Introduction

Service pricing in practice

We live in a world today where a cinema ticket can be obtained for 20p, flight
tickets at £1, songs at 55p and where even the most discerning marketer might
wonder if the pricing for services has gone mad, or if not, perhaps a little out of
control. To top it all, there are now multiple prices for buying any service,
depending on where you are, who you are, why, when and how you are buying.
With new technologies, the capability of firms to offer even more innovative
pricing options is set to grow1 (See Table 1.1).

Table 1.1 When is a buyer charged different prices?

For consuming the same service, Examples

different prices are charged for

When you buy

How much/many you buy
Where you buy
Your age
Your gender
Your health
Your nationality
How many people want it
How much capacity is left
Time of consumption
How much effort you put in
How much effort the firm puts in Haircuts for long hair are more expensive,
Duration of service
How uncertain you are
How much choice you want
How long you are willing to wait Medical services, first class vs second class mail
How ‘smart’ you are
How desperate you are
Whom you buy from
Hotel and flight reservations
Size of loan, text or voice bundles on your mobile
phone
Roaming charges on your mobile, withdrawing cash
around the world, internet bookings
Child fares, senior citizen discounts
Drinks at the club on Ladies night
Life insurance premiums
EU vs international tuition fees at universities
Auctions
Low-cost carrier flights
Weekend vs weekday hotel rates
Home delivery of groceries vs going to the
supermarket
house cleaning services depend on size of house
Phone calls
Insurance
Cable/satellite TV bundles
Bursaries and scholarships for education
Discounted theatre tickets at the last minute or very
high price match tickets
Agent discounts for travel
2 Introduction
Adding to the complexity of pricing is the fact that many services are bundled
with goods, or may be a facilitating service between two or more services and/or
goods e.g. a mobile payment service. Yet, price complexity may be useful to
service firms, as the customisation (versus commoditisation) of a service arising
from a more direct contact with buyers may result in the buyer being less able to
compare prices and consequently, provide more market power to the firm.2
In addition, e-commerce has provided firms today with better access to
buyers’ data. This enables them to do all sorts of demand-based pricing, and to
have far better tailored strategies to reach out to the market. Nowhere is this
more obvious than on the internet, with its proliferation of pricing techniques.
Dynamic pricing models that capture live data that in turn, feeds into systems that
could churn out tailored offerings, are no longer a surprise to the internet buyer.
Box 1.1 provides some examples.

Box 1.1 Examples of pricing techniques on the internet

1 Attribute-driven/customisable service pricing allows buyers to choose
the attributes they want and the firm prices accordingly, e.g. choosing
channels on a satellite or cable service, travel packages where you
choose the different types of add-ons etc.
2 Capacity/Time-based pricing is often used when services are sold
based on how much capacity has been used up. Hence, when there is
ample capacity, the price is low and as the capacity is used up, the
price starts moving up too. This is very common with airlines and
train companies where the price changes with time as capacity is sold
off.
3 Subscription is the charging of buyers on a regular basis for availabil-
ity and access to a service, e.g. online newspapers, music on demand
(see Figure 1.1). This is increasingly popular as it enables the firm to

Figure 1.1 Music is now available to subscribers (source: napster.co.uk).

 Introduction 3
establish a relationship with the buyer. Often, subscription is also
bundled with usage (e.g. efax.com). This method allows the buyer to
have flexibility in terms of when they wish to consume the service.
Subscriptions are also used for services that need to be updated, e.g.
anti-virus software. Microsoft Windows, interestingly, moved from
being a good (i.e. software) to a service with updates given out to
subscribers throughout the lifetime of use.
4 A Dutch auction is a multiple-item listing of a product or service,
often used in auction sites such as Ebay. To illustrate, suppose a
Dutch auction has ten items for sale. The opening price for the items
is £10 each. After the listing opens, 20 people place equal bids for the
items at £10 each. If the listing were to close at this point, the first ten
people to bid would be declared the winners, because earlier bids take
precedence over later bids of equal amount (and in this case, quan-
tity). However, before the listing closes, a new bidder places a bid of
£30 for one of the items. Because this person has the highest bid,
he/she will most certainly win one of the ten items listed. The remain-
ing nine items are won by the first nine bidders who bid at £10.
However, because all bids clear at the lowest winning bid, the person
who bid £30 will only be required to pay £10 for the item. By bidding
over opening price, new bidders can essentially knock the earlier low
bidders out of the running. However, if there are not enough bidders
to satisfy the total quantity available in the listing, all bids will clear at
the opening bid.
5 With English auction listings, the price is raised successively until the
listing closes. The bidder must use the next highest bid increment
when making a bid. The highest bidder(s) at that time is declared the
winner and each bidder is required to pay the seller the amount of
their winning bid.
6 Bids (or reverse auction, as some might call it) allow the buyer to
name their price. For example, when buying a hotel room night, the
buyer chooses the town and dates, select the area where they want to
stay, select the star rating and names their price. If a bid is carefully
constructed, the buyer could potentially obtain a 4-star hotel at 2-star
prices. However, if the bid fails, the buyer has to wait 72 hours to put
a bid in with the same area and star rating combination. ‘Distressed
inventory’ - the hotel industry term for last-minute unsold rooms -
could go cheaply when the bid is made at the last minute. This is a
simple idea that came from Priceline.com back in 1998; the website
allowed buyers to bid on the many (some 500,000) airplane seats that
go unsold each day. The idea was launched by Priceline founder Jay
Walker, who firmly believed in the power of the internet, and his
concept ushered in a new era of internet pricing.
4 Introduction
Pricing has taken centre stage on the internet, where sites like kelkoo.com
assist buyers in finding the lowest prices for a variety of goods and services, and
lendingtree.com help find the lowest mortgages. These aggregator sites have
brought to the forefront issues of segmentation, channel and price. Where previ-
ously, firms could go about segmenting their markets, dealing with channel
issues in reaching out to them and finally deciding on pricing strategies, the
internet cuts through all boundaries and insist firms look at all marketing strat-
egies - from segmentation, positioning to product/service, channel, price and
even promotion - all at once, since a change in one strategy often entails modifi-
cations to the others.
The B2B (business-to-business) world on the internet is experiencing its own
revolution, where purchasing managers can now interact directly with vendors
over the Web, often finding vendors at B2B vertical portal sites like
verticalnet.com or alibaba.com. Sellers, as a result of having to customise their
offerings for each client, could tailor their orders to reap premium prices or
confirm high quantities without leaving their chairs. Purchasing managers can now
take advantage of the demand-based pricing sites similar to those for consumers.

The study of pricing

Pricing is the decision that a firm has to make on how much to charge for its
goods and services. The study of pricing involves, amongst others, the value
buyers have for the products, the quantity the firm is able to sell, the cost and
internal organisational implications, the competitive interaction of the pricing
decision and how to set a price that achieves the objectives of the firm. It sits
within the marketing discipline as one of the 4 ‘P’s of marketing; the point
between the firm and the buyer where the buyer casts a ‘verdict’ on the firm’s
overall marketing strategies through their willingness to buy at a particular price.
Closely related to the study of pricing is the study of price theory, historically seen
as the language of economists.3 There is, however, a stark difference between
the two.
Price theory. Price theory is concerned with the welfare of society and to
predict, with some accuracy, the behaviour of firms and buyers. These predic-
tions should be robust enough for an expert to make public policy recommenda-
tions. These recommendations in turn, will then lead to a ‘good society’, where
social welfare is optimised. What this means is that prices in the macroeconomic
environment play a crucial role to ensure that the market economy functions
well for the good of society. Prices are guideposts that indicate to policy makers
the health of the economy and how resources are being utilised.
There are three macroeconomic functions of price within price theory that
leads to a healthy economy4: allocative, stimulating and distributive. The alloca-
tive function uses price as a rationing tool, allowing the ‘haves’ to consume
more than the ‘have-nots’ and therefore channeling resources towards what to
produce and how much should be produced. At the efficient equilibrium, the
quantity demanded should be equal to the quantity supplied. This allocative
 Introduction 5
function is the primary justification for the perceived fairness of the market
system i.e. some people tend to judge that such a method of allocating resources
is fairer than to have an ideologically driven state allocating them, for example
in the case of a communist state. The stimulative function of price works by
incentivising firms to produce more when prices are high (as well as making the
market attractive for new firms to enter), and reducing output and investment in
industries where prices are low. The price system ideally operates to justify the
move of resources to industries that provide the highest returns, thereby ensuring
efficiency not just in the allocation of consumption but also of resources.
Finally, price has a distributive function. High prices lead to a transfer of income
from buyers to sellers while low prices allow for more to be purchased for the
same outlay and encouraging firms to increase output further.
Academic literature in price theory is often found in economic journals, with
the economy and society as the central focus. In the efficient equilibrium, even
though firms’ motivations may be profit, the pricing behaviours of firms could
still result in a ‘good’ society if competition plays its part. Clearly, the market
economy may not always be efficient. Adam Smith’s ‘invisible hand’ 5 doesn’t
always work well especially when firms’ objectives may not be profit maximisa-
tion, and if marginal analysis (i.e. marginal revenue equals to marginal cost) is
not the mechanism for achieving optimal prices. Hence, regulators may become
involved - the Department of Justice in the US and the Office of Fair Trading in
the UK would police corporate misbehaviour such as collusion and conflicts of
interest that may reduce the effectiveness of the price system.

Pricing
The study of pricing, however, has a different purpose from that of price theory.
The central focus of pricing studies is the firm, and the purpose of pricing is to
single-mindedly aid firms in achieving their pricing objectives. This means that
although the methodologies such as economic models and quantitative analysis
may be used in pricing studies as well as price theory, their objectives are
divided. The pricing expert’s priority is only that of the firm, and any societal or
buyer considerations will be relevant only if they are useful and form part of the
firm’s objectives. Yet, price theory research has an important role in pricing
research. Where any of the three macroeconomic functions of price fail to func-
tion appropriately in certain industries, regulators would often step in. Hence,
pricing experts have to be aware that the pricing strategies they put forward have
to be within a well functioning market system (as studied in price theory), and
the firms have to operate within the macroeconomic boundaries.
It is easy to believe that the objective of pricing is to maximise profit. Unfor-
tunately, that is too simplistic a view. Box 1.2 lists some of the objectives of
pricing. Each objective will result in different strategies and would also be
strongly influenced by different factors. Yet for commercical organisations,
these objectives could be linked back to the need of the firm to enhance its
revenue so as to be profitable in the long run (i.e. the original aim of the firm).
6 Introduction

Box 1.2 Some of the objectives of pricing in services

Profit maximisation
Sales maximisation
Market share maximisation
Market share increase
Return on investment (ROI)
Coverage of the existing capacity
Price differentiation
Distributors’ needs satisfaction
Price stability in the market
Sales stability in the market
Discouraging new competitors from entering the market
Maintenance of the existing customers
Maintaining ‘fair’ prices for customers
Achievement of satisfactory profits
Achievement of satisfactory sales
Achievement of a satisfactory market share
Cost coverage
Return on assets (ROA)
Liquidity maintenance and achievement
Service quality leadership
Creation of prestige image for the company
Price wars avoidance
Market development
Price similarity with competitors
Customers’ needs satisfaction
Attraction of new customers
Achievement of social goals

Source: adopted from Avlonitis G.J. and Kostis K.A. (2005) ‘Pricing Objectives and Pricing
Methods in the Service Sector’, Journal of Services Marketing 19 (1), pp. 47-57.

Price is the only avenue through which a commercial enterprise is able to bring
revenue to the firm,6 and is therefore critical to the firm’s survival. Getting the
pricing right means better profits, but getting it wrong could be disastrous as
mistakes are also not easily tolerated. Yet, despite its importance, pricing has
been the most neglected area of research within the marketing discipline.7
Part of the problem is the multi-disciplinary nature of pricing. Pricing, it
seems, is of interest to almost every major business discipline. Finance and
accounting maintains that pricing makes assumptions about costs and pertains to
the financial health of the firm, and is therefore within their scope. The business
economists model the markets and can provide the optimal price for the firm, in
 Introduction 7
varied demand conditions. In the service industry, operations research has also
gotten into the act through sophisticated revenue management systems and
demand forecasting models, churning out optimal prices and capacity allocations
for the firm. In addition, information system developers are able to develop pro-
grams to sift through the increasing amount of data flowing into firms, to do
everything from predicting buyer reservation prices to proposing bundled offers.
Despite the interest shown by the various disciplines, research progress has
been slow, particularly in the area of service pricing. It is almost as though the
individual disciplines understand the cross-disciplinary nature of pricing and
since they can only ‘feel one part of the elephant’ (to paraphrase from the
famous sufi story), it is assumed that any research within one discipline can only
make a limited contribution to the topic. Given the apparent lack of ownership
towards the subject matter, service pricing research in general has not proceeded
as swiftly as it should.

The importance of the service sector

The lack of research in service pricing is unfortunate indeed, given the current
situation. If you are reading this book in the UK, US, Australia, Japan, Germany
or any of the Organisation for Economic Co-operation and Development’s
(OECD) countries, and you are gainfully employed, chances are your employer
is a service firm. In a world traditionally dominated by goods, the services sector
has been gaining prominence and significance globally. For starters, it now
accounts for about 70 per cent of aggregate production and employment in
OECD economies.8 This sector also comprises some of the world’s largest cor-
porations who are major buyers and users of advanced technology and are the
most active innovators, facilitating a major re-engineering of a growing number
of firms across all sectors of the economy. Service firms are also a major stimu-
lant to productivity and efficiency (through outsourcing services), and, through
e-commerce, are having a catalytic effect by transforming and accelerating
changes that are already underway in the economy. 9 Indeed, the fastest growing
service industries went from being 6.3 per cent of world exports in 1985 to 9.4
per cent in 2002.10 These industries include computer and information services,
financial services, insurance, telecommunications, and personal, cultural and
recreational services.
The commoditisation of goods and increasing competitive pressures are also
driving firms to differentiate through services. Goods firms are now becoming
service firms with a renewed focus on the buyer. Consequently, new service
models and strategies are being used to obtain buyer loyalty and revenues are
increasingly focused on service components within the firm.
The importance of the service sector has led to an expansion in research
worldwide on services. Service research spawned through journals such as Inter-
national Journal of Service Industry Management, Journal of Services Market-
ing, Service Industries Journal and Journal of Service Research have gained
international reputation in their hope of achieving an integrated and globally
8 Introduction
accepted vocabulary, logic and approach towards understanding services that
could be shared by a global research community. This research culminated in the
Services-Dominant logic proposed by Vargo and Lusch (2004) which asserted that
the service experience is the benefit that buyers are wanting to buy at all times and
that even goods are seen as carriers of the service experience. 11 This new Services-
Dominant logic has the potential to shift strategic marketing attention away from a
transaction and exchange focus to a service and relationship focus.
Yet, service research has not had the kind of impact on industry as it could
have. This is because within the service economy lies a heterogeneous set of
activities such as financial services, telecommunication, retail, restaurants, trans-
portation, entertainment, education, public services, and not to mention not-for-
profit activities. Hence, many who attempt to study services have lamented on
its diversity, and each industry is still dominated by its own terms and language
that are highly contextual; this impedes the transferability of knowledge. For
example, the price of a service is termed differently for different types of ser-
vices (see Table 1.2). Current pricing research appears to be growing within
individual industries (telecommunication, tourism, hospitality, finance, airline,
professional services, etc.) without any attempt to consolidate or abstract the
learning from one industry to the other.

Table 1.2 The many different terms for price in services

What service are you buying? Price

Visiting a museum Entrance fee

Getting an education Tuition
Consulting a lawyer Legal fee/retainer
Consulting a tax advisor Consultant fee
Getting insurance Insurance premium
Getting a loan Interest
Taking a flight Airfare
Sending a letter Stamp
Sending a courier Courier charges
Withdrawing money Surcharge
Making a call Call charges
Going to the gym Subscription
Playing golf Green fee
Going to a theme park Park pass
Staying in a hotel Room rate
Getting a job through a head hunter Commission
Renting out your home Agency commission
Getting assistance or skilled help Salary
Services rendered by government Tax
Using a road Toll
A night out at a dance club Cover charge
Utilities/telecommunication Tariff
Staying in an apartment Rent
 Introduction 9
However, aid is starting to come to service industries. Organisations, universities
and firms are coming together to talk about ‘service science’, a transdisciplinary
field that uses technology, management, mathematics and engineering to improve the
performance of service businesses such as transportation, retailing, hospitality and
health care.
Service science integrates service functions such as management, operations,
design, engineering, technology, sociology and other relevant disciplines into
the field, with an aim to deliver knowledge that could be meaningful and useful
across industries. It is hoped that such knowledge could be shared between
researchers and practitioners to help firms advance and compete in the service
economy, with more mature services providing lessons to newer ones. As
Matthew Realff, director of a new programme at the National Science Founda-
tion (US) to finance university research in the field says, ‘Services is a drasti-
cally understudied field. We need a revolution in services’.12

Definition of service
What is this ‘service’ exactly? The term has certainly been bandied about for some
time. Economists talk about the service industry as firms that ‘don’t make things13,’
but instead, perform activities. It is also common to hear about the ‘civil service’
and the ‘health service’. Others refer to ‘service’ as a performance that should meet
some basic expectation, e.g. ‘customer service’. Box 1.3 presents some ways of
thinking about services.

Box 1.3 Some ways of thinking about services

• A change in condition or state of an economic entity (or thing) caused
by another.14
• Intangible and perishable ... created and used simultaneously.15
• Deed, act, or performance.16
• Characterized by its nature (type of action and recipient), relationship
with customer (type of delivery and relationship), decisions (cus-
tomization and judgment), economics (demand and capacity), mode of
delivery (customer location and nature of physical or virtual space).17
• Deeds, processes, performances.18
• An activity or series of activities ... provided as solution to customer
problems.19
• A time-perishable, intangible experience performed for a customer
acting in the role of co-producer.20

Source: IBM Research on Services Sciences, Management and Engineering www.research.

ibm.com/ssme/services.shtml, co-authored by Spohrer, J. and Maglio, P., IBM Almaden
Research Center.
10 Introduction
From its frequent usage, it may seem to be common sense what a service is. Yet
its definition has been elusive simply because its characteristics are constantly
being debated upon. Here follows some of the much-contended characteristics.

Tangible vs intangible
When viewed as an activity, a service may seem to be intangible. Yet some
service firms such as restaurants and those in retailing have a significant tangible
component within its service. Hence, as Gummesson (1994) and several other
authors have commented, buyers hardly ever purchase a pure service; what is
purchased is an offering whose value consists of services and goods. 21 Even the
purchase of tangible goods would often have a service component if one views
the benefit of a good to include how it is made available, and other supplemen-
tary elements that enhance or facilitate its core value. 22 Hence, a service may
operate within a tangibility spectrum 23 according to what tangible or intangible
elements add value to the buyer.

Separable vs inseparable
Conventional wisdom also suggests that the production and the consumption of
a service are inseparable. Both usually occur simultaneously; for instance, being
on a cruise or a flight, or studying a course. Yet, as Lovelock and Gummesson
(2004) suggest24, there are many separable services, such as services rendered to
our possessions, e.g. lawn care, garage services and the like, where the produc-
tion is separate from the consumption, the latter typically occurring when the
buyer takes delivery of the possession that has been ‘serviced’.

Heterogeneity vs homogeneity
Largely because of the highly personalised nature of certain services, many have
assumed that heterogeneity is another characteristic of services. For instance,
service delivery could be inconsistent since the employee-customer interface is
often prone to variable performances or distractions. Yet, there are many ser-
vices that are remarkably homogenous and consistently delivered, due to the fact
that they have been automated, such as a phone call or an automatic teller
machine.

Perishable vs imperishable
Finally, services have been considered perishable, i.e. a hotel room on New
Year’s eve cannot be salvaged after that date and is deemed to have been
‘perished’. However, even with this characteristic, there are exceptions. Parts of a
service may not entirely perish, e.g. a concert performance, a sermon or a lecture
could be recorded and replayed later.
These characteristics of services have been much critiqued by Lovelock and
 Introduction 11
Gummesson (2004), but while they may not necessarily be unique, services have
been found to be different from goods. Sampson’s empirical study 25 showed that
consumers recognise services to be different from goods. It also established that
services are economic activities not accounted for by other sectors of the
economy such as agriculture, mining and manufacturing.
There is existing literature to imply that the absence of a coherent definition
of services among developing countries appear to impede the recognition that
the services industry so deserve.26 Furthermore, Cave and Varnojen (2004) argue
that ‘inappropriate measures in services lead to problems for understanding the
sources of growth and damaging consequences for productivity analysis’.27 In an
effort to promote a wider understanding of the services industry, it is understood
that the OECD has also commissioned a project to regulate the definitions of the
service industries statistics to reflect common understanding.
This book deals with the pricing of services that exhibit the characteristics of,
intangibility, heterogeneity, inseparability and perishability (IHIP). Such ser-
vices include hospitality, travel, leisure, transportation, professional, telecommu-
nication, financial and other similar services. In addition, service with the IHIP
characteristics could also be components of goods - included as part of their
value offering e.g. support services for technological goods, customer care ser-
vices for engine parts or elevators. The impact of the IHIP characteristics on the
pricing decision of these services has so far been poorly investigated, and this
book aims to address this gap.
The most common definition of a service is that of a deed, a process and a
performance,28 and it is this definition to which this book ascribes. Accordingly,
the service described in this book is a performance that is intangible, perishable,
heterogeneous, and whose consumption and production is inseparable. As a
matter of convention, I use the word product in this book to mean both goods
and services.

Service pricing - issues and challenges

One would imagine that pricing ideas such as those highlighted at the beginning
of this chapter would stimulate research in pricing. Sadly, academic research in
service pricing has not kept pace with its growth. Although there appear to be
numerous literatures on the policies and strategies of the pricing of goods 29 there
is a serious lack of literature in the policies and strategies of services pricing.
There has, however, been research in pricing within each service domain. Table
1.3 highlights a selection of industry-specific research in pricing that have been
conducted.
Part of the problem is also the way knowledge is being imparted at universi-
ties and colleges worldwide. Structured disciplines such as computer science,
engineering, economics, marketing, management, human resources management
(HRM) and operations focus on the knowledge within each discipline without
sufficient focus on how they are integrated and applied. A recent speech high-
lights the problem:
Table 1.3 A selection of published articles on services pricing in different industries

Author Year Title Industry Journal

1 Goetz1 1985 The Pricing Decision: A Service

2 Frank2
3 Morris & Fuller3
4 Bonnici4
5 Crompton5
6 Hoffman et al6
7 Kimes et al7
8 Sturts et al8
9 Ladany & Arbel9
10 Ciancimino et al10
Industry Experience Dry cleaners J. Small Business Mgmt
1985 Pricing and Location of Physician
Services Physician Economic Inquiry
1989 Pricing an Industrial Service
1991 Pricing Dimensions in Healthcare Accounting firms Industrial Mktg Mgmt
Services Healthcare J. Professional Service Mktg
1981 Role of Pricing in the Delivery of
Community service Community serv. Community Development J.
2002 Pricing Retail Services
2004 Restaurant Revenue Management at Retail J. Business Research
Chevys: Determining the Best Restaurant Decision Sciences
Table Mix
2005 Pricing Engineering Services
1991 Optimal Cruise Liner Passenger Engineering J. Mgmt in Engineering
Cabin Pricing Policy Cruise line European J Ops Research
1999 Railway Yield Management Programme
Rail Transportation Science

Source: Ng, I.C.L. and Yip, N. (2007) An Interdisciplinary Review of Pricing Services. Exeter: University of Exeter.
Notes
1 Goetz, J.F. (1985) ‘The Pricing Decision: A Service Industry Experience. Journal of Small Business Management, 23 (2), pp. 61-67.
2 Frank, R.G. (1985) ‘Pricing and Location of Physician Services in Mental Health’. Economic Inquiry, 24 (1), pp. 115-133.
3 Morris, M.H. and Fuller, D.A. (1989) ‘Pricing and Industrial Services’. Industrial Marketing Management, 18, pp. 139-146.
4 Bonnici, J.L. (1991) ‘Pricing Dimensions in Health Care Services’. Journal of Professionals Services Marketing, 8 (1), pp. 57-65.
5 Crompton, J.L. (1981) ‘The Role of Pricing in the Delivery of Community Services’ Community Development Journal, 16 (1), pp. 44-54.
6 Hoffman, D.K., Turley, L.W. and Kelley, S.W. (2002) ‘Pricing Retail Services’. Journal of Business Research, 55 (12), pp.1015-1024.
7 Kimes, S.E. and Thompson, G.M. (2003) ‘Restaurant Revenue Management and Chevys: Determining the Best Table Mix’. Decision Sciences, 35 (3), pp.
371-392.
8 Sturts, C.S. and Griffis, F.H. (2005) ‘Pricing Engineering Services’. Journal of Management Engineering, 21 (2), pp. 56-62.
9 Ladany, S.P. and Arbel, A. (1991) ‘Optimal Cruise-liner Passenger Cabin Pricing Policy’. European Journal of Operational Research, 55 (2), pp. 136-147).
10 Ciancimino, A., Inzerillo, G., Lucidi, S. and Palagi, P. (1999) ‘A Mathematical Programming Approach for the Solution of the Railway Yield Management
Problem’. Transportation Science, 33, pp. 168-181
 Introduction 13
Disciplines are like bricks and we teach the subjects within them very well
- their composition, how to make them stronger, how to change their colour
and how they are used in many different buildings. We don’t talk enough
about the cement, or how the different bricks should come together to build
different kinds of buildings or solve different kinds or problems. Some-
times, the way the cement brings the bricks together often require changes
to the bricks themselves, i.e. all the bricks have to think about the larger
picture, the building, the solution, and see how to make that better. But
we’re not structured like that. Individual bricks become threatened when
asked to change themselves for the bigger picture, then politics set in and
that’s the end of that.30

The service world does not box itself easily into the traditional disciplines of
engineering, computer science, economics, marketing, management, HRM or
the like. Knowledge in advancing the service economy is multi-disciplinary and
trans-disciplinary. Yet, except for some journals in service as mentioned earlier,
most publications are discipline or industry specific. This creates incentives for
researchers to ‘box’ their research within these domains. The problem becomes
aggravated particularly when industry-specific research begins to embed the lan-
guage and jargon of the industry into the knowledge, taking certain industry-
specific practices as ‘given’, or becoming tacit. Polanyi (1966) 31 makes clear this
distinction, which he calls explicit and tacit knowledge. Explicit knowledge is
that which is transmittable through a systematic language. Tacit knowledge
however, is the knowledge that is normally not easily articulated since it is
deeply embedded in action and within a specific context. For pricing research to
progress, the knowledge acquired from the research within each industry has to
be abstracted into explicit theory and principles that can be meaningfully applied
to different industries. Failure to do this may result in the false belief that the
research is ‘new’ knowledge when in fact, they are merely the manifestation of a
failure to abstract the contextualised and tacit information embedded within that
industry.
How does one begin to study pricing for such services? Is there a common
thread across all services? Does the pricing of a mobile phone service have anything
in common with that of an airline ticket? What can we learn from the pricing of
one service that we can apply to the pricing of another?

Service characteristics impact on pricing

Research in service pricing that uncovers basic constructs and produces abstract
knowledge common across service industries has been few. It is important to
highlight how some key characteristics shared by service industries have an
impact on pricing. While conventional service literature informs us that services
are intangible, heterogeneous, inseparable and perishable (IHIP), it isn’t too
clear how such specificities affect pricing. Mere descriptions of service
characteristics would not be useful therefore, unless they are translated into
14 Introduction
some meaningful insights that assist firms in the pricing decision. Hence, I aim to
provide some attempt at this by presenting three key areas where the
characteristics would have an impact on the pricing decision.

The service encounter (intangibility and heterogeneity)

The service encounter is defined as all activities involved in the service delivery
process. Managers and service researchers describe this as the ‘moment of truth’
to indicate the defining period when the interaction between the firm and buyer
is of crucial importance to determine customer satisfaction and unlocking cus-
tomer value. This encounter could be very short, e.g. a phone call, or reasonably
long, e.g. a cruise, or disjointed, e.g. a court case. The service encounter often
involves service employees, systems and processes, use of technology and the
environmental setting, thus emphasising the need for disciplines to work
together to create and manage the encounter. Hence, unlike consumer goods
where the firm’s responsibility often ends at purchase (leaving the buyer to
consume whenever they wish), the service firm has a responsibility of delivering
the consumption experience. The consumption experience is often hetero-
geneous and that could add or detract from the benefit buyers expect from a
service. A drunk patron can make a pub experience a nightmare just as meeting
an interesting person could add to it.
Consequently, the firm’s task is not merely to manage the service encounters
but also to understand the promise of the service that is made at the point of pur-
chase. That promise (and its credibility) will impact on expectation and therefore
price. If a firm promises quality service, and wishes to command a price
premium, the firm is in effect not only promising that it is able to deliver supe-
rior service, but also to manage the uncertainties and heterogeneity of the
encounter to a high level of satisfaction even if such uncertainties are not
directly controllable by the firm.
Also, services are performances, and are often described as an ‘experience’
with no ownership of anything tangible after consumption (see Figure 1.2). As
Berry and Yadav32 puts it, ‘Purchasers of goods buy ownership and use; pur-
chasers of services buy only use’. Research has shown that there seems to be a
lack of understanding between the pricing of intangibles and its relationship
with buyer behaviour.33 The intangibility could increase the buyers’ perception
of risk in purchase. While it may seem at first that due to that risk, the buyer
would only be willing to pay a lower price for a service, the opposite could also
occur. Since the risk of purchase is generally higher, risk-averse buyers could
seek greater assurance from the firm and are generally willing to pay a higher
price for that assurance. Consequently, brand promises and reputation that serve
as relevant assurances become central in the marketing of services, and service
firms promising quality services are often able to obtain higher prices. Chapter 2
will discuss further the experiential risks involved in the encounter, and how
these risks impact on the price of the service.
 Introduction 15

Figure 1.2 No tangible product: Customers who buy tour packages consume
only an experience (source: SA Tours Corp. Pte Ltd Singapore,
www.satours.com).

Separation of purchase and consumption (inseparability)

The main difference between the purchase of service as opposed to the purchase
of goods is the fact that services have two parts to the exchange that involves the
firm - the purchase and the consumption. In goods, the state of consumption is
in the hands of the buyer, and the firm is often not present nor is it usually
responsible, e.g. a consumer taking out of a fridge a drink that has been pur-
chased weeks earlier. However, unlike a can of soda, a service cannot be inven-
toried by the buyer before consumption, since it has not yet been produced.
Hence, buyers cannot buy a service and keep it with them until the time they
wish to consume. This means that the inseparability of consumption and produc-
tion adds a complex dimension to the value of the service at the point of con-
sumption/production, and this in turn has a huge impact on how it should be
priced at the point of purchase.
Furthermore, the time of consumption is often a factor in service delivery and
value. For example, buyers who buy flight tickets in advance have to inform the
airline of their date of travel. This seems straightforward enough and the price
could be set by the airline on that basis and accepted by the buyer. However, a
buyer engaging a divorce lawyer also purchases the service in advance but the
price may be uncertain, depending on whether there is an amicable settlement or
if the case goes to court. The same goes with a mortgage, where the purchase is
made in advance, and yet the price (interest rate) may change along the course of
the mortgage period. Chapter 3 will elaborate further such differences and the
impact this has on pricing.
16 Introduction
Perishable capacity and costs (perishability)
The perishability of services implies that no service can be stored after its pro-
duction. This means that firms can only sell a service before its production, and
not after. This is an important point and it alludes to a key difference between
goods and services. For goods, the firm retains the choice of being able to sell
before or after production. Services have no choice but to sell in advance, even
if ‘advance’ could be a matter of minutes, e.g. the sale of movie tickets.
Given that services can only be sold in advance 34, pricing in services is there-
fore an issue of advanced pricing. Yet, how far in advance can a service firm
sell its services? We can see from practices in the service industry that some ser-
vices are able to sell far in advance, like hotel rooms and airline tickets, whilst
others, like restaurants, may not be able to do so. The ability to sell in advance
and the ability to decide when to sell has a great impact on the price.
While service firms are not able to inventory the service produced as a result of
its perishability, it may be able to inventory demand. If demand for the service
streams in at disparate times in advance of production, the firm could manage it
well, in order to match it with the supply of its service that is to be produced at a
particular time, e.g. having a reservations system. If, on the other hand, all demand
arrives at the time the service is produced, and the firm does not have the choice of
managing demand and planning ahead, it can only schedule supply and production to
match demand levels.
To summarise, the perishability of a service therefore results in two con-
sequences in pricing. First, knowing that whatever it produces will be perished, the
firm must attempt to sell all its services, at the highest possible revenue before its
production, balancing the price and the quantity. And second, pricing for services
must necessarily be advanced pricing. These consequences mean that the firm can
either manipulate demand to match supply (demand management) or manipulate
supply to match demand (supply management). Otherwise, there would be a loss
of revenue from either unused or insufficient capacity. Discussions on revenue
management and capacity are presented in Chapters 6 and 7.

The cost-plus approach in pricing

A discussion on service pricing is incomplete without a look at the issues
surrounding the most popular of pricing approaches - cost-plus pricing. Essen-
tially, this approach sets a price that is deemed sufficient to recover the full costs
of the product i.e. variable and fixed costs, and adds a sufficient margin above that
cost to provide the firm with some profit. However, such an approach poses prob-
lems, especially for high fixed cost services. For services like transportation, air-
lines or 3rd Generation (3G) telecommunication services, the major portion of
costs are sunk fixed costs, and variable costs (also called marginal costs) are very
small. For example, the variable cost of a night in a hotel room would just be the
utilities and housekeeping services consumed for the one night. Clearly, a cost-
plus pricing approach based on marginal costs will not be very useful.
 Introduction 17
How should one begin to set a pricing for services that ensures that the fixed
costs can be sufficiently covered? With transportation and airline services, fixed
costs can include the cost of assets such as a cargo ship or an airplane, whilst for
3G services, the fixed cost can be the cost of acquiring the 3G licence. Aside
from the obviously high costs of these assets, the service may reap the benefit of
the asset over the long term, whether 20 or 50 years, or an uncertain number of
years. The cost-based price set for each unit of the service is therefore an amount
that is a contribution towards the overall fixed (and sunk) costs; this is also
called a target-return approach. However, this contribution is not only difficult
to determine, it is also inconsistent across firms. Hence, when variable costs are
negligible, the ‘cost’ assigned to a unit of service e.g. a night in a hotel room
could be computed in the cost-based approach as a percentage of the overall
fixed costs or perhaps as an activity-based cost, 35 and the price is a percentage
above that cost, given the volume to be sold. Such a pricing approach may lead
to uncertain outcomes when firms begin to compete on price. If a service is not
much differentiated from its competitor and there is a price war, how low can
one service price vis-à-vis the other, when each firm apportions its costs
differently?
Cost-based pricing therefore starts unraveling with the onset of competition.
Consider the history of the telephone. High costs were initially sunk into infra-
structural development for the telephone. Hence, in the early days, only the elite
class had access to it which resulted in limited profitability. Prices for long dis-
tance calls were initially based on distance and time of call in the US. Under
competitive pressure, distance dependence has now been eliminated completely
and time of day variation was reduced to only two times (weekdays and week-
ends/ evenings). This competition has also begun to set in for other communica-
tion technologies like internet/broadband as history is set to repeat itself.
Similarly, the downward spiraling prices experienced by the airline industry in
the 1980s after de-regulation is another example of the unsustainability of the cost-
based approach.36 More recently, this situation resurfaced when aggressive pricing
by European low-cost airlines resulted in losses for some, prompting the Chief
Executive of Easyjet to comment that pricing by budget and full-service airlines is
‘unprofitable and unrealistic’.37
Furthermore, service firms who adopt the cost-plus approach show a lack of
understanding of how pricing functions. The simplest criticism 38 is that costs per
unit cannot be determined without knowing the volume to be produced, and the
volume to be produced is dependent on demand that is in turn determined by the
price. By setting a ‘cost-plus’ price, the ‘cost’ is at best an approximation.
Yet, one may still be tempted to argue in its favour by pointing out that since
the future is uncertain, the circularity for pricing can never be squared unless
some forecast is made of the uncertain demand. Hence, it is not far-fetched if the
firm is to forecast the demand characteristics, based on historical data, and price
its product based on the ‘cost’ of producing that forecasted volume.
Following this point, a whole stream of research on demand forecasting and
yield/revenue management in high fixed-cost services such as airlines and hotels
18 Introduction
has emerged. In the majority of these studies, the yield management problem is
structured as one in which firms maximise payoffs/yield, given some forecasted
demand profile.39 Over time, increasingly complex demand profiles, which
require increasingly sophisticated mathematical algorithms to obtain solutions,
have been introduced and investigated.40 Most of these studies deal with how
much capacity should be allotted for a given set of prices. Chapter 6 will discuss
this in greater detail.

Complexity of service pricing

It is clear that service pricing is a complex issue. As the Bank of England’s quarterly
report states:

some of the new service industries may have special economic properties
that do not fit well with the assumptions of conventional economic models.
For example, telephony and computer software production have high initial
costs but very low marginal costs. As a result, pricing strategies may be
more complex, and component services are sometimes embedded in cus-
tomized packages that can obscure the price actually paid or the services
actually bought.41

What this means is that when marginal costs are negligible, as in the case of
high fixed cost services such as telecommunication, hotels, or airlines, the cost
function is a straight line i.e. it does not matter how much the demand is, the
cost is always negligible since all the costs to produce the service has been sunk.
Furthermore, since the service perishes immediately upon production, the
optimal pricing strategy for the firm is to sell at the point on the demand curve
where marginal revenue is zero, i.e., if the maximum capacity of the service has
not been reached. Inasmuch as conventional price theory goes, that is the advice.
Clearly, the disciplines of accounting, decision sciences and economics take a
very different view of pricing in services. Whilst the economists contend that
sunk costs are committed and should not feature in pricing decisions, accoun-
tants and decision scientists insist that pricing decisions have to take into
account the return of fixed costs. Both are correct. To borrow terminology from
economics, ex-ante, pricing decisions should not take into account sunk-costs.
However, ex-post, prices obtained may be used to calculate the returns to invest-
ment using tools such as activity-based costing or time-based activity based
costings.42 The confusion arises when managers insist upon using ex-post analy-
ses of costs and returns to investment to influence ex-ante pricing decisions.
Pricing should, whenever possible, be buyer or demand based (see Chapter 4 on
some of the difficulties in demand-based pricing). Costs have the right of veto as
it is important that there is profitability (or at least, projected profitability) for any
price level proposed.
Yet, despite ex-ante decisions on pricing that do not consider sunk costs, this
book argues that service pricing research has over-simplified the service firm’s
 Introduction 19
pricing decision. The complex pricing programs available in various service
industries today clearly illustrates that more needs to be explored.
From here on, the book is divided into two parts. The first part discusses the
buyer as an individual, and the issues relevant to the pricing decision. The
second part discusses buyers in aggregate in the form of market demand, and the
corresponding supply and capacity concerns. The second part will also discuss the
revenue management of services.