Ch 10 Pricing Strategy

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Pricing Policies and Practices

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PRICINGPricing denotes revenue to sellerPerceived Value to buyer

Pricing strategy Important for new product, modifiedproduct, new market, new market segment, objectiveof firmBasic determinants are supply and demand

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PRICING PRACTICESGeneral Considerations To Be Kept In Mind

While Formulating A Pricing Policy :

Objectives of business- Notwithout considering

its impact on all objectivesMarket structure Competitors strategy

Price Sensitivity/ elasticity(even formonopolist)Conflicting Interests of Manufacturers andMiddlemen, consumers

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General ConsiderationsRoutinisation of Pricing- Speed required indecision-making, quality of data available, competitivemarketRole of Non Business Groups in pricing Decisions-Government, political considerations , farmers andbusiness lobbies, Trade Unions etc

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Types of Pricing1. COST BASED PRICING2. BASED ON FIRMS OBJECTIVE

3. COMPETITION BASED PRICING4. PRODUCT LIFE CYCLE PRICING5. CYCLICAL PRICING6. MULTIPRODUCT PRICING7. ADMINISTERED PRICING

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I. COST BASED PRICING

Cost Based PricingCost Plus or Mark Up

Marginal Cost pricingTarget Return pricing

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Cost Based Pricingi. Cost Plus / Full Cost/Average Cost/ Mark-up

Pricing

Price set to cover cost plus a percentage forpredetermined profits.P= AC+ m

where, m =mark-up percentage

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Mark up depends on target rate of return, degree ofcompetition, price elastiicty, substitutes etc

- Most commonSimple to fix the priceMore defensible on moral grounds

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Cost Based PricingDrawbacks:-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 themarket can bear)

- Ignores marginal cost as it uses average cost- Not suitable if competition is tough or when

entering new market

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Marginal Cost Pricing ii. Marginal Cost Pricing/ Incremental cost

pricing:

Price of product = Variable cost plus a profitmargin.Only those costs which are directly attributable to

the output of a specified productHere price will be lower than the full cost pricing.

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Marginal Cost Pricing All past outlays are historical and a firm shoulddeal solely with anticipated revenues and outlays

Firm is more interested in future changes in cost due to changing decisionsUnlike fixed costs , MCs are controllable in theshort run Total costs can not be of use in case of multiproduct/ markets/ process situations

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Marginal Cost Pricing Useful to beat competition Also, to enter the market

Used for pricing public utility where profit is not themotive Weaknesses:

Can only be a short term strategy (as it omits fixedcosts)Can be only restricted to pricing of specific orders

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Cost Based Pricing

Iii) Target Return PricingProducer rationally decides the minimum rate of return

which must be earned by the productMethodology similar to the above, but margin isdecided on the basis of target rate of return , on thebasis of experienc e, consumers paying capacity , risk

involved etc

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II. Based on Firms Objective

Pricing Based on Firms objective -Profit Maximisation- considers total cost

-Sales Maximisation- should adopt competitive pricing,say marginal pricing

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III. COMPETITION BASED PRICING

i. Penetration Pricing : Low price when entering newmarket dominated by existing players (Nirma, Deccan Air)

ii. Entry Deterring- Price kept low to make marketunattractive for competitors (Common in oligopoly)

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Competition Based Pricing

iii. Going Rate Price: Why?

Firms do not want price warsSmall/ new firms may not be sure of the effect of

charging a different priceProducts are close substitutes with high cross elasticity

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Competition Based Pricing

Popular in monopolistic and oligopoly markets becausea) of low product differentiation and

b) for consumer the cost of switching is minimalUniform price of packaged water or fruit juice

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IV. PRICE DISCRIMINATION

First degree Price Discrimination

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-Each unit of outputis sold at a different price

or each consumer is chargeda different price .

Entire consumers surplus wiped out

Quantity

P r i c e


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Second Degree Price Discrimination

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A

B

C

D

D

Demand

P r i c e

P1

P3

P2

Q1 Q2 Q3O

Seller gets part ofconsumers surplus.

Highest price of OP1for OQ1 units.

Price is OP2 for Q1Q2units

Lowest price of OP3 forthe next Q2Q3 units.Monopolist maximises

revenue atTR= (OQ1*AQ1)+(Q1Q2*BQ2)+(Q2Q3*CQ3)


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Third Degree Price Discrimination

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Quantity Demanded

C o s

t & R e v e n u e

MC

MR

AR=D

Da DbMRa MRb

QaQb Q

T

AB

O Oo


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Third Degree Price DiscriminationMonopolist 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 themonopolist.

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Third Degree Price DiscriminationFirms MC intersects MR curve at T.

Drawing a perpendicular from T we get the optimumlevel of the firms aggregate output at OQ.

At this level of output, MR=MC.

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Third Degree Price DiscriminationOQ 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 themarkets.This is achieved by drawing a line from point Tparallel 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 priceBQb).

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V. PRODUCT LIFE CYCLE PRICINGRefers to different pricing strategies for a productdepending on the different stages of its life cycleEach phase is unique- different demand patterns andcompetitionSo setting same price will mean less than optimumrevenue

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V. PRODUCT LIFE CYCLE PRICING

Sales revenue Curve

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1 2 3 45

1.Introduction

2.Growth

3.Maturity4.Saturation

5. Decline


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PRODUCT LIFE CYCLE PRICING

i) New Product:a) Skimming Policy

: Charging very high initial price and super normalprofits-Lower price during maturityThe first ball pens introduced in 1945 cost 80 centsto produce but were priced at $12.50.

Initial high prices of computers1st day movie tickets

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Why?Demand is likely to be less price-elastic in initialstagesIf life of product is likely to be short , the producercan get as much as possible as fast as possibleThe policy can lead to introduction of product for

lower segments later.High initial price may finance the heavy initialcosts of introducing a new product when othersources of finance may not be available

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Benefits of lower cost due to growing volumes andtechnological development allows for lowering of pricesat a later stage.

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b) Low Penetration Price : Close to customary price- only minor adjustments required eventually.Objective of low penetration pricing is to keep offcompetition

Appropriate where:Sales respond strongly to lower pricesHigh volumes lead to lower costsProduct acceptable for mass consumptionTo capture a large share of market quickly wherethere is a threat of potential competition

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High Skimming price

Low penetration Price


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ii) Rapid Growth- Stable price policy for sustainedgrowth

iii) Maturity: Growth occurs at diminishing rate- firmmay introduce minor quality changes with higher prices

iv) Saturation- Lower prices and discounts to clear stocks

v) Decline- Wind up

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Perceived Value pricing : Psychological pricingdepending on consumers perception of utility -Tanishq jewelry, Parker pens etc-by creating a hypeabout high quality

Value pricing- variant of iv. Try to create high value andcharge a low price ie., price charged is lower thanperceived value e.g., heavy discounts

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Product Life Cycle PricingLoss Leader Pricing : Here, multi product firms sellone product at a low price and compensate the loss byanother product

Charge lower price for a good that is durable and has ahigh value but high price for the complementary, lowvalue consumable (HP printers and cartridges)

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VI.CYCLICAL PRICINGRigid or flexible?Rigid price means Firms selling a stable priceirrespective of the business cycle phase (Flexiblepricing is meaningless for eatables etc where demanddoes not change with cycles; dangerous in case ofdurables as consumers will wait for the next recessionto buy durables)

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VII. MULTIPRODUCT PRICINGTata Sons produces steel as well as trucks and cars where steel is used as input

Demand Interdependence: A firm can producegoods which are substitutes(Zen and wagon R) orcomplements.If substitutes, either price them the same(coke andThums Up) or resort to perceived value pricing; oreven, going price strategyOne firms output may be anothers input

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TRANSFER PRICINGTransfer Prices are the charges made when acompany supplies goods, services, or financialservices to its subsidiary or sister concern.

Globally, 60% of transactions are between associatedcompanies. MNCs are required to set TransferPrices for supply of goods, technical know-how,

marketing rights etc from parent to subsidiary orone subsidiary to another .

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TRANSFER PRICINGGovts keep strict watch on this in order to check taxevasion as companies try to reduce tax incidenceglobally by transferring higher income to low tax jurisdiction and higher expenditure to high taxcountriesIn general regulatory authorities agree on arms

length price - i.e., same price should be charged whether the transaction is between related orunrelated parties

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VIII. PEAK LOAD PRICING

Peak Load Pricing

Higher price at peak level of use and lower at slacktimeExamples-Electricity, telephone charges, air fares

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IX. Administered Price Administered PriceOriginally associated with monopoly

- Now understood as Fixed by authorities- Specific social objectives- social justice, correctingimbalances, price stability

-Conflict between public utility approach and rate of

return approach

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Guidelines for Price Fixing

Bates and Parkinsons Guidelines for PriceFixing :

Find out how your costs compare with yourcompetitors. Keep an eye on the market -if orders are difficult tocome by, drop prices; if easy, raise.Goodwill of customers is probably gained morethrough advertising than keeping price low

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If you can sell all your output at prices that give you substantial profit, consider expandingproduction.If you find that your sales vary over seasons, adjustpricesIf your prices seem to be higher than those of yourcompetitors although they scarcely cover costs, youmay need to take a re-look at your productionmethods and organisational process

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Ch 10 Pricing Strategy

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