Now let me ask you a question, Student. Assuming you have something of value for sale: what is one of the basic questions you will ask yourself?

STUDENT: First of all I would wonder how much to ask for what I have for sale.

WRITER: Exactly. In other words, you will be concerned about the pricing of your product or service. Obviously this is of basic importance for you because the prices of your products will be a key element in your potential profit.

STUDENT: I see that; but what about NPO’s (nonprofit organizations)?

This is an ad where Rotary International -a well known NPO- markets a book: the regular edition priced at $25.-, and a limited edition leather-bound volume priced at $100.- These pricing decisions necessarily affect the number of books sold and the gross and net revenue of this project -producing and selling the book.

WRITER: Nice thought. But since price increases will most probably affect the level of sales, and possibly trigger reactions from competitors, the decision is not such an easy one; it is actually a very complex one.

Now let me mention that the price of a product should be consistent with all other elements of the product itself and how it is presented to the market. Of course quality, production cost, competition in the market, and customer’s perception (the "image") will affect pricing.

Let me show you an ad, and please tell me what level of price you would expect to have to pay for this product. The copy –wording- of the ad states: "Performance. Unlike any other. The S-Class"

WRITER: That is the idea. You see how marketing communication is related to pricing. If you as a potential customer perceive that this vehicle is of superior quality and delivers unrivaled performance, you will expect to pay a higher price compared with other cars cars.

By the same token, if a car is advertised as having the lowest maintenance cost in the market, you would expect to pay a comparatively low price.

STUDENT: I take it that this does not necessarily mean that a low price car must be of low quality.

Now let me mention that a good understanding of some basic economic concepts is necessary –while not always enough- to develop an effective pricing strategy. Since you are supposed to have studied Economics, please tell me which concepts would be critical for pricing.

STUDENT: Demand and Supply analysis; the type of markets faced (monopoly, oligopoly, monopolistic competition, pure competition).

STUDENT: In this case, I’d expect sales to rise by more than 10%, since by definition elastic in this case means that sales will react by a higher percentage than the change in price.

But Writer, isn’t all this theoretical approach too... well, theoretical?

WRITER: Well, I said before that understanding these principles was necessary but not sufficient. In the real world, many other considerations are necessary in addition to a sound economic analysis.

Let me mention that the basic approaches to pricing are based on cost, profit, competition and the image –customer perception- of the product.

As you know, total costs include fixed and variable costs. A pricing strategy based exclusively on costs, would consist simply in adding a markup percentage to the total cost of a product. This markup would be the gross margin delivered by the product.

STUDENT: Simple, but I can’t see it working too well in real life. I could decide to fix prices based on a nice markup of, say, 80%. But would the customers buy?

WRITER: This is exactly the problem with purely cost-oriented techniques; it is not practical to ignore many other factors, such as competition, type of market, etc. This is why in practice markup percentages vary very much for different categories of products. Just as an example, a survey by German and Debra showed that while shoes carry a markup of close to 50%, books and magazines are marked up an average of 28% -in the US, that is.

To calculate a price based on profit, the technique usually employed is breakeven analysis. This technique consists in finding the volume of sales needed to cover costs at a given price.

STUDENT: Just a moment please, Writer. What type of costs are we referring to here?

WRITER: Good question. I will quote from our course Financial Management II, Module 1: "Estimates of what full costs are going to be in the future are used in some types of planning activities. In deciding what price to charge for its products, a company normally uses estimates of full costs plus a profit margin as a guide in arriving at the final selling price." We can work with full manufacturing costs as a basis, but it is necessary to add an estimate of all other costs involved in delivering the goods to the customer and getting the revenue.

WRITER: Yes. A concept we may illustrate with this graph:

STUDENT: Your graph illustrates the point but it is, I assume, a simplification.

WRITER: Of course; we all know by now that the total cost line is not linear (straight) at every production level range. We could also argue that since normally not all units can be sold at the same price, the total revenue curve would not be a straight line either. But as you said, the idea is to illustrate the concept.

In practice a marketer would estimate the breakeven point at several prices, to adjust his or her final number to the firm’s production capacity.

But I have a question now: how does profit enter into this calculation?

WRITER: The normal procedure is to add a profit percentage to the total cost.

As you can see in this graph,

we have plotted a line showing both the breakeven point at a price equal to cost, and the breakeven point at a price formed by cost plus a certain profit. As was to be expected, we will need to sell a larger quantity (Q₁ instead of Q) to reach a breakeven point that now includes a profit in addition to cost.

Now let’s move on to

The competitive situation is always important in pricing, but how important it is depends on many factors.

The worst scenario for marketing is having to sell a product that can not be distinguished –differentiated- from the ones sold by many other competitors. This type of product is usually called a commodity because of its similarity with the actual commodities such a wheat, corn –maize-, coffee, etc.

In these cases the methods described before are useless; the marketer must simple accept the going price, and the only way to increase profits is to reduce costs. In certain cases higher prices can be obtained for a commodity by offering some type of support to the customers. In this way the commodity can be differentiated in the eyes of the customer. As an example, a firm selling glucose – a commodity in a multi-supplier environment- can offer to its industrial customers technical support to help in the designing and manufacturing of the goods that include glucose as an input.

WRITER: When a market is closer to oligopoly than to pure competition, the situation is different since some players in the market may have higher pricing power than others.

Let’s take a look at some competition-based tactics:

1. Follow-the-leader pricing – Typical in oligopoly, this tactic consists in fixing prices very close to the ones charged by the market leader. But depending on the marketing strategy, prices may differ substantially. If price is set at a considerably lower level than the leader’s, this shows an intent to gain market share and possible will cause a reaction from the leader that can result in a price war. This tactic has been followed by supermarkets with their private brands, and in many cases they have forced the market leaders to reduce prices considerably as customers realized that the respective products were not very different in quality. Large consumer product companies such as Procter & Gamble, Heinz, and Unilever have suffered from this transfer of pricing power from them to the large retailers.

1. Opportunistic pricing – This tactic consists in setting prices at a lower level than competitors; the opportunity is real and durable only if competitors do not quickly match the lower prices. In this ad, the Vanguard Mutual Fund group stresses the large savings an investor can make by investing with them, due to their lower fee and expense ratio.

3. Predatory pricing – Prices are set with the specific purpose of hurting the competition, driving them out of business or forcing them to abandon a product line. A company doing this must expect to incur losses for a considerable time –at least for the line of products this practice is used in. A very large diversified corporation marketing several product categories can afford to use this practice to hurt a competitor that is active in only one of these categories. The practice is dangerous for several reasons; it may trigger anti-monopoly actions or be outright illegal; it may not work even after the initiator suffers considerable losses; or another large corporation may be tempted to take over the smaller rival –thus making the resulting competitive situation much worse than it was before.

4. Pricing above the competition – Prices are set higher than the competition as a rule; it is usually referred to as getting a "premium price". This tactic usually results in a sales volume much below the one that could be achieved by a lower price, of course.

STUDENT: This is a surprise for me. Why would a company intentionally sell less by charging more than the competition?

WRITER: Usually to convey and support an image of good quality, often in combination with a limited production capacity. When corn –maize- oil earned the reputation of being good for the heart, and the quantity of oil produced being dependent on the amount of corn processed for other purposes, MAZOLA® corn oil was priced at a premium over other competing corn oils. The company still sold all its production of this "sub-product" of its corn refining operation and made a substantial profit on it.

STUDENT: I assume that a virtuous cycle was in effect; the high profit allowed spending a lot of money in marketing and image building, which in turn helped to get away with the premium price.

WRITER: Yes. Now we will expand the concept of prices based on image.

The approaches to pricing based on cost, profit, competition and "image" –customer perception- of the product are not mutually exclusive. Any company will take costs and profits in consideration, and will keep an eye on the competition.

But customer perception is a key element in any market: even to some degree in a monopolistic one.

In the launching of new products, consumer panels are shown the products and asked how much they would be prepared to pay for it. They are also asked the price they pay for a comparable product. The latter is used as the "reference price", the price against which customers compare the offered product’s price.

STUDENT: Am I right in assuming that the reference price may be higher or lower that the price set for a given product?

Value pricing – We use the term value –as in good value- to indicate that the product’s benefits are perceived as justifying its price.

STUDENT: You mean to say that I may be prepared to pay a premium price if I perceive that the difference in price with a competing product is worth paying due to the higher benefit I get from the former.

WRITER: Yes; but you may also prefer to pay the lower price if you perceive that the higher benefit you’d get does not justify the difference in price. And of course, a consumer’s disposable income level is also important. I may be convinced that a Rolls Royce delivers the best value compared to any automobile in the market; but I may have to be content with an economy car.

STUDENT: Yes, but even in this case you will choose the economy car that –in your perception- delivers the best value, won’t you?

In all cases, a good marketer must find out what the customer considers important to establish the value of a product. This factors may include prestige, low cost operation, durability, safety, product support by the seller, esthetics, good taste, being good for the environment, sex appeal, power, and many others.

STUDENT: I saw an ad from Toyota that reads: "Introducing high performance technology that’s also good for the environment". This refers to Toyota’s Hybrid Synergy Drive, a combination of a gasoline and an electric motor. In this case a combination of two values is used: performance and environment protection.

WRITER: There can be an unlimited amount of combinations, of course. Now I ask you to please look at these ads and tell me what type of value is stressed in each one.

The add on the center –gourmet coffee- stresses good and constant quality, safety, reliability. Certainly the customer is led to perceive that this coffee tastes very good, but in addition there is the suggestion of prestige. If Mr. or Ms. Customer invites his or her friends for coffee at home, it will be apparent that they don’t serve just some cheap supermarket coffee.

The add on the right, from the same firm as the one on the left, is clearly targeted to thrifty customers who want to buy good books at a deep discount.

WRITER: That was a very good analysis, Student. Now we will discuss

Governments in almost all countries impose some limitations on how firms price their products and services. Of course there are many variations between countries. In the US and in most other industrial countries the following practices are not allowed:

Price discrimination – Applies to goods only –not to services. Goods of the same quality and grade must be offered to all customers at the same price when the size of the order is the same –except when there are differences in cost for the seller (as for instance different transportation costs or applicable taxes).

Student, let’s move on to discuss

Pricing Objectives

I am sure you realize that pricing is a very important element of a marketing strategy. It logically follows that pricing strategies should support the overall marketing strategy.

Pricing strategy must have clear objectives: the most common ones are reaching a certain level of sales or market share, earning a specific profit level... or in some cases, simply survive!

Positioning objectives – Price is a basic tool in positioning a product to target specific market segments, since price is a key element in determining what customers will buy the product –or service.

Sales and profit objectives – Depending of course on the famous elasticity concept, price normally affects sales level considerably. A sales objective should of course –in general- be consistent with the overall profit objective of the firm.

I will try to outline a logical, analytical approach to pricing. Do you have something to say about that, Student?

STUDENT: I realize, Writer, that yours is a leading question: obviously, you are expecting me to respond that I suspect that in practice many firms will not behave so rationally and logically when fixing prices.

WRITER: Your suspicion is well founded, Student. But we will describe what firms should do: that is, follow a logical pricing process.

1. The first step should be to determine the pricing objectives: we have already mentioned the basic ones (positioning, sales, market share and profit levels).
2. Once the objectives have been determined, it is necessary to evaluate pricing constraints –such as demand, costs, competition, substitute products, and legal issues.
3. The next step should be to take into consideration the constraints in order to estimate the profit potential of each possible price level.
4. Now it is feasible to set an initial price level, consistent with the overall marketing strategy for the product. And of course, as conditions change, prices should be adjusted. Adjustments can be rather permanent, or can reflect temporary promotions or discounts consisting in a reduction in price for a limited time.

What type of pricing is the one used in this ad from Money Magazine?

WRITER: This is "penetration pricing". A low price is offered to new customers to induce them to try the product and later continue purchasing it at the normal, higher price. In this case, of course, a "present" is included in order to make the offer more appealing.

This is a type of pricing used to capture new customers –as in the case of Money Magazine’s ad- and also used to introduce a new product and quickly reach a critical mass of sales.

In the latter case it is called introductory pricing. Normally profits at these prices are very low, zero, or even negative; obviously the overall strategy here is to get a mass of customers to like the product and later increase prices to a profitable level.

This is an example of introductory pricing:

Named for the skimming of the cream of the milk, this type of pricing is used when a new product is launched at a moment when a considerable number of customers is anxiously waiting for it and wanting to be among the first who have it. Examples are new software products, new video games, the latest CD of a popular artist, etc.

STUDENT: I’d like to add new PC chips as a good example; when Intel introduces a new one, the price is quite high but tends to fall very quickly in order to induce purchases by the second and third tier of customers –the ones not so anxious to get the new product.

WRITER: Good, Student. As the products "matures" prices fall, then stabilize, and eventually the life cycle of many products has an end –especially if, as in the case of computers, they become obsolete relatively soon.

STUDENT: Up to now we have mostly discussed individual products. What is the difference when pricing a whole product line?

WRITER: Good question. Let’s discuss

When pricing a product that is part of a product line, the pricing strategy of the whole line must be taken into consideration.

Relative prices of the different products of the line must reflect their image and the value a customer perceives for them. Let me use a product line consisting of different versions of a car model as example. An automaker may offer a line of several cars of the same basic characteristics, but coming in different versions: more or less powerful engines and various specific items such as leather upholstery, 4 wheel drive, etc. As a general rule, the basic product is proportionally less profitable than the more "loaded" versions.

This is of course a form of market segmentation; different elements of the product line are targeted at different market segments. As said before, the key of product line pricing is keeping relative prices compatible with the value customers assign to the different versions –or sizes, or varieties in some consumer products.

Let’s assume that Unilever markets 12 varieties of Knorr soup in a given market. Soups could be classified as belonging to 3 groups: four are clear soups, four creamy soups, and the other four "gourmet" soups. The company may price all four components of a group at the same price –even if production costs are considerably different. In this case, there would be only 3 price levels, one for each group of soups.

It would also be possible to use "uniform pricing" for an entire mix of products. Unilever might price, say, all varieties of an entire line of Knorr dehydrated broth –chicken, fish, beef, vegetables, etc.- at the same level; again, irrespective of differences in production costs.

STUDENT: And why should the firm accepts a lower profit in some products?

WRITER: Because the consumer is assumed to receive the same perceived benefit from all varieties of broth, and would not be willing to pay more for some than for others..

The basic pricing strategies are the same, but differences in tariffs and currency exchange levels –relative to income- force marketers to price goods accordingly to these differences. Let me give you a single, simple but very illustrative example. One of the books of the highly successful Harry Potter series was launched at the same time in all Spanish speaking markets. All books were printed in Spain –meaning the production costs were the same. However, the book was priced at 43 Euros in Spain and at the equivalent of 12 Euros in Argentina; and consider that in the latter case considerable transportation costs had to be added to the production cost. What do you think is the reason for such a large difference in price for exactly the same product?

STUDENT: The pricing must have been based on the average potential customer’s income level. I assume that –expressed in Euros- this level must have been much lower in Argentina that in Spain at that point in time.

WRITER: Right. The marketers must have calculated –based on estimated income elasticity of this product- that their total revenue would be higher at the lower price.

Now let’s discuss the

Prices are adjusted for many reasons –we have already mentioned pricing over the life cycle of a product, as well as promotions.

Prices are also adjusted by means of discounting –the price paid by the customer is less than the list price. One variation is the cash back practice –common in the automotive market in the USA. The customer pays full list price for the car to the dealer, but gets a given amount in cash back from the manufacturer.

STUDENT: I noticed the term street price; what does it mean?

WRITER: This is the price actually charged by retailers, below the suggested retail price set by the manufacturer.

We can also mention other types of discounts with mostly self-explanatory names: quantity discounts, promotional discounts, seasonal discounts, cash discounts, trade discounts, and loss leaders.

WRITER: A loss leader is a product priced at a level that actually produces a loss when sold. The idea is to attract customers who will then buy other, profitable, products. This practice is commonly used by retailers such as supermarket chains. A supermarket may advertise a few widely consumed products of known brands at a price below its cost; customers are supposed to visit the store to purchase these products and also buy many other, profitable products.

STUDENT: I see. This also may give the public the wrong impression that all products –not only the advertised ones- are low at this store.

WRITER: Sure. This practice is illegal in some countries or states; and manufacturers simply hate it. Why? Because as soon as chain A advertises the producer’s branded product at a price below cost, the rest of the customers will demand a refund or discount, since they will want to set the price at a competitive level but without incurring in a loss. This is why you often will see price leaders advertised without mentioning the brand.

STUDENT: Thanks. And now I realize that I am not completely sure what "trade discounts" are either, Writer.

Let me just mention odd-pricing –such as $9.99 instead of $10-, obviously to lead the customer into perceiving that the price is lower than what it actually is.

And there is also bundle pricing: offering a package with different products at a single price. The components of the package may belong to the same producer, or may be a combination of products from different producers.

WRITER: I see you visited the liquor section of the store, Student! Did you buy any food, too? Anyway, in this case the package takes advantage of the popularity of the drink made by mixing rum and cola, the Cuba Libre. But I am sure you are familiar with this –and other- drinks, aren’t you, Student?

STUDENT: I’ll ignore your sarcasm, Writer. And I admire your command of Spanish, shown by your knowledge of the expression Cuba Libre!

OK, Writer, are we in joking mode because this module is over now?

WRITER: Not yet, Student. And I challenge you to find out yourself what may be missing from our discussion of pricing.

WRITER: Excellent. As you may imagine, marketers try to anticipate how competitors will react to a new pricing strategy. In the absence of collusion, all marketers can do is trying to guess and anticipate how competitors will react, and if necessary adjust their pricing to the competitors’ reaction.

Competitor reactions

Reactions to low prices - Of course the worst type of chain reaction between competitors is a price war, a situation in which all competitors lower prices to the point were all of them lose money.

In some instances a competitor’s reaction to lower prices is to position its products as being of higher quality than the ones sold by the lower price vendors.

Reaction to high prices – We have already mentioned the follow the leader strategy. When a market leader increases prices, other participants in the market may also increase theirs, trying to maintain the same relative position with the leader.

In other cases, some competitors may choose to maintain their prices, hoping to gain some market share as a result of the increase in price difference with the leader.

As for customer reactions, in general –and depending on the product’s demand curve- customers will purchase more in reaction to a fall in prices, and vice-versa.

And now, Student, we have reached the end of this Module. Bye!

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End of Module