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Chapter 8
Pricing Decisions

Many marketing texts compare and contrast the approaches of the marketer and the economist to pricing decisions. This implies that the two disciplines have, virtually, irreconcilable perspectives on ‘best practice’ with respect to pricing. Neither the value nor the validity of these comparisons has ever been convincingly established. Marketing is an eclectic discipline of which the much older science of economics is a principal component. Thus, within this text, marketing is presented as a natural extension of economics, whose fundamental precepts remain intact. Whilst markets rarely behave in precise conformity with the theories of price expounded by economists, it remains the case that our understanding of market behaviour, and our ability to predict it, depend greatly upon those same theories and therefore marketing managers need to be familiar with them. At the same time, marketers must be capable of applying alternative approaches when deterministic economic models prove inconsistent with the realities of a complex marketplace better explained by probabilistic behavioural models.

Chapter Objectives

This chapter seeks to explain:

Structure Of The Chapter

The chapter opens with an extensive discussion of the various objectives of pricing before proceeding to explain price theory. The relationships between costs, sales volumes and revenues are then explored. At this point the perspective on price changes from that of the organisation to that of the consumer. Having explored consumer perceptions of price and the implications of an organisation's cost structure, consideration is given to how these factors can be brought together in the form of a pricing strategy. Alternative pricing strategies are described.

Pricing decisions

All of the decisions made with respect to the elements of the marketing mix are of critical importance and not least the decisions as to what price to ask for the product or service. The task of pricing is reiterative because it takes place within a dynamic environment: shifting cost structures affect profitability, new competitors and new products alter the competative balance, changing consumer tastes and disposable incomes modify established patterns of consumption. This being the case, an organisation must not only continually reassess its prices, but also the processes and methods it employs in arriving at these prices.

Perhaps a logical starting point is for an organisation to clearly articulate what objectives it seeks to achieve through its pricing policies and then to evaluate the factors likely to impinge upon the strategies which it seeks to adopt in pursuit of those objectives.

As figure 8.1 shows, enterprises have a hierarchy of objectives. At the apex of this hierarchy are the corporate objectives and it is from these that the organisation's marketing objectives are derived. Price is an element of the marketing mix, and so pricing objectives are defined in terms of their role within the marketing mix strategy.

Figure 8.1 The process of price determination

Figure 8.1

It can happen that an enterprise designs its marketing mix around its prices. It may be, for instance, that marketing research identifies a market segment for inexpensive instant coffee. The company might set a target selling price and then select ingredients and roasting processes which will keep the product within this target. In such circumstances price is the principal determinant of product positioning, product formulation, packaging, promotional strategy and, perhaps, distribution. On other occasions, price will be determined by the other elements of the marketing mix. The company may decide that in order to achieve a given level of market penetration the product must be promoted through the mass media. The price of the product would have to be set to cover the cost of this relatively expensive channel of communication. Similarly, if the company's initial decisions centred around creating a particular product image or gaining access to a specific channel of distribution or in making use of an innovative form of packaging, then the price would be greatly influenced by these decisions. Whatever the starting point, marketers have to take into account all of the elements of the marketing mix when developing marketing strategies and it is invariably the case that pricing decisions will be central to those strategies.

However, pricing decisions are not made by organisations operating within some kind of vacuum. When making pricing decisions marketers have to take into account a range of factors. Some of these are internal to the company, such as its marketing objectives, its marketing mix strategy and the structure of its costs. Factors which are external to the company, and that are likely to impinge upon pricing decisions, include the state of market development, the pattern of supply and demand, the nature and level of competition and a host of environmental considerations (e.g. legislation, political initiatives, social norms and trends within the economy)

Pricing objectives

Whilst pricing objectives vary from firm to firm, they can be classified into six major groups: (1) profitability, (2) volume, (3) competition, (4) prestige, (5) strategic and (6) relationship objectives. The way in which each of these objectives is expressed can take different forms as figure 8.2 illustrates.

Figure 8.2 Pricing objectives

Figure 8.2

Profitability objectives

Commercial enterprises, and their management, are judged by their ability to produce acceptable profits. These profits may be measured in monetary values and/or as a percentage of sales and/or as a percentage of total capital employed. In addition to the overall profitability of the organisation, the profitability of strategic business units(SBUs), product lines and individual products are also often monitored. The principal approach to ascertaining the point at which profits will be maximised is marginal analysis, which is described later in this chapter.

Prudent managers are likely to take the strategic view when making pricing decisions. That is, they will not necessarily seek to maximise profits in the short-term at the expense of long-term objectives. For instance, profits may be low, or even negative, during a period when the company is seeking to penetrate a new market. Again, heavy investments in capital equipment and/or R&D may adversely affect the short-term profitability of an enterprise, but are likely to provide a foundation for longer term commercial success.

Target return on investment (ROI) goals are common in commerce and these can be either short or long run goals, stated as profit as a percentage of either sales or assets. This is a cost-oriented approach to pricing decisions. The targets set will depend very much upon the economy within which the organisation operates. If one views organisations as competing for limited funds from prospective shareholders, financial institutions and perhaps even government, then the rate of return achieved by an organisation must be competitive with the sorts of returns others in the economy are able to achieve. Potential investors have to consider the opportunity cost they incur by investing in one organisation rather than another. Typical pricing objectives might be a 20–25% annual rate of return on investment (after tax) and a 5–8% return on sales. Individual targets are likely to be set for strategic business units, product lines and individual products.

Maximising revenues: When it is difficult to calculate cost functions (e.g. when costs are indirect and/or are shared by different products) marketing managers often seek to maximise revenues when setting prices. They do so because they need only estimate the patterns of demand and they believe that if current revenues are maximised then, in the long run, profits will be maximised.

Volume objectives

On occasion, the pricing decisions of managers have more to do with sales maximisation than profit maximisation. In these cases, organisations set a minimum acceptable profit level and then set out to maximise sales subject to this profit constraint. This is common where, as a matter of policy, a company commits itself to mass marketing, as opposed to serving narrow market segments. Minimum sales volumes can be more important than profit maximisation in another situation. Agricultural machinery manufacturers, for instance, will seek to keep volumes up, even if it means sacrificing potential profits, if their factories and skilled work force are kept employed as a result. This frequently happens if the firm believes that a downturn in business is short to medium term, since production facilities and a skilled work force are difficult to reinstate once they have been retrenched.

Maximising market share: Another volume-related pricing objective is the maximisation of market share. The organisation's specific goals may be either to maintain its share of a particular market or to increase its market share. There is frequently a positive relationship between high market share and profitability since the additional volumes help lower unit production costs.

In practice, commercial firms are likely to set prices in the context of the company portfolio and corporate strategy. Each product, product line and SBU within the company's portfolio will have a distinct contribution to make towards corporate objectives. But, whilst the prices set for individual products, product lines and SBUs will, in the short term, take account of their individual circumstances, e.g. stage in the product life cycle, degree of competition in the market, relative competitive strength in the market, average prices prevailing in the particular market, in the longer term their prices must be set in accordance with corporate strategy so as to contribute to corporate objectives.

Competitive objectives

As with any other marketing decision, pricing decisions must take into account the current behaviour of competitors and seek to anticipate the future behaviour of those competitors. In particular, a company will wish to anticipate competitors' likely reactions if the pricing strategies and tactics it is considering are actually implemented.

Going-rate pricing: Competing firms will sometimes set out to match the industry leader's prices. The net result is to take the emphasis away from price competition and refocus competition on to other elements of the marketing mix. Although pricing is an effective tool for gaining a differential advantage over competitors, a price move is easily imitated. In certain cases, if the competing firms in a market allow pricing to be the chief basis of competition, the profitability of the whole industry can suffer. Competitors may attempt to promote stable prices by focusing upon product/service strategies, promotion and distribution, i.e. the non-price elements of the marketing mix.

Anti-competitive pricing: On occasion, a firm will price its products with a view to discouraging competitors from entering the market or to force them out of the market. This is done by maintaining relatively low prices and profit margins. The extent to which this sort of pricing can be practised depends upon the firm's own return-on-investment requirements and the vigour with which anti-competitive actions are policed within a country.

Prestige objectives

Prestige objectives are unrelated to profitability or volume objectives. These involve establishing relatively high prices to develop and maintain an image of quality and exclusiveness that appeals to status-conscious consumers. Such objectives reflect a recognition of the role of price in creating the image of an organisation and its products or services.

Strategic marketing objectives

Price stabilisation: The objective of stabilising prices is met in the same way as that of removing price as the basis of competition. That is, the company will seek to maintain its own prices at or around those of competitors. However, the aim is not to negate price as a possible marketing advantage, but to narrow the range of price differentials and fluctuations1.

Supporting other products: Pricing decisions are often focused upon the aim of maximising total profits rather than maximising profits obtained from any single product within the portfolio. To this end, some products may be designated as loss leaders whereby their price is set at a level that produces low or even negative returns in order to improve the sales and profitability of others within the range. Thus, for instance, a manufacturer of crop protection products may sell a knapsack sprayer at or below cost in an attempt to stimulate sales of the high-margin chemicals which it is designed to apply.

Maintaining cash flow: Many businesses fail not so much because there is an inadequate demand for their products and services, but due to cash outflows running ahead of cash inflows. It follows that the maintenance of a sound cash flow position is an important management objective. Much of a company's trade will be on the basis of credit rather than cash sales. The pricing mechanism can be used to manage cash flow. Prices can be structured in such a way that customers are encouraged either to pay cash or to repay credit earlier than they might otherwise do.

Target markets: The sensitivity of buyers to prices can vary across different market segments. Some consumers will view products as commodities and therefore purchase mainly, or wholly, on price. Others will perceive differences between competing brands and will perhaps make their choice on the basis of characteristics such as quality, freshness and convenience rather than on price.

Prospective buyers also differ in their perceptions of what the actual price is that they are being asked to pay. Some farmers, for instance, will focus on the retail price of a piece of agricultural equipment when considering a purchase. Others will take into account the credit terms available on the item. Yet others will calculate the trade-in value for used equipment that one dealer is offering in competition with another dealer.

Product positioning: The category into which a product is placed by consumers, and its relative standing within that category, is referred to as its position within the market. The same product can hold different positions depending upon which segments of its market are under consideration. An example would be Hodzeko, a brand of fermented milk marketed in Zimbabwe. This product is popular among low-income groups who perceive it to be a cheap relish to flavour their staple food of maize porridge (or sadza). The product is also purchased by consumers in the higher income groups, among whom it is used as a substitute for soured cream in baking. These varying perceptions of the product can allow differential pricing according to the position in the market. Hodzeko's price as a relish for the staple food has to be held at fairly low levels, but with some repackaging, and a different brand identity, the more affluent consumers can be persuaded to pay a higher price for a product which still undercuts the price of soured cream.

Price setters have also to take account of perceived price-quality relationships. The product has to be priced at a level commensurate with the target quality image and market positioning.

Relationship marketing

Commercial organisations have several important publics with which they must establish and maintain relations conductive to a positive operating environment. These publics are sometimes termed stakeholders and include such diverse groups as consumers, members of the channel of distribution, suppliers, the general public, shareholders and government. In short, stakeholders are those individuals or groups who affect and/or are affected by, the operations of the organisation. Thus, organisations have relationships with entities other than those with which they trade and those relationships have to be carefully managed. Indeed, it can be argued that the management of those relationships is part of an organisation's overall marketing effort.

Channel of distribution members: The interests of all participants in the channel of distribution for the organisation's products have to be taken into consideration when making pricing decisions. By developing pricing policies and structures which assist intermediaries to achieve their own profit objectives, an organisation is better able to retain the loyalty of channel members. Where there is intense competition for distributive outlets it is the organisation which proves most knowledgeable and sensitive about the needs of intermediaries that will fare best.

Suppliers: Just as the organisation must take account of the interests of its distributors, so it must be concerned about the welfare of suppliers. Japanese automobile manufacturers have revolutionised supplier-manufacturer relations around the world. North American and European car manufacturers traditionally operated a system of having would-be component suppliers tender each time a new model was ready for mass manufacture. The fact that a particular supplier was already satisfactorily producing and supplying components for other models was no guarantee of involvement in the supply of components for the new car model. In contrast, Japanese manufacturers tend to develop long-term relationships with component suppliers who have provided a satisfactory service in the past. Work is rarely put out to open tender. The Japanese philosophy sees the component supplier as an extension of its own business. Whereas a component supplier, to a North American or European automobile manufacturer, could expect to be brought in once the engineering design on the car had been completed. The Japanese manufacturer does not provide the supplier with a set of specifications for the component. Instead, the component supplier is briefed on the concept of the proposed new car and asked to develop a design for the component which will assist in translating the concept into a tangible product. Suppliers to Japanese automobile manufacturers enjoy a measure of security which enables them to plan for a longer period ahead and encourages them to invest in new technology. Car manufacturers from other parts of the world have begun to appreciate the need to develop closer relationships with their suppliers. General Motors, for example, has now adopted the Japanese approach to supplier relations.

The general public: The general public has an interest in the activities of commercial organisations even if they do not buy or use the organisations' products or services. The public will, for instance, be concerned about the state of business ethics within an organisation and with issues such as the impact that an organisation's activities have on the environment, the extent to which the organisation contributes to the local community (e.g. charitable works and contributions), the manner in which it deals with the complaints and concerns of the community and the extent of its profits. Companies have to be careful in the way they report prices and profits since these can easily be perceived as being excessive.

Government: Governments often take a keen interest in the prices charged, particularly if the product is a staple food. This is true even where organisations have been freed from government control over prices because the price of basic foods is a politically sensitive issue in most countries. The government will wish to be seen to be vigilant in preventing profiteering at the expense of the common people. The situation can be particularly difficult for organisations such as agricultural marketing parastatals who after years of suppressed prices find it necessary to raise prices substantially to become commercially viable. Market liberalisation may give them greater freedom in price setting, but substantial price increases have to be ‘marketed’ to both government and the wider public.

The laws of supply and demand

The laws of supply and demand are widely known and understood. Price theory holds that ceteris paribus (i.e. all other things being equal), as prices increase so demand falls and supplies increase. Figure 8.3 depicts the demand and supply schedules for a given product. For the purposes of illustration assume that the product is sunflower cooking oil. These schedules indicate the quantity of the product demanded and supplied at various prices within a given time period. At the intersection of these two curves is the point of equilibrium, the price at which the quantity supplied by sellers equates to the quantity demanded by buyers. In this example, the equilibrium price is $ 10 per litre. Since buyers can obtain all the sunflower oil they need at this price, no producer is able to levy a higher price than $ 10 per litre of sunflower oil. If, however, producers were to supply more than 20 million litres into the market then a new equilibrium point would be established at a lower price.

Figure 8.3 The point of equilibrium in a perfectly competitive market

Figure 8.3

As we have seen, ceteris paribis, a change in the price of the product will cause movement along these curves, but what if all other things are not equal? Suppose, for example, that one or more of the major determinants of demand e.g. disposable income, were to increase, then the whole demand curve could shift to the right as illustrated in figure 8.4. An increase in the price of a substitute product, such as animal fats, would have the same effect. A decrease in the price of complementary products would again cause the demand for sunflower oil to shift to the right. So, for instance, if the price of cooking fuels fell, or the price of foods regularly cooked in oil fell, then the increase in demand for these complements would induce a shift in the whole demand curve for the sunflower oil from D0 to D1 and demand would increase from Q0 to Q1.

Figure 8.4 Shifts in the demand curve

Figure 8.4

Shifts in the supply curve also occur and are a function of the product's own price, related product prices and non-price variables which can bring about a shift in supply levels, e.g. weather and technology.

Elasticity of demand

A key question for any trading organisation is how the level of demand for its product will change in response to a price change. Consider the position of a miller contemplating lowering the service charge for grinding maize cobs into flour by 5 percent. The miller will be uncertain of the effect of such a price change on revenues. A 5 percent decrease in fees should attract more business from the millers, but, this increase in grain coming to be milled may or may not be enough to compensate for the smaller margin per unit sold. Total revenue could either rise or fall depending on how big the increase in demand is in relation to the size of the price cut. A 5 percent increase in milling fees is likely to result in a fall off in demand for the miller's services. The impact of these events on total revenues once more depends upon the magnitude of the change in demand relative to the percentage change in price.

A price cut will increase revenue only if demand is elastic and a price rise can only raise total revenue if demand is inelastic. Price elasticity of demand (or demand elasticity) is a measure of the responsiveness of buyers to price changes. The elasticity of demand is the percentage change in the quantity of a product demanded divided by the percentage change in its price.

The price elasticity of supply of a product is the percentage change in the quantity of product supplied divided by the percentage change in its price. However, the question arises as to whether price and demand changes ought to be measured as a percentage of their initial value or as a percentage of their final value. A fall in the price of a litre of vegetable oil, from say $5 to $4 could legitimately be reported as a 20% decrease ($1/$5 × 100) or alternatively, viewed as a 25% decrease ($1/$4 × 100). To avoid confusion, and inconsistency in measuring elasticity, the average of the initial and final price or quantity demanded can be used as the basis for calculating the degree of price elasticity of demand. The formula is:

where P1 and Q1 denote the old price and quantity and where P2 and Q2 represent the new price and quantity.

When the elasticity of demand, or supply, is greater than 1.0, that demand or supply is said to be elastic. A ratio of less than 1 indicates that demand, or supply, is inelastic. Elasticity will be zero if the quantity demanded or supplied does not change at all when price changes. The greater the elasticity, the bigger the percentage change in quantity demanded for a given percentage change in price. A summary of price elasticity patterns is given in figure 8.5.

Figure 8.5 Degrees of own-price elasticities of demand

Value Of ElasticityInterpretationType
e = 0Quantity demanded does not change at all in response to price changes.Perfectly inelastic
0>e>(-)1Quantity changes by a smaller amount than price.Relatively inelastic
e = (-)1Quantity changes by the same amount as price.Unitary elasticity
(-)1>e>(-)Quantity changes by a larger amount than price.Relatively elastic
e = (-)Consumers will purchase all they can at a particular price but none of the product at all above that price.Perfectly elastic

Suppose that due to the banning of imports the price of sunflower oil rises from $5 to $10 per litre. The effect on a domestic supplier's revenues will greatly depend upon the degree of price elasticity of demand. Figure 8.6 illustrates three possible responses in the marketplace. Figure 8.6a depicts the situation when the market proves highly responsive to the price change. The 100 percent price increase causes demand to slump from 3 to 1 million litres. Since the percentage fall in demand is greater than the percentage rise in price, demand is said to be elastic. Figure 8.6b shows what happens if the change in price and change in demand are proportionally equal to one another, i.e. unitary elasticity is revealed and total revenues remain the same. Figure 8.6c represents a market response where the increase in price is of a greater magnitude than the decline in demand. Put another way, relative to the change in price the change in demand is small and therefore demand is classified as inelastic or, more properly, relatively inelastic.

Figure 8.6 Possible market responses to a doubling of the price of a commodity

Figure 8.6

Colman and Young2 point out that 4 particular factors greatly influence the price elasticity of demand. These are:

Availability of substitutes: Any commodity for which there are close substitutes is likely to have a highly elastic demand. Even relatively modest price increases are likely to bring about a sizeable fall in its demand as consumers switch to substitutes. (This assumes, of course, that those substitutes continue to enjoy a price advantage over the commodity in question). Thus, the demand for sunflower oil is elastic because it has many close substitutes: olive oil, palm oil, vegetable oil, animal fats, etc. Similarly, the demand for beef will be price elastic where other meat products like poultry, lamb, goat and/or fish are available and perceived by consumers to be acceptable substitutes.

Number of uses to which a commodity can be put: The more uses a commodity has, the more elastic will its price elasticity tend to be. Modified starches can be used in a number of manufacturing processes, including paper production, adhesives and a wide variety of processed foods; a price reduction is likely to increase demand in several end-use markets and total demand could be dramatically affected.

Proportion of income spent on the product: The larger the product's share of the consumer expenditure, the more sensitive will the consumers become to changes in its price. Consumers in less developed countries typically spend in excess of 50 percent of their disposable income on food, whereas those in industrialised countries spend nearer 20 percent of disposable income on food. The demand for most foods in poorer countries is generally more elastic than for comparable foodstuffs in rich countries.

Degree of commodity aggregation: The price elasticity of demand will depend on how widely or narrowly a commodity is defined. The demand for meat is normally more price elastic than the demand for all meat. Similarly, the price elasticity of all meat is likely to be more price elastic than the demand for all food. Commodity aggregation reduces the number of substitutes and increases the proportional share of the household budget.

The elasticity of demand is influenced by the time perspective under consideration. Demand is sometimes elastic in the short run, but inelastic in the long run. Consider the position of a farmer faced with a big increase in seed prices. In the short run he is committed to his system of farming and has little alternative, but to continue to buy the seed. In the longer run he can change his behaviour; perhaps use a precision seed drill, switch from a coated to a cheaper uncoated seed, experiment with lower seeding rates, change planting dates, etc. With many consumer products the time effect works in the opposite way. Suppose the price of a housewife's favoured brand of breakfast cereal increases in price by say 5%. Her immediate reaction could be to switch to a cheaper brand on the next purchase occasion. However, if brand loyalty is strong, she will not get as much satisfaction from the substitute brand and so switches back in the long run. In such circumstances, demand is elastic in the short term, but inelastic in the long term.

Case 8.1 Inelastic Demand For Food In Brazil
    Da Silva et al. conducted an analysis of own-price elasticities for livestock products in Brazil, over the period 1947–79. They arrived at the following estimates:
    Beef                 -0.22
    Liquid Milk        -0.14
    Dairy products -0.16
    In each of these cases, the results show inelasticity. How do we interpret and of these figures?
    In Brazil, 90% of beef, milk and dairy products is consumed by the more affluent classes which however, account for only 40% of the population. This being so, the average share of food (of the affluent consumers) in the consumer budget is far less than would be the case if the low income group had a greater weight in consumption. It is also the case that liquid milk and dairy products (an aggregate commodity) have few substitutes and the only clear substitute for beef was poultry. Under these circumstances, the low price elasticities are understandable.3

Elasticity also tends to vary along a demand curve. In general, price elasticity of demand will be greater at higher price levels than at lower price levels. This is illustrated in figure 8.7.

Between points A and B a small change in price brings about a disproportionately large change in quantity purchased and so demand is relatively elastic, but elasticity in the lower price range, between points B and C, is rather less elastic.

Figure 8.7 Variations in the price elasticity along a demand curve

Figure 8.7

The marketer's interest in demand elasticity is readily understood. If demand for his/her product is inelastic then, ceteris paribus, total revenue will fall when price is reduced and will increase when price is raised. Conversely, when demand is elastic, total revenue goes up when price is cut and falls when price is increased. Clearly these patterns of demand, in response to price movements, are of fundamental importance to pricing decisions made by marketing personnel.

Cross-price elasticity of demand

Table 8.1 Own and cross-price elasticities for selected meat products

Elasticity with respect to the price of
 Beef & VealLambPork
Beef & Veal-

Cross price elasticity of demand is a measure of how the quantity purchased of one commodity (Qa) responds to changes in the price of another commodity (Pb), ceteris paribis. This can be expressed as:

The sign of cross elasticity is negative if a and b are complements and positive if a and b are substitutes. For example, the cross-price elasticity of beef with respect to the price of lamb would be positive since, in many countries, the two are substitutes and a rise in the price of lamb will lead to a switching from lamb to beef. Conversely, the cross-price elasticity of a country's major grain crop with respect to fertiliser is likely to be negative (assuming there are no subsidies) since the two products are complementary commodities where grain price increases depress demand for both the grain and fertiliser.

Practical problems of price theory

Price theory concepts are sometimes difficult to apply in practice. The problem is that economic analysis is subject to the same limitations as the assumptions on which it is based. One such assumption is, as we have said, that firms are seeking to maximise profits. However, many firms do not attempt to maximise profits. Furthermore, it is difficult to estimate demand curves. The supply side of the pricing equation is not too difficult since costs can be calculated fairly reliably, but demand must be estimated from market research. Such estimates of demand, at various price levels, are far less reliable than estimates of costs.

Another over-simplified assumption is that, for any commodity, an equilibrium point between supply and demand will be reached. This depends on there being a perfectly competitive market. However, many agricultural commodity markets have market clearance schemes where suppliers are compensated by a minimum price when there is surplus produce around and so a price is actually obtained when demand is at or around zero. It is also common to find stockpiling schemes which push prices higher than the theoretical equilibrium price of the perfectly competitive market. Similarly, when stockpiles are released on to the market, prices are forced below the level they would otherwise reach.

Cost - revenue - supply relationships

Organisations have to consider their costs when making pricing decisions. As will shortly be seen, in some instances selling prices are set as a fixed mark-up on costs, but in most cases costs are treated as only one determinant, albeit an important one, in establishing selling prices. In either case, the calculation of production and marketing costs is essential, but not always easy to achieve, since there are alternative and equally legitimate approaches to the assigning of costs.

Costs can be broadly categorised as fixed and variable. Fixed costs do not vary with the level of production. Rents, insurances, the salaries of administrative staff and depreciation on capital equipment are all examples of expenditures which do not directly vary with the level of production. If the production of an organisation in a given time period were zero, these costs still have to be met. In contrast, variable costs are those expenditures which vary in direct relation to volumes of production. Examples of this class of cost include raw material costs, hourly labour rates and packaging costs. If total fixed costs (TFC) are divided by the number of units produced then the average fixed cost (AFC) is obtained. Similarly, dividing the total variable cost (TVC) by the number of units produced gives the average variable cost (AVC). The relationship between the various classes of cost is illustrated in figure 8.8.

Average total cost (ATC) is obviously the sum of AFC + AVC. As production increases fixed costs are spread over a larger number of units and so AFC falls. AVCs also fall, over a certain range of production levels, as the organisation benefits from economies of scale. However, as figure 8.8 also shows, at some point AVCs will start to rise again as diseconomies of scale take effect. Typically, diseconomies of scale include the higher rates of workers' pay for overtime and the premium prices paid for scarce raw materials and/or components. Since AVCs tend to rise faster than AFCs fall, the average total cost rises too.

Figure 8.8 The movement of average costs as production levels change

Figure 8.8

Given these cost patterns organisations are, naturally, interested in identifying the point at which AVCs are at their lowest. It does not necessarily follow, however, that the organisation will stop production at that point because it may be the case that the market is willing to pay a higher unit price to secure supplies of the product. Thus marketing organisations seldom focus exclusively upon the behaviour of costs when setting prices, they also take account of likely demand and the revenues which flow from it. Ideally, the organisation would like to find the point at which supply, demand, prices and costs would allow it to maximise profits. To this end, marginal analysis is sometimes employed.

The meaning of price to consumers

So far, we have been looking at pricing from the perspective of the organisation. Now, we turn our attention to the meaning of prices to the consumer. The price of a product or service conveys many diverse messages to consumers. Some consumers will see price as an indicator of product quality; others will perceive the price as a reflection of the scarcity value of the product or service; some others will view price as a symbol of social status; and yet others will simply see price as a statement by the supplier about the value he/she places on the product or service. This being the case, consumers will perceive a given price in a variety of ways: as being too high or too low, as reflecting superior or inferior quality, as indicating ready availability or scarcity of supply, or as conveying high or low status.

Irwin Gross4 presents an interesting perspective on the meaning of price to consumers and marketers. His schema conceptualises prices as having two components: the basic price and the premium price differential. It may, in practice, be an entirely fictional view of prices, but nonetheless it provides a useful conceptual framework for understanding both buyer and seller behaviour with respect to price. The basic price is the amount buyers are assumed to be willing to pay for the core product and its associated benefits, e.g. a 1.5 hp hammer mill. The premium price differential represents the additional amount which buyers are willing to pay for the augmented product, e.g. a 1.5 hp hammer mill supplied, as standard, with 6 screen sizes for milling a range of grain types and an 18 month warranty on all wearing parts.

The challenge for marketers, according to Bennett5, is to convince the potential buyer that if he pays the price premium he will be more than compensated by the additional value which the product represents. It is the basic price component which is readily constrained by the laws of supply and demand. The international market for coffee beans illustrates the point. Brazil, which accounts for around one-third of world production, suffered a heavy frost in 1994 and lost a sizeable proportion of its crop. Within a few weeks coffee prices increased by over 200 percent6. Producers elsewhere in the world experienced a financial windfall, but for the previous eight years they had struggled because the price had been depressed because of the adverse balance between supply and demand. Coffee producers are destined to continue riding the roller coaster of world prices. Suppose, however, a producer were able to develop a coffee bean with a lower caffeine content. Both the low and no-caffeine coffee markets are growing worldwide. At present, the caffeine content is modified during processing, but food manufacturers would find it cheaper to buy in a lower caffeine bean if it were available. Such a bean would not be subject to the normal market forces of supply and demand affecting conventional coffee beans.

Figure 8.9 The effect of product augmentation on the price differential

Figure 8.9

Low caffeine arabica beans would have even greater value to food manufacturers and so the price premium would increase. Among those processors who wanted to produce a highly refined, ‘healthy’ coffee, an arabica bean with absolutely no traces of caffeine would be valued higher than any other. Moreover, such a unique product would not be treated as a commodity and therefore would not be subject to the vagaries of the international market for coffee to the same extent as conventional bean supplies.

Price as an indicator of quality

In the absence of other information on which to base their judgement, consumers often take price to indicate the quality level of the product or service7. Low prices can, in certain circumstances, prove as much a barrier to sales as prices which are too high. If the product is perceived to be too cheap then consumers begin to question whether it can be of adequate quality. In electing not to purchase the cheapest brand among competing products, the consumer is seeking to avoid the risk of acquiring a product with a performance considered to be substandard.

Case 8.2 Price-Quality Relationships In Filipino Rice Marketing
    In the Phillipines the relationship between the price and quality of milled rice is extremely weak. New rice milling technology was introduced to reduce the enormous losses during the conversion of paddy to rice. However, insensitivity to the reductions in broken and discoloured kernels on the part of the majority of consumers has severely limited the adoption of the improved rice milling technology.
    The International Rice Research Institute (IRRI) discovered that the number of broken kernels could increase from 14 to 42 percent with only a 9 percent fall in the wholesale price. It seems that Filipino consumers are more concerned with the variety and aroma of the rice than with the percentage of broken kernels. Not all consumers are as unconcerned with the quality of their milled rice. The Thailand export price suffered a drop of almost one-third when the number of broken kernels rose from 14 to 42 percent.
    An alternative conclusion is that the Filipino consumer is quality conscious, and will pay a higher price for better quality, but does not measure quality on the same dimension as those interested in developing improved milling machines (i.e. percentage of broken kernels). The attributes of variety and aroma have already been mentioned. Other plausible measures of quality are moisture content, and the presence of impurities9.

Research by Stoetzel8 suggests that consumers do not set out to make a purchase with a particular price in mind which they consider to be the acceptable price. Rather, the consumer has a price band with an upper and lower limit. Thus, for example, a consumer intent on buying sugar is more likely to have in mind that he/she is prepared to pay between 35¢ and 45¢ per kg rather than having in mind that, say, 40¢ per kg is the only acceptable price. According to Stoetzel, beyond his/her upper limit the consumer considers that the additional expense cannot be matched by additional quality or that he/she does not require additional quality beyond that level. In other words, a product can only carry so much quality or the consumer only needs so much quality. The consumer's lower price limit marks the psychological boundary below which its considered that the product is too cheap to carry an acceptable level of quality. The main implication of Stoetzel's findings for pricing decisions is that in setting product prices, marketers need first to determine the price band within which consumers are relatively insensitive to price movements. It may well be that existing prices can be moved upwards, within the price band, with little or no effect on demand, but with a very positive effect on the marketing margin.

Pricing strategies

Pricing strategies are of two generic types: those that are based upon the organisation's costs and those to which some margin is added. The choices in this approach are confined to establishing a basis for arriving at the margin to be added. Market-oriented methods are the second category of pricing strategy. Whereas cost-plus approaches to pricing are proactive, in that prices are largely determined by the organisation's financial performance objectives, market-oriented approaches are reactive to market conditions and are shaped by the organisation's marketing goals.

Cost-plus methods of price determination

The cost-plus approach to pricing is possibly the most used method. This involves calculating all the costs associated with producing and marketing a product on a per unit basis and then adding a margin to provide a profit. The per unit profit can be expressed either as a percentage of the cost, in which case it is referred to as the mark-up, or as a percentage of the selling price, when it is referred to as the mark-on, or margin.

There are a large number of cost-plus techniques, but they differ only in the detail of how the total costs attached to a product are determined. The two most common cost-oriented pricing procedures are full-cost pricing and incremental-cost pricing.

Full-cost pricing: All the direct costs of production are assigned to the product and, in addition, the indirect costs are apportioned according to a formula adopted by the manufacturer. Under the full-cost method, if a production batch accounts for 0.000005 per cent of the plant's total production then 0.0000005 per cent of the firm's overhead expenses are charged to that batch. This approach permits the recovery of all costs plus the amount added as a profit margin.

There are two principal weaknesses in this approach. First, there is no consideration of competition or of demand for the product. Second, any method of allocating overheads is arbitrary and may be unrealistic. In manufacturing, overhead allocations are often tied to direct labour hours. In retailing, the square footage occupied by a certain group of products is sometimes used.

Incremental-cost pricing: The arbitrary allocation of fixed expenses can be overcome by using incremental-cost pricing which seeks to use only those costs directly attributable to a specific output in setting prices. For example, suppose a fruit juice manufacturer has the following costs and sales:

Sales (10,000 units @ $10 each) $100,000
Net Profit $10,000

Suppose the juice manufacturer is offered a contract for an additional 5,000 units. Since the peak season is over, these items can be produced at the same average variable cost. Assume that the labour force would be idle otherwise. The firm now has to decide how low to price its product in order to get the contract.

Using the full-cost method would give us a lowest price of $9 per unit. This figure is a product of dividing the $90,000 in expenses by a production of 10,000 units. By contrast, the incremental method would allow us to price as low as $5.10 per unit. This price would be composed of $5 variable cost plus a $0.10 per unit contribution to fixed expenses and overheads. With a price of $5.10 the financial position would look like this:

Sales (10,000 units @ $10 each)+(5,000 units @ $5.10) $125,500
-15,000 × $5
Net Profit $10,500

Thus, profits are increased under the incremental approach. The example does assume that the two markets are sufficiently well segmented that selling at a lower price in one will not affect the other.

Having decided upon the approach to the costing of products that is to be employed, attention can be turned towards establishing the margin which is to be added to product cost. This margin can be calculated either as a mark-up or a mark-on.

Breakeven analysis

When considering alternative possible prices for a product, decision makers are interested in establishing the point at which each of these prices breaks even. The breakeven point is where the number of units of the product sold, at a given price, is just sufficient to cover both the fixed and variable costs incurred. At sales volumes above the breakeven point the firm moves into profit and at sales volumes below the breakeven point the firm is making losses.

The formula that needs to be applied to obtain the breakeven point is:

Deducting the variable costs from the selling price gives us the contribution each unit sold makes towards the fixed costs.

Example: A fertilizer manufacturer's NPK production facility carries fixed costs of $500,000. Assume that the variable cost of production, per bag of NPK, is $10 and that the company is considering selling to wholesalers at $20. It can be shown that, given these figures, the company needs to sell 50,000 bags of NPK before it breaks even

Figure 8.10 depicts this example in graphical form. The company has to establish whether the size of the potential market, the prices of close competitors (if there are any) and elasticity of demand for their product is such that sales of this order can be achieved with relative ease.

Figure 8.10 Calculating the breakeven point

Figure 8.10

The company will wish to estimate total sales, and therefore total profitability, at a selling price of $20 per bag. In many cases, marketing managers will repeat the same calculations for several possible selling prices.

Suppose that the demand for NPK fertiliser follows the conventional downward sloping demand curve (i.e. demand increases as the selling price falls) and that three possible wholesale prices are being considered: $15, $20 and $25. Table 8.2 shows the demand estimates at each of these prices and the corresponding breakeven points.

As the selling price is raised the breakeven point falls and the per unit contribution to fixed costs increases. However, it is achieving the right balance between the per unit contribution and demand. Thus whilst the $25 price yields the best per unit contribution and the $15 price maximises demand, it is the $20 price that gives the best profit.

Table 8.2 Estimating the breakeven points and profits at alternative selling prices
Selling Price A
Selling Price B
Selling Price C
Demand= 75,000 bagsDemand= 125,000 bagsDemand= 40,000 bags
Breakeven= 500,000Breakeven= 500,000 Breakeven= 500,000
 20 - 10 15 - 10 25 - 10
Breakeven= 50,000 bagsBreakeven= 100,000 bagsBreakeven= 33,334 bags
Revenue= $20 × 75,000Revenue= $15 × 125,000Revenue= $25 × 40,000
 = $1,500,000 = $1,875,000 = $1,000,000
Fixed costs= -$500,000Fixed costs= -$500,000Fixed costs= -$500,000
Variable costs= $10 × 50,000Variable costs= $10 × 125,000Variable costs 40,000= $10 ×
 = -$500,000 = -$1,250,000 = $400,000
Profit= $500,000Profit= $100,000Profit= $100,000

This simple example serves to illustrate the point that maximising sales volumes and maximising profits are not necessarily one and the same objective. It is equally useful in underlining the fact that maximising sales revenues does not automatically provide the best profit performance. Breakeven analysis is a tool which helps marketers evaluate the dynamic relationships between costs, volumes, revenues and profits with a view to making pricing decisions.

Market-oriented pricing

Up to this point, the approaches to pricing that have been discussed are those which begin from a consideration of the internal factors, i.e. the company's costs structures and target profit margins. In this section, market-oriented approaches to pricing are described. Market-oriented pricing begins from a consideration of factors external to the organisation, i.e. the marketplace.

Two broad alternatives are open to companies launching new products on to the market: skimming or penetrating. Skimming strategies involve setting high prices and heavily promoting the new product. The aim is to “skim the rich cream” off the top of the market. Profit objectives are achieved through a large margin per unit rather than by maximising sales volumes.

Skimming strategies can only really be employed where there is relatively inelastic demand. This is likely to be the case where the product has unique benefits and/or features which the consumer values. The strategy may have to be altered if competitors are able to produce a similar product. A common pattern is for the product innovator to set a high initial price in order to recoup as much of the company's investment, as quickly as possible. Competitors will inevitably join the market at some point if it is potentially profitable to do so and the innovator ultimately follows the downward trend in unit selling prices as supply increases.

Penetration strategies aim to achieve entry into the mass market. The emphasis is upon volume sales. Unit prices tend to be low. This facilitates the rapid adoption and diffusion of the new product. Profit objectives are achieved through gaining a sizeable sales volume rather than a large margin per unit.

Discriminatory pricing

Discriminatory pricing involves the company selling a product/service at two or more prices, where the differences in prices are not based on differences in costs. Discriminatory pricing takes one of several forms:

  1. Segmentation pricing: That is, prices are set to achieve an organisation's objectives within each segment. Customers in different segments will pay different prices, for the same product. Thus, refined sugar may be sold at a higher price in affluent urban areas and at a lower price in poorer rural areas.

  2. Product-form pricing: Here different versions of the product are priced differentially, but often not in proportion to differences in their costs. Kabota market two versions of a tractor-mounted wheat reaper; one with and one without a bundling attachment. The manufacturing cost of the attachment is less than $300, but the difference between the two models is just over $900.

  3. Time pricing: This involves varying prices seasonally. Typically this is done to encourage demand by reducing prices at times when sales are seasonally low and by raising prices to contain demand when it is strong and likely to outstrip supply.

Psychological pricing

Pricing has psychological as well as economic dimensions and marketers should take this into account when making pricing decisions. Quality pricing, odd-pricing, price lining and customary pricing are each forms of psychological pricing designed to appeal to the emotions of buyers.

Quality pricing: When buyers cannot judge quality by examining the product for themselves or through previous experience with it, or because they lack expertise, price becomes an important quality signal. Consequently, if the product is priced at too low a level then its quality may be perceived to be low as well.

Many products are marketed on the basis of their quality and the status which ownership or consumption confers on the buyer. The prestige of such products often depends upon the maintenance of a price which is high relative to others within the product category. It can happen that if the price is allowed to fall then buyers will preceive an incompatibility between the quality/prestige image being projected and the price.

Odd pricing: Odd pricing can create the illusion that a product is less costly than it actually is, for the buyer. An odd numbered price, like $9.99, will be more appealing than $10, supposedly because the buyer focuses on the 9.

Price Lining: Since most organisations market a range of products, an effective pricing strategy must consider the relationship among all of these product lines instead of viewing each in isolation. Product line pricing is the practice of marketing merchandise at a limited number of prices. For instance, a wine company might have 3 lines of wine, one priced at $15, a second at $25 and a third at $45. These price points are important factors in achieving product line differentiation and enable the company to serve several market segments.

Both seller and buyer can benefit from product line pricing. Buyers can select their acceptable price range and then concentrate on other features, e.g. styling, size, colour, etc. and so product line pricing serves to simplify the customer's buying decisions. Sellers can offer specific lines in a limited number of price categories and avoid the management costs and complexities of having a large number of different prices.

Product line pricing can be an effective strategy in expanding a market by adding new users. Potential buyers can be converted to first-time buyers because they are attracted by the lower priced products in the range. Once these buyers have developed a liking for the product they can be encouraged to trade up to a higher priced product within the range.

The skill in price lining lies in selecting price differentials which are sufficiently far apart for consumers to distinguish between them, but not so far apart that a gap is left for competitors to fill. In the previous chapter, in which product management was discussed, reference was made to the case of the manufacturer who was considering marketing a tree lifting machine. That same manufacturer, although experiencing the problem of gaining acceptance among distributors because it did not have a range of tree care equipment to offer, was able to gain customer acceptance by exploiting a price gap in the market. At that time, existing tree moving machines were priced at up to ₤2,000 and then the next range of models retailed at over ₤5,000. The company adopted the strategy of meeting the needs of that market segment that was able pay more than ₤2,000, but less than ₤5,000 by pricing its own model at ₤3,300.

Customary pricing: In some markets and in the case of certain low cost products, such as confectionery, root vegetables and, in some instances, staple foodstuffs, there is widespread resistance to even modest price increases. Under such circumstances a common strategy is to maintain the unit price as far as is possible whilst reducing the size of the unit. This is termed customary pricing”. Thus, although the price of a chocolate bar is held for a long period of time, during that same period the size of the bar might have been reduced several times. When prices must be raised, an often used compensatory strategy is to increase the size of the pack, bunch, bar or lot, but by less than a pro rata amount.

Geographical pricing

Geographic considerations sometimes figure in pricing decisions. The main options are:

FOB pricing: With FOB pricing all customers pay the same ex-factory price and the goods are placed free on board (FOB) a carrier, at which point the title and responsibility pass to the customer, who pays the freight from that point onward. Sales contracts will specify whether the terms are “FOB factory” or “FOB destination.” In the case of the former, purchasers pay all transportation costs beyond the factory gates whilst in the case of the latter the supplier meets all of the costs incurred up to the point where the goods are delivered to the customer.

FOB pricing is fair in so much that each customer picks up his own transport cost. The disadvantage is that for more distant customers a supplier operating the FOB factory pricing system will seem a high cost source of supply. The buyer's problem is overcome if the supplier applies FOB destination pricing, but the supplier's profit margin can be eroded to a substantial extent.

Case 8.3 Kenya Seed Company's Uniform Pricing Strategy
    KSC was jointly owned by the Agricultural Development Corporation (ADC) and the Kenya Farmers Association (KFA). The commitment of the ADC to promoting the development of Kenya's agricultural sector was reflected in KSC's uniform delivered pricing for certified maize seed.
    Maize is Kenya's staple food and is therefore a crop on which farmers primarily depend. KSC was keen to ensure that farmers had ready access to the seed the company processed in its Kitale factory. To this end, KSC hybrid maize was sold nationwide at the fixed retail price of (40 Kenyan Shillings) per 10 kg bag. KSC's initial pricing strategy had been to supply middlemen at a uniform price but it had found that retail prices varied enormously as each distributor added his own margin to the procurement price.
    KSC tackled its problem by copying the distribution strategies of Coca Cola and Wilkinson razor blades. The basic idea behind these strategies was to achieve widespread distribution of the seed at uniform prices to the farmer by giving retailers an attractive but fixed margin. The strategy encouraged retailers to actively promote KSC's seed but discouraged them from increasing their margins. The strategy also served to promote the use of certified seed, in place of farm-saved seed, and prevented price discrimination against more remotely located farmers. As a result the aim of promoting agricultural development was also furthered by the uniform delivered pricing strategy implemented by KSC10.

Uniform delivered pricing: Uniform delivered pricing is the opposite of FOB pricing. The company adopts pan-territorial pricing. The selling price incorporates a freight charge never explicitly identified as such to the buyer which is an average of total freight costs. This system has the advantage that it is easy to administer and the company can advertise its prices nationally. There is always the problem, however, that those customers situated in close proximity to the manufacturer will find cheaper supplies from other manufacturers in the locality offering FOB prices.

Zone pricing: Zone pricing falls between FOB origin pricing and uniform delivered pricing. The company sets up a series of geographical zones. All customers within a zone pay the same total price and this price is higher in the more distant zones. This system can work well enough except that the dividing line between zones has to be drawn somewhere. Customers falling just to the right and the left of the line will be asked to pay quite different prices even though they are close to one another.

Freight absorption pricing: The seller who is anxious to do business with a certain customer or geographical area might absorb all or part of the transport cost in order to get the business. This is termed freight absorption pricing. The seller might reason that gaining more business will result in lower average costs and that this will more than compensate for the extra freight cost. Freight absorption pricing is useful in achieving market penetration and also in holding on to increasingly competitive markets.

Promotional pricing: From time to time organisations might temporarily reduce prices to increase sales. This is promotional pricing and it takes several forms. Loss leaders are specially selected products which are sold at low prices to attract customers in the hope they will also purchase regularly priced merchandise. The technique is commonly employed in retailing. The items chosen to be reduced are normally staple foods and beverages like tea, bread, roller meal, milk, etc., in other words, products which people buy regularly and are therefore aware of their normal price. Not only does the loss leader bring customer traffic into the store, it can also give the outlet the image of being a value-for-money store. Sellers will also use special event pricing to bring in customers when otherwise business might be slow. Stores often have special sales just after major seasonal holidays when trade is traditionally down. Manufacturers sometimes offer cash rebates to customers when they buy a product from a dealer within a given time period. This is commonly used in the marketing of agricultural machinery. Other manufacturers offer low-interest financing, longer warranties or free maintenance to reduce the consumer's ‘price’. Or, the seller may simply offer discounts on the normal list price to stimulate sales and reduce stocks.

Whilst our discussion of pricing strategies has been fairly extensive, so far we have omitted the important topic of transfer pricing. That is, the pricing strategies open to organisations when transferring goods and services between different departments, divisions and/or subsidiaries belonging to the same parent organisation. The reader will find a discussion of transfer pricing in appendix 8A at the end of this chapter.

Administered pricing

So far, this discussion of pricing has assumed that the marketer has freedom in arriving at pricing decisions, but this is not always the case. In many countries, developing and industrialised, the prices of some food and agricultural products are government controlled. The extent of controlled, or administered, pricing has declined markedly over the past decade; especially in the developing world where the practice was most prevalent. IMF and World Bank sponsored market liberalisation programmes have invariably included the dismantling of administered pricing schemes in favour of price determination through the unimpeded interactions between supply and demand.

Westlake11 defines administered prices as;

“…those which are imposed on the market by some external body.”

Westlake goes on to say that, in developing countries, administered prices are usually set by government or by a parastatal organisation acting on behalf of government. Prices are either administered throughout the marketing chain or at particular levels. Moreover, a pricing system can be a combination of market determined and administered pricing. Combinations of pricing systems can be administered in several ways.

First, prices may be administered at one or more points in the pricing system and determined by market forces at others. The system can lead to problems, as the Kenyan Government discovered12. Until the late 1970s the Cotton Lint & Seed Marketing Board sold all lint at auction. Farmers were promised a pre-announced price based on expectations of the prices which would be achieved at the international auction. Thus the pricing and payment system was a mix of market determined and administered prices. Unfortunately it was unstable because the possibility existed that insufficient funds would be raised at auction to meet the pre-announced payments. The Board had to suspend the auction and sold lint to domestic spinners at administered prices calculated on a cost-plus basis.

A second approach is to allow a proportion of the total supply of a commodity to be traded under a formal administered price structure while the remainder is traded informally. This occurs in the case of staple food crops in many developing countries, where the output of large-scale producers, processors and traders is subject to price control, but where much of the output of small farmers trades informally at uncontrolled prices on parallel markets. (Small-scale trade is often subject to the same price control legislation, but the large number of participants and the traders' widespread nature makes law enforcement impractical). Westlake suggests that the existence of a parallel market does not necessarily frustrate the government's price objectives since there are usually close links between the two markets and the control of one can be used to control the other. Indeed it is not in the least unusual, according to Westlake, for substantial quantities of a commodity to be transferred back and forth between controlled and uncontrolled markets as it proceeds up the marketing chain.

A third hybrid pricing system is where a commodity is sold at market prices, but revenues are pooled before being disbursed to farmers. This system results in all farmers in the scheme receiving the same price. The system is termed ‘revenue pooling’ and differs from other forms of administered pricing to the extent that, once the system is established, the government can only influence the price indirectly through, for example, the imposition of taxes and levies. Revenue pooling often results in the farmer receiving different prices from those at which his particular deliveries sell, since the pooling removes the impact of short-term price instability.

Lastly, government intervention may be selectively applied to one sector of agriculture or another. For example, there may be intervention in the prices paid to small holders, but not to plantations or large estates, or vice versa.

The discussion of administered prices is extended in appendix 8B at the end of this chapter.

Chapter Summary

The task of pricing takes place within a dynamic environment and so an organisation must continually review its prices and the procedures employed in arriving at these prices. Enterprises have a hierarchy of objectives. At the apex of this hierarchy are the corporate objectives from which the organisation's marketing objectives are derived. Price is an element of the marketing mix, and so pricing objectives are defined in terms of their role within the marketing mix strategy.

When making pricing decisions, marketers have to take into account a range of factors. Internal factors include company marketing objectives, the marketing mix strategy and cost structures. External factors include the state of market development, the pattern of supply and demand, the nature and level of competition and environmental considerations such as legal, political and economic events and social norms and trends. Pricing objectivescan be classified into six major groups: (1) profitability, (2) volume, (3) competition, (4) prestige, (5) strategic and (6) relationship objectives.

The elasticity of demand indicates the responsiveness of buyers to price changes. Demand is said to be elastic if the percentage change in demand is greater than the percentage change in price; and is inelastic where the percentage change in demand is smaller than the percentage change in price. Unitary elasticity denotes that the percentage change in demand and percentage change in price are equal. Ceteris paribis, an increase in the price of a product will result in a fall in demand, and vice versa. However, if one or more of the major determinants of demand changes or there is a decrease in the price of complementary products would cause the demand curve to shift to the right. Four particular factors influence the price elasticity of demand: the availability of substitutes, the number of uses to which a commodity can be put, the proportion of income spent on a particular product and the degree of commodity aggregation.

Managers have to consider their costs when making pricing decisions. Costs can be broadly categorised as fixed and variable. Fixed costs do not vary with the level of production whereas variable costs vary directly with production levels. As production increases fixed costs are spread over a larger number of units and so average fixed costs fall. Average variable costs also fall, over a certain range of production levels, as the organisation benefits from economies of scale. However, at some point average variable costs will start to rise again as diseconomies of scale take effect. Since average variable costs tend to rise faster than average fixed costs fall, the average total cost rises too.

Market-oriented pricing begins from a consideration of factors external to the organisation, i.e. the marketplace. Market-oriented approaches to pricing include: discriminatory pricing, quality pricing, odd-pricing, price lining, customary pricing, F.O.B. pricing, uniform delivered pricing, zone pricing, freight absorption pricing, and promotional pricing.

In many countries the prices of some food and agricultural products are government controlled. Prices may be administered throughout the marketing chain or at particular levels or points. Some pricing systems are a combination of market determined and administered pricing.

Key Terms

Administered pricingElasticity of demandMarket penetration
Average fixed costElasticity of supplyMarket skimming
Average variable costGeographical pricingPoint of equilibrium
Breakeven pointFixed costsPsychological pricing
Cross-elasticitiesMarginal analysisRelationship marketing
Cost-plus pricingMarginal costReturn on investment
Diseconomies of scaleMarginal revenueVariable costs

Review Questions

From the understanding of the material presented in chapter 8, give brief answers to the following questions.

  1. What are the major types of objectives which organisations seek to achieve through their pricing decisions?

  2. Name two events which might cause a demand curve to move to the right.

  3. Complete the statement below:

    A price cut will increase revenue only if demand is                     and a price rise can only raise total revenue if demand is                    .

  4. What factors tend to influence the degree of price elasticity of demand?

  5. What three pieces of information are required before marginal analysis may be used in arriving at pricing decisions?

  6. What did Gross mean when he differentiated between the basic price and the premium price?

  7. What was Stoetzel's contribution to our understanding of how consumers perceive price?

  8. Explain what is meant by skimming and penetrating the market.

  9. Explain what is meant by discriminatory pricing.

  10. Why might a bread baker employ customary pricing?

  11. Which class of customer is likely to find uniform delivered pricing unattractive?

  12. What form of pricing is said to be between FOB origin pricing and uniform delivered pricing?

  13. How would you define the term, ‘administered prices’?

  14. Outline the chief characteristics of revenue pooling


1. Gaedeke, R.M. and Tootelian, D.H. (1983), Marketing Principles and Applications, West Publishing Co., p. 334.

2. Colman, D., and Young, T. (1989), “Principles of Agricultural Economics”. In: Cambridge University Press, pp. 98–99.

3. Da Silva, J.A., Young, T., and Traill. (1985), “Market Distortions in Brazilian Agriculture: An Analysis of the Effects of Government Policy on the Beef and Dairy Sectors”, Journal of Agricultural Economics, XXXVI (3).

4. Gross, I. “Insights from Pricing Research.” In: Pricing Practices and Strategies, E.L. Bailey, ed., New York: Conference Board, (1983), pp. 34–39.

5. Bennett, P.D. (1988), Marketing, McGraw-Hill Book Company, p. 449.

6. Rake, A. “Coffee Boils Over and Africa is Happy”. In: New Africa No. 322, September 1994, pp. 24–25.

7. Gabor, A. (1969), Pricing: Concepts and Methods for Effective Marketing, Gower Publishing Company Limited, Aldershot, England, 1988, p249.

8. Stoetzel, J. In: Pricing Strategy, B. Taylor & G.Wills (Eds) Staples Press, London, pp. 70–74.

9. Manilay, A.A. (1987), “Marketing Research for Grain Postharvest Systems”. In: Market Research for Food Products and Processes in Developing Countries, R.H. Young & C.W. MacCormac, International Development Research Centre, pp. 31–37.

10. Lynch, J.A. and Tasch, E.B. (Eds.) (1983), “Kenya Seed Company”. In: Food Production and Public Policy in Developing Countries, Praeger Publishers, New York, pp. 215–240.

11. Westlake, M.J. (1993), Economic Management of Administered Agricultural Pricing and Payment Systems in Africa. FAO Economic and Social Development Paper 119, Rome, p. 6.

12. Westlake, M.J. op. cit. pp. 100–101.

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