Chapter 13 Smart Pricing Mc GrawHillIrwin Copyright 2008

Chapter 13 Smart Pricing Mc. Graw-Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

13. 1 Introduction Implicit assumption so far has been that demand cannot be influenced l In reality, this is not true l Demand level changes can be made through: l Advertising, displays, and promotional tools l Pricing l 13 -2

Dell’s Pricing Strategy Product price different based on type of customer l Product price varies over time l Prices of options offered also vary over time l 13 -3

Other Examples IBM is investigating software that will allow it to adjust prices according to demand l Nikon Coolpix Digital Camera sold for about $600. l l l Manufacturer provides a rebate of $100 independently of where the camera is purchased Boise Cascade Office Products sells many products on-line l Prices for the 12, 000 items ordered most frequently on-line might change as often as daily 13 -4

Questions Related to Pricing l l l What are these companies doing? Why does Dell charge a different price for different consumers? At different times? If Dell can do it, can it work for other companies? What is the impact of the mail-in rebate? Shouldn’t Nikon and Sharp just reduce the wholesale price paid by the retailers instead of asking the consumer to mail in the coupon? What is wrong with a traditional fixed-price policy? 13 -5

Revenue Management Principles l l l All companies trying to boost profit by using what are know as smart pricing or revenue management techniques Techniques first pioneered by the airline, hotel, and rental car industries. Airline industry l l Revenue management has increased revenue significantly American Airlines’ estimates of annual incremental revenue of $1 billion through revenue management 13 -6

13. 2 Price and Demand l All things being equal Demand for a product will typically go up as the product’s price goes down l Certain products more or less sensitive to price changes l In general the property holds l l Downward-sloping demand curve 13 -7

Manager’s Issue l l What is the optimal price at which revenue is maximized? Need to characterize the relationship between pricing and demand for each product Utilize this characterization to determine the optimal price for each product May involve many complexities l l l Vast quantities of data may need to be analyzed Competitors’ behavior may need to be captured Many firms do manage to at least approximate this relationship. 13 -8

Example – Single Product Management estimates the relationship between demand, D, and price, p l D = 1, 000 - 0. 5 p l When the p=$1, 600, D=200 l When the p=$1, 200, D=400 l 13 -9

Price vs Revenue Table Pric e $250 $500 $750 $1, 0 00 $1, 2 50 $1, 5 00 Dem and Reve nue 875 $218, 7 50 750 $375, 0 00 625 $468, 7 50 500 $500, 0 00 375 $468, 7 50 250 $375, 0 00 Maximum Revenue = $500, 000 when price = $1, 000 13 -10

Demand-Price Curve FIGURE 13 -1: Price/Demand curve for Example 13 -11

13. 3 Markdowns l l Assumption in example: demand is deterministic based on price Realistic picture l l Demand is random At the end of a selling season, there may be remaining inventory l l Firms frequently employ a markdown or sale to dispose excess inventory Think about demand from the customer’s perspective: l Each customer has a maximum price that he or she is willing to pay for the product l Reservation price 13 -12

Markdown Concept l When the p=$1, 200, D=400 l l 400 customers have a reservation price at or above $1200 When the price is below their reservation price, they will buy The lower the price, the more customers with a reservation price at or above that price l Sell product to customers whose reservation prices were below the original price, but above the sale price. l Traditionally, retailers have tried to avoid markdowns l l l Evidence of mistakes in purchasing, pricing, or marketing Low reservation price customers seen as: less desirable or profitable, l useful to get rid of the excess inventory l 13 -13

13. 4 Price Differentiation l l Customers who are willing to buy at sales price were different than the customers who were willing to buy at original price In fashion, some customers are very fashion conscious l l l Other customers are value-conscious l l l Eager to buy at the start of the selling season Willing to pay more to have fashionable items first Willing to wait until the end of the sales season Unwilling to pay the same high prices as the fashionable customers Different customers charged different prices can result in higher revenue 13 -14

Price Differentiation Example l According to the demand–price curve, the retailer charges many customers who are willing to pay a higher price only $1000 l About 200 customers willing to pay $1, 600 l About 100 willing to pay $1, 800 l By charging a single price, management is leaving a large amount of money on the table 13 -15

Multi-tiered Pricing Strategy l l Money left on the table = (2, 000 - 1, 000) • 500/2 = 250, 000 Consider a differential or customized pricing strategy l l Consider a two-price strategy in which the firm introduces two prices, $1, 600 and $1, 000. l l l Tailors pricing to different market segments At a p=$1, 600, there is demand for 200 items At a p= $1, 000, there is demand for 500 items Total revenue in this case is 1, 600 • 200 + 1, 000 • (500 - 200) = 620, 000 $120, 000 more than in the single-tier strategy A three-tier pricing strategy can do even better l l At p=$1, 800, D=100; p=$1, 600, D=200; p=$1, 000, D=500 Total revenue equals 1, 800 • 100 + 1, 600 • (200 - 100) + 1, 000 • (500 - 200) = 640, 000 $20, 000 more than in two-tier strategy 13 -16

Three-Tier Pricing Strategy FIGURE 13 -3: Three-Tier Pricing Strategy 13 -17

13. 5 Revenue Management l Selling the right inventory unit to the right type of customer, at the right time, and for the right price l l Integrates pricing and inventory strategies to influence market demand, Provides controls for companies to improve the bottom line Revenue management techniques have been traditionally applied in the airline, hotel, and rental car industries Common characteristics of such industries: l l l existence of perishable products fluctuating demand fixed capacity of the system segmentation of the market based on sensitivity to price or service time products sold in advance 13 -18

History of Revenue Management Pioneered by American Airlines in the 1980 s l As a counter to new airlines like People. Express l Techniques employed differentiated pricing l Widely successful l People. Express went out of business l Other airlines started adopting l Hotels and rental companies adopted later l 13 -19

Customer Segments in Airline Industry l Leisure travelers Highly sensitive to price l Not generally sensitive to the duration of the trip l Willing to book non-refundable tickets far ahead of time l l Business travelers Not particularly price-sensitive l Highly sensitive to trip duration l Need high flexibility to adjust their travel plans as needed l 13 -20

Customer Differentiation in the Airline Industry FIGURE 13 -4: Customer differentiation in the airline industry 13 -21

Differential Pricing l “Build fences” to prevent business travelers from moving from the top-left box to the bottom-right box l l l Require weekend stays and early booking The more fare classes, the more fences required Other factors: l l How many of each type of ticket to offer? How much to price for each ticket 13 -22

Revenue Management Systems l Market Segmentation l l l For a specific time and flight (origin to destination), Different products designed and priced to target different market segments Products feature different restrictions l l l Booking Control l Non-refundable Available up to 21 days before the flight. Allocates available seats to fare classes Setting limits on the number of seats that can be allocated to lower fare classes Requires: l l Sophisticated algorithms Basic criterion: Equal marginal revenues in each class 13 -23

Optimal Allocation of Flights Leisure fare is $100 per ticket l Business fare is $250 per ticket l 80 seats on the plane l Company can sell as many seats as they make available at the leisure fare l Business fare is random l 13 -24

Demand Distribution for Business Fares FIGURE 13 -5: Demand distribution for Example 13 -4 13 -25

Marginal Revenues of the Two Classes FIGURE 13 -6: Marginal revenue of leisure and business class for Example 13 -4 13 -26

Marginal Revenues l l Determine expected revenue for each number of allocated seats Determine expected marginal revenue of business class l l l Marginal revenue associated with leisure class seats l l revenue associated with allocating one additional seat can also be calculated this decreases as the number of allocated seats increases unlimited demand for seats implies marginal revenue is constant Marginal revenue of the two is equal at 18 seats l 18 seats should be allocated to business class 13 -27

Complexities of the Real Systems l l Variety of flight classes Different hierarchies of classes More complex demand information Network management l l l A flight can be part of many ultimate origin-destination pairs System needs to account for this by allocating seats to particular flights Prices change over time l l Flight may be expensive on some days and times If a plane is not filling up, the airline might increase the allocation of lower price fares to that flight over time 13 -28

13. 6 Smart Pricing American Airlines’ success prompted other industries to adopt similar practices regarding pricing l Specific techniques and tools of airline revenue management don’t necessarily apply to very different industries l Many of the underlying principles and concepts of revenue management do l 13 -29

Fundamental Approaches to Smart Pricing l Differential Pricing l l Charging different prices to different customers Dynamic pricing l Charging different prices over time 13 -30

Differential Pricing Charge different customers different prices according to their price sensitivity l Dell does this by distinguishing between private consumers, small or large businesses, government agencies, and health care providers l Difficult to do in many cases l 13 -31

Differential Pricing Strategies l Group Pricing l l Channel Pricing l l Discounts to specific groups of customers very common in many industries Senior citizen discounts at diners, software discounts to universities, student discounts at movie theaters, “ladies night” at bars Works only when there is a correlation between group members and price sensitivity Charging different prices for the same product sold through different channels Different prices on web sites vs. retail stores Works only if customers who use different channels have different price sensitivities Regional Pricing l l Exploiting different price sensitivities at different locations Beer is much more expensive in a typical stadium than in a bar 13 -32

Differential Pricing Strategies l Time-based Differentiation l l Similar products differentiated based on time Amazon. com charges different rates for different delivery times l l l A technique for segmenting price sensitive customers and customers who are more delivery time sensitive. Dell charges different prices for repair contracts that complete repairs in different amounts of time (overnight vs. within a week) Product Versioning l l Offer slightly different products in order to differentiate price sensitivities May take the form of branding. l l Store brand vs Generic brand Additional features added to products at the higher end of the line l l l High end buyers are inclined to buy the higher end products in the line Pay significantly more than the lower end products Cost very little more to manufacture. 13 -33

Differential Pricing Strategies Coupons and Rebates l l l Distinguish between customers that place a high value on time or flexibility Those who are willing to spend the time to get a lower price by using a coupon or submitting a rebate form Mail-in rebates at the point of sale l l Adds a significant hurdle to the buying process Customers willing to pay the higher price will not necessarily send the coupon Do not incorporate fences Require a more detailed analysis. 13 -34

Rebates l No rebate l l Each retailer decides on the price and the amount to order from the manufacturer to maximize its profit. Retailer needs to find a price and an order quantity so as to maximize its expected profit Manufacturer would like the retailer to order as much as possible @ the wholesale price Mail-in-rebates l l l manufacturer influences customer demand provides an upside incentive to the retailer to increase its order quantity Retailer’s profit increases Increase in demand forces the retailer to order more from the manufacturer. Optimal order quantity: l Compensates for the rebate/ Implies an increase in the manufacturer’s expected profit. 13 -35

Why Not Discount the Wholesale Price? l l l Rebate strategy implies not every consumer will mail the coupon to the manufacturer. If the manufacturer merely reduces the wholesale price, the retailer may keep the discount and not transfer it to the customers. Even if the retailer uses the discounted wholesale price to optimize its pricing and ordering decisions, and even if every consumer mails back the rebate, the mail-in rebate strategy is a better strategy for the manufacturer – WHY? 13 -36

Mail-in Rebate Strategy Better Assume retailer orders the same amount in both strategies l Order quantity < realized demand l l l the two strategies provide the manufacturer with exactly the same profit Order quantity > realized demand l Manufacturer’s profit with rebate is larger than its profit under discounted wholesale price 13 -37

Dynamic Pricing Retailers change price at the end of the season to get rid of excess inventory l Manufacturers change price during the season to distinguish between low and high reservation price customers l Use pricing to affect demand l 13 -38

Dynamic Pricing Better than Fixed. Price Strategy l Dynamic Pricing may increase profit by 2 -6% l Significant in industries with low margins l Retail industry l Computers industry 13 -39

Conditions under which Dynamic Pricing Is Superior l Available capacity l l Demand variability l l Benefit of dynamic pricing increases as the degree of demand uncertainty increases Seasonality in demand pattern l l Smaller the production capacity relative to average demand, the larger the benefit from dynamic pricing Benefit of dynamic pricing increases as the level of demand seasonality increases Length of the planning horizon l Longer the planning horizon, the smaller the benefit from dynamic pricing 13 -40

13. 7 Impact of the Internet l l Many approaches of smart pricing made more practical by internet and e-commerce Menu cost l l cost that retailers incur when changing the posted price Much lower on the Internet than in the off-line world Updating of prices possible on a daily basis Lower buyer search price l l l cost that buyers incur when looking for a product forces competition between sellers leads to a focus on smart pricing strategies 13 -41

Impact of the Internet l Visibility l l Customer segmentation l l l to the back-end of the supply chain makes it possible to coordinate pricing, inventory, and production information has facilitated growth of smart pricing using buyers’ historical data is possible on the Internet very difficult in conventional stores Testing capability l l l Internet can be used to test pricing strategies in real time On-line seller may test a higher price on a small group of the site visitors Use those data to determine a pricing strategy 13 -42

13. 8 Caveats l Must avoid the appearance of unfair treatment of customers l l l Amazon. com’s failed experimented with a pricing strategy in which customers were paying different amounts for the same DVD based on demographics or the browser used Coke’s development of a soda machine that would measure the outside temperature, and increase prices as the temperature increased On-line sites Priceline and Hotwire. com provide: l l an outlet for last-minute, unsold seats and hotel rooms opaque fares “Protects” the published fares promoted by the airlines and hotels themselves When many published fares are about as good as the opaque fares, it is harder to attract customers to the Priceline and Hotwire sites 13 -43

SUMMARY l l Pricing and promotion can be used to influence the level of demand. Traditionally, fashion retailers have used price markdowns to sell off excess inventory at the end of the season. Mid-1980’s: airline executives began to use a set of more sophisticated approaches to manipulating demand. Revenue management has two goals l l l Variety of techniques l l Differentiate demand Use pricing to adjust aggregate demand Differential pricing Dynamic pricing Made more effective by the Internet and e-business Caveat that customer should not be unfairly treated 13 -44