TOPIC: PRICING STRATEGIES

Unit Structure
1.1 Objectives
1.2 Introduction
1.3 Objectives of Pricing Strategy
1.4 Cost-Plus Pricing
1.5 Pricing Over Life-Cycle of a Product
1.6 Multiple Product Pricing
1.7 Transfer Pricing
1.8 Pricing In Relation To Established Products
1.9 Peak-load Pricing
1.10 Ramsey Pricing
1.11 Limit Pricing
1.12 Loss Leader Pricing
1.13 Summary
1.14 Key Words

1.1 Objectives

After studying this unit, you should be able to

understand: The concept of pricing strategy.
Pricing strategies followed by firms in specific situations.
Pricing strategy and their impact on demand.
The objectives of pricing strategy.
1.2 Introduction

In every economics system, the prices of goods and services are crucial. A price is a sacrifice
for one who pays it but it is a gain for one who gets it. Everybody is concerned with the
prices in one way or another. The price of the commodity would be determined by the
market itself through interplay of demand and supply for the commodity, because there
is a relationship between price and quantity demanded, it is important to understand the
impact of pricing on sales by estimating the demand curve for the product. For existing
products, experiments can be performed at prices above and below the current price in
order to determine the price elasticity of demand. Inelastic demand indicates that price
increases might be feasible.
Pricing strategy as an instrument to achieve the objective of a firm and it should be
formulated in such a way as to maximize the sales revenue and profit. Maximum profit
refers to the highest possible profit. In the short run, a firm not only should be able to
recover its total costs, but also should get excess revenue over costs.
One of the most difficult, yet important, issues you must decide as an entrepreneur is how
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 much to charge for your product or service. While there is no one single right way to
determine your pricing strategy, fortunately there are some guidelines that will help you with
your decision.

1.3 Objectives of Pricing Strategy

The firm's pricing strategy objectives must be identified in order to determine the optimal pricing
in different market situations. Common objectives include the following:
Current profit maximization - seeks to maximize current profit, taking into account
revenue and costs. Current profit maximization may not be the best objective if it results in
lower long- term profits.
Current revenue maximization - seeks to maximize current revenue with no regard to profit
margins. The underlying objective often is to maximize long-term profits by increasing
market share and lowering costs.
Maximize quantity - seeks to maximize the number of units sold or the number of customers
served in order to decrease long-term costs as predicted by the experience curve.
Maximize profit margin - attempts to maximize the unit profit margin, recognizing that
quantities will be low.
Quality leadership - use price to signal high quality in an attempt to position the product as
the quality leader.
Partial cost recovery - an organization that has other revenue sources may seek only partial
cost recovery.
Survival - in situations such as market decline and overcapacity, the goal may be to select a
price that will cover costs and permit the firm to remain in the market. In this case,
survival may take a priority over profits, so this objective is considered temporary.
Status quo - the firm may seek price stabilization in order to avoid price wars and maintain a
moderate but stable level of profit.
1.4 Cost-Plus Pricing

Cost-plus pricing is also known as 'mark-up pricing', 'average cost pricing' or 'full cost
pricing'. The cost- plus pricing is the most common method of pricing used by the
manufacturing firms. It is used primarily because it is easy to calculate and requires
little information. There are several varieties, but the common thread in all of them is
you first calculate the cost of the product, and then include an additional amount to
represent profit.
Calculating price using the cost-plus method
There are several ways of determining cost, and the profit can be added as either a

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 percentage markup or an absolute amount. One example is:
P = (AVC + FC%) x (1 + MK%)
Where:
P = price
AVC = average variable cost
FC% = percentage allocation of
fixed costs MK% = percentage
markup

For example: If variable costs are 30 yen, the allocation to cover fixed costs is 10 yen, and
you feel you need a 50% markup then you would charge a price of 60 yen:
P = (30 + 10) x (1 + 0.50)
P = 40

x 1.5

P=60

An alternative way of doing the same

calculation is: P = (AVC + FC%) / (1 ?

MK%)

To make things simpler, some firms, particularly retailers, ignore fixed costs and just use
the purchase price paid to their suppliers as the cost term. They indirectly incorporate the
fixed cost allocation into the markup percentage. To simplify things even further, sometimes
a fixed amount is applied rather than a percentage. This fixed amount is usually determined
by head- office to make it easy for franchisees and store managers. This is sometimes
referred to as turnkey pricing.
Another variant of cost plus pricing is activity based pricing. This involves being more
careful in determining costs. Instead of using arbitrary expense categories when allocating
overhead, every activity is linked to the resources it uses
Advantages of cost-plus pricing :-
 easy to calculate
 minimal information requirements
 easy to administer
 tends to stabilize markets - insulated from demand variations and competitive factors
 ethical
advantages

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 Disadvantages of
cost-plus pricing :-

 tends to ignore the role of consumers

 tends to ignore the role of competitors
 use of historical accounting costs rather than replacement value
 inclusion of sunk costs rather than just using incremental costs
 ignores opportunity costs

1.5 Pricing during product life cycle

Product life cycle management (or PLCM) is the succession of strategies used by business
management as a product goes through its life cycle. The life-cycle of a product is
generally divided into four stages: (i) Introduction (ii) Growth, (iii) Maturity, (iv) Decline.
Diagram 11.1presents the four stages of a product's life-cycle through a curve showing the
behavior of the total sales over the life cycle. The introduction phase is the period taken to
introduce the product to the market. The total sale during this period is limited to the
quantity put on the market for

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 trial with considerable advertisement. The sales during this period remain almost constant.
Growth is the stage, after a successful trail, during which the product gains popularity among
the consumers and sales increase at an increasing rate as a result of cumulative effect of
advertisement over the initial stage. Maturity is the stage in which sales continue to increase
but at a lower rate and the total sale eventually becomes constant. After the maturity
stage, comes the stage of decline in which total sales register a declining trend for such
reasons as (i) increase in the availability of substitutes, and (ii) the loss of distinctiveness of the
product.The pricing strategy varies from stage to stage over the life-cycle of a product
depending on the market conditions. From the pricing strategy point of view, growth and
maturity stages may be treated likewise. We have first discussed the pricing of a product in
its initial stage as pricing of a new product and then in the 'maturity' and 'decline' stage.
Pricing a New Product:

Pricing policy in respect of a new product depends on whether or not close substitutes
are avail-able. Depending on whether or not close substitutes are available, in pricing a new
product, generally two kinds of pricing strategies are suggested, viz., (i) price skimming and
(ii) price penetration.

Price Skimming:-
It is a pricing strategy in which a marketer sets a relatively high price for a product or service
at first, then lowers the price over time. It is a temporal version of price
discrimination/yield management. It allows the firm to recover its sunk costs quickly before
competition steps in and lowers the market price.

Price skimming is sometimes referred to as riding down the demand curve. The objective
of a price skimming strategy is to capture the consumer surplus. If this is done successfully,
then theoretically no customer will pay less for the product than the maximum they are
willing to pay. In practice, it is almost impossible for a firm to capture this entire surplus.
The initial high price would generally be accompanied by heavy sales promoting
expenditure. This policy succeeds for the following reasons.
First, in the initial stage of the introduction of product, demand is relatively inelastic because
of consumers' desire for distinctiveness by the consumption of a new product.
Second, cross-elasticity is usually very low for lack of a close substitute.

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 Third, step-by-step skimming consumers' surplus available at the lower segments of demand

curve.

Penetration Pricing:-
It is the pricing technique of setting a relatively low initial entry price, often lower than
the eventual market price, to attract new customers. The strategy works on the
expectation that customers will switch to the new brand because of the lower price.
Penetration pricing is most commonly associated with a marketing objective of increasing
market share or sales volume, rather than to make profit in the short term.The success of
penetration price policy requires the existence of the following conditions.

First, the short run demand for the product should have elasticity greater than unity. It
helps in capturing the market at lower prices.
Second, economies of large-scale production are available to the firm with the increase in
sales. Otherwise, increase in production would result in increase in costs which might reduce
the competitive-ness of the price.
Third, the product should have a high cross-elasticity in relation to rival products for the
initial lower price to be effective.
Finally, the product, by nature should be such that it can be easily accepted and adopted by
the consumers.
Pricing in Maturity Period:
Maturing period is the second stage in the life-cycle of a product. It is a stage between the
growth period and decline period of sales. Sometimes maturity period is bracketed with
saturation period. Matu- rity period may also be defined as the period of decline in the
growth rate of sales (not the total sales) and the period of zero growth rate. The concept of
maturity period is useful to the extent it gives out signals for taking precaution with regard
to pricing policy. However, the concept itself does not provide guidelines for the pricing
policy. Joel Dean suggests that the "first step for the manufacturer whose specialty is
about to slip into the commodity category is to reduce real...prices as soon as the system of
deterioration appears." But he warns that "this does not mean that the manufacturer
should declare open price war in the industry". He should rather move in the direction of
"product improvement and market segmentation".
Pricing a Product in Decline:
The product in decline is one that enters the post-maturity stage. In this stage, the total sale of

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 the product starts declining. The first step in pricing strategy in this stage is obviously to
reduce the price. The product should be reformulated and remodeled to suit the consumers'
preferences. It is a common practice in the book trade. When the sale of a hard-bound
edition reaches saturation, paper-back edition is brought into the market. This facility is,
however, limited to only a few

1.6 Multiple Product Pricing

The price theory or microeconomic models of price determination are based on the assumption
that a firm produces a single, homogeneous product. In actual practice, however,
production of a single homogeneous product by a firm is an exception rather than a rule.
Almost all firms have more than one product in their line of production. Even the most
specialized firms produce a commodity in multiple models, styles and sizes, each so much
differentiated from the other that each model or size of the product may be considered a
different product. For example, the various models of refrigerators, TV sets, radio and car
models produced by the same company may be treated as different products for at least pricing
purpose. The various models are so differentiated that consumers view them as different
products and in some cases, as perfect substitutes for each other. It is, therefore, not surprising
that each model or product has different AR and MR curves and that one product of the firm
competes against the other product. The pricing under these conditions is known as multi-
product pricing or product-line pricing.

The major problem in pricing multiple products is that each product has a separate
demand curve. But, since all of them are produced under one organization by
interchangeable production facilities, they have only one inseparable marginal, cost curve.
That is, while revenue curves, AR and MR, are separate for each product, cost curves, AC
and MC, are inseparable. Therefore, the marginal rule of pricing cannot be applied
straightaway to fix the price of each product separately. The problem, however, has been
provided with a solution by E.W. Clements. The solution is similar to the one employed to
illustrate third degree price discrimination. As a discriminating monopoly tries to maximize
its revenue in all its markets, so does a multi-product firm in respect of each of its products.
To illustrate the multiple product pricing, let us suppose that a firm has four different products
- A, B, C and D in its line of production. The AR and MR curves for the four goods are shown
in four segments of Diagram 10.2 The marginal cost for all the products taken together is shown

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by

Diagram 10.2

The marginal cost for all the products taken together is shown by the curve MC, which is
the factory marginal cost curve. Let us suppose that when the MRs for the individual
products are horizontally summed up, the aggregate MR (not given in the figure) passes
through point C on the MC curve. If a line parallel to the X-axis, is drawn from point C
to the Y-axis through the MRs, the intersecting points will show the points where MC and
MRs are equal for each product, as shown by the line EMR, the Equal Marginal
Revenue line. The points of intersection between EMR and MRs determine the output level
and price for each product. The output of the four products are given as OQ1 of product A;
Q1Q2 of B; Q2Q3 of C; Q3Q4 of D. The respective prices for the four products are: P1Q1
for product A; P2Q2 for B; P3Q3 for C, and P4Q4 for D. These price and output
combinations maximize the profit from each product and hence the overall profit of the
firm.

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1.7 Transfer Pricing

Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges
made between related parties for good, services, or use of property (including intangible
property). Transfer prices among components of an enterprise may be used to reflect
allocation of resources among such components, or for other purposes. we can say the
price at which transfer takes place called transfer price. A high price will increase profits of
the units at the earlier stage of production, whereas a low price will make later stage
production more profitable. while an incorrect price can affect the total profit earned by the
firm.
Transfer Pricing with No External Market
The discussion in this section explains an economic theory behind optimal transfer pricing
with optimal defined as transfer pricing that maximizes overall firm profits in a non-realistic
world with no taxes, no capital risk, no development risk, no externalities or any other
frictions which exist in the real world. In practice a great many factors influence the
transfer prices that are used by multinational corporations, including performance
measurement, capabilities of accounting systems, import quotas, customs duties, VAT,
taxes on profits, and (in many cases) simple lack of attention to the pricing.

Diagra
m 10.3
From marginal price determination theory, the optimum level of output is that where
marginal cost equals marginal revenue. That is to say, a firm should expand its output as

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 long as the marginal revenue from additional sales is greater than their marginal costs. In
the diagram that follows, this intersection is represented by point A, which will yield a
price of P*, given the demand at point B.

It can be shown algebraically that the intersection of the firm's marginal cost curve and
marginal revenue curve (point A) must occur at the same quantity as the intersection of the
production division's marginal cost curve with the net marginal revenue from production (point
C).
Transfer Pricing with a Competitive External Market

When a firm is selling some of its product to itself, and only to itself (i.e. there is no
external market for that particular transfer good), then the picture gets more complicated, but
the outcome remains the same. The demand curve remains the same. The optimum price and
quantity remain the same. But marginal cost of production can be separated from the
firm's total marginal costs. Likewise, the marginal revenue associated with the production
division can be separated from the marginal revenue for the total firm. This is referred to
as the Net Marginal Revenue in production (NMR) and is calculated as the marginal
revenue from the firm minus the marginal costs of distribution.

Diagra
m 10.4

If the production division is able to sell the transfer good in a competitive market (as well
as internally), then again both must operate where their marginal costs equal their marginal

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 revenue, for profit maximization. Because the external market is competitive, the firm is
a price taker and must accept the transfer price determined by market forces (their
marginal revenue from transfer and demand for transfer products becomes the transfer
price). If the market price is relatively high (as in Ptr1 in the next diagram), then the firm
will experience an internal surplus (excess internal supply) equal to the amount Qt1 minus
Qf1. The actual marginal cost curve is defined by points A,C,D.
Transfer Pricing with an Imperfect External Market

If the firm is able to sell its transfer goods in an imperfect market, then it need not be a
price taker. There are two markets each with its own price (Pf and Pt in the next
diagram).

Diagram
10.5
The aggregate market is constructed from the first two. That is, point C is a horizontal
summation of points A and B (and likewise for all other points on the Net Marginal Revenue
curve (NMRa)). The total optimum quantity (Q) is the sum of Qf plus Qt.

1.8 Pricing for Established Products

In pricing a product in relation to its well established substitutes, generally three types of
pricing strategies are adopted, viz., (i) pricing below the ongoing price, (ii) pricing at par
with the prevailing market price, and (iii) pricing above the existing market price. Let us
now see which of these strategies are adopted under what conditions.
Pricing Below the Market-Price:
Pricing below the prevailing market price of the substitutes is generally preferred under
two conditions. First, if a firm wants to expand its product-mix with a view to utilizing its
unused capacity in the face of tough competition with the established brands, the strategy

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 of pricing below the market price is gener- ally adopted. This strategy gives the new brand
an opportunity to gain popularity and establish itself. For this, however, a high cross-
elasticity of demand between the substitute brands is necessary. This strategy may,
however, not work if existing brands have earned a strong brand loyalty of the consumers.
If so, the price incentive from the new producers must, therefore, overweigh the brand
loyalty of the consumers of the established products, and must also be high enough to attract
new consumers. This strategy is similar to the penetrating pricing. Second, this technique
has been found to be more successful in the case of innovative products. When the
innovative product gains popularity, the price may be gradually raised to the level of market
price.
Pricing at Market Price:
Pricing at par with the market price of the existing brands is considered to be the most
reasonable pricing strategy for a product which is being sold in a strongly competitive
market. In such a market, keeping the price below the market price is not of much avail
because the product can be sold in any quantity at the existing market rate. The strategy is
also adopted when the seller is not a 'price leader'. It is rather a 'price-taker' in an
oligopolistic market. This is, in fact, a very common pricing strategy, rather the most
common practice.
Pricing Above the Existing Market-Price:
The strategy is adopted when a seller intends to achieve a prestigious position among the
sellers in the locality. This is a more common practice in case of products considered to be
a commodity of conspicuous consumption of prestige goods of deemed to be of much
superior quality. Consumers of such goods prefer shopping in a gorgeous shop of a posh
locality of the city. This is known as the 'Veblen Effect'. Sellers of such goods rely on
their customers' high propensity to consume a prestigious commod- ity. After the seller
achieves the distinction of selling high quality goods, though at a high price, they may sell
even the ordinary goods at a price much higher than the market price. This practice is
common among sellers of readymade garments.
Besides, a firm may sets a high price for its product if it pursues the 'skimming price
strategy'. This pricing strategy is more suitable for innovative products when the firm can
be sure of the distinctiveness of its product. The demand for the commodity must have a
low cross-elasticity in respect of competing goods.

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 1.9 Peak-load Pricing

In this pricing technique applied to public goods. Instead of different demands for
the same public good, we consider the demands for a public good in different periods
of the day, month or year, then finding the optimal capacity (quantity supplied) and,
afterwards, the optimal peak-load prices.

This has particular applications in public goods such as public urban transportation,
where day demand (peak period) is usually much higher than night demand (off-
peak period). By subtracting the marginal costs of operation from the original
demands we find the marginal benefits of capacity, which must then be vertically
aggregated and equated to the marginal cost of increasing capacity. With the
optimal capacity found, the optimal peak-load prices are found by adding the
marginal costs of operation to the marginal benefit generated, in each period, by the
optimal capacity. It may happen, however, that the optimal capacity is not fully used
during the off-peak period. In that case, the capacity expansion will be totally
supported by the peak demanders.

As Diagram 10.6 shows, if electricity price is fixed in accordance with peak-load

demand OP3 will be the price and if it is fixed according to off-load demand, price
will be OP1. The problem is what price should be fixed? If a 'peak-load' price
(OP3) is charged uniformly in all reasons, it will be unfair because consumers
will be charged for what they do not consume. Besides, it may affect business
activities ad- versely. If electricity production is a public monopoly, the government
will not allow a uniform 'peak- load' price.

Diag
ram

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 10.6

On the other hand, if a uniform 'off load' price (OP1) is charged, production will
fall to OQ2 and there will be acute shortage of electricity during peak hours. It
leads to 'breakdowns' and 'load-shedding' during peak-load periods, which disrupt
production and make life miserable. This is a regular feature in Delhi, the capital
city of India. This is because electricity rates in Delhi are said to be one of the
lowest in the country.

Alternatively, if an average of the two prices, say P2 is charged, it will have the
demerits of both 'peak- load' and 'off-load' prices. There will be an excess
production to the extent of AB during the 'off-load' period, which will go waste as it
cannot be stored. It production is restricted to OQ1, price P2 will be unfair. And,
during the 'peak-load' period, there will be a shortage to the extent of BC, which
can be produced only at an extra marginal cost of CD.
1.10 Ramsey Pricing

If an enterprise has common costs, marginal cost pricing may not be feasible.
Ramsey pricing is the second best alternative that allows the firm to recover its
cost while minimizing adverse effects of allocative efficiency.It is applicable to
public utilities or regulation of natural monopolies, such as telecom firms.
Ramsey pricing is sometimes consistent with a government's objectives because
Ramsey pricing is economically efficient in the sense that it can maximize welfare
under certain circumstances. There are, however, problems with Ramsey pricing. A
profit-maximizing operator will choose Ramsey prices only if all markets are
equally monopolistic or equally competitive. If markets are not equally monopolistic
or competitive, then the regulator has an interest in taking steps to ensure that the
extent to which the operator can use Ramsey pricing is limited to groups of
services that are subject to similar degrees of competition. Regulators typically do
this by forming baskets of services that are subject to similar degrees of
competition and allowing the operator price flexibility within each service basket.
Even though Ramsey pricing can be economically efficient, it may not be
consistent with the government's goal of providing affordable service to the poor
and the rate by which prices change to achieve Ramsey- efficient prices may not be
consistent with political sustainability. As a result of these two concerns, the
regulator sometimes limits the operator's ability to pursue Ramsey pricing within a
service basket. In the case of services to the poor, the regulator may place upper limits

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 on the prices. Lastly, regulators often note that Ramsey pricing is a form of price
discrimination - although not necessarily a bad form of price discrimination - and
customers sometimes object to it on that basis. The public sometimes believes that
it is unfair to cause one type of customer to pay a higher mark-up above marginal
cost than another type of customer. In such situations regulators may further limit an
operator's ability to adopt Ramsey prices.

Practical issues exist with attempts to use Ramsey pricing for setting utility prices.
It may be difficult to obtain data on different price elasticities for different
customer groups. Also, some customers with relatively inelastic demands may
acquire a strong incentive to seek alternatives if charged higher markups, thus
undermining the approach. Politically speaking, customers with relatively inelastic
demands may also be viewed as those for whom the service is more necessary or
vital; charging those higher markups can be challenged as unfair.

1.11 Limit Pricing

A limit price is the price set by a monopolist to discourage economic entry into a
market, and is illegal in many countries. The limit price is the price that the entrant
would face upon entering as long as the incumbent firm did not decrease output.
The limit price is often lower than the average cost of production or just low
enough to make entering not profitable. The quantity produced by the incumbent
firm to act as a deterrent to entry is usually larger than would be optimal for a
monopolist, but might still produce higher economic profits than would be earned
under perfect competition. The problem with limit pricing as strategic behavior is
that once the entrant has entered the market, the quantity used as a threat to deter
entry is no longer the incumbent firm's best response. This means that for limit pricing
to be an effective deterrent to entry, the threat must in some way be made credible.
A way to achieve this is for the incumbent firm to constrain itself to produce a
certain quantity whether entry occurs or not. An example of this would be if the firm
signed a union contract to employ a certain (high) level of labor for a long period of
time.
1.12 Loss leader Pricing

A company loses money on one service but earns on a related product. This strategy
is often implemented as a part of a promotion campaign. The intent of this
practice is not only to have the customer buy the (loss leader) sale item, but other
products that are not discounted. These bargains will attract customers who may

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 then purchase other products/services even if they don't buy the product which
price had been initially reduced. This is where a company will make up for the loss
as it will be selling other items that generate high profits. One example is HP
inkjet printers that are often sold to retail customers below their true value, at a
price which seems to be affordable to most consumers. Moreover, these printers are
sometimes offered for free - free after rebate, free with a purchase of an HP
computer, etc. However, consumers have to pay the regular price for ink cartridges.
It is ink cartridges, not the printers that generate high profits for the HP. Another
example is Gillette's safety razor handles that are sold at a loss, but sales of
disposable razor blades are very profitable.

Major forces influencing pricing are company's strategic goals, demand for its
products or services, and/or competition. Management should pay particular
attention when deciding on pricing methods since the success of the entire business
depends on it.

1.13 Summary

Pricing decisions require a synthesis of economic and marketing principles, an

appreciation of legal and ethical constraints, and the ability to use accounting,
financial, and market research data. Pricers face different market conditions which
require distinguished pricing strategies. One of the most important driv-ers of the
variability on those conditions is the state of demand. In real business world, firms
practices numerous pricing strategies followed by firms in specific situations.

1.14 Key Words

Cost-plus pricing: Cost-plus pricing is the simplest pricing method. The firm
calculates the cost of producing the product and adds on a percentage (profit) to
that price to give the selling price. Skimming: Selling a product at a high price.
Penetration pricing: Selling a product at a high price.
Limit price: Limit price is the price that the entrant would face upon entering
aslong as the in cumbent firm did not decrease output.
Transfer pricing: The price that is assumed to have been charged by one
part of a company for products and services it provides to another part of the
same company, in order to calculate each division's profit and loss separately.
Loss leader pricing: A loss leader or leader is a product sold at a low price (at
cost or below cost) to stimulate other, profitable sales.

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 Peak-load pricing: it is a pricing technique applied to public goods Instead of
different
demands for the same public good, we consider the demands for a public
good in different periods of the day, month or year, then finding the optimal
capacity (quantity supplied) and, after wards, the optimal peak-load prices.
Ramsey pricing: Ramsey pricing is concerned with prices that maximize the sum
of industry consumer surplus and profits

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