Copyright © 2001 by Harcourt, Inc. All rights reserved CHAPTER EIGHTEEN PRICE DETERMINATION Text by Profs. Gene Boone & David Kurtz Multimedia Presentation by Prof. Milton Pressley The University of New Orleans

Copyright © 2001 by Harcourt, Inc. All rights reserved CHAPTER OBJECTIVES Outline the legal constraints on pricing Identify the major categories of pricing objectives Explain the concept of price elasticity and its determinants List the practical problems involved in applying price theory concepts to actual pricing decisions Explain the major cost-plus approaches to price setting

Copyright © 2001 by Harcourt, Inc. All rights reserved CHAPTER OBJECTIVES List the major advantages and shortcomings of using breakeven analysis in pricing decisions Explain the superiority of modified breakeven analysis over the basic breakeven model and the role of yield management in pricing decisions Identify the major pricing challenges facing online and international marketers

Copyright © 2001 by Harcourt, Inc. All rights reserved IntroductionIntroduction Price: the exchange value of a good or service © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Legal Constraints On Pricing Federal legislation prohibiting price discrimination that is not based on a cost differential Also prohibits selling at unreasonably low prices to eliminate competition Robinson- Patman Act Unfair Trade Laws Fair Trade Laws © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Legal Constraints On Pricing State laws enacted in the 1930’s which require sellers to maintain minimum prices for comparable merchandise Designed to protect small stores and businesses from the predatory pricing practices of larger chain stores Robinson- Patman Act Unfair Trade Laws Fair Trade Laws © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Legal Constraints On Pricing Allow manufacturers to stipulate minimum prices for their products and force retailers to adhere to them Enable companies to establish and maintain product images Robinson- Patman Act Unfair Trade Laws Fair Trade Laws © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Figure 18.1: Protecting Image by Avoiding Price Discounting

Copyright © 2001 by Harcourt, Inc. All rights reserved California Avocados Legal Restrictions Result in Higher Prices for California Avocados Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-10 THE ROLE OF PRICE IN THE MARKETING MIX Prices, and the resulting sales, determine how much revenue a company receives Prices thus influence a firm’s profits Prices also influence the firm’s employment of the factors of production: Natural resources Capital Human Resources Entrepreneurship © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Table 18.1: Pricing Objectives ObjectivePurposeExample Profitability Objectives Profit Maximization Target Return Low introductory interest rates on credit cards with high standard rates after 6 months. Volume Objectives Sales Maximization Market Share Compaq’s low-priced PCs increase market share and sales of services. Competition Objectives Value PricingPrice wars among major airlines. Prestige Objectives Lifestyle Image High-priced luxury autos such as Ferrari and watches by Rolex. Not-for-Profit Objectives Profit Maximization Cost Recovery Market Incentives Market Suppression High prices for tobacco and alcohol to reduce consumption. Pricing Objectives

Copyright © 2001 by Harcourt, Inc. All rights reserved Pricing Objectives Profitability For-profit firms must set prices with profitability in mind Profit Maximization: point at which the additional revenue gained by increasing the price of a product equals the increase in total costs Target-Return Objectives: Short-run or long-run pricing objectives of achieving a specified return on either sales or investment © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Pricing Objectives Profitability Profit Maximization: point at which the additional revenue gained by increasing the price of a product equals the increase in total costs Target-Return Objectives: Short-run or long-run pricing objectives of achieving a specified return on either sales or investment © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Pricing Objectives Profitability Volume Sales maximization: A minimum profit level is set and firms seek to maximizes sales Market-share objectives: the goal set for controlling a portion of the market for a firm’s good or service © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Figure 18.2: Price as a Tool to Achieve Volume Objectives

Copyright © 2001 by Harcourt, Inc. All rights reserved Glad GladWare Containers Using Price to Achieve a Market Share Objective Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-17 Pricing Objectives Profitability Volume The Product Impact of Market Strategies (PIMS) Project: Research that discovered a strong positive relationship between a firm’s market share and its return on investment Firms with larger shares accumulate greater operating experience and lower overall costs relative to competitors with smaller market shares © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Figure 18.3: Clorox – Increasing Profitability through Product Quality and Market Share

Copyright © 2001 by Harcourt, Inc. All rights reserved Cesar Select Dinners Another Product That Attempts to Increase Profitability Through Product Quality and Market Share Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-20 Pricing Objectives Meeting Competition Seeks simply to meet competitor’s prices Value Pricing: Pricing strategy that emphasizes the benefits derived from a product in comparison to the price and quality levels of competing offerings Profitability Volume © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Figure 18.4: Ford Escort – Meeting Competition Objectives in Pricing

Copyright © 2001 by Harcourt, Inc. All rights reserved Dodge’s Neon: Another Example of Meeting Competition Objectives in Pricing Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-23 Kellogg’s Watched Market Share Drop Drastically Before It Began Implementing Strategies Based on Price & Value (Value Pricing) Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-24 Pricing Objectives Meeting Competition Prestige Prestige Objectives: Prices are set at a relatively high level in order to develop and maintain an image of quality and exclusiveness that appeals to status-conscious consumers Profitability Volume © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Does Amazon.com Employ Primarily a Volume, Meeting the Competition or Prestige Pricing Strategy? Copyright © 2001 by Harcourt, Inc. All rights reserved. Discussion Question

Copyright © 2001 by Harcourt, Inc. All rights reserved Figure 18.5: Royal Secret Marketers Emphasize Prestige

Copyright © 2001 by Harcourt, Inc. All rights reserved Waterford Prestige Pricing Maintains a High- Quality Image Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-28 Rolex Establishes an Image of Prestige and Exclusiveness Through Higher Prices Than Competing Brands Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-29 Flight Options, Attempting to Satisfy the Demand for Business Jets Among Those Who Are Prestige and Price Conscious, Broke the Price Barrier With Pre-Owned Aircraft Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-30 Pricing Objectives Of Not- For-Profit Organizations Profit maximization Cost recovery Provide market incentives Market suppression

Copyright © 2001 by Harcourt, Inc. All rights reserved Non-Profit Organizations Such as the American Diabetes Association Share Similar Pricing Objectives as Commercial Firms Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-32 METHODS FOR DETERMINING PRICES Customary Prices: traditional prices that consumers expect to pay for a good or service © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Figure 18.6: Studio 6 – Enhancing Value through Customary Prices

Copyright © 2001 by Harcourt, Inc. All rights reserved In a Successful Strategy, Wrigley Gum Maintained the Traditional Price by Reducing the Number of Pieces of Gum in Each Pack from 7 to 5 Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-35 PRICE DETERMINATION IN ECONOMIC THEORY Demand: schedule of the amounts of a firm’s good or service that consumers purchase at different prices during a specified period Supply: schedule of the amounts of a good or service that firms will offer for sale at different prices during a specified time period © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Four Market Structures Market structure characterized by homogeneous products in which there are so many buyers and sellers that none has a significant influence on price The agricultural sector is the closest example Pure Competition Pure Competition

Copyright © 2001 by Harcourt, Inc. All rights reserved Another Example of Pure Competition Are the Stocks Sold on the New York Stock Exchange Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-38 eBay Auction Also Operates a Market Which Often Fits the Criteria of Pure Competition Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-39 Four Market Structures Market structure involving a heterogeneous product and product differentiation among competing suppliers, allowing the marketer some degree of control over prices Typical retailer is an example Pure Competition Monopolistic Competition Monopolistic Competition

Copyright © 2001 by Harcourt, Inc. All rights reserved Retailer Bugle Boy Operates in a Market Which Fits the Criteria of Monopolistic Competition Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-41 Retailer Dillards Also Operates in a Market Which Fits the Criteria of Monopolistic Competition Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-42 Four Market Structures Market structure involving relatively few sellers and barriers to new competitors due to high start-up costs The automobile and petroleum industries are examples Pure Competition Monopolistic Competition Oligopoly

Copyright © 2001 by Harcourt, Inc. All rights reserved Southwest Airlines Operating in the Oligopolistic Market Structure Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-44 On This Page of Its Web Site, Oligopolistic Texaco Attempts to Differentiate Its Fuels From the Competition Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-45 Four Market Structures Pure Competition Monopolistic Competition Oligopoly Monopoly Market structure involving only one seller of a good or service for which no close substitutes exist Anti-trust legislation has eliminated nearly all monopolies Government regulated monopolies do exist in certain areas, such as public utilities

Copyright © 2001 by Harcourt, Inc. All rights reserved Entergy, a Major Supplier of Electric Energy in the South and Southwest, Operates As a Monopoly Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-47 Table 18.2: Distinguishing Features of the Four Market Structures Characteristics Pure Competition Monopolistic CompetitionOligopolyMonopoly Number of competitors ManyFew to manyFewNo direct competitors Ease of entry into industry by new firms EasySomewhat Difficult DifficultRegulated by government Similarity of goods or services offered by competing firms SimilarDifferentCan be either similar or different No directly competing goods or service Control over prices by individual firms NoneSome Considerable Demand curves facing individual firms Totally elasticCan be either elastic or inelastic Kinked; inelastic below kink; more elastic above Can be either elastic or inelastic Examples200-acre ranch Gap storesTexacoCommonwealth Edison Type of Market Structure

Copyright © 2001 by Harcourt, Inc. All rights reserved Cost and Revenue Curves Price is often determined by analyzing the cost and revenue curves The cost and revenue curves are based on: Average total costs Marginal cost Average revenue Marginal Revenue

Copyright © 2001 by Harcourt, Inc. All rights reserved Cost and Revenue Curves Average total cost is calculated by dividing the total costs by the number of units produced Marginal cost is the change in total cost that results from producing an additional unit of output

Copyright © 2001 by Harcourt, Inc. All rights reserved Cost and Revenue Curves Average revenue is calculated by dividing total revenue by the quantity of goods or services sold Marginal revenue is the change in total revenue that results from selling an additional unit of output

Copyright © 2001 by Harcourt, Inc. All rights reserved Figure 18.7: Determining Price by Relating Marginal Revenue to Marginal Cost

Copyright © 2001 by Harcourt, Inc. All rights reserved Table 18.3: Price Determination Using Marginal Analysis Price Number Sold Total Revenue Marginal Revenue Total Costs Marginal Costs Profits (Total Revenue – Total Costs) ($50) $341 57$7(23) (2)

Copyright © 2001 by Harcourt, Inc. All rights reserved The Concept Of Elasticity In Pricing Strategy Elasticity: measure of responsiveness of purchasers and suppliers to changes in price © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Determinants Of Elasticity Demand tends to be elastic if consumers can easily find substitutes If the price of Coca-Cola rises, consumers can switch to Pepsi or another substitute Availability of Substitutes Availability of Substitutes

Copyright © 2001 by Harcourt, Inc. All rights reserved As an Internet Service Provider, America Online, Operates in an Elastic Market with Many Substitutes Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-56 Red Roof Inns – Operates in a Market With Relatively Elastic Demand Given the Many Substitutes Available Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-57 Determinants Of Elasticity Demand for luxuries exhibit elastic demand, while demand for necessities tend to be inelastic Insulin, a necessity for Diabetics, must be purchased regardless of the price Availability of Substitutes Luxury or Necessity Luxury or Necessity

Copyright © 2001 by Harcourt, Inc. All rights reserved Figure 18.8: Four Seasons Hotels – Inelastic Demand for a Service Viewed as a Necessity for Upscale Travelers

Copyright © 2001 by Harcourt, Inc. All rights reserved Morton Salt Inelastic Demand for a Product with Few Substitutes Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-60 Determinants Of Elasticity The larger the portion of a budget an item consumes, the higher the elasticity Elasticity is greater for products such as cars and suits, than for matches or ice Availability of Substitutes Luxury or Necessity Portion of Budget Portion of Budget

Copyright © 2001 by Harcourt, Inc. All rights reserved Edmunds.Com Provides Information to Car Buyers Who Typically Consider the Purchase of a Car to Consume a Major Portion of Their Budget Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-62 Determinants Of Elasticity Availability of Substitutes Luxury or Necessity Portion of Budget Demand often shows less elasticity in the short run than in the long run For example, people prefer to pay more for a few months out of the year than to explore options to reduce energy costs. Over time, with global warming becoming a real and present danger, they may search for ways to economize. Time Perspective

Copyright © 2001 by Harcourt, Inc. All rights reserved Elasticity and Revenue Elasticity of demand exerts an important influence on total revenue as a result in the changes in the price of a good or service For example, should a city’s transit authority raise or lower price for public transportation? The answer, of course, lies in the elasticity of demand for public transportation © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Practical Problems of Price Theory Marketers may thoroughly understand price theory concepts but still encounter difficulty in applying them in practice. Practical limitations interfering with price setting include the facts that: Many firms don’t attempt to maximize profits Estimating demand curves is a difficult process © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved PRICE DETERMINATION IN PRACTICE Cost-plus pricing: practice of adding a percentage of a specified dollar amount (markup) to the base cost of a product to cover unassigned costs and provide a profit © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Alternative Pricing Procedures Full-cost pricing uses all relevant variable costs and allocates fixed costs that cannot be directly attributed to the production of the specific item in setting a product’s price Full-cost pricing has two weaknesses: There is no consideration for demand or competition Allocation of overhead costs is arbitrary and often unrealistic © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Alternative Pricing Procedures Incremental-cost pricing attempts to overcome arbitrary allocation of fixed costs by only considering costs directly attributable to the product itself when setting prices © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Breakeven Analysis Breakeven analysis: pricing technique used to determine the number of products that must be sold at a specified price in order to generate sufficient revenue to cover total cost

Copyright © 2001 by Harcourt, Inc. All rights reserved Figure 18.9: Breakeven Chart

Copyright © 2001 by Harcourt, Inc. All rights reserved Target Returns Although breakeven analysis indicates the sales level at which the firm will incur neither profits nor losses, most firms include some target return or target profit in their analysis. The target return may be set as: A desired dollar return A percentage of sales © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Evaluation of Breakeven Analysis Effective tool in assessing the sales required for covering costs and achieving specified levels of profit Easily understood © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Evaluation of Breakeven Analysis Shortcomings of breakeven analysis: Assumes that costs can easily be classified as fixed or variable Assumes stability of per-unit costs at different levels of production Does not consider demand or competition © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved TOWARD REALISTIC PRICING In actual practice, most pricing approaches are largely cost oriented They thus violate the marketing concept New approaches being developed are incorporating the element of consumer demand © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved Modified Breakeven Analysis Modified breakeven analysis: pricing technique used to evaluate consumer demand by comparing the number of products that must be sold at a variety of prices in order to cover total cost with estimates of expected sales at the various prices

Copyright © 2001 by Harcourt, Inc. All rights reserved Figure 18.10: Modified Breakeven Charts - Parts A and B

Copyright © 2001 by Harcourt, Inc. All rights reserved Table 18.4: Revenue and Cost Data for Modified Breakeven Analysis Price Quantity Demanded Total Revenue Total Fixed Cost Total Variable Cost Total Cost Breakeven Point -No. of Sales Required to Break Even Total Profit (or Loss) $152,500$37,500$40,000$12,500$52,5004,000$(15,000) 1010,000100,00040,00050,00090,0008,00010, ,000117,00040,00065,000105,000110,00012, ,000112,00040,00070,000110,00013,3342, ,000105,00040,00075,000115,00020,000(10,000) RevenuesCosts

Copyright © 2001 by Harcourt, Inc. All rights reserved Yield Management Yield Management: pricing strategy designed to maximize sales in situations such as airfares, lodging, auto rentals, and theater tickets where costs are fixed © PhotoDisc

Copyright © 2001 by Harcourt, Inc. All rights reserved American Airlines Utilizes a Yield Management Strategy to Maximize Profits and Revenues as Shown on the Next Slide Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-79 American Airlines Prices for a Round-Trip Flight Between New York City and Miami, Florida (Including a Saturday Night Stopover) Varied in the Chart Below From $190 to $739 in Coach on the Date Checked Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-80 Example of a Firm Offering Yield Management Consulting for the Hospitality Industry Copyright © 2001 by Harcourt, Inc. All rights reserved.

18-81 GLOBAL ISSUES IN PRICE DETERMINATION Global Prices must support the firm’s broader goals including: Product development Advertising and sales Customer support Competitive plans Financial objectives

Copyright © 2001 by Harcourt, Inc. All rights reserved GLOBAL ISSUES IN PRICE DETERMINATION In General, there are five pricing objectives that firms can use to set prices in global marketing Four, profitability, volume, meeting competition, and prestige, are the same as those discussed earlier In addition international marketers work to achieve price stability Price stability is the ability to maintain consistent prices during major economic fluctuations and periods of political change

Copyright © 2001 by Harcourt, Inc. All rights reserved STRATEGIC IMPLICATIONS OF PRICING IN THE 21ST CENTURY The evolution of the internet and E-commerce will continue to empower the customer Competing products and suppliers will only be a mouse-click away Product customization and internet auctions will spur transactions on the net Electronic delivery of music, games and books will lead to further price reductions © PhotoDisc