Price (£)403020100
0 100 200 300 400
Units sold (thousands)Managing the marketing mix 305
the additional income they could have earned
from customers who would have been willing
to pay more. A key to effective pricing is
customizing pricing to minimize these losses.
This is illustrated in Figure 11.5. A com-
pany sets its price at £10 and sells 300 000 units,
it has variable costs of £5 per unit and total
fixed costs of £1.3 million. It then makes a profit
of £200 000. It loses £1 million revenue because
some customers find £10 too expensive, and it
leaves a consumer surplus of £4.5 million
because up to 300 000 could have been sold at
higher prices. A more profitable price would be
£20; this would have led to a smaller consumer
surplus, but a smaller market share, as more
potential customers are lost.
The answer is of course charging different
prices to different segments of the market or,
ideally, to each individual customer. The per-
fect solution would be a range of prices from £5
(i.e. marginal cost) to £40, which would elim-
inate the consumer surplus, and any loss of
profitable customers. The profit would then be
over £3 million.
This type of yield pricing is now becoming
common for airlines and hotels, but is ubiqui-
tous in some form in almost all markets. One
problem is to keep the segments separate so
that high value customers cannot buy at low
prices. Another problem is the perceived
‘unfairness’ of different customers paying dif-
ferent prices. Offering marginally different
products is the usual solution. So business class
passengers on an airline get better meals or
more legroom than economy class. Buyers of
expensive credit cards or brands of whisky get
them coloured gold! As Figure 11.5 suggests,
the gains from such market segmentation and
price discrimination can be enormous.Evaluating competitor reaction
Price competition and price wars can have a
devastating effect in destroying shareholder
value. We noted earlier a small, 5 per cent price
increase can double profits; similarly, small
enforced price cuts can eliminate profits
altogether.
The importance of considering competitive
reactions can be illustrated through game theory
and, in particular, the famous Prisoner’s
Dilemmagame. The game is as follows. Suppose
companies A and B are the only producers of a
certain product. There is only one customer,
who is willing to pay up to £50 per unit for a
one-off contract of 10 000 units. The cost of
producing the product, including an economic
return on the capital employed, is £10 per unit.
The company that offers the lowest price wins
the contract; if both charge the same prices the
contract is shared equally between the two.
Figure 11.6 summarizes the pay-offs of
alternative pricing strategies. If both set their
prices at £50 and divide the contract, each
would make a profit of £200 000. However, this
strategy, though attractive, is not individually
optimal. If A undercut B and charged £49, then
A would win the whole contract, making
£390 000 profit, and B would be out of the
market. Unfortunately, this strategy is also
going to occur to B, who will also seek to
maximize its individual profits by cutting price.
When price wars like this break out, the price isFigure 11.5 Customized pricing