2.5 - Price
Pricing Strategy
A pricing strategy is simply the method a business uses to decide how much to charge for a product. Price matters a lot for viability since it affects a business's ability to attract and keep customers, as well as its revenue and profit.
Businesses always have to keep the per-unit cost of producing and delivering a product in mind when setting a price. A low price can help win market share, but a product isn't actually profitable if the price ends up equal to or lower than its per-unit cost.
Per-unit cost is the total cost of making and delivering a product divided by the number of units. For example, if it costs a candle business $6,000 to make and ship 1,000 candles, its per-unit cost is $6,000 ÷ 1,000 = $6. Per-unit profit is the price minus the per-unit cost. At a price of $10, the business earns $10 − $6 = $4 on each candle. At $6, it earns nothing per candle, and at $5 it loses $1 on every candle it sells, no matter how many customers it wins.
Common Pricing Strategies
Value-based pricing sets the price according to how much value or worth the product holds in the customer's eyes. This tends to work best for highly differentiated or uniquely valuable products, where the focus is on what customers are willing to pay for the benefits they perceive.
A designer handbag is a classic example: its price reflects what buyers think the brand, style, and craftsmanship are worth to them, not just what the leather and labor cost.
Competitive pricing sets the price based on what rivals are charging, sometimes called price matching. If a business believes its product is sufficiently differentiated, it might charge a premium above competitors. If it thinks its product isn't very differentiated, it might price at or below competitors to win market share, even if that means a smaller profit per unit.
For example, gas stations on the same corner usually charge within a few cents of each other, since drivers can see every price from the road and will pull into the cheaper station.
Cost-based pricing sets the price to hit a desired profit per unit, focusing mainly on internal costs rather than customer perception or rival pricing. This approach tends to show up when per-unit costs are clear and easy to explain to customers, like with construction contractors or custom fabrication work.
Cost-based pricing is also called cost-plus pricing. For example, a contractor estimates that a new deck will cost $8,000 in materials and labor, adds the $2,000 profit it wants, and quotes the customer $10,000. The profit is the price minus the cost: $10,000 − $8,000 = $2,000. The weakness is that this method ignores what customers would be willing to pay and what rivals charge.
Penetration pricing means setting a low initial price, sometimes even below the per-unit cost, specifically to pull price-sensitive customers away from competitors and grow market share quickly. The plan is usually to raise prices later once a solid customer base is established.
For example, a new streaming service might charge $1 a month for the first three months, then raise the price to $12 once people are hooked on its shows. The risk is that customers who came only for the low price may leave when it goes up, and if the low price is below per-unit cost, the business loses money on every sale until then.
Developing and Evaluating a Pricing Strategy
Which strategy fits depends on the business's goal and its product. Here's one way to compare them for the candle business above, with a per-unit cost of $6. Rival candles sell for $12, and market research shows customers would pay about $15 for its unique scents.
Strategy | How the price is set | Price | Per-unit profit |
Cost-based | Per-unit cost plus a $4 target profit | $10 | $4 |
Competitive | Match rivals' price | $12 | $6 |
Value-based | What customers say the scents are worth | $15 | $9 |
Penetration | Low price to win customers fast | $5 | −$1 (a loss) |
Value-based pricing earns the most per candle, but only if customers really see the candles as special. If the goal is to grow market share fast against well-known brands, penetration pricing wins customers but loses $1 on each candle until the price goes up. Cost-based pricing is simple, but here it leaves money on the table, since customers would pay more. To evaluate any pricing strategy, check that the price is above per-unit cost (or that there's a plan to get there), fits what target customers are willing to pay, makes sense next to rivals' prices, and matches the business's goal.
Market Conditions and Pricing Power
Pricing power is a business's ability to raise prices without losing much market share. In highly competitive markets with little product differentiation, businesses generally have very little pricing power and are often forced to keep prices as low as possible. In less competitive markets, or when selling highly differentiated products, businesses have more room to raise prices and can use more profitable strategies, like value-based or premium pricing.
Customer responsiveness to price also matters here. If customers are highly responsive to price changes, raising the price could cause them to buy a lot less, cutting into revenue, and cutting the price might boost sales but not enough to offset the lower price, hurting both revenue and profit. Businesses measure this responsiveness using what's called price elasticity of demand. When demand is more elastic, meaning more responsive, businesses have less room to raise prices. When demand is more inelastic, meaning less responsive, businesses can raise prices with less risk of losing sales volume. You don't need to actually calculate elasticity for this exam, just understand that it measures how responsive customers are to price changes.
Here's what that looks like with numbers. A business sells 1,000 phone cases a week at $10, for revenue of $10,000. If it raises the price to $12, many customers switch to rival brands and sales drop to 700, so revenue falls to $12 × 700 = $8,400. If it cuts the price to $8, rivals cut their prices too, so sales rise only to 1,100. Revenue still falls, to $8 × 1,100 = $8,800, because the extra sales don't make up for earning $2 less on every case. A price cut only raises revenue when the added sales bring in more than the business gives up by charging less on every unit. This business has little pricing power: raising the price costs it customers, and cutting the price doesn't pay off either.
Demand tends to be more elastic when there are many close substitutes (one brand of bottled water versus another) or when the purchase isn't a necessity. Demand tends to be more inelastic for necessities with few substitutes, like gasoline or prescription medicine, which is why sellers of those products have more room to raise prices.
Legal Constraints on Pricing Power
There are legal limits on how businesses can set prices.
Collusion happens when competitors agree together to set prices, usually above what a competitive market would produce. In the U.S. and many other countries, this kind of price-fixing is illegal.
In the U.S., price-fixing is banned under antitrust laws like the Sherman Antitrust Act of 1890. For example, in 2013 a federal court ruled that Apple had illegally conspired with major book publishers to raise e-book prices. Collusion hurts customers because it takes away the lower prices that competition would normally bring.
Price gouging means sharply raising prices when demand spikes because of a crisis, like an emergency or natural disaster. It's illegal in many U.S. states and other countries.
For example, a store that triples the price of bottled water, generators, or plywood right after a hurricane could be charged with price gouging. Many state laws take effect when a state of emergency is declared and limit price increases on essential goods.
Illegal price discrimination means charging different prices to different customer groups for the same product based on protected characteristics like race, nationality, or sex. Laws restrict this kind of discriminatory pricing to protect these groups from unfair treatment.
Charging different prices to different groups isn't always illegal. Student discounts, cheaper movie tickets for afternoon shows, and lower airline fares for people who book early are all legal, since they aren't based on a protected status. It's illegal when, for example, a car dealer quotes higher prices to customers because of their race or nationality.