BUAD 307





Pricing Strategies

PowerPoint Narration

Pricing strategies can be categorized based on several different variables.  One variable of interest relates to the consistency of the prices.  Some retailers today attempt to follow a strategy of "everyday low pricing."  Although few firms tend to practice this method with perfect consistency, certain retailers like Wal-Mart tend to focus on providing constant low prices without any real sales.  Other retailers instead feature prices which, when not discounted, are somewhat higher.  To compensate, periodic sales feature price reductions.  Sales can be implemented either with a predictable pattern (e.g., a product is put on sale every fourth week) or in a random manner (e.g., in any given week, there is a 25% chance that the product will offered on sale).  (See chart on overheads).

Note that "high-low" and "everyday low price" strategies are intended to take advantage of different price elasticities across people.  Some consumers are price sensitive and will tend to buy only during sales; other people, in contrast, will buy all the time.  Thus, people who are not willing to switch brands will have to pay full price for your products when they are not on sale; while they are on sale, a large number of "switchers" are attracted and sales volumes are increased.
Other dimensions of interest in pricing involve the price introductory strategy.  The "skimming" strategy entails offering a product first at a relatively high price.

Consider, for example, what we can do when there is a large degree of price elasticity—i.e., when some consumers are willing to pay more than others.  In the chart below, we see that some consumers are willing to pay a lot of money (P1) to get a new product quickly, while others are not willing to pay as much (and P2 and P3).  This often happens, for example, with new computer chips.  It may be possible, then, to charge the first segment more money, and then lower the price enough so that the next segment will buy it.  The process continues until all segments that can be profitably served have bought.

Since consumers differ in how much they are willing to pay for a product, it is possible to make large margins on the price inelastic segment.  For example, Intel tends to charge high prices for its most recent chips, gradually lowering prices as a new generation is introduced.

Alternatively, firms may choose to use the "penetration" pricing strategy.  This strategy also takes advantage of price elasticity and attempts to dramatically boost the number of units sold by offering the product at a low price.

             Since costs of production tend to go down as cumulative production increases, this strategy may be effective.  Penetration pricing is also useful when a firm wishes to establish a large market share early on, and it may be useful to develop a market for accessories to products.  For example, a manufacturer of a new computer system may want to increase sales volumes in order to encourage the development of compatible software so that the computer brand will become more competitively attractive.

            Note that "skimming" and penetration pricing involve tradeoffs.  A clearly preferred strategy may not be obvious, and managers may need to engage in some serious consideration to arrive at a desired strategy.  Both strategies involve some level of risk.  The main risk to "skimming" is the attraction of aggressive competitors who see an opportunity to make large profits by entering.  Penetration pricing, in contrast, gambles on the possibility that sales volumes will in fact increase with lower prices.

            Two other concepts are worth noting.  A "cost-plus" pricing strategy entails marking up the estimated cost of producing a product by a certain, fixed percentage.  We will discuss deficiencies of this approach later.  In contrast, pricing based on consumer perceived value keeps the firm in closer proximity to the market.

In general, simple "cost-plus" pricing is inappropriate because:

  • Your costs, in a market which is not perfectly competitive, may not be reflective of the costs of your competitors.  If theirs are lower than yours, you may be over pricing your products; if it is higher than yours, you may be able to charge higher prices than cost-plus would suggest.
  • Your costs are not reflective of the value of the product to consumers.
  • The prices of some products are more salient than those of others; thus, you may want to use some products as "loss leaders."

            Cost should, however, play some role in pricing decisions:

  • Whether you can produce products at a cost low enough to compete effectively against market existing market prices should help determine whether to enter (or exit) a given market.
  • Understanding the relationship between price and quantity demanded as well as the cost of producing this quantity will help make decisions on pricing and quantity produced.  In this context, note the effects of experience previously discussed in the text.  That is, it may be profitable to sacrifice margin immediately to move along the experience curve and enjoy a cost advantage relative to competitors later.