Summary I. Economic and Behavioral Foundations of Pricing II. Innovative Pricing Concepts and Tools III. Internet Pricing Models Mar 17

Punch-line Factors affect pricing strategy Costs, customer, competition, constraints Flawed pricing strategies Cost-plus pricing Customer-based pricing Competition-driven pricing What are the steps for profitable pricing? Set your strategic objective and consider costs, customer, competition, and constraints simultaneously Mar 17

Differentiation value EVC Analysis Positive Differentiation Value Negative Differentiation value Differentiation Value Superior performance Better reliability Additional features Lower maintenance cost Faster service Reference Values EVC Reference Value Mar 17

Punch-line EVC = Reference value + Differentiation value EVC is the maximum willingness-to-pay, not actual willingness-to-pay Always examine and enhance your product, place, and promotion strategies to attain EVC Pay attention to factors that influence actual willingness to pay Mar 17

Factors Affecting Actual Willingness to Pay (1) Substitutes awareness effect: Buyers are more price sensitive the higher the price difference between this product and the perceived substitute Difficult comparison effect: buyers are less price sensitive the more difficult to evaluate competing offers Switching cost effect: Buyers are less price sensitive the greater the sunk investment they have made in anticipation of its continued use. Price-quality effect: Buyers are less price sensitive to the extent that higher price signals higher quality. (Image and exclusive products or products without quality cues) Mar 17

Factors Affecting Actual Willingness to Pay (2) Unique Value effect: Buyers are less price sensitive the more they value any unique attributes End-benefit effect: When purchasing supplies, buyers are more price sensitive (1) the more price sensitive the demand for the end product; (2) the larger share of the total cost of the end product Expenditure effect: Buyers are more price sensitive the higher the total expenditure, both in dollar terms and as a percentage of income Shared-cost effect: Buyers are less price sensitive the smaller the portion of the price they actually pay Mar 17

Factors Affecting Actual Willingness to Pay (3) Fairness effect: Buyers are more price sensitive when it is outside the range that they perceive as “fair” Inventory effect: Buyers are more price sensitive in the short run when they can hold inventories and believe that the current price is temporarily lower or higher than it will be in the future Mar 17

Course Outline Mar 17

Unaffected Contribution Incremental Break-even Analysis (when fixed & variable costs are unchanged) Contribution Before Price Change Contribution After Price Change Contribution Lost Due to Price (c) P1 P2 Contribution (a) CM1 Unaffected Contribution (a) Contribution Gained Due to Volume (f) VC Additional Variable Costs (e) Variable costs (b) Variable costs (b) Sales Volume Sales Volume ?? Sales Volume S1 S1 Mar 17

Punch-line Only relevant costs (i.e., incremental & avoidable costs) are relevant to pricing decision. General incremental break-even formula Break-even curve Actual sales sensitivity analysis Break-even curve and actual sales sensitivity analysis are the tools for evaluating pricing decision taking into account Costs, Customers, and Competitors Mar 17

Lessons Learned Firms that recognize the sensitivity of the overall market do perform better Even better: if you realize your competitors are using mechanical pricing rules, you can optimize the market for yourself Explanations offered by managers after the 1989 beer price war: We think “they started it” We don’t know the market’s price elasticity Doing well means doing better than the competitor Mar 17

Punch-line Effective pricing depends on an accurate understanding of the relative importance of Your decisions Your competitors The market The importance of “knowing your competitors” Mar 17

Punch-line Price war is often a “negative-sum” game, it hurts the industry in the long-run Three competitive principles: 1) know your opponents and yourselves, 2) use strategic foresight, 3) differentiate between one-time and repeated strategic interactions Decision on initiating or matching price cut should be made based on long-term consequence (i.e., the final outcome in the new world) Mar 17

Course Outline Mar 17

Value/Cost Inputs to Pricing (11 ½-Inch Pads) Value from Fazio Data: $1,272 Value from Colerick Data: $894 Price to Yield 100% Contribution Margin: $54.56 Total Variable Cost: $27.28 Mar 17

Pricing Scorecard Questionnaire Mar 17

Punch-line Skimming versus penetration pricing Pricing scorecard The role of pricing structure Product and cost advantages (both internal and external) Mar 17

Capacitor Market – Incentives to Price Cut COMMODITY PRODUCT OVERCAPACITY PRICE KEY BUYING DETERMINANT ANY BUSINESS PRICED ABOVE DIRECT COST WORTHWHILE INCENTIVE TO CUT PRICE LARGE GAINS TO SINGLE PRICE CUT LARGE INDIVIDUAL TRANSACTIONS BUYER CONCENTRATION PROCUREMENT POLICY Mar 17

Punch-line Manage reference price over time Apply Weber-Fechner Law to announce price increase or decrease accordingly Segregate gains and integrate losses Publicize your high fixed cost or cost increase Use odd pricing to signal low price Mar 17

Why is Conjoint Analysis so Sexy as a Consulting Tool? 3Cs Customer Competitor Company 2 Ps Product (EVC Analysis) Price (demand estimation) Data-driven Decision-driven Mar 17

Course Outline Mar 17

Two Problems with Single Price Strategy Leave money on the table Some customers are willing to pay more Pass-up Profit Some potential customers were not served even though the firm could have served them at prices above the variable cost Mar 17

Single Price Sales Volume $ $2000 Profit 380 Passed-up Profit Money Left on Table 25% 190 50% 25% $ $100 $2000 $3900 Mar 17

Customized Pricing Sales Volume $ $1367 $2633 Profit (first-class) Profit (Economy) 380 Passed-up Profit Money Left on Table 254 (Need to build segmentation fences) 127 $ $100 $1367 $2633 $3900 Mar 17

Punch-line Price customization significantly increases profit. It aims to reduce money left on the table passed-up profit Ways of price customization By consumer: get buyers to act voluntarily By location: prevent arbitrage By time of purchase: manage yield and redistribute usage By product: understand consumers By volume: do not hinder competition Mar 17

An Example: Cellular Phone Service HV USERS (Professional Use) LV USERS (Personal Use) 11 Mar 17 11

Lessons Nonlinear pricing can work whether customers are the same or different. It is more efficient when customers are the same. The more complex forms of nonlinear pricing extract higher value but are more difficult to implement Non-linear pricing has the great advantage of self-selection by the customers Mar 17

Key Lessons: Serving Single Segment Only If consumers are similar in their usage intensity in a single segment, the optimal pricing strategy involves setting a usage based fee equaling marginal cost (in this case it is zero). The fixed fee equals to the consumer surplus of the segment served. Note that here the two-part tariff enables the firm to extract all consumer surplus. Mar 17

Key Learning Points If we are serving multiple segments with different usage intensities, the optimal pricing strategy involves setting a usage based fee higher than marginal cost. The fixed fee in this case equals the consumer surplus of the personal (low-valuation) user. Mar 17

Optimal Menu of Plans HV Users (Professional Users) Monthly Fixed Fee $ 54 Airtime Charges $ 0 per hour Demand 12 LV Users (Personal Users) Monthly Access Fee $ 32 Airtime Charges $ 2 per hour Demand 8 Note that Professional Users is indifferent between the two payment plans Total Profits = 100 x $54 + 100 x ($32 + $2 x 8) = $10.2 K Mar 17

Product Line Interdependencies Image of Brand/Company Image of Product Line +/- Complements + Demand for Product B Demand for Product A Price of Product A - Substitutes +/- Traffic at Outlet Mar 17

Punch-line When making pricing decisions, we should take into account the inter-relationships among products. Complementary relations lead to product-line prices that are lower than optimal isolated prices. Substitutive relations lead to product-line prices that are higher than the optimal isolated prices at the upper end of the price scale. In evaluating the profitability of a price change (with demand interdependencies), we simply need to modify the new contribution margin in the break-even formula in order to obtain the revised break-even sales volume Mar 17

Course Outline Mar 17

Biopure: Punch-line A case on product line pricing: questioning the ability of a firm to effectively price similar products at different prices to different consumers. Market potential: animal market is larger and human market is smaller than expected. Reference price: the prices of many other products other than Oxyglobin can serve as reference prices. Mar 17

Multi-version Case: “Student” and “Industrial” Mar 17

Punch-line “Versioning” strategy can be highly profitable for the firm. Price the premium version low enough to make sure that high-end customers willingly choose it. Beware of lumpiness in demand curve  they can lead to local optima in profit function. Mar 17

Punch-line Price bundling can work when willingness to pays for component products are negatively correlated. Bundling can improve profit because unexploited customer surplus (“money left on the table”) from one product is transferred to a second product. Price bundling can appear in the form of pure and mixed bundling. The distribution of WTPs determines which form is superior. Mar 17

Basic Motivations 1. Trial 2. Purchase Not Time Acceleration driven Known 3. Potential Build-up 4. Peak Load Time driven 5. Peak Load with Demand Shift Information About Demand 6. Demand probing Initially Limited 7. Yield Management Mar 17

3. Potential Buildup of Low-WTP Customers Mr. Coffee coffee maker (unit variable cost = $32) The goal is to charge maximum WTP of a growing proportion of the market that would buy at regular price Suppose customers for a coffee maker are of two types, one valuing the product at $60 and the other at $40. Each group has a “birth” rate of 100 per month 1 2 3 4 5 6 Time Price $60 $40 Mar 17

3. Potential Buildup of Low-WTP Customers Unit Variable Cost = $32 Month N($60) N($40) Contribution if P=$60 Contribution If P=$40 1 100 $2800 $1600 2 200 $2400 3 300 $3200 4 5 6 Mar 17

Punch-line Clearly understand the underlying motivation Design the time-customization plan based on the motivation Consider the potential negative consequences and long-term dynamic effects Mar 17