Pricing strategies

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A look at different pricing strategies a firm may use to try and increase profitability, market share and gain greater brand loyalty.

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Types of pricing strategies

General strategies

  1. Profit maximisation. One strategy is to ignore market share and try to work out the price for profit maximisation. In theory, this occurs at a price where MR=MC. In practice, it can be difficult to work this out precisely.
  2. Sales maximisation. Aiming to maximise sales whilst making normal profit. This involves selling at a price equal to average cost.
  3. Gaining Market Share. Some firms may have a target to increase market share, this could involve setting prices as low as they can afford, leading to a price war. A similar concept to sales maximisation.

See: Objectives of firms

Pricing strategies to attract customers / increase profit

  • Premium pricing. This occurs when a firm makes a good more expensive to try and give the impression that it is better quality, e.g. ‘premium unleaded fuel’, fashion labels.
  • Loss Leaders This involves setting a low price on some products to entice customers into the shop where hopefully they will also buy other goods as well. However, it is illegal to sell goods below cost, so firms could be investigated by OFT.
  • Price Discrimination. This involves charging a different price to different groups of consumers to take advantage of different elasticities of demand. There are different types of price discrimination from first degree to third degree.
  • Reference Pricing. This involves setting an artificially high price to be able to later offer discounts on previously advertised price.
  • Price Matching. The purpose behind price matching is making a promise to match any price cuts by your competitors. The argument is that this discourages your competitors from cutting price. This is because they know there is little point in cutting prices because you will respond straight away. Very clear price matching stances can thus avoid price wars and give the impression of being very competitive. For example, Tesco is offering £10 voucher to customers who can prove their shopping basket would have been cheaper at other supermarkets.
  • Retail price mechanism RPM – when manufacturers set minimum prices for retailers, e.g. net book agreement.

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Effect of the exchange rate on business

Readers Question: What are the effects of the exchange rate on UK businesses?

The exchange rate will play an important role for firms who export goods and import raw materials. Essentially:

  • A depreciation (devaluation) will make exports cheaper and exporting firms will benefit.
    • However, firms importing raw materials will face higher costs of imports.
  • An appreciation makes exports more expensive and reduces the competitiveness of exporting firms.
    • However, at least raw materials (e.g. oil) will be cheaper following an appreciation.

Effect of depreciation in the exchange rate

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If there is a depreciation in the value of the Pound, it will make UK exports cheaper, and it will make imports into the UK more expensive.

In this example:

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  • At the start of 2007, the exchange rate was £1 = €1.50.
  • By Jan, 2009, the Pound had fallen in value so £1 was now only worth €1.10 (a depreciation of 26%)

Impact on British exporters

Suppose a British car costs £4,000 to build and sells for £5,000 in the UK.

  • In 2007, the European price of this car would be €7,500 (5,000 *1.5)
  • In 2008, the European price of this car would be €5,500 (5,000 *1.1)

The 26% depreciation means that European consumers now find British goods much cheaper. The cost of producing the car stays the same (assuming parts are not imported), but the effective market price in Europe has fallen. This should increase demand for British goods.

Increase profit margin or reduce the foreign price?

A British firm has a choice, it can reduce the European price from €7,500 to €5,500; this should lead to an increase in the quantity sold, and increase UK exports.

Alternatively, the firm could keep the price at €7,500 and just make a bigger profit margin. It is a good choice for exporters to have – reduce European price and sell more or keep price the same and make a bigger profit margin.

Impact on importers of raw materials

The downside of a depreciation is that British firms who import raw materials will see an increase in the cost of buying raw materials. If the British car company imports engines from Germany to make the car, it will have to pay more to buy the engines. This will reduce its profit margin.

Suppose an engine costs €1000 to import from Germany. In 2007, this costs £666 (1,000/1.5). In 2009, with the fall in the value of the Pound, they will have to spend £909 (1,000/1.1) to buy the same German engine.

Impact on incentives

In the long term, it is argued that a depreciation may reduce the incentives for exports to cut costs. The depreciation enables an ‘easy’ increase in their profit margin. As a result, there may be less incentive to cut costs and boost productivity. If a firm is facing an appreciation, then they may face a greater incentive to cut costs.

Read moreEffect of the exchange rate on business

Examples of Price Discrimination

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Price discrimination occurs when firms sell the same good to different groups of consumers at different prices. There are often different types of price discrimination offered. Often they are categorised in the following way:

  • 1st-degree price discrimination – charging the maximum price consumers are willing to pay.
  • 2nd-degree price discrimination – charging different prices depending on the quantity or choices of the consumer. (Sometimes known as indirect price discrimination)
  • 3rd-degree price discrimination – charging different prices depending on a particular market segment, e.g. age profile, income group, time of use. (Sometimes known as direct price discrimination.)
  • 4th-degree price discrimination – when prices to consumers are same, but the producer faces different costs. Also known as reverse price discrimination.
  • Premium pricing. In many examples of ‘price discrimination’ consumers are charged different prices for a similar good. In these examples, consumers pay a premium for a slightly more expensive option. For example, ‘premium unleaded petrol’ may cost the firm an extra 1p over standard unleaded, but the firm may sell this premium unleaded at 5p. This is not true price discrimination but uses the same principles – finding customers with more inelastic demand. Its use is widespread, such as first and standard class.

Examples of Price discrimination

1. Time of Purchase

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This petrol station is offering cut-price fuel for two days a week. The petrol station isn’t even telling you which days have cut-price fuel. The logic is that only the most price-sensitive consumers will take the trouble to find out which two days have cut-price fuel and then drive to the petrol station on those days. This takes planning and only the most price elastic consumers will buy on these cut-price days. Most consumers will not take the trouble to visit the petrol station on those two days. They will continue to buy when most convenient.

It is also a clever marketing strategy because from a distance, it is advertising ‘cut-price fuel’ you only notice the ‘2 days a week’ on closer inspection. This is a type of third-degree price discrimination.

2. Airline travel and time of departure

Airlines charge different prices depending on the season and day of the week. During the peak holiday season in August and Easter, the price will be higher because demand is greater and more inelastic. Flights which occur during the week e.g. Mon to Fri will be more expensive because these are typically taken by business travellers. If you stay for over the weekend, the price will be lower, as business travellers will not want to stay over the weekend, just to get a cheaper flight. I often go to New York for a week in October. For a flight from Mon to Fri, the price quoted is usually around £1,500. If I change dates to leaving or arriving on the weekend, the price falls to £450.

Read moreExamples of Price Discrimination

Mobile Phone – Product Life Cycle

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When did you get your first mobile phone? I got mine in 1999, which it turns out was the year of most rapid growth in mobile phone use. Mobile phones look to have the classic product life cycle of introduction, growth and maturity. Introduction A long slow period of introduction from 1985 to 1997. I …

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Profit v Revenue Objectives for Firms

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Readers Question: Is it better to sell more services/products with less profit, than sell less with high profits? What are the pros and cons to the employer, worker, and customer? i.e. high revenue low profit, vs low revenue high profit. Classical economic theory suggests firms will seek to maximise profits. The benefits of maximising profit …

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The problem of rejected / misshaped vegetables

Supermarkets have strict criteria for the cosmetic appearance of fresh fruit and vegetables. The result of these criteria is that a high percentage (10-40%) of a farmers harvest can be rejected because the vegetables do not meet these standard rules of conformity. This problem of rejected vegetables was highlighted on a recent BBC programme ‘War …

Read moreThe problem of rejected / misshaped vegetables

Evaluate methods to avoid product failure?

Product failure is when a new product is launched but fails to gain sufficient sales and market sales, resulting in a net loss for a firm. To understand product failure, it is good to look at a few examples of product failure. (Top 20 product failure here) Some of these examples, give very simple methods …

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Why do bus companies run empty coach services?

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Readers Question: Why may it still make economic sense for the company to put on a coach for just one or two passengers, rather than turning them away?

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Recently I again had to travel to London by coach and discovered that it was a good idea to book early in case the coach was full! Was the coach company being more sensible now?

If a bus has a capacity of 80 seats. It might need an average of say 30 customers per trip to break even.

If the company are averaging less than 30 customers per journey, their fixed and variable costs will be higher than their revenue and eventually they will go out of business.

Can it make sense to run coaches that are nearly empty?

Running a coach service early in the morning or during winter may mean the bus company can expect less than 30 passengers. From one perspective, this does not make sense. It is below the break-even point – average revenue less than average cost. It may even be a case where the marginal cost is greater than the marginal revenue from an extra service.

In fact running services at unsocial hours of the morning will be unpopular with drivers, and the company may have to pay night-time rates.

However, there can be a good long term profit maximising logic behind running these services – even if only a few passengers use them.

  • Marketing. It is a strong marketing ploy to be able to offer 24 hour, 365 days coverage. If people know you run a service all around the clock, it will give them confidence to choose coach journeys as their preferred choice of transport.
  • Attract and hold onto long term customers. Only a few people may use an unpopular service. But, the 24 hour service will encourage many to get the coach in the first place. If customers fear they may turn up and no coaches are available, they may choose other forms of transport, such as car and trains and the company loses the business of customers.
  • If you lose a customer for one journey, the company might not lose very much. But, if the customer would make 50 journeys a year, that is different. Companies have to be aware that one bad experience could make the company lose their services for a long time.
  • Barriers to entry. If an existing coach company is running a 24 hour service, it may deter a new coach company from setting up. They may feel that they couldn’t compete with this all round performance, which makes the industry less profitable. On the other hand, a new company could be sneaky and just cherry pick the busiest times of the day to offer services.
  • Costs. Running a coach service will have both fixed and variable costs. Once you have bought coaches and given drivers an annual contract, the marginal cost of extra services will be relatively low – just the petrol and maintenance. Since you have already paid for many fixed costs (drivers annual salaries, buses, marketing) the marginal cost of an extra journey may be covered by just 10 or 20 passengers. Another way to think about it the topic. Would the company want to lay off drivers for a quiet time in winter? It may lose its drivers. The company might as well keep going through quieter periods.
  • Non-profit maximising decisions. We may assume every company is a profit maximiser. But, there maybe an element within the company, that they want to provide a good, all round comprehensive bus service, and they don’t mind if a few services are loss making.
  • Market share vs Profit. Another issue is that firms often concentrate on gaining market share, rather than profit maximisation. See: Profit vs Revenue maximisation

Read moreWhy do bus companies run empty coach services?

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