Chapter 16 : Pricing in a Digital World

Traditionally, price has operated as a major determinant of buyer choice. Consumers and
purchasing agents who have access to price information and price discounters put pressure on
retailers to lower their prices. Retailers in turn put pressure on manufacturers to lower their
prices. The result can be a marketplace characterized by heavy discounting and sales promotion.

Downward price pressure from a changing economic environment coincided with some longer-
term trends in the technological environment. For some years now, the Internet has been
changing the way buyers and sellers interact. Here is a short list of how the Internet allows
sellers to discriminate between buyers and buyers to discriminate between sellers. Buyers can:

Get instant price comparisons from thousands of vendors. Customers can compare the prices
offered by multiple retailers by clicking mySimon.com. Intelligent shopping agents (“bots”) take
price comparison a step further and seek out products, prices, and reviews from hundreds if not
thousands of merchants.

Check prices at the point of purchase. Customers can use smart phones to make price
comparisons in stores before deciding whether to purchase, pressure the retailer to match or
better the price, or buy elsewhere.

Name their price and have it met. On Priceline.com, customers state the price they want to pay
for an airline ticket, hotel, or rental car, and the site looks for any seller willing to meet that
price. Volume-aggregating sites combine the orders of many customers and press the supplier for
a deeper discount.

Get products free. Open source, the free software movement that started with Linux, will erode
margins for just about any company creating software. The biggest challenge confronting
Microsoft, Oracle, IBM, and virtually every other major software producer is: How do you
compete with programs that can be had for free? “Marketing Insight: Giving It All Away”
describes how firms have been successful with essentially free offerings.

Sellers can:

Monitor customer behavior and tailor offers to individuals. GE Lighting, which gets 55,000
pricing requests a year from its B-to-B customers, has Web programs that evaluate 300 factors
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going into a pricing quote, such as past sales data and discounts, so it can reduce processing time
from up to 30 days to six hours.

Give certain customers access to special prices. Ruelala is a members-only Web site that sells
upscale women’s fashion, accessories, and footwear through limited-time sales, usually two-day
events. Other business marketers are already using extranets to get a precise handle on inventory,
costs, and demand at any given moment in order to adjust prices instantly. Both buyers and
sellers can:

Negotiate prices in online auctions and exchanges or even in person. Want to sell hundreds of
excess and slightly worn widgets? Post a sale on eBay. Want to purchase vintage baseball cards
at a bargain price? Go to www.baseball-cards.com. According to Consumer Reports, more than
half of U.S. adults reported bargaining for a better deal on everyday goods and services in the
past three years; almost 90 percent were successful at least once. Some successful tactics
included: told salesperson I’d check competitor’s prices (57 percent of respondents); looked for
lower prices at a walk-in store (57 percent); chatted with salesperson to make a personal
connection (46 percent); used other store circulars or coupons as leverage (44 percent); and
checked user reviews to see what others paid (39 percent)

A Changing Pricing Environment

Some say these new behaviors are creating a sharing economy in which consumers share bikes,
cars, clothes, couches, apartments, tools, and skills and extracting more value from what they
already own. As one sharing-related entrepreneur noted, “We’re moving from a world where
we’re organized around ownership to one organized around access to assets.” In a sharing
economy, someone can be both a consumer and a producer, reaping the benefits of both roles. 5
Trust and a good reputation are crucial in any exchange, but imperative in a sharing economy.
Most platforms that are part of a sharing-related business have some form of self-policing
mechanism such as public profiles and community rating systems, sometimes linked with
Facebook. Let’s look at bartering and renting, two pillars of a sharing economy.
 Chapter 16 : Pricing in a Digital World

Bartering

Bartering, one of the oldest ways of acquiring goods, is making a comeback through transactions
estimated to total $12 billion annually in the United States. Trade exchange companies like
Florida Barter and Web sites like www.swap.com connect people and businesses seeking win-
win solutions. One financial analyst has traded financial plans to clients in return for a tutorial in
butter churning and trapeze and fire-breathing lessons. Thread UP allows parents to swap kids’
outgrown and unused clothing and toys with other parents in similar situations all over the
United States. Zimride is a ride-sharing social network for college campuses. Experts advise
using barter only for goods and services that someone would be willing to pay for anyway. The
founders of a Web site for swapping sporting goods and outdoor gear drew up these criteria for
sharable objects: cost more than $100 but less than $500, easily transportable, and infrequently
used.

Renting

The sector of the new sharing economy that is really exploding is rentals. Rent The Runway
offers affordable rentals of designer dresses. Customers are sent two different sizes of the dress
they choose—to ensure better fit—at a cost of $50 to $300, or about 10 percent of retail value.
The site is adding 100,000 customers a month, typically 15 to 35 years old. 8 One of the pioneers
in the rental economy is Airbnb.

How Companies Price

In small companies, the boss often sets prices. In large companies, division and product line managers do. Even here, top
management sets general pricing objectives and policies and often approves lower management’s proposals Many
companies do not handle pricing well and fall back on “strategies” such as: “We calculate our costs and add our industry’s
traditional margins.” Other common mistakes are not revising price often enough to capitalize on market changes; setting
price independently of the rest of the marketing program rather than as an intrinsic element of market-positioning strategy;
and not varying price enough for different product items, market segments, distribution channels, and purchase occasions.
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Consumer Psychology and Pricing

Many economists traditionally assumed that consumers were “price takers” who accepted prices
at face value or as a given. Marketers, however, recognize that consumers often actively process
price information, interpreting it from the context of prior purchasing experience, formal
communications (advertising, sales calls, and brochures), informal communications (friends,
colleagues, or family members), point-of-purchase or online resources, and other factors.

Price-Quality Inferences Many consumers use price as an indicator of quality. Image pricing is
especially effective with ego-sensitive products such as perfumes, expensive cars, and designer
clothing. A $100 bottle of perfume might contain $10 worth of scent, but gift givers pay $100 to
communicate their high regard for the receiver. Price and quality perceptions of cars interact.
Higher-priced cars are perceived to possess high quality. Higher quality cars are likewise
perceived to be higher priced than they actually are. When information about true quality is
available, price becomes a less significant indicator of quality. When this information is not
available, price acts

as a signal of quality. Some brands adopt exclusivity and scarcity to signify uniqueness and
justify premium pricing. Luxury-goods makers of watches, jewelry, perfume, and other products
often emphasize exclusivity in their communication messages and channel strategies.

Price Ending

Pricing cues such as sale signs and prices that end in 9 are more influential when consumers’
price knowledge is poor, when they purchase the item infrequently or are new to the category,
and when product designs vary over time, prices vary seasonally, or quality or sizes vary across
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stores.28 They are less effective the more they are used. Limited availability (for example, “three
days only”) also can spur sales among consumers actively shopping for a product

Setting the Price

Step 1: Selecting the Pricing Objective

Survival Companies pursue survival as their major objective if they are plagued with overcapacity, intense competition,
or changing consumer wants. As long as prices cover variable costs and some fixed costs, the company stays in business.
Survival is a short-run objective; in the long run, the firm must learn how to add value or face extinction.

Maximum Current Profit Many companies try to set a price that will maximize current profits. They estimate the
demand and costs associated with alternative prices and choose the price that produces maximum current profit, cash flow,
or rate of return on investment. This strategy assumes the firm knows its demand and cost functions; in reality, these are
difficult to estimate. In emphasizing current performance, the company may sacrifice long-run performance by ignoring
the effects of other marketing variables, competitors’ reactions, and legal restraints on price.

Maximum Market Share Some companies want to maximize their market share. They believe a higher sales volume
will lead to lower unit costs and higher long-run profit, so they set the lowest price, assuming the market is price sensitive.
Texas Instruments famously practiced this market-penetration pricing for years. The company would build a large plant,
set its price as low as possible, win a large market share, experience falling costs, and cut its price further as costs fell. The
following conditions favor adopting a market-penetration pricing strategy: (1) The market is highly price sensitive and a
low price stimulates market growth; (2) production and distribution costs fall with accumulated production experience;
and (3) a low price discourages actual and potential competition.

Maximum Market Skimming Companies unveiling a new technology favor setting high prices to maximize market
skimming. Sony has been a frequent practitioner of market-skimming pricing, in which prices start high and slowly drop
over time. When Sony introduced the world’s first high-definition television (HDTV) to the Japanese market in 1990, it
was priced at $43,000. So that Sony could “skim” the maximum amount of revenue from the various segments of the
market, the price dropped steadily through the years—a 28-inch Sony HDTV cost just over $6,000 in 1993, but a 42-inch
Sony LED HDTV cost only $579 20 years later in 2013. This strategy can be fatal, however, if a worthy competitor
decides to price low. When Philips, the Dutch electronics manufacturer, priced its videodisc players to make a profit on
each, Japanese competitors priced low and rapidly built their market share, which in turn pushed down their costs
substantially. Moreover, consumers who buy early at the highest prices may be dissatisfied if they compare themselves
with those who buy later at a lower price. When Apple dropped the early iPhone’s price from $600 to $400 only two
months after its introduction, public outcry caused the firm to give initial buyers a $100 credit toward future Apple
 Chapter 16 : Pricing in a Digital World

purchases.32 Market skimming makes sense under the following conditions: (1) A sufficient number of buyers have a high
current demand; (2) the unit costs of producing a small volume are high enough to cancel the advantage of charging what
the traffic will bear; (3) the high initial price does not attract more competitors to the market; and (4) the high price
communicates the image of a superior product.

Product-Quality Leadership A company might aim to be the product-quality leader in the market.33 Many brands
strive to be “affordable luxuries”—products or services characterized by high levels of perceived quality, taste, and status
with a price just high enough not to be out of consumers’ reach. Brands such as Starbucks, Aveda, Victoria’s Secret,
BMW, and Viking have positioned themselves as quality leaders in their categories, combining quality, luxury, and
premium prices with an intensely loyal customer base. Grey Goose and Absolut carved out a superpremium niche in the
essentially odorless, colorless, and tasteless vodka category through clever on-premise and off-premise marketing that
made the brands seem hip and exclusive. Other Objectives Nonprofit and public organizations may have other pricing
objectives. A university aims for partial cost recovery, knowing that it must rely on private gifts and public grants to cover
its remaining costs. A nonprofit hospital may aim for full cost recovery in its pricing. A nonprofit theater company may
price its productions to fill the maximum number of seats. A social service agency may set a service price geared to client
income. Whatever the specific objective, businesses that use price as a strategic tool will profit more than those that simply
let costs or the market determine their pricing. For art museums, which earn an average of only 5 percent of their revenues
from admission charges, pricing can send a message that affects their public image and the amount of donations and
sponsorships they receive.

Step 2: Determining Demand

Price Sensitivity The demand curve shows the market’s probable purchase quantity at alternative prices, summing the
reactions of many individuals with different price sensitivities. The first step in estimating demand is to understand what
affects price sensitivity. Generally speaking, customers are less price sensitive to low-cost items or items they buy
infrequently. They are also less price sensitive when (1) there are few or no substitutes or competitors; (2) they do not
readily notice the higher price; (3) they are slow to change their buying habits; (4) they think the higher prices are
justified; and (5) price is only a small part of the total cost of obtaining, operating, and servicing the product over its
lifetime. A seller can successfully charge a higher price than competitors if it can convince customers that it offers the
lowest total cost of ownership (TCO). Marketers often treat the service elements in a product offering as sales incentives
rather than as value-enhancing augmentations for which they can charge. In fact, pricing expert Tom Nagle believes the
most common mistake manufacturers have made in recent years is to offer all sorts of services to differentiate their
products without charging for them

Estimating Demand Curves Most companies attempt to measure their demand curves using several

different methods.
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Surveys can explore how many units consumers would buy at different proposed prices. Although consumers might
understate their purchase intentions at higher prices to discourage the company from pricing high, thetalso tend to actually
exaggerate their willingness to pay for new products or services.

Price experiments can vary the prices of different products in a store or of the same product in similar territories to see
how the change affects sales. Online, an e-commerce site could test the impact of a 5 percent price increase by quoting a
higher price to every 40th visitor to compare the purchase response. However, it must do this carefully and not alienate
customers or be seen as reducing competition in any way (thus violating the Sherman Antitrust Act).

Statistical analysis of past prices, quantities sold, and other factors can reveal their relationships. The data can be
longitudinal (over time) or cross-sectional (from different locations at the same time). Building the appropriate model and
fitting the data with the proper statistical techniques call for considerable skill, but sophisticated price optimization
software and advances in database management have improved marketers’ abilities to optimize pricing.

Price Elasticity of Demand Marketers need to know how responsive, or elastic, demand is to a

change in price. Consider the two demand curves in Figure 16.1. In demand curve (a), a price increase from $10

to $15 leads to a relatively small decline in demand from 105 to 100. In demand curve (b), the same price increase

leads to a substantial drop in demand from 150 to 50. If demand hardly changes with a small change in price, we

say it is inelastic. If demand changes considerably, it is elastic.

The higher the elasticity, the greater the volume growth resulting from a 1 percent price reduction. If demand is

elastic, sellers will consider lowering the price to produce more total revenue. This makes sense as long as the costs

of producing and selling more units do not increase disproportionately.

Price elasticity depends on the magnitude and direction of the contemplated price change. It may be

negligible

with a small price change and substantial with a large price change. It may differ for a price cut

than for a price increase, and there may be a price indifference band within which price changes have little or

no effect.

Finally, long-run price elasticity may differ from short-run elasticity. Buyers may continue to buy from a current

supplier after a price increase but eventually switch suppliers. Here demand is more elastic in the long run

than in the short run, or the reverse may happen: Buyers may drop a supplier after a price increase but return later.

The distinction between short-run and long-run elasticity means that sellers will not know the total effect of a
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price change until time passes.

Research has shown that consumers tend to be more sensitive to prices during tough economic times, but that

is not true across all categories.40 One comprehensive review of a 40-year period of academic research on price

elasticity yielded interesting findings:41

• The average price elasticity across all products, markets, and time periods studied was –2.62. In other words, a

1 percent decrease in prices led to a 2.62 percent increase in sales.

• Price elasticity magnitudes were higher for durable goods than for other goods and higher for products in the

introduction/growth stages of the product life cycle than in the mature/decline stages.

• Inflation led to substantially higher price elasticities, especially in the short run.

• Promotional price elasticities were higher than actual price elasticities in the short run (though the reverse

was true in the long run).

• Price elasticities were higher at the individual item or SKU level than at the overall brand level.
 Chapter 16 : Pricing in a Digital World

Step 3: Estimating Costs

Types of Costs and Levels of Production A company’s costs take two forms, fixed and variable. Fixed costs, also
known as overhead, are costs that do not vary with production level or sales revenue. A company must pay bills each
month for rent, heat, interest, salaries, and so on, regardless of output. Variable costs vary directly with the level of
production. For example, each tablet computer produced by Samsung incurs the cost of plastic and glass, microprocessor
chips and other electronics, and packaging. These costs tend to be constant per unit produced, but they’re called variable
because their total varies with the number of units produced. Total costs consist of the sum of the fixed and variable costs
for any given level of production. Average cost is the cost per unit at that level of production; it equals total costs divided
by production. Management wants to charge a price that will at least cover the total production costs at a given level of

production. Accumulated Production Suppose Samsung runs a plant that produces 3,000 tablet
computers per day. As the company gains experience producing tablets, its methods improve.
Workers learn shortcuts, materials flow more smoothly, and procurement costs fall. The result,
as Figure 16.3 shows, is that average cost. falls with accumulated production experience. Thus the average cost
of producing the first 100,000 tablets is $100 per tablet. When the company has produced the first 200,000 tablets, the
average cost has fallen to $90. After its accumulated production experience doubles again to 400,000, the average cost is
$80. This decline in the average cost with accumulated production experience is called the experience curve or learning
curve. Now suppose three firms compete in this particular tablet market, Samsung, A, and B. Samsung is the lowestcost
producer at $80, having produced 400,000 units in the past. If all three firms sell the tablet for $100, Samsung makes $20
profit per unit, A makes $10 per unit, and B breaks even. The smart move for Samsung would be to lower its price to $90.
This will drive B out of the market, and even A may consider leaving. Samsung will pick up the business that would have
gone to B (and possibly A). Furthermore, price-sensitive customers will enter the market at the lower price. As production
increases beyond 400,000 units, Samsung’s costs will drop still further and faster, more than restoring its profits, even at a
price of $90. Experience-curve pricing nevertheless carries major risks. Aggressive pricing might give the product a cheap
image. It also assumes competitors are weak followers. The strategy leads the company to build more plants to meet
demand, but a competitor may choose to innovate with a lower-cost technology. The market leader is now stuck with the
old technology. Most experience-curve pricing has focused on manufacturing costs, but all costs can be improved on,
including marketing costs. If three firms are each investing a large sum of money in marketing, the firm that has used it
longest might achieve the lowest costs. This firm can charge a little less for its product and still earn the same return, all
other costs being equal

Target Costing Costs change with production scale and experience. They can also change as a result of a concentrated
effort by designers, engineers, and purchasing agents to reduce them through target costing. Market research establishes a
new product’s desired functions and the price at which it will sell, given its appeal and competitors’ prices. This price less
desired profit margin leaves the target cost the marketer must achieve. The firm must examine each cost element—design,
engineering, manufacturing, sales—and bring down costs so the final cost projections are in the target range. When
ConAgra Foods decided to increase the list prices of its Banquet frozen dinners to cover higher commodity costs, the
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average retail price of the meals increased from $1 to $1.25. When sales dropped significantly, management vowed to
return to a $1 price, which necessitated cutting $250 million in other costs through a variety of methods, such as
centralizing purchasing and shipping, using less expensive ingredients, and designing smaller portions.