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Product Cost

Re Prices should reflect the value that consumers are willing to pay (Customer-oriented) versus prices should primarily just reflect the cost involved in making a product or service (Cost-oriented)

I argue that prices should reflect the value that consumers are willing to pay based on the following key observations:

“...death is often a good career move for an author...”(Taleb,2007:30) or any 'creative' – actors, painters, artists, etc - as Aspden(2007) notes “...sales of modern and contemporary art continued to set records...” referring to a painting by Francis Bacon that sold for £14m!; idea generators get the loot – and as Taleb(2007:31) notes “...there is more money in designing a shoe than in actually making it: Nike, Dell, and Boeing can get paid for just thinking, organizing, and leveraging their know-how and ideas while subcontracted factories in developing countries do the grunt work and engineers in cultured and mathematical states do the noncreative technical grind...”;

the sole task of any business is to maximize the present wealth of its shareholders;

individuals and nations use resources under their command to satisfy their wants as fully as possible or to maximize their welfare given their resource constraints;

in market economies, (which produce and consume 83 per cent of world's output but has only about 19 per cent of the world’s population), it is predominantly the price mechanism that provides the signals that indicate how resources should be deployed to produce the goods and services that will maximize society’s utility given the resource constraint;

the market economy may not be perfect (see 'Market Failures' in Appendix C) but, given the apparent basic nature of mankind, namely a ‘selfish’ motivation to improve his lot in life, the market economy currently appears to offer the best chance of converting such a desire into reality;

reliance on market forces in the world today is growing as many socialist government economies are attempting to switch from a group of planners deciding what goods and services to produce to the market mechanism making such decisions;

black markets, despite being illegal in many countries do exist, serve the function of establishing equilibrium prices and quantities in markets where there are price ceilings or organizations/governments attempt to control goods and services - “ticket touts” (Kay,2008), “black markets in dollars”(Mander,2008), “replica football shirts” (Blitz, 2007), “looted antiquities” (Tait, 2007), “pirate DVDs” (Guha, 2004), “(high-class) prostitution” (White,2008) are just a few good examples;

controversy rages about minimum wage laws: some people benefit; others suffer, but there is little disagreement that such laws cause unemployment among various groups of workers and, consequently, make total output lower that it otherwise would be;

“...earned-income initiatives are becoming accepted - even expected - throughout the nonprofit world.” (Foster and Bradach,2005) and managers of nonprofit organizations are increasingly mimicking the behaviour of their counterparts in the for-profit sector; and

explosion in for-profit online higher education is just one effect of globalization and increasing access to technology (Morey, 2004); another trend will be that price competition is likely to be become less intense (Gross et. al., 1995) as firms increasingly move to rapidly growing markets (Aaker and Day, 1986; Magnet, 1994).

Some observations re cost-oriented methods

Perhaps the simplest and most commonly used pricing method is to add a standard markup to the cost of the product. This kind of cost-plus pricing does not explicitly consider the price sensitivity of demand or the pricing practices of competitors. But it is convenient and easy to apply - important considerations when an organization faces hundred or thousands of pricing decisions each year, as in the case of retail stores and wholesaling institutions, and nonprofit organizations. It is also widely used among firms that must submit competitive bids for a variety of projects, as in the case with construction firms.

Target return pricing is similar in principle to, but somewhat more sophisticated in practice than, cost-plus pricing as it brings more one element into the pricing decision – the cost of capital tied up in producing and distributing the product. This pricing approach is common at car companies that price their cars to achieve a target of 15-20 per cent return on investment.

Consider, for example, a government informing a monopoly or oligopoly that they would be allowed to remain in business but their prices would be controlled: the prices would be ones that covered all costs, with additional allowances for ‘normal’ profit. Such a proposed solution, while sound in theory, can lead to conflicts of interest in practice. This is known as the principal–agent problem (see Appendix D).

Price floors can lead to surpluses in controlled markets - many agricultural goods in the European Union exhibit this behaviour because their prices are fixed above the equilibrium level.

As vote seekers governments may be motivated to prompt actions that benefit a vocal minority at the expense of the silent majority.

Prices and resource (re)allocation

Prices, in various guises – taxes, subsidies, transfers, interest rates, rents, wages, bribes, etc see Kotler & Keller(2006:432), play a crucial role in the allocation of resources. Prices tell consumers how far their budgets can stretch and consequently how well off they are (see also Appendix B - 'Scarcity and choice'). Prices tell resource owners when to move their resources into an industry and when to move out. Resource owners will move out of an industry when the returns that could be earned in other industries are higher. Prices tell business firms how much revenue they will receive from different levels of sales. But prices of resources are also business firms’ costs and consequently, for a given level of production, inform businesses what their total costs will be. Putting expected revenues and expected costs together determines expected profits and indicates whether such a business venture is potentially worthwhile.

Making pricing decisions

A manager's freedom to select a price for a given product or service is constrained by several factors. First, the organization's cost determine the floor of the range of feasible prices – at least longer term. At the other extreme, the price sensitivity of demand for the product determines the ceiling of the range of acceptable prices. Beyond some price level, most potential customers seek less costly substitutes, such as private labels, opposition parties (Parker and Sherwood, 2008; Newman,2005), or do without the product or service.

Demand and (perceived) customer value

Nagle and Holden (1995) identified specific factors influencing influencing variations in sensitivity to price across customers and products. Each factor reflects three basic phenomena that determine customers' willingness and ability to pay for a good or service. First, buyers' willingness to pay a given price for a product is influenced by their perceptions and preferences: their needs, desires, awareness of, attitude towards, the item in question.

Second, the price, availability, and attractiveness of alternative brands and substitute products affect buyers' willingness to buy the product. So do the prices of complementary items that customers must buy to gain full value from the product. For example, the rising price of fuel may dampen consumer demand for large, fuel inefficient sports cars.

Finally, the size of their incomes relative to the price influences customers' ability to pay for a product or service. Taken together these factors determine the perceived value a potential customer will associate with a given product-market entry, and thus the price he or she is willing to pay.

As mentioned earlier, demand sets the ceiling on the range of feasible prices for a product. Even before that ceiling is reached, however, the total number of consumers willing to buy during a given period varies according to the price charged. The familiar demand curve depicts this variation in the quantity demanded at different prices.

In most cases there is an inverse relation between a product's price and the quantity demanded: the higher the price, the less people want to buy. Thus, the typical demand curve has a negative, or downward, slope. However, prestigious products (such as expensive wines and liquors) and those whose quality is difficult to judge sometimes have positively sloping demand curves. Some customers use price as an indicator of the prestige or quality of such products, and they are induced to buy more as the price increases.

While an organization's costs establish a minimum floor for long-term profitability, consumers generally do not care what those costs are. The only thing that is important to them is the value they are likely to receive for the price they pay. Thus one danger of cost-oriented pricing methods is that they can produce prices that are lower than perceived value, causing the organization to “leave money on the table.” (Lehmann and Winer, 1994:chp. 9). While this practice may delight customers and stimulate short-term demand, it may also depress the earnings the firm needs to compensate its employees, fund capital investments, and pay for the product development and other marketing activities necessary for long-term growth. Even small mistakes in this direction can have major implications for the firm. For example, for a company with 8 per cent profit margins, a 1 per cent improvement in price realization would boost the firm’s margin dollars by 12.5 per cent (Dolan,1995). Lehmann and Winer(1994) also note that cost-oriented approaches might also result in prices that exceed many customers' perceptions of value, resulting in lost sales and competitive vulnerability.

Some ethical issues re customer-oriented methods

Extreme and unsubstantiated advertising claims abound, such as ‘Our product is far superior to Brand X’

In addition to legal concerns, differential price adjustments can raise some ethical issues as well. One such issue concerns the inherent ‘fairness’ of charging higher prices to some customers simply because they are not very price sensitive (Brady,2000).

As not all customers or competing suppliers adhere to the same ethical standards, marketers sometimes feel pressure to engage in actions that are inconsistent with what they believe to be right – either in terms of personal values or formal company standards – in order to close a sale or stay even with the competition. This point was illustrated by a survey of 59 top marketing and sales executives concerning commercial bribery. While nearly two-thirds of the executives considered bribes unethical and did not want to pay them, 88 per cent also felt that not paying bribes might put their firms at a competitive disadvantage (Bryan, 1989). Such dilemmas are particularly likely to arise as a company moves into global markets involving different cultural values, legal restrictions, and levels of economic development where economic exigencies and ethical standards may be quite different.

References

• Aaker, A. D., George S. Day, S.G., (1986) ‘The Perils of High Growth Markets,’ Strategic Management Journal 7, pp. 409–21
• Aspden, P. (2007) 'Painting by Bacon sells for £14m at Christie's', Financial Times, February 9 2007
• Blitz, R. (2007) 'Black market fears over replica football shirts', Financial Times, June 30 2007
• Brady, D. (2000) ‘Why Service Stinks,’ Business Week, October 23, 2000, pp. 118–28,
• Bryan, D. (1989) ‘Using Gifts to Make the Sale,’ Sales & Marketing Management, September 1989, pp. 48–53. See also, ‘The Destructive Cost of Greasing Palms,’ Business Week, December 6, 1993, pp. 133–38
• Dolan, J. R. (1995) ‘How Do You Know When the Price is Right?’ Harvard Business Review, September–October 1995, p. 174.
• Foster, W., Bradach, J. (2005) 'Should Nonprofits Seek Profits?', Harvard Business Review, Feb 2005
• Guha, M. (2004) 'Action is demanded over black market in movies', Financial Times, December 13 2004
• Gross,N., Coy,P.,Port, O. (1995) ‘The Technology Paradox,’ Business Week, March 6, 1995, pp. 76–84.
• FT, (2008) 'Too high a price', Financial Times, June 5 2008
• Kay, J. (2008) 'A ban on touts will not fix a rigged game', Financial Times, April 29 2008
• Kotler, P., Keller, K. (2006) Marketing Management (12th), Pearson Higher Education
• Magnet,M. (1994) ‘Let’s Go for Growth,’ Fortune, March 7, 1994, pp. 60–72.
• Mander, B. (2008) 'Chávez tackles black market in dollars', Financial Times, April 29 2008
• Morey, I. A. (2004) “Globalization and the Emergence of For-Profit Higher Education”, Higher Education, Vol. 48, No. 1, (Jul., 2004), pp. 131-150
• Nagle, T.T., Holden, K.R. (1995) The Strategy and Tactics of Pricing (Englewood Cliffs, NJ: Prentice Hall, 1995), chapter 14 (Also discussed the legal issues)
• Newman, C. 'Council tax overhaul to be held after next election', Financial Times, September 20 2005
• Parker, G., Sherwood, B. (2008) 'Labour loses London in local election rout', Financial Times, May 2 2008
• Tait, N. (2007) 'Iran ruling could hamper efforts against black market in antiquities',Financial Times, March 30 2007
• Taleb, N. N. (2007) The Black Swan (London: Penguin Group)
• White, B. (2008) 'Prostitution scandal engulfs crusader Spitzer', Financial Times, March 11 2008

Appendices

Appendix A: Needs and wants

Needs are the basic forces that drive customers to take action and engage inexchanges. An unsatisfied need is a gap between a person’s actual and desired states on some physical or psychological dimension. Basic needs are relatively few, but people’s many wants are shaped by social influences, their past history, and consumption experiences. Different people may have very different wants to satisfy the same need. Everyone needs to keep warm on cold winter nights, for instance. But some people want electric blankets, while others prefer old-fashioned down comforters.

This distinction between needs and wants helps put into perspective the charge that ‘marketers create needs,’ or that ‘marketers make people want things they don’t need’. Neither marketers nor any other single social force can create needs deriving from the biological and emotional imperatives of human nature. On the other hand, marketers – and many other social forces – influence people’s wants. A major part of a marketer’s job is to develop a new product or service and then to stimulate customer wants for it by convincing people it can help them better satisfy one or more of their needs.

Appendix B: Scarcity and choice

In all aspects of life, scarcity exists both for individuals and societies. Scarcity exists because there are insufficient resources to satisfy all wants fully. The need for choice arises because resources allocated to the satisfaction of one want cannot, by definition, be available to satisfy other wants simultaneously. Every hour Obama, the US Presidential hopeful, allocates to dealing with foreign policy is one hour less for domestic policy, electioneering, spending with his family, or sleeping. For many individuals and societies, the making of choices is not an unpleasant experience. For a large portion of the world’s population, however, many choices are matters of life and death. Even in more developed countries, scarcity imposes some cruel dilemmas (FT, 2008).

Different societies in the world have tackled the scarcity–choice problem in different ways. Some countries have relied on a small group of individuals making the major economic decisions: those are the centrally planned economies. Others have utilized the market system in which the forces of demand and supply impersonally resolve the scarcity–choice issue: those are the capitalist, or free-enterprise, economies. Others, primarily societies in the less developed world, have relied on traditional methods of economic organization in which the positions of individuals in a society determine primarily their jobs and rewards. No country in the world today provides a pure example of one of the above types of economic systems.

Appendix C: Market Failures

Areas of market failures or partial failures are public goods (e.g. national defense, police, etc.), externalities (e.g. pollution), economies of scale, and income distribution. Collective action or government ‘interference’, while not guaranteeing economic efficiency, can bring the economy closer to an efficient allocation of resources. Collection action also resolves to an extend the 'free-rider' problem.

Appendix D: The principal-agent problem

An agent is an individual or group of individuals to whom a principal has designated decision-making authority. In the case of public utilities, where it is in society’s interest to have only one producer to reap the benefits of economies of scale, it is necessary (if economic efficiency is also to be achieved) that price reflects marginal cost of production. However, to provide an incentive to resource owners to keep the necessary resources in the designated industry, the owners must receive a normal return on these resources. Now, if the principal, for instance the government or regulatory authority, states that prices can be set by the sole producer to cover all costs, an immediate conflict of interest arises. This conflict emerges because there is no incentive for the sole producer to minimize costs in the production process since he is guaranteed a return on whatever costs he incurs. Thus too many resources may be employed by the agent, with no concomitant increase in output. Why shouldn’t the manager have a luxurious office and an expensive car plus chauffeur, and include such resources as a necessary cost of operation? His incentive to do so is personal utility; there is no disincentive because all costs are guaranteed. The principal’s goal of efficiency is thus thwarted by the actions of the agent.

Appendix E: Glossary

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