MATHEMATICAL MODELS OF DECISION MAKING IN TRAVEL INDUSTRY
Price setting and price getting require discipline — not luck. Almost any business can improve its pricing performance, provided it approaches pricing in a structured way.
Companies differ substantially in their approach to price setting but most fall into one of three buckets: cost-based pricing, competition-based pricing or customer value-based pricing.
Renowned investor Warren Buffett has said, “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business.”
Yet pricing receives scant attention in most companies. Fewer than 5% of Fortune 500 companies have a full-time function dedicated to pricing, according to data from the Professional Pricing Society, the world’s largest organization dedicated to pricing. McKinsey & Company has estimated that fewer than 15% of companies do systematic research on this subject. And only about 9% of business schools teach pricing, according to the Association to Advance Collegiate Schools of Business. This neglect is puzzling, as numerous studies have confirmed that pricing has a substantial and immediate effect on company profitability. Studies have shown that small variations in price can raise or lower profitability by as much as 20% or 50%.
Pricing Is a Skill
During the interviews with about 44 managers — from CEOs and CFOs to heads of business units and professionals in marketing, pricing and finance functions — in 15 INDIAN-based industrial companies the dynamics of pricing were discussed. These companies varied in size from about 50 to more than 2000 employees and had dramatically different pricing capabilities. In the course of this research, it was found that pricing power is not destiny, but a learned behaviour. While competition, costs and price sensitivity within a market affect the parameters within which companies set prices, superior pricing is almost always based on skill. The companies that had achieved better pricing all had top managers who championed the development of skills in price setting (price orientation) and price getting (price realization). Regardless of their industry, the degree to which managers focused on developing these two capabilities correlated to their companies’ success in achieving a better price for their product than their competitors. Without managerial engagement, companies typically use historical heuristics, such as cost information, to set prices and yield too much pricing authority to the sales force.
About the Research
In order to identify the current state of pricing practices in INDIAN companies. For this purpose, a Professional Pricing Society was contacted to conduct research on its membership base. To capture contrasting perspectives on pricing within companies, the search was narrowed down to businesses with at least three respondents at three different management levels — at least one respondent from top management (either a CEO, managing director or member of the board of management), at least one respondent from middle management (either a business unit manager or a head of a functional unit), and at least one respondent from lower management (a functional manager). Of the 36 companies meeting these criteria, 15 agreed to participate in this research project. At least three interviews were conducted at each company. Respondents included 15 CEOs or top executives, 18 sales and marketing managers with full or partial responsibility for pricing and 11 finance and accounting managers with decision-making authority. Seven companies were small (as defined by the INDIAN Small Business Administration 2007 size standards by industry), having between 50 and 380 employees and eight were medium-sized, with between 900 and 2,200 employees. Six companies (18 interviews) adopted cost-based pricing, five (14 interviews) used competition-based pricing, and four (12 interviews) relied on customer value-based pricing.
THE PRICING CAPABILITY
To gauge the degree to which the companies was interviewed had developed their pricing function, a pricing capability grid was created. The pricing abilities was categorized into five major categories: the pricing power zone, the value surrender zone, the price capture zone, the zone of good intentions and the white flag zone. Companies in the pricing power zone are able to command significantly higher prices and profitability levels than companies in the white flag zone. It was also observed that companies that were able to learn their way to superior pricing and saw a number of them undergo a transformation that enabled them to evolve from traditional, cost-based pricing toward higher-margin pricing with more disciplined pricing execution.
This study will first discuss the two dimensions of the pricing capability grid: price orientation and price realization. It then describes the characteristics of the five zones of the pricing capability grid and discusses the transformation process through which companies can improve their pricing capabilities.
Price setting, or more formally, price orientation, concerns the methods that companies use to determine final selling prices. Companies differ wildly in their approach to this. Although companies that sell services to individual end-customers, for example, may be radically different from companies that sell jet engines to sophisticated purchasing centers, and although pricing approaches in India may differ considerably from pricing approaches in other countries, academic research and our own findings conclude that pricing approaches across industries, countries and companies usually fall into one of three buckets: cost-based pricing, competition-based pricing or customer value-based pricing.
1. Cost-based pricing. Here, pricing decisions are influenced primarily by accounting data, with the objective of getting a certain return on investment or a certain markup on costs. Typical examples of cost-based pricing approaches are cost-plus pricing, target return pricing, markup pricing or break-even pricing. The main weakness of cost-based pricing is that aspects related to demand (willingness to pay, price elasticity) and competition (competitive price levels) are ignored. The main advantage of this approach is that the data you need to set prices are usually easy to find.
2. Competition-based pricing. This approach uses data on competitive price levels or on anticipated or observed actions of actual or potential competitors as a primary source to determine appropriate price levels. The main advantage of this approach is that the competitive situation is taken into account, and the main disadvantage is that aspects related to the demand function are again ignored. In addition, a strong competitive focus in setting prices can exacerbate the risk of a price war. The 2005-2009 price wars in the domestic car industry in INDIA are a good example of this, and similar developments have occurred in the INDIAN airline industry. Competition-based pricing approaches are frequently justified on the grounds that price is one of the most important purchase criteria for customers.
3. Customer value-based pricing. This approach, which is also often called “value-based pricing,” uses data on the perceived customer value of the product as the main factor for determining the final selling price. Instead of asking, “How to realize higher prices despite intense competition?” customer value-based pricing asks, “How to create additional customer value and increase customer willingness to pay, despite intense competition?” The qualitative and quantified value of a purchase offering to actual and potential customers is the primary driver in setting prices. Customer value-based pricing approaches are driven by a deep understanding of customer needs, of customer perceptions of value, of price elasticity and of customers’ willingness to pay.
The advantage of customer value-driven pricing approaches is their direct link to the needs of the one constituency paying for the respective goods or services: the customer. The big disadvantage of such approaches is that data on customer preferences, willingness to pay, price elasticity and size of different market segments are usually hard to find and interpret. Furthermore, customer value-based pricing approaches may lead to relatively high prices, especially for unique products. Though that may seem optimal in the short run, these pricing approaches may spur market entry by new entrants or create a risk-free zone for competitors offering comparable products at slightly lower prices. Finally, it is important to note that it is an error to assume that customers will immediately recognize and pay for a truly innovative and superior product. Marketers must educate customers and communicate superior value to customers before linking price to value. Customers must first recognize value in order to be willing to pay for value rather than base their purchase decision solely on price.
Despite these shortcomings, many pricing scholars consider customer value-based pricing to often be the most preferable way to set new product prices or to adjust prices for existing products. Some businesspeople have also found that customer value-based pricing can have important benefits. It should be noted that customer value-based pricing is especially relevant in highly competitive industries. Although this might seem counterintuitive, it was found that many managers in such industries mistakenly assume themselves to be in a “commodity” business. They then neglect the possibility for differentiation and customer value creation and resign themselves to competing solely on price. While it is acknowledged that parts of an industry may become heavily price-competitive, it is contended that seeing one’s product as a commodity tends to be a self-fulfilling prophecy. Through deeper research into customer needs, almost any product or service can be differentiated. Such deeper research can also be a powerful weapon to overcome price pressure by retailers. Armed with data on customer willingness to pay, price elasticities and perceptions of value and price, manufacturers can demonstrate to retailers the total value jointly created.
2. How can we deepen our understanding of when to apply which pricing tools and techniques ?
Pricing science is the application of social and business science methods to the problem of setting prices. Methods include economic modeling, statistics, econometrics, mathematical programming. This discipline had its origins in the development of yield management in the airline industry in the 1980s, and has since spread to many other sectors and pricing contexts, including yield management in other travel industry sectors, media, retail, manufacturing and distribution.
Pricing science work is effectuated in a variety of ways, from strategic- advice on pricing on defining segments for which pricing strategies may vary, to enterprise-class software applications, integrated into price quoting and selling processes.
Pricing science has its roots in the development of yield management programmes developed by the airline industry shortly after deregulation of the industry in the early 1980s.
These programmes provided model-based support to answer the central question faced by deregulated airlines: "How many bookings should I accept, for each fare product that I offer on each flight departure that I operate, so that I maximize my revenue?"
Finding the best answers required developing statistical algorithms to predict the number of booked passengers who would show up and to predict the number of additional bookings to expect for each fare product. It also required developing optimization algorithms and formulations to find the best solution, given the characteristics of the forecasts. And for airlines operating hundreds to thousands of flights every day, and selling tickets for daily departures 300 days into the future, the computational challenges are extreme.
The yield management programmes provided dramatic financial benefits to their early adopters in the early- to mid-1980s, and the approach spread rapidly to firms in the related sectors of hotel, rental car, and cruise line industries. While there are important differences between these industries, the dominant drivers of the solutions were the perishable nature of the resource being sold, demand patterns that were time-variable, and the limited capacity available for sale. For a good overview of pricing science methods and applications related to yield or revenue management
Beginning in the early to mid-1990s, these successes spawned efforts to apply the methods, or develop new methods, to support pricing and related decisions in a variety of other settings. Yield management has been applied successfully to broadcast and cable television, online media, oil and gas producers, sporting and theatrical providers, online media, apartment and timeshare rental properties, credit card, and retail settings.
Since about 2000, the application of pricing science to the problems of quoting prices in business-to-business (B2B) transactions has taken off, with adopters reporting financial benefits comparable to the earlier gains in the travel industry.
Instead of optimizing the offers available in response to very dynamic capacity, these business-to-business (B2B) applications provided the means to optimize offers based on the particular characteristics of the transaction being contemplated and the customer. Applications have included business services providers, industrial product manufacturers, and distributors of products ranging from technology to food to office supplies.
Even airlines and other early practitioners began to revisit their original assumption that prices were a "given," a simple input to their optimization technology. The growth of low-cost carriers offering restriction-free pricing, "name your own price" channels, and auctions all stimulated this interest in applying science to the pricing side of the business.
As the applications of scientific methods to these business problems expanded, the discipline of pricing science became more rigorous and methodological. Initially, statistical and optimization methods were adapted by practitioners and theoreticians from the engineering and operations research disciplines. The discipline was typically referred to as operations research and specialization in revenue or yield management methods was viewed as a specialty in the larger discipline of Operations Research and Management Science. INFORMS, the professional body of the larger discipline, has a section devoted to this specialty, the Revenue Management and Pricing section.
As the applications spread from yield management to more general pricing applications, the term Pricing Science has become much more common to refer to the discipline and Pricing Scientists to refer to the practitioners.
The methods employed in pricing science may be categorized into two broad areas: 1. forecasting and 2. optimization. The forecasting problem reflects the fact that the pricing decisions are intended to affect purchase events over some future time horizon. The optimization problem reflects the mathematical complexity required to reach feasible and practical pricing solutions.
There are two forecasting sub-problems: predicting time-phased demand and predicting demand response to the pricing decisions. In yield management-type applications, predicting time-phased demand, at a very granular level, is central since these applications are characterized by fixed capacity against which demand must be balanced by use of pricing or related controls. In many of these types of applications, predicting response to pricing decisions is also important, since price is often the control instrument used to modulate demand. However, there are a number of yield management applications in which the control is directly on product availability; prices are typically taken as fixed in these cases and prediction of price response is not required.
Forecasting time-phased demand
Forecasting methods generally fall into the class of methods known as time series methods, primarily exponential smoothing, or causal methods, where price is taken to be (one of) the causal factors. In pricing science applications, it is necessary to produce forecasts of demand at the level of granularity at which pricing decisions are made.
This introduces both modeling and computation complexity not addressed in standard treatments of forecasting methods. Also, in cases where capacity constraints are present, methods are required to account for the censoring of demand that occurs when demand exceeds capacity. In cases where bookings are closed because they have reached the maximum authorization, one must estimate what the "true" demand would have been had bookings been accepted during those closed periods…..A
Forecasting granular demand
Often, there may be insufficient historical instances of the series of interest to produce a reliable demand forecast. For an airline, this might happen for flights to new markets, where no history is available to reference.
For a retailer, it may simply be sparse data on sales of a particular STOCK KEEPING UNIT. A widely used method used to produce the necessary forecasts in such cases is sometimes referred to as "aggregate and distribute."
This method decomposes the forecast into two components, a forecast of a more aggregated series and a forecast of how that more aggregated demand is distributed across its components, viz.
where is the particular low-level series of interest, is the aggregate of related series (e.g. all itineraries serving a particular origin-destination, or all sizes and colors of the particular style of shirt), is the forecast of the aggregate, and is the forecast of 's share of . Both and may be produced using standard exponential smoothing methods…….B
Accounting for censoring
When the application balances demand against supply through direct control of product availability, as is common in many yield management applications, producing good time-phased forecasts requires either capturing the demand which doesn't result in a sale or booking directly (often referred to as "turndowns" or "loss data"); or using some scientific method to estimate the unobserved demand. Conventionally, these methods are referred to as "unconstraining methods", include manual adjustment, averaging methods, Expectation Maximization (EM) methods, exponential smoothing methods.
When the application uses prices as the control instrument, setting prices to modulate sales, producing good time-phased forecasts may require using causal methods (sometimes referred to as econometric methods) to account for the relationship between the prices in effect at a point in time and the observed sales at that point in time. In this way, the relationship between price and sales volume, often referred to as the "price response effect," can be used to separate the underlying time-phased demand from the sales effects of price changes. Since the objective of these applications of pricing science is precisely to take best advantage of the sale volume effects of price changes, accounting for these effects can be a significant focus of the scientific work in support of these applications. The problem of identifying and estimating these effects is not trivial since, in addition to the price of a specific product, sales volume is affected by numerous other effects, some of which are under the control of the firm (e.g. advertising, prices of related goods) and other which are outside the control of the firm (e.g. competitors' prices, seasonality). In the domain of pricing science, these methods are typically referred to as Market Response Models.
Given models that provide predictions of future sales volume, either as a function of time or price decisions, the firm has certain choices or decisions available to it. Modeling those choices or decisions as an optimization problem provides a means to select the best available set of choices or decisions. In some settings, solutions to this problem may be provided by heuristic methods; in others, by numerical optimization methods; in others, by strict mathematical methods.
The most well-known (and likely, most broadly applied) heuristic method for a large class of yield management problems is known as the Expected Marginal Seat Revenue (EMSR) algorithm. This heuristic provides a decision rule for allocating inventory for sale at lower prices, as a function of the demand at higher prices and the differences in prices.
Numerical optimization methods
Many optimization problems are formulated as constrained or unconstrained mathematical programmes, either linear programmes (LP) or mixed integer programmes (MIP), for which many solution techniques and commercial solvers are available.
Strict mathematical methods
If the market response model is formulated within a certain class, and point estimates of the model parameters obtained, the optimal solution can be obtained analytically exploiting the special structure of the problem.
The most well-known applications of pricing science are to the problems associated with pricing perishable products in the travel industry, notably passenger airline tickets, hotel accommodations, rental car, cruise line berths and the like. These applications are often lumped together under the heading yield management or revenue management.
More recently, yield management has been applied to sporting and theatrical events, automobile parking, casinos, and other sectors where innovative and tailored pricing offers improved returns.
Another important set of pricing science applications addresses the pricing issues confronting traditional retail sales. These include markdown pricing, promotions pricing and shelf pricing. The markdown pricing problem has significant similarities to the problems addressed in yield management, including zero marginal product costs, perishability and time-phased demand.
Business to Business (B2B) Markets
Pricing science applications are found in business service firms (e.g. package shipping and equipment rental), oil and gas production, as well as manufacturing and distribution/wholesaling firms. In the case of business services, and to a lesser extent, manufacturing firms, the applications are intended to address both maximizing margin through differentiated pricing, as well as improving utilization of fixed assets.
In the case of distribution and wholesales sectors, pricing science applications focus exclusively on the problem of identifying opportunities to differentiate prices across different segments of business and computing the optimal prices for each segment.
Very recently, attention is being paid to the problem of accounting for the behavior of sales representatives in the pricing process, as the presence of sales reps who have pricing discretion is a distinguishing characteristic of B2B markets.
There are a variety of practices by which businesses exploit the methods and results of pricing science to make better pricing decisions, most of which are mediated by technology. One organization of the types of technology is to consider (a) general purpose tools used to implement some Pricing Science techniques; (b) use of localized technology, typically standard office tools, configured to utilize Pricing Science methods; and (c) specialized, enterprise-class software designed and developed for this purpose.
In some businesses, pricing decisions are supported using forecasting and optimization methods executed on an as needed based using general purpose analytic tools. In this setting, when periodic, or ad hoc decisions are made, analysis of historical transaction data sets is performed. This approach is often seen in large enterprises which have quantitative analysts familiar with the tools and, to various degrees, with Pricing Science methods, or which retain specialized consultants to perform the analysis.
In many enterprises, the technology used to support pricing and related decisions, using the methods described above, are standard office applications for data management, reporting and analysis. Some very large enterprises have implemented and evolved very elaborate processes of data acquisition and manipulation, using such technology. As the developers and users of these technologies are, for the most part, generalists, there may be frequent issues of quality, reliability and extensibility of such processes.
Since yield management began to take roots in the 1980s, a number of highly specialized enterprise software providers have grown up to meet the needs of businesses that have taken advantage of the margin enhancement opportunities afforded by the methods. The technology provided by such providers have tended to be large-scale applications addressing, to various degrees, not only the scientific methods of pricing but also other execution, work-flow, and reporting requirements that business have. In addition, these providers generally supply specialized expertise in pricing science applications and methods. These software providers fall generally into three classes: those providing technology and expertise related to the yield management problems typically seen in travel and related industries; those providing technology and expertise related to the various pricing problems in the more general retail industry; and those providing technology and expertise related to pricing in B2B commerce.
3. How to use the correct relevant costs in making pricing decisions?
Relevant costing attempts to determine the objective cost of a business decision. An objective measure of the cost of a business decision is the extent of cash outflows that shall result from its implementation. Relevant costing focuses on just that and ignores other costs which do not affect the future cash flows.
The underlying principles of relevant costing are fairly simple and you can probably relate them to your personal experiences involving financial decisions.
For example, assume you had been talked into buying a discount card of ABC Pizza for INR50 which entitles you to a 10% discount on all future purchases. Say a pizza costs INR10 (INR9 after discount) at ABC Pizza and it subsequently came to your knowledge that a similar pizza is offered by XYZ Pizza for just INR8. So the next time you would have ordered a pizza, you would have (hopefully) placed an order at XYZ Pizza realizing that the INR50 you have already spent is irrelevant (see sunk cost below).
Relevant costing is just a refined application of such basic principles to business decisions. The key to relevant costing is the ability to filter what is and isn't relevant to a business decision.
Types of Relevant Costs Types of Non-Relevant Costs
Future Cash Flows
Cash expense that will be incurred in the future as a result of a decision is a relevant cost. Sunk Cost
Sunk cost is expenditure which has already been incurred in the past. Sunk cost is irrelevant because it does not affect the future cash flows of a business.
Only those costs are relevant to a decision that can be avoided if the decision is not implemented. Committed Costs
Future costs that cannot be avoided are not relevant because they will be incurred irrespective of the business decision being considered.
Cash inflow that will be sacrificed as a result of a particular management decision is a relevant cost. Non-Cash Expenses
Non-cash expenses such as depreciation are not relevant because they do not affect the cash flows of a business.
Where different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered. General Overheads
General and administrative overheads which are not affected by the decisions under consideration should be ignored.
Rubber Tire Company (RTC) received a request to provide a price quote for an order for the supply of 1000 custom made tires required for industrial vehicles. RTC is facing stiff competition from its business rivals and is therefore hoping to secure the order by quoting the lowest price. RTC plans to quote a price at 10% above its relevant cost.
Following is the calculation of total cost in respect of the order:
Rubber INR10,000 The order requires a special type of rubber.
Only 25% rubber is currently available in stock. The rubber was purchased 2 years ago at the cost of INR3,000. If the rubber is not used on this order, it will have to scraped at a price of INR1, 000.
Remaining quantity shall have to be procured at the price of INR 7,000.
Oil INR1,000 All the required quantity of oil is currently available in stock. The cost of oil that will be used on the order is INR1,000.
The current market value of the required quantity of oil is INR1,200. If oil is not used on the order, it could be used in the production of other tires.
Other Materials INR2,000 All other materials will have to be procured.
Direct Labour INR5,000 INR5,000 represents the cost that would be paid to direct labour in respect of the time that they work on the order.
If direct labour is not utilized on this order, they remain idle for the entire time. Direct labour is paid idle time equal to 60% of the normal pay in order to retain them.
Supervisor's Salary INR1,000 This represents the share of factory supervisor's salary for the number of days in which production for the order will take place.
Depreciation of equipment INR3,000 This represents the manufacturing equipment's depreciation for the number of days in which production for the order will take place.
Lease rental of factory plant INR12,000 This represents the share of lease rentals of the factory plant for the number of days in which production for the order will take place.
Electricity INR8,000 The order would require 3000 units of electricity which is expected to cost INR8,000.
Overheads Allocation INR6,000 This represents the apportionment of general and administrative overheads based on the number of machine hours that will be required on the order.
Calculate the relevant cost for the order and the price RTC should quote.
Rubber INR8,000 25% - Scrap Value INR1,000
75% - Purchase Cost INR7,000
Relevant Cost INR8,000
The INR3,000 paid two years ago is a sunk cost and should therefore be ignored. INR1,000 represents the opportunity cost of using the rubber available in stock on this particular order.
Oil INR1,200 The INR1,000 cost of oil is a sunk cost.
The INR1,200 current market value of the required oil is the relevant cost because utilizing it on this order will require purchase of additional oil at the market rates to meet the production needs of other tires. Alternatively, the oil could be sold for INR1200.
Other Materials INR2,000 As these materials are not available in stock, these will have to be purchased at the market price which is their relevant cost.
Direct Labour INR2,000 Since INR3,000 (60% of INR5,000) idle time pay will be incurred even if this order is not taken, the relevant cost is the incremental cost of INR2,000 (INR5,000 - INR3,000).
Supervisor's Salary - As supervisor's salary is a fixed cost unchanged by the work performed on this order, it is a non-relevant cost.
Depreciation of equipment - Non-cash expenses are not relevant for decision making.
Lease rental of factory plant - Lease rentals are a committed cost which cannot be avoided by withdrawing from this order which is why they should be ignored for the purpose of this analysis.
Electricity INR8,000 Electricity charges are incremental to this order and therefore relevant.
Overheads Allocation - General and administrative overheads that are not incurred directly as a result of this order should be considered irrelevant.
Relevant Cost of order INR21,200
Profit Margin INR2,120 10% of the relevant cost of INR21,200
Price to be quoted INR23,320
Application & Limitations
While relevant costing is a useful tool in short-term financial decisions, it would probably not be wise to form it as the basis of all pricing decisions because in order for a business to be sustainable in the long-term, it should charge a price that provides a sufficient profit margin above its total cost and not just the relevant cost.
Examples of application of relevant costing include:
Competitive pricing decisions
Make or buy decisions
Further processing decisions
For long term financial decisions such as investment appraisal, disinvestment and shutdown decisions, relevant costing is not appropriate because most costs which may seem non-relevant in the short term become avoidable and incremental when considered in the long term. However, even long term financial decisions such as investment appraisal may use the underlying principles of relevant costing to facilitate an objective evaluation.
4. How to use pricing signaling and price wars as a tool in competing in the market (both inter and intra)
Strategic entry deterrence
In business, strategic entry deterrence refers to any action taken by an existing business in a particular market that discourages potential entrants from entering into competition in that market. Such actions, or barriers to entry, can include hostile takeovers, product differentiation through heavy spending on new product development, capacity expansion to achieve lower unit costs, and predatory pricing.These actions are sometimes deemed anti-competitive and could be subject to various competition laws.
In a particular market an existing firm may be producing a monopoly level of output, and thereby making supernormal profits. This creates an incentive for new firms to enter the market and attempt to capture some of these profits. One way the incumbent can deter entry is to produce a higher quantity at a lower price than the monopoly level, a strategy known as limit pricing. Not only will this reduce the profits being made, making it less attractive for entrants, but it will also mean that the incumbent is meeting more of the market demand, leaving any potential entrant with a much smaller space in the market. Limit pricing will only be an optimal strategy if the smaller profits made by the firm are still greater than those risked if a rival entered the market. It also requires commitment, for example the building of a larger factory to produce the extra capacity, for it to be a credible deterrent.
The incumbent firm has an advantage of being the "first mover" and can therefore act in a way that it knows will influence the entrant's decision. If it is to assume imperfect knowledge (i.e. the incumbent firm's costs are only known privately) the entrant can only make assumptions about the incumbent's cost structure through its price and output levels. Therefore, the incumbent can use these as a signal to any potential entrant.
One way of using this advantage to deter entry is to charge a price less than the monopoly level. If an entrant is considering entry in a number of similar markets, a low cost incumbent can signal its efficiency to a potential entrant through lowering prices – thereby discouraging what the entrant believes would be unprofitable entry. Signaling needs to be credible to be effective – a low cost firm must be able to show that it can withstand lower profits for an extended period of time, which it would not be able to if it had higher costs.
An incumbent who is trying to strategically deter entry can do so by attempting to reduce the entrant's payoff if it were to enter the market. The expected payoffs are obviously dependent on the amount of customers the entrant expects to have – therefore one way of deterring entry is for the incumbent to "tie up" consumers.
The strategic creation of brand loyalty can be a barrier to entry – consumers will be less likely to buy the new entrant's product, as they have no experience of it. Entrants may be forced into expensive price cuts simply to get people to try their product, which will obviously be a deterrent to entry.
Similarly, if the incumbent has a large advertising budget, any new entrant will potentially have to match this in order to raise awareness of their product and a foothold in the market – a large sunk cost that will prevent some firms entering.
In a legal sense, a firm is often defined as engaging in predatory pricing if its price is below its short-run marginal cost, often referred to as the Areeda-Turner Law and which forms the basis of US antitrust cases. The rationale for this action is to drive the rival out of the market, and then raise prices once monopoly position is reclaimed. This advertises to other potential entrants that they will encounter the same aggressive response if they enter.
In the short run, it would be profit maximizing to acquiesce and share the market with the new entrant. However, this may not be the firm's best response in the long run. Once the incumbent acquiesces to an entrant, it signals to other potential entrants that it is "weak" and encourages other entrants. Thus the payoff to fighting the first entrant is also to discourage future entrants by establishing its "hard" reputation. One such example occurred when British Airways' engaged in a competition war with Virgin Atlantic throughout the 1980s over its transatlantic route. This led Richard Branson, chairman of Virgin Atlantic, to say that competing with British Airways was "like getting into a bleeding competition with a blood bank."
The threat to fight any potential entrant is credible if its reputation is built up, or it can set up conditions that make it optimal to fight if a rival enters.
If there are relatively low barriers to exit within a market, an incumbent competing against a more efficient rival may find it optimal to exit the market rather than fight. Hence, one way to make a fighting threat credible is for the incumbent to artificially raise the cost of exit, for example by having high sunk costs.
Examples of this are railroad companies. The high sunk cost of laying a network of railway lines makes it likely that a rail operator will be willing to fight a more costly price war than a rival with lower sunk costs, for example an airline that can switch its aircraft to another route relatively easily. At the extreme, if the incumbents sunk costs are very high, any entry by a rival will end in a mutually destructive outcome.
5. How to frame and implement prices optimally in the market ?
Background. Pricing decisions are extremely important for the firm. Some of the reasons:
• Pricing is the only part of the marketing mix which brings in revenue.
• Once a price has been set, consumers will often show a great deal of resistance to any attempts to change it.
• Pricing frequently has important implications for the positioning of a product.
• Price is the marketing mix variable for which a competitive response can be most quickly implemented.
Conceptualizing price. A logical examination suggests that price should be defined as
That is, it wasneed to consider the quantity you receive as well as the amount of money you have to fork out. To say that gasoline costs INR1.29 is meaningless outside the context that this cost is per gallon.
WAYS TO CHANGE PRICE
The above conceptualization suggests that the marketer has several ways available to change price:
• Increasing or decreasing the "sticker price" of a product.
• Increasing or decreasing the quantity of material received. As prices of chocolate increased in the 1970s, firms found it difficult to raise candy bar prices. Instead, they simply made them smaller.
• Changing the quality of a product. Firms may cut back on services or dilute products more, possibly reducing or cutting out expensive ingredients.
• Change the terms of a sale. Firms may begin charging for previously free delivery. In recent years, many software manufacturers have stopped providing free telephone support for their programmes.
Pricing strategies can be categorized based on several different variables. One variable of interest relates to the consistency of the prices. Some retailers today attempt to follow a strategy of "everyday low pricing." Although few firms tend to practice this method with perfect consistency, certain retailers like Wal-Mart tend to focus on providing constant low prices without any real sales. Other retailers instead feature prices which, when not discounted, are somewhat higher. To compensate, periodic sales feature price reductions. Sales can be implemented either with a predictable pattern (e.g., a product is put on sale every fourth week) or in a random manner (e.g., in any given week, there is a 25% chance that the product will offered on sale). (See chart on overheads).
Note that "high-low" and "everyday low price" strategies are intended to take advantage of different price elasticities across people. Some consumers are price sensitive and will tend to buy only during sales; other people, in contrast, will buy all the time. Thus, people who are not willing to switch brands will have to pay full price for your products when they are not on sale; while they are on sale, a large number of "switchers" are attracted and sales volumes are increased.
Another dimension of interest in pricing the price introductory strategy. The "skimming" strategy entails offering a product first at a relatively high price.
Consider, for example, what one can do when there is a large degree of price elasticity—i.e., when some consumers are willing to pay more than others. In the chart above, it is seen that some consumers are willing to pay a lot of money to get a new product quickly, while others are not willing to pay as much. This often happens, for example, with new computer chips. It may be possible, then, to charge the first segment more money, and then lower the price enough so that the next segment will buy it. The process continues until all segments that can be profitably served have bought. In the chart below, it one can introduce the product at price P1. This means that it will only sell a limited quantity--Q1. Later, when price was reduced to P2, enabling one to sell a quantity of Q2. Eventually, when it was lowered to P3, selling will have increased to Q3.
Since consumers differ in how much they are willing to pay for a product, it is possible to make large margins on the price inelastic segment. For example, Intel tends to charge high prices for its most recent chips, gradually lowering prices as a new generation is introduced.
Alternatively, firms may choose to use the "penetration" pricing strategy. This strategy also takes advantage of price elasticity and attempts to dramatically boost the number of units sold by offering the product at a low price.
Since costs of production tend to go down as cumulative production increases, this strategy may be effective. Penetration pricing is also useful when a firm wishes to establish a large market share early on, and it may be useful to develop a market for accessories to products. For example, a manufacturer of a new computer system may want to increase sales volumes in order to encourage the development of compatible software so that the computer brand will become more competitively attractive.
Note that "skimming" and penetration pricing involve tradeoffs. A clearly preferred strategy may not be obvious, and managers may need to engage in some serious consideration to arrive at a desired strategy. Both strategies involve some level of risk. The main risk to "skimming" is the attraction of aggressive competitors who see an opportunity to make large profits by entering. Penetration pricing, in contrast, gambles on the possibility that sales volumes will in fact increase with lower prices.
Two other concepts are worth noting. A "cost-plus" pricing strategy entails marking up the estimated cost of producing a product by a certain, fixed percentage. In contrast, pricing based on consumer perceived value keeps the firm in closer proximity to the market.
Several objectives can be pursued in pricing. One is product line pricing. In some cases, it may be useful to settle for small margins on some members of the product line in order to assure the success of others. For example, Avery, the maker of adhesive labels, sells relatively inexpensive software for printing on the labels in order to stimulate demand for the higher margin labels. Two-tier pricing involves an attempt to entice the consumer into buying a product at a low price with the expectation that he or she will buy accessories later. For example, makers of razor blades tend to sell the razors at low prices so that the consumer has an incentive to go with the same brand of blades later on. Tying, which is often illegal in the INDIAN when it is based on unreasonable exercise of monopoly power by a dominant firm in a market, involves requiring the consumer to buy a less desirable product in order to be able to buy a more desired one. Back when Xerox was the dominant manufacturer of copy machines, for example, a court case forced the company to abandon its policy of including service of the copiers with machine purchase; consumers were now free to seek out any cheaper third party service available. For a more contemporary example, let's imagine that rap singer Joyoys J has two albums on the market: A Rated X-Mas and X-Mas Gift 'wrapping'. If market research suggests that X-Mas Gift 'wrapping' will be received as a mediocre album while A Rated X-mas is likely to reach Platinum status, Joyoys J might refuse to sell A Rated X-Mas without a simultaneous purchase of the less desirable product. The legal issues here are complex, in part because there are often serious questions about the extent to which it is reasonable for the customer to be able to buy only one product when most customers would want to buy the combination. It is probably not reasonable, for example, to insist on being allowed to buy only pink M&Ms® since most customers appear to prefer a mix of colors.
Product price bundling, generally legal, presents an alternative to outright tying. Here, the consumer can buy each product separately, but a discount is offered for buying two or more items simultaneously. In Joyoys J’s case, a possible pricing schedule might be:
A Rated X-mas INR20.00
X-Mas Gift 'wrapping' INR10.00
Both for INR25.00 (>INR20.00+INR10.00=INR30.00)
In general, simple "cost-plus" pricing is inappropriate because:
• The costs, in a market which is not perfectly competitive, may not be reflective of the costs of your competitors. If theirs are lower than yours, you may be over pricing your products; if it is higher than yours, you may be able to charge higher prices than cost-plus would suggest.
• The costs are not reflective of the value of the product to consumers.
• The prices of some products are more salient than those of others; thus, you may want to use some products as "loss leaders."
Cost should, however, play some role in pricing decisions:
• Whether you can produce products at a cost low enough to compete effectively against market existing market prices should help determine whether to enter (or exit) a given market.
• Understanding the relationship between price and quantity demanded as well as the cost of producing this quantity will help make decisions on pricing and quantity produced. In this context, note the effects of experience previously discussed in the text. That is, it may be profitable to sacrifice margin immediately to move along the experience curve and enjoy a cost advantage relative to competitors later.
CONSUMER PRICE AWARENESS
Research suggests a large segment of consumers does not give much attention to the prices of individual products. Consumers were found on the average to spend only about 12 seconds between arriving at the site within a store where a frequently purchased product was located and departing; on the average, consumers inspected only 1.2 products. Only 55.6%, seconds after having selected a product, could specify its price within 5% of accuracy. Note that this study does not indicate a total lack of consumer price sensitivity since consumers are undoubtedly making some inferences about the overall price levels of a store. Thus, the store has some incentive to maintain reasonable overall prices.
COMPETITION AND ANTITRUST ISSUES IN PRICING
The United States maintains relatively stringent (by international standards) antitrust laws. Much of the rest of the World is catching up with us, but traditionally, anti-competitive laws in many European and Asian countries were either non-existent, intended to actively encourage collusion, or not enforced. In fact, a professor at INSEAD, the premier French business school, reported that his students—who came from countries throughout Europe—actually expected him to teach them how to collude with each other. Antitrust issues relevant to prices can be categorized into the following main categories:
• Minimum prices: It is generally, with a few relatively complicated exceptions, illegal to sell products below your cost of production. (For firms holding a large market share, these costs, in accounting terms, must be "fully absorbed"—that is, overhead and development costs must be apportioned among products sold).
• In selling to entities that compete against each other, price discrimination or volume discounts are generally only legal to the extent that a manufacturer can prove actual cost savings associated with serving a large account. In the INDIAN criminal justice system, one is used to think of a person being "innocent until proven guilty," but this standard does not apply in this kind of civil case. The law provides that the manufacturer has the burden of proof to establish that cost savings exist. The overheads indicate the pricing structure of Morton Salt employed in the 1940s. Although the volume discounts are modest and seem reasonable, the U.S Supreme Court held against Morton because the firm failed to prove cost savings. (Federal Trade Commission v. Morton Salt Company, 334 U.S. 37 ).
• The prohibition on price discrimination generally applies only to entities competing against each other. This means that differences in prices charged by a firm to competing restaurants must be justified by demonstrable cost savings, but it may be legal to charge supermarkets different prices than those charged to grocery stores to the extent that restaurants and grocery stores do not significantly compete in the affected product category. Restaurants, for example, tend to use hot sauce as an ingredient in food served while grocery stores tend to resell the hot sauce.
• Anti-competitive pricing: In general, collusion, or firms getting together to fix prices, is outright illegal in INDIA (but not in all countries—it is sometimes legal, for example, in Switzerland). In the late 1980s and early 1990s, certain airlines were accused of fixing prices by communication through their computerized reservation systems. Most airlines settled the suit, agreeing to certain injunctions limiting this practice.
• Price maintenance refers to the practice of encouraging a certain minimum resale price of products. In 2007, the U.S. Supreme Court reversed its previous holding and ruled in the case Leegin Creative Leather Products, Inc. v. PSKS, Inc. that it is not automatically (“per se”) illegal for manufacturers to require as a condition of sale that retailers of its products agree to charge a price no lower than a “floor” price established by contract. Courts may still decide, depending on the facts and conditions of a particular case, that certain minimum price agreements between manufacturers and retailers result in a “restraint of trade” in violation of the Sherman Act. This conclusion is, however, no longer automatic and has to be established through the “rule of reason.” A theory asserted is that, under some circumstances, retail price maintenance may actually increase inter-brand competition, or competition among brands since retailers will now have a greater incentive to provide services and make investments in brand building knowing that they will not be undersold by retailers not offering these services. Intra-brand competition—or competition among the retailers selling the same brand—is likely to be reduced, but it is argued that the non-price benefits of increased service may be more valuable to customers in some circumstances than facing the lowest possible prices. In the U.S., manufacturers generally cannot prevent retailers from selling their inventory at a lower priced than what has been contractually specified, but the manufacturer can stop selling to such discounting retailers without being in automatic violation. As a matter of pragmatics, very few manufacturers would actually want to enforce price maintenance today. Discounters have now become a major force in the economy and the source of a large number of sales. Refusing to sell to discounters, or pressuring them to charge higher prices, is almost certainly not a viable strategy for most firms today.
• Tying: it is generally illegal to require a customer to buy a less desired product in order to buy a more desired one. In practice, it is difficult to decide where to draw the line. For example, most consumers would probably prefer to buy a fishing rod and reel together; so it is not unreasonable, for the sake of expediency, to sell the two only together. On the other hand, Ford in the 1950s refused to drill holes in auto dashboards if the consumer did not purchase a radio with the vehicle. This made buying third party radios quite unattractive, and Ford was forced by litigation to abandon this practice.
CONSUMER REFERENCE PRICES
Consumers typically maintain reference prices for products. These are typically based on prices they have seen or paid in the past or perceived fairness of prices.
There are two kinds of reference prices:
• Internal reference prices are price expectations based on the consumer's experience. These are:
o Typically lower than actual retail prices; thus, consumers frequently experience "sticker shock" when shopping for certain products.
o Frequently updated, but somewhat difficult to change dramatically.
o Confined to a narrower range for some products than others.
• External reference prices are prices supplied by a marketer as a means of influencing a consumer's price expectations—e.g., "Regularly INR3.99; Now INR2.99." Although one might think that an implausible (unbelievable) external reference price would suggest to the consumer that the retailer is lying, research has shown that clearly implausibly high external reference prices actually increase internal reference prices.
Research shows that both experience (prices previously paid) and the sale context (prices of competing brands) influence a consumer's internal reference price.
Consumers tend to experience two sources of value for a product. Acquisition utility refers to the utility of obtaining a product, while transaction utility refers to the difference between a subject's reference price and the featured price.
Traditionally, managers have believed that you need to approach a certain threshold of some 15-20% discount before consumers will respond significantly to sales. More recent research, however, shows that a large segment of the population will apparently respond to "negligible" discounts. For example, if a product is reduced in price from INR3.98 to INR3.96 (a "whopping" one half of one percent price cut!), a large number of consumers will "bite." A store manager similarly found that just placing a sign saying "EVERYDAY LOW PRICE" randomly among store products increased sales of the affected products by some 20%.
There is some question as to whether "odd" product prices (those ending in "9," "95," or "99) actually increase sales. Some effect has been found in the INDIAN markets, but no effect was found in Germany. Note, however, that "odd" prices may communicate the idea that you are receiving a bargain, which may nor may not be consistent with the desired positioning of the product.
As some firms have painfully learned, changing the price of a product can be difficult. Some experimenters tried to introduce a laundry detergent both at a "high" and "low" price in stores. After eight weeks, the price of the laundry detergent under the "low" intro price condition was changed to match that of the "high" introductory condition.
Although sales were higher in the low introductory price condition while the price was low, sales dropped dramatically after the price had been raised—in fact, after sixteen weeks, cumulative sales were higher in those stores where the price had been high all along. This suggests that consumers started thinking about the product as a "low price" one and had difficulty adjusting when the price was later changed.
There are other cases where changing product prices has proven difficult. In the 1970s, consumers were reluctant to pay above an effective INR2.00 "ceiling" for cereal. The Coca Cola Company also found it difficult to raise its price above its highly salient 5 cent level.
The "framing" of products tends to dramatically influence consumer response. The Automobile Club of Southern California, for example, indicates that upgrading to "AAA Plus" service costs "only pennies a day" rather than emphasizing the yearly cost. Note that this framing effect may also have implications for the practice of sales—when the sale is retracted, consumers may see this as a loss rather than the termination of a gain.
MANUFACTURER VS. RETAILER PRICING INTERESTS
Retailers and manufacturers often have conflicting interests since:
• Retailers seek to maximize category profits. For many product categories, consumers simply switch brands (but do not buy more) when one brand goes on sale. Thus, the retailer might as well "pocket" much of the price difference. In fact, marketing professors Gerard Tellis and Fred Zufryden have developed an econometric model (based on observations of consumer response to price changes across brands) indicating to retailers the optimal proportion of price cuts passed on to pass on to consumers. This is one reason why it may pay to for manufacturers to use coupons or mail-in rebates, which circumvent retailer efforts to pocket discounts.
• Manufacturers may resent having their products used as loss-leaders (possibly damaging their brand image).
ADVERTISING: DOES IT INCREASE OR DECREASE PRICE ELASTICITY?
Economists such as John Kenneth Galbraith have traditionally held that advertising serves to create artificial differentiation among products where few real differences exist and thus allows the firm to charge higher prices. This effect can be observed on whole-sale prices, where heavily advertised products tend to sell for higher prices.
Research shows, however, that advertising may have the opposite effect on prices at the retail level. Retailers will often use highly advertised products as loss leaders, and thus advertising may depress retail prices of products. It has also been found that prices of eye-glasses are lower in those states that allow advertising (containing price information), and after deregulation, air fares were negatively correlated with advertising on the route in question (again making prices more readily comparable)