Pricing activities

(because of high levels of differentiation), and firms pursuing a focus strategy could benefit from customer value pricing (because of narrow market appeal).

From the perspective outlined above, based on the price management literature and studies on pricing strategies/price determinants, the prime challenge facing firms seems to reside in the assessment of, and subsequent adjustment to, relevant environmental determinants or characteristics of the firm’s overall strategic position.

3.3.2 Demand analysis

The purpose of demand analysis is to generate information needed in deciding on the price to charge different customers or customer seg-ments. One way of using this information is to set different prices for different customers or customer segments. Another is to charge the same price to all customers. Hence, pricing policy can be seen as con-taining two different uses of demand information: uniform pricing and price discrimination (Png, 2002). Uniform pricing involves the policy of setting the same price for a certain product across the market. The uniform pricing policy ignores the fact that different buyers place dif-ferent value on or receive difdif-ferent levels of benefit from the product and thus are willing to pay different amounts for the product. Price dis-crimination involves charging different prices to customers according to their received benefit from the product, which allows the seller to ap-propriate parts of the buyer surplus. There are three main levels of price discrimination. (1) Complete price discrimination – the seller prices each unit at the buyer’s benefit and sells a quantity so that marginal benefit equals marginal cost. (2) Direct segment discrimination – the seller charges different incremental margins to each identifiable buyer segment in the market. (3) Indirect segment discrimination – the seller structures a choice for buyers in order to earn different incremental margins from each segment.

From an economic perspective, the different levels of price discrimina-tion represent different levels of attractiveness to the selling firm. Com-plete price discrimination is the most attractive alternative, as buyer surplus is perfectly appropriated by the seller. However, complete price discrimination is in most situations not achievable as the seller must know each individual buyer’s demand curve. The second most

attrac-tive alternaattrac-tive is direct segment discrimination. This alternaattrac-tive de-pends on the segments being directly identifiable (for example based on age, student/non student, etc.) and allows the seller to appropriate some of the buyer surplus without risking opportunistic customer behavior such as customers posing as more price sensitive than they actually are (because each customer can be directly tied to a certain segment). Indi-rect segment discrimination is the least attractive approach. This ap-proach is used in situations where there are no direct buyer characteris-tics for buyer identification, which means that the seller has to differen-tiate between segments by offering different products/service attributes to different segments so that the offer only becomes attractive to the targeted segment.

Pricing decisions are often made in a more or less aggregated format involving several customer segments with different preferences. Hence, in addition to the willingness-to-pay of individual customers or cus-tomer segments, pricing decisions involve trade-offs between price and volume. One practical tool suggested in the price management litera-ture for calculating or estimating the volume-effect of a price change is the price response curve (Dolan & Simon, 1996). The price response curve, which is a graphical representation of the relationship between price and volume, draws heavily on the logic of the demand curve.

There are four basic approaches creating the price response curve. (1) Expert judgment – Suggested in cases where a pricing decision is made for an innovation or a new competitive situation. “Internal market ex-perts” are asked to correlate price and volume by answering questions like; “what is the lowest realistic price and the expected sales volume at this price”, “what is the highest realistic price and the associated sales volume”, “what is the expected sales volume at the medium price”. This would create three “price-volume points” from which to create a rough price response curve. (2) Analysis of historical market data – If prices have varied naturally in a market, segment or across similar markets for the same product, the different historical price-volume data points can be used to construct a price volume estimate for relevant mar-kets/segments. (3) Customer survey – Two different methods for ex-tracting price response estimates from the customer are suggested: to directly ask customers how they would respond to a certain price, or to infer the response from an analysis of data on customer preferences for

one product over another²⁰. (4) Price experiment – Response is ob-served in an actual controlled purchase situation. The method has the benefit of providing the opportunity of observing actual purchase be-havior (has limited relevance in a business-to-business situation).

3.3.3 Cost and profitability analysis

The firm’s cost structure affects the price in two related ways. First, costs determine the lower limit at which a product can be profitably sold (representing the seller’s break-even restriction). Second, the size of the firm’s operating leverage determines the effect a price change will have on profits (presuming that E ≠ 0). Operating leverage is a form of elasticity measure, which shows to what degree profits are sensitive to changes in sales volume (and thus changes in price).²¹ Firms with a higher proportion of fixed costs and low variable costs per unit have a higher operating leverage for a certain sales volume (i.e. profitability is more sensitive to the volume effects of price changes).

Operating leverage can play an important role in understanding pricing behavior in a specific market. For example, firms in the UK petrol mar-ket have been shown to increase prices in some situations despite facing a highly elastic demand (Cohen, 1999). The suggested explanation be-ing that the low contribution/price ratio in the industry made firms less sensitive to the subsequent decrease in volume (Cohen, 1999). Hence, operating leverage and thus the individual firm’s cost structure can be used for analyzing the profitability effect of different pricing alternatives even when demand and the own price elasticity of demand are un-known.

In general, price changes have two types of effect on profitability: the contribution margin of all units sold will change, and the number of units from which contribution is earned will change. In the case of a decrease in price at original volume X, the contribution earned from X

20The method suggested here is conjoint measurement/analysis; see Dolan and Simon (1996) or Monroe (2003) for an explanation of the method.

21The degree of operating leverage is calculated as the total contribution at sales volume X divided by operating profits at sales volume X, or as the percentage change in operating profits divided by the percentage change in volume (Mon-roe, 2003).

units will decrease (the price effect), but as the price is lowered, Y addi-tional units will be sold earning an addiaddi-tional contribution (the volume effect). ²² A key issue in evaluating such a decrease in price is the num-ber of additional units (Y) that need to be sold in order to recover the loss in contribution from X.

The type of analysis described above is termed incremental breakeven sales analysis (Nagle & Holden, 2002). The benefits of using the firm’s operating leverage to calculate the necessary change in volume for a price change to breakeven is that, even though the own price elasticity of demand may not be known, the method enables the firm to ap-proximate under what price elasticity a certain change in price is profit-able, thus showing what percentage change in sales volume is required, given a certain percentage change in price (i.e. the two components needed to calculate the own price elasticity of demand). The strategic implications of this are that firms need to take into account their oper-ating leverage or contribution percentage relative to competitors when analyzing the applicability of a certain pricing policy. For a price cut to be profitable in the long run the product must have a relatively large contribution margin prior to the price reduction; the market should be in a growth situation (i.e. elastic demand) and the firm should have an advantage in its operating leverage towards competitors (Monroe, 2003).

3.3.4 Competitor intelligence

Competitor intelligence involves activities aimed at gathering and ana-lyzing information about competitors’ present and future price points, their product/service characteristics, capabilities and cost structure.

Information about competitors is required by the selling firm in a number of areas related to pricing, some of which are associated with the other activities addressed in this section. First, many practical methods of evaluating a customer’s willingness-to-pay, such as Eco-nomic Value Estimation™ (Nagle & Holden, 2002), involves an as-sessment of buyer alternatives (the opportunity cost to the customer), which is determined by competing products’ price and function. Sec-ond, the applicability of a certain pricing policy is contingent on the

22Assuming that the own price elasticity of demand is less than 0 (E<0).

firm’s cost structure or operating leverage relative to competitors.

Third, competitor price information can be used to validate or com-plement information given by customers in negotiations, thus reducing the risk of being misled by customers deliberately trying to bring prices down by spreading false price information (Nagle & Holden, 2002).

Fourth, information about competitors can be used to understand or predict competitive responses to a certain pricing policy or price change (Nagle & Holden, 2002).

3.3.5 Communication and negotiation

Communication and negotiation involves interaction with market ac-tors such as customers and competiac-tors. The success of any pricing pol-icy is dependent on the seller being able to communicate the benefits that is associated with the firm’s products and how these benefits are linked to actual price points. In addition, having communicated the firm’s pricing policy, the reaction of both customers and competitors is contingent on the credibility of the firm’ commitment, for example, in terms of how willing the firm is to negotiate its prices downwards (Nagle & Holden, 2002). The two items addressed above are con-nected in the sense that the value of the product is partly judged, from the customers’ point of view, based on how the product is priced on other occasions or towards other customers. Hence, consistency in prices over time and towards different customers is important to gain credibility towards other parties.

In a more normative vein, Nagle & Holden (2002) offer two specific recommendations regarding how communication and negotiation should be managed. First, firms should rely on fixed pricing policies based on customer value that deter opportunistic customer behavior brought forth in price negotiations where the customer has incentives to either give the impression that they are more price sensitive than they actually are, or deny the products actual benefits. Second, firms should understand and communicate the value of the product to the customer in such a way that the customer understands that the selling firm is aware of the benefits or value it is providing.