348 The Marketing Book
realistic? Will existing customers really buy that
much more of our product and/or will suffi-
cient numbers of new customers be attracted to
bring about the needed extra volume? And will
our competitors sit back and do nothing when
we lower our prices by 10 per cent or will they
retaliate by matching or even exceeding our
price cut? And what about the possibility that
the whole thing may backfire if customers
perceivethat the price reduction also reflects a
quality reduction and end up buying lessrather
than more? Questions of this nature go a long
way towards making the implications of any
pricing moves transparent and identifying
potential sticky points. Lamentably, such ques-
tions are seldom asked in practice; as Urbany
(2000, p. 4) points out, ‘because of potential
ambiguity in estimating demand and profit at
alternative prices and predicting competitive
reactions, pricing practice in many firms may
systematically ignore these two important
fundamentals’.
As can be seen in Figure 13.2, sales volume
plays a crucial role in the system of relation-
ships between price, cost and profit. As a
dependent variable, sales volume (q) reflects
customer demand and is a function of both the
firm’s own price (p) than those of competitors
(pj); the specific nature of the relationship
between volume and price is captured by the
price response function, q = f(p, pj).^2 As an
independent variable, sales volume (q) is a
determinant of the firm’s costs (c), a relation-
ship which is captured by the cost function, c =
g(q). Thus, ultimately, cost is a function of price
andnot vice versa^3 or, what amounts to the same
thing, any pricing system that uses costs as the
basis of price determination is illogical and
bound to result in sub-optimal decisions;^4 as
Backman (1953, p. 148) aptly put it a long time
ago, ‘the graveyard of business is filled with the
skeletons of companies that attempted to price
their products solely on the basis of costs’.
The above should not be interpreted as
implying that costs have no place in pricing
decisions. Costs are important, but only as
constraintson the viability or relative attractive-
ness of different pricing alternatives;^5 they are
not important, or even relevant, as guidesto
setting prices, not least because ‘the customer
does not care about the firm’s costs... only
about the valuehe/she is getting’ (Diamanto-
poulos, 1995, p. 187, emphasis in the original).
In fact, the most fundamental lesson in pricing
is that ‘price is a statement of value not a statement
of cost’ (Morris and Morris, 1990, p. 2, emphasis
in the original); the next section shows why this
is the case.Price from the customer’s perspective
The very definition of price as ‘the amount of
money we must sacrifice to acquire something
we desire’ (Monroe, 1990, p. 5) provides a clear
clue as to the way in which customer considera-
tions impact on pricing. Several points are of
importance here.
First, the notion of price as a ‘sacrifice’
implies that the buyer must give something
up. In this context, ‘what must be given up(^2) It is assumed here that competitive actions directly
impact upon the firm’s own demand, i.e. there is interde-
pendence among suppliers (oligopolistic market structure).
In the case of a single supplier (monopoly) or many
suppliers with differentiated products (monopolistic com-
petition), the price response function reduces to q = f(p).
(^3) Since q = f(p, pj) and c = g(q), it follows that c = h(p, pj);
this demonstrates the irrationality of cost-based approa-
ches, according to which ‘price is considered a function of
cost, whereas the true causal relationship is just the reverse’
(Simon, 1989, p. 48).
(^4) There are some very special (read: extremely rare)
circumstances under which a cost-based approach can lead
to optimal (i.e. profit maximizing) prices; for more details,
see Simon (1989 or 1992).
(^5) For example, variable costs or marginal costs act as
short-term price floors (assuming no capacity constraints),
while total costs act as long-term price floors; for compre-
hensive analyses, see Riebel (1972) and Reichmann (1973).