23 Pricing Decisions – I

Dr. Meenu Saihjpal

  1. Learning Outcome

 

After completing this module the students will be able to understand:

  • The meaning of pricing and the problems associated with pricing.
  • The different objectives of pricing policy.
  • The role played by market structure in deciding the pricing policies.
  • The different factors that affect the pricing policies.
  1. Introduction

Garda highlights that if ‘pricing’ is used effectively then it can change the game for the business corporations. Pricing decisions are one of the most critical decisions that any firm has to take. Prices can either make or break a firm. Let us take the example of two companies;

 

company A and company B. Both enter at the same time in a market X which was earlier a closed market. Company A is a fast food chain and company B specializes in the breakfast items. Market X has been a traditional market, whereby the customers have always loved their traditional food items. Thus, this market has not been exposed to foreign food items for breakfast, lunch or dinner. Both the companies adopt different pricing strategies. Company A decides to charge a low price for its food items. This is done intentionally so that on the basis of price, its product becomes a close substitute of the local food items. Thus, on one ground, its product became approachable to the customer. Next, company A localizes the taste of its fast food items by incorporating local spices and local ingredients. This further brought its product closer to the customers. Company B makes no changes in its price policy despite the fact that most of the competitors of its food items are local products which were priced low. This company does not make any change in the ingredients of its breakfast items and hence, does not try to attach the traditional food loving customer to the alien food item. Which company, according to you, would easily penetrate into market X? Definitely, it is company A. This is because it has priced its product low and has made changes in its food items as per the local taste. Further, as the customer start preferring the food items of company A to traditional food then company A introduces more products with higher prices so as to make profits. All those who can afford a higher price for a better taste are offered a high priced food item. Those who do not want to spend more can continue to enjoy the same food items which were introduced initially at the same price. This way, company A has expanded its profits and customer base.

 

Thus, pricing can give success or pose a threat to the existence of the firm. An over- priced product may cause losses to the firms and an under-priced product may bring profits for the firms or vice-versa. Thus, pricing of the products is the key to the future of the firms in the market.

  1. Objectives :

 

Objectives of the pricing policy specify the route of the pricing strategies or decisions. These set the road map which guides the pricing decisions and lead the company to success.

Therefore, the firms must explicitly specify their objectives. In theory, we always say that the goal of the firm is to maximize profits, however, in reality; there are many other objectives that a firm can pursue through prices. A firm may have a single objective or may pursue more than one objective. Sometimes, a firm may pursue a different objective initially and then may pursue some other pricing policy after sometime. The case of ‘potato- chips’market is an apt example here. Before the introduction of reforms, the Indian ‘chips’ category constituted only a few companies. However, with the opening up of the economy, many international brands have entered into this area. Penetration of ‘Lays’ into the Indian market was not easy as most of the Indians were addicted to having traditional home made chips or those made in a traditional way by the local companies. Therefore, the strategy of the company was to not to cause a drain in consumer’s pocket and simultaneously to introduce the consumer to the new taste. So, the company started with the introduction of small sized packs which were priced low at Rs 5. As the consumer became addicted to the taste, the company started to introduce various other types of packs i.e. Rs 10 packet, Rs 20 packet, family pack and the party packs etc. Once, the consumer became used to buying these packets then the company changed its policy to making profits by withdrawing the Rs 5 packet from the market. Now, Rs 5 packets are reserved for markets where customer demand is low. For example, in students canteen Rs 5 packets are easily available but these are not available in bigger markets.

This example reveals that the companies may not solely pursue one objective, may have different objectives at different times, and may not follow same pricing strategy in all the markets. The objectives of the different pricing strategies can be groups under two heads. These are:

 

 

a) Quantitative objectives: In this category, those objectives are included which are related with the firm’s profits, sales, market share etc. Such objectives are measurable and can be quantified. These are discussed below:

 

i) Maximisation of sales: Some firms have the objective of maximising their sales thereby leading to the growth of the firm. Therefore, the firms will set the prices of their products accordingly.

 

ii) Increasing the share of the firm in the market: Firms also tend to pursue the objective of increasing their share in the market. To attain this, firm may reduce their price. This is more pronounced in product markets which have few sellers. This is evident from the price war between Ola and Uber cabs in India.

 

iii) Restricting the entry of new firms: When the objective of the firm is to block the entry of the new firms in the market then it may set a price accordingly. It might set the price below the costs so as to keep the new entrants at bay.

 

iv) Returns on investment: Firms invest huge amounts in business ventures. Therefore, many a times, firms have the objective of earning returns on their investment and thus,may set the prices accordingly.So, we can briefly sum up these objectives as:

 

 

Qualitative objectives: Though quantitative objectives appeal more to our common sense and can also be easily measured, yet these have certain inherent limitations. The study of the actual practices of the firms pertaining to the prices of their products reveals that the firms, many a times, prefer qualitative objectives over the quantitative objectives. Qualitative objectives are the ones which cannot be measured. Such goals help the company to attain a social acceptability and ensure the social attachment and loyalty of the customers towards itself. The different types of qualitative objectives are discussed below in detail:

 

  1. Survival of the firm: The present day markets are full of upheavals due to increased competition, frequent technological innovations leading to product innovations and different uses of the existing products or raw materials, increased awareness and opportunities due to the availability of internet etc. Considering these reasons, the survival of the existing firms is always under threat. Therefore, firms may have their long term survival as the pricing objective.
  2. Building a good relationship with the customers: Many firms aim at developing a long term relationship with their customers so as to bring them back to buy their products / services. Such firms cater exclusively to the specifications as desired by the individual customers. Here, it is pertinent to quote the pricing strategy of the Gynaecologists. Once a lady conceives or plans to conceive and visits a doctor, the doctor preferably charges low fee for the initial tests so as to lay foundation stone for building a long term relationship which may bring the patient back for future treatment. Once, the trust and the association are established then the doctors may change their pricing policy.

    Though, theoretically, these objectives are segregated, however, in real life it is very difficult to separate these. The attainment of one is not possible without the attainment of the other

 

This is so, because a firm has to earn profits and have a share in the market so as to remain in business along with retaining the existing customers and attracting new ones. If a firm takes care of its customers then it ensures the long term stay of the firm in the market. Some even believe that there seems to be a hierarchy of objectives as pursuance of qualitative objectives lead to the attainment of the quantitative objectives by the firm. For example, these days’ firms aspire to earn increased profits or maximize sales along with maintaining a good relationship with the customers. This relationship is established by giving priority to the queries of the customers and attending to their complaints and grievances and also guiding them in their purchase. This also includes making calls to the customers on their birthdays and anniversaries. Although such a strategy is structured on the qualitative objectives but eventually, it builds long term relationship with the customer and reserves a loyalty of the customer towards the company and thus, leads to the maximization of sales or attainment of profits which are quantitative objectives.

 

Another classification of the objectives can be short run and long run objectives. The former aspires to attain specific objectives in a short period of time. The short period could be six months or one year. Thus, the impact of such objectives is realized immediately in short period. The long run objectives are meant to be attained after year i.e. their impact is realized after one year. Pricing objectives can further be classified into single objective or multiple objectives. In the modern day world, due to increased competition and increased awareness and expectations of the consumer, firms are forced to endeavour for multiple objectives. However, it has been observed that some goals may not be compatible with each other which make it difficult for the firms to pursue multiple objectives. For example, if a firm fixes its goal to maximize its sales then it cannot pursue the goal of profit maximization. Thus, sometimes, a firm has to forcibly remain content with one pricing objective.

  1. Impact of market structure on pricing policies:

Before fixing the pricing policies, a firm needs to ponder upon certain points. While fixing the prices, the firm must consider the market structure in which it operates. Theoretically, economists used to believe that perfect competition prevails in the market. In such a market system, the firms are just the price makers and not the price takers. Hence, in such a market structure, the firms are not bothered about fixing the prices. However, this form of the market structure rarely prevails in reality. If the firm operates in monopoly then it has to set its own price. Sometimes, in monopoly the firm has to set the price so as to use it as a tool for blocking the entry of the competitors. Usually, firms operate under imperfect market conditions and set their own prices. Joel Dean pointed out that the firms must take care of the conditions prevailing in the market before setting the prices for their products. The first factor is the availability of substitutes in the market. If the number of substitutes is high and the substitutes also have a high degree of closeness with the product of the firm under consideration then it cannot have a high control over the prices. It will have to fix a price closer to the prices of the substitutes. If there are very few substitutes available in the market then the firm has fairly high control over the price of its product. Another factor to be considered is the entry barriers and the expected entry by new firms in the market. If there is a threat of entry by new rivals and the existing firms want to block their entry by reducing the price then the new firm cannot charge a high price. Many academicians believe that the pricing policy also depends upon whether the product of the firm (under consideration) is highly differentiated from the products of the other firms or not, possibility of segmenting the market and also on advertisement expenditure. A good degree of product differentiation enables the firm to have some power in fixing the prices.

 

Lastly, a firm must also consider the elasticity of demand for the product. If the demand for its product is highly elastic and close substitutes are available then it should not fix a very high price as it may not have enough buyers. If the demand for its product is less elastic then it can have some control over the prices.

 

For this purpose, a firm also needs to keep in mind the cross price elasticity of demand for its product. If the cross price elasticity of demand is low then the firm can fix a higher price and vice-versa.

 

It is also pointed out that while fixing the prices and even after the fixation of prices, the firm must be totally flexible and vigil. The firm must constantly keep a watch on the market and must adjust its pricing policy as per the changing conditions otherwise it may lose the customers.

 

  1. Factors affecting price decisions:

 

In this section, we shall put all the factors affecting the price decisions of the firm under one head. These are given below:

 

  1. Cost of production:

 The first and the most important variable that sets the price is the cost of production. The short term pricing policy covers the variable costs and the long run pricing policy covers the fixed as well as variable costs. No firm wants to charge a price that is not able to cover its costs. However, sometimes a firm may, intentionally, charge a price which is below the costs of the product. This is done to block the entry of the new firms. Such a policy may also be done by a new entrant to command a major share in the market as has been done by Reliance Jio in India. Since, this is a very critical variable in the price fixation; therefore, it is very necessary that the firms must efficiently cut down their costs as well. However, a reduction in costs may or may not cause a reduction in the prices of the firms.

  1. Consumer preferences:

 

The price policy of the products of the firm is highly determined by the preferences of the consumers. Consumer preferences are highly influenced by their income, age-group, habits, fashion etc. Whenever the income of the consumer increases the demand for durable goods like air conditioners, television etc., increases and vice versa. Thus, the firms that supply durable goods may design their policy keeping in mind the income of the consumers. Further, the age group of the consumers is also a significant variable. If the population of the economy has more of young people than the older population then the demand for products would be relatively high this is because younger people have a greater tendency to spend more than the older population. Other variables like advertising also affect the consumer. Many times consumers do not have a preference for certain commodities but due to the influence of advertising, they purchase those commodities. Thus, advertising may help in the determination of prices indirectly.

 

 Rivals:

 

The pricing  policy of a firm is also determined by its rivals; their number and their pricing and output decisions. If there are few rivals offering very close substitutes then the firm under consideration has to charge a price which is closer to others. If the firm under consideration is the single seller then the firm has to fix a price considering the threat of the entry of new firms.

 

Profits:

 

Though profits are the main consideration while deciding the prices of the products yet the firms, in reality, strive for a reasonable profit in the long run. This is due to the increased competition, improvements in technology and the pressure to retain consumers. In fact, firms which aim to be there in the long run, prefer to not to change their prices so as not to lose their customer base. Even if the firms increase their price then the price changes may be very subtle over a period of time. However, sometimes, if one firm is financially stronger and it wants to evade out its rival then the former may indulge in price war forcing its opponent to reduce price and ultimately leave the market when the price falls below the costs. In such cases the consumers enjoy the benefit of reduced prices. Thus, high profits may not be the sole consideration all the time.

 

  1. Government policy:

 

Pricing policy of the firms is highly dependent on government policy. Sometimes, there are restrictions from the side of the government which may force the producers to fix price within a limit. Before 1991, Indian economy was highly regulated and controlled by the government. Though the private sector existed yet there were numerous controls. If at times the prices of the commodities increased sharply then the government forced the producers to sell the commodities at lower prices. For many years certain essential commodities like sugar and cement were sold at controlled rates. The private companies used to manufacture these commodities. Since, there was huge demand for these commodities and the domestic resources were limited so, the distribution of these commodities was done by the government. Government agencies used to procure these items and sell the specified quantities at reduced prices. Thus, the prices were highly governed at that time. Also, government controlled the ‘number’ of producers in the market by way of licensing. Through licensing the firms were assured of no threat of entry and thus, might have charged a higher price. However, after 1991, the Indian economy was opened up and liberalization, privatization and globalization were introduced. Because of which competition increased in the market. Now, government interference is relatively less and thus, firms have a free hand in deciding their price policies. The entry of the firms in different markets is also opened up largely. Thus, with the increase in the number of rivals in the markets and with the withdrawal of government control, pricing strategies have evolved to a larger extent in the post-reform period.

 

6 Conclusions

 

In this chapter we have seen the significance of pricing decisions of the firms. An under or over priced product could lead to losses to the firm. This chapter, thus, explained the different objectives of the pricing policies of the firms. The objectives of pricing policy can be quantitative and qualitative. We also discussed the impact of market structure on the pricing policy and the factors that affect the pricing decisions of the firms. The different types of the pricing strategies are discussed in the next chapter.

 

Learn More

  • Avlonitis, G.J. and Indoinas, Kostis. A. (2004), Pricing Strategy and Practice- The Impact of Market Structure  on  Pricing  Objectives  of  Service  Firms,  Journal  of  Product  and  Brand Management, Volume 13, Number 5, pp-343-358, accessed from: file:///C:/Documents%20and%20Settings/Administrator/My%20Documents/Downloads/34.Pricin g_practices_and_strategy.pdf, accessed on March 18, 2017.
  • Mithani, D.M. (2014), Managerial Economics, Himalaya Publishing House, Mumbai.
  • Rangnekar, Amit, McDonald’s India Entry Strategy, accessed from: http://C:/Users/acer/Downloads/McDonald’s%20India%20Entry%20Strategy.pdf, viewed on March 14.2017.
  • Sengupta, Mousoumi, Sengupta, Nilanjan and Raghupathi, Suma, 2012, http://sdmimid.ac.in/SDMRCMS/cases/CIM2012/6.pdf, accessed on March 18, 2017.