Pricing Strategy
Pricing strategy tests how firms set and adjust prices using costs, customer value, and competition. Expect calculations and scenario questions on elasticity, new-product pricing, and product-mix pricing.
Approaches and objectives
- Cost-based: cost-plus, break-even, target-return. Easy to justify but ignores demand and competition.
- Value-based: set price from perceived value, then design cost; works when differentiation is clear.
- Competition-based: going-rate or sealed-bid pricing.
- Objectives include survival, current profit, market-share leadership, and quality leadership.
Elasticity and new products
- Demand is elastic when a percentage price change produces a larger percentage quantity change; raising price then lowers total revenue. It is inelastic when quantity changes less than price.
- Skimming sets a high initial price to recover investment from early adopters; it works with inelastic demand, strong differentiation, and barriers to imitation.
- Penetration sets a low price to gain share quickly; it works with elastic demand and scale economies.
Product-mix pricing
- Line pricing, optional-product pricing, captive-product pricing (razor and blades), by-product pricing, and product-bundle pricing.
- Psychological pricing uses reference prices, odd-even endings, and prestige cues.
Worked example
Fixed costs are $120,000; variable cost is $30 per unit; price is $50. Contribution per unit is $20, so break-even is 6,000 units. To earn $20,000 profit, required volume is ($120,000 + $20,000) / $20 = 7,000 units. If the firm instead marks up cost by 25%, a $40 cost gives a $50 price; that is a 25% markup on cost but only a 20% margin on price. Reasoning: distinguish contribution, break-even, markup, and margin before choosing a price.
Traps that cost marks
- Confusing markup on cost with margin on selling price.
- Raising price under elastic demand and expecting revenue to rise.
- Using skimming when demand is highly price-sensitive.
- Forgetting that captive products require a compatible primary product.
- Ignoring competitor and legal reactions to price changes.