 Course Title: PRICING STRATEGIES

Module I: - The role of pricing in value creation

 Why pricing is becoming a central issue to businesses today
 Conventional approaches to pricing – and their limitations
 Strategic pricing principles
 Legal issues in pricing

 Why pricing is becoming a central issue to businesses today

1. Pricing is the process whereby a business sets the price at which it will sell its products and
services, and may be part of the business's marketing plan. In setting prices, the business will
take into account the price at which it could acquire the goods, the manufacturing cost, the
market place, competition, market condition, brand, and quality of product.

2. Pricing is a fundamental aspect of financial modeling and is one of the four Ps of

the marketing mix. (The other three aspects are product, promotion, and place.) Price is the
only revenue generating element amongst the four Ps, the rest being cost centers. However,
the other Ps of marketing will contribute to decreasing price elasticity and so enable price
increases to drive greater revenue and profits.

3. Pricing can be a manual or automatic process of applying prices to purchase and sales
orders, based on factors such as: a fixed amount, quantity break, promotion or sales
campaign, specific vendor quote, price prevailing on entry, shipment or invoice date,
combination of multiple orders or lines, and many others. Automated systems require more
setup and maintenance but may prevent pricing errors. The needs of the consumer can be
converted into demand only if the consumer has the willingness and capacity to buy the
product. Thus, pricing is the most important concept in the field of marketing, it is used as a
tactical decision in response to comparing market situations.

 Some mistakes of these prices are:

1. Many companies make common pricing mistakes.

2. Weak controls on discounting (price override)
3. Inadequate systems for tracking competitors' selling prices and market share (Competitive
intelligence)
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4. Cost-plus pricing

 Strategic pricing principles: -

fundamental Pricing Principles:

1. Cost-Plus Pricing approach: - Cost plus pricing involves adding a markup to the cost of
goods and services to arrive at a selling price. Under this approach, you add together the
direct material cost, direct labor cost, and overhead costs for a product, and add to it a
markup percentage in order to derive the price of the product. Cost plus pricing can also be
used within a customer contract, where the customer reimburses the seller for all costs
incurred and also pays a negotiated profit in addition to the costs incurred.

2. Competitive pricing: -Is the process of selecting strategic price points to best take
advantage of a product or service-based market relative to competition. This pricing method
is used more often by businesses selling similar products since services can vary from
business to business, while the attributes of a product remain similar. This type of pricing
strategy is generally used once a price for a product or service has reached a level of
equilibrium, which occurs when a product has been on the market for a long time and there
are many substitutes for the product.

3. Value-based pricing: - Is a strategy of setting prices primarily based on a consumer's

perceived value of a product or service. Value pricing is customer-focused pricing, meaning
companies base their pricing on how much the customer believes a product is worth.

 Value-based pricing is different than "cost-plus" pricing, which factors the costs of
production into the pricing calculation. Companies that offer unique or highly valuable
features or services are better positioned to take advantage of the value pricing model than
companies which chiefly sell commoditized items.

4. Price skimming: - Is a product pricing strategy by which a firm charges the highest initial
price that customers will pay and then lowers it over time. As the demand of the first
customers is satisfied and competition enters the market, the firm lowers the price to attract
another, more price-sensitive segment of the population. The skimming strategy gets its
name from "skimming" successive layers of cream, or customer segments, as prices are
lowered over time.

5. Penetration pricing: - Is a marketing strategy used by businesses to attract customers to a

new product or service by offering a lower price during its initial offering. The lower price
helps a new product or service penetrate the market and attract customers away from
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 competitors. Market penetration pricing relies on the strategy of using low prices initially to
make a wide number of customers aware of a new product.

 The goal of a price penetration strategy is to entice customers to try a new product and build
market share with the hope of keeping the new customers once prices rise back to normal
levels. Penetration pricing examples include an online news website offering one month free
for a subscription-based service or a bank offering a free checking account for six months.

 Conventional approaches to pricing – and their limitations

1. KEYSTONE PRICING

Keystone pricing is one of the most common pricing strategies, thanks to its simplicity. The
final selling price is 2X the item’s cost.

Keystone pricing is the best place to start whenever possible. However, the likelihood that it
remains your only pricing strategy is low. Many of today’s products simply cannot be set at
keystone due to high product costs versus the general market rate.

Consider another pricing strategy if your business competes at either ends of the spectrum
— from discount competitors to high-end luxury brands. Adopting keystone pricing at either
end nearly guarantees a loss.

SUMMARY

Keystone pricing is a simple and straightforward approach to pricing. However, it doesn’t

account for supply and demand, a critical component of maximizing revenue

2. MULTIPLE UNIT PRICING

Multiple unit pricing, multiple pricing, or bundle pricing offers shoppers a lower price per
unit for the purchase of two or more products of the same type.

Multiple pricing is particularly useful for clearing excess inventory or introducing new
products. Use this strategy sparingly or customers may think your regular items are
overpriced and will eventually be discounted.

SUMMARY

The ideal time to use multiple pricing is at the end of a season for products that have not
sold well or when you need to introduce new products that customers may be hesitant to try.
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TIP: Read up on your state’s regulations when considering these strategies. For example,
some states will not allow you to sell products below cost or giving products away for free.

3. DISCOUNT PRICING

Discount pricing offers price reductions to customers through sales events or special offers.

Lowering the price of a product to encourage purchases is a conventional strategy employed

in every area of sales, but simply announcing your latest price drop may not be enough. It
can even have adverse effects if your customers perceive the discounted price as the
product's true value. Effective discounting dispels this idea and creates a sense of urgency.

Discount offers are not a one-size-fits-all. Let your product influence your strategy —
specifically, gauge its relevance to the market and its sales history.

SUMMARY

Discount pricing is an easy way to attract new customers and works best when timed for
special events or holidays.

TIP: Provide a reason for every discount. Otherwise, customers will think less of your brand
and product value.

4. LOSS LEADER

A loss leader is a product is priced below its market cost to stimulate the sales of more
profitable goods or services.

Loss leader strategies are great for traffic generation and product introduction. For example:

1. Magazine publishers can attract more long-term subscribers by offering the first few
editions at little to no cost.

2. Cable service providers can offer lower pricing on a competitive feature to recruit new
annual contract signups.

3. Hardware stores often sell larger tools for cost or below, expecting customers to buy
accessories along with the new tool. Accessory items tend to have a much higher
profit margin, and are often impulse buys.

The past success of loss leader pricing has led to many states passing laws that severely limit
— or explicitly forbid — selling products below cost. For some, these limitations may
actually be a blessing. Loss leader strategies can backfire, with customers purchasing only

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products that are priced near or below acquisition cost. Such purchasing patterns effectively
foil the strategy underlying loss leader pricing.

SUMMARY

The loss leader strategy is great for marketing efforts and acquiring new customers.
However, carefully consider your loss leader product and how you intend to promote other
offerings in parallel so that your loss is actually a gain. Most importantly, be aware of your
state’s laws on loss leaders.

5. PSYCHOLOGICAL PRICING

Psychological pricing relies on the nature of human psychology to make prices appear more
attractive to consumers.

There are several types of psychological pricing: odd-even pricing, prestige pricing, anchor
pricing, and price lining.

1. Odd-Even Pricing: The practice of setting prices in odd numbers just below an even
price. For example, marking an item $19.99 rather than the even price of $20.00. This
strategy makes the price appear considerably lower than it is.

2. Prestige Pricing: On the opposite end, prestige pricing inflates prices in order to create a
sense of greater value. For example, a “limited edition” canvas print might be priced at
$70 rather than $30 to give the impression that it is a better and rare product.

3. Anchor Pricing: Anchoring refers to the consumer’s tendency to heavily rely on the first
piece of information offered when making decisions. To apply, place premium products
and services near standard options to help create a clearer sense of value for potential
customers. They will perceive the less expensive option as a bargain in comparison.

4. Price Lining: Better suited for businesses with an extensive product line, this tactic
involves creating a price range for a particular line. For example, Brandless.com has
built an entire business on this strategy with all items priced at $3.

SUMMARY
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Psychological pricing allows business owners to influence how consumers perceive a
product’s value without actually changing the product. This makes it a cost-effective way to
influence consumer purchase decisions.

TIP: Research shows prices ending in “9” are more likely to drive sales.

6. BELOW COMPETITION

This pricing strategy requires retailers to list competing products at prices lower than the
competitions.

Pricing below competition can help businesses carve out a market niche, appealing to every
consumer’s love for low prices. However, by guaranteeing lower prices and therefore lower
profit margins, you will not make a significant return on this strategy until you can realize a
large sales volume. Additionally, even with low overhead costs secured, you remain subject
to your competitors’ actions, i.e. price wars.

One of the worst outcomes of below competition pricing is a "price war,” where competing
businesses race to cut costs and ultimately hurt their bottom line and their brand perception.
Some companies have resolved price wars while still maintaining below competition prices
by redesigning their products for fast and easy manufacturing.

SUMMARY

Pricing below the competition is a common pricing strategy because it’s easy, but it’s also
dangerous if you don’t have a clear understanding of your business’s financials

7. ABOVE COMPETITION

Retailers price above the competition when they have a clear advantage on non-priced
elements of their products, services, and reputation.

In order to charge an amount above the competition, you must differentiate your brand and
products. For example, Apple can consistently charge consumers more because they’ve
established a reputation as makers of high-quality products, ensuring the market sees its
offerings as unique or innovative.

SUMMARY: -Have a good reason if your products are priced significantly higher than the
competition.

 Legal issues in pricing: -

Pricing a product ethically is a major decision for any business. Businesses who use ethical
pricing strategies to sell their products and earn a profit are far more respected than those that
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 hurt and defraud competitors or even consumers. To practice ethical pricing, you need to be able
to spot the ethical issues that hinder fair pricing.
5 ethical pricing issues that hurt businesses
1. Price fixing: Collusion at its worse
 Price fixing involves an agreement between a group of people on the same side of a market to
buy or sell a good or service at a fixed price. Typically, competition between these participants
for consumers drives down prices for goods and services. Yet, imagine a world where every ice
cream shop in America vowed that all single scoops were now $15. Consumers would lose out,
because we’d find alternatives or shell out an exorbitant amount of cash, as we couldn’t go to
another neighborhood joint to battle the high prices/low quality offering of another.

The bottom line: Look at your competitors to understand the market, but don’t get in a room
with them and try to take advantage of consumers. Check out more about competitor

2. Bid rigging: Favoritism

 This one’s more for the proposal crows, but bid rigging involves promising a commercial
contract to one group, even though you make it look like multiple parties had the opportunity
to submit a bid. Not only is this a moral no, but it’s also one of the few the government follows
up on, especially within their own ranks, because of the number of bids and contracts the
government deals with on a yearly basis. This practice hurts consumers considerably, because
the best producer doesn’t receive the work necessarily.
The bottom line: Even if “you know a guy” keep the bidding process honest on both sides.
Everyone will end up better off.
3. Price discrimination: Anti-favoritism
 Price discrimination is the strategy of selling the same product at different prices to different
groups of consumers, usually based on the maximum they are willing to pay. The practice also
surfaces in hiding lower priced items from customers who have a higher willingness to pay.
This one is a little tricky, because it is socially accepted in some cases, yet rejected in others.
For example, very few people would complain that the 80-year-old man and his 2-year-old
great-granddaughter pay $10 less to enter the carnival. Yet, only showing the more expensive
hotels to more affluent customers caused an enormous amount of PR backlash for travel site
Orbitz.

The bottom line: Charge different types of customers differently through product
differentiation, bundling, and the like, but be exceptionally careful about communicating
differences in price.

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 4. Price skimming: Discriminating through time
 Once again, another shady area. Price skimming is when the price for a product is first sold at a
very high price and then gradually lowered. The goal here is pretty obvious, producers want to
capture each step on the demand curve; consumers who are willing to pay more buy the product
first, and then a new groups’ purchases are triggered with each decrease in price.
The bottom line: Find ways to lower prices to new tranches of customers discreetly. Coupons,
promotions, and lightweight versions of a product are all exceptionally effective while keeping
the same number on the page. Check out more on how Apple crushed the latest iPhone price
optimization.
5. Supra competitive pricing: Monopoly gouging
Sometimes the value that consumers place on a good is much greater than the cost of producing
that good. In such cases, there is controversy about whether the corporation is justified in
charging a much higher price and matches the perceived value. This situation can take place
during a shortage, such as the price of food or fresh water after a hurricane, or when a certain
product is the only one of its kind available. Pharmaceuticals and the patents that surround them
are a great example.

The bottom line: This is a common sense scenario, but a good litmus is to ask yourself if the
pricing change hinders an individuals’ necessities. Software products are phenomenal for
improving efficiency, but if the Internet blew up tomorrow, we’d still need food and water.

 Module II Costs & profitability analysis

 Identifying relevant costs for making pricing decisions
 Pricing for profit-maximization – break-even sales analysis
 How cost structures influence pricing strategy
 Cost impact of pricing decisions

 Identifying relevant costs for making pricing decisions

 A relevant cost is a cost that only relates to a specific management decision, and which will
change in the future as a result of that decision. The relevant cost concept is extremely useful
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 for eliminating extraneous information from a particular decision-making process. Also, by
eliminating irrelevant costs from a decision, management is prevented from focusing on
information that might otherwise incorrectly affect its decision.

 This concept is only applicable to management accounting activities; it is not used in financial
accounting, since no spending decisions are involved in the preparation of financial
statements.

 For example, the Archaic Book Company (ABC) is considering purchasing a printing press for
its medieval book division. If ABC buys the press, it will eliminate 10 scribes who have been
copying the books by hand. The wages of these scribes are relevant costs, since they will be
eliminated in the future if management buys the printing press. However, the cost of corporate
overhead is not a relevant cost, since it will not change as a result of this decision.

Types of Relevant Cost Decisions

 Continue Operating vs. Closing Business Units
A big decision for a manager is whether to close a business unit or continue to operate it, and
relevant costs are the basis for the decision. Assume, for example, a chain of retail sporting
goods stores is considering closing a group of stores catering to the outdoor sports market. The
relevant costs are the costs that can be eliminated due to the closure, as well as the revenue lost
when the stores are closed. If the costs to be eliminated are greater than the revenue lost, the
outdoor stores should be closed.

 Make vs. Buy

Make vs. buy decisions are often an issue for a company that requires component parts to
create a finished product. For example, a furniture manufacturer is considering an outside
vendor to assemble and stain wood cabinets, which would then be finished in-house by adding
handles and other details. The relevant costs in this decision are the variable costs incurred by
the manufacturer to make the wood cabinets and the price paid to the outside vendor. If the
vendor can provide the component part at a lower cost, the furniture manufacturer outsources
the work.

 Factoring in a Special Order

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A special order occurs when a customer places an order near the end of the month, and prior
sales have already covered the fixed cost of production for the month. If a client wants a price
quote for a special order, management only considers the variable costs to produce the goods,
specifically material and labor costs. Fixed costs, such as a factory lease or manager salaries are
irrelevant, because the firm has already paid for those costs with prior sales.

 Pricing for profit-maximization – break-even sales analysis

 Break-even analysis seeks to investigate the inter relationships among a firm’s sales revenue
or total turnover, cost, and profits as they relate to alternate levels of output. A profit-
maximizing firm’s initial objective is to cover all costs, and thus to reach the break-even
point, and make net profit thereafter.
 The break-even point refers to the level of output at which total revenue equals total cost.
Management is no doubt interested in this level of output. However, it is much more
interested in the broad question of what happens to profits (or losses) at various rates of
output. Break-even analysis is a very generalized approach for dealing with a wide variety of
questions associated with profit planning and forecasting.

 How cost structures influence pricing strategy

 The cost structure has a greater influence on pricing in marketing. There is a close
relationship between prices, costs and sales volume of a product, because the price
charged affects sales volume by increasing or decreasing the overall demand. As a result of
producing or marketing larger volumes, the unit cost of an individual product reduces, and
so, of all the factors, often this becomes the initial stimulus for firms taking the decision.
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1. Price-quality relationship:
Customers use price as an indicator of quality, particularly for products where objective
measurement of quality is not possible, such as drinks and perfumes. Price strongly influences
quality perceptions of such products.
2. Competition:
A company should be able to anticipate reactions of competitors to its pricing policies and
moves. Competitors can negate the advantages that a company might be hoping to make with its
pricing policies. A company reduces its price to gain market share.
The company has to take care while defining competition. The first level of competitors offers
technically similar products. There is direct competition between brands which define their
businesses and customers in similar way.
The second level of competition is dissimilar products serving the same need in a similar way.
Such competitors’ initial belief is that they are not being affected by the pricing moves of the
company.
The third level of competition would come from products serving the problem in a dissimilar
way. Again, such competitors do not believe that they will be affected. But once convinced that
they are being affected adversely, swift retaliation should be expected.
3. Political factors:
Where price is out of line with manufacturing costs, political pressure may act to force down
prices. Exploitation of a monopoly position may bring short term profits but incurs backlash of
a public enquiry into pricing policies. It may also invite customer wrath and cause switching
upon the introduction of suitable alternatives.
4. Explicability:
The company should be able to justify the price it is charging, especially if it is on the higher
side. Consumer product companies have to send cues to the customers about the high quality
and the superiority of the product.

5. Negotiating margins:
A customer may expect its supplier to reduce price, and in such situations the price that the
customer pays is different from the list price. Such discounts are pervasive in business markets,
and take the form of order-size discounts, competitive discounts, fast payment discounts, annual
volume bonus and promotions allowance.

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 Cost impact of pricing decisions

 Costs should never determine price, but costs do play a critical role in formulating a pricing
strategy. Pricing decisions are inexorably tied to decisions about sales levels, and sales
involve costs of production, marketing, and administration. It is true that how much buyers
will pay is unrelated to the seller's cost, but it is also true that a seller's decisions about which
products to produce and in what quantities depend critically on their cost of production.

 Firms that price effectively decide what to produce and to whom to sell it by comparing the
prices they can charge with the costs they must incur. Consequently, costs do affect the
prices they charge.

 A low-cost producer can charge lower prices and sell more because it can profitably use low
prices to attract more price-sensitive buyers. A higher-cost producer, on the other hand,
cannot afford to underbid low-cost producers for the patronage of more price-sensitive
buyers; it must target those buyers willing to pay a premium price. Similarly, changes in
costs should cause producers to change their prices, not because that changes what buyers
will pay, but because it changes the quantities that the firm can profitably supply and the
buyers it can profitably serve.

 Costs are central considerations in pricing. Without understanding which costs are
incremental and avoidable, a firm cannot accurately determine at what price, if any, a market
can profitably be served. By erroneously looking at historical costs, a firm could sell its
inventory too cheaply.

 By mistakenly looking at no incremental fixed costs, a firm could overlook highly profitable
opportunities where price is adequate to more than cover the incremental costs. By
overlooking opportunity costs, successful companies frequently underprice their products. In
short, when managers do not understand the true cost of a sale, their companies
unnecessarily forgo significant profit opportunities. They tend to overprice when they have
excess capacity, while underpricing and overinvesting when sales are strong relative to
capacity.

Module III Managing Competitive Dynamics

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 Pricing as a “game” – Prisoner’s Dilemma
 Key building blocks for managing price competition: competitive analysis, competitive
strategy and signaling
 Effective responses to competitive pricing moves
 Applications of foundational pricing concepts and techniques

 Pricing as a “game” – Prisoner’s Dilemma

 The prisoner’s dilemma, one of the most famous game theories, was conceptualized by
Merrill Flood and Melvin Dresher at the Rand Corporation in 1950. It was later formalized
and named by Princeton mathematician, Albert William Tucker.

 The prisoner’s dilemma basically provides a framework for understanding how to strike the
prisoner’s dilemma scenario works as follows: Two suspects have been apprehended for a
crime and are now in separate rooms in a police station, with no means of communicating
with each other. The prosecutor has separately told them the following:

 If you confess and agree to testify against the other suspect, who does not confess, the
charges against you will be dropped and you will go scot-free.

 If you do not confess but the other suspect does, you will be convicted and the prosecution
will seek the maximum sentence of three years.

 If both of you confess, you will both be sentenced to two years in prison.

 If neither of you confesses, you will both be charged with misdemeanors and will be
sentenced to one year in prison. Balance between cooperation and competition and is a
useful tool for strategic decision-making.

 The prisoner’s dilemma elegantly shows when each individual pursues his or her own self-
interest, the outcome is worse than if they had both cooperated. In the above example,
cooperation–wherein A and B both stay silent and do not confess–would get the two suspects
a total prison sentence of two years. All other outcomes would result in a combined sentence
for the two of either three years or four years.

 Key building blocks for managing price competition: competitive analysis, competitive
strategy and signaling
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 A price Competition is a competitive exchange among rival companies who lower the price
points on their products, in a strategic attempt to undercut one another and capture greater
market share. A price war may be used to increase revenue in the short term, or it may be
employed as a longer-term strategy.

 Price wars can be prevented through strategic price management, that relies on non-
aggressive pricing, a thorough understanding of the competition, and even robust
communication with competitors.

1. The company may choose to reveal its strategic intentions to its competitors without
responding to the price cut in any other manner.

 For instance, it may reveal its low-cost structure to competitors that could allow it to sustain
the price war longer, if required.
 It may also let it be known to competitors that it does not intend to compete on the basis of
price in this market. Maybe the firm could alert the regulators indirectly against such
predatory moves of the competitor. The basic intention of this move is to scare the
competitor, or to let it know that it would eventually lose out in the race.

2. The company would also have to emphasize high quality or value-added features in its
communications or provide more value or denigrate the attempt of competitors to shift the
focus of customers away from quality to price. Perhaps they could also try to convince
customers of the dangers of buying lower priced products, or warn them against future
competitive moves.

3. It is important to remember that there is life after price wars for brands. The brand
should strengthen itself by providing more features and benefits and advertising more
stridently. A stronger brand is the ultimate deterrence against price slashing competitors. But
if brands reduce prices indiscriminately during the price war as a retaliatory measure, it
damages the brand image for good.

4. The last option for the company is to fight the price war. The company has to resort to
this option if it stokes in the industry are high i.e. the business is strategically important for
the company. However, the ability to fight out the war depends on the financial strength of
the company.

5. If the company cannot fight the price war, and it is foreseen that the war would be
fought by other stronger players in the industry, the company should start planning
exit strategies. There is no point fighting a battle which one can never expect to win.

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 The competitive analysis is a statement of the business strategy and how it relates to the
competition. The purpose of the competitive analysis is to determine the strengths and
weaknesses of the competitors within your market, strategies that will provide you with a
distinct advantage, the barriers that can be developed in order to prevent competition from
entering your market, and any weaknesses that can be exploited within the product
development cycle.

 The first step in a competitor analysis is to identify the current and potential competition. As
mentioned in the "Market Strategies" chapter, there are essentially two ways you can identify
competitors. The first is to look at the market from the customer's viewpoint and group all
your competitors by the degree to which they contend for the buyer's dollar. The second
method is to group competitors according to their various competitive strategies so you
understand what motivates them.

 The competitive strategy: - Michael Porter uses 4 strategies that an organization can choose
from. He believes that a company must choose a clear course in order to be able to beat the
competition.

 The four strategies to choose from are:

1. Cost Leadership
2. Differentiation
3. Cost Focus
4. Differentiation Focus
1. Cost Leadership
You target a broad market (large demand) and offer the lowest possible price. You can opt to
keep costs as low as possible; or ensure that you have a larger market share with average prices.
In both cases, the point is to keep the company costs as low as possible. The consumer price is a
different story.
2. Differentiation
You target a broad market (high demand), but your product or service has unique features. With
this strategy, you make your product as exclusive as possible, making it more attractive than
comparable products offered by the competition. Succeeding using this strategy requires good
research & development, innovation and the ability to deliver high quality. Effective marketing
is important, so that the market understands the benefits of your unique product. It’s important
to be flexible and to be able to adapt quickly in a changing market, or you risk the competition
beating you at it. Such an organization is focused on the outside world and has a creative
approach.

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3. Cost Focus
You target a niche market (little competition, ‘focused market’) and offer the lowest possible
price. In this strategy, you choose to target a clear niche market and through understanding the
dynamics of the market and the wishes of the consumers, you can ensure that the costs remain
low.

4. Differentiation Focus
You target a niche market (little competition, ‘focused market’) and your product or service has
unique features. This strategy often involves strong brand loyalty among consumers. It’s very
important to ensure that your product remains unique, in order to stay ahead of possible
competition.

In order to choose the right strategy for your organization, it’s important be aware of the
competencies and strengths of your company.

o Signaling: - A price signal is a change in the price of goods or services which indicates that
the supply or demand should be adjusted.

o For example, if there is a shortage of oranges, the price will increase, signaling that the
purchase and consumption of oranges must be reduced.

 Applications of foundational pricing concepts and techniques

 Pricing Technique: -

1. Cost-based Pricing:
Cost-based pricing refers to a pricing method in which some percentage of desired profit
margins is added to the cost of the product to obtain the final price. In other words, cost-based
pricing can be defined as a pricing method in which a certain percentage of the total cost of
production is added to the cost of the product to determine its selling price. Cost-based pricing
can be of two types, namely, cost-plus pricing and markup pricing.

2. Demand-based Pricing:

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 Demand-based pricing refers to a pricing method in which the price of a product is finalized
according to its demand. If the demand of a product is more, an organization prefers to set
high prices for products to gain profit; whereas, if the demand of a product is less, the low
prices are charged to attract the customers.

 The success of demand-based pricing depends on the ability of marketers to analyze the
demand. This type of pricing can be seen in the hospitality and travel industries. For
instance, airlines during the period of low demand charge less rates as compared to the
period of high demand. Demand-based pricing helps the organization to earn more profit if
the customers accept the product at the price more than its cost.

3. Competition-based Pricing:

 Competition-based pricing refers to a method in which an organization considers the prices

of competitors’ products to set the prices of its own products. The organization may charge
higher, lower, or equal prices as compared to the prices of its competitors.

 The aviation industry is the best example of competition-based pricing where airlines charge
the same or fewer prices for same routes as charged by their competitors.

 Pricing Concept

a. Cost based pricing:

i) cost plus pricing:
In cost plus pricing, price of the product is the sum of cost-plus profit margin. It is also known
as markup pricing. It can be represented by:
Price = AC + M, where AC = average cost, M = profit margin.
ii) Marginal cost pricing:
In marginal cost pricing, price of the product is the sum of variable cost plus a profit margin.
iii) Target return pricing:
In target return pricing, a producer rationally decides the minimum rate of return that the
product must earn.

b. Pricing based on firm’s objectives:

17
Firm may aim at maximizing profit or sales or growth or managerial function.
i) Profit maximization:
A firm which aims to earn maximum profit would naturally consider total cost of production
for determination of price and hence will adopt markup pricing.
ii) Sales maximization:
Some firms maximize sales instead of profit maximization. Such firms will adopt competitive
pricing.
c. Competition based pricing:
Degree of competition depends on entry and exit barriers.
i) Penetration pricing: When a firm plans to enter a new market, which is dominated by
existing players, its only option is to charge low price, even lower than the ongoing
price.
ii) Entry deterring pricing:
In Entry deterring pricing, the price is kept low, thus making the market unattractive for other
market players.
iii) Going rate pricing:
In going rate pricing, most of the players do not indulge in separate pricing but prefer to follow
the prevailing price in the market.
d. Product life cycle-based pricing:
Product life cycle-based pricing refers to different pricing for a product at different stages of its
lifecycle.
i) Price skimming:
Under Price skimming, producers charge a very high price in the beginning to skim the market
and earn super margins on sales.
ii) Product bundling or packaging:
In Product bundling or packaging, two or more products are bundled together for a single price.
iii) Perceived value pricing:
In Perceived value pricing, value of the goods for different consumers depends upon their
perception of the utility of the good.

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iv) Value pricing:
In Value pricing, sellers try to create a high value of the product and charge a low price.
v) Loss leader pricing:
In Loss leader pricing, multi-product firms sell one product at a low price to compensate the
loss by other products.
e. Cyclical pricing:
Due to the ups and downs in the prevailing economic condition, this cyclical pricing exists.
i) Rigid pricing:
Rigid pricing states that firms should follow a stable pricing policy irrespective of the phase of
the economic cycle.
ii) Flexible pricing:
In Flexible pricing method, firms keep their prices flexible to meet the challenges of change in
demand.
f. Multiproduct pricing:
There are 2 options for a multiproduct firm namely: It may produce and sell only its final
product to the end consumer; and/or it may produce and sell products which are used as
intermediary goods. Based on the product utility pricing differs and is termed as multiproduct
pricing.

 Module IV Segmented Pricing

 Benefits of segmented pricing

 Techniques for segmented pricing
 Framework for investigating segmented pricing opportunities
 Negotiated pricing: Structuring and managing price negotiations
 Menu pricing
 The elements of price: Quantity discounts; Two-part tariffs (signup plus usage fees)
 Bundling Product Line Pricing: Pricing substitutes and complementary products,
Pricing to drive image or to drive traffic
 Markdown Pricing
 Performance-based Pricing Price Rationalization: “Pocket price” and “pocket price
band”
 SKU pricing analysis

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 Segmented Pricing

 A situation that occurs when a company sets more than one price for a product without
experiencing significant differences in the costs of producing or distributing the product.
For example, a segmented pricing structure might be used by a business to take advantage of
pricing disparities observed between different geographical regions.
 Price segmentation is simply charging different prices to different people for the same or
similar product or service. You see examples every time you go shopping: student prices at
movie theaters, senior prices for coffee at McDonald’s, people who use coupons and many
more.

 Benefits of segmented pricing

 Price segmentation (offering different prices to different market segments) increases overall
revenues and profits, and it is particularly beneficial to industries that have high fixed cost
structures. Obviously, price segmentation works better to the extent to which there are real
customer need segments and to which you can effectively isolate those segments.

 Price segmentation is a suitable strategy if you have a narrow product range and can
identify groups of prospects who would buy if the price was lower or who would be
prepared to pay a higher price in return for a factor that they felt added value to the product.

 To target prospects looking for lower prices, you could, for example, offer the same product
in simpler packaging or offer a lower price to online buyers. Reduce your costs by stripping
out extras, such as quality packaging or discounts to retailers. To charge higher prices, offer
customers a service, such as first-class delivery, or distribute the product through retailers
that offer a high level of personal service to customers.

 Techniques for segmented pricing

1. PRICE SEGMENTATION BY CUSTOMERS
 Some customers are more sensitive to price than others. They’re motivated by how much
they pay rather than what they get out of the deal. While my team and I emphasize the

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 importance of pricing and selling on value, that angle won’t work very often with this type
of customer.

 To serve these thrifty customers, split them up by the different ways they prefer to save
money. These methods can include coupons or promotions for those who crave the reward of
a one-time price concession or discounts for students seeking a reason to stay loyal to a
business during their lower-income years. These customers will put in more effort to save on
price, so don’t be afraid to make them jump through a few hoops to get a concession.

2.PRICE SEGMENTATION BY BUYING SITUATION

 Offering customization and personalization by a customer’s specific buying situation is the

most difficult ─ and therefore least utilized – kind of price segmentation for B2B businesses.
It involves recognizing that targeting for a specific type of customer isn’t enough; you have
to consider their needs and state of mind at the point of every purchase they make.
 To deliver the best experience for your customers, always consider the immediate needs of
their unique buying situation when building deals. For example, a customer may need a
quick turnaround time, a drop ship order, or special packaging. Some companies even make
special allowances for customers who need to place orders on the weekends.

3.PRICE SEGMENTATION BY VOLUME

 You can also segment customers by volume purchased. There are two different ways to do
this – by order volume and annual volume.

 The first type segments customers for the size of their purchases. By separating those who
make high volume purchases from those who make lower volume ones and customizing
your strategies accordingly, you can increase profitability for each group. For example, you
can give customers seeking incentives for larger orders a discount or freight allowance. You
can also require customers pursuing smaller orders to pay a below-minimum-order free.

 The second type of price segmentation by volume takes a year’s worth of purchases into
consideration. Some customers may make small, frequent purchases but end up being a
high-volume customer when you add up their purchases over the span of a year. Other
customers may make one large purchase, and you don’t hear back from them for another
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 twelve months. Those who frequently purchase may take more time and resources to serve
and should therefore pay a higher price.
4. PRICE SEGMENTATION BY STOCK LEVELS
 Product-based companies organize their pricing strategy by product stock levels.
Customers are willing to pay more for a rare item and often expect to pay less for something
they can find practically anywhere, anytime.

 To profit from this strategy, price products in high stock and demand slightly lower to gain a
competitive advantage and reduce purchase barriers. For rarer products, do the opposite.
Having a rare product in stock is important for that one customer who needs it. By having it
on hand, you give the product incremental value, which you can capture with an increased
price.

5. PRICE SEGMENTATION BY LOCATION

 Next consider how your customers vary by location. Some areas are more expensive than
others for any number of reasons, including shipping, tariffs, and the general costs of doing
business. Consider, for example, the price difference of a beer or pack of cigarettes in New
York City and Springfield, Ill.

 Customers in these various markets are used to paying more or less, and there’s no reason
for you to not jump into the game. Capture higher prices in locations where it makes sense. I
recommend keeping an eye on your competitors’ prices or on the prices of products in a
similar industry. If they are pricing higher with little resistance, it’s a good sign you should
be doing the same.

 Negotiated pricing: Structuring and managing price negotiations

Negotiated Price: - A price agreed upon for the supply of goods or services by both buyer and
seller.

 6 Steps for Structuring Negotiations

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1. Listen – No matter what type of negotiations you find yourself involved with; it is mandatory
to be a good listener. Listening is not simply hearing your client, but actively processing what is
being discussed, as well as understanding what your client is asking for. There is no easier way
to ruin a negotiation than to be a poor listener, so be cognizant of your communication skills
and practice pacing your delivery, thereby allowing the client to be involved and heard.

2. Know your client’s pain points –Know what your client is looking for and is motivated by
before entering the negotiation session. This knowledge will help you tailor your approach to
give the client what is desired as best as possible, but also prepare you in streamlining your
negotiating pitch. Winning a government contract is always predicated on lowest bid, but
dealing with a private entity can involve numerous other hot button considerations. Know the
differences, and proceed accordingly.

3. Prepare your negotiating strategy – Just as you must be prepared by knowing your client’s
pain points and projecting your client’s desired outcomes, you need to prepare your own
Opening Position and Bottom Line, clearly understanding your own essentials and
expendables, setting yourself up to be able to make concessions in exchange for agreement on
your own essentials.

4. Don’t give away too much, too soon – There is no denying the fundamental give-and-take
dynamic that is the foundation of every negotiation. The adage, “To get along, you have to go
along” rings true and must be heeded, albeit cautiously. Will some sort of compromise
capability be part of your negotiating skills repertoire? Absolutely, but never give anything
away until you are ready. Knowing the proper time to bend has much to do with the two
previously discussed steps.

5.Quality vs. Price – Beware the negotiating proclamation, “It’s not about the money.” It’s
ALWAYS about the money and to win you must redirect the dialogue toward the inherent value
that you offer a client. Cheapest is rarely best, and your negotiating focus must be on
differentiating the goods or services you offer as valuable commodities, not merely the most
cost-effective options. Be prepared to explain what you can provide your clients, and educate
them on the overall picture, not merely the dollar signage. When a client makes demands that
you cannot meet, look to understand the needs behind those demands and identify

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 Managing price negotiations: -

1. Ask questions.
 If you spend time asking questions and listening, instead of just repeating your bottom line
over and over again, you can get to the heart of what your customer is really looking for.
Perhaps they're comparing your price to another that isn't an apples-to-apples scenario, and a
detailed look at that can help resolve things. Perhaps they've been "ripped off" before, and
what they're really looking for is a little control or a little respect. Find out their true
priorities and you may uncover how you can provide something they really care about.

2. Avoid negotiating on price alone.

 If your customers aren't opening up about their needs, consider all the ways you can add
value that don't involve price—and be prepared to use these as variables in the discussion.
As you discuss value-added propositions from your end, you may trigger interest on the
customers' side that shows what they're really looking for. When you understand your
customers' agenda, and the ways you can add value beyond price, you may find your win-
win.
3. Make smart concessions.
 Consider giving a little by offering things your customer values highly, but that have a low
incremental cost for your business. Perhaps there is a service or follow-up you can provide
that will make the customer feel they are getting a longer-term commitment and more value.
Perhaps there are timelines that can be adjusted so the work is done faster than anticipated.
That can feel like a great bonus. Perhaps there is something in the payment schedule that can
be adjusted. Maybe it isn't the price they're balking at, but when it is due. If your customer is
in negotiation mode, they probably want to walk away with something.

4. Be transparent about your dual needs.

 Conversations are more productive when both sides are open. Instead of standing firm with
no explanation, have a discussion that involves their needs and your needs. Explain what the
cost involves and why it is what it is. If your price is different than a competitor, try letting
the customer know why and what they are getting for the additional cost. Make sure they
understand that you want to satisfy them and make them happy, but that you also have a
business to run and can only go so far.

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 The elements of price: Quantity discounts; Two-part tariffs (signup plus usage fees)

 Quantity discounts: - A quantity discount is an incentive offered to a buyer that results in a

decreased cost per unit of goods or materials when purchased in greater numbers. A quantity
discount is often offered by sellers to entice customers to purchase in larger quantities.

 The seller is able to move more goods or materials, and the buyer receives a more favorable
price for them. At the consumer level, a quantity discount can appear as a BOGO (buy one,
get one discount) or other incentives, such as buy two, get one free.

 Two-part tariffs (signup plus usage fees)

 The two-part tariff. The two-part tariff is related to price discrimination and provides
another means of extracting consumer surplus. It requires consumers to pay a fee up front
for the right to buy a product. Consumers then pay an additional fee for each unit of the
product they wish to consume.

 Bundling Product Line Pricing: Pricing substitutes and complementary products,

Pricing to drive image or to drive traffic

 Product line pricing refers to the practice of reviewing and setting prices for multiple
products that a company offers in coordination with one another. Rather than looking at each
25
 product separately and setting its price, product-line pricing strategies aim to maximize the
sales of different products by creating more complementary, rather than competitive,
products. If you offer more than one product or service, consider the impact that one
product's or service's price will have on the others.
 Pricing substitutes and complementary products Complements are goods that are
consumed together. Substitutes are goods where you can consume one in place of the other.
The prices of complementary or substitute goods also shift the demand curve. When the
price of a good that complements a good decrease, then the quantity demanded of one
increase and the demand for the other increases. When the price of a substitute good
decreases, the quantity demanded for that good increases, but the demand for the good that it
is being substituted for decreases.

 Pricing to drive image or to drive traffic

1. Run Paid Social Media Ad Campaigns

To increase website traffic for your online store, you need to be able to get your business in
front of your ideal customers. With paid social media ads, you can create highly targeted
campaigns that serve tailor-made ads to the customers who are most likely to click through and
purchase your products.

2. Use SEO to Increase Your Store’s Discoverability

Can your customers actually find your store online?
When customers search for your products online, you want your store to be one of the top
results for that search, especially since ⅓ of all clicks go to the first organic result on Google.
That prized top position is a key ingredient for generating sustained, qualified website traffic for
your online store.
Search Engine Optimization, or SEO, is the process of fine-tuning your website to increase its
chances of ranking highly in search results for relevant keywords.

3. Reach New Audiences with Influencer Marketing

Influencer marketing is the process of building relationships with influencers to get your online
store in front of new audiences.

26
With influencer marketing, you can harness the creativity and reach of relevant influencers in
your industry while leveraging the trust that they’ve already formed with their audiences.
4. Drive Excitement with Contests and Giveaways
While many of these methods may seem like long term solutions for increasing your traffic,
there are ways to give your business a short-term boost in numbers as well.
With viral contests, giveaways, and sweepstakes you can quickly drive more traffic to your
store by offering exciting prizes in exchange for your customers’ participation. Prizes and
rewards are powerful incentives for getting both current and new customers to actually visit
your store.

 Markdown Pricing: - A price markdown is a deliberate reduction in the selling price of

retail merchandise. It is used to increase the velocity (rate of sale) of an article, typically
for clearance at the end of a season, or to sell off obsolete merchandise at the end of its life.

 The timing and level of markdowns in a selling season is critical to maximizing return on
sales. This is often measured as revenue realization: the proportion of the potential original
selling price achieved. For example, a revenue realization of 50% means that only half the
potential full-price sales value was achieved by the end of the season. It is also important in
minimizing terminal inventory, i.e. the amount of merchandise left when the season is
finished.

 A recent trend has been to use demand optimization software to establish the most
desirable timing and level of markdown. Optimization techniques can be used to determine
where the best combination of revenue realization and terminal inventory is going to
come from, for example, comparing a tactic of low-level markdowns from early in the
season against one of later, deeper reductions.

When to use Markdown Price?

 Buying products and marking down the price of the products is not a good strategy. You
should know when to mark down the prices of products before you end up having expired or
out of trend products.

 To do this, you should make the use of your calendar to mark down the price of products
with time. Markdown the price only if the product has remained in the store for a long period
of time.

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 For example, some retailers mark down the price of a product if it has been on the shelves
for more than two months. The markdown of the price should not be a random decision. You
should mark down the price of the product at regular intervals.

 Performance-based Pricing Price Rationalization: “Pocket price” and “pocket price

band”

 Performance-based pricing is an arrangement in which the seller is paid based on the

actual performance of its product or service. It is becoming much more popular. In the
advertising industry, agencies had been traditionally paid 15 percent of the cost of the
media they bought for a client.

 The pocket price is the list price minus discounts, rebates, promotions, free freight, and
similar offers. The contribution margin of a sale transaction can be determined by
subtracting the cost of goods sold from the pocket price. For example, a business sells a
product that has a list price of $100. There are associated discounts and rebates totaling $20,
so the pocket price is $80. The cost of goods sold is $50. This means that the contribution
margin is $30.

 A variation on the pocket price concept is the pricing waterfall, which begins with the list
price and then individually subtracts every possible deduction allowed to a customer, to
arrive at the pocket price. This visual presentation is useful for understanding the size and
scope of the discounts being granted to customers.

 The pocket price band plots the range of pocket prices over which any given unit volume
of a single product sells. Wide price bands are commonplace: some manufacturers'
transaction prices for a given product range 60%; one fastener supplier's price band ranged
up to 500%. Managers who study their pocket price waterfalls and bands can identify
unnecessary discounting at the transaction level, low-performance accounts, and misplaced
marketing efforts. The problems, once identified, are typically easy and inexpensive to
remedy.

 SKU pricing analysis: - A stock-keeping unit (SKU) is a scannable bar code, most often
seen printed on product labels in a retail store. The label allows vendors to automatically
track the movement of inventory. The SKU is composed of an alphanumeric combination of
eight-or-so characters. The characters are a code that the price, product details, and the
manufacturer. SKUs may also be applied to intangible but billable products, such as units of
repair time in an auto body shop or warranties.

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 P/E Ratio
A common method to analyzing a stock is studying its price-to-earnings ratio. You calculate the
P/E ratio by dividing the stock’s market value per share by its earnings per share. To determine
the value of a stock, investors compare a stock’s P/E ratio to those of its competitors and
industry standards. Lower P/E ratios are seen as favorable by investors.

 Earnings Per Share

A company’s earnings per share show how efficiently its revenue is flowing down to investors.
An increasing EPS is taken as a good sign by investors. According to NASDAQ, the higher a
company’s EPS, the more your shares are worth, because investors seek to purchase a
company’s stock when earnings are high.

 PEG Ratio
The price-to-earnings growth ratio takes the P/E ratio a step further by considering the growth
of a company. To calculate the PEG, you divide the P/E ratio by the 12-month growth rate. You
estimate the future growth rate by looking at the company’s historical growth rate. Investors
typically consider a stock valuable if the PEG is lower than 1.

 Book Value
Another method used to analyze a stock is determining a company’s price-to-book ratio.
Investors typically use this method to find high-growth companies that are undervalued. The
formula for P/B ratio equals the market price of a company’s stock divided by its book value of
equity. Book value of equity is derived by subtracting the book value of liabilities from the book
value of assets. Investors view a low P/B ratio as a sign that the stock is potentially
undervalued.

 Return on Equity
Investors use return on equity to determine how well a company produces positive returns for
its shareholders. Analyzing ROE can help you find companies that are profit generators. ROE is
calculated by dividing net income by average shareholders’ equity. A continual increase in ROE
is a good sign to investors.

 Module VI Pricing Strategies

 Theories influencing Pricing Strategies
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 o Positioning of the product/ service
o Perception around the product/ service
 Penetration Pricing
 Price Skimming
 Monopoly Pricing
 Every-day low pricing strategy
 Pricing of Services
 On-line pricing
 Sectoral Pricing

 Theories influencing Pricing Strategies

 Positioning of the product/ service

 Product positioning is an important element of a marketing plan. Product positioning is the

process marketers use to determine how to best communicate their products' attributes to
their target customers based on customer needs, competitive pressures, available
communication channels and carefully crafted key messages. Effective product positioning
ensures that marketing messages resonate with target consumers and compel them to take
action.

 Effective product positioning requires a clear understanding of customer needs so that the
right communication channels are selected and key messages will resonate with customers.
Product positioning starts with identifying specific, niche market segments to target – not
just women over 25 but women from 25 to 30 who work in senior-level management
positions, make $X per year, are single and enjoy sporting activities. The more specific, the
better.

 In addition to identifying the customer based on demographic and psychographic

(personality/lifestyle) attributes, marketers need to understand customer needs, especially
relative to the products and services they have to offer, to clearly convey value as part of
their marketing plan.

 Perception around the product/ service

 The Business Dictionary defines consumer perception as a “marketing concept that

encompasses a customer’s impression, awareness or consciousness about a company or its

30
 offerings. Typically, customer perception is affected by advertising, reviews, public relations,
social media, personal experiences, and other channels.”

 The truth is that everything affects customer perception, from the way you position your
product vertically and horizontally on a shelf, to the colors and shapes you use in creating
your logo. Even things outside of your control, which may seem innocuous, such as the time
of the day when your customer interacts with your brand - even this will affect consumer
perception. Your customers might have a positive perception of you if they come across your
products and your niche during a certain time of the day, but they may hold a negative
perception at another time of day.

 Penetration Pricing: -

 Penetration pricing is a marketing strategy used by businesses to attract customers to a new

product or service by offering a lower price during its initial offering. The lower price helps
a new product or service penetrate the market and attract customers away from competitors.
Market penetration pricing relies on the strategy of using low prices initially to make a wide
number of customers aware of a new product.

 The goal of a price penetration strategy is to entice customers to try a new product and build
market share with the hope of keeping the new customers once prices rise back to normal
levels. Penetration pricing examples include an online news website offering one month free
for a subscription-based service or a bank offering a free checking account for six months.

 Price Skimming: - Price skimming is a product pricing strategy by which a firm charges the
highest initial price that customers will pay and then lowers it over time. As the demand of
the first customers is satisfied and competition enters the market, the firm lowers the price to
attract another, more price-sensitive segment of the population. The skimming strategy gets
its name from "skimming" successive layers of cream, or customer segments, as prices are
lowered over time.

 Price skimming is often used when a new type of product enters the market. The goal is to
gather as much revenue as possible while consumer demand is high and competition has not
entered the market.

 Once those goals are met, the original product creator can lower prices to attract more cost-
conscious buyers while remaining competitive toward any lower-cost copycat items entering
the market.

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 This approach contrasts with the penetration pricing model, which focuses on releasing a
lower-priced product to grab as much market share as possible. Generally, this technique is
better-suited for lower-cost items, such as basic household supplies, where price may be a
driving factor in most customers' production selections.

 Monopoly Pricing: - Monopoly pricing is a pricing strategy followed by a seller whereby

the seller prices a product to maximize his or her profits under the assumption that he or she
does not need to worry about competition. In other words, monopoly pricing assumes the
absence of competitors being able to garner a larger market share by charging lower prices.

 Monopoly pricing requires not only that the seller have significant market power, possibly a
monopoly or near-monopoly or a cartel of oligopolists, but also that the barriers to entry for
selling that good are high enough to dissuade potential competition from being attracted by
the high pricing. In particular, monopoly pricing is infeasible in contestable markets.

 Every-day low pricing strategy

 Everyday low price is a pricing strategy promising consumer a low price without the need to
wait for sale price events or comparison shopping. EDLP saves retail stores the effort and
expense needed to mark down prices in the store during sale events, and is also believed to
generate shopper loyalty.

 Everyday Low Pricing advantages

 Those stores using EDLP strategy can focus on marketing message on quality rather than
adverting sales.

 Everyday pricing strategy provides consumers the convenience to avail low prices everyday
than competitors’ prices. Competitors may provide low prices at regular interval but will not
be available on everyday basis.

 EDLP pricing strategy minimizes demand fluctuations that would occur regularly in
traditional sales promotion and loyalty programs. For example, many retailers who offer
sale promotion only on Black Friday or New Year will face it difficult to forecast demand
accurately.

 for example, Wal-Mart, Amazon, Procter & Gamble, Winn-Dixie and Trade Joe’s who are
offering everyday low pricing approach. According to a study 26% American retailers follow
EDLP and 74% follow high low promotions.

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 Pricing of Services

 Pricing is a vital area in marketing. Price is one of the significant elements in the marketing
mix. It is the sole and an important element in the marketing mix of a firm that brings
revenue to the business. Organizations should use a sophisticated approach to pricing. While
pricing the services, due regard should be given to shifts in demand, the rate at which supply
can be expanded, prices of available substitutes, the price – volume relationship and the
availability of future substitutes. Service companies must understand how customers
perceive prices of services.

 On-line pricing: - Online pricing is the price assigned to items that are purchased via
internet shopping. Some retailers offer items online as well as at their physical store
locations, while other retailers only offer items online or at a physical location for in person
purchasing. Prices may vary depending on whether the item is purchased online or at a store.

Module V Theories of Consumer Behavior

 Theories of consumer behavior (that focus on price perceptions and response)

o Utility Theory; Indifference Theory; Attitude formation/ change; Individual and
Collective Change; Quality Perception
 Rational views, Subjective views
 Framework for analyzing customer WTP (willingness to pay) and response to price changes
 How marketers can influence price perceptions and elasticity

 Utility theory

 Utility theory provides a methodological framework for the evaluation of alternative choices
made by individuals, firms and organizations. Utility refers to the satisfaction that each
choice provides to the decision maker. Thus, utility theory assumes that any decision is made
on the basis of the utility maximization principle, according to which the best choice is the
one that provides the highest utility (satisfaction) to the decision maker.

 Economics concept that although it is impossible to measure the utility derived from a good
or service, it is usually possible to rank the alternatives in their order of preference to the
consumer. Since this choice is constrained by the price and the income of the consumer, the
rational consumer will not spend money on an additional unit of good or service unless its
marginal utility is at least equal to or greater than that of a unit of another good or service.
33
 Therefore, the price of a good or service is related to its marginal utility and the consumer
will rank his or preferences accordingly.
The utility theory then makes the following assumptions:

Completeness: Individuals can rank order all possible bundles. Rank ordering implies that the
theory assumes that, no matter how many combinations of consumption bundles are placed in
front of the individual, each individual can always rank them in some order based on
preferences.
More-is-better: Assume an individual prefers consumption of bundle A of goods to bundle B.
Then he is offered another bundle, which contains more of everything in bundle A, that is, the
new bundle is represented by αA where α = 1. The more-is-better assumption says that
individuals prefer αA to A, which in turn is preferred to B, but also A itself. For our example, if
one week of food is preferred to one week of clothing, then two weeks of food is a preferred
package to one week of food.
Mix-is-better: Suppose an individual is indifferent to the choice between one week of clothing
alone and one week of food. Thus, either choice by itself is not preferred over the other. The
“mix-is-better” assumption about preferences says that a mix of the two, say half-week of food
mixed with half-week of clothing, will be preferred to both stand-alone choices. Thus, a glass of
milk mixed with Milo (Nestlé’s drink mix), will be preferred to milk or Milo alone.
Rationality: This is the most important and controversial assumption that underlies all of utility
theory. Under the assumption of rationality, individuals’ preferences avoid any kind of
circularity; that is, if bundle A is preferred to B, and bundle B is preferred to C, then A is also
preferred to C. Under no circumstances will the individual prefer C to A. You can likely see
why this assumption is controversial.
 Indifference Theory: -

 An indifference curve is a graph that shows a combination of two goods that give a
consumer equal satisfaction and utility, thereby making the consumer indifferent.
Indifference curves are devices used in contemporary microeconomics to demonstrate
consumer preference and the limitations of a budget. Recent economists have adopted the
principles of indifference curves in the study of welfare economics.

 An indifference curve shows a combination of two goods that give a consumer equal
satisfaction and utility thereby making the consumer indifferent.

 Along the curve, the consumer has no preference for either combination of goods because
both goods provide the same level of utility.
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 Each indifference curve is convex to the origin, and no two indifference curves ever
intersect.

 Quality Perception: -

 Perceived quality can be defined as the customer's perception of the overall quality or
superiority of a product or service with respect to its intended purpose, relative to
alternatives. Perceived quality is, first, a perception by customers.

 Perceived quality cannot necessarily be objectively determined, in part because it is a

perception and also because judgments about what is important to customers are involved.
An evaluation of washing machines by a Consumer Report expert may be competent and
unbiased, but it must make judgments about the relative importance of features, cleaning
action, types of clothes to be washed, and so on that may not match those of all customers.
After all, customers differ sharply in their personalities, needs, and preferences.

 Perceived quality is an intangible, overall feeling about a brand. How-ever, it usually will be
based on underlying dimensions which include characteristics of the products to which the
brand is attached such as reliability and performance. To understand perceived quality, the
identification and measurement of the underlying dimensions will be useful, but the
perceived quality itself is a summary, global construct.

 Rational views, Subjective views

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 Rationality is the quality or state of being rational – that is, being based on or agreeable to
reason. Rationality implies the conformity of one's beliefs with one's reasons to believe, and
of one's actions with one's reasons for action. "Rationality" has different specialized
meanings in philosophy, economics, sociology, psychology, evolutionary biology, game
theory and political science.

 To determine what behavior is the most rational, one needs to make several key assumptions,
and also needs a logical formulation of the problem. When the goal or problem involves
making a decision, rationality factors in all information that is available (e.g. complete or
incomplete knowledge). Collectively, the formulation and background assumptions are the
model within which rationality applies.

 Rationality is relative: if one accepts a model in which benefitting oneself is optimal, then
rationality is equated with behavior that is self-interested to the point of being selfish;
whereas if one accepts a model in which benefiting the group is optimal, then purely selfish
behavior is deemed irrational. It is thus meaningless to assert rationality without also
specifying the background model assumptions describing how the problem is framed and
formulated.

A subjective point of view is something based on one’s opinions, perspectives, beliefs,

discoveries, desires, and feelings. It has no concern with right or wrong, other than the person’s
opinion of what is right and wrong. Likewise, subjective writing or point of view is based on
the writer’s own observation and experience. It focuses on the writer’s personal point of view
and not built on facts that others see or things others go through.

Third person point of view can also be subjective. It is known as “limited omniscience,” in
which a writer knows every detail about a character and sees the whole story through that
character’s eyes.

 Framework for analyzing customer WTP (willingness to pay)

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 Willingness to pay (WTP) is the maximum price at or below which a consumer will
definitely buy one unit of a product.[1] This corresponds to the standard economic view of a
consumer reservation price. Some researchers, however, conceptualize WTP as a range.

 Customer willingness to pay (WTP) is estimating how much a given customer would be
willing to pay for a particular product or service.

 Different customers will have a different willingness to pay for a firm’s product which
would place them in a different market segment. We should start from understanding the
relative valuations of each segment.

 Understanding WTP is also valuable for more tactical reasons such as pricing and new
product design. The basic approach to calculate WTP is attribute valuation.

Attribute Valuation
There are a number of techniques that can be used to calculate a customer’s willingness to pay
for a product and even to value a particular attribute or feature of that product. The most
obvious is market research that simply asks customers, how much would you pay for this
product? However, more accurate and sophisticated techniques such as revealed preference
(valuable for products already on the market) where analysis of the actual consumer purchases
can reveal their willingness to pay and discrete choice(valuable for new products) which is
useful for identifying the value of individual attributes of a product or combinations of features
that have not yet been offered for sale in the market.

Revealed Preference
Data on actual customer purchase behavior is a natural starting point for analyzing WTP if there
are limited customer segments. The analysis of such actual purchase data can reveal the
underlying preferences of customers. Simple regression can be used to infer customer
preferences from the purchase data. The weakness of this approach is that it identifies the
average market value of each attribute rather than a segment value of the attribute.
Discrete Choice
The best method to determine customer’s WTP is discrete choice analysis and the principle
underlying this approach is based either on actual purchase data or by asking the customer her
preference across alternatives that contain different bundles of attributes. While customers
cannot directly articulate the value, they attribute to any characteristic, everyone can say

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whether they prefer package A to package B. Something similar to regression analysis of a
sufficiently large number of these discrete choices can then identify a customer’s implicit
valuation of each characteristic called conjoint analysis.

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