Fundamentals of Business

Chapter 14:

Pricing Strategy
Content for this chapter was adapted from the Saylor Foundation’s
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Lead Author:
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Richard Parsons,
Anastasia Cortes,
Anita Walz

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Layout: Anastasia Cortes Cover design:
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Chapter 14
Pricing Strategy

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 Learning Objectives
1) Identify pricing strategies that are appropriate for new and
existing products
2) Understand the stages of the product life cycle.

Pricing a Product

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 As introduced in a previous chapter, one of the four Ps in the marketing mix is price.
Pricing is such an important aspect of marketing that it merits its own chapter. Pricing a
product involves a certain amount of trial and error because there are so many factors to
consider. If a product or service is priced too high, many people simply won’t buy it. Or your
company might even find itself facing competition from some other supplier that thinks it can
beat your price. On the other hand, if you price too low, you might not make enough profit to
stay in business. Let’s look at several pricing options that were available to those marketers at
Wow Wee who were responsible for pricing Robosapien, an example we introduced earlier.
We’ll begin by discussing two strategies that are particularly applicable to products that are
being newly introduced.

New Product Pricing Strategies

When Robosapien was introduced to the
Figure 14.1 Sony’s robot dog, Aibo.
market, it had little direct competition in its product
category. True, there were some “toy” robots available,
but they were not nearly as sophisticated. Sony
offered a pet dog robot called Aibo, but its price tag of
$1,800 was really high. Even higher up the price-point
scale was the $3,600 iRobi robot made by the Korean
company Yujin Robotics to entertain kids and even
teach them foreign languages. Parents could also
monitor kids’ interactions with the robot through its
video-camera eyes; in fact, they could even use the
robot to relay video messages telling kids to shut it off
and go to sleep.1

Skimming and Penetration Pricing

Because Wow Wee was introducing an innovative product in an emerging market with
few direct competitors, it considered one of two pricing strategies:
1) With a skimming strategy, Wow Wee would start off with the highest price that
keenly interested customers would pay. This approach would generate early profits,
but when competition enters—and it will, because at high prices, healthy profits can

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 be made in the market—Wow Wee would have to lower its price. Even without
competition, they would likely lower prices gradually to bring in another group of
consumers not willing to pay the initial high price.
2) Using penetration pricing, Wow Wee would initially charge a low price, both to
discourage competition and to grab a sizable share of the market. This strategy
might give the company some competitive breathing room (potential competitors
won’t be attracted to low prices and modest profits). Over time, as its dominating
market share discourages competition, Wow Wee could push up its prices.

Other Pricing Strategies

In their search for the best price level, Wow Wee’s marketing managers could consider
a variety of other approaches, such as cost-based pricing, demand-based pricing, prestige
pricing, and odd-even pricing. Any of these methods could be used not only to set an initial
price but also to establish long-term pricing levels.

Before we examine these strategies, let’s pause for a moment to think about the pricing
decisions that you have to make if you’re selling goods for resale by retailers. Most of us think
of price as the amount that we—consumers—pay for a product. But when a manufacturer
(such as Wow Wee) sells goods to retailers, the price it gets is not what we the consumers will
pay for the product. In fact, it’s a lot less.

Here’s an example. Say you buy a shirt at the mall for $40 and that the shirt was sold to
the retailer by the manufacturer for $20. In this case, the retailer would have applied a
mark-up of 100 percent to this shirt, or in other words $20 mark-up is added to the $20 cost to
arrive at its price (hence a 100% markup) resulting in a $40 sales price to the consumer.
Markup allows the retailer to cover its costs and make a profit.

Cost-Based Pricing
Using cost-based pricing, Wow Wee’s accountants would figure out how much it costs
to make Robosapien and then set a price by adding a profit to the cost. If, for example, it cost
$40 to make the robot, Wow Wee could add on $10 for profit and charge retailers $50.
Costbased pricing has a fundamental flaw – it ignores the value that consumers would place
on the product. As a result, it is typically only employed in cases where something new or

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customized is being developed where the cost and value cannot easily be determined before
the product is developed. A defense contractor might use cost-based pricing for a new missile
system, for example. The military might agree to pay costs plus some agreed amount of profit
to create the needed incentives for the contractor to develop the system. Building contractors
might also use cost-based pricing to protect themselves from unforeseen changes in a project:
the client wanting a home addition would get an estimate of the cost and have an agreement
for administrative fees or profit, but if the client changes what they want, or the contractor has
unexpected complications in the project, the client will pay for the additional costs.

Demand-Based Pricing
Let’s say that Wow Wee learns through market research how much people are willing to
pay for Robosapien. Following a demand-based pricing approach, it would use this
information to set the price that it charges retailers. If consumers are willing to pay $120 retail,
Wow Wee would charge retailers a price that would allow retailers to sell the product for $120.
What would that price be? If the 100% mark-up example applied in this case, here’s how we
would arrive at it: $120 consumer selling price minus a $60 markup by retailers means that
Wow Wee could charge retailers $60. Retailer markup varies by product category and by
retailer, so this example is just to illustrate the concept.

Dynamic Pricing
In the hospitality industry, the supply of available rooms or seats is fixed; it cannot be
changed easily. Moreover, once the night is over or the flight has departed, you can no longer
sell that room or seat. This fact combined with the variation in demand for rooms or flights on
certain days or times (think holidays or special events), has led to dynamic pricing. Revenue
management, and the growth of online travel agencies (OTA’s) like Hotwire, Expedia, and
Priceline are methods of maximizing revenue for a given night or flight. Hotels and airlines
use sophisticated revenue management tools to forecast demand and adjust the availability
of various price points. Online travel agents like Hotwire publicize last-minute availability with
special rates so that unsold rooms or flights can attract customers and still earn revenue. This
approach allows hotels and airlines to maximize revenue opportunities for high demand times
such as university graduations and holidays, and also for special events like the Super Bowl or
the Olympics. Losses are minimized during low-demand times because unused capacity is

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offered at a discount, attracting customers who might not have considered travelling at off peak
times.

Prestige Pricing
Some people associate a high price with high quality—and, in fact, there generally is a
correlation. Thus, some companies adopt a prestige-pricing approach—setting prices
artificially high to foster the impression that they’re offering a high-quality product.

Competitors are reluctant to lower their prices because it would suggest that they’re
lower-quality products. Let’s say that Wow Wee finds some amazing production method that
allows it to produce Robosapien at a fraction of its current cost. It could pass the savings on by
cutting the price, but it might be reluctant to do so: what if consumers equate low cost with
poor quality?

Figure 14.2: Odd-even pricing—it’s less

Odd-Even Pricing than $60.00! Do you think $9.99
sounds cheaper than $10? If you do, you’re part of
the reason that companies sometimes use odd-
even pricing— pricing products a few cents (or
dollars) under an even number. Retailers, for
example, might price Robosapien at $99 (or even
$99.99) if they thought consumers would perceive it
as less than $100.

Loss Leaders
Have you ever seen items in stores that were priced so low that you wondered how the
store could make any money? There’s a good chance they weren’t – the store may have been
using a loss leader strategy – pricing an item at a loss to draw customers into the store. Once
there, store managers hope that the customer will either buy accessories to go along with the
new purchase or actually select a different item not priced at a loss. You might have visited the
store to buy a specially-priced laptop and ended up leaving with a more expensive one that
had a faster processor. Or perhaps you bought the HDTV that was advertised, but then also
bought a new surge protector and a streaming player. In either case, you did exactly what the
store hoped when they priced the advertised item at a loss.

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 Bundling
Perhaps you are one of the many customers of a cable television provider that also
buys their high-speed internet and/or their phone service. Or when you stop by your favorite
fast-food outlet for lunch, maybe you sometimes buy the combo of burger, fries, and a drink. If
you do, you’ve experienced the common practice of a bundling strategy – pricing items as a
group, or bundle, at a discount to the cost of buying the items separately. Bundling has
significant advantages to both buyers and sellers. Obviously, buyers receive the discount.
Sellers, on the other hand, can sell more goods and services with this approach. Perhaps you
would have settled for a water instead of a soft drink, but the combo price made the soft drink
just a few cents more. Without bundling, that soft drink might not have been sold.

If the sale involves some kind of recurring service – like the previously-mentioned
example of cable – bundling can also result in higher levels of customer retention. If you
decided one day that you wanted to replace your cable with satellite TV, for example, you
might well find that the discount from moving to satellite was far less than you expected,
because unbundled from cable TV, the price for your internet service could take a substantial
jump. If so, like many others who have likely considered making this move, you might find it in
your best interests to stick with the original bundled package, no matter how trapped or
frustrated you might feel as a result.

The Product Life Cycle

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 Figure 14.3: A Toyota RAV-4, a top-selling small sized SUV.

Sport utility vehicles (SUVs) are among the most popular categories of passenger car
on U.S. roads. Offering an elevated view of the road, the safety that comes with size, spacious
interior and cargo areas, and often superior handling performance in bad weather – especially
4-wheel-drive SUVs – it is no wonder that American consumers have bought tens of millions of
these vehicles. For a long time, SUV sales followed close to the classical pattern of what is
known as the product life cycle:
Figure 14.4: The Product Life Cycle

Yet in 2009, when the economy faltered due to the financial crisis and oil prices surged
from about $40 a barrel to nearly $80,2 many pundits declared the SUV to be in permanent

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 Figure 14.5: SUV sales by category, 1990-2012

decline. In fact, the data appeared to support this contention:

As you can see from the figure, SUV sales did in fact decline, rather dramatically. But
SUV sales are too critical to the profitability of the major automakers for them to just watch
their cash flows disappear.3 Instead, the automakers redesigned their products, including an
increased emphasis on smaller SUVs. In fact, the Honda CR-V and the Toyota RAV4, two of
the smaller SUV’s on the market, now battle each other for the crown of top-selling SUV in the
U.S.4 Many consumers adapted their budgets to compensate for higher oil prices. Sales,
particularly of mid-sized SUVs, roared back in 2010, with sales of large SUV’s showing a
similar, but smaller, upward trend too.

While their new designs certainly helped to reinvigorate sales, more recently
automakers have gotten a somewhat unexpected additional boost from declining oil prices. For
all their benefits, SUVs are not the most fuel efficient cars on the market. But as consumers
began to pay less at the pump, the cost of operating SUVs declined, and SUV sales have
continued to be strong. Automakers continue to invest in new models – for example, German
automaker Volkswagen introduced a new 5-seat mid-sized SUV at the Detroit auto show in
January, 2015. The company is assembling a group of about 200 experts, including
representatives of its dealer network, to help it better cater its offerings to the American
market.5

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 Many products tend to follow the classical product life cycle pattern of Figure 14.4. Let’s
take a closer look at the product life cycle and see what we can learn from it. The graph is a
simplified depiction of the product life cycle concept. Many products never make it past the
introduction stage. Some products avoid or reverse decline by reinventing themselves. In part,
reinvention is what the SUV market has experienced, in addition to the boost it has received
from lower gas prices.

The Life Cycle and the Changing Marketing Mix

As a product or brand moves through its life cycle, the company that markets it will shift
its marketing-mix strategies. Figure 14.6 summarizes the market and industry features of each
stage. Let’s see how the mix might be changed to address the differences from one stage to

Figure 14.6: The Product Life Cycle: characteristics of each stage. the
next.

Stage: Introduction Growth Maturity Decline

Depends on choice Converges as Initially high but Initially declines

Price Levels of introductory competitors tend to decline as but may rise as
strategy enter market growth disappears competitors exit

Number of Begins to decline

Few Rapidly Rising through Few or one
Competitors consolidation

Industry
Negative Rising Highest Declining
Profits

Few – Innovators Rising – Early High/Stable, begins

Customers Declining
Only Adopters to drop late in cycle
Milk Remaining
Awareness and Gain Market Defend Share and
Objectives Value, Minimize
Adoption Share Maximize Profits
Investment

Introduction Stage
At the start of the introduction stage, people – other
than those who work in the industry – are likely to be Figure

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14.7: Google Glass completely unaware that a product even exists. Building awareness is
a key to adoption of the product. Companies invest in advertising to make consumers
aware of their offerings and the benefits of becoming a customer. For many products, the
early adopters are people who value newness and innovation. If a company faces only
limited competition, it might use a skimming approach to pricing because people who
want to be among the first to have the product will generally be willing to pay a higher
price (recall that
“skimming” means that the company will set initial prices high,
and only those consumers who feel especially excited about the product will buy it). The
company will then lower prices to appeal to the next layer of consumers – those who wanted
the product but were unwilling to pay the high introductory price. The company will continue to
gradually lower prices, in effect taking off layer after layer of potential customers until the
product is priced low enough to be afforded by the mass market.

If the company has or expects a lot of competition, though, it may decide to use
penetration pricing and capture a lot of market share, which may discourage some potential
competitors from entering the market at all. The higher the price levels in a market, the more
likely it is that new competitors will want to enter.

During the introductory stage, the industry as whole will sell only a relatively small
quantity of the product, so competitors will distribute the product through just a few channels.
Most retailers charge what is called a “slotting fee” – a payment the manufacturer makes to
persuade the retailer to stock the item. If the product fails, they do not offer refunds on these
charges, so producers will want to be confident that a product will draw enough customers
before they pay these fees and so may limit its initial distribution. Because sales at this stage
are low while advertising and other costs are high, all competitors tend to lose money during
this stage.
Growth Stage
As the competitors in an industry focus on building sales, successful products will enter
a stage of rapid customer adoption, which is not surprisingly called the growth stage in the
product life cycle. Depending on how innovative

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 Figure 14.8: A Samsung smart watch
and attractive a product is, the industry might
reach the growth stage relatively quickly – or it
could take many months or even longer for that
point to arrive, if it happens at all. In order for
industry sales to increase rapidly, advertising
costs will generally be very high during the growth
stage. If competition appears, companies may
respond by lowering prices to retain their market
shares. Competitors will also be looking for
channels in which to distribute their products. Where possible, they will try to establish
exclusive arrangements with distributors, at least for a period of time, so that their product may
be the only one available in a product category at a particular retail outlet. During the growth
stage, it is also important for companies to invest in making improvements to their products so
as to maintain any advantage they may have established over their competitors. Since sales
are rising rapidly during the growth stage, many products begin to turn a profit here, even
though they are still investing heavily in advertising, establishing distribution, and refining the
product itself.

Maturity Stage Figure 14.9: Smartphones

If a product survives the growth stage,
it will probably remain in the maturity stage
for a long time. Sales still grow in the initial
part of this stage, though at a decreasing
rate. Later in the maturity stage, sales will
plateau and eventually begin to move in a
slightly downward direction. By this stage, if
not sooner, competitors will have settled on a
strategy intended to deliver them a sustainable competitive advantage – either by being the
low cost producer of a product, or by successfully differentiating their product from the
competition. Since at least one competitor will generally move towards a low-cost strategy,

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after initially peaking, price levels begin to decline during the maturity stage. Price wars may
even occur, but profits still tend to be strong because sales volume remains high.

As the product becomes outdated, the company may make changes in keeping with
changing consumer preferences, but usually not as rapidly as in the earlier stages of the life of
a product. Branding becomes a key aspect of success in the maturity stage, particularly for
those companies seeking to differentiate their products as their source of competitive
advantage. Also during the maturity stage, industry consolidation is high; in other words, larger
competitors will buy up smaller competitors in order to find synergies and build share and scale
economies. Some models of the product life cycle reflect a stage called “shakeout”, which
occurs towards the end of the growth and the beginning of the maturity stages. The term
shakeout reflects this trend towards industry consolidation. Some competitors survive and
others get “shaken out,” either by going out of business or by being acquired by a stronger
competitor.

Decline Stage
Figure 14.10: a landline phone
At some point, virtually every product will reach the
decline stage, the point at which sales drop significantly.
New innovations, changes in consumer tastes, regulations,
and other forces from the macro-level business
environment can change the outlook for a product almost
overnight. Products with a very short life cycle are known
as “fads”. They may move through the entire product life
cycle in a matter of months. Many products, particularly
those which have experienced a long period in maturity,
may stay in the decline phase for years. Ironically, price levels during the decline stage may
actually increase, which occurs because the number of competitors is few – in fact, there may
be only one remaining, giving that company great pricing power over the few consumers who
still want or need the product. New product development is usually very limited, unless a
company believes that innovation can restart growth in the category, as we saw with new SUV
models. Also, advertising is typically limited or non-existent – those who need the product are
likely to know about it already. So while it may seem counter-intuitive, many companies make a

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lot of money while they are riding the downward shape of the product life cycle curve during
the decline stage.

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Key Take -Aways
1) There are several pricing strategies appropriate for different
product and market situations:
a. A new product can be introduced with
skimming
a
strategy—starting off with a high price that keenly
interested customers are willing to pay. The alternative is a
penetration strategy,charging a low price, both to keep
out competition and to grab as much market share as
possible
b. Withcost-based pricing, a company determines the cost
of making a product and then sets a price by adding a profit
to the cost.
c. Withdemand-based pricing, marketers set the price that
they think consumers will pay.
d. Companies useprestige pricing to capitalize on the
common associationof high price and quality, setting an
artificially high price to substantiate the impression of high
quality.
e. Finally, withodd-even pricing, companies set prices at
such figures as $9.99 (an odd amount), counting on the
common impression that it soundseaper
ch than $10 (an
even amount).

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Key Take -Aways

2) The stages of development and decline that products go

through over their lives is
called theproduct life cycle.
3) The stages a product goes through areintroduction,
growth, maturity, and decline.
4) As a product moves through its life cycle, the company that
markets it will shift its marketing
-mix strategies.

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Chapter 14 Text References and Image Credits
Image Credits: Chapter 14
Figure 14.1: Kate Nevens (2005). “Aibo.” CC BY-SA 2.0. Retrieved from:
https://www.flickr.com/photos/katenev/72775121

Figure 14.2: © BrokenSphere / Wikimedia Commons (2010). “FF XIII Xbox 360 version

price tag with gift card offer at Target.” CC BY-SA 3.0 Retrieved from:
https://commons.wikimedia.org/wiki/File:FF_XIII_Xbox_360_version_price_tag_with_gift_card_offer_at
_Target,_Tanforan.JPG

Figure 14.3: Mr. Choppers (2013). “A 2013 Toyota RAV4 XLE AWD.” CC BY-SA 3.0. Retrieved from:
https://en.wikipedia.org/wiki/Toyota_RAV4#/media/File:2013_Toyota_RAV4_XLE_AWD_front_left.jpg.

Figure 14.5: SUV sales and gas prices: Data sources: Office of Energy Efficiency & Renewable Energy
(2016). “Fact #915: March 7, 2016 Average Historical Annual Gasoline Pump Price, 1929-2015.”
Energy.gov. Retrieved from: http://energy.gov/eere/vehicles/fact-915-march-7-2016-average-
historicalannual-gasoline-pump-price-1929-2015 and United States Department of Transportation
Bureau of
Transportation Statistics (2013). “Table 1-21: Period Sales, Market Shares, and Sales-Weighted Fuel
Economies of New Domestic and Imported Light Trucks (Thousands of vehicles).” U.S. Department of
Transportation. Retrieved from:
https://www.rita.dot.gov/bts/sites/rita.dot.gov.bts/files/publications/national_transportation_statistics/html
/table_01_21.html

Figure 14.7: Dr. Ned Sahin (2014). “Dr. Ned Sahin wearing Google Glass.” CC BY_SA 4.0. Retrieved
from: https://commons.wikimedia.org/wiki/File:Dr._Ned_Sahin_wearing_Google_Glass.png

Figure 14.8: JustynaZajdel (2016). “Smartwatch Samsung Gear S2.” CC BY_SA 4.0. Retrieved from:
https://commons.wikimedia.org/wiki/File:Smartwatch_Samsung_Gear_S2.jpeg

Figure 14.9: Maurizio Pesce (2014). “OnePlus One vs LG G3 vs Apple iPhone 6 Plus vs Samsung
Galaxy Note 4.” CC BY-SA 2.0. Retrieved from:
https://www.flickr.com/photos/pestoverde/16324871102

Figure 14.10: Anton Diaz (2008). “Siemens Gigaset A165.” CC BY-SA 3.0. Retrieved from:
https://en.wikipedia.org/wiki/Push-

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button_telephone#/media/File:%D0%A0%D0%B0%D0%B4%D0%B8%D0%BE%D1%82%D0%B5%D0
%BB%D0%B5%D1%84%D0%BE%D0%BD.jpg

References: Chapter 14
1
Cliff Edward (2004). “Ready to Buy a Home Robot?” Business Week. Retrieved from:
http://www.bloomberg.com/news/articles/2004-07-18/ready-to-buy-a-home-robot
2
Ron Scherer (2009). “Oil prices top $78 a barrel - double the cost of a year ago.” The Christian Science
Monitor. Retrieved from: http://www.csmonitor.com/USA/2009/1224/Oil-prices-top-78-a-barrel-double-the-cost-
ofa-year-ago

3
Eric Mayne (2005). “Big 3 SUV Blitz could Backfire.” The Detroit News. May 2, 2005.
4
Kelsey Mays (2016). “Top 10 Best-Selling Cars: February 2016.” Cars.com. Retrieved from:
https://www.cars.com/articles/top-10-best-selling-cars-february-2016-1420683940927/
5
Andreas Cremer (2015). “VW aims to tune in to local tastes in latest U.S. turnaround plan.” Reuters.
Retrieved from: http://www.reuters.com/article/autoshow-volkswagen-idUSL6N0UR0NR20150112

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