Factors to Consider When Setting Prices

A company's pricing decisions are affected by both internal company factors and external environmental factors (see Figure 11.1).⁷

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

Before setting a price, the company must decide on its strategy for the product. If the company has selected its target market and positioning carefully, then its marketing mix strategy, including price, will be fairly straightforward. For example, when Honda and Toyota decided to develop their Acura and Lexus brands to compete with European luxury-performance cars in the higher-income segment, this required charging a high price. In contrast, Motel 6, Econo Lodge, and Red Roof Inn have positioned themselves as motels that provide economical rooms for budget-minded travelers; this position requires charging a low price. Thus, pricing strategy is largely determined by decisions on market positioning.

Active Figure 11.1	Factors affecting price decisions

At the same time, the company may seek additional objectives. Common objectives include survival, current profit maximization, market share leadership, and product quality leadership. Companies set survival as their major objective if they are troubled by too much capacity, heavy competition, or changing consumer wants. To keep a plant going, a company may set a low price, hoping to increase demand. In the long run, however, the firm must learn how to add value that consumers will pay for or face extinction.

Many companies use current profit maximization as their pricing goal. They estimate what demand and costs will be at different prices and choose the price that will produce the maximum current profit, cash flow, or return on investment. Other companies want to obtain market share leadership. To become the market share leader, these firms set prices as low as possible.

A company might decide that it wants to achieve product quality leadership. This normally calls for charging a high price to cover higher performance quality and the high cost of R&D. For example, Caterpillar charges 20 percent to 30 percent more than competitors for its heavy construction equipment based on superior product and service quality. Gillette's product superiority lets it price its Mach3 razor cartridges at a 50 percent premium over its own SensorExcel and competitors' cartridges. And A. T. Cross doesn't sell just ballpoint pens—you can get those from Bic. Instead, it sells "fine writing instruments" in models bearing names like Classic Century, Ion, Morph, Matrix, ATX, and Radiance, selling for prices as high as $400.

A company might also use price to attain other, more specific objectives. It can set prices low to prevent competition from entering the market or set prices at competitors' levels to stabilize the market. Prices can be set to keep the loyalty and support of resellers or to avoid government intervention. Prices can be reduced temporarily to create excitement for a product or to draw more customers into a retail store. One product may be priced to help the sales of other products in the company's line. Thus, pricing may play an important role in helping to accomplish the company's objectives at many levels.

Not-for-profit and public organizations may adopt a number of other pricing objectives. A university aims for partial cost recovery, knowing that it must rely on private gifts and public grants to cover the remaining costs. A not-for-profit hospital may aim for full cost recovery in its pricing. A not-for-profit theater company may price its productions to fill the maximum number of theater seats. A social service agency may set a social price geared to the varying income situations of different clients.

Price is only one of the marketing mix tools that a company uses to achieve its marketing objectives. Price decisions must be coordinated with product design, distribution, and promotion decisions to form a consistent and effective marketing program. Decisions made for other marketing mix variables may affect pricing decisions. For example, producers using many resellers who are expected to support and promote their products may have to build larger reseller margins into their prices. The decision to position the product on high-performance quality will mean that the seller must charge a higher price to cover higher costs.

Companies often position their products on price and then tailor other marketing mix decisions to the prices they want to charge. Here, price is a crucial product-positioning factor that defines the product's market, competition, and design. Many firms support such price-positioning strategies with a technique called target costing, a potent strategic weapon. Target costing reverses the usual process of first designing a new product, determining its cost, and then asking, "Can we sell it for that?" Instead, it starts with an ideal selling price based on customer considerations, then targets costs that will ensure that the price is met.

The original Swatch watch provides a good example of target costing. Rather than starting with its own costs, Swatch surveyed the market and identified an unserved segment of watch buyers who wanted "a low-cost fashion accessory that also keeps time." Swatch set out to give consumers in this segment the watch they wanted at a price they were willing to pay, and it managed the new product's costs accordingly. Like most watch buyers, targeted consumers were concerned about precision, reliability, and durability. However, they were also concerned about fashion and affordability. To keep costs down, Swatch designed fashionable but simpler watches that contained fewer parts and that were constructed from high-tech but less expensive materials. It then developed a revolutionary automated process for mass-producing the new watches and exercised strict cost controls throughout the manufacturing process. By managing costs carefully, Swatch created a watch that offered just the right blend of fashion and function at a price consumers were willing to pay. As a result, the company sold more than 2 million watches in its first two years. Based on this initial success, consumers have placed increasing value on Swatch products, allowing the company to introduce successively higher-priced designs.⁸

Product quality leadership: Four Seasons starts with very high quality service—"we await you with the perfect sanctuary." It then charges a price to match.

Other companies deemphasize price and use other marketing mix tools to create nonprice positions. Often, the best strategy is not to charge the lowest price, but rather to differentiate the marketing offer to make it worth a higher price. For example, for years Johnson Controls, a producer of climate-control systems for office buildings, used initial price as its primary competitive tool. However, research showed that customers were more concerned about the total cost of installing and maintaining a system than about its initial price.

Thus, marketers must consider the total marketing mix when setting prices. If the product is positioned on nonprice factors, then decisions about quality, promotion, and distribution will strongly affect price. If price is a crucial positioning factor, then price will strongly affect decisions made about the other marketing mix elements. But even when featuring price, marketers need to remember that customers rarely buy on price alone. Instead, they seek products that give them the best value in terms of benefits received for the price paid.

Costs set the floor for the price that the company can charge. The company wants to charge a price that both covers all its costs for producing, distributing, and selling the product and delivers a fair rate of return for its effort and risk. A company's costs may be an important element in its pricing strategy. Many companies, such as Southwest Airlines, Wal-Mart, and Union Carbide, work to become the "low-cost producers" in their industries. Companies with lower costs can set lower prices that result in greater sales and profits.

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

COSTS AT DIFFERENT LEVELS OF PRODUCTION    To price wisely, management needs to know how its costs vary with different levels of production. For example, suppose Texas Instruments (TI) has built a plant to produce 1,000 calculators per day. Figure 11.2A shows the typical short-run average cost curve (SRAC). It shows that the cost per calculator is high if TI's factory produces only a few per day. But as production moves up to 1,000 calculators per day, average cost falls. This is because fixed costs are spread over more units, with each one bearing a smaller share of the fixed cost. TI can try to produce more than 1,000 calculators per day, but average costs will increase because the plant becomes inefficient. Workers have to wait for machines, the machines break down more often, and workers get in each other's way.

Active FIGURE 11.2	Cost per unit at different levels of production per period

If TI believed it could sell 2,000 calculators a day, it should consider building a larger plant. The plant would use more efficient machinery and work arrangements. Also, the unit cost of producing 2,000 calculators per day would be lower than the unit cost of producing 1,000 units per day, as shown in the long-run average cost (LRAC) curve (Figure 11.2B). In fact, a 3,000-capacity plant would even be more efficient, according to Figure 11.2B. But a 4,000-daily production plant would be less efficient because of increasing diseconomies of scale—too many workers to manage, paperwork slowing things down, and so on. Figure 11.2B shows that a 3,000-daily production plant is the best size to build if demand is strong enough to support this level of production.

COSTS AS A FUNCTION OF PRODUCTION EXPERIENCE    Suppose TI runs a plant that produces 3,000 calculators per day. As TI gains experience in producing calculators, it learns how to do it better. Workers learn shortcuts and become more familiar with their equipment. With practice, the work becomes better organized, and TI finds better equipment and production processes. With higher volume, TI becomes more efficient and gains economies of scale. As a result, average cost tends to fall with accumulated production experience. This is shown in Figure 11.3.¹⁰ Thus, the average cost of producing the first 100,000 calculators is $10 per calculator. When the company has produced the first 200,000 calculators, the average cost has fallen to $9. After its accumulated production experience doubles again to 400,000, the average cost is $7. This drop in the average cost with accumulated production experience is called the experience curve (or the learning curve).

If a downward-sloping experience curve exists, this is highly significant for the company. Not only will the company's unit production cost fall, but it will fall faster if the company makes and sells more during a given time period. But the market has to stand ready to buy the higher output. And to take advantage of the experience curve, TI must get a large market share early in the product's life cycle. This suggests the following pricing strategy: TI should price its calculators low; its sales will then increase, and its costs will decrease through gaining more experience, and then it can lower its prices further.

Some companies have built successful strategies around the experience curve. For example, Bausch & Lomb solidified its position in the soft contact lens market by using computerized lens design and steadily expanding its one Soflens plant. As a result, its market share climbed steadily to 65 percent. However, a single-minded focus on reducing costs and exploiting the experience curve will not always work. Experience-curve pricing carries some major risks. The aggressive pricing might give the product a cheap image. The strategy also assumes that competitors are weak and not willing to fight it out by meeting the company's price cuts. Finally, while the company is building volume under one technology, a competitor may find a lower-cost technology that lets it start at prices lower than the market leader's, who still operates on the old experience curve.

Active Figure 11.3	Cost per unit as a function of accumulated production: The experience curve

Management must decide who within the organization should set prices. Companies handle pricing in a variety of ways. In small companies, prices are often set by top management rather than by the marketing or sales departments. In large companies, pricing is typically handled by divisional or product line managers. In industrial markets, salespeople may be allowed to negotiate with customers within certain price ranges. Even so, top management sets the pricing objectives and policies, and it often approves the prices proposed by lower-level management or salespeople.

In industries in which pricing is a key factor (aerospace, steel, railroads, oil companies), companies often have a pricing department to set the best prices or help others in setting them. This department reports to the marketing department or top management. Others who have an influence on pricing include sales managers, production managers, finance managers, and accountants.

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

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

PRICING IN DIFFERENT TYPES OF MARKETS    The seller's pricing freedom varies with different types of markets. Economists recognize four types of markets, each presenting a different pricing challenge.

Under pure competition, the market consists of many buyers and sellers trading in a uniform commodity such as wheat, copper, or financial securities. No single buyer or seller has much effect on the going market price. A seller cannot charge more than the going price, because buyers can obtain as much as they need at the going price. Nor would sellers charge less than the market price, because they can sell all they want at this price. If price and profits rise, new sellers can easily enter the market. In a purely competitive market, marketing research, product development, pricing, advertising, and sales promotion play little or no role. Thus, sellers in these markets do not spend much time on marketing strategy.

Under monopolistic competition, the market consists of many buyers and sellers who trade over a range of prices rather than a single market price. A range of prices occurs because sellers can differentiate their offers to buyers. Either the physical product can be varied in quality, features, or style, or the accompanying services can be varied. Buyers see differences in sellers' products and will pay different prices for them. Sellers try to develop differentiated offers for different customer segments and, in addition to price, freely use branding, advertising, and personal selling to set their offers apart. Thus, Kinko's differentiates its offer through strong branding and advertising, reducing the impact of price. Because there are many competitors in such markets, each firm is less affected by competitors' marketing pricing strategies than in oligopolistic markets.

Under oligopolistic competition, the market consists of a few sellers who are highly sensitive to each other's pricing and marketing strategies. The product can be uniform (steel, aluminum) or nonuniform (cars, computers). There are few sellers because it is difficult for new sellers to enter the market. Each seller is alert to competitors' strategies and moves. If a steel company slashes its price by 10 percent, buyers will quickly switch to this supplier. The other steelmakers must respond by lowering their prices or increasing their services. An oligopolist is never sure that it will gain anything permanent through a price cut. In contrast, if an oligopolist raises its price, its competitors might not follow this lead. The oligopolist then would have to retract its price increase or risk losing customers to competitors.

In a pure monopoly, the market consists of one seller. The seller may be a government monopoly (the U.S. Postal Service), a private regulated monopoly (a power company), or a private nonregulated monopoly (DuPont when it introduced nylon). Pricing is handled differently in each case. A government monopoly can pursue a variety of pricing objectives. It might set a price below cost because the product is important to buyers who cannot afford to pay full cost. Or the price might be set either to cover costs or to produce good revenue. It can even be set quite high to slow down consumption.

In a regulated monopoly, the government permits the company to set rates that will yield a "fair return," one that will let the company maintain and expand its operations as needed. Nonregulated monopolies are free to price at what the market will bear. However, they do not always charge the full price for a number of reasons: a desire not to attract competition, a desire to penetrate the market faster with a low price, or a fear of government regulation.

CONSUMER PERCEPTIONS OF PRICE AND VALUE    In the end, the consumer will decide whether a product's price is right. Pricing decisions, like other marketing mix decisions, must be buyer oriented. When consumers buy a product, they exchange something of value (the price) to get something of value (the benefits of having or using the product). Effective, buyer-oriented pricing involves understanding how much value consumers place on the benefits they receive from the product and setting a price that fits this value.

A company often finds it hard to measure the values customers will attach to its product. For example, calculating the cost of ingredients in a meal at a fancy restaurant is relatively easy. But assigning a value to other satisfactions such as taste, environment, relaxation, conversation, and status is very hard. And these values will vary both for different consumers and in different situations. Still, consumers will use these values to evaluate a product's price. If customers perceive that the price is greater than the product's value, they will not buy the product. If consumers perceive that the price is below the product's value, they will buy it, but the seller loses profit opportunities.

ANALYZING THE PRICE–DEMAND RELATIONSHIP    Each price the company might charge will lead to a different level of demand. The relationship between the price charged and the resulting demand level is shown in the demand curve in Figure 11.4. The demand curve shows the number of units the market will buy in a given time period at different prices that might be charged. In the normal case, demand and price are inversely related; that is, the higher the price, the lower the demand. Thus, the company would sell less if it raised its price from P₁ to P₂. In short, consumers with limited budgets probably will buy less of something if its price is too high.

In the case of prestige goods, the demand curve sometimes slopes upward. Consumers think that higher prices mean more quality. For example, Gibson Guitar Corporation recently toyed with the idea of lowering its prices to compete more effectively with Japanese rivals such as Yamaha and Ibanez. To its surprise, Gibson found that its instruments didn't sell as well at lower prices. "We had an inverse [price-demand relationship]," noted Gibson's chief executive officer. "The more we charged, the more product we sold." At a time when other guitar manufacturers have chosen to build their instruments more quickly, cheaply, and in greater numbers, Gibson still promises guitars that "are made one-at-a-time, by hand. No shortcuts. No substitutions." It turns out that low prices simply aren't consistent with "Gibson's century-old tradition of creating investment-quality instruments that represent the highest standards of imaginative design and masterful craftsmanship."¹¹ Still, if the company charges too high a price, the level of demand will be lower.

Active Figure 11.4	Demand curves

Most companies try to measure their demand curves by estimating demand at different prices. The type of market makes a difference. In a monopoly, the demand curve shows the total market demand resulting from different prices. If the company faces competition, its demand at different prices will depend on whether competitors' prices stay constant or change with the company's own prices.

In measuring the price–demand relationship, the market researcher must not allow other factors affecting demand to vary. For example, if Sony increased its advertising at the same time that it lowered its television prices, we would not know how much of the increased demand was due to the lower prices and how much was due to the increased advertising. The same problem arises if a holiday weekend occurs when the lower price is set—more gift giving over the holidays causes people to buy more televisions. Economists show the impact of nonprice factors on demand through shifts in the demand curve rather than movements along it.

PRICE ELASTICITY OF DEMAND    Marketers also need to know price elasticity—how responsive demand will be to a change in price. Consider the two demand curves in Figure 11.4. In Figure 11.4A, a price increase from P₁ to P₂ leads to a relatively small drop in demand from Q₁ to Q₂. In Figure 11.4B, however, the same price increase leads to a large drop in demand from Q₁ to Q₂. If demand hardly changes with a small change in price, we say the demand is inelastic. If demand changes greatly, we say the demand is elastic. The price elasticity of demand is given by the following formula:

The demand curve sometimes slopes upward: Gibson was surprised to learn that its high-quality instruments didn't sell as well at lower prices.

Suppose demand falls by 10 percent when a seller raises its price by 2 percent. Price elasticity of demand is therefore –5 (the minus sign confirms the inverse relation between price and demand) and demand is elastic. If demand falls by 2 percent with a 2 percent increase in price, then elasticity is –1. In this case, the seller's total revenue stays the same: The seller sells fewer items but at a higher price that preserves the same total revenue. If demand falls by 1 percent when price is increased by 2 percent, then elasticity is –1/2 and demand is inelastic. The less elastic the demand, the more it pays for the seller to raise the price.

What determines the price elasticity of demand? Buyers are less price sensitive when the product they are buying is unique or when it is high in quality, prestige, or exclusiveness. They are also less price sensitive when substitute products are hard to find or when they cannot easily compare the quality of substitutes. Finally, buyers are less price sensitive when the total expenditure for a product is low relative to their income or when the cost is shared by another party.¹²

If demand is elastic rather than inelastic, sellers will consider lowering their price. A lower price will produce more total revenue. This practice makes sense as long as the extra costs of producing and selling more do not exceed the extra revenue. At the same time, most firms want to avoid pricing that turns their products into commodities. In recent years, forces such as deregulation and the instant price comparisons afforded by the Internet and other technologies have increased consumer price sensitivity, turning products ranging from telephones and computers to new automobiles into commodities in consumers' eyes. Marketers need to work harder than ever to differentiate their offerings when a dozen competitors are selling virtually the same product at a comparable or lower price. More than ever, companies need to understand the price sensitivity of their customers and prospects and the trade-offs people are willing to make between price and product characteristics. In the words of marketing consultant Kevin Clancy, those who target only the price sensitive are "leaving money on the table."

Even in the energy marketplace, where you would think that a kilowatt is a kilowatt is a kilowatt, some utility companies are beginning to wake up to this fact. They are differentiating their power, branding it, and marketing it, even if it means higher prices. For example, Green Mountain Energy (GME) targets consumers who are not only concerned with the environment but are also willing to support their attitudes with dollars. Offering electricity made from cleaner sources such as water, wind, and natural gas, GME positions itself as "the nation's leading brand of cleaner energy." By providing energy from clean, renewable sources and developing products and services that help consumers protect the environment, GME completes successfully against "cheaper" brands that focus on more price-sensitive consumers. "Is helping to clean the air worth the price of a movie?" the company asks. "That's about how much extra it costs each month when you choose cleaner, Green Mountain Energy electricity."¹³

Another external factor affecting the company's pricing decisions is competitors' costs and prices and possible competitor reactions to the company's own pricing moves. A consumer who is considering the purchase of a Canon camera will evaluate Canon's price and value against the prices and values of comparable products made by Nikon, Minolta, Pentax, and others. In addition, the company's pricing strategy may affect the nature of the competition it faces. If Canon follows a high-price, high-margin strategy, it may attract competition. A low-price, low-margin strategy, however, may stop competitors or drive them out of the market.

Canon needs to benchmark its costs against its competitors' costs to learn whether it is operating at a cost advantage or disadvantage. It also needs to learn the price and quality of each competitor's offer. Once Canon is aware of competitors' prices and offers, it can use them as a starting point for its own pricing. If Canon's cameras are similar to Nikon's, it will have to price close to Nikon or lose sales. If Canon's cameras are not as good as Nikon's, the firm will not be able to charge as much. If Canon's products are better than Nikon's, it can charge more. Basically, Canon will use price to position its offer relative to the competition.

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