Multimedia Marketing/Marketing.iso/market/chapter8.5p

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SECTION 8.5 Some Demand Based Pricing Strategies

INSTRUCTIONS Think about how companies should include demand estimates when
they set price. Then go into this section for an introduction to the usage of these estimates.

EXAMPLE

Historically an overlooked market, auto manufacturers had a
virtual monopoly for years in the aftermarket for parts. Producing
and supplying replacement fenders, hoods, bumpers, and other parts
was one of the most profitable portions of the business. Body shops
were happy to go along with the high prices charged by the companies,
as they marked up the inflated parts and generated high profits for
themselves. Only insurance companies (who were left to pay the bill)
and consumers (who paid high insurance premiums as a result) suffered
in the process.

Offshore manufacturers (most in Asia) began to produce several of
the most commonly-used replacement parts as early as the early
1980's. A large car insurer commissioned a company to develop a
computerized repair estimating and parts locating system from a
customized data base. The system enabled the insurance company to
make their claims estimates using the "gypsy" parts sold by the
copycat companies.

There were complaints about the quality of the replacement parts by
the auto manufacturers, body shops, and some customers. But the
monopoly by the auto manufacturers was broken. The prices of many
parts went down in several years, by as much as half.

DETAILS

Management is wise to consider all aspects of demand when making
pricing decisions. As is illustrated in the auto parts manufacturing
aftermarket example, inattention to demand can result in major losses
of profit and market share. This section looks at price perceptions
and price discrimination and skimming strategies.

Price perceptions are an important phenomenon for management to
consider. In reality, consumers' perceptions of the appropriateness
of a particular price, rather than the actual price level, are
what is important in considering demand. A retail drug store, for
instance, has a low-price reputation. This firm uses newspaper
advertising that frequently mentions the discounts and bargains
available. The interior of the store is very cluttered and disorganized.
In addition, the salespersons are very difficult to find.

In fact, this store charges prices that are no lower than others
in the same market area. Yet consumers believe that they are lower.
The store manager might err if she tried to improve the appearance
of the store and hire better salespersons. Many bargain-hunting
consumers would interpret these moves as signifying that the retailer
is no longer a low-price outlet.

Marketing managers, then, should study the perceptions of consumers
regarding prices and not the actual prices. To do otherwise is to
ignore the very important role of demand.

An important demand-related pricing strategy is price discrimination.
Price discrimination exists when a marketer charges different prices
for items of the same kind and grade to different buyers. The discount
fare structures for advance purchases of major airlines are examples
of price discrimination.

This method is generally illegal under the provisions of federal price
discrimination laws for the sale of goods (not services) to
different members at the same level of distribution channels,
unless the firm can raise one of the legally prescribed defenses.
However, this law does not prohibit price discrimination involving
consumers.

Further, foreign markets sometimes present an opportunity to charge
different prices to channel members,  although an increasing number
of countries have passed "anti-dumping, laws that prohibit the
selling of excess inventories in foreign markets at lower-than-normal
prices. The United States has such a regulation in effect against
Japanese cars.

PROBLEM 1

It would not be wise for a bicycle manufacturer to discriminate in
the prices charged to retailers when:

A. The price differences are based on cost differences.
B. The price differences reflect company efforts to meet competition.
C. The retailers' demand elasticities for bicycles are different.
D. It sells in foreign countries with anti-dumping laws.

WORKED

It would not be wise for a bicycle manufacturer to disciminate in
the prices charged to retailers when it sells in foreign countries
with anti-dumping laws. These laws prohibit selling excess inventories
in foreign markets at lower-than-normal prices. Many foreign countries
do not like the idea of serving as depositories of goods that foreign
producers want to dispose of at depressed prices. They feel that such
practices harm producers (in this case, of bicycles) who are
headquartered in the foreign country. Often companies are willing to
get rid of excess inventory at very low prices because the only
alternative is to destroy it or give it away. And foreign markets
are appealing because of the price discrimination laws in effect in
the United States.
ANSWER D
INSTRUCTIONS Think about how companies should include demand estimates when
they set price. Then go into this section for an introduction to the usage of these estimates.

EXAMPLE

Historically an overlooked market, auto manufacturers had a
virtual monopoly for years in the aftermarket for parts. Producing
and supplying replacement fenders, hoods, bumpers, and other parts
was one of the most profitable portions of the business. Body shops
were happy to go along with the high prices charged by the companies,
as they marked up the inflated parts and generated high profits for
themselves. Only insurance companies (who were left to pay the bill)
and consumers (who paid high insurance premiums as a result) suffered
in the process.

Offshore manufacturers (most in Asia) began to produce several of
the most commonly-used replacement parts as early as the early
1980's. A large car insurer commissioned a company to develop a
computerized repair estimating and parts locating system from a
customized data base. The system enabled the insurance company to
make their claims estimates using the "gypsy" parts sold by the
copycat companies.

There were complaints about the quality of the replacement parts by
the auto manufacturers, body shops, and some customers. But the
monopoly by the auto manufacturers was broken. The prices of many
parts went down in several years, by as much as half.

DETAILS

By pricing to meet the demand of each individual buyer, a seller
can realize a high average price and total profit. For example,
prices for most durables such as automobiles, furniture, and major
appliances as listed by retail stores are typically negotiable. Further,
industrial goods marketing, especially for large purchases on items
such as plant and equipment, involves extended price negotiations.
This practice enables sellers to increase their overall profits in
the process.

Some buyers are willing to pay high prices (their demand is inelastic).
Others are willing to buy only at lower prices (elastic demand).
In some regions of the country, for example, competition may be less
severe than others and demand may be more inelastic. In the case of
stylized clothing, for instance, demand on the west and east coasts
tends to be more elastic than it is in the interior of the country,
because competition is much more severe on the coasts.

There are major differences in demand elasticities for gasoline.
Gasoline stations and convenience stores located just off major
freeways often charge high prices for gasoline. They know that
travelers--both business and tourist--leave the highway and look
for a convenient source of gasoline. They probably will stop at the
first service station they see, provided that it appears to be
reasonably clean and well-kept. They ordinarily will pay whatever
price is posted, rather than taking the time and effort to drive
to other areas in search of lower prices. Their demand tends to be
inelastic.

In contrast, gasoline stations and convenience stores located away
from the highways primarily serve local residents. Marketers know that
these individuals will shop around for gasoline. If one station
posts a lower price than others, many consumers will purchase there.
Demand is elastic in this case and prices tend to be relatively low.
In short, price discrimination in this industry has a rationale.

How much will a price discriminating marketer be willing to reduce
prices in sectors where demand is elastic? In most cases,
each item's average cost plus some minimally acceptable unit profit
serves as a floor below which the seller is very reluctant or unwilling
to sell.

PROBLEM 2

Under what circumstances would a paint wholesaler discriminate in
its pricing to paint dealers?

A. If the extent of competition does not differ between markets.
B. If buyers in all of the markets do not readily perceive prices
   as being high.
C. If customers in different markets differ in their brand loyalty
   toward company brands.
D. If buyers in all markets believe that higher prices are justified
   by inflation.

WORKED

A paint wholesaler might decide to discriminate in price if customers
in different markets differ in their brand loyalty toward company
brands. The markets in which their loyalty is high will have a
lower elasticity than those in which loyalty is weak. This would
justify a higher price in the first market than in the second. If
the extent of competition does not differ between the markets, buyers
in all of the markets do not readily perceive prices to be high,
and if buyers in all markets believe that higher prices are justified
by inflation,  the elasticity would be similar from one market to
another, and price discrimination might not be justified.

ANSWER  C
INSTRUCTIONS Think about how companies should include demand estimates when
they set price. Then go into this section for an introduction to the usage of these estimates.

EXAMPLE

Historically an overlooked market, auto manufacturers had a
virtual monopoly for years in the aftermarket for parts. Producing
and supplying replacement fenders, hoods, bumpers, and other parts
was one of the most profitable portions of the business. Body shops
were happy to go along with the high prices charged by the companies,
as they marked up the inflated parts and generated high profits for
themselves. Only insurance companies (who were left to pay the bill)
and consumers (who paid high insurance premiums as a result) suffered
in the process.

Offshore manufacturers (most in Asia) began to produce several of
the most commonly-used replacement parts as early as the early
1980's. A large car insurer commissioned a company to develop a
computerized repair estimating and parts locating system from a
customized data base. The system enabled the insurance company to
make their claims estimates using the "gypsy" parts sold by the
copycat companies.

There were complaints about the quality of the replacement parts by
the auto manufacturers, body shops, and some customers. But the
monopoly by the auto manufacturers was broken. The prices of many
parts went down in several years, by as much as half.

DETAILS

In effect, the objective of price discrimination is to turn consumer
surplus into profit for the firm. "Consumer surplus" is the term
used to describe the "net savings, that people would accrue by not
having to pay the amount they would be willing to pay for an item.
It reflects a value to consumers--somewhat like an unexpected gift.

To illustrate, under "normal" circumstances, such as if there were
pure competition,f the price that people would have to pay would
equal average cost plus the prevailing margin in the industry. This
is called the "equilibrium price", because it is where the quantity
that buyers are willing to buy equals the amount that sellers are
willing to pay. Consumers would like to obtain a lower price, but
marketers are not interested. Marketers would not hesitate to
charge higher prices, were it not for the fact that consumers would
simply patronize another company.

Some of the buyers would be willing to pay a higher price for the
item but do not have to because the market price is lower. The
net "savings" for these buyers is called consumer surplus. Thus,
under price discrimination, management adjusts its prices to turn
this surplus into profits. It earns extra profits because at lower
prices more consumers will buy the product and some of those who
already buy it will purchase larger quantities.

A major problem with price discrimination is that it requires
extensive control and the ability to "feel out" a buyer's
demand through negotiation. Consequently, a price discrimination
strategy makes most sense in situations involving substantial
personal selling effort and where negotiation is the norm. So
long as the lowest price covers the firm's average costs plus an
acceptable profit margin, it can result in higher overall profits
than if all customers paid identical prices.

Firms that discriminate need to take steps to see that the markets
are insulated. This means concealing the fact that some buyers pay
a higher price than others. If a sporting goods company sells an
exercise machine through retail stores at a high price to reach one
market segment and through the mail at a lower price to reach
another segment, there is always the danger that the retail buyers
will discover that they are paying a premium price for an identical
product. If a department store sells products in a "bargain
basement" at a lower price than it sells the same items upstairs,
some upstairs consumers are likely to find out about this and tell
their friends what is happening and the price discrimination strategy
will not only fail but will creat hostility among some customers.

PROBLEM 3

A home appliance dealer sells its coffeemaker at a higher price in
department than it does in discount stores. How can the markets
be insulated?

A. Advertise to the two segments in different media.
B. Extend credit to department store but not to discount store buyers.
C. Offer free delivery to department store but not to discount store
   buyers.
D. Stock smaller inventories in department than in discount stores.

WORKED

If a home appliance dealer wants to sell its coffeemaker at a higher
price in department than it does in discount stores, it can insulate
the market by advertising to the two segments in different media.
This will not fully insulate the markets, of course, but it should
help. Research can be conducted to discover the media viewing habits
of each market segment and what qualities they want in a coffee pot.
Then media can be chosen based on the research, with different
appeals for each set of target customers. If the research and
advertising effort are well-conceived and implemented, only one
group of target customers will receive each of the sets of
advertisements.

ANSWER  A
INSTRUCTIONS Think about how companies should include demand estimates when
they set price. Then go into this section for an introduction to the usage of these estimates.

EXAMPLE

Historically an overlooked market, auto manufacturers had a
virtual monopoly for years in the aftermarket for parts. Producing
and supplying replacement fenders, hoods, bumpers, and other parts
was one of the most profitable portions of the business. Body shops
were happy to go along with the high prices charged by the companies,
as they marked up the inflated parts and generated high profits for
themselves. Only insurance companies (who were left to pay the bill)
and consumers (who paid high insurance premiums as a result) suffered
in the process.

Offshore manufacturers (most in Asia) began to produce several of
the most commonly-used replacement parts as early as the early
1980's. A large car insurer commissioned a company to develop a
computerized repair estimating and parts locating system from a
customized data base. The system enabled the insurance company to
make their claims estimates using the "gypsy" parts sold by the
copycat companies.

There were complaints about the quality of the replacement parts by
the auto manufacturers, body shops, and some customers. But the
monopoly by the auto manufacturers was broken. The prices of many
parts went down in several years, by as much as half.

DETAILS

Skimming is another strategy designed to turn consumer surplus into
profits. In this case, management initially establishes high prices
for a new product or service and and directs it  to market
segments with relatively inelastic demand. As these high-price
segments become saturated, the firm lowers its price to capture
additional customers. Successive rounds of price cuts follow until
further reductions appear unprofitable.

A telephone company provides a classic example of skimming. The
firm charges a significant premium rate for new items it offers
customers, such as extra-long telephone cords, color phones, caller
identification, and new types of phones. After it satisfies initial
demand, the company reduces an item's premium rate to attract
additional customers. To bring in still more customers, it lowers
prices still further so that any premium is essentially nominal.

There are two major problems with skimming:

. Initial high prices raise the temptation for competitors to market
  similar items, but at lower prices, resulting in low long-run
  profits for all. An example is the initial high price charged for
  cordless telephones, which led to intensive competition, falling
  prices, and eventual poor profit positions for the remaining
  competitors.

. Cutting prices too often might signal to buyers that something is
  wrong with the product or the company.

Therefore, a skimming strategy makes most sense in situations where
there exists significant barriers to entry by competitors. Further,
the strategy should not result in price changes being made too
frequently.

A direct alternative to skimming for a new product is "penetration
pricing" (also called "premptive penetration" when accompanied
by heavy promotion during a product's introduction) which requires
setting initial prices relatively low to rapidly penetrate those
who seek bargains and are very responsive to low prices.

This pricing method is closely related to competition-based approaches,
as management intends for it to generate economies of scale before
competitors have a chance to enter the market. By successfully
obtaining a large sales volume through low prices, a firm might be
able to attain low average costs due to the scale of its operations
and its experience. This may drive away potential new competitors
because entry into a new market is generally accompanied by low
volumes and high average costs.

Penetration pricing does mean that a firm foregoes the opportunity
of generating extra profit from first setting high prices to meet
high initial demand and then lowering them, to capture further
customers. But in large, highly-competitive markets, such a strategy
makes sense; it serves to strengthen a company's long-run profitability.

When new supermarkets open they frequently pursue a penetration
strategy. During the first few weeks of operation, the stores sell
many items, or sometimes their entire stock, at very low prices. The
idea is to attract substantial store traffic. After the initial
discount period is over, the store gradually increases most or all
of its prices to market levels.

PROBLEM 4

A baked goods company is about to bring out a new cracker and use
a skimming strategy. What is a possible problem with this technique?

A. The company may keep prices so low that it will not recover its
   return on investment.
B. Competitors may be attracted by high prices and enter the market
   at lower prices.
C. The company will not lower its prices often enough after the
   product has been in existence over a period of time.
D. Low prices may prompt prestige-seeking consumers to avoid the
   product.

WORKED

If a baked goods company is about to enter the market with a new
cracker and will use a skimming strategy, a possible problem is
that competitors may be attracted by the high prices and enter the
market at lower prices. This may prevent the company from attaining
economies of scale and taking advantage of the learning curve. The
problem is even greater if demand is elastic, as the firm may
quickly lose market share. The competition may force the company to
lower its prices, which often sets off price wars. In such cases the
firm, as well as its competitors, may not earn an adequate return on
invested capital.

ANSWER  B