Pricing Concepts The Concept Of Price Economics Essay

It all started with Spice Jet slashing its air fares. In January, 2013, this low frills carrier from India announced that it had slashed its fares on a limited – period sale for 10 lakh seats on all its domestic flights. Spice Jet offered its passengers to fly at Rs. 2013, across India for a travel between February 1 and April 30. The fare being offered by Spice Jet was lower than the train fares too which had recently been hiked, and thus was a huge hit among the customers. The news spread like fire on various social networking sites and through other media. The airline’s official site witnessed mad rush to the extent that some visitors had to wait for their turn to book tickets as the site said “We are experiencing heavy rush. Please wait for your turn”. As expected by the industry experts, other airlines too followed suit. Round-trip fares from Mumbai to Delhi were trimmed from the usual Rs 7,000-9,000 to around Rs 4,000 from February 1 to April 30.

The airlines were expecting low passenger load in the coming months and thus they lured the customers with a price almost 40% lower than the normal prices. The season ended December 2012 had not been great for the airlines and they were expecting the passenger load to decrease in the coming months as well. Since the airline industry is one marred by intense competition, if one airline reduces its fares, the other have to follow the same to survive competition, thus the discounted airfares were available across all carriers on domestic routes. This move by the airlines resulted in huge rush and was also helpful in creating demand during the sluggish season.

Companies today face stiff competition in the market and in order to survive this competition pricing comes as an effective and handy tool. Price has implications on a number of other marketing functions, and thus the pricing decision is of prime concern to the marketer. Attractive pricing not only attracts customers but also helps firms in controlling demand, both during seasons and off seasons accordingly.

The pricing strategy adopted by any firm shall get reflected thereby in the quantity of product sold, the contribution made to profits and the strategic position of the product in the marketplace. Price is the only element of marketing mix that represents revenue for the company, while all other elements of marketing mix signify costs.

The price of any good or service may be defined as its monetary value. But this monetary value is not only the cost of the product but it also encompasses the value that customers exchange for the benefits of having or using the product or service.

Dynamic Pricing is a form of Price Discrimination wherein different customer are charged different prices based on circumstances and situations. Customers are divided into different groups based on customer characteristics or other criteria and different groups are charged different prices.

In 2000, Amazon was caught in a controversy when it was discovered that Amazon was analyzing its customers based on customer’s past purchase history, place of residence and other factors to judge their ability to pay. Based on the given criteria, the company analyzed how much a customer would be willing to pay for a particular product and would then price it accordingly for that particular customer. Thus different sets of customers would buy the same product at different prices. The company received a lot of negative publicity, but they argued that they only charged the customer based on how much the customer valued the product.

Looking back in history, one would notice that different pricing strategies have been employed at various times. Price is nothing but an exchange value, where in a good / service and its associated benefits are being exchanged for some other good / service or some monetary value. This was the beginning of the concept of price – also known as the barter system. Prices were also decided by a negotiation between buyers and sellers. Fixed price policies are a relatively modern concept that was introduced at the end of nineteenth century. With the advent of internet, a new concept of Dynamic Pricing has been introduced. There are a number of e – commerce websites such as ebay, amazon etc. which work on the concept of dynamic pricing.

Price Theory offers the marketers a means to understand the factors that influence price levels. Economists have proposed a model of price determination and the factors affecting price with the help of theory of demand and supply. The other factors that determine price decisions are: costs, elasticity of demand to price, competitor cost and prices, general trend and lifestyle etc.

Definitions

Maurice Mandell and Larry Rosenberg defined pricing as the art of translating into quantitative terms the value of the product to customers at a point in time. Pricing cuts across marketing and economics – while marketers set prices, economists explain the interaction of prices with other factors. Different industries make use of diverse pricing policies depending on the level of industry competition.

According to the Dictionary of Marketing by American Marketing Association, “Price is the formal ratio that indicates the quantities of money goods or services needed to acquire a given quantity of goods or services.”

Philip Kotler defined Price as “the amount of money charged for a product or service, or the sum of the values that consumers exchange for the benefits of having or using the product or service.”

Kotler has also defined price as one of the most flexible elements of Marketing Mix. Unlike other elements, such as the features of a product or the promotional mix, price can be changed quickly as and when required. Although being flexible, price also carries with itself the power to create or erode brand equity. Marketers may get caught in the trap by reducing prices too frequently and thus eroding equity.

Pricing Considerations

There are various factors that make an impact on the pricing decisions of a firm. These factors act as a consideration as to what pricing strategy and pricing method the company shall choose. These factors are:

Marketing Objectives: A company may decide to aim at one of the following objectives – survival, profit maximization, market share leadership or product quality leadership. Depending on the objective chosen, the company shall identify a suitable pricing method which shall help it in achieving its desired objectives. For instance, a company that adopts profit maximization as its marketing objective determines its demand and costs for the product and then selects a price that produces maximum current profit.

Marketing Mix Strategy: Price forms one of the 4P’s of Marketing Mix, the others being Product, Place & Promotion. The price of any product should be decided in a way that it reflects the other components of this mix as well. This shall help the company in designing a coordinated marketing program and shall also be helpful in creating the desired impact among its target customers.

Costs: Price cannot be fixed lower than the costs, and thus they are the most crucial factor when it comes to price determination. Cost covers not only the manufacturing costs associated with a product, but also costs attributable to its sales and distribution, marketing and advertising, after sales services etc. Companies with lower costs may fix lower prices and thus gain a larger market share.

Organizational Considerations: The management needs to decide who decides prices in the organization. While for a few prices may be decided by the top management, while a few firms may have separate departments dedicated to pricing.

Pricing Policies and Strategies

The ultimate aim of pricing is profit maximization, and various pricing policies and strategies equip the marketer with a tool to achieve this aim. A firm may aim at a larger market share over earning more profit.

The figure below enumerates the steps followed during a pricing decision:

Figure: Steps followed during a Pricing Decision

A Pricing Policy helps the company in identifying the wholesale and retail prices for its products and services. Based on the pricing objective identified, a company devises a suitable pricing policy for its products and services. The policies provide a general framework based on which firms make pricing decisions to achieve their desired objectives.

Companies do not set one fixed price for a particular product, but depending upon the competitive and market conditions, and the life cycle stage in which the product is companies define a Price Structure. Thus, the change in demand, costs and other market conditions gets reflected in the price changes introduced under a given price structure.

Pricing Strategy

A Pricing Strategy encompasses all those activities that a firm may undertake to identify a product’s optimum price such as its marketing objectives, consumer demand, product attributes, competitive pricing and market trends etc.

Accordingly companies may choose from one among the different Pricing Strategies listed below:

Pricing Strategy

Definition

Examples

Market Skimming

A new product is introduced with a high price tag to “skim” revenues, when there is large competitive advantage. The firm may slowly lower the prices later to reach a wider market.

Apple i-phone: Though initially bearing a premium price tag, prices of i-phone 4 have been lowered down slowly making it available to a wider market.

Market Penetration

A new product is introduced at a low price to gain a larger share of market. The firm may increase the price later though.

Micromax Mobile Phones: Micromax has launched its mobile handsets at lower prices when compared to the competition. The handsets offer features similar to high priced competitor brands like Samsung, Nokia etc., yet are priced low.

Product Line Pricing

Products within the same product line are priced at different price points based on cost differences between the products, customer evaluations of different features and competitor’s prices.

Different variants of an i – pad are priced at different levels depending on the features incorporated into each and their associated costs. The price differential could be on the basis of internal memory, features offered (with / without 3G) etc.

Optional Product Pricing

Optional extras are sold with a product – this increases the turnover of the company while also increasing the frequency of purchase.

Panasonic offered to sell its home theatre system as an optional extra along with its Smart TV. The home theatre was priced a little lower than its usual price for the offer.

Captive Product Pricing

Setting the price of complementary product higher than the main product.

Products available in multiplex food lounges are priced higher than the normal.

Product Bundle Pricing

Combining different products and offering at a reduced price over buying each product at its individual price.

Companies create product bundles of shampoo and conditioner and then sell the bundle at a reduced price when compared to buying both the products individually.

Psychological Pricing

The price is based on factors such as signals of product quality, popular price points and consumer perception. The price is used to say something about the product.

The products ending with a “9”, e.g – Rs. 399, Rs. 499 carry a psychological price tag. Consumers decipher Rs. 399 as less than Rs. 400. It’s a minor distinction but may make a big difference.

Promotional Pricing

A temporary form of pricing, which lists products below their list price and even below cost at times to increase short run sales. Mainly done attract customers hoping that they shall buy other products at normal prices as well.

Special – event Pricing such as seasonal discounts offered by retailers. Big Bazaar offers promotional pricing as “Saal ke Sabse Saste Din”.

Geographical Pricing

Items are priced based on location. A product may be priced lower in regions where it is plentiful compared to places where it is rare.

Kashmiri Shawls are available at lower prices in Kashmir while buying them from other places might be costlier comparatively.

Pricing Methods

The price set for a product cannot be less than the cost of the product. Thus cost acts as a floor based on which prices are to be set. Other considerations that firms need to take care of while deciding prices are competitor prices and other factors listed in the chapter earlier. Apart from these factors, one important consideration while fixing prices is the consumer perception of value of a product. If the consumer perceives the product to be of very high quality, the firm may decide to price the product higher than its competitors to gain more profits.

There are various methods and approaches based on which companies arrive at a final price for their product. Let us take a look at these approaches in this section.

Following are the broad categories under which the different pricing methods may be categorized into:

Demand Adjusted Pricing

Cost Adjusted Pricing

Competition Adjusted Pricing

Value Adjusted Pricing

Demand Adjusted Pricing

The Demand Adjusted Pricing method takes cues from the economic theories of demand and supply. Economics defines price to be dependent on the forces of demand and supply – An increase in demand is caused by falling prices and vice versa. Similarly, an inadequate supply of goods / services may result in an increase in prices. An industry may be categorized into one of the following market structures depending on the level of industry competition: perfect competition, monopoly, oligopoly and oligopolistic competition. Thus, firms adjust their prices based on the demand and supply conditions, and the existing market structure in the industry. For a firm in a perfect competition environment, the forces of demand and supply shall decide the price, while for a firm which holds a monopoly in the industry; the prices may be decided by the firm itself based on the profits it is targeting at without considering the demand and supply factors to a large extent though they shall not be completely ignored either.

Cost Adjusted Pricing

The Cost Adjusted Pricing method is used by firms to fix prices based on costs incurred. Prices are determined by adding a profit element to the cost incurred in manufacturing the product / service. This method is based on the periphery of customer’s perception of value of a product. Customers are not interested in the cost of making a product but their focus is on the price of the product and its associated value. The following types of methods may be used by the firm when adopting cost oriented pricing:

Cost Plus Pricing: In this method, the firms first calculate the cost of the product. A standard markup is then added to the cost to arrive at the final price. This method of pricing is also known as the “Markup Pricing Method”. This method of pricing is generally followed by retailers, where the gross profit associated with each sale can be determined with certainty. The margin is known as the “mark – up”.

Selling price = Unit Total Cost + Desired Unit Profit

The markup added to the cost in order to get the desired profit may differ from firm to firm. It is dependent upon industry competition, distinctness of product etc. The Markup Price may be determined using the following formula:

Markup Price = Unit Cost

1 – Desired Return on Sales

Although this method offers the marketer ease and convenience, yet it does not take into consideration the customer demand on the markup price and competitor prices. Also, the method adopts a fixed profit margin on the product while the firm may increase their margin on increasing demand and thus earn more profits.

Marginal Cost Pricing: This pricing method is employed when the firm has complete information about the demand and revenue conditions in the market. While costs are broadly categorized as fixed costs (which remain fixed in the short term and can be varied only in the long term) and variable costs (which may vary in the short term), Marginal Cost is defined as the extra cost of producing one unit of product. Marginal Cost Pricing implies that the price of the product shall be equal to the cost of producing one extra unit of output or the marginal cost of the product. This method is employed mainly during times of low sales, wherein the marginal cost is calculated using only the manufacturing and direct labour costs, while other costs and expenses are ignored.

Marginal Cost of a product may be calculated using the following formula:

Marginal Cost = Total Cost

Total Quantity

Break Even Analysis: This method is also known as the Target Profit Pricing. A firm is said to achieve its Break Even Point when its revenues are equivalent to its costs. Beyond this point, a firm is said to be making profits. This method takes into consideration the demand for the product along with its costs. This technique is a sophisticated technique which establishes relationship between costs, volume of production, profit / loss and sale.

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Figure: Break Even Chart

The figure above shows a break – even chart for a manufacturer. The fixed cost for the firm is Rs. 20,000. The variable cost shall vary with the volume of production, while the total cost is a function of both the fixed and variable costs. The slope of revenue curve reflects the per unit price of the product. The revenue curve and the total cost curve intersect at 40,000 units, which is also the breakeven point for the firm. Any quantity produced beyond this volume of production shall result in a profit for the firm. Thus, the firm must sell atleast 40,000 units of product in order to break even or to earn profits.

Breakeven Volume = Total Fixed Cost

Selling Price Per Unit – Variable Cost Per Unit

The manufacturer must thus consider different prices and estimate breakeven point for these prices at the given demand level. The final price shall then be selected based on the firm’s desired level of production for the breakeven point.

Competition Adjusted Pricing

In the Competition Adjusted Pricing Method, prices are fixed keeping in mind the competition level and competitor prices. This method is generally followed in industries characterized by intense competition levels or when the products from different companies are similar in nature with little or no differentiation. This pricing method is based on the premise that customer judgement of a product is based on the prices competitors are charging for a similar product.

Following methods may be used by firms when adopting Competition Adjusted Pricing:

Going Rate Pricing: The firm using this pricing method pays less attention to costs and other related factors, but decides its price based on what competitor is charging for the same product. The firm at its own will may charge a price higher than the competitor, or equivalent to or lower than the competitor. Such businesses are price takers, as they must accept the price going in the industry. The small firms follow the leader, and change prices when the market leader changes its pricing. Since prices charged by all the firms are almost the same. Firms must engage in other activities to attract the customer. For example, the cola companies price their products at almost the same levels, but engage the customers by various methods such as sponsoring college fests, catchy advertisements etc. to attract more customers and to increase awareness levels.

Sealed Bid Pricing – Firms using this method, base their price on what they think the competitor will price its product at rather than based on the actual cost of the product or demand. This method is generally used by companies bidding for government projects. The company cannot set its price below its costs, but the higher the company sets its price above its costs, the chances of its winning the contract get lower as a competitor may have quoted less price.

Value Adjusted Pricing

In the Value Adjusted Pricing Method, prices are decided based on the customer perception of value of the product. The customer value of the product could be its perceived value or an estimate of value the product could have. In this method, the pricing does not begin with an estimate of cost or related demand, but with an analysis of customer needs and their value perceptions, along with the price which shall match this perception. In this case the price is decided before the marketing program in contrast to cost based pricing where the marketing program is first defined and then the prices are set. The perceived value and the price then decide the product design and the costs to be incurred.

In the Value Adjusted Pricing Method, the firm first determines the customer needs and the value they attach to the product. Based on the perceived customer value, prices are determined for the product, which act as a basis for determining the costs to incur on making the product and the product design. Thus, while cost pricing begins from the product and ends at the customer, value based pricing model begins from the customer and ends at the product. The figure below shall provide more clarity on this:

Figure: Value Based Pricing

Value Pricing is a form of Value Based Pricing wherein the firm offers just the right combination of quality and service at a price that represents the offer rightly. Value based pricing model is followed by companies who were earlier offering goods at high prices but have now introduced the less expensive versions of the same product. For example, laptops companies have introduced new models of smaller sizes, which combine the basic functionality of its bigger version at a lower price.

Summary

Pricing is an important aspect of marketing. The marketers must be careful while designing their pricing strategies and programs, as pricing is the final communication about the product from the firm to its customers. A pricing gone wrong may ruin the product completely. Marketers must keep their pricing objective in mind before they decide to select a particular pricing method or strategy. Prices are also helpful in controlling demand, an increase or decrease in price may regulate demand accordingly. There are various considerations that need to be taken care of before the firm decides on a final price. These considerations lay the basis of pricing strategy and pricing methods which the firm may adopt in future. There are different types of pricing strategies and pricing methods – and the one chosen by the firm for its product is dependent on its objectives.