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How do firms choose their pricing strategies?
Do higher prices automatically result in higher profits?
How do firms that opt for premium pricing compare to firms that opt for volume?
Do price increases always result in higher total revenues?
These strategic policy questions relate to the optimal price points of a business enterprise – the appropriate mix of value propositions that maximizes net income and thus the return on investment and shareholders’ wealth while minimizing the cost of operations, simultaneously.
Factors Influencing Pricing Strategies
There are divergent pricing objectives and many factors influence pricing strategies. For those familiar with the relevant academic literature, the critical factors are well known and supported by contemporary research. The primary goals of effective pricing strategies and core elements of effective pricing strategies are equally well established. However, some industry watchers and practitioners continue to identify profit maximization as the primary goal of business enterprises. As we have advised in previous review and guidance, this focus on profit maximization is a bit misguided.
While profit maximization is a legitimate strategic business goal, for several reasons the primary goal of a business is survival at least in the short run. There is gathering empirical evidence suggesting that when businesses overlook this reality and make profit maximization their primary and dominant goal, they tend to engage in conduct and pursue strategies that threaten their very existence. Contemporary case studies are replete with modern examples such as AIG, Bear Stearns, Enron, Global Crossing, Lehman Brothers, Refco, Washington Mutual, and WorldCom, etc.
In this review, we highlight some basic economic theory and best industry practices of effective pricing strategies. This article provides general guidelines for establishing optimal pricing strategies and effective cost minimization strategies. For specific pricing and cost management strategies, please consult competent professionals.
Optimal Pricing Strategies
A close review of relevant extant academic literature indicates that most firms seek to maximize net income (difference between total revenues and total costs) based on several factors such as the stage of the industry life cycle, product life cycle, and market structure. Indeed, as we have already established, the optimal value proposition for each firm differs markedly based on overall industry dynamic, market structure-degree of competition, height of entry/exit barriers, market contestability, and its market competitive position.
Additionally, as with most market performance indicators, firm-specific profitability index and revenue growth rate are insightful only in reference to the industry expected value (average) and generally accepted industry benchmarks and best practices.
In practice, firms use pricing objectives and the price elasticity of demand for products and services to set effective pricing policies. Basic economic principles suggest that price elasticity of demand indicates the sensitivity of customers to changes in pricing, which in turn affects sales volumes, total revenues, and profits. Economic principles suggest that the price elasticity is low for essential goods because people have to buy them even at higher prices. On the other hand, the price elasticity is high for non-essential and luxury goods because consumers may not buy them at higher prices, ceteris paribus.
Operational Guidance
Basic economic principles are supported by gathering empirical evidence suggesting that higher prices do not guarantee profit and higher total revenues do not guarantee profit. In practice, most world-class firms know that the critical variable is effective cost management. The objective functions are revenue enhancement and cost minimization. Indeed, competitive advantage in the global marketplace derives from strategic options based on EQIC: Efficiency, quality, innovation, and customer responsiveness. Further, because profit is the difference between total revenues and total costs, there are several ways firms with market power maximize the profit-producing capacity of their enterprise. Firms can increase profit by increasing total revenues while reducing total costs; and they can increase profit by increasing total revenues while keeping total costs from rising; or they can increase profit by increasing total revenues more than they increase total costs.
Additionally, revenue enhancement can be quite expensive, and often, the relationship between profitability and revenue growth is quadratic, which implies that revenue growth rate may be functional and profit-enhancing or dysfunctional and profit-reducing. For most successful firms, the strategic objective is to locate the optimal revenue growth rate of the enterprise where profit is maximized, ceteris paribus. Two strategic value propositions and pricing options based on Du Pont ROI model are available to most firms: Premium pricing (emphasizing high mark-ups, high-profit margins, and profitability); and High turn-over rate (emphasizing high productivity and effective use of available assets). There is significant empirical evidence suggesting firms that opt for scale and volume tend to outperform those that opt for segment and premium, all things being equal.
Price Elasticity and Optimal Pricing
Managerial economic principles suggest that price effects depend on the size of income effect and substitution effect. Further, the effect of price changes on total revenues depends on price elasticity of demand. When products are price elastic, price increases will reduce total revenues while price reductions will decrease total revenues when products are price inelastic. The opposite is equally true. Therefore, firms seeking revenue enhancement should lower prices if products are price elastic and increase prices if products are price inelastic, all things being equal.
Moreover, the target is optimal scale of operation – the Minimum Efficiency Scale (MES) where firms minimize their long-run average cost via economies of scale. As we have already established, scale economies derive from economies of scope, division of labor, specialization, experience curve, and learning effects. A careful analysis of the extant academic literature suggests that the optimal price path should be largely based on the sales growth pattern. However, in the real world, we rarely find new opportunities for restructuring that allow the firm to completely redesign its operations.
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