BM1805

PRICING THEORIES AND STRATEGIES

Price Theory
The theory of price involves the concept of supply and demand to determine the appropriate price point
for a good or service. This theory aims to achieve equilibrium in which the quantities of goods or services
match the corresponding market's desire and ability to acquire the good or service. The concept allows
for price adjustments as market conditions change.
For instance, market forces determine that it costs P5 for a bread loaf. This suggests that the buyers are
willing to forgo the utility in P5 to possess the bread loaf and that the sellers perceive that P5 is a fair price
in exchange for giving up the bread loaf. The following factors are associated with the theory of price:
• Supply. It denotes the amount of products or services the market can provide. This includes tangible
goods such as automobiles or intangible goods such as the ability to make an appointment with a
skilled service provider. In each instance, the available supply is finite in nature. There are only a
certain number of automobiles available and only a certain number of appointments available, at any
given time. The supply curve is presented below as a graphical representation of the correlation
between the cost of a good or service and the quantity supplied for a given period. In a typical
illustration, the price appears on the left vertical axis, while the quantity supplied appears on the
horizontal axis as follows:

Figure 1. Supply curve

• Demand. It applies to the market’s desire to acquire a tangible or intangible item. At any time, there
is also only a finite number of potential consumers available. Demand may fluctuate depending on a
variety of factors, such as whether an improved version of a product is available or if a service is no
longer needed. Demand can also be affected by an item's perceived value or affordability, by the
consumer market. The demand curve is presented below showing the relationship between the price
of a certain item and the quantity that the customers are willing to buy given a particular price as
follows:

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Figure 2. Demand Curve

• Equilibrium. It pertains to the price point that allows supply to reasonably serve the potential
customers. If the price is too high, customers may avoid the good or service, resulting in excess
supply. In contrast, if a price is too low, demand may significantly outweigh the available supply.
Economists use price theory to find the selling price that brings supply and demand as close to the
equilibrium as possible. The graphical approach to equilibrium analysis is illustrated as follows:

Figure 3. Equilibrium graph

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EXAMPLE: A farmer is selling apples for P10 each. After a month, he decided to lower the price at P8
since it is the fruit’s full harvest season, expecting to yield more apples compared to the previous
month. This will allow the farmer to maximize sales by allowing consumers to purchase more or to
increase the demand due to lower price and to avoid spoilage of excess supply garnered during the
harvest season. Thus, any movement in supply or demand always triggers change in prices resulting
to shifting of price equilibrium to attain beneficial impact to both the supplier and customers.
Prospect Theory
This theory assumes that losses and gains are valued differently, and thus individuals make decisions
based on perceived gains instead of perceived losses. The general concept of this theory is that if two (2)
options are presented before a consumer, both equal, with one presented in terms of potential gains and
the other in terms of possible losses, the former option will be chosen.
EXAMPLE: An investor is given a pitch for the same mutual fund by two (2) separate financial advisors.
One advisor presents the fund to the investor, highlighting that it has an average return of 12% over
the past three (3) years. The other advisor tells the investor that the fund has above-average returns
in the past 10 years but has been declining in the recent years. Prospect theory assumes that though
the investor was presented with the exact same mutual fund, he is likely to buy the fund from the
first advisor, who expressed the fund’s rate of return as an overall gain instead of the advisor
presenting the fund as having high returns and losses.
According to the prospect theory, paying a price to purchase a product or service generates negative
utility. On the other hand, the purchase and use of a product or service represents a gain and generates
positive utility. The following are the underlying assumptions of prospect theory:
• Free or paid. The prospect theory explains that the negative utility is greater when a product or
service is paid/bought personally by a consumer. For instance, the odds that you go to the concert
despite of a bad weather is much greater if you paid for the ticket with your own money than if
you had received the ticket as a gift. The money is gone, regardless of whether you attend the
concert. But the urge to “earn back” the price of the ticket is much higher if you paid with your
own money.
• Better to pay in cash. The prospect theory explains that the negative utility from a cash payment
is greater in comparison to a cashless or credit/debit card payment. This states that consumers
who want to have an overview of their expenditures tend to avoid paying with credit cards.
• Moon prices. The prospect theory explains that rebate provides the customers with additional
positive utility. For instance, sellers are pricing products for P100 and offers a 25% discount, which
allows the customers to purchase the product for only P75. This states that the discount received
by the customers tend to create a positive perception or utility.
Pricing Strategies
The following are the various strategies and techniques that businesses use when setting prices on their
products and services:
• Markup pricing. It involves assessing various costs and adding a standard percentage above the
total cost, which will serve as profit.

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• Cost-based pricing. It involves building a profit margin directly into the price of a product or
service. It requires calculating and enumerating the cost to deliver a product or service, then
adding a margin to the total computed cost.
• Target-return pricing. It involves setting the price of a product or service at a level, which will yield
target rate of return on investment made by the company.
• Break-even pricing. It involves determining the point wherein an organization would incur neither
profit nor loss.
• Rate-based pricing. It involves pricing a service based on hourly pricing model. Freelancers,
consultants, and coaches most commonly use this strategy for pricing their services.
• Project-based pricing. It involves pricing a product or service based on a flat fee arrangement
agreed for the launch of a project. The seller often makes an estimate of how many hours s/he
thinks the project will take and then price accordingly. For this to work, the scope of work should
be well-defined up-front.
• Pricing at a premium. It involves setting higher prices in comparison to the prices of the
competitors or companies that sell similar products or services. It is often most effective in the
early days of a product’s life cycle, and ideal for small businesses that sell unique goods.
• Pricing for market penetration. It involves offering relatively lower prices of goods and services.
While many new companies use this technique to draw attention away from their competition,
this does tend to result in an initial loss of income for the business.
• Economy pricing. It involves minimizing the costs associated with marketing and production in
order to keep the prices of products or services relatively low. A wide range of businesses
including generic food suppliers and discount retailers uses this strategy.
• Price skimming. It involves setting higher rates during the introductory phase of a product or
service. The company then lowers prices gradually as competitor goods appear on the market.
One of the benefits of price skimming is that it allows businesses to maximize profits on early
adopters before dropping prices to attract more price-sensitive consumers.
• Psychology pricing. It involves the techniques that marketers use to encourage customers to
respond on emotional levels rather than logical ones in purchasing a good or service. For example,
setting the price of a watch at P199 is proven to attract more consumers than setting it at P200,
even though the true difference is quite small. One explanation for this trend is that consumers
tend to put more attention on the first number on a price tag than the last. The goal of this pricing
strategy is to increase demand by creating an illusion of enhanced value for the consumer.
• Bundle pricing. It involves selling multiple products for a lower rate in comparison to purchasing
the items individually. This strategy is more effective for companies that sell complimentary
products. For example, a restaurant can take advantage of bundle pricing by including dessert
with every meal sold on a particular day of the week.
• Optional product pricing. It involves increasing the amount customers spend once they start to
buy. For example, airlines charge for optional extras such as guaranteeing a window seat or
reserving a row of seats next to each other. Budget airlines are prime users of this approach when
they charge you extra for additional luggage or extra legroom.
• Captive product pricing. It involves charging a premium price when the consumer has no other
option. For example, a razor manufacturer charges a low price for the first plastic razor and
recover its margin from the sale of the blades that fit the razor. Another example is when printer

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manufacturers sell inkjet printers at a low price. In this instance, the printer manufacturer knows
that once the customers’ ran out of consumable ink, they need to buy more and this tends to be
relatively expensive.
• Geographical pricing. It involves variations in price of a similar product or service in different parts
of the world. Some examples that affect the price of a product depending on the location include
the shipping costs, taxes, and government legislation, which limit the number of products that
can be imported resulting to raise in price.
• Value pricing. It involves external factors such as recession or increased competition, which forces
companies to provide value products and services to retain sales. Examples of this include the
value meals being offered in fast food chains and restaurants.

References
Investopedia. (n.d.). Prospect theory. Retrieved on October 31, 2018, from
https://www.investopedia.com/terms/p/prospecttheory.asp
Investopedia. (n.d.). Theory of price. Retrieved on October 31, 2018, from
https://www.investopedia.com/terms/t/theory-of-price.asp
Lalitha, R. & Rajasekaran, V. (2010). Costing accounting. India: Pearson.

Maguire, A. (n.d.). 6 different pricing strategies: Which is right for your business. Retrieved on October
31, 2018, from https://quickbooks.intuit.com/r/pricing-strategy/6-different-pricing-strategies-
which-is-right-for-your-business
Marketing Teacher. (n.d.). Pricing strategies. Retrieved on October 31, 2018, from
http://www.marketingteacher.com/pricing-strategies
Rante, G. A. (2016). Cost accounting. Mandaluyong City: Millenium Books, Inc.

Simon, H. (2015). Confessions of the pricing man. Switzerland: Springer International Publishing.

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