What is Variable Pricing?
Variable Pricing is a marketing strategy that allows a different price to be charged to different customers or at different times. This type of pricing is common among street vendors, antique dealers, and other small, independently owned businesses but is not practical for direct marketers, who rely upon preprinted promotion forms. Variable pricing risks the loss of customer goodwill when one customer discovers another paid less. Federal and state laws protect competing retailers from discriminatory pricing that gives competitors an unfair advantage
Most firms use a Fixed price policy. That is, they examine the situation, determine an appropriate price, and leave the price fixed at that amount until the situation changes, at which point they go through the process again. The alternative has been variable pricing, a form of first degree price discrimination, characterized by individual bargaining and negotiation, and typically used for highly differentiated, high value items (like real estate).
Two variants of variable pricing are price shading (in which sales people are given the authority to vary the price by a certain amount or percentage), and auctions (in which potential buyers have the option of bidding on a product and thereby varying the price). Consumers generally prefer fixed prices because they don’t need to worry about being out-negotiated by a professional with expert knowledge and skills. The exceptions are people that enjoy the social aspect of negotiating, and people that think they might have an advantage due to their product knowledge or negotiating skills.
Due to advances in technology, another variant of variable pricing, called real time pricing, has arisen. In some markets events occur so fast that there is insufficient time to either set a fixed price or engage in lengthy negotiations. By the time you have all the information to determine a price, everything has changed. Examples include Airline tickets, equity markets and currency markets. In each case prices can change in less than a second. By linking all the market participants through internet connections, price changes are disseminated instantly as they occur.
A variant of real time pricing is online auction business model (such as eBay). All participants can view the price changes soon after they occur (technically this is not quite real time pricing because there is a delay built into the eBay system). Traditional auctions are inefficient because they require bidders (or their representatives) to be physically present. By solving this problem, online auctions reduce the transaction costs for bidders, increase the number of bidders, and increase the average bid price.
In addition to these examples of variable pricing in the short term, there are long term pricing practices that could be considered instances of variable pricing. They are price skimming, penetration pricing, and seasonal discounts.
This kind of price discrimination is largely and widely used by rental car companies. Usually those firms need to know what your country of residence is so they can adjust the price. Depending on the answer you can get significantly different quotes for the same vehicle, date and time of rental. It is also true when accessing the rental car site through the .com main site
Profit Maximization
Definition
•A process that companies undergo to determine the best output and price levels in order to maximize its return. The company will usually adjust influential factors such as production costs, sale prices, and output levels as a way of reaching its profit goal. There are two main profit maximization methods used, and they are Marginal Cost-Marginal Revenue Method and Total Cost-Total Revenue Method. Profit maximization is a good thing for a company, but can be a bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
Basic Definitions
Any costs incurred by a firm may be classed into two groups: fixed cost and variable cost. Fixed costs are incurred by the business at any level of output, including zero output. These may include equipment maintenance, rent, wages, and general upkeep. Variable costs change with the level of output, increasing as more product is generated. Materials consumed during production often have the largest impact on this category. Fixed cost and variable cost, combined, equal total cost.
Revenue is the total amount of money that flows into the firm. This can be from any source, including product sales, government subsidies, venture capital and personal funds.
Marginal cost and revenue, depending on whether the calculus approach is taken or not, are defined as either the change in cost or revenue as each additional unit is produced, or the derivative of cost or revenue with respect to quantity output. It may also be defined as the addition to total cost as output increase by a single unit. For instance, taking the first definition, if it costs a firm 400 USD to produce 5 units and 480 USD to produce 6, the marginal cost of the sixth unit is approximately 80 dollars, although this is more accurately stated as the marginal cost of the 5.5th unit due to linear interpolation. Calculus is capable of providing more accurate answers if regression equations can be provided.
Total Cost-Total Revenue Method
To obtain the profit maximizing output quantity, we start by recognizing that profit is equal to total revenue (TR) minus total cost (TC). Given a table of costs and revenues at each quantity, we can either compute equations or plot the data directly on a graph. Finding the profit-maximizing output is as simple as finding the output at which profit reaches its maximum. That is represented by output Q in the diagram.
There are two graphical ways of determining that Q is optimal. Firstly, we see that the profit curve is at its maximum at this point (A). Secondly, we see that at the point (B) that the tangent on the total cost curve (TC) is parallel to the total revenue curve (TR), the surplus of revenue net of costs (B,C) is the greatest. Because total revenue minus total costs is equal to profit, the line segment C,B is equal in length to the line segment A,Q.
Computing the price at which to sell the product requires knowledge of the firm's demand curve. The price at which quantity demanded equals profit-maximizing output is the optimum price to sell the product
Marginal Cost-Marginal Revenue Method
If total revenue and total cost figures are difficult to procure, this method may also be used. For each unit sold, marginal profit equals marginal revenue minus marginal cost. Then, if marginal revenue is greater than marginal cost, marginal profit is positive, and if marginal revenue is less than marginal cost, marginal profit is negative. When marginal revenue equals marginal cost, marginal profit is zero. Since total profit increases when marginal profit is positive and total profit decreases when marginal profit is negative, it must reach a maximum where marginal profit is zero - or where marginal cost equals marginal revenue. This is because the producer has collected positive profit up until the intersection of MR and MC (where zero profit is collected and any further production will result in negative marginal profit, because MC will be larger than MR). The intersection of marginal revenue (MR) with marginal cost (MC) is shown in the next diagram as point A. If the industry is competitive (as is assumed in the diagram), the firm faces a demand curve (D) that is identical to its Marginal revenue curve (MR), and this is a horizontal line at a price determined by industry supply and demand. Average total costs are represented by curve ATC. Total economic profits are represented by area P,A,B,C. The optimum quantity (Q) is the same as the optimum quantity (Q) in the first diagram.
If the firm is operating in a non-competitive market, minor changes would have to be made to the diagrams. For example, the Marginal Revenue would have a negative gradient, due to the overall market demand curve. In a non-competitive environment, more complicated profit maximisation solutions involve the use of Game Theory.
Suppose that a firm is Competitive Market
A competitive market is one in which there are many buyers and sellers trading homogeneous goods so that each buyer and seller is a price taker. Firms can freely enter or exit this type of market.
Marginal revenue is the change in revenue from an additional unit sold.
For a competitive firm, the demand curve is perfectly elastic.
The marginal cost curve is also the firm’s supply curve because the marginal cost curve determines the quantity of the good the firm is willing to supply at any price.
Short-Run Decision to Shut Down
Shut down if…
The competitive firm’s short-run supply curve is the portion of its marginal-cost curve that lies above average variable cost.
Sunk cost is a cost that has already been committed and cannot be recovered.
Long-Run Decision to Exit/Enter a Market
Exit if…
TR < TC
TR/Q < TC/Q
P < ATC
Enter if…
P < ATC
Measuring Profit
At the end of enter/exit, firms that remain in the market must be making zero economic profit.
Entry and exit ends only when P and ATC are driven to equality.
Tuesday, August 25, 2009
Penetration pricing
What is Penetration pricing?
•Penetration Pricing is the charging a low initial price for a new product in order to attract customers and build market share.
•Penetration Pricing is the strategy of entering the market with a low initial price so that a greater share of the market can be capture
•Penetration Pricing is a strategy adopted for quickly achieving a high volume of sales and deep market-penetration of a new product. Under this approach, a product is widely promoted and its introductory-price is kept comparatively lower. This strategy is based on the assumption that (1) the product does not have an identifiable price-market segment, (2) it has elasticity of demand (buyers are price sensitive), (3) the market is large enough to sustain relatively low profit margins, and (4) the competitors too will soon lower their prices.
•Penetration pricing is the pricing technique of setting a relatively low initial entry price, a price that is often lower than the eventual market price. The expectation is that the initial low price will secure market acceptance by breaking down existing brand loyalties. Penetration pricing is most commonly associated with a marketing objective of increasing market share or sales volume, rather than short term profit maximization.
The advantages of penetration pricing to the firm
1.It can result in fast diffusion and adoption. This can achieve high market penetration rates quickly. This can take the competition by surprise, not giving them time to react.
2.It can create goodwill among the all-important early adopter segment. This can create valuable word of mouth .
3.It creates cost control and cost reduction pressures from the start, leading to greater efficiency.
4.It discourages the entry of competitors. Low prices act as a barrier to entry (see: porter 5 forces analysis).
5.It can create high stock turnover throughout the distribution channel. This can create critically important enthusiasm and support in the channel.
6.It can be based on marginal cost pricing, which is economically efficient.
The main disadvantage with penetration pricing is that it establishes long term price expectations for the product, and image preconceptions for the brand and company. This makes it difficult to eventually raise prices. Some commentators claim that penetration pricing attracts only the switchers (bargain hunters), and that they will switch away from you as soon as you increase prices. There is much controversy over whether it is better to raise prices gradually of a period of years (so that consumers don’t notice), or employ a single large price increase (which is more efficient). A common solution to the price expectations problem is to set the initial price at the long term market price, but include an initial discount coupon. In this way, the perceived price points remain high even though the actual selling price is low. Another potential disadvantage is the low profit margins may not be sustainable long enough for the strategy to be effective.
Price Penetration is most appropriate when:
1.Product demand if highly price elastic.
2.Substantial economies of scale are available.
3.The product is suitable for a mass market (ie.: sufficient demand).
4.The product will face stiff competition soon after introduction.
5.There is inadequate demand in the low elasticity market segment for price skimming.
6.In industries where standardization is important. The product that achieves high market penetration often becomes the industry standard (eg.: Microsoft Windows) and other products, even very much superior products, become marginalized.
In interesting variant of the price penetration strategy is the bait and hook model (also called the razor and blades business model) in which an initial product is sold at a very low price but subsequently purchased products (such as refills) are sold at a higher price.
The implications of an imperfect market's downward sloping demand curve are evident in a typical new product pricing decision: should a product be launched with an aggressively low price from the start (penetration strategy), or should the product be introduced at a high initial price with subsequent price reductions as the market matures (a skimming strategy).
Again, if the product were being launched into a perfectly competitive market, there would be no pricing decision to make per se. The prevailing market price would be the price. So, the company's decision is whether or not to launch the product.
But, a substantially new product is, in effect, a mini or local monopoly. That is, for at least some segments of the market for which the product is targeted, the new product is initially unique with no substitutes. So, the innovating company has pricing leeway. The more the product is unique (i.e. differentiated) and strategically targeted, the greater the monopoly effect and the broader the pricing leeway.
From a strategic perspective, a market share focused penetration strategy is most appropriate when it is important to exploit a potentially transient first mover advantage, or to quickly establish a broad installed base in anticipation of:
(a) Cost improvements from scale, scope or experience (learning curve)
(b) Substantial complementary product sales (e.g. razors and blades, toner cartridges for printers and copiers)
(c) Subsequent upgrade cycles (software)
(d) Network effects that provide increasing benefits as more customers buy the product (e.g. fax machines)
To quickly penetrate the market, the company launches the product at relatively low price (P1), expecting to sell quantity Q1, and generate revenues equal to P1 times Q1 (the area of the shaded box). The penetration strategy capitalizes on the downward sloping demand curve since the company can pick the price and, within some reasonable bounds, optimize the resulting short-run sales quantity.
The penetration price selected (P1 in this case) will typically be driven by two factors: price elasticity and marginal cost.
Price elasticity is a measure of the market's responsiveness to a price change. If the quantity demanded increases (in percentage terms) more than a price decreases (also in percentage terms), then revenue goes up and demand is said to be price elastic at that point. Conversely, if quantity increases less than price decreases, then revenue goes down and demand is inelastic.
In most instances, companies will only consider a lower price if revenue is projected to increase, i.e. demand is elastic with respect to price. But, since the ultimate objective is profitability, a revenue increase is necessary but not sufficient: profits may decrease even if revenues increase since a company typically incurs higher total product cost (fixed plus variable) when volume increases, unless scale economies or experience effects are sufficiently large that variable costs per unit decline.
More specifically, the penetration price is usually set higher than the firm's marginal cost to bolster profitability. In some special cases, though, the penetration price may actually be lower than marginal cost. For example, a firm may be willing to incur initial losses (i.e. price below cost) if substantial future-related profitable sales are expected from complementary sales, upgrades, or price increases.
For example, HP tries to sell as many printers as it can, even at slim margins, and then make money from ink and other consumables. According to Fortune, "Every second of every day, HP makes one new printer and ten new ink-jet cartridges. The company controls 60% of the ink-jet-printer market and 55% of the laser business. Last year, HP sold about $9 billion of ink and supplies, or nearly as much as it took in from printers. But while printers carry gross profit margins of 15% to 20%, the margins on ink are 50%. Indeed, ink accounts for most of the company's profits. Call it HP's black gold."
The polar opposite to penetration pricing is called skim pricing.
•Penetration Pricing is the charging a low initial price for a new product in order to attract customers and build market share.
•Penetration Pricing is the strategy of entering the market with a low initial price so that a greater share of the market can be capture
•Penetration Pricing is a strategy adopted for quickly achieving a high volume of sales and deep market-penetration of a new product. Under this approach, a product is widely promoted and its introductory-price is kept comparatively lower. This strategy is based on the assumption that (1) the product does not have an identifiable price-market segment, (2) it has elasticity of demand (buyers are price sensitive), (3) the market is large enough to sustain relatively low profit margins, and (4) the competitors too will soon lower their prices.
•Penetration pricing is the pricing technique of setting a relatively low initial entry price, a price that is often lower than the eventual market price. The expectation is that the initial low price will secure market acceptance by breaking down existing brand loyalties. Penetration pricing is most commonly associated with a marketing objective of increasing market share or sales volume, rather than short term profit maximization.
The advantages of penetration pricing to the firm
1.It can result in fast diffusion and adoption. This can achieve high market penetration rates quickly. This can take the competition by surprise, not giving them time to react.
2.It can create goodwill among the all-important early adopter segment. This can create valuable word of mouth .
3.It creates cost control and cost reduction pressures from the start, leading to greater efficiency.
4.It discourages the entry of competitors. Low prices act as a barrier to entry (see: porter 5 forces analysis).
5.It can create high stock turnover throughout the distribution channel. This can create critically important enthusiasm and support in the channel.
6.It can be based on marginal cost pricing, which is economically efficient.
The main disadvantage with penetration pricing is that it establishes long term price expectations for the product, and image preconceptions for the brand and company. This makes it difficult to eventually raise prices. Some commentators claim that penetration pricing attracts only the switchers (bargain hunters), and that they will switch away from you as soon as you increase prices. There is much controversy over whether it is better to raise prices gradually of a period of years (so that consumers don’t notice), or employ a single large price increase (which is more efficient). A common solution to the price expectations problem is to set the initial price at the long term market price, but include an initial discount coupon. In this way, the perceived price points remain high even though the actual selling price is low. Another potential disadvantage is the low profit margins may not be sustainable long enough for the strategy to be effective.
Price Penetration is most appropriate when:
1.Product demand if highly price elastic.
2.Substantial economies of scale are available.
3.The product is suitable for a mass market (ie.: sufficient demand).
4.The product will face stiff competition soon after introduction.
5.There is inadequate demand in the low elasticity market segment for price skimming.
6.In industries where standardization is important. The product that achieves high market penetration often becomes the industry standard (eg.: Microsoft Windows) and other products, even very much superior products, become marginalized.
In interesting variant of the price penetration strategy is the bait and hook model (also called the razor and blades business model) in which an initial product is sold at a very low price but subsequently purchased products (such as refills) are sold at a higher price.
The implications of an imperfect market's downward sloping demand curve are evident in a typical new product pricing decision: should a product be launched with an aggressively low price from the start (penetration strategy), or should the product be introduced at a high initial price with subsequent price reductions as the market matures (a skimming strategy).
Again, if the product were being launched into a perfectly competitive market, there would be no pricing decision to make per se. The prevailing market price would be the price. So, the company's decision is whether or not to launch the product.
But, a substantially new product is, in effect, a mini or local monopoly. That is, for at least some segments of the market for which the product is targeted, the new product is initially unique with no substitutes. So, the innovating company has pricing leeway. The more the product is unique (i.e. differentiated) and strategically targeted, the greater the monopoly effect and the broader the pricing leeway.
From a strategic perspective, a market share focused penetration strategy is most appropriate when it is important to exploit a potentially transient first mover advantage, or to quickly establish a broad installed base in anticipation of:
(a) Cost improvements from scale, scope or experience (learning curve)
(b) Substantial complementary product sales (e.g. razors and blades, toner cartridges for printers and copiers)
(c) Subsequent upgrade cycles (software)
(d) Network effects that provide increasing benefits as more customers buy the product (e.g. fax machines)
To quickly penetrate the market, the company launches the product at relatively low price (P1), expecting to sell quantity Q1, and generate revenues equal to P1 times Q1 (the area of the shaded box). The penetration strategy capitalizes on the downward sloping demand curve since the company can pick the price and, within some reasonable bounds, optimize the resulting short-run sales quantity.
The penetration price selected (P1 in this case) will typically be driven by two factors: price elasticity and marginal cost.
Price elasticity is a measure of the market's responsiveness to a price change. If the quantity demanded increases (in percentage terms) more than a price decreases (also in percentage terms), then revenue goes up and demand is said to be price elastic at that point. Conversely, if quantity increases less than price decreases, then revenue goes down and demand is inelastic.
In most instances, companies will only consider a lower price if revenue is projected to increase, i.e. demand is elastic with respect to price. But, since the ultimate objective is profitability, a revenue increase is necessary but not sufficient: profits may decrease even if revenues increase since a company typically incurs higher total product cost (fixed plus variable) when volume increases, unless scale economies or experience effects are sufficiently large that variable costs per unit decline.
More specifically, the penetration price is usually set higher than the firm's marginal cost to bolster profitability. In some special cases, though, the penetration price may actually be lower than marginal cost. For example, a firm may be willing to incur initial losses (i.e. price below cost) if substantial future-related profitable sales are expected from complementary sales, upgrades, or price increases.
For example, HP tries to sell as many printers as it can, even at slim margins, and then make money from ink and other consumables. According to Fortune, "Every second of every day, HP makes one new printer and ten new ink-jet cartridges. The company controls 60% of the ink-jet-printer market and 55% of the laser business. Last year, HP sold about $9 billion of ink and supplies, or nearly as much as it took in from printers. But while printers carry gross profit margins of 15% to 20%, the margins on ink are 50%. Indeed, ink accounts for most of the company's profits. Call it HP's black gold."
The polar opposite to penetration pricing is called skim pricing.
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