Determining the appropriate price for a product or service is an intricate problem. Three factors need to be considered: The lowest price that can be charged for the product or service without sustaining a loss, the value of the product or service to the potential customer, and the price charged by the competition for similar products or services. These factors are complicated by whether or not a product is durable or consumable as well as whether or not the target market is able to pay. Optimal pricing is also affected by vertical differentiation (i.e., perceived higher quality goods or services) and horizontal differentiation (i.e., different characteristics within a single product line). Prices are not necessarily set in stone, however. It is often advantageous to offer discounts to attract customers and maintain customer loyalty.
Keywords Consumer; Customer Relationship Management (CRM); Customer Value; Gross Margin; Markov Chain; Price Band Analysis; Strategy; Target Market
Marketing: Pricing Policy
There is an old adage that cautions that one should not charge more than the market will bear. This is, of course, sound advice. Although one wants to make as much money as possible from a transaction for a number of reasons, it is not feasible to simply set a high price. First, no matter how specific one's market niche, there is virtually no business that is without competition. If a business prices its product or service too high, it is relatively easy for a competitor to set their prices lower and take over a larger portion of the market share. In addition, most consumers have a good idea of what a product or service is worth and what they are willing to pay. For example, although I might be willing to invest a significant amount when purchasing a solid wood dresser, it is unlikely that I would be willing to pay the same amount for a fiberboard replica of the dresser because I know the various advantages and disadvantages of each and what their relative price ranges are. Similarly, although I might like to have an expensive new piece of electronic equipment for my business, if the price is such that the equipment will not save me at least a comparable amount of time and money, I am unlikely to make the purchase no matter how reasonably the price is set vis a vis the value of the item.
From the business's point of view, pricing is as complicated as the buying decision is for the consumer. Sometimes, for example, it is cost effective for a business to make little or no profit in the short term in order to bring in a larger customer base and higher profits in the long term. This marketing philosophy can be seen illustrated in the Sunday supplement of most major newspapers every week which carries coupons for products both old and new. Similarly, most days one can find advertisements and coupons in the mail offering first-time customers discounts for trying a product or service. By not making as much profit on the first sale, the businesses offering the products or services hope to earn customer loyalty and continued higher profits over the long term.
Determining Best Price
To enable a business to best price its goods or services, three factors need to be considered and understood. First, as a general rule, the lowest price one can offer a product at is the cost of that product to the business. (There are occasional exceptions where a business prices an item or service below cost to harm a competitor or gain new customers. However, this approach tends to be successful only as a short term strategy.) This low price limit must include other factors such as the costs associated with the personnel, equipment, and administration associated with selling and delivering the product or service. Pricing must take into account the salaries of all the personnel involved with that product line such as production, management, human relations, shipping and receiving, and accounting personnel. In addition, pricing needs to take into consideration overhead costs such as the cost to rent facilities, pay for utilities, taxes, and so forth. The second factor that needs to be taken into consideration when setting a price for a product or service is its value — in other words, what is it worth to the customer? This is one of the reasons that purchasing a drink at the movies is more expensive than purchasing a drink at the grocery store. Since the customer cannot bring in his/her own soda or water to the theatre, the value of the drink rises. In the grocery store, however, there are more choices not only within the store but at other stores to which the customer can go. So, value places a cap on how much a business can charge for a product or service. Somewhere in the middle between the cost of the product or service to the business and its value to the customer is typically where the actual price of the item will fall. This actual price is influenced by a third factor: The price charged by the competition. Even if one sets the price lower than the value, if a competitor offers the same or a similar product or service at a lower price, it is more likely that the customer will choose the competitor's product or service.
In addition to the old adage about setting prices that the market will bear, there is another old adage that cautions that one gets what one pays for. Indeed, research has found that many consumers do not do sufficient research to differentiate between similar products but often use price as an indicator of quality. There are, of course, limits to this philosophy. Carried to an extreme, this would mean that the higher the price, the more likely people would be to buy a product or service. Although this may be true in some instances, it is not a universal truth. Some purchasing decisions are made not on getting the "best," but on getting the "good enough." Also, some people are out to get a bargain. If offered the same item at two different prices, most people would opt for the less expensive of the two.
Relationship between Price
The literature on consumer buying habits reflects the same complicated relationship between price and purchase probability. Recent research into this phenomenon examined three levels of products: A durable product (specifically, a color television set), a semi-durable product (specifically, a T-shirt), and a non-durable product (specifically, toothpaste). It was found that the relationship between price and consumer buying decisions was complex. For durable goods, the study found that too low a price negatively affected the customer's impression of the product's quality and the probability that the customer would purchase the item. For this level of product, customers tended to purchase a mid- to high-priced product, on the assumption that the price was an indicator of the quality of the item. In fact, customers surveyed in the study believed that it was risky to buy a low-priced product. Another reason that customers hesitated to buy a low-priced product is because they thought it would negatively affect their image. These results imply that pricing for durable goods such as television sets should not be set too low in order to give the product a higher image. However, this approach is not without its limits. When setting the price of such goods, it is also important to take into consideration competitors' prices on similar products as well as the purchase power of the target market. Whether or not they think that an item is a good value, if it is out of their price range most people will not purchase it.
For the semi-durable product, price was again found to be a factor. Once again, those consumers surveyed believed that the lower the price of the T-shirt, the lower the quality of the garment. However, customers purchasing semi-durable goods were more skeptical about the relationship between price and value than were those who were purchasing durable goods. For this type of item, purchasing decisions were more likely to be made based on the perceived value of the item (e.g., strength, texture, colorfastness) than on price alone. This makes pricing items of this nature more difficult than pricing for durable goods such as television sets. Part of the problem with pricing T-shirts is that the customers tend to be young and have limited purchasing power. Therefore, even though they might like to purchase a name-brand product, they often chose a less expensive item instead. From a marketing perspective, therefore, it is helpful to select the appropriate segment of the target market and price the item accordingly.
Finally, it was found that customers tended to pay less attention to price when buying the non-durable product than the other types of products. Other factors such as brand loyalty, reputation, and features were more important in the purchase decision...
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