Chapter 1

Boundaries of a Good Price

MKT1105 - Pricing Models and Strategy
Guide Questions
1. Who is involved in pricing decisions?
2. Why is pricing so important to the health of the firm?
3. Can firms influence their pricing power?
4. What is the nature of a good price?
5. How relevant are marginal costs and consumer surplus in setting a good price?
6. How should the comparable alternatives on the market influence the pricing of a
product?
7. How can exchange value models be used to set prices?
Pricing Errors Are Costly
Too high
➢ Lost profits from lack of volume
➢ The price is eventually dropped, and the company must fight for market
interest and perception repositioning
➢ Potential allegations of price gouging and unfairness, leading to public
relations and regulatory ramifications

Too low
➢ Forgone profit to gain volume which may not come
➢ Incorrectly set expectations for the product category, making future price
increases being driven against a headwind of customer expectations
Pricing Decisions are Stakeholder
Decisions

CFO
Sales and Marketing
Production
CEO
Value Exchange and Profit Capture
Price is the value that the firm captures in a mutually beneficial exchange with its customers

Profit
Profit = Quantity X (Price – Variable Costs) – Fixed Costs

p = Q (P – V) – F or p = Q (P – V) – F

Variable Costs (V)

Fixed Costs (F)
Volume or Quantity Sold (hence the Q)
Price (P)
Profit (p or p)
Value Exchange and Profit Capture
Problem No. 1

Suppose that a firm operates under the following conditions: Variable costs are P10.00
for each unit of production and fixed costs are P1 million per quarter. Currently, prices
average P25.00 per unit and volumes are 80,000 units per quarter. What is the current
profitability of the firm per quarter?
Profit = Quantity X (Price – Variable Costs) – Fixed Costs

p = Q (P – V) – F or p = Q (P – V) – F

Variable Costs (V)

Fixed Costs (F)
Volume or Quantity Sold (hence the Q)
Price (P)
Profit (p or p)
Value Exchange and Profit Capture
Problem No. 2

Assume that a firm produces an industrial product at a variable cost of P8,500.00 and
has fixed costs of P25,000.00 per week. Currently, the firm sells 20 units per week priced
at P10,625.00 per unit. What is the current company’s profit?

Profit = Quantity X (Price – Variable Costs) – Fixed Costs

p = Q (P – V) – F or p = Q (P – V) – F

Variable Costs (V)

Fixed Costs (F)
Volume or Quantity Sold (hence the Q)
Price (P)
Profit (p or p)
Marginal Improvement – Price Has Impact
Problem No. 3

Suppose that a firm operates under the following conditions: Variable costs are P10.00
for each unit of production and fixed costs are P1 million per quarter. Currently, prices
average P25.00 per unit and volumes are 80,000 units per quarter. What is the current
profitability of the firm?
Improve either P, Q, V, or F by 1%. How does this
Variable Costs (V) – P10.00
affect profit?
Fixed Costs (F) – P1,000,000.00
Volume or Quantity Sold (hence the Q) – 80,000
❑ Fixed Cost Reduction
units
❑ Variable Cost Reduction
Price (P) – P25.00
❑ Quantity Sold Increase
Profit (p or p) – P200,000.00
❑ Price Increase
Marginal Improvement – Price Has Impact
Consider a firm that improves one of the levers • Fixed Cost Reduction
– New Fixed Cost = P990,000.00
in the profit equation by 1%, holding all else – New Profit = P210,000.00
constant – Change in Profitability = P10,000.00
– Improvement of 5%

Example:
P = P25.00 • Variable Cost Reduction
– New Variable Cost = P9.90
Q = 80,000 units – New Profit = P208,000.00
V = P10.00 – Change in Profitability = P8,000.00
– Improvement of 4%
F = P1,000,000.00
• Quantity Sold Increase
Improve either P, Q, V, or F by 1% – New Quantity = 80,800
How does this affect profit? – New Profit = P212,000.00
– Change in Profitability = P12,000.00
– Improvement of 6%
Initial Profitability
p= 80,000 (P25-P10) – P1,000,000 • Price Increase
p = 80,000 (P15) – P1,000,000 – New Price = P25.25
– New Profit = P220,000.00
p = P1,2000,000 – P1,000,000 – Change in Profitability = P20,000.00
p = P200,000 – Improvement of 10%
The Art and Science of Pricing
The science of pricing refers to the act of gathering information, conducting quantitative
analysis, and revealing an accurate understanding of the range of prices likely to yield
positive results.

The art of pricing refers to the ability to influence consumer price acceptance, adapt
pricing structures to shift the competitive playing fi eld, and align pricing strategy to the
competitive strategy, marketing strategy, and industrial policy.
Boundaries of Price
There is a range of “right prices”
- Range implies boundaries, upper and lower

Marginal Cost = Extreme Lower Bound Consumer Utility = Extreme Upper Bound

➢ Marginal costs are the seller's bottom line. ➢ Consumer utility are the buyers bottom line.
➢ Any price below marginal costs leave the ➢ The customer would be worse off if they paid
seller worse off then they would be without more for a product than they gained in utility
the transaction. ➢ Any price below consumer utility would be
➢ Any price above it leaves the seller better off. leave the customer better off than going
Thus, marginal costs are the extreme lower without
boundary of the “right” price.
Competing Alternative and Differential Value
Narrow Boundaries
Marketing Strategy
➢ Products are valued because they enable a customer to do something, accomplish a goal,
from that product.
➢ Utility is derived from Goal accomplishment
➢ Prior to the existence of the product, most consumers found an alternative means of
accomplishing the same goal
- What are those alternatives?
- How much better can they achieve that goal, and perhaps others simultaneously, from
the product?
Competing Alternatives or Substitutes
Competing offers are often readably identifiable and form a
reference price.

Reference Price = Price of nearest comparable offer

Substitutes are sometimes more challenging to identify, but they

always exist.

Substitutes: any alternative means of achieving a similar set

of benefits

When possible, use more direct competitors to consider when

modeling price decisions
Differential Value
Differential value is the change in customer utility that a product delivers in comparison
to the alternative.

The economic exchange value of a product is the price of the nearest comparable
alternative adjusted for the differential value of the product.

Exchange Value = Price of Comparable Alternative (Reference Value) + Differential Value

Differential Value
Problem No. 4

Old Product is sold at P5.00 and Improved Product delivers P2.00 more in value to
customers than Old Product. Improved Product costs P3.00 per unit to make.

a. What is the price of the nearest comparable alternative for Improved Product?
b. What is the differential value of Improved Product in comparison to Old Product?
c. What is the exchange value of Improved Product?

Exchange Value = Price of Comparable Alternative (Reference Value) + Differential Value

Exchange Value Model
Consumer Surplus

Exchange Value

Maximum Potential Price

Transaction Price -----------------------------------------
Differential Value

Consumer Utility Reference Price

Comparable
Alternative
Price of
Marginal
Cost
Reference
Smith, T. (2013). Pricing Strategy: Setting Price Levels, Managing Price Discounts, and
Establishing Price Structures, 1st Edition. Cengage