related pricing strategy is combination pricing, such as two-for-one or buy-one-get-one-free. Consumers tend to react very positively to these pricing techniques.

Key Terms

Price Points: Price points are prices at which demand for a given product is supposed to stay relatively high.
customary price: A price that customers identify with particular items.

Price, as is the case with certain other elements in the marketing mix, has multiple meanings beyond a simple utilitarian statement. One such meaning is often referred to as the psychological aspect of pricing. Inferring quality from price is a common example of the psychological aspect of price. For instance, a buyer may assume that a suit priced at $500 is of higher quality than one priced at $300.

Products and services frequently have customary prices in the minds of consumers. A customary price is one that customers identify with particular items. For example, for many decades a five-stick package of chewing gum cost five cents and a six-ounce bottle of Coca-Cola also cost five cents. Candy bars now cost 60 cents or more, which is the customary price for a standard-sized bar. Manufacturers tend to adjust their wholesale prices to permit retailers to use customary pricing.

Another manifestation of the psychological aspects of pricing is the use of odd prices. We call prices that end in such digits as 5, 7, 8, and 9 “odd prices.” Examples of odd prices include: $2.95, $15.98, or $299.99. Odd prices are intended to drive demand greater than would be expected if consumers were perfectly rational.

Odd Pricing

Odd prices end with digits like 5, 7, 8, and 9. They are intended to drive demand higher.

Psychological pricing is one cause of price points. For a long time, marketing people have attempted to explain why odd prices are used. It seemed to make little difference whether one paid $29.95 or $30.00 for an item. Perhaps one of the most often heard explanations concerns the psychological impact of odd prices on customers. The explanation is that customers perceive even prices such as $5.00 or $10.00 as regular prices. Odd prices, on the other hand, appear to represent bargains or savings and therefore encourage buying. There seems to be some movement toward even pricing; however, odd pricing is still very common. A somewhat related pricing strategy is combination pricing, such as two-for-one or buy-one-get-one-free. Consumers tend to react very positively to these pricing techniques.

The psychological pricing theory is based on one or more of the following hypotheses:

Consumers ignore the least significant digits rather than do the proper rounding. Even though the cents are seen and not totally ignored, they may subconsciously be partially ignored.
Fractional prices suggest to consumers that goods are marked at the lowest possible price.
When items are listed in a way that is segregated into price bands (such as an online real estate search), the price ending is used to keep an item in a lower band, to be seen by more potential purchasers.

8.7.4: Pricing During Difficult Economic Times

During a recession, companies must consider their unique situation and what value they provide customers when devising a pricing strategy.

Learning Objective

Discuss pricing strategies during difficult economic times

Key Points

Many companies are tempted to slash prices during a recession, but this strategy should be carefully considered.
Cutting prices can degrade the value of the brand, lead to a price war, and also lead customers to put off buying when times are good in expectation of price cuts when times are bad.
Unlike traditional brands that are designed with target consumers in mind, fighter brands are created specifically to combat a competitor that is threatening to take market share away from a company’s main brand.
When the strategy works, a fighter brand not only defeats a low-priced competitor, but also opens up a new market.

Key Terms

fighter brand: A pricing strategy where a company prices items lower than the competition in order to protect or gain market share.
recession: A period of reduced economic activity

Pricing During Difficult Economic Times

Every company has a unique pricing strategy during a boom period, based on their own product, market, and managerial decision making. However, during a recession, many companies may be tempted to abandon these strategies. After all, if customers are less willing to spend money, simplistic logic suggests that, by cutting prices, you can attract more customers. However, this strategy should be approached with caution.

Cutting prices can quieten customer complaints and help boost sales for a time, but can have longer-term effects on profitability, and weaken the brand’s image. Reductions can also lead customers to expect discounts whenever the economy dips, causing them to wait to make purchases in the future.

A model of pricing based on ‘rational’ economic theory suggests that prices are set by the forces of supply and demand, and individual companies in a perfectly competitive market must follow the equilibrium price. However, real life is not so simple; people do not always act in the prescribed logic. Sometimes prices go up and people buy more, and vice versa.

A smart pricing strategy during a recession can become a competitive advantage. By knowing what value a company delivers to its customers, it can price more confidently and not panic into slashing prices when it does not necessarily need to. Price-cutting may even lead to price wars where nobody wins. If cuts must be made, companies should focus on cutting the prices of low-value items and retaining high-value products.

Price Cuts

Slashing prices on low value goods (while maintaining prices on high value goods) is a potential pricing strategy during difficult economic times.

Customers shop in a store that has lots of different sale signs.

Similarly, price increases during a recession can also be a bad idea. Many firms try to recover higher costs through price increases, which can turn away customers. Customers locked into contracts may have no regress if a company raises prices on them, but it tarnishes the seller’s reputation and will make the customer think twice when the time comes to renew.

Ultimately, the pricing strategy becomes even more important during a recession, and companies must consider all these factors when attempting to adjust. It is important to protect the brand, not alienate customers, and remember what value the company offers in order to get through the difficult economic period unscathed.

Fighter Brands

In marketing, a fighter brand (sometimes called a fighting brand) is a lower priced offering launched by a company to take on, and ideally take out, specific competitors that are attempting to under-price them. Unlike traditional brands that are designed with target consumers in mind, fighter brands are created specifically to combat a competitor that is threatening to take market share away from a company’s main brand.

The strategy is most often used in difficult economic times. As customers trade down to lower priced offers because of economic constraints, many managers at mid-tier and premium brands are faced with a classic strategic conundrum: Should they tackle the threat head-on and reduce existing prices, knowing it will reduce profits and potentially commoditize the brand? Or should they maintain prices, hope for better times to return, and in the meantime lose customers who might never come back? With both alternatives often equally unpalatable, many companies choose the third option of launching a fighter brand.

When the strategy works, a fighter brand not only defeats a low-priced competitor, but also opens up a new market. The Celeron microprocessor, shown here , is a case study of successful fighter brand. Despite the success of its Pentium processors, Intel faced a major threat from less costly processors that were better placed to serve the emerging market for low-cost personal computers, such as the AMD K6. Intel wanted to protect the brand equity and price premium of its Pentium chips, but it also wanted to avoid AMD gaining a foothold on the lower end of the market. So it created Celeron as a cheaper, less powerful version of its Pentium chips to serve this market.

Fighter Brands

The Celeron microprocessor is a case study of a successful fighter brand.

8.7.5: Everyday Low Pricing

Everyday low price is a pricing strategy offering consumers a low price without having to wait for sale price events or comparison shopping.

Learning Objective

Translate the meaning of the EDLP (everyday low price) pricing strategy

Key Points

Every day low pricing saves retail stores the effort and expense needed to mark down prices in the store during sale events, as well as to market these events.
One 1994 study of an 86-store supermarket grocery chain in the United States concluded that a 10% EDLP price decrease in a category increased sales volume by 3%, while a 10% Hi-Low price increase led to a 3% sales decrease.
Trader Joe’s is an example of successful EDLP. It is unique because it does not market itself like other grocery stores do, nor are customers required to obtain membership to enjoy its low prices – at Trader Joe’s, its everyday low prices are available to everyone.

Key Terms

Hi-low price: High-low pricing (or hi-low pricing) is a type of pricing strategy adopted by companies, usually small- and medium-sized retail firms, where a firm charges a high price for an item and later sells it to customers by giving discounts or through clearance sales.
supermarket: a large self-service store that sells groceries and, usually, medications, household goods and/or clothing

Everyday low price (EDLP) is a pricing strategy promising consumers a low price without the need to wait for sale price events or comparison shopping.

EDLP saves retail stores the effort and expense needed to mark down prices in the store during sale events, as well as to market these events. EDLP is believed to generate shopper loyalty. It was noted in 1994 that the Wal-Mart retail chain in America, which follows an EDLP strategy, would buy “feature advertisements” in newspapers on a monthly basis, while its competitors would advertise 52 weeks per year.

Procter & Gamble, Wal-Mart, Food Lion, Gordmans, and Winn-Dixie are firms that have implemented or championed EDLP. One 1992 study stated that 26% of American supermarket retailers pursued some form of EDLP, meaning the other 74% were Hi-Lo promotion-oriented operators.

One 1994 study of an 86-store supermarket grocery chain in the United States concluded that a 10% EDLP price decrease in a category increased sales volume by 3%, while a 10% Hi-Low price increase led to a 3% sales decrease; but that because consumer demand at the supermarket did not respond much to changes in everyday price, an EDLP policy reduced profits by 18%, while Hi-Lo pricing increased profits by 15%.

An example of a successful brand (other than the infamous Wal-Mart) that uses the EDLP strategy is Trader Joe’s . Trader Joe’s is a private-brand label that conducts a Niche marketing strategy describing itself as the “neighborhood store. ” The firm has been growing at a steady pace, offering a wide variety of organic and natural food items that are hard to find, enabling the business to enjoy a distinctive competitive advantage.

Trader Joe’s

Trader Joe’s is unique because it doesn’t require membership for its customers to enjoy its low prices.

Apart from the many strengths of Trader Joe’s, the most prominent is their commitment to quality and lower prices. The company has worked hard to manage this economic image of value for its products that competitors, even giant retail stores, are unable to meet. Trader Joe’s is not an ordinary store. It is unique because it does not market itself like other grocery stores do nor does it require its customers to take out a membership to enjoy its low prices.

At Trader Joe’s, its everyday low prices are available to everyone. The firm states that “every penny we save is every penny our customer saves” (Trader Joe’s 2010).

8.7.6: High/Low Pricing

High-low pricing is a strategy where most goods offered are priced higher than competitors, but lower prices are offered on other key items.

Learning Objective

Recognize the mechanism of High/Low pricing strategies

Key Points

The lower promotional prices are designed to bring customers to the organization where the customer is offered the promotional product as well as the regular higher priced products.
The basic type of customers for the firms adopting high-low price do not have a clear idea about what a product’s price would typically be or have a strong belief that “discount sales = low price”.
The way competition prevails in the shoe and fashion industry is through high-low price strategies.

Key Terms

belief: mental acceptance of a claim as truth regardless of supporting or contrary empirical evidence
everyday low price: Everyday low price (“EDLP”) is a pricing strategy promising consumers a low price without the need to wait for sale price events or comparison shop.

High-low pricing is a method of pricing for an organization where the goods or services offered by the organization are regularly priced higher than competitors. However, through promotions, advertisements, and or coupons, lower prices are offered on other key items consumers would want to purchase. The lower promotional prices are designed to bring customers to the organization where the customer is offered the promotional product as well as the regular higher priced products.

High-low pricing is a type of pricing strategy adopted by companies, usually small and medium sized retail firms. The basic type of customers for the firms adopting high-low price will not have a clear idea about what a product’s price would typically be or have a strong belief that “discount sales = low price. ” Customers for firms adopting this type of strategy also have strong preference in purchasing the products sold in this type or by this certain firm. They are loyal to a specific brand.

There are many big firms using this type of pricing strategy (ex: Reebok, Nike, Adidas). The way competition prevails in the shoe industry is through high-low price. Also high-low pricing is extensively used in the fashion industry by companies (ex: Macy’s and Nordstrom) This pricing strategy is not only in the shoe and fashion industry but also in many other industries. However, in these industries one or two firms will not provide discounts and works on fixed rate of earnings. Those firms will follow everyday low price strategy in order to compete in the market.

High-Low Pricing Strategies

Many big firms are using high-low pricing strategies, especially in the shoe industry (ex: Reebok, Nike, and Adidas).

A Nike swoosh on a shoe.

8.7.7: Other Pricing Strategies

One pricing strategy does not fit all, thus adapting various pricing strategies to new scenarios is necessary for a firm to stay viable.

Learning Objective

Describe various pricing strategies

Key Points

Cost-plus pricing is the simplest pricing method. The firm calculates the cost of producing the product and adds on a percentage (profit) to that price to give the selling price.
Dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customer’s willingness to pay. The airline industry is often cited as a success story. Most of the passengers on any given airplane have paid different ticket prices for the same flight.
Non-price competition means that organizations use strategies other than price to attract customers. Advertising,credit, delivery, displays, private brands, and convenience are all examples of tools used in non-price competition.

Key Terms

economies of scale: The cost advantages that an enterprise obtains due to expansion. As the scale of output is increased, factors such as facility size and usage levels of inputs cause the producer’s average cost per unit to fall.
marketing mix: A business tool used in marketing products; often crucial when determining a product or brand’s unique selling point. Often synonymous with the four Ps: price, product, promotion, and place.

Pricing strategies for products or services encompass three main ways to improve profits. The business owner can cut costs, sell more, or find more profit with a better pricing strategy. When costs are already at their lowest and sales are hard to find, adopting a better pricing strategy is a key option to stay viable. There are many different pricing strategies that can be utilized for different selling scenarios:

Cost-Plus Pricing

Cost-plus pricing is the simplest pricing method. The firm calculates the cost of producing the product and adds on a percentage (profit) to that price to give the selling price. This method although simple has two flaws: it takes no account of demand and there is no way of determining if potential customers will purchase the product at the calculated price.

Limit Pricing

A limit price is the price set by a monopolist to discourage economic entry into a market, and is illegal in many countries. The limit price is the price that the entrant would face upon entering as long as the incumbent firm did not decrease output. The limit price is often lower than the average cost of production or just low enough to make entering not profitable. The quantity produced by the incumbent firm to act as a deterrent to entry is usually larger than would be optimal for a monopolist, but might still produce higher economic profits than would be earned under perfect competition.

Dynamic Pricing

A flexible pricing mechanism made possible by advances in information technology, and employed mostly by Internet based companies. By responding to market fluctuations or large amounts of data gathered from customers – ranging from where they live to what they buy to how much they have spent on past purchases – dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customer’s willingness to pay. The airline industry is often cited as a success story . In fact, it employs the technique so artfully that most of the passengers on any given airplane have paid different ticket prices for the same flight.

Dynamic Pricing

Dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customer’s willingness to pay.

An Air Canada airplane.

Non-Price Competition

Non-price competition means that organizations use strategies other than price to attract customers. Advertising, credit, delivery, displays, private brands, and convenience are all examples of tools used in non-price competition. Business people prefer to use non-price competition rather than price competition, because it is more difficult to match non-price characteristics.

Pricing Above Competitors

Pricing above competitors can be rewarding to organizations, provided that the objectives of the policy are clearly understood and that the marketing mix is used to develop a strategy to enable management to implement the policy successfully. Pricing above competition generally requires a clear advantage on some non-price element of the marketing mix. In some cases, it is possible due to a high price-quality association on the part of potential buyers. Such an assumption is increasingly dangerous in today’s information-rich environment. Consumer Reports and other similar publications make objective product comparisons much simpler for the consumer. There are also hundreds of dot.com companies that provide objective price comparisons. The key is to prove to customers that your product justifies a premium price.

Pricing Below Competitors

While some firms are positioned to price above competition, others wish to carve out a market niche by pricing below competitors. The goal of such a policy is to realize a large sales volume through a lower price and profit margins. By controlling costs and reducing services, these firms are able to earn an acceptable profit, even though profit per unit is usually less. Such a strategy can be effective if a significant segment of the market is price-sensitive and/or the organization’s cost structure is lower than competitors. Costs can be reduced by increased efficiency, economies of scale, or by reducing or eliminating such things as credit, delivery, and advertising. For example, if a firm could replace its field sales force with telemarketing or online access, this function might be performed at lower cost. Such reductions often involve some loss in effectiveness, so the trade off must be considered carefully.

8.8: Pricing Tactics

8.8.1: Discounting

Discounts and allowances are reductions to a basic price of goods or services and can occur anywhere in the distribution channel.

Learning Objective

Analyze the use and types of discounts as part of pricing tactics

Key Points

Seasonal discounts are price reductions given for out-of-season merchandise.
Cash discounts are reductions on base price given to customers for paying cash or within some short time period.
Senior discounts are discounts offered to customers who are above a certain age, typically a round number such as 50, 55, 60, 65, 70, and 75.
Educational or student discounts are price reductions given to members of educational institutions, usually students but possibly also to educators and to other institution staff.
Quantity discounts are reductions in base price given as the result of a buyer purchasing some predetermined quantity of merchandise. A noncumulative quantity discount applies to each purchase and is intended to encourage buyers to make larger purchases.

Key Terms

functional discount: payments to distribution channel members for performing some service
quantity discount: price reductions given for large purchases
List Price: The manufacturer’s suggested retail price (MSRP), list price or recommended retail price (RRP) of a product is the price which the manufacturer recommends that the retailer sell the product.

Discounts and allowances are reductions to a basic price of goods or services. There are many different types of price reduction, each designed to accomplish a specific purpose. They can occur anywhere in the distribution channel, modifying either the manufacturer’s list price (determined by the manufacturer and often printed on the package), the retail price (set by the retailer and often attached to the product with a sticker), or the list price (which is quoted to a potential buyer, usually in written form).

Quantity discounts are reductions in base price given as the result of a buyer purchasing some predetermined quantity of merchandise. A noncumulative quantity discount applies to each purchase and is intended to encourage buyers to make larger purchases. This means that the buyer holds the excess merchandise until it is used, possibly cutting the inventory cost of the seller and preventing the buyer from switching to a competitor at least until the stock is used. A cumulative quantity discount applies to the total bought over a period of time. The buyer adds to the potential discount with each additional purchase. Such a policy helps to build repeat purchases. Building material dealers, for example, find such a policy quite useful in encouraging builders to concentrate their purchase with one dealer and to continue with the same dealer over time.

Seasonal discounts are price reductions given for out-of-season merchandise. An example would be a discount on snowmobiles during the summer. The intention of such discounts is to spread demand over the year. This can allow fuller use of production facilities and improved cash flow during the year. Electric power companies use the logic of seasonal discounts to encourage customers to shift consumption to off-peak periods. Since these companies must have production capacity to meet peak demands, the lowering of the peak can lessen the generating capacity required.

Cash discounts are reductions on base price given to customers for paying cash or within some short time period. For example, a 2% discount on bills paid within 10 days is a cash discount. The purpose is generally to accelerate the cash flow of the organization.

Trade discounts, also called functional discounts, are payments to distribution channel members for performing some function. Examples of these functions are warehousing and shelf stocking. Trade discounts are often combined to include a series of functions, for example 20/12/5 could indicate a 20% discount for warehousing the product, an additional 12% discount for shipping the product, and an additional 5% discount for keeping the shelves stocked. Trade discounts are most frequent in industries where retailers hold the majority of the power in the distribution channel (referred to as channel captains). Trade discounts are given to try to increase the volume of sales being made by the supplier.

Educational or student discounts are price reductions given to members of educational institutions, usually students but possibly also to educators and to other institution staff. The provider’s purpose is to build brand awareness early in a buyer’s life, or build product familiarity so that after graduation the holder is likely to buy the same product, for own use or for an employer, at its normal price. Educational discounts may be given by merchants directly, or via a student discount program, such as CollegeBudget in the United States or NUS and Studentdiscounts.co.uk in the United Kingdom.

Senior discounts are discounts offered to customers who are above a certain relatively advanced age, typically a round number such as 50, 55, 60, 65, 70, and 75; the exact age varies in different cases. The rationale for a senior discount offered by companies is that the customer is assumed to be retired and living on a limited income, and unlikely to be willing to pay full price; sales at reduced price are better than no sales. Non-commercial organizations may offer concessionary prices as a matter of social policy.

Discounts

Discounts, such as 75% off, are used to draw customers to purchase items.

8.8.2: Value-Based Pricing

Value-based pricing seeks to set prices primarily on the value perceived by customers rather than on the cost of the product or historical prices.

Learning Objective

Examine the rationale behind value based pricing as a pricing tactic

Key Points

Value-based pricing is most successful when products are sold based on emotions (fashion), in niche markets, in shortages (e.g., drinks at open air festival at a hot summer day), or for indispensable add-ons (e.g., printer cartridges, headsets for cell phones).
Although it would be nice to assume that a business has the freedom to set any price it chooses, this is not always the case. Firms are limited by constraints such as government restrictions.
Value-based pricing is predicated upon an understanding of customer value. In many settings, gaining this understanding requires primary research through interviews with customers and various surveys. The results of such surveys often depict a customer’s willingness to pay.

Key Terms

consumer buying process: There are 5 stages of a consumer buying process. They are: The problem recognition stage, the search for information, the possibility of alternative options, the choice to purchase the product, and then finally the actual purchase of the product. This shows the complete process that a consumer will most likely, whether recognizably or not, go through when they go to buy a product.
willingness to pay: The willingness to pay (WTP) is the maximum amount a person would be willing to pay, sacrifice, or exchange in order to receive a good or to avoid something undesired, such as pollution.

Value-based pricing sets prices primarily, but not exclusively, on the value, perceived or estimated, to the customer rather than on the cost of the product or historical prices. This strategy focuses entirely on the customer as a determinant of the total price/value package. Marketers who employ value-based pricing might use the following definition: “It is what you think your product is worth to that customer at that time.” This image shows the process for value based pricing .

Value-Based Pricing

Value-based pricing focuses entirely on the customer as a determinant of the total price or value package.

A chart that shows what value-based pricing takes into account (customers, value, price, cost, and product).

Goods that are very intensely traded (e.g., oil and other commodities) or that are sold to highly sophisticated customers in large markets (e.g., automotive industry) usually are sold based on cost-based pricing. Value-based pricing is most successful when products are sold based on emotions (fashion), in niche markets, in shortages (e.g., drinks at open air festival at a hot summer day) or for indispensable add-ons (e.g., printer cartridges, headsets for cell phones).

Many customer-related factors are important in value-based pricing. For example, it is critical to understand the consumer buying process. How important is price? When is it considered? How is it used? Another factor is the cost of switching. Have you ever watched the television program,”The Price is Right”? If you have, you know that most consumers have poor price knowledge. Moreover, their knowledge of comparable prices within a product category (e.g., ketchup is typically worse). So price knowledge is a relevant factor. Finally, the marketer must assess the customers’ price expectations. How much do you expect to pay for a large pizza? Color TV? DVD? Newspaper?Swimming pool? These expectations create a phenomenon called “sticker shock” as exhibited by gasoline, automobiles, and ATM fees.

Value-based pricing is predicated upon an understanding of customer value. In many settings, gaining this understanding requires primary research. This may include evaluation of customer operations and interviews with customer personnel. Survey methods are sometimes used to determine value a customer attributes to a product or a service. The results of such surveys often depict a customer’s willingness to pay. The principal difficulty is that the willingness of the customer to pay a certain price differs between customers, between countries, even for the same customer in different settings (depending on his actual and present needs), so that a true value-based pricing at all times is impossible. Also, extreme focus on value-based pricing might leave customers with a feeling of being exploited which is not helpful for the companies in the long run.

Although it would be nice to assume that a business has the freedom to set any price it chooses, this is not always the case. There are a variety of constraints that prohibit such freedom. Some constraints are formal, such as government restrictions in respect to strategies like collusion and price-fixing. This occurs when two or more companies agree to charge the same or very similar prices. Other constraints tend to be informal. Examples include matching the price of competitors, a traditional price charged for a particular product, and charging a price that covers expected costs.

8.8.3: Geographic Pricing

Geographical pricing is the practice of modifying a basic list price based on the location of the buyer to reflect shipping costs.

Learning Objective

Describe the different types of geographic pricing from a pricing tactic perspective

Key Points

Zone pricing is a pricing tactic where prices increase as shipping distances increase. This is sometimes done by drawing concentric circles on a map with the plant or warehouse at the center and each circle defining the boundary of a price zone.
FOB origin (Free on Board origin) is a pricing tactic where the shipping cost from the factory or warehouse is paid by the purchaser. Ownership of the goods is transferred to the buyer as soon as it leaves the point of origin.
Freight-absorption pricing is where the seller absorbs all or part of the cost of transportation. This amounts to a price discount and is used as a promotional tactic.

Key Terms

list price: The retail selling price of an item, as recommended by the manufacturer or retail distributor, or as listed in a catalog.
zone pricing: The practice of modifying a basic list price based on the geographical location of the buyer.

Geographical pricing is the practice of modifying a basic list price based on the geographical location of the buyer. It is intended to reflect the costs of shipping to different locations. There are several types of geographic pricing:

FOB origin (Free on Board origin): The shipping cost from the factory or warehouse is paid by the purchaser. Ownership of the goods is transferred to the buyer as soon as it leaves the point of origin. It can be either the buyer or seller that arranges for the transportation.

FOB

FOB is used for sea freight. The purchaser is responsible for the shipping costs.

A container ship loads cargo at a loading dock.

Uniform delivery pricing (also called postage stamp pricing): The same price is charged to all.
Zone pricing: Prices increase as shipping distances increase. This is sometimes done by drawing concentric circles on a map with the plant or warehouse at the center and each circle defining the boundary of a price zone. Instead of using circles, irregularly shaped price boundaries can be drawn that reflect geography, population density, transportation infrastructure, and shipping cost. (The term “zone pricing” can also refer to the practice of setting prices that reflect local competitive conditions (i.e., the market forces of supply and demand, rather than actual cost of transportation). Zone pricing, as practiced in the gasoline industry in the United States, is the pricing of gasoline based on a complex and secret weighting of factors, such as the number of competing stations, number of vehicles, average traffic flow, population density, and geographic characteristics. This can result in two branded gas stations only a few miles apart selling gasoline at a price differential of as much as $0.50 per gallon. Many business people and economists state that gasoline zone pricing merely reflects the costs of doing business in a complex and volatile marketplace. Critics contend that industry monopoly and the ability to control not only industry-owned “corporate” stations, but locally owned or franchise stations, make zone pricing into an excuse to raise gasoline prices virtually at will. Oil industry representatives contend that while they set wholesale and dealer tank wagon prices, individual dealers are free to see whatever prices they wish and that this practice in itself causes widespread price variations outside industry control. Zone pricing is also used to price fares in certain metro stations.
Basing point pricing: Certain cities are designated as basing points. All goods shipped from a given basis point are charged the same amount.
Freight-absorption pricing: The seller absorbs all or part of the cost of transportation. This amounts to a price discount and is used as a promotional tactic.

8.8.4: Transfer Pricing

Transfer pricing describes all aspects of intracompany pricing arrangements between business entities for goods and services.

Learning Objective

Outline the concept and rationale of transfer pricing as a pricing tactic

Key Points

Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges of goods and services within a multi-divisional organization, particularly in regard to cross-border transactions.
Intra-company transactions across borders are growing rapidly and are becoming much more complex. Compliance with the differing requirements of multiple overlapping tax jurisdictions is a complicated and time-consuming task.
Division managers are provided incentives to maximize their own division’s profits. The firm must set the optimal transfer prices to maximize company profits or each division will try to maximize their own profits leading to lower overall profits for the firm.

Key Terms

marginal cost: Marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good.
marginal revenue: Marginal revenue is the additional revenue that will be generated by increasing product sales by one unit.

Example

Company X produces car engines in a plant in Michigan and puts together the entire car in Indiana. Each of these locations are a division of the company that has to meet their own profit margins. Company X tells the engine division in Michigan that they must make a profit of 500 per engine. They also tell the final assembly division in Indiana that they must make a profit of 500 per engine. They also tell the final assembly division in Indiana that they must make a profit of 2,000. The engine division in Michigan wants to set a price in which they will make the required profit. However, if they set this price too high then the Indiana division will not make their required profit, and the total company will have less of a profit. Each division must set a transfer price in which the company will be the most profitable and not based on each division being the most profitable.

Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges of goods and services within a multi-divisional organization, particularly in regard to cross-border transactions. Transfer pricing describes all aspects of intra company pricing arrangements between related business entities, including transfers of intellectual property, transfers of tangible goods, services and loans, and other financing transactions.

For example, goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary, with the choice of the transfer price affecting the division of the total profit among the parts of the company. This has led to the rise of transfer pricing regulations as governments seek to stem the flow of taxation revenue overseas, making the issue one of great importance for multinational corporations.

Intra-company transactions across borders are growing rapidly and are becoming much more complex. Compliance with the differing requirements of multiple overlapping tax jurisdictions is a complicated and time-consuming task. At the same time, tax authorities from each country are imposing stricter penalties, new documentation requirements, increased information exchange and increased audit/inspection activity.

Division managers are provided incentives to maximize their own division’s profits. The firm must set the optimal transfer prices to maximize company profits, or each division will try to maximize their own profits leading to lower overall profits for the firm. Double marginalization is when both divisions mark up prices in excess of marginal cost and overall firm profits are not optimal.

One can use marginal price determination theory to analyze optimal transfer pricing, with optimal being defined as transfer pricing that maximizes overall firm profits in a non-realistic world with no taxes, no capital risk, no development risk, no externalities, or any other frictions which exist in the real world. From marginal price determination theory, the optimum level of output is that where marginal cost equals marginal revenue. That is to say, a firm should expand its output as long as the marginal revenue from additional sales is greater than their marginal costs. In the diagram that follows , this intersection is represented by point A, which will yield a price of P*, given the demand at point B.

Optimal Transfer Pricing Diagram

From marginal price determination theory, the optimum level of output is where marginal cost equals marginal revenue.

When a firm is selling some of its product to itself, and only to itself (i.e., there is no external market for that particular transfer good), then the picture gets more complicated, but the outcome remains the same. The demand curve remains the same. The optimum price and quantity remain the same. But marginal cost of production can be separated from the firm’s total marginal costs. Likewise, the marginal revenue associated with the production division can be separated from the marginal revenue for the total firm. This is referred to as the Net Marginal Revenue in production (NMR) and is calculated as the marginal revenue from the firm minus the marginal costs of distribution.

It can be shown algebraically that the intersection of the firm’s marginal cost curve and marginal revenue curve (point A) must occur at the same quantity as the intersection of the production division’s marginal cost curve with the net marginal revenue from production (point C).

8.8.5: Consumer Penalties

Penalties, in the form of fees and restricted user access, exist for consumers who violate terms in contracts.

Learning Objective

Review the rationale and use of consumer penalties as part of pricing tactics

Key Points

Most organizations reserve the right to restrict a user’s access to the service if they violate the terms in the agreement.
Other forms of penalties can exist as fees. An early-termination fee is charged by a company when a customer wants or needs to be released from a contract before it expires.
Early payment penalties and fees also exist when people pay off a loan earlier than expected, making a firm lose out on interest fees. The fees typically negate this advantage at least in part.

Key Term

surcharge: An addition of extra charge on the agreed or stated price.

Consumer Penalties

Penalties, in the form of fees and restricted user access, exist for consumers who violate terms in contracts. Terms of service are rules which one must agree to abide by in order to use a service.

Certain websites are noted for having carefully designed terms of service, particularly eBay and PayPal, which need to maintain a high level of community trust because of transactions involving money. Terms of service can cover a range of issues, including acceptable user behavior online, a company’s marketing policies, and copyright notices. Some organizations, such as Yahoo!, can change their terms of service without notice to the users.

Most organizations reserve the right to restrict a user’s access to the service if they violate the terms in the agreement. In serious cases, the user may have his or her account terminated. In extreme cases, the company may pursue legal action.

Other forms of penalties can exist as fees or surcharges. An early-termination fee is charged by a company when a customer wants or needs to be released from a contract before it expires. One example is when a renter leaves an apartment before a year-long contract is over. If tenants rent for a shorter period, or month-to-month, they are instead charged significantly more per month, and are often denied any promotional deals. Mobile phone companies in the U.S., such as Verizon Wireless , are notorious for large early-termination fees, which can be in the hundreds of dollars . Some mortgage companies also chargeearly payment penalties if the homeowner pays more than is due in order to reduce the interest owed and to shorten the remaining term of the loan. The fees typically negate this advantage, at least in part.

Mobile Phones

Mobile phone service providers often charge an early termination fee on their service, which is a form of consumer penalty.

8.9: Pricing Legal Concerns

8.9.1: Unfair Trade Practices

Unfair business practices are oppressive or unconscionable acts by companies against consumers or other stakeholders.

Learning Objective

Explain the concept of unfair trade practices relative to legal concerns and pricing

Key Points

Unfair business acts are generally prohibited by law, so committing them may force a company to provide for the award of compensatory damages, punitive damages, and payment of the plaintiff’s legal fees.
Two major forms of unfair trade practice are fraud and misrepresentation.
Unfair trade practices not only affect consumers, but may affect other stakeholders as well, such as competitors and investors.

Key Terms

misrepresentation: A false statement of fact made by one party to another party, which has the effect of inducing that party into the contract.
fraud: Any act of deception carried out for the purpose of unfair, undeserved, or unlawful gain.

Example

Samuel Israel III was a former hedge fund manager who ran the former fraudulent Bayou Hedge Fund Group, and faked his suicide to avoid jail. Approximately $450 million was raised by the group from investors. Its investors were defrauded from the start with funds being misappropriated for personal use. After poor returns in 1998, the investors were lied to about the fund’s returns and a fake accounting firm was set up to provide misleading audited results.

Unfair Trade Practices

Unfair business practices include oppressive or unconscionable acts by companies against consumers and others. In most countries, such practices are prohibited under the law. Unfair trade practices can occur in many different areas such as insurance claims and settlement, debt collection, and tenancy issues.

Unfair trade practices also include such acts as:

Fraud: This is an intentional deception made for the company’s gain or to damage the other party .
Misrepresentation: This is a false statement of fact made by one party to another party, which has the effect of inducing that party into the contract. For example, under certain circumstances, false statements or promises made by a seller of goods regarding the quality or nature of the product may constitute misrepresentation.

In addition to providing for the award of compensatory damages, laws may also provide for the award of punitive damages as well as the payment of the plaintiff’s legal fees. When statutes prohibiting unfair and deceptive business practices provide for the award of punitive damages and attorneys fees to injured parties, they provide a powerful incentive for businesses to resolve the claim through the settlement process rather than risk a more costly judgment in court.

In the European Union, each member state must regulate unfair business practices in accordance with the Unfair Commercial Practices Directive, subject to transitional periods. This is a major reform of the law concerning unfair business practices in the European Union.

Unfair trade practices not only affect consumers, but other stakeholders as well. Unfair competition in a sense means that the competitors compete on unequal terms, because favorable or disadvantageous conditions are applied to some competitors but not to others; or that the actions of some competitors actively harm the position of others with respect to their ability to compete on equal and fair terms. Often, unfair competition means that the gains of some participants are conditional on the losses of others, when the gains are made in ways which are illegitimate or unjust.

8.9.2: Illegal Price Advertising

Deceptive price advertising uses misleading or false statements in advertising and promotion and is usually illegal.

Learning Objective

Describe the concept and types of illegal price advertising

Key Points

While deceptive price advertising is usually illegal, in practice, it can be difficult to stop or difficult to enforce any law relating to it.
False and deceptive advertising methods include hidden fees and surcharges, “going out of business” sales, manipulation of measurement units, fillers, oversized packaging, bait and switch, etc.
Advertising need not be proven to be deceptive for it to be illegal. What matters is the potential to deceive, which happens when consumers see the advertising to be stating to them, explicitly or implicitly, a claim that they may not realize is false and material.

Key Terms

bait-and-switch: Relating to use of bait and switch (offering one attractive exchange initially, but not honoring the offer) in business, politics, and elsewhere.
surcharge: An addition of extra charge on the agreed or stated price.

Illegal Price Advertising

Deceptive or false advertising is the use of misleading or outright false statements by companies in their advertising and promotional material. Depending on the type and the severity, deceptive advertising is usually illegal, because it is recognized that advertising has the potential to persuade people to enter into commercial transactions that they may otherwise avoid. However, advertisers still find ways to deceive consumers in ways that are legal or technically illegal but unenforceable.

Types of Illegal Price Advertising

Hidden fees and surcharges

These are fees that are not stated in the advertised price. These are particularly common for services, such as cell phone activation, broadband, gym memberships, and air travel. Generally, companies get away with it, because the fees are hidden in fine print and obfuscated by technical language.

“Going out of business” sales

Often, companies that supposedly are liquidating will raise prices on items marked for clearance, meaning that the company increases the price and “discounts” it. Thus, the discount is less than advertised. Another case, at liquidating stores (if it is a retail chain), the sales prices at the chain’s other stores is lower than the liquidator’s prices at the closing stores. On top of this, sale items are often “final sale,” meaning returns are not accepted. Thus, there is no recourse for customers.

Manipulation of measurement units and standards

Sellers may manipulate standards to mean something different than their widely understood meaning. One example is the personal computer’s hard drive. By stating the sizes of hard drives in “megabytes” of 1,000,000 bytes, instead of 1,048,576, they overstate capacity by nearly 5%. With gigabytes, the error increases to over 7% (1,073,741,824, instead of 1,000,000,000) and nearly 10% for the newer terabyte. Seagate Technology and Western Digital were sued in a class-action suit for this deception. Both companies agreed to settle the suit and reimburse customers in kind, yet they still continue to advertise this way.

In another example, Fretter Appliance stores claimed “I’ll give you five pounds of coffee if I can’t beat your best deal. ” While initially they gave away that quantity, they later redefined them as “Fretter pounds,” which, unsurprisingly, were much lighter than standard pounds.

Fillers and oversized packaging

Some products are sold with fillers, which increase the legal weight of the product with something that costs the producer very little compared to what the consumer thinks that he or she is buying. Food is an example of this, where TV dinners are filled with gravy or other sauce instead of meat. Malt and cocoa butter have been used as filler in peanut butter.

Manipulation of terms

Many terms do have some meaning, but the specific extent is not legally defined, leading to their abuse. A frequent example (until the term gained a legal definition) was “organic” food. “Light” food also is an even more common manipulation: The term has been variously used to mean low in calories, sugars, carbohydrates, salt, texture, thickness (viscosity), or even light in color. Tobacco companies, for many years, used terms like “low tar,” “light,” “ultra-light,” “mild,” or “natural” in order to imply that products with such labels have less detrimental effects on health but in recent years, it was proven that those terms were considered misleading. Naturally, these manipulations of terms are used to charge a higher price, particularly on “‘organic” products.

Incomplete/inconsistent comparison

“Better” means one item is superior to another in some way, while “best” means it is superior to all others in some way. However, advertisers frequently fail to list in what way the items are being compared (price, size, quality, etc.) and, in the case of “better,” to what they are comparing. In an inconsistent comparison, an item is compared with many others, but only compared with each on the attributes where it wins, leaving the false impression that it is the best of all products, in all ways. This is common with price-comparing Internet websites.

Bait-and-switch

Advertisers advertise an item that is unavailable when the consumer arrives at the store and is then sold a similar product at higher price. Bait-and-switch is legal in the United States, provided that ads state that there is a limited supply and that no rain checks will be offered.

Legal regulations

Advertising is regulated by the authority of the Federal Trade Commission to prohibit “unfair and deceptive acts or practices in commerce. ” What is illegal is the potential to deceive, which is interpreted to occur when consumers see the advertising to be stating to them, explicitly or implicitly, a claim that they may not realize is false and material. The goal is prevention rather than punishment, reflecting the purpose of civil law in setting things right rather than that of criminal law.

Listerine Advertisement, 1932

From 1921 until the mid-1970s, Listerine was also marketed as a preventive and remedy for colds and sore throats. In 1976, the Federal Trade Commission ruled that the claims were misleading.

8.9.3: Predatory Pricing

Predatory pricing is the practice of selling a product or service at a very low price, intending to drive competitors out of the market.

Learning Objective

Examine the characteristics of predatory pricing relative to legal concerns

Key Points

After the weaker competitors are driven out, the surviving business can raise prices to supra competitive levels. The predator hopes to generate revenues and profits in the future that will more than offset the losses it incurred during the predatory pricing period.
While predatory pricing is illegal in many countries, it is very difficult to prove that a company has undertaken a strategy of predatory pricing rather than competitive pricing.
Critics argue that the prey know that the predator cannot sustain low prices forever, so it is essentially a game of chicken: if they can ride it out, they will survive.

Key Terms

low-cost signalling: A strategy of signalling to competitors that you intend to pursue a low-cost strategy.
predatory pricing: A strategy of selling goods or services at a very low price in order to drive one’s competitors out of business (at which point one can raise one’s prices more freely).

Example

In the Darlington Bus War, Stagecoach Group allegedly offered free bus rides in order to put the rival Darlington Corporation Transport out of business.

Predatory Pricing

Predatory pricing is the practice of selling a product or service at a very low price, with the intention of driving competitors out of the market, or create barriers to entry for potential new competitors. Since competitors cannot sustain equal or lower prices without incurring losses, they may be forced out of business. After chasing competitors out of the market, the incumbent would have fewer competitors (and may in fact be a monopoly), and can then – in theory – raise prices above what the market would otherwise bear.

In many countries, predatory pricing is considered anti-competitive and is illegal under competition laws. However, It is usually difficult to prove that prices dropped because of deliberate predatory pricing rather than legitimate price competition. In any case, competitors may be driven out of the market before the case is ever heard. Thus, many economists are doubtful that the concept of predatory pricing is actually practical and transferable to the real world.

Economic Rationale

In the short run, profits for the incumbent will fall due to predatory pricing, possibly even into negative territory. The incumbent will not mind so long as they can maintain these losses, which can be made up for once they raise prices above the would-be market level: after the weaker competitors are driven out, the surviving business can raise prices above competitive levels (to supra competitive pricing). The predator hopes to generate revenues and profits in the future that will more than offset the losses it incurred during the predatory pricing period. There must be substantial barriers to entry for new competitors for predatory pricing to succeed. But the strategy may fail if competitors are stronger than expected, or are driven out but replaced by others. In either case, this may force the predator to prolong or abandon the price reductions. The strategy may fail if the predator cannot endure the short-term losses, either because it takes longer than expected or simply because the loss was not properly estimated. So the predator should hope this strategy to works only when it is much stronger than its competitors and when barriers to entry are high. The barriers prevent new entrants to the market replacing others driven out, thereby allowing supra competitive pricing to prevail long enough to dwarf the initial loss.

Criticism and Support

Criticism

Some economists claim that true predatory pricing is rare because it is an irrational practice and that laws designed to prevent it only inhibit competition. This stance was taken by the US Supreme Court in the 1993 case Brooke Group v. Brown & Williamson Tobacco. The Federal Trade Commission has not successfully prosecuted any company for predatory pricing since. Economists argue that the competitors (the ‘prey’) know that the predator cannot sustain low prices forever, so it is essentially a game of chicken. If they can ride it out, they will survive. And even if they cannot, bankrupcy does not by itself eliminate the fallen prey’s ability to produce: the physical plant and people whose skills made it a viable business will exist, and will be available – perhaps at very low prices – to others who may replace the fallen prey once supra-competitive prices set in.Critics of laws against predatory pricing may support their case empirically by arguing that there has been no instance where such a practice has actually led to a monopoly. Conversely, they argue that there is much evidence that predatory pricing has failed miserably.

Support

Prey may not see it as a game of chicken, if they truly believe that the prey has actually found a way to achieve a lower cost of production than them. Thus, they would not know predatory pricing is occurring. They would exit the market, thinking it is no longer profitable. This is known as ‘low-cost signalling’. However, this does not support the idea that the new virtual monopoly could raise and sustain prices at monopoly levels, even though there are certain barriers to entering monopolized markets that could, in theory, prevent the entry of competition.

Examples

According to an International Herald Tribune article, the French government ordered Amazon.com to stop offering free shipping to its customers, because it was in violation of French predatory pricing laws. After Amazon refused to obey the order, the government proceeded to fine them €1,000 per day. Amazon continued to pay the fines instead of ending its policy of offering free shipping. Low oil prices during the 1990s, while being financially unsustainable, effectively stifled exploration to increase production, delayed innovation of alternative energy sources and eliminated competition from other more expensive yet productive sources of petroleum such as stripper wells. It is important to note that in both these and other cases, the predatory pricing policy is alleged, and difficult to prove comprehensively.

Oil Refinery

In the 1990s, low oil prices were considered a case of alleged predatory pricing.

8.9.4: Price Discrimination

Although there are legal concerns around monopolistic practices, price discrimination is a popular tactic for capturing consumer surplus.

Learning Objective

Construct the concept of price discrimination relative to legal concerns in pricing

Key Points

In theoretical markets there exists perfect information, no transaction costs, and perfect substitutes, and in these cases price discrimination can only exist in monopolistic or oligopolistic markets.
For price discrimination to take place, companies must be able to identify market segments by their price elasticity of demand, and they must be able to enforce the scheme.
There are four degrees of price discrimination (including reverse price discrimination), that all occur under slightly different circumstances, depending on the market structure and the company’s ability to discriminate.

Key Terms

consumer surplus: The monetary gain obtained by consumers because they are able to purchase a product for a price that is less than the highest price that they would be willing to pay.
price discrimination: Occurs when sales of identical goods or services are transacted at different prices from the same provider.

Example

Airlines use several different types of price discrimination, including: bulk discounts to tour operators, incentive discounts for higher sales volumes to corporate buyers, seasonal discounts, etc. The price of a flight from Singapore to Tokyo can vary widely if one buys the ticket in Singapore compared to Tokyo (or New York or elsewhere). First degree price discrimination based on customer also occurs: it is not accidental that hotel or car rental firms may quote higher prices to their loyalty program’s top tier members than to the general public.

Price discrimination is the sale of identical goods or services at different prices from the same provider. Price discrimination also occurs when the same price is charged for goods with different supply costs.

Price discrimination’s effects on social efficiency are unclear; typically such behavior leads to lower prices for some consumers and higher prices for others. Output can be expanded when price discrimination is very efficient, but output can decline when discrimination is more effective at extracting surplus from high-valued users than expanding sales to low valued users. Even if output remains constant, price discrimination can reduce efficiency by misallocating output among consumers.

Legal Concerns

Although price discrimination is the producer’s or seller’s legal attempt to charge varying prices for the same product based on consumer demand, price discrimination can be illegal in some cases. For example, it is illegal for manufacturers to set different prices for anti-competitive purposes. Beer companies during the 1960’s attempted to price discriminate based on location to price below competitors and run them out of business.

Economic Rationale

In theoretical markets there exists perfect information, no transaction costs, and perfect substitutes. In these cases price discrimination can only exist in monopolistic or oligopolistic markets: otherwise, a buyer can buy the good at a lower price and sell it immediately at a slightly higher place (but lower than the price discrimination level), making a profit. In the real world, product heterogeneity, market frictions and moderate fixed costs allow for a level of price description in many markets.

Two conditions are necessary for price discrimination:

Companies must be able to identify market segments by their price elasticity of demand;
They must be able to enforce the scheme.

For example, airlines routinely engage in price discrimination by charging high prices for customers with relatively inelastic demand–business travelers –and discount prices for tourists who have relatively elastic demand. The airlines enforce the scheme by making the tickets non-transferable thus preventing a tourist from buying a ticket at a discounted price and selling it to a business traveler (arbitrage). Airlines must also prevent business travelers from directly buying discount tickets. Airlines accomplish this by imposing advance ticketing requirements or minimum stay requirements conditions that would be difficult for average business traveler to meet.

Third Degree Price Discrimination

Instead of supplying one price and taking the profit (old profit) the total market is broken down into two sub-markets. They’re priced separately to maximize profit.

Three curves that show third-degree price discrimination – industry (old profit), elastic submarket (profit), and inelastic submarket (higher profit).

Types of Price Discrimination

First degree

Here, the monopoly seller knows the maximum price each individual buyer is willing to pay, allowing them to absorb the entire consumer surplus. More is produced than the non-discriminating monopoly case, and there is no deadweight loss. This is mostly a theoretical outcome.

Second degree

Price varies according to demand: larger quantities are available at a lower unit price. Unlike first degree, sellers are unable to differentiate between individual consumers, and so they provide incentives for consumers to differentiate themselves. For example, airlines differentiate according to first, business and coach passengers.

Third degree

Price varies by attributes such as location or by customer segment, or in the most extreme case, by the individual customer’s identity; where the attribute in question is used as a proxy for ability/willingness to pay. Sellers are able to differentiate between different types of consumers. An example is student discounts. In third degree discrimination, it is not always advantageous to discriminate.

Fourth degree/reverse price discrimination

Prices are the same for different customers, even if organizational costs may vary. For example, a coach class airplane passenger may order a vegetarian meal. Their ticket cost is the same, but it may cost more to the airline to obtain a vegetarian meal for them.

Examples of Price Discrimination

Price discrimination is very common in services where resale is not possible; an example is student discounts at museums. Price discrimination in intellectual property is also enforced by law and by technology. In the market for DVDs, DVD players are designed–by law–with chips to prevent an inexpensive copy of the DVD (for example legally purchased in India) from being used in a higher price market (like the US).

Price discrimination can also be seen where the requirement that goods be identical is relaxed. For example, so-called “premium products” (including relatively simple products, such as cappuccino compared to regular coffee) have a price differential that is not explained by the cost of production. Some economists have argued that this is a form of price discrimination exercised by providing a means for consumers to reveal their willingness to pay. For instance, Starbucks will charge more for a coffee than, say, a local cafe, even if there is no discernable difference in quality.

8.9.5: Price Fixing

Price fixing is a collusion between competitors in order to raise prices of a good or service, at the expense of competitive pricing.

Learning Objective

Examine the characteristics of price fixing and its legal implications

Key Points

Price fixing is inefficient, transferring some of the consumer surplus to producers and results in a deadweight loss.
Price fixing is illegal in most developed countries. In the United States, price fixing can be prosecuted as a criminal federal offense. However, price fixing is perfectly legal in many countries.
When sovereign nations rather than individual firms come together to control prices, the cartel may be protected from lawsuits and criminal antitrust prosecution.

Key Terms

deadweight loss: A loss of economic efficiency that can occur when equilibrium for a good or service is not achieved or is not achievable.
price fixing: In antitrust law, collusion between competitors in order to raise prices, at the expense of competitive pricing.
collusion: A secret agreement for an illegal purpose; conspiracy.

Example

OPEC is perhaps the most important cartel in the world: the member countries come together to fix oil prices at levels beneficial to them. However, because of the sovereign nature of the members, no action is taken against them.

As it is commonly understood, the term “price fixing” refers to a collusion between sellers in a market to coordinate pricing—usually pushing it above the competitive level—for their collective benefit. While this is price fixing as commonly understood, the actual definition is much broader. It is an agreement between participants on the same side in a market to buy or sell a product, service, or commodity only at a fixed price, or maintain the market conditions such that the price is maintained at a given level by controlling supply and demand . The defining characteristic of price fixing is any agreement regarding price, whether expressed or implied. The intent of price fixing may be to push the price of a product as high as possible, leading to profits for all sellers but may also have the goal to fix, peg, discount , or stabilize prices.

There are many things sellers may do during a price fix. They might agree to sell at a common target price, set a common minimum price, buy the product from a supplier at a specified maximum price, adhere to a price book or list price, engage in cooperative price advertising, standardize financial credit terms offered to purchasers, use uniform trade-in allowances, limit discounts, discontinue a free service or fix the price of one component of an overall service, adhere uniformly to previously announced prices and terms of sale, establish uniform costs and markups, impose mandatory surcharges, purposefully reduce output or sales in order to charge higher prices, or purposefully share or pool markets, territories, or customers. These are all instances of price fixing.

Economic Argument and Legal Status

In neoclassical economics, price fixing is inefficient, transferring some of the consumer surplus to producers and results in a deadweight loss. Because of this, price fixing is illegal in most developed countries. In the US, price fixing can be prosecuted as a criminal federal offense. Under American law, even exchanging prices among competitors can violate the antitrust laws. This includes exchanging prices with either the intent to fix prices or if the exchange affects the prices individual competitors set.

In countries other than the United States, Canada, Australia, New Zealand, Japan, Korea and within the European Union, price fixing is not usually illegal and is often practiced. When the agreement to control price is sanctioned by a multilateral treaty or is entered by sovereign nations as opposed to individual firms, the cartel may be protected from lawsuits and criminal antitrust prosecution. This explains, for example, why OPEC, the global petroleum cartel, has not been prosecuted or successfully sued under US. antitrust law. International airline tickets have their prices fixed by agreement with the IATA, a practice for which there is a specific exemption in antitrust law.

Prominent Price Fixing Examples

Air Travel

In August 2007 British Airways was fined £121.5 million for price fixing. The fine was imposed after BA admitted to the price fixing of fuel surcharges on long haul flights . The allegation first came to light in 2006 when Virgin Atlantic reported the events to the authorities after it found staff members from BA and Virgin Atlantic were colluding. Virgin Atlantic has since been granted immunity by both the Office of Fair Trading and the United States Department of Justice who have been investigating the allegations since June 2006. The US Department of Justice later announced that it would fine British Airways $300 million (£148 million) for price fixing. BA maintained that fuel surcharges were “a legitimate way of recovering costs. “

Beer

In April 2007 the European commission fined Heineken €219.3m, Grolsch €31.65m and Bavaria €22.85m for operating a price fixing cartel in Holland, totalling €273.7m (InBev, another brewer, was convicted for price fixing but escaped punishment) . The brewers controlled 80% of the Dutch market, with Heineken claiming 50% and the two others 15% each. Neelie Kroes said she was “very disappointed” that the collusion took place at the very highest (boardroom) level. She added, Heineken, Grolsch, InBev and Bavaria tried to cover their tracks by using code names and abbreviations for secret meetings to carve up the market for beer sold to supermarkets, hotels, restaurants and cafes. The price fixing extended to cheaper own-brand labels and rebates for bars.

Heineken

Heineken was fined 219.3 million euro for its role in a price fixing cartel in Holland in 2007.