PRICE SENSITIVITY

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• PRICE SENSITIVITY
• Peter P. Oppenheim
• University of Ballarat

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• The art of pricing is to equate the price to the
  value of the product to the customer - anything
  less than that represents a sacrifice in
  potential profits.
• E. Raymond Corey

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Role of Value in Pricing

• Economic value.
• Reference value (price of best
  alternative).
• Differentiation value (value of
  differentiating features).
• The total economic value is the maximum price
  that an informed rational buyer would pay.
• Economic value analysis.
• Excellent tool when buyers are very price
  sensitive.

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Economic Value Analysis

• Industrial markets.
• Value translates directly into financial savings.
• Consumer markets.
• Values are less tangible.
• Difficult to quantify.
• Market research required to estimate values.
• Conjoint analysis.
• Simulated test markets.
• Discrete choice analysis.

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Steps in Economic Value Analysis

• Identify the REFERENCE VALUE.
• i.e. The cost of the competitive product
  (identified as the best alternative)
• Identify differentiating factors
• Performance maintenance cost
• Startup costs reliability
• Service features
• Determine the DIFFERENTIATION VALUE
• Total economic value reference value
• Differentiation value
• Determine selling price

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Limitations of the Economic Value Approach

• Economic value approach.
• Knowledgeable.
• Sophisticated.
• Rational.
• Often buyers do not choose best value for price.
• Unaware of alternatives.
• Reluctant to invest effort required.
• Hedonic considerations need to impress.
• An effective pricing strategy requires an
  understanding of buyers price sensitivity, to
  explain why the model of Economic Value often
  fails to predict actual buyer behavior .

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Factors Affecting Price Sensitivity

• Perceived substitutes effect.
• Buyers are more price sensitive the higher the
  products price relative to the prices of the
  buyers perceived substitutes.
• What alternatives are buyers aware of when making
  a purchase?
• To what extent are buyers aware of the prices of
  those substitutes?
• To what extent can buyers price expectations be
  influenced by the positioning of one brand
  relative to particular alternatives?

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Factors Affecting Price Sensitivity

• Unique value effect.
• Buyers are less sensitive to a products price
  the more they value any unique attributes that
  differentiate the offering from competitive
  products.
• Does the product have any unique attributes that
  differentiate it from competitors?
• What attributes do customers believe are
  important when choosing a supplier?
• How can the perceived importance of
  differentiating attributes be increased?

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Factors Affecting Price Sensitivity

• Switching Cost Effect.
• Buyers are less sensitive to the price of a
  product the greater the additional cost
  associated with switching.
• To what extent have buyers already made
  investments in dealing with one supplier?
• How long are buyers locked in by those
  expenditures?

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Factors Affecting Price Sensitivity

• Difficult comparison effect.
• Buyers are less sensitive to price of a known or
  reputable supplier when they have difficulty in
  comparing alternatives.
• How difficult is it for buyers to compare the
  offers of different suppliers?
• Can the attributes of a product be determined by
  observation or following consumption.
• Are prices of suppliers easily comparable or
  stated in a way that makes comparison difficult?

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Factors Affecting Price Sensitivity

• Price-quality effect.
• Buyers are less sensitive to a products price to
  the extent that a higher price signals better
  quality.
• Is a prestige image an important attribute of the
  product?
• Is the product enhanced in value when its price
  excludes some consumers.
• Is the product of unknown quality and are there
  few reliable cues for ascertaining quality before
  purchase?

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Factors Affecting Price Sensitivity

• Expenditure effect.
• Buyers are more price sensitive when expenditure
  is larger, either in dollar terms or as a
  percentage of household income.
• How significant are buyers expenditures for the
  product in absolute terms (business) and as a
  proportion of income (consumers).

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Factors Affecting Price Sensitivity

• End benefit effect.
• Derived demand the more price sensitive the
  demand for a companys product, the more price
  sensitive are input products.
• What end benefits do buyers seek from the
  product?
• Share of total cost buyers are more price
  sensitive as price of input accounts for greater
  share of total cost.
• What portion of the end-benefit does the product
  price account for?

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Factors Affecting Price Sensitivity

• Shared Cost Effect The effect of partial or
  complete reimbursement on a purchase. The
  strategy often adopted is to provide awards to
  customers which are valued more highly than price
  cuts that would be reimbursed anyway.
• Does the buyer pay the full cost of the product?
• If not, what portion of the cost does the buyer
  pay?

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Factors Affecting Price Sensitivity

• Fairness effect.
• Buyers are more sensitive to a products price
  that is outside the range perceived as fair.
• A price is considered unfair if
• A large price increases has occurred?
• There is a variance with prices paid for similar
  products?
• The product is perceived as a necessity?

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Factors Affecting Price Sensitivity

• Inventory effect.
• The ability of buyers to hold an inventory of a
  product, substantially increases their
  sensitivity to temporary price variations.
• Do buyers hold inventories of the product?
• Do buyers expect the current price to be
  temporary?

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Managerial Analysis of Price Sensitivity

• Every pricing strategy should begin with a
  managerial analysis of price sensitivity.
• Identify market segments.
• Identify range of prices.
• Understand consumers.
• Such an analysis should provide
• Estimate of price sensitivity.
• Understanding of factors that influence
  sensitivity.
• Awareness of alternatives.
• Confidence in making brand comparisons.
• Share of cost paid by others.
• Etc.

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Economics of Price Sensitivity

• Price elasticity - used to define price
  sensitivity
• PE ( change in sales) / ( change in price)
• Generally negative
• Greater the value, the more elastic the demand
• Permits price sensitivity to be discussed
  independent of particular price change
• PE can be converted into expected change in sales
• e.g. PE -2.5 then a 10 price increase
  would reduce sales by (-2.5 x 10) 25

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Price Elasticity of Demand

• EFFECTS OF DIFFERENT TYPES OF ELASTICITY

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Measuring Price Sensitivity

• Techniques for measuring price sensitivity
• Actual purchases
• Sales data
• Experimentally controlled
• Laboratory purchase
• Preference and intentions
• Direct questioning
• Trade-off analysis
• Conjoint analysis
• Choice-based conjoint

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Using Choice-based Conjoint to Assess Price
Sensitivity

• In a study reported by Pinnell and Olsen (1996),
  a DBM survey was sent to 2000 respondents.
  Response rate 53. The study incorporated 4
  attributes brand (4), distribution (3) ,
  performance (3) price (4).
• Which of these would you be most likely to
  purchase?

Brand A Brand B Brand C Brand D None
Retail or mail order Mail order only Retail or mail order Retail only If these were my only choices Id postpone my purchase.
Below average performance Above average performance Average performance Below average performance If these were my only choices Id postpone my purchase.
285 410 335 290 If these were my only choices Id postpone my purchase.
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Developing Measures of Price Sensitivity

• Percentage of time respondents as a group choose
  each brand at each price used to create a
  graphic representation of the relative demand for
  each

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Developing Measures of Price Sensitivity (Cont.)

• At the current average price the sales for brand
  D 56. A 10 price increase would change sales
  to 45. To estimate this sensitivity in terms of
  price elasticity the change in sales
  (-11/56) 20 is divided by the price
  increase of 10 (-20/10) to give an elasticity
  estimate of -2.0.
• Using the same price points brand C has a sales
  level 17 at its current average price and
  11with a 10 price increase. The percentage
  change in sales is (-6/17) 35 implying an
  elasticity of 3.5.
• Although brand Cs sales fell by 6 points c.f.
  11 points for brand D, as a percentage, brand C
  lost 35 of its share and brand D lost only 20.
• These elasticity estimates may then be used
  together with volume and cost data to assess the
  impact of various pricing strategies on profits.

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Small change in price
Relatively smaller change in demand
Customers are price insensitive Demand is
inelastic
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Small change in price
RELATIVELY LARGER CHANGE IN DEMAND
Customers are price sensitive Demand is elastic
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Pricing Exercise

• We have elastic demand with the price elasticity
  of -1.4
• Suggests that lowering prices could be a good
  idea because total revenue will increase. (NB
  TR ? Profit)

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When demand is inelastic

• Demand is considered inelastic when the price
  elasticity is between 0.0 and -1.0
• Suggests that raising prices could be a good
  idea because revenue will increase.

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Properties of a Power function

• A power function is a function that permits a
  line of best fit to be drawn as a curve.
• y apb
• Where y demand or sales
• p price
• b an exponent that determines the
• shape of the curve

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Properties of a Power function

• An important property of the power curve is that
  when p changes by 1, y changes by a constant
  percentage which is approximately equal to b.
• i.e. the price elasticity of demand
• For example
• if y 100p-2.35
• then every 1 increase in p leads to
  approximately a 2.35 decrease in y.

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Example 1
Month Price Demand
1 450 45
2 300 103
3 440 49
4 360 86
5 290 125
6 450 52
7 340 87
8 370 68
9 500 45
10 490 44
11 430 58
12 390 68
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Determining the Optimum Price

• Assume a company produces with a cost of
  production and marketing 50.
• The selling price must therefore be gt 50.
• If the company charges P dollars, profit will be
  (P-50)D where D sales.
• But D depends on P. As price increases, demand
  decreases.
• Therefore need to identify how D varies with P
  i.e. identify a demand function.

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Identification of a demand function

• As a minimum two points are required, say
• When price 70, sales 400
• When price 80, sales 300

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Determining the Optimum Price

• Construct an Excel spreadsheet
• Enter formula to compute sales
• Sales Constant Price Elasticity
• Enter formula to compute profit
• Profit (Price Cost) Sales
• Use SOLVER to determine the optimum price by
  maximizing profit subject to price gt cost

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• Solver is part of a suite of commands sometimes
  called what-if analysis tools. With Solver, you
  can find an optimal value for a formula in one
  cell called the target cell on a worksheet.
  Solver works with a group of cells that are
  related, either directly or indirectly, to the
  formula in the target cell. Solver adjusts the
  values in the changing cells you specify called
  the adjustable cells to produce the result you
  specify from the target cell formula. You can
  apply constraints to restrict the values Solver
  can use in the model, and the constraints can
  refer to other cells that affect the target cell
  formula.
• Use Solver to determine the maximum or minimum
  value of one cell by changing other cells for
  example, you can change the amount of your
  projected advertising budget and see the affect
  on your profit amount.

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Determining the Optimum Price
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Solver Dialog Box
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Conclusion

• Numerical estimation of price sensitivity is no
  shortcut to knowing a products buyers.
• Numerical estimates are an important source of
  objective information that can supplement the
  more subjective observations that usually
  dominate managerial judgments about price
  sensitivity.
• As a supplement they can substantially improve
  the accuracy of such judgments.

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References

• Nagle, T.T. and R.K. Holden (1995), The Strategy
  and Tactics of Pricing, Englewood Cliffs,
  NJPrentice Hall.
• Peter, J. P. and J.C. Olson (1999), Consumer
  Behaviour and Marketing Strategy, Boston
  Irwin/McGraw-Hill.
• Pinnell, J. and P. Olsen (1996), Using
  Choice-Based Conjoint to Assess Brand Strength
  and Price Sensitivity, Sawtooth News.