1.3.3 Pricing Strategies

Pricing Strategies

Key Definitions

Price: The amount paid for a good or service by the customer. 

Price Sensitivity: When a customer considers the price of a product as the primary factor when deciding whether to buy the product/service or not.

Price Skimming: A strategy used on an innovative product. The price is initially set high but is gradually lowered over time to appeal to more customers. 

Penetration Pricing: A strategy used when launching a product into a market with existing similar products. The price is initially set low, but it is gradually increased to increase profitability. 

Cost-Plus Pricing: When the price of the product is based on the calculation of the production costs of the product and the addition of a percentage mark-up that reflects the amount of profit the business wants from the product.

Competitive Pricing: When the price of a product is set at the existing market level, or at a discounted price compared to the market prices. This happens in highly competitive markets, or markets with one clear leader.

Predatory Pricing: When the price of a product is set low enough to drive a competitive rival or rivals out of business and out of the market, with intention to raise the prices in the future.

Psychological Pricing: When the price of a product is psychologically appealing to the consumers, and it is set below psychological pricing barriers in order to keep sales high.

Product Differentiation: The degree to which a consumer sees that your brand is different to another brand through the features and the unique selling point.

Product Life Cycle: The path a product follows from the initial research and product development to stagnation and, occasionally, the use of extension strategies. 

Loss Leader: When a product is priced at the below average rate in order to attract more profitable business from elsewhere. 

Price Elasticity: A measurement of the extent to which demand for a product changes based on how much its price changes.

Pricing Tactics: Short-term pricing responses to opportunities and/or threats to products.

How Important are Decisions about Price?

Price is one of the main links between the consumer and the producer, who are representative of demand and supply. The price is an indicator of product quality to the consumer, and it is crucial to the revenue incomes and profit margins for businesses. It is one of the key components to the Marketing Mix discussed previously, and it is a crucial thing customers consider when buying products. The important of price to the customer is dependent on the following 3 key factors:

1. The Quality of the Product

Products that are seen to have a higher quality often carry a price premium, meaning companies can get away with charging more for those products as customers are willing to pay more for the products. This can be real quality or just the perceived quality.

2. Consumer Demand for the Product

As all purchases are personal, customers will be willing to pay more for goods and services they need or want. 

3. Consumer Income

This is crucial, as a consumer will only buy the products that are within their income range - also, consumers with higher levels of disposable income will be less concerned about the prices. Uncertainty about future income levels has the same effect on pricing as having a lower income. 

Types of Pricing Strategy

The pricing strategy is the company's long term plan for pricing its products. There are 2 main pricing strategies that are used by businesses:

1. Price Skimming

This is used when the product is a brand new, highly innovative product. As the product is brand new there will be no competition for it, so there is no need to consider what competitors are charging for their similar products, therefore enabling the business to charge high prices for the product and customers will be willing to pay these prices. The business is able to recover some of the development costs by doing this, making sure that those who really want the product will pay the high price they are expected to pay. Businesses will use the initial sales period to asses how the market reacts to the new product - if the sales became stagnant then they could lower the price to attract new customers who were previously unwilling to pay the high price. Price can also be lowered if new competitors enter the market.

2. Penetration Pricing

This is used when a product is launched into a market with existing competitors selling similar products. The price is set lower initially to gain market share and attract customers. Once the product has become more established it is believed that the high level of initial sales are enough to recover the development costs and lead to lower average costs as the business benefits from bulk-buying benefits such as economies of scale. 

The advantages and disadvantages of these pricing strategies are compared in the table below:

	Price Skimming	Penetration Pricing
Advantages	-          High prices for a new item helps to establish the product as a must-have item. -          Early adopters of the product usually want exclusivity and are willing to pay high prices, so price skimming makes sense for the retailer and the supplier. -          Innovation can be expensive, so it makes sense to charge high prices to recover the research and investment costs.	-          Low priced new products may attract a high sales volume which makes it very hard for a new competitor to break into the market -          High sales volumes help to cut production costs per unit as the producer can buy in bulk and therefore cut purchasing costs. -          Achieving high sales volumes ensures that shops will provide high distribution levels and good in-store displays.
Disadvantages	-          Some customers may be put off by “rip-off prices” at the start of the product’s life. -          When the firm decides to cut the prices the brand image may suffer as people could be put off by the fact that buyers who bought it early may be annoyed that prices fell soon after they bought it.	-          Pricing low may affect the brand image making the product appear ‘cheap’ -          It may be hard to gain distribution in more upmarket retail outlets due to mass-market pricing. -          Pricing on the basis of value for money can cause customers and competitors to become highly price sensitive.

Pricing Strategies for Existing Products

For existing products it is important that it is clear where the brand is positioned on the market. Pricing strategy for existing brands will often be based on the confidence the company has in the strength of its brand name. Many brands use different pricing strategies depending on the products they offer and the strength of their brand name.

Cost-Plus Pricing

More well-known "stronger" brand names will use cost-plus pricing strategies on their products in order to gain more revenue. Cost-plus pricing involves adding a percentage mark-up to the initial unit production cost. This pretty much guarantees that the business will generate profit from the sale of their product, especially as the percentage mark-up is set based around the amount of profit the business would like to generate. However, this tends to involve the business ignoring the pricing strategies used by competitors, and very few businesses are in the position on the market to actually do this. 

Competitive Pricing

This involves the business setting the price of their products equal to or less than the existing market level for their products. This is most often seen in highly competitive markets or in markets with one clear dominant market leader. 

Predatory Pricing 

This is the method of pricing a product low enough to drive a competitive rival or rivals out of business. The predator typically hopes that, once the rival has been eliminated, they can raise the prices of their products in order to boost their revenue income. This strategy can only work if:

• The predator is financially strong, because if the product or service in the price war is not an important part of the overall business

• The rival is financially weaker, to ensure that the rival can easily be undercut in terms of pricing

Psychological Pricing

This can be considered more of a tactic than a strategy. It is believed that certain products have psychological price barriers that cannot be crossed for fear of price elasticity increasing. This means that, for example, if the price of a product was 99p, but it increased to £1, the price elasticity would increase and sales would, theoretically, decrease as £1 can be considered as a lot more than the 99p  it was before, so sales become reduced. 

Choosing a Pricing Strategy

The pricing strategy used by a business depends on how competitive the market is. When there is a lot of direct competition the main pricing strategies used include competitive pricing, penetration pricing and predatory pricing. When there is not much prevalent competition a business may used cost-plus pricing and price skimming. 

Factors that Determine the Appropriate Pricing Strategy

Many companies regularly use market research into pricing. They use monthly retail 'audits' to get regular feedback on whether customers see their pricing as value for money. If there is a decrease in this more thought would be given by the business into cutting the prices down and trying to rebuild value by advertising more, or having a packaging or product redesign. A business will know that pricing is the key to sales revenue, and they will therefore keep a close eye on it. 

Product Differentiation

No matter how much competition there is on the market a well-differentiated product is able to stand apart from the competition. If people feel strongly towards a product, be it love it or hate it, the product is likely to be able to stay in a good position against competition. Highly-differentiated products will also be able to adapt cost-plus pricing. 

Strength of the Brand

Strong branding is one of the most effective methods of differentiation. A particularly strong brand in the eyes of the consumer and business would be able to take advantage of cost-plus pricing, and it will also be able to launch new products into the market using the price-skimming pricing strategy. This can massively benefit the profitability of the brand. 

Amount of Competition

The more competition on the market, the more important price becomes to consumers choosing to buy the product as customers have more choice. This means they will be more price sensitive and choose the cheaper option. A business with a highly differentiated product would be able to charge higher prices for their goods. If there is more direct competition between brands it is more likely that competitive pricing will be used. Predatory pricing can be used here, but only ever as a last resort for the business.

Price Elasticity of Demand

Differentiation, branding, and competition prevalence can all be summarized in a single figure: price elasticity of demand. A highly differentiated, strong brand will have low price elasticity of demand so the business is able to charge whatever price it wants to without having to consider the impact on sales volumes. This makes it ideal for a cost-plus pricing strategy. 

However, a product with high price elasticity of demand will find that the use of competitive pricing is inevitable, which may make it harder for the business to make a profit. It is in situations like these that a business may use a predatory pricing strategy as it can help eliminate weaker competition and remove some of the pressure on the business to cut their prices. 

Stage in the Product Life Cycle

Pricing is particularly important during certain stages of the Product Life Cycle, especially in the product launching stage and the point of stagnation. There are two important basic pricing decisions that need to be made: pricing a new product, and managing the price of the product throughout its lifespan. Both of these require a good understanding of the market, especially of the consumers and competitors involved. 

Many businesses launch their products at reasonably good value prices, and these prices are kept down in the early stages of business or product growth. When growth develops these prices are gradually increased and they remain higher during the maturation and early decline stages of the product life. It is only during the "heavy decline" that the price of the product decreases in order to keep it going for longer. 

Costs and the Need to Make a Profit

Pricing is crucial because it is related directly to revenue. It involves finding a balance between being competitive and being profitable, and an important part of this is to have a good understanding of costs. These costs must include the purchasing, manufacturing, distribution, administration and marketing of the business and/or product. The lowest price a business can charge is set by costs, and most of the time this is always higher than the variable cost of the product (the only exception to this is when the product is a loss leader). This ensures that the revenue earned from the product contributes to covering the fixed costs of the business. 

Changes in Price to Reflect Social Trends

Online Sales

There has been a major increase in online sales, with an increased presence of Amazon and online grocery shopping such as Tesco Online, and this has impacted pricing strategies. Buying online has made it easier for prices to be compared, and for people to be able to buy the cheapest goods. This is great for consumers, as they are able to save money, for as long as there are competitors to the retail giant Amazon. 

Price Comparison Websites

These sites tend to suffer from conflicts in interest, which leads to a lack of clarity about what they truly are. They are not always necessarily designed to find the best deal for consumers, but to propose the 'best deal' in terms of the best commission to the site instead of the cheapest deal the consumers are looking for. Despite this, the usage of price comparison websites has seen an increase in traffic, and they are supported by huge advertising investments.