Chapter 15 Notes
Pricing Strategies and Determination
Learning objective 1: Define price, explain why cost-based pricing methods are used so
widely, and understand the drawbacks of these methods.
Price is some unit of value given up by one party in return for something from another
party. Our specific focus will be on price as a monetary value charged by an organization
for the sale of its products.
Cost-plus pricing is cost plus overhead plus a fair profit. This is looking at price as an
accountant would. This is a natural way to look at price; however, it often is not the best
There are two common approaches to setting prices based on cost. One is to use a
standard rule-of-thumb markup. The second is to build up the price by adding together
both cost per unit and desired profit.
Learning objective 2: Incorporate demand considerations into pricing and determine a
short-term profit-maximizing price.
One of the fundamental principles of economics: price cause demand. If your price is
lower, demand usually is higher, and vice versa. Elasticity of demand is the relationship
between changes in price and quantity sold.
Break-even analysis [BEA] is an analysis technique that literally means “to have zero
profit”. It is that point at which total cost and total revenue are equal.
Break-even sales = Fixed Cost / Selling Price – Variable Costs.
Demand schedules provide a systematic look at the relationship between price and
quantity sold. Economists quantity the relationship between price and quantity sold using
a concept called elasticity. The elasticity coefficient is the absolute value of the
percentage change in quantity divided by the percentage change in price.
Elasticity coefficient E = Percentage change in Q / Percentage change in P
Inelastic demand is reflected by an elasticity coefficient of less than 1. If you are
looking only at total revenue, then higher prices are favored when demand is inelastic.
Elastic demand is reflected by an elasticity coefficient of greater than 1. Generally
speaking, when demand is elastic, lower prices are favored [again, when considering total
Unitary elasticity means that the coefficient is exactly 1. In these cases, quantity
demanded changes at the same rate as the price does.
Marginal revenues are the change in a firm’s total revenue per unit change in its sales
level. Marginal costs are the change in a firm’s total costs per unit change in its output
Learning objective 3: Identify and explain strategic drivers of prices.
Important strategic factors that will play a role in setting a base price are:
• Positioning strategy
• Specific new product-pricing strategies
• Price-quality inferences.
Opposite ends of the competitive strategy positioning continuum are “low-cost
leadership” and “differentiation”.
Pricing to meet objectives:
• Achieve a target return on investment (ROI). Return on investment (ROI) is the
percentage of the dollar profit generated by each dollar invested in the business.
• Stabilize price and margin
• Reach a market-share target
• Meet or prevent competition.
Two classic pricing strategies are commonly discussed for new products:
• Market (price) skimming is a strategy of pricing the new product at a relatively
high level and then gradually reducing it over time.
• Penetration strategy requires that the firm enter the market at a relatively low
price in an attempt to obtain market share and expand demand for its product.
Learning objective 4: Explain and evaluate reasons why base prices change over time in
both business and consumer markets.
Most of the pricing decisions made for a product in its lifetime are price-change
decisions. Base price may change as a natural function of different objectives over the
product life cycle in response to specific competitive price moves or as a function of
special pricing tactics that may create a “schedule” of prices or even unique prices for
Variation in Objectives over the Product Life Cycle:
• In the introductory phase, firm may choose skimming or penetration.
• In the growth phase, pricing may be more aggressive.
• Maturity is likely to bring stable or competitive pricing.
• In decline the firm should try to keep prices up if harvesting.
Competitive Price Moves:
Very often, one firm’s price change prompts a reaction from another. This is particularly
true today as markets move quickly into maturity and face commodity status.
Price Flexing: Different Prices for Different Buyers:
Price Flexing to Business Customers:
• Price Shading occurs when, during negotiation, a salesperson reduces the base
price of a product.
• Cash or Payment Discount are discounts the buyer receives for either paying in
cash or paying promptly.
• Volume Discounting are given to customer buying in large volumes.
• Geographic Pricing is common for business customers in different regions since
transportation costs may be accounted for in pricing. Sellers deal with freight in
different ways. Free on-board (FOB) pricing requires the customer to pay for all
costs of transportation. An alternative to FOB pricing is uniform delivered
pricing, where the seller averages the cost of transportation across all customers.
• Sales-Promotion Allowances are discounts that business customers receive for
putting the manufacturer’s product on sale to consumers.
• Creative Alternative to Discounting; financing, long-term contracts, services
• Price Customization. New technology makes it possible for prices to be literally
customized on a transaction-by-transaction basis, depending on the conditions of
supply and demand at the moment. In the free market, prices are determined by
the interplay of supply and demand. Prices will be higher when demand exceeds
supply and they will be lower as more suppliers enter the market.
Price Flexing to Consumers:
• Price Promotion is a ubiquitous and effective practice in many situations,
particularly early in a product’s life.
• Couponing provides those who wish to take the time and effort to clip coupons
the capability of paying lower prices.
• Pricing for Different Segments:
1. Geographic Segments
2. Usage Segments
3. Demographic Segments
4. Time Segments
Learning objective 5: Explain basic legal and ethical constraints on pricing behavior.
Price-fixing is a conspiracy to fix competitive prices.
Sherman Antitrust Act prohibits any contract, combination or conspiracy that restrains
trade. It was passed by Congress in 1890 in an effort to prevent companies from
controlling (monopolizing) an industry.
Cartel is an organization of firms in an industry where the central organization makes
certain management decisions and carries out certain functions (often regarding pricing,
output, sales, advertising and distribution) that would otherwise be performed by the
Price discrimination occurs when a seller offers a lower price to some buyers than it does
to other buyers.
If I’m a manufacturer and you’re a retailer selling my product, we are in violation of the
law if we get together and agree upon some minimum price to be charged to consumers
at retail. I can; however, suggest retail-price levels to you.
Predatory pricing is a practice where one firm attempts to drive out rivals by pricing at
such a low level that the rival cannot make money.
Markup laws are state laws that require a certain markup above cost in particular
industries to protect consumers and small businesses from predatory pricing.