Deciding what price to charge for a product.
What to consider to get the price right
1. Customer benefits
The price customers will pay for a product will depend on the benefits (actual and perceived) they get
from it e.g. quality, image, style, convenience, etc.
They must think that it is a fair price.
These pricing methods are used to make a product appear more beneficial and
a) psychological pricing
Price changes affecting customer perceptions (e.g. £1.99 instead of £2) and high prices for high quality and
exclusivity like designer clothes (also called premium pricing).
b) loss leaders
Products sold at a loss to attract customers to other products (often used in supermarkets).
c) variable pricing (or price discrimination) - charging different prices to different
customers for the same product e.g. night time electricity.
d) discount pricing – lower prices for a limited time.
2. Market forces and competition
The market price is determined by supply (from producers) and
demand (from customers):
- With the same supply, higher (lower) demand means higher (lower) prices.
- With the same demand, higher (lower) supply means lower (higher) prices.
The economist’s concept of price elasticity of demand measures the impact of price changes
A product may have elastic or inelastic demand:
a) elastic demand
i.e. a percentage decrease in price leads to a higher percentage increase in demand (making a price
reduction more profitable).
This happens when there are lots of competitors selling similar products.
A company is also more likely to reduce prices, if it can benefit from economies of
scale (cost reductions from mass production).
Penetration pricing sets low prices to gain high sales and is normally used for fast
moving consumable goods (fmcg’s) e.g. cola.
b) inelastic demand
i.e. a percentage increase in price leads to a lower percentage decrease in demand (making a price
increase more profitable).
This happens when customers are prepared to pay a higher price (or premium price) for products
that are better than competitors (i.e. there is product differentiation).
For example, a “skimming” strategy charges a high price to richer customers (usually used
for revolutionary new products).
Price must pay for a product’s costs (fixed and variable – see costing) and provide a profit.
So cost-plus pricing calculates price as follows:
Costs per product (unit costs) + profit (called the mark-up or profit
But there are problems with this:
- It ignores competition (so price may be either too high or too low relative to
- Product costs may be difficult to calculate.
Contribution pricing chooses a price that maximizes a product’s contribution i.e. sales
revenue (price x products sold) less total variable costs.
4. Capital employed
In analysing accounts, we saw that every business has
capital employed (or the amount of money invested in it), and an important measure of its profitability is
return on capital employed:
Net profit x 100%
Target return pricing sets a price to achieve a certain return on capital
Target return – 10%
Products sold – 2,000
Capital employed - $100,000
Total costs - $10,000
A price of $10 leads to a net profit of $10,000 ($20,000 revenue
less $10,000 costs)
This profit leads to a return on capital employed of 10% (the target return) - (10,000 ÷ 100,000) x 100%.
Key quotes explained
“Never knowingly undersold”
- John Spedan Lewis, founder of the British
department store chain, the John Lewis Partnership, which became its
John Lewis has this policy of matching another store’s price for the same product, however low it might be.
“Pleasing ware is half sold”
Herbert ,English poet (pictured right)
This is just as true today as when he wrote this in 1651! A pleasing product is at least as important as its
Even a cheap price is wasted, if the product is no good.
“Poor lawyers, like poor paintings, are dear at any price”, said the American artist,
“The real price of everything...is the toil and trouble of acquiring
- Adam Smith (Scottish
philosopher and economist, pictured right)
People spend their hard earned cash buying something, so value for money is vital.
Alfred Marshall (pictured
right), Principles of Economics (1890)
Professor Marshall was the first person to show that price is determined by supply and demand, coining the term,
price elasticity of demand.