CHAPTER 14 Pricing Techniques and
undertaken. Careful demand estimations showed that
Analysis
CHAPTER PREVIEW
 This chapter builds on the price and output
determination models developed in Chapters 10–13 as
it considers more complex pricing issues.
 The first two sections examine a value-based pricing
conceptual framework.
 Then we characterize differential pricing in segmented
markets where different target customers are charged
non-uniform prices.
 Differential pricing is often accomplished with bundled
pricing, couponing, and two-part tariffs (an access or
entry fee combined with a user fee).
 Finally, we discuss the concept of pricing throughout
the product life cycle including target pricing,
penetration pricing, pricing for organic growth, limit
pricing, and niche pricing.
 We conclude with a section on pricing of goods and
services sold over the Internet.
 Finally, applications of revenue management in
airlines, fashion clothing, consulting firms, and
baseball are explained.
 Together, the pricing practices presented in this
chapter provide an extensive overview of the way
actual managers apply pricing techniques to maximize
shareholder wealth.
 Two additional pricing topics closely related to
accounting (pricing of joint products and transfer
pricing) are presented in Web Appendix E.
A CONCEPTUAL FRAMEWORK FOR PROACTIVE,
SYSTEMATIC-ANALYTICAL, VALUE-BASED PRICING
 In the past, pricing decisions were often treated as an
afterthought.
 Companies either routinely marked up prices or
reacted in an ad hoc fashion to a competitor’s
discounting.
 Today, systematically analyzing the customer value
basis for an asking price and thereafter carefully
selecting which orders to accept and which to refuse
has become a critical success factor for many
businesses.
 Pricing decisions must always be systematic and
analytical, based on hard facts instead of ad hoc
hunches.
 In the men’s aftershave business, an established
incumbent recently encountered a new entrant with a
penetration price 40 percent below the leading brands
Skin Bracer, Old Spice, and Aqua Velva.
 The incumbent increased advertising but maintained
its original price point and was astounded to observe a
50 percent decline in market share through its grocery
store distribution channel.
 Only after the fact was asystematic analysis
customers in the grocery store channel were price
elastic and advertising inelastic.
 Proactive pricing must also be tactically astute and
internally consistent with a company’s operations
strategy.
 A high-cost, full-service, hub-and-spoke airline cannot
slash prices dramatically even if it means 10 or 20
percent increases in market share in a high-margin
segment.
 It must instead anticipate a matching price reaction by
its lower-cost rivals, perhaps followed by still further
price cuts below its own cost.
 Knowing these probable reaction paths in advance
makes the attempt to gain market share through
discounting much less attractive despite additional
incremental sales at a high margin.
 Most importantly, pricing should be value based.
 Prestone and Zerex sell leading anticorrosive radiator
fluids whose product characteristics warrant a price
premium.
 Under apparent price pressure, Zerex often simply
matches any competitor’s discount as long as
competing prices on generic radiator fluid cover
Zerex’s cost.
 A thorough value analysis reveals, however, that this
reactive cost-based pricing fails to realize about one-
third of Zerex’s sustainable profit margin.
 Cost-based pricing has been called one of the “five
deadly business sins” by Peter Drucker; what firms
should do instead is “pricebased costing.”
 That is, firms should segment customers, perform an
extensive customer value analysis, and then develop
products whose costs allow substantial profitability in
each product line the firm chooses to enter.
 Each firm’s marketing and operations capabilities are
then key to sustaining that profitability.
 Costs are not irrelevant. Indeed, a key to effective
pricing management is to know precisely what
activity-based costs are associated with each type of
order from each customer segment.
 Knowing these costs allows firms with optimal
differential prices to identify which orders to refuse.
 This insight—that every company has orders that it
should refuse—is the key to a new set of pricing
techniques known as “yield management,” or more
generally, “revenue management (RM).”
 In an RM approach, costs become the consequence of
a value-based pricing and product development
strategy.
 The appropriate conceptual framework for setting
prices is the target customer’s value-in-use.
 Value-in-use is the cost savings that arise from the use
of your product or service relative to a next best
competitor.
 A faster commute on a toll road or a nonstop jet to a
distant city saves the $220-an-hour attorney or
accountant’s time value per hour.
 A Google ad with a documented click-through rate
saves the advertising expenditure on magazine ads or
TV commercials.
 An integrated and easy-to-use Canon digital
photography system saves the casual photographer
time, money, and inconvenience in image capture,
photo editing, developing, distribution, and storage.
 Table 14.1 lists various tangible and psychological
sources of value-in-use, including product
specifications and ease of use, delivery reliability,
service frequency, change order responsiveness,
loyalty programs, and empathy in order processing.
 Many of these sources of cost savings are functional
points of differentiation, but others are relationship-
based.
 In addition, marketing communications seeks to
position and brand the product through advertising,
personal selling, and event marketing.
 Viral marketing identifies trend setters among the
target customer group and seeks to place the product
with those individuals, hoping that others will follow
their lead.
 Because consumers strive to avoid psychological
dissonance, products that affirm a particular lifestyle
or group identity can often generate perceived value
well beyond tangible cost savings.
 Coca-Cola and Starbucks each offers a lifestyle
association and identity that would otherwise
necessitate much larger clothing, travel, auto, and
entertainment expenditures to achieve a similar
result.
 Importantly, lowest price is seldom what triggers a
purchase. Instead, a target customer’s purchase is
triggered by either (1) value through functions, cost
savings, and relationships that exceed the product’s
asking price or (2) a ratio of value to asking price that
is greater than a competitor’s.
 In Table 14.1, $0.50 is not the lowest price for a digital
photography print, but Kodak’s offering will
nevertheless trigger a purchase if the excess customer
value with the Kodak digital photography system
($2.00 − $0.50) exceeds the excess value from less
valuable $0.29 products—perhaps ($1.00 − $0.29).
 Consequently, firms should begin their pricing
decisions by identifying the value drivers in each and
every customer segment.
 Business air travelers, for example, value conformance
to the schedule, delivery reliability, and the ability to
change itineraries on short notice more than they
value frequent flights, good meals, and wide seats.
 Because that first set of process-based value drivers is
harder to imitate, sustainable price premiums are
often associated with those operations processes
rather than the product or service characteristics of
flights, meals, and seats.
 Because business travelers account for only 27
percent of the traffic but 80 percent of the
profitability, a critical success factor for legacy airlines
is to have hub processes and route planning that
sustain these hard-to-imitate processes on nonstop
flights.
 In sum, pricing decisions should be proactive and
systematically analytical, not reactive and ad hoc.
 Most importantly, pricing should be value-based, not
cost-based.
 The value-in-use conceptual framework leads
naturally to a differential pricing environment in which
mass-produced products or services are customized to
the requirements of target customer segments.
 Value-in-use. The difference between the value
customers place on functions, cost savings, and
relationships attributable to a product or service and
the life cycle costs of acquiring, maintaining, and
disposing of the product or service.
OPTIMAL DIFFERENTIAL PRICE LEVELS
 The first step in setting optimal differential prices is
then to estimate demand by market segment—say,
for each of two customer classes (business and
nonbusiness air travelers) on the Thursday 11:00 A.M.
flight from DFW to LAX.
 The expense account business traveler tends to make
less flexible travel plans and reserve space later and
thus faces fewer close substitute alternatives than the
nonbusiness traveler.
 Average revenue and marginal revenue schedules for
business travelers therefore prove to be less price
elastic than for nonbusiness travelers, as indicated in
Figure 14.1.
Graphical Approach
 Previously, the airline’s capacity planning department
will have summed all the expected marginal revenues
E(MR) from the various segments and determined an
optimal total capacity by setting summed marginal
revenue [ΣE(MR)] equal to the marginal cost of the
last seat sold (MClss).
 The result in Figure 14.1 is that a plane with 170 seats
should be scheduled for the Thursday 11:00 A.M.
flight departure.
 One may think of the optimal differential pricing
decision as determining how this total capacity of 170
 seats should be allocated across the customer  Expected marginal revenue is the increase in total
segments. revenue realized from selling one more seat in the
 Because at the margin a firm forgoes revenue unless business class.
the last customer in each segment contributes a  For example, when a single seat is sold at $1,084, total
marginal revenue equal to the marginal cost of the revenue is also $1,084.
last seat sold (MClss), the optimal allocation of seating  When two seats are sold at a fare of $1,032, however,
capacity results from equating the segment-level MRs total revenue jumps to $2,064, and marginal revenue,
to one another: which is the difference in total revenue realized from
 MRbus = (MClss) = MRnonbus [14.1] selling one more seat, is $2,064 minus $1,084, or
$980.
 which in Figure 14.1 is at MR = $130. Consider a case
 Similarly, the marginal revenue associated with the
in which this condition does not hold.
third seat sold is $2,922 minus $2,064, or $858.
 Suppose the 62nd seat sold in the business class
 Table 14.2 also shows corresponding information for
contributed $160 of marginal revenue and the 108th
leisure-class passengers.
seat sold in the nonbusiness class contributed $120.
 Note that the first leisure-class seat is sold at $342,
Clearly, one could raise $40 additional revenue for
the second at $331, and so on.
unchanged costs by selling one less seat in
 The last two columns depict total seats sold and
nonbusiness and one more in business, leaving both
marginal cost, which is the variable cost associated
classes with, say, an MR = $130.5
with serving one additional passenger in either class.
 What prices can achieve the capacity allocation of 63
 Using this simple two-booking-class example, marginal
seats to the business class and 107 seats to the
revenue equals rising marginal cost at $130 per seat.
nonbusiness class? The answer is deceptively simple.
 (Marginal cost increases by steps with the addition of
 Optimal differential prices are whatever asking prices
flight attendants needed to serve additional
will clear the market if the firm supplies 63 and 107
passengers and the additional fuel consumed because
seats in these two fare classes.
of worsening aerodynamics at high load factors.)
 In Figure 14.1 the answer appears to be $261 and
 At MC = $130, optimal fares are obtained by equating
$188 with some effective barrier or “fencing” that
individual marginal revenues of both segments and
prevents resale from the lower to the higher fares.
the marginal cost of the last seat expected to be sold
 The difficulty, of course, is predicting demand
(the 170th seat in this example).
sufficiently well to know what prices will have this
 Business and leisure traveler marginal revenues equal
effect for the 11:00 A.M. flight next Thursday.
$130 at 63 and 107 seats, respectively, and fares of
 To find aggregate demand, remember that individual
$261 and $188 are optimal at these seat allocation
demands (and MRs) are horizontally summed for rival
levels.
goods that cannot be shared (such as airplane seats
and bite-sized candy bars), whereas demands for Multiple-Product Pricing Decision
nonrival goods (e.g., outdoor statues, tennis courts,  Figure 14.2 illustrates an analogous decision with five
and national defense) are vertically summed. products; D1 represents the demand for Product 1, D2
 Note that the MR of each segment is not set equal to for Product 2, and so on.
MC. Rather, the summed MR of all segments has been  Again, profits are maximized when the firm produces
set equal to MC. The individual MRs are set equal to and sells quantities of the five products such that
the MC of the last unit sold (i.e., $130), and therefore marginal revenue is equal in all markets and equal to
equal to one another. marginal cost.
 The line EMR represents equal marginal revenue, the
Algebraic Approach
firm’s marginal revenue opportunity in other product
 Table 14.2 shows the spreadsheet data on which such
lines.
a decision would be based in practice.
 Because it is assumed that new product markets were
 The first three columns show the number of seats
entered in order of their profitability, the prices
demanded, fares, and marginal revenue for business-
charged for the five products are arranged in declining
class travelers.
order, from P1 to P5, and the elasticity of demand
 For example, at a fare of $1,084, only one seat on the
increases from D1 to D5.
entire plane would be sold, and it would go to a
 The height of the EMR line is determined by the
business-class passenger.
intersection of the firm’s marginal cost curve MC and
 If the fare falls to $1,032, two seats are taken by
the marginal revenue curve for the last product
business-class passengers.
market that may be profitably served, MR5 at Q5.
 At a fare of $974, three seats are taken, and so on.
 The equilibrium condition in the marginal market D5
where P, MR, and MC are virtually equivalent
illustrates the well-known fact that nearly all firms
produce some products that generate little or no
incremental operating profit and are on the verge of
being dropped or replaced because the contribution
margin approaches zero.
Differential Pricing and the Price Elasticity of
Demand
 In all of the preceding examples, an inverse
relationship exists between optimal price and the
price elasticity of demand in separate submarkets.
 Recall that for profits to be maximized, marginal
revenue must be equal in each of the separate
submarkets.
 In Chapter 3 the relationship between marginal
revenue (MR) and price (P) was shown to be the
following (Equation 3.7):

 where ED is the price elasticity of demand. If P1, P2,
E1, and E2 represent the prices and price elasticities in
the two submarkets, we may equate marginal revenue
by setting equal
Hence,
 Perhaps JetBlue Airways has determined that the price
elasticity of demand for two customer segments (New
York to Los Angeles unrestricted coach and for Super
Saver Saturday night stay overs) is −1.25 and −2.50,
respectively.
 To determine the relative prices (P1/P2) that JetBlue
should charge if it is interested in maximizing profits
on this route, substitute E1 = −1.25 and E2 = −2.50
into Equation 14.4 to yield
or
 Thus the price of an unrestricted coach seat (P1)
should be 3.0 times the price of a Super Saver coach
seat (P2).
 Price elasticity is the key; the larger the number of
close substitutes, the higher the price elasticity of
demand, and therefore the lower the optimal markup
and price-cost margin.
 In electricity pricing, industrial customers such as
factories and hospitals can now buy their power from
competing public utilities.
 The industrial customer has so many more close
substitute alternatives that the price per kilowatt hour
is less than half the price of residential or small
commercial users.
 Again, the higher the price elasticity, the lower the
optimal price, ceteris paribus.
 The increase in profitability from engaging in
differential pricing as opposed to uniform pricing
across all customer segments can be illustrated with
the following example.
DIFFERENTIAL PRICING IN TARGET MARKET
SEGMENTS
 After identifying the different value drivers for various
segments of the target market and setting an optimal
differential price, firms must prevent resale between
the segments using a variety of “fences.”
 Two of the most frequent methods of direct
segmentation that prevent resale involve
intertemporal pricing (1) by time-of-day or day-of-
week and (2) differential pricing by delivery location.
 Congestion-based pricing at peak-demand periods on
roadways, bridges, and subway systems is an example
of intertemporal pricing, illustrated in Figure 14.4.
 Peak-period-drivers place demands on the Dulles toll
road between 6:00 A.M. and 9:00 A.M. far in excess of
its carrying capacity (QC).
 Charging commuters, a toll equal to just the wear and
tear imposed by their vehicle passing over the toll
road pavement (i.e., an off-peak marginal cost, MCOP)
induces many more cars to enter the highway (QPEAK)
than can be accommodated (i.e., QP > QC).
 The result is slowdowns, stoppages, and a markedly
increased travel time for each commuter.
 Beyond QC, the traffic volume at which this
congestion begins, MCP rises steeply, representing the
incremental fuel and time costs imposed (by one
additional car) on all the other drivers along a 10-mile
stretch of congested toll road.
 The advantage of a congestion toll such as (PP –
MCOP) = $2 is that it induces discretionary peak-
period travelers to switch to other travel times and
alternative modes of transportation.
 If a toll road authority set peak-period prices of $3 just
sufficient to cover this congestion cost plus the off-
peak MC, traffic volume would decline from QPEAK
(POP) to QP, and the equilibrium differential prices PP
and POP would emerge.
 Such congestion pricing reflects the true resource cost
of the scarce transportation system capacity at peak
travel times.
 Like peak–off-peak roadway pricing, many other
examples of differential pricing entail charging
differential prices for the same capacity at different
times.
 Hence, such customers are not in rivalry for the same
capacity.
 Parking meters in San Francisco can now raise price
between 10:00 A.M. and 2:00 P.M.
 Coca-Cola has new cold drink machines that vary the
price by time of day, as well as by the predicted high
temperature for the day.
 The demanders of matinee ($5) and evening movie
theaters ($9) are not in rivalry for the same theater
seats.
 First-run movies and subsequent movie videos,
hardback and later paperback editions of books,
seasonal discounts in the resort and cruise ship
businesses, and weekend discounts in hotels all
represent effective segmentation of different target
customer classes by time of purchase.
 Congestion pricing. A fee that reflects the true
marginal cost imposed by demand in excess of
capacity.
Direct Segmentation with “Fences”
 Direct segmentation of target customer classes not in
rivalry with one another for the same capacity can
also be accomplished by selling various versions of a
product customized for target segments, or by varying
the price by delivery location.
 Customers who arrive at the suburban neighborhood
rental counters of Hertz and Avis have flexibly timed,
convenience-based uses for rental cars.
 Consequently, demand is much more price sensitive
than the demand at the airport by business travelers.
 A recent study found that weekday rates for a midsize
sedan were $43 in neighborhood rental locations
versus $69 on average in airport rental locations.
 Because round-trip taxi fares from airports to the
neighborhood locations would typically far exceed the
$26 price difference, Avis and Hertz customers are
effectively segmented by rental location.
 Another example of location-based segmentation
would be fashion clothing from France’s Arche or
Ralph Lauren sold less expensively in discount outlets
along interstate highways than in suburban
storefronts or vacation resorts.
 Outlet mall shoppers almost never overlap with the
customers these companies find in their trendy
boutiques.
 Hence, geographic segmentation works.
 Outlet shoppers will also buy a less costly, less durable
version of the product (e.g., a lighter-weight chemise
cloth in Polo golf shirts), so in differential pricing,
Ralph Lauren accomplishes more than just inventory
clearance without any danger of cannibalizing full-
price sales.
 So, total sales expands to address this new segment
created by the new location.
 Hal Varian and Carl Shapiro argued that such
“versioning” is an especially good way to sell
information economy items such as software.
 A voice recognition package sells for $79 as general-
purpose Voice ProPad, for $795 as Office Talk, and for
$7,995 as Voice Ortho, a special-purpose medical
transcriber for surgical theatres.
 All three versions derive from the same source code,
but the more comprehensive version generates 100
times as much value to particular target customers.
 In contrast, when Amazon sells the same book or DVD
at different prices to customers with different
clickstreams, that degree of differential pricing for
identical versions of the product often leads to
adverse customer reactions.
 Coca-Cola is finding the same resistance to its
differential time-of- day pricing in soft drink machines.
 As a result, many sellers adopt the techniques of
indirect segmentation using two-part tariffs,
couponing, and bundling. With indirect segmentation,
the customer herself selects what differential price to
pay from a variety of available alternatives.
Optimal Two-Part Tariffs
 Two-part tariffs entail charging both a lump-sum entry
fee for access to the facility or service and a per-unit
user fee for each unit sale consumed.
 Amusement parks, nightclubs, golf and tennis clubs,
copier leasing companies, cellular phone providers,
Internet access providers, and rental car companies
often employ such pricing.
 Their revenue per unit sale is a nonlinear function of
two parts: a lump-sum monthly or daily fee that
provides access to the facility, phone, computer, or
rental car independent of use, and a per-hour or per-
minute or per-mile fee that varies with usage.
 The magnitude per unit of user fees should at least
cover marginal costs so that heavy demanders “pay
the freight” through higher total user fees.
 Tying the price for a leased copier to a metering
counter that effectively measures intensity of use
results in a differential monthly leasing fee across
customer segments plus a cheap incremental cost per
copy.
 Companies differ on whether to set high or low entry
fees and whether to charge high or low user fees.
 AT&T Wireless and Gillette practically give away their
cell phones and razors but then charge steep prices
for the calls and blades.
 In contrast, iPods are pricey at the front end but
iTunes thereafter are quite cheap.
 Similarly, most golf and tennis clubs charge substantial
membership fees and annual dues, but thereafter
adopt trivial user fees (e.g., $5 per court hour or $25
for greens fees).
 As we will see, just how much above marginal cost to
set the optimal user fee depends on how dissimilar
are the segments of customer demand.
 Let’s investigate how to analyze an optimal two-part
tariff.
 Consider the situation depicted in Figure 14.5 for
separate customer segments with relatively elastic
(D1) and relatively inelastic demand (D2) for rental
autos.
 These might be young couples who are renting cars
for vacationing (D1) and manufacturers’ trade
representatives renting cars for making sales calls
(D2).
 The challenge is to find a uniform daily rate (the lump-
sum access fee) and a mileage charge (the user
charge) that maximize profit and keep both customer
segments in the market.
 One alternative would be to price the mileage at its
marginal cost (MC) = height OA and elicit Q1 and Q2
usage from each segment while realizing from both
the maximum daily rate that the price-sensitive
vacationer along D1 will pay (namely, hatched area
AEF).
 Perhaps, however, a better alternative is available.
Suppose the car rental agency raises the mileage
charge to P* and reduces the daily access fee to the
hatched and shaded area P*DF.
 Mileage will decline in both segments (to Q0 1 and Q0
2, respectively), and area P*DEA will be net revenue
lost by virtue of the reduced daily access fee in both
segments.
 However, the additional net revenue from mileage
charges (P*DGA in one segment and P*HIA in the
other segment) will more than offset the lost access
fees.
 In particular, profits of the car rental agency will
increase by the difference of area DHIE—area DEG.
 This result is generalizable to other optimal two-part
tariff decisions.
 Consequently, in addition to charging a positive lump-
sum access fee, a price-discriminating monopolist will
adopt two-part tariffs that price usage above its
marginal cost.
 The more similar the price elasticity of demands of the
target customer segments, the closer the user charge
should be to marginal cost.
 The more dissimilar the segment demands, the higher
the user charge should be raised above MC.
Couponing
 Another pricing mechanism for indirectly segmenting
the market and allowing the customer to select what
level of consumption and total price to pay is
couponing.
 The $49 billion spent on direct-mail marketing with
accompanying rebate and coupon offers surpassed
the amount spent on newspaper ($45 billion) and
television ($43 billion) advertising for the first time in
the United States in 2003.
 This direct marketing approach is made possible by
successful forecasting based on consumer spending
patterns.
 Companies have access to cash register and credit
card data as well as property tax and public utility
usage records.
 These sources allow Lowe’s Home Improvement, for
example, to project with more than 80 percent
accuracy the month in which a particular household
will buy a gas grill.
 Such laser-like precision in targeting encourages
differential pricing.
 If coupons worth 25 cents off the price of a box of
cereal, 40 percent off the price of fashion clothing, or
$50 rebates off the price of an expensive gas grill are
redeemed religiously by some segments but ignored
by others, Kellogg, Neiman Marcus, and Lowe’s will
segment the market with these direct mail
promotions.
 The price-sensitive customers who constantly redeem
coupons and file for rebates receive a lower net price,
consistent with Equation 14.4.
Bundling
 Bundling is another highly effective pricing mechanism
that sellers use to capture profit from differential
pricing across target customer segments.
 Have you ever wondered why Time Warner Cable
offers Showtime, the channel for popular first-run
movies, only in a bundled package that includes the
History channel?
 One insight is that this paired bundle of product
offerings occurs because some other Time Warner
customer is a history buff who is wondering why the
History channel comes with access to largely
unwatched movies.
 That is, the operating profit to a seller from bundling
negatively correlated demands is always larger than
the operating profit from selling equally costly
products separately.
 Let’s see why.
 Suppose that two sets of customers have the
following reservation prices for two cable channels,
each of which incurs variable licensing fees of $1 for a
single showing to a single household. Movie buffs
would pay $9 for access to first-run movies and $2 for
access to historical documentaries.
 History buffs would pay $8 for access to the History
channel and $3 for access to Showtime.
 If the channels are priced uniformly to both customer
segments as separate products, Time Warner can
realize at most $8 (or $9 – $1) on Showtime and $7 (or
$8 – $1) on the History channel for a total of $15
operating profit.
 However, note that both types of customers would
pay up to $11 for the combined pair of channels
rather than do without.
 If Time Warner made them available only as a bundled
package, sales revenue would be $22 minus $4
licensing fees for a total of $18 operating profit, which
is greater than the $15 we previously calculated.
 As long as one customer is willing to pay more for
product A that another customer wants less than
product B, the seller who is restricted to charging the
two customers the same uniform price will always be
better off bundling the two items, assuming all
reservation prices exceed variable cost.
 Such inversely correlated demands occur in many
settings.
 All-inclusive Caribbean resorts such as $595 per day
Bitter End on Virgin Gorda or Hotel Isle de France in St.
Bart’s have guests who value $75 gourmet lunches
and $350 per night fabulous cabanas but would not
pay much for all the water sports activities and
equipment, while other guests value $170 per day
water sports activities but would not pay such high
prices for better food or cabanas.
 Similarly, Elizabeth Arden’s $225 all-inclusive half-day
spas have clients who would not pay high-margin $50
prices for at least one of the following five services:
facials, mud wraps, massage, manicures, and
pedicures.
 Bundling all these services together always raises
profitability when target customer demand is
inversely correlated across the offerings as long as
variable costs of the separate components are below
the customers’ willingness to pay for each.
 Now suppose the variable costs are higher at, say, $3.
 The History channel valued at $2 by the movie buff is
no longer a profitable sale.
 Pure bundling includes this unprofitable sale and
generates the same $22 revenue but now incurs $12
of total variable cost, yielding a profit of only $10.
 Forgoing the sale of the History channel to the movie
buff by selling each product separately at a $9 price
for Showtime and an $8 price for the History channel
generates $6 (or $9 – $3) on Showtime and $5 (or $8 –
$3) on the History channel, yielding a total of $11
operating profit.
 Quite intuitively, pure bundling will be less attractive
than pricing separately when some of the bundled
sales are unprofitable.
 It is also easy to see why positively correlated demand
across customers works against bundling.
 Figure 14.6 displays reservation prices along a
“budget” line that our customers in the earlier
example are willing to spend on the two products.
 The y-intercept is the total willingness-to-pay
constraint for the two products—namely, Ph + Pm =
$11.
 With Showtime reservation prices on the vertical axis
and History channel reservation prices on the
horizontal axis, each customer’s mix of reservation
prices lies along the line Pm = $11 − 1Ph [14.12]
 The −1 in Equation 14.12 signifies the perfect negative
correlation between the reservation prices (demand)
of our movie buff and those of our history buff.
 But suppose Time Warner has a third type of customer
whose reservation prices are positively correlated with
those of the movie buffs—that is, a third type of
customer who values Showtime at $8 and the History
channel at $5.
 These reservation prices are high when the movie
buff’s reservation price is high and low when the
movie buff’s reservation price is low.
 Such positively correlated demand lies above the
budget constraint in Figure 14.6 because the total
willingness to pay on the left-hand side of Equation
14.12 is no longer $11 but rather is now $13, as shown
for Point 3.
 With positively correlated demands across two of the
three customer types, Time Warner could sell the
Showtime-History bundle to all three for $11 and earn
$15 [3 × ($11 − $6)].
 However, a better alternative is available. Mixed
bundling sells the products both separately and as a
bundle with the bundled price discounted below the
sum of the two separate prices.
 In our three-customer-type example, Time Warner
could sell Showtime for $9 and the History channel for
$8, while making the Showtime-History bundle
available for the package price of $13.
 The third type of customer would opt for the bundle,
whereas each of the other types of customers would
buy one product only.
 Revenue for this mixed bundling approach totals $30,
but only four license fees are required, therefore
earning $18 in profit. In general, pure bundling
generates less profit than mixed bundling when
positively correlated demands are involved.
 That’s why Arden’s salons sell their beauty treatments
bundled for $225 or $50 each.
 Figure 14.6 can be used to characterize the
attractiveness of pure bundling for the seller.
 If all customers have perfectly negatively correlated
demands, their reservation prices lie, as we have seen,
along the $11 budget constraint.
 If customers have positively correlated demands, their
reservation prices will lie consistently either above or
below this reservation budget constraint.
 With separate product prices of Pm = $9 and Ph = $8,
customers with reservation prices in Quadrant I will
always buy both products rather than one of the
separate products alone (Quadrants II and IV) while
those in Quadrant III will never buy either product
sold separately.
 In addition, however, we know that customers with
reservation prices above the reservation budget
constraint will buy the bundled package and those
below will not.
 Optimally, Customer 3 will therefore purchase the
bundle, Customer 1 will purchase Showtime alone,
and Customer 2 will purchase the History channel
alone.
 Only mixed bundling can achieve this result.
 To summarize, two-part tariffs, couponing, and
bundling are pricing mechanisms that induce
customers to segment themselves indirectly.
 Two-part tariffs are particularly effective in capturing
higher profits than uniform prices when customer
segments are more nearly identical in their price
elasticity of demand.
 Couponing works best when target segments are
extraordinarily different in their price elasticity of
demand.
 Bundling captures additional profit when segmented
target customer demand is inversely correlated across
multiple products.
 Reservation prices. The maximum price a customer
will pay to reserve a product or service unto their own
use.
 Mixed bundling. Selling multiple products both
separately and together for less than the sum of the
separate prices.
Price Discrimination
 Price discrimination is defined as selling the same
product or service out of the same distribution
channel at different prices to different buyers during
the same period of time.
 Examples of price discrimination include the following:
• Doctors, dentists, hospitals, lawyers, and tax
preparers who charge clients who reside in
wealthy zip codes more for the same service than
those who reside in poorer zip codes
• Dell Inc.’s ultralight laptop, which it sells for
$2,307 to small business customers, for $2,228 to
health care companies, and for $2,072 to state
and local governments
 Most differential pricing to a firm’s retail customers is
perfectly legal.
 It raises profits because it transfers some of the excess
customer value (the satisfaction gained from the
purchase of the product) from buyer to seller relative
to the excess value generated for customers who pay
a lower uniform price.
 If a coffee aficionado were willing to pay $4.00 for a
large cup of fresh brewed java for which Dunkin’
Donuts charges $1.95, and $5.00 for the same cup of
fresh brewed java bundled (on request) with a shot of
espresso for which Starbucks charges $3.50, the
consumer’s excess value would decline from $2.05 at
Dunkin’ Donuts to $1.50 at Starbucks.
 Nevertheless, in the case where this customer
declines the shot of espresso, Starbucks must have
offered something else of value because the
customer’s willingness to pay rose from $4.00 to
$5.00.
 If this customer kept returning to Starbucks, we
should assume that the lifestyle and group identity
available at Starbucks attracted his or her business.
 When Nationwide and GMAC auto insurance lower
rates based on the reduced theft and collision risk
exposure of the places you drive, that is not price
discrimination.
 A GPS tracking device in the car confirms that the loss
protection service is different.
 In the limiting case of perfect price discrimination
(PPD), sometimes called first degree price
discrimination, the seller discovers the maximum price
each individual is willing to pay for each unit
purchased.
 A PPD monopolist then charges each purchaser this
maximum reservation price in order to capture the
consumer’s entire perceived excess value above the
cost-covering price.
 However, because the information required for such
pricing is so extensive, perfect price discrimination
almost never occurs. Instead, as we have seen in
studying two-part tariffs, couponing, and bundling,
firms often price discriminate by allowing customers
within indirectly segmented groups to determine their
own price through intensity of use, redemption
behavior, or selection of packages of products such as
Disney World entrance fees (so-called second-degree
price discrimination).
 Finally, firms may attempt to price discriminate
through directly segmenting classes of customers by
time or location of purchase and then charging one
 uniform price within each customer class (so-called
third-degree price discrimination).
 The Robinson-Patman Act prohibits price
discrimination in wholesale business-to-business
transactions where the product is going to be resold
but allows whatever the market will bear in retail
transactions not accompanied by duress,
misrepresentation, or outright fraud.
 Price discrimination. The act of selling the same
good or service, distributed in a single channel, at
different prices to different buyers during the same
period of time.
PRICING IN PRACTICE
 To this point, the chapter discussed firms that seek to
maximize short-run profits.
 However, pricing is an area where a longer-run life
cycle view of the firm’s decision making is helpful.
Product Life Cycle Framework
 In the early stages of life cycle pricing, the marketing,
operations, and financial managers decide what the
customer will value, how the firm can manage the
supply chain to consistently deliver those
characteristics, and how much it will cost, including
the financing costs.
 If the value-based prices can cover this long-run full
cost, the product becomes a prototype.
 Each proposed product or service then proceeds to
marketing research, where the demand at various
price points in several distribution channels usually is
explored.
 Marketing research will identify a target price that the
cross-functional product manager or the general
managers will know is required on average over the
product life cycle in order for the new product to
provide sufficient revenue to cover fully allocated
cost.
 Once a product or service rollout takes place (usually
at target price levels), the marketing plan often
authorizes promotional discounts.
 In this stage of the life cycle, the firm is interested in
penetrating the market.
 To do so requires coupons, free samples, name
recognition advertising, and slot-in allowances on
retail shelves.
 Penetration pricing therefore characterizes this early
stage of the product life cycle at which net prices to
the manufacturer fall below the firm’s target price, as
shown in Figure 14.7.
 When a new product is introduced by a firm, pricing
for that product is a difficult and critical decision,
especially if the product is a durable good—one that
has a relatively long useful life.
 The difficulty of pricing the new product comes from
not knowing the level of demand with confidence.
 If the price is initially set too low, some potential
customers will be able to buy the product at a price
below what they are willing to pay.
 These lost profits will be gone forever.
 This problem is accentuated when the firm initially has
limited production capacity for the new product.
 Under these circumstances, many firms adopt a
strategy of price skimming, or pricing down along the
demand curve.
 The initial price is set at a high level, even though the
firm fully intends to make later price reductions.
 When the product is first introduced, a group of
fashion-conscious or technology-conscious early
adopters will pay the high price established by the
firm.
 Once this source of demand is exhausted, the price is
reduced to attract a new group of customers.
 Flat-screen TVs and handheld computers such as the
Blackberry and Palm’s Treo are excellent examples of
this phenomenon.
 As we discussed in Chapter 13, manufacturers who
engage in price skimming on industrial equipment
(e.g., mainframe computers and corporate jets) need
credibility mechanisms to assure early full-price
customers that later discounting will be limited.
 In the mature stage of the product or service life cycle,
organic growth comes from focusing on product
differentiation and commitment to building the brand.
 Marketing team initiatives will add value in both
product refinements and order management
processes through brand-name advertising, product
updates, or increased flexibility in accepting change
orders from regular customers.
 Each decision at this mature stage is motivated by a
desire to realize the highest value-based pricing
allowed by the competitive conditions and potential
entry threats.
 Although at times this approach to pricing can be
overwhelmed by the necessity of short-term tactics to
defend market share, the product life cycle remains a
planning framework to which the pricing manager
often returns.
 At a late mature stage of the product or service life
cycle, product managers may decide to limit price,
reducing it well below the value-based pricing level in
order to deter entry.
 Limit pricing appears to be inconsistent with profit
maximization but in fact is motivated by a long-term
profitability objective.
 Because competitors are constantly devising lower-
cost ways of imitating leading products, limit pricing
sometimes has only temporary success.
 If the entry threat materializes into a real live new
entrant, many incumbent firms then decide to
accommodate by raising prices in a particular high-
price, high-margin market niche.
 This pricing practice is often referred to as niche
pricing.
 Concluding that declining market share from entry
into the mass market is inevitable, the incumbent
moves upmarket and sells its experience and expertise
at high prices in the top-end segments of the market,
much as it did at the start of the product life cycle.
 Life cycle pricing. Pricing that varies throughout the
product life cycle.
 Price skimming. A new-product pricing strategy that
results in a high initial product price being reduced
over time as demand at the higher price is satisfied.
Full-Cost Pricing versus Incremental Contribution
Analysis
 Some inadvisable pricing practices are widely
adopted: two examples are full-cost pricing and target
return-on-investment pricing.
 Full-cost pricing requires that not only direct fixed
costs of a particular product line such as licensing and
maintenance and advertising be considered in pricing,
but even indirect fixed costs of overhead and capital
financing be added to variable costs to arrive at a final
price.
 Indirect costs may be allocated among a firm’s several
products in a number of ways.
 One typical method is to estimate total indirect fixed
costs assuming the firm operates at a standard level of
output, such as 70–80 percent of capacity, and then
allocate the indirect costs by volume.
 Target return-on-investment pricing begins by
selecting an acceptable profit rate on investment,
usually defined as earnings before interest and taxes
(EBIT) divided by total gross operating assets.
 This return is then prorated over the number of units
expected to be produced over the planning horizon.
 Advocates of full-cost and target return pricing argue
that it is important to allocate all fixed costs among
the various products produced by the firm and that
each product should be forced to bear its fair share of
the fixed-cost burden.
 However, each product should instead be viewed in
the light of its incremental contributions to covering
the business plan’s fixed costs.
 Incremental contribution analysis provides a better
basis for considering whether the manufacture and
sale of a product should be expanded, maintained, or
discontinued in favor of some higher-profit
alternative.
 Every firm should have an effective control system in
which a general manager continually monitors the
overall contribution of the firm’s complete product
line.
 This person can then ensure that value-based prices
contribute to both the variable cost of each product
and the total fixed costs of the firm.
 Such target pricing is especially relevant at the launch
of a product line and later at the decision to exit (see
Figure 14.7).
 Full-cost pricing. A method of determining prices
that over overhead and other indirect fixed costs, as
well as the variable and direct fixed costs.
 Target return-on- investment pricing. A method of
pricing in which a target profit, defined as the (desired
profit rate on investment × total gross operating
assets) is allocated to each unit of output to arrive at a
selling price.
 Incremental contribution analysis. An incremental
managerial decision that analyzes the change in
operating profits (revenue – variable costs – direct
fixed costs) available to cover indirect fixed costs.
Pricing on the Internet
 E-business encounters several problems unique to
Web-based transactions.
 First is the anonymity of buyers and sellers who often
are identified by only a Web address.
 Offers to buy (and sell) may be reneged, receivables
may never be collected, and items delivered may not
be what buyers thought they had bought.
 The incidence of all these events is much greater in
the virtual sales environment.
 As a result, offers are higher, and bids are lower.
 From another perspective, the bid-ask spread in an
Internet transaction rises to cover the cost of fraud
insurance.
 A second problem that the Internet accentuates is the
inability to confirm variable product quality with
hands-on examination.
 Internet pricing of commodity products such as crude
oil, sheet metal, and newsprint paper, shown in Table
14.4, often pursues a low-cost strategy.
 The availability of quick resale at predictable
commodity prices reassures buyers and sellers, and
here Internet pricing at tight bid-ask spreads proves
quite efficient.
 However, as one moves to the right in Table 14.4,
product quality becomes harder and harder to detect
at the point of sale.
 Firms such as Amazon and CDNow seek to substitute
brand equity for the inability of customers to examine
the product.
 America Online (now AOL Inc.), Amazon, and Priceline
spent tens of millions of dollars establishing their
brand equity.
 When it comes to toys, suits, homes, and new autos,
consumers search for that look-and-feel for which
they’re willing to pay.
 Brands again play an important role in certifying
quality, but in this case, it is product branding (e.g.,
Game Boy, Hart Schaffner Marx, Harris Tweed) that
matters, not Web site brands.
 Customers rely on the hostage associated with the
sunk cost investment in the product brand names to
establish credibility.
 Finally, with highly variable quality in tires, PCs,
produce, and lumber, only strong warranties, escrow
accounts, and replacement guarantees or deep
discounts can replace the reputation effects that help
sell these experience goods in nonvirtual settings.
 Internet sellers can add value and reduce some
transaction costs in these markets by customizing and
selling direct to the customer like Dell, who provides
order fulfillment and manufactures almost nothing.
 For this reason, services have grown quickly on the
Net; the travel industry itself accounted for 35 percent
of all online sales in 2002.
 Table 14.5 shows that the growth rate of services far
surpassed growth in consumer products online.
 In business-to-business (B2B) transactions, pricing is
more complex than in business-to- consumer
transactions.
 In B2B, multiple attributes come into play in the price
negotiation.
 B2B customers haggle over date of shipment, delivery
costs, warranty service times and locations, delivery
reliability, and replacement guarantees.
 These additional considerations typically mean pricing
is a part of a two- or three-step process.
 First, customers match their nonnegotiable
requirements to the suppliers with those attributes,
and those firms become the order-qualified suppliers.
 Then, the remaining attributes may be negotiated
away against demands for a lower price point.
 In the heyday of the Internet bubble, B2B Internet
sales grew twenty-fold from $8 billion in 1997 to $183
billion in 2002; see Table 14.5.
 Internet pricing in these B2B settings requires a
matching process to qualify for an order and then a
dynamic pricing algorithm to trade off the remaining
attributes.
 Information technology complexity in these B2B
transactions arises because customers are
heterogeneous, and the attributes that qualify a firm
to supply one group of customers may not match the
requirements of other customers.
 In addition, as we shall see in the next section,
delivery reliability (i.e., the probability of stockout and
back order) is a continuous variable that should be
optimized with a revenue management solution, not a
simple on-again/off-again attribute to promise or
refuse a potential customer in exchange for a
somewhat larger or smaller markup.
 Dynamic pricing. A price that varies over time based
on the balance of demand and supply, often
associated with Internet auctions.
SUMMARY
 All pricing decisions should be proactive, systematic-
analytical, and value-based, not reactive, ad hoc, and
cost-based.
 Two conditions are required for effective differential
pricing:
 One must be able to segment the market and prevent
the transfer of the product (or service) from one
segment to another.
 Differences in the elasticity of demand at a given price
between the market segments must be discernible.
 To maximize profits using differential pricing, the firm
must allocate output in such a way that marginal
revenue is equal in the different market segments.
 Differential pricing is often implemented through the
direct segmentation of intertemporal pricing or pricing
by delivery location.
 Indirect segmentation to support differential pricing is
often accomplished through two-part pricing.
 Optimal two-part prices entail a lump-sum access fee
and a user charge that equals or exceeds marginal cost
and varies with units consumed.
 Couponing is another way to price discriminate while
charging the same list prices to different customers,
some of whom are highly price sensitive and will
redeem coupons and others who will not.
 Bundling is a third pricing mechanism that indirectly
segments customers with inversely correlated
demand across multiple products.
 Price discrimination is the act of selling at the same
time the same good or service produced by a given
distribution channel at different prices to different
customers.
 A good’s pricing strategy varies throughout the
product or service’s life cycle.
 A frequent pattern is target pricing, followed by
penetration pricing, price skimming, value-based
pricing, limit pricing, and finally niche pricing.
 Full-cost pricing and target pricing are inconsistent
with the marginal pricing rules of economic theory.
 Incremental contribution analysis is a widely
applicable method of economic analysis that can help
pricing managers achieve a more efficient and
profitable level of operation.
 Pricing on the Internet suffers from anonymity and
lack of reputation effects, along with search across
various product qualities being especially difficult to
verify prior to purchase.
 These complications imply distinctly different pricing
approaches for commodity-like products, search
goods, and experience goods.
 B2B pricing on the Internet requires a two-step
process of multi-attribute matching to qualify for
consideration as a supplier and then a dynamic pricing
scheme to trade off additional features and functions
as sources of value-in-use against lower price point
alternatives.
 Yield management (YM) or revenue management
(RM) consists of pricing and capacity allocation
techniques for fixed-capacity manufacturers or service
firms with perishable inventory and random demand.
 Flexible manufacturing systems and production-to-
order with JIT delivery can seldom fully resolve the
spill and spoilage problems addressed by RM.
 RM provides an optimal order acceptance and refusal
process with cross-functional resolution of account
management, demand forecasting, and scheduling
decisions.
 Proactive price discrimination equates the marginal
revenue from different segments of the target market.
 It does so with differential value-based prices that
reflect delivery reliability, change order
responsiveness, scheduling convenience, conformance
to expectations, and the value of these service quality
characteristics to the particular class of customers
(i.e., third-degree price discrimination).
 RM reallocates inventory or service capacity in
accordance with the condition (P − MC)a(Prob
Shortage)a = (P − MC)b.
 This procedure identifies optimal protection levels for
high-margin segments, accounts, and customers and
an optimal authorization level for release of capacity
to lower-margin segments, accounts, and customers.
 The optimal overbooking decision equates the
declining marginal cost of spoilage as load factor or
capacity utilization increases with the rising marginal
cost of spill (i.e., oversales).