Using the marketing mix: pricing

Using the marketing mix: pricing

Pricing strategies: approaches adopted in order to achieve marketing objectives

There are 5 main pricing strategies:

• Price skimming: a strategy in which a high price is set to yield a high profit margin.
• Penetration pricing: a strategy in which low prices are set to break into a market or to achieve a sudden spurt in market share.
• Price leadership: a strategy in which a large company (the price leader) sets a market price that smaller firms will tend to follow.
• Price taking: a strategy in which a small firm follows the price set by a price leader.
• Predator (or destroyer) pricing: a strategy in which a firm sets very low prices in order to drive other firms out of the market.

Pricing tactics

Pricing tactics: pricing or approach techniques used in the short term to achieve specific objectives.

There are 2 main types of pricing tactics:

• Loss leaders (leadership): a tactic in which a firm sets a low price for its product(s)  in order to encourage consumers to buy other products that provide profit for the firm.
• Psychological pricing: a tactic intended to give the impressionof value (e.g selling a good for 9.99 instead of 10 pounds). The frequency of its used among retailers suggests that firms believe it does attract extra customers.

Influences on pricing decisions

Two main influences are examined:

• The costs of production
• The price elasticity of demand

All the pricing stategies and pricing tactics described earlier rely on setting a price that customers find acceptable. however, a business also needs to ensure that it makes a profit, so the price of a product must be high enough to cover costs (unless a loss leader or predator pricing approach is being used). To make sure that the price suits both the customer and the business, businesses often use cost-plus pricing. 

In cost-plus pricing the price set is the average cost of a product plus a sum to ensure profit. For example, a clothes retailer typically adds 100% to the whole sale cost of purchasing a dress, while a pet food manufacturer adds 30% to the manufacturing costs when selling to a supermarket chain. Thus a dress purchased wholesale by a retailer for 50 pounds is sold to the customer for 100 pounds. The percentage added onto the average cost is known as the mark-up.

The percentage added on depends on a number of factors: the level of competition, the price that customers are prepared to pay, the firms objectives - for example, whether it is aiming to break-even or maximise profit, or aim for a higher market share.

Price elasticity of demand

Price elasticity of demand: the responsiveness of a change in the quantity demanded of a good or service to a change in price.

The formula for calculating the price elasticity of demand is:

% change in quantity demanded / % change in price X 100

Price elasticity of demand can be elastic, inelsatic or unitary: 

Elastic demand: If the percentage change in price leads to a greater percentage change in the quantity demanded (ignoring the minus sign), the calculation yields an answer greater than 1. This indicates that demand is relatively responsive to a change in price.

Inelastic demand:If the percentage change in price leads to a smaller percentage change in the quantity demanded, the calculation yields an answer less than 1 (ignoring the minus sign). This indicates that demand is relatively unresponsive to a change in price.

Unitary demand:  This name is given to the situation where both percentage changes are the same, giving an answer of (-1) 1. In theory, the price change is exactly cancelled out by the change in the quantity demanded, so sales revenue stays the same.

Determinants of price elasticity of demand

Necessity: the more necessary a product is the more inelastic is the demand e.g. essentials like food.

Habit: The stronger the habit the more inelastic the demand is for the product e.g. cigarettes, alcohol, chocolate etc.

Availability of substitutes: If there are no alternatives to a product, a consumer is likely to buy similar quantity if the price changes. However, if there are many alternatives, customers will switch to a close alternative. The impact will also depend on consumer tastes; for example, how close the alternative is seen to be, Some buyers may see beef as a close alternative to pork, but other customers will not see them as substitutes. The greater the availability of close substitutes, the more elastic the demand is, as small price rises will encourage consumers to buy the alternatives.

Brand loyalty: Firms attempt to create brand loyalty by various means, such as the quality of the product, advertising and other forms of promotion. In addition to increasing sales volume, the creation of loyal customers will also influence people's reactions to price changes. A consumer who insists on wearing Armani clothing will not be put off by a higher price. The greater the level of brand loyalty, the more inelastic is the demand.

Proportion of income spent on a product: Consumers will be less concerned about price rises if a product takes up only a small percentage of their income. For example, a 20% increase in the price of a box of matches will only be 2p or 3p, so the consumer is unlikely to change the number of boxes bought (demand is inelastic). On the other hand, buying a car will use up a large amount of income, so consumers will be affected by small percentage changes in price. This factor will make demands for cars more elastic.

Income of consumers:Rich people are less worried about price rises than poorer individuals. Thus they (as individuals) are going to have more inelastic demand for the products that they buy. David Beckham may pay hundreds of pounds for a haircut, but most consumers would try to find a cheaper alternative if this was the price advertised by their local hairdresser or barber. For this reason, businesses often target rich people. The prices of brands bought predominantly  by wealthy consumers can be increased without affecting sales a great deal, so their demand is inelastic. Shops in exclusive areas can often set higher prices because their customers are less conscious of price.

The importance of price elasticity of demand can be seen by looking at its influence on sales revenue and profit, following changes in price. A business planning a change in price as part of its marketing mix will want to be able to predict the effects of such a price change. The effect of price elasticity of demand on sales revenue and profit depends on whether demand is elastic, inelastic or unitary.

Inelastic demand: If demand for a product is inelastic, when its price rises the quantity demanded falls by a smaller percentage. This means that the the impact of the price increase outweighs the relatively small % change in demand, so sales revenue increases. E.g. a 50% rise in price from 1 pound to 1 pound 50p leads to a smaller (20%) fall in sales from 100 to 80 units. Price elasticity is -0.4. Sales revenue increase from (1 pound X 100 = 100 pounds) to (1 pound 50p X 80 = 120 pounds). Does this mean extra profit? Yes. The total costs of producing 80 units will almost certainly be lower than those of producing 100 units, so costs will tend to fall at the same time as revenue increases. Thus a price rise always increases sales revenue and profit if demand is inelastic. Similarly a price fall leads to lower sales revenue and profit if demand is inelastic.

Elastic demand: If demand for a good is elastic, when the price rises the quantity demanded falls by a larger percentage. This means that the impact of the price increase is outweighed by the relatively large percentage change in demand, so sales revenue decreases. For example, a 20% rise in price from 1 pound to 1 pound 20 leads to a larger (50%) fall in sales from 100 units to 50 units. Price elasticity is -2.5. * Sales revenue decreases from (1pound X 100 = 100 pounds) to (1pounds 20p X 50 = 60 pounds). Does this mean a decrease in profit? The answer is not necessarily. It will be cheaper to produce 50 units than 100, so costs will fall as well as income. If costs fall by more than income, profit will still be improved. But if costs fall by a smaller amount, profit will fall. Thus a price rise always decreases sales revenue if price elasticity of demand is elastic, but the effect on profit depends on costs savings. The chances of more profit are higher if there is a high profit margin on the good. * In the case of the price fall, the sales revenue of a good with a price-elastic demand always increases. However, the quantity demanded rises and so production costs also rise. Consequently, it is impossible to predict the effect on profits without knowing about the costs of production.

Unitary elasticity: If demand for a good is unitary, sales revenue is the same whether price rises or falls. A price rise would then be advisable if the business is aiming to increase profit, because this means a lower volume of sales would be required, which would enable production costs to fall. However, the business may not increase price if it has other aims, such as increasing its market share.

Price discrimination

Firms can use price elasticity  of demand to practice price discrimination. Price discrimination involves charging a higher price to some customers for the same product or service because they are prepared to pay such a price. Typical examples are train fares and charges for telephone users. Consumers who use peak-time trains or phones are willing to pay the higher price because they value their use so highly at those times (when their demand is price inelastic). People who are less desperate to use the service at that time can recieve it more cheaply during off-peak periods (their demand is price elastic).

Price elasticity of demand can be very unreliable because of the difficulties involved in calculating it. Price elasticity of demand calculations assume that 'other things remain equal' while price changes. In practice, this does not happen. The main difficulties in calculating (and using) elasticity of demand are as follows:

• Other factors not 'remaining equal': There might have been significant changes in the market, affecting the level of demand independently of price. For example, consumer tastes might have changed; new competitors might have entered the market or previous competitors might have left it; technological change might have influenced the market; or the image of the product might have changed.
• Competitors reactions: Changes in price might provoke a reaction from rival firms, which may try to match the change or modify their marketing in response to the change. This reaction may not always be the same. For example, in some markets competitors are more likely to match a rival's cut in price than they are to match a rival's increase in price.

• Consumer's reactions: Consumers may react differently to increases in price than to decreases. For example, a decrease in price might not encourage consumers to buy more, but an increase in price may tempt them to buy from competitors.
• Market research: It may be difficult to use secondary market research to calculate elasticity, as the planned change in the price may be different from anything experienced in the past. At the same time, consumers may be unable to predict how their spending will be affected by price changes, and so primarily surveys may be unreliable. Even the company's own actions may reduce the reliability of any calculations. Firms often promote their price reductions and so brand awareness (and thus the quantity demanded) may increase for this reason rather than because of the price cut.