Marketing Management II

Professor Hayden Noel

Module 3: Capturing Value (Pricing)

Table of Contents
Module 3: Capturing Value (Pricing) ....................................................................................... 1
Lesson 3-1: What is it Worth to You? ................................................................................................ 2
Lesson 3-1.1 What is it Worth to You? ................................................................................................................. 2

Lesson 3-2: Customized Pricing Strategy ......................................................................................... 22

Lesson 3-2.1 Customized Pricing Strategy.......................................................................................................... 22

Lesson 3-3: Consumer Psychology and Pricing ................................................................................ 37

Lesson 3-3.1 Consumer Psychology and Pricing................................................................................................. 37

Lesson 3-4: Setting Price - The Impact of Demand and Elasticity ..................................................... 56
Lesson 3-4.1 Setting Price - The Impact of Demand and Elasticity .................................................................... 56

Lesson 3-5: Professor Noel's Board Walk: New Product Pricing Strategy ......................................... 73
Lesson 3-5.1 Professor Noel's Board Walk: New Product Pricing Strategy ........................................................ 73

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Lesson 3-1: What is it Worth to You?

Lesson 3-1.1 What is it Worth to You?

Today we'll be discussing the concept of price. What is price really? What factors are
important when setting a price? We'll also examine the consumer psychology behind
pricing strategies. Then finally, we will review the steps involved in setting a price.

How much is this watch worth to you?

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It is a, forgive me as I say this, a Vacheron Constantin Patrimony watch. The Swiss

watchmaking company was established in 1955 by Jean-Marc Vacheron. They
manufacture just 20,000 watches a year, 20,000. The company's motto since inception
has been, do better if possible, and it is always possible. Again, how much is this
Patrimony gold case watch worth to you? It has an 18 carats rules gold case and gold
hands, scratch resistance via crystal, and a black alligator strap. This watch retails for
$282,000, 282K. Was it worth that much to you? To me, it wasn't even with anywhere
near that amount. What about this? A tour for two of the Emirates Stadium, home of the
Arsenal, great, great soccer team or football as we call it in Trinidad.

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On this tour, you get two tickets, two guidebooks, and your tour guide is an ex-Arsenal
player. In my case, his name was Lee Dixon. How much is this worth to you? Well, this
was very well priced at a £110.

To me, it's with so much more than that. I would have paid £200 for that specific tour. If
the tour guide were one of the best players to ever play for Arsenal, the legendary
forward Thierry Henry, I would have paid up to £400. What is that tour worth to you? I'm

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sure it might be worth a lot. I actually did complete the tour and paid the going rate of
£110. But as I said, it was worth so much more to me, go Gunners.

Segway is a great study in how price should reflect value. Famous venture capitalist
John Dewey said that Segway sales might hit one billion dollars as fast as any company
in history. The company spent about $100 million developing the product.

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Segway's introductory price was about $5,000. What segway did not understand was at
its price point did not reflect the value that potential consumers placed on the product.
Consumers valued it at much less than $5,000. This was a contributing factor to the
poor sales for this device.

What is price? Very narrowly, it is the amount of money that you pay in exchange for a
product or service. But more broadly, it is what the sum total of the value of all of the

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benefits provided by the product or service. How much is that worth to you? There are
many synonyms for price, including fee, honorarium, wage, fare. But these terms all
mean an amount that you're willing to exchange for something that you value. Let's see
where price fits in with the marketing process.

A firm's marketing efforts are directed toward creating value for its chosen customers.
Understanding customers' wants and needs is a foundation for building this value. In
turn, capturing that value falls to the marketing mix.

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The four Ps. Developing a product that satisfies those wants and needs. Designing a
promotion program that conveys the value of that product to the customers. Choosing a
distribution program that the place that makes that product readily available. Finally,
designing a pricing strategy that simultaneously creates a customer's incentive to buy
that product, and the firm's incentive to sell the product. The first three of these
marketing mix variables represent cost to the firm. Pricing's role in the marketing mix is
to tap into the value created and generate revenue. This revenue helps to fund the
firm's current value creation activities, support research that would lead to future value
creation, and also generates a profit from the firm's activities.

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The job of the fourth P, price, is to determine how the value that has been created can
be divided between the customer by providing them with an incentive to buy the
product, and the organization by covering the cost associated with this value creation
effort, and then generating profit. There are two very general approaches to how firms
view price; The first is by examining cost of production.

This is known as cost-plus pricing.

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In cost-plus pricing, the company first determines its break-even price for the product.
This is done by calculating all of the costs involved in production, marketing, and
distribution of the product. Then a mock-up is set for each unit based on the profit the
company needs to make and it's sales objectives.

Why do companies use cost-plus pricing? It is far easier to determine cost than to
estimate customer value, so it is a quick and dirty method to pricing products. Cost-plus

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is used to price large development projects, particularly in government contracts.
Another area that applies cost-plus pricing is services, particularly those provided to
federal and state governments by large and small businesses alike. Cost-plus pricing is
commonly used in processing credit card transactions as well.

A pricing system which is called Interchange Plus, adds a merchant service providers
fee to the rate charged by the credit card provider for each transaction. One problem
with cost-plus pricing is that it does not take into account the price of competing
products. If a competing product is selling for less, cost-plus may not be a very good
strategy to use. More importantly though, cost-plus pricing ignores what the product is
worth to the buyer. Buyers may be willing to pay more for some products. Ultimately, a
cost-plus strategy may not be responsive to changes in the market and can certainly be
an obstacle to long-term success.

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Price isn't just about recovering costs though, it's about extracting the value that
customers place on the product. But in doing so, the firm incentivizes a customer to
purchase a product by not extracting the maximum value that they have estimated the
benefits to be worth to the customer. Effective pricing will result in very accurate
estimation of the value of these benefits to the customer. In addition to customer's
perceived value, companies who pursue value-based pricing must also be cognizant,
they must be aware of competitors prices, and the intensity of competition as measured
by potential competitive response to price changes.

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Firms have difficulty extracting their products true value from customers. Two
researchers, Wiesel and Hunter Hubel stated that, even though companies were aware
of the importance of a customer value-based pricing approach, this was difficult to
pursue since effective implementation required deep structural changes in the
organization. While the design and implementation of a true value-based pricing
approach requires a commitment to organizational change, the returns from that effort
are great. Researchers have found that companies that adopted a value-based pricing
strategy, and built the organizational capabilities to implement the strategy, earned 24
percent higher profits than industry average.

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These are the different components of this value-based pricing approach. Let's start
with the true economic value. This is a value that a fully informed buyer would or should
ascribe to the product. Note that the customer's needs and preferences are important
here. This value comprises of the cost of the next best available product that satisfies
the customer's need, plus how much the consumer values the relative advantage
provided by the product in question, how much is the difference in performance worth to
the customer.

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While true economic value represents what a fully informed a rational consumer should
be willing to pay for a product. In reality, bars' willingness to pay is governed by the
value she or he perceives in the new product. Generally, perceived value is less than
true economic value or TEV. Why? Perhaps a potential buyer is unaware of all of the
relative benefits of the new product. The degree to which perceived value approaches
true economic value can often be influenced by the level and quality of internal and
external factors, including marketing efforts that impact the customer. Ideally, an
organization's marketing efforts should transform an uninformed customer who isn't fully
aware of the benefits of the product into a fully informed buyer. The result is that the
buyer's perceived value will now be closer to the product's true economic value. Think
of it.

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The difference between the cost of goods sold and the product price, in This instance, is
the incentive for the firm to sell their product to that specific customer segment. Then
the difference between the product price and the customer's perceived value is what
incentivises the consumer to purchase. To that consumer, he's getting value for money,
so to speak. He's paying less for the good than what it is worth to him. These elements
are major considerations when setting that final price.

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Let's dive a little deeper into true economic value and discuss an example. True
economic value is the cost of the next best alternative plus the value of any additional
benefits derived by using one product over the other.

I'm a frequent flier with American Airlines and I know have been granted goal status for
life based on all the models I've flown, regardless of if I travel annually or not.

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Let's think of it. If I travel from Chicago to Puerto Spain, Trinidad via United, the FA
$760 on United Airlines. Since I don't have any special status with United, I'd have to
pay $65 in baggage fees for a total of $833. But what about the additional benefits of
flying on American Airlines?

First off, I get TSA pre-check, and that allows me to move through airport security much
faster. That is worth about $200 to me.

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I get upgrades when space is available. That is worth about $400 to me. It could be
more depending on the length of the trip. For trips over four hours, I value first-class
seating much more than that $400.

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Then I get frequent flier miles, multiply by some variable, giving my frequent flier status.
This could be used for future flights. This would be worth about $300 for This Trinidad
trip, to me, that is.

So what is the true economic value of This trip to me? About $1,733. This is a cost of
the trip on American? No, it's not. The cost to me was $860. For me, I feel like I'm
getting a really good deal here, value for money. Note, if I did not have frequent flight

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status, the trip would be with much less to me given the fact that I would not accrue all
These additional benefits and my true economic value would be much lower.

Consumer perceived value is based on the benefits about which consumers are aware.
Marketers must ensure that consumers are fully informed of the benefits to be derived
from using the product and that consumer is assigned the appropriate value to These
benefits. In my case, I'm aware of what the marginal cost if I had to buy them. I'm also
aware of the price of a first-class seat. I've discounted This somewhat since the first leg
of my trip, the first class seat was not so important to me. But for the second leg, from
Miami to Trinidad, given the length of the flight, it becomes much more important.

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Lesson 3-2: Customized Pricing Strategy

Lesson 3-2.1 Customized Pricing Strategy

Understanding customer's perceived value is truly the path to long-term profitability.

Now, companies should maximize profit if they are able to charge different customer
segments as close to their perceived value as possible. After a firm attempts to develop
a fully informed consumer regarding the benefits that they provide, then several
segments of the market might attach different value to some benefits compared to
others.

The firm should offer different variations of the product or sell the same product, but
offer different prices at different times in order to extract as much of the value as
possible.

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Airlines do this all the time by offering different benefits, different classes of customers,
for example, business versus economy class. Also you pay more for airline ticket the
closer to the time of your departure.

What factors impact pricing decisions? This can be both internal to the firm or external
and being dictated by the environment. Internal factors such as the marketing mix and
objectives, external factors such as the nature of demand and type of competition that

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exists in the marketplace. Let us examine these. As we discussed earlier, the firm's
marketing efforts must be focused on informing and convincing the customer of the
benefits of the product.

The more informed the customer is, the greater value they'll place on consuming the
product.

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Perceived value, in that case, moves closer to true economic value.

External factors include the market and the nature of demand and competition. Social
concerns and also government regulation are considered external factors that impact
price as well. Let's examine the market and the native demand in some more detail.
Now, the firm's ability to set price is impacted to a large extent by the type of market in
which it operates.

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In different markets, two factors that impact the final price are the relative power of
buyers and sellers and the availability of appropriate substitutes. There are four basic
types of markets, and the relative power varies in each of these markets. The markets
are: pure competition, sometimes known as perfect competition, monopoly,
monopolistic competition, and oligopolistic competition. Let's talk about monopolies first.

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A monopoly is a market in which a single seller sells a unique product to the market.
There is no competition. The firm is the sole seller of a specific good with no close
substitutes. What can lead to a company maintaining monopoly? Factors like
government licensing, ownership of specific resources, copyright and patent, and very
high startup costs make an entity a single seller of goods. All of these factors restrict the
entry of other sellers into the market. Monopolies also possess some information that is
not known to other sellers.

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Characteristics associated with a monopoly market make the single seller, the market
controller, as well as a price setter. They enjoy the power of setting the price for their
goods. Since the company has most of the power, they're able to charge prices close to
what the estimate to be the true economic value, regardless of customer perceived
value.

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Historically, electric power companies have had monopolies in specific localities. With
the regulation of the electricity industry, this has changed somewhat and these markets
are more like oligopolies, and we'll talk about that pretty soon.

The Sherman Antitrust Act was established to prevent monopolies in the USA. This act
goes back to 1890, but that doesn't mean there aren't still companies out there with way
too much power and market share. The law's intended to prohibit anti-competitive

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business practices and protect the public from the failure of the market. It required the
federal government to step in when necessary. The term monopoly suggests complete
control of an entire supply of goods or services in a certain area of the market.
Ultimately, what constitutes a true monopoly is determined by the Federal
Communications Commission and other regulatory bodies like that. But there are plenty
of companies that most would agree have too much power.

The world's leading manufacturer of zippers is known as YKK. That's an aim of the
company. It's a Japanese company that goes back to 1934. YKK makes more than 7
billion zippers every year, over 50 percent of all of the zippers on the planet. There's a
good chance you're wearing a YKK product right now. Don't go checking. Trust me.

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Also, more than 80 percent of IRA brands are designed and retailed by a company
known as Luxottica. What's more, the company controls both high-end brands like Ray-
Ban and the discount sunglasses that you pick up at stores like Target and Walmart. In
a 2012, 60 Minutes special and 60 Minutes is a television news program in the USA. It
was suggested that Luxottica uses its dominant position to artificially jack up prices on
designer sunglasses that are made in the same facility as the cheaper brands. In other
words, they were acting as a monopoly, even though they weren't a true monopoly. The
next type of market is an oligopoly.

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Oligopoly is a market structure in which a small number firms has the large majority of
the market share and oligopoly is similar to monopoly, except that rather than one firm,
two or more firms dominate the market. There's no precise upper limit to the number of
firms in an oligopoly. But the number must be low enough that the actions of one firm
significantly impacts or influences the others. With power shared amongst such few
sellers, potential competitive response limits the ability of individual sellers to set price.

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The airline industry is a perfect example of an oligopoly. Traditionally think of it, if one
airline has a fare sale and charges lower prices for tickets on a specific route, say
Chicago to Miami, then other airlines must follow. The cell phone industry in the USA is
also an example of an oligopoly. These markets have not received the same amount of
oversight as monopolies, and this is certainly not in the consumer's best interest.

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In an article in The New Yorker, Tim was quoted as saying, the US has nearly
abandoned scrutiny of oligopoly behavior, leaving consumers undefended. What
prompted the statement?

T-mobile had recently broken with longstanding industry norms and had abandoned
termination fees, overcharges, and other practices that negatively impacted consumers.
Although T-Mobile's decision was welcome news for consumers doesn't change the fact

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that these practices had remained for years and that they remain in place now for the
vast majority of Americans who are still trapped in contracts with other companies like
Verizon and AT&T. It sheds light on a longstanding problem with how we think about
and treat anti-competitive practices in the United States. Our current approach focused
near exclusively on monopoly, and this fails to address the serious problems posed by
highly concentrated industries. If a monopolist did what the wireless carriers did as a
group, neither the public nor the government will stand for it. Scrutiny and regulation of
monopolists is well-established. Just ask Microsoft or the old AT&T. But when three or
four firms pursue identical practices, we say that the market is competitive and
everything is fine. There is in fact, no major difference between a monopoly and a group
of firms operating an oligopoly, but working together to set price and establish business
practices. As was the case with mobile carriers in the USA.

Let's move on to another form of market. Many small businesses operate under
conditions of monopolistic competition, including independently owned and operated
stores and restaurants. In the case of restaurants, each one offers something different
and possesses an element of uniqueness. But all essentially competing for the same
customers. They must price their products competitively. More of the power in this
relationship resides in the hands of the customer. Each firm makes independent
decisions about price and output based on its product, its market, and its cost of
production. Knowledge is widely spread between participants, but it is unlikely to be
perfect.

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For example, diners can review all the menus available from restaurants in a town
before they make their choice. Once inside the restaurant that can view the menu again
before ordering. However, they cannot fully appreciate the restaurant or the meal until
after they have dined. The entrepreneur has a more significant role than in firms that are
perfectly competitive because of the increased risk associated with decision-making.
There's freedom to enter or leave the market, as there are no major barriers to entry or
exit. A central feature of monopolistic competition is that products are differentiated in
order for firms to compete for customers.

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Lesson 3-3: Consumer Psychology and Pricing

Lesson 3-3.1 Consumer Psychology and Pricing

Consumers typically maintain reference prices for products. These are prices that
established the amount that customers consider reasonable and fair. These are typically

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based on prices they've seen or paid in the past. There are two kinds of reference
prices.

Internal reference prices, these expected prices based on the consumer's experience.
These are sometimes lower than actual retail prices. Therefore, consumers may
experience sticker shock when shopping for certain products. For products that
consumers buy more frequently than others, the range of internal reference prices is
much narrower.

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External reference prices or prices supplied by a marketer as a means of influencing a

consumer's price expectations.

You might see a sign in a store that reads regularly or usually priced at 54.95, now
29.95, that's an external reference price.

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How can reference prices be used? First, companies can set very high external
reference prices as the typical price. It may seem that setting an unbelievably high
external reference price would suggest that the consumer, that the retailer is being
misleading.

However, research has shown that when retailers set very high external reference
prices, this actually leads the consumers increasing the internal reference prices.

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Imagine that. Companies could then offer the product on sale and customers would find
this price, although still somewhat high, to be reasonable. Second, some stores use a
competitive reference price strategy, what would competitors charge?

You would see tags including selling for $75 at a discount store that would read, "Sold
for 125 at Macy's." Research shows in addition to the customer's experience, the sale
context, that is the prices of competing brands, influences consumer's internal reference
prices.

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Consumers usually infer that price and quality are correlated, so the higher the price,
the higher the assumed quality of a product. However, research has found that the
effect differs if a consumer is evaluating a product that is part of a single line of
products, or one that is from a brand that has multiple product lines. For multiline
products, price supplies independent information about quality. When products exist in a
structure where different quality levels exist under a single brand name, consumers
perceive an association between price and quality regardless of the nature of the brand
name.

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Think of Sony digital cameras. They manufacture many types of digital cameras and
they sell for as little as $119 to as much as four or $5,000 so consumers will make
quality inferences at different price levels. For brands that have a single-line product
strategy, you might expect consumers to judge quality from brand name and ignore
price since only one quality level exists for the brand. When brand names cannot low or
unknown quality, price has no effect. Charging a very high price on a new and unknown
brand will not lead to quality inferences.

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When brand name quality is high and known, however, price has a significant effect on
quality inferences. This is most likely the case since the price matches consumer's
expectations of the brand. However, as long as marketers offer multiple levels of quality
under a single brand name, they invite consumers to rely on price information even
though brand or point of purchase information may be available.

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Consumers are cognitive misers. They don't search for pricing information as much as
you think. We'll discuss this shortly. They use what's known as heuristics or shortcuts to
help make purchase decisions. In spite of the current information age, this occurs much
more frequently than you may think.

For example, signs such as semi-annual sale are used by consumers as information
about how much money they could save by shopping at a specific store. Just placing a

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sales sign next to specific items could temporarily increase demand by up to 50 percent.
Stores do not have to reduce prices greatly in order to benefit from consumer's use of
sale signs as [inaudible]. Traditionally, managers have believed that you need to
approach a certain threshold of some 15-20 percent discount before consumers will
respond significantly to sales.

More recent research though shows that a large segment of the population will
apparently respond to negligible or very small discounts. For example, if a product is
reducing price from $3.98 to $3.96, just half of one percent of a price cut, a large
number of consumers will purchase this product since they'll perceive it as a good deal.

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Anderson and Simester also found that for most items, people do not have accurate
price points they can recall at a moment's notice. But each of us probably knows some
benchmark prices, typically on items we buy frequently. Many customers for instance,
know the price of a 12 ounce can of Coke or the cost of admission to a movie. They can
distinguish expensive and inexpensive price levels for such signpost items without the
help of pricing cues. Research suggests that customers use the prices of signpost items
to form an overall impression of a store's prices. That impression then guides their
purchase of other items for which they have less price knowledge.

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For instance, when I visited the grocery store to buy some McCormick Caribbean jerk
seasoning, I didn't know if the price I was paying $3,99 was a reasonable price or not.
But I didn't know what would be a reasonable price for a bottle of Coca-Cola. I used that
as a signpost to tell me if I was paying a reasonable price for the seasoning and for
other goods that I was buying at the store.

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Additional research done by Anderson and Simester show that simply changing the last
number of a price to nine could increase demand regardless of whether this would
decrease or increase in price. This is because consumers use this as a sign that they're
getting a good deal. There's some question as to whether odd product prices, those
ending in nine, 95 or 99 actually increase sales across different countries. This effect
has been found in the US and Canada, but no effect was found in Germany and other
European countries, strange but true.

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When would you use price cues? When customers do not have accurate pricing
information, you could use sale signs and change prices to end with the number 9.
When they purchase items infrequently or they are new customers, then you can use
price cues as well. Additionally, if products vary over time or change seasonally. When
quality varies within a store, this can lead to consumers making price quality inferences.

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On the other hand, signpost items would be used when consumers have accurate
knowledge of the price of these signposts items, which would then allow them to make
inferences about the pricing structure within the store as I did with the seasoning.
Research has shown that consumers really do not have accurate pricing information at
all. Even when it is available, they don't search for it. In a study led by professors Peter
Dickson and Alan Sawyer, who worked with me at University of Florida. We said it just
with clipboards stood in supermarket aisles pretending to be stock takers.

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Just as a shop would place an item in a cart, a researcher would ask him or her the
price. About 47 percent of customers give an accurate answer, 47. Most
underestimated the price of the product and more than 20 percent did not even venture
a guess. They simply had no idea about the price. Additionally, most shoppers took very
little time to make a decision.

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Forty two percent took five seconds or fewer to make a decision and only 25 percent
took more than 15 seconds.

In addition, consumers could not recall special prices. These prices where they're
offered a lower price. Most believed that these prices were actually 10 percent lower on
average than the actual special price. What does this tell us? Consumers do not spend
time searching for price information.

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They rely on the retailer to provide them with information that the prices they are paying
are fair and this leaves them susceptible to the impact of pricing cues.

Retailers sometimes abuse this trust that consumers place in them. For example, in
December of 2016, the Los Angeles District Attorney sued four major retailers over
claims that they deliberately inflated the original price on some items, and this misled
customers into thinking they were getting a better deal.

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You know who those retailers were? JC Penney, Sears, Kohl's, and Macy's. Yes four
big retailers, and they falsely advertised high list or regular prices on merchandise that
was never actually for sale at that price. The lawsuits alleged that the misleading and
deceptive false price advertising scheme played a major role in the stores marketing
strategies and that the companies used false reference prices on thousands of
products. For instance, a lawsuit against Sears alleged advertiser front load washer with
a false original price of $1,179.99. But the retailer never offered the item for more than
$999 online in roughly six months after it was first made available online for purchase.
The claim against Macy's alleged misleadingly offered a cross pendant necklace at 75
percent off. Sounds great. The lawsuit claims the necklace was first made available to
purchase online in May for $30 with an original price of $120. However, it was never
priced above $30 in the five months that followed. According to the claim, California law
prohibits retailers from advertising a price of an item unless it has actually been on the
market at that price within the last three months or the date when it was being sold at
that price has made clear to shoppers. This allowed the district attorney to take this
stores to court and win.

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Lesson 3-4: Setting Price - The Impact of Demand and Elasticity

Lesson 3-4.1 Setting Price - The Impact of Demand and Elasticity

What are the steps that we should follow in setting price? We must first select the price
objective. Next, we must estimate cost. Since this will be the price floor, the lowest price
we could charge. We must also examine competitors' pricing. Then, determine the
pricing method ; value-based or cost-based. Then, select a final price.

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There are several different pricing objectives that a firm can select. For example, they
can pursue a path of profit maximization. Here the firm tries to extract as much of the
true economic value of the product out of the market. The prices charged would be high
relative to competing products, but taking the additional benefits provided in mind. Or, a
firm could pursue a product quality leadership objective. Tiffany Jewelry Stores are well-
known for the beautiful engagement rings.

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You could buy a Tiffany engagement ring for $10,000, to as much as a million dollars.
Tiffany charges very high prices and never puts its products on sale. This maintains its
position as a product quality leader. When establishing a new price, companies must
decide if they want to engage in penetration pricing or market skimming. Each of these
strategies has different goals and also different challenges.

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The skimming strategy entails offering a product first at a relatively high price. Consider,
for example, what we can do when there's a large degree of price elasticity. That means
when consumers are willing to pay more than others. These consumers would be willing
to pay a lot of money to get a new product quickly, while others are not willing to pay as
much. This often happens, for example, with new tech devices, so-called wearables,
such as the Apple Watch for instance.

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This was first introduced at more than $300. Now, those same first-generation watches
were available one-year later at about $199. Like many tech companies trying to recoup
research and development costs, Apple charge the first segment to purchase these
watches more money than they did subsequent buyers. Then they lower the price
enough so that the next segment would buy more of it. This process will continue until
all segments that can be profitably served have bought the device. Penetration pricing
occurs when the manufacturer sets an initial lower price. This is useful when a firm
wishes to establish a large market share early on. It may be useful to develop a market
for accessories to products. For example, a manufacturer of a new computer system
may want to increase sales volume in order to encourage the development of
compatible software so that the computer brand will become more competitively
attractive.

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Both strategies involve some level of risk. The main risk to skimming, is the attraction of
aggressive competitors who see an opportunity to make large profits by entering the
market. Penetration pricing, in contrast, gambles on the possibility that sales volume will
in fact increase with lower prices.

The next step in the process is determining the level of potential demand for a product.
High-demand, of course, could mean the possibility of charging higher prices. Lower

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demand, lower prices. The nature of demand is also important. The more elastic the
demand, the less opportunity to raise prices. We'll discuss that pretty soon. At different
price levels, consumers will demand different quantities of a good. This is illustrated in
what's known as the demand curve.

The demand curve is a graphical representation of the relationship between the price of
a good or service and the quantity demanded for a given period of time.

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In a typical representation, the price will appear on the left vertical axis, the quantity
demanded on the horizontal axis. The demand curve will move downward from left to
right, which illustrates what's known as the law of demand. As the price of a given
commodity increases, the quantity demanded decreases, all other things being equal, or
as they say in economics, ceteris paribus. For example, if the price of taking a taxi ride
rises, consumers will have an incentive to travel by taxi less. They'll either walk, use
their own transportation or take substitutes like Uber. Therefore, the total quantity of taxi
rides consumers demand will fall. Gibson Guitars realize that charging lower prices did
not lead to higher quantity demanded, so this manufacturer of high-quality guitars had to
increase prices and demand increased at the same time.

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This resulted in an upward sloping demand curve, which can occur with certain prestige
goods, higher price leads to higher demand.

The degree to which the quantity demanded changes with respect to price is called the
elasticity of demand. Price elasticity of demand is a measure of the relationship
between a change in quantity demanded of a particular good and the change of its

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price. Price elasticity is a term in economics often used when discussing price
sensitivity.

If a small change in price is accompanied by a larger change in quantity demanded, the

product is said to be elastic or responsive to price changes.

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Conversely, a product is inelastic if a large change in price is accompanied by a

subsequent smaller amount of change in quantity demanded. Let's look at the
relationship between price elasticity and total revenue.

If the demand is price inelastic, then an increase in price would lead to an increase in
total revenue.

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However, if demand is price elastic, then even a small increase in price could lead to a
drop or decrease in total revenue. When will consumers be less sensitive to price
changes?

When the product is of very high-quality, when there are few substitutes, or if the price
paid is small, relative to income. Increasing the price of a bottle of Coca-Cola from 50 to
55 cents might not have an appreciable impact on quantity demanded.

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Next step in setting price, we must estimate the cost. This helps us to set the base level
for price charge. Any price lower than the cost of goods sold would lead to a loss. Note
that as companies gain experience in manufacturing a certain good, the cost actually
decrease. This means that the company has greater latitude in terms of reducing price
to capital market share.

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The next step in setting price is to analyze competitors prices. Why should we analyze
competitors prices? This helps us establish reference prices. It determines what our
potential competitive response could be, because competitors who compete on price,
leave little room for us to lower our prices. Their response would be to lower their prices
even more.

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The next step in the process is to select the pricing method. We earlier spoke about
using cost-based versus value-based pricing, including why some companies still prefer
to use cost-based pricing. There is also another type of pricing method called sealed-bid
pricing, which is used for government contracts. When companies in this case, they
submit a sealed bid and hopefully, the lowest bid with an acceptable quality outcome
would win.

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Now, we arrive at the final price, which hopefully captures the value assigned to the
product by the consumer.

Here's a question for all of you. Is the right price a fair price? Take a position.

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Prices should reflect the value that consumers are willing to pay, or prices should
primarily just reflect the cost involved in making a product? Which is better? Which
position would you take and why?

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Lesson 3-5: Professor Noel's Board Walk: New Product Pricing Strategy

Lesson 3-5.1 Professor Noel's Board Walk: New Product Pricing Strategy

The streaming entertainment market is one of the most difficult spaces for new
companies to enter. Established brands like Netflix and Hulu have serious brand
recognition and a loyal customer base. When Disney Plus decided to launch its own
streaming platform at the end of 2019. It decided that entering the market at a very low
price was its best shot. Disney's initial offering of $6.99 was cheaper than Netflix but
was well under its customers willingness to pay.

At the time, consumers were willing to pay $10.89 for Netflix and up to $15.23 for a
Disney subscription service. But the streaming market was highly competitive at the
time with many providers; Netflix, Hulu, Amazon Prime my favorite, YouTube TV, and
several televisions, studios were getting into the market as well. CBS with Paramount
Plus and NBC with Peacock. Instead of making people choose which streaming service
to go with, Disney Plus priced itself aggressively low to entice new customers to buy
their service while also keeping Netflix, which was a major streaming provider at the
time. If it had priced itself closer to Netflix at launch, it would have increased its average
revenue per acquisition, it's ARPA but would not have been able to build its customer
base as fast.

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Disney Plus used the pricing strategy that is used by some companies when They
launch new products known as penetration pricing. Entering a market is noisy task.
Especially, when there's an established brand industry market like Netflix. Netflix of
course had great brand recognition and the customer base was very, very well-
established. Despite having the Disney brand name going after this market with a new
product or service regardless of whether it's better than what's currently available is a
Herculean task. Especially, since Disney was not known for streaming. I mean, who
wants to watch cartoons and kids movies all day. But Disney did have a very
programming schedule, not just kid shows. Penetration pricing helped the service gain a
foothold in the market. Penetration pricing is an acquisition strategy for companies that
are trying to gain a foothold in highly competitive markets. These companies penetrate
the market by offering a lower price than their competitors, enticing customers away
from their current provider to gain market share.

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Given this discussion, the benefits of penetration pricing should be obvious. First, a
penetration pricing strategy makes it easier to enter a highly competitive market. It's
easier to do so, especially one with well-known established brands. By pricing below
what current customers expect to pay, companies can increase awareness of their
product or service early on and attract customers faster. Instead of having to compete
with established brand solely on the value their product service provides, this
penetration strategy helps companies acquire new customers through price alone.
Second, this strategy helps you gain customers very quickly. This is usually at the
expense of existing firms in the market. Remember that this strategy does come with
drawbacks. It makes it difficult to build loyalty with your customer base. You must work
harder to ensure that you build a relationship quickly with your customers, one that you
can develop and maintain over time. This can be done through regular communication
with customers regarding their preferences and a frequent update in product design and
delivery. Another negative is that this strategy requires you to raise prices sooner rather
than later to grow the business and make it more profitable. However, increasing prices
can be difficult given customer's expectations after the initial low-price. Several
customers who jump ship to go for the cheaper offering are more likely to do so again
as prices increase. This pricing strategy does not work for all goods, especially luxury
goods or innovations. Selling high-quality items at a lower price risks diluting the brand.
When launching These types of products, companies use a different pricing strategy.

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They use price or market skimming. Price skimming is when you launch a product with
a higher than usual markup and then incrementally lower the price over time. As we
said, typically price skimming applies to new innovative products. As time passes and
the product becomes less novel and more accessible, the price steadily declines. The
name skimming comes from the idea of looking at all potential buyers like a stack.
Those at the top are willing to pay the most, while those at the bottom want to pay the
least. Once all who are willing to pay at the high price have made their purchase, you
skim them off the top of the stack and adjust the price to what the next group of buyers
are willing to pay. Price skimming. The window of opportunity for a skimming pricing
strategy isn't indefinite though, because your business will eventually run out of
customers who value your product enough to pay the very high prices for it. However, if
you price your offering strategically, you'll be able to leverage their enthusiasm to
maximize your profit for a time. DVD players are a good example of this pricing strategy.
When DVD players first hit the market in the late 90s, some of you might remember this,
they could cost up to $1,000. Now, if you do a quick search on Amazon, you'll see that a
new DVD player will set you back a mere $33 or so if you can find one at all. In the late
90s, this was an innovation that technophiles wanted to have and they certainly paid a
lot for it. Even before streaming became a thing, DVD player prices started to fall given
softening demand at the very high prices they were charging.

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What are the benefits of price skimming? First, it can maximize initial revenue.
Companies that employ price skimming tactics do so to recoup investments early and
sell as many products as possible at the highest price point the product is likely ever to
see. This immediately boosts both revenue and profit which the company can utilize to
expand marketing and distribution, as well as cover R&D costs, which is very important.
Second, this type of strategy can help create buzz. Price skimming works well when
paired with a slow roll-out strategy. When price skimming is their tactic, companies
know that their market share will be small at the start. However, as the price drops, the
anticipation to access the product at a more affordable price often rises. For some
products, consumers and businesses eagerly await the opportunity to purchase it when
the price is right, especially when they can't afford it at first. I fall in that category. It's a
classic example of you always want what you can't have. But with skimming, you may
be able to have it a few months down the line. What are the drawbacks of a skimming
strategy? First, it can't last forever. I know, but it can't. When a rival business sees how
much money can be made on a product, they'll oftentimes swoop in with a similar
product at a lower price. This leaves you with two options: leave your price the same
and hope that its prestige and quality will keep your sales unaffected or change your
price to a lower price point earlier than planned just to stay competitive. Let's also
remember that even without competition, you'll likely hit a limit of people you can
feasibly sell to at each price point. Eventually, price skimming dictates you will have to
lower your prices. Keep that in mind when making of sales forecast. Next, you can
frustrate early buyers. Technophiles who are eager to get the new big thing or those
who front a larger than needed sum of money to buy your product might be a tad
disappointed, or worse, even angry when they see that the price of what they purchased

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a month ago dropped 20 percent overnight. The counter to this argument, of course, is
that the price skimming strategy is not exactly a secret in many industries, especially
tech. While early adopters may be annoyed when the price goes down, they tend to
know what they're getting into and they're usually willing to pay more to get their hands
on the product first. Both of these pricing strategies have pros and cons. Really, it
depends on the type of product you sell, your brand image, and your strategic goals. Do
you want to attract new customers quickly or do you want to recoup your investment?
As for Disney Plus, how are they doing now? Well, Netflix still commands the field of
battle in the streaming wars, but Walt Disney is making significant inroads with its
Disney Plus service and is beginning to take a toll on the industry giant. Data from
Nielsen for 2020 shows that Netflix holds a commanding 20 percent share of the
streaming market compared to Disney Plus with just 6 percent. In 2019, however,
Netflix had a 31 percent share, suggesting most of the gains Disney has made have
come from Netflix. So penetration pricing has worked for Disney. I know, I'm a
subscriber.

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