Lecture 5: Pricing: Goals, revenue models, & approaches Flashcards
Goals of Pricing
Three goals for setting a price:
- To earn revenue – what all firms crave
- To change how people behave towards your product, e.g., set a low price to generate buzz for your product, and get people to try your product.
- To signal that the product is something nice, e.g., deliberately setting a high price point to signal to people that your product belongs in the high-end product category.
Note: After you figure out your value proposition, then you determine what price to set. In other words, price is in service of your positioning strategy.
Revenue Models in Pricing
Three main revenue models:
- Per unit by the customer, e.g., buying apples, each apple you buy you for that one apple (one unit).
- Access or subscription, e.g., a subscription to the New York Times (regardless of how much I read or don’t read, I pay the same price).
- Third-party or sponsorship, i.e., not trying to earn revenue directly from your customers; instead, you are trying to earn revenue from the third parties/sponsors who pay for your services, e.g., ad-based revenue.
Approaches to Pricing: Quantifying the Process of Pricing
- Cost-/activity-based pricing: Mark up the cost of producing a unit. Take the total cost of manufacturing the product and mark up the cost of producing each unit.
Note: Looks internally at your own company (the third C).
- Competition-based pricing: Benchmark against competition or substitutes. Looking at what your competitors or substitutes are pricing their products at. You use the prices of other products that serve the same goal/fulfill the same value drivers as your product as a benchmark against which you set your own price.
Note: Looks at your competitors (the second C).
- Value-based pricing: Use the value to the customer (VTC) as the basis of price (pricing your product).
Note: Looks at your customers (the third C).
- Demand curve-based pricing: Set profit-maximizing prices based on the demand curve (economic approach).
Price Thermometer
When determining the price of your product, it is advisable to consider all four approaches to pricing.
If you just focus on your competitors’ /substitutes’ prices, then you are ignoring important parameters that would constrain the price you can set. It can also limit the profitability of selling your product.
Cost/Activity-based pricing: focuses on the full costs, including fixed and incremental cost values.
Competition-based pricing: focuses on the values of substitutes and competition. How much does it cost for consumers to buy your competitors’ products or substitutes?
Value-based pricing: focuses on the incremental benefit of VTC, the subjective value, and willingness to pay (WTP).
Value-Based Pricing
Pricing Decisions: We assume that you have the product. The objective is to set its price.
Starting point: We first eliminate demand from those consumers who will never buy your product regardless of what price you charge—even if you charge marginal cost (meaning your not making any profit, and yet they still won’t buy your product).
E.g. For Nokia, there might be people who will never buy a Nokia phone, no matter the price.
Pricing Decisions: Broad Horizontal Segment
Show pricing for a simple case where in the broad horizontal segment: two scenarios.
All consumers value product attributes similarly => similar sensitivity to value drivers => one vertical segment (simplest scenario).
Consumers are different in their attribute valuation => more than one vertical segment (the pricing decision will differ slightly based on the more complicated scenario).
Pricing Decisions: 1 Vertical Segment Calculation
Objective: Calculate the WTP (willingness to pay) for your product.
First step: Determine the VTC of the new product by calculating the net value of all the features of the new product (Fnp) minus the price of the new product (Pnp).
FNP is the total of adding the value ascribed to each feature (weight multiplied by the feature). We are wanting to find Pnp.
Note: Some features might be a negative value ( a bad feature from the perspective of the consumer). Negative features undermine the overall Fnp.
Second Step: To find Pnp, we determine the net value of a reference product: the net value of all the features of the reference product (Fnp) minus the price of the reference product (Pnp).
The idea here is if people are spending $100 to buy a product and they’re getting a value of $150 from using the product, then the net value of the product to them is $50, and we want to use that as our metric for evaluating the value of want to use that as our metric for evaluating the value of products and the net value of products.
Third Step: Calculating the VTC of the New Product by adding the price of the reference product plus the value differential (all the features of the new product (Fnp) - all the features of the reference product (Frp).
Pricing Decisions: 1 Vertical Segment (Company’s Perspective)
From the company’s perspective: What should be the order of the following numbers (from highest to lowest)?
- Variable Cost of new product (VC)
- Value of new product to the customer (VTC)
- Price of new product (P)
Answer: Typically, VTC > P > VC
Value to the Customer is higher than the price you can charge the customer because if you charge a higher price than the value of the product to the customer, customers will not buy your product.
The Price charged to the customer is higher than the variable cost in order to be profitable.
Pricing Decisions: 1 Vertical Segment (Consumer’s Perspective)
From the consumer’s perspective:
WTP = Subjective VTC – Switching Costs
Willingness to Pay is the variable we use to measure how much the customers will pay for your product.
WTP is determined by two parameters: their subjective value of the product t to the customers minus the switching costs involved in using the product.
Note: We take switching costs into account because there’s a reference product that people are already using/or could be using, and to switch from that product to the new product that you’re trying to price involved some costs. If the switching costs are too high, nobody is going to switch to your product.
Examples of factors that lower consumers’ WTP
- Monetary switching costs: switching from a carrier provider (Bell to Rogers) can incur monetary switching costs or switching from one bank to another (moving your bank accounts from CIBC to TD).
note: There may also be emotional switching costs, where customers feel it’s too much of a hassle/annoyance to switch from another product to yours, which can also lower consumers’ WTP.
- Unawareness of the benefits: Lowers the subjective value of your product to customers because the value to the customer of the new product hinges on people understanding the benefits/features of your product. If they are not even aware of the benefits, that will lower the subjective VTC.
- Perceived risks: If people perceive high risks in using the product, that will again lower the subjective VTC of your product.
- Other barriers to adoption: An unwillingness to try new things, for example, will lower the TWP.
Pricing Decisions: Simple 1 Vertical Segment
Summary: The goal is to determine consumers’ willingness to pay for the new product.
Note: WTP for the new product will be similar to the VTC of the new product, but they may not be identical due to other factors that can shape customers’ subjective valuation of the product.
Pricing Decisions: More than 1 Vertical Segment
- Identify the vertical segments
For each segment, find out its:
- VTC (value of the new product to the customers in that segment).
- WTP.
- Demand (the size of the segment, how many people are in the segment ).
- Identify the Variable Cost of manufacturing your product.
- Find the profit-maximizing price.
Pricing Decisions: Vertical Segment Example
Suppose Dell came up with a laptop with a CPU speed of 3200 Mhz
Vertically segment the market such that consumers in each segment differ in their product valuation.
Note: Do not consider those segments that will never buy the 3200 MHz laptop, regardless of what price you charge (we only consider the subset of the population that is potentially interested in buying the laptop depending on the price that you can charge them).
Dell’s product satisfies all the segments if you only consider the product’s features, as the product has over 1000 (low segment), 2000(middle segment), and 3000 (top segment) at 3200 megahertz
The upper segment has the highest WTP for the 3200 MHz speed (high sensitivity to CPU speed indicates that they have the highest WTP).
The middle segment has the middle WTP
The lowest segment has the lowest WTP
Pricing Decisions: Vertical Segment Example Part 2
For each segment separately, determine the VTC and the WTP.
Exactly the way we did before for one segment.
Note: in this simple scenario, we are always assuming there is a $100 difference between VTC and WTP within each segment.
Pricing Decisions: Vertical Segment Example Part 3
Determine the demand for the product for the three levels of WTP
Proper Way: use conjoint analysis (beyond the scope of our course).
Approximate Way: determine the total potential demand at each of the three levels of WTP.
Using the approximate way, you make an important assumption: if you charge a price that caters to a particular segment, you will cater to that segment and all segments above it.
If you charge people a price of $700, then only the top segment is willing to pay for the product: the potential demand of 3 million people.
If you charge people a price of $500, then both the top and middle segments are willing to pay for the product: potential demand of 9 million people (3 + 6).
If you charge people a price of $300, then all the segments are willing to pay for the product: potential demand of 19 million ( 3 + 6+ 10)
Pricing Decisions: Vertical Segment Example Part 4
Using your company’s per-unit cost, determine which segment you should cater to.
Formula: Price - Per Unit Cost * Potential Demand
($700 - $200) x 3 M = $1500 M
($500 - $200) X 9 M = $2700 M
($300 - $200) X 19 M = $1900 M
Answer: If you just care about revenue, you should cater to the middle segment.
Pricing Decisions: Vertical Segment Example Demand Curve
Demand Curve: With three Price points you can choose from, how should the demand curve look to reflect the calculation above?
If you have a price on the Y axis and quantity on the X axis: the curve should be a stepwise function where you have three different price points and three different corresponding quantities.
If you create a more “fine grained” kind of segmentation where rather than three segments, you identify ten segments, how would the demand curve look? The demand curve would have smaller steps .
Price Discrimination:
Why price-discriminate?
- First-degree
- Second-degree
- Third-degree
Course on pricing: Beyond the scope of our class (don’t memorize).
Economics of Pricing: Basic Terminology
Cost: Unit Cost of Product: $600
Contribution: Profit made on Product: $40
Selling Price: Price you sell the product at: $1000
Markup: Contribution divided by Cost (calculate as a percentage)
400/600 = 67% markup
Margin: Contribution divided by Selling Price (calculate as a percentage)
400/ 1000 = 40%
Unit Contribution: Selling Price minus the Cost
1000 - 600 = 400
Total Contribution: Demand multiplied by Unit Contribution
Profit: Total Contribution minus Fixed Cost
Note: Fixed cost is used as the unit cost is already taken into account in the calculation of the unit contribution and therefore taken into the total contribution value.
Profit Equation: Optimal Pricing
Profit = (Price of Product - Marginal Cost) multiplied by Demand(given the Price charged) minus Fixed Cost
Profit equation plotted on a graph. As you charge a higher price, fewer people are willing to pay for your product.
On the Profit Curve: Find the profit-maximizing point, and that’s the price you charge that will give you the most profit.
Note: The optimal price gives us the corresponding optimal quantity.
Price Discrimination (different groups of people paying different prices).
Price discrimination aims to reduce the total area of “Money left on Table” and “Passed Up Profit.”
If you can only charge people the optimal price, you end up with two triangles where you could have made more money.
Money left on the table: Could have charged a higher price, and these people would have still been willing to buy your product for the higher price.
Passed-up Profit: Could have charged a lower price to get more people to buy your product.
If you charge two different prices that correspond with peoples’ WTP, you can charge one person a higher price and the other person a lower price based on their WTP and thereby reduce the total area of the two triangles (Money Left on Table & Passed up Profit) and increase the total area of the two rectangles.
Perfect Price Discrimination: The idea is to segment the market further so that every person would pay exactly their WTP for the product. Difficult goal to accomplish.
In practice, this could backfire due to consumers’ behaviour toward receiving different prices. The exact same product at different price points usually induces a negative reaction from customers (feels unfair and unethical).
Companies will try to respond to this by using a reference point, but this argument does not go very far. Example: Epipen had an increase of $500 in price (from $100 to $600); pharmaceutical companies argue that it’s better than going to the hospital and it’s a life-saving product, so it’s worth that new additional price.
