In the last section, we looked at factors internal to the organization that impact the pricing strategy. In this section we will explore external factors that impact the pricing decision. These factors cannot be controlled by the organization but can be influenced and addressed by proper research and strategizing.
The Distribution Channel
In the case of service providers or direct channels, the producer determines the price to the end user. This is not the case when middlemen are involved. With indirect channels, the producer sets a price for the next channel member (i.e. wholesaler). That channel member will then add their mark-up, based on their costs and profit requirements, and set a new price for the next channel member (i.e. retailer), where this process is repeated. In other words, the price the producer sets is not the price charged to the end user.
To ensure a final competitive price that is congruent with the marketing strategy, the producer needs to set an initial price that allows for the costs and profit requirements of the rest of the channel.
Customer Reactions and Expectations
Price elasticity, or buyers’s sensitivity to price changes, affects the demand for products. Think about a pair of sweatpants with an elastic waist. You can stretch an elastic waistband like the one in sweatpants, but it’s much more difficult to stretch the waistband of a pair of dress slacks. Elasticity refers to the amount of stretch or change. For example, the waistband of sweatpants may stretch if you pull on it. Similarly, the demand for a product may change if the price changes. Imagine the price of a six-pack of sodas changing to $1.50 a pack. People are likely to buy a lot more soda at $1.50 per six-pack than they are at $4.50 per six-pack. Conversely, the waistband on a pair of dress slacks remains the same (doesn’t change) whether you pull on it or not. Likewise, demand for some products won’t change even if the price changes. The formula for calculating the price elasticity of demand is as follows.
When consumers are very sensitive to the price change of a product—that is, they buy more of it at low prices and less of it at high prices—the demand for it is price elastic. Goods such as TVs, stereos, and freezers are more price elastic than necessities. People are more likely to buy them when their prices drop and less likely to buy them when their prices rise. By contrast, when the demand for a product stays relatively the same and buyers are not sensitive to changes in its price, the demand is price inelastic. Demand for essential products such as many basic food and first-aid products is not as affected by price changes as demand for many nonessential goods.
The number of competing products and substitutes available affects the elasticity of demand. Whether a person considers a product a necessity or a luxury and the percentage of a person’s budget allocated to different products and services also affect price elasticity. Some products, such as cigarettes, tend to be relatively price inelastic since most smokers keep purchasing them regardless of price increases and the fact that other people see cigarettes as unnecessary. Service providers, such as utility companies in markets in which they have a monopoly (only one provider), face more inelastic demand since no substitutes are available.
To determine the elasticity of a product the following formula is used: Price elasticity = percentage change in quantity demanded ÷ percentage change in price.
If the price elasticity is greater than -1, the demand is inelastic. If the price elasticity is less than -1, the demand is elastic.
How important is price to you? My guess is your first response is “Very!” But is that true? There are some product you purchase that you simply look for the lowest price. There are some products you purchase where price is not important at all. Probably the majority of your purchases fall somewhere between where price is considered but it is not the most important element is making your choice. Understanding how the target market for a specific product views the importance of price, guides the pricing decision.
As discussed in the previous section, pricing impacts the ability to compete. Students often assume that to be a competitive, an organization needs to price their product below the competition. In some situations, that is accurate. But, in many situations, it is not. Pricing sends a message about the quality of the product. It also reflects the reputation of the brand. In terms of their competition, a company has three choices when setting their product’s price:
- set the price higher than the competition thus sending a message of higher quality and/or exclusivity
- set the price the same as the competition thus engaging in non-price competition
- set the price lower than the competition thus competing on price and running the risk of a price war. With a price war, competitors keep trying to win market share by having the lowest price. Buyers win with a price wars; competitors do not.
Government Laws and Regulations
Pricing decisions are affected by federal and state regulations. Regulations are designed to protect consumers, promote competition, and encourage ethical and fair behavior by businesses. For example, the Robinson-Patman Act limits a seller’s ability to charge different customers different prices for the same products. The intent of the act is to protect small businesses from larger businesses that try to extract special discounts and deals for themselves in order to eliminate their competitors. However, cost differences, market conditions, and competitive pricing by other suppliers can justify price differences in some situations. In other words, the practice isn’t illegal under all circumstances. You have probably noticed that restaurants offer senior citizens and children discounted menus. The movies also charge different people different prices based on their ages and charge different amounts based on the time of day, with matinees usually less expensive than evening shows. These price differences are legal. We will discuss more about price differences later in the chapter.
Price fixing, which occurs when firms get together and agree to charge the same prices, is illegal. Usually, price fixing involves setting high prices so consumers must pay a high price regardless of where they purchase a good or service. Video systems, LCD (liquid crystal display) manufacturers, auction houses, and airlines are examples of offerings in which price fixing existed. When a company is charged with price fixing, it is usually ordered to take some type of action to reach a settlement with buyers.
Price fixing isn’t uncommon. Nintendo and its distributors in the European Union were charged with price fixing and increasing the prices of hardware and software. Sharp, LG, and Chungwa collaborated and fixed the prices of the LCDs used in computers, cell phones, and other electronics. Virgin Atlantic Airways and British Airways were also involved in price fixing for their flights. Sotheby’s and Christie’s, two large auction houses, used price fixing to set their commissions.
By requiring sellers to keep a minimum price level for similar products, unfair trade laws protect smaller businesses. Unfair trade laws are state laws preventing large businesses from selling products below cost (as loss leaders) to attract customers to the store. When companies act in a predatory manner by setting low prices to drive competitors out of business, it is a predatory pricing strategy. As we will discuss later in this chapter, there are times loss leaders are legal. The differentiation become the intent. If the intent is to put competitors out of business, it is illegal.
Bait and Switch
Similarly, bait-and-switch pricing is illegal in many states. Bait and switch, or bait advertising, occurs when a business tries to “bait,” or lure in, customers with an incredibly low-priced product. Once customers take the bait, sales personnel attempt to sell them more expensive products. Sometimes the customers are told the cheaper product is no longer available.
You perhaps have seen bait-and-switch pricing tactics used to sell different electronic products or small household appliances. While bait-and-switch pricing is illegal in many states, stores can add disclaimers to their ads stating that there are no rain checks or that limited quantities are available to justify trying to get you to buy a different product. However, the advertiser must offer at least a limited quantity of the advertised product, even if it sells out quickly.
It is legal to ‘upsell’ a product. Upselling means trying to get customers to purchase a ‘better’, more expensive product. It is when customers are prevented from buying a promoted product that the legal line is crossed.
You Try It! – Factors Impacting Pricing