Chapter 8: Pricing of Interrelated Products

We have seen how the pattern of a firm’s prices is affected by the use of various fences to accomplish price
segmentation. A second aspect of price structure is the pattern of prices over the array of products offered by the firm.

Up until now, we have talked about the pricing of products considered individually. However, most sellers offer more
than one product. Often there are interrelations between these products such that a price that is set for one item affects
the sales levels of one or more other items. There are at least two general means by which the price of one item can
affect the sales levels of others:

 In image interactions, an item’s price affects the sales levels of other items by influencing the consumer’s
perception of the seller’s other prices. For example, a grocer’s low price on paper towels may increase sales of
other items by enhancing the store’s low-price image.
 In product interactions, an item’s price affects the sales levels of related items by affecting its own sales. For
example, if consumers usually use salad dressing when they use lettuce, then this product interaction may lead
an increase in lettuce sales caused by lowering its price to also cause an increase in the sales level of salad
dressing.

In this chapter, we discuss each of these two means by which the price of one item can affect the sales levels of other
items.

PRODUCT INTERRELATIONS THROUGHIMAGE INTERACTIONS

The ability of an item’s price to affect the sales levels of other items by virtue of its effect on the consumer’s perceptions
of the seller’s other prices could have to do with the item’s price being high or its being low. We first look at some image
interactions that suggest benefits of pricing an item high and then some image interactions that suggest benefits of
pricing an item low.

Image Effects of a High Price

Some sellers try to maintain an overall high-price image in order to help communicate high product quality and to
encourage the sense that owning their products is a sign of affluence and good taste. This practice is known as prestige
pricing. Prestige pricing can be weakened by even a few products or product lines that include items at low price points.
Sometimes the ability of an item’s high price to affect customer price perceptions does not involve the overall price
image of a manufacturer or store but rather customer price impressions of only a few specific items.

This effect of a high price suggests the benefits of offering customers at least one very high-priced alternative, even if it
is known that few customers will purchase this high-priced item. This could be done by introducing a new high-priced
item or by raising the price of one that is currently being sold. Such a high priced item, offered to enhance consumers’
perceptions of other items, could be termed a “price decoy.” This effect of high price also suggests the benefits of
presenting consumers with the higher-priced items of a product line before presenting them with the lower-priced
items. This is perhaps a reason why many mail order and other retail catalogs show their most expensive offerings in the
first few pages.

Image Effects of a Low Price

In marketing environments characterized by aggressive price competition, such as grocery retailing, it can be important
for a seller to maintain an overall low-price image. To do this, it is usually not necessary to have a lower price than
competitors on all items. One finding from consumer research is that a low-price image is determined more by the
number of products sold at a lower price (which could be termed a frequency cue) than by the size of the price
differences (which could be termed a magnitude cue).

It has also been found that not all items are equal in contributing to a retailer’s price image. Items that are particularly
powerful in influencing a retailer’s price image are known as price exemplars. Because a consumer must be aware of an
item’s usual price to know if the item’s price at a particular store is high or low, price exemplars are likely to be the items
that show the highest levels of consumer price awareness.

When an item’s price influences the sales levels of other items through an image interaction, it is the influencing item’s
price rather than its sales that is having the effect.
 Chapter 8: Pricing of Interrelated Products
By contrast, when an item’s price influences the sales levels of other items through a product interaction, the sales of
the influencing item do matter. This is because of the connections between the various products that are sold by a
company, which are based on how these products are purchased or used by customers. As a result of these connections,
a price change that affects the sales of one product will also affect the sales of others. There are two possibilities
concerning the direction of the effect that a product’s sales can have on the sales of another product.

Substitutes

When a change in the sales level of one item causes the sales level of another item to change in the opposite direction,
then the two items are referred to as substitutes. This relation means that when the sales level of the first item
increases, the sales level of the second item will decrease, or when the sales level of the first item decreases, the sales
level of the second item will increase. In other words, if one item is a substitute of another, then their sales levels are
negatively correlated. Usually, such negative sales correlations are caused by the purchased items being alternatives to
each other.

Complements

When a change in the sales level of one item causes the sales level of another item to change in the same direction, then
the two items are referred to as complements. This relation means that when the sales level of one item increases so
will the sales level of the other item, or when the sales level of one item decreases so will the sales level of the other
item. In other words, if one item is a complement of another, then their sales levels are positively correlated. Usually,
such positive sales correlations are caused by the items being purchased or used together.

The same logic that indicates that offering substitutes makes it more difficult for a seller to profit from a price decrease
and easier to profit from a price increase also indicates that the opposite is true for complements.

Loss-Leader Discounts

This ability of complements to help make a price decrease profitable leads many sellers to offer loss-leader discounts.
These discounts are often called “promotional,” but they differ from promotional discounts in that their main purpose is
not to communicate information about a product or even about a store. Rather, the main purpose of offering a loss-
leader discount on an item is to lead customers to make the purchases that are complementary to the purchase of the
discounted item. The discounted item is known as a loss leader because its discounted price may be less than its variable
costs.

The success of a loss-leader discount is dependent on two factors. The first is that the prospective loss leader should
have a sufficient number of complements that provide sufficiently high contribution margins. The second factor is that
the prospective loss leader’s low price is able to attract a large number of customers to purchase the loss-leader item.

Identifying Product Interactions

To effectively take product interactions into account when pricing interrelated products, it is necessary to be able to
identify the relevant interactions that occur within any particular group of products. The task of identifying these
interactions should be based on an understanding of the customer’s needs and behaviors. Note that it is important to
understand the causal order in the customer’s activities.

In looking for product interactions, the manager should consider the full range of possibilities. For identifying possible
substitute items, we saw how a manager should look for products that are considered by consumers to be alternatives.
But, to be complete in identifying possible product substitutes, the manager might also consider the broader effect of
one purchase on the customer’s ability to make other purchases.

For identifying possible complementary items, we saw how a manager should look for products that are purchased or
used together. But, to be complete in identifying possible product complements, the manager should also consider the
following:

 Products purchased at different times. For example, if first-time car buyers, who often purchase small cars, are
likely to purchase larger cars from the same company in subsequent years, then these larger cars could be
considered complements of the company’s small cars.
 Chapter 8: Pricing of Interrelated Products
 Products sold through different distribution channels. For example, if attending a rock band’s concerts lead
consumers to purchase CDs of the band’s music, then the band’s CDs could be considered complements of the
band’s concert tickets.
 Products purchased by other customers. For example, if increases in the number of women patrons of a dating
bar lead to increases in the number of male patrons, then the drinks purchased by the men could be considered
complements of those purchased by the women.

Interactive Pricing: Auctions and Negotiation

In Chapter 1, we introduced the issue of buyer–seller interactivity in determining prices. When prices are set through
interactions between buyers and sellers, the process is known as interactive pricing. The alternative of interactive pricing
is for the seller to unilaterally establish a schedule of fixed prices. These are posted prices that must be paid by a
customer regardless of any interaction that the customer might have with the seller. Since Chapter 1, we have focused
entirely on situations where fixed prices are involved.

However, there are many situations where fixed prices are not used. In fact, despite their greater familiarity, fixed prices
may not be the most prevalent type of pricing, at least in terms of the number of dollars being spent.1 Interactive pricing
is widely used for transactions that involve large amounts of money and is used most of the time in business-to-business
transactions. Further, interactive pricing has been spreading more widely with the rise of Internet commerce, and this
trend can be expected to continue. Thus, we need to consider some of the issues and challenges involved in managing
this alternative to the fixed-price policy.

Interactive pricing can be divided into two broad categories based on the number of parties involved in the interaction.
When prices are determined by many-to-one interactions, the price setting is by auction. In what most people think of as
a typical auction, the price is determined by one seller interacting with numerous buyers. However, auctions can also
have many sellers interacting with one buyer, as when a number of providers of equipment maintenance services bid for
a contract with a large manufacturing organization. When prices are determined by the interactions between one buyer
and one seller, the price setting is by negotiation. We first discuss price setting by auction. Then we discuss price setting
by negotiation.

Although there are many possible mechanisms by which an auction can be carried out, the following four mechanisms
cover the vast majority of business auctions:

1. In an English auction, ascending bids from numerous buyers are entertained by the seller. If the bid prices
exceed the seller’s reservation price—the minimum that the seller is willing to receive for the item—then the
auctioned item will be sold to the last remaining bidder. This bidder will pay the highest bid amount. This is
illustrated in Figure 14.1 for the case where there are three bidders: A, B, and C (note that “knocks lot down to”
is a traditional auction term for “sells to”). The English auction mechanism is used, for example, by producers
when selling commodities such as meat, fish, and tobacco and by auction houses such as Sotheby’s, Christie’s, or
Heritage Galleries when selling antiques or other rare or unique items. The English auction, also known as an
“ascending-bid auction,” is the most familiar auction mechanism to most people.
 Chapter 8: Pricing of Interrelated Products
2. In a Dutch auction, the auctioneer sets a high initial price and starts a clock. At regular intervals, the price of
the item is lowered until the first bid is made, which stops the clock. The bidder who makes the first bid
purchases the item and pays the amount of his or her bid. This is illustrated in Figure 14.2. The Dutch auction
mechanism, also known as a “descending-price auction,” received its name from its long use in tulip auctions in
the Netherlands. It is much less commonly used than the English auction mechanism.2 Note that in market
trading venues such as the New York Stock Exchange, prices are set by a combination of ascending bids and
descending-price offers. This is known as a double-auction system.

3. In a first-price sealed-bid auction, all bidders submit bids without any awareness of the bids of others. Bids are
accepted for a specified time period. At the end of the time period, the bidder who submitted the highest bid
purchases the item and pays the amount he or she bid. Although first-price sealed-bid auctions are sometimes
carried out by sellers, this auction mechanism is most often used in auctions carried out by buyers. An auction
that involves a buyer seeking bids from a number of sellers is known as a procurement auction. Procurement
auctions will be discussed further in a later section of this chapter.

4. A second-price sealed-bid auction differs from a first-price sealed-bid auction in only one respect. The bidder
who submits the highest bid purchases the item, but pays the price bid by the second highest bidder raised only
by the smallest allowable bidding increment. Note that choosing this procedure over the firs price mechanism
does not necessarily involve the seller giving away revenue, because anticipation of not having to actually pay
the amount they bid could lead some customers to bid higher than they otherwise would. This auction
mechanism is sometimes called a “Vickrey auction,” after the economist who noted that having the winning
bidder pay an amount just above the second highest bid serves to make a sealed bid auction equivalent to the
English auction mechanism. To understand why this is so, consider a situation in an English auction where an
item has a value to the customer (VTC) of $40 to the second highest bidder and $50 to the highest bidder. The
second-highest bidder can be expected to stop bidding at $40. The highest bidder then need bid only the
minimum increment over $40.00, say a bid of $40.50, to obtain the item. Thus, the price paid by the highest
bidder is just above the second highest bid.

When to Set Prices by Auction

The main reason that sellers choose to use an auction mechanism to set prices is because they believe that the
use of auctions will result in higher revenues for the items they sell. This is interesting, because a large part of
the appeal of an auction to customers is the sense that they will be able to get items at prices much below their
true value!

Traditionally, an auction has been a relatively slow and expensive way to sell something. For example, when
holding an English or a Dutch auction, a large number of potential buyers would have to be present in the same
place, an auctioneer would have to be employed, and a process taking at least several minutes would have to be
devoted to each item or lot to be sold. Because of these high transaction costs, the auction was practical only for
commercial transactions that involved large amounts of money. And even within large transactions, there had to
be some particular reason to use an auction to set an item’s price.
 Chapter 8: Pricing of Interrelated Products
One such reason for an auction would be situations where there is considerable uncertainty about the best price
for an item. There is often such uncertainty when selling items that are used. The exact condition of each item
must be evaluated by buyers, and it is hard to predict how any particular sign of usage will affect the value of an
item to buyers. There is also uncertainty about the best prices for many commodity items. For example, fresh
fish have long been sold by auction because of the rapid fluctuation of value-related factors, such as the size and
quality of the day’s catch and the level of demand for fish on that particular day.

A second reason for an auction would be when there are large differences among potential buyers in a product’s
VTC. This reason is particularly relevant for the pricing of items that are rare or unique. As we saw in Chapter 4, a
seller who has many units of an item available for sale should consider the trade-off between selling at high
prices to the few customers with high VTCs or at low prices to penetrate the market. By contrast, a seller with
only one rare item for sale need not consider this trade-off; only one buyer is needed. It then makes sense to set
the price close to the VTC of the potential customer who values it most, and auctions can be an effective means
of doing that. For example, the light saber used by Luke Skywalker in the 1977 movie Star Wars is of little value
to most people. However, there is likely to be at least one collector who was a particular fan of that movie and
would be willing to pay $60,000 or perhaps much more for this item.

A third reason for an auction involves the impression that it is a fair price-setting method. There is often a
transparency in the auction process that leads people to judge that a selling price, even if it is a high one, was
arrived at fairly. Indeed, research has shown that losers of an auction tend to blame the other bidders rather
than the seller.5 This aspect of auctions makes them particularly appropriate when price legitimacy is
particularly important. Thus, we often see auctions used for setting the selling prices of public assets, such as the
rights to conduct logging on government land or licenses for the use of frequencies on the radio spectrum.