24 Pricing Decisions -II

Dr. Meenu Saihjpal

  1. Learning Outcome

 

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

  • The different types of pricing strategies.
  • The determination of different types of prices strategies.
  • The limitations and advantages of the different strategies.
  1. Introduction

 

In the last chapter we studied the different objectives of the pricing policies and the different factors that affect the pricing decisions of the firms including the impact of market structure on its pricing decisions. In the present chapter we shall discuss the different types of pricing strategies that a firm can have. In economic theory, it is believed, that the firms follow the MC and MR rule. This implies that the price is decided at a point where marginal cost of the product is equal to the marginal revenue earned from the product. In real life, firms deviate from this principle and base their pricing strategies differently. These are discussed in the next section.

  1. Types of pricing strategies

 

The different types of pricing strategies are given below:

 

Let us discuss these one by one.

  1. a) Pricing based on cost: The following strategies are covered under this category:

i) Marginal cost pricing: This is a concept of short period. This principle covers variable costs In economic theory, we use the word, ‘marginal’ but in practice, entrepreneur use the word, ‘incrementalism’. In daily life, entrepreneurs do not estimate the change in costs with the change in per unit of output rather they consider the changes in the costs due to the larger proportions of output. Principle of marginalism says that the price of the firm is decided by the equality of the marginal cost and marginal revenue. The theory says that if the price falls to the level where it is just covering variable costs then the firms shut down, however, the principle of incrementalism shows that the firms do not shut down at this level and continue with production. Such a pricing strategy is helpful when the firms have stocks of unsold products and can sell this stock by reducing the price to just cover the variable costs. This strategy also helps the firms when they introduce new products or face a stiff competition in the market. However, such a strategy cannot be continued in the long run as fixed costs are needed to be covered.

 

ii) Mark up pricing: Many economists like Hall and Hitch showed that in real life firms followed mark up pricing instead of marginal cost and marginal revenue approach. In this method, the firms add the variable costs and the fixed costs of a product and then add a mark up to it. If the cost of a cup of coffee is Rs 100 to the producer and the mark up is Rs 20 then the sale price of coffee would be Rs 120 (Rs 100 + Rs 20). So, here, the mark up is 20%. Fixing a mark- up can be rigid or flexible. It is rigid when the mark – up is added to the variable cost only. In such a case mark – up is so large that it covers up the fixed costs. However, in the case of flexible mark- up, different mark ups are fixed for fixed and variable costs. Mark – up pricing is followed when the business firms do not have a correct estimate of the market demand of their product and the pricing strategies of the rivals are unknown.

 

iii) Rate of return pricing: Such a strategy is used when the firms want to revise the prices of their products. It helps the firm to fix a mark up based on rate of return on capital invested. The first step is to find the expected rate of return by dividing the total earnings by the amount invested by the firm. The firm then estimates its full cost and divide the total amount invested by the firm by the cost. This is called as capital turnover ratio. Mark up percentage is estimated by multiplying capital turnover ratio with the expected rate of return which essentially comes out to be total earnings divided by the costs. Then the rate of return is estimated by adding the mark up to the costs. Thus, here, the guiding principle for the firm is to get returns from the money invested.

 

b) Pricing based on competition: This type of pricing strategy includes the following:

 

i) Going Rate Pricing: In this pricing strategy, the firms, first, observe the prices of their rivals. Thus, costs are not the guiding principle. This type of strategy is used when the firm do not want to disturb the existing situation in the market. Hence, the firm fixes its own price based on the prices of their rivals. Such a strategy is also adopted when the firms feel that the product market has reached a certain level of maturity and the customers also prefer the products of the firm and do not want any hiccups in the price pattern. In such cases firms try to minimize their costs rather than disturbing their customers with frequent price changes. Such a type of the strategy may also be followed by a new entrant in the industry. Being a new entrant, the firm, first, observes the prices of its rivals and then fixes its own price based on the rate going in the market.

 

ii) Loss leader pricing: ‘Loss leader’ refers to the product of the industry. This is usually applied in retail selling. If a seller is selling more than one product (which most of the modern sellers do) and one of its product has higher sales as compared to the others, then the seller may intentionally lower the price of its more selling product. This is done because the seller feels that when consumer comes to buy this product, may also buy other products. Therefore, the seller intentionally keeps its main product at low price. Therefore, it is called as ‘loss leader’ as the product is the leader in terms of attracting the consumers but does not give profits to the seller.

 

c) Other pricing strategies: It includes the following types of pricing strategies:

 

i) Administered prices: The term administered prices was originally given in context with The monopolist intentionally administers the prices of its products and does not go by the principle of demand and supply for price fixation. Now, administered prices refer to the fixation of the price of a product by the government. Such a price fixation is intentional and is done to benefit a particular section of the economy. In India, price of petrol, gas etc has been administered since long. Such type of pricing strategy has legal support and is used to correct market inequalities. Administered prices are needed when there are huge inequalities of income in the economy i.e. the number of poor is very high and the commodity under consideration is a necessity. Therefore, the government needs to fix the prices of the necessary commodities so as to make these available for the poor and the needy. Such a policy is also needed to control the prices of essential raw materials that are highly scarce. If this is not done then the process of industrialisation gets affected by bending towards a few entrepreneurs who can use this as a strategy to restrict the entry of new firms or may cause the exit of rival firms. This type of strategy is also used in case of agricultural produce. Since, agricultural produce is heavily dependent on weather, therefore, to give some assured incomes to the farmers, the government may fix either the prices of the agricultural produce or may fix a limit below which the prices may not fall. This type of intervention is needed as, these days, the states are not just performing their basic functions but are also expected to provide welfare functions. Therefore, it is the duty of the state to provide basic commodities at affordable prices. Hence, the need for administered prices arises. The prices are administered either fully or partially. Full administered prices means the government administers the prices of the total output produced. The partial prices are discussed in the next category.

 

ii) Dual Pricing:

 

This pricing strategy is followed when for the same commodity two different prices are charged. This happens in monopoly. A monopolist may charge two different prices for the same product in the two different markets. However, his demand and supply curves for the two markets would be different. This type of pricing strategy is also followed by the government in case of electricity or in case of essential commodities.

In India, government charges different rates of electricity from the households and from commercial enterprises. Similarly, the government may force two different prices for the same commodity. The private sector may continue to produce the commodity but the government procures a part of it and sells at lower prices to the poor and the remaining output can be sold by the private producers at the market rate. In such a case, the demand and supply curves of the commodity would show a kink indicating the two different markets and two different prices. In India, this kind of pricing strategy was adopted by the government from 1950’s. Later on, the distribution of the commodities at concessional rates came to be known as public distribution system (PDS).

 

At the different depots of PDS, the commodities of essential nature are made available to the general public. However, in such a system, the burden of filling up the costs of the private sector falls on the government and secondly, the identification of the target beneficiaries is faulty because of which many actual beneficiaries do not get the real benefit. Many a time’s wrong commodities also, enter into the list of essential commodities. It has also been observed that due to the corruption in depots, the traders buy the commodities at lower rates from the depots and sell these at higher rates in the open market. However, in a welfare system, the government cannot overlook the marginalized sections of the economy.

 

iii) Predatory pricing: This type of pricing policy is followed by a discriminating The market of the monopolist can be divided into two categories and the monopolist charges two different prices of the product. If, in one market, there is a threat of entry then the monopolist may charge a price below the variable costs so as to block the entry of its rivals. The losses of this market are funded by the profits of the other market where the price charged is relatively high. The difference between dual pricing and predatory pricing is that in the latter market price in one market is intentionally reduced below the cost and profits are funded from the other market. This type of strategy may also be followed in an oligopolistic market where one of the firm may indulge in lowering the prices below the costs. For example, in India, Ola and Uber cabs have entered into virtual price wars and have slashed the rates much below the costs.

 

This is done to wipe out the other from the market. The loss in one market is filed up with the profits from the other market.

 

iv) Multiple pricing: These days, most of the firms produce multiple products. In multiple pricing strategy, the firm pursues more than one price strategy for its different products. For example, Patanjali Ayurved has entered the Indian fast moving consumer goods sector and has claimed a considerable share in the total market. It has two types of products: one which is low priced and the other which is highly priced. For example: it offers two types of soaps: the first is Patanjali Saundarya and the second one includes: Patanjali Aloe vera kanti, Rose kanti etc. Both these types are for different set of customers. The latter one is for those who want to pay less for a good brand and the former one is for those who can pay more for a good brand.

 

v) Skimming pricing: Skimming pricing refers to the strategy of fixing a high price when a new product is introduced in the market. Such a product is different due to innovation and technological superiority. Since, the product is new, so the firm has to create a market for the product which calls for incurring certain expenditure. As a result, the firm may have to spend heavily on advertising. This increases the costs of the product and becomes one reason for fixing a high price for it. Another factor in deciding the price strategy in this case is the number of rivals in the market. Since, the product is new, therefore, it may not have any rivals. So, the firm fixes a high price initially. Eventually, as the new firms enter into the market, the market for the product may expand due to the increased acceptability of the product in the consumers. This may lead to the decline in the price of the product. Another factor is the elasticity of demand of the product. If the product has inelastic demand then the firm may fix a higher price.

 

In skimming strategy, the concerned firm fixes, initially, a high price due to high costs on advertising for creating a market and due to inelastic demand but once, the product is accepted and new firms enter into the market then the firm under consideration moves on to the other customers by reducing its price. Such a strategy is basically used for technological products. This strategy is quite common in the smart phone market. Whenever, a new phone is introduced, if its features are technically superior or different from the existing products in the market then the price of the new phone is fixed at a high level. Once, the rivals introduce their products with similar features then the concerned firm reduces the price of its phone. This is typically true of iphone by Apple Incl. Whenever a new model of iphone is launched; Apple fixes a high price for its products. The company knows that there are consumers in the market who are ready to pay a higher price for the latest technology. Such, first time buyers are, usually, called as ‘innovators’.

 

Gradually, the rivals also launch new phones at par with the technological level of the latest iphone. Also, by that time, Apple has captured most of the ‘innovators’ segment of the market and then it reduces the price of the iphone to cater to the next segment of consumers who want to buy the iphone at reduced prices.

 

‘Reverse’ skimming pricing is the opposite of skimming pricing. In such a strategy, the initial price is low and the firm increases its price after some time. Reverse skimming pricing is followed in the bookings of air tickets. Airlines offer different rates of the tickets depending on the date of the scheduled flight.

 

The price of the tickets is low, if the bookings are done many days prior to the scheduled flight. The price of the tickets is enhanced once the date of the scheduled flight approaches.

 

vi) Differential pricing: Differential pricing implies charging different prices for the same unit of a product from the different customers. This may happen at different points of time or may continue over a period of time.

 

vii) Penetration pricing: Penetration pricing is pursued when there are many sellers of the product and the new entrant wants to penetrate and carve a space for itself in the market. Since, the product of most of the companies is the same, therefore, the new entrant distinguishes itself by offering a low price or by giving special ‘offers’ to the customers.

 

This leads to the deviation of the customers of the existing firms to the new entrant and once, it has established itself then the prices are increased. The entry of Reliance Jio in the Indian telecom market is an apt example here.

For penetrating into the market it offered free services for a limited time period. This increased its customer base and shook its rivals. However, through this strategy, it has been able to create a big share in the market for itself.

 

viii) Product line pricing: Product line pricing is used when the firm manufactures more than one product and all are related to each other. For example: Britannia offers many types of biscuits like good day biscuits, nutri choice etc. Likewise, ITC offers farmlite, dark fantasy, delishus etc. The decisions of fixing the prices depend upon the cross price elasticity of demand and other factors. The firm may either choose to have same price for all the products that fall under the same category or it may go for different prices.

 

In shoe industry for the same type of shoes, usually, firms fix the same price irrespective of the size of the shoe. In other industries, however, some firms may reduce the price of the product when it is offered in large amounts. For example, the price of the one kilograms of oil is more than the price of five kilograms of oil.

 

ix) Strategy based on the prices of the new firm: Such a strategy is adopted by the already established firms in the market. When it is expected that a financially strong firm is expected to enter into the markets, the already established firms may not reduce their price rather these firms wait for the new firm to reveal its price strategy and then adjust their price accordingly.

 

4 Conclusions

In this chapter, we have discussed the different types of pricing strategies that are followed by the firms in the real markets. The strategies are opted on the basis of the cost structure and the prevailing market conditions. Although there are many strategies, however, it must be kept in mind that the firms may not always pursue same strategy throughout the life cycle of the product. Also, apart from the other factors, the size of the firm and the brand name of the firm also play a significant role in deciding the pricing strategies. Large firms may not prefer to respond quickly to the market upheavals.

 

These firms may continue to charge the same price or may alter their prices with significant time interval. Such firms know that their products are sold on the basis of their reputation and brand name and thus, do not want to alter their customer base. When Kellogg entered India, its penetration was very slow. However, they did not immediately lower their price to attract customers. It, rather, waited and established customer base on the basis of its brand. However, small firms may not follow the same strategy as the large firms. They may be quick to respond to price challenges posed by their rivals or by new firms. Thus, pricing strategies varies according to size, rivals, costs and many other factors.

 

Learn More

  • Mithani, D.M. (2014), Managerial Economics, Himalaya Publishing House, Mumbai.
  • Kumar, Raj and Gupta, Kuldip (2010),UDH Publishers and Distributors, New Delhi. Points to Ponder:
  • A new entrant may follow a cut in the prices for a long time for wiping out the already established firms.
  • Customers are at a long term loss due to the price wars.
  • Though administered prices are much needed by the developing countries yet these are not possible in the present scenario of WTO.