25 Nov 2023.
This blog is intended to discuss certain pricing concepts that are not taught in management classes to the marketing students. Hence, it is written is a manner that it could be understood without much technical knowledge.
Most commonly, in management, one of the frequently taught pricing models is Capital Asset Pricing Model known as CAPM in short. CAPM discusses the relationship between the risk and expected return of an investment. This is in many ways, form the beginning of asset pricing theory that the management students specializing in finance study. It is based on the concept that the asset price is determined by the demand and supply. This is the where the similarity between CAPM and what this blog is set out to explain ends. This article focuses on pricing models in marketing, where too, the price depends on the demand and supply.
Exploring pricing models in marketing is very engaging and glamorous. This because, pricing is a critical element of marketing mix which directly has greatest impact on the top line. Price also impacts customers’ perception towards the product. Above all, there are various concepts of pricing strategies that a firm can employ to maximize their profitability.
The discussion starts with few of the concepts which the students are exposed to in their classes and later we take some that are in practice.
- Cost-Plus Pricing: Deciding on a price based on production costs and adding a desired profit margin. This method is simple and ensures that all costs are covered. However, the price may not reflect the correct market price.
- Skimming Pricing: Here, the firm sets a high price for a new product to take advantage of rich customers who can afford it. Once the cream of rich customers is covered, the price is gradually lowered to cover the rest of the market. Though this strategy cannot be applied to all the products, many companies adopt it for their innovative or technologically advanced products to maximize early profits.
- Penetration Pricing: In this strategy, products are offered at a low initial price for a new product or by a new company to quickly gain market share. This can be effective in attracting price-sensitive customers.
- Value-Based Pricing: The price of the product is set based on the perceived value of the product or service to the customer. This approach focuses on the benefits and value the product provides rather than production costs.
- Bundle Pricing: In this approach, multiple products or services as a package at a lower price than the sum of their individual prices. This encourages customers to buy more items and can enhance perceived value.
- Price unbundling: Price unbundling is when the firm separates products or services into different components or options, and charge separately for each of them.
- Loss Leader Pricing: Offering a product at a price below its cost to attract customers and encourage additional purchases of higher-margin products. This strategy is common in retail.
- Captive product pricing: This strategy is adopted by a company when it has a product that has both a “core product” and a number of “accessory products.” The company will set its price of the core product to primarily attract a large volume of customers and gain in the long run from the accessory products.
- Time-Based Pricing: Here the company adjusts prices based on the time of day, day of the week, or season. For example, hotels and airlines often use dynamic pricing based on peak demand periods.
- Subscription Pricing: Charging customers a recurring fee for access to a product or service over time. This model is common in industries such as streaming services, software, and publications.
- Psychological Pricing: In this strategy of setting prices the prices are just below round numbers (e.g., $9.99 instead of $10.00) to create a psychological effect that the product is more affordable. This approach takes advantage of consumer perception.
- Geographic Pricing: Adjusting prices based on the geographic location of the customer. This can account for factors like shipping costs, local market conditions, and regional preferences.
- Price discrimination: Price discrimination is a competitive pricing strategy where the company charges different prices to various customers for the same product or service. There are three most common types of price discrimination viz., first-, second-, and third-degree discrimination. In first-degree price discrimination, also called personalized pricing or perfect price discrimination the firm charges each customer a separate price, depending on the intensity of his or her demand.
In second-degree price discrimination, the firm charges less to customers who buy in bulk over those who buy a single product.
In third-degree price discrimination, the firm charges different amounts to different consumer segments.
Some of the above discussed strategies may overlap. For example, time-based pricing, subscription pricing and geographic pricing are also viewed as third degree price discrimination.
subscription pricing and geographic pricing are also viewed as third degree price discrimination.
- Dynamic pricing: It is also known as surge pricing, demand pricing or time-based pricing — is a strategy where businesses adjust the prices of their offerings to account for changing demand. This is also considered as price discrimination.
- Decoy pricing is a tactic firms adopt to “force” customers’ choices. The “decoy” consists of either a product with a slightly lower price but much lower quality or a product with a much higher price but slightly higher quality. The decoy effect has two specific effects: the attraction effect
and the compromise effect. (For details see my earlier blog titled “Forcing a customer to buy a specific product size: Decoy pricing”
Besides the above, which are taught to the students, there are few techniques that are generally not taught to the students. The methods include direct methods such as estimation of willingness to pay , indirect methods such as Gabor-Granger and van Westendorp techniques, and product/price mix methods. All of them are widely used in practical marketing research for evaluation of optimal prices for different products.
Direct Price Techniques The basis for these methods is the willingness to pay (WTP) estimation. The potential customers are asked the highest price that they would be willing to pay. There are different variations to the survey such as the participants are obligated to purchase a product if the price drawn from a lottery is less than or equal to their stated prices (Miller, Hofstetter, Krohmer, & Z. J. Zhang, 2011).
Indirect Price Models
Gabor-Granger (GG) Indirect Price Models: This model is one of the indirect pricing methods. Indirect methods are generally more accurate than direct methods as respondents are faced with more realistic scenarios. In GG model, the respondents are shown a price and asked their willingness to purchase. If the respondent is willing to purchase the product at that price, they are shown a higher price and asked about their willingness. This process continues till the highest price. If the respondents is not willing to purchase at the first price shown the process is repeated by showing a lower price until they express willingness to purchase. There are many variations to GG model of estimation of price in marketing.
Product/Price Mix Models: In this technique, an optimal price is presented by various pricing techniques used in conjoint and discrete choice models (DCM). This is a realistic approach mimicking actual choices people are faced with in the store.
Further to the above, there is one more instance of price fixing. Actually it is a marketing strategy but has impact on the price. It is known as Hunger marketing.
Hunger marketing is a marketing strategy focused on manipulating consumer emotions. By bringing products to market with an attractive price point and restricted supply, consumers have a stronger desire to make a purchase. Hunger Marketing is a strategy that leverages the psychology of scarcity and anticipation to drive demand and sales. While it can be highly effective, businesses must be cautious about its ethical implications and ensure that it aligns with their brand image and values. When executed thoughtfully, hunger marketing can create excitement and buzz around a product or service, leading to successful launches and sustained interest. First, the hunger marketing strategy can improve the total profit of the supply chain by increasing the retail price and the total sales volume. Second, the hunger marketing strategy aggravates the double marginalization effect.
Case questions for discussion
The above is not an exhaustive on pricing methods. One must be creative in fixing price to one’s product. So, if you were to fix a price for a product that your company has manufactured, what pricing method will you choose and why? What additional information, if any, will be required?