Unit 2 · Topic 2.5 · about 35 minutes
Price
Choose and defend a pricing strategy for a product, judge how much pricing power a business has, and recognize pricing the law does not allow.
Predict first
A phone case company sells 2,000 cases a month at $20 each.
To win more customers, it cuts the price to $15, and sales climb to 2,500 cases a month. What happens to its monthly revenue?
What a price has to do
A pricing strategy is a way of determining how much to charge for a product. Setting the right price is critical to a business's viability, because price helps attract and keep customers and decides how much revenue and profit each sale brings in. Price too high and customers go to rivals; too low and every sale can lose money.
Whatever the strategy, a business considers its per-unit cost: what it costs to produce one unit of a good or service and get it to the customer. For Kestrel Bottle Co., which makes insulated water bottles, the per-unit cost is $12.50 once making and shipping each bottle are counted.
The price minus the per-unit cost is the per-unit profit. A low price may help a business gain market share, but a product is not profitable if its price is equal to or lower than its per-unit cost. If Kestrel sold its bottles for $11, it would lose a dollar and a half on every one, and selling more would only make the loss bigger.
| Strategy | What sets the price | More likely when |
|---|---|---|
| Value-based pricing | The perceived value or worth of the product to the customer | The product is highly differentiated or uniquely valuable |
| Competitive pricing | The prices of rival products, often called price matching | Rivals sell similar products, and differentiation decides whether the price sits above, at or below theirs |
| Cost-based pricing | The per-unit cost plus the per-unit profit the business wants | Per-unit costs are clearly defined and can be explained to customers, as with construction contractors |
| Penetration pricing | A low price, possibly below per-unit cost, that the business plans to raise later | The goal is to pull price-sensitive customers from competitors and grow market share quickly |
How each strategy works
Value-based pricing starts with the customer: what is the product worth to the people who buy it? It fits highly differentiated or uniquely valuable products, because customers will pay for what they cannot get elsewhere. A violin maker whose instruments are played in professional orchestras does not price them by the cost of the wood.
Competitive pricing starts with rivals' prices. A business that believes its product is sufficiently differentiated may charge a premium over competitors. One whose product lacks differentiated features may price at or below them to gain market share, giving up per-unit profit to do it.
Cost-based pricing starts with the per-unit cost and adds the per-unit profit the business wants, without considering perceived customer value or rivals' prices. A deck builder can walk a homeowner through the cost of the lumber and labor, then add its profit on the job.
Penetration pricing is low on purpose, possibly below per-unit cost, and meant to be raised later. A new streaming service that charges a few dollars a month for its first year is trying to attract price-sensitive customers away from competitors and grow market share quickly.
Sort it
Tap each business, then tap the pricing strategy it is using.
Value-based
Competitive
Cost-based
Penetration
Worked examplePricing Kestrel's new bottle
Kestrel is launching a 32-ounce bottle with a built-in water filter that no rival offers. Its goal is the highest per-unit profit its target customers, hikers and campers, will accept.
- Per-unit cost: $12.50
- Rivals' 32-ounce bottles, none with a filter: about $26
- Survey of 400 hikers: a bottle with the filter is worth about $38 to them
Which pricing strategy fits the goal, and at about what price?
Set the floor. At or below $12.50, every bottle earns nothing or loses money. Penetration pricing could go that low, but it serves fast growth in market share, not per-unit profit.
Cost-based. Adding a desired profit of $10.00 to the per-unit cost sets the price at 12.50 + 10.00 = $22.50, so Kestrel earns $10.00 a bottle. That ignores the filter and undercuts rivals' plainer bottles.
Competitive. Matching rivals at about $26 earns 26 minus 12.50 = $13.50 a bottle. The filter clearly differentiates the bottle, so a premium over rivals is possible.
Value-based. Pricing at what hikers say the bottle is worth earns 38 minus 12.50 = $25.50 a bottle, the most of the three. No rival offers a filter, so hikers cannot find one cheaper elsewhere.
Value-based pricing at about $38. A survey answer is still a hypothesis about what people will pay, so Kestrel should test the price with real customers first. Had the goal been fast growth in market share, penetration pricing would have fit better. The goal picks the strategy as much as the numbers do.
Pricing power
Some businesses can raise prices and keep their customers; others lose them the moment they try. Pricing power is the ability to raise prices without risking market share.
Market conditions decide much of it. A business in a highly competitive market with little product differentiation has little pricing power, and competition may force it to keep prices as low as possible: if one of five smoothie shops on a block charges more for the same smoothie, customers walk next door. A business in a less competitive market, or one selling a highly differentiated product, has more pricing power and can use more profitable pricing strategies.
Customers' reactions matter too. When they are highly responsive to price changes, a price increase can reduce revenue because they buy significantly less. A price cut can raise sales without raising them enough to make up for the lower price, as the phone case company found at the top of this lesson.
| Smoothie shop on a block with four rivals | The only ferry to an island | |
|---|---|---|
| Old price | $6.00 | $15.00 |
| New price | $6.60 | $16.50 |
| Sold per week before | 1,000 smoothies | 2,000 tickets |
| Sold per week after | 820 smoothies | 1,940 tickets |
| Weekly revenue before | $6,000 | $30,000 |
| Weekly revenue after | $5,412 | $32,010 |
Elastic and inelastic demand
The smoothie shop's customers are highly responsive: plenty of other shops sell smoothies, so the higher price cost it 180 sales a week and its revenue fell. The ferry's riders have no other way to the island, so almost all of them kept riding, and the same increase raised the ferry's revenue. The ferry has far more pricing power.
Businesses measure this responsiveness, and how a price change will affect sales and revenue, with price elasticity of demand. Demand is more elastic when customers are responsive to price changes, like the smoothie buyers, and more inelastic when they are less responsive, like the ferry riders. A business facing more elastic demand is limited in its ability to raise prices compared with one facing more inelastic demand.
Where pricing breaks the law
- Collusion. Colluding with competitors to set an agreed-upon price, typically one higher than the competitive market price, is illegal in many countries, including the U.S. Two concrete suppliers that agree to charge contractors the same high price are colluding. A gas station that matches a rival's price on its own is using competitive pricing, which is legal. The agreement is what makes it collusion.
- Price gouging, raising the price of a product when demand rises because of a crisis, is illegal in many U.S. states and in many countries. A store that triples its price for generators the day after a hurricane knocks out power is gouging. A ski resort that charges more in holiday weeks is not, because a busy season is not a crisis.
- Price discrimination, charging different prices to different customer segments for the same product, is illegal in many places when done on the basis of race, nationality, sex or another protected status. A museum's student discount is legal. A car dealer that quotes higher prices to customers of one race is breaking the law.
Check your understanding
A new frozen yogurt shop opens on a street with two established shops. For its first three months it charges $3 a cup, less than it costs to make and serve each cup, and it plans to raise the price once it has won over regular customers. Which pricing strategy is it using?
A food truck raised the price of its tacos and tracked its weekly sales.
- Before: $4 a taco, 1,200 tacos a week
- After: $5 a taco, 900 tacos a week
By how many dollars did weekly taco revenue change? Use a negative number for a decrease.
Two sandwich shops in different towns each raise their prices by 10%. Afterward, Shop A sells 25% fewer sandwiches and Shop B sells 3% fewer. Which conclusion is best supported?
Which of these pricing practices is illegal in the United States?
A candle company wants to win market share from a much larger rival.
- Its per-unit cost: $14 a candle
- The rival's price: $12 a candle
The company matches the rival's price and has no plan to raise it later. Which statement best evaluates this plan?
Course alignment, for teachers
AP Business with Personal Finance topic 2.5, Unit 2: Marketing.