How should you approach the problem of how to price your products? Economics tell us that you should price at the point which marginal revenue equals marginal costs to maximize short run profits. However it is often the case that demand and costs are not fixed, and price can affect perceived quality. Therefore another approach is to try and maximize long-run profits based on a scenario for market evolution and your company’s strategic advantages. This approach assumes that price can convey meaning and works in concert with other aspects of your marketing strategy.
Traditional Pricing Techniques
Traditional pricing typically follows three approaches:
1. Look at competitors. The easiest and most commonly used method is to simply look at what your competitors are charging and price the product according to your competitor’s price. However this assumes that you’re in a competitive market and there are other people selling something similar to what you offer. A potential issue with competitor pricing is that it signals a commoditized product to customers, so it’s helpful to just use this as a benchmark for pricing and think more about what type of competitive advantages you can bring to the table.
2. Cost plus pricing. If you are selling a brand new product without any competitors, perhaps a new invention or something really unique, then a common tactic is to use cost plus pricing. In cost plus pricing you basically take the cost of each unit of product and add a markup (eg. 25%). The problem with cost plus pricing is that it does not really consider customer willingness to pay. If your product solves a very real and compelling problem, then customers may be willing to pay much more for the product then what you are charging, and you’re potentially leaving a large chunk of consumer surplus on the table.
3. Value based pricing. The gold standard in today’s pricing world, and it takes into consideration both of the two techniques listed above. Value based pricing sets a price based on the value of the product to the customer. You start with a reference value, which is the price of what customer views as the best substitute. You then add the differentiation value, which is the value of the differentiating attributes your product offers.
For example if you open a new coffee shop, the marginal cost of production for a cappuccino may be $1. If the price of the competitor a block away is $3.50, then consider what is the economic value to the customer based on your differing attributes. Perhaps your store is more conveniently located. Perhaps the store down the street is a franchise and you are the cool new indie store. Or maybe you offer free wifi. Identify all of these differentiating factors and calculate the willingness that customers will pay for each factor.
3.50 Same coffee
Given enough time, you would optimally determine the value associated with each factor using actual survey or customer data.
Once you have this information though, should you set the price at $4.25 right off the bat? Probably not. This price only sets your upper bound, while cost plus pricing should set your lower bound. You now need to evaluate how plausible the customer perceives these effects through your communication efforts and price accordingly.