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Chapter 11 - Pricing Strategy
Chapter 11
Pricing Strategy
High-Level Chapter Outline
I. Demand Influences on Pricing Decisions
A. Demographic Factors
B. Psychological Factors
C. Price Elasticity
II. Supply Influences on Pricing Decisions
A. Pricing Objectives
B. Cost Considerations in Pricing
C. Product Considerations in Pricing
Perishability
Distinctiveness
Life Cycle
III. Environmental Influences on Pricing Decisions
A. The Internet
B. Competition
C. Government Regulations
IV. General Pricing Model
A. Set Pricing Objectives
B. Evaluate Product-Price Relationships
C. Estimate Costs and Other Price Limitations
D. Analyze Profit Potential
E. Set Initial Price Structure
F. Change Price as Needed
Detailed Chapter Outline
I. Demand Influences on Pricing Decisions
Demand influences on pricing decisions concern primarily the nature of the target market and
expected reactions of consumers to a given price or change in price.
There are three primary considerations here—demographic factors, psychological factors, and
price elasticity.
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Chapter 11 - Pricing Strategy
A. Demographic Factors
Demographic factors that are particularly important for pricing decisions include the
following:
oNumber of potential buyers
oLocation of potential buyers
oPosition of potential buyers (organizational buyers or final consumers)
oExpected consumption rates of potential buyers
oEconomic strength of potential buyers
These factors help determine market potential and are useful for estimating expected sales at
various price levels.
B. Psychological Factors
Psychological factors related to pricing concern primarily how consumers will perceive
various price or price changes.
While psychological factors have a significant effect on the success of a pricing strategy and
ultimately on marketing strategy, they may require considerable marketing research.
There are three types of psychological pricing strategy:
oPrestige pricing
oOdd pricing
oBundle pricing
C. Price Elasticity
Both demographic and psychological factors affect price elasticity.
Price elasticity is a measure of consumers’ price sensitivity, which is estimated by dividing
relative changes in the quantity sold by the relative changes in price:
Two basic methods are commonly used to estimate price elasticity:
oPrice elasticity can be estimated from historical data or from price/quantity data across
different sales districts.
oPrice elasticity can be estimated by sampling a group of consumers from the target
market and polling them concerning various price/quantity relationships.
Both of these approaches provide estimates of price elasticity; but the former approach is
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Chapter 11 - Pricing Strategy
limited to the consideration of price changes, whereas the latter is often expensive and there is
some question as to the validity of subjects’ responses.
II. Supply Influences on Pricing Decisions
Supply influences on pricing decisions can be discussed in terms of three basic factors. These
factors relate to the objectives, costs, and nature of the product.
A. Pricing Objectives
Pricing objectives should be derived from overall marketing objectives, which in turn should
be derived from corporate objectives.
Since it is traditionally assumed that business firms operate to maximize profits in the long
run, it is often thought that the basic pricing objective is solely concerned with long-run
profits.
However, the profit maximization norm does not provide the operating marketing manager
with a single, unequivocal guideline for selecting prices.
Research has found that the most common pricing objectives are:
oPricing to achieve a target return on investment
oStabilization of price and margin
oPricing to achieve a target market share
oPricing to meet or prevent competition
B. Cost Consideration in Pricing
The price of a product usually must cover costs of production, promotion, and distribution.
Cost-oriented pricing is the most common approach in practice, and there are at least three
basic variations: markup pricing, cost-plus pricing, and rate-of-return pricing.
Markup pricing is commonly used in retailing: A percentage is added to the retailer’s invoice
price to determine the final selling price.
Closely related to markup pricing is cost-plus pricing, in which the costs of producing a
product or completing a project are totaled and a profit amount or percentage is added on.
Rate-of-return pricing is commonly used by manufacturers. With this method, price is
determined by adding a desired rate of return on investment to total costs.
Cost-oriented approaches to pricing have the advantage of simplicity, and many practitioners
believe that they generally yield a good price decision. However, such approaches have been
criticized for two basic reasons.
oThey give little or no consideration to demand factors.
oThey fail to reflect competition adequately.
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Chapter 11 - Pricing Strategy
C. Product Consideration in Pricing
Although numerous product characteristics can affect pricing, three of the most important are:
oPerishability
oDistinctiveness
oStage in the product life cycle
Perishability
Some products are physically perishable and must be priced to sell before they spoil.
Typically, this involves discounting the products as they approach being no longer fit for
sale.
Products can also be perishable in the sense that demand for them is confined to a specific
time period.
Distinctiveness
Marketers try to distinguish their products from those of competitors and if successful,
can often charge higher prices for them.
While such things as styling, features, ingredients, and service can be used to try to make
a product distinctive, competitors can copy such physical changes.
Thus, it is through branding and brand equity that products are commonly made
distinctive in customers’ minds.
Life Cycle
The stage of the life cycle that the product is in can have important pricing implications.
With regard to the life cycle, two approaches to pricing are skimming and penetration
price policies.
oA skimming policy is one in which the seller charges a relatively high price on a new
product.
oA penetration policy is one in which the seller charges a relatively low price on a
new product.
III. Environmental Influences on Pricing Decisions
Environmental influences on pricing include variables that the marketing manager cannot control.
Two of the most important of these are competition and government regulation.
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Chapter 11 - Pricing Strategy
A. The Internet
One of the biggest influences on pricing decisions has been the development of the Internet.
Prior to its development, it was difficult for consumers to compare prices effectively.
Consumers would have to travel from store to store or call each store and try to find identical
brands and models to compare prices.
However, consumers now can simply go from store to store online and compare prices, or go
to websites that do price comparisons for them and find the best deals (e.g., kayak.com and
expedia.com).
In sum, the Internet has made prices much easier for consumers and organizational buyers to
compare and has forced marketers to be much more transparent in their pricing strategies.
B. Competition
In setting or changing prices, the firm must consider its competition and how competition will
react to the price of the product. Initially consideration must be given to such factors as:
oNumber of competitors
oMarket shares, growth, and profitability of competitors
oStrengths and weaknesses of competitors
oLikely entry of new firms into the industry
oDegree of vertical integration of competitors
oNumber of products sold by competitors
oCost structure of competitors
oHistorical reaction of competitors to price changes
These factors help determine whether the firm’s selling price should be at, below, or above
competition.
Pricing a product at competition is called going-rate pricing and is popular for homogeneous
products, since this approach represents the collective wisdom of the industry and is not
disruptive of industry harmony.
An example of pricing below competition can be found in sealed-bid pricing, in which the
firm is bidding directly against competition for project contracts.
A firm may price above competition because it has a superior product or because the firm is
the price leader in the industry.
C. Government Regulations
Prices of certain goods and services are regulated by state and federal governments. Public
utilities are examples of state regulation of prices.
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Chapter 11 - Pricing Strategy
The list below is a summary of some of the more important legal constraints on pricing.
oPrice fixing—is illegal per se. Sellers must not make any agreements with competitors
or distributors concerning the final price of goods. The Sherman Antitrust Act is the
primary device used to outlaw horizontal price fixing. Section 5 of the Federal Trade
Commission Act has been used to outlaw price fixing as an unfair business practice.
oDeceptive pricing—practices are outlawed under section 5 of the federal trade
commission law. An example of deceptive pricing would be to mark merchandise with
an exceptionally high price and then claim that the lower selling price actually used
represents a legitimate price reduction.
oPrice discrimination—(the practice of charging different prices to different buyers for
goods of like grade and quality) is outlawed by the Robinson-Patman Act.
oPredatory pricing—involves charging a very low price for a product with the intent of
driving competitors out of business. It is illegal under the Sherman Act and Federal
Trade Commission Act.
IV. A General Pricing Model
It should be clear that effective pricing decision involves consideration of many factors, and
different industries may have different pricing practices.
Figure 11.1 presents a general model for developing prices for products and services.
A. Set Pricing Objectives
Given a product or service designed for a specific target market, the pricing process begins
with a clear statement of the pricing objectives.
These objectives guide the pricing strategy and should be designed to support the overall
marketing strategy.
B. Evaluate Product-Price Relationship
As noted, the distinctiveness, perishability, and stage of the life cycle a product is in all affect
pricing.
Marketers also need to consider what value the product has for customers and how price will
influence product positioning. There are three basic value positions.
oA product could be priced relatively high for a product class because it offers value in
the form of high quality, special features, or prestige.
oA product could be priced at about average for the product class because it offers value
in the form of good quality for a reasonable price.
oA product could be priced relatively low for a product class because it offers value in the
form of acceptable quality at a low price.
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Chapter 11 - Pricing Strategy
Setting prices so that targeted customers will perceive products to offer greater value than
competitive offerings is called value pricing.
C. Estimate Costs and Other Price Limitations
The costs to produce and market products provide a lower bound for pricing decision and a
baseline from which to compute profit potential.
If a product cannot be produced and marketed at a price to cover its costs and provide
reasonable profits in the long run, then it should not be produced in its designed form. One
possibility is to design the product so that its costs are lower.
Other price limitations that need to be considered are government regulations and the prices
that competitors charge for similar and substitute products.
D. Analyze Profit Potential
Analysis in the preceding stages should result in a range of prices that could be charged.
Marketers must then estimate the likely profit in pricing at levels in this range.
At this stage, it is important to recognize that it may be necessary to offer channel members
quantity discounts, promotional allowances, and slotting allowances to encourage them to
actively market the product.
Quantity discounts are discounts for purchasing a large number of units.
Promotional allowances are often in the form of price reductions in exchange for the channel
member performing various promotional activities.
Slotting allowances are payments to retailers to get them to stock items on their shelves.
E. Set Initial Price Structure
The price structure takes into account the price to various channel members such as
wholesalers and retailers, as well as the recommended price to final consumers or
organizational buyers.
F. Change Price as Needed
There are many reasons why an initial price structure may need to be changed. Channel
members may bargain for greater margins, competitors may lower their prices, or costs may
increase with inflation.
In the short term, discounts and allowances may have to be larger or more frequent than
planned to get greater marketing effort to increase demand to profitable levels.
In the long term, price structures tend to increase for most products as production and
marketing costs increase.
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Chapter 11 - Pricing Strategy
KEY TERMS
Bundle pricing: A form of psychological pricing that involves selling several products together at a
single price in order to suggest a good value.
Cost-plus pricing: A cost-oriented pricing approach that involves totaling up the costs of producing a
product or completing a project and then adding on a percentage or fixed profit amount. This approach is
used when costs are difficult to estimate in advance such as military weapon development.
Deceptive pricing: Illegal under the Federal Trade Commission Act, an approach that involves price
deals that mislead the consumer. For example, putting a fake price on a product much higher than the
product sells for in the market, crossing it out, and then offering the product at the market price and
claiming a price reduction could easily mislead consumers.
Going-rate pricing: Pricing a product at the average charged in the industry.
Markup pricing: A cost-oriented pricing approach that involves adding a percentage to the invoice
price in order to determine the final selling price. For example, if a retailer used a 50 percent markup on
a product that was bought from a wholesaler for $1, the selling price to the consumer would be $1.50.
Odd pricing: Also called odd-even pricing, a form of psychological pricing in which the prices are set
at one or a few cents or dollars below a round number in order to create the perception that the price is
low, for example, 99 cents or $129 rather than $1 or $130.
Penetration pricing policy: Approach to pricing in which the seller charges a relatively low price on a
new product initially in order to grow a market, gain market share, and discourage competition from
entering the market.
Prestige pricing: A form of psychological pricing that involves charging a high price to create a signal
that the product is exceptionally fine.
Predatory pricing: Practice that involves charging a very low price for a product with the intent of
driving competitors out of business. It is illegal under the Sherman Act and Federal Trade Commission
Act.
Price discrimination: The practice of charging different prices to different buyers for goods of like
grade and quality which is illegal under the Robinson-Patman Act if it lessens or is deemed injurious to
competition.
Price elasticity: A measure of consumers’ price sensitivity which is estimated by dividing relative
changes in the quantity sold by the relative changes in price. If demand is elastic, a slight lowering of
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Chapter 11 - Pricing Strategy
price will result in a relatively large increase in quantity demanded.
Price fixing: An unfair business practice outlawed by the Sherman Antitrust Act and the Federal Trade
Commission Act that involves competitors in a market colluding to set the final price of a product.
Promotional allowances: Price reduction offered to channel members in exchange for performing
various promotional activities such as featuring the product in store advertising or on in-store displays.
Quantity discounts: Discounts offered for purchasing a large number of units.
Rate-of-return pricing: Cost-oriented approach to pricing that involves adding a desired rate
of return on investment to total costs. Generally, a breakeven analysis is performed for expected
production and sales levels and a rate of return is added on.
Sealed-bid pricing: Bidding process in which each seller submits a sealed bid and attempts to price
below competition in order to get the contract. Many large construction and military projects are bid this
way.
Skimming pricing policy: Approach to pricing in which the seller charges a relatively high price on a
new product initially in order to recover costs and make profits rapidly and then lowers the price at a
later date to make sales to more price-sensitive buyers.
Slotting allowances: Payments to retailers to get them to stock items on their shelves, a common tactic
for getting new products into stores.
Value pricing: Setting prices so that targeted customers will perceive products to offer greater value
than competitive offerings. For existing products, this can be accomplished by offering more product or
service while maintaining or decreasing the dollar price.
ADDITIONAL RESOURCES
Macdivitt, Harry, and Mike Wilkinson. Value-Based Pricing. New York: McGraw-Hill, 2012.
Mazumdar, Tridib; S. P. Raj, and Indrajit Sinha. “Reference Price Research: Review and Propositions.”
Journal of Marketing, October 2005, pp. 84–102.
Monroe, Kent B. Pricing: Making Profitable Decisions. 3rd ed. New York: McGraw-Hill, 2003.
Nagle, Thomas T., John Hogan, and Joseph Zale. The Strategy and Tactics of Pricing. 5th ed.
Englewood Cliffs, NJ: Prentice Hall, 2011.
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Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 11 - Pricing Strategy
Smith, Tim. Pricing Strategy. Mason, OH: Southwestern, 2012.
Winer, Russell S. Pricing. Cambridge, MA: Marketing Science Institute, 2005.
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