FINANCE & PRICING

Session 1 – Finance and Pricing Strategy

Why Finance & Pricing?

 If our revenue is going to grow by this much then marketing’s proposal -> we should prioritise
marketing
 Quant analysis is a must today
o Huge amount of data available
o More and more sophisticated analytical tools -> transform the data into actionable insights
 Know essential finance to measure impact
 Evaluate post-action performance
 Will focus on pricing but can be applied to other elements in the marketing mix

 Conceptual knowledge
 Need to have a structure in your mind (the theory) so that when you face a practical situation, you
can use it (targeted pricing etc.)
 Analytical Skills
 Managerial Intuition
 You must be able to explain the theory to people who have not taken the course.

Cases
 Individual prep
o First reading: skim through, general impression
o 2nd read: careful, critical reading, analysis, summary, contrast with initial impressions
o Think about alternative courses of action. Come up with a clear recommendation
o I will post case questions to guide you (check dropbox)
 Team prep
o Share your findings and perspectives, update your position
 Class discussion

Assessment
 50% exam
o Comprehensive (finance + pricing)
o Both quant and managerial questions
 Given a brand and strategic question
 50% coursework (group report)
o Ridesharing and/or delivery apps

 Important to have: Clarity of questions, comprehensive analysis, appropriate use of tools, good
writing

Financial statements
 Balance sheet
o At a point in time what is the situation of the business
o Asset vs liabilities at. A point in time
 Income statement
o Income and expenses over a period of time
 Reading

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 o Berk and DeMarzo (2019), Ch. 2.2., 2.3., 2.6.

Tesco Balance Sheet

Current asset (within a year) and non-current asset (more time)

 Current asset -> if I desperately need cash, I can use current asset to sell it and convert it into cash
and use the cash for the purposes that I have in mind
 Non-current assets -> much harder to sell. We are not so liquid, so we are classified differently
 When I add current assets and non-current assets, I have my total assets on the left hand side of
the balance sheet, which shows what the company has.
 On the right-hand side, we have the liabilities, what the company owes: current liabilities & non-
current liabilities (long-term).
 Current Liabilities -> Liabilities you would have to pay back within a year. Non-current ones -> have
more time to pay back.
 I can finance the business by borrowing money (liabilities) or with shareholder equity (people who
own the company, they have put some money into the company and therefore are part of the
company)

Balance Sheet
 How is the business financed? I can look at the ratio between liabilities and equity to understand
whether this is a business which heavily relies on credit, or it relies on financing from the owners of
the business
 Can it meet its obligations?
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 o Compare liabilities and assets – If the liabilities are so much, especially current liabilities
(due to be paid very soon) compare them to current assets – is this a company which is
potentially in trouble because we will not be able to meet their short-term obligations?
Which mean that we’ll have to go to the market and look for new creditors or we will have
to go to the owners and ask them for more investment into the company.
 What is the value of the business?
o Balance sheets gives me an idea, as a potential investor, I can look at the balance sheet and
kind of have some understanding of the value of the business (what kind of asset we have)
o If I take over this company, what kind of assets I’ll have and what kind of liabilities I’ll have
to pay off. Problematic company or good financial health?

Balance Sheet Quiz

 What is goodwill?
o Intangible asset, Brand value, market presence, customer loyalty -> intangible aspect of the
brand
o Goodwill will only appear in a balance sheet in the context of M&A
o Difference between depreciation and amortization?
 Depreciation – when the value of tangible assets goes down (i.e., factory becomes
older etc.)
 Amortization – same concept but for intangible assets (i.e., patent)
 What element in the balance sheet shows in the market value?
o There is no element in the balance sheet which gives you the market value.
o To understand the market value, you go to the stock market, and we see the price at which
the stock of this company is currently trading.
o An important & useful ratio to understand the relationship between the market value and
book value is the Market-to-book ratio.
 Essentially, looking at how much the market values are. Uber: Let’s see how much
shareholders equity this company has. Let’s compare this, it will give you an idea
about whether the market is optimistic about this company or not.
 If the market-to-book ratio is very high, it means that even though this company
doesn’t have too much equity for the owners, still, it’s highly appreciated in the
market because people believe that in the future of this company, we will be
bringing in a lot of profit.
 What is the balance sheet identity
o Unsurprisingly, the balance sheet must be balanced – Left hand side needs to be equal to
the right-hand side
o Assets = liabilities + stockholder’s Equity
o In other words, the business has a bunch of assets (cash, goodwill, factories etc.). we need
to understand how all of this is financed so we need to look at the right-hand side of the
balance sheet -> liabilities (how much of the assets were acquired using credit from the
bankers etc.), and the stockholder’s equity is the remaining assets owned by the
stakeholders. If the company tomorrow goes bankrupt, part of the assets will eb used to pay
off all the liabilities (whatever remains, it’s going to the stockholders – their part of the
participation in the business)
o Can the stockholder’s equity be negative? Yes. If liabilities are exceeding assets, it means
that you end up with negative stockholders’ equity. In other words, if tomorrow the
company goes bankrupt, even if you sold everything that the company has, you wouldn’t be
able to pay off all the debts that you have to the creditors.
o Is it a good or bad thing that the stockholder’s equity is negative?

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  Bad - Risky situation because I have borrowed a lot of money
 If I am a start-up and I am just entering the market – one way I could do it is to go to
the VCs, and they give you money and they ask for a portion of the stock of the
company. Giving up equity to bring finance from the VC. An alternative route is to go
directly to the bank and ask for the money as you don’t want to give up equity. So I
go to the bank and I say: can you give me this much money and it will count as a
liability for me. If the interest rate is small enough, this might be a preferrable way of
attracting finance (shouldn’t be overused and the bankers will feel uncomfortable
too if you go too often)

Why are balance sheets useful?

 Investors learn about financial health of the company
o Current assets vs current liabilities – if this is a company which will face trouble paying off its
debt or not, this indicates financial health of the company over solvency issues.
 Management identifies potential issues
o It is useful not only for investors but also for management too. You can look at the balance
sheet and see some potential avenues for improving your performance. For example, you
can see the inventory, but your firm keeps the inventory costly. Some of it may expire etc.
o Too much inventory, too much/too little cash, etc. – It can be a negative signal to the market
if you have too much cash: investors may think ‘this company has run out of opportunities’
They don’t know what to do with their money.
 How else can balance sheet information help you as managers?
o There is a lot of cash, at least we can finance some projects
o Part of the assets will be receivables (stuff I sold, but failed to collect the money
immediately). If I see that receivables are becoming too high, it is posing a potential
problem for me. It takes longer time for me to collect the price for the product or service
that I am selling. Therefore, I might change my marketing tactic: maybe stop offering
delayed payment scheme.
o Information about B2B customers (give you an idea of how much I should price the product
– should I focus on quality and charge higher or reduce the price?).
o Information about suppliers (looking at the balance sheet of a supplier can be very helpful. I
want to have a reliable supply chain. I don’t want some components for my product to
suddenly start missing in a month or two. Looking at the balance sheet of my suppliers may
also be helpful for me. This is a sound company; they will say in the business for a long time
– reliable to have a partnership)
 Balance sheets are not only useful for investors but as managers you can also draw some insights
from the balance sheet.

Income statement
 Shows how Tesla performed during the year

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  What was the net income? After paying all the expenses, what is the income that Elon Musk is
going to take home and build some spacecraft
 Income statement
o Revenue (Sales) - At the top of the income statement, we have revenue (depending on the
textbook you use, sometimes we will use the term sales)
o Cost of revenue
 Variable costs – COGs (cost of goods sold, costs that vary as I change the production
output)
 Fixed cost – costs that do not change as the product output changes (e.g., salary)
 Gross income = Revenue – VC
o When we subtract this variable cost of revenue from revenue, we have the gross income
 Operating expenses
o Fixed costs
 Operating Income = revenue – VC – FC
= Unit Sales * (Price – AVC) – FC

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  So essentially, with operating income, which we are going to focus on, is going to be equal to the
number of products sold * mark up (difference between the price and the per unit cost) minus FC.
 Price enters the picture
o Revenue (operating income and gross income) are pretty much driven by price and unit
sales => PRICE really important
 If I increase my price by 10%, how will things change?
o If I change the price – price will definitely change
o Will unit sales change? – Unit sales will change
 If I increase the price, its’s likely that my sales will decrease (by the law of demand)
o What about my Average variable cost? – It depends
 If I have constant marginal cost, it means that as I change the volume of my output,
of course the total variable cost change but per unit variable cost do not change.
 However, in reality, often firms have increasing or decreasing returns to scale. Most
often, it’s increasing returns to scale, which means that as you produce more and
more, your per unit cost declines. In other words, as I am producing more and more
handbags, the rate at which I buy extra leather, it’s not going to increase at the same
pace as the number of bags I am producing.
 => as production of output increases, average cost decreases
o What about fixed cost?
 Fixed costs will not change. At least in the short run.
 Often ignore fixed cost and focus on the first part of the equation
 Another explanation: Return to scale – when I produce more, there are many avenues for return to
scale
o May start using the resources more efficiently. The more I produce, the fewer fraction of
these materials will be wasted, and a bigger fraction will turn into products. As the waste
part is reduced, my cost (average cost) will go down.
o Learning by doing – start doing things more efficiently. I start doing things better as I
become good at it.

How are marketing actions reflected in Income Statement?

 Increase/decrease price – sales would go up
 Launch a new social-media campaign. I have to make some expenses (e.g., higher influencers or
something etc.). Fixed costs may go up. Price is the same as sales go up. Variable costs could
potentially change too. Unlike the example of changing the price, certain marketing actions will also
affect my fixed costs. Marketing expense which is not sensitive to the output, therefore it would go
under the operating expenses (which is FC)
 Stop sending promotional coupons – promotional coupons means that people who are getting a
discount. If I stop sending the coupons means the average price per sales will go up and maybe
sales will go down if people are price sensitive. Maybe there are some fixed costs related to sending
out promotional material.
 Must use a consistent measure to evaluate actions
o Using gross profit will not account for the impact on FC
o Operating profit

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Practice exercise

 We have this information: COGS, variable costs, gross profit, and then fixed costs + some consumer
data: how many customers we started with, how many new customers gained. Therefore, we can
have our acquisition rate and we also know how many customers we lost during the year (churn
rate). As a result, we can estimate and finally know the average number of purchases per customers
during the year – it’s seven. We multiply the number of customers. We have the total number of
purchases. Finally, we have info about the average spending per purchase. => marketing
intelligence information
 We are thinking about 3 possible actions which we could take with the company
 What is the impact of each action?
 Action 1
o Acquisition rate up from 8% to 11%
 If acquisition rate goes up, by how much would sales go up?
o Costs £20,000
 Cost of goods -> how much was the percentage of revenue generated
 Action 2
o Churn rate down from 5% to 3%
o Increases average cost per purchase

o Required an additional £5 per sale

o Action 2 is not very attractive; profit is going to be less than in Action 1.
 Action 3
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 o Increases average sales per customer from 7 to 7.15
o Marketing expenses up by £10,000, average cost per purchase up by £10

 Many actions: one could be social media marketing, and another one could be just using radio ads
and whatever. The question is: how do we evaluate these different types of marketing actions? We
need to translate these numbers into money metric. What is the impact these different actions are
going to have, and which one is more preferrable than others?

On excel

 Action 1
o Acquisition rate up from 8% to 11%
o Costs £20,000

 I need to estimate my resulting operating profit right at the end of the day if I follow action 1.
Therefore, I need to do projections about customer behaviour.
o If acquisition rate goes up, by how many my number of purchases will go up? And therefore,
what is the new revenue that my company will be making?
o So, we know at the end of the previous year, we had 775 customers -> this is what we are
going to start with the next year.
o The acquisition rate is going to go up to what you will have 11% -> add acquisition rate on
the sheet
 The number of new customers gained would be –> acquisition rate * number of old
customers = 85.25
o Churn rate not changed, so same as before -> 5% - therefore I am going to lose 5% * 775
(number of customers I started with) during the year
o There will be an inflow and outflow of customers – the total number of customers as a
result of this movement is: number of customers I started with + new customers acquired –
customers lost = 775 + 62 – 35 = 821.5
o Average number of purchases per customer – remaining the same as last year
o Total number of purchases during the year = Average number of purchases per customer *
Number of customers = 5750.5
o Average customer spending per purchase – same as last year -> £267.28
 Using this information, can I get the revenue using the right-hand side information?
o What is revenue? It’s number of sales * price (or instead of price we have the average
spending of the customer – To find a revenue, I multiply the number of sales (the number of
purchases) by the average spending amount = 5750.5 * 267.28 = £1,536,993.64
 How do I get to the cost of goods sold? Same as last year. Variable costs are costs which are
changing with the production output. One way I could get them is to go back to my previous year
and see what percentage of my revenue went to the variable costs. Then, it is relatively safe to
assume that in the next year, assuming my sales don’t change very dramatically, the percentage is
going to be roughly the same -> so I could apply the same percentage to the new revenue to find
the cost of goods sold. -> go back to the previous year -> cost of goods sold / sales = 65%. 65% of
the revenue I generate goes into materials and so on and so forth.
o I am going to use the same percentage to estimate the new cost of goods sold.
o New revenue * the percentage found -> gives the new cost of goods sold.
o Be careful: if you are expressing the cost of goods sold as a negative number to get gross
profit, you add revenue and cost of goods sold. If the cost of goods sold is a positive number
then you have to subtract cost of goods from revenue.

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  SG&A – stands for sales general and administrative expenses. In other words, operating expenses.
o Fixed costs – they don’t change as the production output changes but the what is the cost of
action 1 - £20,000 -> I have allocated the budget a new expense to implement this action 1
which increases acquisition rate – so I am going to take my old fixed cost minus £20,000,
which is the cost of implementing action 1. I have my new operating expenses and finally my
operating profit is going to be gross profit minus operating expenses which is going to be
235.
 Action 2
o Churn rate down from 5% to 3%
o Increases average cost per purchase by £5

 If I implemented, acquisition rate will be the same as last year. However, my churn rate will go
down from 5% to 3%. But to implement action 2, I’ll be making £5 extra expense per sale. So this
means that this new cost of implementing action 2 comes from variable costs rather than fixed
costs. Can you quickly go through the similar steps and estimate the new operating profit if action 2
is implemented?
 I start with 775 customers. Acquisition rate is going to be the same as last year which is 8%. The
number of new customers is going to be 62. However, the churn rate is going to jump down from
5% to 3%
o Therefore, number of customers lost = churn rate * number of customers = 3% * 775 =
23.25
 The number of purchases we’ll make is still 7. The total of number of purchases be: 7 * 813.75 =
5696.25
 Average spending is still the same as before to find revenue
 To find revenue -> amount of purchases * average customer spending per purchase
 COGs -> revenue * percentage found. This is not the only thing -> remember that to implement
action 2, there is an increase of average cost per purchase increased by £5.
o Expenditure is now a function of the sales I make, the more sales I make the more the cost
to implement increase and therefore my variable costs are going to be different -> we have
to do -> - 5 * number of purchases = £1,025,977.12
 Gross profit -> sales – COGS (+here because COGs is -ve)
 Action 2 doesn’t require any fixed cost investments, so I just simply copy last year’s number
 Operating profit -> gross profit – operating expenses = £251,518.75

 Action 2 is not as attractive then. Profits are going to be less than action 1, even less than what I
had last year -> means that the costs are too high for implementing this action and reducing the
churn rate by 2% points.

 The point of this exercise is to show you how I can use marketing analytics which gives me
information about customers and then integrate it with financial statements like in the income
statement and see how my marketing actions will affect the bottom line of the company at the end
of the year.
 The problem with documents like the balance sheet and income statements is that we’d like
context. Unless you know the context, you wouldn’t be able to evaluate these numbers by
themselves.

Financial analysis using ratios

 Numbers in fin. Statements can be very different between companies
o Hard to compare

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  Stand-alone numbers lack context
o Company A made £X in profit
o Company B made £2X in profit
o Is B performing better than A?
 What’s the context? If company B has a lot of resources whereas company A has a
very small amount, and company B makes only twice the profit of company A, is this
good? We need some context, and this context comes from analysis of financial
ratios. [don’t have to memorise the definition of each ratio]

Profitability ratios
 These are based on income statement data

 Gross margin
o For a company like Apple would you expect high or low margins? High margin because it’s a
luxury brand, charging a high price
o For companies trying to keep the price low -> low margins. These companies try to attract as
many customers as possible instead of trying to squeeze as much customer surplus as
possible.
 Operating margin – essentially similar idea, but it looks at operating income divided by revenue.
 EBIT Margin -> also a common metrics, revenue is taken as a benchmark against which you
compare a specific metric of performance of the company. We can track how companies perform
over time.
 Graph: airline market – you can see similar trend. Everyone is losing margins when the economy is
bad and gaining margins when the economy is good.
 Margins are very important, but we shouldn’t forget about the absolute number as well.

Ferrari vs. Ford

 Ferrari has a higher margin, but Ford makes more profit
o In 2020, Ferrari’s and Ford’s margins were 21% and 3.3% respectively
o Ford’s operating profit was about 6 times higher than Ferrari’s

Operating returns
 How well is investor’s equity used to generate income?
 Return on Equity – telling you from an investor’s perspective: how is my investment in this
company used to generate profit?
 Return on Asset – As a company, we have a certain amount of assets which are financed from
equity or from liabilities. But the question is how efficiently are we using our assets? What is the
ratio between our income divided by the amount of assets that we have?

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 o Interest rate expenses are added to net income because part of the assets is actually
financed from liabilities. I took credit to buy the assets and now assets are generating more
revenue.

 When will ROE = ROA?

o When I have no credit and no liabilities, it means that my equity is equal to assets. So
denominators are equal to each other. Then, if I have no credit, I don’t have to make any
interest payments. In the numerator, I have net income and net income so these 2 values
are equal to each other. When the company is totally financed through equity

Working capital ratios

(check the book)

Leverage ratios
 Debt to equity ratio tells you what is the ratio between liabilities and equity. There is no golden
number about this ratio. You should look at the industry, understand the industry standard and see
how the company is doing with respect to the industry standard. In some industries, we rely on
liabilities more than in other industries. In general, if we take an average across industries, we say 2
is a good number.

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  For a company like Domino’s, if you look at their balance sheet, you will notice that the equity is
negative, they have taken a lot of loans.
o For a company like Domino’s, the debt equity ratio will not make much sense because it’s
going to be a negative number. They found that instead of giving up some shares to
investors, it’s much cheaper to get credit -> bank is happy to give a loan with small interest
rate. Why not take it?

 For such companies, we can look at the Market Debt-Equity Ratio. Since equity is negative, let’s
look at the market value: how much do the traders think the company is worth and then compare
to the total debt, this will give you a better idea. If we see that the market value is very high, it
means that these liabilities are used effectively in order to create value in the company.

Liquidity ratios

 Basically, is this company in trouble or not?

Financial reporting in the digital age

 Article: deficiencies of financial statement for digital companies
 What makes a digital company successful?
o R&D
o Equity
o Patents
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 o Ultimately, you need a good idea
o This aspect of the company is not really in the balance sheet yet because the balance sheet
is looking at one point in time.
 Are these factors captured in the balance sheet?
o Most are reported as expenses in the income statement, leading to large losses
 Is market value driven by recorded profits in the income statement?
 How can these issues be addressed?

What does this mean for our analysis?

 For these companies, it’s important to not only look at the financial statements but often there’s an
appendix to these financial statements where the management is describing, where is the company
headed, what kind of projections we can make and so on. This is where some crucial information
about this kind of digital companies can be hidden.
 Is it wrong to use profit-based calculations for evaluating marketing actions?
 Digital companies aim to reach profitability too
o Standard analysis will apply to them sooner or later
 Important to keep company’s strategic objectives in mind
o Profits are not always the priority
o Need to use the correct metric to evaluate actions

Key takeaways
 Balance sheet reflects financial health at a point in time
o This info can be useful for outsiders and for the management team
 Income statement shows the outcome of the company’s activities over a period of time
o Income statement can be used as a framework for evaluating marketing activities and
choosing the optimal course of action.
 Financial ratios summarise the data in financial statements
 ‘Good’ numbers vary from industry to industry
o Know the standard in the industry you work in, as it gives you a useful benchmark to
compare against
 Old accounting standard may not work for digital companies

Session 2 – Project Evaluation

Financial detective simulation

o Chosen 4 companies and we will see the financial statements of these 4 companies, but we
do not know which financial statement belongs to which company.
o Our task is to see the numbers draw some logic and then try to match the financial
statements with the company
 American Express
 Exxon Mobil
 Samsung
 Spotify
o Representation in the vertical form – we start with 100% revenue – shows everything as a
percentage

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  In terms of the income statement, is there any logic that we could start with to try to pin down
which company belongs where?
o We have 4 corporations from different fields: technology, oil extraction, financial services,
digital start-up.
 Digital companies
o Low cost of goods sold
o We have 2 digital companies: American Express and Spotify
o Company D has 0% - variable cost = 0% - who is more likely to have 0 variable cost?
 Spotify – pay commission to the artist
 American Express – financial intermediary, no cost
 Probably American Express. What can we do to double check?
o We go to the balance sheet, we look at assets, property, plant equipment
 This company D has indeed 2.4%, very little non-current assets

o Company B has only 2.3% of plant & equipment. Inventory = 0% -> digital company ->
Spotify
o Exxon mobile – energy company. They have a lot of mines. They need a lot of machinery.
Expect to have a great share of current asset. High fixed costs – Exxon (own many fields
they have.
o R&D 6.8 for company A and 0.4% - Samsung has probably more R&D than Exxon
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  By looking at the numbers, you can see that the numbers are different. In some industries we have
very low variable cost, in some industries the R&D costs are very high. By looking at the financial
statements, even without knowing what company it is coming from, we can draw some insights.

 Financial management and at the core it’s project evaluation

o How do I choose between project 1 and project 2.

Net Present Value (NPV)

 Converts future cash flow into today’s money
 The idea is that $1 today is not the same as $1 tomorrow or one year from now
o If I give you the choice to have either £100 today or tomorrow – which one would you
choose? Today because you can put it in your saving account. In other words, time changes
the value of money.
o How do I compare the cashflow from different points in time. For now, I am comparing
apple to oranges as the money that I have today is different from what I am going to get
from this investment in 2 years.
 Need to convert everything to the present value
 Allows for more consistent comparison between projects
 More efficient decisions
 Example

 How do I evaluate this project?

o How much is it worth to me today? Convert everything into today’s money is the first step.
o In 1 years’, time we are going to get £6,500. How much is it worth today?
 $1 tomorrow is worth less than $1 today.
 The difference is essentially the opportunity cost. If I had $1 today, how could I
invest and what would I get as a result of this investment today?
 $1 today can be used to earn $1 + $X tomorrow
 Hence, tomorrow’s $1 must be discounted to find its worth today
 The discount rate is influenced by inflation rate to find its worth today (if inflation or interest rates
are high, the discount rate will be high too)
 Risk-free discount rate
o Gov. bonds, savings account return
 So, there is an idea, a concept about risk free discount rate. Essentially this is the
benchmark which we will be using most of the time
 Imagine you have an opportunity to invest risk free. There is 0 chance of the
bank going bankrupt or the government defaulting on the bonds and so on
and so forth.
 When you are trying to evaluate a project which is risk free, you will use the
risk-free discount rate to convert future cash flows into present value.
 How much is £6,500 in one year worth today?
o Let’s put it differently: how much do I need to invest today to receive £6,500 in 1 year?
 Suppose the project is risk-free => use risk-free discount rate

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  Let r = 2% be the risk-free discount rate

 £6,373 * 1.02 = £6,500

 1/(1+2%) -> discount rate

 If I invest £6,373, then I will receive £6,500 in one year

 Therefore, £6,373 is the present value of £6,500 in one year

 Next, how much is £6,500 in two years worth today?

o Compounding

 If I invest 6248 under 2% annually in two years, you’ll get exactly £6,500.
 What happens to the value for money as I move further away from today -> it decreases.

 How do I calculate the NPV?

o 1ST thing I do is that I calculate the discount rate
o The discount factor for one year is going to be one divided by one, plus the discount rate.
2% in this example. In 2 years, it’s going to be one divided by one + 2 to the power 2. In 3
years, to the power of 3 etc.
o 2nd step – multiply the factors by the respective cashflow

 Excel trick: Put the dollar sign before the letters/numbers -> it will keep this particular formula
unchanged.
 When decreased the discount factor, PV came down.
o You can think of the discount rate as the opportunity cost. So you have X amount today. You
could invest it in this default option, which gives you a return exactly equal to the discount
rate. The higher the discount rate, therefore, the bigger the attractiveness of this default
option. The higher the saving account return, the bigger the temptation to invest your
money in the savings account rather than in this project that you are being offered.
16
 Therefore, you are more critical to the cash flow from the project. You have a good
alternative opportunity. So you are discounting the cash flow from the project even more
because you have a more attractive alternative option. Therefore, as the discount rate goes
up, the NPV tends to come down. You are applying a greater discount factor to each term in
the cash flow.
On excel
 When you use the NPV formula, excel assumes that cash flows happen at the end of period.
 The way around this

 The way we found 3442 is that we assumed 15,000 is invested at the start of the year and then
everything else happens at the end of the year. When your cash flow actually happens makes a
difference
 If the investment is happening earlier, the NPV is going to be greater because the cash flow is going
to happen faster. If we assume that cash flow happens at the end of each period, it means that you
start receiving the first positive cash flow after two years.
 PV is about a specific amount of money which is flowing in at some future date. We convert the
specific amount. NPV pulls all the PV together by adding them. You will have some cash outflows
and inflows when

 You accept the project if NPV is positive, and you reject the project if NPV is negative.
 NPV already essentially compares this project intrinsically with the best alternative option you
already have which was the default option to use the risk free discount rate and invest in the
savings account

 More generally, consider a project with a cash flow CF0, CF1, …, CFt
 Annual interest rate is r
 Then, the NPV of the project is as follows

Planning horizon
 What is T?
o Perhaps as a corporation, I have a certain planning horizon, I’m looking at a 10 years period.

17
 o I assume that beyond 10 years there is going to be too much uncertainty, it makes no sense
for me to predict how things will go after 10 years.
o Planning horizon is 10 years and within these 10 years, if the project is going to give me
positive outcome, I am going to accept it. If it’s negative, I am not going to accept it.
o It’s a decision variable when it comes to your decision-making process.
 If you are a big corporation, you are probably going to be more patient: so you can
invest in projects which initially don’t give you too much profits, but then they are
very promising in the long run.
 If you are a small business and you have issues with obtaining cash, you are not
going to be very patient if this project cannot pay off in 3 years. You can’t keep
investing.
 T is a decision variable, and you have to decide what is a good option for your business.

Internal Rate of Return (IRR)

 IRR is the discount rate that ensures NPV = 0
 Instead of fixing a specific discount rate, keep it as a variable and find the key threshold in terms of
the discount rate, which will guarantee NPV = 0. -> think of it as some sort of breakeven discount
rate.
 Replace the discount rate with a variable called IRR.

 After finding IRR, compare it to the actual discount rate (r)

 What is IRR going to give me at an intuitive level? You have a project, it gives you some cashflow.
Alternatively, you can invest your money in another project which will give you a certain
percentage back annually. What is the alternative project? How attractive is the alternative project
which will make you exactly indifferent between this alternative project and the focal project that
you are considering now?
 You solve the equation and find this critical point.
 Once you have it you compare this number with the return you can get from the
best alternative comparable project.
 If the best alternative project is giving you a lower rate of return than IRI, you are
better off by accepting this focal project that you are considering. If the IRI is smaller,
then this is the best alternative project you have. You reject this project, and you go
for the alternative.
 After finding IRR, compare it to the actual discount rate ®
 What if IRR > discount rate?
 What if IRR < discount rate?
 If IRR <discount rate -> go for the best alternative project
 If IRR > discount rate -> go for the focal project (for which the IRR was calculated)

Example
 IRR formula on excel – use it and take a guess as to the number it would take (here 1), we find that
it is going to be 16% for the internal rate of return of project X is 16% -> compare with the best
alternative I have (saving account with 2% cashback) – 16% is > %2 -> therefore I accept project X.

18
  What is the relationship between NPV and IRR?
o If you rely on IRR, it could lead to some misleading decision because you could have done
better.

Practice
 ABC Inc. owns a small plot of land
 The land can be used for one of the following projects

 Which one do you choose?

o Project A – IRR = 15% / NPV around 3,000
o Project B – IRR = 8% / NPV almost 9,000
 If you were an investor and you just looked at the internal rate of return, you would have chosen
Project A because it’s 15% versus 8%. Twice more profitable. But then if you look at the absolute
numbers, you will choose Project B, because it would make you almost 3 times more rich
 So, IRR and NPV are pointing in different directions in this example.
 You are not giving up anything if you are relying only on NPV. However, if you are relying on IRR,
you can end up choosing the project that would have less return.
 Sometimes a small project in terms of its net return would have a higher rate of return

IRR vs NPV
 ABC Inc. example illustrate a drawback of IRR

19
  IRR ignores absolute numbers, focuses on percentages
 ABC is clearly better off choosing project B, although its IRR is smaller

Risk
 Need to take into account the level of risk

Risk vs. uncertainty

 Risk can be ‘quantified’
o For example, we can estimate probabilities for events
 With uncertainty, we may not identify events or assign probabilities
o Scenario analysis
 What is the level of uncertainty? How can we quantify it? And how can we integrate it into our
models so that despite this certain level of uncertainty, we are still able to make a reasonable
rational call

Risk
 Objective probabilities
o Can be established mathematically
o Or based on historical data
 Subjective probabilities
o Based on experience, intuition

Analyzing risk
 (i) Risk-adjusted discount rate
 (ii) Sensitivity analysis
 (iii) Scenario analysis
 (iv) Probability analysis

Risk-adjusted discount rate

 Example with three levels of risk: low, medium, high

 Let’s evaluate project A using risk-adjusted discount rates

 3 different classifications of the risk level: low risk, medium risk, high risk project.
 The higher the risk, the greater risk premium I am going to request.
 I am going to use the risk adjusted discount rates to calculate NPV of the project, depending on the
risks designation that I give to the specific project.
 As I am increasing the discount rate, it means that the discount factor is becoming smaller and
smaller. Therefore, this cash inflows that are coming into the future are going to be worth less and
less today. Essentially, I am making this project less attractive for me. But if the NPV is still positive,
I am going to accept the project.

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  What are the drawbacks of using risk-adjusted discounting?
o Positive: very simple
o Negative:
 If there is uncertainty, things could go well and the NPV could have been much
higher than the estimate.
 There is a chance that things would go badly, NPV would be lower.
 This risk adjustment method just pulls different scenarios and gives an average
situation.
 Next method (sensitivity analysis) is going to take care of this problem

Sensitivity analysis
 So far, NPV analysis has been very static
o All variables are given, nothing moves anywhere.
 We have made some assumptions about the cash flows, about the discount factors and so on and
so forth. But what if our assumptions turn out a little bit incorrect?
 But – this estimates that you have, how sensitive it is to your assumptions, what if we change your
starting assumptions a little bit? How will the results change?
 See how the estimate is going to change by changing assumptions

Example:
 Gerry & Co. is considering launching a new product targeting Gen Z.
 The following estimates are available

 We know all this info + it’s a medium risk project so the discount rate is 9%.

21
  Instead of just focusing on cashflows, we need to look at the sources of each cashflows (sources are
going to be revenues when we are charging £200 and generating £60,000 sales.

 The advantage of having such detailed information about the estimated price, estimates sales, costs
and so on and so forth, I can challenge my assumptions. I can test – what if I guess the price a bit
incorrectly? Not £200 but £190 because competitors are going to enter the market and it’s going to
be much tougher
 New NPV = £1,310,854 -> 5% change in price is going to massively affect my NPV. The change is
going to be 1.8 million – 2.8 million = -1.5 million => NPV estimate is very sensitive to price

 On excel

The advantage of having such detailed estimations is that I can challenge my assumptions
Case 1 is going to assume that price is 5% lower -> 190 instead of 200.
Therefore, we change -> revenue = price*projected sales = 190*60,000,000

 Change in MPV is high which means that the NPV is very sensitive to price. A tiny difference in the
estimate of the price is going to make a difference in the NPV value

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  I can create a graph with all this info: sensitivity graph
 At the start NPV = 2.8 million (case 0)
 Price changing by 5% -> NPV goes down
 Sales decreases by 5% -> NPV goes down as well
 If R&D increases by approx. 6.6% -> NPV goes up
o Always through case 1

 Which factor is the most important to get right. The steepest one is the one I need to pay more
attention to
 Essentially, we tried to address one of the fundamental flows of this risk adjustment method of just
creating risks premium by opening the black box and seeing what are the sources of uncertainty.
Once we identified the key sources of uncertainty, we can perhaps take certain actions to reduce
the level of uncertainty in this specific dimension.

 Drawback:
 Keeps all variables fixed except one. Just one at a time.

Scenario Analysis
 Allows us to move more than one variable at a time
 Creating different scenarios where different variables can take different values at the same time.

Example
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  Suppose that these estimates represent the neutral scenario

 What if what happens is worse than what I expected?

 Better case? Higher sales etc.

 Evaluate NPV’s in each scenario: we have different attitudes towards risk.

 How bad is the worst-case scenario?
 How good is the best-case scenario?

 For a sound evaluation, we still need to estimate probabilities

Probability analysis
 Let’s start with some basics
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  What is the probability of getting tails?
 Lottery ticket price £25

 Expected return from the lottery

 Expected Return = 0.5 [100-25] + 0.5 [-80-25] = 50-40-25 = -15
o As you play it, ultimately you will be worse
 The lottery is a bad deal and you should reject it

 More Generally, suppose there are N possible outcomes/events

 Outcome #i gives payoff Xi
 Probability of outcome i is Pi
o Note that (p1 + p2 + … + pN) = 1

 Then,

Practice
 What’s the likelihood of a boom, recession, or stagnation happening?

Expected value = 7375609*0.1+2865919*0.6+(-2143771*0.3)=£1,813,981

 Another important metric is not only the expected value but it’s the variance of the payoffs
 If I just care about the expected value, I don’t care about the variance (I don’t care about how bad
the worst-case scenario is)
 4 projects need to be evaluated (From MR, determine the probabilities)

 Project A gives 90, no matter what the economic situation is

 Project B gives high payoff when it’s a boom and relatively low payoffs when it’s a recession
25
  Etc.

 And the variance of the payoffs – underlying level of uncertainty underlying a project
 How do I evaluate these projects?
 1st thing to do is understand expected return

 Project A has the expected return of 90, B had 93, C has 60, and D has -7
 Based on this, just looking at the expected return – I will choose 93, project B

 But we are in a business, estimates about future cashflows matter a lot (salaries to pay, R&D
investments etc.)
 So, if suddenly you are not lucky and you end up in a situation where you are getting only 60 or
losing -50 -> this could be dramatic. Therefore, having a certain degree of certainty in your
operations is very valuable. Even though project A is generating lower expected return, you might
as well go for it because then your ability to plan for the future will be much better.
 This also depends on the industry

 Ability to plan for the future would be better for Project A (boom, stagnation, recession), always the
same.

 SD shows how much payoffs are dispersed from the expected return
 If SD is very high, means that the spread is huge.
 The greater the spread the higher the non-predictability of the outcome variable

(on excel)

 Expected value = 0.1*150+0.6*100+0.3*60=93

 Outcome – EV =

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  150-93= 57
 100-93= 7
 60-93= -33
(Need to put the dollar sign in the EV value to drag the formula) => $C$7
 Raise (outcome – EV) cell to the power 2
 Variance = 0.1*3249+0.6*49+0.3*1089=681
 Standard deviation formula -> = SQRT(variance) = SQRT(681)
 The greater the spread, the higher the unknown predictability of the outcome

Calculations for projects C and D

Summary of the payoffs

27
Profitability analysis

Mean-variance rule
Projects with higher expected return and lower SD are more preferrable

 So, reject project C & D

 Remain to choose between project A & B. There is a trade-off and you as a manager will have to
decide how important it is to have more certainty vs. more return.
 If you are in a big business with big pockets, go for B because if it’s a promising area, to generate a
lot of money/profits.
 If you are a small business and the outcome of your decisions will lead to whether you’ll be to pay
employees or not, then maybe project A is better -> be more risk averse (look at the SD more
closely)

Risk analysis in practice

 Percentage of firms that use a specific method

 Note: Some firms use more than one method

 Probability analysis is unpopular because it requires higher sophistication of managers, in terms of

training. At the same time, it requires more MR to the sources of uncertainty (not only identifying
them, but also evaluate the likelihood of happening) => large firm
 Sensitivity scenario analysis is the most common one but also risk adjusted discount rate.

28
Main takeaways
 Time affects the value of money
o Discount cash flows to compare apples to apples
 NPV and IRR help evaluate projects based on discounted cash flows
 Risk assessment and incorporation into project evaluation
o 4 different methods
 Conduct sensitivity analysis to measure how sensitive your qualitative conclusions (accept vs reject)
are with respect to quant. Assumptions
 Probability analysis for more sophisticated decision making

Session 3 – Break-even analysis

Project evaluation
 Will the project be sustainable? How soon will the expenses be covered? What targets are realistic?
Should I go ahead and implement the project?
 Break-even analysis provides an important reference point (reference point at which our
investments are recuperated. It doesn’t say what will happen, you have to compare it to you
estimate about how many units of this product you are going to sell-> if it’s less than the break
even point you are going to lose profits and if it’s more, you are going to make profits)

Break-even analysis
 Shows conditions under which the project NPV will reach zero
o In the case of IRR, it was the discount rate -> IRR was the discount rate which made NPV=0 -
> now we will generalise this. It doesn’t have to be discount rate, it can be other variables
and we solve NPV=0 to find the threshold for this specific focal variable to know how much
it should be in order to generate exactly 0 net profit for us, making us indifferent between
taking or rejecting the project.
 Break-even analysis does not say what will happen
 It shows what should happen for the zero-NPV point to be reached
 Break-even point is a reference
o Compare your estimates about what will happen to the B-E point

Example
 ABC is considering an investment project
o £15mn investment will be needed before the projects starts running
 ABC’s planning horizon is 5 years
o By the way, what will affect the planning horizon?
o Bigger companies tend to be more patient, whereas smaller companies tend to be more
resource constraint (more critical about the planning horizon, making it shorter because we
want to generate money to pay obligations)
 Returns from the investment are expected to increase at 5% annually
o From market research
 What is the project’s break-even point?

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  The company knows how much they are going to invest today
 They don’t know what the return would be in 1y time (X)
 The company estimates that this X is going to increase by 5% from year to year
 The company doesn’t have to do market analysis to estimate actual returns in the 1 st year etc.
 It’s just estimates that this variable will increase by 5% from year to year.

 Discount rate is 3%
 Find NPV and set it equal to 0
 Solve for X

 NPV = 5.05 X -15 = 0

 If X= this number, NPV exactly equal to 0.
 If X is greater than this number, NPV will be positive
 If X is lower than this number, NPV will be negative
 Break-even return in the first year is going to be 2.97mn (equation resolution)
 Should I invest in this project
o Yes, if you think you can make more than £2.97 mn in the first year

 As a manager, need to understand how much the return is it going to be in the first year – with
market research ->
o Set it as X and understand how much the return should be
o should be £2.97 mn in the first year in order to be able to break-even in the 5 years.

 Question becomes simpler: how likely am I to receive 1st year return above 2.97 mn?
 If after doing MR, you realise that you’ll receive 4/5 million in 1st year, no matter how much exactly
but as long as it’s above £2.97 mn, the project is going to bring you net present value -> so worth
implementing
 £2.97 mn is the return I need to generate in the first year to break-even within the 5 years period.

30
  The logic is the same as IRR -> you find the point at which you are exactly indifferent between
accepting and rejecting the project

Example
 Graphical illustration

 if X = 0, then the NPV = -15 (because it’s the initial investment). NPV = 0 -> X= the result of the
equation
 You can also set a target
o What’s the first year return I need to generate in order to have NPV equal to 5 million
over this 5-year period?
 This graph would tell you that you need to generate about 4.3 million in the first
year so that your NPV is equal to 5 million in the 5-year period

Practice
 Flybus specializes in mid-range planes, but considers producing its first long-range plane to target a
new market segment
 Price for each long-range plan is expected to be $105m

 What is the break-even volume of sales for this project of producing long range planes to generate
zero profit.
 Now the key variable is volume of sales – how much sales do I need to generate to exactly earn 0
profit in a specific period of time.
 So far, we have been doing NPV analysis, CF happening in different time points, we convert them
into present value. We compare it to 0 and we get the breakeven estimate.
 When it comes to break even sales volume, we’ll be overlooking the discounting part. We will
assume the discount factor is 0, we have a perfectly patient firm who cares about future cashflow
as much as current cash flows.
 What’s the reason for this?
o If we didn’t do this? The sales I make in the first year are more important than the sales I
make in the second year. The sales that I make in the first year will be generating returns
right away
o Another argument – if we have these different discounting rates/discount factors for sales
happening in different periods. Then instead of 1 variables (sales volume) we will have sales
31
 variable in Y1, Y2, etc. And when we said NPV equal to 0, we will have one equation in
several variables, which means an unlimited number of solutions.

Break-even sales
 Here is the formula for estimating break-even sales
 Net profit = Q(P-C) – FC = 0

- Fixed cost – all of them but unit production cost

- C -> Unit production cost

 FC: fixed costs associated with the new product

 P-c: markup from the new product

 Net return from introducing a product: sales * price – cost – FC. = number of sales I make * profit I
am taking from each sale = gross profit per unit which is price – production cost.

Incremental break-even analysis

 How many sales do I need to generate to justify a price adjustment?
 E.g., how many extra sales do I need to generate to justify a $5 drop in the price of T-shirts I am
selling
 A reduction in price by a certain amount, how many sales do I need to make to justify this price
reduction
 In the Flybus example, the price is fixed
o The question we asked: should we start the project?
 Incremental break-even analysis asks a different question
o How many extra sales do we need to generate to justify a price cut by 1%?
 The price is no longer fixed and the decision is about making a price cut

 How many extra sells I need to make in order to justify this price reduction

On excel

 Break-even: (sum of fixed costs)/(price-cost) = (new plant+R&+marketing)/(expected price-unit

production cost) = 69

Incremental break-even analysis

 In the Flybus example, the price is fixed
o The question we asked: should we start the project?

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  Incremental break-even analysis asks a different question
o How many extra sales do we need to generate to justify a price cut by 1%?
 The price is no longer fixed and the decision is about making a price cut
Trade-offs
 Positive – If I reduce my price, I’ll be able to generate more sales, people would be buying more
often
 Negative – Each sale I make is now generating lower profit for me. I have to find a balance between
these two.
Example
 C-turtle is an apparel brand popular for its t-shirts
 Last year it sold 1.5m t-shirts
o Expected to stay the same this year If nothing changes
 An average t-shirt is priced at £49.99
 The following cost information is available

 C-Turtle is considering a £5 reduction in prices

 The question is: How many extra sales will need to be made to justify this? To break-even and make
the same profit that I would make without a price reduction (answer the trade-off)

 So, what do we need to compare?

o Do nothing – no price adjustment
 Profit = Q0 * (P0 – c) – FC
o Change price to P1 (Instead of P0)
 Profit = Q1*(P1-c)-FC
 When Q0*(P0-c) =Q1(P1-c) -> indifferent about the change in price
 If Q0*(P0-c)<Q1(P1-c) -> prefer to reduce the price
 If what I have on the right-hand side is greater than what I have on the left hand side
– the profit from doing nothing is less than the profit from adjusting the price from
P0 to P1, then not adjust price is better
o When I adjust the price, my fixed cost is not going to change (price will change my sales and
output) but not FC. The profit of doing nothing is less than the profit from reducing the price
to P1.

Incremental break-even sales

33
  You are introducing a new product to the market
 There are some fixed costs to do the introduction -> marketing, R&D etc.
 The question is: how many units do I need to sell to cover the fixed costs needed for the
introduction of the product

 How to get the formula

On excel

 Incremental BE = Q0*(p0-p1)/p1-c=1,500,000*(49.99-44.99)/ (44.99-13.49) =238,095

 I need generate 238,095 extra sales so the total sales should go up from 1,500,000 to 1,738,095 in
order to exactly justify the reduction in price. If I think that I’m going to generate more than
238,000 extra sales, then reducing the price is going to increase my profits. If I think consumers are
not so price sensitive and extra sales will not be so high, then it’s a bad idea to reduce price

 Once you find the break-even volume, you do the MR and determine if it is likely that the price
reduction with increase our sales by this much? You have to figure out the price sensitivity level of
customers. If customers are really sensitive and the demand function is going to lead to great
34
 adjustment in sales. If consumers are very price insensitive (changes in price don’t change their
behaviour much), it means that the price reduction is not going to change the sales much.
Therefore, you are going to lose profit.

Product line effects

 Break-even analysis is often applied to product line extensions
 Should the new product be introduced?
 Need to consider its effect on existing products

Alienation effect
 Alienation happens when the new product is a bad fit with the overall brand, product positioning
o Conflict between the new and the established induces consumers to dump the brand
 Taking actions not in line with the brand values
 Consumers will not only not buy your new product, but they would also stop buying previous
products. No longer have trust in the brand.

Alienation effect – example

 CGC is an electronics producer
 One of its key value propositions is the use of recycled plastic
 CGC is thinking about producing a line of electric kettles made of plastic
 Recycled plastic was found inappropriate for kettles
o Will have to use new, high-quality plastic
o => contradicts the positioning
 How to take into consideration the alienation effect in the breakeven analysis?
 Here are cost estimates for the new product line

 CGC anticipates to charge $80 for each kettle

 Using non-recycled plastic may alienate some customers and reduce the sales of other CGC
products
o Alienation effect estimated to be 15% (based on MR)

 More information about CGC prior to the introduction of kettles. In addition to all this information,
we also know financial projections for the company’s traditional products assuming electric kettle is
not introduced in the market. If it is not introduced in the next year.
 I would have a revenue of $11.5 million and these are the different costs and will end up with
$4,410,000 in net income

35
  First thing to do is to calculate the BE when the kettle is not introduced
o On excel

o Breakeven without alienation = FC/(p-c) = (750,000+5,000,000)/(80-35)

nd
 2 you calculate BE with alienation effect
o In addition to this cost without introduction of the new product, you are going to have
additional costs
o The profits you were getting from selling refrigerators is also going to go down
o => so need to take in to consideration the indirect cost of introducing kettles
o Sales is going down by 15% because of the alienation effect -> 0.85*11,500,000 = 9,775,000
o Since sales changed, then Cost of sales changes too -> since sales are reduced by 15%, the
cost of sales will also be reduced by 15%
o Overhead would not change
 Excel
o Sales is going down by 15% because of the alienation effect -> 0.85*11,500,000 = 9,775,000
o Since sales changed, then Cost of sales changes too -> since sales are reduced by 15%, the
cost of sales will also be reduced by 15%
o Overhead and tax would not change
o Profit loss from alienation => net income before new kettle is introduced – and net income if
new kettle is introduced = £843,750. This is how much I am going to lose from selling my
traditional product if I introduce this new environmentally harmful kettle to the market.
o BE with alienation = FC/markup= (750,000+5,000,000+843,750)/(80-35)
o Alienation effect -> 843,750 (profit loss from alienation) is considered as a FC

36
 o The final step to find a breakeven volume is to set the change in profit is equal to zero
 What is the change in profit if I introduce a new product? These are the sales of
kettles. Each kettle I sell is going to give me $80 in price – 35$ pe unit cost -

 Because of alienation, breakeven volume goes up from 127,778 to 146,527. Therefore, I’ll need to
sell an extra 20,000 kettles in order to cover indirect costs because of the reduced sales of my
original product
 Here is the formula more generally

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  a is the rate of the alienation effect (here it’s 15%) and then I have the profit from the old product

Cross-product synergy effect -> introducing a new product could increase the sales of old product (e.g.,
one stop shop, just buy everything from there). It would appear that if you’re reducing your FC -> instead
of + becomes –
 BE volume would become smaller & it would be easier to meet the BE volume -> essentially
introducing this product helps you make more incentives to start selling this product.

Overall profit of the company would be profit from the core product + profit from the new product

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  Break even requires that 1=2+3
 => Q0(p0-c0)-FC0 = Q1*(p1-c1)-FC1 + (1-a)*Q0*(p0-c0)-FC0
o FC0s cancel out. FC1 survives
 => a *Q0*(p0-c0)+F1=Q1*P1-C1

Cannibalization effect
 Cannibalization happens when the new product steals sales from the old one
 The greater the substitutability between products, the stronger the cannibalization effect
 12% cannibalization effect means that if 100 green shirts are sold, 12 of these sales would have
gone to the red shirt if the green shirt was introduced.

Cannibalization effect – example

 Let’s return to the Flybus example
 Assume that introducing long-range aircrafts will cannibalize the sales of the medium-range
aircrafts. People who used to buy the long range one instead of the mid-range plane

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  Cannibalization rate is 10%
 Recall the following cost information about long-haul planes

 Each long-haul plane sells for $105m

o For mid-range planes, the price is $85m and production cost is $30m
 What is the break-even sales volume of long-haul planes?
o Derive the formula

 B is the cannibalisation rate -> I need to remove this percentage from the initial quantity as B stop
buying the old product

 On excel

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  Break-even with cannibalization = (1,250,000,000+1,500,000,000+25,000,000)/(105,000,000-
65,000,000)-0.1*(85,000,000-30,000,000)=80.4
 Because of cannibalisation, I need to sell about 10 extra units to justify the introduction -> from 70
to 80, that’s more than 10% increase. If you wouldn’t have accounted for the effect of
cannibalization, you would have been overly optimistic: selling 10 extra planes might be a big deal
for the company and it could make a difference
 If the rate is 100%, it means that when you introduce the new product, it’s not generating any sales
on its own, bringing new customers into the company. It’s just stealing the customers from the old
product entirely if B=100%.
 If your old product per unit was making more profit than the new product (p0-c0>p1-c1), it means
these customers are dumping a product which is more profitable for you and opting for a product
which is less profitable for you => bad situation. You’ll need to take some action to control
cannibalisation and guide customers back into buying the old product.
 Alternatively, if cannibalization is low or the new product is actually more profitable, you might
actually not mind when customers switch to the new product, then introducing the new product is
definitely worth it.

 Break-even without cannibalization: 69.38

 Break-even with cannibalization: 80.43
 Because of cannibalisation, I need to sell 10 extra units to justify the introduction
 The difference is more than 10% so as a manager if you didn’t account for the effect of
cannibalisation, you would have been overly optimistic.
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  If cannibalisation is low but the new product is more profitable than the old one and wouldn’t mind
if the cannibalisation was high -> you can take some action
Main Takeaways
 Break-even analysis provides a reference point
o Benchmark for project evaluation
 Compare with projected sales or cash inflow to evaluate the project
 Incremental break-even analysis guides price adjustments
 Product line effects need to be accounted for
o Alienation effect is similar to increases fixed costs
o Cannibalization effects acts similarly to reduced price markup
o Alienation and cannibalization can exist at the same time
 In this case, we would have:
 In this formula for cannibalization, alienation would appear in the numerator: FC + a
* Q0*(P0-C0)
 The formula with both would be
 Qbe = (FC + a * Q0*(p0-c0))/(p1-c1)-b*(p0-c0))

Session 4 – Mountain Man Case

Review
 Several different perspectives from which we can look at break-even analysis
o The idea is that the consequences of taking an action are equal to zero
o The profit implication of a certain action are equal to zero, which tells us the conditions
under which we will be indifferent between implementing this specific action versus not
implementing it.
o Applied this idea in various context:
 NPV analysis where we took the discount rate as the variable. We found the special
discount rate , which was IRR.
 First year return was unknown – NPV as a function of the unknown variable. Found
1st year profits I need to guarantee in order for this project to be ultimately
profitable within a 5-year time period to break even
o Related to pricing
 We can look at price adjustments as projects. When I adjust the price, there would
be costs and benefits. Benefit of price reduction would be increase in sales,
disadvantage would be a lower mark-up
 Incremental break-even analysis: how many extra sales do I need to make in order to
justify a price reduction of a certain amount?
Mountain Man
 For generation, Mountain man has been associated with toughness and perseverance in difficult
situations -> very strong loyalty towards the brand + very strong brand recognition in the region
 Eastern Europe
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  Beers
 Strong loyalty towards the brand + recognition
 Challenges the company is facing
o Older people would stop drinking after some point. If you are dependent on the segment,
you’re losing customers
o Lagger beer sales as a product category were declining by 4% annually from year to year.
Less and less people drink this strong beer
o By contrast, the light beer category was increasing by 6%.
 If I am a lagger company – I should be worried and think whether I should start
producing light beer? Dilemma that the company is facing
o Trade-off of the company: on one hand you face the risk of alienating your core customers
who have been loyal for generations and generations, and which can be veery costly for you
o Secondly, you’re potentially gaining some customers who seem not very committed: maybe
they could try mountain man for one night but then they would switch again to another
brand. Younger customers tend to have less loyalty, they like to jump from one brand to
another brand. -> if you are not going to be very loyal, lot of marketing investment to retain
 Start with qualitative elements – now try to translate this into quantitative numbers
 We are in December 2005 and we want to figure out if we do nothing, what would happen to our
financial performance over the next five years.
o In the previous year, 2005 compared to 2004, the revenues declined by 2%. The category is
declining by 4% but because of high loyalty rate among its customers, Mountain man is in a
better shape relative to the entire category. Its sales declined only by 2%. Let’s assume that
sales will continue to decline by 2% annually. What’s the impact on operating income?
(EBIT)
 On excel

 Take this information from the case. Can we figure out the impact on operating income (EBIT).
Assume that revenue are going to decline y 2% year from year.
 If revenues decline by 2%, Cost of sales would also decline by 2%. Cost of sales is 2*cost
o 2006 -> revenue = 0.98*revenue of 2005 -> extend it for the rest of the years
o 2006 -> cost of sales = 0.98* cost of sales of 2005 -> extend it for the rest of the years
o Gross profit -> revenue – cost of sales
o Operating costs -> stays the same because it’s fixed cost
o EBIT = Gross profit – operating costs
o Change in EBIT between 2005 and 2010 = (3,138,147.5-4,640,480)/4,640,480=-0.3237 => -
32%

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  If revenues decline by 2%, COGs will decline by 2% too (revenue = Q * Price). If sales
decline by 2%, it means that Q is becoming 0.98 Q after one year
o Compute percentage change in 2010 vs 2005 -> -32%
 If we do nothing, our operating profits will go down by 32%. 32% of your profits are going to go
away if you continue doing the same thing as what you are doing right now. + this decline might
accelerate as well since the overall industry is going down.
 Introduce the Mountain Man light since it’s a growing category
o Break even volume is the first step (need to make an assumption about alienation rate
(there is a mismatch, higher rate of alienation. In your analysis, it’s safer to make a more
pessimistic assumption rather than overly optimistic assumption)
o Second step is compared estimate market share to breakeven volume. Then this would give
us an idea of whether we have good chances in this new industry or not. Or we should stay
out.
 Need to make an assumption on the alienation rate -> Chris’ dad said between 5 to
20%. Let’s go for 15% because of the high brand loyalty that customers have. People
would feel betrayed and wouldn’t want to be associated with a mountain man light
(safer to make a more pessimistic assumption than more optimistic assumption ->
accounting principle)
 On excel, adjust for the alienation effect: In revenue, add * (1-a) = * (1-15%)
 So it’s 0.98*revenue of previous year*(1-15%)
o Imagine that in 2006 I introduce Mountain Light, my numbers for 2006 will not only decline
by 2% compared to the previous year, there will also be the additional effect of alienation
kicking in. Alienation means I am going to lose 15% of my customers who would have
bought the product. 0.98 time is what would have happened without alienation and then I
multiply by (1-15%) to account for alienation. Alienation effect is going to be carried over
throughout the years but this doesn’t mean that we are accounting for extra alienation. =>
trickle effect
o Cost of sales is also going to go down by 15% because of alienation. -> add (1-15%
o Because of alienation, we are going to get 1M if we did nothing we would have got 3 million

 We have the numbers and estimates of what is going to happen in each year if there is an
alienation effect happening. To get the net result, I need to look at what would have happened if I
chose the status quo: I didn’t introduce light beer. Compared to what happens to my old product
when I introduce light beer. The difference is going to be the effect of alienation in terms of
operating profit.

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  To summarize, I know the introduction of the new product will affect the performance of my old
product. How do I find the effect of my new product on my old product? First, I do the analysis
when the product is not introduced, what would the performance be of the old product without
the new product? Then I do the analysis when the new product is introduced. What will be the
performance of my old product when the new product is introduced? Compare these 2 and find
the net effect.
 Next, I am going to focus on the rest of the analysis, which is more related to long term in light.
What’s the upside? How much revenue and profit will I make if I introduce Mountain Light?
 The sales in MM lager in 2005 is 520,000. How can I figure out the price per barrel?
o Revenue. Q*P=revenue. P=revenue/Q= 50,440,000/520,000
o Cost per sale = cost of sales/number of products
o Mark-up is per unit price minus per unit cost = 30 – when I sell a barrel of lager beer, this is
how much I’m going to keep as gross profit

 Mark-up for light beer

o The production of light beer is costlier than the production of lagger by 4.69 (from case).
How can I use this information to find a mark-up? If the mark-up from the lagger is 30.07,
therefore the mark-up from light beer (assuming the price of light beer is the same as lager
beer, important assumption based on market data)
 The price is the same -> 97
 The cost is 66.93+4.69
 Therefore, the mark-up from the light beer is going to be 30.07 – 4.69 = 25.38 (P1-
C1)
 In the break-even formula, 25.38 is P1-C1.
 MM light non-variable: (non-variable cost is the numerator in the BE formula) ->
launch advertising + SG&A + loss in EBIT due to MML launch

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  Sum FC and alienation effect together to find the numerator
 If we do 1 year break-even, how many sales of light beer do I need to generate in one year to
break-even?
 If I look at 2 years, need to look at all the costs related to the period
 One years BE = MM Light non-variable costs/MM light Light markup
 Two years BE = (sum 2006 and 2007 MM light non-variable costs)/MM light markup
 Three-year break-even = (sum 2006, 2007, and 2008 MM light non-variable
costs)/MM light markup)
 Next step – figure out what kind of sales do we expect to make in 3 years and see whether we can
break even
o MM light sales projections

 Light beer market size 2006 – 1.04*light beer market size 2005 -> extend it (growth
of 4% per year)
 MM light’s projected share -> hope to increase by 25% every year
 MM Light’s projected sales = light beer market size * MM Light’s projected sales
 One year sale = 49,672
 Two-year sale = 49,672+105,305=154,978
 Three-year sale = 49,672+105,305+167,436=322,414
 Four-year sale = 49,672+105,305+167,436+236,643=559,056
 If planning horizon was 3 years, I would reject this project (based on the current alienation rate) ->
because 322,414<402,232
 In 4 years’ time, the company will be able to break-even
 4 years break-even point is 522,932.88.
 4 years horizon projected sales is 559,056
 Actual sales > break even sales -> 559,056>522,932.88
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  For 3 years horizon, I am not generating enough sales to break even
 You could try to calculate the NPV of launching Mountain Man light
o Homework
Session 5 – Pricing

 If we have tax information, do we take it into account when calculating alienation?

 Mountain man
o Step 1 – Computed operating profits without introducing the new product: Mountain Man
Light
o Step 2 – Computed operating profits if we introduce Mountain Man light
 Profits after introducing Mountain Man light will tend to be lower because of the
alienation effect (some customers would be leaving the brand)
o Step 3 – Compare profits with Mountain Man Light vs without Mountain Man Light ->
difference was the alienation effect (To answer the question about tax – should we take
into consideration the net profit by deducing tax or the operating profit, to compare with
mountain man light vs without mountain man light. The answer is that the break-even
volume will not change whether you do tax or without tax, but the formula changes a little
bit. If you use after-tax profit when calculating breakeven value
 Talking about alienation effect, how do I figure out the break-even volume when I
introduce the product? I can use the formula or the profit without the introduction
vs the profit with the introduction of the product and set them equal to each other
to find the break-even volume
 If I don’t introduce the product
 (Q0*(P0-C)-FC0)*(1-t)
 t = tax rate
 if I introduce the product
 ((1-a)*Q0*(P0-C)-FC0))*(1-t) + (Q1*(P1-C)-FC1)*(1-t)
 Profit from old product + profit from new product
 How do I find the BE volume of Q1 -> Equation 1 = equation 2 + equation 3
o The tax (1-t) just cancels out. So the breakeven volume will not
change as a result.
 However, formula for the BE would have to change a bit
o Equation 1 = equation 2 + equation 3
o Which is: (Q0 *(PO-C)-FC0)*(1-t)=((1-a)*Q0*(P0-C)-FC0))*(1-t) + (Q1*(P1-C-
FC1)*(1-t)
o = a*(Q0-C)-FC0*(1-t)=(1-t)Q1(P1-C)-(1-t)FC1
 The tax (1-t) just cancels out. So, the breakeven volume will not change as
a result.
o If instead of using the formula, you go and do the comparison between the
profits to figure out the level of alienation. What are you essentially doing?
 If you compare the after-tax income with the introduction of the product
vs without the introduction of the product, you would have ended up
with the left-hand side of the equality => a*(Q0-C)-FC0*(1-t) and you
would have stayed with the (1-t) instead of cancelling it out. Therefore,
the formula for the BE volume would be:
( 1−t ) FC 1+ a∗Q 0 (P 0−C)(1−t)
 Q 1 BE=
(1−t)(P 1−C)
 Don’t have to do this for the exam

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  It is safe to go with the operating profit when you are trying to figure out the effect of alienation on
the profits of the existing product.

Why is pricing important?

 Price is important to generate sales. From consumers perspective, price is usually number one most
important aspect related to the product that consumers pay attention to before they examine what
kind of features are attached. (is it within my budget or am I in the wrong store? When deciding
which product to buy as well -> if price is lower but value is perceived the same + consumers are
price sensitive)
 Cheap in terms of implementation but very powerful.
 Having the right price can affect the perception of the product
o If I paid more money for a product, I’ll enjoy it more
 Price is a major part of finance – to pay salaries etc.

Cost-plus pricing

 Cost of sales is 75 and your target markup is 25%, what would be the price that you would set?
o 0.25 = (P-75)/75
o => P=93.75
 Set a target margin - As a business, I can say that I can make sure that I have a margin of 20%
o How much does it cost + 20% margin -> price
 Markup -> you obtain the price as a function of the markup rate you decide as a business
 Difference between markup and margin -> the main difference between the two is that profit
margin refers to sales minus the cost of goods sold while markup to the amount by which the cost
of a good is increased in order to get to the final selling price

Competitor-based pricing
 Even easier than cost-plus pricing
 Monitor competitor’s price
 Use it as benchmark to decide your own price

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  Would want to have alpha greater than 1.
o If you have an advantage compared to competitors
o Extra benefit (brand or feature)
o Could also compare the services
 If I see that I have a disadvantage compared to the competition
 If you charge alpha too low, it means that even if you will probably get the sales, but then you will
not be making much profit from each sale or so.

Cost-plus and competitor-based pricing

 Extremely popular, Easy to implement etc.
 But they also have significant disadvantages
o Businesses are very different from each other – maybe competitors they are very cost-
effective
o Characteristics of consumers are not taken into consideration (e.g., how much are they
willing to pay etc.)

What price to choose?

 Not an easy task
o Any number can potentially be your price
 Try to simplify the task
o Pin down the range prices that can work
 Minimal price to charge - At least my price should be above cost of sales (most of the
time)
 Lost leader – reduce the price of such products (milk, bread) to drive traffic
into the store and then compensate the losses by pushing customers to buy
other products with high profits, on the way to the milk.
 If you are trying to push your competitors out of the market – if you think
that your competitors’ costs are high, you might even go below your existing
cost of sales in order to convert consumers to your brand and push the
competitor out of the market if the competitor does not have enough cash to
keep them afloat -> competitors would have to exist.
 Maximal price to charge
 Utility framework for decision making
o Consumer’s utility from your product (option A): Va – pa
 Va is the values that consumers get form the product
o Consumer’s utility from best alternative (option B): Vb-pb
 (if they value the surplus they get which is Va-Pa, it’s greater
than what they can get from the best alternative, which is Vb-
pb. If the fist one > second one -> consumers would go for
option a
o Consumer will choose your product if Va – pa >= Vb-pb or
pA=<pb+Va-Vb

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  So, this is the upper bound
 If my price is above this level, then customers will choose option B against option A
 This formula is called the Economic value to the Customer

 MR and Marketing Intelligence would help you determine the upper bound.
 EVC is consumer’s maximum willingness to pay (WTP) for your product
 If consumers have perfect information, complete information about what kind of feature/benefits
we are getting from each product, if you go above EVC level, people are going to choose option B

 Differentiation Value
o Superior performance
o Better reliability
o Additional feature
o Lower maintenance cost
o Faster service
 Reference price

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  If the green box is on top of the red box, it means that I am adding something to the reference
point. This is the premium that I am going to charge for providing consumers the greater benefit

Pricing zone

 The region between Variable cost and EVC is the pricing zone
 I figured that the price at which customers value the product is Va, so why don’t I charge the Va
price?
o You could but in that case, consumers would say: this guy is taking too much surplus benefit
versus price. Pricing too close to Va would make the competitors’ product more attractive
for consumers.
o EVC takes into account the competitive aspect. If you have competitors in the market EVC is
the highest price you can charge

Example: Estimating EVC

 You are a social media influencer with 1 million followers
o Trying to decide how much to charge for a single post
 Your closest competitor has 0.5 million followers
o Charges $7,000 per post
 What factors will affect the EVC of your single post?
o Estimate EVC
 Reference price -> 7000 (what the competitor is charging)
 Differentiation value
 Engagement

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  => What matters for the company is how many extra sales I’ll make after this
influencer puts out the post?
 Follow vs like ratio

 I have 1M followers
 10% who see ad -> 100,000
 2.2% who engage -> 2,200
 Out of people who engage, % who buy -> 550
 These 550 are going to spend on average 200$ => 550*200= 110,000$ -> increase in revenue for
the company due to this single post by the influencer
 Out of this revenue, 30% is the profit -> 33k$

 Differentiation value is $15k

o Then I can charge up to $15,000 more than my competitor
o EVC = 7000 + 15000 = $22,000
o If I am famous and high in demand, then price I am going to charge should be close to EVC
level

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 o If I am still establishing my personal brand as an influencer, I’ll charge lower. And as my
influence grows, I’ll start reducing the gap between my price and the EVC level.
 In all cases, this gives an idea of the price ceiling to the price that I can charge.

Price = EVC?
 EVC is the maximum price that consumers would pay
 However, EVC assumes that consumers know all product benefits
o Va and Vb are often estimated in a lab setting
o Lab results do not always fully match the reality
 As a business producing these products, you have a lot of information about the values that you are
providing to consumers. Remember that not all consumers know all of these benefits that you are
providing. It is important to be in touch with consumers, and get enough information about their
perception of your product.
o Even if consumers know about your product, they may not fully realise all the value we can
get out of these different functionalities. E.g., We are only using very simple functions on
excel
 In order to get a better understanding of this -> need to do market research
 Actual willingness to pay the product may be below EVC because consumers do not have
information etc.
 The difference between willingness to pay and EVC is the gap which emerges as a result of lack of
information, lack of appreciation for the different benefits that you are providing or your
competitor is providing.
o You need to estimate this gap accordingly. If customers don’t know your benefits and you
charge a price that is close to EVC level (customers will say that it is above my willingness to
pay)

 What to do about this? If we realise that the WTP is below the potential
o 1. Reduce the price to WTP level - Unfortunately, customers do not know the features of
the product – so let’s price the product low to make sure that we make the sales right – to
make sure that we convert
o 2. Increase consumers’ WTP to EVC level - We know what the potential of our product is.
Instead of reducing the price, let’s keep the price at the level that we think it should be in
the long run, closer to EVC but then we are going to invest heavily in different activities in
order to push consumers’ willingness to pay up to the level it should more or less objectively
be.
 We can run advertisements to create awareness about different functionalities of
the product, we can provide free trial etc. => educate customers about the product.
 Am I taking the long-term perspective or short term?

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 o In terms of the LT approach, it’s better to work on the WTP and charge high price but if you
can’t afford the LT perspective, would need to bring the price down
o If I charge a high price, it also induces some curiosity and learning on consumer side to find
out what the value is to justify this price.

Pricing at WTP
 Known as Perceived-value pricing – what is the perception of value in consumers’ minds that’s how
much I am going to price the product to match the benefits that consumers perceive they are
getting from the product.

 EVC would be 110,000 but 100,000 price just for you  people would think that thy are given a
better deal than what they are paying -> higher surplus
o Maybe you are charging less to create a LT environment etc.
 Perceived-value pricing can help avoid price wars
o Example from P&G
 In 1990, P&G switched to perceived-value pricing to avoid reducing its prices too
much due to competitive pressure.
 We are selling all these products, but we are not getting too much profit from
each sale. It’s not a good deal for us, let’s rethink our pricing
 The marketing mix of P&G

 Invest more in advertising, reduce deals what we spend on which allowed the supermarkets to
provide some discounts at the POS. We are also going to reduce the spending on coupons.
 With the reduced investment on Deals and coupons, the price for the average P&G product went
up by 20%.
 Competitors reciprocated the advertising spend but increased deals and reduced coupons -> net
price went up by 8.4%
 Relatively speaking, P&G increased the price more than competitors. Before these changes, maybe
the company used mark-up pricing, margin pricing where we are after sales (let’s charge 5% to
make sure the price is very low so that we have as much market share as possible. And then they
thought that customers are very happy with the product, and they are providing great value, so the
customers would be willing to pay a higher price because EVC is relatively high compared to the

54
 actual price they are charging -> they increase the price. This allowed the competitors to also
increase the price a bit
o Let’s put the price closer to the actual willingness to pay of consumers
 Effect of perceived-value pricing for P&G
o 16% lower market share
o $1.09 billion increase in net profits
o Lost market share, but increased profits!
 Even though your sales go down, if the price goes up sufficiently, the net effect is going to be
positive for your company.
 When you are thinking about your market positioning and the pricing that you choose as a result of
your positioning -> don’t be too focused just on sales. The price is the other part of the equation
and sometimes giving up some more segments or positions in the market where the sales would
have been huge is more than justified if some other positioning allows you to charge a much high
price even though your sales are going to be lower.
 The switch to perceived value pricing also allowed the companies to escape this downward spiral of
price reductions. If every firm reduces the price by the same amount? The consumers are going to
make the same purchase.
 We are not going to take our competitors’ price as the main driver of our price, we are also going to
anchor on consumers perceptions. If consumers think that the value is high, which will push their
price upward and this downward spiral will become less likely.

Factors influencing actual WTP

 When can a firm (profitably) set price closer to EVC?
 Substitute awareness effect
o Buyers are less price sensitive if they are not aware of or if there are fewer substitutes
 (How close are competitors in consumers’ minds? Etc.)
 Difficult comparison effect
o Buyers are less price sensitive if they cannot easily compare or evaluate competing offers
 Sunk-cost effect
o Buyers are less price sensitive when the product is used in conjunction with a previously
purchased product. The greater the sunk investment, the less price sensitive they are.
 Price-quality effect
o Buyers are less price sensitive if the product is assumed to be prestigious/exclusive or is
associated with higher quality or brand/personal image
 Unique-value effect
o Buyers are less price sensitive the more they value any unique attributes
 End-benefit effect
o Your product is an essential part of a known end-use. For example, when purchasing
supplies for an end product, buyers are less price sensitive; or if your product is a small part
of the total cost of the end product
 Total expenditure effect
o Buyers are less price sensitive if the total expenditure is small relative to their income
 Shared-cost effect
o Buyers are less price sensitive if the total expenditure is shared
 Fairness effect
o Buyers are less price sensitive when the price is in the range that they perceive as ‘fair’
 Inventory effect
o Buyers are more price sensitive if they can hold inventories (stockpile) and believe that the
current price is temporarily lower or higher than it will be in the future.

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  If consumers are less price sensitive, it means that I can charge closer to EVC level and the
reduction in sales will be small because consumers don’t care about price too much
 By contrast, if consumers are very price sensitive, it means a small increase in price is going to
reduce the sales by a lot -> so I don’t want to increase the price too much.

Choosing the price

 Should your price always equal WTP?
 Sometimes not
 Aggressive pricing below WTP to …
o Push competitors out
o Prevent entry
o Lock in customers (switching costs)
o Pre-empt competitor

Using demand data for pricing

 In reality, WTP tends to differ from consumer to consumer
o Even within a narrowly defined segment
 Hence, price changes can still affect sales
o If I charge higher than WTP, sales will go down
o If I charge lower than WTP, sales will go up

Example
 Historical data

 I charge different prices in different locations, and I can infer what the sales are going to be
depending on my price
 At high level, you have data about your price and the associated sales controlling for other factors
like level of level of advertisement, competitors’ price etc.

 Should we price in the lower range or upper range?

o If I charge a lower price (closer to £3, my sales are high, if I charge a higher price, closer to
£4, sales will be lower) -> where should the optimal price be.
 Price elasticity of demand

 Change in demand as a result of a change in price – if I change the price by one percentage point,
by how many percent will demand change? If I increase my price by 1%, instead of 100, I charge
101, by how many percent will demand go down?
 Note that e is a negative number: higher price decreases demand
o As Positive change in price leads to negative change in demand
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 o If e < -1, demand is elastic
 1% increase in price leads to more than 1% decrease in demand.
o If e > -1, demand is inelastic
 1% increase in price leads to less than 1% decrease in demand
 If I have price and sales data, I could compute the elasticity of demand, which will give me some
intuition about where my price should be.

 Demand is inelastic
o Should increase the price a little bit because the sales would not be affected too much.
o If I decrease the price further, I will not get too many extra sales.

 Elasticity is very high which means that closer to £4, the demand is very elastic
o I should reduce the price here, because a small reduction in price will lead to large
increase in sales.
 Elasticity analysis would give you an idea of where should the price be? Should it be closer to £3 or
to £4 level?
Using demand data for pricing
 Can I do better than elasticities?
o We can use historical data to estimate the demand line, the entire demand line
 Data is useful beyond elasticities
 Use data to estimate a linear demand line

 Profit analysis allows us to pin down a specific price point which maximises profit based on
estimated demand. The model predicts that by charging 3.16. I will maximise my profit, the blue
curve here is my estimated profit.

On excel:
 Go to data and use the regression function
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Regression function summary output
- I have the sales data
- I have the price data
- Sales are my independent variable
- Price is my dependent variable
o I want to see how price explains sales. So, I run the regression. I find that there is an
intercept 1064 and then my x variable is price and it shows how sensitive are sales to price.
So the slope of the demand line is -200 (downward sloping line)
 It’s the orange line
 The blue points are the data points that I had, that I observed in the market. I use
the data points to feed the best demand line that reduces the level of error between
actual sales and estimated sales
 Now that I have the orange line, you can see that I can consider prices like
3.6, 3.8 etc. and the orange line would tell me what are the estimated sales
under each of these price points.
 => I could use this information to maximise my profit

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  It is possible to maximise the profit by doing
 Gross profit = (1064 -200*price)*(price-cost)
o Let’s assume that cost is equal to £1. So serving each cup of coffee costs me only £1
o Using this, I can find the optimal price on wolfram alpha => maximize (1064-200*p)*(p-1)
o Gives you that the optimal price would be £3.16
o The profit analysis allows us to pin down a specific price point which maximises profit based
on estimated demand
 Steps:
o 1st – get market data
o 2nd – Analyse market data to estimate your sales
o 3RD – Once you have estimated your sales, you know roughly how many sales you generate
depending on the price
o 4th – If you know this, then you essentially have your demand curve so you can maximise
your gross profit

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 Session 6: Pricing games

Revision
 Cost-plus pricing
 Competitor-based pricing
 Cost-plus and competitor-based pricing
o Key disadvantage is that we are abstracting away from consumers which are an important
party of the transaction. You are setting a price without considering the buyer’s side
 EVC
o EVC = Reference price + differentiation value (compared to the competitions’ offer, is my
offer at an advantage/disadvantage?)
o When we are computing EVC, attributes which are more intangible. e.g., brand perception
wouldn’t enter the picture
o Often companies would do their focus groups, will do conjoint analysis, Will figure out the
value consumers attach to different attributes which are more or less tangible – so you can
use them to add them up and consider the value that consumers have for your product
o Because brand perceptions are hard to value and companies may have trouble adding
monetary amount for the brand perception itself, especially as brand perceptions tend to
vary so much across consumers. -> brand perceptions might not appear in the value
difference aspect, which is a disadvantage. You could measure band perception as well and
include branding as part of the value that consumers get from buying product A or product
B. If this is difficult, you can focus on the tangible attributes of the product/service in order
to estimate the values. Then, you will have to at least have some idea of what are the
differences in brand perceptions, is your branding stronger than competitors’ branding?
Depending on this perception, it might affect the gap you leave between you price and the
EVC.
 If my brand perception is very strong, I would keep the gap relatively low -> the price
would be closer to EVC.
 If I feel that my brand is not so strong relative to the competitor, I have to give a
bigger surplus to the consumers. Therefore, my price would be lower than the EVC –
the gap would be larger to compensate the lack of brand’s strength.
o With EVC, we looked at the difference between the WTP and EVC
 Think of EVC as the maximum willingness to pay of consumers.
 The actual WTP may be lower or much lower so you have 2 strategies about this:
 1. Reduce price to the WTP level
 2. Try to increase the actual WTP closer to EVC level
 Otherwise consumers will not buy
 Utilise a huge amount of data that today’s businesses are able to collect. Easy to obtain a lot of info
about my cost, sales, etc.
 Sales as a function of price -> run a regression and estimate sales as a function of price
o Using historical observations, I make a prediction on how my demand line looks like.
o Once I have this, I could use the sales function or the demand function in order to obtain my
profit function, which is:

 Next step is to maximise gross profit – what is the price that I should set to maximise
gross profit? Why don’t I maximise operating profit which would mean gross profit – FC
 Fixed cost stay the same as I change the output, therefore it is not taken into account
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On excel:
 Gross Profit = (1064-200 *price)*(price-cost)
 Demand Estimates = (1064-200*price)
 Gross profit = demand estimate * (price-cost)
o Cost in this case is £1
 Check where the highest profit is: here the highest profit is £933.10, therefore the optimal price is
around £3.15

 Once I have generated a demand line, it can be a function of my invitation to price, to competitors’
price, level of advertising, all kinds of factors, trends and so on that you have data about. You can
use it to generate you demand line as a function and maximising it
 This would be the most nuanced and to the point approach to find the profit maximising price
o If your objective is not about growing sales, creating awareness and you are just profit
driven – what is the price that is going to make me better off within a specific period of time
when sales are happening? Vs the approach that you would take to find estimates of
prospective sales as a function of price and then maximise gross profit.
 Procedure: Start with data points, use datapoints to estimate demand, you estimate demand it
means you have gross profit estimates. Maximise it to find the profit maximising price

Pay what you want pricing

 Panera Bread example
 Restaurant with pay what you want idea
 Business is sustainable because out of 5 consumers, one is going to give more than the suggested
donation rate => that’s why they are able to generate more profit
 Social responsibility – creating impact on people
 Usually, it is non-sustainable
 Example of pricing that is not all about profit maximisation -> marketing (a lot of publicity)
 Some companies would want to do this because they are not financially driven
o Generate customer loyalty
o WoM
o Buzz etc.
 Flexibility of pricing allows you to achieve non-profit outcomes

Key Takeaways
 EVC = Reference value + Differentiation value
 EVC is the maximum WTP (not actual) & may not be best price
 Always examine and enhance your product, place and promotion strategies to attain EVC
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  10 factors affecting WTP or price sensitivities
o Depending on how these factors interact in the market you are reoperating in, you would
decide how much gap to leave between EVC and your actual price.
 Other pricing approaches can be easier to implement

 So far, What we have looked at: we have one firm trying to decide its price and the market
conditions are pretty much given for us.
o We take our competitors price as given, our cost as given, the suppliers prices as given etc.
o In reality, it’s not the entire story – things are not static, and the world is not revolving
around your decisions
o Your decision could trigger another party’s decision and so on and so forth, and then you
will respond -> you need to look at your decision-making process as part of the entire
system and try to predict how your specific decisions will influence market outcomes.
Therefore, knowing what will happen in the future, you would make better decisions today
and stay out of trouble.

Example: Story about the short-sighted manager

 A few years ago, we were working with a retailer and we had sales data from the store (sales data
about what transactions were made during each day in the week)
o We can see that from Monday to Thursday, the activity in the store was relatively low.
o Then on Friday, things started picking up. Saturday was the busiest day and then Sunday
was also very busy.
 From the perspective of the store owner, this kind of price sales pattern was considered
problematic.
o Some items could get spoiled -> inventory management
o A lot of fixed costs. If you have days we not too much traffic into the store, you have a lot of
underutilised resources -> staff members are just hanging around. Still have to incur the cost
in terms of lightning etc. but all these costs go towards relatively few purchases
 By contrast, on the days where the traffic increases significantly, now you have the opposite pb p
not enough staff members

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 o Manager was thinking: is there a way in which I could push some of these people who are
shopping in the weekends to change their habits and perhaps start shopping during the
weekdays instead of the weekend.
o He thought: During the week days, I’m going to put certain discounts on popular products.
Once people realise this, they will start shopping during the weekdays. Worked: there was a
shift in sales from weekends to weekdays.

 New customers would come to your store because you have reduced the prices.
 This pattern maintained itself for several weeks.
 After several weeks it started changing. So compared to the initial effect now, fewer people started
shopping on weekdays again

o All kinds of hypotheses with diminishing returns, but still couldn’t figure it out.
o Competitors could have reacted
 Competitors realised that they are losing sales -> started offering discounts too. Now
both companies had roughly similar sales but now the prices are lower as they are
offering this discount => price war situation
 Prices went down, sales didn’t increase too much and profits decreased
o Maybe people tried but then said that it wasn’t convenience.
 What actually happened:
o Competitors realised that they are losing sales. They figured out what was happening, so
they started offering discounts too -> roughly similar sales but lower price => lose-lose
situation for everyone (price war situation) -> prices went down, sales didn’t increase too
much, and profit decreased.

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AA’s value pricing
 In April 1992, American Airline announces value pricing
o Simplified pricing (used to be 12+ prices for the same flight)
o 4 pricing tiers: first-class, regular, 7-day discount coach, 21-day discount coach
 Consumer’s pricing is a mess. If we simplify it, we would gain a lot of advantage
 What they did is that we reduced the pricing tiers just for 1st class, regular, then depending on how
much in advance you buy, you are getting a discount.
o First class fares dropped by 20-50%
o Coach fares dropped by 38% on average
 $20m on advertising within 2 weeks of launching new prices
 Number of fares down from 500,000 to 70,000
 Expected to increase revenues by $350m
 This was dubbed a ‘revolution’ in airline industry!

 In October 1992, AA scrapped value pricing

 Why?
 AA had not anticipated competitors’ aggressive response with price cuts because competitors
realised that AA is trying to steal customers by lowering prices
o The industry lost $2b
o Shows the importance of analysing competitors’ strategy
 Game theory is a framework to try and analyse for analysing different players’ strategies and
trying to predict what will happen in the industry in the long run -> equilibrium situation
(part of making better decisions)
 How is my closest competitor going to react?

Game theory
 Analytical framework for firm and competitor analysis
 GT trains you to take into account competitor’s strategy when shaping your own strategy
 Our plan
o Intro to basic games
o Learn how to predict future outcomes
o Apply it to business situations

Elements of a game: PAPI

 We have players and each player has actions. What are the different things that each player can
do?

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  Given that everyone has chosen a specific action, there will be a payoff in the outcome in the
market => in the air industry, everyone’s action was to lower fares and the payoffs were negative
profits
 Information – when making our decisions, what kind of information do we have? Have we already
observed what the competitor did? Or we are in a situation where we have simultaneously
essentially made decisions without observing each other’s decisions. Is there any uncertainty about
the market?

Example

 Imagine 2 competitors: firm A and B and each firm has a manager. We are trying to decide which
price point to choose.
o We did market research and we have figured out there are 2 salient price points which they
could go for $150 or $100 (price tag that managers are choosing for the product outcome is
given in the table)
 1st price in this sale is showing the payoff of manager A would be 10m in profits and
the payoff for firm B is also going to be 10m.
 If firm A is charging a high price $150 and firm B is charging the low price $100. Then
firm A will lose a lot of sales to firm B and the profits will only be 2m for firm A while
the profit for firm B would be 14 m.
 This is a simultaneous game where players do not observe each other’s actions before they have to
make their decision. At the time they are trying to make a decision on their price, they do not know
what their competitors’ price will be.

Practice example
 Consider the tobacco industry of 1970s
 All the regulations and taxes and so on, pushed the markup to low levels
o Each box of tobacco, didn’t make many profits
o From this perspective they didn’t have much opportunity to lower the price further as it was
already low. So the main tool for competition in the tobacco industry is marketing
campaigns -> the more you spend on marketing, the greater awareness and conversion. So
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 in order to generate sales you don’t try to decrease the price but you spend more money
into advertising and marketing in general and this is the main driver of your profits and extra
sales
 Major competitors

 Not too much price competition

o Low margin, heavy regulation
 Compete on marketing expenditure (ad campaigns, etc.)
 Suppose that each firm is considering launching a nationwide ad campaign
 Cost: $50m
 Payoff estimates
o If neither launches, operating profits stay at $1bn
o If both launch, gross profit will increase by $10m for each firm
o If only one firm launches, its gross profit increases by $100m. Competitor’s gross profit
decreases by $80m. (many competitors will choose the competitors because they’ve
seen the campaign)
 Construct the game PAPI

 Both launching the campaign – 10m increase and they spent 50m
 If they did nothing – they would have received 1bn. They are going to lose 40m. (1bn-40m)
therefore each company is making 960m.
 What if both companies don’t launch? They’ll just be making 1bn
 What if Philip Morris doesn’t launch advertising? How much will Phillip morris make? American
tobacco launches
o The company that doesn’t launch is going to lose 80 million while the company that
launches is going to gain 100 million
o So Phillip Morris is going to make 920 million whereas American tobacco is going to
make 1bn and 100million -> 1bn and 50million because advertising cost 50m

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Action and strategies
 Players decide their strategies: what they will do
 Not to confuse with actions: what they can do
 Having modelled the market situation (what are the payoffs, what are the possible actions), the
ultimate objective is to predict what companies will do. The strategies which are sustainable or the
strategies which constitute an equilibrium outcome. This is what we expect what will happen in the
market in the long run.

Nash equilibrium
 Each player has a strategy
 Idea: an equilibrium must be sustainable in the sense that no player would want to change his/her
strategy (it’s sustainable – if something is in equilibrium then it must be sustainable)/(if someone
wants to change something, it means that it is not a sustainable situation, things will keep
changing)
o Hence each player is doing the best he/she can, given what other player(s) is doing
 Nash equilibrium leads to the strategies of all players. These strategies will lead to a market
outcome and this outcome is an equilibrium because it is supported by each player’s optimal
strategy (meaning that as a player you don’t want to change your strategy (given what everyone
else is doing)
o Each player is doing the best it can given what other players are doing

 Example with managers

 Imagine the situation where a manager is charging 150, manager B is charging 150. Is the
situation sustainable or not?
o Each player is getting 10m but there is an incentive to reduce the price to 100 as
there should be an increase of 4m in the payoffs Therefore it is not a sustainable
situation for both managers to charge 150.

How to find the equilibrium?

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  1st, find players’ best responses
o Given what your competitor is doing, what is the best thing you should do as a
response to competitors actions
o What a player should do given competitor’s action
 nd
2 , check if there is an outcome where both players are best-responding to each other
o If I am best responding to what you are doing and if you are best responding to what
I am doing, it means that we are doing the best we can given what each party is
doing. So therefore, we don’t have any incentives to change our strategies because
they are doing the best we can.
 If yes, then the strategies corresponding to this outcome comprise a Nash equilibrium

Firm A’s best-response

 If manager B is charging 150, what is the best thing manager A can do?
o Charge 100, because if I charge 100, I am going to get 14m.
o If I charge 150, I am going to get 10m => better-off by charging 100
o If manager B is charging 100. If I charge 100, I am going to get 4m. bests response to
charge 100.
 In other words, regardless of what manager B is doing, I am better off by
charging 100.

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  Let’s do the same for manager B – what is the best response of manager B if manager A’s
charging 150? She’ll get 10m. If she charges 100, she’ll get 14m -> 14m is better so 100 is the
best response.
 Same thing if manager A charges 100 as well because 4m is greater than 2m.
 Next, I am looking for an outcome where firms are best responding to each other.
o In other word, an outcome where I have 2 stars. I see that only when both firms are
charging 100.
o 4m and 4m. This outcome has 2 stars, therefore in equilibrium, I predict from this
analysis. But the equilibrium is that both managers will be charging $100 for this
product and every company will be making 4 million in profits.
o This kind of situation contains a puzzle in it.
 It’s puzzling that they could have potentially obtained 10million by agreeing
to charge 150 each. It would have been a win-win situation. But the
equilibrium is much worse for them. They end up charging low prices and
obtaining 4million -> this situation is called prisoners’ dilemma. Prisoners
dilemma is the situation where Because of lack of coordination, parties end
up in a worse situation than what they could have obtained if they could
coordinate among themselves. If managers A and B were in good relations
and they would hang out, they would possibly try to agree. (would be illegal
in most situation) -> because of self-interest. (because they cannot
coordinate and because they don’t trust each other, they realise that the
party that we are facing is just trying to maximise its profit could. Just
knowing this, you can rationally calculate that the equilibrium outcome is
going to be 100 / 100 because charging 150 is not sustainable)
 Because you don’t want to be in a situation where your competitor is
undercutting you, you act pre-emptively and you charge 100.
Therefore, every manager thinks this way and they end up charging
low prices and obtaining lower profit.

Combine best responses

 Realising the importance of anticipating competitors actions can save you a lot of trouble and lead
to better decisions

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  Want to emphasize that it’s not that in every single situation, the equilibrium is to charge low
prices.
 The equilibrium will depend on the actual payoffs (what you have in the table). Sometimes, it’s
possible to have a situation where you have 2 equilibria (depending on the payoff)
o Means that the market could end up in 2 situations and wherever it ends up, it’s kind off
supportable
o Then reaching the equilibrium could be affected by some exogenous factors which are not
controlled by the firms. Maybe the personality of the managers (if aggressive the likelihood
of ending up in a lower equilibrium would be higher than the likelihood of being in the more
cooperative high profits equilibrium). Sometimes some managers are just not sophisticated
enough to think about this indirect effect of their actions -> that If they charge lower price, it
is going to trigger a response from the competitor: instead of obtaining 14m or 10m, will
end up getting 4m after the competitor’s response.
 Knowing how to do competitor analysis and realising the importance of anticipating competitors’
actions can save you a lot of trouble and lead to better decisions.

Equilibrium
 Equilibrium strategies
o Firm A: charge $100
o Firm B: charge $100
 Equilibrium outcome
o Prices: ($100, $100)
o Profits: ($4m, $4m)
 Prisoner’s dilemma
o Both could have earned $10m if they agreed to charge $150

Prisoners’ game
 Equilibrium is for each prisoner to confess that they did the crime
o When they confess, they end up going to prison for a longer time than if they kept quiet

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Law banning tobacco ads
 In 1970, there were active discussions on banning tobacco ads
o A law was proposed in the US Congress
 The companies needed to decide whether to lobby against
 Will the advertising ban hurt their profits?
 If the congress takes action, it would deprive companies from this important strategy for generating
sales.
 How will this affect the competitive dynamics in the market if you and the competitors cannot do
advertising?
 Need to go back to the game we drew earlier where Philip Morris and American Tobacco, the two
major competitors are deciding whether to launch advertising or not.
 Let’s try to predict what is the outcome in this market in terms of profits when the firms can launch
advertising campaign and then see if the regulators remove the option to launch advertising
campaign, how will the profits be impacted? Will the companies be worse off relative to when they
had the choice to launch the campaigns?

 Let’s start with Philip Morris. Phillip Morris has to decide whether to launch advertisement or not. If
American is launching advertisement, what should Morris’ best response be?
o I have to compare the payoffs that Phillip Morris will get from launching vs not launching. If
American is launching vs Philip Morris also launches, how much is it going to get?
 9.60
o If Philip decides not to launch
 9.20
o 9.60 > 9.20 -> putting a star.
o If American is not launching advertisement, what should Philip Morris do?
 If Philip launches, it is going to get 1bn and 50m.
 If it’s not launching, going to get 1bn
 So launching an advertisement is better here (best response)

 Let’s move to American.

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 o Similar situation if Philip Morris is launching advertisement
 American compares 9.60 for launching and 9.20 from not launching. -> launching
advertisement is best
 If Philip Morris is not launching advertisement -> American is better by launching
advertising because 1bn 50 is better than 1bn

 Finally, I look at the outcomes where each player is best responding to the competitor. -> where
there is 2 stars

o Launch / launch -> companies end up burning money. Because you are afraid that your
competitors are out there spending money on advertising, and you are nowhere to be seen
by consumers.
o So, each company ends up spending a lot of money and profits are lower than what we
would have earned if we didn’t launch

 If you have to decide whether to lobby against the congress or not, what would you do?
o Let the law pass
 You realise – we are now currently in a prisoner’s dilemma situation because we can’t coordinate.
 Each of us are spending money on advertisement, which negatively impacts our profits. If law
makers are trying to ban advertisement, it’s actually to our benefit. We will avoid prisoner’s
dilemma because in that situation, the action: launching will be deleted. The only thing that will
survive is the remaining strategy of not launching and it will be beneficial for companies.

Law banning tobacco ads

 Ability to advertise leads to a prisoner’s dilemma
 Both firms would prefer not to advertise
 But knowing that competitor will advertise, pushes each firm to spend heavily oon advertising
 The law was adopted, and Nixon signed
 Tobacco companies’ profits increased!

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  You can see how using game theory, we can understand the competitive dynamics in the industry
and the situation where not only our company but the entire industry, including the competitors:
what situation we are facing and look for ways in which we could avoid this situation and move to
better outcomes.

Game theory
 Game theory teaches us to keep competitors’ in mind.
 GT model can give managerial insights that are easy to overlook or are hard to detect
 If you think that after their response, you will not be in a better position, then you might prefer not
to make the initial action yourself. (reading)

Practice Case: Sony vs PlayStation

 Situation: PlayStation vs Xbox -> who are the main competitors in the gaming consoles market
 The price were initially high but then gradually the prices started decreasing.
o Finally, they reached a point where the companies are charging 399 for each gaming
console. So now the industry analysts are scratching their head and thinking – where is this
market headed? Should we expect another reduction in prices? The prominent price point is
299.
o Will these companies reduce the prices by another $100 to $299 or we have already
reached an equilibrium 399 is the equilibrium prices, we should not expect any substantial
reductions in prices.
 If you are working for Sony on the PlayStation – that’s an important question to decide on
o Are prices going to be sustainable? Or we should prepare for a reduction in prices?
 If we expect a reduction in prices, we should contact our manufacturers and tell
them that we expect a huge shift in the volume of orders – should stockpile
 If you are an industry analyst – what are the profits you are going to get?
o Is this an industry where they are tied up in price wars and we are going to burn all their
profits competing against each other – should I bet against their stocks or in favour of
their stocks?
o Very important questions to make both internally inside the company and also for
parties outside the company.
 Our job is to make a prediction – put yourselves in the shoes of either Sony or Xbox
o What are you going to charge, or are you going to keep it at 399 or reduce to 299?
o If you are an industry consultant, try to make a prediction about where the market is
headed?
o Exhibit 1 – Expected sales under different price points

 Companies have done their MR, which is the next generation of products which we
have introduced. So we have historical data bout past sales and they predict that if
the prices are high – 399 / 399, PS3 is going to make roughly 875 million sales, XBox
is going to make 8 million sales.
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  If prices are lower, sales are going to be much higher

 Here we have the sales and price – the remain thing is to figure out the profit – cost of sale

 Exhibit 2 – you can see the cost component depending on the output level

 As the company changes the production volume, the cost for producing the product as well as
overhead distribution – they may or may not change depending on whether it’s a fixed cost or not

 You can see different production volumes and the corresponding estimates for different cost
components

So, I have
- Cost
- Price points
- Estimated sales
 I have all the components to figure out the profit of each firm.
 If I know the profits under different outcomes, I can construct the game. I have the players, I have
the action, the payoffs, I know the information -> I can try and make a prediction and see what
would happen in this game.

If we are charging 399, PS3 is going to be 8.75 -> 399 * 8.75 = 3491.25 (revenue)

 Revenue – cost

Cost – if I make 8.75 produced, per unit cost = $343.86

Some costs are variable and others are fixed
 Total cost = variable + FC
 Per unit total cost * number of sales = total costs
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  = $343.86 *8.75=3,008.75 -> operating profit (because subtracted not only variable costs but also
fixed costs) -> you could say that you only want to include variable cost and in this case you would
only remove the overhead part and keep production labour, material and parts as well as
distribution -> to get gross profit

 This is the approach you could take to compute the profit of each company under each price payer.
Once you have done it (you would do it 8 times), you would populate this table and then you would
try to make a prediction about what market prices would be
Timeline

 If you are observing these dynamics, you are understanding some competitive friction kicking in so
we have started reducing prices, trying to target consumers who are more price sensitive, who have
been delaying their purchases etc. why is this question important? Why is it important to know
where the prices are headed?
o If I know that the prices are moving downwards, it means that my markup is going to
become smaller and smaller even if the costs stay at the same level.
o It means that the profit I am making from each sale is going to become smaller so I have
more pressure to think about how I could have some efficiencies which would allow me to
cut the costs which will also increase my flexibility -> heading into a price war.
 The lower my costs, the greater my position for this price war situation. It means I
can cut my price even lower because my costs are low. So, knowing where the prices
are headed will allow me to prepare in terms of cost planning.
 It is more profitable to sell your products at a high price than when the prices are
low – maybe while the price is high, advertise more aggressively trying to
communicate this value and convincing consumers to buy the product while the
price is high. By contrast, if I know that the price is going to go down, the profit that I
make from each sale is going to be smaller, therefore spending a lot on advertising
may not be justified because with advertising spending may not be recovered by this
lower profits, which I am going to obtain later.
o The production process/inventory – if the demand goes up by 1M units, you cannot
immediately supply 1M units. Knowing where your prices are headed and therefore what
your sales will likely be gives you a lot of advantages (often we see companies running out
of stock – poor planning from the company’s side)
 How can we try to make these predictions?

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 
We have to understand firms incentives – will they gain by reducing the
price? If we reduce the price, we will obtain additional sales but then we are
losing the markup $100 less
o For this you need data about the competitors cost structure (can get
this info from suppliers, price they are charging you, they are charging
them). When you are doing market research, you also want to study
consumers perception of some of your competitors products out of
hundreds consumers that you invite to do a survey. Which fraction
are more likely to buy your product? Which fraction is more likely to
buy your competitors products?
 Homework was: complete the analysis and make prediction for where the prices are headed
o If we do the analysis, the equilibrium will be 299, 299.
o How do we do the analysis?
Side note
 We need to estimate the operating profit = Q*(p-c)-FC
 It follows that

 Small c -> total variable cost

o The case readily gives us the total cost per unit -> use this number and multiply it with the
quantity of sales

Profit estimation
o If both companies charge 399, the table shows that
o PlayStation will sell 8.75 million, Xbox will sell 8M.
o Estimated total cost per unit
o For play station = $343.86 and for Xbox = 335.25
o Estimated operating profit (in millions)
o Profit play station = 8.75 * 399 – 8.75*343.86 = $482.5
o Profit Xbox = 8*399 – 8*335.25 = $510

 When I do it for all price payers: I am going to have all these numbers, and what I find is that each
firm would have an incentive to cut the price to $299.
o So the equilibrium outcome that I predict is going to be that both companies would reduce
the prices to $299.
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 o In reality, this is what happened as well.

- So if you were in 2009 and you were conducting this analysis at some point in 2008 or 2007, you
would have known where things are headed and you would be in a much better shape relative to
the situation if you were caught up by surprise.

Key Takeaways
1. Understand competitor’s incentives and strategy
 (Is the competitor profit driven? Sales driven? They are in a stage in the company
development process where their objective is to maximise sales rather than
profit. Important to know the objective function of your competitor. Secondly –
obtain the data about competitor which comes from your market research or
with respect to consumers, but also in your research when you try to gather
intelligence about your competitors operational performance, what are the
suppliers etc. how much do we spend on getting the suppliers to produce the
product and so on and so forth etc. all of this would allow you to have a good
idea where your competitor is standing, estimate their profits, sales under
different strategies and therefore be able to predict what the competitor is likely
to do once you have a good prediction of what the competitor can do )
2. Predict long-term outcome
3. Allows you to prepare in advance and exploit long-term opportunities
4. Having a strategic foresight can be a key source of competitive advantage

Price matching guarantees

 So often, game theory would allow us to see the strategic implications of strategies.
o In other words, it will allow us when evaluating the outcomes from a specific strategy. Doing
game theoretic analysis allows us to take into consideration competitors reactions to our
strategies and the resulting long-term outcome.
o Suddenly strategies which might seem counterintuitive and unappealing, might actually turn
out to be very appealing
 E.g., the choice of your capacity. How many units your factories can produce during a
month? What’s the orientation? Should I invest in having a greater capacity or not? If
there is an upward shift in demand, can I quickly produce the number of products
require and sell to consumers.
 Prisoner’s dilemma Companies are charging lower prices in order to make greater
sales but on the contrary situation (I am not going to upgrade my factory), if I restrict
my production capacity => which means that my incentive to cut the price to
generate more sales are going to be low because I don’t have the capacity to service
additional sales. This will be a mechanism for the market to maintain high prices
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 because reducing the price even though demand will go up, you don’t have the
capacity to serve this additional demand.
 Price matching guarantee
o If you find another retailer that is selling the same product at a lower price, we will match
the price
 Cutting the price is less attractive for me when I know my competitor is using price
match guarantee and therefore if I cut my price, I am not going to generate so many
sales.
 In a situation where there are no price guarantees offered, by cutting my price, I can
generate extra sales. The competitor can reduce the price too -> price competition is
high
 => when competitors offer price matching guarantee, the incentive to cut prices is
lower
 Games theory is a tool for us not only to understand my actions but also competitors’ actions and
try to predict what the LT outcome will be and knowing the LT outcome offers a lot of benefits

Price match guarantees

 Allow us to take into consideration, competitors’ strategies
 How many units can factories produce in a given month
 If you find another retailer that sells at a lower price, the first retailer would be reduced
 If my competitors is using price matching guarantee, I shouldn’t cut my price -> price competition
would become more intense

Session 7 – Psychological aspects of pricing

Pre-class Questions
 How to prepare for the exam
o Conceptual knowledge is the foundation
 Here is this thing that we see in the market. What’s the firm’s strategy
o Build practical skills
o Here is the situation: cost etc. what do you think will
o Assess the implications of each marketing technique and which one to go
o 1 hard question targeting students who invested a lot of time trying to understand
o Grades in the difficulty of questions
o 3 questions
 First 2 – you will understand
 Last 1 – plus complique
 Group work
o You can find global data
o Local market: what happens in this market is consequential for the company
o Pricing analysis – focus on the local market
o Figure out the price that the company charges for one mile
o You can also do a survey to get the data
 Debt equity and debt financing
o In your report, you are essentially telling a story
 High price competition in the industry.
 Intro: this business has been quite tough. Ratios will help build the story
o Whatever happens at the company level might impact what
o Data: ok to make a reasonable assumption.

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  I would like to see what you have done had you obtained the actual data from the
market but if you don’t have the data, what was the right thought process. If we had
the data, this is how we would have used it and interpreted the results
- Different product features – either surveys or assumptions
- Mixed strategy equilibrium exist too

 Any other reason companies might be interested in reducing the prices of consoles?
o Any other reason in addition to maximising the profits from console sales
o Maybe a new product is coming soon – they want to make as many sales as possible now
before introducing the new product
o Encourage purchases of consoles as much as possible because this will lead to purchases of
games. You might actually sometimes sell the consoles at a loss to you, charge a price below
the cost of producing the console because you know that the cost will be more than
recovered when consumers start buying the games
 This puts additional incentives, creates additional incentives for the company to cut
the price of the console – this is called razor blade pricing. Sell the complimentary
product at a high price

 Why is it important to foresee where prices are headed

o Try to prepare for it in terms of cost planning
o Profit I am making from each sale is going to be lower
 Need to understand firm’s incentives

Survey
 You are looking for a shared apartment in London. Your budget is £800. Your friend Sharon tells you
that one of her classmates, Chris, is looking for a flatmate. Sharon knows that Chris’ rent is £1200 so
you will probably pay just £600.
 You visit Chris’ apartment, and you like it. Chris tells you that the rent is £750. Will you rent the
apartment?

 So far, we’ve discussed that if price is below your willingness to pay, it’s a good deal and you should
buy the product. In addition to WTP and the actual price and the difference between them, there
are additional factors which are influencing consumers decisions. And we are going to look at some
of these additional factors which we call psychological factors influencing consumers decision.
 The interaction is not only giving me an economic benefit and an economic cost but there is also a
psychological utility or disutility

Individual rationality
 Buy the product if
Price < WTP

 Describe the decision process of a perfectly rational consumer who is not taking into
account these fairness issues and the personality of the salesperson or the flatmate or
whatever – just compare price and willingness to pay
 We often observe otherwise
o WTP focuses on rational aspects, does not tell the entire story
 Consumers’’ decisions also affected by psychological utility

What is psychological utility?

 Prospect Theory
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  Reference point
o The expected or fair price in your mind that is compared to actual price
o Divides psychological utility into gains and losses
o E.g., 600 was probably a fair price most of us would have in our minds (splitting the rent
equally 50.50) -> any variation of this upwards would cause us some disutility (unfairness
feeling that the price is higher than it should be) also maybe you’d feel uncomfortable if he
says you pay 500 and I pay 700
 There are diminishing returns to gains and losses
o For example, you walk in the street and find £5 and you walk a bit more and you find £1.
Thee benefit you get from finding another £1 is going to bee much less than the gain you
had finding £5. -> it will be more than 5 times less
=> essentially you become used to it
o Same thing with losses – the second loss would create less disutility than the first one
 Losses are steeper than gains
o Increase in happiness from a gain is less than increase in unhappiness from an equal amount
of loss (loss aversion) => more sensitive too losses than to gains
 Gaining $5 is going to give mee less utility than the disutility that I would get from
losing $5 -> more sensitive to losses than to gains -> you are loss averse

 As I move to the right, the slop of the green line is becoming smaller and smaller. This the
diminishing sensitivity to gains => additional gains matter less (you become used to gains)
 As you move to the left, additional losses is not going to affect your utility as much.
 Loss aversion means that the gain from obtaining extra x (could be the £5 note that you find on the
way to school) would give me less utility than disutility generated by losing £5

 Length of interval l is going to be greater than the length of interval g => more sensitive to losses
than to gain.
Reference point
 How is your reference point formed? What is a fair price for you?

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  What are the factors affecting consumers’ perceptions of fair price?
o Oil prices go up, you’ll see that in a station that has a slightly lower price (£0.01), there is a
huge line of cars (while waiting in their cars, they keep their motors running and consuming
gas -> the cost of waiting in the car is much higher than paying $0.01 less for the gas but
because when the gas prices are up, people become very sensitive (they have fairness
concerns) ‘we used to pay $2 for a gallon and now we have to pay $4’. So when a company
is charging $0.01 less, in your mind it’s like ‘these guys are fair and are for the consumer’

Implications – gift card

 Who will spend more money?
o Consumers with a $50 gift card
o Consumers with $50 cash
 Consumers with a gift card tend to spend more
o Gift cards essentially shift consumers’ reference points
o I am planning to spend $100 on new shoes but with a $50 gift card, my reference point
shifts to $150
 Consumers with the gift card are more likely to spend than consumers without a gift card

Implications – price framing

 Two retailers selling the same product
 Each retailer charges £80 but frames prices differently

 In terms of the prospect theory, which do you think is going to make the sale?
 It’s Retailer B – creates a reference point in your mind (£100), the actual price is £80. So you are
gaining £20. So in your mind, you are gaining something on top of the product itself
 Whereas for retailer A, the reference point is not created, no impression of a greater gain

Implications – price framing

 Rising costs force both retailers to increase price by £10
 Which retailer will suffer more?

 Which retailer is going to suffer more from the price increase?

 Prospect theory assumes that consumers are going to be more loss averse meaning that a gain of
the similar amount vs a loss of a similar amount, the gain is not going to affect the utility as much as
the loss.

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  If I am retailer A, I am creating a loss in consumer’s mind of having to pay additional 10, which is a
loss and consumers are very sensitive to losses
 What happens to the consumers buying from retailer B, they see the price has increased but, in
their mind, they were getting 20 extra. Now the gain has become only 10. Because consumers are
more sensitive to losses than gains, a reduction in gains by x amount versus an increase in losses by
X amount. The losses are going to prevail. => therefore, prospect theory predicts that retailer A will
suffer more than retailer B.
 Prospect theory assumes that consumers tend to be loss averse meaning that a gain of the similar
amount vs a loss of a similar amount -> the gain is not going to affect the utility as much as the loss.
o When the prices go up, If I am retailer A, I am creating a loss in consumers mind of having to
pay additional £10 (which is a loss)
o For consumers who regularly shop at B, the price has increased, but in their mind, under the
old price, they were getting £20 extra (gain of £20), and now the gain has become only £10.
Because consumers are more sensitive to losses than gains, a reduction in gains by X
amount versus an increase in losses by X amount -> the losses are going to prevail. =>
therefore, prospect theory predict that retailer A will suffer more than retailer B. (a certain
majority of people think like that but not everyone)

Implications – price adjustments

 The firm has to increase its price by £10
 Two managers argue about the best way to proceed
 Mng. 1 argues there should be two monthly increases by £5
 Mng. 2 argues price should be increased by £10 right away
 How should the firm proceed?
o Reference point has shifted – the new loss caused to the consumer, is going to be the same
 It is then better to reduce by £10 in the first place (perception of loss only once)

 Implications – price adjustments

 Reference point changes with each price change
 Diminishing returns to gains
o Several small gains feel better than one big gain
 Diminishing returns to losses
o Several small losses feel worse than one big loss
 Don’t deliver bad news piecemeal
o Bundle it up with small gain for customers
 E.g., if you are a retailer, putting some candies at the checkout and giving it to
customers (especially customers with kids) can go a long way

Pricing and psychology of consumption

 If you want to obtain great satisfaction, might want to go for monthly payment plan

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  Depending on when consumers are going to make a payment, the consumption of the product is
going to be very high.
 Gradually, consumers forget about the gym. Looking at the data, every time there is a payment
made, consumer is reminded of the pain of paying so the usage rate goes up and then it starts
declining. (consumers have to justify the loss so they start consuming)
 Do we benefit if consumers use the facilities more vs less?
 Depending on what plan you are going to offer to consumers, this is going to affect the usage rate
o E.g., if you have a small gym, you don’t want too many people at the gym at the same time,
this will decrease the satisfaction of consumers.
o If I am concerned about the renewal -> If I offer them an annual payment plan, they don’t
use it so much – people are more likely to opt out
o If you want to obtain greater product satisfaction, you might want to go with more frequent
payments to encourage better usage.
 We realised that in addition to the economic trade-off, there is something else going on – we try to
understand the psychological aspect and create a framework within which we can understand what
is going on in consumers’ minds (prospect theory)
o Essentially, no matter what happens to you in life – it’s either a gain or a loss relative to your
reference point
 This framework creates all kinds of implications for our pricing decisions.

Before class (from previous session)

 Prospect theory to assess the motivations of consumers
 Over time as we gain and more or lose more and more -> we get used to it
 Consumers tend to be loss averse – same amount of gain vs same amount of loss -> losses are going
to hurt more and more than the happiness you feel from gain
 We really try to avoid losses as consumers
 Prospect theory can recommend specific actions which can minimise the damages and maximise
the benefits. How should I frame the price? How should I communicate the price changes?
 The effect of pricing on consumption usage
o If your objective is to maximise the likelihood of plan renewal in the next year, in the next
month etc. you want high level of usage, so probably you will not go with an annual
payment plan; you would try to go with quarterly or monthly payment plan to make sure
consumers are engaged. So, they use your product and they are happy with it and therefore
more likely to renew.

Pricing and psychology of choice

 Menu design and pricing can guide choices
o Add a decoy
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  If you have 3 options, more likely to go for the middle one. When you add the third option, you
price it high enough and you make consumers buy the second one and make it the compromise

 Compromise effect
o Go for the middle option
o Existence of an extreme option (angus beef filet) justifies choosing the middle option (beef
bourguignon)
 Attraction effect
o Create a product that is dominated by another product
 Instead of selling 1 product, I sell 2 or 3 products and make one of these products
look bad
 Creating this print option, print + digital becomes attractive in consumers’ minds

o The product that dominates becomes more likely to be purchased

o Directing the perception of consumers in terms of value -> getting something that is worth
£105 at the price of £70.
 By creating an option which is not so desirable, the other option which is dominating
this undesirable option now looks more attractive in consumers’ minds.

 Another example of attraction effect

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 o Big jump between 11 and 11 Pro but not a big jump between 11 pro and pro Max, this
makes you think that the pro max is a good deal
o Is the 11 pro a compromise?
 It might be stronger if the price of iPhone 11 pro was a bit higher
 Compromise effect is not very strong
 Once you understand the attraction and compromise effects, you can think strategically about what
kind of products you offer to consumers and how you price and sometimes you might want to
introduce a decoy product – your intention is not to sell the decoy product to influence consumers
decisions towards non decoy main products but you want to maximise sales. And to do this you use
the attraction and compromise effects to achieve what you want
 IPhone 11 is targeting a different segment of consumers compared to 11 pro and 11 pro max

Main takeaways
 Utility consists of economic surplus and psychological utility
 Prospect theory
o Actual price is compared to a reference point
o Diminishing returns to gains and losses
o Losses are steeper than gains (loss aversion)
 Pricing can affect consumers’ consumption pattern
o Influences user experience and purchase satisfaction
 Decoy effect
o Create products that you do not intend to sell
o Compromise and attraction effects

Session 8 – Price Discrimination

Benchmark with uniform pricing
 Every consumer is charged at the same price
 Example
o Café serves students (70%) and local residents (30%)
 Students’ WTP is £3
 Local residents’ WTP is £4.5
 Cost per cup of coffee is £1
 What is the café’s optimal uniform price?
o Wouldn’t make sense to charge £4 because you’ll be missing out on students and I might as
well put £4.5 as local residents are willing to buy.
o No sense to charge below £3
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 o If I am a profit driven company, I just estimate my profits from charging 4.5 vs my profits
when I charge £3
 If I charge £3 -> profit will be £2. I am serving 100% of the market. Let’s assume
there are 100 consumers in the market -> 2*100 will be the profit = £200
 If I charge 4.5, the profit from each sale will be £3.5 but how many am I going to
serve: only 30% of the market, which is 30 consumers -> 3.5*30= £105, which is less
than £200 (What I can get from charging a lower price and also charging students)
 If I am charging a uniform price, I would choose the price to be £3 and I’ll
make £200 per day

Uniform pricing vs price discrimination

 Café example shows that consumers with high WTP benefit from uniform pricing
o They end up paying a lower price than their WTP
 The café might want to increase its price to extract more surplus, but it will lose its more price-
sensitive customers
 Price discrimination solves this problem for the café
o What pricing scheme would you propose?
 Charge £4.5 to residents and £3 to students
 Profits are up by 23%
 I have a segment of consumers, the local residents, who are willing to pay 4.5, but the actual price
they are paying is £3.
o Consumers with higher willingness to pay are getting a good deal and usually when prices
are uniform, it’s the wealthier, less price sensitive consumers who are getting a good deal
because essentially, when the firms cannot discriminate, wealthier consumers are pulling
themselves with less wealthy consumers – the firm cannot distinguish and because the firm
also wants to serve less wealthy consumers, it is charging lower price.
 What would happen if the firm could discriminate between the 2 types of consumers?
 £3 for students and £4.5 for local residents. What would be my new profits as a result?
o 30*(4.5-1) + 70*(3-1) = £245
o = Locals + students
o => prices are up by £45 (before I was making £200 when I was charging the same to
everyone) -> 22.5% increase just by being able to observe consumer types.

Third-degree price discrimination

 The firm charges different prices to different consumer segments

Framing
 What do you think about this?
o As the word discrimination suggests, it’s something that consumers might be uncomfortable
with. I have to be careful about how I frame my prices.

This sounds bad. Highlighting – if you are a local you are at a disadvantage.

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This sounds better. Regular price is 4.5 and students get 33% off. Students are getting a discounts which
seems fair.

Now everyone is getting a discount. If you are a local regular customer, you are getting a 10% discount and
if you are a student, you are getting a 40% discount. I can frame it in a way for each consumer segment to
perceive that we are getting a deal.
Prospect theory – create a reference point so everyone believes that you are getting a gain

 Based on demographics
o Discounts for children, students, elderly, etc.
o Location-based (prices for flights – Lufthansa maybe thinks that in Rome they’ll have to
compete with local carriers. In Frankfurt, I am a monopolist, not so many airplanes fly from
there, I can charge higher prices. Maybe the company has some data saying that people
flying from Rome are more price sensitive.

o Behaviour-based
 Discount for new or established customers (different deals to customers/non-
customers)
 I interact with consumers over time and learn about their preferences and
this allows me to charge different prices to different consumers
o In the US there are some aggressive advertisements – switch from T-
Mobile to AT&T, get $650 or something like this. To cover the
expenses of the switch
o What the company does is that it is offering different deals to its
customers vs non-customers

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 o Another example – Subscription to Norton anti-spyware and antivirus software. It shows
that initially when you subscribe, you are paying this low price 34 or 24 etc. but then it says
that price shown is for first year and then it’s £64.99/year. So, I am price discriminating
between my new customers versus long-term customers. New customers are getting a
lower price vs the long-term customers who have been subscribing for a long time.
 An important factor here are the switching costs, switching to another operator is
extremely costly. Even if they increase the price a bit you wouldn’t mind because the
switching costs are high.

Example
 MSX sells digital subscriptions to its software
o Historical sales data available

 Monthly subscription sales depending on the price point where it charges

o When the price point is £9.99, the company observes 15M subscriptions.
o When the price point is £12.99 -> 13.1M subscriptions
o When the price is high £14.99 -> 10.5M subscriptions
 From this data, I can make inferences about the distribution of consumers WTP
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 o 10,500 customers with WTP above £14.99
 First, I observe that there are at least 10,500 customers whose willingness to pay is
above 14.99
o 2,600 customers with WTP between £12.99 and £14.99
 When price goes down to £12.99, 2,600 more people buy. 14.99 was too high for
them
o 1,900 customers with WTP between £9.99 and £12.99
 Once I reduce the price from £12.99 to £9.99, the number of subscriptions goes up
by 1,900. Therefore, 1,900 customers whose willingness to pay is between these two
price points.
 Price adjustments can be used to gather customer data and implement price discrimination
o As I change my price, I am able to observe how my sales respond and therefore I can make
inferences about consumers
o If I always charge the same price, unless I do market research right, I will not observe how
consumers are different. Maybe the price is too low, maybe the price is too high.
 So, observing historical price and sales data allows me to make inferences about the distribution of
consumers’ willingness to pay.

MSX location-based pricing Excel

 Of course, we can do better than this: we could us historical sales and price data to construct the
demand line and choose the price point, which actually maximises the overall profit.
 We have 3 price points. How do I choose which one is the best? I compute the profit

 Profit = (price point – cost) * sales

o First, let’s find the uniform price (assume cost = 0) -> so in this case we just put price * sales
 Observe that £12.99 is the optimal price
o Next, suppose customers with WTP < £14.99 are international. Those with WTP > £14.99 are
mainly domestic. When I look at customers data, I realise that one segment off consumers is
international and the other one is domestic and I also observe that when I charge high price,
domestic customers stick around and when I reduce the price, there is no increase in
domestic sales but the increase is coming from international sales. Therefore, I conclude
that the WTP of domestic consumers is at least £14.99 (it’s the international customers who
have relatively low WTP)
 Two prices: one for domestic purchases, one for international
 What is the international price?
 What if 50% of consumers with WTP > £14.99 are international?

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Situation A

 For domestic
o Domestic price -> keep it at £14.99
o Profit from domestic sales -> = 14.99 * 10,500 = 157,395
 For international
o Calculate the profits for both prices
o £9.99 -> 9.99 *(1900+2600) = £44,955
o £12.99 -> 12.99*2600= £33,774
o Best to charge £9.99 as the profits will be higher (everyone is served)
 Calculate the total profit -> 157,395 + 44,955 = £202,350
 I realised that some consumers are domestic, and others are international and there is a Correlation
between willingness to pay and location is absolutely crucial for price discrimination to be sensible.
o If consumers were identical in your international market and in your domestic market, you
would charge identical prices. Therefore, knowledge about where the consumer is coming
from would be irrelevant. It is because there is correlation between WTP and location, this is
what allows you to charge different prices and earn more profits

Situation B
 Change the example. Let’s now assume that I observed that 50% of customers who are willing to
pay £14.99 or more are actually coming from international markets. Before, everyone willing to pay
£14.99 was from domestic market and now I am saying only 50% is from domestic, the rest are
from international markets. The distribution of consumers now looks a little bit different.

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  Domestic
o £14.99*5250 = £78,698
 International
o Profits if I charge £9.99 -> 9.99*(1900+2600+5250)=£97,403
 Charging the lower price so I am going to serve every customer in the international
market)
o Profits if I charge £12.99 -> 12.99*(2600+5250)=£101,972
o Profits if I charge £14.99 -> 14.99*5250=£78,698
 Optimal price is £12.99
 Total profits = £101,972 + £78,698= £180,669

 Consumers who have low WTP are still coming from international markets, but consumers with
high willingness to pay, half of them come from domestic, half of them come from international
o If the number of customers with high willingness to pay in the international market goes up,
I have more incentive to charge a higher price instead of keeping the price down.
o Before I was charging 9.99 and now I am charging 12.99, which makes sense. (Correlation
between WTP and location became weaker -> profitability of price discrimination also goes
down. So ideally, in order to achieve highest profits from discriminating segments, you want
to identify segments which are very different from each other. The greater the differences,
the greater the potential from charging different prices to the different segments) If we are
pretty close to each other, the extra profits you make from price discrimination goes down.

Third-degree price discrimination

 Implementation may not be easy
o Why?
 Needs lots of data (about price points, about customer types)
 Explain why I am doing this – it’s unfair etc.
 Second-degree price discrimination relies on consumers self-selecting into the right pricing range
o I know this type of customers are going to prefer product number 2 and this type of
consumers are going to prefer product 1

Second-degree price discrimination

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  Different products at different prices

 As a company I no longer need to say these people are coming from a big house, I need to charge
them more -> I’ve created a special product for them to choose
 I have created several products, I no longer have to track and try to guess the type of customer
o Customers reveal themselves by choosing the appropriate product and paying the
appropriate price
o So from the perspective of gathering data, analysing data, this becomes an easier task, when
it comes to everyday operations and data analysis
o Of course, I’ll need to do a lot of data analysis, market research at the very start when I am
about to design my product line
o But once I do, I am good to go. I don’t need to dynamically adjust my price based on the IP
address the consumer uses and so on.

Example
 Fulton sells security software for computers. The company wants to enter the B2C market instead
of focusing only on B2B.
 Its market research provides data about consumers’ WTP for different product attributes

 Design two products

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 o Product 1 is the standard product intended for type I consumers
o Product 2 is the premium product intended for type II consumers
 Must have more/better features than product 1
 Let be type i consumer’s WTP for product j
 Individual Rationality (IR) constraints

 So, if I want type I customers to buy product I, if I want more price sensitive consumers to buy the
standard product, I got to make sure the price of the standard product is below the WTP for the
standard product that low type consumers have.
 Similarly, If I am designing my premium product for type II consumers (premium), the price that I’m
charging must be below the willingness to pay of premium customers for my premium product

 For the premium customers, the price that I am charging must be below the willingness to pay of
premium customers for my premium product.

 Incentive Compatibility (IC) constraints -> Want to make sure that type I customers to buy product
2. I also don’t want type II customers to buy product 1. So, I have to understand consumers
incentives and design the product and price it in a way that guides consumers to the right choice. I
want the customer who is price sensitive to go for the standard product and a customer who is less
price sensitive to go for the premium product.

 Type I consumers prefer buying product 1

 The surplus with a low willingness to pay customer or type one customer gets from
buying product 1 (the surplus is WTP – price) must be greater than the surplus that this
customer would get if he or she were to purchase the premium product?
 If this was not the case, low willingness to pay a customer would say ‘I am getting a
better surplus by buying the premium product’
 => So, I have to price and design my standard product in a way that consumers who are
of type one/who are more price sensitive – they prefer to buy product 1 instead of
product 2

 Type II consumers prefer buying product 2

o I want the surplus that we get from buying the premium product to be greater than the
surplus we would get from buying the standard product.
o If Andreas is a premium customer, I don’t want to price the product too high so customers
like Andreas say hey this is overpriced, I am going for the standard product.
 I have essentially 4 different inequalities and when I solve this stuff, here is the prices I end up with.

 Solution to IR and IC (thee four inequalities)

 For product 1, you price it as close as possible to the customers willingness to pay of type 1
customer

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  For product 2, you have product 1 price + the difference in values that this type of customers are
getting from 2 vs product 1.
 Remember
o Standard product captures entire surplus from low-valuation consumers (type I)
o Premium product leaves some surplus to high-valuation consumers (type II)
o Otherwise type II consumers will not pay the price premium

Second-degree price discrimination – Fulton example (Excel)

 For the willingness to pay parts -> you sum the multiplications of customers willingness to pay and
the different features
 Price
o product 1 price = WTP Type I customer
o Product 2 price = product 2 willingness to pay – (product 1 type 2 customer WTP – product 1
type 1 WTP) = 17 – (12-12)=17
o Profit = 17*800+12*1200=28000

 Product design lab

o If I have a 1, it means that the corresponding product attribute is included
o 2 products are identical to each other

 Charge 26 (when you apply the formula), what if I charge 31?

o Exactly my valuation for it, so I get 0 surplus.
o By contrast, if I buy product 1, my valuation is 28 and price is 23 – I am getting a surplus of 5
so I would go and buy product 1
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  I need to make sure that the price of product 2 is not too high because otherwise
premium customers are going to buy the standard product instead of the premium
product. What is the highest price I can charge? It’s 26 -> 31-26 = 5 which is exactly
equal to the surplus the customer also gets from the standard option -> it’s the
highest price I can charge. You are charging them a premium but you make sure that
the premium is not too high to induce these customers to go with the standard
product.
 There is a limit to the premium that you can charge to customers, otherwise
they will not choose the product that you intend them to choose.
 If I charge 31 -> 0 surplus whereas I would have a surplus for product 1 (my
WTP is 28 but the price is 23 -> surplus of 5), therefore I would buy product 1
instead of product 2
 Remove password manager -> profits go up – so making my standard product worse can improve
my profits
o I make my standard product less attractive for my premium customer segment where
incentives to buy the standard product go down because password manager is not included
and these guys like password managers. They are more incline to buy product 2 therefore
the premium I can charge for product 2 goes up. => this allows me to make more profit from
the premium product.
o I am charging 29 now. The price difference you see, it has increased to £7, whereas before it
was only £3. So by sacrificing the quality of product 1, and reducing its price, I am able to
charge a higher price for my premium product and the net effect on profits goes up. That’s
why sometimes in reality we observe companies producing products and then taking extra
costs to remove some functionalities from this product to make it worse because we want
to have more differentiation between the products in their product line. They don’t want
quality levels to be too close to each other because it compromises their ability to use
second degree price discrimination.
 To use second degree price differentiation, you need the products to be sufficiently differentiated
from each other and intended for different consumer segments. This differentiation in product
allows you to charge a premium for the high-quality product.
 Finally, last point to make here is the product attribute with which you would want to play with?
o VPN - WTP is the same no matter which segment they belong to. So including or not
including them is not going to help you price discriminate consumers so effectively.
o => you want to identify elements for which consumers willingness to pay differentiation is
highest. This is what you are going to use when designing the products
o You understand that type II customers have much greater WTP for password manager than
type I customers => so let me include the password manager only in product 2.
o Same thing for Backup
 So, identify product attributes for which consumers’ willingness to pay have greatest variation, this
is what you are going to use to differentiate the products
 When it comes to product design, you don’t want to include too much stuff in your standard
product. Find product attributes for which consumers’ willingness to pay are most different
across segments. These are the product attributes that you would want to make available in your
premium product, but unavailable in your standard product.

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First degree price discrimination
 Relevant in B2B context and online because you have a lot of customer data
 Customized prices for individual customers (within a customer segment, there is still variation in
terms of willingness to pay)
 How is it possible?
o E.g., airline – are you using a MAC or not
o Browsing history

 Different price discrimination depending on the type of data that you have available to you
 Some are more difficult to implement than others
 Each type is present in reality in different contexts
 Group project: you can use this and make recommendations to the companies. If you think they are
not using price discrimination, you can say, this is something that the company could do. Here are
the relevant consumer segments that could be price discriminated. Here is the difference in WTP.
We think this kind of premium could be charged on top. Be creative. Don’t just do descriptive
analysis of what is happening in the market.

1st degree price discrimination

 Customized priced for individual customers
 Get personal data about consumers and price accordingly
 Different customers, different prices, Thanks to big data
 As managers, would you implement first-degree price discrimination if it could increase profits by
20%?
o Could compromise trust between consumers and the company
o Give same discounts by from higher prices
o Make it harder to get a discount – price sensitive consumers would make the effort whereas
the non-price sensitive would not make the effort -> people would self-select

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  1st - High fixed cost
 2nd – It can be very tricky if consumers find out about this and it can really compromise your brand
integrity and consumers’ perception of the brand etc. but it is possible to justify this different prices
by using coupons for example

Strategic effect of price discrimination

 Price discrimination has a positive direct effect
o Can customize the price to extract more surplus from each customer
 However, it can backfire in competitive markets
 With uniform pricing, price reductions are less tempting
o All consumers will get the reduced price => big profit loss
 Easier and less painful to implement
 Customized pricing makes price cuts for individual customers less costly
o Only a specific customer is getting the lower price
 Firms start competing for individual customers
o Before adopting the technology, are your competitors going to adopt the same technology,
how is this going to affect the nature of competition in your industry?
 Are you focusing on short-term gains at the expense of long-term big losses?
o Can start spiral of price reductions => prisoner’s dilemma
 Price cuts becomes less costly

Psychological effects of price discrimination

 Betrayal effect
o Firm offers a better deal to new customers than regular ones
 Jealousy effect
o Competitors offer a better deal to its regular customers than the firm.

Key takeaways
 Price discrimination exploits consumers’ differences in WTP
 Requires data
o More data => more precise pricing (first-degree instead of third degree)
 Product line design should take into account prices for each product
o Reduce the quality of the standard product to be able to charge a higher premium on the
high-end product
 Downsides of price targeting
o Can intensify price competition
o Negative perceptions among consumers

E.g., Mango Yogurt is the preferred flavour. Should the company charge higher for this flavour to have
more profits? Wouldn’t want to do that because people would start focusing on price and not on the
quality

Session 9 – Price in channels / Pricing Luxury

Luxury
 What is a luxury product?
 Standard definition: a product for which demand grows as consumer’s income increases
 Key characteristics
o High quality and service

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 o Uniqueness and authenticity
o Scarcity (demand vs supply driven)
o Signalling ability
 Even an internal signal to themselves
o High price
 I take care of myself, I deserve this kind of product

 Conspicuous consumption
 Send a signal
o Wealth, status, achievements …
o Consumers willing to pay a premium to send a signal
 What is needed for conspicuous consumption to work?
o Visibility
o Awareness

 Discussion Birkin bags

 What are the factors that drive the prices of Birkin bags up?
o What are the differences from other luxury goods?
 Conspicuous consumption
 Celebrity uses it
 Expertise – source material from limited supply etc.
 Investment product as well (unlikely it will go down)
 Status symbol
 What are the differences from other luxury goods?

Pricing scarcity
 As I produce more -> cost of production goes down
 As you increase the number of product, Exclusivity goes down and willingness to pay goes down.
o Need to analyse the sensitivity to the scarcity of the product by doing market research
 The perception of the product is related to the availability and scarcity of the
product
 WTP changes depending on the band your production output belongs to
 Once you identify the different ranges, you need to figure out what’s the consumer
sensitivity to availability, depending on the quantity you produce
 As I increase the production volume from 1 to 2. How much reduction in WTP is
there?
 Pricing based on WTP (perceived-value pricing)
 Two components of WTP
o Core: quality, design, brand, prestige etc.
o Value of scarcity
 Scarcer -> high WTP
 Allows the firm to charge a high scarcity premium
Example – Kiro
 Kiro is a Japanese brand of watches
o The brand boasts long traditions and top-notch craftsmanship
 Kiro targets a small segment of wealthy consumers interested in exquisite watches
 Kiro is about to launch a new line of watches, Hinonde from Kiro
 Based on past data and market research, Kiro estimates that targeted customers will pay 2,000,000
yen (about $18,000)

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  This will have a positive effect on the brand as a whole
 Will also allow the firm to charge a higher price – By how much should I limit my production to
charge scarcity premium?
o Scarcity premium
 Scarcity premium
o The extra price consumers are willing to pay for marginally more scare product
 Scarcity threshold
o The quantity threshold below which product is perceived as scarce
o Not scare if Q > scarcity threshold

 Company can get more profit if it doesn’t produce scarce products

o Compare the revenue from selling for quantity at the lower price with selling few products
at higher price
o On one hand reducing the production volume allows me to charge a higher price but the
negative side is that my sales number also goes down as I produce lower number of
products – so I need to find a balance of these 2 opposing effects
 If I am producing less than 200, for each unit that I reduce, I will be able to charge extra 25,000 yen.
(scarcity premium)
 What will be the WTP if only 1 watch is produced?
o 6,975,000 yen
 What is the optimal Q to maximize profit?
o Assume that it costs 1,000,000 to produce each watch
 Maximize Q*(Price – 1,000,000)
o Q*(2,000,000 + 25,000*(200-q)-1,000,000)
o Use WolframAlpha
o Optimal Q is 120 units. Gross profits = 360,000,000 yen
o Each watch will cost 4,000,000 yen

Pricing in Channels
Role of channels
 Access to markets
 Operations management
o Inventory control, maintenance, warranty service, risk sharing, …
 Information gathering/sharing
 Promotion
o Advertising, consumer education, branding …

 Pricing affects the channel relationship across all of these dimensions. Keep them in mind when
setting a price

Channel structures

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Indirect channel
 Vertical conflict
o Retailer’s price may be too high -> low sales
o Double marginalisation problem

Double marginalisation

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Profit of Feezly = 100,000 (1.5-0.45) = (500,000 -200,000 x1.5)(1.5-0.45)

 Revenue sharing contact -> use two part tariff contrct

Two-part-tariff contracts
 Can significantly improve channel efficiency
 Contract consists of two parts
o Retailer makes

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 SAMPLE EXAM ANSWERS

PROBLEM 1

Differentiation value = (-0.24/0.1)*0.3 + (-0.3/0.1)*15 + (+3.6/2)*11 + (-10/10)*9

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PROBLEM 2

PROBLEM 3

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PROBLEM 4

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