Grasp the concept of pricing based on overall costs, and identify the various cost inputs involved
Cost-based pricing is a fairly straight-forward concept, where the organization understands the operation costs of producing a given good and prices that good as close to this cost level as possible. It is often referred to as cost-plus pricing, as the firm (unless it is a non-profit organization) must retain some value or profit from the sale. This markup can be set at a fixed percentage, such as 5%. If a given good will cost $10 to develop, a perfect cost-based pricing would be to sell it at $10. A cost-plus pricing model at 5% would be to sell the product at $10.50.
While the concept of cost-based pricing is quite simple, the accurate measurement of cost can sometimes be a bit complex. There are fixed costs, variable costs, and indirect costs that all must be factored into the overall calculation. Each of these costs are impacted differently by volume, and as a result, cost-based pricing may fluctuate over time. This creates some requirements for projecting volume, basing cost off of a certain volume and understanding the potential in variance.
Fixed cost changes over time, for the simple reason that each additional unit produced will lower the average cost per unit relative to fixed investments. Take, for example, an investment in a machine for $10,000. The machine can produce 10,000 units in a year. At maximum capacity, this machine will cost $1 per unit. However, the demand is not high enough to produce at this capacity. Instead, it is only producing 5,000 units a year. Now the cost per unit is $2.
The variable cost is consistent for each new unit, and as a result is not sensitive to overall volume (in most cases). What this means is that producing 1 unit will cost $5, and producing 10 units will cost $50, 100 units $500.
Indeed, sensitivity to volume is often one of economy of scale, which is to say that purchasing inputs for production may even become cheaper the higher the quantity that is produced. As a result, variable costs and quantity have a very different relationship than fixed costs and quantity.
Complicating the concept of cost-based pricing is the indirect cost of doing business. Many aspects of an organization are not directly related to production, and are therefore somewhat difficult to factor into the overall equation. Salaries of corporate staff, administration costs, legal costs, office costs, utilities, electricity, and other supports must be accurately projected and built into the cost-based pricing model in order to ensure that the organization is properly pricing the product for profitability.
Overall, when a company decides to price goods based on cost, it is important that the internal mechanisms of measurement for fixed, variable, and indirect inputs are highly accurate and developed. This cost method is often considered a low-cost method, as the firm is attempting to forward as much value as possible to the consumer. This model is best for organizations working to compete on price, and striving for optimal efficiency in the production process.
Demand-based pricing, also known as customer-based pricing, is any pricing method that uses consumer demand – based on perceived value – as the central element. These include: price skimming, price discrimination, psychological pricing, bundle pricing, penetration pricing, and value-based pricing.
Pricing factors are manufacturing cost, market place, competition, market condition, and quality of the product.
Price skimming is a pricing strategy in which a marketer sets a relatively high price for a product or service at first, then lowers the price over time. In other words, price skimming is when a firm charges the highest initial price that customers will pay. As the demand of the first customers is satisfied, the firm lowers the price to attract another, more price-sensitive segment.
The objective of a price skimming strategy is to capture the consumer surplus. It allows the firm to recover its sunk costs quickly before competition steps in and lowers the market price. If this is done successfully, then theoretically no customer will pay less for the product than the maximum they are willing to pay. In practice, it is almost impossible for a firm to capture all of this surplus .
Price discrimination exists when sales of identical goods or services are transacted at different prices from the same provider. Product heterogeneity, market frictions, or high fixed costs (which make marginal-cost pricing unsustainable in the long run) can allow for some degree of differential pricing to different consumers, even in fully competitive retail or industrial markets. Price discrimination also occurs when the same price is charged to customers that have different supply costs. Price discrimination requires market segmentation and some means to discourage discount customers from becoming resellers and, by extension, competitors. This usually entails using one or more means of preventing any resale, keeping the different price groups separate, making price comparisons difficult, or restricting pricing information.
Psychological pricing is a marketing practice based on the theory that certain prices have a psychological impact. The retail prices are often expressed as “odd prices”: a little less than a round number, e.g. $19.99. The theory is this drives demand greater than would be expected if consumers were perfectly rational. Bundle pricing is a marketing strategy that involves offering several products for sale as one combined product. This strategy is very common in the software business, in the cable television industry, and in the fast food industry in which multiple items are combined into a complete meal. A bundle of products is sometimes referred to as a package deal, a compilation, or an anthology.
Penetration pricing is the pricing technique of setting a relatively low initial entry price, often lower than the eventual market price, to attract new customers. The strategy works on the expectation that customers will switch to the new brand because of the lower price. Penetration pricing is most commonly associated with a marketing objective of increasing market share or sales volume, rather than to make profit in the short term. The main disadvantage with penetration pricing is that it establishes long term price expectations for the product as well as image preconceptions for the brand and company. This makes it difficult to eventually raise prices.
Value-based pricing sets prices primarily, but not exclusively, on the value, perceived or estimated, to the customer rather than on the cost of the product or historical prices. Value-based-pricing is most successful when products are sold based on emotions (fashion), in niche markets, in shortages (e.g. drinks at open air festival at a hot summer day), or for indispensable add-ons (e.g. printer cartridges, headsets for cell phones). By definition, long term prices based on value-based pricing are always higher or equal to the prices derived from cost-based pricing.
Understand why matching the price of competitors is important, and how it can be misused (i.e. price fixing)
Determining the optimal price for a given product or service can be approached in many different ways. Some organizations simply look at what it will cost (on average) to produce a product or service, and sell it at an acceptable profit margin above that expense rate. Other businesses may focus more on what the consumer is willing to pay, and try to capture as much of that potential as possible. Other organizations may be non-profit oriented, and will sell at the lowest possible price while remaining in business.
Organizations that sell products or services, usually in mature industries, may look at what price a product is generally being sold at and emulate that sales price. This can be done for a variety of reasons, and firms must be careful of ethical and legal concerns when considering this approach:
While competitor-based pricing may be in pursuit of the cheapest possible price for consumers, this is unfortunately not always the case. Price fixing is a risk for organizations that pursue this pricing strategy, as it essentially would allow industries which are oligopolies (with a small number of providers) to remove the competitive aspect of capitalism through establishing a fixed price across all firms.
All this really means is that organizations within certain industries are NOT allowed to agree on a price that each competitor will stick to. If organizations were allowed to do this, competition on a key component of the marketing mix would be lost completely (i.e. price). Without this competitive force, organizations would gain pricing power over consumers through price fixing. As a result, competitor-based pricing is more appropriate for firms trying to grow more efficient and become more competitive, but not as appropriate for firms who are already established.
Examine the rationale behind the use of markup pricing as a general pricing strategy
Several varieties of markup pricing – also known as cost-plus pricing – exist, but the common thread is that one first calculates the cost of the product, then adds a proportion of it as markup. The amount to be marked up is decided at the discretion of the company. Basically, this approach sets prices that cover the cost of production and provide enough profit margin to the firm to earn its target rate of return.
Cost-plus pricing is used primarily because it is easy to calculate and requires little information. Information on demand and costs is not easily available; however, this information is necessary to generate accurate estimates of marginal costs and revenues. Moreover, the process of obtaining this additional information is expensive. Therefore, cost-plus pricing is often considered a rational approach to maximizing profits. Cost-plus pricing is especially useful in the following cases:
There are two steps which form this approach. The first step involves calculation of the cost of production, and the second step is to determine the markup over costs. The total cost has two components: total variable cost and total fixed cost. In both cases, costs are computed on an average basis . In cost-plus pricing, we use quantity to calculate price, but price is the determinant of quantity. To avoid this problem, the quantity is assumed. This rate of output is based on some percentage of the firm’s capacity. The objective of determining markup over costs is to set prices in a manner that a firm earns its targeted rate of return. This return can be considered RsX, where Rs is the ratio of the respective share of total profit. Therefore, the markup over costs on each unit of output will be X/Q. Price will be calculated through the formula in.
Profit maximization is the short run or long run process by which a firm determines the price and output level that returns the greatest profit. Any costs incurred by a firm may be classed into two groups: fixed costs and variable costs.
Fixed costs, which occur only in the short run, are incurred by the business at any level of output, including zero output. These may include equipment maintenance, rent, wages of employees whose numbers cannot be increased or decreased in the short run, and general upkeep.
Variable costs change with the level of output, increasing as more product is generated. Materials consumed during production often have the largest impact on this category, which also includes the wages of employees who can be hired and laid off in the span of time (long run or short run) under consideration.
Fixed cost and variable cost, combined, equal total cost. Revenue is the amount of money that a company receives from its normal business activities, usually from the sale of goods and services (as opposed to monies from security sales such as equity shares or debt issuances).To obtain the profit maximising output quantity, we start by recognizing that profit is equal to total revenue (TR) minus total cost (TC).
Given a table of costs and revenues at each quantity, we can either compute equations or plot the data directly on a graph.
The profit-maximizing output is the one at which this difference reaches its maximum. In the accompanying diagram, the linear total revenue curve represents the case in which the firm is a perfect competitor in the goods market and thus cannot set its own selling price. The profit-maximizing output level is represented as the one at which total revenue is the height of C and total cost is the height of B; the maximal profit is measured as CB. This output level is also the one at which the total profit curve is at its maximum.
If, contrary to what is assumed in the graph, the firm is not a perfect competitor in the output market, the price to sell the product at can be read off the demand curve at the firm’s optimal quantity of output. The above method takes the perspective of total revenue and total cost. A firm may also take the perspective of marginal revenue and marginal cost, which is based on the fact that total profit reaches its maximum point where marginal revenue equals marginal cost.
8.7: Specific Pricing Strategies
8.7.1: New Product Pricing
With a new product, competition does not exist or is minimal, hence the general pricing strategies depend on different factors.
Compare and contrast penetration pricing and skimming pricing
- Penetration pricing is the pricing technique of setting a relatively low initial entry price, often lower than the eventual market price, to attract new customers. The strategy works on the expectation that customers will switch to the new brand because of the lower price.
- Skimming involves goods being sold at higher prices so that fewer sales are needed to break even. By selling a product at a high price, sacrificing high sales to gain a high profit is therefore “skimming” the market.
- The decision of best strategy to use depends on a number of factors. A penetration strategy would generally be supported by the opportunity to keep costs low, and the anticipation of quick market entry by competitors. A skimming strategy is most appropriate when the opposite conditions exist.
- Market Share
The percentage of some market held by a company.
- market penetration
having gained part of a market in which similar products already exist
With a totally new product, competition does not exist or is minimal. Two general strategies are most common for setting prices:
(1) Penetration pricing
In the introductory stage of a new product’s life cycle means accepting a lower profit margin and to price relatively low. Such a strategy should generate greater sales and establish the new product in the market more quickly. Penetration pricing is the pricing technique of setting a relatively low initial entry price, often lower than the eventual market price, to attract new customers. The strategy works on the expectation that customers will switch to the new brand because of the lower price. Penetration pricing is most commonly associated with a marketing objective of increasing market share or sales volume, rather than to make profit in the short term. The advantages of penetration pricing to the firm are as follows:
- It can result in fast diffusion and adoption. This can achieve high market penetration rates quickly. This can take the competitors by surprise, not giving them time to react.
- It can create goodwill among the early adopters segment. This can create more trade through word of mouth.
- It creates cost control and cost reduction pressures from the start, leading to greater efficiency.
- It discourages the entry of competitors. Low prices act as a barrier to entry.
- It can create high stock turnover throughout the distribution channel. This can create critically important enthusiasm and support in the channel.
- It can be based on marginal cost pricing, which is economically efficient.
A penetration strategy would generally be supported by the following conditions: price-sensitive consumers, opportunity to keep costs low, the anticipation of quick market entry by competitors, a high likelihood for rapid acceptance by potential buyers, and an adequate resource base for the firm to meet the new demand and sales.
Companies and businesses set prices at certain levels in order to attract customers.
A gas station sign in Taiwan that shows prices.
Skimming involves goods being sold at higher prices so that fewer sales are needed to break even. Selling a product at a high price and sacrificing high sales to gain a high profit is therefore “skimming” the market. Skimming is usually employed to reimburse the cost of investment of the original research into the product. It is commonly used in electronic markets when a new range, such as DVD players, are firstly dispatched into the market at a high price. This strategy is often used to target “early adopters” of a product or service. Early adopters generally have a relatively lower price-sensitivity and this can be attributed to their need for the product outweighing their need to economize, a greater understanding of the product’s value, or simply having a higher disposable income.
This strategy is employed only for a limited duration to recover most of the investment made to build the product. To gain further market share, a seller must use other pricing tactics such as economy or penetration. This method can have some setbacks as it could leave the product at a high price against the competition. A skimming strategy would generally be supported by the following conditions:
- Having a premium product. In this case, “Premium” does not just denote high cost of production and materials- it also suggests that the product may be rare or that the demand is unusually high. An example would be a USD 500 ticket for the World Series or an USD 80,000 price tag for a limited-production sports car such as this .
- Having legal protection via a patent or copyright may also allow for an excessively high price. Intel and their Pentium chip possessed this advantage for a long period of time. In most cases, the initial high price is gradually reduced to match new competition and allow new customers access to the product.
8.7.2: Product Line Pricing
Line pricing is the use of a limited number of price points for all the product offerings of a vendor.
Describe the characteristics of line pricing
- Line pricing is beneficial to customers because they want and expect a wide assortment of goods, particularly shopping goods. Many small price differences for a given item can be confusing.
- From the seller’s point of view, line pricing is simpler and more efficient to use. The product and service mix can then be tailored to select price points.
- Line pricing suffers during inflationary periods, where such a strategy can be inflexible.
- shopping goods
Goods that require more thought and comparison than convenience goods. Consumers compare multiple attributes such as price, style, quality, and features.
- product line pricing
the practice of charging different amount for goods or services that are variations on a base good or service
- basing-point pricing
goods shipped from a designated city are charged the same amount
- price point
Price points are prices at which demand for a given product is supposed to stay relatively high.
Line pricing is the use of a limited number of prices for all the product offerings of a vendor. This is a tradition started in the old five and dime stores in which everything cost either 5 cents or 10 cents . Its underlying rationale is that these amounts are seen as suitable price points for a whole range of products by prospective customers. It has the advantage of ease of administering, but the disadvantage of inflexibility, particularly in times of inflation or unstable prices.
Five and Dime Stores
Traditional five and dime stores followed a line pricing strategy. All of the goods were either $0.05 or $0.10. The dollar store is a modern equivalent.
Line pricing serves several purposes that benefit both buyers and sellers. Customers want and expect a wide assortment of goods, particularly shopping goods. Many small price differences for a given item can be confusing. If ties were priced at $15, $15.35, $15.75, and so on, selection would be more difficult. The customer would not be able to judge quality differences as reflected by such small increments in price. So having relatively few prices reduces this kind of confusion.
From the seller’s point of view, line pricing holds several benefits:
- It is simpler and more efficient to use relatively fewer prices. The product and service mix can then be tailored to select price points.
- It can result in a smaller inventory than would otherwise be the case. It might increase stock turnover and make inventory control simpler.
- As costs change, the prices can remain the same, but the quality in the line can be changed. For example, you may have bought a $20 tie 15 years ago. You can buy a $20 tie today, but it is unlikely that today’s $20 tie is of the same fine quality as it was in the past.
8.7.3: Psychological Pricing
Psychological pricing is a marketing practice based on the theory that certain prices have meaning to many buyers.
Explain the types of psychological pricing
- Products and services frequently have customary prices in the minds of consumers. A customary price is one that customers identify with particular items.
- Odd prices appear to represent bargains or savings and therefore encourage buying. Thus, marketers often use odd prices that end in figures such as 5, 7, 8, or 9.
- A somewhat related pricing strategy is combination pricing, such as two-for-one or buy-one-get-one-free. Consumers tend to react very positively to these pricing techniques.
- Price Points
Price points are prices at which demand for a given product is supposed to stay relatively high.
- customary price
A price that customers identify with particular items.
Price, as is the case with certain other elements in the marketing mix, has multiple meanings beyond a simple utilitarian statement. One such meaning is often referred to as the psychological aspect of pricing. Inferring quality from price is a common example of the psychological aspect of price. For instance, a buyer may assume that a suit priced at $500 is of higher quality than one priced at $300.
Products and services frequently have customary prices in the minds of consumers. A customary price is one that customers identify with particular items. For example, for many decades a five-stick package of chewing gum cost five cents and a six-ounce bottle of Coca-Cola also cost five cents. Candy bars now cost 60 cents or more, which is the customary price for a standard-sized bar. Manufacturers tend to adjust their wholesale prices to permit retailers to use customary pricing.
Another manifestation of the psychological aspects of pricing is the use of odd prices. We call prices that end in such digits as 5, 7, 8, and 9 “odd prices.” Examples of odd prices include: $2.95, $15.98, or $299.99. Odd prices are intended to drive demand greater than would be expected if consumers were perfectly rational.
Odd prices end with digits like 5, 7, 8, and 9. They are intended to drive demand higher.
Psychological pricing is one cause of price points. For a long time, marketing people have attempted to explain why odd prices are used. It seemed to make little difference whether one paid $29.95 or $30.00 for an item. Perhaps one of the most often heard explanations concerns the psychological impact of odd prices on customers. The explanation is that customers perceive even prices such as $5.00 or $10.00 as regular prices. Odd prices, on the other hand, appear to represent bargains or savings and therefore encourage buying. There seems to be some movement toward even pricing; however, odd pricing is still very common. A somewhat related pricing strategy is combination pricing, such as two-for-one or buy-one-get-one-free. Consumers tend to react very positively to these pricing techniques.
The psychological pricing theory is based on one or more of the following hypotheses:
- Consumers ignore the least significant digits rather than do the proper rounding. Even though the cents are seen and not totally ignored, they may subconsciously be partially ignored.
- Fractional prices suggest to consumers that goods are marked at the lowest possible price.
- When items are listed in a way that is segregated into price bands (such as an online real estate search), the price ending is used to keep an item in a lower band, to be seen by more potential purchasers.
8.7.4: Pricing During Difficult Economic Times
During a recession, companies must consider their unique situation and what value they provide customers when devising a pricing strategy.
Discuss pricing strategies during difficult economic times
- Many companies are tempted to slash prices during a recession, but this strategy should be carefully considered.
- Cutting prices can degrade the value of the brand, lead to a price war, and also lead customers to put off buying when times are good in expectation of price cuts when times are bad.
- Unlike traditional brands that are designed with target consumers in mind, fighter brands are created specifically to combat a competitor that is threatening to take market share away from a company’s main brand.
- When the strategy works, a fighter brand not only defeats a low-priced competitor, but also opens up a new market.
- fighter brand
A pricing strategy where a company prices items lower than the competition in order to protect or gain market share.
A period of reduced economic activity
Pricing During Difficult Economic Times
Every company has a unique pricing strategy during a boom period, based on their own product, market, and managerial decision making. However, during a recession, many companies may be tempted to abandon these strategies. After all, if customers are less willing to spend money, simplistic logic suggests that, by cutting prices, you can attract more customers. However, this strategy should be approached with caution.
Cutting prices can quieten customer complaints and help boost sales for a time, but can have longer-term effects on profitability, and weaken the brand’s image. Reductions can also lead customers to expect discounts whenever the economy dips, causing them to wait to make purchases in the future.
A model of pricing based on ‘rational’ economic theory suggests that prices are set by the forces of supply and demand, and individual companies in a perfectly competitive market must follow the equilibrium price. However, real life is not so simple; people do not always act in the prescribed logic. Sometimes prices go up and people buy more, and vice versa.
A smart pricing strategy during a recession can become a competitive advantage. By knowing what value a company delivers to its customers, it can price more confidently and not panic into slashing prices when it does not necessarily need to. Price-cutting may even lead to price wars where nobody wins. If cuts must be made, companies should focus on cutting the prices of low-value items and retaining high-value products.
Slashing prices on low value goods (while maintaining prices on high value goods) is a potential pricing strategy during difficult economic times.
Customers shop in a store that has lots of different sale signs.
Similarly, price increases during a recession can also be a bad idea. Many firms try to recover higher costs through price increases, which can turn away customers. Customers locked into contracts may have no regress if a company raises prices on them, but it tarnishes the seller’s reputation and will make the customer think twice when the time comes to renew.
Ultimately, the pricing strategy becomes even more important during a recession, and companies must consider all these factors when attempting to adjust. It is important to protect the brand, not alienate customers, and remember what value the company offers in order to get through the difficult economic period unscathed.
In marketing, a fighter brand (sometimes called a fighting brand) is a lower priced offering launched by a company to take on, and ideally take out, specific competitors that are attempting to under-price them. Unlike traditional brands that are designed with target consumers in mind, fighter brands are created specifically to combat a competitor that is threatening to take market share away from a company’s main brand.
The strategy is most often used in difficult economic times. As customers trade down to lower priced offers because of economic constraints, many managers at mid-tier and premium brands are faced with a classic strategic conundrum: Should they tackle the threat head-on and reduce existing prices, knowing it will reduce profits and potentially commoditize the brand? Or should they maintain prices, hope for better times to return, and in the meantime lose customers who might never come back? With both alternatives often equally unpalatable, many companies choose the third option of launching a fighter brand.
When the strategy works, a fighter brand not only defeats a low-priced competitor, but also opens up a new market. The Celeron microprocessor, shown here , is a case study of successful fighter brand. Despite the success of its Pentium processors, Intel faced a major threat from less costly processors that were better placed to serve the emerging market for low-cost personal computers, such as the AMD K6. Intel wanted to protect the brand equity and price premium of its Pentium chips, but it also wanted to avoid AMD gaining a foothold on the lower end of the market. So it created Celeron as a cheaper, less powerful version of its Pentium chips to serve this market.
The Celeron microprocessor is a case study of a successful fighter brand.
8.7.5: Everyday Low Pricing
Everyday low price is a pricing strategy offering consumers a low price without having to wait for sale price events or comparison shopping.
Translate the meaning of the EDLP (everyday low price) pricing strategy
- Every day low pricing saves retail stores the effort and expense needed to mark down prices in the store during sale events, as well as to market these events.
- One 1994 study of an 86-store supermarket grocery chain in the United States concluded that a 10% EDLP price decrease in a category increased sales volume by 3%, while a 10% Hi-Low price increase led to a 3% sales decrease.
- Trader Joe’s is an example of successful EDLP. It is unique because it does not market itself like other grocery stores do, nor are customers required to obtain membership to enjoy its low prices – at Trader Joe’s, its everyday low prices are available to everyone.
- Hi-low price
High-low pricing (or hi-low pricing) is a type of pricing strategy adopted by companies, usually small- and medium-sized retail firms, where a firm charges a high price for an item and later sells it to customers by giving discounts or through clearance sales.
a large self-service store that sells groceries and, usually, medications, household goods and/or clothing
Everyday low price (EDLP) is a pricing strategy promising consumers a low price without the need to wait for sale price events or comparison shopping.
EDLP saves retail stores the effort and expense needed to mark down prices in the store during sale events, as well as to market these events. EDLP is believed to generate shopper loyalty. It was noted in 1994 that the Wal-Mart retail chain in America, which follows an EDLP strategy, would buy “feature advertisements” in newspapers on a monthly basis, while its competitors would advertise 52 weeks per year.
Procter & Gamble, Wal-Mart, Food Lion, Gordmans, and Winn-Dixie are firms that have implemented or championed EDLP. One 1992 study stated that 26% of American supermarket retailers pursued some form of EDLP, meaning the other 74% were Hi-Lo promotion-oriented operators.
One 1994 study of an 86-store supermarket grocery chain in the United States concluded that a 10% EDLP price decrease in a category increased sales volume by 3%, while a 10% Hi-Low price increase led to a 3% sales decrease; but that because consumer demand at the supermarket did not respond much to changes in everyday price, an EDLP policy reduced profits by 18%, while Hi-Lo pricing increased profits by 15%.
An example of a successful brand (other than the infamous Wal-Mart) that uses the EDLP strategy is Trader Joe’s . Trader Joe’s is a private-brand label that conducts a Niche marketing strategy describing itself as the “neighborhood store. ” The firm has been growing at a steady pace, offering a wide variety of organic and natural food items that are hard to find, enabling the business to enjoy a distinctive competitive advantage.
Trader Joe’s is unique because it doesn’t require membership for its customers to enjoy its low prices.
Apart from the many strengths of Trader Joe’s, the most prominent is their commitment to quality and lower prices. The company has worked hard to manage this economic image of value for its products that competitors, even giant retail stores, are unable to meet. Trader Joe’s is not an ordinary store. It is unique because it does not market itself like other grocery stores do nor does it require its customers to take out a membership to enjoy its low prices.
At Trader Joe’s, its everyday low prices are available to everyone. The firm states that “every penny we save is every penny our customer saves” (Trader Joe’s 2010).
8.7.6: High/Low Pricing
High-low pricing is a strategy where most goods offered are priced higher than competitors, but lower prices are offered on other key items.
Recognize the mechanism of High/Low pricing strategies
- The lower promotional prices are designed to bring customers to the organization where the customer is offered the promotional product as well as the regular higher priced products.
- The basic type of customers for the firms adopting high-low price do not have a clear idea about what a product’s price would typically be or have a strong belief that “discount sales = low price”.
- The way competition prevails in the shoe and fashion industry is through high-low price strategies.
mental acceptance of a claim as truth regardless of supporting or contrary empirical evidence
- everyday low price
Everyday low price (“EDLP”) is a pricing strategy promising consumers a low price without the need to wait for sale price events or comparison shop.
High-low pricing is a method of pricing for an organization where the goods or services offered by the organization are regularly priced higher than competitors. However, through promotions, advertisements, and or coupons, lower prices are offered on other key items consumers would want to purchase. The lower promotional prices are designed to bring customers to the organization where the customer is offered the promotional product as well as the regular higher priced products.
High-low pricing is a type of pricing strategy adopted by companies, usually small and medium sized retail firms. The basic type of customers for the firms adopting high-low price will not have a clear idea about what a product’s price would typically be or have a strong belief that “discount sales = low price. ” Customers for firms adopting this type of strategy also have strong preference in purchasing the products sold in this type or by this certain firm. They are loyal to a specific brand.
There are many big firms using this type of pricing strategy (ex: Reebok, Nike, Adidas). The way competition prevails in the shoe industry is through high-low price. Also high-low pricing is extensively used in the fashion industry by companies (ex: Macy’s and Nordstrom) This pricing strategy is not only in the shoe and fashion industry but also in many other industries. However, in these industries one or two firms will not provide discounts and works on fixed rate of earnings. Those firms will follow everyday low price strategy in order to compete in the market.
High-Low Pricing Strategies
Many big firms are using high-low pricing strategies, especially in the shoe industry (ex: Reebok, Nike, and Adidas).
A Nike swoosh on a shoe.
8.7.7: Other Pricing Strategies
One pricing strategy does not fit all, thus adapting various pricing strategies to new scenarios is necessary for a firm to stay viable.
Describe various pricing strategies
- Cost-plus pricing is the simplest pricing method. The firm calculates the cost of producing the product and adds on a percentage (profit) to that price to give the selling price.
- Dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customer’s willingness to pay. The airline industry is often cited as a success story. Most of the passengers on any given airplane have paid different ticket prices for the same flight.
- Non-price competition means that organizations use strategies other than price to attract customers. Advertising,credit, delivery, displays, private brands, and convenience are all examples of tools used in non-price competition.
- economies of scale
The cost advantages that an enterprise obtains due to expansion. As the scale of output is increased, factors such as facility size and usage levels of inputs cause the producer’s average cost per unit to fall.
- marketing mix
A business tool used in marketing products; often crucial when determining a product or brand’s unique selling point. Often synonymous with the four Ps: price, product, promotion, and place.
Pricing strategies for products or services encompass three main ways to improve profits. The business owner can cut costs, sell more, or find more profit with a better pricing strategy. When costs are already at their lowest and sales are hard to find, adopting a better pricing strategy is a key option to stay viable. There are many different pricing strategies that can be utilized for different selling scenarios:
Cost-plus pricing is the simplest pricing method. The firm calculates the cost of producing the product and adds on a percentage (profit) to that price to give the selling price. This method although simple has two flaws: it takes no account of demand and there is no way of determining if potential customers will purchase the product at the calculated price.
A limit price is the price set by a monopolist to discourage economic entry into a market, and is illegal in many countries. The limit price is the price that the entrant would face upon entering as long as the incumbent firm did not decrease output. The limit price is often lower than the average cost of production or just low enough to make entering not profitable. The quantity produced by the incumbent firm to act as a deterrent to entry is usually larger than would be optimal for a monopolist, but might still produce higher economic profits than would be earned under perfect competition.
A flexible pricing mechanism made possible by advances in information technology, and employed mostly by Internet based companies. By responding to market fluctuations or large amounts of data gathered from customers – ranging from where they live to what they buy to how much they have spent on past purchases – dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customer’s willingness to pay. The airline industry is often cited as a success story . In fact, it employs the technique so artfully that most of the passengers on any given airplane have paid different ticket prices for the same flight.
Dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customer’s willingness to pay.
An Air Canada airplane.
Non-price competition means that organizations use strategies other than price to attract customers. Advertising, credit, delivery, displays, private brands, and convenience are all examples of tools used in non-price competition. Business people prefer to use non-price competition rather than price competition, because it is more difficult to match non-price characteristics.
Pricing Above Competitors
Pricing above competitors can be rewarding to organizations, provided that the objectives of the policy are clearly understood and that the marketing mix is used to develop a strategy to enable management to implement the policy successfully. Pricing above competition generally requires a clear advantage on some non-price element of the marketing mix. In some cases, it is possible due to a high price-quality association on the part of potential buyers. Such an assumption is increasingly dangerous in today’s information-rich environment. Consumer Reports and other similar publications make objective product comparisons much simpler for the consumer. There are also hundreds of dot.com companies that provide objective price comparisons. The key is to prove to customers that your product justifies a premium price.
Pricing Below Competitors
While some firms are positioned to price above competition, others wish to carve out a market niche by pricing below competitors. The goal of such a policy is to realize a large sales volume through a lower price and profit margins. By controlling costs and reducing services, these firms are able to earn an acceptable profit, even though profit per unit is usually less. Such a strategy can be effective if a significant segment of the market is price-sensitive and/or the organization’s cost structure is lower than competitors. Costs can be reduced by increased efficiency, economies of scale, or by reducing or eliminating such things as credit, delivery, and advertising. For example, if a firm could replace its field sales force with telemarketing or online access, this function might be performed at lower cost. Such reductions often involve some loss in effectiveness, so the trade off must be considered carefully.
8.8: Pricing Tactics
Discounts and allowances are reductions to a basic price of goods or services and can occur anywhere in the distribution channel.
Analyze the use and types of discounts as part of pricing tactics
- Seasonal discounts are price reductions given for out-of-season merchandise.
- Cash discounts are reductions on base price given to customers for paying cash or within some short time period.
- Senior discounts are discounts offered to customers who are above a certain age, typically a round number such as 50, 55, 60, 65, 70, and 75.
- Educational or student discounts are price reductions given to members of educational institutions, usually students but possibly also to educators and to other institution staff.
- Quantity discounts are reductions in base price given as the result of a buyer purchasing some predetermined quantity of merchandise. A noncumulative quantity discount applies to each purchase and is intended to encourage buyers to make larger purchases.
- functional discount
payments to distribution channel members for performing some service
- quantity discount
price reductions given for large purchases
- List Price
The manufacturer’s suggested retail price (MSRP), list price or recommended retail price (RRP) of a product is the price which the manufacturer recommends that the retailer sell the product.
Discounts and allowances are reductions to a basic price of goods or services. There are many different types of price reduction, each designed to accomplish a specific purpose. They can occur anywhere in the distribution channel, modifying either the manufacturer’s list price (determined by the manufacturer and often printed on the package), the retail price (set by the retailer and often attached to the product with a sticker), or the list price (which is quoted to a potential buyer, usually in written form).
Quantity discounts are reductions in base price given as the result of a buyer purchasing some predetermined quantity of merchandise. A noncumulative quantity discount applies to each purchase and is intended to encourage buyers to make larger purchases. This means that the buyer holds the excess merchandise until it is used, possibly cutting the inventory cost of the seller and preventing the buyer from switching to a competitor at least until the stock is used. A cumulative quantity discount applies to the total bought over a period of time. The buyer adds to the potential discount with each additional purchase. Such a policy helps to build repeat purchases. Building material dealers, for example, find such a policy quite useful in encouraging builders to concentrate their purchase with one dealer and to continue with the same dealer over time.
Seasonal discounts are price reductions given for out-of-season merchandise. An example would be a discount on snowmobiles during the summer. The intention of such discounts is to spread demand over the year. This can allow fuller use of production facilities and improved cash flow during the year. Electric power companies use the logic of seasonal discounts to encourage customers to shift consumption to off-peak periods. Since these companies must have production capacity to meet peak demands, the lowering of the peak can lessen the generating capacity required.
Cash discounts are reductions on base price given to customers for paying cash or within some short time period. For example, a 2% discount on bills paid within 10 days is a cash discount. The purpose is generally to accelerate the cash flow of the organization.
Trade discounts, also called functional discounts, are payments to distribution channel members for performing some function. Examples of these functions are warehousing and shelf stocking. Trade discounts are often combined to include a series of functions, for example 20/12/5 could indicate a 20% discount for warehousing the product, an additional 12% discount for shipping the product, and an additional 5% discount for keeping the shelves stocked. Trade discounts are most frequent in industries where retailers hold the majority of the power in the distribution channel (referred to as channel captains). Trade discounts are given to try to increase the volume of sales being made by the supplier.
Educational or student discounts are price reductions given to members of educational institutions, usually students but possibly also to educators and to other institution staff. The provider’s purpose is to build brand awareness early in a buyer’s life, or build product familiarity so that after graduation the holder is likely to buy the same product, for own use or for an employer, at its normal price. Educational discounts may be given by merchants directly, or via a student discount program, such as CollegeBudget in the United States or NUS and Studentdiscounts.co.uk in the United Kingdom.
Senior discounts are discounts offered to customers who are above a certain relatively advanced age, typically a round number such as 50, 55, 60, 65, 70, and 75; the exact age varies in different cases. The rationale for a senior discount offered by companies is that the customer is assumed to be retired and living on a limited income, and unlikely to be willing to pay full price; sales at reduced price are better than no sales. Non-commercial organizations may offer concessionary prices as a matter of social policy.
Discounts, such as 75% off, are used to draw customers to purchase items.
8.8.2: Value-Based Pricing
Value-based pricing seeks to set prices primarily on the value perceived by customers rather than on the cost of the product or historical prices.
Examine the rationale behind value based pricing as a pricing tactic
- Value-based pricing is most successful when products are sold based on emotions (fashion), in niche markets, in shortages (e.g., drinks at open air festival at a hot summer day), or for indispensable add-ons (e.g., printer cartridges, headsets for cell phones).
- Although it would be nice to assume that a business has the freedom to set any price it chooses, this is not always the case. Firms are limited by constraints such as government restrictions.
- Value-based pricing is predicated upon an understanding of customer value. In many settings, gaining this understanding requires primary research through interviews with customers and various surveys. The results of such surveys often depict a customer’s willingness to pay.
- consumer buying process
There are 5 stages of a consumer buying process. They are: The problem recognition stage, the search for information, the possibility of alternative options, the choice to purchase the product, and then finally the actual purchase of the product. This shows the complete process that a consumer will most likely, whether recognizably or not, go through when they go to buy a product.
- willingness to pay
The willingness to pay (WTP) is the maximum amount a person would be willing to pay, sacrifice, or exchange in order to receive a good or to avoid something undesired, such as pollution.
Value-based pricing sets prices primarily, but not exclusively, on the value, perceived or estimated, to the customer rather than on the cost of the product or historical prices. This strategy focuses entirely on the customer as a determinant of the total price/value package. Marketers who employ value-based pricing might use the following definition: “It is what you think your product is worth to that customer at that time.” This image shows the process for value based pricing .
Value-based pricing focuses entirely on the customer as a determinant of the total price or value package.
A chart that shows what value-based pricing takes into account (customers, value, price, cost, and product).
Goods that are very intensely traded (e.g., oil and other commodities) or that are sold to highly sophisticated customers in large markets (e.g., automotive industry) usually are sold based on cost-based pricing. Value-based pricing is most successful when products are sold based on emotions (fashion), in niche markets, in shortages (e.g., drinks at open air festival at a hot summer day) or for indispensable add-ons (e.g., printer cartridges, headsets for cell phones).
Many customer-related factors are important in value-based pricing. For example, it is critical to understand the consumer buying process. How important is price? When is it considered? How is it used? Another factor is the cost of switching. Have you ever watched the television program,”The Price is Right”? If you have, you know that most consumers have poor price knowledge. Moreover, their knowledge of comparable prices within a product category (e.g., ketchup is typically worse). So price knowledge is a relevant factor. Finally, the marketer must assess the customers’ price expectations. How much do you expect to pay for a large pizza? Color TV? DVD? Newspaper?Swimming pool? These expectations create a phenomenon called “sticker shock” as exhibited by gasoline, automobiles, and ATM fees.
Value-based pricing is predicated upon an understanding of customer value. In many settings, gaining this understanding requires primary research. This may include evaluation of customer operations and interviews with customer personnel. Survey methods are sometimes used to determine value a customer attributes to a product or a service. The results of such surveys often depict a customer’s willingness to pay. The principal difficulty is that the willingness of the customer to pay a certain price differs between customers, between countries, even for the same customer in different settings (depending on his actual and present needs), so that a true value-based pricing at all times is impossible. Also, extreme focus on value-based pricing might leave customers with a feeling of being exploited which is not helpful for the companies in the long run.
Although it would be nice to assume that a business has the freedom to set any price it chooses, this is not always the case. There are a variety of constraints that prohibit such freedom. Some constraints are formal, such as government restrictions in respect to strategies like collusion and price-fixing. This occurs when two or more companies agree to charge the same or very similar prices. Other constraints tend to be informal. Examples include matching the price of competitors, a traditional price charged for a particular product, and charging a price that covers expected costs.
8.8.3: Geographic Pricing
Geographical pricing is the practice of modifying a basic list price based on the location of the buyer to reflect shipping costs.
Describe the different types of geographic pricing from a pricing tactic perspective
- Zone pricing is a pricing tactic where prices increase as shipping distances increase. This is sometimes done by drawing concentric circles on a map with the plant or warehouse at the center and each circle defining the boundary of a price zone.
- FOB origin (Free on Board origin) is a pricing tactic where the shipping cost from the factory or warehouse is paid by the purchaser. Ownership of the goods is transferred to the buyer as soon as it leaves the point of origin.
- Freight-absorption pricing is where the seller absorbs all or part of the cost of transportation. This amounts to a price discount and is used as a promotional tactic.
- list price
The retail selling price of an item, as recommended by the manufacturer or retail distributor, or as listed in a catalog.
- zone pricing
The practice of modifying a basic list price based on the geographical location of the buyer.
Geographical pricing is the practice of modifying a basic list price based on the geographical location of the buyer. It is intended to reflect the costs of shipping to different locations. There are several types of geographic pricing:
- FOB origin (Free on Board origin): The shipping cost from the factory or warehouse is paid by the purchaser. Ownership of the goods is transferred to the buyer as soon as it leaves the point of origin. It can be either the buyer or seller that arranges for the transportation.
FOB is used for sea freight. The purchaser is responsible for the shipping costs.
A container ship loads cargo at a loading dock.
- Uniform delivery pricing (also called postage stamp pricing): The same price is charged to all.
- Zone pricing: Prices increase as shipping distances increase. This is sometimes done by drawing concentric circles on a map with the plant or warehouse at the center and each circle defining the boundary of a price zone. Instead of using circles, irregularly shaped price boundaries can be drawn that reflect geography, population density, transportation infrastructure, and shipping cost. (The term “zone pricing” can also refer to the practice of setting prices that reflect local competitive conditions (i.e., the market forces of supply and demand, rather than actual cost of transportation). Zone pricing, as practiced in the gasoline industry in the United States, is the pricing of gasoline based on a complex and secret weighting of factors, such as the number of competing stations, number of vehicles, average traffic flow, population density, and geographic characteristics. This can result in two branded gas stations only a few miles apart selling gasoline at a price differential of as much as $0.50 per gallon. Many business people and economists state that gasoline zone pricing merely reflects the costs of doing business in a complex and volatile marketplace. Critics contend that industry monopoly and the ability to control not only industry-owned “corporate” stations, but locally owned or franchise stations, make zone pricing into an excuse to raise gasoline prices virtually at will. Oil industry representatives contend that while they set wholesale and dealer tank wagon prices, individual dealers are free to see whatever prices they wish and that this practice in itself causes widespread price variations outside industry control. Zone pricing is also used to price fares in certain metro stations.
- Basing point pricing: Certain cities are designated as basing points. All goods shipped from a given basis point are charged the same amount.
- Freight-absorption pricing: The seller absorbs all or part of the cost of transportation. This amounts to a price discount and is used as a promotional tactic.
8.8.4: Transfer Pricing
Transfer pricing describes all aspects of intracompany pricing arrangements between business entities for goods and services.
Outline the concept and rationale of transfer pricing as a pricing tactic
- Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges of goods and services within a multi-divisional organization, particularly in regard to cross-border transactions.
- Intra-company transactions across borders are growing rapidly and are becoming much more complex. Compliance with the differing requirements of multiple overlapping tax jurisdictions is a complicated and time-consuming task.
- Division managers are provided incentives to maximize their own division’s profits. The firm must set the optimal transfer prices to maximize company profits or each division will try to maximize their own profits leading to lower overall profits for the firm.
- marginal cost
Marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good.
- marginal revenue
Marginal revenue is the additional revenue that will be generated by increasing product sales by one unit.
- Company X produces car engines in a plant in Michigan and puts together the entire car in Indiana. Each of these locations are a division of the company that has to meet their own profit margins. Company X tells the engine division in Michigan that they must make a profit of 500 per engine. They also tell the final assembly division in Indiana that they must make a profit of 500 per engine. They also tell the final assembly division in Indiana that they must make a profit of 2,000. The engine division in Michigan wants to set a price in which they will make the required profit. However, if they set this price too high then the Indiana division will not make their required profit, and the total company will have less of a profit. Each division must set a transfer price in which the company will be the most profitable and not based on each division being the most profitable.
Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges of goods and services within a multi-divisional organization, particularly in regard to cross-border transactions. Transfer pricing describes all aspects of intra company pricing arrangements between related business entities, including transfers of intellectual property, transfers of tangible goods, services and loans, and other financing transactions.
For example, goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary, with the choice of the transfer price affecting the division of the total profit among the parts of the company. This has led to the rise of transfer pricing regulations as governments seek to stem the flow of taxation revenue overseas, making the issue one of great importance for multinational corporations.
Intra-company transactions across borders are growing rapidly and are becoming much more complex. Compliance with the differing requirements of multiple overlapping tax jurisdictions is a complicated and time-consuming task. At the same time, tax authorities from each country are imposing stricter penalties, new documentation requirements, increased information exchange and increased audit/inspection activity.
Division managers are provided incentives to maximize their own division’s profits. The firm must set the optimal transfer prices to maximize company profits, or each division will try to maximize their own profits leading to lower overall profits for the firm. Double marginalization is when both divisions mark up prices in excess of marginal cost and overall firm profits are not optimal.
One can use marginal price determination theory to analyze optimal transfer pricing, with optimal being defined as transfer pricing that maximizes overall firm profits in a non-realistic world with no taxes, no capital risk, no development risk, no externalities, or any other frictions which exist in the real world. From marginal price determination theory, the optimum level of output is that where marginal cost equals marginal revenue. That is to say, a firm should expand its output as long as the marginal revenue from additional sales is greater than their marginal costs. In the diagram that follows , this intersection is represented by point A, which will yield a price of P*, given the demand at point B.
Optimal Transfer Pricing Diagram
From marginal price determination theory, the optimum level of output is where marginal cost equals marginal revenue.
When a firm is selling some of its product to itself, and only to itself (i.e., there is no external market for that particular transfer good), then the picture gets more complicated, but the outcome remains the same. The demand curve remains the same. The optimum price and quantity remain the same. But marginal cost of production can be separated from the firm’s total marginal costs. Likewise, the marginal revenue associated with the production division can be separated from the marginal revenue for the total firm. This is referred to as the Net Marginal Revenue in production (NMR) and is calculated as the marginal revenue from the firm minus the marginal costs of distribution.
It can be shown algebraically that the intersection of the firm’s marginal cost curve and marginal revenue curve (point A) must occur at the same quantity as the intersection of the production division’s marginal cost curve with the net marginal revenue from production (point C).
8.8.5: Consumer Penalties
Penalties, in the form of fees and restricted user access, exist for consumers who violate terms in contracts.
Review the rationale and use of consumer penalties as part of pricing tactics
- Most organizations reserve the right to restrict a user’s access to the service if they violate the terms in the agreement.
- Other forms of penalties can exist as fees. An early-termination fee is charged by a company when a customer wants or needs to be released from a contract before it expires.
- Early payment penalties and fees also exist when people pay off a loan earlier than expected, making a firm lose out on interest fees. The fees typically negate this advantage at least in part.
An addition of extra charge on the agreed or stated price.
Penalties, in the form of fees and restricted user access, exist for consumers who violate terms in contracts. Terms of service are rules which one must agree to abide by in order to use a service.
Certain websites are noted for having carefully designed terms of service, particularly eBay and PayPal, which need to maintain a high level of community trust because of transactions involving money. Terms of service can cover a range of issues, including acceptable user behavior online, a company’s marketing policies, and copyright notices. Some organizations, such as Yahoo!, can change their terms of service without notice to the users.
Most organizations reserve the right to restrict a user’s access to the service if they violate the terms in the agreement. In serious cases, the user may have his or her account terminated. In extreme cases, the company may pursue legal action.
Other forms of penalties can exist as fees or surcharges. An early-termination fee is charged by a company when a customer wants or needs to be released from a contract before it expires. One example is when a renter leaves an apartment before a year-long contract is over. If tenants rent for a shorter period, or month-to-month, they are instead charged significantly more per month, and are often denied any promotional deals. Mobile phone companies in the U.S., such as Verizon Wireless , are notorious for large early-termination fees, which can be in the hundreds of dollars . Some mortgage companies also chargeearly payment penalties if the homeowner pays more than is due in order to reduce the interest owed and to shorten the remaining term of the loan. The fees typically negate this advantage, at least in part.
Mobile phone service providers often charge an early termination fee on their service, which is a form of consumer penalty.
8.9: Pricing Legal Concerns
8.9.1: Unfair Trade Practices
Unfair business practices are oppressive or unconscionable acts by companies against consumers or other stakeholders.
Explain the concept of unfair trade practices relative to legal concerns and pricing
- Unfair business acts are generally prohibited by law, so committing them may force a company to provide for the award of compensatory damages, punitive damages, and payment of the plaintiff’s legal fees.
- Two major forms of unfair trade practice are fraud and misrepresentation.
- Unfair trade practices not only affect consumers, but may affect other stakeholders as well, such as competitors and investors.
A false statement of fact made by one party to another party, which has the effect of inducing that party into the contract.
Any act of deception carried out for the purpose of unfair, undeserved, or unlawful gain.
- Samuel Israel III was a former hedge fund manager who ran the former fraudulent Bayou Hedge Fund Group, and faked his suicide to avoid jail. Approximately $450 million was raised by the group from investors. Its investors were defrauded from the start with funds being misappropriated for personal use. After poor returns in 1998, the investors were lied to about the fund’s returns and a fake accounting firm was set up to provide misleading audited results.
Unfair Trade Practices
Unfair business practices include oppressive or unconscionable acts by companies against consumers and others. In most countries, such practices are prohibited under the law. Unfair trade practices can occur in many different areas such as insurance claims and settlement, debt collection, and tenancy issues.
Unfair trade practices also include such acts as:
- Fraud: This is an intentional deception made for the company’s gain or to damage the other party .
- Misrepresentation: This is a false statement of fact made by one party to another party, which has the effect of inducing that party into the contract. For example, under certain circumstances, false statements or promises made by a seller of goods regarding the quality or nature of the product may constitute misrepresentation.
In addition to providing for the award of compensatory damages, laws may also provide for the award of punitive damages as well as the payment of the plaintiff’s legal fees. When statutes prohibiting unfair and deceptive business practices provide for the award of punitive damages and attorneys fees to injured parties, they provide a powerful incentive for businesses to resolve the claim through the settlement process rather than risk a more costly judgment in court.
In the European Union, each member state must regulate unfair business practices in accordance with the Unfair Commercial Practices Directive, subject to transitional periods. This is a major reform of the law concerning unfair business practices in the European Union.
Unfair trade practices not only affect consumers, but other stakeholders as well. Unfair competition in a sense means that the competitors compete on unequal terms, because favorable or disadvantageous conditions are applied to some competitors but not to others; or that the actions of some competitors actively harm the position of others with respect to their ability to compete on equal and fair terms. Often, unfair competition means that the gains of some participants are conditional on the losses of others, when the gains are made in ways which are illegitimate or unjust.
8.9.2: Illegal Price Advertising
Deceptive price advertising uses misleading or false statements in advertising and promotion and is usually illegal.
Describe the concept and types of illegal price advertising
- While deceptive price advertising is usually illegal, in practice, it can be difficult to stop or difficult to enforce any law relating to it.
- False and deceptive advertising methods include hidden fees and surcharges, “going out of business” sales, manipulation of measurement units, fillers, oversized packaging, bait and switch, etc.
- Advertising need not be proven to be deceptive for it to be illegal. What matters is the potential to deceive, which happens when consumers see the advertising to be stating to them, explicitly or implicitly, a claim that they may not realize is false and material.
Relating to use of bait and switch (offering one attractive exchange initially, but not honoring the offer) in business, politics, and elsewhere.
An addition of extra charge on the agreed or stated price.
Illegal Price Advertising
Deceptive or false advertising is the use of misleading or outright false statements by companies in their advertising and promotional material. Depending on the type and the severity, deceptive advertising is usually illegal, because it is recognized that advertising has the potential to persuade people to enter into commercial transactions that they may otherwise avoid. However, advertisers still find ways to deceive consumers in ways that are legal or technically illegal but unenforceable.
Types of Illegal Price Advertising
Hidden fees and surcharges
These are fees that are not stated in the advertised price. These are particularly common for services, such as cell phone activation, broadband, gym memberships, and air travel. Generally, companies get away with it, because the fees are hidden in fine print and obfuscated by technical language.
“Going out of business” sales
Often, companies that supposedly are liquidating will raise prices on items marked for clearance, meaning that the company increases the price and “discounts” it. Thus, the discount is less than advertised. Another case, at liquidating stores (if it is a retail chain), the sales prices at the chain’s other stores is lower than the liquidator’s prices at the closing stores. On top of this, sale items are often “final sale,” meaning returns are not accepted. Thus, there is no recourse for customers.
Manipulation of measurement units and standards
Sellers may manipulate standards to mean something different than their widely understood meaning. One example is the personal computer’s hard drive. By stating the sizes of hard drives in “megabytes” of 1,000,000 bytes, instead of 1,048,576, they overstate capacity by nearly 5%. With gigabytes, the error increases to over 7% (1,073,741,824, instead of 1,000,000,000) and nearly 10% for the newer terabyte. Seagate Technology and Western Digital were sued in a class-action suit for this deception. Both companies agreed to settle the suit and reimburse customers in kind, yet they still continue to advertise this way.
In another example, Fretter Appliance stores claimed “I’ll give you five pounds of coffee if I can’t beat your best deal. ” While initially they gave away that quantity, they later redefined them as “Fretter pounds,” which, unsurprisingly, were much lighter than standard pounds.
Fillers and oversized packaging
Some products are sold with fillers, which increase the legal weight of the product with something that costs the producer very little compared to what the consumer thinks that he or she is buying. Food is an example of this, where TV dinners are filled with gravy or other sauce instead of meat. Malt and cocoa butter have been used as filler in peanut butter.
Manipulation of terms
Many terms do have some meaning, but the specific extent is not legally defined, leading to their abuse. A frequent example (until the term gained a legal definition) was “organic” food. “Light” food also is an even more common manipulation: The term has been variously used to mean low in calories, sugars, carbohydrates, salt, texture, thickness (viscosity), or even light in color. Tobacco companies, for many years, used terms like “low tar,” “light,” “ultra-light,” “mild,” or “natural” in order to imply that products with such labels have less detrimental effects on health but in recent years, it was proven that those terms were considered misleading. Naturally, these manipulations of terms are used to charge a higher price, particularly on “‘organic” products.
“Better” means one item is superior to another in some way, while “best” means it is superior to all others in some way. However, advertisers frequently fail to list in what way the items are being compared (price, size, quality, etc.) and, in the case of “better,” to what they are comparing. In an inconsistent comparison, an item is compared with many others, but only compared with each on the attributes where it wins, leaving the false impression that it is the best of all products, in all ways. This is common with price-comparing Internet websites.
Advertisers advertise an item that is unavailable when the consumer arrives at the store and is then sold a similar product at higher price. Bait-and-switch is legal in the United States, provided that ads state that there is a limited supply and that no rain checks will be offered.
Advertising is regulated by the authority of the Federal Trade Commission to prohibit “unfair and deceptive acts or practices in commerce. ” What is illegal is the potential to deceive, which is interpreted to occur when consumers see the advertising to be stating to them, explicitly or implicitly, a claim that they may not realize is false and material. The goal is prevention rather than punishment, reflecting the purpose of civil law in setting things right rather than that of criminal law.
Listerine Advertisement, 1932
From 1921 until the mid-1970s, Listerine was also marketed as a preventive and remedy for colds and sore throats. In 1976, the Federal Trade Commission ruled that the claims were misleading.
8.9.3: Predatory Pricing
Predatory pricing is the practice of selling a product or service at a very low price, intending to drive competitors out of the market.
Examine the characteristics of predatory pricing relative to legal concerns
- After the weaker competitors are driven out, the surviving business can raise prices to supra competitive levels. The predator hopes to generate revenues and profits in the future that will more than offset the losses it incurred during the predatory pricing period.
- While predatory pricing is illegal in many countries, it is very difficult to prove that a company has undertaken a strategy of predatory pricing rather than competitive pricing.
- Critics argue that the prey know that the predator cannot sustain low prices forever, so it is essentially a game of chicken: if they can ride it out, they will survive.
- low-cost signalling
A strategy of signalling to competitors that you intend to pursue a low-cost strategy.
- predatory pricing
A strategy of selling goods or services at a very low price in order to drive one’s competitors out of business (at which point one can raise one’s prices more freely).
- In the Darlington Bus War, Stagecoach Group allegedly offered free bus rides in order to put the rival Darlington Corporation Transport out of business.
Predatory pricing is the practice of selling a product or service at a very low price, with the intention of driving competitors out of the market, or create barriers to entry for potential new competitors. Since competitors cannot sustain equal or lower prices without incurring losses, they may be forced out of business. After chasing competitors out of the market, the incumbent would have fewer competitors (and may in fact be a monopoly), and can then – in theory – raise prices above what the market would otherwise bear.
In many countries, predatory pricing is considered anti-competitive and is illegal under competition laws. However, It is usually difficult to prove that prices dropped because of deliberate predatory pricing rather than legitimate price competition. In any case, competitors may be driven out of the market before the case is ever heard. Thus, many economists are doubtful that the concept of predatory pricing is actually practical and transferable to the real world.
In the short run, profits for the incumbent will fall due to predatory pricing, possibly even into negative territory. The incumbent will not mind so long as they can maintain these losses, which can be made up for once they raise prices above the would-be market level: after the weaker competitors are driven out, the surviving business can raise prices above competitive levels (to supra competitive pricing). The predator hopes to generate revenues and profits in the future that will more than offset the losses it incurred during the predatory pricing period. There must be substantial barriers to entry for new competitors for predatory pricing to succeed. But the strategy may fail if competitors are stronger than expected, or are driven out but replaced by others. In either case, this may force the predator to prolong or abandon the price reductions. The strategy may fail if the predator cannot endure the short-term losses, either because it takes longer than expected or simply because the loss was not properly estimated. So the predator should hope this strategy to works only when it is much stronger than its competitors and when barriers to entry are high. The barriers prevent new entrants to the market replacing others driven out, thereby allowing supra competitive pricing to prevail long enough to dwarf the initial loss.
Criticism and Support
Some economists claim that true predatory pricing is rare because it is an irrational practice and that laws designed to prevent it only inhibit competition. This stance was taken by the US Supreme Court in the 1993 case Brooke Group v. Brown & Williamson Tobacco. The Federal Trade Commission has not successfully prosecuted any company for predatory pricing since. Economists argue that the competitors (the ‘prey’) know that the predator cannot sustain low prices forever, so it is essentially a game of chicken. If they can ride it out, they will survive. And even if they cannot, bankrupcy does not by itself eliminate the fallen prey’s ability to produce: the physical plant and people whose skills made it a viable business will exist, and will be available – perhaps at very low prices – to others who may replace the fallen prey once supra-competitive prices set in.Critics of laws against predatory pricing may support their case empirically by arguing that there has been no instance where such a practice has actually led to a monopoly. Conversely, they argue that there is much evidence that predatory pricing has failed miserably.
Prey may not see it as a game of chicken, if they truly believe that the prey has actually found a way to achieve a lower cost of production than them. Thus, they would not know predatory pricing is occurring. They would exit the market, thinking it is no longer profitable. This is known as ‘low-cost signalling’. However, this does not support the idea that the new virtual monopoly could raise and sustain prices at monopoly levels, even though there are certain barriers to entering monopolized markets that could, in theory, prevent the entry of competition.
According to an International Herald Tribune article, the French government ordered Amazon.com to stop offering free shipping to its customers, because it was in violation of French predatory pricing laws. After Amazon refused to obey the order, the government proceeded to fine them €1,000 per day. Amazon continued to pay the fines instead of ending its policy of offering free shipping. Low oil prices during the 1990s, while being financially unsustainable, effectively stifled exploration to increase production, delayed innovation of alternative energy sources and eliminated competition from other more expensive yet productive sources of petroleum such as stripper wells. It is important to note that in both these and other cases, the predatory pricing policy is alleged, and difficult to prove comprehensively.
In the 1990s, low oil prices were considered a case of alleged predatory pricing.
8.9.4: Price Discrimination
Although there are legal concerns around monopolistic practices, price discrimination is a popular tactic for capturing consumer surplus.
Construct the concept of price discrimination relative to legal concerns in pricing
- In theoretical markets there exists perfect information, no transaction costs, and perfect substitutes, and in these cases price discrimination can only exist in monopolistic or oligopolistic markets.
- For price discrimination to take place, companies must be able to identify market segments by their price elasticity of demand, and they must be able to enforce the scheme.
- There are four degrees of price discrimination (including reverse price discrimination), that all occur under slightly different circumstances, depending on the market structure and the company’s ability to discriminate.
- consumer surplus
The monetary gain obtained by consumers because they are able to purchase a product for a price that is less than the highest price that they would be willing to pay.
- price discrimination
Occurs when sales of identical goods or services are transacted at different prices from the same provider.
- Airlines use several different types of price discrimination, including: bulk discounts to tour operators, incentive discounts for higher sales volumes to corporate buyers, seasonal discounts, etc. The price of a flight from Singapore to Tokyo can vary widely if one buys the ticket in Singapore compared to Tokyo (or New York or elsewhere). First degree price discrimination based on customer also occurs: it is not accidental that hotel or car rental firms may quote higher prices to their loyalty program’s top tier members than to the general public.
Price discrimination is the sale of identical goods or services at different prices from the same provider. Price discrimination also occurs when the same price is charged for goods with different supply costs.
Price discrimination’s effects on social efficiency are unclear; typically such behavior leads to lower prices for some consumers and higher prices for others. Output can be expanded when price discrimination is very efficient, but output can decline when discrimination is more effective at extracting surplus from high-valued users than expanding sales to low valued users. Even if output remains constant, price discrimination can reduce efficiency by misallocating output among consumers.
Although price discrimination is the producer’s or seller’s legal attempt to charge varying prices for the same product based on consumer demand, price discrimination can be illegal in some cases. For example, it is illegal for manufacturers to set different prices for anti-competitive purposes. Beer companies during the 1960’s attempted to price discriminate based on location to price below competitors and run them out of business.
In theoretical markets there exists perfect information, no transaction costs, and perfect substitutes. In these cases price discrimination can only exist in monopolistic or oligopolistic markets: otherwise, a buyer can buy the good at a lower price and sell it immediately at a slightly higher place (but lower than the price discrimination level), making a profit. In the real world, product heterogeneity, market frictions and moderate fixed costs allow for a level of price description in many markets.
Two conditions are necessary for price discrimination:
- Companies must be able to identify market segments by their price elasticity of demand;
- They must be able to enforce the scheme.
For example, airlines routinely engage in price discrimination by charging high prices for customers with relatively inelastic demand–business travelers –and discount prices for tourists who have relatively elastic demand. The airlines enforce the scheme by making the tickets non-transferable thus preventing a tourist from buying a ticket at a discounted price and selling it to a business traveler (arbitrage). Airlines must also prevent business travelers from directly buying discount tickets. Airlines accomplish this by imposing advance ticketing requirements or minimum stay requirements conditions that would be difficult for average business traveler to meet.
Third Degree Price Discrimination
Instead of supplying one price and taking the profit (old profit) the total market is broken down into two sub-markets. They’re priced separately to maximize profit.
Three curves that show third-degree price discrimination – industry (old profit), elastic submarket (profit), and inelastic submarket (higher profit).
Types of Price Discrimination
Here, the monopoly seller knows the maximum price each individual buyer is willing to pay, allowing them to absorb the entire consumer surplus. More is produced than the non-discriminating monopoly case, and there is no deadweight loss. This is mostly a theoretical outcome.
Price varies according to demand: larger quantities are available at a lower unit price. Unlike first degree, sellers are unable to differentiate between individual consumers, and so they provide incentives for consumers to differentiate themselves. For example, airlines differentiate according to first, business and coach passengers.
Price varies by attributes such as location or by customer segment, or in the most extreme case, by the individual customer’s identity; where the attribute in question is used as a proxy for ability/willingness to pay. Sellers are able to differentiate between different types of consumers. An example is student discounts. In third degree discrimination, it is not always advantageous to discriminate.
Fourth degree/reverse price discrimination
Prices are the same for different customers, even if organizational costs may vary. For example, a coach class airplane passenger may order a vegetarian meal. Their ticket cost is the same, but it may cost more to the airline to obtain a vegetarian meal for them.
Examples of Price Discrimination
Price discrimination is very common in services where resale is not possible; an example is student discounts at museums. Price discrimination in intellectual property is also enforced by law and by technology. In the market for DVDs, DVD players are designed–by law–with chips to prevent an inexpensive copy of the DVD (for example legally purchased in India) from being used in a higher price market (like the US).
Price discrimination can also be seen where the requirement that goods be identical is relaxed. For example, so-called “premium products” (including relatively simple products, such as cappuccino compared to regular coffee) have a price differential that is not explained by the cost of production. Some economists have argued that this is a form of price discrimination exercised by providing a means for consumers to reveal their willingness to pay. For instance, Starbucks will charge more for a coffee than, say, a local cafe, even if there is no discernable difference in quality.
8.9.5: Price Fixing
Price fixing is a collusion between competitors in order to raise prices of a good or service, at the expense of competitive pricing.
Examine the characteristics of price fixing and its legal implications
- Price fixing is inefficient, transferring some of the consumer surplus to producers and results in a deadweight loss.
- Price fixing is illegal in most developed countries. In the United States, price fixing can be prosecuted as a criminal federal offense. However, price fixing is perfectly legal in many countries.
- When sovereign nations rather than individual firms come together to control prices, the cartel may be protected from lawsuits and criminal antitrust prosecution.
- deadweight loss
A loss of economic efficiency that can occur when equilibrium for a good or service is not achieved or is not achievable.
- price fixing
In antitrust law, collusion between competitors in order to raise prices, at the expense of competitive pricing.
A secret agreement for an illegal purpose; conspiracy.
- OPEC is perhaps the most important cartel in the world: the member countries come together to fix oil prices at levels beneficial to them. However, because of the sovereign nature of the members, no action is taken against them.
As it is commonly understood, the term “price fixing” refers to a collusion between sellers in a market to coordinate pricing—usually pushing it above the competitive level—for their collective benefit. While this is price fixing as commonly understood, the actual definition is much broader. It is an agreement between participants on the same side in a market to buy or sell a product, service, or commodity only at a fixed price, or maintain the market conditions such that the price is maintained at a given level by controlling supply and demand . The defining characteristic of price fixing is any agreement regarding price, whether expressed or implied. The intent of price fixing may be to push the price of a product as high as possible, leading to profits for all sellers but may also have the goal to fix, peg, discount , or stabilize prices.
There are many things sellers may do during a price fix. They might agree to sell at a common target price, set a common minimum price, buy the product from a supplier at a specified maximum price, adhere to a price book or list price, engage in cooperative price advertising, standardize financial credit terms offered to purchasers, use uniform trade-in allowances, limit discounts, discontinue a free service or fix the price of one component of an overall service, adhere uniformly to previously announced prices and terms of sale, establish uniform costs and markups, impose mandatory surcharges, purposefully reduce output or sales in order to charge higher prices, or purposefully share or pool markets, territories, or customers. These are all instances of price fixing.
Economic Argument and Legal Status
In neoclassical economics, price fixing is inefficient, transferring some of the consumer surplus to producers and results in a deadweight loss. Because of this, price fixing is illegal in most developed countries. In the US, price fixing can be prosecuted as a criminal federal offense. Under American law, even exchanging prices among competitors can violate the antitrust laws. This includes exchanging prices with either the intent to fix prices or if the exchange affects the prices individual competitors set.
In countries other than the United States, Canada, Australia, New Zealand, Japan, Korea and within the European Union, price fixing is not usually illegal and is often practiced. When the agreement to control price is sanctioned by a multilateral treaty or is entered by sovereign nations as opposed to individual firms, the cartel may be protected from lawsuits and criminal antitrust prosecution. This explains, for example, why OPEC, the global petroleum cartel, has not been prosecuted or successfully sued under US. antitrust law. International airline tickets have their prices fixed by agreement with the IATA, a practice for which there is a specific exemption in antitrust law.
Prominent Price Fixing Examples
In August 2007 British Airways was fined £121.5 million for price fixing. The fine was imposed after BA admitted to the price fixing of fuel surcharges on long haul flights . The allegation first came to light in 2006 when Virgin Atlantic reported the events to the authorities after it found staff members from BA and Virgin Atlantic were colluding. Virgin Atlantic has since been granted immunity by both the Office of Fair Trading and the United States Department of Justice who have been investigating the allegations since June 2006. The US Department of Justice later announced that it would fine British Airways $300 million (£148 million) for price fixing. BA maintained that fuel surcharges were “a legitimate way of recovering costs. “
In April 2007 the European commission fined Heineken €219.3m, Grolsch €31.65m and Bavaria €22.85m for operating a price fixing cartel in Holland, totalling €273.7m (InBev, another brewer, was convicted for price fixing but escaped punishment) . The brewers controlled 80% of the Dutch market, with Heineken claiming 50% and the two others 15% each. Neelie Kroes said she was “very disappointed” that the collusion took place at the very highest (boardroom) level. She added, Heineken, Grolsch, InBev and Bavaria tried to cover their tracks by using code names and abbreviations for secret meetings to carve up the market for beer sold to supermarkets, hotels, restaurants and cafes. The price fixing extended to cheaper own-brand labels and rebates for bars.
Heineken was fined 219.3 million euro for its role in a price fixing cartel in Holland in 2007.