Review

Factors that influence how reference price is formed




purchase context
cost
current prices
past prices
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Lecture 3
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Prospect theory
Value creation
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Prospect Theory
20" iMac MA876LL/A
Option A
$999.99
with $200 mail-in rebate
Option B
$799.99
3
Prospect Theory
Theory
 Consumers evaluate purchases as ______ and
______ relative to reference price


______ and _____ have a diminishing effect as they
grow larger
Consumers are more sensitive to _____ than to
_____
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Shape of the Value Function (According to
Prospect Theory)
Utility(+)
Value function
V(x)
-x
losses
0 w x
y
gains
V(-x)
Disutility(-)
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What is the Utility
for Option A?
An Illustrative Example
Loss
Change
in Utils
$200
-80
+30
$400
-60
$600
+20
$600
$800
+10
$800
-20
$1000
+5
$1000
-10
Gain
$200
Change
in Utils
+40
$400
What is the Utility
for Option B?
-40
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Value Creation
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Transaction Utility
Reference price
Transaction
Utility
Price
$0
Economic Value
For the consumer
Price consumer
is willing to pay
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Value Creation
Defining VALUE
Use Value (Utility)



Savings gained from using a product/service offering
Monetary gain from using a product/service offering
Satisfaction received from using a product/service offering
Economic Value/Exchange Value

Value based on substitutes/alternatives in marketplace

Calculated using reference value and differentiation value

Economic value is highly contingent on perceptions (or perceived
value). Marketing plays a large role in shaping consumer
perceptions of a firm’s products/services, as well as those of
competitors.
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Illustration of Value: the case of Market
Research Valuable

market research helps to provide information and
___________ in decision making
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Value of Information

How much should you pay for such information?



As much as the information is worth, but no more
Value of information is based on improved decision.
Value of perfect information vs. value of imperfect
information:

Value of _________ information will be LESS!
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Example


3M company is considering a new product that
targets outdoorsy college students.
The estimated R&D cost is $5 million and the
marketing cost is $5 million.
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Market Research
3M company is considering a new product that targets college
students.

The estimated R&D cost is $5 million and the marketing cost is
$5 million.

Consider two cases
(1) there is no uncertainty in the revenue.
(2) there is uncertainty in the revenue.

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Case 1: No uncertainty in revenue

The estimated R&D cost is estimated to be $10 million and the
marketing cost is $5 million.

Should 3M approve the project if the revenue is $10 million?

Should 3M approve the project if the revenue is $25 million?
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Case 2.1: Uncertainty in revenue



Suppose with 50% of chance, the product will be very popular,
bringing $30 million in revenue; and 50% of chance it will be
so-so, bringing $20 million.
Notice that the expected revenue is $ 25 million
A market research can ascertain which outcome is going to
arise. The cost of doing research is $1 million
Should the research be done? Why?
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Case 2.2: Uncertainty in revenue



Suppose with 50% of chance, the product will be a great
success, bringing $40 million in revenue; and 50% of chance it
will be a failure, bringing $10 million.
Notice that the expected revenue is again $ 25 million
A market research can ascertain which outcome is going to
arise. The cost of doing research is $1 million
Should the research be done? Why?
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Value Creation by Market Research


In case 2.1, what is the value, or the maximal amount of money
that the company is willing to pay for the market research?
In case 2.2, what is the value, or maximal amount of money
that the company is willing to pay for the market research?
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Value of Perfect Information
An important concept:
Expected Value of Perfect Information (EVPI)
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Expected Value of Perfect Information
(EVPI)

Frequently, information is available that can improve the
probability estimates for the states of nature.

The expected value of perfect information (EVPI) is the
increase in the expected profit that would result if one
knew with certainty which state of nature would occur.

The EVPI provides an upper bound on the expected value
of any sample or survey information.
Expected Value of Perfect Information
(EVPI)

The expected value of perfect information is defined as
EVPI = |EMVwPI – EMVwoI|
where:
EVPI = expected value of perfect information
EMVwPI = expected value with perfect information
about the states of nature
EMVwoI = expected value without information
about the states of nature
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Suppose with 50% of chance, the product will be a great success,
bringing $40 million in revenue; and 50% of chance it will be a failure,
bringing $10 million.
Without information
With perfect information
Success
0.5
Approve
25
0.5
Approve
Failure
Disapprove
Approve
-5
0.5
Disapprove
25
Success
0
-10
Failure
0
EMV(the best alternative without new info) = 10
0.5
Disapprove
0
EMV(the best alternative with free perfect info) = 12.5
EVPI = EMVwPI - EMVwoI
=
The most you are willingness to pay for any information
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Another way to look at it…

Remember: market research can only be valuable when it
can change the status quo course of action when there is
no information.
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Calculation

1. Identify the status quo course of action when no market
research is available, by calculating expected revenue and/or
expected cost.
 2. Identify the scenario in which market research can
change the course of action.
 3. Determine the gain conditional on that scenario.
 4. Multiply the conditional gain and the probability for the
occurrence of the scenario.
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A Worked Example


The estimated R&D cost is estimated to be $10 million and the
marketing cost is $5 million.
Suppose with 50% of chance, the product will be a great
success, bringing $18 million in revenue; and 50% of chance it
will be a failure, bringing $10 million.
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Calculation

1. Identify the status quo course of action when no market
research is available, by calculating expected revenue and/or
expected cost.
 2. Identify the scenario in which market research can
change the course of action.
 3. Determine the gain conditional on that scenario.
 4. Multiply the conditional gain and the probability for the
occurrence of the scenario.
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Hint: there are 2 scenarios in which the research has the
potential to change status quo course of action.

A Final Example (with answer)


The estimated R&D cost is estimated to be $20 million and the
marketing cost is $5 million.
Suppose with 1/3 of chance, the product will be a great success,
bringing $90 million in revenue; with chance of 1/3 it will be a
failure, bringing $15 million revenue, and with 1/3 it will be a
disaster and will generate zero revenue.

What is the value of the market research here?

The answer is $11.67 million
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EVA - based on product differentiation
Total Economic Value
Reference Value
or
Reference Price
Positive
Differentiation
Value
Negative
Differentiation
Value
+$
Final $
-$
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Importance of Differentiation Value

Selling hot dogs at the street corner of
NYC
Case A
Case B
WTP
WTP
Your cost
Competitor
cost
Your cost
Competitor
cost
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Importance of Having Differentiation Value
Netflix
Inventory
# of distribution
center
Price charged
For 2 at a time
Approx. 100,000
Cleanfilms.com
Approx. 1,000
40+
1
$17.99
$19.99
Secret of survival?
Happy together thereafter?
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
A not-so-fairy-tale ending
• The Directors Guild of America and the Motion Picture Association of
America sued most of these industry players for copyright infringement
and claims regarding derivative works.
• In 2006, Judge Richard P. Matsch of the United States District Court for the
District of Colorado ruled that it was a copyright violation to distribute reedited movies without the consent from the movie studios.
• Cleanfilms.com notified its subscribers the loss of the battle while
ensuring them that they commit to rent only the “clean” films.
• Cleanfilms.com went out of business soon after.
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Next Lecture

More on Value Creation

Value Measurement & Communication
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