ECON 325 - Other Pricing Strategies

Sources: Confessions of the Pricing Man: How Price Affects Everything by Hermann Simon; “7 Examples Of Freemium Products Done Right,” by Sujan Patel (http://www.forbes.com/sites/sujanpatel/2015/04/29/7-examples-of-freemium-products-done-right/#709723fff720 ), “The Pros and Cons to Freemium Pricing in Tech,” Tech.co; others noted in the lecture.

Let’s start with some basic practices we haven’t discussed (at least in detail).

“Because free features are a potent marketing tool, the model allows a new venture to scale up and attract a user base without expending resources on costly ad campaigns or a traditional sales force. The monthly subscription fees typically charged are proving to be a more sustainable source of revenue than the advertising model prevalent among online firms in the early 2000s. Social networks are powerful drivers: Many services offer incentives for referring friends (which is more appealing when the product is free).”

a. The seller is trying to entice customers into paying for additional, premium features or other products. Giving away a “free trial period” for example, can get customers hooked.

a. The seller can get more media coverage. People who write about apps and other tools can try it out for free and then write about it. In fact the firm might even want to reach out to some bloggers, etc. and tell them about the product.

b. The seller can get more word of mouth marketing exposure for their product. While people are using the free trial, the seller can send them a message via email or within the product that invites them to share a tweet or Facebook post about how much they love the free product. Hopefully, they will be receiving so much value that they are happy to share.

Example: Paywalls that many online newspaper publications are now using. A reader can view 10 free articles online per month before they have to pay a subscription fee, or else the website simply redirects them.

“Freshbooks is an invoicing software for freelancers and small businesses. You can also track expenses and manage projects with their platform.

FreshBook’s freemium approach is to allow you to see their software in action with one client and the basic features. Additional clients and features are offered in the paid plans.

Their approach works because most freelancers and small businesses do not have the time to try one platform to the next. If they like how it works for one client, they’ll commit to the paid plans to stick with what they know for the rest of their clients.”

a. Sometimes customers get angry and frustrated if they’re continually being badgered to upgrade.

This is especially true with aggressive methods by the seller – for example, constantly being “spammed” by unwanted ads or emails. This can make customers feel like the company is going back on the deal.

b. Sometimes consumers can feel that – once they have had the free version – it can seem unfair to suddenly pay money for what they once had for free (especially true for something like the newspaper example).

b. Identify the target conversion rate from the beginning – don’t keep changing it.

d. Keep track – make sure there are enough customers signing up for the upgrade – and if not – switching to value based pricing might be the way to go.

For a loss-leader strategy to work, the profits made on other merchandise sold during your loss-leader promotion must cover the low profits or losses taken on the featured merchandise.

Loss leaders are often impossible to resist, even for people who have sworn brand loyalty to another store.

It can also be good for public relations – the company can say they are cutting costs in a difficult economy, thus helping people out.

Low prices attract customers to stores. When a customer comes into a store, the likelihood he will see something else to buy is high.

Example: Even e-commerce effectively uses loss-leader pricing to attract customers. Notice the "customers also looked at these products" messages showing other similar products the customer might find attractive.

If you want to build a brand image as a local low-cost provider of certain goods – this can be one strategy to use. This trains your target customer to automatically shop first at your store.

Example: Costco provides discounted gasoline at some of its stores, discounted tires and special purchases inside the store that represent significant cost savings. On the other hand, many of their regular items are not discounted below the prices available at other stores. The great price deals bring people to Costco to do all their shopping.

A big problem for retailers is knowing how effective their ad spending is in attracting customers. Repeatedly monitoring the results of customer visits is one way to tell if your ads are reaching your target market.

Example: Advertise a loss-leader product at a price that will certainly attract customers. Couple this with a coupon that can be traced to a particular newspaper, or neighborhood flier - this will show how well your ads are targeting by the amount of merchandise that is sold.

Loss-leader pricing strategy can be seen in Labor Day sales at department stores. Faced with a changing season and the need to attract customers shopping for back-to-school clothes, department stores advertise discounts on summer clothes, back yard barbecue cooking and table wares to make way for the accumulation of fall and winter holiday shopping merchandise.

Example: When Apple Computer reduces the prices on its latest products, savvy Apple watchers know a new release is just around the corner.

The philosophy behind this is one of "tit for tat." The customer gets a great deal and then subconsciously feels obliged to buy more.

Example: Supermarkets cook up free samples of food and offer them to shoppers who are walking the aisles. They will often hand out coupons too and have products at the food stall that the customer can take with them.

a. Probably the biggest downside can take place if the firm is not prepared – and they run out of stock! Great way to make customers angry!

b. If the loss leader is priced too low, the firm may never recoup the money they have lost on it Related to this are:

c. Cherry Pickers - Cherry pickers are customers who only buy the loss leaders – they cherry pick the best deals and leave without buying anything else.

There’s actually a network of deal hunters that have appeared via the Internet (where they can get more information on deals). So the store may find that their loss leaders don't lead to big sales due to this network, and they have basically just given away their product for almost nothing – without the benefit (and revenue) of other sales.

Normally the standard theory states that a firm prices where MR = MC (as you know) – Again, the graph:

It becomes more complicated for a manager to set price when his firm has interrelated products.

Example: Proctor and Gamble sells both Luvs and Pampers – which are substitutes for each other. A change in one price will affect the demand for the other.

Plus, if both products use the same production facilities – the firm must determine how costs are to be allocated between the two goods.

When firms produce interrelated products – let’s consider three types of interrelationships:

The basic objective of the firm should be to determine the prices that give the owners a total profit that they would be satisfied with (given their opportunity costs), rather than profit earned by individual products.

Caveat: But as we go through this standard analysis (for all of these interrelated products) – think about if and when a firm might actually be able to use this and what they need to consider besides what this analysis indicates.

The firm should still try to consider Marginal Revenue (MR) and Marginal Cost (MC) – if this is possible.

Remember that marginal = additional. Therefore, marginal is the change in total.

Consider the MR analysis for both products (assume the firm produces two products – X and Y).

MRx = Change in TRx due to a Change in Qx + Change in Try due to a Change in Qx.

What does this say? The marginal revenue of good X = the change in total revenue (from good X) from selling Q additional units of X + the change in total revenue (from good Y) from selling Q additional units of X.

Example: The change in total revenue from selling 10 additional units of X = $100. But, since these two goods are complements – the sale of X increases the sale of Y. So we add the sale of Y to the MR of X. If, when 10 more units of X are sold, an additional 5 units of Y are sold, then $50 is added to the MR of X ($50 is the change in total revenue of Y).

MRy = Change in Try due to a Change in Qy + Change in TRx due to a Change in Qy.

What does this say? The marginal revenue of good Y = the change in total revenue (from good Y) from selling Q additional units of Y + the change in total revenue (from good X) from selling Q additional units of Y.

NOTE: The signs of the interdependency terms depend on the nature of the relationship:

If we want to go to the point where MR = MC, then the output of X should increase (if they are complements) until:

Change in TRx due to a change in Qx + Change in Try due to a Change in Qx = MCx.

So we will produce less than we otherwise would have if we ignored the extra revenue generated through the sale of Y OR

On the other hand, if they are substitutes, then we will probably overproduce if we ignore the effect on Y.

In addition to taking interdependencies into account – must also consider the reactions of competition.

Example: Texas Instruments introduced home computers and options like disk drives and printers. They knew no one would buy the options without the basic machine (add-ons) – so they sold the basic computer for a lower price than otherwise but this stimulated sales on options – which they priced much higher than otherwise. This worked for a while – until the competition started offering the options at lower prices. They had to change their pricing strategy.

The main point here is that the firm has to take into account how the pricing of one good (and the sales that take place at that price) will also affect the sales of another product they sell.

Common costs are costs that cannot be assigned to any specific product or service.

High voltage transmission lines – serves residential customers electricity but also industrial and commercial. How should the costs be assigned? (Basically, the service will be provided even if one group is not served – costs are still there).

This allocates a portion of the firm’s common costs to each product or service. All common costs are distributed among the products and services for the firm.

Then set the price of each such that it covers the designated portion of common costs plus costs that are directly related to the provision of the product or service.

This assignment must be arbitrary – but – the choice of allocation scheme may have an impact on the price set and hence the quantity demanded of the goods and services provided by the firm.

Provision of the first service is very labor intensive – 80% of all labor costs involve the secretarial workers.

In contrast, data processing is capital intensive, 80% of all capital costs involve this service.

a. Apportion common costs on the basis of labor costs resulting from each service.

b. Apportion common costs on the basis of capital investment resulting from each service.

If 80% or 8 million is assigned to secretarial work, the price would have to be relatively higher vs. 20% or 2 million for data processing and vice versa.

Although a firm must cover its common costs – it is not necessary that the price of each product be high enough to cover an arbitrary apportioned share of common costs.

2. Price must cover incremental or MC – as we have learned before. As long as it exceeds MC, there is an increase in total profit by supplying the product. Hence decisions, as always, should be based on an evaluation of MC or incremental costs.

Example: Suppose there is a train that runs from San Francisco (SF) to San Diego (SD). The train owners are wondering if they should stop in Los Angeles (LA).

The added cost of the stop in LA would be energy due to extra passengers and the LA station.

The common costs are the rails, trains, engines, cars, etc. The accounting office has determined that this is = $120 per train trip (one way from SF to SD).

It is determined that a bus ticket to LA is the main competition and if the train is to compete – the price should not go above $30.

Using MC – with rail lines in place and already operating the additional expense of transporting a passenger from SF to LA is $15.00 (assuming capacity is not an issue and there isn’t an opportunity cost of losing a passenger going form SF to SD).

The service should be offered and priced between $15 and $30 – the train can cover its MC plus contribute toward the common costs – if they sell tickets!

Total profit of the firm would increase AND in fact the price from SF to SD could be reduced (their common costs have gone down due to the LA contribution – again assuming they can sell tickets at a price above $15.

Obviously common costs have to be paid somewhere – not all products in a firm can be priced by their incremental costs.

But it is not necessary that all products carry some of this cost. As long as price exceeds incremental costs – total profit can be increased by providing the product.

So the use of the fully distributed costs can lead to poor pricing decisions.

When a firm is vertically integrated – there are intermediate goods – goods that are needed as inputs at a later stage of the firm’s operations.

Two problems that a vertically integrated firm might have are difficulty in measuring the productivity of each stage in the production process and diseconomies of scale:

Once a firm has vertically integrated, management can break it up into separate units of operations or divisions with their own function and management. Each management team is rewarded on the basis of the unit’s profit or performance.

The problem arises of how to determine the profit or value creation of each unit.

Transfer Pricing: the price that one division of a company charges another division of the same company for a product transferred between the two divisions.

If one unit is to provide an input for the next stage of the production process – revenue will depend on the price that is charged for the intermediate good. A high price will increase profit at earlier stages and vice versa.

Also – an incorrect price set for an intermediate good can affect the total profit earned by the firm. Especially if each unit tries to increase profit – total profit for the firm could go down.

Example: Let’s assume two stages of production: 1. Rolls of paper manufactured and 2. Paper cut into tablets and sold.

a. There is an External Market – there is an external market for the rolls of paper – can sell and also stage 2 can buy elsewhere.

Even if there is excess supply within the firm – can sell it in the external market. Or if not enough, can buy from the external market.

b. There is no External Market. The intermediary good is specific to the firm. In this case, the theory goes – to determine the price that would maximize profit for the overall firm –

From the firm’s perspective, the MC of the product is the sum of the MC of tablets and of paper. So the best strategy is to set MC (total) = MR and then determine price at that point.

The paper unit should be required to set its price = MC of the paper – this way the paper division will supply just enough paper to produce Q* units of tablets.

This is trying to use consumer demand (value) to determine the price as best as possible.

Usually headquarters does reserve the right to step in and arbitrate if necessary.

Again, in the absence of an established market price many companies base the transfer price on the production cost of the supplying division. The most common methods are:

When transfers are made at full cost, the buying division takes all the gains from trade while the supplying division receives none. To overcome this problem the supplying division is frequently allowed to add a mark-up in order to make a “reasonable” profit. The transfer price may then be viewed as an approximate market price.

Other Issues that Might Change the Transfer Price – Taxes and Profit of Multinationals

Many argue that multinational corporations use transfer pricing to avoid paying taxes. Maybe.

The A division is located in Silver where the marginal corporate income tax rate is 50%.

The B division is located in Sand where the marginal corporate income tax rate is 15%.

The A division produces an intermediate product at a cost of $100 per unit and then transfers this product to the B division where it is finished at an additional cost of $100 and sold for $500 in Sand.

Assume 1,000 units are transferred annually and that the minimum transfer price allowed by the Silver IRS is the variable cost.

Also must be aware of exchange rate fluctuations, tariffs, quotas, and other differences in international laws.

1. Generate separate profit figures for each division and thereby evaluate the performance of each division separately.

2. Help coordinate production, sales and pricing decisions of the different divisions (via an appropriate choice of transfer prices).

3. Transfer pricing allows the company to generate profit (or cost) figures for each division separately. This plays to the benefits of divisions or profit centers

4. The transfer price will affect not only the reported profit of each center, but will also affect the allocation of an organization’s resources – hopefully in a more efficient way.

1. There can be disagreement among divisional managers as to how the transfer price should be set. If there is no clear and quick way to dissolve these disputes – the process can get costly and cause delays.

2. Additional costs, time and manpower will be required to execute transfer prices and design the accounting system necessary to deal with it.

3. For some departments or divisions, for example service departments, transfer prices do not work equally well because these departments do not provide measurable benefits in the form of unit costs, for example.

Obviously, in smaller organizations there really isn’t a need for profit or cost centers, for example – and no need for transfer prices.