Pricing Strategies For Established Products

Changes in the marketing environment may require a review of the prices of products already on the market. For example, an announcement by a large firm that it is going to lower its prices makes it necessary for other firms in the industry to examine their prices. In 1976, Texas Instruments announced that it would soon sell a digital watch for about $20. The announcement jolted the entire industry because only 15 months earlier the lowest-priced digital was selling for $125. It forced a change in everyone's strategy and gave some producers real problems. Fairchild Camera and Instrument Corporation reacted with its own version of a $20 plastic-cased digital watch. So did National Semiconductor Corporation. American Microsystems, however, decided to get completely out of the finished watch business.8

A review of pricing strategy may also become necessary because of shifts in demand. In the late 1960s, for example, it seemed that, with the popularity of miniskirts, the pantyhose market would continue to boom. But its growth slowed when the fashion emphasis shifted from skirts to pants. Pants hid runs, or tears, making it unnecessary to buy as many pairs of pantyhose. The popularity of pants also led to a preference for knee-high hose over pantyhose. Knee-high hose, which cost less, meant lower profits for manufacturers. Although the pantyhose market was dwindling, two new entrants, Bic Pen Corporation and Playtex Corporation, were readying their brands for introduction. Their participation made it necessary for the big three hosiery manufacturers—Hanes, Burlington, and Kayser-Roth—to review their prices and protect their market shares. An examination of existing prices may lead to one of three strategic alternatives: maintaining the price, reducing the price, or increasing the price.

If the market segment from which the company derives a big portion of its sales is not affected by changes in the environment, the company may decide not to initiate any change in its pricing strategy. The gasoline shortage in the aftermath of the fall of the Shah of Iran did not affect the luxury car market because buyers of Cadillac, Mercedes-Benz, and Rolls-Royce were not concerned about higher gas prices. Thus, General Motors did not need to redesign the Cadillac to reduce its gas consumption or lower its price to make it attractive to the average customer.

The strategy of maintaining price is appropriate in circumstances where a price change may be desirable, but the magnitude of change is indeterminable. If the reaction of customers and competitors to a price change cannot be predicted, maintaining the present price level may be appropriate. Alternatively, a price change may have an impact on product image or sales of other products in a company's line that it is not practical to assess. Several years ago, when Magnavox and Sylvania cut the prices of their color television sets, Zenith maintained prices at current levels. Because the industry appeared to be in good shape, Zenith could not determine why its competitors adopted such a strategic posture. Zenith continued to maintain prices and earned higher profits.

Maintaining the Price

Reducing the Price

Politics may be another reason for maintaining prices. During the year from 1978 to 1979, President Carter urged voluntary control of wages and prices. Many companies restrained themselves from seeking price changes in order to align themselves behind the government's efforts to control inflation.

Concern for the welfare of society may be another reason for maintaining prices at current levels. Even when supply is temporarily short of demand, some businesses may adopt a socially responsible posture and continue to charge current prices. For example, taxi drivers may choose not to hike fares when subway and bus service operators are on strike.

There are three main reasons for lowering prices. First, as a defensive strategy, prices may be cut in response to competition. For example, in October 1978, Congress authorized the deregulation of the airline industry. Deregulation gave airlines almost total freedom to set ticket prices. Thus, in spring of 1998, in response to Continental Airline's $298 round-trip fare on its New York-Los Angeles route, United Airlines acted to meet this competitive fare. United's regular round-trip coach fare at the time was about $750. Similarly, other carriers were forced to reduce their fares on different routes to match these prices. In addition, to successfully compete in mature industries, many companies reduce prices, following a strategy that is often called value pricing. For example, in light of slipping profit margins and lower customer counts, McDonald's cut prices under pressure from major rivals Burger King, Wendy's, and Taco Bell.9

A second reason for lowering prices is offensive in nature. Following the experience curve concept (see Chapter 12), costs across the board go down by a fixed percentage every time experience doubles. Consequently, a company with greater experience has lower costs than one whose experience is limited. Lower costs have a favorable impact on profits. Thus, as a matter of strategy, it behooves a company to shoot for higher market share and to secure as much experience as possible in order to gain a cost and, hence, a profit advantage. A company that successfully follows this strategy is Home Depot, the largest home repair chain in the country. The policy of everyday low prices has enabled the company to grow into a $4.0 billion chain of 150 stores, mostly in the sunbelt. Home Depot's goal is to go national with $10 billion in sales at more than 350 locations by the year 2000.10

Technological advances have made possible the low-cost production of high-quality electronics gear. Many companies have translated these advances into low retail prices to gain competitive leverage. For example, in 1978 a Sony clock radio, with no power backup and a face that showed nothing more than the current time, sold for $80. In 1988, a Sony clock radio priced at about $40 had auxiliary power and showed the time at which the alarm was set as well as the current time. In 1997, the same radio was available for less than $20.

Texas Instruments has followed the experience curve concept in achieving cost reductions in the manufacture of integrated circuits. This achievement is duly reflected in its strategy to slowly lower prices of such products as electronic calculators. Compaq Computer Corp. followed a similar strategy to make a dramatic comeback in the PC market. Even in other businesses where technological advances have a less critical role to play in the success of the business, a price reduction strategy may work out. Consider the case of Metpath, a clinical laboratory. In the late 1960s, at about the time Metpath was formed, the industry leader, Damon Corporation, was acquiring local labs all around the country; by the early 1970s, other large corporations in the business—Revlon, Bristol-Myers, Diamond Shamrock, and W.R. Grace—began doing the same. Metpath, however, adopted a price-cutting strategy. In order to implement this strategy, it took a variety of measures to achieve economies of scale. Figuring that there were not many economies of scale involved in simply putting together a chain of local labs that operated mostly as separate entities, to reduce costs, Metpath focused on centralizing its testing. A super lab that did have those economies of scale was created, along with a nationwide network to collect specimens and distribute test results. Metpath's strategy paid off well. It emerged as the industry leader in the clinical lab-testing field. Heavy price competition, much of it attributed to Metpath, led some of the big diversified companies, including W.R. Grace and Diamond Shamrock, to pull out of the business.11

The recession in the early 1990s caused consumers to tighten belts and to be more sensitive to prices. Sears, therefore, adopted a new pricing policy whereby prices on practically all products were permanently lowered. The company closed its 824 stores for two days to remark price tags and to implement its "everyday low pricing" strategy. A number of other companies, such as Wal-Mart, Toys "R" Us, and Circuit City, also pursue this strategy by keeping prices low year-round, avoiding the practice of marking them up and down. Consumers like year-round low prices because constantly changing sale prices makes it hard to recognize a fair deal.12 Similarly, fast-food chains have started offering "value" menus of higher-priced items.

The third and final reason for price cutting may be a response to customer need. If low prices are a prerequisite for inducing the market to grow, customer need may then become the pivot of a marketing strategy, all other aspects of the marketing mix being developed accordingly.

As an example, in 1993 Philip Morris used price as an aggressive marketing tactic to seek growth for its Marlboro brand of cigarette. Its 40-cents-per-pack cut grabbed consumers' attention, narrowed the gap with discount brands, and squeezed competitors. In less than a year, Marlboro's share of the U.S. cigarette market increased from 20 percent to 25 percent, higher than it has been before.13 However, Philip Morris's move depressed the profits of the entire industry, since other cigarette manufacturers responded by reducing their own brands' prices. Philip Morris repeated the same strategy by cutting down prices about 20% on its Post and Nabisco ready-to-eat cereals. However, other cereal companies, such as Kellogg and General Mills, did not go along with Philip Morris's lead.14

In adopting a low-price strategy for an existing product, a variety of considerations must be taken into account. The long-term impact of a price cut against a major competitor is a factor to be reckoned with. For example, a regional pizza chain can cut prices to prevent Pizza Hut from gaining a foothold in its market only in the short run. Eventually, Pizza Hut will prevail over the local chain through price competition. Pizza Hut may lower prices to such an extent that the local chain may find it difficult even to recover its costs. Thus, competitive strength should be duly evaluated in opting for low-price strategy.

In a highly competitive situation, a product may command a higher price than other brands if it is marketed as a "different" product—for example, as one of deluxe quality. If the price of a deluxe product is reduced, the likely impact on its position should be looked into. Sony television sets have traditionally sold at premium prices because they have been promoted as quality products. Sony's higher-price strategy paid off: the Sony television rose to prominence as a quality product and captured a respectable share of the market. A few years later, however, consumer pressures led Sony dealers to reduce prices. This action not only hurt Sony's overall prestige, it made some retailers stop selling Sony because it had now become just one of the many brands they carried. In other words, the price cut, though partly initiated by its dealers, cost Sony its distinction. Even if its sales increased in the short run, the price cut did not prove to be a viable strategy in the long run because it went against the perception consumers had of Sony's being a distinctive brand. Ultimately, consumers may perceive Sony as just another brand, which will affect both sales and profits.

It is also necessary to examine thoroughly the impact of a price cut of one product on other products in the line.

Finally, the impact of a price cut on a product's financial performance must be reviewed before the strategy is implemented. If a company is so positioned financially that a price cut will weaken its profitability, it may decide not to lower the price even if lowering price may be in all other ways the best course to follow. For instance, a mere 1 percent price decrease for an average company might destroy over 11 percent of the company's operating profit dollars.15

Increasing the Price

An increase in price may be implemented for various reasons. First, in an inflationary economy, prices may need to be adjusted upward in order to maintain profitability. During periods of inflation, all types of costs go up, and to maintain adequate profits, an increase in price becomes necessary. How much the price should be increased is a matter of strategy that varies from case to case. Conceptually, however, price should be increased to such a level that the profits before and after inflation are approximately equal. An increase in price should also take into account any decline in revenue caused by shifts in demand due to price increases. Strategically, the decision to minimize the effects of inflationary pressures on the company through price increases should be based on the long-term implications of achieving a short-run vantage.

It must also be mentioned that it is not always necessary for a company to increase prices to offset inflationary pressures. A company can take nonprice measures as well to reduce the effects of inflation. For example, many fast-food chains expanded menus and seating capacity to partially offset rising costs. Similarly, a firm may substantially increase prices, much more than justified by inflation alone, by improving product quality or by raising the level of accompanying services. High quality should help keep prices and profits up because inflation-weary customers search for value in the marketplace. Improved product quality and additional services should provide such value.

Price may also be increased by downsizing (i.e., decreasing) package size while maintaining price. In a recession, downsizing helps hold the line on prices despite rising costs. Under inflationary conditions, downsizing provides a way of keeping prices from rising beyond psychological barriers. Downsizing is commonly practiced by packaged-goods companies. For example, recently Procter & Gamble cut the number of diapers in a package from 88 to 80 while leaving the price the same. In this example, downsizing effectively resulted in a price increase of 9.1 percent. Similarly, H. J. Heinz reduced the contents of its 6.5-ounce StarKist Seafood (tuna) can by three-eighths of an ounce. By keeping exactly the same price as before, the company gained an invisible 5.8 percent price increase.16

Prices may also be increased when a brand has a monopolistic control over the market segments it serves. In other words, when a brand has a differential advantage over competing brands in the market, it may take advantage of its unique position, increasing its price to maximize its benefits. Such a differential advantage may be real or may exist just in the mind of the consumer. In seeking a price increase in a monopolistic situation, the increase should be such that customers will absorb it and still remain loyal to the brand. If the price increase is abnormal, differential advantage may be lost, and the customer will choose a brand based on price.

The downside of increasing price may be illustrated with reference to coffee. Let us say that there is a segment of customers who ardently drink Maxwell House coffee. In their minds, Maxwell House has something special. If the price of Maxwell House goes up (assuming that the prices of other brands remain unchanged), these coffee drinkers may continue to purchase it because the brand has a virtual monopoly over their coffee-drinking behavior. There is a limit, however, to what these Maxwell House loyalists will pay for their favorite brand of coffee. Thus, if the price of Maxwell House is increased too much, these customers may shift their preference.

From the perspective of strategy, this example indicates that, in monopolistic situations, the price of a brand may be set high to increase revenues and profits. The extent of the increase, however, depends on many factors. Each competitor has a different optimum price level for a given end product for a given customer group. It is rare that such optimum prices are the same for any two competitors. Each competitor has different options based on different cost components, capacity constraints, financial structure, product mix, customer mix, logistics, culture, and growth rate. The competitor with the lowest optimum price has the option of setting the common price; all others must follow or retreat. However, the continued existence of competitors depends on each firm retreating from competition when it is at a disadvantage until each competes primarily in a "competitive segment," a monopolistic situation where it has an advantage compared to all others. This unique combination of characteristics, matched with differentials in the competitive environment, enables each firm to coexist and prosper in its chosen area (i.e., where it has monopolistic control).

Sometimes prices must be increased to adhere to an industry situation. Of the few firms in an industry, one (usually the largest) emerges as a leader. If the leader raises its price, other members of the industry must follow suit, if only to maintain the balance of strength in the industry. If they refuse to do so, they are liable to be challenged by the leader. Usually, no firm likes to fight the industry leader because it has more at stake than the leader.

In the U.S. auto industry, there are three domestic firms: General Motors, Ford, and Chrysler. General Motors is the industry leader in terms of market share. If General Motors increases its prices, all other members of the industry increase prices. Thus, a firm may be compelled to increase price in response to a similar increase by the industry leader. The leader also sets a limit on price increases, with followers frequently setting their prices very close to those of the leader. Although an increase is forced on a firm in this situation, it is a good strategic move to set a price that, without being obviously different, is higher than the leader's price.

Prices may also be increased to segment the market. For example, a soft drink company may come out with a new brand and direct it toward busy executives/professionals. This brand may be differentiated as one that provides stamina and invigoration without adding calories. To substantiate the brand's worth and make it appear different, the price may be set at double the price of existing soft drinks. Similarly, the market may be segmented by geography, with varying prices serving different segments. For example, in New York City, a 6.4-ounce tube of Crest toothpaste may sell for $3.89 on Park Avenue, for $3.29 on the Upper East Side, and for $2.39 on the Lower East Side. Furthermore, companies with products that customers want and that are not easily matched by competitors may increase the price without any negative repercussions. For example, in 1998 when inflation was merely 2.1%, some industries, such as airlines, mutual-fund houses, sellers of mainframe software, and entertainment companies, boosted their prices far faster.17

Hewlett-Packard Company operates in the highly competitive pocket calculator industry, where the practice of price cutting is quite common. Nonetheless, Hewlett-Packard thrives by offering high-priced products to a select segment of the market. It seems to appeal to a market segment that is highly inelastic with respect to price but highly elastic with respect to quality. The company equips its calculators with special features and then offers them at a price that is much higher than the industry average. In other words, rather than running the business on the basis of overall volume, Hewlett-Packard realizes high prices by being a specialist that serves a narrow segment. In cosmetics or automobiles, for example, there may be a tenfold cost difference between mass market products and those designed, produced, packaged, distributed, and promoted for small high-quality niches. Up-market products are often produced by specialists, companies such as Daimler-Benz or BMW, that can compete successfully around much larger producers of standard products.

Many airlines have successfully used price structure to differentiate market segments and objectives based on customer price sensitivity. Business travelers are relatively price insensitive, whereas tourists are very sensitive to the price of tickets. In order to increase the volume of tourist traffic without forgoing bread-and-butter revenues from business customers, airlines have developed price structures based on characteristics that differentiate these two customer segments.

For example, tourists generally spend a weekend at their destination; business travelers do not. By changing the structure from pricing flights to pricing itineraries, the airlines can discount itineraries that include a Saturday night stay. Most business customers cannot take advantage of such discounts without incurring substantial inconvenience. This enables the airline to increase tourist volume while maintaining high prices among the business customer segment. Such pricing policies have led to as much as 10 times the difference in fares paid for the same seat. Thus, a flexible pricing strategy permits a company to realize high prices from customers who are willing to pay them without sacrificing volume from customers who are not.18

Increase in price is seductive in nature. After all, improvements in price typically have three to four times the effect on profitability as proportionate increases in volume. But the increase should be considered for its effect on long-term profitability, demand elasticity, and competitive moves. Although a higher price may mean higher profits in the short run, the long-run effect of a price increase may be disastrous. The increase may encourage new entrants to flock to the industry and competition from substitutes. Thus, before a price increase strategy is implemented, its long-term effect should be thoroughly examined. Further, an increase in price may lead to shifts in demand that could be detrimental. Likewise, the increase may negatively affect market share if the competition decides not to seek similar increases in price. Thus, competitive posture must be studied and predicted. In addition, a company should review its own ability to live with higher prices. A price increase may mean a decline in revenues but an increase in profits. Whether such a situation will create any problem needs to be looked into. Will laying off people or reassigning sales territories be problematic? Is a limit to price increases called for as a matter of social responsibility? In 1979, President Carter asked businesses to adhere to 7 percent increases in prices and wages voluntarily. In a similar situation, should a company that otherwise finds a 10 percent increase in price strategically sound go ahead with it? Finally, the price increase should be duly reinforced by other factors in the marketing mix. A Chevy cannot be sold at a Cadillac price. A man's suit bearing a Kmart label cannot be sold on a par with one manufactured by Brooks Brothers. Chanel No. 5 cannot be promoted by placing an ad in TV Guide. The increased price must be evaluated before being finalized to see whether the posture of other market mix variables will substantiate it.

Finally, the timing of a price increase can be nearly as important as the increase itself. For example, a simple tactic of lagging competitors in announcing price increases can produce the perception among customers that you are the most customer-responsive supplier. The extent of the lag can also be important.

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