Pricing Strategy

Setting Price Levels,

Managing Price Discounts, &

Establishing Price Structures

Pricing Strategy

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States

Tim J. Smith

Wiglaf Pricing

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Pricing Strategy: Setting Price Levels,

Managing Price Discounts, & Establishing

Price Structures

Tim J. Smith

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Though we live in an infi nite universe that is constantly

expanding, and we are all increasingly infi nitesimally

small by comparison, if we have a good stick and a

well-placed fulcrum, we can move the world. To the next

generation, may your questions be your stick

and your wisdom defi ne your fulcrum.

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

iv

Brief Contents

Part 1 Setting the Price 1

Chapter 1 Boundaries of a Good Price 2

Chapter 2 Profi t’s Sensitivity to Price 23

Chapter 3 Customer Perception–Driven Pricing 45

Chapter 4 Price to Value 60

Chapter 5 Psychological Infl uences on Price Sensitivity 79

Part 2 Managing Price Variances 101

Chapter 6 Price Segmentation 102

Chapter 7 Price Promotions 125

Chapter 8 Discount Management 143

Part 3 Establishing Price Structures 158

Chapter 9 Price Structures and Multipart Pricing 159

Chapter 10 Add-ons, Accessories, and Complementary Products 179

Chapter 11 Versioning 195

Chapter 12 Bundling 214

Chapter 13 Subscriptions and Customer Lifetime Value 237

Chapter 14 Yield Management 253

Part 4 Pricing Strategy 270

Chapter 15 Competition and Pricing 271

Chapter 16 Product Life Cycle Pricing 286

Chapter 17 Pricing Decisions and the Law by

Dennis P. W. Johnson 303

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v

Table of Contents

FOREWORD BY JANICE D. CHAFFIN xvi

PREFACE xviii

ACKNOWLEDGMENTS xix

ABOUT THE AUTHOR xx

INTRODUCTION xxi

PART 1 SETTING THE PRICE 1

CHAPTER 1 BOUNDARIES OF A GOOD PRICE 2

Informing Price Decisions 3

The Importance of Price 3

Cross Functional 4

Impacting Profi ts 5

Infl uencing Price Capture 6

The Art and Science of Pricing 8

Exchange Value Models 8

Extreme Boundaries 9

Narrower Boundaries 12

Pricing in Proportion to Value 16

Setting Prices 17

Summary 17

Exercises 18

Appendix 1: Inferior Goods 20

Notes 21

CHAPTER 2 PROFIT’S SENSITIVITY TO PRICE 23

Profi t Sensitivity Analysis 24

Volume Hurdles 25

Decision Implications 27

Elasticity of Demand 29

Elastic Markets 31

Inelastic Markets 31

Measured Elasticity of Demand 32

Necessary, but Insuffi cient 33

Economic Price Optimization 34

Profi t Sensitivity Analysis with Changing Cost Structures 36

Summary 38

Exercises 39

Appendix 2.A: A Discrete Demand 41

Appendix 2.B: Derivation of Economic Price Optimization 43

Notes 44

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vi Table of Contents

CHAPTER 3 CUSTOMER PERCEPTIONDRIVEN PRICING 45

Matching the Price-Setting Approach to the Market Stage 46

Revolutionary Markets 46

Evolutionary Markets 47

Mature Markets 48

Conjoint Analysis 48

Using Customer Preferences to Reveal

Part-Worth Utilities 49

Study Design 53

Summary 56

Exercises 57

Notes 59

CHAPTER 4 PRICE TO VALUE 60

Price-to-Benefi ts Map 61

Value Equivalence Line 62

Zone of Indiff erence 63

Value Advantaged 64

Value Disadvantaged 65

Customer Perceptions 65

Dispersion in Perceived Price 66

Dispersion in Perceived Benefi ts 67

Dispersion in Both Perceived Price and Perceived Benefi ts 68

New Product Positioning 69

Price-Neutral Positioning 70

Penetration Pricing 71

Price Skimming 71

Summary 72

Exercises 73

Appendix 4: General Motors: Price Management

in Summer 2007 76

Notes 77

CHAPTER 5 PSYCHOLOGICAL INFLUENCES ON PRICE SENSITIVITY 79

True Economic Costs 81

Shared Cost Eff ect 81

Switching Costs 82

Expenditure Eff ect 82

Diffi cult Comparison Eff ect 83

Perceptual Challenges 84

Prices Ending in 9 84

The Fairness Eff ect 86

Overconfi dence of Control over Future Behavior 87

Small-Pie Bias 87

Promotional Infl uence 88

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Table of Contents vii

Prospect Theory 88

Losses Weigh Heavier than Gains 89

Infl ection at the Point of Reference 89

Diminishing Sensitivity 89

Risk Aversion in the Positive Frame and Risk Seeking

in the Negative Frame 90

Utility Function from Prospect Theory 90

Prescriptions 90

Eff ects Related to Prospect Theory 91

Reference Price Eff ects 91

Endowment Eff ect 92

Anchoring 93

Comparison Set Eff ect 94

Framing Eff ect 94

Order Bias 95

End-Benefi t Eff ect 95

Summary 96

Exercises 97

Notes 99

PART 2 MANAGING PRICE VARIANCES 101

CHAPTER 6 PRICE SEGMENTATION 102

Value of Price Segmentation 103

Increasing Profi ts and Customers Served 103

The Segmentation Hedges Key 105

Price Segmentation Classifi cations 106

First-, Second-, and Third-Degree Price Discrimination 106

Complete, Direct, and Indirect Price Segmentation 106

Strategic or Tactical Price Segmentation 107

Designing Segmentation Hedges 107

Common Price Segmentation Hedges 108

Customer Demographics/Firmographics 108

Time of Purchase 110

Purchase Location 110

Buyer Self-Identifi cation 111

Product-Engineered 112

Quantity Purchased 112

Customer Usage 113

Negotiation 115

Examples of Price Segmentation 115

Bank Fees 115

Tavern Drinks 115

Airlines 116

Industrial Markets 116

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viii Table of Contents

Summary 117

Exercises 118

Appendix 6: Economic Model of Unit Prices and Price

Segmentation 120

Notes 123

CHAPTER 7 PRICE PROMOTIONS 125

Positive Eff ects of Price Promotions 126

Price Segmentation 126

Market Size and Share 127

Negative Eff ect of Price Promotions 128

Imperfect Segmentation Hedge 128

Customer Churn 128

Reference Price Eff ect 128

Loss of Price Credibility 129

Increase of Price Sensitivity 129

Managing Vagueness 129

Price Promotion Design 130

Targeted 130

Temporary 131

Special 132

Irregular 132

Examination of Popular Forms of Price Promotions 132

Coupons 132

Trial Off ers 133

Rebates 133

Promotional Bundles 134

Tradeoff s between Popular Price Promotions 134

Newspaper versus In-store Coupons 134

Mail-in versus Instant Rebates 137

Hi-Lo versus EDLP 137

Summary 138

Exercises 139

Notes 142

CHAPTER 8 DISCOUNT MANAGEMENT 143

Challenges in Discount Management Policy 144

Field Executives Push for More Discounts 144

Centralized Executives Push for Higher Prices 145

Disparity Abounds 145

Executives React 145

Identifying Discounting Management Opportunities 146

Net Price Band 147

Net Price by Market Variable 149

Price Waterfall 151

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Table of Contents ix

Discount Decision Management 152

Decision Rights 153

Decision Incentives 153

Summary 155

Exercises 156

Notes 157

PART 3 ESTABLISHING PRICE STRUCTURES 158

CHAPTER 9 PRICE STRUCTURES AND MULTIPART PRICING 159

Price Structures 160

Rethinking the Unit 160

Using Demand Heterogeneity 161

Multipart Price Structures 162

Two-Part Tariff s 162

Tying Arrangements 163

Jazz Clubs and Multipart Pricing—An Illustrative

Example 165

Multipart Price Structures in Industry 167

Refi ning the Entrance Fee and Metered Price 169

Summary 170

Exercises 171

Appendix 9: An Economic Model of a Two-Part Tariff 173

Homogeneous Market 173

Heterogeneous Market 175

Notes 178

CHAPTER 10 ADDONS, ACCESSORIES, AND COMPLEMENTARY PRODUCTS 179

Add-on Price Structure 180

Price Segmentation in Add-on Price Structures 182

Infl uences to Price Levels in Add-on Price Structures 184

Signpost Eff ect 184

Optional Equipment Eff ect 185

Network Externalities 186

Lock-in with Complementary Products 187

Summary 187

Exercises 188

Appendix 10: Economic Model of Add-on Pricing 190

Notes 194

CHAPTER 11 VERSIONING 195

Price Segmentation with Versioning 197

Infl uences on a Versioning Strategy 199

Marginal Costs 199

Prospect Theory 200

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x Table of Contents

Extreme Aversion 200

Version Range, Order, and Number Eff ects 201

Discounting and Constant, Divergent, or Convergent

Price Diff erentials 202

Mixed Versioning and Add-on Price Structures 205

Summary 206

Exercises 206

Appendix 11: Economic Model of Versioning 208

Notes 213

CHAPTER 12 BUNDLING 214

Price Segmentation with Bundling 215

Strategic Bundling 217

Bundle Design 220

Marginal Costs 220

Promotional Bundling and Brand Switching 220

Disaggregated Savings Improve

Bundle Selection 221

Buyers’ Mental Arithmetic of Bundles 222

Legal Issues 224

Tradeoff s in Add-on, Version, and Bundle Pricing 224

Summary 226

Exercises 226

Appendix 12.A: Promotional Bundle Volume Hurdle 231

Appendix 12.B: Economic Model of Bundling 233

Notes 236

CHAPTER 13 SUBSCRIPTIONS AND CUSTOMER LIFETIME VALUE 237

Pricing the Subscription 239

Total Period Price 239

Customer Period Value 240

Customer Lifetime Value 243

Behavioral Eff ects with Subscriptions 244

Market Segmentation 244

Lock-in 244

Increased Consumption Patterns 245

Overestimation Bias 245

Value Proposition Changes and SaaS 246

SaaS 246

Example: QuickBooks 247

Summary 249

Exercises 250

Notes 252

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Table of Contents xi

CHAPTER 14 YIELD MANAGEMENT 253

Fare Classes and Booking Control 255

Fixed Allotment 255

Dynamic Nesting 256

Cancellations, No-shows, and Overbooking 258

Capacity Allocation and Revenue Optimization 258

Capacity Allocation with Certain Demand 258

Capacity Allocation with Uncertain Demand 259

Decision Tree Approach 264

Further Enhancements to Yield Management 266

Summary 266

Exercises 267

Appendix 14: The Normal Distribution Function 268

Notes 269

PART 4 PRICING STRATEGY 270

CHAPTER 15 COMPETITION AND PRICING 271

The Origin of Price Wars 272

Prisoner’s Dilemma 273

Structural Drivers 275

Reacting to Price Reductions 277

Direct Costs and Benefi ts 277

Secondary Consequences 278

Strategic Position 278

Initiating Price Reductions 280

Price as a Strategic Focus 280

Gauging Competitive Response 281

Managing Price Actions 282

Price Signaling 282

Tit-for-Tat Pricing 283

Summary 284

Sony vs. Microsoft Game Console Case Exercise 284

Notes 285

CHAPTER 16 PRODUCT LIFE CYCLE PRICING 286

Introduction 288

Customers of Introductory Markets 290

Pricing in Introductory Markets 292

Growth 293

Customers of Growth Markets 294

Pricing in Growth Markets 294

Intertemporal Price Discrimination 295

Maturity 296

Decline 297

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xii Table of Contents

Summary 297

Amazon Kindle Case Exercise 299

Appendix 16: Bass Diff usion Model 300

Notes 302

CHAPTER 17 PRICING DECISIONS AND THE LAW BY DENNIS P. W. JOHNSON 303

The Aims of the Law of Pricing 304

Unlawful Pricing Behavior 305

Price Fixing 305

Non-Price Vertical Restraints 307

Exclusionary or Predatory Pricing 308

Price and Promotional Discrimination 309

International Antitrust Enforcement 311

Intel Rebates Case Exercise 311

Notes 312

INDEX 314

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xiii

Table of Exhibits

Exhibit 1-1 Profi t Levers 6

Exhibit 1-2 Kenyan Coff ee Negotiation 7

Exhibit 1-3 Expected Total Costs for Standard Metal Stent Implantation 15

Exhibit 1-4 Exchange Value for Drug Eluting Stent 15

Exhibit 1-5 Price Boundaries for Superior Goods: Cypher 16

Exhibit 1-6 Price Boundaries for Inferior Goods 21

Exhibit 2-1 Profi t Sensitivity Analysis of a Price Reduction 26

Exhibit 2-2 The Volume Hurdle: The Volume Hurdle as a Function of Price

Changes for a Firm with a 25 percent Contribution Margin 30

Exhibit 2-3 Volume Hurdle and Demand Curve for Elastic Markets: An Elastic

Demand Curve (« 5 210) is Plotted in Gray. The Volume Hurdle for

a Firm with a 25 percent Contribution Margin is Plotted in Black 31

Exhibit 2-4 Volume Hurdle and Demand Curve for Inelastic Markets: An Inelastic

Demand Curve (« 5 20.5) is Plotted in Gray. The Volume Hurdle for a

Firm with a 25 percent Contribution Margin is Plotted in Black 32

Exhibit 2-5 Measured Elasticity of Demand 33

Exhibit 2-6 Price Optimization 35

Exhibit 2-7 Volume Hurdle with a Changing Contribution Margin 37

Exhibit 2-8 Demand for Aluminum (1930–1950) 42

Exhibit 3-1 Mango Juice Attributes 50

Exhibit 3-2 Mango Juice Rankings 51

Exhibit 3-3 Mango Juice Scores 51

Exhibit 3-4 Mango Juice Part-Worth Utility 52

Exhibit 3-5 Mango Juice Utilities 52

Exhibit 3-6 Paired Comparison: Which Commuter Cycle do you Prefer? 55

Exhibit 3-7 Rating Scale 55

Exhibit 4-1 Sketch of Price to Benefi ts for Sedans 62

Exhibit 4-2 Price-to-Benefi ts Zones 62

Exhibit 4-3 Dispersion in Perceived Price 66

Exhibit 4-4 Dispersion in Perceived Benefi ts 67

Exhibit 4-5 Uncertain Value Proposition with Multiple Products 69

Exhibit 4-6 Neutral Pricing 70

Exhibit 4-7 Penetration Pricing 71

Exhibit 4-8 Price Skimming 72

Exhibit 4-9 Dynamics in Price to Benefi ts During Summer Incentive

Periods in the Automotive Industry 77

Exhibit 5-1 Price Ending Frequency: January 1965 Study by D. W. Twedt of Price

Endings of 30,878 Products in 1,865 Supermarkets in 70 Cities 85

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