Pricing and Sales Promotion:DEMAND CONSIDERATIONS

1. DEMAND CONSIDERATIONS

One of the most important cornerstones of price determination is demand. In particular, the volume of a product that buyers are willing to buy at a specific price is that product’s demand. In this section we will review some important analytical concepts for practical pricing decisions.

Influence of Price on Buyer Behavior

In economic theory, price influences buyer choice because price serves as an indicator of product or service cost. Assuming the buyer has perfect information concerning prices and wants satisfaction of comparable product alternatives, he or she can determine a product / service mix that maximizes satisfaction within a given budget constraint. However, lacking complete and accurate information about the satisfaction associated with the alternative choices, the buyer assesses them on the basis of known information. Generally, one piece of information available to the buyer is a product’s price. Other pieces of information about anticipated purchases are not always known, and buyers cannot be sure how reliable and complete this other information is. And because this other information is not always available, buyers may be uncertain about their ability to predict how much they will be satisfied if they purchase the product. For example, if you buy a new car, you do not know what the relative incidence of car repairs will be for the new car until after some months or years of use. As a result of this imperfect information, buyers may use price both as an indicator of product cost as well as an indicator of quality (want satisfaction attributes).

Useful Economic Concepts

This brief outline of how price influences demand does not tell us about the extent to which price and demand are related for each product / service choice, nor does it help us to compare, for example, engineering services per dollar to accounting services per dollar. The concept of elasticity provides a quantitative way of making comparisons across product and service choices.

Demand Elasticity

Price elasticity of demand measures how the quantity demanded for a product or service changes due to a change in the price of that product or service. Specifically, price elasticity of demand is defined as the percentage change in quantity demanded relative to the percentage change in price. Normally, it is assumed that quantity demanded falls as price increases; hence, price elasticity of demand is a negative value ranging between 0 and -x.

Because demand elasticity is relative, various goods and services show a range of price sensitivity. Elastic demand exists when a given percentage change in price results in a greater percentage change in the quantity demanded. That is, price elasticity ranges between -1.0 and -x. When demand is inelastic, a given percentage change in price results in a smaller percentage change in the quantity demanded. In markets characterized by inelastic demand, price elasticity ranges between 0 and -1. Another important point about price elasticity: it does change and is different over time for different types of products and differs whether price is increasing or decreasing.

A second measure of demand sensitivity is cross price elasticity of demand, which measures the responsiveness of demand for a product or service relative to a change in price of another product or service. Cross price elasticity of demand is the degree to which the quantity of one product demanded will increase or decrease in response to changes in the price of another product. If this relation is negative, then, in general, the two products are complementary; if the relation is positive, then, in general, the two products are substitutes.

Products that can be readily substituted for each other are said to have high cross price elasticity of demand. This point applies not only to brands within one product class but also to different product classes. For example, as the price of ice cream goes up, consumers may switch to cakes for dessert, thereby increasing the sales of cake mixes.

Revenue Concepts

There is a relationship between sellers’ revenues and the elasticity of demand for their products and services. To establish this relationship we need to define the concepts of total revenue, average revenue, and marginal revenue. Total revenue is the total amount spent by buyers for the product (TR = P X Q). Average revenue is the total outlay by buyers divided by the number of units sold, or the price of the product (AR = TR / Q). Marginal revenue refers to the change in total revenue resulting from a change in sales volume.

The normal, downward-sloping demand curve reveals that to sell an additional unit of output, price must fall. The change in total revenue (marginal revenue) is the result of two forces: (1) the revenue derived from the additional unit sold, which is equal to the new price; and (2) the loss in revenue which results from marking down all prior saleable units to the new price. If force (1) is greater than force (2), total revenue will increase, and total revenue will increase only if marginal revenue is positive. Marginal revenue is positive if demand is price elastic and price is decreased, or if demand is price inelastic and price is increased.

Consumers’ Surplus

At any particular price, there are usually some consumers willing to pay more than that price in order to acquire the product. Essentially, this willingness to pay more means that the price charged for the product may be lower than some buyers’ perceived value for the product. The difference between the maximum amount consumers are willing to pay for a product or service and the lessor amount they actually pay is called consumers’ surplus. In essence, it is the money value of the willingness of consumers to pay in excess of what the price requires them to pay. This difference represents what the consumers gain from the exchange and is the money amounts of value-in-use (what is gained) minus value-in-exchange (what is given up). Value-in-use always exceeds value-in-exchange simply because the most anyone would pay must be greater than what they actually pay, otherwise they would not enter into the trade.

Understanding How Buyers Respond to Prices

As suggested above, a successful pricer sets price consistent with customers’ perceived value (Les- zinski and Marn 1997). To understand how customers form value perceptions, it is important to recognize the relative role of price in this process. Because of the difficulty of evaluating the quality of products before and even after the product has been acquired, how customers form their perceptions of the product becomes an important consideration when setting prices. During this perceptual proc- ess, buyers make heavy use of information cues, or clues. Some of these cues are price cues and influence buyers’ judgments of whether the price differences are significant. For example, buyers may use the prices of products or services as indicators of actual product quality.

Price, Perceived Quality, and Perceived Value

Would you buy a package of 25 aspirin that costs only 50 cents? Would you be happy to find this bargain, or would you be suspicious that this product is inferior to other brands priced at 12 for $1.29? In fact, many consumers would be cautious about paying such a low relative price. Thus, the manufacturers of Bayer and Excedrin know that some people tend to use price as an indicator of quality to help them assess the relative value of products and services.

Since buyers generally are not able to assess product quality perfectly (i.e., the ability of the product to satisfy them), it is their perceived quality that becomes important. Under certain conditions, the perceived quality in a product is positively related to price. Perceptions of value are directly related to buyers’ preferences or choices; that is, the larger a buyer’s perception of value, the more likely would the buyer express a willingness to buy or preference for the product. Perceived value represents a trade off between buyers’ perceptions of quality and sacrifice and is positive when perceptions of quality are greater than the perceptions of sacrifice. Figure 1 illustrates this role of price on buyers’ perceptions of product quality, sacrifice, and value. Buyers may also use other cues, such as brand name, and store name as indicators of product quality.

Price Thresholds

Those of us who have taken hearing tests are aware that some sounds are either too low or too high for us to hear. The low and high sounds that we can just barely hear are called our lower and upper absolute hearing thresholds. From psychology, we learn that small, equally perceptible changes in a response correspond to proportional changes in the stimulus. For example, if a product’s price being raised from $10 to $12 is sufficient to deter you from buying the product, then another product originally priced at $20 would have to be repriced at $24 before you would become similarly dis- interested.

Our aspirin example above implies that consumers have lower and upper price thresholds; that is, buyers have a range of acceptable prices for products or services. Furthermore, the existence of

a lower price threshold implies that there are prices greater than $0 that are unacceptable because they are considered to be too low, perhaps because buyers are suspicious of the product’s quality. Practically, this concept means that rather than a single price for a product being acceptable to pay, buyers have some range of acceptable prices. Thus, people may refrain from purchasing a product not only when the price is considered to be too high, but also when the price is considered to be too low. The important lesson to learn is that there are limits or absolute thresholds to the relationship between price and perceived quality and perceived value (Monroe 1993).

When buyers perceive that prices are lower than they expect, they may become suspicious of quality. At such low prices, this low perceived quality may be perceived to be less than the perceived sacrifice of the low price. Hence, the mental comparison or trade-off between perceived quality and perceived sacrifice may lead to an unacceptable perceived value. Thus, a low price may actually reduce buyers’ perceptions of value. At the other extreme, a perceived high price may lead to a perception of sacrifice that is greater than the perceived quality, also leading to a reduction in buyers’ perceptions of value. Thus, not only is it important for price setters to consider the relationship among price, perceived quality, and perceived value, but to recognize that there are limits to these relationships.

Usually a buyer has alternative choices available for a purchase. However, even if the numerical prices for these alternatives are different, it cannot be assumed that the prices are perceived to be different. Hence, the price setter must determine the effect of perceived price differences on buyers’ choices. As suggested above, the perception of a price change depends on the magnitude of the change.

Generally, it is the perceived relative differences between prices that influence buyers’ use of price as an indicator of quality. In a similar way, relative price differences between competing brands, different offerings in a product line, or price levels at different points in time affect buyers’ purchase decisions. A recent experience of a major snack food producer illustrates this point. At one time, the price of a specific size of this brand’s potato chips was $1.39 while a comparable size of the local brand was $1.09, a difference of 30 cents. Over a period of time, the price of the national brand increased several times until it was being retailed at $1.69. In like manner, the local brand’s price also increased to $1.39. However, while the local brand was maintaining a 30-cent price differential, the national brand obtained a significant gain in market share. The problem was buyers perceived a 30-cent price difference relative to $1.69 as less than a 30-cent price difference relative to $1.39. This example illustrates the notion of differential price thresholds, or the degree that buyers are sensitive to relative price differences.

From behavioral price research, a number of important points about price elasticity have emerged:

1. Buyers, in general, are more sensitive to perceived price increases than to perceived price decreases. In practical terms, this difference in relative price elasticity between price increases vs. price decreases means it is easier to lose sales by increasing price than it is to gain sales by reducing price.

2. Sometimes a product may provide a unique benefit or have a unique attribute that buyers value.

These unique benefits or attributes serve to make the product less price sensitive.

3. The frequency of past price changes can influence buyers’ sensitivity to price changes. If prices have been changing relatively frequently, buyers may not have adjusted to the previous price change when a new change occurs. If buyers have not adjusted to the last price increase, then another price increase will be perceived as a larger increase than it actually is, making them more sensitive to the increase. The issue this point raises is the concept of reference prices and is discussed next.

Effects of Reference Prices on Perceived Value

In the past few years, evidence has emerged confirming the existence of a reference price serving as an anchor for price judgments. One of the most important points stemming from the concept of reference prices is that buyers do judge or evaluate prices comparatively. That is, for a price to be judged acceptable, too high, or too low, it has to be compared to another price. This other comparative price is the buyer’s reference price for that particular judgment. The reference price serves as an anchor for buyers’ price judgments. Buyers may use as a reference point the range of prices last paid, the current market price or perceived average market price, a belief of a fair price to pay, or an expected price to pay to judge actual prices.

Price perceptions are relative. That is, a specific price is compared to another price or a reference price. The illustration for relating this important point to pricing strategy and tactics comes from a firm introducing a new product with an introductory low price. Initially, the product was targeted to sell at a price of $17.50. However, the firm used the tactic of introducing the product at a low price of $14.95. Later, when it was time to remove the introduction price because of increased costs, the regular price was set at $20.00. The product failed to sustain sufficient sales volume to warrant its continued existence. The error in this situation was that the pricing tactic of a low introductory price established a baseline or reference price of $14.95 rather than $17.50. Hence, the $20.00 price, when compared to $14.95, was perceived to be too expensive and buyers stopped buying.

Recent behavioral research has provided additional explanations of how people form value judg- ments and make decisions when they do not have perfect information about alternatives. Moreover, these explanations further our understanding of why buyers are more sensitive to price increases than to price decreases and how they respond to comparative price advertisements, coupons, rebates, and other special price promotions. The common element in these explanations is that buyers judge prices comparatively, that is, a reference price serves to anchor their judgments (Monroe 1993).

The Effect of E-commerce on Pricing

There is a clear emerging trend toward electronic commerce becoming a significant aspect of the economy. Estimates of online sales indicate that the $7.8 billion in sales in the United States recorded in 1998 grew to approximately $15 billion in 1999 and is expected to grow to $23–28 billion in 2000 (Schmeltzer 2000; Sparks 2000). Accompanying this rapid growth of electronic sales is an emphasis on exchanges occurring at lower prices than in conventional exchanges. Several questions naturally arise with this knowledge of increasing electronic sales at relatively lower prices:

1. How does information play a role in this phenomenon?

2. What forces exist to pressure or enable online sellers to sell at lower prices?

3. Can these relatively lower prices (and accompanying lower profit margins) be sustained?

The Role of Information

In Section 3.1, we pointed out that traditional economic theory assumes that buyers and sellers have perfect information about prices, their own tastes and preferences, and their budget or income avail- able for purchasing goods and services. However, when buyers are faced with imperfect information and the inability to assess quality, and therefore the ability to determine their degree of satisfaction prior to purchase, they may use price to infer quality and their expected degree of satisfaction. However, the quality of the attributes of some goods can be assessed prior to purchase. We call these goods search products. Examples of search products would include books, videotapes and music CDs, brand-name hard goods, airline tickets, toys, pet supplies, and standard industrial supplies. Indeed, a recent survey indicated that online shoppers purchased more books and videotapes online than in stores (Chicago Tribune 2000). Further, the CPI inflation rate for November 1999 for recre- ational products was 0.7% compared to the overall CPI inflation rate of 2.2% (Cooper and Madigan 1999). Products in the recreational category include toys, music, books, and pet supplies. Buyers perceive less risk in buying products that they believe vary little in quality across alternative sellers. Thus, searching online for the lowest prices for these types of products is convenient, quick, and virtually costless. For example, CompareNet offers detailed information on more than 100,000 prod- ucts. Other sites provide software agents to find products (Green 1998). Moreover, the online shopper

can search in a wider geographical area than in the local community. Finally, consumers and corporate buyers can pool their purchasing power and get volume discounts. General Electric Co. was able to reduce its purchase cost by 20% on more than $1 billion in purchases of operating materials by pooling orders from divisions on a worldwide basis (Hof 1999).

Pressures on E-commerce Prices

As indicated above, the online buyer may be able to reduce search costs while not incurring any significant increase in risk. At the same time, the direct supplier–buyer relationship in e-commerce transactions reduces or eliminates the various intermediaries in traditional distribution systems. Fur- ther, the information intermediary may take a smaller percentage of the final selling price for the information service provided (perhaps 10% as opposed to 40–50% traditional intermediary margins) (Hof 1999). Also, a large and growing number of information intermediaries, manufacturers, distrib- utors, and retailers are providing buyers access to buying on the internet. This increasing competitive pressure will keep prices relatively low, as expected from traditional economic theory. But the ques- tion is, how long will we see both this intensive competition and these relatively very low prices?

The Feasibility of Sustainable Low Internet Prices

Currently almost all online sellers are losing money because they do not have sufficient sales at the relatively low profit margins to recover their fixed costs (Sparks 1999). Further, to get the sales growth necessary to become profitable will require increasing amounts of investment in marketing, that is, increasing fixed costs. Without infusion of large amounts of venture capital, many of these enterprises will not succeed and will either fail outright or will be acquired by more successful online sellers or manufacturers and retailers with the financial and marketing capital to generate the necessary sales growth.

Further, as more manufacturers, distributors, and retailers enter electronic selling, it is likely that their online sales will be at lower unit profit margins, given the current pressure on prices. Initially, their online sales will be at the expense of their higher-margin conventional sales, reducing their overall profit margins. Overcoming this negative effect on profitability will require new sales growth from new buyers who may shift from other electronic sellers. At some point there will be a shakeout between the e-commerce sellers and prices will likely stabilize at relatively higher levels than we encounter in this early stage of electronic commerce. This expectation is not different from the various revolutions in selling that have occurred over the years. The real problem will be predicting when the shakeout will occur leading to prices stabilizing profits at sustainable levels from electronic sellers. And if there is little perceived quality variation across sellers, then buyers are more likely to minimize the price paid for these items.

However, searching for the lowest price from alternative sellers can be time consuming in tradi- tional shopping. Most busy people have neither the time nor the willingness to visit multiple outlets seeking the lowest price for a purchase they are considering.