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Factors Affecting Pricing Decisions for Consumer Goods - Literature Review Example

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Middlebury College
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Literature review
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Pricing describes the perceived value of the product to the consumers or end-users. Usually, price entails what it costs the end users to have the product. How a product is priced can have a significant impact on how it sells. If the product is priced higher than competitors, it may become less attractive to competitors (Kotler & Keller, 2006). However, if there is a perceived positive value, then the product can be priced higher than competitors offers. Conversely, a product may need to be underpriced if it has a small value in the perception of consumers. It is thus imperative for companies to understand how customers perceive their products.

Brennan, Canning, and McDowell (2011) have noted that pricing is distinct from the other elements of the marketing mix in that it is the only one that helps in generating revenue. As such, it is imperative for firms to adopt a well-planned approach when making pricing decisions. Most importantly, firms must understand the various factors that influence prices of products in the market. One of these factors relates to organizational objectives. According to Kotler and Gary (2011), price setting should be done in such a manner as to reflect the business goals of the firm. For instance, a firm may have a goal of offering quality products or services. Therefore, price setting should reflect the high quality of products (Martijn, 2011). In the same manner, if the firms primary goal is to expand sales revenue by a certain percentage, then reasonable prices should be set to so that the revenue goal can be achieved.

The second factor that influences pricing decisions is cost. All other factors constant, businesses usually set prices at a certain percentage higher than the cost of production. This helps in creating profit, which ensures long-term growth and ability to compete effectively. In other words, firms analyze costs before setting prices to mitigate losses and maximize profits (Hess & Gerstner, 2001). In rare cases, a company may set its prices lower than what competitors offer even costs are high. This can be the case, for instance, if the firm is seeking to maximize sales volume and revenue in the short run so that it can compete better in the long run.

Regulatory and legal issues have been cited in research as among the most important factors that influence pricing decisions. As explained by White (2014), the government frequently sets prices for certain products and services such as dairy items and insurance products. These laws may necessitate freezing, fixing or controlling of prices at either maximum or minimum levels. One of the reasons why governments set laws on product prices is to protect consumers from exploitation by unscrupulous businesses (French & Gordon, 2015). Another reason is to protect domestic industries against competition from low priced foreign products. Price control laws imply that firms cannot sell below or above the recommended price level.

Product characteristics are an equally important factor that influences pricing decisions. Certain attributes of the product such as the availability of substitutes, stage in the life cycle, nature of the product and diversification have been found to have a huge impact on the pricing decisions (Cohen, Ghiselli & Schwartz, 2006). The availability of substitutes is perhaps the most important factor because it affects the competitive landscape (Monroe, 2013). Usually, organizations match prices with what competitors offer with the aim of making their products appear more attractive to competitors. As to achieve this objective, firms routinely monitor competitor moves in line with the pricing of substitute products.

The last major factor in pricing decisions is the price elasticity of demand. It describes the responsiveness of product demand about change in prices. Three situations are related to price elasticity of demand (Gregson, 2015). First, products whose demand is inelastic will be priced higher because their demand is not affected by changes in price. Secondly, products with more than elastic demand tend to attract low prices. This is the case with products that have numerous substitutes (Walter, Michael & Craig, 2011). Lastly, products with elastic demand will be priced reasonably. For most products, there is a direct relationship between demand and prices hence firms must take into account the dynamics of price elasticity when setting prices.

Types of Pricing Strategies

Research has identified different types of pricing strategies used by firms across industries. The most common type is market-based pricing. Here, the forces of demand and supply determine the equilibrium price, which sellers charge buyers (Nagle & Reed, 2014). In market-based pricing, sellers have little control over the pricing mechanism although they can decide to charge below or above the market equilibrium price. The decision to charge a price other than the equilibrium one is based on the need to maximize sales and gain more customers in the market (Blythe, 2009). Thus, sellers may base their prices on a reference point, which could be the price of an alternative or substitute product. The reference point is, in essence, chosen such that it reflects the customers perceived alternative to a given product.

Another common pricing strategy is competitive pricing. This strategy is common in markets where there are so many substitute products and involves setting prices relatives to what the most important competitors are offering. The objective of competitive pricing is to gain a competitive edge over rival market players (Dess, Lumpkin & Taylor, 2005). Usually, businesses that employ competitive pricing reduce the prices of their products, a phenomenon called cost leadership. The aim is to stand out by offering the lowest possible prices in the market. The downside of competitive pricing is that the undercutting of prices is not a viable business strategy, especially if it leads to price wars.

Cost-based pricing is another common strategy used to set product prices. This strategy involves adding a certain percentage to the cost of the product to arrive at the final price at which the product will be sold. Hitt, Freeman, and Harrison (2006) have noted that while cost must always be taken into account when determining prices, the cost-based strategy relies on a rigorous chronology involving several steps. At the very least, the strategy involves setting a volume and cost-based prices for each volume of products. A more efficient approach is to begin by identifying a value that customers are likely to accept and then build the quantity and numbers based on that price.

Cost-based pricing is often used interchangeably with the strategy of target return pricing. In target return pricing, the firm sets prices in such a way that helps in return of the capital employed (Kotler & Armstrong, 2013). The objective is to ensure that that enough sales revenue is achieved within a very short time to offset the costs involved in developing the product and to maintain the desired level of firm liquidity. Although target return pricing is a common practice, it can only be effective in markets where products face little competition.

Meyer, Estrin, Bhaumik, and Peng (2009) have discussed the issue of value-based pricing, which is one of the strategies businesses use to differentiate their products from those of competitors. This strategy involves setting prices about the actual value that customers expect to get regarding the product. This means that products with greater value are likely to attract higher prices and vice versa. Value-based pricing can be an effective tool, especially when firms when companies wish to differentiate their products and services concerning quality. Ideally, customers who are looking for quality will not hesitate to pay a higher price for a product that satisfies their desires.

The strategy of price skimming has been discussed extensively by various authors such as Fisher (2001) and Liedka (2006). This strategy involves setting a very high initial price (when the product is introduced in the market) and then lowering that price gradually over time. The primary objective of price skimming is to enable a company to recover from sunken costs within a very short period before competitors lower the market price. Through this strategy, firms can build a large market share, which they can defend in the long run by lowering prices. According to Devaraj, Fan, and Kohli (2002), price scheming is effective in a new market where there are nil or very few competitors. In such markets, firms can establish a monopolistic position, which allows them to charge high initial prices.

The strategy of customized pricing involves setting different prices for each customer. The strategy is based on the individual needs of each customer and is common in business to business (B2B) markets. In such markets, customers may have different needs, which can only be addressed by developing different solutions for each customer (Kim, Park & Jeong, 2004). A good example is in the development of software for business needs. Here, customers will need customized products that suit their business needs. In that case, customers are likely to be charged different prices depending on product specifications. In the case where the utility of the product is what drives value, customized prices can be set to reflect the unique value.

Closely related to customized pricing is segmentation-based pricing. Here, a firm sets different prices for different market segments based on the willingness and ability of customers to pay (Porter, 2004). For example, a company that sells bottled water may set higher prices for high income and lower prices for low-income consumers. For the high-income consumers, the higher prices will make them think that product is of higher quality, which might or might not be the case.

Studies have shown that certain products or services are priced regarding hourly-based billing. According to Janda, Trocchia, and Gwinner (2002), hourly-based billing is the most effective and common strategy for pricing labor. In some countries such as the United States and Canada, there are specific laws stipulating minimum hourly wage rates. The drawback of hourly based pricing is that it is not an effective strategy for determining the value that firms provide to their customers. Often, the hourly fee is related to the cost of developing the product, but this does not have to be the case for all products.


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