[Instructor] Hello and welcome
to this week's topic which is pricing.
So we'll think about
how do you price your product
or your service.
How do you know what's a good price?
What are the strategies involved here
to get an effective price?
So we'll start with the basic parameters
and I'm gonna talk about three of them.
Cost-based, competition-based, and customer-based.
And then wanna walk through
some basic strategies and vocabulary.
So why does it matter?
Why are we spending whole week on this?
Why is it important
to have the right price?
What happens if the price is too low?
And what happens if the price is too high?
I'll let you think about it
at this minute.
So a price too low, it might mean
that it doesn't even cover your costs.
So you're selling something at a loss
or just if it's below what people
can reasonably expect to pay,
then you lose that little bit
of margin on every sale.
And also, price can be an indicator of quality.
And what happens if you price it too high?
Well, it might be so high
that nobody will buy it.
So there are some basic parameters here.
The price ceiling
is consumer willingness to pay.
So what is the most
that anybody is willing to pay?
Then in economics,
we call this the reservation price.
So if you could read somebody's mind
and learn what is the absolute maximum price
that they would be willing to pay.
That's called the reservation price.
And the very bottom,
the price floor are your costs
that for the most part,
if the price that you charge
doesn't cover all of your costs,
you're going to be losing money
and you will not be in business for long.
And then in the middle,
there's a lot of,
a lot of middle ground here
but you can think about
what do your competitors charge?
What is the going rate
in the marketplace for a product
or service like yours?
I imagine a lot of you
have had this already
but I wanna make sure
that you know it.
So variable costs are those that change
depending on how much you produce.
So if you're a farmer,
the more that you grow,
the more labor that you use
and the more you'll have to spend on labor.
The more you grow,
you'll need to spend more
on inputs like seeds.
If you're a coffee shop,
the longer that you're open
or the more busy that you are,
the more you have to pay for little labor,
the more coffee and other supplies.
And in many times,
marketing is a variable cost.
And so if you are spending a percentage
of income on marketing,
then that would clearly be a variable cost.
In contrast, fixed costs
also known as overhead costs
are those that do not change.
So no matter what you do,
how much you produce,
some things are kind of fixed
like your rent or your mortgage,
the cost of equipment, in many cases,
the cost of office supplies.
Whether you grow and sell a lot
or don't grow or sell anything,
just being in business,
you have these overhead costs.
And in some cases,
marketing might be fixed too.
So if you buy an advertisement
on some media for a fixed amount over time,
then this would be a fixed cost.
So it's kinda depend.
So one example of cost-based pricing
is to add up all of your costs.
And we'll see a few examples.
So you add up all your fixed costs.
You add up all your variable costs
to get your total costs
and then you divide
by the expected volume.
So this is what we call the break-even price.
This is what that which you would charge
which would just cover all
of your costs and no more.
So at the end of the day,
if you sell everything,
you don't make any money.
You don't lose any money.
You exactly break-even.
So you can think about
what would be cost like this
for a business like a restaurant?
What would be for a service business?
For your business?
So think about what would be the various fixed
and variable costs that you might incur
for your business.
So two pricing strategies based on cost
are cost-plus and target based.
And I will run you through each one.
So cost-plus is where you have a standard markup
and this is fairly common
in the retail industry.
So you base it on how much
you are buying something for.
So you say that you're buying an item for $20
and this is what we call COGS
or cost of goods sold.
So you might have a fixed 50% markup.
So you take that $20 to multiply
times 0.5 and add it on.
So you sell the good for $30.
This is a 50% markup.
And since your margin is $10
on a $30 good, your margin is 33%.
And these are terms
that you will hear a lot
if you use this model.
A more interesting one perhaps came about
and I'm going to cite an example
of work I did with a number
of organic farmers some years ago.
So imagine that there's a farmer.
Her name is Sue.
And she raises fresh produce on 10 acres.
She decides that $60,000 is her goal.
That is a viable income for her family.
That is the minimum
that she will wanna earn
to make it worth her while.
So she has to earn 6,000 an acre.
60,000 net divided by 10 acres.
And she grows a lot of things
including one fourth acre of carrots.
So she adds up all her costs.
She pays 200 for seeds
and fuel and stuff.
She pays 300 for marketing
for all the farmers market stalls fees
and fixed costs of 500.
And so her cost
of growing this crop is $1,000
and she expects a yield of 4,500 pounds.
So if you take this 1,000
and divide it by 4,500,
that is her break-even price.
Now, since she wants
to earn 6,000 net per acre
on one fourth of an acre,
she wants to add 1,500.
So she adds this the thousand
to the thousand costs
to 1,500 target net
and provides this yields 56 cents per pound.
So this should be sort of the minimum
that she should charge
to earn what she hopes to earn.
And note that this assume
that she sells all that she grows.
So as in almost everything else in life,
this approach has pros and cons.
The pros is it's fairly straightforward.
If it's done right,
it will show our profit
and it stems from break-even analysis
and knowing your costs.
So it's really important
to know your costs.
The con are, it doesn't really look
at what your customers wanna pay,
what your competitors are charging.
And again, there's no signal of quality.
So as I had said,
price can be a powerful signal of quality.
And if it doesn't reflect that,
it could send the wrong signal.
That might be that you charge too little
and someone will think there's something wrong
with your good and won't buy it.
We're gonna spend some time in class
but think about and come
with a number of reasons.
Why is it important for a business
to know its costs?
And be ready to discuss this in class.
So another thing that you should think about
is how much someone is willing to pay?
So here is a demand curve.
So you can see,
price is on the y-axis
and quantity is on the x.
And it basically tells
how much will you sell
if you offer at this price?
Or what is the demand?
So you can see, at a very high price,
hardly anybody will be willing to pay this.
But then at a low price, a lot are.
The slope of this line
is determined by the elasticity.
And we will talk in class
about what elasticity means
and some examples of this.
But it might be good
to bone up on this concept
if you haven't had it in class
or maybe haven't had it in a while.
But what determines elasticity?
So here are a number of factors that
determine what is a good price.
So and this is from the supplier's
or the seller's standpoint.
Hopefully, these all make sense.
Have a look.
Bring a list of any questions
that you might have to class.
But in each case,
these are from the seller's standpoint.
What you can expect from the price?
The final set is competition-based.
So it looks at
what are similar products
being sold for in the marketplace?
What is the going rate?
So you can think about the going rate
is sort of,
that if you wanna charge the same amount.
And then if you want
to charge slightly above that
where you're positioning it
as a higher quality good,
this is called skimming.
And if you sell it slightly below that,
positioning as a bargain,
then this is called penetration.
And I will discuss each one.
So a skimming strategy.
So you can think of this sort
of skimming a little bit
of profit off the top.
So you're charging a slightly higher price
so you can skim a little bit of profit.
So you're positioning your good
as a premium good, high quality
that there will be a strong desire,
high value, high perceived benefit.
They're gonna tend to sell this to folks
that are not quite as price-sensitive.
So in a more inelastic market
maybe at times
when you have fewer direct competitors
and this is often used in the beginning
that if you wish to recoup your development cost,
you position it
as a new unique premium product
and sell slightly above
what you think would be the going rate.
On the other side,
if you sell it slightly below this going rate
so you can position it as a bargain.
Here, you will sell
to more price-sensitive customers.
You may discourage competitors
that this is good for elastic demand
and things that have a low entry costs.
Here's an approach that I think
is interesting and has some merit.
So there is a non-profit
fresh produce broker
in the northeast here called Red Tomato
and their job is to sell farmer's produce
to local buyers.
In many cases, to supermarket chains.
And they have a conversation
with farmers each year.
They ask for three things.
First, what is their aspirational price?
What's a really good price
that they hope that they can get?
Realistic but optimistic.
What would be a really good price?
What would they really realistically hope to get?
Two, what was last year's average price?
What did you get last year for it?
And three, and this is kind
of the interesting part.
What is their dignity price?
So they define this as the price,
the lowest price that a farmer can accept
without feeling like they're losing
both money and dignity.
So what is the lowest price
that the farmer will accept
and feel like they're not being had,
that they're not being taken advantage to?
And of course, when Red Tomato goes out
and negotiates prices,
they wanna get as close to one
and as far away
and always be preferably above
or at very worst at three.
Here's another heads up
for a discussion we will have in class.
So here are two approaches
where each time you go out to sell,
you bargain with multiple buyers
and find the highest price
that you can get
for that batch of goods.
Or two, working with a single buyer
to get a fair
but maybe slightly lower price
but a more consistent price each time.
Both of these may work.
I'm not saying one
is better than the other
but there are some clear pros and cons here
and I would like you
to think about what they are
and be ready to discuss them in class.
I wanna talk to you now
about two more concepts
that of a loss leader
and that of bundling.
The first concept is loss leader.
So this is a time
where you sell a good
at a very low price
maybe even less than
what you paid for it.
But the idea is,
it brings the customers into the store.
And once they're there,
they will buy a whole bunch of other things.
So the classic example of this
is Thanksgiving turkeys.
So right before Thanksgiving,
you'll often see grocery stores
offering a really, really low price on turkeys
with the hope that that bargain
will draw people into the store
and while they're there,
that they will buy all the other ingredients
for their Thanksgiving dinner
like cranberry sauce and sweet potatoes
and stuffing and all the other things.
What they hope that they do not do
is what is called cherry picking
which is walk into the store,
buy the cheap turkey,
don't buy anything else, leave,
and buy the other items
at another store.
So that's the danger there.
Another strategy is bundling
where you offer a bundle of goods
or services at a price that is less
than the sum of the individual ones.
So Burlington Telecom
who I get my WiFi from offers this
and so do a lot of other...
telecom providers that if you get all three,
if you get cable, landline,
phone and internet, all through them,
that they will give you a lower price
than you would get than if you just
then the sum of them individually.
Insurance is another one.
So if you bundle your home
and car insurance,
they will offer you
premiums that are less than
what you would pay
if you just got each one individually.
The final concept that I want
to introduce to you
is the idea of price discrimination.
So this is simply charging different prices
for the same item to different people.
So there are three degrees of this.
So the first one is so-called perfect
or first degree price discrimination.
This is really only a theoretical thing
that it wouldn't be realistic
to actually do it
but this is to charge everybody's reservation price.
So whenever you encounter a buyer,
you can read their mind
and know what the most
that they would ever pay was
and charge of that.
Next is second degree.
This is where you charge a different price
based on quantity bought.
So this is an example of a bulk discount.
So the more that you buy,
the lower the per unit cost.
And we see this very often.
Say in dog food,
the per pound price
for a five pound bag of dog food
is greater than the per pound price
for a 50 pound.
And finally, there's third degree
which is different prices
to different people and it's sort
of offering different prices
to different segments.
So there's geographic.
So a farmer might charge a bit more.
If they sell
at the Shelburne Farmer's Market thinking
that there are more affluent buyers in Shelburne,
charge a bit less in the old north end
where there are fewer well-off buyers.
There's also demographic.
So many places will offer
a senior citizen's discount.
Others will offer a student discount.
So here, it's based on age
or by occupation where you say like,
where they will offer you a bargain
if you're a student
and you may have to show your student ID.
And last is behavioral.
And I'm gonna talk about the hurdle model
in the next one.
But an idea is the early bird.
So if you go into a restaurant
and order your meal,
let's say four o'clock or five o'clock
when it's not really very busy,
they may offer you a better price
on the meal knowing
that they have capacity there.
They're open, they already have the cooks
and wait staff there.
And to sort of use that excess capacity,
they might offer
an early bird special on dinner.
So the hurdle model looks at,
again, it's different prices
for different behavioral segments.
And this is an example of third degree.
And it's basically offering a lower price
for someone who will jump over a hurdle.
It isn't a real hurdle.
It's a conceptual hurdle.
So things like people really don't like
to fly on a Saturday
or especially fly on Christmas day.
So if you'll fly on that,
if you'll jump over
that hurdle of inconvenience,
they'll give you a lower price.
Scratches and dents sale.
So appliances that might
have a slight scratch or dent
or a second sale
at a clothing store.
It has a slight defect
or slightly oddly shaped chocolates.
They'll offer for a lower price
or mailing in a rebate.
So in each case, the consumer
has to endorse some sort of inconvenience
or slightly lower quality
to get the discount.
And the ideal is that the hurdle
should be such that only those
who wouldn't pay the higher price
will go to the bother
and those that are willing
to pay the higher price
won't bother to jump over it.
So it has to be such
that the hurdle makes those
who require a discount sort
of reveal themselves.
So you should be able to rank these
and maybe we'll do it in class.