Supply and Demand

If you have taken a course in Economics in high school or in college, you will recall the basic principle of Supply and Demand. The relationship between these two variables is the foundation of a free-market economy. It determines market prices for goods and services and affects each one of us as consumers, business owners, and employees.

Think about an increase in gas prices a few years ago. As the supply of oil decreased (due to international politics), the price per gallon went up as high as $4 in some areas in the US. After new participants joined the market (new oil production in the US, Russia, Venezuela), the prices at the gas pump decreased.

No matter how plentiful something may seem, it is not limitless. Supply of oil, food, clothing, coffee, homes, and other products is limited and depends largely on how many businesses (suppliers) are willing to manufacture the product and participate in the market.

Demand fluctuates based on the number of people interested in purchasing a particular product or service. During the Holidays, many seasonal items are priced higher – Holiday decorations (Christmas trees and wreaths, lights), tickets to seasonal performances (Nutcracker ballet and The Christmas Carol) – because more shoppers are interested in buying.

When a new movie comes out, theaters (supply) sell out if many people (demand) at a time want to see the movie.

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Pricing (a marketer’s perspective)

A price is what the customer is willing to give up in order to obtain a product or service. Many manufacturers use cost-based pricing: design product, figure out what it costs per unit to manufacture, decide how much profit you want to make (10%, 20%, 50%), price the item: cost + profit = price. This approach is intuitive and simple to follow (especially for those of you studying  accounting.) The problem with cost-based pricing is that it does not take value into consideration. Value is about customer perception. Marketers should ask: how valuable is our product/service to the consumers? What problems does it solve? Would consumers be willing to pay more? How much more? We also must consider what competitors are doing and how our pricing strategy reflects our positioning.

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Value-based pricing is complicated, but it’s worth the effort. It reverses the process by starting with figuring out how much the consumer would be willing to pay to solve a particular problem (with a product or a service). For example, when we choose to outsource services like dry cleaning, housekeeping, child care, landscaping, we decide “if it’s worth the money”. Obviously, consumers, in this case, can simply do it themselves. But if my time is more valuable to me, say if I need to be at work or at school, how much would I be willing to pay for these services? The answer may vary based on my circumstances. Say, on any regular day I pay a babysitter $10/hour to watch my kids. But if I have a job interview and I cannot be distracted, and I need someone who is extremely reliable and will not be late and can handle anything that comes up with my kids without my involvement, I may be willing to pay twice as much.

Virgin America, for example, airline fairs were priced slightly higher for the added value of individual TV screens, in-flight WiFi, new planes, and leather seats aboard Virgin America flights. Tech-savvy travelers from Silicon Valley were willing to pay a bit more for these features. Some of you agreed – you would pay more too, while others commented that the cheapest fair, safety, and convenient location is more important to you.

As a marketer, if you underestimate how valuable your product/service is to the customer, you will be leaving money on the table. If you overestimate that value, you will lose customers. Price is the only revenue-producing element in the marketing mix (Product, Price, Place, Promotion). Knowing what’s valuable to your customer leads to more profits and customer loyalty.

Pricing Strategies: New Products

When a company introduces a new product to the market, one of the main goals is to recoup the costs of Research and Development (R&D). Some products take years to develop: pharmaceuticals, medical equipment, heavy machinery, new technology. During the R&D phase, the company is spending money on labor and materials, while not making any money on sales of the product. Price skimming is a strategy that allows the company to cover the cost of R&D and bring the product to the market. Apple is known to use this strategy when it introduces a new generation of iPhones. At the launch of a new iPhone, the price is the highest. Within a year of product launch, after the costs of R&D are covered, prices start falling.

Some companies, like Amazon, for example, use a market penetration strategy.

When Amazon introduced Kindle Fire, the price was set at $99. The closest competitor, Nook from Barnes & Noble, was selling for $249. Amazon’s vision was (and still is today) is that Kindle is simply a vehicle to distribute Amazon content such as music, videos, books. Amazon set out to penetrate the market with Kindle at a low prices and lock consumers into accessing Amazon content.

Using Price to Win Market Share

Large companies with deep pockets may engage in what’s known as “price wars” to win market share from each other. After Amazon acquired Whole Foods, the company started slashing prices to win consumers as the grocery shop for holidays. In the short run, such a strategy benefits consumers and allows the company to achieve a larger market share. But in the long run, price wars deplete company resources of the company and, eventually, it results in one of the competitors dropping out of the market – which reduces competition and drives the prices back up. The only long term strategy that succeeds in growing market share and keeping loyal customers, is a good quality product, customer service, and innovation.

Take a look at this NBC Nightly News report on Whole Foods price wars from November 15, 2017.

Amazon Forces Change On The Grocery Business | NBC Nightly News (Links to an external site.)Amazon Forces Change On The Grocery Business | NBC Nightly News

 

Using Price to Communicate Brand Positioning

Consumers often use price references to describe products/services: “A restaurant meal was reasonable”, or “Football tickets are pricey” or “Outfit looks expensive”. Marketers use psychological pricing to signal to consumers the brand image or quality. For example, Louis Vuitton bags are perceived as high quality because they are expensive. LV supports that image by never discounting the bags even if they don’t sell. At the end of each season, the unsold bags are shredded. Yes, shredded!

 

Reference pricing is an effective tool used by retailers. On a price tag, you will see the sale price of the item and the original price. Referencing the original price, the consumer feels good about getting a good deal. Discount retailers often set prices ending with $.99, which references a bargain. Consumers, of course, know that the difference between $10 and $9.99 is negligible. The $9.99 price reinforces the purpose and positioning of discount retailers.