pricing

practices
That
endanger
propits
How do buyers perceive
and respond to pricing?

By Kent B. Monroe and Jennifer L. Cox

42 I M M S e p t e m b e r / O c t o b e r 2001
Pricing decisions can be complex and
difficult, but they're also some of
the most important marketing decision variables a man-
ager faces. Companies that make profitable pricing deci-
sions take what may be called a proactive pricing
approach. By considering how pricing decisions affect
the way buyers perceive prices and develop perceptions
of value, these companies manage to leave less money
on the table and successfully raise or reduce prices.

Eight Pricing Fallacies

Many companies continue to develop their pricing
strategies and tactics naively and, consequently, don't
get the results they expect. Tradition-bound solutions
and outdated practices have helped perpetuate a num-
ber of pricing misconceptions that can cause problems
for companies. We outline eight of the most common
ones here.

1. Most companies have a serious pricing strategy

based on serious pricing research. On the contrary. A
recent study found that only about 8% of the companies
surveyed could be classified as conducting serious pric-
ing research to support developing an effective pricing
strategy. In fact, 88% of them did little or no serious pric-
ing research. McKinsey & Company's Pricing
Benchmark Survey estimated that only about 15% of
companies do serious pricing research. A 1997 Coopers
& Lybrand study found that, in the previous year, 87% of
the surveyed companies had changed prices. However,
only 13% of the price changes came after a scheduled
review of pricing strategy.
These numbers indicate that strategic pricing deci-
sions tend to be made without an understanding of the
likely buyer or competitive response. Further, it shows
that managers often make tactical pricing decisions with-
out reviewing how they may fit into the firm's overall
pricing or marketing strategy. The data suggest that
many companies make pricing decisions and changes
without an existing process for managing the pricing
activity. As a result, many of them do not have a serious
pricing strategy and do not conduct pricing research to
develop their strategy.

MM September/October 2001 j 43
 EXECUTIVE b r i e f i n g
Some companies are starting to embrace a proactive pricing strategy, but many still cling to old misconceptions about markets and
the entire pricing process. Understanding and overcoming the pricing fallacies that continually plague managers, the pricing process,
and price perceptions among buyers requires a truly proactive pricing approach. Once managers understand these problems, they can
better develop and implement a product and market strategy for the current economic and competitive environment.
2. Prices can be set annually, typically during the budget-
ing exercise, and don't require continuous managerial atten-
tion between annual reviews. To understand a firm's approach
to price management, first consider how it sets its pricing objec-
tives; gathers, processes, and analyzes relevant information;
provides for an orderly decision process; and establishes proce-
dures for anticipating and responding to customer, market, and
competitor changes. Although managers consistently identify
pricing as a major pressure point or marketing headache,
organizations have been slow to develop a proactive approach
to pricing. This state of affairs exists partly because managers
have misconceived price management as setting prices per se
rather than as a process.
By not considering pricing as a process, companies fail to
distinguish between pricing strategy and pricing tactics; to coor-
dinate pricing decisions across departments; and to have an
organizational unit responsible for regularly monitoring price
adjustments and price policies. For example, a survey of the 20
largest pharmaceutical companies revealed that companies with
an organized pricing function approached pricing as an ongoing
process. Those without a permanently assigned pricing respon-
sibility, however, treated pricing decisions episodically, with lit-
tle or no continuity.
3. Buyers compute price differences easily and unambigu-
ously. This misconception leads to a host of strategic pricing
errors. Failing to consider the complex underlying psychology
of how people encode, perceive, learn, and retrieve numbers
(i.e., prices) when making buying decisions can lead to several
errors. What follows are some important psychological concepts
as well as problems that occur when pricing managers don't
understand these concepts.
Reference Prices
4. Buyers don't evaluate prices comparatively. Not quite.
In fact, behavioral pricing research provides explanations of
how people form value judgments and make decisions when
they don't have perfect information about alternatives. Why are
buyers more sensitive to price increases than to price decreases?
How do buyers respond to comparative price advertisements
{i.e., regular price $65, sale price $49), coupons, rebates, and
other special price promotions? The common response is that
buyers judge prices comparatively through the anchoring effects
of reference prices.
The reference price for a specific product category is a func-
tion of tbe frequency of different prices for that category (i.e., the
distribution of prices). Further, tbe reference price is a function
of the relative magnitude of tbe prices, tbe range of prices, and
44 I MM September/October 2001
the dispersion of prices from tbe average price. A buyer's refer-
ence price is influenced by practice and past experience and by
the sequence in which the buyer observes tbe prices for the cate-
gory. A reference price may be an external price in an advertise-
ment or the sbelf price of another product. It may also be an
internal price the buyer remembers from a previous purchase,
an expected price, or some belief about the price of a product in
the same market area.
Tbe concept of reference price supports tbe notion that buy-
ers judge or evaluate prices comparatively. Managers who ignore
this point make tbe mistake of not distinguishing between pric-
ing strategies and pricing tactics. The marketing group manager
of Frito-Lay Inc. told the story of a local tortilla chip producer in
the Phoenix market that did not understand this relationship.
The local tortilla chip enjoyed a competitive advantage until
Frito-Lay upgraded its Tostitos chip. Instead of raising its mone-
tary price to continue to reflect a perceived quality/value rela-
tionship similar to Tostitos, the local producer reduced its quality
and costs, but maintained tbe monetary price to protect its mar-
gin. Customers soon recognized that the local chip was now an
inferior product and shifted their purchases to FHto-Lay. In tbis
case, tbe local tortilla producer tactically maintained price to be
competitive on price with Frito-Lay but ignored the important
strategic issue of competing on perceived value.
Absolute Price Tiiresiioids
5. There is just one acceptable price for a product or serv-
ice. The truth is that buyers typically have lower and upper
price thresholds, or a range of acceptable prices for a purcbase.
The upper and lower price limits are not constant and shift as
buyers obtain more information about tbe actual price range in
the market or about tbe range of prices in a specific product line.
Plus, a lower price threshold implies that positive prices greater
than $0 exist and are unacceptable because they are considered
to be too low, perhaps because buyers are suspicious of the
product's quality at prices below the lower price threshold.
A number of factors influence the varying levels and widths
of buyers' acceptable price ranges. For a specific product catego-
ry the upper price threshold will be lower if buyers recognize
the availability of similar alternative offerings. However, if cus-
tomer satisfaction increases or buyers become more loyal, the
upper tbresbold tends to increase. Conversely, if customer satis-
faction declines, leading to lower buyer loyalty, then buyers'
upper price thresholds decrease.
When buyers are relatively uncertain about prices for a
product category, tbeir acceptable price ranges tend to be rela-
tively narrow and their lower and upper acceptable price limits
tend to be lower than those of more knowledgeable buyers.

Buyers who infer quality on the basis of price usually have
higher acceptable price levels, higher upper acceptable price
limits, and wider acceptable price ranges. On the other hand,
price-conscious buyers typically tend to have lower acceptable
price levels, lower upper acceptable price limits, and narrower
acceptable price ranges. The sidebar on this page illustrates the
pricing error made when French buyers were unwilling to pay
more than a specific amount to enter Disneyland Paris.
Differential Price Thresholds
Usually a buyer selects from among alternative choices avail-
able for a contemplated purchase. The prices of these alternative
choices may provide cues (or information) to facilitate the decision
process. However, even if the numerical prices are different, we
can't assume prices are perceived to be different. Hence, the prob-
lem becomes one of determining how perceived price differences
affect buyer choice. The two most relevant concepts when consid-
ering this are price elasticity and cross-price elasticity of demand.
6. Absolute price is more important than relative price.
The experience of a major snack food producer illustrates the
error of not recognizing the difference between absolute and rel-
ative price. Several years ago, a specific size of this brand's pota-
to chips was priced at $1.59 while a comparable size of the local
brand was $1.29, a difference of 30 cents. Over time, the price of
the national brand increased several times until it was being
retailed at $1.89. In like manner, the local brand's price increased
to $1.59. However, while the local brand was maintaining a 30-
cent price differential, the national brand obtained a significant
gain in market share. The problem was that buyers perceived a
30-cent price difference relative to $1.89 as less than a 30-cent
price difference relative to $1.59.
As this example shows, relative price is a more important
concept than absolute price. The concept of price elasficity of
demand indicates the sensitivity of buyers to a price change for
a particular product. Thus, if buyers perceive the product's price
as different from the last time they purchased it, then the issue is
whether this perceived price difference alters their purchasing
behavior. For example, a price reduction from $1.30 to $1.25 may
not be sufficient to induce buyers to buy more of the product,
whereas reducing the price to $1.15 might lead to increase
demand. Conversely, a price increase from $1.30 to $1.35 might
not deter some buyers from purchasing it, but an increase to
$1.40 might lead to noticeably decreased demand.
7. The way price information is communicated can't
change buyers' preferences between products. The differential
price issue examines how the price of one product is perceived to
differ from the price of another alternative offering. These alter-
native products could be sold by different competitors or they
could be mtxlel variations sold by a single seller. For example,
Kodak cameras compete with Minolta, Polaroid, and other
brands as well as with different models within the Kodak camera
line. From a managerial perspective, it's important to know how
Perceived Value vs. Price (Mickey Goofed!)
Disneyland Paris, formerly itnown as Euro Disney, opened
in Aprii 1992 on the eastern outskirts of Paris, However,
this new venture didn't lare well at first. In tad, it got so
bad Ihat by 1994. losses were averaging $1 million a day.
Prior to the April 1995 opening, a market research survey
discovered that French consumers were unwilling to
spend more ttian 200ff (Frencti francs) for a single adult
to enter the park. So Disneyland Paris set the 1995
admission price for a single adult at 195 francs. The
number of visitors increased by approximately 23% in
1995 and by 33% by the end of the 1996 season.
Importantly, by 1996, 40% of the visitors were
French, hall of them from the Pafis area. In 1995.
the park operated at a profit for the first time.
So what's the lesson here? Apparently, man-
agers at Disney did not immediately understand
that the relationship between price, perceived
quality, and perceived value has limits or
absolute thresholds. Disney initially failed lo recognize the important link
between perceptions of quality and perceptions of value,
—_—
to price the different cameras within the product line as well as
how to price the cameras relative to the competitors' cameras.
Perhaps the most important strategic aspect of a pricing manag-
er's job is to team how to manage the price differentials within a
product line as well as relafive to competitors' products.
Take a look at the sidebar on page 46. Can you figure out
why sales of B increased after a compefitor introduced a much
higher-priced version? First consider how buyers would evaluate
B relative to A when they were the only two products in this cate-
gory available for purchase. On a subjective scale, B would be
judged as expensive, or perhaps high-priced. However, after the
competitor had introduced C, then B would be judged as not
expensive, or perhaps moderately priced. Second, the $16 price
difference between C and B made the $4 price difference between
A and B perceptually smaller than it was before. The competitor's
pricing caused a product that had been perceived as expensive to
be perceived as not expensive. Third, it's well-known that people
usually don't choose extremes when there is a middle option.
Indeed, we found that when buyers have multiple choices, their
preferences tend to gravitate toward the "middle-priced" brands.
Thus, for these three reasons, consumers who had previously pre-
ferred A now purchased B. This example clearly indicates that
when buyers cannot evaluate quality, the strategic use of price
information can infiuence preferences and choices.
Decomposing Price Elasticity
8. Price elasticities are constant. In reality, price elasticiHes
vary according to the direction of a price change, a brand's price
posifion, and the magnitude of the price change. Buyers, in gen-
eral, are more sensitive to perceived price increases than to per-
ceived price decreases. !n practical terms, this difference in rela-
five price elasticity between price increases and price decreases
means it's easier to lose sales from current buyers by increasing
price than it is to gain sales from new buyers by reducing price.
MM S e p t e m b e r / O c t o b e r 2001 | 45

For example, price elasticity for local telephone calls following a
price decrease was estimated to be -0.022, while tbe price elastic-
ity following a price increase was -0.215. In tbis case, the ratio of
price increase elasticity to price decrease elasticity was 9.77.
Other researchers have estimated this ratio to vary between 1.3
and 4.0 for different products.
Research also confirms that price elasticity of demand
varies over brands within tbe same product category. In one
product category, elasticity varied from -0.84 to -4.56. However,
price elasticity is not independent of the relative price level. Tbe
further a brand's price is from tbe product category's average
price, in either direction, the lower its price elasticity will be, If a
brand's price is already at the extreme end of the price-market
range, then a more substantial price change will be needed to
produce a perceived price change. And extreme prices, high or
tow, will become more price-elastic as the prices are changed
toward the market average or as competitors' pricing moves the
brand's price toward the market average. Further, price elasticity
will be relatively higher for offerings positioned in the middle of
a category because such a position makes it more difficult to
establish either a low price or high-quality image.
How price-elastic or inelastic the demand for a product or
brand is depends on its cross-price elasticity relative to compet-
ing products. Moreover, a brand's price-quality positioning rela-
tive to its competitors influences its price elasticity. These com-
petitive effects not only are asymmetric relative to price increas-
es or decreases, but also are relative to the price-quality posi-
tions of the competing products. That is, price promotions by a
higher-priced brand affect the market share of a lower-priced
brand more than the reverse. Also, brands closer to each other in
price have larger cross-price effects than brands that are priced
further apart.
In summary, price elasticities are not constant and they can
be managed over products, brand, and time to a greater extent
than previously recognized. Managers need to pay attention to
the nature and duration of a price change and to bow extensive-
ly the price change will be communicated or promoted to the
market. Unfortunately, most companies do not make sufficient
efforts to track the sensitivity of demand from their products to
price changes and to price differences over time.
Becoming Proactive Pricers
The pricing misconceptions we've discussed here can pre-
vent managers from becoming proactive pricers. Too often, com-
panies fail to conduct proper research to guide tbeir pricing
strategy. They base price setting on annual budgeting exercises
and misunderstand how buyers compute price differences and
form value judgments.
To overcome these hurdles, managers need to understand
the realm of pricing, including their customers' perceptions of
prices, price changes, and price differences. To become proac-
tive pricers, managers should take certain steps. First, research
46 I M M S e p t e m b e r / O c t o b e r 2 0 0 1
A Competitor Lends a Helping Hand
A producer of a consumer packaged good developed
and marketed two versions of a product, A and B.
The two versions were quite similar except that the
label used for B and the packaging gave it an image
of being a better product. Initially A and B were the
oniy two products in the market, and the firm priced them as follows:
A B
$14.95 $18.95
As would be expected, the lower-priced version. A, was the firm's best-selling
product in this line. However, after a time, a competitor inlroduced its version
of the product, C, positioning it as a high-price, high-quality product. Now
the prices of the three products were:
A B C
$14.95 $18.95 $34,95
In a very short time, version B became the first firm's best-selling product in
this product category! The product manager was mystified and sought help io
figure out what had happened.
your pricing environment to understand the factors that influ-
ence tbe dynamics of supply and demand. Next, recognize that
strategic pricing decisions define an organization's value image
in the eyes of customers and competitors. In fact, one of the
most important statements a firm can make about a product or
service is its price. Finally, understand that tactical pricing deci-
sions concern tbe day-to-day management of tbe pricing
process and must be made within tbe firm's overall pricing
strategy By mastering these three principles, management can
leave behind reactive or stagnant pricing practices and fully
embrace a new era of proactive pricing. •
Additional Reading
Monroe, Kent B. and Angela Y. Lee (1999), "Remembering Versus
Knowing: Issues in Buyers' Processing of Price Infonnation,"
journal of the Academy of Marketing Science, 27(2), 207-225.
Sivakumar, K. (2000), "Price-Tier Competition: An Integrative
Review," fourtial of Producf & Brand Managcmetil Featuring
Pricing Strategi/ & Practice, 9(5), 276-290.
Urhany, Joel E. (2001), "Justifying Profitable Pricing," Journal of
Product & Mmmgetnent Featuring Pricing Strategy & Practice,
10(3), 141-157.
About the Authors
Kent B. Monroe is tbe J. M. Jones professor of marketing, depart-
ment of business administration, University of Illinois, Champaign,
111. He may be reached at k-monroe@uiuc.edu.
Jennifer L. Cox is a marketing specialist with John Deere,
Worldwide Commercial & Consumer Equipment Division, Raleigh,
NC. She may be contacted at JCoxUl@aol.coni.