Pricing of Products & Services

The following sections are included:

• About the Author
• Acknowledgments
• Contents

Price is perhaps the most ubiquitous marketing information available to customers. Prices of hotels and motels are posted on highway billboards; grocery stores send out flyers with promotional prices to attract store traffic; online retailers send out discount information and store coupons for the products on sale; realtors publish prices of houses or condos on sale in the neighborhoods; hospitals and medical practitioners posts prices for certain types of services offered; even philanthropic organizations ask for donations to help their causes…

Top line (revenue) and bottom line (profit) growths are two important indicators of the financial success of a firm. Business analysts use a firm’s guidance on revenue and earnings growth to assess its valuation. Managers are compensated with salaries, commissions, or bonuses based on revenues and profits of the product or brand they manage. Without revenue and profit growth, a firm will likely cut investments in innovations and new product initiatives, and may resort to other cost-cutting initiatives leading to closures and lay-offs…

Price is an important tool for managers to influence demand. Retailers implement temporary price reductions to clear inventory and make room for new shipments. New products are sold at low introductory price to create an interest for the product. Toll roads raise toll rates to reduce traffic. Ride share companies raise prices to contain demand and increase the supply of drivers. The question however is: How does the firm know that the change in prices will actually influence the demand and achieve the desired results? Also, it is not enough for the firm to know that the demand will increase (or decrease) due to a price decrease (or increase). It needs to have a more precise estimate of the demand due to the price change…

As discussed in the previous chapters, a demand function is central to the understanding of how price influences demand, and therefore revenue. Despite its importance, managers do not always use a formal demand function, and instead rely on their intuition and experiences to speculate how price might affect demand. Such situations are especially prevalent for new products when prior sales and price information needed to develop a demand function is not available. In this chapter, we offer a few simple ways to develop a demand function based on surveys and online experiments. In the following chapter, we will provide a detailed discussion on how to model demand functions using different types of sales response function that can include other factors that may also influence sales.

While online experiments are an effective way to test the effect of price on demand in a realistic setting, they can accommodate only a limited set of factors and their respective levels. In reality, demand is a function of not only price but also other factors such as product quality and features, marketing communication (e.g., messages and intensity), and the marketing channels (e.g., number of territories, stores, salesforce). Therefore, an expanded view of a demand function is one that relates demand to not only price but also other marketing mix variables as well as competitive information. Having such an expression of demand function helps managers in evaluating the effectiveness of total marketing efforts, not just price. A comprehensive demand function also helps the firm predict demand with greater certainty, and plan for its sourcing, production, inventory, and salesforce allocations. Finally, such a demand function helps the firm with optimal resource allocation decisions. For instance, the firm can investigate whether a price reduction or an increase in advertising results in greater revenue and profits. With increased availability of actual sales or consumption data at the point of sales (or consumption), analysts are able to use realistic data to investigate the effects of price on demand.

Thus far, we had focused on the microeconomic perspective that consumer purchase decisions are predicated on the consumer’s assessment of the product’s value and its price. In reality, however, consumer assessments of a product’s value and their knowledge about prices are often imperfect. Firms have responded to such imperfections by developing price communication strategies that go beyond communicating the objective price (dollars and cents) to consumers, but additionally shaping consumer perception about the attractiveness of the offer. The informational roles of price have created an area of research and practice commonly labeled as “behavioral pricing.”

Firms spend several years and large sums of money developing and testing products or services. And the moment of truth comes when the firm has to decide what should the right price for the product be. As aforementioned the iPhone X pricing illustrates, if a product is priced “too high,” customers find the value that the product offers is not worth the price and switch to competitive alternatives, or do not buy at all. Indeed, an unacceptably high price of a product may also cause imbalance in prices and demand of other products in the company’s product line, and the high price may actually damage the firm’s reputation. Of course, pricing the product too “low” also has its harmful effects on firm profitability and shareholder valuation. Pricing too low may actually be masked by quick market acceptance and rapid market share growth. It is a classic “sinking the boat” versus “missing the boat” situation when it comes to finding the “right” price for a product or service…

In Chapter 7, we suggested that customer valuation for a product or service, firm costs, and industry competition are the three central components in a pricing environment. This chapter will focus on customer value and discuss how the concept of value may be used not just in the determination of price but also in developing value-based strategies for the firm. We will specifically address the following:

• Define the concept of value and identify potential sources of value to customers.
• Discuss how to communicate customer values to appropriate value segments.
• Present some approaches and methodologies to measure customer values.
• Illustrate the application of customer values in price discrimination and price bundling strategies.

In Chapter 8, the focus was entirely on customers and their valuations of a product or a service, and how to consider their valuation in pricing decisions. While pricing a product, a firm also has to consider the costs that it has to recover and make some profits. Thus, a pricing decision involves sharing the difference between value and cost, sketched as follows:

In many industries, costs to serve vary across customers who are otherwise buying the same product or service. Consider the following examples:

• A firm serves a geographically dispersed market and the cost of delivery differs due to the customer’s location relative to the location of the firm (or shipment point).
• Tax experts retained by online tax preparation companies spend more time on the phone with certain “difficult” clients than clients with simpler tax situations.
• Banks have to deal with customers with bare minimum balances to avail all permitted privileges, while others keep more healthy balances and do not engage in frequent transactions (e.g., ATM usage).
• In handling a home remodeling project, demanding customers require a consultant to spend more time on them than do others. Increased product complexity vis-vis customer product knowledge may require a firm to spend more time with certain customers than others.
• Some customers in a restaurant occupy tables for a longer period of time resulting in higher opportunity costs for the restaurant.
• Given the “free return” option that many online retailers offer, some discerning customers are more prone to returning previously purchased products resulting in higher costs for the firm. Amazon, for instance, is currently revisiting its free return policy and the cost of its Prime subscription as it is observing a steep rise in cost and frequency of returns by their Prime members.
• Healthcare costs differ due to customer health conditions…

Setting prices requires a careful analysis of competitive factors, both at the industry (or category) level as well as at the product level. A framework to address competitive factors in pricing decisions is presented as Figure 1.

The following sections are included:

• Definition and Rationale
• Direct Price Discrimination Based on WTP
• Price Discrimination using Two-Part Pricing
• Price Discrimination Based on Quantity Purchased
• Price Discrimination Based on Consumer Characteristics and Behavior
• Appendix 1: A Numerical Example of Two-Part Pricing
• End of Chapter Discussion Questions
• Recommended Cases

In discussing price discrimination strategies, we have thus far considered contexts where price discrimination by a single product or service firm is based on variations in customers’ willingness to pay (WTP) for that product or service. However, most firms are multiproduct firms and products or services are targeted to different customer groups. Consider the following home and auto insurance commercials:

• “Liberty Mutual customizes your car insurance so you only pay for what you need.”
• “Could save up to 20 % by bundling their home and auto insurance with Nationwide”…

A firm serves a variety of customers, with different needs and preferences. Consider the following examples:

• Netflix targets different customers with a Basic Plan (at $8.99) that lets the subscriber stream on one device at a time, a Standard Plan (at $12.99) that allows streaming on two devices at the same time and a Premium Plan (at $15.99) that allows streaming on four devices. Netflix also enforces its cancellation policy, rejoining policy, overage charges, etc.
• In order to cater to customers looking for different service levels, Orange Theory offers its customers three options, Basic (4 classes for $59/month), Elite (8 classes for $99/month) and Premier (unlimited classes for $159/month).
• A travel company has to serve people who travel only during the holiday seasons when hotels and airlines are in high demand as well as those who would rather travel during off-season for a better deal.
• Avis rents to customers who need a car for local transportation as well as to customers who may need it for long distance interstate travel, or may just need one-way rental.
• Cable TV and Internet providers or gyms may offer a free month of service or a promotional rate if the customer enters into a long-term contract…

Under a dynamic pricing strategy, prices of products or services change over time, across customers, or due to competitive actions. While the idea that pricing should adjust to changes in customer characteristics and market conditions is not new, the topic of dynamic pricing has gained special interest in certain industry sectors such as e-commerce, airlines, hospitality, and ride shares, where prices change by the weeks, days, and even by the minute. Business Insider reports that Amazon changes prices 2.5 million times a day, which translates into a price change every 10 minutes. While frequent price changes boost Amazon’s profits, it can potentially confuse customers to see prices change soon after their purchase of the same product. Amazon implements their dynamic pricing strategy using its vast reservoir of data on consumer purchase and browsing history and predictive algorithms to set prices of its thousands of products for its 100+ million customers at any point in time…

Price promotions are temporary price reductions to create spikes in demand for a product or service. In formulating price promotions, a firm has to decide on the magnitude of the price cuts, when to lower the price, and how long to keep the price at that lower level. Price promotions additionally involve communicating to customers that the price has been reduced and how long the offer is valid.

Managing the pricing function is a daunting task for retailers. A customer, on average, visits a grocery store 1.6 times a week and spends about 43 minutes during each visit. An average physical grocery store carries about 40,000 items; even a convenience store carries about 3,000 items in about 400 categories. Walmart Supercenters, on average, carries about 120,000 items. The complexity of pricing of such a large number of items arises from the fact that the retailer’s goal is to improve the profitability of the entire store rather than the profits for individual items. Thus, the retailer has to consider the cost and demand relationships across the items it carries. For instance, lowering of prices of certain items cuts into store profits but increases store traffic; but does increased store traffic boost demand other products at regular prices and higher margins? What effects do lower cost private labels have in the store profitability as well as the store image…

During the past 30 years or so, electronic retailing (or e-commerce) has revolutionized the practice of retailing and the ways consumers interact with retailers. The growth in e-commerce can be attributed to several factors coming together. Although the history of e-commerce can be traced back to 1984 with the establishment of the electronic mall by CompuServe, the launch of Netscape Navigator in 1994 made e-commerce of today technologically feasible. E-commerce got a major boost in 1995 when Amazon and e-Bay launched online marketplace through which third-party vendors (e.g., resellers, entrepreneurs, publishers, etc.) could sell their products by paying a commission. Alibaba followed suit in 1999 and now has a significant presence in the e-commerce marketplace in the world. The launch of PayPal in 1998, an e-commerce payment system, made it possible for customers to buy and sell products online. With the introduction of broadband in the early 2000, not only did online sales increase manifold it also increased customer engagement in search for products and prices without visiting a physical store. Not having to pay taxes gave e-commerce an edge over B & M retail. Finally, widespread availability of mobile services in 2010 as well as the growth of social media platforms such as Twitter, Facebook, and Instagram helped monetizing customer clicks of electronic sites and online advertising, and stimulated commercial transactions across different platforms. A related outcome of the growth in e-commerce is the production of unprecedented amount of data that are now being used to develop predictive algorithm for automating pricing and other related decisions…

In this concluding chapter, we will first summarize the main points discussed in the previous chapters. Then, we will offer some guidelines on the creation of a pricing organization dedicated to making and implementing pricing strategies within a firm.

The following section is included:

• Index