Pricing

1. Professor Joel Huber BA 360 Marketing Management Fuqua School of Business Introduction Three C’s Four P’s Product Placement Promotion Price Summary Pricing

2. Agenda • Introduction • Common pricing approaches • 8 Steps to better pricing

3. Pricing is the Firm’s Endeavor to Capture the Value of its Offerings • Product strategy creates value for the customer • Promotion strategy communicates and enhances value of offerings to the customer • Distribution policy delivers value to the customer—convenience, assistance, assortment • Pricing strategy is the only one of the 4P’s devoted to capturing value for the firm!

4. Comparison of Profit Levers 1% improvement in ... … creates operating profit improvement of Source: McKinsey & Co., based on average economics of 2,463 companies

5. Common Pricing Approaches • Cost-plus • P = (FC+Target Profit)/Q + VC • The problem: Unit sales, Q, are typically a function of price, P • Sales force -driven • The sales force can set the best price • The problem: (1) Sales is motivated by volume; not profitability (2) Customers can learn to extract lower prices from salespeople • Competition-driven • Price lower than competition to yield high sales • The problem: Price (in long-run) should be lower than competition only if value of offering is less than that of competition

6. 8 Steps to a Better Pricing Decision 1. Assess what value your customers place on the product or service 2. Implies a price sensitivity - and aggregate optimal price 3. Look for variation in the way customers value the product 4. Analyze whether segments are worth the cost to serve 5. Consider competitors and their reactions 6. Put it all together and set the price 7. Assess customers’ psychological response 8. Monitor prices realized at transaction level

7. 1. Assess Value Customers Place on the Product or Service • Methods to estimate customer value • Economic “Value-In-Use” analysis • Market research • Employees with direct customer contact

8. 2. Assess Customers’ Price Sensitivities • Heterogeneity in Econ.Value leads to a demand curve • Methods to assess price sensitivity • Expert Judgement • Customer Surveys • Price Experiments • Analysis of Historical Market Data • Useful measurement tool: Price Elasticity of Demand ( ) • = % change in Quantity/% change in Price • = [(Q1-Q2)/Q1] / [(P1-P2)/P1] • Own- and cross- elasticities

9. Empirical Estimates of Price Elasticities

10. Using Elasticities to Set Price • Profit = (P-C)*Q(P) - FC • Q(P) comes from elasticities • Find optimal profits • Graph profit function • Use calculus (set d(Profit)/dP = 0) and solve

11. Using Elasticities to Set Price Volume (million units) Profit Index 12 11 Sales Volume Profit 120 10 9 110 8 100 7 6 Price DM 0.60 0.63 0.65 0.68 0.70 0.73

12. 3. Variation in price/quality sensitivity

13. An example 25 Customer 1 20 Customer 2 Customer 3 Reservation Price 15 Customer 4 Customer 5 10 5 • You are a monopolist; your unit cost is $9; you can charge each customer a different price. • What price should you charge Customer 1? Customer 2? etc. • What will be your total contribution? • How many customers will you serve?

14. Example • Since you can charge each customer a different price … • You serve every customer, and everyone is better off than they are without you • This is an example of perfect price discrimination Total Customer Price Contribution Contribution 1 20.00 10.99 10.99 2 17.50 8.49 19.48 3 15.00 5.99 25.47 4 12.50 3.49 28.96 5 10.00 0.99 29.95

15. Variable Pricing Requires • Multiple segments--reachable • Inability to resell • Revenues of segments > costs • Minimal resentment from differential pricing • Must be legal

16. Resellers may be hard to block

17. Watch out for consumer reactions: Reaction to Amazon.com’s differential pricing • I work over 80 hours a week. As a small business owner, I may make good money, but does that mean I should be charged more than unmotivated individuals who are broke because they don't want to work more than 30 hours a week? I don't think so.

18. Base price variations on customers’ different product valuation • Time based pricing • Skimming v. penetration • Benefit pricing • Airline fares: Business versus Leisure (Yield Management) • Payment options • Magazines: Single issue versus Subscriptions • Usage • Heavy users versus Light users • Different applications • Computer (Business versus Home buyers) • Above strategies work if EVC varies across customers

19. 4. Are returns worth cost to serve? • Create a customer grid where each customer is plotted at the intersection of the revenue she or he generates and the company’s cost to serve that customer • Need to manage customers for profits, not just sales • Avoid “Strategic Accounts” or make them strategic! Equity Axis High Price Received STRATEGIC ACCOUNTS Low High Low Cost to Serve

20. 5. Consider Competitors’ Reactions • Simple competitive reactions • Multiple competitive reactions • AA Value Pricing: AA cut prices; SouthWest responded by advertising: “We’d like to match their new fares, but we’d have to raise ours” • Game theoretic analyses (recall competition lecture) • Nash game: d(Profit)/dp1 = 0 , …, d(Profit)/dpn = 0 • where n is number of firms • implies no firm has a unilateral incentive to deviate in price

21. 6. Identify an Optimal Pricing Structure

22. 6. Identify an Optimal Pricing Structure • Objective: How should these movies be priced?

23. 7. Assess Customers’ Psychological Response • Manage price perceptions • Reference price • Odd pricing • Price- perceived quality relationship • Issues of fairness • Market research required to assess customer reaction in terms of quality, fairness and purchase intention

24. Reference Prices • Reference price is systematically affected by • Framing effects • low priced good next to high priced good • “regular” price next to “sale” price (“was $999, now $799”) • Order effects • Primacy i.e., reference prices influenced by what is seen first, have prices been raising or falling?

25. Even-Odd Pricing • For which pair of prices is the lower price more of a bargain? • First pair: $0.89 $0.74 • Second pair: $0.93 $0.78 • Effect of advertised odd-price endings on sales of margarine: Parkay brand: Price/lb ($) Unit sales Regular price: 0.83 2817 Discount price 0.62 8283 (+ 194%) Odd discount price 0.59 14,567 (+406%)

26. 8. Monitor Prices Realized at Transaction Level • A product may have only 1 list price, but can have several final prices • Returns, damage claims, special incentives drive revenue • Unfortunately, most companies spend 90% of their effort in setting list prices • Need to devote more care and attention to • quality and logistics (manage returns / damage) • account analysis (where are revenues actually coming from?)

27. Price: Take Aways • Price is the only component of the marketing mix that brings in revenue. It has a significant impact on profitability. • Key requirements of pricing policy • It must be viewed strategically • It should be derived from common, company-wide objectives • 8 steps to pricing are useful because they incorporate: • Customer factors • Company factors • Competition factors