PRICING STRATEGIES

There are pricing theories based on the profit maximization hypothesis. Firms follow a variety of pricing rules and methods other than the marginal rule depending on the conditions they face. Here we discuss some important pricing strategies and pricing practices.

LOSS LEADER PRICING

The loss leader approach is widely used in retailing business. Loss leader as “an item the price of which produces a less than customary contribution or a negative contribution to overhead but which is expected to create profits through its effect on future sales or sales of other items” (Haynes, W.W.) Firms manufacturing or selling multiple products follow this approach. They charge a very low price for some popular product hoping that the customers who come to buy this product will buy some other products giving it profits. Such a low priced product is the loss leader. The term does not mean that the product is sold at a loss. It means that the actual price charged is lower than what could have been charged. The basic idea of making a popular product a loss leader is that the profits thus sacrificed will be made good by profits on the other products.

There are some conditions for a product to be a loss leader.(Holdren, B.R.)

(i)                 The buyers should have knowledge of prices of the same good in other selling units.

(ii)               The quantity bought is large enough so that the buyers feel the benefit of price reduction.

(iii)             Demand for the commodity should not be elastic.

(iv)             The price reduction should be significant to be perceptible.

(v)               The product should be of the same quality as sold by others.

(vi)             The buyers should not feel a loss in quality through price reduction.

The loss leader tactic is only a method of selective price-cutting. The seller of the loss-leader product hopes to be a profit leader. Such price- cutting should not trigger a price war.

CUSTOMARY PRICING

Customary pricing is a policy of setting prices on the basis of tradition. Economic conditions may result in fairly wide price side fluctuations, but some prices remain constant over a long period of time. Products such as chewing gum, fast food, magazines, and candy use this approach to pricing. In some cases, the size of the product is changed instead of the price. For years, the price of a candy bar was 5 cents. Rather than change the price, manufacturers changed the size of the nickel candy bar as the cost of its ingredients fluctuated. Obviously, the nickel candy bar is a thing of the past. Nevertheless, customary pricing is still used in this market.

PEAK – LOAD PRICING

A firm that uses the same facility to supply several markets at different points in time can increase total profits by use of peak-load pricing. It involves charging a higher price for consumers who require service during period of peak demand and a lower price for those who consumes during low- or off-peak period. Pricing of long-distance telephone calls is a good example. The fundamental principle of peak-load pricing is that those who impose the greatest demand on a firm for production capacity should be those who pay for most of that capacity. Peak-load pricing may be appropriate if three conditions are met in producing a good or service.

1. The product cannot be storable. For example, in the case of long-distance telephone calls, the service involves direction communication between two or more people. Calls cannot be stored for use at a later time.
2. The same facilities must be used to provide the service during different periods of time. Again, using long-distance telephone service, calls placed at different times use the same lines and switching equipment.
3. There must be variation in demand characteristics at different periods of time. Demand for long-distance calls is greater during business hours that at other times. In addition, demand for business calls at any given time is usually less elastic than is the demand for personal calls.

PRICE SKIMMING

The skimming price strategy is characterized by high initial price of the product when it is introduced in the market where close substitutes of a new product are not available.  It is set by keeping in view the upper level of the estimated demand curve. The purpose of this strategy is to fully exploit the product distinctiveness by offering the product to consumers in the higher-income level group so as to skim the milk of the product. The initial high price would generally be accompanied by heavy sales promoting expenditure.

            The post-skimming strategy involves the decisions regarding the time and size of price reduction. The appropriate occasion for price reduction is the saturation stage of the top -level demand or a strong competition is apprehended.

PENETRATION PRICING

Contrary to price skimming, penetration pricing is characterized by low initial price of the product when product is introduced in the market. It is set by keeping in view the lower level of the estimated demand.  This pricing policy is adopted generally in the case of new products for which close substitutes are available in the market. Its purpose is to attain a large volume and reduce cost by stimulating rapid and widespread market acceptance

The choice between the two pricing policies depends on the rate of market growth, the rate of erosion of distinctiveness and the cost-structure of the producers. If the rate of market growth is slow, penetration pricing will be unsuitable, as low price will not mean a large sale.  If the product were likely to lose its distinctiveness at a faster rate, price skimming would be inappropriate. If the cost-structure shows increasing returns over time, penetration pricing would be more appropriate as it enables the producer to reduce his cost and raises the barrier to entry.

   

INCREMENTAL COST PRICING

Incremental cost pricing focuses attention on the impact of changes in output on revenue, cost and profit. Incremental cost pricing relies on the principles of marginal theory.  But it is more appropriate for decision-making in conditions of uncertainty and where information is costly to collect. Incremental analysis is considered the real world counterpart to marginal analysis because it deals with the relationship between the changes in revenues and costs on account of managerial decisions.  Such a pricing decision guides the manager to accept any action that increases net profits and reject any action that reduces profit.

In following these rules of incremental pricing, following facts must be considered.

Incremental analysis involves long run as well as short run effect. For instance, an excess capacity in the short run may make the firm opt for the production of a new product, as it is profitable in the incremental sense. But in the long run, if the equipment wears out, it has to be replaced which involves huge additional fixed costs. This may affect its opportunities to expand other new products as it is committed to this product, introduced the on grounds of increment cost analysis. In the final analysis, for short run analysis, fixed cost is irrelevant and must not be included in incremental analysis.

Incremental cost analysis and marginal cost analysis differ on this count that marginal cost represents the change in the total cost due to a unit change in output, incremental cost is the change in total cost resulting from a policy decision.

Incremental cost pricing helps the business firms to adopt a far more aggressive pricing policy than full cost pricing. It helps them to fix a price over the life cycle of the product that requires short run marginal cost and separate fixed cost data relevant to each stage of the cycle. Therefore, incremental cost analysis is more useful than full cost pricing because of the relevance of multi-product, multi-process and multi- market firms that makes absorption of fixed costs into product cost difficult.

               

PRODUCT BUNDLING

Product bundling is the practice of selling two or more products together for a single price. When the products are only available as a package, the pricing strategy is referred to as pure bundling. If at least some products can also be purchased separately, then the firm is using mixed bundling. For example, many restaurants offer complete meals that include appetizers and desert. Car manufacturers provide vehicles with features such as air conditioning, antilock brakes, cassette decks, and airbags as standard equipment at “no extra” price. Computer companies often include certain software, such as an operating system and a word processor, with the machines that they sell.

Bundling is a common strategy as firms can reduce their production and marketing costs by packaging goods and services in this way. But product bundling can be profitable even where there are no cost savings. Like price discrimination, bundling allows firms to increase their profits by extracting additional consumer surplus. However, in some situations, bundling may be preferable to price discrimination because it requires less information about tastes and preferences of consumers.

 For bundling to be profitable, there must be at least some consumers whose preferences are negatively correlated with others. If there are consumers who have a high reservation price for one good but place a low value on the second, there must be other consumers whose reservation price for the second good is higher than for the first.