Growth Strategies

The Importance of Pricing

Jagmohan Raju, Joseph J. Aresty Professor of Marketing

The Importance of Pricing

• Setting the price is probably one of the most important decisions an

entrepreneur makes
• It is not just about setting the price, but more broadly thinking about what is
the right revenue model, and price is just one part of that
• When you set the price, you should focus on both the numerator and the
denominator
• Price per what?
• Will it be per unit of the product or per year?
• People often think of just the numerator
The Importance of Pricing

• Pricing is important, but it’s hard to do it well

The Four Inputs into Pricing

• Cost
• What does it cost me to make the product?
• In most cases, cost provides a floor, but not always
• You might consider freemium pricing in some cases, just as Dropbox did
• The next factor that sets the upper bound is Maximum Willingness to Pay or
WTP
• Economists often refer to it is as the Reservation Price
• We shall study three popular methods to measure willingness to pay
The Four Inputs into Pricing

• The next factor is competition

• Competition forces us to charge less than the maximum willingness to
pay
• We may need to give some incentive to the potential customers to switch
from what they are doing today to our product— accounting for switching
costs
The Four Inputs into Pricing

• Finally, our channel partners and collaborators also influence our pricing
decisions— usually pushing it higher because we have to make sure they
also make some money and are rewarded for their efforts
• Automobile companies charge a higher price to the consumer because
the car dealers must also make some money from their efforts
• Many direct to consumer startups avoid using channel partners to save on
this
• Tesla sells directly to the customer and is changing the industry practice
Setting a Price

Price Ceiling (Maximum WTP)

Competitive Factors
Customer Factors

Price
Final Pricing Decision
Range

Company Factors
Customer Factors
Price Floor (Usually Direct Variable Cost)
Growth Strategies
Price Elasticity

Jagmohan Raju, Joseph J. Aresty Professor of Marketing

What is Price Elasticity?

• The most common answer I get is “it’s an indicator of how sales change
when you change price”
• While this answer is not wrong, it is not accurate either
• The word sales means different things to different people and we need to
be precise
• Price elasticity is about how unit sales are affected by price changes, but
even that is not precise enough
Price Elasticity of Demand

• Why do we make our life complicated by dealing with percentages?

• You do not want a concept or its measurement to change just because
you measure quantities in 1000’s or 100’s, or tons or pounds, or price in
dollars or cents
• Elasticity is a “pure” number, and it does not matter whether we are talking
about meters, pounds, gallons, tons, dollars, or euros
Elastic or In-elastic

• We often hear business people use the phrase “my demand is elastic”
or “my demand is in-elastic”
• What do we mean by elastic or in-elastic?
• The typical answer I get is “it is about whether demand changes with
price or not”
• Once again, it is good to be more precise
• When we talk about elastic or inelastic, our conversation shifts from unit
sales to revenues
• Revenue elasticity
Relationship Between Quantity and Revenue Elasticity

• Using the chain rule from calculus we can show that:

• Inelastic: (revenue decreases when price is cut), 0 > elasticity > -1

• Elastic: (revenue increases when price is cut), elasticity < -1
Concept 3: Break-Even Profit Elasticity

• What is the price elasticity needed for profits to break even?

• Helps us link cost structure to elasticity and profits
Break-Even Profit Elasticity: Example

• Admiral Electric has 3 different products (business groups)

• It is thinking about changing the prices for these products
• Contribution margins for the three products are 85%, 55%, and 15%
• The company is considering lowering prices by 5%
• Will such a price change work out?
• What will be the potential impact of such a price change on profits?
Break-Even Profit Elasticity: Example
Break-Even Profit Elasticity: Admiral Electric Example

• If the original gross margin is 15% and we are planning to decrease prices
by 5% then break-even profit elasticity:
• -1/(0.15-0.05) = -1/(0.1) = -10
• If the original gross margin is 25% and we are planning to decrease prices
by 5% then break-even profit elasticity:
• -1/(0.25-0.05) = -1/(0.2) = -5
• If the original gross margin is 55% and we are planning to decrease prices
by 5% then break-even profit elasticity:
• -1/(0.55-0.05) = -1/(0.5) = -2
Break-Even Profit Elasticity: Admiral Electric Example

• If the original gross margin is 15% and we are planning to decrease prices
by 5% then break-even profit elasticity:
• -1/(0.15-0.05) = -1/(0.1) = -10
• What does it mean that we need a price elasticity of -10
• Does it mean demand must go up 10 times?
• No, it means demand must go up 10 times the contemplated change in
price which is 10 x 5% = 50%
• If this does not seem likely, then such a price change will not work out
and lead to lower profits
• For higher margin businesses it may work out
• Important to keep in mind that break even profit elasticity increases non-
linearly with margins going down
Summary

• Three important foundation concepts

• Price elasticity or simply demand elasticity
• Revenue elasticity
• Break-even profit elasticity
Growth Strategies
Measuring Price Elasticity: Part 1

Jagmohan Raju, Joseph J. Aresty Professor of Marketing

Price Sensitivity: Overview

• Measuring price elasticity

• Surveys
• Controlled experiments
• Analysis of historical data
• A/B testing
• What does price elasticity mean in different contexts?
Price Elasticity: Contexts

Are we talking about response to a permanent price change or a temporary or

short-term price change?
• By and large, consumer response is much higher for short term price
changes than it is to long term price changes
• Often an order of magnitude higher
• When short term price discounts are offered, consumers switch brands, buy
early or sometimes even stockpile or consumer more
Price Elasticity: Contexts

Are we talking about response to a permanent price change or a temporary or

short-term price change?
• In some cases, short term price changes lead to no change in demand
• For example, demand is not very elastic to price of gasoline in the short
run
• But if consumers were to know with certainty that gasoline prices will go
up and remain at say $5/gallon or even higher, they will shift to EV’s
more readily
Price Elasticity: Contexts

Are we talking about the response of the entire market (segment) level or an
individual level price response?
• Market level responses to price are usually smoother
• It is aggregated over many consumers
• At the individual level, because we often buy in discrete units (say one
toothpaste, or two tubes of toothpaste), the response can be discrete, and
we need different types of statistical methods when response is discrete
Measuring Price Elasticity

• Surveys
• Controlled experiments
• Analysis of historical data
• A/B testing
Measuring Price Sensitivity: 2x2 Summary of Methods
Measuring Price Sensitivity: 2x2 Summary of Methods
Using Surveys to Measure Price Sensitivity

• Let us assume that FedEx is trying to determine how consumers will

respond to the price of a new delivery service
• Start with a representative sample of 150 buyers
• Administer the survey to 5 randomized groups of 30 representative
consumers
• To each group, describe the product in depth, state potential competitive
offerings and their prices, and provide additional useful information
Using Surveys to Measure Price Sensitivity

• Then ask the question: Would you buy the new service if its price were $10
[$10; $11; $12; $13; $14]?
• Yes
• No
• Different groups are responding to a different price — one group to $10,
another to $11, and so on
• Examine the % of yes answers in each group and plot a demand function
Example: Fraction of Consumers Saying Yes
Strengths and Weaknesses of This Approach

Strengths Weaknesses
• Easy to do • Does not account for competition —
• Inexpensive what if competition changed their
• Fast prices?

• Gives a demand function — • Does not account for how many

may not be great, but we get units people will buy, only whether
something or not they will buy
• It is measuring intent to buy, not
actual purchase behavior
How do we create a better relationship between intent to buy and actual
purchases?
Ideal Relationship Between Intentions and Behavior

• What is the ideal relationship between intentions and behavior?

• Most will say it is a 45 degree line, pointing upwards
• Does it have to be a 45 degree line — suppose it is exactly the opposite?
• You have a friend, and every time when
he/she says a stock will go up, it goes
down, and every time he/she says a stock
with go down, it goes up
• Is he/she a good friend?
• What we are looking for is a stable,
predictable relationship and not
necessarily a 45 degree line
Improving Intentions as a Predictor of Behavior

• A major manufacturer of routers is thinking of launching a new G-class router

• The company conducts a survey of 100 potential buyers and asks them to
state their intention to purchase on a 1-5 scale

Intent to Purchase # of
G-Class Router (1-5) Consumers
1 15
2 20
3 40
4 15
5 10
100
Improving Intentions as a Predictor of Behavior

• The company launches the G-class router — what did people actually do?

Intent to Purchase # of Actually

G-Class Router (1-5) Consumers Bought
1 15 0
2 20 2
3 40 5
4 15 3
5 10 3
100
Improving Intentions as a Predictor of Behavior

• The company launches the G-class router — what did people actually do?

Intent to Purchase # of Actually

% Bought
G-Class Router (1-5) Consumers Bought
1 15 0 0
2 20 2 10%
3 40 5 12.5%
4 15 3 20%
5 10 3 30%
100
Improving Intentions as a Predictor of Behavior

• Now this company is launching an N-Class router

• It again conducts a survey of 100 potential buyers and asks their intentions
to buy on 1-5 scale
Intent to Purchase Intent to
# of Actually
G-Class Router % Bought Purchase
Consumers Bought
(1-5) N-Class Router
1 15 0 0 10
2 20 2 10% 20
3 40 5 12.5% 30
4 15 3 20% 20
5 10 3 30% 20
100 100
Improving Intentions as a Predictor of Behavior

• Now this company is launching an N-Class router

• It again conducts a survey of 100 potential buyers and asks their intentions
to buy on 1-5 scale
Intent to Purchase Intent to
# of Actually %
G-Class Router % Bought Purchase
Consumers Bought Conversion
(1-5) N-Class Router
1 15 0 0 10 0
2 20 2 10% 20 10%
3 40 5 12.5% 30 12.5%
4 15 3 20% 20 20%
5 10 3 30% 20 30%
100 100
Improving Intentions as a Predictor of Behavior

• Now this company is launching an N-Class router

• It again conducts a survey of 100 potential buyers and asks their intentions
to buy on 1-5 scale
Intent to Purchase Intent to
# of Actually %
G-Class Router % Bought Purchase Forecast
Consumers Bought Conversion
(1-5) N-Class Router
1 15 0 0 10 0 0
2 20 2 10% 20 10% 2
3 40 5 12.5% 30 12.5% 3.75
4 15 3 20% 20 20% 4
5 10 3 30% 20 30% 6
100 100 15.75
Improving Intentions as a Predictor of Behavior

• This helps improve the relationship between intentions and behavior

• We are codifying our past experience
• More details are in a paper by Professors Jamieson and Bass
Growth Strategies
Measuring Price Elasticity: Part 2

Jagmohan Raju, Joseph J. Aresty Professor of Marketing

Using Historical Data on Actual Purchases

• Package delivery company case

• The data in the case are adapted from an HBS case study on Fedex when
they launched a document delivery service called Courier Pak
• They had data on prices and unit sales for the first 29 weeks
• The company used a penetration pricing strategy (start low… slowly
increase price)
• Should the company raise price one more time, this time by $1?
• As we do not have access to cost data, we can focus on the impact of price
changes on revenues
Price and Unit Sales History Over 29 Weeks
Start By Regressing Units Against Price

• We observe a positive price coefficient that

is statistically significant
• Does it imply price increases result in
demand increases?
• What else is going on while prices are
increasing:
• More advertising?
• More word of mouth? Diffusion effects?
Use Time (Weeks) as a Surrogate for Changes in Other Variables
Regressing Units Against Price and Weeks
Start by Computing Elasticity

• Week 29:
• Unit sales = 1304, Price = 12.50
• Elasticity:
• % change in sales = -44.15/1304 = -0.0339 = -3.39%
• % change in price = 1/12.50 = 0.08 = 8%
• Elasticity = -3.39/8 = -0.42
• Therefore demand is in-elastic
• Raising price will raise revenues
• Can this go on forever?
Start by Computing Elasticity

• Is elasticity computed from past data valid going forward?

• Compute elasticity at different points on the curve
• Another approach would be to see how well a constant elasticity model fits
the data (Log Log is a constant elasticity model)
Regressing Log Units Against Log Price and Log Week
Measuring Price Sensitivity: Summary of Methods
Comparison of Methods

• Historical data, if analyzed carefully, can give quite good measures of price
elasticity
• Good estimates within existing range of operation
• Must institute good controls
• Estimates of price elasticity computed in experiments invariably result
higher than actual numbers