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Pricing Strategies: How Firms Set a Price

A price starts from cost (cost-plus: cost + mark-up), is limited by what customers will accept (price sensitivity or elasticity), and can be shaped by one price for all, different prices for different buyers, package prices, yield management and dynamic pricing, or even a free offer paid for in another way.

đŸŽŦ Step-by-step story

  1. A shop sells a bag. It costs the shop 40 to make or buy. Every price starts from this cost (the red block).
  2. Add a mark-up of 50%, which is 20. Cost 40 + mark-up 20 = price 60. This is cost-plus pricing.
  3. Ten customers come. Each bar shows the most that person will pay. At price 60, seven bars reach the line, so seven buy (green).
  4. Raise the price to 90. The line goes up and only four bars reach it. Price up, buyers down. This is price sensitivity.
  5. Now use two prices, 55 and 100. Careful shoppers still buy at 55 and keen shoppers pay 100. Profit rises from 200 to 255.
  6. Your turn. Slide the price, or press One, Two or Three prices. Find the plan with the most profit.

Tip: drag the 3D scene to turn it. Use two fingers to zoom.

🤔 Common doubts, cleared

Why not just add a big mark-up?

Because buyers decide. A higher price leaves fewer bars reaching the line, so fewer sales.

What is the red block?

It is the cost of one item. It is the floor, since selling below it makes a loss.

Where does the mark-up go?

It pays the firm's other costs and profit. The amber block shows it on top of the cost.

Why does a higher price lose buyers?

Each customer has a top price. A rising line passes the top of more bars, and those customers turn grey.

Why do two prices earn more than one?

Keen buyers pay 100 instead of 80, and careful buyers still buy at 55. Profit goes from 200 to 255.

How does a free app earn money?

Not from the user. Ads, a few paid upgrades or later sales pay for it. Check that this money is more than the cost of the free users.

Where a price starts: costs and mark-up

A firm cannot sell for ever below what the item costs it. So most prices start from cost.

Cost-plus pricing: price = cost + mark-up. The mark-up rate is the extra as a share of the cost: mark-up rate = (price − cost) Ãˇ cost × 100. A bag that costs 40 sold at 60 has a mark-up rate of 20 Ãˇ 40 = 50%.

Do not mix it up with the margin rate, which divides by the price: 20 Ãˇ 60 = 33.3%.

Target cost works the other way round. The firm first finds the price customers accept, takes away the profit it wants, and what is left is the most the item may cost: target cost = acceptable price − wanted profit. Then it designs the product to fit that cost.

What buyers accept: target, image and competition

Cost is only the floor. The ceiling is the acceptable price: the range in which a buyer thinks "fair" and does not walk away. Three things shape it.

Price sensitivity tells how much buying changes when the price changes. We measure it with the price elasticity of demand = % change in quantity Ãˇ % change in price. It is usually negative. If the size is more than 1 (elastic), buyers react a lot and a price rise cuts revenue. If it is less than 1 (inelastic), buyers react little, as with salt or medicine, and a price rise adds revenue.

Single, differentiated and package prices

A single price is the same for everyone. It is simple and fair-looking, but it loses two groups: buyers who would pay more (they pay less than they could), and buyers who would pay less (they leave). The 3D bars show both.

Differentiated prices charge different groups different prices for the same product, by age (child ticket), time (matinee show), place or quantity. It only works if the groups can be kept apart (student card, time of day).

A package price sells several items together for one price (a meal combo, a phone plus a plan). The buyer feels a saving and the firm sells more items.

Yield management and dynamic pricing

A hotel room or an airline seat that stays empty tonight earns nothing, and cannot be stored. Yield management changes the price so that the firm earns the most from a fixed number of rooms or seats: cheaper early or at quiet times to fill them, dearer when demand is high or few are left.

Dynamic pricing is the same idea done by software, changing the price often (cab surge, flight fares, online shops).

A flat rate is the opposite: one fixed price for unlimited use (a monthly data pack, a gym membership). It is easy to understand, and the firm earns from people who use less than they pay for.

A useful measure is revenue per available room = occupancy rate × average room price.

Free models

"Free" for the user does not mean no income. Freemium: the basic app is free and a few users pay for extras. Advertising: the user is free, advertisers pay. Free sample: a trial leads to a later sale. The firm must be sure the money from the paying part covers the cost of the free part.

Try it: price a lemonade

In the 3D, put the price on 130 and count the buyers. Then 30. Which price gives the best profit? Now press Two prices. Next, at home: ask five friends the most they would pay for one cold drink, write the numbers as bars on paper, and test one price against two prices. Predict the winner first, then check.

Key formulas and definitions

Worked examples

1. A bag costs $40. The shop wants a mark-up rate of 50%. What is the price?

Mark-up = 50% of 40 = $20. Price = 40 + 20 = $60.

2. A shirt costs $60 and sells at $90. Find the mark-up rate and the margin rate.

Profit per shirt = 30. Mark-up rate = 30 Ãˇ 60 = 50%. Margin rate = 30 Ãˇ 90 = 33.3%.

3. Customers accept $120 for a headset. The firm wants a profit of 25% of the price. Find the target cost.

Wanted profit = 25% of 120 = 30. Target cost = 120 − 30 = $90. The headset must be made for $90 or less.

4. A price goes from $10 to $12 and sales fall from 500 to 400. Find the elasticity and say what happens to revenue.

% change in price = +20%. % change in quantity = −20%. Elasticity = −20 Ãˇ 20 = −1 (unit elastic). Revenue before = 5,000; after = 4,800, so it falls a little.

5. A hotel has 50 rooms and sells 35 at $80. Find the occupancy rate and the revenue per available room.

Occupancy = 35 Ãˇ 50 = 70%. Revenue per available room = 0.70 × 80 = $56.

6. Ten customers will pay at most 35, 45, 55, 60, 70, 80, 90, 100, 110, 120. Cost is 40. Compare one price of 80 with two prices of 55 and 100.

One price 80: 5 buy, profit = 5 × 40 = 200. Two prices: the 100, 110, 120 customers pay 100 (3 × 100 = 300); the 55, 60, 70, 80, 90 customers pay 55 (5 × 55 = 275). Money in = 575, cost = 8 × 40 = 320, profit = 255. Two prices earn more.

Common mistakes

Practice quiz

1. Cost 80 and mark-up rate 25% gives a price of:
2. Charging students less than adults for the same ticket is:
3. If demand is inelastic, raising the price will usually:
4. Yield management is most useful when the firm has:
5. A free app that earns from ads is an example of:

Practice: answer these yourself

Type or choose your answer, then press Check. Use a hint if you are stuck; the full solution appears after you answer.

Frequently asked questions

What is the difference between mark-up and margin?

Both use the same profit. Mark-up divides it by the cost; margin divides it by the selling price. So margin is always smaller.

Why do airlines change fares all the time?

A seat cannot be stored. The airline raises or lowers the fare to earn the most from the seats it has. This is yield management.

How can a business give a product for free?

It earns elsewhere: advertisers pay, a few users buy a paid version, or the free trial leads to a later purchase.

Where this is taught

FranceTerminaleHospitality management — economic performance
FranceTerminaleSpecific option — marketing

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