II. Literature Review
2. Innovation and Pricing
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2. Innovation and Pricing
2.1 Pricing and the Value Capturing of Innovation
According to Tawfik and Albrecht, for an enterprise to be successful, it must not only be able to create value for a sustained period but must also be able to acquire value (value created) made in the form of economic profit (producer surplus)51. For creating value, the company must provide customers with higher use value than the costs incurred in providing the product.
Thus, the value is created by the difference between the value of use (perceived use value) that the customer perceives for the product and the cost that the company has spent providing the product. Following figure shows the relationship between these two concepts.
Figure II-1. Value Creation Depends on Benefit and Cost Positions
Source: Jelassi, Tawfik and Enders Albrecht. (2008), Strategies for e-Business, 2nd edition: Pearson,
51 Jelassi, Tawfik and Enders Albrecht (2008), Strategies for e-Business, 2nd edition: Pearson.
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Figure II-2. Value Created between Producers and Consumers
Source: Tawfik Jelassi and Albrecht Enders, 2008
Therefore, the overall goals of the strategy are as follows:
Maximize the value creation by raising perceived use value,
Minimize the cost to provide these values,
Acquire the value creation as much as possible in the form of producer surplus
The above three strategies are the highest priority conditions in order to form a competitive advantage in the market to which the company belongs. The best ways to get a competitive advantage are product innovation and the process innovation, which the competitors cannot imitate perfectly.
According to the Oslo Manual, Innovation can be applied to business practices, workplace organizations or external relationships as an implementation of new or significantly improved products or processes, new marketing methods or new organizational methods. A variety of innovations can be included within this broad definition. Innovation can also be classified more narrowly as an implementation of one or more types of innovation. The definition of technological product and process innovation related with this narrower definition of product and process innovations.52
The introduction of new and significantly improved products in relation to the nature of the
52 Oslo Manual. Op. cit.
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product or its intended use creates product innovation. Significant improvements include technical specifications, components and materials, integrated software, user friendliness, or other functional characteristics. And the implementation of a new and significantly improved production or supply method becomes process innovation. This also includes significant changes in technology, equipment, and/or software.
The form of value creation created through innovations can not only increase the perceived use value but also reduce cost. The value created in these innovations lead to an increase in the perceived use value.
Figure II-3. Modified Value Created between Producers and Consumers
Source: Tawfik Jelassi and Albrecht Enders, Strategies for e-Business, 2nd edition, Pearson 2008 (Modified by Author)
According to Tawfik Jelassi (2004), it's equally important to create better value than the value created by the competition, and to capture some (or producer surplus) of the value generated in the form of profit. Increased value creation by itself does not provide any information about how the value is distributed between consumers and producers, as shown in Figure 3. Through the price the company can charge for a product or service, the company makes this distribution possible. The value generated as two separate entities, the producer surplus and the consumer surplus, is the price.
The profits generated by the company are represented when the company sells the product and are referred to as producer surplus. The difference between the price and the cost of selling a product is called a profit.
The difference between the maximum consumer benefit that the customer is willing to pay and the price that the customer actually pays for the product is called consumer surplus.
Generally, customers pursue the largest consumer surplus they can enjoy, which can
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usually be the largest consumer surplus they can obtain at the same price as other products or at a lower price of similar quality.
Now, the following two factors that influence a firm’s profitability are the answer to the overarching question regarding the factors that influence the distribution of value between buyers and sellers:
The market structure and
The relative level of a company’s value creation.
Thus, the nature of innovation type accomplished by companies, the type of market it belongs to, and the company’s internal decisions, will determine the price of the company’s commodity within the value created. In other words, it can expand value by innovation and decide its pricing based on internal and external factors. This decision is made by the company to make an important decision to determine the magnitude of the value that can be enjoyed in the market.
Therefore, innovation and price directly affect the profitability of the company.
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Schumpeter (1912) first proposed the economic theory of innovation, which enables innovators to enjoy a temporary monopolistic situation. Therefore, in this case, the company becomes a
"price maker" until an imitator enters the market at the moment when attracted to the profit achieved by the innovator53.
There are two alternative ways to set pricing of innovation.
The monopolist innovator price or "premium pricing" is based on high cost and acceptance of cost premium for new commodities. This is a common practice in automotive industry where innovation is introduced at the beginning of the line. This is also the dominant practice in pharmaceuticals, electronic components and software industry. In certain high-tech markets, this pricing strategy is sometimes called "cream skimming pricing" because consumers are always ready to pay for novelty premiums and become "early adopters."
In the case of export markets, different prices may be set, particularly depending on the changes in foreign exchange rates, changes in prices and income elasticity.54
Zantac antiulcer drug, released by Glaxo in 1983, is one of the most famous examples of successful "premium pricing" for patients. Compared with Zametac of SmithKline Beecham, the world leader at the time, Zantac had more convenient dosing schedules, reduced side effects, and drug contraindications. Glaxo decided to charge a premium of 50%, not parity or low price. In four years, Zantac became the world market leader.
Market pricing or competitive pricing considering options to select innovative products and services alternatives and options to balance demand and supply. Cost constraints, consumer's economic satisfaction, etc.
In fact, according to Smith and Nagle, the pricing of new products and services is often the result of a "political" decision arising from conflict between strict accounting requirements.
The cost covers development and production the price must be sufficiently low for the sale of products, such as the price which is high enough and the vision based on marketing55.
According to management science, price is one of many strategic variables. It is also a very complicated problem because consumer expectations and corporate development strategies must be considered as well. Price is customer's signal reflecting an analysis of the value perceived by the product.
53 Chanaron, J.J., (1990), Innovation Technologique et Developpement economique, Cours d’Economie Appliquee, DGES, Universite Pierre Mendes France, Grenoble.
54 Khalaf, L., Kichian, M., (2000), Testing the Pricing-to-Market Hypothesis: Case of the Transportation Equipment Industry, Bank of Canada Working Paper, 2000-8, May.
55 Smith, G.E., Nagle, T.T., (1994), Financial Analysis for Profit Driven Pricing, MIT Sloan Management Review, Vol. 25, 3, pp. 71-80
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Over the past thirty years, interest in innovation in the popular press, governments, and business firms has accelerated, creating a crescendo of concern and enthusiasm for innovation. In 1999, The Economist described innovation as ‘the industrial religion of the late 20th century’56 . Nowadays, innovation features as a prominent slogan amongst the heads of nations.
This part begins with defining an economist who means innovation. Economists have focused on two main types of products and processes. A product innovation that improves the scope and quality of a product is an act to propose a new market.57 For example, compared to Sony Walkman, a portable device that can play music, the Apple iPod is an innovative product.58 Creating new ways of creating or delivering goods or services is called process innovation. For example, there is a new way for a customer visiting a hospital to touch the screen and receive treatment instead of talking to a receptionist.59 This section shall highlight the basic innovations concept of the stages and process in different types and impacts of innovation.
3.1 Basic Definition of Innovation 3.1.1 Introduction
The Oslo manual60distinguishes innovation into four areas: product, process, marketing, and organization. Although concept establishment has not yet been ensured compared to product innovation and process innovation, marketing and organizational innovation are also well-known concepts of innovation for many countries and enterprises.
3.1.2 Defining Innovation
According to the Oslo Manual, innovation is the implementation of new products or processes, new or significantly improved, new marketing methods or organizational methods in business practices, work organizations or external relationships.61
This innovation range includes a various of possible innovations. Innovation can be classified in more detail when innovation, such as product and process innovation, is implemented.62 The minimum requirement for innovation is that the company need to update (or greatly improve) their products, processes, marketing methods or organizational methods. This
56 Industry gets religion, Feb 18 1999, from: http://www.economist.com/node/186620
57 Christine Greenhalgh & Mark Rogers (2010), Innovation Intellectual Property, and Economic Growth, Research Policy: Princeton University Press.
58 The nature and importance of innovation, from: http://assets.press.princeton.edu/chapters/s9221.pdf
59 Christine Greenhalgh & Mark Rogers (2010), Op. cit.
60 Oslo Manual (2005), Guidelines for Collecting and Interpreting Technological Innovation Data: Organisation for Economic Co-Operation and Development.
61 Oslo Manual (2005), Op. cit.
62 Oslo Manual (2005), Op. cit.