Understanding a Competitive

Advantage
Firm objectives
l Pricing is driven by managerial objectives
l Management might pursue profit maximization, corporate growth
maximization, sales revenue maximization, or they might attempt
to maximize their own sense of well-being.
l Profit as a long-run objective
l Sales revenue (turnover)
- Use of a higher/lower proportion of capacity output
- A higher proportion of capacity output will usually imply a lower cost base,
and therefore lower price for any given percentage mark-up
Competitive advantage
• A competitive advantage, also called a differential advantage, is a set
of unique features of a company and its products that are perceived
by the target market(s) as significant and superior to those of the
competition.
• Competitive advantage is the factor that causes customers to
patronize a specific firm and not the competition.
• There are four types of competitive advantage: cost, product
differentiation, service differentiation, and niche.
Strategies Differentiation – better, or at
least different
for
Competitive
Advantage Cost leadership – cheaper
Cost Competitive Advantage 1
• A firm that has a cost competitive advantage can produce a product
or service at a lower cost than all its competitors while maintaining
satisfactory profit margins.
• Firms become cost leaders by obtaining inexpensive raw materials,
making plant operations more efficient, designing products for ease
of manufacture, controlling overhead costs, and avoiding marginal
customers.
• Over time, the cost competitive advantage may fail
• Example: Southwest Airlines – secondary airports, no frills service,
efficient utilization of equipment.
Differentiation 2
• Differentiation is concerned with providing uniqueness. A firm’s
opportunities for creating uniqueness are not located within a particular
function or activity but can arise in virtually everything the firm does.
• Experience differentiation - Engaging a customer with a product through
imaginative use of the five senses, so the customer “experiences” the
product.
• Uniqueness can go beyond both the physical characteristics and service
attributes to encompass everything that impacts customer’s perception of
value.
• Safeskin gloves – leading edge products
• Walt Disney Magic Kingdom – experience differentiation
• Hard Rock Cafe – dining experience
Achieving Competitive Advantage and
The Pricing Decision
Competitive
Decisions Strategy Example Advantage

Product DIFFERENTIATION:
Innovative design Safeskin’s innovative gloves
Broad product line Fidelity Security’s mutual funds
Quality After-sales service Caterpillar’s heavy equipment
service
Process Experience Hard Rock Café’s dining
experience

Location COST LEADERSHIP:

Low overhead Franz-Colruyt’s warehouse-type
stores Differentiation
Layout Effective capacity Southwest Airline’s (better)
use aircraft utilization
Human
resource Inventory Walmart’s sophisticated
management distribution system
Supply chain Cost
RESPONSE: leadership
Inventory Flexibility Hewlett-Packard’s response to (cheaper)
volatile world market
Reliability FedEx’s “absolutely, positively,
Scheduling on time”
Quickness Pizza Hut’s 5-minute guarantee
at lunchtime
Maintenance
What Is a Product?
Tangible and
Intangible
Attributes of a
Product Create
Value
Classifying Consumer Products
• Unsought products are products unplanned by the potential buyer or
known products that the buyer does not actively seek.
• Convenience products are relatively inexpensive items that require
little shopping effort. Soft drinks, candy bars, milk, bread, and small
hardware items are examples.
• In contrast to convenience products, shopping products are bought
only after a brand-to-brand and store-to- store comparison of price,
suitability, and style.
• Specialty products are products for which consumers search long and
hard and for which they refuse to accept substitutes. E
Classifying Consumer Products
Product example Degree of Effort Expended
Consumer
Unsought products Life insurance Some to considerable effort
Burial plots
Time-share condos
Convenience products Soft drinks Very little or minimum effort
Bread
Milk
Coffee
Shopping products Automobiles Considerable effort Considerable
Homes effort Considerable effort
Vacations
Specialty products Expensive jewelry Maximum effort
Gourmet restaurants
Limited-production automobiles
Pricing in theory and practice
Key concepts
l Barometric price leadership: where some firm (often
small) is widely used by other firms as the “barometer”
of the market. Other firms tend then to follow the
prices set by this firm which is presumed to be close to
market developments
l Cartel: a formal type of collusion
l Collusion: where firms act together, formally or
informally, to influence price and/or output
Key concepts
l Games: used in oligopoly models to try to predict
action/reaction of rivals. Games can use various
strategies and can be expressed using values for
different outcomes (payoffs)
l Kinked demand curve: a model used to help explain
price rigidity or “stickiness” said to be observed in
oligopoly markets
l Oligopoly: a market dominated by a few large
producers
Key concepts
l Price discrimination: setting different prices for
identical units of a good or service.
l Tacit collusion: an informal type of collusion
l Zero-sum game: a “game” where any benefit to one can
only be made by an equivalent loss to another.
Introduction
l The pricing decision does not rely on any single subject
discipline but rather encompasses many different
theoretical aspects such as accounting, economics and
marketing
l Price of a good or service will have
- a minimum level determined by the costs incurred in production
and sales COSTS

- a maximum level which will be determined by the prevailing

market conditions MARKET CONDITIONS
1. Determining costs COSTS

l Two main approaches have been identified to determine which

costs are relevant for inclusion in making pricing decision:
- Full (absorption) costing
- Contribution costing
l Activity-based costing
1.1. Full (absorption) costing
l Full (absorption) costing requires that all business costs are applied
to products and services
- Direct costs allocated to a given product
- A proportion of indirect (overhead) costs absorbed according to some unit
of business activity, typically business hours
1.2. Contribution costing
l The cost element within the price is calculated by considering only
those costs that directly relate to output
l No consideration of overhead costs at this stage
1.3. Activity-based costing
l It differs from conventional costing in its treatment of overhead
costs, including only those that are related to the production
process but which are relatively independent of production volume
2. Market conditions
l The price of a good or service is influenced by market
conditions
l Most industries in developed countries could be said to be
imperfectly competitive
l Oligopolistic market:
- Supply in the industry must be concentrated in the hands of
relatively few firms
- Significant barriers to entry (technological barriers, high start-
up costs, product proliferation)
- Firm must be interdependent
2.1. Pricing and the competitive environment
• In perfectly competitive markets the supplier is a price-taker.
• In a monopoly situation, the firm is a price-maker.
• In a monopolistically competitive market (large number of
competitors and product differentiation), the firms still have some
control over the price of their output.
• In oligopoly markets it is crucial to know how competitors are likely to
react to a price change. Will they follow suit or not? Oligopoly
markets are prone to collusions and the formation of cartels and to
price leadership.
PAUSE FOR THOUGHT

l Is it possible to estimate the effect of a change in the firm’s price or

output without first making some assumption about the reaction of
other firms?
Answer
l Oligopolistic market:
- No. Is it impossible to estimate the effect of a change in the firm’s price or
output without first making some assumption about the reaction of other
firms.
- Depending on the nature of the assumptions, different predicted
outcomes will be arrived at.
2.2. Non-price competition
l Non-price competition is a marketing strategy in which one
firm tries to distinguish its product or service from
competing products on the basis of attributes like design
and workmanship.
l Advertising campaigns
l Creation of strong brand image -> demand for the product is
less price elastic
PAUSE FOR THOUGHT

l Consider a number of television advertising campaigns

that are currently ongoing.
l Make a list of the products that are being promoted.
l An interesting exercise is then to identify who owns the
brands being advertised and to consider the nature of
these industries in terms of their market structure.
CASE STUDY: Competition under oligopoly – the
Hoover free flight promotion
l In what respects was the Hoover free flight campaign a success
and in what respects was it a failure?
l What, if any, long-term damage do you think this offer will do
to Hoover?
l Do you think that the “free-offer” type of strategy has any
long-term effect on the market share of firms in an industry?
PAUSE FOR THOUGHT

l As a consumer would you prefer simply to see a reduction in

the price of the goods that you are purchasing rather than have
it linked into some special offer or other promotional
campaign?
l Can you think of five special offers that you have actually taken
advantage of? If not, why not?
2.3. Oligopoly, collusion and price
l A price war is when two or more rival companies lower prices of
comparable products or services with the goal of stealing customers
from their competitors—or gaining market share.
- This can be very damaging for the firms involved in the industry
l A firm can withdraw from the market place
l Merger activity in the industry which reduces the number of
competing players
l If the firms decided to collude with each other, damaging price wars
can be avoided
- Setting output quotas, limiting product advertising, restricting
product development or agreeing to segment the market in such a
way as to provide a designated niche for each firm.
2.4. Cartel
l A formal collusive agreement is called a cartel
l The industry will act like a monopoly
l Cartels are illegal under restrictive trade legislation, unless
the firms involved can provide evidence that their
agreement is in the public interest
l Tacit collusion does not involve a formal agreement
between firms
2.5. Dominant firm price leadership
l “The leader”
l Other firms in the industry will follow price movements
l The firms that are not dominant (“the followers”) might not
be content to remain as such
- Risks
- The largest firm in the market will have the greatest
financial resources
2.6. Barometric firm price leadership
l Some firm (often small) is widely used by other firms as the
“barometer” of the market.
l Other firms tend then to follow the prices set by this firm
which is presumed to be close to market developments
2.7. Average cost pricing
l This is an alternative to having an established leader in the
industry
- The cost base for the pricing policy is based on national
output (say two-thirds of capacity) rather than actual output
l The ‘rule of thumb’ may simply be to add a certain percentage for
profit on top of average costs.
- The firm lacks full knowledge concerning demand and cost
curves
- The percentage mark-up tends to rise in situation when firms
find it easier to make profits (boom) and fall in situations
when firms find it difficult to make profits (recessions)
2.8. Price benchmarks
l In certain industries there are accepted levels of price
increases that are often invoked when prices are set to rise
l There are a great many examples of this in consumer goods
that end in the price suffix of 0.99. In these instances if costs
rise (for example), then a good that was previously charged at
12.99 if often subsequently priced at 13.99.
15 May 1993 New York London
‘Diva’, Annie Lennox $11.99 (£7.78) £10.99
‘The body Guard’, Whitney
$11.99 (£7.78) £10.99
Houston
‘Lady in Satin’, Billie Holliday $13.99 (£9.07) £11.99
2.9. Price discrimination
l When a firm charges different prices to different consumers for
exactly the same product (good or services), it is said to be
engaging in price discrimination.
l Two conditions are necessary if price discrimination is to occur:
- Producers must be able to prevent consumers transferring
from the dearer to the cheaper market (barriers: geographical
distance, border tariffs, legislation, time, …)
- Each market must have a different price elasticity of demand
from the other markets
2.10. Price stability
l Oligopolistic industries
l Changing price is not a strategy that should be entered into
lightly
- If a firm raises price, it loses market share and suffers
reduced profitability
- If it reduces price, other firms respond and again
reduced profitability is likely
l Price stability is commonplace
PAUSE FOR THOUGHT

l Can you think of three products that you regularly purchase for
which the firms involved are operating in an oligopolistic
market?
l Do you agree with the view that prices in these markets are
stable and there is little price competition?
l Do you think this is fair on you as a consumer? Who gains, and
who loses from price stability?
General pricing strategies
 Marginal cost
General Incremental pricing
pricing
strategies Breakeven pricing

Mark-up pricing
Marginal cost pricing
• Marginal cost pricing involves setting prices, and therefore
determining the amount produced, according to the marginal costs of
production, and is normally associated with a profit-maximizing
objective.
• A firm maximizes its profits when the difference between total sales
revenue and total supply costs is at its greatest. This is equivalent to
the output level where marginal cost equals marginal revenue.
Incremental pricing
• Incremental pricing deals with the relationship between larger
changes in revenues and costs associated with managerial decisions.
• Proper use of incremental analysis requires a wide-ranging
examination of the total effect of any decision rather than simply the
effect at the margin
Breakeven pricing
• Breakeven pricing requires that the price of the product is set so that
total revenue earned equals the total costs of production.
• We will cover this topic in detail in the 9th week
Mark-up pricing (1)
• Mark-up pricing is similar to breakeven pricing, except that a desired
rate of profit is built into the price (hence this pricing is also
sometimes referred to a cost-plus pricing, full-cost pricing or target-
profit pricing).
m = (P – AC) / AC
where m is the mark-up, AC is the fully allocated average cost,
and P – AC is the profit margin.
• The price, P, is then given by: P = AC (1+m)
Mark-up pricing (2)
• For example, assuming a desired mark-up of 25%, the average
variable cost per unit at BAM 10 and the fixed cost per unit at BAM 6,
such that AC = BAM 16, the selling price, P, is equal to 16 (1 + 0.25) =
BAM 20.
Specific pricing strategies
 Price Skimming

Penetration Pricing

Leader Pricing
Pricing Pricing of Services
Strategies Bundling

Odd-Even Pricing

Prestige Pricing
Price Skimming
• The practice of introducing a new product on the market with a high
price and then lowering the price over time is called price skimming.
• As the product moves through its life cycle, the price usually is
lowered because competitors are entering the market.
• As the price falls, more and more consumers can buy the product.
Penetration Pricing
• A company that doesn’t use price skimming will probably use
penetration pricing.
• With this strategy, the company offers new products at low prices in
the hope of achieving a large sales volume.
• Penetration pricing requires more extensive planning than skimming
does because the company must gear up for mass production and
marketing.
Leader Pricing
• Pricing products below the normal markup or even below cost to
attract customers to a store where they wouldn’t otherwise shop is
leader pricing.
• A product priced below cost is referred to as a loss leader. Retailers
hope that this type of pricing will increase their overall sales volume
and thus their profit.
Pricing of Services
• Pricing of services tends to be more complex than pricing of products
that are goods.
• Services may be priced as standard services, such as the price a hair
stylist might charge for a haircut, or pricing may be based on tailored
services designed for a specific buyer, such as the prices charged for
the design of a new building by an architect.
Bundling
• Bundling means grouping two or more related products together and
pricing them as a single product.
• Marriott’s special weekend rates often include the room, breakfast,
and free Wi-Fi.
• Department stores may offer a washer and dryer together for a price
lower than if the units were bought separately.
Odd-Even Pricing
• Psychology often plays a big role in how consumers view prices and
what prices they will pay.
• Odd-even pricing (or psychological pricing) is the strategy of setting a
price at an odd number to connote a bargain and at an even number
to imply quality.
• For years, many retailers have priced their products in odd numbers—
for example, $99.95 or $49.95—to make consumers feel that they are
paying a lower price for the product.
Prestige pricing
• The strategy of raising the price of a product so consumers will
perceive it as being of higher quality, status, or value is called prestige
pricing. This type of pricing is common where high prices indicate
high status.