Confessions of the Pricing Man: How Price Affects Everything

by Hermann Simon

the law of declining margi...

I admit that the approach has practical advantages. First, it depends on hard cost data, not on assumptions. It also guarantees the seller a positive unit contribution on every unit sold. Finally, if competitors use the same approach to set their prices, and also have similar buying power , this method minimizes price competition for the product and encourages the sellers to compete on aspects other than price. Cost-plus pricing can create a de facto price cartel , with the resulting stability and predictability. All these factors explain why this method is so popular.

However, this method also has very serious disadvantages. It does not take customer reactions into account, because the sellers only use costs.

With cost-plus you have a good chance that your price is either too high or too low.

Of course a company needs to keep an eye on its competitors’ prices and use them as input in setting its own.

Remember the pricing = best alternative + benefits on top of competitors offering in Tim J Smith book

it is not the end of the world if you don’t have the optimal price figured out down to the last decimal place. It is more important to be in the right vicinity.

you should pass along only half of any cost savings to your customers.

The same principle applies to exchange rate fluctuations. It is neither optimal nor wise to pass on exchange rate fluctuations to customers in full.

This same principle likewise applies to increases of a sales tax. For every tax increase of 1 %, your price should rise by less than 1 %. The exact amount depends on the slope of your demand curve

What if the customers’ willingness to pay changes?

The rule of thumb, again, is to share the impact of the changes—whether positive or negative—evenly with your customers.

There is only a small number of proven, practical ways to derive a demand curve.

Van Westendorp Price Sensitivity Meter .

my recommendation is that you do not rely solely on these direct methods as your input in determining a demand curve or setting your prices. You must complement this data with data from other methods.

The general term for this category of research methods is conjoint measurement

Today these methods effectively help managers determine their demand curve s and their profit-maximizing price

A company changes the real prices at the shelf or online in a systematic way, and carefully tracks how customers respond to the price change s.

The ability to collect real-life data is clearly the big advantage of this approach.

Lester G. Telser, a professor at the University of Chicago , predicted that past market data has very limited relevance for predicting future behavior.

Professor Telser was right.

What I have found over the years is that a combination of the methods I have described above produces the most reliable results.

The cross-price elasticity

is the percentage change of our volume divided by the percentage change in the competitor ’s price.

It is evident that we need to incorporate competitors’ prices into our demand curve s.

If you want to take a more structured approach to anticipating competitive reaction and observing its potential effects, I would recommend either the expert-judgment approach or the indirect questioning approach (conjoint measurement ) described earlier in this chapter.

a symmetrical oligopoly

One company’s own price has twice the effect on volume as the competitor ’s price does.

There are two classical hypotheses for the potential competitive reaction s: the Chamberlin Hypothesis and the Cournot Hypothesis.

Chamberlin Hypothesis

This is the kind of result one would expect in a market characterized by price leadership

George Stigler, who won the Nobel Prize in economics in 1982, claims that price leadership is the best solution for companies in a highly competitive oligopoly .

Cournot Hypo...

That assumption, however, typically turns out to be false. In reality, A and B almost always respond in a way that optimizes their own respective prices.

It turned out that the Chamberlin solution occurred very rarely. The Cournot solution was far more common.

If your company is part of an oligopoly , please keep these three points in mind:

No clear optimal price exists:

Chamberlin outcomes are possible if certain conditions apply:

It is wise to leave prices as they are if those conditions do not exist:

A particularly challenging situation for price adjustments is the occurrence of inflation

an attempt to establish a price advantage will not work unless customers notice and understand it.

Price signals are harder to convey clearly in a period of high inflation

under inflationary conditions I strongly recommend a series of small, regular price increase s instead...

uniform price taps only about half of the profit potential—is

even if a company succeeds in setting an optimal uniform price, it still leaves a large portion of its potential profits on the table.

Another method for tapping individual willingness to pay is auctions. The auction mechanism of eBay is set up so that every bidder submits his or her maximum price , but without the other bidders seeing it. If the bidder wins, he or she pays only the price of the next highest bidder plus a slight differential. This method is known as a Vickrey auction in which it is optimal for the bidder to reveal his or her maximum price.2

the profit increase that we can realize from differentiated prices is greater than the profit increases we can get from fine-tuning our way to an optimal uniform price

Sellers who don’t differentiate their prices run the risk of sacrificing a large amount of profit.

Price differentiation only makes sense when one succeeds in erecting a “fence” between the potential buyers with a higher and those with a lower willingness to pay.

a prerequisite for optimal price differentiation is detailed knowledge about the buyers’ willingness to pay

Bundling is a very effective way to differentiate prices.