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C H A P T E R 1
Introduction: Pricing as an
Element of the Marketing Mix
Anytime anything is sold, there must be a price involved. The focus of this book is to
present concepts, principles, and techniques that provide guidance to help a seller set the best price. Our study of how to set the best prices will take the marketing approach. In this chapter, we will describe the business context for pricing and provide an overview of how the basic principles of marketing can guide effective price setting. THE COMMERCIAL EXCHANGE Although people often think of marketing as synonymous with advertising or salesman- ship, it is actually much broader. Marketing consists of the full range of activities involved in facilitating commercial exchanges and having all of these activities be guided by a con- cern for customer needs. The central idea here is that of the commercial exchange (see Figure 1.1). This is where a seller provides a product to a buyer in return for something in exchange (usu- ally an amount of money). The product could be something tangible, which is referred to as a good , or the product could be the result of human or mechanical effort, which is referred to as a service. The buyer could be a consumer —an individual who pur- chases a product for his or her own use—or the buyer could be a business customer — an individual or group who purchases the product in order to resell it or for other business purposes. One aspect that makes the commercial exchange a very important idea is that it describes an interaction that is voluntary. Both the buyer and seller participate in the exchange voluntarily because the exchange will lead them both to be better off. For exam- ple, consider the vending machine in the office lounge. You put in your dollar and get a large package of M&M’s. You do that voluntarily because you would rather have the bag of candy than that dollar. On the other hand, the Mars company, which produces M&M’s, also
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engages in this transaction voluntarily. As we know, the company would rather have your dollar than that extra package of candy. Although we tend to take commercial exchanges for granted, we shouldn’t forget that there is something very important and wonderful involved here. Because both parties to the exchange are better off after the exchange than before, one could say that the exchange makes the world a just a little bit better place. There is a little more happiness after the exchange than before it. Although there may be only a tiny bit of increased happiness from any one commercial exchange, these little pleasures can quickly mount up. In a society where the distribution of most goods and services is governed by a free-market economy , every person engages in numerous commercial exchanges every day. Each little increase in pleasure that a commercial exchange brings is then multiplied many times, and the societal benefits can become considerable. In all of this, it must be recognized that there are degrees of voluntariness, and that choices may be so limited for some buyers that they may not feel much better off after an exchange. Also, it is possible that a product purchased voluntarily could fail to perform as expected or that a third party (other than the buyer and seller) may be harmed by an exchange. These illustrate the need for some governmental regulation—a free-market economy cannot be entirely free. Nevertheless, in modern free-market societies, people experience the pleasures of choice and are energized by entrepreneurial possibilities. The commercial exchange is at the heart of the free-market economic system, which, as we have seen in recent years, has become more and more widely adopted among the various nations of the world. Figure 1.1 The Commercial Exchange Source: Adapted from W. M. Pride and O. C. Ferrell, Marketing: Concepts and Strategies (Boston: Houghton Mifflin Co). Seller Buyer Product Something in exchange
- Product: good or service
- Buyer: consumer or business customer
- Something in exchange: price
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“Price” Versus “Cost” Although a price may go by many names, one name it should not go by is cost. This is because, in this book, we will usually be taking the viewpoint of the seller. If we were taking the viewpoint of the buyer, this would not be an issue. Buyers, par- ticularly consumers, will typically use the terms price and cost synonymously. For example, a woman could tell her friend, “The price of this sweater was only $30.” Or she could just as easily say, “This sweater cost me only $30.” However, from the viewpoint of the seller, the difference between prices and costs is quite important. A price is what a business charges, and a cost is what a business pays. Thus, a grocery manager may set a price of $3.79 for a 17-ounce box of Honey Nut Cheerios, may price large navel oranges at 3 for $1.99, or may sell ground chuck at the price of $3.49 per pound. But the manager must also attend to his costs. These costs include, for example, what he pays the wholesaler per case of Cheerios, what he pays employees to stock it on the shelves, what he pays for the building, for heat and lights, for advertising, and so on. PRICING AS A MARKETING ACTIVITY Marketing activities are those actions an organization can take for the purpose of facilitating commercial exchanges. There are four categories of marketing activities that are particularly important, which are traditionally known as the four elements of the marketing mix :
- Product— designing, naming, and packaging goods and/or services that satisfy customer needs - Distribution— efforts to make the product available at the times and places that customers want - Promotion— communicating about the product and/or the organization that produces it - Pricing— determining what must be provided by a customer in return for the product If you use the term place for the activities of distribution, the four elements of the marketing mix can be referred to as “the four Ps,” a mnemonic that has proved useful to generations of marketing students. Note that there is an important way in which pricing differs from the other three ele- ments of the marketing mix. This is illustrated in Figure 1.3. Product, distribution, and promotion are all part of the process of providing something satisfying to the customer. Product activities concern the design and packaging of the good or service itself, distribu- tion involves getting the product to the customer, and promotion involves communicating the product’s existence and benefits to customers and potential customers. All three of these types of marketing activities contribute to the product being of value to customers. In this book, the term value will refer to the benefits, or the satisfactions of needs and wants, that a product provides to customers.
CHAPTER 1 Introduction: Pricing as an Element of the Marketing Mix 5
Pricing, on the other hand, is not primarily concerned with creating value. Rather, it could be said to be the marketing activity involved with capturing, or “harvesting,” the value created by the other types of marketing activities.^1 In the words of Philip Kotler, “Price is the marketing-mix element that produces revenue; the others produce costs.”^2 Because it is a marketing activity fundamentally different than the others, it is important that the implications of pricing’s uniqueness be fully understood. This is one of the reasons that a course in pricing is an important part of a business education. The Marketing Concept The marketing approach to business involves not only engaging in a variety of marketing activities but also having these marketing activities be guided by the marketing concept. The marketing concept can be expressed as follows: The key to business success is to focus on satisfying customer needs. What this means is that an organization that works toward satisfying customer needs in every feasible way when carrying out marketing activities is likely to see more long-run suc- cess than a company that does not have such a customer focus. Sellers who rely only on their own opinions and ignore those of their customers or sellers who view their customers as “marks” to be tricked or manipulated may do well at a particular time but are unlikely to be able to sustain whatever short-term success they may have. The marketing concept is a modern form of the philosophical viewpoint known as “enlightened self-interest”: One’s self-interest is best served by focusing one’s attention on the needs of others. Figure 1.3 Pricing Harvests the Value Created by the Other Three Marketing Mix Elements Source: Based on Nagle (1987). Product Distribution Promotion Create value Pricing “Harvests” value
CHAPTER 1 Introduction: Pricing as an Element of the Marketing Mix 7
large city, at a minimum 40,000 people,” says UCLA professor Robert Englund, one of the few experts on the Uruk documents. “So some of the quantities are very high—hundreds of thousands of pounds of barley, for instance.” But here’s the really remarkable thing. The earliest Uruk tablets aren’t just the oldest pricing records ever found. They are the oldest examples of human writing yet discovered. In other words, when humans first took stylus to wet clay, the first things that they were compelled to record were... prices.^3 In the earliest commercial exchanges, goods or services were exchanged for other goods or services. For example, the price that a farmer might pay for a bolt of cloth could be a bushel of corn. This practice, termed barter , still goes on today, especially in less developed countries. Barter occurred in recent years when Shell Oil purchased sugar from a Caribbean country by giving in return one million pest control devices.^4 Although barter is still used, it can make exchange difficult. For example, what if the seller of the bolt of cloth had no need for the farmer’s bushel of corn? Because of such inefficiencies of barter, almost all modern commercial transactions use a medium of exchange —something that is widely accepted in exchange for goods and services in a market.^5 A medium of exchange could be anything that the buyers and sellers in a society agree upon. In the past, items such as cattle, seashells, dried cod, and tobacco have been used as a medium of exchange. However, many of these presented certain difficulties. In his book The Wealth of Nations, Adam Smith gives an example of this: The man who wanted to buy salt, for example, and had nothing but cattle to give in exchange for it, must have been obliged to buy salt to the value of a whole ox, or a whole sheep, at a time. He could seldom buy less than this, because what he was to give for it could seldom be divided without loss.... 6 Over time, it became clear that the best medium of exchange is one that is finely divis- ible, such as the metals of various weights used in coins. This use of coins and notes to represent them led to national systems of money, such as dollars, yen, or euros. It is prices expressed in such monetary terms that will be considered in this book. THREE CATEGORIES OF PRICING ISSUES As the use of prices in monetary terms proliferated among human societies, various ques- tions that required pricing decisions began to arise. Most of these issues fall into one of the following three categories: (1) buyer–seller interactivity, (2) price structure , and (3) price format. Buyer–Seller Interactivity in Determining Prices Throughout most of history, prices were not the fixed amounts displayed in stores and advertising that are so familiar today. Rather, prices were negotiated during an interaction
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between the buyer and the seller. The basic elements of price negotiation can be illus- trated by imagining how, for many centuries, the price determination process typically occurred: A customer arrives at the seller’s stall in the local marketplace and examines the merchandise. When he finds something he wants, the customer asks the seller, “How much?” The seller then states an asking price , which is higher than his reservation price , the lowest price at which he would sell the item: “23 ducats.” The customer then states his initial offer. This, of course, is lower than the customer’s reservation price (the highest price that the customer would pay for the item): “I can’t pay more than 14.” The seller and the customer would then try to arrive at an amount they can both agree on by haggling , a process involving some number of prices and offers and statements supporting the validity of each. “This item is really of the very highest quality,” the seller might argue, “but since I’m in a good mood today, I’ll let you have it for 21.” The customer might respond, “I’ve seen items at least as good as this in other shops, but since I’m here, I’ll give you 16.” If there is overlap between the reservation price of the seller and that of the customer, then they could be successful in arriving at a negotiated price—that is, one that is agreeable to both. In that case, the object’s price would have been the number that resulted from an interaction between the buyer and seller. A price arrived at by the buyer–seller interactions of negotiation or the interactions of auction bidding would be referred to as an interactive price. If you find yourself a little uncomfortable with the deception involved in the process of price negotiation, you are not alone. Religious leaders were among the earliest critics of this type of business practice. In fact, it was George Fox, the founder of the Society of Friends (often called the Quakers), who first suggested that an alternative was possible. He led his followers to carry over to their businesses the principle of total honesty that they adhered to in their personal lives. As a result, Quaker merchants adopted the practice of stating to the customer the price that they actually expected to receive and sticking to it. Such a price is referred to as a fixed price. It is interesting that, rather than hurting their competitive position, the use of fixed prices actually tended to help the Quakers in their businesses. Customers appreciated the quicker and less stressful buying process associated with fixed prices and often tended to feel more trusting of Quaker merchants. The use of fixed prices spread steadily and was strongly stimulated by the development, in the middle of the nineteenth century, of new types of retailing designed to serve mass markets. In particular, fixed prices helped make possible the large department store (pioneered by entrepreneurs such as F. W. Woolworth, John Wanamaker, and J. L. Hudson), which depended on a large number of quick transac- tions and staffing by low-paid, relatively unskilled clerks. In an 1859 advertisement for his growing New York department store, Rowland Macy claimed, “Best products, and same prices for all customers!” Also, the use of fixed prices enabled the growth of mail-order sales and the development of large catalog companies such as Sears Roebuck.^7 During the twentieth century, the use of fixed prices became predominant in retail pric- ing throughout the developed world. Although we take fixed prices for granted when we
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pocket the payment. However, research on early price advertising has indicated that just- below prices were more likely to be used when the advertised item was claimed to be a discount or an otherwise low price. This suggests that the use of the just-below price format Figure 1.4 Macy’s Ad From 1880, Showing 9-Ending Prices Source: New York Times, 1880.
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was, from the start, motivated by managerial intuitions about its effects on the perceptions of the consumer. Price format also involves the question of how many numbers are required to express an item’s price. For example, a price advertisement could directly show the price of a mush- room and pepperoni pizza, or it could express that price as a base price plus an additional amount for the two toppings (see Figure 1.5). The price of a lamp in a home furnishings catalog might be expressed as a price for the lamp that includes shipping or as a price for the lamp alone along with a separate price for the shipping of the lamp to the purchaser. The question of whether a price should be expressed as a single number or as the sum of more than one number is the issue of price partitioning. Figure 1.5 Alternative Price Formats for a Mushroom and Pepperoni Pizza Pizza Heaven Prices: Cheese & tomato $9. Cheese & tomato with mushrooms $10. Cheese & tomato with mushrooms and pepperoni $11. Pizza Heaven Prices: Cheese & tomato $9. For each additional topping $1. Available toppings: Mushrooms, pepperoni THE PRICING ACTIVITY The marketing activity of capturing the value created by the other marketing activities is obviously of essential importance to a business organization. One could imagine an orga- nization failing to carry out distribution or promotion activities and still be in business. But if there is no attention to pricing, a business organization cannot be viable. The activity of making decisions about prices consists of two general components. One component is price setting, which consists of decisions about individual prices. These deci- sions concern the price of a specific item to a specific customer or market in the current
CHAPTER 1 Introduction: Pricing as an Element of the Marketing Mix 13
departments in the company.^9 For pricing decisions to be made effectively in a large orga- nization, it is important that these decisions either involve high-level management in the organization or use some other means to centrally coordinate and constrain the many pricing-related decisions that are likely to be made by many different people throughout the organization.^10 There are at least three reasons why such organization of pricing activ- ities is important. First, it is possible for a large company to experience problems in the effective imple- mentation of pricing decisions. For example, the product manager of a manufacturing company that sells to distributors and retailers may set an item’s invoice price —the price of the item that will appear on the customer’s bill. However, a large or longtime customer may be able to convince his or her sales representative into offering a small off-invoice discount—say, an annual volume rebate. Further, the customer may contact the company’s advertising department and arrange a small discount for, say, displaying the product in the customer’s flyers. The accounts receivable department may be convinced to give this good customer more favorable payment terms, the transportation department might give this customer a break on shipping costs, and the account services department could allow this customer a more generous return policy. Employees in each part of the company might be assuming that it makes sense to give a break to such a good customer. However, together, all of these actions may substantially reduce the item’s pocket price —the amount that’s actually left in the company’s pocket after the transaction. Without central pricing coordi- nation, such revenue “leaks” could be as high as 20 percent of invoice prices.^11 Second, a business organization should take steps to help insure that everyday pricing decisions fit with the organization’s strategies and long-term interests. As will be seen in later chapters, pricing decisions made for immediate purposes can have consequences that are far-reaching. For example, price cutting done in response to competition can lead to price warfare and serious erosion of profits. Recent financial difficulties among companies in the U.S. airline industry may be, at least partly, a consequence of such price warfare. On the other hand, small price increases, it they continue to occur, could eventually have the effect of leading customers to find alternative types of products to serve their needs. Kellogg’s, General Mills, and other breakfast cereal manufacturers made continual small price increases for many years until, eventually, sales in the entire cold cereal category began to decline as more consumers switched to bagels, muffins, and other breakfast alter- natives. It is important that a person or a group with a broad view of the selling organization consider the possibility of such long-term effects of pricing decisions. Third, for a business organization to follow the marketing concept and effectively focus on satisfying customer needs, marketing activities need to be well-coordinated with each other and with the other functions of the organization. Having pricing activities managed by a central authority can help accomplish this coordination. For example, if a price decrease is expected to lead to a sales increase, then it is useful to make sure that produc- tion, procurement, customer service, and other functions of the organization are prepared to handle this price decrease. Or if new cost economies are achieved by some aspect of the company’s operations, rapid knowledge of this could contribute to more efficient pricing decisions. In addition, new possibilities, such as lowering costs by purchasing a component in an Asian country, could be more effectively evaluated with the combined input of mar- keting research and centrally coordinated pricing decision makers.
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Relevance of Studying Pricing It is hoped that the previous discussion helps make clear that pricing is a relevant topic to study even if you do not expect to be directly involved in the pricing activities of an organization. Pricing is so critical to a business organization that it affects, and is affected by, virtually every function of the organization. Thus, for example, if you are interested in advertising, keep in mind that the pricing of a product affects how it should be promoted—a product’s pricing influ- ences what is said about the product and to whom. Correspondingly, what is effectively com- municated about the product can strongly affect the price that can be charged. In addition, price setting is relevant to our personal lives. Even if we do not sell things at garage sales or on eBay, we are almost all marketers of our professional services. Our compensation—salary, bonuses, and benefits—constitutes the price we charge employers for our services. As managers of what is most likely, over the course of our careers, a multimillion- dollar product, it makes good sense for us to be familiar with the principles of effective pricing. PLAN OF THE BOOK We will begin our study of pricing with the situation where an organization is offering a product, or form of a product, that it has not sold before. What should its price be? Focusing on this relatively well-defined situation will enable us to introduce some basic pricing principles and procedures. Of course, setting an initial price is not the most commonly occurring situation. More often than not, the manager is faced with an existing product that already has a price. The question then would be, is this existing price the best price? If it were higher, or lower, would more profits be likely to result? We will introduce a breakeven formula that can be of considerable help in decisions about modifying existing prices. However, this breakeven formula alone does not make effective pricing decisions pos- sible. What is needed also is some ability to predict (and perhaps even influence) how the customers in the market will respond to the product’s price change. In order to gain this predictive ability, we will focus on understanding four types of factors that deter- mine the market’s price-change response: (1) economic, (2) competitive, (3) cognitive, and (4) emotional. The latter two types of factors will also shed light on issues of price format. Following discussion of these four types of price-response factors, we will discuss market- research procedures for directly measuring the market’s price-change response. At this point, we will have a basic ability to set a price: We will be able to set the price of a newly offered product, and we will be able to effectively modify the price of a product that is currently being offered. We then expand our focus to the design of an organiza- tion’s price structure. We first discuss the use of price structure to accomplish price seg- mentation. We then discuss how a product’s price may need to be adjusted because of interrelations with the other products that are being sold by the organization. The last section of the book addresses several other pricing issues of importance. We will discuss some of the special challenges involved in managing interactive prices, such as prices arrived at through negotiation and auctions. Auction pricing has taken on a renewed impor- tance with the rise of the Internet. We will become familiar with some of the basic ideas
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REVIEW AND DISCUSSION QUESTIONS
- Describe the two parties in a commercial exchange and what is given and received by each party.
- How is the voluntary nature of the commercial exchange related to its potential for creating benefits for society?
- Give some terms other than “price” that are commonly used to refer to prices.
- In a business organization, describe how what a manager is referring to when speaking of “prices” differs from what a manager is referring to when speaking of “costs.”
- What are the four categories of marketing activities, usually referred to as the marketing mix? In what important way does pricing differ from the other three categories?
- What is the marketing concept? How can pricing activities be guided by the marketing concept?
- What is barter? Give an example of barter, either from your reading or from your own experience.
- What is a medium of exchange? What is most commonly used in our society as a medium of exchange?
- Describe the basic elements of price negotiation. Why is a price arrived at through negotiation referred to as an “interactive price”?
- What are fixed prices? What do customers like about fixed prices? What do retailers like about fixed prices?
- What is price segmentation? Why might a seller want to engage in price segmentation?
- Give an example of how different numbers could be used to express what would be substantially the same price.
- What is the difference between price setting and pricing policy?
- Give some examples of job titles of those in a large organization who are likely to have direct responsibility for making pricing decisions.
- What are some of reasons that a item’s pocket price may not be the same as the item’s invoice price? What could be done about this?
- Give an example of a way that everyday pricing decisions could work against a company’s long-term interests.
- Describe some benefits of coordinating pricing activities with the other functions of a business organization.
- Why might the study of pricing be relevant to a student who does not plan to ever set prices within a business organization?
CHAPTER 1 Introduction: Pricing as an Element of the Marketing Mix 17
EXERCISES
- The CEO of a large company selling seeds and garden supplies to consumers and businesses through catalogs and the Internet is unhappy with its overall profitability. He feels that part of the solution is to be more professional in price setting, and he asks the director of marketing to hire an experienced person for a new position of pricing manager. While interviewing one candidate, the marketing director explains that the company has been advised to listen more to customers and respond to their needs and asks the candidate how he would implement this advice in the area of pricing. The candidate responds as follows: “It’s great to listen to the customer when you are designing your product, but it’s just not practical in pricing. All the customers have to say is that they want lower prices. If you want me to increase profits, I can’t very well listen to that!” a. What should the marketing director make of this response? b. If you were the candidate, how would you have responded to this question?
- An entrepreneur is starting a business selling decorative items, such as vases, wall hangings, and prints (framed or unframed) over the Internet. She is aware that she needs to make a number of pricing decisions. a. Describe a decision that the entrepreneur must make that would be an example of price setting. Describe a decision that she would have to make that would be an example of pricing policy. b. Describe a decision that she would need to make regarding price format, and describe one regarding price structure.
- As the marketer of your own professional services, you are responsible for price setting. Thus, it is necessary that you think about your pricing policy. a. Describe how a business professional might implement the following pricing policies in the pricing of his or her services: negotiated price policy and fixed price policy. b. Give and justify your views as to which of these pricing policies would be more appropriate in an individual’s professional services pricing.
- Identify someone you know who works in a business organization. Talk with that person to learn about the individuals in the organization who are involved in the setting of prices. a. Describe the job of a person within the organization who plays a direct role in price setting. b. Describe the job of a person within the organization who plays an indirect role in price setting. What is the information or expertise provided by that person? When during the price-setting process does that person interact with an individual who has a more direct role in price setting?
