SCHOOL OF ECONOMICS

UNIVERSITY OF DAR ER SALAAM

Lecture Note Five

Pricing Systems and Strategies

By

Semboja Haji Hatibu Haji

Unedited Training Notes

Presented at the EC 367: Industrial Economics I

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 Date Wednesday, 25 January 2023

5.0. Introduction
Price (P) is the result of an exchange and from that trade we assign a numerical
monetary value to a good, service or asset, (Q). Price is only part of the information we
get from observing an exchange in a given market. The other part is the volume of the
goods traded per unit time, called the rate of purchase or sale, (Q). From this additional
information we understand the extent of the market and the elasticity of the demand and
supply.

The concept of price is central to microeconomics where it is one of the most important
variables in resource allocation theory (also called price theory). Price is also central to
marketing where it is one of the four variables in the marketing mix that business people
use to develop a marketing plan.

In general terms price is the result of an exchange or transaction that takes place between
two parties and refers to what must be given up by one party (i.e., buyer) in order to
obtain something offered by another party (i.e., seller).

Yet this view of price provides a somewhat limited explanation of what price means to
participants in the transaction. In fact, price means different things to different
participants in an exchange:

Example - Price is commonly confused with the notion of cost as in “I paid a high cost
for buying my new mobile phone”. Technically, though, these are different concepts,
price is what a buyer pays to acquire products from a seller. The unit cost concerns the
seller’s investment (e.g., manufacturing expense) in the product being exchanged with a
buyer. For marketing organizations seeking to make a profit the hope is that price will
exceed cost so the organization can see financial gain from the transaction.

Finally, while product pricing is a main topic for discussion when a company is
examining its overall profitability, pricing decisions are not limited to for-profit
companies. Not-for-profit organizations, such as charities, educational institutions and
industry trade groups, also set prices, though it is often not as apparent.

For instance, charities seeking to raise money may set different “target” levels for
donations that reward donors with increases in status (e.g., name in newsletter), gifts or
other benefits. While a charitable organization may not call it a price in their promotional
material, in reality these donations are equivalent to price setting since donors are
required to give a contribution in order to obtain something of value

5.1. Definition - Economic Theory

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In ordinary usage, price is the quantity of payment or compensation for something.
People may say about a criminal that he has 'paid the price to society' to imply that he has
paid a penalty or compensation. They may say that somebody paid for his folly to imply
that he suffered the consequence.
Economists view price as an exchange ratio between goods that pay for each other. In
case of barter between two goods whose quantities are x and y, the price of x is the ratio
y/x, while the price of y is the ratio x/y.

This however has not been used consistently, so that old confusion regarding value
frequently reappears. The value of something is a quantity counted in common units of
value called numeraire, which may even be an imaginary good. This is done to compare
different goods. The unit of value is frequently confused with price, because market value
is calculated as the quantity of some good multiplied by its nominal price.

Market Price

Theory of price asserts that the market price reflects interaction between two opposing
considerations. On the one side are demand considerations based on marginal utility,
while on the other side are supply considerations based on marginal cost. An equilibrium
price is supposed to be at once equal to marginal utility (counted in units of income) from
the buyer's side and marginal cost from the seller's side.

Though this view is accepted by almost every economist, and it constitutes the core of
mainstream economics, it is a function of the nature of markets.

There was time when people debated use-value versus exchange value, often wondering
about the paradox of value (diamond-water paradox). The use-value was supposed to
give some measure of usefulness, later refined as marginal benefit (which is marginal
utility counted in common units of value) while exchange value was the measure of how
much one good was in terms of another, namely what is now called relative price.

5.2. Relative and nominal price

The difference between nominal price and relative or real price (as exchange ratio) is
often made.

Nominal price is the price quoted in money while relative or real price is the exchange
ratio between real goods regardless of money. The distinction is made to make sense of
inflation. When all prices are quoted in terms of money units, and the prices in money
units change more or less proportionately, the ratio of exchange may not change much. In
the extreme case, if all prices quoted in money change in the same proportion, the relative
price remains the same.

It is now becoming clear that the distinction is not useful and indeed hides a major
confusion. The conventional wisdom is that proportional change in all nominal prices

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does not affect real price, and hence should not affect either demand or supply and
therefore also should not affect output. The new criticism is that the crucial question is
why is there more money to pay for the same old real output.

If this question is answered, it will show that dynamically, even as the real price remains
exactly the same, output in real terms can change, just because additional money allow
additional output to be traded. The supply curve can shift such that at the old price, the
new higher output is sold. This shifts if not possible without additional money.

From this point of view, a price is similar to an opportunity cost, that is, what must be
given up in exchange for the good or service that is being purchased. For example, if x=1
and y=2, the relative price of x in terms of y is 2, and the price of y in terms of x is 0.5.

The price of an item is also called the price point, especially where it refers to stores that
set a limited number of price points. For example, in many cases there are general stores
setting price points only at even amounts, such as exactly one, two, three, five, or ten
dollars (among others). Other stores (such as dollar stores, pound stores, euro stores, 100-
yen stores, and so forth) only have a single price point ($1, £1, 1€, ¥100), though in some
cases this price may purchase more than one of some very small items. Price is relatively
less than the cost price. Loss always be there when the cost price is higher than the selling
price.

5.3. Austrian theory

One objection is also sometimes interpreted as the paradox of value, which was observed
by classical economists, Adam Smith described what is now called the Diamond – Water
Paradox. Diamonds command a higher price than water, yet water is essential for life,
while diamonds are merely ornamentation. One solution offered to this paradox is
through the theory of marginal utility proposed by Carl Menger, the father of the Austrian
School of economics.

As William Barber put it, human volition, the human subject, was "brought to the centre
of the stage" by marginalist economics, as a bargaining tool. Neoclassical economists
sought to clarify choices open to producers and consumers in market situations, and thus
"fears that cleavages in the economic structure might be unbridgeable could be
suppressed".

Without denying the applicability of the Austrian theory of value as subjective only,
within certain contexts of price behavior, the Polish economist Oskar Lange felt it was
necessary to attempt a serious integration of the insights of classical political economy
with neo-classical economics. This would then result in a much more realistic theory of
price and of real behavior in response to prices. Marginalist theory lacked anything like a
theory of the social framework of real market functioning, and criticism sparked off by
the capital controversy initiated by Piero Sraffa revealed that most of the foundational
tenets of the marginalist theory of value either reduced to tautologies, or that the theory
was true only if counter-factual conditions applied.

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One insight often ignored in the debates about price theory is something that businessmen
are keenly aware of: in different markets, prices may not function according to the same
principles except in some very abstract (and therefore not very useful) sense. From the
classical political economists to Michal Kalecki it was known that prices for industrial
goods behaved differently from prices for agricultural goods, but this idea could be
extended further to other broad classes of goods and services.

5.4. Price as Productive Human Labour Time

Marxists assert that value derives from the volume of socially necessary simple labour
time exerted in the creation of an object or service. This value does not relate to price in a
simple manner, and the difficulty of the conversion of the mass of values into the actual
prices is known as the transformation problem

5.5. Pricing

Pricing is a fundamental aspect of financial modelling, and is one of the four Ps of the
marketing mix. The other three aspects are product, promotion, and place. It is also a key
variable in microeconomic price allocation theory. Price is the only revenue generating
element amongst the four Ps, the rest being cost centers. Pricing is the manual or
automatic process of applying prices to purchase and sales orders, based on factors such
as: a fixed amount, quantity break, promotion or sales campaign, specific vendor quote,
price prevailing on entry, shipment or invoice date, combination of multiple orders or
lines, and many others. Automated systems require more setup and maintenance but may
prevent pricing errors.

5.5.1. Questions involved in pricing

Pricing involves asking questions like:

 How much to charge for a product or service? This question is that a typical
starting point for discussions about pricing, however, a better question for a
vendor to ask is - How much do customers value the products, services, and other
intangibles that the vendor provides.
 What are the pricing objectives?
 Do we use profit maximization pricing?
 How to set the price?: (cost-plus pricing, demand based or value-based pricing,
rate of return pricing, or competitor indexing)
 Should there be a single price or multiple pricing?
 Should prices change in various geographical areas, referred to as zone pricing?

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  Should there be quantity discounts?
 What prices are competitors charging?
 Do you use a price skimming strategy or a penetration pricing strategy?
 What image do you want the price to convey?
 Do you use psychological pricing?
 How important are customer price sensitivity (e.g. "sticker shock") and elasticity
issues?
 Can real-time pricing be used?
 Is price discrimination or yield management appropriate?
 Are there legal restrictions on retail price maintenance, price collusion, or price
discrimination?
 Do price points already exist for the product category?
 How flexible can we be in pricing? : The more competitive the industry, the less
flexibility we have.
o The price floor is determined by production factors like costs (often only
variable costs are taken into account), economies of scale, marginal cost,
and degree of operating leverage
o The price ceiling is determined by demand factors like price elasticity and
price points
 Are there transfer pricing considerations?
 What is the chance of getting involved in a price war?
 How visible should the price be? - Should the price be neutral? (ie.: not an
important differentiating factor), should it be highly visible? (to help promote a
low priced economy product, or to reinforce the prestige image of a quality
product), or should it be hidden? (so as to allow marketers to generate interest in
the product unhindered by price considerations).
 Are there joint product pricing considerations?
 What are the non-price costs of purchasing the product? (e.g.: travel time to the
store, wait time in the store, disagreeable elements associated with the product
purchase - dentist -> pain, fish market -> smells)
 What sort of payments should be accepted? (cash, check, credit card, barter)
Pricing

5.5.2. What a price should do

A well chosen price should do three things:

1) Achieve the financial goals of the company (e.g., profitability)

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 2) Fit the realities of the marketplace (Will customers buy at that price?)
3) Support a product's positioning and be consistent with the other variables in the
marketing mix
i. Price is influenced by the type of distribution channel used, the type of
promotions used, and the quality of the product
ii. Price will usually need to be relatively high if manufacturing is expensive,
distribution is exclusive, and the product is supported by extensive
advertising and promotional campaigns
iii. A low price can be a viable substitute for product quality, effective
promotions, or an energetic selling effort by distributors

From the marketer's point of view, an efficient price is a price that is very close to the
maximum that customers are prepared to pay. In economic terms, it is a price that shifts
most of the consumer surplus to the producer. A good pricing strategy would be the one
which could balance between the price floor (the price below which the organization ends
up in losses) and the price ceiling (the price beyond which the organization experiences a
no demand situation).

5.6. Definitions

Pricing is the process of determining what a firm, individual or supplier will receive in
exchange for its products in the market. Pricing factors are manufacturing cost, market
place, competition, market condition and quality of product.

The effective price is the price the firm receives after accounting for discounts,
promotions, and other incentives.

5.6.1. Price lining

Price lining is the use of a limited number of prices for all your product offerings. This is
a tradition started in the old five and dime stores in which everything cost either 5 or 10
cents. Its underlying rationale is that these amounts are seen as suitable price points for a
whole range of products by prospective customers. It has the advantage of ease of
administering, but the disadvantage of inflexibility, particularly in times of inflation or
unstable prices.

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A loss leader is a product that has a price set below the operating margin. This results in a
loss to the enterprise on that particular item, but this is done in the hope that it will draw
customers into the store and that some of those customers will buy other, higher margin
items.

5.6.2. Promotional Pricing

Promotional pricing refers to an instance where pricing is the key element of the
marketing mix.

5.6.3. Price/Quality Relationship

The price/quality relationship refers to the perception by most consumers that a relatively
high price is a sign of good quality. The belief in this relationship is most important with
complex products that are hard to test, and experiential products that cannot be tested
until used (such as most services). The greater the uncertainty surrounding a product, the
more consumers depend on the price/quality hypothesis and the more of a premium they
are prepared to pay. The classic example of this is the pricing of the snack cake Twinkies,
which were perceived as low quality when the price was lowered. Note, however, that
excessive reliance on the price/quantity relationship by consumers may lead to the raising
of prices on all products and services, even those of low quality, which in turn causes the
price/quality relationship to no longer apply.

5.6.4. Premium Pricing

Premium pricing (also called prestige pricing) is the strategy of consistently pricing at, or
near, the high end of the possible price range to help attract status-conscious consumers.
A few examples of companies which partake in premium pricing in the marketplace
include Rolex and Bentley. People will buy a premium priced product because:
1. They believe the high price is an indication of good quality;
2. They believe it to be a sign of self worth - "They are worth it" - It authenticates
their success and status - It is a signal to others that they are a member of an
exclusive group;
3. They require flawless performance in this application - The cost of product
malfunction is too high to buy anything but the best - example: heart pacemaker.

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5.6.5. Goldilocks Pricing

The term Goldilocks pricing is commonly used to describe the practice of providing a
"gold-plated" version of a product at a premium price in order to make the next-lower
priced option look more reasonably priced; for example, encouraging customers to see
business-class airline seats as good value for money by offering an even higher priced
first-class option. Similarly, third-class railway carriages are said to have been built
without windows, not so much to punish third-class customers (for which there was no
economic incentive), as to motivate those who could afford second-class seats to pay for
them instead of taking the cheaper option. This is also known as a potential result of price
discrimination.

The name derives from the Goldilocks story, in which Goldilocks chose neither the
hottest nor the coldest porridge, but instead the one that was "just right". More
technically, this form of pricing exploits the general cognitive bias of aversion to
extremes. This practice is known academically as "framing". By providing three options
(i.e. small, medium, and large; first, business, and coach classes) you can manipulate the
consumer into choosing the middle choice and thus, the middle choice should yield the
most profit to the seller, since it is the most chosen option.

5.6.6. Demand-Based Pricing

Demand-based pricing is any pricing method that uses consumer demand - based on
perceived value - as the central element. These include: price skimming, price
discrimination and yield management, price points, psychological pricing, bundle pricing,
penetration pricing, price lining, value-based pricing, geo and premium pricing. Pricing
factors are manufacturing cost, market place, competition, market condition, quality of
product.

5.6.7. Multidimensional Pricing

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Multidimensional pricing is the pricing of a product or service using multiple numbers. In
this practice, price no longer consists of a single monetary amount (e.g., sticker price of a
car), but rather consists of various dimensions (e.g., monthly payments, number of
payments, and a down payment). Research has shown that this practice can significantly
influence consumers' ability to understand and process price information

5.7. The 9 Laws of Price Sensitivity

In their book, "The Strategy and Tactics of Pricing", Thomas Nagle and Reed Holden
outlined 9 laws or factors that influence a buyer's price sensitivity with respect to a given
purchase:

1) Reference Price Effect

Buyer’s price sensitivity for a given product increases the higher the product’s price
relative to perceived alternatives. Perceived alternatives can vary by buyer segment, by
occasion, and other factors.

2) Difficult Comparison Effect

Buyers are less sensitive to the price of a known / more reputable product when they have
difficulty comparing it to potential alternatives.

3) Switching Costs Effect

The higher the product-specific investment a buyer must make to switch suppliers, the
less price sensitive that buyer is when choosing between alternatives.

4) Price-Quality Effect

Buyers are less sensitive to price the more that higher prices signal higher quality.
Products for which this effect is particularly relevant include: image products, exclusive
products, and products with minimal cues for quality.

5) Expenditure Effect

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Buyers are more prices sensitive when the expense accounts for a large percentage of
buyers’ available income or budget.

6) End-Benefit Effect

The effect refers to the relationship a given purchase has to a larger overall benefit, and is
divided into two parts:
Derived demand: The more sensitive buyers are to the price of the end benefit, the more
sensitive they will be to the prices of those products that contribute to that benefit.

Price proportion cost: The price proportion cost refers to the percent of the total cost of
the end benefit accounted for by a given component that helps to produce the end benefit
(e.g., think CPU and PCs). The smaller the given components share of the total cost of
the end benefit, the less sensitive buyers will be to the component's price.

7) Shared-cost Effect

The smaller the portion of the purchase price buyers must pay for themselves, the less
price sensitive they will be.

8) Fairness Effect

Buyers are more sensitive to the price of a product when the price is outside the range
they perceive as “fair” or “reasonable” given the purchase context.

9) The Framing Effect

Buyers are more prices sensitive when they perceive the price as a loss rather than a
forgone gain, and they have greater price sensitivity when the price is paid separately
rather than as part of a bundle.

5.8. Approaches

Pricing is the most effective profit lever. Pricing can be approached at three levels. These
are industry, market, and transaction levels.

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Pricing at the industry level focuses on the overall economics of the industry, including
supplier price changes and customer demand changes.

Pricing at the market level focuses on the competitive position of the price in comparison
to the value differential of the product to that of comparative competing products.

Pricing at the transaction level focuses on managing the implementation of discounts

away from the reference, or list price, which occur both on and off the invoice or receipt.
5.9. Tactics

Micromarketing is the practice of tailoring products, brands (microbrands), and

promotions to meet the needs and wants of micro segments within a market. It is a type of
market customization that deals with pricing of customer/product combinations at the
store or individual level.

5.10. Pricing Mistakes

Many companies make common pricing mistakes. Bernstein's article "Supplier Pricing
Mistakes" outlines several which include:
 Weak controls on discounting
 Inadequate systems for tracking competitor selling prices and market share
 Cost-Up pricing
 Price increases poorly executed
 Worldwide price inconsistencies
 Paying sales reps on dollar volume vs. addition of profitability measures

5.11. Pricing strategies

There are many ways in which the price of a product can be determined. The following
are the foremost strategies that businesses are likely to use.

5.11.1. Competition-Based Pricing

Setting the price based upon prices of the similar competitor products.

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Competitive pricing is based on three types of competitive product:
 Products have lasting distinctiveness from competitor's product. Here we can
assume
o The product has low price elasticity.
o The product has low cross elasticity.
o The demand of the product will rise.
 Products have perishable distinctiveness from competitor's product, assuming the
product features are medium distinctiveness.
 Products have little distinctiveness from competitor's product. assuming that:
o The product has high price elasticity.
o The product has some cross elasticity.
o No expectation that demand of the product will rise.

The pricing is done based on these three factors.

5.11.2. Cost-Plus Pricing

Cost-plus pricing is the simplest pricing method. The firm calculates the cost of
producing the product and adds on a percentage (profit) to that price to give the selling
price. This method although simple has two flaws; it takes no account of demand and
there is no way of determining if potential customers will purchase the product at the
calculated price.

Price = Cost of Production + Margin of Profit.

5.11.3. Creaming or Skimming

Selling a product at a high price, sacrificing high sales to gain a high profit, therefore
‘skimming’ the market. Usually employed to reimburse the cost of investment of the
original research into the product – commonly used in electronic markets when a new
range, such as DVD players, mobile phones and other ICT gargets are firstly dispatched
into the market at a high price. This strategy is often used to target "early adopters" of a
product or service. These early adopters are relatively less price-sensitive because either
their need for the product is more than others or they understand the value of the product
better than others. This strategy is employed only for a limited duration to recover most
of investment made to build the product. To gain further market share, a seller must use

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other pricing tactics such as economy or penetration. This method can come with some
setbacks as it could leave the product at a high price to competitors.

5.11.4. Limit Pricing

A limit price is the price set by a monopolist to discourage economic entry into a market,
and is illegal in many countries. The limit price is the price that the entrant would face
upon entering as long as the incumbent firm did not decrease output. The limit price is
often lower than the average cost of production or just low enough to make entering not
profitable.
The quantity produced by the incumbent firm to act as a deterrent to entry is usually
larger than would be optimal for a monopolist, but might still produce higher economic
profits than would be earned under perfect competition. The problem with limit pricing as
strategic behavior is that once the entrant has entered the market, the quantity used as a
threat to deter entry is no longer the incumbent firm's best response. This means that for
limit pricing to be an effective deterrent to entry, the threat must in some way be made
credible. A way to achieve this is for the incumbent firm to constrain itself to produce a
certain quantity whether entry occurs or not. An example of this would be if the firm
signed a union contract to employ a certain (high) level of labor for a long period of time.

Loss Leader

In the majority of cases, this pricing strategy is illegal under national competition
policies, laws and regulations. No market leader would wish to sell below cost unless this
is part of its overall strategy. The idea of selling at a loss may appear to be in the public
interest and therefore not often challenged. Only when the leader pushes up prices, it then
becomes suspicious. Loss leadership can be similar to predatory pricing or cross
subsidization; both seen as anti-competitive practices.

5.11.5. Market-Oriented Pricing

Setting a price based upon analysis and research compiled from the targeted market. Also
with the cost price.

5.11.6. Penetration Pricing

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The price is deliberately set at low level to gain customer's interest and establishing a
foot-hold in the market.

5.11.7. Price Discrimination

Setting a different price for the same product in different segments to the market. For
example, this can be for different ages or for different opening times, such as cinema
tickets. Market orientated pricing is also a very simple form of pricing used by very new
businesses. What it involves is, setting the price of your product/service according to
research conducted on your target market.

5.11.8. Premium Pricing

Premium pricing is the practice of keeping the price of a product or service artificially
high in order to encourage favorable perceptions among buyers, based solely on the price.
The practice is intended to exploit the (not necessarily justifiable) tendency for buyers to
assume that expensive items enjoy an exceptional reputation or represent exceptional
quality and distinction.

5.11.9. Predatory Pricing

Aggressive pricing intended to drive out competitors from a market. It is illegal in some
places.

5.11.10. Contribution Margin-Based Pricing

Contribution margin-based pricing maximizes the profit derived from an individual

product, based on the difference between the product's price and variable costs (the
product's contribution margin per unit), and on one’s assumptions regarding the
relationship between the product’s price and the number of units that can be sold at that
price. The product's contribution to total firm profit (i.e., to operating income) is
maximized when a price is chosen that maximizes the following: (contribution margin
per unit) X (number of units sold).

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5.11.11. Psychological Pricing

Pricing designed to have a positive psychological impact. For example, selling a product
at $3.95 or $3.99, rather than $4.

5.11.12. Dynamic Pricing

A flexible pricing mechanism made possible by advances in information technology, and

employed mostly by Internet based companies. By responding to market fluctuations or
large amounts of data gathered from customers - ranging from where they live to what
they buy to how much they have spent on past purchases - dynamic pricing allows online
companies to adjust the prices of identical goods to correspond to a customer’s
willingness to pay. The airline industry is often cited as a dynamic pricing success story.
In fact, it employs the technique so artfully that most of the passengers on any given
airplane have paid different ticket prices for the same flight.

5.11.13. Price Leadership

An observation made of oligopic business behavior in which one company, usually the
dominant competitor among several, leads the way in determining prices, the others soon
following.

5.11.14. Target Pricing

Pricing method whereby the selling price of a product is calculated to produce a

particular rate of return on investment for a specific volume of production. The target
pricing method is used most often by public utilities, like electric and gas companies, and
companies whose capital investment is high, like automobile manufacturers.

Target pricing is not useful for companies whose capital investment is low because,
according to this formula, the selling price will be understated. Also the target pricing
method is not keyed to the demand for the product, and if the entire volume is not sold, a
company might sustain an overall budgetary loss on the product.

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5.11.15. Absorption Pricing

Absorption pricing is the method of pricing in which all costs are recovered. The price of
the product includes the variable cost of each item plus a proportionate amount of the
fixed costs. A form of cost plus pricing

5.11.16. Marginal-Cost Pricing

In business, the practice of setting the price of a product to equal the extra cost of
producing an extra unit of output. By this policy, a producer charges, for each product
unit sold, only the addition to total cost resulting from materials and direct labour.
Businesses often set prices close to marginal cost during periods of poor sales. If, for
example, an item has a marginal cost of $1.00 and a normal selling price is $2.00, the
firm selling the item might wish to lower the price to $1.10 if demand has waned. The
business would choose this approach because the incremental profit of 10 cents from the
transaction is better than no sale at all.

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