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MGT301 - Principles of Marketing - Lecture Handout 24

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Lesson overview and learning objectives:

Price goes by many names in our economy. In the narrowest sense, price is the amount of money charged for a product or service. Price is the only element in the marketing mix that produces revenue; all other elements represent costs. Price is also one of the most flexible elements of the marketing mix. Unlike product features and channel commitments, price can be changed quickly. At the same time, pricing and price competition is the number-one problem facing many marketing executives. Yet, many companies do not handle pricing well. The most common mistakes are pricing that is too cost oriented rather than customer-value oriented; prices that are not revised often enough to reflect market changes; pricing that does not take the rest of the marketing mix into account; and prices that are not varied enough for different products, market segments, and purchase occasions. This Lesson looks at the factors marketers must consider when
setting prices so our today’s topic is:

Price the 2nd P of Marketing Mix.

A. Introduction

All profit and nonprofit organizations must set prices on their products and services. Price goes by many names (rent, tuition, fee, fare, rate, interest, toll, premium, et cetera). Price is the amount of money charged for a product or service or the sum of the values that consumers exchange for the benefits of having or using the product or service. Historically, price has been the major factor affecting buyer choice. Recently, however, nonprice factors have become increasingly important in buyer-choice behavior. Throughout history, prices were set by negotiation between buyers and sellers. Fixed price policies--setting one price for all buyers--is a relatively modern idea that arose with the development of large-scale retailing at the end of the nineteenth century. Today, we may be returning to dynamic pricing--charging different prices depending on the individual customers and situations. The Internet is helping to tailor products and prices. It should be remembered that price is the only element in the marketing mix that produces revenue; all other elements represent costs. Price is also one of the most flexible of elements of the marketing mix. It has been stated that pricing and price competition is the number-one problem facing many marketing executives. Many companies do not handle pricing well. Common mistakes that they make are:

  1. Pricing is too cost-oriented.
  2. Prices are not revised often enough to reflect market changes.
  3. Prices do not take into account the other elements of the marketing mix.
  4. Prices are not varied for different products, market segments, and purchase occasions.

All profit organizations and many nonprofit organizations must set prices on their products or services. Price goes by many names Price is all around us. You pay rent for your apartment, tuition for your education, and a fee to your physician or dentist. The airline, railway, taxi, and bus companies charge you a fare; the local utilities call their price a rate; and the local bank charges you interest for the money you borrow.
In the narrowest sense, price is the amount of money charged for a product or service. More broadly, price is the sum of all the values that consumers exchange for the benefits of having or using the product or service. Historically, price has been the major factor affecting buyer choice. This is still true in poorer nations, among poorer groups, and with commodity products. However, non-price factors have become more important in buyer-choice behavior in recent decades.

Throughout most of history, prices were set by negotiation between buyers and sellers. Fixed price policies—setting one price for all buyers—is a relatively modern idea that arose with the development of large-scale retailing at the end of the nineteenth century. Now, some one hundred years later, the Internet promises to reverse the fixed pricing trend and take us back to an era of dynamic pricing—charging different prices depending on individual customers and situations. The Internet, corporate networks, and wireless setups are connecting sellers and buyers as never before.
New technologies allow sellers to collect detailed data about customers' buying habits, preferences—even spending limits—so they can tailor their products and prices.

B. Factors to Consider When Setting Prices

Factors to Consider When Setting Prices

A company's pricing decisions are affected by both internal company factors and external environmental factors

a) Internal Factors Affecting Pricing Decision

Internal factors affecting pricing include the company's marketing objectives, marketing mix strategy, costs, and organizational considerations.

I. Marketing Objectives

Before setting price, the company must decide on its strategy for the product. If the company has selected its target market and positioning carefully, then its marketing mix strategy, including price, will be fairly straightforward. Pricing strategy is largely determined by decisions on market positioning. At the same time, the company may seek additional objectives. The clearer a firm is about its objectives, the easier it is to set price. Examples of common objectives are survival, current profit maximization, market share leadership, and product quality leadership.
Companies set survival as their major objective if they are troubled by too much capacity, heavy competition, or changing customers’ wants. To keep a plant going, a company may set a low price, hoping to increase demand. In this case, profits are less important than survival. As long as their prices cover variable costs and some fixed costs, they can stay in business. However, survival is only a short-term objective. In the long run, the firm must learn how to add value that consumers will pay for or face extinction.
Many companies use current profit maximization as their pricing goal. They estimate what demand and costs will be at different prices and choose the price that will produce the maximum current profit, cash flow, or return on investment. In all cases, the company wants current financial results rather than long-run performance. Other companies want to obtain market share leadership. They believe that the company with the largest market share will enjoy the lowest costs and highest long-run profit. To become the market share leader, these firms set prices as low as possible.
A company might decide that it wants to achieve product quality leadership. This normally calls for charging a high price to cover higher performance quality and the high cost of R&D. A company might also use price to attain other, more specific objectives. It can set prices low to prevent competition from entering the market or set prices at competitors' levels to stabilize the market. Prices can be set to keep the loyalty and support of resellers or to avoid government intervention. Prices can be reduced temporarily to create excitement for a product or to draw more customers into a retail store. One product may be priced to help the sales of other products in the company's line. Thus, pricing may play an important role in helping to accomplish the company's objectives at many levels.
Nonprofit and public organizations may adopt a number of other pricing objectives. A university aims for partial cost recovery, knowing that it must rely on private gifts and public grants to cover the remaining costs. A nonprofit hospital may aim for full cost recovery in its pricing. Marketing Mix Strategy: Price is only one of the marketing mix tools that a company uses to achieve its marketing objectives. Price decisions must be coordinated with product design, distribution, and promotion decisions to form a consistent and effective marketing program. Decisions made for
other marketing mix variables may affect pricing decisions. For example, producers using many resellers who are expected to support and promote their products may have to build larger reseller margins into their prices. The decision to position the product on high-performance quality will mean that the seller must charge a higher price to cover higher costs.
Companies often position their products on price and then base other marketing mix decisions on the prices they want to charge. Here, price is a crucial product-positioning factor that defines the product's market, competition, and design. Many firms support such price-positioning strategies with a technique called target costing, a potent strategic weapon. Target costing reverses the usual process of first designing a new product, determining its cost, and then asking, "Can we sell it for that?" Instead, it starts with an ideal selling price based on customer considerations, and then
targets costs that will ensure that the price is met.
Other companies de emphasize price and use other marketing mix tools to create nonprice positions. Often, the best strategy is not to charge the lowest price, but rather to differentiate the marketing offer to make it worth a higher price. Thus, the marketer must consider the total marketing mix when setting prices. If the product is positioned on nonprice factors, then decisions about quality, promotion, and distribution will strongly affect price. If price is a crucial positioning factor, then price will strongly affect decisions made about the other marketing mix elements.
However, even when featuring price, marketers need to remember that customers rarely buy on price alone. Instead, they seek products that give them the best value in terms of benefits received for the price paid. Thus, in most cases, the company will consider price along with all the other marketing-mix elements when developing the marketing program.

II. Costs

Costs set the floor for the price that the company can charge for its product. The company wants to charge a price that both covers all its costs for producing, distributing, and selling the product and delivers a fair rate of return for its effort and risk. A company's costs may be an important element in its pricing strategy. Companies with lower costs can set lower prices that result in greater sales and profits.

Types of Costs

A company's costs take two forms, fixed and variable. Fixed costs (also known as overhead) are costs that do not vary with production or sales level. For example, a company must pay each month's bills for rent, heat, interest, and executive salaries, whatever the company's output. Variable costs vary directly with the level of production. Each personal computer produced involves a cost of computer chips, wires, plastic, packaging, and other inputs. These costs tend to be the same for each unit produced. They are called variable because their total varies with the number of units produced. Total costs are the sum of the fixed and variable costs for any given level of production. Management wants to charge a price that will at least cover the total production costs at a given level of production. The company must watch its costs carefully. If it costs the company more than competitors to produce and sell its product, the company will have to charge a higher price or make less profit, putting it at a competitive disadvantage.

Costs at Different Levels of Production

To price wisely, management needs to know how its costs vary with different levels of production. This is because fixed costs are spread over more units, with each one bearing a smaller share of the fixed cost.

III. Organizational Considerations

Management must decide who within the organization should set prices. Companies handle pricing in a variety of ways. In small companies, prices are often set by top management rather than by the marketing or sales departments. In large companies, pricing is typically handled by divisional or product line managers. In industrial markets, salespeople may be allowed to negotiate with customers within certain price ranges. Even so, top management sets the pricing objectives and policies, and it often approves the prices proposed by lower-level management or salespeople. In industries in which pricing is a key factor (aerospace, railroads, oil companies), companies often have a pricing department to set the best prices or help others in setting them. This department reports to the marketing department or top management. Others who have an influence on pricing include sales managers, production managers, finance managers, and accountants.

b) External Factors Affecting Pricing Decisions

External factors that affect pricing decisions include the nature of the market and demand, competition, and other environmental elements.

I. The Market and Demand

Whereas costs set the lower limit of prices, the market and demand set the upper limit. Both consumer and industrial buyers balance the price of a product or service against the benefits of owning it. Thus, before setting prices, the marketer must understand the relationship between price and demand for its product. In this section, we explain how the price–demand relationship varies for different types of markets and how buyer perceptions of price affect the pricing decision. We then discuss methods for measuring the price–demand relationship.

Pricing in Different Types of Markets

The seller's pricing freedom varies with different types of markets. Economists recognize four types of markets, each presenting a different pricing challenge.
Under pure competition, the market consists of many buyers and sellers trading in a uniform commodity such as wheat, copper. No single buyer or seller has much effect on the going market price. A seller cannot charge more than the going price because buyers can obtain as much as they need at the going price. Nor would sellers charge less than the market price because they can sell all they want at this price. If price and profits rise, new sellers can easily enter the market. In a purely competitive market, marketing research, product development, pricing, advertising, and sales promotion play little or no role. Thus, sellers in these markets do not spend much time on marketing strategy.
Under monopolistic competition, the market consists of many buyers and sellers who trade over a range of prices rather than a single market price. A range of prices occurs because sellers can differentiate their offers to buyers. Either the physical product can be varied in quality, features, or style, or the accompanying services can be varied. Buyers see differences in sellers' products and will pay different prices for them. Sellers try to develop differentiated offers for different customer segments and, in addition to price, freely use branding, advertising, and personal selling to set their offers apart. Because there are many competitors in such markets, each firm is less affected by competitors' marketing strategies than in oligopolistic markets.
Under oligopolistic competition, the market consists of a few sellers who are highly sensitive to each other's pricing and marketing strategies. The product can be uniform (steel, aluminum) or differentiated (cars, computers). There are few sellers because it is difficult for new sellers to enter the market. Each seller is alert to competitors' strategies and moves. If a steel company slashes its price by 10 percent, buyers will quickly switch to this supplier. The other steelmakers must respond by lowering their prices or increasing their services. An oligopolist is never sure that it will gain anything permanent through a price cut. In contrast, if an oligopolist raises its price, its competitors might not follow this lead. The oligopolist then would have to retract its price increase or risk losing customers to competitors.
In a pure monopoly, the market consists of one seller. Pricing is handled differently in each case. A government monopoly can pursue a variety of pricing objectives. It might set a price below cost because the product is important to buyers who cannot afford to pay full cost. Or the price might be set either to cover costs or to produce good revenue. It can even be set quite high to slow down consumption. In a regulated monopoly, the government permits the company to set rates that will yield a "fair return," one that will let the company maintain and expand its operations as needed. Unregulated monopolies are free to price at what the market will bear. However, they do not always charge the full price for a number of reasons: a desire to not attract competition, a desire to penetrate the market faster with a low price, or a fear of government regulation.

Consumer Perceptions of Price and Value

In the end, the consumer will decide whether a product's price is right. Pricing decisions, like other marketing mix decisions, must be buyer oriented. When consumers buy a product, they exchange something of value (the price) to get something of value (the benefits of having or using the product). Effective, buyer-oriented pricing involves understanding how much value consumers place on the benefits they receive from the product and setting a price that fits this value.
A company often finds it hard to measure the values customers will attach to its product. For example, calculating the cost of ingredients in a meal at a fancy restaurant is relatively easy. But assigning a value to other satisfactions such as taste, environment, relaxation, conversation, and status is very hard. These values will vary both for different consumers and different situations. Still, consumers will use these values to evaluate a product's price. If customers perceive that the price is greater than the product's value, they will not buy the product. If consumers perceive that
the price is below the product's value, they will buy it, but the seller loses profit opportunities.

Analyzing the Price–Demand Relationship

Analyzing the Price–Demand Relationship

Each price the company might charge will lead to a different level of demand. The relationship between the price charged and the resulting demand level is shown in the demand curve in Figure. The demand curve shows the number of units the market will buy in a given time period at different prices that might be charged. In the normal case, demand and price are inversely related; that is, the higher the price, the lower the demand. Thus, the company would sell less if it raised its price from P1 to P2. In short, consumers with limited budgets probably will buy less of something if its price is too high. In the case of prestige goods, the demand curve sometimes slopes upward. Consumers think that
higher prices mean more quality. Most companies try to measure their demand curves by estimating demand at different prices. The type of market makes a difference. In a monopoly, the demand curve shows the total market demand resulting from different prices. If the company faces competition, its demand at different prices will depend on whether competitors' prices stay constant or change with the company's own prices.
In measuring the price–demand relationship, the market researcher must not allow other factors affecting demand to vary. For example, if any company increases its advertising at the same time that it lowers its product prices, we would not know how much of the increased demand was due to the lower prices and how much was due to the increased advertising. Economists show the impact of nonprice factors on demand through shifts in the demand curve rather than movements along it.

Price Elasticity of Demand

Price Elasticity of Demand

Marketers also need to know price elasticity—how responsive demand will be to a change in price. Consider the two demand curves in Figure. In Figure, a price increase from P1 to P2 leads to a relatively small drop in demand from Q1 to Q2. In Figure b, however, the same price increase leads to a large drop in demand from Q′1 to Q′2. If demand
hardly changes with a small change in price, we say the demand is inelastic. If demand changes greatly, we say the
demand is elastic. The price elasticity of demand is given by the following formula: Price Elasticity of Demand= %change in Quantity demanded / % change in Price Suppose demand falls by 10 percent when a seller raises its price by 2 percent. Price elasticity of demand is therefore –5 (the minus sign confirms the inverse relation between price and demand) and demand is elastic. If demand falls by 2 percent with a 2 percent increase in price, then elasticity is –1. In this case, the seller's total revenue stays the same: The seller sells fewer items but at a higher price that preserves the same total revenue. If demand falls by 1 percent when price is increased by 2 percent, then elasticity is –½ and demand is inelastic. The less elastic the demand, the more it pays for the seller to raise the price. What determines the price elasticity of demand? Buyers are less price sensitive when the product they are buying is unique or when it is high in quality, prestige, or exclusiveness. They are also less price sensitive when substitute products are hard to find or when they cannot easily compare the quality of substitutes. Finally, buyers are less price sensitive when the total expenditure for a product is low relative to their income or when the cost is shared by another party.
If demand is elastic rather than inelastic, sellers will consider lowering their price. A lower price will produce more total revenue. This practice makes sense as long as the extra costs of producing and selling more do not exceed the extra revenue. At the same time, most firms want to avoid pricing that turns their products into commodities. In recent years, forces such as deregulation and the instant price comparisons afforded by the Internet and other technologies have increased consumer price sensitivity, turning products ranging from telephones and computers to new automobiles into commodities in consumers' eyes. Marketers need to work harder than ever to differentiate their offerings when a dozen competitors are selling virtually the same product at a comparable or lower price. More than ever, companies need to understand the price sensitivity of their customers and prospects and the trade-offs people are willing to make between price and product characteristics.

II. Competitors' Costs, Prices, and Offers

Another external factor affecting the company's pricing decisions is competitors' costs and prices and possible competitor reactions to the company's own pricing moves. When setting prices, the company also must consider other factors in its external environment. Economic conditions can have a strong impact on the firm's pricing strategies. Economic factors such as boom or recession, inflation, and interest rates affect pricing decisions because they affect both the costs of producing a product and consumer perceptions of the product's price and value. The company must also consider what impact its prices will have on other parties in its environment. How will resellers react to various prices? The company should set prices that give resellers a fair profit, encourage their support, and help them to sell the product effectively. The government is another important external influence on pricing decisions. Finally, social concerns may have to be taken into account. In setting prices, a company's short-term sales, market share, and profit goals may have to be tempered by broader societal considerations.

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