Lesson Proper for Week 3

INTRODUCTION

Economic determinants of price management, which necessarily are costs, value-to-customer,

When we ask managers how they set prices, or what information they base their price
decisions on, they typically give one or more of the following answers:

· Our prices come from our history in the market.

· We figure out our costs and apply the typical markup for our industry.

· We orient ourselves to what the competition is doing.

· The market determines the price.

· We try to estimate value-to-customer, but that is difficult.

ANALYSIS OF PRICE-RELEVANT INFORMATION

1. Cost-Plus Pricing

Companies must consider their corporate goals as well as their costs when setting prices. Thus,
we will now focus on the cost information, which is significant both for setting the lower limit for an
estimate as well as for ensuring the company’s profitability. It’s worth noting in this context that some
historical theories considered costs as the sole determinant of price.

2. Customers

The core piece of customer information is the customer’s willingness to pay. It reflects the
customer’s perceived value (“value-to-customer”). At the individual customer level, the question is
what personal willingness to pay exists for a product and what the distribution of that willingness of
different customers looks like. At the aggregated market level, we have to ask what effect different
prices have on sales volume, i.e., what does the price-response function look like.

3. Competition

Companies must take competition into account in price decisions, primarily for three reasons:

· In many markets, competitors’ prices exert a strong influence on a company’s sales volume. In
other words, the so-called cross-price elasticity is significantly different from zero.

· If competitors feel threatened by price measures, they tend to react, i.e., their reaction elasticity
is likewise significant.

· A company can implement its price actions quickly, but competitors can usually respond just as
fast.
Three Tasks in Competition

· Identifying the relevant competitors.

· Analyzing the current prices of the competitors.

· Anticipating their potential future price behavior.

Spheres of Competition

· Narrow sphere of competition (similar/identical products)

· Broader sphere of competition (same types of products)

· Outer sphere of competition (products which provide similar/related kinds of value)

THE PRICE-RESPONSE FUNCTION

Classification of Price-Response Functions

The demand curve, also called the price-response function, describes the functional
relationship between the price p and the sales volume or quantity q:

q = q (p)

The price is the independent variable, and the sales volume is the dependent variable. In
economic textbooks, one sees in most cases the mirror-image function p=p(q) with size as the
independent variable and price as the dependent variable. This demand function is based on the idea
that a supplier offers a certain quantity, and the market determines the price.

The price-response function is a prerequisite for price optimization.

1. Aggregation level: Individual vs. aggregated price-response functions.

2. Market form: Here, one distinguishes between monopoly and competitive markets.

3. Form: Price-response functions can be expressed in tabular or graphical form or as a

4. Data sources: The data used to determine a price-response function can come from expert
judgment, customer surveys, experiments, or market data.

Price-Response Functions and Price Elasticity

1. Individual and Aggregated Price-Response Functions

· Durables: The demand curve reflects a yes-no decision by each customer. We refer to this as the
“yes-no” case. People buy one washing machine, one smartphone, one camera, or one notebook. Or
they don’t buy at all.

· Consumables: In this case, buyers often purchase several units at a time, depending on the
price. We call this the “variable-quantity” case. Foods such as yogurt and soft drinks fall into this
category, as do services such as going to a movie. If the price is lower, the individual customer buys
more and consumes more often.

2. The Aggregated Price-Response Function

The aggregated price-response function results from the addition of the volumes for each price
across all customers. The customers can be homogenous or heterogeneous. In reality, they are almost
always heterogeneous, which means they have different maximum rates.

3. Definition of Price Elasticity

The price elasticity measures the influence of price on sales volume. Elasticity is the ratio of the
percentage change in one variable to the percentage change in the variable causing the change. The
flexibility is dimensionless. The price elasticity is defined as:

E = (sales change in percent) / (price change in percent)

If a price decrease of 10% results in a volume expansion of 20%, the price elasticity has a value of -2.
The negative sign indicates that volume and price changes move in opposite directions. The price
elasticity of -2 says that the percentage change in sales volume is twice the percentage change in
price. For infinitesimal changes the price elasticity is defined mathematically as:

E = (∆q / ∆p) × (p / q )

EMPIRICAL DETERMINATION OF THE PRICE-RESPONSE FUNCTION

Surveys and observations are two fundamental options for collecting the data needed to
determine a price-response function. Among studies, we distinguish between expert judgment and
various forms of customer surveys. We divide observations into experiments and market
observations.
1. Survey

· Expert Judgment - The expert judgment method involves surveying specialists or experts who
have in-depth knowledge of markets, individual market segments, or specialized price knowledge.

Price-Response Function

· Company employees: executives, managers, sales, and marketing team members.

· Management consultants with expertise on the market or market segments, products, or price
management in general

· Customer Surveys

§ Direct Customer Surveys

§ Indirect Customer Surveys

2. Observations

· Experiments

§ Price Experiments - test buyers are exposed to alternative prices in a real or realistic purchase
situation.

§ Experimental Auctions – The significance of auctions has grown sharply as the Internet expanded

· Market Observations

§ Market Data – used for price analysis typically has been collected at an earlier time for another
purpose. In many markets, standardized data is available which can support price decisions

§ Data from Online Auctions - With the advent of the Internet, new business models emerged online
based on reverse pricing.

Synopsis of Instruments

The analytical effort required should correspond to the relevance of the price decision to be
made. The richness of the information collected is an essential factor in choosing a method, but costs
and time required also play a role.