Session 9: Pricing Policies and Practices

1. Session 9: Pricing Policies and Practices

2. Pricing denotes revenue to seller • Perceived Value to buyer • Pricing strategy Important for new product, modified product,, new market, new market segment, objective of firm • Basic determinants are supply and demand

3. PRICING PRACTICES General Considerations To Be Kept In Mind While Formulating A Pricing Policy: • Objectives of business- Notwithout considering its impact on all objectives • Market structure • Competitor’s strategy • Price Sensitivity/ elasticity(even for monopolist) • Conflicting Interests of Manufacturers and Middlemen, consumers

4. General Considerations • Routinisation of Pricing- Speed required in decision-making, quality of data available, competitive market • Role of Non Business Groups into pricing Decisions- Government, political considerations , farmers and business lobbies, Trade Unions etc

5. Cost Based Pricing • Cost Plus or Mark Up • Marginal Cost pricing • Target Return pricing

6. Cost Based Pricing i. Cost Plus / Full Cost/ Mark-up Pricing Price set to cover cost (inputs such as labour and raw materials and overheads) plus a percentage for predetermined profits. P= AVC+ AVC (m) Where, m =mark-up percentage, and AVC (m)= Gross Profit Margin

7. Cost Based Pricing • Most common • Easy to fix the price • More defensible on moral grounds But -Historical cost rather than current cost data is used, which may lead to over/under pricing -Inappropriate if variable cost fluctuates frequently -Some critics say it ignores demand side (But firm determines mark up on the basis of ‘what the market can bear’ • Ignores marginal cost as it uses average cost

8. Cost Based Pricing ii. Marginal Cost Pricing Only those costs which are directly attributable to the output of a specified product Logic: • All past outlays are historical and a firm should deal solely with anticipated revenuesand outlays • Firm is more interested in future changes in cost due to changing decisions

9. Cost Based Pricing • MCs are controllable in the short run unlike fixed costs • Total costs can not be of use in case of multi- product/ markets/ process situations But Major weakness is omission of fixed costs Therefore this method is restricted to pricing of specific orders

10. Cost Based Pricing • Iii) Target return Pricing • Producer rationally decides he minimum rate of return which must be earned by the product • Methodology similar to the above, but margin is decided on the basis of target rate of return, on the basis of experience, consumer’s paying capacity, risk involved etc

11. Pricing Based on Firm’s objective -Profit Maximisation- considers total cost -Sales Maximisation- should adopt competitive pricing, say marginal pricing

12. Competition Based Pricing i. Penetration Pricing : Low price when entering new market dominated by existing players (Nirma, Deccan Air) ii. Entry Deterring- Price kept low to make market unattractive for competitors (Common in oligopoly)

13. Competition Based Pricing iii. Going Rate Price: Why? Firms do not want price wars Small/ new firms may not be sure of being able to shift the demand by charging a different price Products are close substitutes with high cross elasticity

14. Competition Based Pricing • Popular in monopolistic and oligopoly markets because a)of low product differentiation b) for consumer the cost of switching is minimal • Uniform price of packaged water or fruit juice

15. 3.PRICE DISCRIMINATION First degree Price Discrimination • Each unit of output • is sold at a different price • or each consumer is charged • a different price . • Entire consumer’s surplus wiped out Price Quantity

16. Second Degree Price Discrimination Seller gets part of consumer’s surplus. Highest price of OP1 for OQ1 units. Price is OP2 for Q1Q2 units Lowest price of OP3 for the next Q2Q3 units. Monopolist maximises revenue at TR= (OQ1*AQ1)+ (Q1Q2*BQ2)+ (Q2Q3*CQ3) D A P1 P2 B Price C P3 D O Q1 Q2 Q3 Demand

17. Third Degree Price Discrimination MC B Cost & Revenue A T AR=D Da Db MRa MR MRb o Qb O Q O Qa Quantity Demanded

18. Third Degree Price Discrimination • Monopolist has 2 markets, A and B. • For market A, Da is the average revenue (demand) curve and MRa is the marginal revenue curve. • For market B, Db is the average revenue (demand) curve and MRb is the marginal revenue curve. • Horizontal summation of the two markets give the aggregate AR=D and MR curves for the monopolist.

19. Third Degree Price Discrimination • Firm’s MC intersects MR curve at T. • Drawing a perpendicular from T we get the optimum level of the firm’s aggregate output at OQ. • At this level of output, MR=MC.

20. OQ is divided between the two markets in such a way that the profit maximisation condition (i-e., MC (=TQ ) is equal to MR) is satisfied in both the markets. • This is achieved by drawing a line from point T parallel to X axis , through MRa and MRb. • Optimum share for market A is OQa (at price AQa) and for market B the share is OQb (at price BQb).

21. Product Life Cycle Pricing Sales revenue Curve 1.Introduction 2.Growth 3.Maturity 4.Saturation 5. Decline 5 2 3 4 1

22. Product Life Cycle Pricing • New Product: Skimming Skimming Policy: Charging very high initial price and super normal profits-Lower price during maturity • The first ball pens introduced in 1945 cost 80 cents to produce but were priced at $12.50. • Initial high prices of computers • 1st day movie tickets • First degree price discrimination

23. Product Life Cycle Pricing Why? • Demand is likely to be less price-elastic in initial stages • If life ofproduct is likely to be short, the producer can get as much as possible as fast as possible • The policy can lead to introduction of product for lower segments later. • High initial price may finance the heavy initial costs of introducing a new product when other sources of finance may not be available

24. Product Life Cycle Pricing Benefits of lower cost due to growing volumes and technological development allows for lowering of prices at a later stage.

25. Product Life Cycle Pricing ii. Low Penetration Price: Close to customary price- only minor adjustments required eventually. • Objective of low penetration pricing is to keep off competition Appropriate where: • Sales respond strongly to lower prices • High volumes lead to lower costs • Product acceptable for mass consumption • To capture a large share of market quickly where there is a threat ofpotential competition

26. Product Life Cycle Pricing High Skimming price Low penetration Price

27. Product Life Cycle Pricing ii) Rapid Growth- Stable price policy for sustained growth iii) Maturity: Growth occurs at diminishing rate- firm may introduce minor quality changes with higher prices iv) Saturation- Lower prices and discounts to clear stocks v) Decline- Wind up

28. Product Life Cycle Pricing iii. Product Bundling- Two or more products bundled together for a single price • Strategy for both new and mature product • Iv. Perceived Value pricing: Psychological pricing- value differs between consumers • V. Value pricing: variant of iv. Try to create high value and charge a low price Koutons Men’s Wear

29. Product Life Cycle Pricing • Vi. Loss Leader Pricing: Here, multi product firms sell one product at a low price and compensate the loss by another product (HP printers and cartridges)

30. CYCLICAL PRICING • Rigid or flexible?

31. MULTIPRODUCT PRICING • Demand Interdependence • Supply Interdependence • Input- output Relationship • Ramsay Pricing • Transfer Pricing

33. 5. Peak Load Pricing 5. Peak Load Pricing • Higher price at peak level of use and lower at slack time Examples- Electricity, telephone charges, air fares

34. 6. Administered Price 6. Administered Price- - Fixed by authorities - Specific social objectives- social justice, correcting imbalances, price stability -Conflict between ‘public utility approach’ and ‘rate of return’ approach

35. Guidelines for Price Fixing Bates and Parkinson’s Guidelines for Price Fixing: • Find out how your costscompare with your competitors’. • Keep an eye on the market-if orders are difficult to come by, drop prices; if easy, raise. • Goodwill of customers is probably gained more through advertising than keeping price low

36. If you can sell all your output at prices that give you substantial profit, consider expanding production. • If you find that your sales vary over seasons, adjust prices • If your prices seem to be higher than those of your competitors although they scarcely cover costs, you may need to take a re-look at your production methods and organisational process

37. If you are one of very few producers in the industry, what your competitors are likely to do may be a more important consideration in fixing prices rather than your costs. • If you are a monopolist and follow a pricing policy that is seen as being against public interest, beware of government action and potential competition…

39. Capital Budgeting Process of conceiving, analysing, evaluating, and selecting the most profitable project for investment. Significant because i) capital expenditure is generally irreversible ii) survival of firm depends on how well planned the capital expenditure is.

40. Prerequisites/Steps in Capital Budgeting • Defining Capital Expenditure Expenditure on acquiring assets which yield returns over a number of years -Only long term expenditure involving a commitment of at least one year is taken into consideration.

41. Defining Capital Expenditure Examples: • Expenditure on new capital equipment • Expenditure on long term assets by a new firm • Expenditure on expansion or diversification of assets and addition to stock by old firms • Expenditure on replacement of depreciated capital • Expenditure on R&D and innovation

42. Deciding the Project Period 2. Deciding the Project Period Determining the span of the project A clear vision is required for- • Effective planning, execution and control; • For possible dovetailing of old plan with the new • Assessment of economies of scale and determination of plant size • Timely arranging of finances

43. Appraisal Criteria 3. Choice of Decision Rules/ Appraisal Criteria -Criteria for accepting or rejecting a project The first step is to clearly define the objective of investment. Objective may be profit maximization, asset building, regular cash flow or maximization of short term or long term gains etc. Normally, criteria for accepting or rejecting is chosen on the basis of the objective of the firm. .

44. Appraisal Criteria The second step is to select the criterionfor evaluatingthe projects. The important criteria for evaluation are: i) Pay back period ii) Discounted cash flow (Present value criterion) iii) IRR.

45. Choice of Decision Rules Once the evaluation criterion is decided, the third step is to decide on the final selection of the projects. There are 2 approaches for this - a) Accept-reject approach b) Ranking approach

46. Data 4. Relevant, Reliable and Adequate Data on- • Alternative avenues of investment • Cost of the projects • Expected returns from the projects, • Period of maturity and productive life of each project • Market rate of interest • Availability of internal and external finances

47. i)Pay-back or pay-out method Pay-back Period : Time required to recover the total investment outlay from the cumulative net revenue. In this period cumulative net revenue equals original investment. Projects are ranked in increasing order of their pay-back period. All other things being equal, a project with a shorter pay-off period is preferred.

48. Pay-back or pay-out method Pay- back Period = Total Investment Outlay/Return per period If a project costs Rs. 40,000 and is expected to yield an annual income of Rs. 8000, then, Pay-off period = 40,000/ 8,000 = 5 years

49. Pay-back or pay-out method • In case inflows are not uniform, it is calculated by taking cumulative total of annual returns until the total equals the investment outlay. • Simple and realistic method • Crude ‘rule of thumb’ method • But assumes that cash inflows are known with a high degree of certainty • Neglects the profits over the whole life of the investment and after the pay off period.

50. ii) NPV Criterion Time lag between investment and its returns -Time Value of Money: A Rupee received today is worth more than a Rupee received tomorrow , or present value of an income expected at a future date is lower than the same amount received today.