4.5. Price

The appropriateness of the following pricing strategies: cost-plus (mark-up), penetration, skimming, psychological, loss-leader, price discrimination, price skimming and price leadership

There are three main types of influence on price setting: costs, competition and customers (3cs). Other aspects of the pricing mix include factors such as any bulk purchases discounts given, credit offered and methods of payment.

Price setting strategies

1. Economy Pricing. This is a no frills low price. The cost of marketing and manufacture are kept at a minimum. Supermarkets often have economy brands for soups, spaghetti, etc.

2. Market penetration: the organization sets a relatively low price for the product or service in order to stimulate growth of the market and/or obtain a large share of it. This strategy is appropriate under three conditions:

a. Unit costs will fall with increased output (economies of scale) and experience (experience curve)

b. The market is price sensitive and relatively low prices will attract additional sales

c. Low prices will discourage new competitors.

Advantages claimed for penetration pricing include:

§ Catching the competition off-guard / by surprise

§ Encouraging word-of-mouth recommendation for the product because of the attractive pricing (making promotion more effective)

§ It forces the business to focus on minimising unit costs right from the start (productivity and efficiency are important)

§ The low price can act as a barrier to entry to other potential competitors considering a similar strategy

§ Sales volumes should be high, so distribution may be easier to obtain

Penetration pricing strategies do have some drawbacks, however:

§ The low initial price can create an expectation of permanently low prices amongst customers who switch. It is always harder to increase prices than to lower them

§ Penetration pricing may simply attract customers who are looking for a bargain, rather than customers who will become loyal to the business and its brand (repeat business)

§ The strategy is likely to result in retaliation from established competitors, who will try to maintain their market share.

3. Market skimming: the organization sets a high initial price for a new product in order to take advantage of those buyers who are ready to pay a much higher price for it. A typical price would be initially to set a premium price and then gradually to reduce the price to attract more price sensitive segments of the market. This strategy is appropriate under three conditions:

a. There is insufficient production capacity and competitors cannot increase their capacity

b. Some buyers are relatively insensitive to high prices

c. High price is perceived as high quality

Advantages of Price Skimming

§ The following are advantages of using the price skimming method:

§ High profit margin. The entire point of price skimming is to generate an outsized profit margin.

§ Cost recovery. If a company competes in a market where the product life span is short, price skimming may be the only viable method available for ensuring that it recovers the cost of developing products.

§ Dealer profits. If the price of a product is high, then the percentage earned by distributors will also be high, which makes them happy to carry the product.

§ Quality image. A company can use this strategy to build a high-quality image for its products, but it must deliver a high-quality product to support the image created by the price.

Disadvantages of Price Skimming

The following are disadvantages of using the price skimming method:

§ Competition. There will be a continual stream of competitors challenging the seller's extreme price point with lower-priced offerings.

§ Sales volume. A company that uses price skimming is limiting its sales, which means that it cannot lower costs by building sales volume.

§ Consumer acceptance. If the price point remains very high for too long, it may defer or entirely prevent acceptance of the product by the general market.

§ Annoyed customers. Early adopters of the product may be highly annoyed when the company later drops its price for the product, thereby generating bad publicity and a very low level of customer loyalty.

§ Cost inefficiency. The very high profit margins engendered by this strategy may cause a company to avoid making the cost cuts required to keep it competitive when it eventually lowers its prices.

4. Premium Pricing: Use a high price where there is uniqueness about the product or service. This approach is used where a substantial competitive advantage exists. Such high prices are charge for luxuries such as Cunard Cruises, Savoy Hotel rooms, and Concorde flights.

Cost-based strategies

Cost-plus pricing: the organisation sets its price by marking up its unit costs by a certain % or fixed amount.

Advantages

1. Fair method: It is a fair method of price fixation. The business executives are convinced that the price fixed will cover the cost.

2. Assured Profit: If price is greater than cost, the risk is covered. This is true when normal expected capacity basis of cost estimation is used.

3. Reduced risks and uncertainties: A decision maker has to take decisions in the face of many uncertainties. He may accept a pricing formula that seems reasonable for reducing uncertainty.

4. Considers market factors: This sort of pricing does not mean that market forces are ignored. The mark up added to the cost to make a price reflect the well established customs of trade, which guide the price fixer towards a competitive price.

Disadvantages

1. Ignores demand: It fails to take into account the buyers’ needs and willingness to pay which govern the sales volume obtainable at each series of prices.

2. Ignores competition: It fails to reflect competition adequately.

3. Arbitrary cost allocation: It takes for granted that the costs have been estimated with exact accuracy which is not often true particularly in multi-product firms because the common costs are allocated arbitrarily.

Task 1: If a firm is using a cost-based pricing strategy, what other factors in addition to cost should the enterprise factor into the pricing of their product(s)?

Competition-based

Price Leadership

Price leadership: a price leader dominates price levels for a class of products; the market participants follow increases or decreases by the price leader.

Advantages of Price Leadership

The following is an advantage of the price leadership method:

• High profit margin. If a company can set high price points and competitors are willing to follow those price points, then the company can earn inordinately high profits.

Disadvantages of Price Leadership

The following are disadvantages of using the price leadership method:

• Defensive effort. There are several reasons why an industry may accept a particular company as its price leader, several of which involve having to monitor competitors and take reactive steps if they do not follow the company's price leadership position.
• Complacency. A company that successfully exercises price leadership may become complacent and not keep its cost structure sufficiently lean to allow it to still earn a profit if a price war develops.

Predatory Pricing

Predatory pricing is a similar strategy but the reason for setting a low price is to damage the competition.

Advantages of Predatory Pricing

The following are advantages of using the predatory pricing method:

• Entry barrier. If a company communicates its willingness to use predatory pricing again, possible new entrants to the market will be deterred from competing.
• Reduces competition. Financially weaker competitors will be driven from the market, or into smaller niches within the market.
• Market dominance. It is possible to achieve a dominant market position with this strategy, though predatory pricing may have to be used again in the future to drive away new market entrants.

Disadvantages of Predatory Pricing

The following are disadvantages of using the predatory pricing method:

• Illegal. It may be illegal, depending upon the government jurisdiction.
• Questionable actual value. The concept can certainly work in the short term, but may not be viable in the long term, since new competitors may enter the market place.

Going rate pricing/competitive pricing

Going rate/competitive prices: Going rate pricing is a pricing strategy where firms examine the prices of their competitors and then set their own prices broadly in line with these.

Going rate pricing is most likely to occur where:

• there is a degree of price leadership taking place within a particular market
• businesses are reluctant to set significantly different prices because of the risk of setting off a price war, which would reduce profits to all firms
• there is a degree of collusion taking place between firms

If there is one price leader and firms are tending to follow the prices set by the price leader, then they will often feel frustrated that they are not able to mark themselves out by reducing their prices. To compensate for this, they may try, through their marketing strategy, to establish a strong brand identity. This will enable them to differentiate themselves from the competition.

Task 2: Question – The price of price wars

‘The world’s largest supermarket chains have huge market power to reduce prices. Price reductions are a key technique used by supermarkets. For example, the British consumer has grown accustomed to supermarket price wars, with over £1 billion of price reductions each year. Price wars are also common in the airline and mobile phone industries’. (Hoang, Paul. Business and Management, IBID Victoria, 2011, p463)

a. Describe what is meant by a price war

b. Examine the winners and losers of a price war in the short-term and long-term

c. What forms of non-price competition could supermarkets use to increase their competitiveness?

Psychological Pricing

Advantages of Psychological Pricing

The following are advantages of using the psychological pricing method:

• Price bands. If a customer is accessing information about product prices that are segregated into bands, the use of fractional pricing can shift the price of a product into a lower price band, where customers may be more likely to make a purchase. For example, if a customer only wants to consider automobiles that cost less than $20,000, pricing a vehicle at $19,999 will drop it into the lower price band and potentially increase its sales.
• Non-rational pricing. If customers are swayed by the incremental price reductions advocated under psychological pricing (which is a debatable premise) then sales should increase.
• Control. It is much more difficult for an employee to create a fraudulent sales transaction and remove cash when product prices are set at fractional levels, since it is more difficult to calculate the amount of cash to steal.
• Discount pricing. If a company is having a sale on selected goods, it can alter the ending digits of product prices to identify them as being on sale. Thus, any product ending with a ".98" price will receive a 20% discount at the checkout counter.

Disadvantages of Psychological Pricing

The following are disadvantages of using the psychological pricing method:

• Calculation. It can be difficult for cashiers to calculate the total amount owed when fractional prices are used, as well as to make change for such purchases. This is less of a problem when credit card and other types of electronic payments are used.
• Rational pricing. If customers are more rational than psychological pricing gives them credit for, then they will ignore fractional pricing and instead base their purchases on the value of the underlying products.

Loss Leader Pricing

Loss leader: A business strategy in which a business offers a product or service at a price that is not profitable for the sake of offering another product/service at a greater profit or to attract new customers. This is a common practice when a business first enters a market; a loss leader introduces new customers to a service or product in the hope of building a customer base and securing future recurring revenue.

Advantages of Loss Leader Pricing

The following are advantages to using the loss leader pricing method:

• Sales increase. When buyers purchase other items in addition to the loss leader, the seller can make a larger profit than would have been the case if it had not offered the loss leader.
• New stores. Loss leader pricing is an excellent way to attract shoppers to a new location, since they might otherwise never enter the store, but will do so to take advantage of a particular pricing deal. Thus, it can be used to build a customer base.
• Merchandise elimination. The strategy can be used to clear out older merchandise, so the seller can restock its warehouse with newer products.
• Marketing. Loss leader pricing is an alternative form of marketing, where the seller is essentially paying customers in the amount of any losses sustained on its loss leader products to enter the company store.

Disadvantages of Loss Leader Pricing

The following are disadvantages of using the loss leader pricing method:

• Risk of loss. A company may incur a substantial loss from this pricing strategy if it does not closely monitor sales of other items positioned alongside the loss leader; the risk is that customers may buy only the loss leader, and in large quantities.
• Stockpiling. If the loss leader price is unusually good, and it is for a necessary item that a consumer may use in bulk, it is possible that each buyer will purchase the largest possible quantity of the item, and then stockpile it for later use. A seller can avoid this issue by limiting purchase quantities or only offering products that have a limited shelf life and which therefore cannot be stockpiled.
• Pricing perception. Retaining a deep discount for too long can give buyers the impression that a product should have a lower price at all times, which can reduce its unit sales once management stops the loss leader promotion and returns the product to its normal price.

Price Discrimination

Price discrimination/selective pricing: the organization sets different prices for the same product when it is sold in different markets.

a. Category: the product is cosmetically modified to justify a price differential. For example, a budget version of a product is modified into a premium version.

b. Consumer group: the price differential is justified by targeting different consumer groups for example OAPs and student prices

c. Peak: the price is set in accordance with demand. For example, a train ticket is often more expensive during rush-hour.

Advantages of Price Discrimination

1. Firms will be able to increase revenue. This will enable some firms to stay in business who otherwise would have made a loss. For example price discrimination is important for train companies who offer different prices for peak and off peak.

2. Increased revenues can be used for research and development which benefit consumers

3. Some consumers will benefit from lower fares. E.G. old people benefit from lower train companies, old people are more likely to be poor.

Disadvantages of Price Discrimination

1. Some consumers will end up paying higher prices. These higher prices are likely to be allocatively inefficient because P > MC.

2. Decline in consumer surplus.

3. Those who pay higher prices may not be the poorest. E.g. adults could be unemployed, OAPs well off.

4. There may be administration costs in separating the markets.

5. Profits from price discrimination could be used to finance predatory pricing.

Promotional pricing

Promotional pricing is the use of pricing strategies to support specific promotional strategies. This may include the use of offers (buy one, get one free - BOGOF), discounts or perhaps simply offers. These offers will often be associated with a particular promotional campaign or perhaps time-limited. An example may include the sales that most retail stores will have a few times a year.

The aim of these sales is to encourage people to purchase at a time when demand might otherwise have been low and perhaps the firm has excess stock. This discounted policy is likely to happen towards the end of a product's life cycle. It may also be employed when a new outlet opens and the firm wants to create a buzz of excitement and encourage customers to visit the store.

Task 3: Explain with examples the the idea of a variable pricing strategy

Task 5: Identify the type of pricing strategy being pursued by the firm/industry and determine how effective it will be in the medium-term.

Task 6: ‘Virgin Blue is the creation of Sir Richard Branson, founder and CEO of the Virgin Group. The airline carrier was launched in 2000 by Branson and Virgin Blue CEO Brett Godfrey to enter the Australian market. Initially set up as a low-fare carrier, the company only flew between Brisbane and Sydney. Since then, it has become Australia’s largest airline catering for all major cities in Australia. To cut costs, customers pay for their in-flight meals and drinks and Virgin Blue uses a system of e-ticketing (a telephone and internet-based ticketing system)’ - (Hoang, Paul. Business and Management, IBID Victoria, 2011, p. 465)

(a) Describe three potential pricing strategies that airline companies can adopt when entering a new market

(b) Evaluate two of the pricing strategies mentioned in part (a) that airlines can use to increase their sales revenue.

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