Price is the value that is put to a product or service and is the result of a complex set of calculations, research and understanding, and risk-taking ability. A pricing strategy takes into account segments, ability to pay, market conditions, competitor actions, trade margins, and input costs, amongst others. It is targeted at the defined customers and against competitors.
Models of pricing
Dynamic pricing, also referred to as surge pricing, demand pricing, or time-based pricing is a pricing strategy in which businesses set flexible prices for products or services based on current market demands. Businesses are able to change prices based on algorithms that take into account competitor pricing, supply and demand, and other external factors in the market. Dynamic pricing is a common practice in several industries such as hospitality, tourism, entertainment, retail, electricity, and public transport. Each industry takes a slightly different approach to dynamic pricing based on its individual needs and the demand for the product.
Dynamic pricing in air transportation.
Dynamic pricing re-appeared in the market at large in the 1980s airline industry in the United States. Before the 1980s, the airline industry’s seat prices were heavily regulated by the United States government, but changes in legislation during the decade gave airlines control over their prices. Companies invested millions of dollars to develop computer programs that would adjust prices automatically based on known variables like departure time, destination, season, and more.
Dynamic pricing in rideshare services.
The most recent innovation in dynamic pricing—and the one felt most by consumers—is the rise of dynamic pricing in rideshare apps like Uber. Uber’s “Surge Pricing” model, where riders pay more for a trip during peak travel times, began as a way to incentivize drivers to stay out later in Boston, according to Bill Gurley, former board member of Uber. The incentive worked, and the number of drivers on the road in the early morning hours increased by 70%-80%, and the number of unfilled Uber requests plummeted.
- Dynamic pricing today
- Professional sports
- Theme parks
- Brands and Dynamic Pricing
Contribution margin-based pricing
Contribution margin-based pricing maximizes the profit derived from an individual product, based on the difference between the product’s price and variable costs (the product’s contribution margin per unit), and on one’s assumptions regarding the relationship between the product’s price and the number of units that can be sold at that price. The product’s contribution to total firm profit (i.e. To operating income) is maximized when a price is chosen that maximizes the following:
Contribution margin per unit*number of units sold
In cost-plus pricing, a company first determines its break-even price for the product. This is done by calculating all the costs involved in the production such as raw materials used in its transportation etc., marketing and distribution of the product. Then a markup is set for each unit, based on the profit the company needs to make, its sales objectives, and the price it believes customers will pay. For example, if the company needs a 15 percent profit margin and the break-even price is $2.59, the price will be set at $3.05 ($2.59 / (1-15%)).
Cost-plus pricing is a cost-based method for setting the prices of goods and services. Under this approach, the direct material cost, direct labor cost, and overhead costs for a product are added up and added to a markup percentage (to create a profit margin) in order to derive the price of the product.
Creaming or skimming
Price skimming occurs when goods are priced higher so that fewer sales are needed to break even. Selling a product at a high price, sacrificing high sales to gain a high profit is, therefore “skimming” the market. Skimming is usually employed to reimburse the cost of investment of the original research into the product: commonly used in electronic markets when a new range, such as DVD players, is firstly sold at a high price. This strategy is often used to target “early adopters” of a product or service. Early adopters generally have a relatively lower price sensitivity—this can be attributed to: their need for the product outweighing their need to economize; a greater understanding of the product’s value; or simply having a higher disposable income.
This strategy is employed only for a limited duration to recover most of the investment made to build the product. To gain further market share, a seller must use other pricing tactics such as economy or penetration. This method can have some setbacks as it could leave the product at a high price against the competition.
Method of pricing where the seller offers at least three products, and where two of them have a similar or equal price. The two products with similar prices should be the most expensive ones, and one of the two should be less attractive than the other. This strategy will make people compare the options with similar prices; as a result, sales of the more attractive high-priced item will increase.
Differential pricing occurs when firms set various prices for the same product depending on their consumer’s portfolio, geographic areas, demographic segments, and the intensity of competition in the region.
A form of deceptive pricing strategy that sells a product at the higher of two prices communicated to the consumer on, accompanying, or promoting the product.
Freemium is a revenue model that works by offering a product or service free of charge (typically digital offerings such as software) while charging a premium for advanced features, functionality, or related products and services. The word “freemium” is a portmanteau combining the two aspects of the business model: “free” and “premium”. It has become a highly popular model, with notable successes.
Methods of services offered by the organization are regularly priced higher than competitors, but through promotions, advertisements, and or coupons, lower prices are offered on key items. The lower promotional prices are designed to bring customers to the organization where the customer is offered the promotional product as well as the regular higher priced products.
A retail pricing strategy where the retail price is set at double the wholesale price. For example, if a cost of a product for a retailer is £100, then the sale price would be £200. In a competitive industry, it is often not recommended to use keystone pricing as a pricing strategy due to its relatively high-profit margin and the fact that other variables need to be taken into account.
A limit price is a price set by a monopolist to discourage economic entry into a market and is illegal in many countries. The limit price is the price that the entrant would face upon entering as long as the incumbent firm did not decrease output. The limit price is often lower than the average cost of production or just low enough to make entering not profitable. The quantity produced by the incumbent firm to act as a deterrent to entry is usually larger than would be optimal for a monopolist, but might still produce higher economic profits than would be earned under perfect competition.
The problem with limit pricing as a strategy is that once the entrant has entered the market, the quantity used as a threat to deter entry is no longer the incumbent firm’s best response. This means that for limit pricing to be an effective deterrent to entry, the threat must in some way be made credible. A way to achieve this is for the incumbent firm to constrain itself to produce a certain quantity whether entry occurs or not. An example of this would be if the firm signed a union contract to employ a certain (high) level of labor for a long period of time. In this strategy price of the product becomes the limit according to budget.
A loss leader or leader is a product sold at a low price (i.e. At cost or below cost) to stimulate other profitable sales. This would help the company to expand its market share as a whole. Loss leader strategy is commonly used by retailers in order to lead the customers into buying products with higher marked-up prices to produce an increase in profits rather than purchasing the leader product which is sold at a lower cost. When a “featured brand” is priced to be sold at a lower cost, retailers tend not to sell large quantities of the loss leader products and also they tend to purchase fewer quantities from the supplier as well to prevent loss for the firm. Supermarkets and restaurants are excellent examples of retail firms that apply the strategy of loss leader
In business, the practice of setting the price of a product to equal the extra cost of producing an extra unit of output. By this policy, a producer charges, for each product unit sold, only the addition to total cost resulting from materials and direct labor. Businesses often set prices close to marginal cost during periods of poor sales. If, for example, an item has a marginal cost of $1.00 and a normal selling price is $2.00, the firm selling the item might wish to lower the price to $1.10 if demand has waned. The business would choose this approach because the incremental profit of 10 cents from the transaction is better than no sale at all.
Odd-Even pricing is often used by sellers to portray their products to be either cheaper or more expensive than their actual value. Sellers competing for price-sensitive consumers will fix their product price to be odd. A good example of this can be noticed in most supermarkets where instead of pricing milo at £5, it would be written as £4.99. Contrarily, sellers competing for consumers with low price sensitivity will fix their product price to be even. For example, often in upscale retail stores, handbags will be priced at £1250 instead of £1249.99.
Penetration pricing includes setting the price low with the goal of attracting customers and gaining market share. The price will be raised later once this market share is gained.
Companies do their pricing in diverse ways. In small companies, prices are often set by the boss. In large companies, pricing is handled by the division and the product line managers. In industries where pricing is a key influence, pricing departments are set to support others in determining suitable prices.
Penetration pricing strategy is usually used by firms or businesses that are just entering the market. In marketing, it is a theoretical method that is used to lower the prices of goods and services causing high demand for them in the future. This strategy of penetration pricing is vital and highly recommended to be applied over multiple situations that the firm may face. Such as, when the production rate of the firm is lower when compared to other firms in the market and also sometimes when firms face hardship in releasing their product in the market due to an extremely large rate of competition. In these situations, it is appropriate for a firm to use the penetration strategy to gain consumer attention.
Predatory pricing, also known as aggressive pricing (also known as “undercutting”), is intended to drive out competitors from a market. It is illegal in some countries.
Companies or firms that tend to get involved with the strategy of predatory pricing often have the goal to place restrictions or a barrier for other new businesses from entering the applicable market. It is an unethical act that contradicts antitrust law, attempting to establish within the market a monopoly by the imposing company. Predatory pricing mainly occurs during price competitions in the market as it is an easy way to obfuscate unethical and illegal acts. Using this strategy, in the short term consumers will benefit and be satisfied with lower-cost products. In the long run, firms often will not benefit as this strategy will continue to be used by other businesses to undercut competitors’ margins, causing an increase in competition within the field and facilitating major losses. This strategy is dangerous as it could be destructive to a firm in terms of losses and even lead to complete business failure.
Premium decoy pricing
Method of pricing where an organization artificially sets one product price high, in order to boost sales of a lower-priced product. Let’s say there are two products, beef, and pork. The organization may increase the price of beef so that it becomes expensive in the eyes of the customers. Subsequently, pork becomes cheaper. Customers will then opt for cheaper pork.
Premium pricing is the practice of keeping the price of a product or service artificially high in order to encourage favorable perceptions among buyers, based solely on the price. The practice is intended to exploit the (not necessarily justifiable) tendency for buyers to assume that expensive items enjoy an exceptional reputation, are more reliable or desirable, or represent exceptional quality and distinction. Moreover, a premium price may portray the meaning of better quality in the eyes of the consumer.
Consumers are willing to pay more for trends, which is a key motive for premium pricing, and are not afraid on how much a product or service costs. The novelty of consumers wanting to have the latest trends is a challenge for marketers as they are having to entertain their consumers.
The aspiration of consumers and the feeling of treating themselves is the key factor of purchasing a good or service. Consumers are looking for constant change as they are constantly evolving and moving.
Examples of premium pricing
- Ethical consumption
- Fair traders
These are important drivers and examples of premium pricing, which help guide and distinguish how a product or service is marketed and priced within today’s market.
Price discrimination is the practice of setting a different price for the same product in different segments of the market. For example, this can be for different classes, such as ages, or for different opening times.
Price discrimination may improve consumer surplus. When a firm price discriminates, it will sell up to the point where marginal cost meets the demand curve. There are three conditions needed for a business to undertake price discrimination, these include:
- Accurately segment the market
- Prevent resale
- Have market power
There are three different types of price discrimination that revolve around the same strategy and the same goal – maximize profit by segmenting the market, and extracting additional consumer surplus
- First-degree price discrimination
- The business charges every consumer exactly how much they are willing to pay for the product.
- Second-degree price discrimination
- The business uses volume discounts which allow buyers to purchase a higher inventory at a reduced price. While this benefits the high-inventory buyer, it obviously hurts the low-inventory buyer who is forced to pay a higher price. This buyer may then be less competitive in the downstream market.
- Third-degree price discrimination
- This occurs when firms segment the market into high-demand and low-demand groups.
Firms need to ensure they are aware of several factors of their business before proceeding with the strategy of price discrimination. Firms must have control over the changes they make regarding the price of their product by which they can gain profitability depending on the number of sales made. The price can be increased or decreased at any point depending on the fluctuation of the rate of buyers and consumers. Price discrimination strategy is not feasible for all firms as there are many consequences that the firms may face due to the action. For example: if a firm sells a product to their customer for a cheaper price and that customer resells the product demanding a higher price from another buyer then the chances of the firm failing to make a higher profit is predicted because they could have sold their product at a higher rate than the re-seller and made a further profit.
An observation made of oligopolistic business behavior in which one company, usually the dominant competitor among several, leads the way in determining prices, the others soon following. The context is a state of limited competition, in which a market is shared by a small number of producers or sellers.
Pricing is designed to have a positive psychological impact. For example, there are often benefits to selling a product at $3.95 or $3.99, rather than $4.00. If the price of a product is $100 and the company prices it at $99, then it is using the psychological technique of just-below pricing. In most consumers’ minds, $99 gives the impression of being considerably less than $100. A minor distinction in pricing can make a big difference in sales. A company that succeeds in finding appropriate psychological price points can improve sales and maximize revenue.
The economic concept of sliding scale at its most basic: people pay as they are able to for services, events, and items. Those with access to more resources pay more and thus provide the cushion for those with less access to pay less, creating a sustainable economic underpinning for said services, events, and items.
Target pricing business
Pricing method whereby the selling price of a product is calculated to produce a particular rate of return on investment for a specific volume of production. The target pricing method is used most often by public utilities, like electric and gas companies, and companies whose capital investment is high, like automobile manufacturers.
Target pricing is not useful for companies whose capital investment is low because, according to this formula, the selling price will be understated. Also, the target pricing method is not keyed to the demand for the product, and if the entire volume is not sold, a company might sustain an overall budgetary loss on the product.
A flexible pricing mechanism made possible by advances in information technology and employed mostly by Internet-based companies. By responding to market fluctuations or large amounts of data gathered from customers – ranging from where they live to what they buy to how much they have spent on past purchases – dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customer’s willingness to pay. The airline industry is often cited as a dynamic pricing success story. In fact, it employs the technique so artfully that most of the passengers on any given airplane have paid different ticket prices for the same flight.] As of 2018, several third-party tools have allowed merchants to take advantage of time-based dynamic pricing including Pricemole, sweet pricing.
Time-sensitive pricing is a cost-based method for setting prices for goods that have a short shelf life. Careful consideration has to be taken to the “Use By” and “Best Before” dates of the products, in relation to the “Mark Up” or “Return” of the products. That is to say, the shorter period of time should have a lower Mark-up/Return margin, thus increasing the Turnover/sales of the product, and decreasing the Wastage/loss of products.
Pricing a product is based on the value the product has for the customer and not on its costs of production or any other factor. This pricing strategy is frequently used where the value to the customer is many times the cost of producing the item or service. For instance, the cost of producing a software CD is about the same independent of the software on it, but the prices vary with the perceived value the customers are expected to have. The perceived value will depend on the alternatives open to the customer. In business, these alternatives are using a competitor’s software, using a manual workaround, or not doing an activity. In order to employ value-based pricing, one must know its customers’ business, one’s business costs, and one’s perceived alternatives. It is also known as perceived-value pricing.
Value-based pricing has many effects on the business and consumer of the product. Value-based pricing is a fundamental business activity and is the process of developing product strategies and pricing them properly to establish the product within the market. This is a key concept for a relatively new product within the market, because, without the correct price, there would be no sale. Having an overly high price for an average product would have negative effects on the business as the consumer would not buy the product. Having a low price on a luxury product would also have a negative impact on the business as in the long run the business would not be profitable. This can be seen as a positive for the consumer as they are not needing to pay extreme prices for the luxury product.
There has been an evident change in the marketing area within a business from cost-plus pricing to value.
Variable pricing strategies
Variable pricing strategy sums up the total cost of the variable characteristics associated with the production of the product. Examples of variable characteristics are interest rates, location, date, and region of production. The sum total of the following characteristics is then included within the original price of the product during marketing. Variable pricing enables product prices to have a balance “between sales volume and income per unit sold”. A variable pricing strategy has the advantage of ensuring the sum total of the cost businesses would face in order to develop a new product. However, the variable pricing strategy excludes the cost of fixed pricing. Fixed pricing includes the price of dedication received from manufactures in the production of developing the product and other involvement of factors.
Yield management strategy
Yield management is a strategy that aims to monitor consumer behavior to gain and achieve maximum profit through selling goods and services that are perishable. The theory behind this strategy is to focus on the following aspects: buying behavior patterns of consumers, external environmental factors, and market price to successfully gain the most profit. This strategy of yield management is commonly used by the firms associated with the airline industry. For example, a customer may purchase an airline ticket in the daytime for $600 and another customer may purchase the same airline ticket on the same day in the evening for $800 – the reason being that during the day time the airline contained many seats that were spare which needed to be occupied and sold. Thus, prices were decreased in order to attract and manipulate the customers into buying an airline ticket with great deals or offers. However, during the evening time, most seats were filled and the firm decided to increase the price of the airline ticket for the desperate customers who needed to purchase the spare seats that were available. This type of strategy is a vigilant way of connecting with the target consumers as well as flourishing the business.
A pricing strategy in which the seller is paid based on the effectiveness of its product or service. Examples of sellers who often use performance-based pricing are real estate agents, online advertising platforms, and personal injury attorneys. Performance-based pricing increases the risk of the seller but it creates opportunities for greater rewards. Sellers who use this pricing strategy have an advantage in attracting customers. Performance-based pricing has fewer chances to work if the desired outcome is not clearly defined and quantified between the two parties.
Nine laws of price sensitivity and consumer psychology
In their book, The Strategy and Tactics of Pricing, Thomas Nagle and Reed Holden outline nine “laws” or factors that influence how a consumer perceives a given price and how price-sensitive they are likely to be with respect to different purchase decisions.
- Reference Price Effect– buyer’s price sensitivity for a given product increases the higher the product’s price relative to perceived alternatives. Perceived alternatives can vary by buyer segment, occasion, and other factors.
- Difficult Comparison Effect– buyers are less sensitive to the price of a known or more reputable product when they have difficulty comparing it to potential alternatives.
- Switching Costs Effect– the higher the product-specific investment a buyer must make to switch suppliers, the less price-sensitive that buyer is when choosing between alternatives.
- Price-Quality Effect– buyers are less sensitive to price the more that higher prices signal higher quality. Products for which this effect is particularly relevant include image products, exclusive products, and products with minimal cues for quality.
- Expenditure Effect– buyers are more price-sensitive when the expense accounts for a large percentage of buyers’ available income or budget.
- End-Benefit Effect– the effect refers to the relationship a given purchase has to a larger overall benefit and is divided into two parts: Derived demand: The more sensitive buyers are to the price of the end benefit, the more sensitive they will be to the prices of those products that contribute to that benefit.
- Shared-cost Effect– the smaller the portion of the purchase price buyers must pay for themselves, the less price-sensitive they will be.
- Fairness Effect– buyers are more sensitive to the price of a product when the price is outside the range they perceive as “fair” or “reasonable” given the purchase context.
The Framing Effect – buyers are more price-sensitive when they perceive the price as a loss rather than a foregone gain, and they have greater price sensitivity when the price is paid separately rather than as part of.