Abstract and Keywords
Pricing is a topic of interest in a number of different fields including economics, operations research, management science, operations management, marketing, and, increasingly, computer science. This book brings together insights and results from each of these fields regarding pricing. The focus is on the prices set (or negotiated) between a profit-maximizing company and its customers. An overview of the six parts of the book is presented.
“Pricing is the moment of truth—all of marketing comes to focus in the pricing decision.” Harvard Business School Professor E. Raymond Corey wrote these words more than thirty years ago and they remain as true today as they were then. As noted in Chapter 34 in this volume by Thomas Jacobson and his co- authors from Accenture, pricing remains one of the most powerful levers to increase profitability available to most companies—a 1 percent increase in pricing will lead to a 7–15 percent improvement in operating profit. Yet, despite its importance, pricing is a scattered and under-managed process in many organizations. The pricing process within a company often incorporates input from the sales, marketing, and finance divisions. Many different individuals from many different groups typically influence the final price in a transaction. This fragmentation is mirrored in academia—there is no one home for “pricing studies” in the university. Rather, pricing is a topic of interest in a number of different fields including economics, operations research, management science, operations management, marketing, and, increasingly, computer science. One of the purposes of this book is to bring together insights and results from each of these fields regarding pricing into one volume.
The theory and practice of pricing have greatly advanced over the last twenty-five years. There is strong interest in and need for better pricing methods in industry and a growing number of conferences, consultants, and software vendors seeking to help fill that need. Pricing is a growing field of research and teaching within a number of different university departments. Because pricing is both a critical corporate function and a field of academic study, we have commissioned articles for this volume from both pricing practitioners and from leading researchers in pricing. We hope that including authors from these broad communities will serve two purposes. First, we wish to emphasize that what may seem theoretically optimal in pricing may not be practical. Secondly, we hope to stimulate future research inspired by the specific pricing challenges faced in different industries.
The scope of this handbook is primarily the prices set (or negotiated) between a profit-maximizing company and its customers. Except for the article entitled “For what IT’s Worth: Pricing Internal IT Services,” by Diogo Rau and Paul Willmott, we do not consider internal transfer pricing. In addition, we have not addressed the pricing of social goods or (p. 4) services nor have we addressed some topics that could conceivably be included in the broad definition of pricing such as wages.
Organization and Contents of This Volume
This book is divided into six parts. After the introductory section, Part II, Pricing in Selected Industries, introduces the wide variety of pricing approaches that are taken in different industries. The first chapter in this part discusses three approaches to understanding why a particular mechanism is used in a particular setting. The remaining chapters are written primarily by practitioners and consultants describing the pricing challenges in fourteen different industries. Part III, Pricing Fundamentals, contains chapters describing some of the fundamental concepts from economics and management science useful for analyzing pricing across many settings. Part IV, Pricing Tactics, describes specific pricing tactics such as nonlinear pricing and markdown management and how prices are analyzed and set using each tactic. Part V, Organization and Processes, discusses the issues involved in creating an effective pricing organization and an effective pricing process. Finally, Part VI, Current Challenges and Future Prospects, describes some promising areas for current and future research. We next describe the contents of each part in more detail.
Part II: Pricing in Selected Industries
The processes by which prices are set, updated, evaluated, and managed can vary widely from industry to industry and even from company to company within an industry. Understanding how prices are set, communicated, and updated in a particular industry is a fundamental pre-condition for modeling the pricing process within that industry or prescribing approaches (analytical or otherwise) for improving pricing. A pricing optimization or analytic approach built for a passenger airline is unlikely to work for pricing wine, health care, or telecommunication services. The purpose of this section is to give a sample of how pricing is performed in a number of different industries.
In his chapter, Robert Phillips discusses a “pricing modality” as the mechanism by which buyers, sellers, and intermediaries determine the price for a transaction in a market and compares three approaches to understanding why a particular modality will predominate within a particular market at a given time. He stresses the variety of ways in which prices can be determined and claims that arguments from optimality cannot predict which modality will predominate in a given industry at a particular time. He provides examples from three different markets—television advertising, movie tickets, and retail pricing—to support his thesis.
The authors of the remaining chapters in this part are primarily practitioners and consultants. They describe how pricing is performed in fourteen different industries ranging from airlines and cruise lines to health care and consumer credit as well as pricing in the Grand Bazaar in Istanbul. Each author has provided a summary of the key processes and issues involved in setting prices in the industry of interest, a discussion of why prices (p. 5) are set the way they are in that industry, and a discussion of current and future trends. These chapter are not only useful for those looking to understand pricing in those industries; taken together, they provide vivid evidence of the wide variety of pricing approaches in use today.
Part III: Pricing Fundamentals
While pricing practices vary from industry to industry and even from company to company within an industry, there are analytical approaches that can be applied to pricing situations independent of the setting. The chapters in this part describe some of the fundamental tools and concepts that can be used to analyze pricing.
In “Price Theory in Economics”, Thomas Weber describes how prices are treated in economic theory. He introduces the basic concepts of consumer choice including rational preferences and utility functions. He then shows how consumer choice combined with the elements of an exchange economy can give rise to equilibrium prices that are efficient. He then discusses the important issue of market externalities and nonmarket goods. He also describes the relationship between information and pricing which leads quite naturally to the question of how pricing mechanisms can be designed to be informative and efficient.
One of the key elements in pricing analysis is representing how demand will change as prices change. Garrett van Ryzin’s chapter “Models of Demand” provides a primer on such models. He shows how the forms of demand models can be derived from the underlying principles of consumer choice. He describes the desirable properties of such models and discusses a number of such models in common use. Finally he describes how the parameters of these models can be estimated from sales and pricing data.
In most markets, pricing satisfies the conditions of a game as originally defined by von Neumann and Morgenstern: the results of a pricing action by firm A will depend upon how its competitors react and vice versa. There is a long tradition of game theory being applied to pricing: in 1883, Joseph Bertrand used game theoretic reasoning to argue that prices in a perfect market would equilibrate to marginal cost. In their chapter entitled “Game Theory Models of Pricing”, Praveen Kopalle and Rob Shumsky introduce the basic concepts of game theory as applied to pricing. They describe the classic models of Bertrand and Cournot competition and introduce Stackleberg pricing games. They show how game theory can be used to derive insights about pricing behavior in a variety of settings from dynamic pricing, to promotions, to airline revenue management.
Neoclassical economics was based on the assumption that consumer behavior followed certain axioms of rationality. Since the pioneering work of Kahnemann and Tversky in the 1970s, it has been increasingly demonstrated that actual consumer behavior can deviate significantly from rationality. Behavioral economics is the term that has been given to the study of these deviations from rationality and their implications. In their chapter, Özalp Özer and Yanchong Zheng discuss the implications of the findings of behavioral economics for pricing. They describe the principal regularities that have been found in deviation from “economically rational” behavior such as loss aversion, framing, and concern for fairness. They then show how these can influence price response for both consumers and businesses.
(p. 6) Part IV: Pricing Tactics
The chapters in this part describe and provide an overview of specific pricing management problems, their settings, and approaches to determining prices within these settings. This part also illustrates the wide variety of methodologies that are needed to support pricing decisions and processes faced in different industries. One key dimension that is particularly important in determining the appropriate pricing tactic is the amount of “customization” that the seller can apply to his pricing and how it is applied. At one extreme—typically found in business-to-business settings—the seller has considerable information about each buyer and their needs and the ability to quote a different price for each transaction based on that information. A “customized pricing” approach is often used to set the price in this case. At the other extreme, the seller may have limited information about each customer and/or little ability to set different prices for different customers. In this case, some sort of “list pricing” is used, often with various promotions, markdowns, or “nonlinear pricing” approaches to segment potential customers. If capacity or inventory is scarce and perishable, then pricing a unit needs to incorporate the possibility of selling the item later at a higher price—this is the classic “revenue management” problem. Finally, when there are many potential buyers contending to purchase a scarce item, sellers often use auctions as a mechanism to maximize their revenue and ensure that the item is purchased by the seller with the highest valuation. This section covers tactical pricing in all of these settings.
Customized pricing describes a pricing modality in which the seller has the ability to set the price to a customer based on some knowledge of that customer’s identity and expressed needs. It is an approach widely used in business-to-business settings as well as in consumer lending and insurance. Robert Phillips’ chapter describes how customized pricing works in a number of different market settings. It further describes how to determine the customized prices that best meet corporate goals given a bid–response function as well as how to estimate a bid–response function given historical sales data.
Nonlinear pricing is the phrase used to describe pricing schemes in which the price is not strictly proportional to the amount purchased (hence nonlinear). It is a tactic that is widely used in many industries. Shmuel Oren’s chapter on nonlinear pricing describes direct and indirect price discrimination methods such as bundling, quantity discounts, Ramsey pricing, priority pricing, efficient rationing, and pricing through quality (product attribute) differentiation and self-selection. The chapter also covers nonlinear pricing applications in different industries such as electric power and telecommunication.
List pricing refers to the situation in which a seller sets a price and each potential customer decides whether or not to purchase at that price. It is one of the most common pricing modalities and is the standard for most retail trade (on-line and off-line) in Western economies. The chapter by Yossi Aviv and Gustavo Vulcano entitled “Dynamic List Pricing” describes methods for setting and adjusting list prices over time in order to maximize profitability. They discuss response estimation for list pricing, how to incorporate multiple products that are complements or substitutes, the forecasting process, dynamic list pricing when customers are strategic (for example, when they wait for sales and time their purchase decision), and the effect of product assortment on optimal dynamic list pricing methods.
In their chapter entitled “Sales Promotions”, Robert Blattberg and Richard Briesch describe how temporary discounts of various sorts can be used to drive sales and improve (p. 7) profitability. There are a vast number of sales promotions types ranging from coupons, to temporary sales, to “buy one get one free”. Blattberg and Briesch describe the different sales promotions mechanisms in use and how they work. They discuss what is known about the effects of the different promotions and their effectiveness. Finally, they describe how the effects of promotions can be analyzed and how managers can select the right promotional approach in a particular situation.
The markdown management problem is faced by retailers who sell inventory that either deteriorates (such as fresh food) or becomes less valuable over time (such as fashion goods). In such situations, the retailer needs to determine how much discount to apply and how to update that discount over time in order to maximize revenue from his inventory. In the chapter entitled “Markdown Management”, Rama Ramakrishnan reviews the reasons for markdowns and the characteristics of industries in which they occur. He formulates the markdown management problem and describes the business rules and operating practices that constrain markdown decisions. He discusses the different approaches that are used to solve the markdown management problem and some of the challenges faced in implementing automated markdown management systems.
Following deregulation in the United States, airlines faced the problem of how many seats to allocate to different fares on different flights. This was the origin of revenue management, which has become an important tool for increasing profitability in many industries including hotels, rental cars, cruise lines, and freight carriers. The chapter by Kalyan Talluri entitled “Revenue Management” notes that the key characteristics of revenue management industries include limited supply and immediate perishability. In this situation, it can be optimal to reject low-fare customers even when supply is available in order to preserve capacity for later booking higher-fare customers. The chapter describes the field of application of revenue management, describes approaches to revenue management applicable to a single resource (such as a flight leg) as well as how revenue management can be applied to a network of resources (such as an airline schedule).
Auctions are among the most durable market mechanisms: the ancient Romans used them to sell property and Google uses them to sell keywords. Richard Steinberg’s chapter “Auction Pricing” gives some historical background on auctions and describes the different varieties of auction, such as English, Dutch, Japanese, candle, silent, sealed-bid, Vickery, and simultaneous ascending auctions. The chapter summarizes the most important results from auction theory including the optimality of the Vickery auction and the revelation principle. It also describes some of the current topics in auction research including approaches to combinatorial auctions.
One of the newest trends in service operations is offering virtual modifications of an underlying service in order to segment customers and increase profitability. One example is the use of “opaque” channels such as Priceline and Hotwire to sell airline seats. Opaque channels are inferior to traditional booking channels because the identity of the airline and the exact time of departure are unknown at the time of booking. Another example of a virtual modification is an “option” by which a seller offers a discount conditional on their right to recall the service at some point before delivery. In their chapter, “Services Engineering: Design and Pricing of Service Features”, Guillermo Gallego and Catalina Stefanescu discuss a number of such virtual modifications including fulfillment and repayment options, flexible services, opaque selling, and bundling/unbundling. In each case, they discuss how pricing is intimately linked to the design of the product.
(p. 8) The chapter by Murat Kaya and Özalp Özer entitled “Pricing in Business- to- Business Contracts” discusses how pricing terms in supply chain contracts are used to share profits, align incentives, share risks, and signal or screen information across firms. For example, pricing can be used to signal quality and screen private information such as demand forecasts. Their chapter also highlights some of the issues that a firm should consider when designing a pricing contract, such as channel coordination, efficiency, and risk. The chapter reviews a variety of pricing contract structures including wholesale price, revenue sharing agreements, consumer and manufacture rebates, buy- back agreements, advance purchase contracts, capacity reservations, and service- level agreements.
The chapter by Xin Chen and David Simchi- Levi entitled “Pricing and Inventory Management” surveys academic research on price optimization models in which inventory replenishment plays a critical role. The chapter summarizes some of the optimal policies that can be used to jointly optimize prices and inventory replenishment decisions for systems with finite planning horizons and multiple decision periods. The chapter covers topics such as base- stock list price policy and (s,S,p) policy.
Part V: Organization and Processes
The chapters in this part address the practical issues involved in managing the pricing process. These include establishing the right pricing organization; hiring the right mix of people into the organization; establishing processes for setting, updating, and evaluating prices; determining ways to measure the success of pricing; and providing the right incentives to the people involved in pricing decisions.
A precondition for pricing success is an effective pricing organization. The chapter entitled “Structuring and Managing an Effective Pricing Organization” by Michael Simonetto and his co- authors from Deloitte Consulting discusses the challenges that companies face in developing and managing their pricing organizations. In many companies, pricing decisions and processes are dispersed across finance, sales, marketing, and operations. The authors argue that the pricing process should be closely managed and coordinated with other corporate decisions. They present an approach for structuring and managing a pricing organization to accomplish this.
Selling globally adds complexity to pricing. In their chapter, “Global Pricing Strategy”, Greg Cudahy and his co- authors from Accenture discuss the issues faced by companies selling into many different countries. They focus on the specific challenge of transforming an underperforming global pricing organization into a more effective one and illustrate with the example of a chemical manufacturing company.
Lean and Six Sigma are methodologies originally developed to improve the efficiency and quality of manufacturing operations. Six Sigma was designed to reduce the quality variation of manufacturing outputs while Lean manufacturing was designed to reduce waste at every step of a process. In their chapter, “Using Lean Six Sigma to Improve Pricing Execution”, ManMohan Sodhi and Navdeep Sodhi describe how the two methodologies can be applied to the pricing process to increase efficiency and reduce “bad” pricing quotes. They illustrate the concept with a case study application to a US- based global manufacturer of industrial equipment.
(p. 9) In business- to- business selling, prices are often set through a complex process of negotiation. In the chapter “Mastering your Profit Destiny in Business-to-Business Settings,” Thomas Jacobson and his co- authors from Accenture discuss the challenges that sellers face in this environment. They stress that procurement departments are becoming far more sophisticated and use a variety of tactics to negotiate better deals. They describe these tactics and also make recommendations that can help sellers maintain reasonable prices in the face of aggressive procurement departments.
Part VI: Current Challenges and Future Prospects
The concluding chapter by Özalp Özer and Robert Phillips describes two specific areas of current research that they believe will be significant for the future of pricing management. One area they discuss is the need for more empirical studies of pricing—categorizing and understanding how pricing is performed in different companies and different industries, what pricing processes and organizations are most effective, and what benefits have been delivered by automated systems. A second area is pricing with unknown response—the need for companies to learn about customer response at the same time that they are trying to make money. Some studies have shown that seemingly rational processes by which companies might update their customer response models based on new information could lead to suboptimal pricing. More research is needed to understand how pervasive this issue might be in practice and how such processes could be improved.
A reader intrepid enough to read all of the chapters in this book should gain a strong appreciation of the challenges posed by pricing in the real world. She would have an excellent overview of the “state- of- the art” in analytical approaches used to improve pricing and of current thought in how pricing should be organized and performed within an organization. While many readers will not read all the chapters, we hope that any reader with an interest in pricing will find something valuable and interesting in every chapter. (p. 10)