Competing on Price
Pricing Strategies
Pricing strategy: the approach a firm takes to setting the price of a product over time.
The spec names six. Each one suits some situations and fails in others, which is where the marks for evaluation come from.
Cost-Plus Pricing
Cost-plus pricing: adding a percentage mark-up to the cost of making each unit to set the price.
\[ \text{Price} = \text{Unit cost} + (\text{Unit cost} \times \text{Mark-up}) \]
Worked Example: A Cake Maker
A cake maker spends £6 on ingredients and £8 on labour for each celebration cake, and adds £6 per cake to cover rent and other overheads. She uses a 40% mark-up.
| Step | Working | Answer |
|---|---|---|
| Unit cost | £6 + £8 + £6 | £20 |
| Mark-up | 40% × £20 | £8 |
| Selling price | £20 + £8 | £28 |
Each cake sells for £28 and earns £8 above its unit cost. That only holds if she sells as many cakes as she planned: the £6 overhead share assumes a set number of orders, and with fewer, each cake carries more of the rent.
To find the mark-up from a price and a unit cost, work backwards: \[ \text{Mark-up } (\%) = \frac{\text{Price} - \text{Unit cost}}{\text{Unit cost}} \times 100 \]
A mark-up is a percentage of cost, not of price. The cake maker's £8 mark-up is 40% of the £20 cost, but only 28.6% of the £28 price (8 ÷ 28 × 100). Divide by unit cost for the mark-up. Dividing by the selling price gives the profit margin instead, a different figure.
Cost-plus is simple and makes sure each sale covers its cost. Its weakness is that it ignores demand and rivals' prices. If a rival sells a similar cake for £24, customers will not pay £28 because that is what it cost to make.
Price Skimming
Price skimming: launching a new product at a high price, then lowering it over time.
A new games console is first bought by enthusiasts who will pay most. High launch price → a large margin on each early sale → R&D costs are recovered quickly → later price cuts bring in more cautious buyers.
It needs a product rivals cannot copy straight away, often protected by a patent (unit 2.1.3). The high profit attracts rivals, and early buyers may resent a quick price cut.
Penetration Pricing
Penetration pricing: launching at a low price to win market share quickly, then raising it.
Low launch price → customers try the product and switch from rivals → market share and higher output → economies of scale lower unit cost. It suits a mass market where demand is price elastic, such as a new streaming service with a cheap first year. The risks are low profit or losses at first, and customers leaving when the price goes up.
Predatory Pricing
Predatory pricing: setting a price below cost to force rivals out of the market, then raising it.
Price below cost → rivals make losses and leave, or a new entrant gives up → less competition → the firm raises prices and recovers its losses. Only a large firm with enough cash to survive the losses can do this, and it is illegal when a dominant firm uses it (unit 4.2.2).
Competitive Pricing
Competitive pricing: setting a price at or close to rivals' prices.
It is the norm where products are similar and customers compare prices, such as petrol or supermarket staples. Charging more loses sales, and charging less may start a price war, so firms compete on service, location and brand instead (unit 2.2.3).
Psychological Pricing
Psychological pricing: setting a price for its effect on how customers see the product.
A price of £9.99 → customers read it as "£9 and something" → it feels much cheaper than £10 → more sales. It can work the other way too. A high, round price such as £500 for a watch signals quality and status, and a lower price could put buyers off.
Choosing the Right Strategy
Which strategy is most appropriate depends on:
- Number of USPs and amount of differentiation: a product with features rivals lack can be skimmed or priced at a premium. A standard product has to be priced competitively.
- Price elasticity of demand: inelastic demand supports skimming and higher prices. Elastic demand favours penetration or competitive pricing, because a price cut wins many extra sales (unit 2.2.1).
- Amount of competition: with many close rivals, the firm has little choice but to match their prices. With few, it has room to set its own.
- Strength of brand: a well-known brand can charge more than rivals and keep its customers, so it rarely needs to compete on price.
- Stage in the product life cycle: skimming or penetration at launch, competitive pricing in maturity, and price cuts to clear stock in decline (unit 2.1.3).
- Costs and the need to make a profit: in the long run the price has to cover unit cost. A small firm cannot afford months of penetration or predatory losses that a large firm can absorb.
Pricing, Online Sales and Price Comparison Sites
More shopping now happens online, and price comparison sites (unit 2.1.4) show every seller's price side by side. Pricing has changed as a result:
- Sellers of standard products: shoppers see every price in seconds → demand for each seller becomes more price elastic → firms are pushed into competitive pricing → lower margins and profit.
- Online retailers: no shops to rent or staff → lower costs → lower prices → high-street rivals lose sales unless they match the price or give a reason to pay more.
- Firms that change prices often: online prices cost nothing to change → airlines and hotels raise them when demand is high and cut them when it is low → more revenue from the same seats and rooms.
Firms respond by making their prices harder to compare: bundles, versions sold through only one retailer, and loyalty-card prices.
How much this changes a firm's pricing depends on:
- How easy the product is to compare: broadband deals and flights are compared mainly on price. A restaurant meal or a haircut is not.
- Brand loyalty: loyal customers may not look at a comparison site at all.
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