Pricing is the exercise of determining the right price, i.e., the one that will maximize your sales and your margin. It is a complicated exercise because a price that is too high could decrease demand, and a price that is too low will decrease the margin. You can find pricing in the 4Ps of marketing, but it has some specificities. If the first 3 “P’s” (Product, Promotion, Place) allow us to plant the seeds of success, pricing allows us to achieve this success through sales. Let’s end this introduction by underlining that a good price is not a guarantee of success, but a bad price is a guarantee of failure.
In this article, we cover the main topics related to pricing to give you a synthetic overview. Of course, we cannot be exhaustive and do not pretend to replace the reference books on the subject.
- Pricing as a component of the company’s strategy
- The economic theory of price formation
- The 3 main types of pricing
- 6 price-based business models
- 6 pricing techniques to influence the consumer
- Defining price sensitivity: 10 pricing techniques explained
Pricing as a component of the company's strategy
Pricing is a key factor for the profitability and, therefore, the survival of companies. Research conducted on 394 companies between 1970 and 2013 showed that the best performances were achieved by those who focused on profitability rather than growth.
Yet pricing is a difficult exercise. Determining the best price is a strategic exercise for the company because it requires understanding the value perceived by the customer. However, understanding this value is theoretically impossible without putting yourself in the customer’s shoes. It is, therefore, necessary to use market research techniques to get as close as possible to;
- the perceived value
- the differences in perception according to the prospect’s profile
Determining the best price requires understanding the customer’s perceived value.
From this exercise, segmentation is born, and the possibility of applying different pricing models to maximize margins.
We understand that pricing is not an exercise reserved for the company’s financial department. It is an exercise that:
- is born where innovation takes place, and new products/services are conceived
- continues in the market research department
- ends in a dialogue between the marketing and finance departments
The economic theory of price formation
The pricing exercise must consider the microeconomic laws governing a free market’s price setting.
Microeconomics teaches us that the price is established at the intersection of the supply and demand curves. When supply exceeds demand, the price falls. When demand exceeds supply, the price rises. This model works in a free market, and we have seen that it is true:
- on the automotive market in 2021 with a drastic decrease in supply (lack of components) and an explosion of profits for car manufacturers
- on the luxury watch market with an increase in demand and an explosion in the prices of certain models on the secondary market
Like any model, it has its exceptions, and we must consider pricing. Price elasticity is a component of the law of supply and demand that must always be kept in mind.
Demand is logically affected by price. Demand is expected to decrease as prices increase because fewer customers will want to pay a higher price.
However, many real-life situations show that a price can be inelastic. In other words, in some cases, demand does not decrease in the same proportion as a price increase:
- When energy prices rise, demand remains relatively constant because people need to travel, heat and light. This is a constrained expenditure.
- When the price of a product increases, it can implicitly send a quality signal to the consumer that encourages him to buy. On the other hand, a price that is too low may arouse suspicion, and the prospect may abandon the purchase.
The elasticity of demand as a function of price is, therefore, a variable to be considered in pricing. Enzo Ferrari’s rule is exemplary: “Always produce one vehicle less than the demand.” Thanks to this, your pricing is optimal. Many luxury players apply this rule.
The 3 main types of pricing
As you can see, pricing is the activity that allows us to determine the “right” price.
The “Cost Plus Pricing” method is probably the most basic and common. It consists of adding a margin to the costs of the product/service sold. It is an approach to pricing that is purely financial and in the hands of the department of the same name.
This pricing method is far from ideal because it requires understanding the product/service cost structure: fixed and variable costs. It also requires a fair allocation of overheads and ABCosting-type calculations. Finally, production costs can vary over time, and “Cost Plus Pricing” requires a permanent recalculation.
The “customer-driven pricing” approach is undoubtedly better than the previous one. It takes into account the willingness to pay (WTP) of customers.
This requires understanding the value that a consumer can attach to a product. This is a particularly risky exercise when the product or service is innovative, and the consumer has no reference point. Research has shown that the first consumers did not perceive the value of the first mp3 players and air conditioners, … and that pricing according to “logical” criteria would have led to an unviable situation.
The third type of pricing is called “share-driven.” It involves letting competitive forces dictate the market price. Its objective is to gain market share.
In most cases, there is no good reason to try to gain market share at all costs. It will only harm your margins and profitability in the long term. Share-driven pricing is, therefore, not recommended in all situations.
6 price-based business models
6 price-based business models
In the following paragraphs, we present 6 business models based on price. From low cost to luxury to freemium, pricing becomes a central element for companies adopting these models.
Price can be an element of differentiation. The price then becomes the essential element of the company’s strategy. Examples are numerous, and the current crisis context can only reinforce the popularity of this business model.
Companies that opt for low-cost hope to capture additional market share through low prices. They are inspired by an old pricing theory (PIMS or Profit Impact of Market Share) which made low margins a growth factor by capturing market shares.
Freemium is a business model where pricing plays a central role. A product or service is proposed for free to the user. The latter can enjoy it without paying until he wants to unlock certain features.
This pricing model comes in many forms. Some restaurants apply an “all you can eat” formula, which has become their trademark. But the most common form is, of course, the subscription model.
Subscription is a business model that has spread in many sectors; this article gives 11 examples in sectors as diverse as e-commerce, VOD, retail, or software.
PWYW is a very special pricing model. The customer decides what he wants to pay (Pay What You Want).
One airline company had tried it, but it was more of an auction model when you look at it closely.
Real examples of PWYW are still rare, but they do exist. A few years ago, we talked about a shoe brand, Garçonne et Chérubin, and even interviewed its founder to get his feedback on this pricing method.
Dynamic pricing consists in varying the prices for the same product/service according to:
- of the demand
- the offer
- the consumer’s profile
To vary prices according to supply and demand is the basis of microeconomics. Airlines do this well, and it even has a name: yield management.
What is more questionable is to vary prices according to your profile. Of course, pricing is according to the risk profile (the insurance model), but we are talking about even more dynamic pricing. The price can vary according to your actions, assumed profile, and purchasing power. This raises real ethical questions. Are we all equal in front of prices?
Technology, and in particular algorithms, have made it possible to create these consumer profiles almost in real time and calculate a probability of sale. Some applications are really “borderline.” For example, they presented facial recognition technology at the NRF retail show in New York. It opened the way to pricing “according to the customer’s head” (literally).
A high price is part of the DNA of luxury. According to Jean-Noël Kapferer, a company active in the luxury sector has no choice but to raise its prices to send a signal to the market. This “pricing power” also reflects the attraction it has on its customers.
To maintain its pricing power, a brand like Ferrari always makes sure to “produce one less car than the demand.” This probably explains why it is doing so well, and its sales are only growing (see graph below).
LVMH is another case in point. In October 2022, during the crisis, the parent company of Louis Vuitton raised its prices in Europe. The weakness of the Euro against the dollar is encouraging American tourists to make massive European purchases. LVMH’s pricing power allows brands to easily increase their margins without fearing a decrease in demand.
Defining price sensitivity: 10 pricing techniques explained
We saw earlier that the price level and elasticity determine the level of demand. The pricing strategy must therefore include the price sensitivity of the target customers. This sensitivity depends on the product/service sold and can be studied using various technical approaches. We present them briefly in the table below.
|Controlled environment experience
|Actual purchases (observed data)
|transaction history (e.g., via loyalty card or CRM)
consumer panel data aggregated by a market research firm
checkout (data collected by the retailer)
|in-situ experiment (in-store)
|Preferences or intentions
|In-store short interviews
semi-structured face-to-face interview
We can follow several technical approaches to understand the price sensitivity of consumers. We must then reuse this sensitivity analysis to feed the reflections around pricing. We regularly perform these exercises in our B2C and B2B research.
We distinguish several situations depending on the nature of the data (purchases/purchase intentions) and the environment (controlled/uncontrolled).
A consumer’s transaction history or group of consumers can be used to understand how price changes affect their buying propensity. Structural equation models are the most common. These are statistical research studies that model behavior and predict the effects of a price change.
This allows you to define your pricing according to your strategic objectives:
- increase your market share
- maximize your revenue
- maximize your margin
Data from the consumer panels
Consumer panels (which we use for our B2C research) are very useful for tracking household consumption. In particular, you can observe consumption trends for each product type and deduce whether price sensitivity increases or decreases.
Data from the checkout
We can also analyze checkout data held by the retailer to detect trends in price changes.
Short interviews at the checkout can be realized. They have the advantage of taking place in situ, i.e., in the purchase context. This is the ideal moment to make the customer’s memory work.
We can ask questions about purchase intentions via online surveys. Our market research firm uses this approach for many surveys. The difficulty remains in differentiating between aspirations and actual behavior. A famous example is that of organic consumption. For years, surveys delivered very enthusiastic results about consumers’ intentions, but purchases did not take off. To learn more, go here for figures on the European organic market and an analysis of the 2021-2022 trends.
Note, however, that there is some skepticism about whether those surveyed can put a monetary value on an object or service. We recommend reading this article to learn more about the limitations of this type of approach.
The semi-structured interview is more in-depth than the checkout interview. It allows us to link price sensitivity to the respondent’s situation and understand the hidden factors influencing their choices.
It is a qualitative technique whose usefulness can be understood within a more global market research approach here.
Research sometimes takes place in situ. For example, environmental factors (light, noise, odors) modify consumer behavior. It is, therefore, interesting, as in this research, to vary these factors to observe customers’ reactions. We are, therefore, in a controlled environment.
Regarding price sensitivity, there are also many possibilities for conducting in-situ research.
You can use a website and decide to show one price to one group of users and another price to the second group. This is called A/B testing.
If you have access to a physical location, you can imagine doing the same thing by changing the labels (or changing the prices on electronic labels). These give a lot of flexibility and minimize the costs of in-situ pricing research.
Laboratory experiments can also better control the ambient parameters and measure the customer’s reactions. Often eye-tracking technologies are very useful.
Building a real fake store just for research purposes is, of course, expensive. It exists, but technology offers new possibilities. Virtual reality allows, for example, to recreate virtual environments where customers can move around.
Experiments are also possible to simulate purchases. In this case, we will work with a panel of testers who will have to choose from several options. This is similar to A/B testing except that the environment in which the simulation is done is a test environment.
In pricing, you will often hear about conjoint analysis. A conjoint analysis works by making the participant choose between 2 options. This technical approach does not measure absolute amounts (see the limitations raised by Diamond and Hausman in this article).
6 pricing techniques to influence the consumer
Marketers have several techniques that allow them to influence customers’ choices unconsciously. These techniques are based on psychological mechanisms and, therefore, relate to nudge marketing.
When you go shopping, the environment (physical or online) “sends” signals that are unconsciously interpreted by your brain. Light, sounds, smells, but also visible or suggested images are all factors that will influence your decisions.
The brand positioning will also influence your choices without you realizing it. The simple fact of hammering in your communication that you are the cheapest will change the customers’ perceptions. In every country, retailers have positioned themselves in this niche. In Belgium, for example, the lowest price statement is part of the Colruyt logo.
Frequency and depth of promotions
The frequency and number of promotions can influence customer behavior. Alba et al. (1999) have shown that a pricing strategy based on small, frequent discounts helps to anchor the brand’s positioning in the consumer’s mind. Based on frequency, this strategy is more effective than the one that offers one-off but higher discounts.
The price differences
This pricing technique is very common. It consists of proposing an alternative as an option rather than displaying a total price. You will find 2 real examples below:
- A car rental company that applies this technique to propose extra charges (extended insurance, additional driver, …)
- A magazine (Harvard Business Review) that proposes different subscription packages but does not apply this pricing technique
Avoid round prices (“just below pricing”)
This pricing technique is very common. It forms prices that are not “round”: 15,99€, 299$, 9990€, …
The brain interprets 9990€ as being significantly cheaper than 10000€.
The underlying psychological mechanism has been explained in research like this. As we read from left to right, it is the first numbers read that form the impression of the price.
An advertised price influences consumer perception. Northcraft and Neale (1987) have shown that the advertised price of property influences the perception of quality and the price paid.
For example, this pricing technique is applied when “crossed-out prices” are promoted after a promotion. The former price and the applied discount will likely modify your behavior and purchase decision.
Prices of the past
The final mechanism that influences purchasing decisions is past prices. In another context (school), Caverni and Pris (1990) showed that teachers were influenced by a student’s previous grades when they had to correct a new copy.
In pricing, it’s the same thing. If you are used to always paying more or less the same price, you don’t think twice when buying the item. However, if the price increases in proportions that you find unacceptable, your brain will start working again. In times of inflation, like now, buying decisions can be questioned, which is not good for retailers. This is why producers opt for shrinkflation to keep prices constant.
Posted in Strategy.