MARKETING MATERIAL
In the context of economics this is the most important chapter. In this text its role is (again possibly controversially) more peripheral - since price is seen as being just one of the product attributes. The student objectives are:
1. To understand what the mainstays of traditional economics-based pricing theory are, and what theoretical frameworks underpin these.
2. To understand what shortcomings are inherent in these theories, and the problems these may pose.
3. To understand how these theories may be used in practice without risking these problems.
4. To appreciate the range of factors which may influence prices in practice, and the practical pricing techniques which may be used.
This chapter is, once more, important since price is the most important single product/service attribute; though it is perhaps much less important than all the other attributes put together. Again, though, it is also important for negative reasons. Thus, it encapsulates some important economic principles which have been assumed, by economists (and increasingly by business academics), to be at the heart of any 'market economy'. In practice the theory, whilst interesting, does not relate easily to practice - and this is the point which must be conveyed to the students.
The key objective, again possibly controversially, is to put these assumptions in their true context.
The traditional theory of pricing, that of supply versus demand, is developed from economics. Unfortunately, most of the parameters needed to apply this theory are not normally measurable in practice; and customer needs and market factors tend to dominate the more 'practical' marketing theory.
New product pricing, whether to 'skim' profits or to 'penetrate' the market, is a particular form of pricing, which poses rather different challenges.
Much of the chapter is, however, taken up with a description of the various practical pricing policies adopted; from cost-plus and market-based strategies to selective ones. Discounts are also investigated; as is, in some detail, competitive pricing.
Much of the theory in this chapter comes from economics, which sees price as the pre-emminent factor (often to the exclusion of almost all others). Indeed, although a more pragmatic business management approach would admit to the fact that other elements in the marketing mix may in combination outweigh the significance of price, and may thus belie the economists' claims to its dominance as the all-important marketing factor, by itself it does usually outweigh any other single factor.
As the text spells out, the main reason for this is that it is one of the three 'accounting' variables which determine the level of profit. The simple equation
Profit = Price - Cost
[Acetate 7.02]
says it all (though be careful to note that this equation is for profit per unit, not for total profit, which requires that this equation be multiplied by the number of units sold). What is more, sensitivity analyses for most products show that it can make the greatest contribution to profit. Thus, one of the marketer's prime tasks, after profitably maximizing volume (the factor deliberately missed from the above equation), is to maximize the price.
In many respects, though, this is the reverse of the way that the economists would have us see it; since their preoccupation is with setting price at the level which maximizes profit (where, unlike marketing, there is a set of curves - those of supply and demand - which directly links price to sales levels). In marketing, where other devices (such as creating a brand monopoly) are used to break this link, the aim is to get the price much higher than economists would allow for (just below the level where price becomes so high that it destroys any monopoly).
Much the same principles apply to service prices, with a few changes in emphasis:
NEGOTIATION - because of the variability of the service being offered (and the face-to-face sales situation) there may in theory be more flexibility in pricing - though in practice (apart from some 'commodity' business services) this is not generally seen.
DISCOUNTS - there may well be, though, substantial discounts during off-peak periods (where the 'perishability' of the offering means that these slots are much less saleable).
QUALITY - prices may be set even higher, since customers (with nothing else to judge by) often see the quality of a service as directly relating to its price; and quite sophisticated business customers will choose a consultant who charges $2,000 a day over one who charges $1,000 (because they expect that the former will probably be twice as good). It is easy to try this test on your audience, by offering them two identical tins of baked beans, one branded (albeit, as they are in plain bags, an unknown 'brand leader') and 50% more expensive than an own brand.
This is the aspect of pricing which causes the most problems - justifiably, since non-profit organizations are by definition not so directly interested in the relation between price and cost. Even so, many such organizations still have to price their offering and (despite not making a profit) must get that price right.
There remain, however, many organizations where no money changes hands in the transaction (where, say, they are funded by grant aid from government). In these cases it may be as well to tell the students to ignore the material (except from the point of view of general interest). On the other hand, if they replace the term 'profit' by that of 'perceived value' they may still be able to get something out of the chapter - even if less than their commercial counterparts. Using perceived value as a means of rationing the offering may, indeed, throw new light on how it should be managed.
We now return to the economic theory which is at the traditional heart of this chapter. Demand (the volume which customers demand) is, in economics, assumed to fall as the price rises. This may not always be the case, and a smooth curve may also not be always seen, but the concept is probably applicable in the majority of cases - and it is a good starting point for pricing theory. The resulting theoretical (and simplified) graph of demand against price is shown on acetate 7.03:
[Acetate 7.03]
Here the curve is shown as straight, but more conventionally it is shown curved (since it is normally expected to show some non-linear effect, demand drops off more steeply as the price rises). More important, and more technically, this curve results from choosing a fixed 'price elasticity of demand' - though you probably will not want to explain the mathematics of this!
Much of economics was traditionally taught on the basis of such graphs, and they do seem to make the relationships that much more understandable to students - and hence are a useful aid to marketing as much as economics (and you could explain this idea to students at this point, since the next sections use them extensively).
If, on the other hand, they wish to adopt a mathematical approach (with which modern economists seem obsessed) you should refer them to one of the main student economics texts (such as Lipsey or Samuelson).
The supply curve follows similar principles, though (as might be expected) it slopes the other way (since supply volumes increase as the price increases).
The culmination of these graphical exercises is to superimpose the demand curve over the supply curve:
[Acetate 7.04]
Where the two cross is the equilibrium price; the price at which supply equals demand - and (in economic jargon) the market 'clears'; in other words, at the end of the day no buyers or sellers are left unsatisfied.
THESE GRAPHS ENCAPSULATE WHAT HAVE COME TO BE KNOWN AS THE LAWS OF SUPPLY AND DEMAND. They were developed in the nineteenth century, when most goods were pure commodities (basic essentials) and where price was the only variable to be considered. They may still hold in commodity markets (even though some of these also now tend to be heavily regulated - which is less obvious, but this fact significantly influences some prices, such as those set by OPEC), but elsewhere the position has become much more complex (where the objective of marketers has been to beat such laws - and they have in general succeeded).
The main problem, though, is that few (if any) markets have ever had their demand curves plotted. What seems easy in theory turns out to be impossibly difficult in practice. Too many other factors enter into the equation to separate out accurately the effect of price alone. NICE THEORY, NOT MUCH PRACTICAL USE!
[Acetate 7.05]
This, core economic theory merely states in the form of an equation that some goods are more sensitive (in terms of changes in sales volumes) to price than others. Thus, commodities are very sensitive to price (elastic); if you are a minute amount above the market price you will sell nothing. On the other hand, some goods are very insensitive (inelastic), so brands for which a brand monopoly has been created can justify prices well above the comparable commodity prices
Cross-price elasticity relates to substitute goods, rather than to identical competitors - but the principle is the same.
Even in theory, at least the theory which takes account of some of the behavioural aspects of the pricing process, the picture becomes much more complex.
[Acetate 7.05A]
This complexity is explained in this section of the student text.
So much for the theory, which is interesting but unfortunately gives very few practical leads as to what the price should be; though it does give useful insight. This section, therefore, looks at some of the practical factors which may need to be taken into account
The first practical move is to try to quantify some of the theory.
STATISTICAL ANALYSIS OF HISTORICAL DATA
As we have already seen, this may be applicable in very few cases. There is no justification for even trying to plot the demand curve (no matter how sophisticated the computer regression analyses) in most markets.
EXPERIMENT
This too is applicable in very few cases, though retailers may be able to undertake such experiments (where they are one of the few organizations which can control all the variables). In their case, however, there should be a good justification for undertaking the necessary experiments, since they should be able to plot the curve quite accurately (and hence optimize their price). On the other hand, even here there are problems. The number of goods to be investigated will be large, and the markets will probably change quite rapidly, so the amount of experimental work needed will be large. Anyway, little work has been done in this area - none, as far as I am aware, commercially (though the availability of large volumes of EPOS data may eventually change that).
According to conventional management theory, there are a number of factors which influence price. The first, general group contains those relating to the organisation itself.
[Acetate 7.06]
product life cycle
In theory the price may be set according to the position in the life cycle. Indeed, price competition should not break out until the end of maturity (although real life turns out to be rather different).
In practice the main related decision is that between skimming or penetration in the early stages. These are important pricing decisions.
[Acetate 7.07]
portfolio
Pricing may emerge from the Boston Matrix work - though it is not designed for pricing.
More generally, you may be fortunate enough to have more than one product or service in a market. You may be then able to plan prices across this range, balancing your portfolio, so that each product has a different strategy. This may allow much more adventurous policies to be explored - a high price (or a very low one) - without the threat of losing the whole market. But this luxury is available only to those with the resources to employ it.
product line pricing
In this case prices cannot be set in isolation - since they have an impact on other members of the range. There are two opposing impacts:
[Acetate 7.08]
In the case of interrelated demand price change in one product will affect the performance of another.
Interrelated costs are more complicated. The classic example is an oil refinery where one set of inputs produces a wide variety of outputs - and a reduction in demand for one of these will cause major cost impacts on the others.
segmentation and positioning
This is the classic means for justifying higher prices - and should be the starting point for any pricing exercise. If your positioning is right prices should not need to be cut to the bone. If price competition is vicious the first thing to look at is your positioning.
branding
Another way of avoiding direct price competition is to create a brand monopoly. This is a very effective way of avoiding price wars.
Paradoxically, the evidence is that monopolies tend to set lower prices - perhaps their prime motivation is the perpetuation of the monopoly rather than high price (the reverse of what economists would suggest).
regulation
Quite a number of markets are, though, regulated (or self-regulated, especially in terms of prices).
Another general group of factors relates to the customer.
[Acetate 7.09]
demand
In essence this is the economic demand discussed earlier.
benefits
It is the bundle of benefits (which may be different for each of the competing products) which the consumer sees as justifying the price. The exact bundle of benefits should, therefore, be investigated - to establish the premium that can be justified;
[Acetate 7.10]
This is a useful concept. It concentrates the attention on the two opposing aspects of the price: the basic (commodity) price, which is the same for all products in the market, and the premium, which is justified by the different (detailed) benefits it offers.
customer (perceived) value
The parcel of benefits is conceptualized (in the price context) as the value that the customer sees in the product. This perceived value should then balance against the price being charged. In theory, and in practice (as far as it can be applied), the optimum price should be achieved when it is balanced against the perceived value.
At this point the text introduces the economic concept of utility and indifference curves - this is a specialized topic, however, and requires rather more teaching than this to do it justice (again any of the main economic texts - Samuelson etc. - will cover the topic). It is, though, somewhat esoteric, so should perhaps be avoided!
In the student text the concept of perceived value is explored in terms of its use in the non-profit sector. Thus, it looks at the concept of using the life cycle to judge the perceived value. It also highlights the general concentration on price reduction as an basic aim (not just to increase 'sales'). But, it must be admitted, pricing theory is of limited value here - so you will need to judge your audience carefully if you consider using this.
distribution channel
The point of this section is quite simply that in many situations the producer has no control over price; the intermediaries in fact control this.
MARKET FACTORS
The final group of factors relate to the market in which the brand operates.
[Acetate 7.11]
activity
To consolidate these sections, it is probably best to take some examples of actual pricing (probably in the FMCG markets, because it is then easy to compare prices along the supermarket shelves) and see what factors might apply in each case.
competition
This is a particularly important factor.
activity
It might be a good idea to get the students to discuss some examples of price wars - and of their outcome. The most obvious examples are probably the car manufacturers, but the airlines may also be offered (and are interesting, for their mix of market and regulation - and the dire consequences for those who fail; from Laker to Pan Am).
Severe price competition should be a cue to explore the ways of managing this, to reduce its impact (and to signal your intentions to competitors) as discussed in chapter 4.
environment
Students often ignore the impact of the wider environment on prices. In particular they underestimate the impact of regulation on prices; obvious examples are the state monopolies (including the privatized ones) but the role of the government in discouraging price increases (by legislation or just by heavy persuasion - as it does with the banks and building societies over their interest rates) also tends to be ignored.
This is only normally of relevance in very large markets (such as the US) or export business, where transport costs over long distances may become significant. Prices may be uniform across the whole market (the producer bearing the cost of delivery to remote areas) or FOB (where all transport is charged to the customer) or zone pricing where prices vary by zones (and may be determined by the competitive prices in those zones as much as by transport costs).
This is an especially important aspect of pricing. There is much greater freedom here - there is no history of existing prices which will lead to complaints from customers. On the other hand, there may be no past history on which to base pricing decisions.
EXISTING MARKET
If the new product or service is entering an existing market (which it often is) then price is just one of the variables which have to be decided in positioning the brand - see the earlier chapter. It will, however, be a particularly important aspect of the overall decisions, not just in terms of positioning (though that will be critical in determining whether it is a mass market/cut-price entrant or a high-price quality one), but also in terms of optimizing the profit.
NEW MARKETS
In totally new markets the decision is the one described before (as well as in chapter 8), whether to maximize short term payback by skimming (the traditional approach to new products) or to aim for long-term domination of the market by penetration (the approach now favoured).
[Acetate 7.12]
All that has gone before has been theory. Some of it, the latter part, has been closer to reality than some of the economic approaches - but even so it has not touched on how you set prices in reality. This section does just that.
activity
It might be worthwhile opening this session by asking the students what they expect the main pricing techniques will be. Despite the fact that this is a new topic for them, they should by now be able to predict the outlines of some of the techniques - since they follow patterns which have been established in earlier chapters.
[Acetate 7.13]
These represent the traditional approaches to the problem.
[Acetate 7.13A]
A much more basic decision, but one which is almost universally ignored (not least in textbooks), is that relating to what the pricing environment actually is!
If the market is dominated by (aggressive) commodity pricing then you must focus on gaining a price advantage. Fortunately, since it is very difficult to make a profit in such price competitive markets, only 10% of real-life markets fall into this category.
If, as is usually the case (indeed in 90% of markets), prices are not the major feature of the market, then profit levels will be decided by the price premium you can obtain.
[Acetate 7.13B]
Returning to the traditional approaches;
COST-PLUS PRICING
Whether the theorists like it or not, this is the starting point for most real-life prices. It is, of course, the worst possible approach, since it takes no account of what the customer is willing to pay; and, at its most cynical extreme (in cost-plus contracts awarded by government) it actually offers an incentive for inefficiency (the higher the cost the higher the profit).
[Acetate 7.14]
In any case, what should be the cost is very open to debate - since (as we have seen) overhead allocation (which contributes a major element of cost) is a matter of choice not fact. In practice many prices set on a cost-plus basis probably show a loss (because the cost used does not, despite the fond hopes of those who espouse this approach, reflect all the inputs).
That said, when you have a large number of products to price it is difficult to do anything else.
COMPETITIVE PRICING
This is the one form of practical pricing, but looks only to the competitors (and not directly to the consumers). The need in this case is to understand what motivates competitors' actions (see chapter 13).
The importance of the competitors, in pricing decisions, depends on your own strength. If you are the owner of a commodity you must follow. If you have something approaching a brand monopoly you can largely ignore others.
TARGET PRICING
This is a derivative of cost-plus, but the 'target' is set against ROI - which adds several levels of complexity for no obvious advantage. Dissuade the students from even considering this approach.
HISTORICAL PRICING
This is the other main approach - to take today's prices and add a percentage (often an arbitrary one, or one related to the rise in the cost of living - rather the correct index for the product). Again, it is easy to implement - but there is no obvious link to any marketing variables.
RANGE PRICING
This simply reflects the fact that may products will be part of ranges and the overall pricing for the range will determine the price of the individual item.
Price lining is a related approach used in retailing.
MARKET-BASED PRICING
This is classically how you should price products or services - what the customer is willing to pay. Needless to say it is not that easy; it is remarkably difficult to find out what they might be willing to pay - except where the prices are very obvious and have a long history (the five-cent candy bar etc.), which is 'customary pricing'.
Within this area, though, there is at least one obvious decision to be taken:
[Acetate 7.15]
QUALITY or CUT-PRICE.
SELECTIVE PRICING
[Acetate 7.16]
CATEGORY PRICING
In this case the supplier provides much the same product to the market at a range of prices (under different brand names) to meet different price categories.
CUSTOMER GROUP PRICING
In this case the price is directly related to the category of customer. It is more prevalent in the service sector - where cheap prices for the less well off (OAPs, students, unwaged etc.) are common; though this is not just charity since they help to cover the overheads whilst not setting a price-cutting precedent.
PEAK PRICING
Another example from the service sector, where off-peak price reductions also help to achieve throughput, which spreads the overheads.
SERVICE LEVEL PRICING
In this case the different categories are clearly separated by the level of service associated with them.
A wide range of types of discounts is possible, most of which are largely self-explanatory (and are explained in the student text).
[Acetate 7.17]
CASH DISCOUNTS
These may seem to be straight-forward, usually being given to improve cash flow (rather than competitiveness) - but they can have major problems in business to business trading (where they are taken, but then so also is the credit)
ALLOWANCES
Trade-ins are the usual form - to persuade consumers to buy a replacement.
OPTIONAL FEATURES
Here a very basic product is discounted, but then (optional) features are added which the customer is likely to buy at standard prices - and which recoup some of the lost profit.
PRODUCT BUNDLING
This is the reverse: extra product (in the form of features) is offered for a reduced price (or even free) - which may be much cheaper for the vendor to provide and still be very attractive to the consumer.
PSYCHOLOGICAL PRICING
Here very high prices are set against which to discount. This poses severe credibility problems when the customer finds out, and may well be illegal in some countries.
activity
This is perhaps best taught be getting students to relate their own successes in such negotiations; and drawing out the main points. In any case, as with much of the selling process in general it is very much a skill which is specific to the individual.
[Acetate 7.18]
The classic justification for a price reduction is to increase sales significantly, ideally to the level where economies of scale reduce the unit cost to offset the price reduction. THE KEY IS TO ENSURE THAT GENUINE ECONOMIES OF SCALE REALLY CAN BE ACHIEVED - AT THE VOLUMES LIKELY TO RESULT FROM THE PRICE REDUCTION.
OTHER STIMULI
[Acetate 7.19]
MARKET LEADERSHIP TARGETING
In a market which is not yet dominated by one brand (or is led by one which is under-resourced), there may be a good, positive, justification for making the investment necessary to win the brand leadership - and a price reduction may be an important part of the overall strategy. This is probably the only worthwhile justification for price reductions - but even then it is an option which is rarely available (and the investment level may be high; and will be even higher, affordable only by the Japanese who seem to specialize in this approach, if there is already a strong brand leader).
EXCESS CAPACITY
This is probably the most dangerous move of all, and is almost never justified. It almost always happens when everyone in the market has excess capacity - so any move is likely to start a disastrous price war!
FALLING BRAND SHARE
Much the same comments apply here, though the market may be more buoyant - but any attempt to buy share may prompt defensive responses from everyone else.
The dangers resulting from a price war include:
[Acetate 7.20]
LOW QUALITY IMAGE
The worst thing that can happen to a quality product is to become involved in a price war - for that is surely all the consumer will see (to the complete destruction of any quality image).
TEMPORARY ADVANTAGE
In any case, any increase in sales will last only as long as the price advantage is maintained - not usually for very long.
INVESTMENT POTENTIAL
The best advice on entering into any price war is to find out who can afford to stay until the bitter end. The one with the deepest pockets is bound to win - unless you can succeed in a very risky bluff - so if that isn't you then watch out!
MINOR BRANDS
The one exception to all the above comments is those, many, small brands which have no advantage to offer other than price (usually by reducing any profit to the point of invisibility). They can, though, compete on price per unit where they cannot in terms of media spend etc.
[Acetate 7.21]
REDUCE PRICE
The traditional response has been also to reduce price - in which case you should do it immediately and obviously (so your competitors recognize that you will match them - which may discourage another such move in the future).
MAINTAIN PRICE
You could also do nothing, in the hope that it was a temporary aberration by the competitor - but this holds some risk, since it may undermine confidence (not least of retailers) in the brand's position.
REACT WITH OTHER MEASURES
On the other hand, it would be possible to take the offensive by spending on advertising, say, and thus undermine any competitive gains (and also gain the 'quality' high ground).
SPLIT THE MARKET
A particularly effective response is to split your response, moving the main brand up-market (using advertising to reinforce its image, say), and also launch a 'fighting brand' (unconnected with the main brand) which undercuts the competitor.
Best of all, avoid price cutting.
The 'Prisoner's Dilemma' is a very useful analogy - and is well worth exploring with the students; getting them to explain to you what is happening.
The significant difference in real life is that the participants are not held incommunicado - so they can exchange signals. As the students will appreciate, this should allow them to select the optimal strategy; if they only communicate (which they often do not, and hence lose out).
activity
You might also ask them to suggest what is the best answer if there are no signals.
One of the best answers was developed by Robert Axelrod[1], who described it as 'Tit for Tat'. The strategy requires you to cooperate on the first move and then to do what your opponent did in the previous round. He describes it as a 'nice' strategy, that is one which is never first to defect. But it handles defectors well: it is caught out only once and then defects itself, but it is clear what is happening and it is forgiving. This means defectors gain little and have every incentive to behave better, where it gains significantly if the others also pursue a nice strategy.
[Acetate 7.22]
It was developed as a computer program and won both rounds of a major competition between theorists in the field.
John Winkler's very practical suggestions[2] encapsulate a positive approach to this subject, which many theorist ignore and as many managers duck:
[Acetate 7.23]
activity
If you use computer games to teach marketing, as we sometimes do, it is usually easy to get across the competitive strategy messages (not least that there is more to gain from cooperation) by this medium. If you don't use these, then the best approach is not an exercise (which often proves to be very artificial) but another debate; which usually is quite boisterous, because this is one subject students think they know and like arguing about!
[1] Axelrod, Robert (1990) The Evolution of Cooperation, Penguin Books
[2] Winkler, John (1987) Pricing - in The Marketing Book ed Baker, Michael J - Heineman
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