Pricing lecture 2018

Price is not a
number
!
The secrets of
pricing and

DON’T THINK PRICE –
THINK PRICING
SYSTEM

PRICING ASSUMPTIONS
• Our customers always prefer low prices
ASSUMPTIO
N
REALITY
• Only if you are incredibly accurate with your sales
projections and cost projections
• Customers will always say they like lower prices.
However, in many markets price serves as a guide
to quality, and pricing too low can send out a
negative signal
• Lack of customer price knowledge makes how you
present the price even more important. This is
where strategies such as good-better best and price
ending cues are key
• Simpler for who? Simplifying pricing structures
means giving away money. Due to the taxi-meter
effect, customers may not always appreciate it when
firms do price simply
• Price segmentation is actually going to be most
effective for already-profitable firms, because
effective segmentation requires market power
implied by profitability
• Simpler pricing structures are better
• If we are profitable, we do not need to price-discriminate
• Our customers do not know prices, so our pricing
strategy is unimportant
• If we use cost-plus pricing, we will make a profit

PRICING ASSUMPTIONS
• Razor Blade pricing works because our customers are
stupid
ASSUMPTIO
N
REALITY
• Razor blade pricing works because it is actually subtle
price segmentation
• Price sensitivity increases the more you use something
• Even when a product has network effects, price
segmentation is key. The crucial questions for network
goods are: Whom do I set a low price to and whom do
I set a high price to?
• It can be more profitable to have unused inventory or
capacity
• Statements like this lead to jail time. It is the
responsibility of the firm, and the firm alone, to avoid a
price war
• Firms have to actively manage perceptions of their
pricing by competitors, regulators and other
stakeholders
• Our competitors understand our pricing strategy
• Industries need to work together to ensure that they
avoid harmful price wars
• Firms need to adjust prices until I fill capacity
• High-value, high-usage customers pay more. Low-
value, low-usage customers pay less
• Our product has network effects, so we need to set a
low price

STRATEGIC PRICING
• Businesses often price a product offering based on
 Cost plus pricing – determine a unit cost, then add a percentage mark-up
 Competitive pricing – trying to beat or undercut competitors’ value offering
• However, optimal price depends on product’s perceived value to the customer
• Price affects perceived value
 Under-priced products may be perceived as low-value/quality and actually
attract fewer customers than a higher price would
• ‘Value pricing’ is usually more appropriate for new/innovative products
 though cost must be reviewed to check that your business will be financially
viable!
• Strategy also impact your pricing (i.e. a land grab could make you under-price or give
away for free)
• Free – is a price, consumers will have some form of cost attached

Pricing process
Value Setting
Core
Brand
Quality
Affordability
segmentation
Identifiable
segment
affordability
differentiation
Demand
sensitivity
Time to event
(or after)
Logistics/
Hassle
Needs
Charging
intervals
Value points
Payment
intervals
When do you
ask for
payments
Inducement
Behavioral
Psychology
Discounts
Lock-in
INTRINSIC INTRINSIC INTRINSICEXTRINSIC EXTRINSIC INTRINSIC

Many consumers
don’t know the
pricing of items,
and seek ‘price
cues’ to inform
them as to whether
something is a
good deal or not.
This lack of price
knowledge means
that they constantly
look for clues as to
whether a price they
are seeing is a good
deal relative to an
unknown reference
PRICING UNDER CONSUMER UNCERTAINTY

THE COMPROMISE EFFECT
Customers often choose the mid-priced option to protect themselves from
making a bad choice. The implication here is that one can increase profits by
adding a low-price or high-price option in addition to an existing product.
• Works successfully in both B2C and B2B markets.
• Products need to be from the same brand.
•Everyone at the firm needs to know what the intention of introducing ‘decoys’ is.
– Architectural software firm lost money after sales force manager misunderstood its
decoy premium product and started discounting it to match the mid-price product.

DISCOUNTING
One way that firms can signal that their price will be cheaper than the unknown reference
price is to advertise a discount, so that the reference price is anchored upwards. However,
to be effective, a discount needs to have a credible reason, and not be overused.
• People tend to think of prices in terms of proportion or percentage changes rather than
absolute changes.
• When discounting, discount cheapest part of the product bundle:
– More effective to discount off dessert than total meal.
– More effective to discount car financing than entire car price.
• MIT research suggests that effectiveness of sales signs decreases at around 30 percent
saturation.

ECONOMIC VALUE TO THE CUSTOMER
EVC:
• A customer will buy a product only if its value to them outweighs the value of the
closest alternative (i.e. another way of solving the problem)
• Value communication is important as EVC is perceived differentiation value
• The price should be the same or below its competitor’s price plus the value advantage its
product has to the customer over the rival product
• The EVC describes only the maximum price a firm might theoretically charge
It is best to use EVC as a pricing formula when:
• Competitor’s prices are well-known and concrete
• A product’s differentiation value is easy to calibrate
• A product’s differentiation value is easy and believable to communicate

EVC Example
• NETFLIX
– Drive to DVD store
– Rent DVD
– Late fees
– Return DVD
• SPOTIFY
– Drive to music store
– Buy CD
OR
– Borrow from a friend
OR
- Find online and download

THIS IS NOT THE
PRICE YOU ARE
LOOKING FOR

ASYMMETRIC INFORMATION ABOUT PRODUCT QUALITY.
High prices may imply high quality if quality is uncertain.
High prices as a signal of quality work well with:
• Customers of middling sophistication who are uncertain about quality
– Some survey evidence of limited ability to think iteratively through the credibility
of price as a signal of quality
• Scenarios when people who are not knowledgeable anticipate that there will be
repeat or more knowledgeable purchasers in the market too.
– I might buy more expensive cigars as I assume they are priced right for cigar
fans
• Capacity constraints
– Show promoters in Vegas sell more seats at higher prices

SIGNALING BY THE CUSTOMER.
One potential source of differentiation value is for Veblen or ‘snob’ goods, where part of the
product’s appeal is its high price.
• High prices allow customers to signal their worth to other individuals
– When a fountain pen manufacturer raised its prices, it sold more
• It also allows customers to signal their worth to themselves and others
• It also allows gift-buyers to signal the value of their present.
– Scottish whiskies had difficulty in Japan when they tried to enter with lower
prices.
– L’Oreal has had huge success with the ‘Because you’re worth it’ campaign

PRICING ELASTICITY
The price elasticity of a product measures the responsiveness of sales to a change in price.
If elasticity=1, revenues will be the same from a price
change
If elasticity is >1, revenues will be higher with a price
decrease
If elasticity<1, revenues will be higher with a price increase

PRICING ELASTICITY
Why is a price elasticity useful?
Relative margins:
An electronics retailer priced batteries the same all over....[Price Elasticity Analysis] showed
the battery that had the highest ”price sensitivity” in Dallas had the lowest price sensitivity
in Boston. In other words, while Texans would buy this particular battery only within a
narrow price range, Bostonians were far less picky about it. The store altered its prices
accordingly, sold more batteries and made more money at it.
Rule of thumb pricing tool, especially in retail sector with a large number of SKUs. This
caries a weighty health warning since you are effectively assuming away your competitors,
that you are already optimizing and that you have increasing marginal costs.

PRICING ELASTICITY
Ways of improving historical pricing analysis.
• Calculate different price elasticities for each type of customer, each region, each
product. Use more data than just aggregate sales and prices
• DHL employed software that included the reactions of customers who called and got a
quote but didn’t ship - that is, a failed sale. By including data from this group of
customers, they improved their ‘quote to book ratio’ from 17 percent to 25 percent.
• Use panel data econometrics where you include controls for places and times in your
regression analysis. The problem is that this can get very expensive both in terms of
personnel and costs of acquiring data.

PRICING TO SEGMENT CUSTOMERS
The most crucial insight is
that we shouldn’t think
about where we should
price along our demand
curve. Instead we should
think, how many different
prices to different
customers can I charge
along my demand curve?
How can we charge a
lower price to low-
valuation types and
get them to ‘enter’ the
market, but still
persuade the high-
valuation types to pay
the high price.

Strategic assessment of whether a firm should move from a single price strategy:
• Does my product offering have differentiation value?
• Can I identify 2+ customer value profiles who theoretically have different valuations for
my product?
• Is there empirical evidence that these different customers actually have the EVC
differences you expect them to have?
• Very different price elasticities indicate that they do have different EVC.
• Is there empirical evidence that customers in this value profile have similar enough
EVC?
• You can find out whether you have segmented enough, by trying to segment again.
If the new price-elasticities that you calculate are noticeably different from each
other then you have not segmented enough.

Necessary criteria for success: low cost vs high cost
• Can identify an unambiguous component of differentiation value (e.g. convenience).
• ‘Distortion’: This component of differentiation value must be correlated strongly enough
with overall EVC that high-valuation types will pay a premium rather than not have it. Or
in other words, you are going to force your low-valuation customers to signal that they
have low-valuations because you are going to distort your product quality downwards.
• Comfort, Speed, Reliability, Ease of use are good places to start.
• ‘Compensation’: This component of differentiation value must be not so essential that
low-valuation types will never buy the product without it. Price to compensate them. This
is why we see discounts for economy class discomfort.

Necessary criteria for success:
• Can identify an unambiguous component of differentiation value correlated with overall
EVC (e.g. convenience).
• ‘Distortion’: This component of differentiation value must be correlated strongly enough
with overall EVC that high-valuation types will pay a premium rather than not have it. Or
in other words, you are going to force your low-valuation types to signal that they have
low-valuations because you are going to distort your product quality downwards.
• Comfort, Speed, Reliability, Ease of use are good places to start.
• ‘Compensation’: This component of differentiation value must be not so essential that
low-valuation types will never buy the product without it. Price to compensate them. This
is why we see discounts for economy class discomfort.

PRODUCT ATTRIBUTE BASED PRICING
• Must be able to structure price to meet key attribute
• Creating different products/price based on the attributes
– Time of day
– Delivery
– Colour
– Remnant/premium
– Urgency

TIME AND PRICE
TIMING STRATEGIES
Getting the timing of pricing right can actually aid how much consumers enjoy your good.
Basically, consumers prefer to avoid a payment that is timed when either they are enjoying
the good, or when they expect in particular to not enjoy the good.
• Decouple the pain of paying from consumption for experience goods:
– For example, people are willing to pre-pay and pay a premium for things they enjoy
(such as vacations)
• Decouple the pain of paying from the pain of learning how to use a technology product:
– Customers are more likely to switch if they do not have to pay full price for a
technology service in the same month they are learning how to use it.
• Decouple pain of paying from possibility of bad experience of products:
– Cellphone companies gain more customers if they preannounce an automatic rebate
when there is service interruptions.

Framing
The context in which a price is communicated to a customer affects how much the
customer may be willing to pay for something.
PRICING & BEHAVIOURAL ECONOMICS
In the hearing aid market, audiologists could frame their offerings by demonstrating key
features relative to potential alternatives that cost considerably more. For example, once the
likely long-term consequences of doing nothing about hearing loss is shared with the patient,
it helps frame the benefits of a pair of professionally-fitted hearing aids.
Another example of framing is the use of bundling (or unbundling) your offerings. When
many of the key technology and service features are itemized and a dollar value is assigned
to each, it frames your offering much differently than if you were to simply list one price in a
bundled format. Research has shown that unbundling results in many patients willing to pay
more for the same offering.

Anchoring
The price you expect to pay for a product or service is an anchor. Price anchors are mainly
determined by your experience buying a particular product, and they can change based on
the season, time of day or even economic conditions.
Based on previous buying experience, customers know they are receiving a “good deal”
when a special low sale price is spotted in a newspaper ad or coupon. The challenge
associated with respect to anchoring in the hearing aid market is that the average consumer
is not very familiar with the time and expertise usually required to successfully fit hearing
aids. When a dispensing practice runs advertising using low price points to drive traffic, an
unintended consequence is anchoring a low price point in the mind of the prospective buyer.
Once a price has been anchored in the mind of the customer it is difficult to change it.

Default Bias
Consumers generally take a path of least resistance when making purchases. When an
obstacle - even one as simple as checking a box to become eligible for a service or
upgrade - is placed in front of a customer, they oftentimes do not voluntarily opt to buy it.
Employers make 401k retirement plans something their employees can opt into. When this is
the default option upwards of 50% of employees do nothing and, therefore, opt out of the
voluntary retirement plan. However, when the employer makes automatic enrollment the
default option, very few employees voluntarily opt out of the program.

MARKETPLACES E.G. AIRBNB/PLAY
STORE

PRICING POWER
• Market has limited capacity for purchase
• Increasing demand by small customer set
• Strong differentiation between products
• High cost of switching

TIMING & PRICE
• Pre-payments
• Early payment discounts
• Lower price with same payment terms not ideal to change cashflow metrics unless
– Elasticity is high
– Margin can support lower price at greater volumes

Yield vs Revenue vs Cash
• Yield measures a return on a unit (margin)
– Usually used for property and non-perishable assets
• Depending on strategy, you can price to maximise revenue (cashflow hopefully) but not
yield (return)
• Low price does not equal better cashflow

TESTING PRICE
• Interview customers and ask
– Interview bias
• Online questionnaires (structure them well)
– Instant Insights
– Survey monkey
• Fake products and ads
– Google/FB campaign to target market
– Same ad, different price points
– Look for highest CTR at similar impression share

WHAT IS LTV
• The life time value of a customer
– Gross margin (or revenue) X expected length of time as a customer
– Other factors
• segmentation in customer groups (some are longer than others)
• Value of customer segments
– They introduce new customers
– They are more profitable
• How to use LTV
– Business models
– Benchmark
– Segmentation analysis

CHANNELS
• Is your product bought or sold
– Bought – you put it in front of consumers and they take it off the shelf/digital
storefront
– Sold – somebody has to convince them and/or they need service to use it
• Channels impact pricing due to
– Mark-up required by channel
– Cost of sales via the channel
– Cost of logistics/training/service via the channel

BOUGHT
• Bought products rely heavily on reach/distribution to be seen by as many potential
customers as possible
– Physical stores
• Distributors
• Agents
• Direct to retailers
– Digital stores
• Distributors
• High fragmentation
– Direct to consumer
• Own stores
• Own digital footprint

SOLD
• Who sells it
• Who delivers the service
– Is it the same place that sells it
• Direct (own sales & service)
• Mix direct/indirect

BROAD OR NARROW DISTRIBUTION
• Limited availability (higher price)
– Easier to train up or have stronger relationship
– Cost of going broad is often under-estimated from logistics and channel
management perspective

CHANNEL MANAGEMENT
• Indirect channels need to be maintained
– Distributor relationships
– Understanding competitor behavior
– In-store/on-line visibility & promotion
– Training & after sales support

THAT’S
ALL
nevo@andinnovation.com
@nevoda
Linkedin.com/nevohadas

Pricing lecture 2018

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