Introduction to Pricing Theory
When it comes to pricing there are a number of pricing strategies 1 that can be used. These include:
1 pricing strategies
- Yield management (YM)
- Profit maximization 2 and mean profit management.
- Revenue management (RM)
- Revenue maximization 3 and mean revenue management.
2 Profit maximization strategy
3 Revenue maximization strategy
Service Definitions
- Nonstorability
- Services are time dependent. Service providers cannot transfer unused capacity from one service date to another. 4
- Advance purchase/booking
- Purchase date can be different from service delivery date. 5
4 sellers my try to avoid this e.g. Some charter flights.
5 capacity utilization level can increase profits
- Early booking without ability to cancel is a commitment by the consumer to use the service.
- Cancellations
- Consumers who book in advance may not show up and may even cancel their reservation. Service providers should be able to segment the market according to how much refund (if any) is given upon no-shows.
- Service classes
- The service can be provided in different quality classes. Market segmentation is profitable whenever the difference in price between, say, first and second class exceeds the difference in marginal costs.
Questions
Why travelers sitting in the same economy class on the same flight pay different airfares. Why people who stay at identical hotel room sizes end up paying different prices.
This is because passengers pay near their maximum willingness to pay and as long as consumers are heterogeneous in this respect, use of price discrimination results in having people paying different prices for what appears to be an identical service.
Why capacity underutilization is often observed, such as empty seats on an aircraft and vacant hotel rooms. 6
This is due to service providers which by seeking to maximize profit, will prefer to reserve some capacity in case consumers with high willingness to pay show up at the last minute.
Last minute sales hurts seller reputation and will lead to avoid making early commitments.
Rule for sellers: Make an effort to set the price according to buyers’ value and not according to cost.
Rule for buyers: Bargain, if you can, for prices closer to marginal cost.
6 Seller’s commitment problem
We will generally assume that sellers know the consumers’ value and willingness to pay for the services and products they sell. By this I mean that sellers know the distribution of the willingness to pay among different consumer groups.
If sellers lack this information, they can use market surveys7
7 Market surveys are less reliable
If the seller is a monopolist, the seller can set the price according to the consumers’ willingness to pay. Otherwise, the seller faces competition from other firms and the consumers may base their willingness to pay on the prices charged by the competing firms, i.e. there may be a reference value for the product or service.
\begin{aligned} \text{Brand Value } &= \text{Reference value} \\ &+ \text{"Positive" differentiation values} \\&− \text{"Negative" differentiation values} \end{aligned}
- Switching costs
- If the seller is an established firm with a large number of returning customers, the seller can add to the price the cost consumers would pay to switch to a competing brand.
- If the seller is a new entrant, the seller may want to reduce the price to subsidize consumer switching costs; 8.
- Essential input
- Sellers can augment the price in cases in which the product/service serves as an essential input to goods and services produced by buyers. Some economists refer to this type of action as the “holdup problem.”
- Location costs
- When reference prices are used, the cost of shipping or the location of the service should be reflected in the price, or shared by the parties.
8 penetration pricing strategy
Overview of Pricing Techniques
Economic theory suggest that in economies of scale with perfect competition, prices should be equal to marginal costs. 9. In practice, prices are usually not set according to costs. Sellers try to get different buyers to pay different prices for the same product or service.
9 cost based pricing strategy
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Citation
@online{bochman2024,
author = {Bochman, Oren},
title = {Pricing {Theory}},
date = {2024-09-17},
url = {https://orenbochman.github.io/notes/pricetheory/},
langid = {en}
}