Apart from factors within a company, external factors affecting pricing decisions in a firm also include the nature of the market and demand, competition, and other environmental elements. We shall be looking at each of the factors in the sections that follow.
Table of Contents
THE MARKET AND DEMAND
You were made to understand that cost sets the lower limit (or the floor) of prices. The market and demand set the upper limit (or the ceiling). Both consumer and industrial buyers balance the price of a product or service against the benefits of owning it. In this regard therefore, the marketer must understand the relationship between price and demand for its product. It will thus be necessary to explain how the price-demand relationship varies for different types of markets and how buyer perceptions of price affect the pricing decision. We shall also be discussing the methods for measuring the price-demand relationship.
Apart from factors within a company, external factors also affect a firm’s pricing decisions. Such factors include the nature of the market and demand, competition, and other environmental elements. We shall be looking at each of the factors in the sections that follow.
THE MARKET AND DEMAND
You were made to understand that cost sets the lower limit (or the floor) of prices. The market and demand set the upper limit (or the ceiling). Both consumer and industrial buyers balance the price of a product or service against the benefits of owning it. In this regard therefore, the marketer must understand the relationship between price and demand for its product. It will thus be necessary to explain how the price-demand relationship varies for different types of markets and how buyer perceptions of price affect the pricing decision. We shall also be discussing the methods for measuring the price-demand relationship.
Pricing In Different Types of Markets
The pricing freedom of sellers actually varies with different types of markets. There are four types of markets recognized by economists, and each poses a different pricing challenge.
Under pure competition, for example, the market consists of many buyers and sellers trading in a uniform commodity such as cocoa, maize, banking, or telephone services. No single buyer or seller has many effects on the ruling market price.
For instance, a seller cannot charge more than the ruling price because buyers can obtain as much as they need at the going price. Neither would sellers charge less than the market price because they can sell all they want at the current ruling price. If prices and profits rise, new sellers can easily enter the market. In a purely competitive market, marketing research, product development, pricing, advertising, and sales promotion play very little or no role. Hence, sellers in these markets do not spend much time on marketing strategies.
In the case of monopolistic competition, the market consists of many buyers and sellers who trade over a range of prices rather than a single market price. This is because sellers can differentiate their offers from buyers. For instance, the physical product can be varied in quality, features, or style, or the accompanying services can be varied. Since buyers can clearly see differences in sellers’ products, they will be ready to pay different prices for them thus, sellers try to develop differentiated offers for different customer segments and, in addition to price, often use branding, advertising, and personal selling to set their offers apart.
Under Oligopolistic competition, the market consists of a few sellers who are highly sensitive to each other’s pricing and marketing strategies. The product can be uniform or nonuniform. There are few sellers because it is difficult for new sellers to enter the market.
Each seller is typically alert to competitors’ strategies and moves. If a seller cuts its price by, say 10 percent, buyers will quickly switch to this supplier. The other suppliers must also respond by lowering their prices or increasing their services. You should note that an oligopolist is never sure that it will gain anything permanent through a price cut. On the other hand, if an oligopolist raises its price, its competitors might not fol ow this lead. In this instance, therefore, the oligopolist might have to withdraw its price increase or risk losing customers to competitors.
In a pure monopoly, the market consists of just one seller. The seller may be a government monopoly, a private regulated monopoly, or a private non-regulated monopoly. In each of these, pricing is handled differently. For instance, a government monopoly can pursue a variety of pricing objectives. It might set a price below cost because the product is important to buyers who cannot afford to pay the full cost. Alternatively, the price might be set either to cover costs or to produce good revenue. It can even be set quite high to slow down consumption.
In a regulated monopoly, the government permits the company to set, one that will allow the firm to maintain and expand its operations as needed. Non-regulated monopolies are free to price at what the market will bear. Usually, they do not want to charge full price for a number of reasons: a desire not to attract competition, a desire to penetrate the market faster with a low price, or a fear of government regulation.
Consumer Perceptions Of Price And Value
At the end of the day, the consumer will decide whether a product’s price is right. Therefore, when setting prices, the company must consider consumer perceptions of price and how these perceptions affect consumers’ buying decisions. You should remember that pricing decisions, like other marketing-mix decisions, must be buyer-oriented.
Why consumers buy a product, they exchange something of value (the price) to get something of value (the benefits of having or using the product). This situation can be represented by a value equation
V = B/P
Where: V = Value
B = Benefits, and
P = Price.
Based on this consideration, an effective, buyer — oriented pricing should therefore involve understanding how much value consumers place on the benefits they receive from the product and setting a price that fits this value. Analysing the Price — Demand Relationship
Each price a firm charges will lead to a different level of demand. The relationship between the price charged and the resulting demand level is illustrated in the demand curve in Figure 11.2
Figure 11.2 Demand Curves
The demand curve shows the number of units the market will buy in a given time period, at different prices that might be charged. For normal goods, demand and price are inversely related, the higher the price are inversely related, the higher the price, the lower the demand. For example, the firm would sell less if it raised its price from Pi to P2. In the case of luxury goods, the demand curve sometimes slopes upward.
COMPETITORS’ COSTS, PRICES, AND OFFERS
The second set of external factors affecting the firm’s pricing decision is competitors’ costs and prices, and possible competitor reactions to the firm’s own pricing moves. For instance, a consumer who is considering the purchase of a GSM phone from NITEL will evaluate NITEL’s price and value against the prices and Value of comparable products from ECONET and MIN. In addition, the firm’s pricing strategy may affect the nature of the competition it faces. For example, if a particular firm follows a high-price, high margin strategy, it may attract competition. However low-price, the low-margin strategy may stop competitors, or drive them out of the market.
It is necessary for companies to benchmark their costs against competitors’ costs so as to learn whether they are operating at a cost advantage or disadvantage. You should remember that costs typical y set the floor for the price a firm can charge.
Companies also need to learn the price and quality of each competitor’s offer. This can be done in several ways. For instance, a firm can:
(i) Send a comparison shoppers to price and compare competitors’ products
(i ) Get competitors’ price lists and buy competitors’ products and dismantle it for the purposes of thorough examination of the features they contain
(iii) Ask buyers how they view the price and quality of each competitor’s products.
Once a company is aware of competitors’ prices and offers, it can use them as starting point for its own pricing. For instance, if its products are similar to those of a particular competitor, it will have to place its price close to that competitor’s price otherwise it will lose sales. If the company’s products are not as good as those of the particular competitor in question, the company will not charge less, then it can charge more. In essence, a company should use price to position its offers relative to the competition.
OTHER EXTERNAL FACTORS
Companies also need to consider other factors in their external environment when setting prices. Economic conditions can have a strong impact on a firm’s pricing strategies. For instance, economic factors such as boom, or recession, inflation and interest rates affect pricing decisions because they affect both the costs of producing a product, as well as consumer perceptions of the product’s price and value.
It is also very necessary for the marketer to consider what impacts its prices will have on other parties in its environment. Of particular importance is the way re-sellers or marketing intermediaries will react to the company’s various prices. In actual fact, the company should set prices that give these intermediaries a fair profit, encourage their support and loyalty, and help them to sell the product effectively. Finally, the company must also take social concerns into serious consideration. Hence, when selling prices, a company’s short-term sales, market share, and profit goals may have to be tempered by broader societal considerations.
GENERAL PRICING APPROACHES
After discussing the various considerations affecting pricing policies, it would be useful to discuss the alternative pricing methods most commonly used. These methods are:
- Cost-plus or Full-cost pricing
- Pricing for a rate of return, also called target pricing
- Marginal cost pricing
- Going rate pricing, and
- Customary prices.
The first three methods are cost-oriented as the prices are determined on the basis of costs. The last two methods are competition-oriented as the prices here are set on the basis of what competitors are charging.
COST-PLUS OR FULL-COST PRICING
This is most common method used in pricing. Under this method, the price is set to cover costs (materials, labour and overhead) and a predetermined percentage for profit. The percentage differs strikingly among industries, among members-firms and even among products of the same firm. This may reflect differences in competitive intensity, differences in cost base and differences in the rate of turnover and risk. In fact, it denotes some vague notion of a just profit.
What determines the normal profit? Ordinarily, margins charged are highly sensitive to the market situation. They may, however, tend to be inflexible in the fol owing cases: (i) they may become merely a matter of common practice, (ii) mark-ups may be determined by trade associations either by means of advisory price lists or by actual lists of mark-ups distributed to members, (iii) profits sanctioned under price control is discontinued.
These margins are considered ethical as well as reasonable. Its inadequacies are:
1. It ignores demand: there is no necessary relationship between cost and what people will pay for a product.
2. It fails to reflect the forces of competition adequately. Regardless of the margin of profit added, no profit is made unless what is produced is actual y sold.
3. Any method of allocating overheads is arbitrary and may be unrealistic. Insofar as different prices would give rise to different sales volumes, unit costs are a function of price, and therefore, cannot provide a suitable basis for fixing prices. The situation becomes more difficult in multi-product firms.
4. It may be based on a concept of cost, which may not be relevant to the pricing decision.
(a) To illustrate marking pricing, suppose a jug manufacturer had the following costs and expected sales:
Variable cost N10
Fixed cost N300,000
Expected unit sale 500,000
Then the manufacturer’s cost per jug is given by:
F i x e d C o s t N 3 0 0 , 0 0 0
UnitCost=VariableCost+ MO + Unit Sale 50,000
=N16
Now, suppose the manufacturer wants to earn a 20 per cent marketing on sales. The manufacture’s marking price is given by:
Marking Price = Unit Cost = 1416
I—Desired Return on Sales 1 — 0.2
=N20
The manufacturer would charge dealers N20 a jug and make a profit of N4 per unit. The dealers, in turn, will mark up the jug. For instance, if dealers want to earn 50 per cent on sales price, they will mark up the jug to N40 (N20 +50%
of N40). This number is equivalent to a marking on cost of 100 percent (N20/N20)
The explanation for the Widespread use of Full-cost Pricing
A clear explanation cannot be given for the widespread use of full-cost pricing, as firms vary greatly in size, product characteristics and product range, and face varying degrees of competition in markets for their products. However, the fol owing points may explain its popularity:
1. Prices based on full-cost look factual and precise and maybe more defensible on moral grounds than prices established by other means.
2. Firms preferring stability, use full-cost as a guide to pricing in an uncertain
market where knowledge is incomplete. In cases where coasts of getting information are high and the process of trial and error is costly, they use it to reduce the cost of decision-making.
3. In practice, firms are uncertain about the shape of their demand curve and bout
the probable response to any price change. This makes it too risky to move away from full-cost pricing.
4. Fixed costs must be covered in the long-run and firms feel insecure that if they
are not covered in the long-run either.
5. A major uncertainty in setting a price is the unknown reaction of rivals to that
price. When products and production processes are similar, cost-plus pricing may offer a source of competitive stability by setting a price that is more likely to yield acceptable profit to most other members of the industry also.
6. Management tends to know more about products costs than other factors which are
relevant to pricing.
7. Cost-plus pricing is especially useful in the following cases:
(a) Public utilities such as electricity supply, transport, where the objective
is to provide basic amenities to society at a price which even the poorest can afford.
(b) Product tailoring, i.e. determining the product design when the selling
price is predetermined. The selling price may be determined by the government, as in the case of certain drugs, cement, and fertilizers. By working back from this price, the product design and the permissible cost is decided upon. This approach takes into account the market realities by looking from the viewpoint of the buyer in terms of what he wants and what he will pay.
(c) Pricing products that are designed to the specification of a single buyer as applicable in case of a turnkey project. The basis of pricing is estimated cost plus gross margin that the firm could have got by using facilities otherwise. ,
(d) Monophony buying — where the buyers know a great deal about suppliers’ costs as in case of an automobile buying, components from its ancillary units. They may make the products themselves if they do not like the price. The more relevant cost is the cost that the buying company, say, the automobile manufacturer, would incur if it made the profit itself.
MARGINAL COST PRICING
Both under full-cost pricing and the rate-of-return pricing, prices are based on total costs comprising fixed and variable costs. Under marginal cost pricing, fixed costs are ignored and prices are determined on the basis of marginal cost. The firm uses only those costs that are directly attributable to the output of a specific product.
a) The prevalence of multi-product, multi-process and multi-market concerns
makes the absorption of fixed costs into product costs absurd. The total costs of separate products can never be estimated satisfactorily, and the optimal relationships between costs and prices will vary substantial y both among different products and between different markets.
b) In many businesses, the dominant force is an innovation combined with
constant scientific and technological development, and the long-run situation is often highly unpredictable. There is a series of short-run. When rapid developments are taking place, fixed costs and demand conditions may change from one short-run to another, and only be maximizing contribution in each short-run will profit be maximized in the long-run.
Limitations
1. The encouragement to take on business which makes only a small contribution may be so strong that when an opportunity for higher contribution business arises, such business may have to be foregone because of inadequate free capacity unless there is an expansion in organization and facilities with the attendant increase in fixed costs.
2. In a period of business recession, firms using marginal cost pricing may lower prices in order to maintain business and this may lead other firms to reduce their prices leading to cut-throat competition. With the existence of idle capacity and the pressure of fixed costs, firms may successively cut down prices to a point at which no one is earning sufficient total contribution to cover its fixed costs and earn a fair return on capital employed.
In spite of its advantage, due to its inherent weakness of not ensuring the coverage of fixed costs, marginal cost pricing has usually been confined to pricing decisions relating to special orders.
GOING-RATE PRICING
Instead of the cost, the emphasis here is on the market. The firm adjusts its own price policy to the general pricing structure in the industry. Where costs are particularly difficult to measure, this may seem to be the logical first step in a rational pricing policy. Many cases of this type are situations of price leadership. Where price leadership is well established, charging according to what competitors are charging may be the only safe policy.
It must be noted that ‘going-rate pricing’ is not quite the same as accepting a price impersonal y set by a near-perfect market. Rather it would seem that the firm has some power to set its own price and could be a price maker if it chooses to face all the consequences. It prefers, however, to take the safe course and conform to the policy of others.
Customary Pricing
Prices of certain goods become more or less fixed, not by deliberate action on the sellers’ part but as a result of their having prevailed for a considerable period of time. For such goods, changes in costs are usually reflected in changes in quality or quantity. Only when the costs change significantly the customary prices of these goods are changed.
Customary prices may be maintained even when products are changed. For example, the new model of an electric fan may be priced at the same level as the discontinued model. This is usually so even in the face of lower costs. A lower price may cause an adverse reaction from the competitors leading to a price war so also on the consumers who may think that the quality of the new model is inferior. Perhaps, going along with the old price is the easiest thing to do. Whatever be the reasons, the maintenance of existing prices as long as possible is a factor in the pricing of many products.
If change in customary prices is intended, the pricing executive must study the pricing policies and practices of competing firms and the behaviour and emotional make-up of his opposite number in those firms. Another possible way out, especially when an upward move is sought, is to test the new prices in a limited market to determine the consumer reaction.
