Chapter 6 Pricing Practices That Endanger Profits Mc

Chapter 6 Pricing Practices That Endanger Profits Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Chapter Objectives • To understand how consumers perceive prices, price changes, and price differences • To develop the concept of reference price and further develop the concept of price thresholds • Key pricing principle – Prices should be set so as to reflect customers’ perceptions of value • Irrationally held truths may be more harmful than reasoned errors. -Thomas H. Huxley Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Adaptation-level Theory • Based on the assumption that stimuli are judged with respect to internal norms representing the combined effects of present and past experiences • All judgments are relative to an individual’s existing adaptation level – The adaptation level represents a region on a continuum, and there is a changing adaptation level at all times Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Adaptation-level Theory • An individual’s behavior represents an adaptation to three classes of stimuli or cues: – Focal cues are the stimuli the individual is directly responding to • Purchase offers, including price – Contextual or Background cues are other behaviorally based stimuli • Available monetary resources, purpose of purchase, purchase environment – Organic cues refer to the inner physiological and psychological processes affecting behavior • Amount of cognitive resources available to process the information about the product and the offer Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Adaptation-level Theory • The adaptation-level price for a specific product category is a function of: – The frequency of different prices for that category (normal or skewed) – The relative magnitude of prices – The range of prices – The dispersion of prices from the average price – Influences by practice and past experience and by the sequence that the buyer observes the prices for the category Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Adaptation-level Theory • Anchoring effect – Every new price encountered by an individual tends to move the adaptation-level price in its own direction • Contrast effect – New prices far above or below the original adaptation level may change the individual’s perception of other prices in the series Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Implications of Adaptation-level Theory Ø Price perceptions are relative to other prices and to the product use Ø There is a reference price for each discernible quality level for each product category and this price influences judgments of other prices Ø There is a region of indifference about a reference price such that changes in price within this region produce no change in perception Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Implications of Adaptation-level Theory Ø The reference price may be some average of the range of prices for similar products, and need not correspond to any actual price nor the price of the leading brand Ø Buyers do not judge each price singly; rather each price is compared with the reference price and the other prices in the price range Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Assimilation-contrast Theory • Based on the assumption that new stimuli encountered by an individual are compared against a background of previous experience with the stimuli category – This experience forms an individual’s reference scale which serves as a basis for an individual to compare and evaluate other subsequently encountered stimuli Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Assimilation-contrast Theory • Assimilation effect occurs when judgments of these previously perceived low prices in the category do not change when a new price is encountered – This occurs because the new price is perceived as similar to the reference prices • Contrast effect occurs when the new price displaces the reference price range sufficiently far and the original low prices will be perceived as lower than previously – This occurs because the new prices are perceived as different from the reference price, but as still belonging to the same price category Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Assimilation-contrast Theory • Three different price cues affect price judgments: – The reference price – The lowest price – The highest price • Anchoring stimuli are prices used by individuals to make perceptual judgments about other prices • Price judgment is the individual’s assessment of whether a price is too low, acceptable, or too high Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Cognitive Reference Points • Suggests that prices near the reference price are more easily assimilated to, and therefore, judged to be closer to the reference price • The psychological distance around reference prices may not be symmetrical – The numbers 5 through 9 may be perceived to be closer than the numbers 1 through 5 Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Prospect Theory and Transaction Utility • Prospect theory shows that an evaluation of an outcome is strongly influenced by a standard of comparison, reference point, or “zero” point – Determines whether outcomes are gains or losses – Stimuli equidistant from the reference point are perceived to be closer to the reference point if they are larger than if they are smaller Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Integrating the Theories • 1. The reference “point” is really a range of prices that are judged to be neutral or medium • 2. The internal reference range is for prices within a specific product category or for a specific product in that category • 3. The reference point or reference range is continuously changing as new prices are encountered • 4. The asymmetrical nature of perceptions of prices equidistant from the reference price, but in opposite directions Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Product-Line Pricing Ø The lowest and highest prices in the product line are more noticeable than those between, and thus, anchor buyers’ judgments Ø The perception of a sale price may depend on the position of the price in the price range Ø Price is less dominant in purchase decisions if the price range is narrowed by shifting the end prices toward the middle of the range, or if there is little variation in prices Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Order of Presenting Prices • Buyers who are exposed initially to high prices will perceive subsequent lower prices as less expensive than they would if they were initially exposed to low prices Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Introductory Pricing Strategies and Tactics • Sellers introduce new products with short-term “introductory low-price promotions” – Facilitates market penetration – Produces lower long-run sales volume than if the product is introduced at its regular price – The introductory low price serves as a reference price for evaluating a perceived price increase when the price is raised to its normal price Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Singapore Sheraton • Market situation, Singapore, 1986 -1990: – Five-star and four-star hotel construction to double supply of beds – Ministry of tourism predicts the number of visitors to remain steady at two million annually for the next few years. • What do you expect will be the effect on hotel prices by 1988 - 1990? • What strategy should management of the new Singapore Sheraton follow? • What should be their pricing objective? Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Singapore Sheraton • Purchased major credit card mailing list on world-wide basis • Mailed brochure and five one-night free stay coupons – Brochure described the new hotel – Room rates included in the brochure • The results: – Gave away 20, 000 room-nights – By 1990, 80% of business was repeat visits – Maintained five-star room rates Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Absolute Price Thresholds • Acceptable price range – Upper price threshold (price tolerance or reservation price) – Lower price threshold – How wide is the range of acceptable prices and what is the price level around which this range is centered? • Based on alternative offerings, customer satisfaction and loyalty, knowledge about other prices and quality Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Disneyland Paris • Opened in 1992 - admission 250 francs – By 1994, 1994 losses averaged $1 million per day; hotels half empty • Market research survey - 1994 – Price of 200 francs was psychological threshold • 1995 - Set admission price for one adult at 195 francs ($39) – Operated at a profit for first time • 1996 - 11. 7 million people visited – 33% increase over 1994; 9% increase over 1995; 40% of visitors were French Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Disneyland Paris (Prices – April 1 –November 5, 2000) Adult Child 1 day 220 FF 170 FF 2 day 425 FF 330 FF 3 day 595 FF 460 FF Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Relative Price Is More Important Than Absolute Price v. Price elasticity is how buyers perceive a price relative to another price, whether that price is. v. The last price paid, v. The price of the leading competitive offering, v. The highest or lowest price in the product line, or. v. The expected price to pay. Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Relative Price Is More Important Than Absolute Price v. Price elasticity will differ: vfor price increases, vfor price decreases, vover similar products, vover market segments, and vthe further a product’s price is from the category average. Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Relative Price is More Important than Absolute Price v. Buyers, in general, are more sensitive to perceived price increases, than to perceived price decreases. v. This difference in sensitivity is most apt to occur when the price change originates from the vicinity of the market average. Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Relative Price is More Important Than Absolute Price v. If the original price is at the extreme of the market range, then a more substantial price change is needed to produce a perceived price change. v. Extreme prices, high or low, will become more price elastic as the prices shift toward the market average. v. Prices of the market share leader generally are less price elastic than other competitive offerings. Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Price Elasticity • Price elasticity of demand is the percentage change in quantity sold relative to (divided by) the percentage change in price. • If the value of elasticity is < -1, (i. e. , -2 or 3), then price elastic. • If the value of elasticity is , 0, but > -1 (e. g. , -0. 5), then price inelastic. Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Cross-price Elasticity • How the price of one product is perceived to differ from the price of another offering that buyers believe is an alternative choice to consider • Differential price thresholds – The degree to which buyers are sensitive to relative price differences Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Cross-price Elasticity • Cross-price elasticity refers to the % change in demand for one product relative to (divided by) the % change in price of another product. • If the value is > 0, then the two products are substitutes. • If the value is < 0, then the two products are complements. Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Cross-price Elasticity • Trading up pricing strategy refers to theory that buyers typically purchase the “better” product in each price position • Segmented pricing strategy refers to theory that buyers perceive each price to stand by itself Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Decomposing Price Elasticity • Prices increases vs. price decreases – Difference in relative price elasticity between price increases and price decreases means it is easier to lose sales from current buyers by increasing price than it is to gain sales from new buyers by reducing price Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Decomposing Price Elasticity • Competitive effects – If a brand’s price is already at the extreme end of the price-market range, then a more substantial price change will be needed to produce a perceived price change – Extreme prices will become more price elastic as the prices are changed toward the market average or as competitor’s pricing moves the brand’s price toward the market average Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Decomposing Price Elasticity • Asymmetric competition – The degree that demand for a product or brand is price elastic or inelastic depends on its crossprice elasticity relative to competing products Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Decomposing Price Elasticity • The effect of price thresholds – Demand is very price elastic at upper and lower absolute price threshold – Buyers have different price thresholds for different products, while different buyers have different price thresholds for a given product Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Decomposing Price Elasticity • Other influences on price elasticity – Does the product have unique attributes? – What alternative suppliers or substitute products are available? – How does the product compare to those of different suppliers? – How significant are buyers’ expenditures on the product as a portion of their incomes? – What benefit do buyers seek from the product? – What is the frequency of past price changes? Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Decomposing Price Elasticity • Price elasticities are not constant and they can be managed over products, brands and time to a greater extent than previously recognized Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Decomposing Price Elasticity • Managers need to pay attention to: – Nature of a price change – Magnitude of a price change – Characteristics or the targeted market segment – Direction of the price change – Duration of the price change – Extent that the price change will be communicated or promoted to the market Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.