Setting the Price in the Face of Competitive
Understanding how to accurately define the price point that reflects the value
created by a new product or service, especially when the market already has
a competitive alternative, is a challenging task. Pricing a product too low,
too high or committing other pricing errors can be detrimental to profits,
volume, and a firm’s market existence. In this article, the author compares
different pricing methods for determining appropriate new product/service
price levels and demonstrates, from an economics standpoint, the strengths
and weaknesses of each approach. Curry W. Hilton is a senior pricing analyst at Wiglaf Pricing and economics lecturer at Elon University. He can be
reached at [email protected].
P
rice setting of new offerings proves to be a challenging
task. Understanding how to accurately define the price
point that reflects the value created by the new product or
service provides tremendous financial impact to a firm’s
bottom line. Pricing too low may be useful for driving volume
and gaining market share but comes at the cost of losing potential profit and inaccurately setting price-to-value expectations.
Pricing too high may lead to greater reaped profit margins from
infrequent transaction occurrences but usually results in lost
profit from lack of volume and increased market interest from
fringe firms. Ultimately, pricing errors are detrimental to profits,
volume, and a firm’s market existence.
Cost-based pricing has been the norm ever since the presence
of trade. In some instances, firms presently use cost-based pricing to meet current pricing needs. The cost paradigm hinges on
understanding the marginal cost structure of production and
marking up according to industry best practices to deliver price.
Although, the efficiency of truly capturing a consumer’s willingness to pay and perceived value using off the cuff cost-based pricing strategies is quite unrealistic. The evolution of price setting
techniques in the business landscape has allowed firms to price
closer to value realized.
Value driven pricing strategies have emerged to become the forefront in aligning product’s observed benefits with price capture.
Reversing the normal cost-based value chain to fully understand
customer dynamics first allows for successful implementation of
value-based pricing methods. Identifying the importance placed
on products or services by consumers is the primary objective of
value-based pricing. After defining value customers recognize,
price can accurately be set accordingly. Cost feasibility based on
the price arrived at determines if the product is profitable. After
value has been identified, price set, and cost derived, the product
is then offered if deemed necessary. When firms use value-based
pricing, the likelihood of product success and healthy profit margins being realized is quite promising.
Price Setting Techniques
Price setting methodologies tend to mirror the offering and the
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maturity of the market. In the market for evolutionary goods,
products that offer marginal enhancements to the status quo,
conjoint analysis proves to be the most useful. Conjoint analysis
provides statistical evidence on how different product features
stack up in relationship to consumers’ part-worth utilities. Identifying prominent product components that add more value to
the product as a whole allows firms to align benefits to price
more accurately.
Exchange value models offer a range of potential price points between the exchange value and comparable alternative, defined by
differential value. Exchange value models tend to provide the most
insight in setting the price of revolutionary products. Developing
the zone of possible prices starts by determining whether the new
good offers more or less value than the comparable alternative.
Based off the previous determination, positive or negative differential value can be assigned to better understand the change
in consumer’s utility provided by the new offering.
Differential value plus the price of the comparable alternative sets
the exchange value. The price of a revolutionary product falling
between the exchange value and the price of a competing alternative delivers the best suited price according to value received.
Value that cannot be captured or value left on the table gives indication on how close the actual price is to the exchange value.
Price optimization tends to be the favored approach to price
setting in theoretical scenarios where elasticities of demand on
the individual and industry level are transparent and converge.
Mature markets where products are relatively commoditized allow the use of price optimization when determining which price
maximizes profit. Price optimization techniques often lead to
misstated prices because of the short-run perceived lens. The
disparity of elasticities between industry and consumer levels as
well as pinpointing the appropriate price elasticity challenges the
efficacy of price optimization. Representing true marginal cost
depends highly on which time frame the analysis is occurring.
Firm decision makers must tread lightly when utilizing economic
price optimization models when uncertainty is prevalent.
First Quarter 2013
The Journal of Professional Pricing
M stands
for the income
understand the change in consumer’s utility provided byalternative.
the new offering.
Differential
valueendowment
plus the of the consu
maximize
their
utility
by
consuming
X
N and X
C subject to the b
price of the comparable alternative sets the exchange value. The price of a revolutionary product
falling
that
characterizes
an evolutionary
product
between the exchange value and the price of a competing
alternative
delivers
the best suited
pricemarket with perfec
according to value received. Value that cannot be captured or value left on the table gives indication on
how close the actual price is to the exchange value.
Substitutes – An Economics Approach
α andsetting
θ are strictly
positivescenarios
numbers that
measure the value o
Price optimization tends to be the favored approach to price
in theoretical
where
alternative to the consumer. These scalars show the rate of su
elasticities of demand on the individual and industry level are transparent and converge. Mature
other
words the ratio of scalars represents the slope of the ind
Figure
1:
Optimal
Choice
Consumer Theory Price
markets
where
products
are
relatively
commoditized
allow
the
use of price optimization when
Setting: A Mixed Bag
differential value in exchange value models. Any other monot
determining
whichtheory
price maximizes
techniques often lead to misstated prices
Economic
consumer
represents profit. Price optimization
function would be a sufficient model for analysis.
how
a demander
consumption
because
of theallocates
short-run
perceived lens. The disparity of elasticities between industry and consumer
behavior
two
goods to maximize
levels asbetween
well as
pinpointing
the appropriate price elasticity challenges the efficacy of price optimization.
Exhibit 1: Optimal Choice
utility under constraints such as prices,
Representing
true
marginal
cost
depends
highly
on
which
time frame the analysis is occurring. Firm
time, and income. Consumer theory rests
decision
makers
mustthat
tread
lightly when utilizing economic price optimization models when uncertainty
on
the simple
foundation
individuals
are
utility maximizing entities with the
is prevalent.
driven purpose to make trade-offs depending on preferences and constraints.
Consumer
Theory
PriceofSetting:
Usually
the end
objective
consumerA Mixed Bag
theory in general equilibrium is to define
the
consumption
set thattheory
maximizes
the
Economic
consumer
represents
how a demander allocates consumption behavior between two
utility function and still remains on the
goods to maximize utility under constraints such as prices, time, and income. Consumer theory rests on
budget constraint. Other tangents can
thefollowed
simpletofoundation
that
individuals are utility maximizing entities with the driven purpose to make
be
derive equally
beneficial
outcomes.
tradeoffs depending on preferences and constraints. Usually the end objective of consumer theory in
general equilibrium is to define the consumption set that maximizes the utility function and still remains
Price determination of new product ofon the budget constraint. Other tangents can be followed to derive equally beneficial outcomes.
ferings can be the product of consumer
theory if massaged. This new way of
theoretically
thinking about
priceproduct
deri- offerings can be the product of consumer theory if massaged. This
Price determination
of new
positive numbers
that measure
vation
fits
best
in
the
evolutionary
product
setting
where
mar- α and θ are
new way of theoretically thinking
about
price
derivation
fits best instrictly
the evolutionary
product
settingthe value of
ginal improvements are distinguishable. Assumptions outlining the new good and comparable alternative to the consumer. These
where
marginal
improvements
are distinguishable.
Assumptions
approach
to pricing
scalars showoutlining
the rate ofthe
substitution
between
both products. In
the
approach
to pricing
through consumer
theory are as follows:
through consumer theory are as follows:
other words the ratio of scalars represents the slope of the indif1. Prices are linear (Price discrimination cannot be implement- ference curve and could be compared to differential value in exvalue models. Any otherprice
monotonic
transformation of the
ed…single
price model)
I.
Prices
are linear (Price discrimination cannotchange
be implemented…single
model)
generic utility function would be a sufficient model for analysis.
II. of comparable
Prices of comparable
are known
2. Prices
alternatives arealternatives
known
III.
The value of all goods are well understood Lagrangian optimization techniques or setting the marginal rate
ofLagrangian
substitutionoptimization
along the indifference
curveorequal
to the
price
ra3. TheIV.value of
all goods areare
well
understood price takers
Consumers
considered
techniques
setting
the
marginal
ra
tio will not offer a unique solution due to the perfect substitute
curve
equal
to
the
price
ratio
will
not
offer
a
unique
solution
d
assumption. The equimarginal principle will deliver the con4. Consumers are considered price takers
Perfect Substitute Case
The equimarginal
principle
deliver
the current
consumption
sumption
behavior, choice,
andwill
price
using the
model. behav
The
marginal
of theutility
new product
by its price
must by its
Perfect Substitute Case
model.
Theutility
marginal
of the divided
new product
divided
exceed
or
be
equivalent
to
the
marginal
utility
of
the
comparable
The
basic
utility
maximization
problem
facing
consumers
is
marginal
utility
of
the
comparable
alternative
divided
by its pr
The basic utility maximization problem facing consumers is outlined by
alternative divided by its price. In this instance a consumer will
outlined by:
choose to consume the new product due to marginal improve
choose to consume the new product due to marginal improvein price.
ment
in value according to a static change in price.
where X N and XC represent the quantity of new good consumed
and the quantity of comparable alternative consumed, respectively. PN and PC stand for the prices of the new and comparable
where XN and
XC represent
the quantity
of new
good
consumed and the quantity of comparable
alternative.
M stands
for the income
endowment
of the
consumer.
alternativeaconsumed,
respectively.
PN and
PC utility
stand for
the prices of the new and comparable
Essentially,
consumer prefers
to maximize
their
by conalternative.
M
stands
for
the
income
endowment
of
the
consumer. Essentially, a consumer prefers to
suming X N and XC subject to the budget constraint. A generic
maximize
their
utility
by
consuming
X
and
X
subject
to
the
utility function that characterizes an evolutionary
N
C product mar- budget constraint. A generic utility function
ket
perfect substitutes
is:
thatwith
characterizes
an evolutionary
product market with perfect substitutes is
α and
θ are strictly
positive numbers
value
of the
new
good andderivation
comparable
The
theoretical
of the new product price provides
The
Journal
of Professional
Pricing that measure the
First
Quarter
2013
23
alternative to the consumer. These scalars show the rate of substitution
between
both
products.
In
tradeoff factor between products and the price of the compa
The theoretical derivation of the new product
Figure 2: Optimal Choice
price
a means
evaluateof
value
ew product
price
provides
atomeans
totheevaluate
the valueprice
ratioprovides
or
Theprovides
theoretical
derivation
the
new product
a means to evaluate the value ratio or
or trade-off
factor
betweenalternative.
products
andand the price of the comparable alternative.
tradeoff
factor
between
products
nd theratio
price
of the
comparable
At the optimal choice, the slope of the indifference curve (MRS) is e
the price of the comparable alternative.
constraint (Price ratio). Mathematically deriving the optimal choice
product offering proves useful in price setting. Taking the natural l
easier manipulation and determination of the marginal rate of subs
Cobb-Douglas Case
Cobb-Douglas Case
Still under the assumptions outlined earlier
Still
under
theconstraints,
assumptions
outlined earlier and same budget constraints, but modifying the generic
and
same
budget
but modifying
utility
function
to
represent
Cobb-Doulas
preferences,
theand
generic
utility
function
to represent
Cobbd earlier
same
budget
constraints,
but modifying
the genericprice setting will occur through constrained
Douglas
preferences,The
pricenew
setting will occur
maximization.
function encompassing Cobb-Douglas preferences will offer a price
Doulasthrough
preferences,
pricemaximization.
setting utility
will occur
constrained
constrained
newthrough
determination
that does notThe
require
goods to be perfect substitutes.
tion encompassing
Cobb-Douglas
preferences will offer a price
utility function encompassing
Cobb-Douglas
preferences
will offersubstitutes.
a price determination that
e goods
to be perfect
does not require goods to be perfect substitutes.
In this case, α and θ are taste parameters essentially leading to different slopes of indifference curves.
Cobb-Douglas utility functions provide well-behaved indifference curves that prove to be easily
Inalgebraically
this case, α and θ are
taste parameters
leading means
to
managed.
Exhibitslopes
2 essentially
offers
a visual
of determining optimal choice through setting
metersdifferent
essentially
leading
to different
of indifference
curves.
slopes
of
indifference
curves.
Cobb-Douglas
utility
functhe marginal
rate of substitution
(MRS)
equal
to the price ratio.
ide well-behaved
indifference
curves that
prove
be easily
tions provide well-behaved
indifference
curves
thatto
prove
to be
Figure
2 offerschoice
a visualthrough
means of setting
fers a easily
visualalgebraically
means of managed.
determining
optimal
Exhibit 2:optimal
Optimal
Choice
determining
choice
through
setting
the
marginal
rate of
MRS) equal to the price ratio.
substitution (MRS) equal to the price ratio.
At the optimal choice, the slope of the indifference curve (MRS)
isAt
equal
the slope
of thethe
budget
constraint
(Price ratio). curve
Math-(MRS) is equal to the slope of the budget
the to
optimal
choice,
slope
of the indifference
take and
awaysolving
from the
constrained
ematically
the optimal
choice and solving
forthe
the optimal
price The
constraintderiving
(Price ratio).
Mathematically
deriving
choice
for
the price maximization
of the new approach rests
on
interpreting
the
differential
parameters, α and θ.
The slope of
ofproduct
the newoffering
product offering
proves
useful
in
price
setting.
Taking
proves useful in price setting. Taking the natural log of the utility function allows for
the natural log of the utility function allows for easier manipu- the indifference curve, regardless of which case, defines the tradeeasier manipulation and determination of the marginal rate of substitution.
off between competing products. Managers understanding the
lation and determination of the marginal rate of substitution.
taste parameters of consumers can better position their products
according to benefits of competitor’s products. The price determination in each case shows the magnitude of differential power between products. Accurately estimating such differences allows executives to better price products.
The challenges posed by this price setting model are similar to
those of economic price optimization. Capturing individual
utility and ordinal preference relationships will be the primary
downfall to the proposed technique. If such variables could be
measured the price point realized by this model would fall between the boundaries defined by exchange value models.
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First Quarter 2013
The Journal of Professional Pricing