How do firms choose their pricing strategies? Do higher prices automatically result in higher profits? How do firms that opt for premium pricing compare to firms that opt for volume? Do price increases always result in higher total revenues? These strategic policy questions relate to the optimal price points of a business enterprise-the appropriate mix of value propositions that maximizes net income and thus the return on investment and shareholders’ wealth while minimizing the cost of operations, simultaneously.
There are divergent pricing objectives and many factors influence pricing strategies. For those familiar with the relevant academic literature the critical factors are well known and supported by contemporary research. The primary goals of effective pricing strategies and core elements of effective pricing strategies are equally well established. However, some industry watchers and practitioners continue to identify profit maximization as the primary goal of business enterprises. As we have advised in previous review and guidance, this focus on profit maximization is a bit misguided.
While profit maximization is a legitimate strategic business goal, for several reasons the primary goal of a business is survival at least in the short run. There is gathering empirical evidence suggesting that when businesses overlook this reality and make profit maximization their primary and dominant goal, they tend to engage in conduct and pursue strategies that threaten their very existence. Contemporary case studies are replete with modern examples such as AIG, Bear Stearns, Enron, Global Crossing, Lehman Brothers, Refco, Washington Mutual, and WorldCom, etc. In this review, we highlight some basic economic theory and best industry practices of effective pricing strategies. This article provides general guidelines for establishing optimal pricing strategies and effective cost minimization strategies. For specific pricing and cost management strategies please consult competent professionals.
A close review of relevant extant academic literature indicates that most firms seek to maximize net income (difference between total revenues and total costs) based on several factors such as the stage of the industry life cycle, product life cycle, and market structure. Indeed, as we have already established, the optimal value proposition for each firm differs markedly based on overall industry dynamic, market structure-degree of competition, height of entry/exit barriers, market contestability, and its market competitive position. Additionally, as with most market performance indicators, firm-specific profitability index and revenue growth rate are insightful only in reference to the industry expected value (average) and generally accepted industry benchmarks and best practices.
In practice, firms use pricing objectives and the price elasticity of demand for products and services to set effective pricing policies. Basic economic principles suggest that price elasticity of demand indicates the sensitivity of customers to changes in pricing, which in turn affects sales volumes, total revenues and profits. Economic principles suggest that the price elasticity is low for essential goods because people have to buy them even at higher prices. On the other hand, the price elasticity is high for non-essential and luxury goods because consumers may not buy them at higher prices, ceteris paribus.
Optimal Pricing Strategies
Optimal pricing points maximize profits by charging exactly what the market will bear. Managers may adjust their pricing strategies depending on changes in the competitive environment and in consumer demand. Most successful world-class firms rely on effective environmental scanning, environmental analysis and market analytics to make informed decisions that create and sustain competitive advantage in the global marketplace. In practice, the core elements of optimal pricing strategy include the value of the product to prospective customers, the price charged by key competitors, and the costs incurred by the firm from new product idea generation to commercialization.
Further, optimal pricing is derivative of effective price discrimination which means that firms segment their market into distinct customer groups and charge each group exactly what it is willing to pay. The optimal price and volume refer to the selling price and volume at which firms maximize profits. While some small-businesses often may not know exactly what consumers are willing to pay because of limited market analytics, inept marketing information systems and ineffectual environmental scanning, most firms use historical cost data, price points, and sales data to establish market trends. In practice, most small businesses make reliable assumptions and useful estimates based on historical sales patterns and set product mix and pricing strategy accordingly.
Managerial economic principles suggest that long-term success and profitability depend on optimal pricing, or producing an output to the point where the additional revenue of an extra unit of output equals the additional cost of producing that unit: (MR=MC); in other words, producing where marginal revenue equals marginal cost. In practice, we can derive marginal revenue from the firm’s demand. The mathematical derivation is given by: MR = P(1+(1/Ed)) =MC. However, an easier method of deriving marginal revenue is to use the price elasticity of demand. Since maximizing profit requires marginal revenue equals marginal cost, we can derive optimal price from the relationship between marginal revenue and the price elasticity of demand. Consequently, the optimal price is P = MR = MC(Ed/(Ed+1)). As we know, based on law of demand price elasticity is a negative. Therefore, optimal price, P = (MC*Ed)/(Ed-1).
Additionally, there is a confluence of empirical evidence in the extant academic literature suggesting that optimal pricing is possible only when there is a difference in price elasticity for different consumer groups. For example, a store chain may price the same item higher in a wealthy neighborhood, where consumers may be less sensitive to price, and lower in a working-class neighborhood, where consumers may be more sensitive to prices. The factors that affect price elasticity include whether the product is a necessity or luxury, the availability of substitute products and the proportion of disposable income required to buy certain product. The price elasticity will be high if consumers can buy alternative products or if they have to spend too much of their discretionary income.
Some Operational Guidance
Basic economic principles are supported by gathering empirical evidence suggesting that higher prices do not guarantee profit and higher total revenues do not guarantee profit. In practice, most world-class firms know that the critical variable is effective cost management. The objective functions are revenue enhancement and cost minimization. Indeed, competitive advantage in the global marketplace derives from strategic options based on EQIC: Efficiency, quality, innovation and customer responsiveness. Further, because profit is the different between total revenues and total costs, there are several ways firms with market power maximize the profit producing capacity of their enterprise. Firms can increase profit by increasing total revenues while reducing total costs; and they can increase profit by increasing total revenues while keeping total costs from rising; or they can increase profit by increasing total revenues more than they increase total costs.
Additionally, revenue enhancement can be quite expensive and often, the relationship between profitability and revenue growth is quadratic which implies that revenue growth rate may be functional and profit-enhancing or dysfunctional and profit-reducing. For most successful firms, the strategic objective is to locate the optimal revenue growth rate of the enterprise where profit is maximized, ceteris paribus. Two strategic value propositions and pricing options based on Du Pont ROI model are available to most firms: Premium pricing (emphasizing high mark-ups, high profit margins and profitability); and High turn-over rate (emphasizing high productivity and effective use of available assets). There is significant empirical evidence suggesting firms that opt for scale and volume tends to outperform those that opt for segment and premium, all things being equal.
Managerial economic principles suggest that price effects depend on the size of income effect and substitution effect. Further, the effect of price changes on total revenues depends on price elasticity of demand. When products are price elastic, price increases will reduce total revenues while price reductions will decrease total revenues when products are price inelastic. The opposite is equally true. Therefore, firms seeking revenue enhancement should lower prices if products are price elastic and increase prices if products are price inelastic, all things being equal.
Moreover, the target is optimal scale of operation-the Minimum Efficiency Scale (MES) where firms minimize their long-run average cost via economies of scale. As we have already established, scale economies derive from economies of scope, division of labor, specialization, experience curve, and learning effects. A careful analysis of the extant academic literature suggests that the optimal price path should be largely based on the sales growth pattern. However, in the real world we rarely find new products that have such pricing pattern. Indeed, we observe either a monotonically declining pricing pattern or an increase-decrease pricing pattern that does not seem close to the actual historical sales path.
Contemporary research on optimal pricing for the most part contend that the dominant firms and most firms with market power will maximize their present value by either charging the short-run profit maximizing price and allowing their selective demand-market share to decline or by setting price at the limit price and precluding all new entry. And because price sends multiple signals to diverse stakeholders including regulators, current and potential competitors, firms that opt for short-run profit maximization would have to ignore continually the reality of induced potential and new entrants and close scrutiny by diligent industry regulators.
Conversely, firms charging the limit price have to be convinced that their prevailing market share is optimal, that is P = (MC*Ed)/(Ed-1). While there is only limited analytic justification for this strategic dichotomy, professional intuition suggests that the optimal strategy requires careful balancing between current profits and future market share. Managerial economic principles strongly suggest that the rate of entry of rival producers into a specific market is a function of current product price. There is strong empirical evidence indicating that the variation in rate of firms entering or exiting an industry is positively correlated with the level of industry profits. Therefore, a dominant firm with high current product price and profit levels may be sacrificing some future profits through gradual erosion of its selective demand-market share.
In sum, optimal pricing strategy depends on effective cost management, market dynamism, and price elasticity of demand. Regardless of market structure-degree of competition, the output level where MR = MC is always optimal, whether the firm is earning an economic profit, breaking even, or operating at a loss. Firms seeking to minimize costs should operate at the output level where P = MR = MC = minimum ATC -the price is equal to marginal revenue, and the marginal cost; and the minimum of average total cost. This is a very useful economic principle because when a firm is earning profits-it maximizes profit where MR = MC and when a firm is incurring losses, it minimizes loss where MR = MC and the minimum of the ATC, ceteris paribus.