Pricing Decisions (AQA A-Level Business): Revision Notes

Pricing decisions

The pricing strategies used by businesses

Price refers to the amount of money a business expects customers to pay when purchasing a good or service. Setting the right price is crucial because it directly affects sales revenue and profitability.

Pricing strategies are the overall approaches a business takes to setting prices over an extended period (medium to long term). These strategies form part of the marketing mix and help businesses achieve their wider commercial objectives.

The four main pricing strategies

There are four principal pricing strategies that businesses commonly use:

1. Price skimming

This strategy works best when launching new, innovative products that face little direct competition initially. The business sets a high price at launch, which achieves limited sales volume but generates a high profit margin on each unit sold. This approach allows the firm to recover some of the product's development costs quickly. As competitors enter the market, the price is gradually lowered to attract more price-sensitive customers.

Price skimming is particularly effective for:

• Technology products (e.g. new gaming consoles, smartphones)
• Products with patent protection
• Premium brands launching new ranges

2. Penetration pricing

Firms entering a market where similar products already exist often use penetration pricing. The business deliberately sets the price low to gain a foothold and build market share quickly. The strategy relies on attracting customers away from established competitors. Once the product has become established and customer loyalty has developed, the business increases the price to boost profit margins.

This approach works well for:

• New brands entering competitive markets
• Businesses prioritising market share over immediate profits
• Products with potential for customer loyalty

3. Price leadership

This strategy suits established products with strong brand images and significant market power. The firm adopting price leadership will substantially dominate the market, and other businesses typically follow their pricing lead. Price leaders have the confidence and market position to set prices that others must match or undercut.

UK examples include:

• Supermarkets like Tesco setting prices that competitors respond to
• Leading brands in various sectors (e.g. Cadbury in chocolate, Coca-Cola in soft drinks)

4. Price taking

Price takers set their prices equal to the 'going rate' or established market price. This common strategy suits small and medium-sized businesses that operate in competitive markets. Price takers have no influence over the market price because they are normally one of many smaller firms competing for business. If they raise prices above the market rate, customers will simply buy from competitors instead.

This strategy is typical for:

• Small independent retailers
• Businesses in highly competitive markets
• Firms selling largely undifferentiated products

Pricing tactics

Once a business has determined its overall pricing strategy, it may use various pricing tactics. Unlike strategies, tactics are short-term pricing techniques used to achieve specific goals quickly.

Loss leaders

This tactic involves setting prices very low, often below the cost of production, to attract customers into the store or onto the website. Businesses using loss leaders hope that customers will purchase other full-price products during the same shopping trip, generating overall profit despite the loss on individual items.

Supermarkets frequently use this approach, offering heavily discounted items (e.g. milk, bread) to encourage store visits.

Special-offer pricing

This approach involves reduced prices for a limited period or special deals such as 'three for the price of two' or 'buy one get one free' (BOGOF). These offers create urgency and encourage customers to purchase more than they originally intended.

Influences on pricing decisions

Various factors influence a firm's pricing decisions. The choice between different strategies and tactics depends on several key considerations:

Market share objectives: A firm seeking to expand its market share is more likely to select strategies and tactics resulting in lower prices. This approach may appeal particularly to businesses in a financially strong position that can afford lower profit margins in the short term.

Product differentiation: In contrast, a business selling a highly differentiated product or one facing increasing popularity may opt for higher price levels. When customers perceive unique value, they become less sensitive to price.

Financial position: Companies with strong cash reserves have more flexibility to use penetration pricing or loss leaders, whereas businesses under financial pressure may need to maintain higher prices to generate immediate revenue.

Competitive environment: The number and strength of competitors significantly affects pricing freedom. In markets with intense competition, businesses often have limited pricing power.

Price elasticity of demand

One key factor influencing managers in their pricing decisions is price elasticity of demand (PED). This concept measures the extent to which the level of demand for a product is sensitive to price changes.

Price elastic demand

Demand is price elastic if it is sensitive to price changes. When demand is price elastic:

• An increase in price results in a significant lowering of demand
• This leads to a fall in the firm's total revenue
• Products with substantial competition typically have price elastic demand

Price inelastic demand

Price inelastic demand exists when price changes have relatively little effect on the level of demand. Products with price inelastic demand include petrol and other essentials. Consumers continue buying these products even when prices rise because they have few alternatives.

When demand is price inelastic:

• Price increases cause relatively small decreases in demand
• Total revenue typically increases when prices rise
• The business has more freedom in pricing decisions

Calculating price elasticity of demand

The formula for calculating PED is:

$\text{price elasticity of demand} = \frac{\text{percentage change in quantity demanded}}{\text{percentage change in price}}$

Or expressed as:

$\text{PED} = \frac{\%\Delta Q}{\%\Delta P}$

Making demand more price inelastic

Firms generally prefer to sell products with price inelastic demand. This gives greater freedom in selecting pricing strategies and more opportunity to raise prices, increase total revenue and boost profits.

Businesses can adopt several techniques to make demand for their products more price inelastic:

Differentiating products from competitors

Making a product significantly different from competitors' offerings can increase brand loyalty. When consumers perceive unique characteristics or superior quality, they are more likely to continue purchasing even if the price rises. This differentiation might involve:

• Superior quality or features
• Strong brand image and reputation
• Excellent customer service
• Unique design or functionality

Reducing competition through takeovers and mergers

In recent years, many markets have experienced consolidation, with fewer but larger firms competing. This process results in fewer alternative products being available to consumers. When choice is limited, demand becomes less responsive to price changes because customers have fewer substitutes to switch to.