Taguig City University

Gen. Santos Avenue,Central Bicutan, Taguig City

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COLLEGE OF BUSINESS MANAGEMENT

PRICING AND COSTING

1. MODULE 2:

2. INTRODUCTION

An executive charged with managing prices must address four fundamental issues:
(1) What should be the price? (2) When should discounts be granted and how
discounts be managed? (3) Will the structure of prices generate the highest profits?
(4) How will competition and industry dynamics influence pricing decisions?. To
address these fundamental pricng challenges, there are also structured Pricing
Strategy into four parts: Setting the Price, Managing Price Variances, Establishing
Price Structures and Pricing Strategy.

This module will discuss the setting the price and managing price variances.

Setting the price explores quantitative methods for and qualitative influences to price
setting. The three most commonly used quantitative methods for determining list
prices are exchange value models, economic price optimization, and consumer
perception-based pricing. Each of these quantitative approaches to setting prices is
founded on a common philosophical belief, that price should reflect value. As such,
we explore the conceptual relationship between price and value directly through both
qualitative models. Accepting value is in the mind of the beholder, we then explore
the many psychological and behavioral influences to the perception of value.

Managing price variances examines price discounting decisions. Treat discounts as

a form of price segmentation, historically known as price discrimination. It started by
examining the reasons why firm would grant discount once they have already
identified an optimal price, followed by an examination of the profit, consumer
behavior, and organizational challenges created by discounting. To address these
challenges, in this module will be discuss industry leading accepted methods for
monitoring and managing discount decisions. One of the method for managing
discount decisions, volume hurdles arising from a profit sensitivity analysis, was
developed earlier en route to revealing economic price optimization.

3. OVERVIEW
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How should executives price a new product? Should they price the product the same
as the competing product? Should they price it low to grab market share? Should
they price high to grab greater profits with each individual sale? Perhaps they should
accounting position and simply add a reasonable mark up to the marginal cost of
production. If so, what is the reasonable mark up?

Pricing questions are perhaps the most vexing decisions facing an executive. Few
other strategic decisions will have a greater impact on the profitability of the fir,, the
demand customers will have for its products, and latitude that the frim will develop to
adjust its competitive position. Pricing questions span organiztational boundaries
because of their strategic importance, crossing over into marketing, sales, finance,
and operations.

Exchange value models reveal the boundaries of a good price that a firm should use
to market a new product. In developing an exchange value model, we will reveal the
importance of using the customer’s perspective of value in pricing decisions.

A profit sensitivity analysis demonstrates the impact of a small change in price on

profits. Price changes have both direct and indirect effects on profits. The direct
effect is seen in linear relationship between profits and prices. The indirect effect
derives from the influence of the price changes on customer demand. In normal
markets, higher prices lead to fewer purchases and lower prices lead to greater
purchases. Because profit depends on the quantity sold as well as price, and the
quantity sold itself depends on prices, price changes indirectly affect profits through
their influence on demand.

Customer perception-driven pricing has become the dominant approach to pricing in

many industries. Through market research, the willingness of customers to pay is
identified, either directly or indirectly. The most common methodology for using
customer perceptions to set prices is conjoint analysis. Conjoint analysis is marketed
under many different trade names and will vary in forms; however, all these forms
and trade names share a common foundation. Conjoint analysis reveals the
tradeoffs that customers make in purchasing decisions and therefore identifies the
best price that can both encourage customer purchases and deliver profits.
Furthermore, conjoint analysis can be used to expand a pricing challenge beyond
pricing a specific product to the more complex challenge of uncovering the
willingness to pay for alternative variations of that product.

Value – based pricing is not just the underspinning of the price setting methods
considered so far, it is also starting point for all refinements to prices that we all
consider in future chapters.

4. OBJECTIVES
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On completing the module, you should be able to


Understanding the discounting decisions be managed.

Understanding the price structure and multipart pricing.

Defining terms that are related in price structures.

Explaining the add-ons accessories and complementary products and
versioning.
 Understanding the bundling and how it works.
 Explaining the bundle design.
 Defining terms that are related in bundling.
 Determining the different calculations.
 Understanding the subscription and customer lifetime value.
 Understanding the yield management.
 Explaining the three issues can be considered when calibrating a response to
a competitor’s price action.
 Determining the different capacity allocation.

 Understanding the product life cycle pricing.

 Explaining the unlawful pricing.
 Defining terms that are related in product life cycle pricing.

5. TOPIC DISCUSSION

LESSON 10: DISCOUNT MANAGEMENT

Discount means a reductions of the regular price of a product or service in

order to obtain or increase sales. These discounts—also commonly referred
to as "sales" or markdowns—are utilized in a wide range of industries by both
retailers and manufacturers.

Discount management means that you won't fall below the prices you want
for your products, thus increasing your revenue. If your sales staff know
exactly how far they can go, they will moderate the number of discounts
they grant, leaving you with a bigger margin.

Challenges in Discount Management Policy

One of the most common discount management challenges facing

organizations is the disparity in incentives and knowledge between field and
centralized executives.

- Field Executives Push for more discounts to pursue market share.

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- Centralized Executives Push for higher prices while expecting the volume
to simply be delivered.

Identifying Discounting Management Opportunities

1. Net Price Band- The net price is the actual price paid by costumer after
accounting for all forms of discount, including on-invoice and off-invoice
discounts.
2. Net Price by Market Variable- If the net price band is wide and
executives conclude that there is sufficient room for improvement, their
next step is typically to examine the net price paid by certain market
segments. This is the net price by market variable. This approach
enables senior executives to identify quickly whether there is slack in
sales management and potential to improve discounting practices
within the firm or if there are true differences between market
segments.
3. Price Waterfall- The third means of aggregating data concerning
discounting for senior executive review is the price waterfall. As stated,
the net price band identifies the size of the opportunity for improving
discount practices.

Discount Decision Management- For managing specific discount

decisions, organizations have come to rely on two key approaches to
ensure that decisions are made with the best interest of the firm at
heart. These are limitations on decision-making authority and
alignment of incetives.

1. Decision Rights- Discount requests greater than that which

individual executives are allowed to grant are then reffered to
higher-level managers for their approval or rejections. In this
manner, discount decisions are escalated up through the
organization as their impact increases.

2. Decision Incentives- This implies that the financial incentive

structure, or more specifically the compensation package offered to
indiividuals with discount authority, is structured to address certain
decisions biases that those individuals may hold.

LESSON 11: PRICE STRUCTURES

 Defines the method by which total transaction prices are determined.

 For instance, the price structure of a typical residential utility bill includes
multiple items that add up to form the total transaction charge.
 On monthly basis, some of the items constant, while other items vary with the
amount of service delivered.
 These items in this utility bill form what is known as multipart pricing.
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MULTIPART PRICE STRUCTURES

TWO-PART TARIFFS
 The most common economic example of a price structure beyond unit pricing.
 Two part tariffs have two elements in the pricing
 The first element can be likened to an entrance fee.
 The second element is a per-use level of consumption or some other form of
a metered fee.

ENTRANCE FEE
 It is a fixed sum charged to all customers regardless of their level of
consumption.

METERED FEE
 It is determined through some measurement of the units consumed.

TYING ARRANGEMENTS
 Like a two-part tariff, tying arrangements use two prices for selling multiple
products that function together to deliver value to customers.
 In a tying arrangement, the firm will sell two related products that function
together to deliver value to a customer. Customer may be able to derive some
value from the products independently, but most of the value that a customer
derives is from the joint use of the two products.
 In a classic deployment of a tying arrangement, the first product is a durable
good and the second product is a consumable good that is used in
conjunction with the durable good. For example, consider razor handles and
razor blades.
 Razors are commonly sold with an introductory package that includes both
the handle and the blades.
 Once the customer consumes the initial sets of blades, further blades are
purchased that are designed to be used with specific handles
 If customers want to use a competitor’s blades with their initial handle, they
will find that the competitor’s blades do not fit.
 By designing the razor handle and blades to fit each other specifically and not
fit a competitor’s handle or blade, the firm has tied the initial sale of the handle
to all future sales of blades.

MULTIPART PRICE STRUCTURES IN INDUSTRY

 The multiple price structure can enable a firm to better capture profits from
their customers. Combined, the entrance fee plus the metered fee, or durable
plus consumable good sales, enable the firm to shift profits between different
parts of the pricing structure.
 Furthermore, the unit being priced can be closely related to the true driver of
customer benefits while not actually reflecting any metric of costs or delivering
significant benefits in and of itself.

UTILITIES
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 It uses one of the purest forms of a two-part tariff. They regularly charge a
metering fee or connection fee plus a price per quantity of utility delivered.
 For electricity, the unit metered is typically the kilowatt-hours of power
delivered.
 In natural gas, the gas delivered is typically metered and priced per therm or
cubic meter.
 For water, a utility might measure cubic feet of water, liters, or some other
volumetric measure.
 For telecommunications, minutes used or gigabytes transferred can be
measured and priced.

ENTERPRISE SOFTWARE
 The price of an enterprise software license is often constructed from come
combination of base plus unit prices, where unit is some metric that reflect
use.

PARTIAL OWNERSHIP
 Multipart price structures are also common in partial ownership industries,
such as time-share vacation homes, leased-time yachting, or car sharing.
 An annual membership fee may be associated with the cost of customer
management, while also granting members access to the shared asset.
 Usage fees have been observed to be determined on a per-week, per
weekend, per-day, or per-hour basis.
 Heavy users pay a lower average price per use, while light users pay a
higher average price per use. As with other multipart price structures, the
average price paid will somewhat match the consumers’ willingness to pay
for marginal consumption.

HEALTHCARE
 One may say that even healthcare pricing functions effectively as a
multipart price structure.
 Healthcare customers may purchase insurance that ensures access to
health care and then pay a second fee per doctor’s visit or medical
service. As with the products and services, customers derive value from
having access to the service separate from the value that they derive from
actually using the service, making multipart pricing palatable as a pricing
mechanism for the market.

LESSON 12: ADD-ONS, ACCESSORIES, AND COMPLEMENTARY PRODUCTS

ADD-ON PRICE STRUCTURE

 It is the default approach for most products, and the approach is relatively
unlimited in its application.
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 We see add-on price structures in pizza and pizza toppings, automobiles

and optional features, mobile handsets and related accessories, even
tennis rackets and ball.
 In an add-on price structure, distinct products are priced and sold
individually. The products may be independent complements, wherein the
purchase of any one product increases the likelihood of the purchase of
any other complementary product, but each product can provide benefits
independently.
 For instance, vanilla ice cream and Reese’s peanut butter cups each
provide value independently, but they can also be consumer jointly.
 Alternatively, the products may be tied complements, wherein the base
product defines the product category and complementary products can be
purchased to enhance the benefits of the base product, yet the
complementary products provide little benefit without the base product.
 For example, customers may want cheese pizza and enhance it with
pepperoni topping, but they rarely purchase pepperoni without the base
pizza product.
PRICE SEGMENTATION IN ADD-ON PRICE STRUCTURES
 To demonstrate an add-on price structure, let us examine the option
associated with a Nokia 6103 mobile phone handset in 2007. The Nokia
6103 could be purchased with many additional accessories.
 There was a car kit for enabling hands-free conversations while driving; a
connectivity cable to enable the handset to work in conjunction with a
computer for updating contacts, synchronizing the calendar, downloading
photos, or uploading ringtones and music; a travel charger for various
countries with different plug receptor styles; an automobile charger; and an
audio adapter for listening to music or having conversations without
holding the phone against the ear. See exhibit 10-1.

Exhibit 10-1 Potential Accessories for Nokia 6103 Handset (2007)

Car Kit CK-10 €139

Connectivity Adapter CA-42 € 49
Wireless Headset BH-200 €59
Travel Charger AC-4 €19
Mobile Charger DC-4 €19
Audio Adapter AD-46 €25

 An individual customer may seek a specific set of features. In an add-on

price structure, each customer can select the specific features that he or
she desires. Moreover, different customers may have different levels of
demand for a specific accessory. Demand for one feature may be high for
some customer and low for others.
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INFLUENCE TO PRICE LEVELS IN AD PRICE STRUCTURES

SIGNPOST EFFECT
 The signpost effect argues for a low price on popular or frequently
purchased products to induce purchase of less popular or frequently
purchased items that are priced to yield a higher relative contribution
margin.
OPTIONAL EQUIPMENT EFFECT
 Manufacturers can couple lower-margin base models with higher-margin
optional equipment. If the baseline product is compared with competing
offers and the add-on products are rarely compared, the difficult
comparison effect allows manufacturers to capture higher margins on add-
on optional equipment.
NETWORK EXTERNALITIES
 Products are said to benefit from network externalities when the value of
the product increases with the number of people who use it.
 For instance, the value of Adobe Portable Document Format (PDF) files
increases with the number of people who are able to read a PDF file.
LOCK IN WITH COMPLEMENTARY PRODUCTS
 Complementary products that increase switching costs of base products
can encourage firm to price the base product high while pricing
complementary products low, if not altogether abdicating any monopoly
power over add-on products. This occurs in cases where the base product
is frequently purchased or is semi-durable and purchased on the time
scale of a year or two.
LESSON 13: VERSIONING
 It is an alternative approach to price segmentation from add-ons and other
individual unit price structures. Like add-ons and unit pricing, versioning
attempts to price-segment customers according to their willingness to pay
for marginal improvements in attributes features, and benefits.
 Unlike unit pricing, versioning constrains the route to customers for gaining
additional benefits to the purchase of the next, higher value product in a
product lineup.
PRICE SEGMENTATION WITH VERSIONING
 Strategies using versioning often rely on a good-better-best progression of
products. The good product is priced lowest and has the fewest features
and benefits; it is an entry-level product.
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 The good product is feature-deprived, providing the minimal functionality to

satisfy customers.
 In an extreme form, it is stripped-down version of a higher value product,
with the bare-bones features required to compete within the product
category.
 The best product is priced the highest and has the most features and
benefits; it is a top level offering.
 The best product is the most feature-enhanced, providing further
functionality to meet the demands of a more discriminating clientele.
 In an extreme form, it is loaded with fancy features to satisfy even the
most demanding customer of the product category.
 Between good and best lies the better product, which is priced in the
middle of the spectrum and loaded with a medium level of features and
benefits.

INFLUENCES ON A VERSIONING STRATEGY

MARGINAL COSTS
 Versioning strategies have often been defended from a marginal cost
standpoint. If the marginal cost of producing an enhanced version is less than
that of producing individual products that can be added to each other to
deliver the same benefits as the enhanced version, then versioning will be
more profitable than producing individual items.
PROSPECT THEORY
 Indicates that is better to unbundle gains and bundle pains.
 In terms of versioning, the gains that customers receive are the many benefit
delivered through the product.
 High-level versions deliver more benefits; lower-level versions deliver fewer
benefits.
 While all the benefits are bundled in a single product, the individual benefits
can be isolated and highlighted during purchase decisions to encourage
customers to select a higher-value product.
EXTREME AVERSION
 Arises from loss aversion. Compared to reference point, consumers are more
averse to losses away from that reference point than they are gain-seeking to
improvements to that reference point, as discussed with respect to prospect
theory.
 The losses in benefits in moving from a middle version towards a lower-quality
version will loom larger than the gains in savings by purchasing at a lower-
price; hence, humans may be averse to the lowest product within a lineup.
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LESSON 14: BUNDLING

 Is a loosely applied term. However, in pricing, this term refers to a very

specific situation.
 Price bundling, as discussed here and defined by many authors,
specifically deals with the sale of two or more distinct products at a single
bundled price.
 By considering distinct products, bundling differs slightly from the prior
discussions of add-on strategies and version pricing in that the distinct
products themselves can be used in isolation or in combination.

PRICE SEGMENTATION WITH BUNDLING

 Price bundling is a strategy that benefits from heterogeneity in demand-

specifically, demand that is contrasting between products. Heterogeneity
in demand implies that different customers value different items differently.
 Contrasting demand heterogeneity implies that different customer
segments will hold contrasting viewpoints on the value of specific items
within the bundle.
 For example, consider a price bundle created from two different products.
One segment of customers might value the first product highly and second
product very little, while another segment will hold the polar opposite view,
valuing the first product little and the second product highly. In this case,
we would state that the customer segments hold contrasting demand.
 The McDonald’s Value Meal is a familiar price bundle that can illustrate
how price bundling works.
 To simplify this example, consider a McDonald’s Value Meal that contains
a burger and fries (ignore the drink for the purpose of this discussion)
being offered to a market with two hypothetical market segments.
 The burger lover segment might be satisfied with just a burger
 The Fries lover segment might be satisfied with just fries.
 In this example, the burger lovers and Fries lovers have contrasting
demand for burgers and fries.
 By selling both the burger and fries at a bundle discount, burger lovers are
encouraged to enjoy fries, while Fries lovers are encouraged to partake of
a burger.

STRATEGIC BUNDLIN G
 An example will best illustrate the effect of bundling on volumes, prices
and profits and can form the basis of a template for analyzing bundling n
different situations. While price bundling can be found in many industries,
we have chosen to use an opera house selling tickets to Wolfgang
Amadeus Mozart’s Don Giovanni and Antonin Dvorak’s Rusalka. Both of
these pieces premiered in Prague, Czech Republic, and are performed
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periodically at the Estates Theater in the Old Town Square section of the
city.

Exhibit 12-1 Willingness to Pay for Opera of Two Market Segments

Market Segment Don Giovanni Rusalka

Comedy Lovers 1,500 CZK 700 CZK
Tragedy Lovers 700 CZK 1, 500 CZK

Exhibit 12-2 Willingness to Pay Opera of Four Market Segments

Market Segment Don Giovanni Rusalka

Comedy Lovers 1,500 CZK 700 CZK
Tragedy Lovers 700 CZK 1,500 CZK
Mozart Devotees 1, 600 CZK 100 CZK
Dvorak Devotees 100 CZK 1,600 CZK

BUNDLE DESIGN

MARGINAL COSTS
 Price bundling is favored with products that have a low marginal cost of
production.
 Bundling involves a discount over the sum price of the individual items.
 If the marginal cost to produce the individual items is significant, bundling
can be detrimental to profits because of the discount.

PROMOTIONAL BUNDLING AND BRAND SWITCHING

 Accepting that bundling can improve profits by encouraging customers to

pursue more items than they would have in absence of the bundle, the
natural next question is the origin of these purchases.
 For instance, retailer promotional bundling often comes in the form of “buy
one, get one free” or “buy two and get $0.50 off.” It has been found that
these type of bundles are strong at encouraging consumers to switch
brands or retail outlets but they are very limited at either encouraging
consumers to accelerate buying (buying earlier and stocking up) or
increasing category –level spending (buying more than what would usually
be purchased). Even when customers fail to purchase the necessary
quantity to qualify for the bundle discount, the bundle promotion is
effective at encourage sales, perhaps by creating the perception of being a
low-priced outlet.

LESSON 15: SUBSCRIPTIONS AND CUSTOMER LIFETIME VALUE

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 Subscription price structures may have been pioneered with magazines

and newspapers, but from this humble origin, they have become standard
pricing practices in many industries.
 Subscriptions also can separate the timing of the payment from that of
consumption.
 In pricing the subscription relative to the sale of the individual items, there
are two key metrics.
 The first is the total period price or the sum price that customers would pay
if they purchased all the items within the subscription.
 This is the maximum price that can be charged for the subscription in
absence of a significant change in the value proposition.
 The second is the customer period value, or the sum price that the
customer would pay during the period given average customer purchasing
patterns
 The customer period value sets the minimum price for the subscription that
the firm should offer.

PRICING THE SUBSCRIPTION

 When considering adding subscription sales to individual product sales,

the firm should ensure that it will be more profitable with subscriptions than
it is with individual product sales at a minimum.
 The method calculating the customer period value is extremely similar to
that of the customer lifetime value.

TOTAL PERIOD PRICE

 It is simply the price that customers would pay if they purchased every
item within the subscription. It is the maximum price that customers would
consider paying.

CUSTOMER PERIOD VALUE

 Calculates the expected profits earned from a customer during the period,
given a customer’s actual purchase behavior.
 By calculating the customer period value, we can identify the minimum
price that the firm should consider charging for a subscription.

CUSTOMER LIFETIME

 Influence pricing decisions in many areas outside of subscriptions.

 Many times, firms make an initial sale at a loss in the hopes of earning
profits on the sales of subsequent items.
 For instance, consider tying arrangements. The sale of razor handles may
be subsidized by the expected profits on the sale of future razors; the sale
of printers may be subsidized by the profits earned on the future sale of
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ink; and the sale of game consoles may be subsidized by the profits
earned on the future sales of gaming titles.

BEHAVIORAL EFFECTS WITH SUBCRIPTIONS

 The subscription price should be less than the total period price if it is to
attract customers into the subscription arrangement; hence, it would be
less than $47.40 in the magazine example. Also, the subscription price
should be higher than that which would leave the customer period value
unchanged if it is to improve the profitability of the firm; hence, it should be
above $27.48 in the magazine example. Within the range, subscription
prices are influenced by a number of qualitative behavioral effects.

MARKET SEGMENTATION
 Differences in market segments regarding the desire of customers to
purchase the entire series of products should encourage firms to price the
subscription at a price higher than that which would be predicted by
consideration of the average customer loyalty alone.
 Effectively, those who would purchase the subscription are also signaling
their product loyalty and can be anticipated to have a higher retention rate.
 Customers with a higher retention rate have a higher customer period
value.
 As the customer period value increases, so too does the minimum
subscription price, which improves the profitability of the firm.

LOCK-IN
 When customers subscribe to a series of products, they become locked
into an arrangement with the supplier. Many customers are aware of the
value of pre-committing their purchases to suppliers.
 However, customers suffer from uncertainty about their ability to predict
their future demand.
 They also value the ability to abandon to a supplier relationship in the
future if that supplier fails to deliver the expected set of benefits. Because
of the negative impact that lock-in presents to customers, the subscription
price must be below the total period price to induce customers to
purchase.

INCREASED CONSUMPTION PATTERNS

 With some subscription offerings, customer’s tent to consume more of the

product than they otherwise would.
 One reason for this increased consumption is that once customer has
entered into the subscription arrangement, future consumption of the
product comes with a zero or otherwise low marginal price.
 For instance, research has shown that magazine subscribers typically read
more articles than customers who buy the magazines at the newsstand.
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 Another factor that increases consumption is the ability of subscription

offerings to address a market failure arising from information asymmetries.

OVERESTIMATION BIAS

 When customers are choosing between a subscription membership and a

pay-for- use offer, they sometimes fall subject to an overestimation bias of
their positive future behavior.
 For example, people join gyms in the hope that they will exercise more, an
activity that contributes positively to their quantity and quality of life.
 Unfortunately, customers are poor predictors of their own future behavior.
 Many times, customers will join the gym, attend a few times, and then fail
to return to the gym even though their gym membership is still active. This
is an example of an overestimation bias: Humans tend to overestimate
their own future positive behavior.

VALUE PROPOSITION CHANGES AND SaaS

 In many cases, the benefits delivered through subscription arrangement

are greater than those delivered on a pay-per-item basis.
 For instance, magazine subscriptions often include other items positioned
as gifts, such as a boo, reference guide, or other token of appreciation.
 Similarly, gyms will often provide a “free” T-shirt or other gift to new
members. These gifts are usually provided without increasing the price of
the subscription due to their inconsequential nature.
 However, other subscription offerings do include specific items and
benefits that are substantially consequential to the customers and are not
offered directly by the supplier for separate purchase.
 When the value proposition changes significantly between the subscription
offering and that of the sale of individual products, firms have the
opportunity to opportunity to increase the subscription price to that of a
premium offer as well.

SaaS

 With Software as a Service (SaaS) offerings in enterprise software, the

benefits delivered through the subscription are substantially more
valuable, and the variable costs to serve are also higher.
 SaaS offerings include not only the license to use the software, but also
the management of the software and the customer’s data itself.
 The inclusion of managing a customer’s data not only increases the
benefits to the customer but also increases the costs to the provider. As
such, firms marketing SaaS have sought to increase the price of their
offering over that of the total period price of the software alone.

LESSON 16: YIELD MANAGEMENT

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 Is one of many dynamic pricing techniques.

 In yield management, the price offered to customers increases as capacity
approaches exhaustion.
 It is a technique for maximizing the expected revenue earned on a fixed-
capacity resource by selling units of that capacity at different prices.
 It uses timing and expectations of demand as a means to price-segment
the market.
 It is a probabilistic pricing technique that relies on probability-weighted
demand expectations to determine the availability of fare classes, each of
which has a different price.
 The practice of yield management expands beyond the airline industry and
can be used in a number of industries.
 Similarly, hotels face the same set of constraints and opportunity for using
yield management.
 Yields pricing, has also found its place within industrial markets. Freight
transport firms, including air freight, container ships, and even trucking,
face the same constraints in capacity flexibility and perishability.

FARE CLASSES AND BOOKING CONTROL

 Yield management is a technique to maximize revenue by dynamically
controlling the number of units sold within any given fare class.
 For example, consider airline fare classes and booking processes.
 The airline will market a number of fare classes on a given flight.
 Just as the total number of seats available on a given flight is
fundamentally limited, the airline will limit the number of seats available in
any given fare class on that flight. The booking limit is the number
available seats within a given fare class on a specific flight.
 When a customer attempts to make reservation, the firm will review the
booking limit on the available fare classes.
 If there is sufficient availability within the fare class, the reservation is
booked.
 If the reservation for a fare class would exceed the booking limit, that
reservation to capture that customer.
 For example, consider a family booking four seats on flight.
 If the booking limit is currently three seats for the lower priced fare class
but there are ample seats at the higher priced fare class, then the offer is
made to book the seats at the higher priced fare and denied at the lower
priced fare. This person is known as booking control.

FIXED ALLOTMENT
 One of the first approaches to controlling bookings was through fixed
allotment.
 In the fixed allotment approach, available capacity is divided into discrete
chunks (fare classes), and each fare class is allocated a fixed number of
seats.
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 Customers can book seats in any fare class until the fixed allotment of
seats in that fare class has been filled.
 Once that fixed allotment has been reached, seats on that flight will be
offered only in other fare classes.

DYNAMIC NESTING

 It is the approach taken to controlling bookings that improves on the

limitations of the fixed allotment approach.
 As with the fixed allotment method, dynamic nesting assigns each fare
class a booking limit.
 Unlike a fixed allotment method, the booking limits on all fare classes are
reduced as seats are reserved in any individual fare class in dynamic
nesting to prevent the possibility of rejecting high-fare bookings while
reserving seats for low fare bookings

CANCELLATIONS, NO-SHOWS, AND OVERBOOKING

 It is common for customers to make reservations and subsequently cancel

them before departure or fail to appear at the time and departure.
 To manage cancellations and no-shows, two techniques are commonly
used in yield management.
 First, to account for no-shows, booking limits can be initially adjusted
upward above available capacity according to the expected number of no
shows. If all customers show up for an overbooked flight the airline may
make an offer to encourage customers to accept a later flight.
 Second, to manage cancellations, seats can be added back to the booking
limits of the appropriate fare classes once a reservation is canceled.
 Other approaches are used and are profit-effective, yet these two are the
simplest.

CAPACITY ALLOCATION AND REVENUE OPTIMIZATION

 Capacity allocation refers to the method by which booking limits are

defined for the relevant fare classes.
 Capacity allocations with multiple classes can be managed conceptually
with the same approach as that presented in this section.

CAPACITY ALLOCATION WITH CERTAIN DEMAND

 If the demand is known ahead of time (that is, if demand is perfectly

forecasted), then the capacity allocation challenge is trivial. Giving the
highest priority to the most expensive fare class and the lowest priority to
the least expensive, capacity would be allocated according to forecasted
demand.
 For example, supposed a hotel operator was managing 30 rooms each
with equal amenities. At this hotel, the stranded room rate is $250 per
night and the discount rate is $15.
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 To improve revenue, the hotel may have a yield management policy to

hold some full-fare rooms available for last-minute customers arriving on
the night of the stay, while selling discounted rooms to customers who
make early reservations.

CAPACITY ALLOCATION WITH UNCERTAIN DEMAND

 Yield management can be extended to include uncertainties in demand.

 Even when demand is uncertain, past experience can be used to forecast
that demand will lie within some range.
 To optimize capacity allocation decisions in the face of uncertain demand,
yield management techniques can rely on the quantification of the
probability that demand will lie at different levels.

DECISION TREE APPROACH

 Yield management optimizes revenue by allocating capacity between

different fare classes in a manner that maximizes the expected overall
revenue earned on the resource.
 As seen in the hotel example, yield management includes a careful
tradeoff between the expected revenue earned from lower-price customer
versus that from higher price customers.
 On one hand, if the firm turns away discount bookings in the hopes of
earning a full-price customer that never materializes, the empty seat or
room goes unsold. This is called spoilage because inventory becomes
spoiled the moment the plane takes off or the evening comes to a close.
 On the other hand, if the firm accepts discounted sales that force it to turn
away full-price customers, it runs the risk of selling seats at a less
favorable price. This is called dilution because the potential revenue is
diluted with excess low-price sales.
 The goal in capacity allocation decisions within yield management is to
balance the lost revenue of spoilage with that of dilution to maximization
expected revenue.

FURTHER ENHANCEMENTS TO YIELD MANAGEMENT

 The yield management techniques described in this chapter have been

extended to improve revenue further in a number of ways, most notably in
improving capacity allocation rules to take into account multiple price
classes and potential dependent demand effects.
 While the various yield management techniques share many conceptual
commonalities, they differ in specifics.
 Optimal capacity allocations with more than two price classes quickly
become more computationally complicated as price classes are added.
 To address these challenges, firms often turn to Expected Marginal Seat
Revenue (EMSR) heuristics to accelerate calculations for the multiple
price class problems. (Discussions on EMSR can be found in advanced
texts that specifically explore yield management.)
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LESSON 17: COMPETITION AND PRICING

THE ORIGIN OF PRICE WARS

“The purpose of all war is ultimately peace.”- Saint Augustine of Hippo

 Rarely do companies enter e price war on purpose. Despite popular

hearsay that a firm enters into price wars with the motive to drive
competitors out of a market and then increase its price and gain higher
profits, there has been scant economic evidence of success with this
energy.
 This is good reason: it is hard to make this strategy work. The cost of a
price war is inherently expensive, with the immediate loss of profits or,
worse, mounting losses over time. Furthermore, the benefits of winning a
price war are highly uncertain.

PRISONER’S DILEMMA
 The prisoner’s dilemma is so named because it describes the situation
faced by two suspected criminals put into separate rooms for questioning
 Law enforcement investigators then make offers to both suspects to
confess and implicate the other in exchange for a lighter sentence.
 If no suspect confesses, the investigators don’t have a case, and both
suspects can communicate his intention not to confess to the other, and
because both of them are facing the offer of confessing in exchange for a
lighter sentence, one of them is likely to yield to the pressure.
 Once that happens, both prisoners get a criminal sentence although the
one who confesses gets a lighter punishment than the holdout.
 Competing firms considering a price reduction often face a payoff matrix is
similar to that faced by suspected criminals in the prisoner’s dilemma.
Consider two hypothetical competitors in the same industry, Alpha and
Beta, and the payoff matrix that they face by taking a price action.

STRUCTURAL DRIVERS
 If all firms face short-term incentives to lower prices but long-term
incentives not to lower prices, then any rational executive in any industry
should understand that price reductions that encourage destructive
retaliation should be avoided, and all price wars would be cease.
 However, we know that somehow, price wars break out anyway.

NUMBER OF COMPETITORS

 Industries with fewer competitors tend to be able to monitor one another’s

pricing practices and respond appropriately.
 Therefore, a price action by any one competitor is likely to be observed
and followed by a swift response from the other competitors, resulting in
an overall destruction of industry-level profits, as previously discussed.
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 Executives operating in industries with fewer competitors are also more

likely to learn the costs of unnecessary price wars and the resulting
negative-sum gains in initiating one.

COMPETITOR’S MANAGERIAL MATURITY

 Mature competitors are better positioned to both anticipate competitors’

response to prices and be aware of competitors’ pricing practices. New
entrants or immature competitors may lack the ability to detect
competitors’ pricing actions or make grievous errors in anticipating the
response to a price action.
 This kind or maturity may not just be a reflection of the executives at one
particular firm, but the ability of the least reflective executive within that
industry to avoid setting off an unnecessary price war.
 In highly competitive industries, executives are known to state: “I can price
only as well as the stupidest competitor.”

HIGH FIXED COSTS AND LOW MARGINAL COST

 Industries facing high fixed costs but low marginal costs often face
extreme pressure to lower prices to capture marginal revenue. Because
marginal costs are low (and in some cases zero), most marginal revenue
can be added directly to the overall corporate bottom line
 Software firms, which face extreme pressures to gain revenue that
translates into profit, are operating in an environment that encourages an
inordinate amount of price discounting.
 In software markets, discounting up to 90 percent from the list price is not
unheard of, and many enterprise-class software firms consider discounts
around 60 percent from the list price to be normal.

INDUSTRY MATURITY AND ECONOMIC SAVINGS

 The need for maturity extends beyond the executives and into the issue of
the industry growth rate. With young, high growth industries, executives
face numerous incentives to grab market space in the hope of leveraging
their operational demands into lower cost structures as the industry
matures.
 These incentives may come from the expectation of future economies of
scale, scope, o leaving, it may have an incentive to use low prices to
capture market share, penetrate new capabilities, or accelerate the
learning curve in the expectation of long-term cost savings.

ECONOMIES OF SCALE
 Refers to the cost savings that a firm can gain that depend on the size of
the firm as measured by its long-run, sustainable rate of output. As
production volume increases, fixed incremental costs that arise from
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product development or capacity increases can be spread over a larger

number of units, reducing the long-run average cost.

INDUSTRY MATURITY AND NETWORK EXTRNALITIES

 Just as companies may be willing to price low in new industries in the

hopes of gaining future cost savings from economies in scale, scope, or
learning, they may also feel pressure to price low in the hopes of gaining
an inordinate portion of the future revenue due to network externalities.
 Products are said to benefit from network externalities when the value of
the product increases with the number of people who use it.
 Network externalities can drive price wars in industries facing two-sided
markets or highly profitable complementary goods markets.
 For instance, the format war between Toshiba’s HD-DVD and Sony’s Blu-
ray was largely driven by the network externalities in the creation of game
titles and the number of uses with consoles.
 Similarly, Apple’s iPhone and Research in Motion’s BlackBerry face strong
network externalities in the distribution of mobile handsets and
applications for these handsets. Even user share can drive network
externalities, as it does for social networking websites like Facebook,
LinkedIn, and Skype.

REACTING TO PRICE REDUCTIONS

“It is often better to be a small competitor in a profitable industry than a large

competitor in an unprofitable industry.”

 The reaction must be limited so as not to create the conditions for a price
war to break out, but the reaction must be strong enough to counter a
competitor’s price action and improve the firm’s profits.
 If possible, the reaction should also communicate the message to a firm’s
competitors that price wars will be mutually destructive.

THREE ISSUES CAN BE CONSIDERED WHEN CALIBRATING A

RESPONSE TO A COMPETITOR’S PRICE ACTION.

1. DIRECT COSTS AND BENEFITS

 When considering a response to a competitors’ price reduction, executive

should evaluate the costs and benefits of their response. To reduce the
chance of the response tipping off a price war, executive can focus any
price response on the direct revenue at risk and the direct profits
threatened rather than the general malaise generated from a competitor’s
price reduction.
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 A competitor’s price reduction will generally threaten some of the firm’s

revenue, but rarely all of it.
 In fact, sometimes it will threaten only a very small portion of the firm’s
revenue.
 By identifying the exact nature of the revenue at risk of loss, the firm can
target any matching price reduction to recapture that specific marginal
revenue.

2. SECONDARY CONSEQUENCES.

 When a firm respond to a price reduction by a competitor, two serious

secondary consequences can arise. First, a price reduction in one
situation may affect sales outside of the specific opportunity at risk.
 Second, the firm’s response to price reduction by competitor by matching
that price reduction may lead to further rounds of price reductions.

3. STRATEGIC POSITION

 Price reductions by a competitor may be driven by a difference in

competitive advantage. When a competitor has a cost advantage, its
ability to reduce prices and remain profitable is greater than the original
firm’s ability to follow suit.
 Firms at a cost disadvantage have a higher strategic interest in raising
industry-level prices- or at least not lowering them-than those with a cost
advantage.
 As such, a firm may be better off averting a price war and granting market
share concessions rather than entering into a war that it cannot win.

INITIATING PRICE REDUCTIONS

“The general who wins the battle makes many calculations in his temple
before the battle s fought. The general who loses makes but few
calculations beforehand. “ – Sun Tzu, The Art of War

“Measure twice, cut once.” – Anonymous

PRICE AS A STRAGETIC FOCUS

GAUGING COMPETITIVE RESPONSE

 In reducing prices or increasing the price-to-value tradeoffs faced by
customers, executives, should gauge the response of their competitors.
 That is, if a company reduces price, will competitors react at all? What
options option will the competitor actively consider? Which option will the
competitor most likely choose?
 Two facts make this process effective:
1. Surveys show that most companies use rudimentary analytical
techniques in determining a competitive response and therefore their
competitive responses will be somewhat predictable.
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2. Most companies follow a predictable pattern in reacting to a

competitor’s move; and therefore, executives can anticipate a
competitor’s future reactions by studying its past reactions.

WILL THE COMPETITOR REACT AT ALL?

 In many situations, competitors will not react to a pricing action. Four lines
of inquiry will enable executives to gauge the likelihood of a competitor
response:
1. Will your rivals see your pricing action?
2. Will competitors feel threatened?
3. Will mounting a response be a priority?
4. Can your rivals overcome organizational inertia?

MANAGING PRICE ACTIONS

“The best victory is when the opponent surrenders of its own accord before
there
are any actual hostilities. It is best to win without fighting.”- Sun Tzu, The Art
of War

“Speak softly and carry a big stick.” – Theodore Roosevelt

PRICE SIGNALING

 In pricing signaling, firms communicate a strategic pricing action to their

competitors indirectly, Direct communication with competitors regarding
prices is a form of illegal collusion; therefore, firms cannot talk directly to
each other about pricing decisions. However, communicating price
decisions to markets in general is often viewed as necessary market
function to let customers know of a future price change or investors know
of a potential revenue impact.
 Hence, firms may communicate a price action in a public forum, such as to
the press or investors, with the intention of informing the market of a price
change.
 In the process, they will also be signaling to competitors their strategic
pricing action.

TIT-FOR TAT PRICING

 It is an extreme form of price followership in which firm matches its

competitor’s price actions at every stage of the game.
 If the competitor lowers its price, the firm lowers its own price as well.
 If the competitor raises its price, the firm follows suit. All prices moves are
done in response to the competitor’s price actions.

PRODUCT LIFE CYCLE PRICING

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 During the introduction phase, a revolutionary product is launched, which

creates an entirely new market.
GROWTH
 The growth phase of the product life cycle is marked with rapid changes in
every dimension of the newly emerged market. New customers enter the
market and adopt the products within the emergent category, leading to
multiple market segments.
MATURITY
 In the mature phase of the product life cycle, demand growth, competitor
turbulence, and rapid product evolution are replaced with more predictable
industry dynamics. Further market growth is limited as product penetration
reaches saturation.
DECLINE
 Eventually, a product may become outdated as new products are introduced.
In this case, the product category will go through decline.

LESSON 18: PRICING DECISIONS AND THE LAW BY DENNIS P. W. JOHNSON

THE AIMS OF THE LAW OF PRICING
 It is important to understand both what the antitrust laws seek to police and
what they do not. The general goal of U.S. antitrust law is to promote
competition, not to protect competitors. The law therefore targets pricing
behavior that deprives consumers of the benefits of competition. This is the
conceptual starting point for any court evaluating a pricing scheme. Although
it is too soon to know how future administrations may change federal antitrust
enforcement, the current administration’s policy statements promise a
renewed focus not only on enhancing competition but also preventing
exclusionary or predatory conduct that may harm competition and ultimately
consumers.
UNLAWFUL PRICING BEHAVIOR
PRICE FIXING
 Price fixing may be horizontal (by competitors selling to common customers)
or vertical (by firms in the same chain of distribution). Manufacturers of
competing products that both sell to distributors (horizontal competitors) may
not agree to set or maintain the price or terms of sale of common products.
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This is the clearest single example of conduct that will land you in jail. Vertical
price fixing (“resale price maintenance”) involves an agreement between
manufacturer and its distributors to sell at a stated price. Unlike horizontal
price fixing, these vertical pricing agreements are not illegal per se, as
described later in this chapter. The first conclusion is that despite the
language of section 1 of the Sherman Act, not every “contract, combination, or
conspiracy” is one considered “in restraint trade” without further analysis.
Courts decide competitors cannot agree upon prices.

HORIZONTAL PRICE FIXING AND OTHER AGREEMENTS

 Agreements can be provided in several ways. Courts do not require a written
contract between competitors (“direct” evidence) to demonstrate a collective
agreement. Price-fixing conspiracies, like any other type of conspiracy, can be
proved by a mosaic of indirect (“circumstantial”) evidence without an explicit
agreement. Courts even may infer an agreement where entities are imitating
their competitors–known as “conscious parallelism”–if additional factors are
present.
VERTICAL PRICE FIXING
 The law as it pertains to vertical price fixing, including resale price
maintenance, is more nuanced. Courts test the legality of agreements to fix
prices within supply chain under the rule of reason by, as described
previously, balancing the anticompetitive effects of given scheme against its
pro-competitive effects. Vertical agreements to set maximum resale prices
(“ceiling” prices) have been tested under rule of reason for more than decade;
yet agreements between manufacturers and dealers to set minimum prices
(“floor prices”) were subject to the per se rule until 2007.
RESALE PRICE ENCOURAGEMENT
 These techniques are also called vertical non-price restraints. Rather than
directly dictating particular resale prices to their dealers, suppliers can induce
their adherence to a desired resale scheme through various incentives. Such
incentive scheme are judged under the rule of reason.
NON-PRICE VERTICAL RESTRAINTS
 Manufacturers also may use various non-price restraints on dealers to control
the marketing of their products and combat against discounting and dealer
free-riding. These include the customer or territorial restrictions discussed
later in this chapter, which are evaluated under the rule of reason applied
under Section 1 of the Sherman Act.
CUSTOMER AND TERRITORIAL RESTRICTIONS
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 Sellers may mandate that dealers sell their product only to certain customers
or only within certain geographic territories. Courts will uphold these
arrangements if the pro-competitive effect on interbrand competition
outweighs the anticompetitive effect on intrabrand competition.
PRODUCT RESTRICTIONS
REFUSALS TO SUPPLY
 Generally speaking, suppliers may refuse to sell to whoever they choose–
manufacturers or customers–so long as the decision is not part of a horizontal
agreement with competitors or part of a strategy to acquire or maintain a
monopoly. Thus, for example, a supplier may lawfully agree to sell only to a
particular dealer within given territory.

EXCLUSIVE DEALING AGREEMENTS

 Manufacturer-imposed product restrictions on dealers are also typically
upheld. Manufacturers use “exclusive dealing contracts” to prevent retailers
from purchasing a certain type of product from other manufacturers.

EXCLUSIONARY OR PREDATORY PRICING

TYING
 In a tying arrangement, the seller conditions the sale of one product (the tying
product) on the simultaneous purchase or a second, usually less-desirable
product (the tied product)
PREDATORY OR BELOW-COST PRICING
 Predatory pricing is one means by which a seller may use its monopoly power
unilaterally to preserve or attempt to gain monopoly. Both are violations or
Section 2 of the Sherman Act that require definition of the “relevant” market in
terms of the products and geographic boundaries.
PRICE AND PROMOTIONAL DISCRIMINATION
 When Congress first passed legislation directed at price discrimination
The Robinson-Patman Act prohibits:
 Sellers from discriminating between different buyers when it adversely affects
competition, unless the sellers matching a competitor’s price (“meeting
competition”)
 Buyers from knowingly inducing or receiving such as discrimination price
 Sellers from granting and/or buyers from receiving certain commissions or
brokerage fees except for services actually rendered
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 Sellers from providing or paying for promotion or advertising in a product’s

resale unless they offer equivalent terms to all competing buyers
INTERNATIONAL ANTITRUST ENFORCEMENT
 In addition to enforcing U.S. antitrust laws against firms whose conduct has
domestic competitive impact, the Department of Justice’s Antitrust Division
currently emphasizes the importance of consistent enforcement of common
antitrust prohibitions, so that firms operating in the global economy will be
evaluated under consistent standards. This requires a level of coordination
with other countries’ law that prohibit anticompetitive actions similar to those
prohibited under U.S. law. For example, in the European Union (EU), Article
81 of the Treaty of the European Communities (the European Community’s
competition law) prohibits cartels and vertical agreements that restrain
competition within the common market. The statute also prohibits price fixing
and market sharing, but it exempts collusion that promotes distributional or
technological innovation if the restraints are not unreasonable
(“disproportionate”) and do not risk eliminating competition. Article 82 prohibits
dominant firms from abusing their position by price discrimination and
exclusive dealing, similar to U.S. antitrust laws. EU law prohibits mergers that
might significantly impede effective competition, similar to U.S. law. Canada
and Japan have similar provisions.

6. SUPPLEMENTARY READINGS AND MATERIALS / REFERENCES

AUTHOR TITLE EDITION DATE

Tim J. Smith Pricing Strategy 2012

Online Link: https://study.com/academy/lesson/pricing-strategy-in-marketing

definition-types-examples.html Study.Com, Pricing Strategy in Marketing
Online Link: https://www.investopedia.com/terms/i/incomeeffect.asp
Investopedia, Income effect
Online Link: https://conjointly.com/pricing/
Conjoint.ly, Pricing Psychology
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