II. Literature Review
1. Pricing Strategies of a Firm
國
立 政 治 大 學
‧
N a tio na
l C h engchi U ni ve rs it y
II. Literature Review
This chapter discusses the conceptual foundation of the research: relationships between different market structures pricing strategies in theory, pricing strategies of individual firms in practice, elements of innovation, and relationships between price and innovation.
1. Pricing Strategies of a Firm
According to Blackburn, price strategy is an important strategic issue that changes based on the market structure of the company. Obviously, pricing and market structure, depending on their market structure companies determine the prices of products and services.
What greatly affects profitability is price. The pricing strategy varies considerably depending on industry, country and customer. Nevertheless, price strategies can generally be divided into three groups21:
Cost-based Pricing,
Competition-based Pricing, and
Value-based Pricing.
A summary of the key features of these different approaches is the Table 3. As mentioned in the table, each strategy has strength and weakness. The advantages of the first two methods are that they are not sufficiently focused on customer needs and requirements, but data can be easily used.22 Conversely, a value-based approach that is considered from a customer's perspective has difficulties compared to other methods in obtaining and interpreting relevant data.23
21 Hinterhuber, Andreas. (2008), “Customer Value‐Based Pricing Strategies: Why Companies Resist.” Journal of Business Strategy, vol. 29, pp. 41–50.
22 ibid.
23 ibid.
‧
Table II-1. Major Characteristics of Pricing Strategies
Item Cost-based Pricing Competition-based Pricing Value-based Pricing
Definition
▪ Determine pricing based on cost accounting data is Cost-based pricing
▪ Use anticipated or observed price levels of competitors as primary source for setting is Competition-based pricing
▪ Apply the value a product or service delivered to a predefined segment of customers as the main factor to setting prices is Value-based pricing
▪ Pricing according to average market prices
available ▪ Data readily available ▪ Consider the customer’s perspective
Main
▪ Does not consider customer’s willingness to pay
▪ Not easy to obtain related data and interpret
▪ Long-term profitability is considered, so it can be priced relatively high.
▪ Customer value was not given in the first place but needs communication for value.
Overall
Evaluation ▪ Weakest approach
▪ Need to come up with an
▪ Direct connection to customer needs is the best approach
Source: John S. Blackburn, (2012), Market Structure Differences and Pricing Strategies, Managerial Economics.
As pricing textbooks make clear, Realistically, pricing is the most difficult and challenging task in the business.24 That's why the more capable companies they are, the better the way they handle the complexity of pricing policies.25
To simplify the complexity of pricing, companies use only the information they need, without analyzing all the available information.26
In other words, pricing refers to a series of activities carried out by the company's organizational managers.27 In the process, pricing information is collected and shared and interpreted among the organizational processes. The pricing strategy in the market is hidden from the boundaries of the organization, but it also appears as price changes, price bundles, and price levels within the product line, etc.28
As mentioned in the above table, the three most commonly used strategies in pricing are as follows.
24 Monroe, Kent B., (1990). Pricing: Making Profitable Decisions. New York: McGraw Hill.
25 Dutta, Shantanu, Mark Zbaracki, and Mark Bergen, (2001). “Pricing Process as a Capability: A Case Study,”
Marketing Science Institute Working Paper, No. 01-117. Cambridge, MA: Marketing Science Institute.
26 Hague, D.C., (1971). Pricing in Business. London: George Allen & Unwin Ltd.
27 Noble, Peter M. and Thomas S. Gruca, (1999). “Industrial Pricing: Theory and Managerial Practice,”
Marketing Science, 18 (3), 435-54.
28 ibid.
‧
國立 政 治 大 學
‧
N a tio na
l C h engchi U ni ve rs it y
‧
This approach, characterized by financial attention, is the most common and most frequently used way to determine the price of a product.29 Basically, pricing is required to fully and fairly allocated all the costs of product production. It's a simple guide to profitability in theory, but it's actually designed in anticipation of average financial performance. Because the costs for production have been fully exposed, the paradigm calculates prices based on the industrial production environment and the level of pricing is determined by the extent to which the producer considers appropriate.30 Today, however, it is impossible to determine the unit price of the product in advance before deciding the price because the unit price of the raw material is very flexible. Cost-based pricing therefore follows a different pricing approach for different markets, with higher pricing in narrower and weaker markets and lower pricing in powerful and diverse markets.31
The price of a product is set at cost, and a fixed percentage is added to cost.32 The most basic reason for using a cost-based pricing policy is simplicity. The reason why it is not possible to accurately predict profit maximization points is because it is difficult to obtain information about marginal revenues and marginal costs. Cost-based pricing makes it simple to mark up and include company's desired return. Desirability from the standpoint of public relations is another advantage of cost-based pricing.33 This cost-based pricing approach also provides a good foundation for cost increases when they are needed.34
There are two steps involves Cost-based pricing typically. First, determine unit price or average total cost of product production. When the company determines unit production costs, it must first specify the level of production because the average total cost varies as the yield varies.35 After the company sets the unit price, the entity raises the unit price. Mark-up is typically calculated as a percentage of the cost that a company cannot easily allocate to a particular product that it produces and the return on its investment.36
The cost-based pricing method is determined by the following equation:37
Price = Average total cost per unit ⅹ (1 + mark-up)
The focus on averages rather than marginal costs is considered one criticism of cost-based
29 Nagle, T.T., Hogan, J. E., & Zale, J., (2011). The Strategy and Tactics of Pricing – A guide to growing more progitable. New Jersey: Prentice Hall.
30 ibid.
31 ibid.
32 Robert J. Graham, (2013). Managerial Economics for Dummies, Wiley.
33 ibid.
34 ibid.
35 ibid.
36 ibid.
37 ibid.
‧
國立 政 治 大 學
‧
N a tio na
l C h engchi U ni ve rs it y
pricing. In order to maximize profits, marginal cost information equivalent to marginal revenue information is needed. However, cost-based pricing is not the case and may not lead to profit maximization.38
The idea of ignoring demand conditions is another criticism of cost-based pricing.39 As a result of ignoring demand, the company sets a higher price than the market equilibrium price. As a result, the company is making surplus. The result is a situation where all products produced by the company are not sold to the market.
Cost-based pricing doesn't work for a particular business, and here are two important reasons.40
Although demand for products has a direct effect on prices, cost-based pricing determines prices without considering customer demand. Customers in the market will gladly pay more to buy the product if they feel they are short of supply compared to demand. On the other hand, if the market demand is very low, customers will be looking for lower amounts through discounts.41
Price-based pricing is predicated on a market that does not compete. Companies admit the value of their products in the market through competition and set prices. However, this simple formula that adds a level or percentage of profit can be difficult to operate outside a very limited industry. Cost-based pricing also makes it easier for other competitors to set a low price with a simple formula.42
38 Robert J. Graham, (2013). Op. cit.
39 ibid.
40 Methods to Price Your Product, from: http://www1.agric.gov.ab.ca/$department/deptdocs.nsf/all/agdex1133
41 ibid.
42 ibid.
‧
國立 政 治 大 學
‧
N a tio na
l C h engchi U ni ve rs it y
1.2 Value-based Pricing
The price of a particular product depends on the value that the customer feels about the product.
Its value depends on hundreds of different reasons and situations. The essential purpose of the value-based pricing is to reduce the deficit and reflect the customer's willingness to pay for a particular product in the price.43 The overall level of satisfaction a customer can gain by offering a product or service is called "value."44 This value is often referred to as "economic value". And The value-based pricing approach starts with an understanding of how customers value a product clusters. To avoid the general error that may be made in pricing, customers first need to understand the source of value.45 This pricing strategy, which seems easy to understand, is very difficult to calculate when compared to other pricing strategy, Cost-based and Competition-based, and requires a lot of follow-up research. The reason why this pricing method is not used much is because it is explained by psychological and intangible things that are difficult to convert into monetary values.46
The Following are disadvantages of value-based pricing47.
Disregard for production costs
Insufficient consideration of competition
43 Sveinn Porarinsson. (2013), Deciding on the Price of a Product/Service in a Start-up Setting: Coping with diverse objectives, market dynamics and uncertainty, University of Gothenburg.
44 Sveinn Porarinsson. (2013), Op. cit.
45 Hinterhuber, A. (2003), Towards value-based pricing - An intergrative framework for desicion making.
Industrial Marketing Management, 765-778
46 ibid.
47 Methods to Price Your Product. (1999), Alberta Agriculture, Food and Rural Development: Agricultural Marketing Resource Center.
‧
國立 政 治 大 學
‧
N a tio na
l C h engchi U ni ve rs it y
1.3 Competition-based pricing
Competition-based pricing is the second-most-popular pricing approach. Although owners may call this a strategic pricing, it is not particularly strategic. The pricing approach is to price the company's products at or very similar prices after checking the prices of competitors.48 This pricing strategy, which has the advantage of being very simple, is a way to determine prices even without thorough market research. It also seems comparably secure. In other words, companies can lower their risk of losing market share by setting prices similar to their competitors.49
If market has strong competition, there are more products that customers can choose from. The customer's choice is probably the cheapest item or the provider that suggests the best customer service. However, consumers should pay attention to reasonable and normal prices in the market.
The big advantage of competition-based pricing could be focusing on the industry in which the company is competing. The industry is closely watching existing and emerging competition types. Knowing the inside of a competitor can help the company's management decide how to manage the company.
To understand competition, further research is needed. One needs to understand what the company is selling, the type of company competes with, the quantity and type of substitutes, and how the company works in its industry.
Companies using a competitive pricing policy must consider the following disadvantages:50
The practice of lowering prices of known competitors and applying them to products
Not suitable growth strategy
Competitors can easily mimic whatever price it selects
48 Jagmohan Raju, Z. John Zhang, (2010), Smart Pricing: How Google, Priceline, and Leading Businesses Use Pricing Innovation for Profitability, Pearson Prentice Hall.
49 ibid.
50 Nagle, T. T., Holden, R. K, (2002), The Strategy and Tactics of Pricing, Upper Saddle River, NJ: Pearson Education Inc.
‧
國立 政 治 大 學