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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. Course Outline
Mar 17

9. 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

10. 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

11. 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

12. 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

13. 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

14. Course Outline
Mar 17

15. 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

16. Pricing Scorecard Questionnaire
Mar 17

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

18. 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

19. 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

20. 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

21. Course Outline
Mar 17

22. 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

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

24. 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

25. 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

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

27. 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

28. 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

29. 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

30. 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 $ x ($32 + $2 x 8) = $10.2 K
Mar 17

31. 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

32. 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

33. Course Outline
Mar 17

34. 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

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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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