Table of Contents
- The difference between market-based pricing and cost-based pricing
- Types of market-based pricing methods
- Factors affecting market-based pricing strategies
- Advantages and Disadvantages of Market-Based Pricing Methods
What’s it: Market-based pricing is a pricing strategy in which a company considers the market situation to set its price. In other words, the company focuses on customers (demand) and competitors.
Compared with competitors, three options are possible for the company: at market price, below market price, or above market price. Each of them has different implications for profits and promotion strategies.
For example, suppose a firm charges a price slightly above the market price. The company will then compete on other factors such as quality, convenience, or after-sales service.
The difference between market-based pricing and cost-based pricing
Two general classifications are in determining the selling price of a product. The first is a cost-based pricing strategy. And the second is a market-based pricing strategy.
You may find three general classifications, cost-based pricing, competitive-based pricing, and customer-based pricing in some literature. Yes indeed. You can divide the market-based pricing approach into competitive-based pricing and customer-based pricing.
In the market-based pricing method, the company considers market conditions to set the selling price. And two vital market condition variables influence decisions: customers and competitors.
- Under the cost-based pricing method, the company allocates costs to the selling price and the expected profit (markup). Since easy to implement and manage, this strategy is more popular.
- Under the market-based pricing method, companies set prices based on considerations such as taste, perceived value and image, level of market competition, and product life cycle. Thus, the firm assigns more significant weight to these variables than costs.
Types of market-based pricing methods
Compared to competitors’ price, a market-based pricing approach will produce three possible pricing, namely:
- Above market pricing, where the firm’s price sets a price above the market’s average price. Because it is more expensive, this option is suitable for products that are prestigious or have a strong brand image.
- At market pricing, the company sets a price equal to or close to the market price. This option is common for commodity companies. Products are relatively uniform among companies.
- Below market pricing, where companies set prices below market prices. Companies typically target budget-conscious consumers.
You will likely come across a wide variety of market-based pricing strategies. They will usually combine the following three variables:
- Average competitor prices – consists of three possibilities as I have mentioned above
- Pricing duration – short term vs. long term
- Characteristics of consumers in the market such as tastes, habits and other psychological factors
Well, I’m going to make a quick list of the main types of market-based pricing methods.
- Price skimming
- Penetration pricing
- Discriminatory pricing
- Promotional pricing
- Premium pricing
- Loss leader pricing
- Psychological pricing
In this pricing strategy, the company sets a high selling price at the start of selling a new product. Slowly, as customers increase, the company will lower prices.
Indeed, this pricing approach is out of the ordinary. In the common case, the firm sells at a low price and then increases it as demand increases.
Therefore, not all new products fit this approach. Long story short, price skimming is only suitable for a few highly differentiated products or new inventions.
What is an example?
At the beginning of the launch of cell phones or computers, manufacturers adopted this method. At that time, people didn’t know what a cell phone or computer was because they didn’t exist yet. So, only a few people are willing to take the plunge and buy it. They usually fall into innovators or early adopters categories in the diffusion theory of innovation.
It is the opposite of price skimming. Under this strategy, the company will charge a lower selling price than the average competitors.
Low prices are to attract consumers to buy. Why? The new product has no customer base. So, companies expect low prices to make them buy the product.
The main objective of penetration pricing is to build a customer base and market share. When the market position becomes strong, the company will slowly increase its selling price.
The basic idea of pricing discrimination is that each consumer has a different reservation price – the highest price consumers are willing to pay -. Because of this, companies set varied prices among consumers.
Companies will set the selling price to consumers according to their reservation price in the most extreme form. That way, the company can get maximum profit. This strategy is known as perfect price discrimination (or first-degree discrimination).
Why do I say extreme? It’s impossible to put into practice in the real world, and you won’t find it. First, it is difficult to measure the price of a reservation precisely. Second, the firm can’t prevent the resale of goods from consumers who pay low prices to consumers who pay high prices. Both conditions must be met for price discrimination to be successful.
Say, for the second point, you pay $ 10, which is your reservation price. Your friend, for example, is willing to pay $ 20.
If you know he will buy, you will most likely sell the product to your friend and prevent him from buying from the company. You can sell them for anywhere from $ 10- $ 20 to your friends. You make a profit and can then buy a second product from the company.
Under this approach, companies charge high selling prices for high-quality products. Companies like Apple usually apply it to differentiate their products from competitors in the mass market. The high price is to give the impression that the company’s product is better than its competitors.
Companies will usually target a group of quality-conscious ones than the mass market. They are attracted to premium brands because they think they have a higher value. They are less sensitive to price changes and tend to be loyal.
The promotional pricing strategy is to stimulate demand in the short term. Basically, this program allows you to pay less than usual if you buy more products regularly.
Companies can use a variety of promotional programs to do this. Companies may provide discounted prices for some products at this time. Also, they can use coupons, product bundles, or loyalty cards to increase sales.
Loss leader pricing
Under this approach, firms set prices below market cost. This strategy is common to the retail industry. The goal is to attract more customers to visit the store and buy products.
To compensate for possible losses, retailers will direct visitors to buy more expensive products. That way, these products subsidize the price of loss leader products.
A more extreme strategy is predatory pricing. In this strategy, the company charges a price below the average variable cost, enabling it to incur losses. The goals are not only to attract more customers but also to drive competitors out of the market. When successful, the predator enjoys monopoly power, enabling it to raise prices or lower quality to achieve higher profits.
Under this strategy, companies set prices that can have an impact on consumer psychology. For example, suppose a company sells a product for $ 2.99. Consumers will likely find the price cheaper than a $ 3.00 product. In fact, both are only 1 cent different and immaterial.
Usually, companies will target consumers who are less rational in shopping. And when successful, it can drive greater demand for the product.
Factors affecting market-based pricing strategies
The pricing approach chosen is usually dynamic, depending on demand and competition. Several variables are considered by companies in determining a market-based pricing method.
Mass markets require a different approach than differentiated markets. Likewise, the approach may also differ if the company is targeting a niche market.
Types of the target market
Is it a new market or an existing market?
For new markets, the company will probably choose penetration pricing. The company charges a lower price to get more customers to buy the product.
The company may consider charging a high price if the demand for its product is high. Conversely, during a decrease in demand, the company may set a promotional price by offering incentives and other discounts to keep customers interested.
Pricing by competitors
If a competitor charges significantly less, then the company may also be lowering its price. When players compete to lower prices, it can lead to price wars, which are likely to harm all market players.
Resources and capabilities
Becoming more competitive than competitors is important. However, a competitor may have better resources and capabilities because it is a market leader. Instead of outright imitating, the firm might choose a follower strategy and scrutinize the market leader’s point of pricing.
Product life cycle
Companies usually use a market pricing strategy before the market reaches the decline stage. Conversely, as the market reaches the end of the life cycle, products begin to be replaced gradually because they are substituted by competing products or updated versions by the same company.
Owned product portfolio
The company may have several products. Each has a varied market share and operates in different markets. In the BCG matrix, they fall into four categories:
- Dog – Low market share and in a market with a low growth rate.
- Cash cow – High market share and operates in low growth markets.
- Question mark – Low market share and operates in a market with high growth rates.
- Star – High market share and operates in high growth markets.
Products under the Question mark category usually require a more aggressive strategy. Companies usually will invest more to increase market share and dominate the market. For that reason, the company may charge low prices to attract more sales.
Meanwhile, Star and Cash cows need a less aggressive marketing strategy. The company will choose a pricing strategy that allows it to maintain market dominance.
Price elasticity of demand
The price elasticity of demand represents the change in demand when the firm changes its price. When the demand is elastic, a 5% decrease in price will increase the demand by more than 5%, ceteris paribus. Conversely, if demand is inelastic, a 5% reduction in price will increase demand by less than 5%.
When demand is elastic (the customer is price sensitive), the company can set a selling price just below its price. Due to sensitivity, some of the competitors’ customers may turn to the company’s products.
Advantages and Disadvantages of Market-Based Pricing Methods
The pricing method has pros and cons. Therefore, not all firms adopt market-based pricing methods. Apart from being challenging, this approach may not be suitable for companies considering some of the above variables.
Market-based pricing advantages
This method is ideal for supporting both competitiveness and revenue. The company uses competitors as benchmarks, enabling it to choose the most competitive price. At a lower price than competitors, the company should be able to attract more sales. At a higher price, the company can add features that competitors’ products don’t have.
Considering the demand, the company should be able to determine a selling price that maximizes sales. For example, when launching a new product, the company charges a low price to gain market position.
This may not be achieved if the company uses a cost-based pricing approach. Under this last strategy, the company will set a high selling price because it usually bears the high initial costs (development costs and marketing costs). That may lead to product failure because consumers are not willing to buy (because it is more expensive).
Market-based pricing disadvantages
Measuring consumer satisfaction, tastes, or preferences is a difficult task. Consumer satisfaction is a subjective concept and difficult to assess. So, it is difficult to quantify it into prices.
Also, consumer tastes and preferences continue to be dynamic. The price may be right, and it has brought success in the past. But, that does not guarantee current and future success.
Prices might not properly satisfy consumers. Various factors influence customer satisfaction and demand, not just price and product features. Company image also affects demand. For instance, in developed countries, consumers prefer products from companies that operate in an environmentally friendly manner, even though the price may be higher.
Competition and demand are dynamic. That requires companies to adjust their prices to the needs and desires of consumers and competitive conditions. Such adjustments are often expensive, quicker, and do not match the company’s capabilities and resources.
Prices may only be suitable for some consumers. Consequently, companies will usually segment the market into several groups (market segments).
Consumers in one group tend to be homogeneous in terms of taste, preference, and willingness to pay. In selling products, companies can differentiate prices by charging different prices to different groups of consumers.