Section overview
• Many firms base price on what consumers demand rather than simple cost-plus rules.
3.2.1 Product life cycle
The product life concept is relevant to pricing policy. The concept states that a typical product moves through four stages:
(a) Introduction
The product is introduced to the market. Heavy capital expenditure will be incurred on product development and perhaps also on the purchase of new non-current assets and building up stocks for sale.
On its introduction to the market, the product will begin to earn some revenue, but initially demand is likely to be small. Potential customers will be unaware of the product or service, and the
organisation may have to spend further on advertising to bring the product or service to the attention of the market.
(b) Growth
The product gains a bigger market as demand builds up. Sales revenues increase and the product begins to make a profit. The initial costs of the investment in the new product are gradually recovered.
(c) Maturity
Eventually, the growth in demand for the product will slow down and it will enter a period of relative maturity. It will continue to be profitable. The product may be modified or improved, as a means of sustaining its demand.
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At some stage, the market may reach 'saturation point'. Demand will start to fall. For a while, the product will still be profitable in spite of declining sales, but eventually it will become a loss-maker and this is the time when the organisation should decide to stop selling the product or service, and so the product's life cycle should reach its end.
Remember, however, that some mature products may never decline: staple food products such as milk or bread are the best example.
Not all products follow this cycle, but it remains a useful tool when considering decisions such as pricing.
The life cycle concept is relevant when considering what pricing policy will be adopted.
3.2.2 Markets
The price that an organisation can charge for its products will also be influenced by the market in which it operates.
Definitions
Perfect competition: many buyers and many sellers all dealing in an identical product. Neither producer nor user has any market power and both must accept the prevailing market price.
Monopoly: one seller who dominates many buyers. The monopolist can use this market power to set a profit-maximising price.
Oligopoly: relatively few competitive companies dominate the market. While each large firm has the ability to influence market prices, the unpredictable reaction from the other giants makes the final industry price indeterminate.
3.2.3 Competition
In established industries dominated by a few major firms, a price initiative by one firm will usually be countered by a price reaction by competitors. In these circumstances, prices tend to be stable.
If a rival cuts its prices in the expectation of increasing its market share, a firm has several options:
(a) It will maintain its existing prices if the expectation is that only a small market share would be lost, so that it is more profitable to keep prices at their existing level. Eventually, the rival firm may drop out of the market or be forced to raise its prices.
(b) It may maintain its prices but respond with a non-price counter-attack. This is a more positive response, because the firm will be securing or justifying its current prices with a product change, advertising, or better back-up services.
(c) It may reduce its prices. This should protect the firm's market share so that the main beneficiary from the price reduction will be the consumer.
(d) It may raise its prices and respond with a non-price counter-attack. The extra revenue from the higher prices might be used to finance an advertising campaign or product design changes. A price increase would be based on a campaign to emphasise the quality difference between the firm's own product and the rival's product.
3.2.4 Price leadership
Given that price competition can have disastrous consequences in conditions of oligopoly, it is not unusual to find that large corporations emerge as price leaders. The price leader indicates to the other firms in the market what the price will be, and competitors then set their prices with reference to the leader's price.
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3.2.5 Market penetration pricing
This is a policy of low prices when the product is first launched in order to obtain sufficient penetration into the market. A penetration policy may be appropriate:
• If the firm wishes to discourage new entrants into the market.
• If the firm wishes to shorten the initial period of the product's life cycle in order to enter the growth and maturity stages as quickly as possible.
• If there are significant economies of scale to be achieved from a high volume of output, so that quick penetration into the market is desirable in order to gain unit cost reductions.
• If demand is likely to increase as prices fall.
3.2.6 Market skimming pricing
In contrast, market skimming involves charging high prices when a product is first launched and spending heavily on advertising and sales promotion to obtain sales. As the product moves into the later stages of its life cycle (growth, maturity and decline) progressively lower prices will be charged.
The profitable 'cream' is therefore skimmed off in stages until sales can only be sustained at lower prices.
The aim of market skimming is to gain high unit profits early in the product's life. High unit prices make it more likely that competitors will enter the market than if lower prices were to be charged.
Such a policy is appropriate:
• Where the product is new and different, so that customers are prepared to pay high prices so as to be one up on other people who do not own it. Games systems are a good example.
• Where the strength of demand and the sensitivity of demand to price are unknown. It is better from the point of view of marketing to start by charging high prices and then reduce them if the demand is insufficient.
• Where products may have a short life cycle, and so need to recover their development costs and make a profit quickly.
3.2.7 Differential pricing
In certain circumstances the same product can be sold at different prices to different customers.
There are a number of bases on which such prices can be set.
Basis Example
By market segment A cross-Tasman airline would market its services at different prices in Australia and New Zealand, for example. Services such as cinemas and hairdressers are often available at lower prices to senior citizens and/or juveniles.
By product version Many car models have 'add on' extras which enable one brand to appeal to a wider cross-section of customers. The final price need not reflect the cost price of the add on extras directly: usually the top of the range model would carry a price much in excess of the cost of provision of the extras, as a prestige appeal.
By place Theatre seats are usually sold according to their location so that patrons pay different prices for the same performance according to the seat type they occupy.
By time This is perhaps the most popular type of price discrimination. Railway companies, for example, are successful price discriminators, charging more to rush hour rail commuters whose demand remains the same whatever the price charged at certain times of the day.
3.2.8 Price and the price elasticity of demand
Economists argue that the higher the price of a good, the lower will be the quantity demanded. We have already seen that in practice it is by no means as straightforward as this (some goods are bought because they are expensive, for example), but you know from your personal experience as a consumer that the theory is essentially true.
An important concept in this context is price elasticity of demand (PED).
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Definition
The price elasticity of demand (η) measures the extent of change in demand for a good following a change to its price.
Formula to learn
Price elasticity (η) is measured as: % change in sales demand
% change in sales price
Demand is said to be elastic when a small change in the price produces a large change in the quantity demanded. The PED is then greater than 1. Demand is said to be inelastic when a small change in the price produces only a small change in the quantity demanded. The PED is then less than 1.
There are two special values of price elasticity of demand:
• Demand is perfectly inelastic (η = 0). There is no change in quantity demanded, regardless of the change in price.
• Demand is perfectly elastic (η = ∞). Consumers will want to buy an infinite amount, but only up to a particular price level. Any price increase above this level will reduce demand to zero.
An awareness of the concept of elasticity can assist management with pricing decisions.
• In circumstances of inelastic demand, prices should be increased because revenues will increase and total costs will reduce (because quantities sold will reduce).
• In circumstances of elastic demand, increases in prices will bring decreases in revenue and decreases in price will bring increases in revenue. Management therefore have to decide whether the increase/decrease in costs will be less than/greater than the increases/decreases in revenue.
• In situations of very elastic demand, overpricing can lead to a massive drop in quantity sold and hence a massive drop in profits, whereas underpricing can lead to costly stock outs and, again, a significant drop in profits. Elasticity must therefore be reduced by creating a customer preference which is unrelated to price (through advertising and promotional activities).
• In situations of very inelastic demand, customers are not sensitive to price. Quality, service, product mix and location are therefore more important to a firm's pricing strategy.
3.2.9 The demand-based approach to pricing
Price theory or demand theory is based on the idea that a connection can be made between price, quantity demanded and sold, and total revenue. Demand varies with price, and so if an estimate can be made of demand at different price levels, it should be possible to derive either a profit-maximising price or a revenue-maximising price.
The theory is dependent on realistic estimates of demand being made at different price levels. Making accurate estimates of demand is often difficult as price is only one of many variables that influence demand.
Some larger organisations go to considerable effort to estimate the demand for their products or services at differing price levels by producing estimated demand curves.
For example, a large transport authority might be considering an increase in bus fares or underground fares.
The effect on total revenues and profit of the increase in fares could be estimated from a knowledge of the demand for transport services at different price levels. If an increase in the price per ticket caused a large fall in demand, because demand was price elastic, total revenues and profits would fall whereas a fares increase when demand is price inelastic would boost total revenue, and since a transport authority's costs are largely fixed, this would probably boost total profits too.
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Many businesses enjoy something akin to a monopoly position, even in a competitive market. This is because they develop a unique marketing mix, for example, a unique combination of price and quality. The significance of a monopoly situation is:
(a) The business does not have to 'follow the market' on price. In other words it is not a 'price-taker', but has more choice and flexibility in the prices it sets.
(i) At higher prices, demand for its products or services will be less.
(ii) At lower prices, demand for its products or services will be higher.
(b) There will be a selling price at which the business can maximise its profits.