Pricing: The Basics

Innovation & New Business Planning - TUHH Institute of Innovation Marketing & Institute of Entrepreneurship, Hamburg · part of my Technology Management MBA · study notes for revision.

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After several sessions on communication, the module turns to the second half of the market-launch problem. Communication decides whether the customer understands the offer. Price decides whether understanding turns into money. The session objectives put it plainly: the aim is to make better pricing and sales decisions when launching a new product or service, and to see how market-facing decisions feed straight through into firm performance.

The opening slide of the pricing block makes a claim that sounds obvious and is not: prices have multiple direct and indirect effects, and that is exactly why pricing matters so much. Price is the only marketing instrument that shows up on both sides of the profit equation at once. It sets revenue per unit directly, it moves the volume you sell, and through volume it moves your unit cost as well. Nothing else in the marketing mix does all three.

This chapter follows the deck’s first block, Basics of pricing. It builds the profit chain from price down to profit, shows why price is the strongest of all profit levers, sets out the three anchors that any price has to be argued from, draws the corridor between the lowest price you can survive and the highest price the market allows, and then gets technical with price-response functions and price elasticity. It closes with the two behavioural points the deck raises and with the problem of pricing something that has never been sold before. Dynamic pricing and value-based pricing are the next two blocks, and they get their own chapters.

Tip

The one idea to carry through. Price is the fastest-acting profit lever you own, because one extra euro of price is one extra euro of profit while one extra euro of revenue from volume still has to pay for its own variable cost. But that leverage cuts both ways, which is why a price has to be argued from customer value, with cost as the floor and the competitor’s price as the reference point, and never simply calculated up from your own cost sheet.

1 · What a price actually sets in motion

The first content slide is a small causal chain, and the whole block hangs off it. Setting a price is not one decision with one consequence; it starts a sequence.

Price pthe one number you actually set

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Sales volume q(p)how many units the market takes at that price

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Unit cost c(q)what one unit costs you once you are making that many

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Revenue, cost and profitall three follow from the two steps above

The direct effect of price is on revenue per unit. The indirect effects run through volume, and through volume into unit cost. This is why a pricing decision is never only a pricing decision.

RevenueR = p · q(p)

CostC = q(p) · c(q)

ProfitP = R - C

Read the notation carefully, because the brackets carry the argument. Volume is written q(p), a function of price, so raising the price changes how much you sell. Unit cost is written c(q), a function of volume, so selling more changes what a unit costs. Cost is therefore a function of price too, at one remove. If you change the price and hold everything else fixed in your head, you have already made a modelling error.

2 · Price is the strongest profit lever

The deck attacks two comfortable beliefs it calls pricing myths, both taken from an article on the myths that kill profits.

Myth 1: small price changes have little impact. The truth is the opposite: small price changes have a significant effect on profitability. The example is Volkswagen. In 2012 it ran an operating profit margin of 3.5 percent of sales. Raise price by 1 percent with everything else held constant, and profitability rises by a startling 28.5 percent. The arithmetic is simple once you see it: the extra 1 percent of sales is pure profit, and 1 divided by 3.5 percent is roughly 28.5. The thinner your margin, the more violent the leverage. The slide’s conclusion is a slogan worth remembering: fight for pennies. Good pricing is not one heroic repricing of one flagship product; it is getting a great many small details right across a great many small transactions.

Myth 2: costs are the basis for pricing. The truth the deck insists on is that pricing has to be based on customer value. The illustration is Nike, which describes its shift over recent years as putting the consumer at the centre of price setting and thinking in terms of the value equation it is trying to create with that consumer. Understand and create customer value first, then let that value be the main basis for the price.

To make the first myth quantitative, the deck reproduces the classic result from a McKinsey study of 1,200 companies worldwide. Each lever is moved by exactly 1 percent and the effect on profitability is measured.

Lever moved by 1 percent	Effect on profitability
Increase in price	11.0 percent
Decrease in variable costs	7.2 percent
Increase in sales volume	3.7 percent
Decrease in fixed costs	2.7 percent

The ordering is the lesson: price beats variable cost, variable cost beats volume, and volume beats fixed cost. Price is roughly three times as powerful as the equivalent push on volume. The reason is structural. One percent more price adds revenue without adding a single unit, so it drops through to profit untouched. One percent more volume adds revenue but drags its own variable cost along, so only the contribution margin survives the trip. Cutting variable cost sits in between, because it improves every unit you already sell.

Caution

Note the assumption printed on the slide, because every exam question hides here: the price increase is assumed not to lower the sales volume. In the real world it usually does, and how much it does is precisely what price elasticity measures. The 11.0 percent figure is the size of the prize, not a promise.

3 · The three C’s of price

Any price has to be argued from three anchors. The deck calls them the three C’s: Company, Competition and Customer. None of the three can produce a price on its own, and the trick is knowing what each one is good for.

Company what we need to earn

Costs, market objectives, payback ambitions, capacity

Competition what the alternative costs

Next best alternatives, competitive dynamics, our own advantages

Customer what it is worth to them

Value perception, ability to pay, price sensitivity per segment

Three anchors, three different kinds of evidence. A defensible price is a sentence that uses all three.

Company. The slide lists cost of goods sold including administration, marketing, service and logistics costs; market strategy and market objectives such as market share and growth targets, competitive strategy, reputation and brand value; the desired payback period for the R&D investment; and the current level of capacity utilisation. That last item is easy to skip and it matters: a half-empty factory and a fully booked one justify very different prices for the same product.

Customer. The value perception of different customer segments, the ability to pay of different segments, and the price sensitivity of different segments. Notice that all three are written per segment, which is the seed of the whole price-differentiation chapter that follows. In B2B, where prices are often set for one named account, the deck adds the individual-customer attributes: the cost to serve that customer, their lifetime value, and their negotiating power.

Competition. The prices and quality of the next best competitive alternatives and the differentiation value of your own offer against them; the competitive dynamics and general level of competition, which depend on market growth and entry barriers; the number, size, resources and market position of your competitors; your own cost advantage; and any other competitive advantage you hold, for example exclusive access to complementary assets.

Anchor	What it can tell you	What it cannot tell you
Company / cost	The price below which you lose money, and how fast the R&D has to be paid back	Anything at all about what the market will pay. Cost is a constraint, not an argument
Competition	A credible reference point that the customer already accepts, and the size of the gap you have to justify	Whether the whole category is underpriced, and whether your differentiation is worth anything to this particular buyer
Customer value	The ceiling, and the reason the customer should accept a premium	How to survive it. Value tells you the top of the range, never the bottom

4 · The price corridor: upper limit, lower limit, and what decides where you land

Putting the three C’s together gives a picture the deck presents as a corridor. There is a highest price the market permits and a lowest price the company can survive, and the slide is explicit that any price inside those limits is profitable for the company. Pricing is therefore not the search for one correct number; it is the choice of a position inside a range.

Upper price limitcustomers willingness and ability to pay · competitors prices and quality · regulation

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Price rangeevery price in here is profitable; corporate objectives decide where you sit

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Lower price limittotal costs

The corridor. Cost fixes the floor, the market and the regulator fix the ceiling, and strategy chooses the point in between.

Where it acts	The factors the deck names
Upper limit	Customers’ willingness and ability to pay; competitors’ prices and their quality; regulations
Inside the range	Corporate objectives: a cost-leader versus a quality-leader strategy; sales growth and market share objectives; amortisation objectives for the money already invested; investors’ preferences
Lower limit	Total costs

The middle row is the interesting one. Two firms with identical costs facing identical competitors will still land on different prices, because one is buying market share and the other is buying margin, or because one has investors who want cash now and the other has investors who want scale first.

5 · Cost-based pricing: a floor, not a basis

Cost occupies exactly one position in the deck’s framework: it is the lower price limit. Everything else the deck says about cost is a warning not to promote it beyond that role, which is the entire content of Myth 2.

A note on what is and is not on the slides

The deck does not put a mark-up or cost-plus formula on a slide. It names total cost as the lower limit and then argues against making cost the basis of the price. The arithmetic below is the standard mechanics of computing that floor and turning it into a number, included because you cannot use a floor you cannot calculate. Treat it as scaffolding for the deck’s point, not as a slide.

Full unit costc = variable cost per unit + (fixed costs / planned volume)

Cost-plus price, mark-up on costp = c · (1 + m)

Cost-plus price, target margin on the pricep = c / (1 - s)

Here m is the mark-up expressed as a percentage of cost and s is the target profit share of the selling price. The two are constantly confused and they are not the same number: a 25 percent mark-up on cost is only a 20 percent margin on price. Get this wrong in a business plan and every downstream figure is wrong with it.

Why the deck refuses to treat this as a pricing method:

• It is circular. The formula needs a planned volume to spread the fixed costs over, but volume is q(p), which depends on the price you have not set yet. You have assumed the answer in order to compute it.
• It knows nothing about the customer. Two products with identical cost sheets can be worth wildly different amounts to a buyer. Cost-plus charges them the same.
• It leaves the most money on the table exactly where the value is highest. The better your innovation, the bigger the gap between cost and value, and the more a cost-plus price gives away.
• It gets the reflex backwards. Under cost-plus, a rise in your own costs becomes a reason to raise the price, at the very moment the market may be least willing to accept one.
• The company slide’s own items break it. Capacity utilisation, payback ambitions and market share objectives all pull the price away from cost, and all of them sit inside the “Company” C alongside cost.

The honest use of cost is therefore defensive. Compute it so you know when to walk away from a deal, and so you can tell a loss-making price from a strategic one. Then set the actual price from the other two C’s.

6 · Competition-based pricing: reference value, differentiation value and price autonomy

If cost is the floor, the competitor’s price is the reference point in the customer’s head. The deck formalises this with a single stacked bar and one hard rule.

Total economic customer valueTECV = reference value + positive differentiation value

Reference valuethe price of the next best competitive alternative (NBCA)

The rule: a company has price autonomy only if it offers a positive differentiation value against the next best competitive alternative. That is worth reading twice. Freedom to set your own price is not something you own because you are a separate company; it is something you earn by being measurably better than the alternative the customer would otherwise buy. With zero differentiation value your price is dictated by the competitor’s price, and the only question left is how far below it you have to go.

This is also where competition-based pricing genuinely makes sense: where products are close substitutes, where the customer can compare easily, where you have no defensible differentiation, and in commodity-like markets where a market price already exists and simply has to be met.

How prices actually get set in B2B

A slide worth remembering, because it undercuts the whole idea that the seller picks a number. In B2B, the end price is not set by the vendor alone from its costs; it comes out of market mechanisms or interactions with customers and competitors. Three mechanisms are named.

Mechanism	How it works	Where it applies
Requests for proposals or tenders	The lowest bid that meets the specification wins. If price is the only criterion at all, it becomes a reverse auction	Public procurement and any well-specified purchase
Spot markets	Mostly electronic marketplaces matching supply and demand through price mechanisms such as auctions	Especially commodities
Negotiations	Bilateral bargaining over the final number	Practically all B2B goods except commodities, and particularly customised, complex, innovative and high-price goods

The last row is the one that concerns an innovator. A genuinely new, complex, high-priced offer is almost always negotiated, which means your list price is an opening position and your differentiation value is the argument you defend it with.

Case: AETHAER, selling bottled British air

The in-class exercise. AETHAER is a British company that sells freshly bottled air. The customer opens the vessel and inhales pure British countryside air; the experience lasts a few seconds and delivers the smell of the English countryside. The customers are mostly wealthy Asian individuals living in polluted areas, and British goods are sought after there for a reputation of being luxurious and posh. The glass jars cost 1 euro each. The air is harvested by hand, with the air farmers travelling long distances away from the cities to capture the purest air they can, and the allocated cost of each trip works out at 4 euros per jar. The strongest competitor, the Canadian firm Vitality Air, sells bottled Rocky Mountain air at 25 euros. The class is asked to suggest a price.

Run the three C’s. Company gives a floor of 5 euros per jar, and a cost-plus habit would produce something like 7 euros, which would be the single most expensive mistake available. Competition gives the reference value: the customer already accepts that bottled air costs 25 euros, so that number, not your cost, is the anchor in their head. Customer decides everything above it, because the product being sold is not oxygen, it is British provenance and status for a buyer for whom the price is a negligible share of income. If the British reputation is a genuine positive differentiation value against Vitality Air, then by the deck’s own rule AETHAER has price autonomy, and the price belongs above 25 euros. The deck poses the question and does not print an answer, so the reasoning is the deliverable, not the number.

7 · The price-response function and price elasticity

Everything so far has been qualitative. To model q(p) properly you need a functional form, and the deck shows that the price-response function can be modelled in several different ways.

Linearq_i = a - b · p_i + c · p_j

Multiplicativeq_i = a · p_i to the power b

Attractionshare of i = attraction of i / sum of attractions of all j

Gutenbergq_i = a - b · p_i + c1 · sinh(c2 · (p_i - p_j))

The notation on the slide: q_i is the quantity of good i, p_i its price, p_j the average price of the competitors j, where j runs from 1 to J, m_i the relative attraction of good i, and a, b and c are parameters to be estimated.

• The linear form is the workhorse. Demand falls by a constant amount b for every unit of your own price and rises by c for every unit of the competitors’ average price. Easy to estimate, but it implies a constant absolute response, which is unrealistic at the extremes.
• The multiplicative form puts price in the exponent. Its great convenience, and the reason the slide labels the two parameters demand and price elasticity, is that the exponent is the price elasticity and it stays constant across the whole curve.
• Attraction models compute a relative attractiveness for each offer and turn it into a market share by dividing that offer’s attraction by the sum of everybody’s. They are the natural choice when what you care about is share rather than absolute units.
• The Gutenberg form adds a hyperbolic-sine term in the gap between your price and the market average. The effect is that demand reacts only mildly while you stay near the average price and then reacts sharply once you move far away from it, which captures the everyday intuition that there is some room to manoeuvre around the going rate before customers notice.

Price elasticity of demand

Elasticity is the single number that summarises the steepness of whichever curve you chose. The deck defines it as the measure of how responsive demand for a good is to changes in the price of that good, and puts it in words as follows: the price elasticity indicates the percentage change of demand that results from a 1 percent increase in price.

Price elasticityε = (dq / q) / (dp / p) = (dq / dp) · (p / q)

Reading the symbolsdq = absolute change in demand, q = original demand, dp = absolute change in price, p = original price

It is a ratio of two relative changes: the relative change of demand on top, the relative change of price underneath. Because demand normally moves against price, ε is normally negative, and in practice people quote and compare its magnitude.

Magnitude of ε	Name	What a price increase does to revenue
Magnitude above 1	Elastic demand	Quantity falls proportionally more than price rises, so revenue falls
Magnitude equal to 1	Unit elastic	The two effects cancel and revenue is unchanged
Magnitude below 1	Inelastic demand	Quantity barely moves, so revenue rises

That table follows directly from the definition rather than from a separate slide, and it is the practical payoff of the whole concept. One refinement matters for profit as opposed to revenue: because every unit you no longer sell also saves its variable cost, a price rise can improve profit even when it slightly reduces revenue. The break-even calculation for that sits in the worked example below.

How the deck estimates it. No list of formal estimation techniques appears in this block. What the session does instead is run an interactive auction experiment: each participant writes their name and states the price they would bid for one can of MyMuesli with the basic mix plus four ingredients of their choice. Collecting individual bids and stacking them from highest to lowest is a direct, hands-on way to build a demand curve out of stated willingness to pay, and it makes the point that elasticity is something you measure from customers, not something you assume.

8 · When demand is less elastic, and why price signals quality

Low elasticity is valuable, because it is exactly the condition under which the profit leverage of section 2 can be realised without losing the volume. The deck lists six situations in which elasticity tends to be lower, and pairs each with product categories where it shows up.

Condition	Why demand goes quiet	Categories the deck names
Monopolistic position	The product holds a unique position with no close substitutes available	Utility services such as water and gas; patented pharmaceuticals
Premium quality perception	Customers associate the product with high quality, prestige and exclusivity	Luxury watches; high-end electronics, for example Apple
Switching barriers	High loyalty or significant changeover costs make it hard to move to a competitor	Enterprise software such as ERP; cloud infrastructure
Limited quality-price knowledge	Customers do not know the alternatives, or cannot compare quality across products	Complex insurance products; specialised consulting
Low price-to-income ratio	The price is insignificant next to the customer’s income or budget	Salt, matches; glue or rivets, when they are a negligible share of total product cost
Low total cost of ownership share	The purchase price is small compared with the lifecycle costs of the product	Industrial HVAC systems; medical imaging units

Reading down the list, these are not six unrelated accidents. Each one removes a different ingredient the customer would need in order to react to a price: an alternative to switch to, the ability to compare, a reason to care about the amount, or the freedom to leave. Take away any of those and price sensitivity collapses.

Price as a proxy for quality

The one clearly behavioural slide in this block. Price is not only something the customer pays; it is something the customer reads. The deck gives four reasons why price gets used as a stand-in for quality.

Past experiences

• Most buyers have learned over a lifetime that higher prices really do tend to go with higher quality
• So the inference is not irrational, it is an accumulated rule of thumb

Simplicity

• Price is one-dimensional and it is known before the purchase decision
• It allows an immediate, direct comparison between products, which nothing else on offer does

Price as a quality symbol

• The higher the price, the higher the value of the product as a status object or a symbol of prestige
• This is the snob or Veblen effect, where demand can rise precisely because the price is high

Credibility

• Prices are perceived as more credible and better justified than advertising claims
• Anyone can say their product is excellent; charging like it is costs the seller something

The managerial consequence is uncomfortable but real: pricing low can destroy the very perception you were hoping to buy volume with. If the customer cannot judge quality directly, as with the specialised consulting and complex insurance rows above, a low price is read as a confession.

Caution

The deck’s behavioural content stops here. Two things people often expect in a pricing chapter, price thresholds such as the jump in resistance at a round number, and odd pricing such as ending a price in 99, do not appear anywhere in this block, so they are deliberately not covered. Reference prices do appear, but in the economic sense of the reference value of the next best competitive alternative from section 6, rather than as a psychological anchoring mechanism.

9 · Pricing a genuinely new product

Here the framework runs into its hardest case. Cost gives you a floor. Customer value is what you want. But competition gives you a reference value only if there is something to reference, and a real innovation may have no obvious competitor at all. The deck’s answer is that the next best competitive alternative always exists; it is just that you have to go looking for it, and it may not be in your own category.

The worked illustration is the Segway. The question on the slide is what the next best competitive alternative to a Segway actually is, and therefore what the innovation should sell for. The answer depends entirely on which job the customer is hiring it for, and the same machine sits in three completely different price worlds.

Segment the Segway could be sold into	The next best alternative	Price range of that alternative
Low segment	A medical device or walking aid	100 to 6,000 dollars
Medium segment	A means of transportation	500 to 10,000 dollars
Premium segment	Lifestyle and outdoor sports equipment	13,000 to 50,000 dollars

The Segway itself costs between 5,000 and 8,000 dollars, and it is heavily rented, in the same way the premium products such as the Jetlev are. That last observation is the tell. A product that people rent for an experience is behaving like the premium segment, not like the walking aid, so the reference value to argue from is the top range rather than the bottom one. Choosing your segment is therefore not a marketing decision that happens after pricing; it is the pricing decision, because it selects which reference value the customer will measure you against.

Who else solves this jobWhat do they chargeWhat do we do betterIs that worth money to this segmentReference value plus differentiation valueCheck it clears the cost floor

Where this goes next: skimming and penetration

Setting the first price is only half of new-product pricing, because prices can and often must change over time. The next block of the session handles that under dynamic pricing, and its two headline strategies are worth naming here so the connection is visible.

Skimming start high, come down

• Enter at the highest price the market will bear
• Fewer sales, higher margins
• Reduce the price gradually to win more share and to answer growing competition

Penetration start low, build a base

• Price below comparable products from the start
• The aim is market share and fast growth
• Once a large installed base exists, the price may be raised

The two dynamic strategies, named here only as a pointer. The full evaluation of when each applies belongs to the next chapter.

The link back to adoption and diffusion. The deck’s condition for skimming is innovations offered to early adopters with a high willingness to pay, and this is exactly the Rogers curve from the first chapter of this module. The first 16 percent of the market, the innovators and early adopters, buy because the thing is new and are relatively insensitive to price. The early and late majority, the other 68 percent, are pragmatists who judge on total cost of ownership. So the diffusion curve is also a willingness-to-pay curve running downhill over time, and skimming is simply the pricing policy that walks down it in step with the adopter categories. Penetration is the opposite bet, appropriate where scale effects, learning curves or network effects mean that owning the majority early is worth more than the margin you gave up to get there.

Worked example

A compact indoor air-quality monitor sold to commercial building operators. The numbers are invented for practice; the method is the deck’s.

Step 1: find the cost floor. Variable cost is 40 euros per unit, annual fixed costs are 600,000 euros, and the plan is to sell 30,000 units a year.

Fixed cost per unit600,000 / 30,000 = 20 euros

Full unit costc = 40 + 20 = 60 euros

Step 2: apply a target mark-up of 25 percent on cost.

Mark-up on costp = 60 · (1 + 0.25) = 75 euros

The same 25 percent as a margin on price would givep = 60 / (1 - 0.25) = 80 euros

Take 75 euros as the cost-plus price and build the base case: revenue is 75 × 30,000 = 2,250,000 euros, variable cost is 40 × 30,000 = 1,200,000 euros, contribution is 35 × 30,000 = 1,050,000 euros, and after 600,000 euros of fixed cost the profit is 450,000 euros, an operating margin of 20 percent.

Step 3: move each lever by 5 percent and compare. As on the deck’s leverage slide, assume the price increase does not cost any volume.

Scenario	Revenue	Variable cost	Fixed cost	Profit	Change in profit
Base: 75 euros, 30,000 units	2,250,000	1,200,000	600,000	450,000	-
Price up 5 percent to 78.75	2,362,500	1,200,000	600,000	562,500	+25.0 percent
Variable cost down 5 percent to 38	2,250,000	1,140,000	600,000	510,000	+13.3 percent
Volume up 5 percent to 31,500 units	2,362,500	1,260,000	600,000	502,500	+11.7 percent
Fixed cost down 5 percent to 570,000	2,250,000	1,200,000	570,000	480,000	+6.7 percent

The ranking reproduces the McKinsey ordering exactly: price, then variable cost, then volume, then fixed cost. Price and volume both add 112,500 euros of revenue, but the volume route hands 60,000 euros of it straight back as variable cost.

Step 4: what happens when volume does react. Suppose the price really is raised to 78.75 euros and sales fall from 30,000 to 28,500 units.

Elasticityε = (-1,500 / 30,000) / (3.75 / 75) = -0.05 / 0.05 = -1.0

Reading magnitude exactly 1, so demand is unit elastic and revenue should be roughly flat

Check it: 78.75 × 28,500 = 2,244,375 euros, against 2,250,000 before, so revenue is essentially unchanged. Profit, however, is not. Unit contribution rises from 35 to 38.75 euros, contribution becomes 38.75 × 28,500 = 1,104,375 euros, and profit becomes 504,375 euros, up 54,375 euros or 12.1 percent. The price rise paid off even though revenue did not grow, because the 1,500 units you did not make also did not cost you 40 euros each.

Step 5: the break-even volume change. The general question is how much volume you can afford to lose after a price rise, or must gain after a price cut, before the change stops being worth it.

Break-even volumeq_break-even = old contribution / new unit contribution

As a percentage changebreak-even change in q = -Δp / (new price - variable cost)

For the 5 percent price rise: 1,050,000 / 38.75 = 27,097 units, which is 2,903 fewer than 30,000, a fall of 9.7 percent. The direct formula agrees: -3.75 / 38.75 = -9.7 percent. So volume could have dropped by almost 10 percent before the rise turned bad, and it only dropped by 5 percent. In elasticity terms the break-even elasticity is -9.7 divided by 5, which is about -1.94; any magnitude below 1.94 makes the price rise profitable, and the actual 1.0 is comfortably inside that.

For a 5 percent price cut to 71.25 euros the arithmetic reverses and turns brutal: unit contribution drops to 31.25 euros, so break-even volume is 1,050,000 / 31.25 = 33,600 units, a required gain of 12 percent. A 5 percent discount has to buy a 12 percent sales increase just to leave you exactly where you started. That asymmetry between 9.7 percent of downside tolerated and 12 percent of upside demanded is the arithmetic behind the whole leverage argument.

Apply it to your project

1. Compute your floor before anything else. Variable cost per unit plus fixed costs divided by a realistic planned volume. You are not doing this to set the price, you are doing it so you can recognise a loss-making deal when a customer offers you one.

2. Name the next best competitive alternative, from the customer’s point of view rather than yours. Ask what this customer would genuinely do if you did not exist, including doing nothing or doing it manually. Whatever that costs is your reference value.

3. If the alternative is not obvious, run the Segway exercise. List two or three different segments that could hire your product for different jobs, write down the alternative and its price range in each, and notice how far apart the resulting anchors are. Then choose the segment, knowing you have just chosen the price.

4. Write one sentence of differentiation value against that alternative, and ask whether it is positive and whether the customer would pay for it. Positive differentiation value is what buys you price autonomy; without it, the competitor sets your price.

5. Build the corridor. Floor from step 1, ceiling from reference value plus differentiation value, and then place yourself inside it according to what you actually want: share, margin, fast payback, or the impression of quality.

6. Ask which of the six low-elasticity conditions you can honestly claim. No substitutes, premium perception, switching barriers, hard-to-compare quality, negligible share of the customer’s budget, or a small slice of lifecycle cost. Each one you can claim is a reason to sit higher in the corridor.

7. Check whether your price is being read as a quality signal. If the customer cannot verify quality before buying, a low price is evidence against you, not a favour to them.

8. Run the break-even volume test on the price you have chosen, in both directions. Work out how much volume a 5 percent rise could cost you before it hurts, and how much a 5 percent discount would have to win back. Do this before any sales conversation, because that is where the discount will be requested.

9. Decide your direction of travel over time, at least provisionally: enter high and come down as the adopter categories widen, or enter low to buy the installed base. That is the dynamic pricing question, and it is the next chapter.

Key terms

Term	What it means in plain words
Price-response function q(p)	The relationship between the price you set and the quantity the market takes, modelled as linear, multiplicative, attraction or Gutenberg
Price elasticity of demand	How responsive demand is to a price change; the percentage change in quantity caused by a 1 percent change in price
Elastic demand	Elasticity magnitude above 1: customers react strongly, so raising the price reduces revenue
Inelastic demand	Elasticity magnitude below 1: customers barely react, so raising the price increases revenue
Profit leverage	How much profit moves for a given percentage move in a lever; price is the strongest lever, then variable cost, then volume, then fixed cost
The three C’s	The three anchors any price must be argued from: Company, Competition and Customer
Upper price limit	The ceiling, set by willingness and ability to pay, by competitors’ prices and quality, and by regulation
Lower price limit	The floor, set by total costs; every price above it is profitable for the company
Cost-plus pricing	Working out the full unit cost and adding a mark-up; useful for finding the floor, dangerous as a pricing method because it ignores value and is circular in volume
Mark-up versus margin	A mark-up is a percentage of cost, a margin is a percentage of the selling price; 25 percent mark-up equals only 20 percent margin
Contribution margin	Price minus variable cost per unit; the amount each extra unit contributes to fixed costs and profit
Next best competitive alternative (NBCA)	Whatever the customer would buy or do instead of buying from you
Reference value	The price of that next best alternative, which is the number already sitting in the customer’s head
Differentiation value	The extra economic value your offer delivers over the next best alternative; reference value plus differentiation value is the total economic customer value
Price autonomy	The freedom to set your own price, which you only have if your differentiation value against the alternative is positive
Price as a quality proxy	The customer reading price as evidence of quality, because of past experience, its simplicity, its status value (the snob or Veblen effect) and its credibility relative to advertising

Test yourself

1. Write out the chain from price to profit with the three equations, and explain why unit cost is written as a function of quantity rather than as a constant.
2. A firm earns an operating profit margin of 4 percent of sales. It raises price by 1 percent and volume does not move. By roughly how much does profit rise, and what does this tell you about thin-margin businesses?
3. Rank the four profit levers from the McKinsey study with their numbers, and explain in one sentence why price beats volume.
4. A product sells 10,000 units at 50 euros. The price rises to 55 euros and sales fall to 8,800 units. Compute the elasticity, say whether demand is elastic or inelastic, and state what happened to revenue. Then, given a variable cost of 30 euros per unit, say what happened to profit.
5. State the rule about price autonomy, and explain what a company’s price is determined by when the rule is not satisfied.
6. Give four of the six conditions under which price elasticity tends to be lower, with one product category for each, and then explain why deliberately pricing low can backfire in exactly those categories.

Answers

1. Price p drives sales volume q(p), which drives unit cost c(q). Revenue R = p · q(p), cost C = q(p) · c(q), profit P = R - C. Unit cost depends on quantity because fixed costs are spread over however many units you actually make and because scale and learning effects change the cost of production, so a price change alters cost indirectly through volume.
2. Profit rises by roughly 1 divided by 0.04, which is about 25 percent. The thinner the margin, the more violent the leverage, which is why the deck uses Volkswagen at a 3.5 percent margin, where a 1 percent price rise lifts profitability by 28.5 percent, and concludes that you should fight for pennies.
3. Price 11.0 percent, variable costs 7.2 percent, sales volume 3.7 percent, fixed costs 2.7 percent, each for a 1 percent move. Price beats volume because extra price adds revenue with no extra units and therefore no extra variable cost, while extra volume only contributes its contribution margin.
4. Elasticity is (-1,200 / 10,000) divided by (5 / 50), which is -0.12 / 0.10 = -1.2. The magnitude is above 1, so demand is elastic and revenue falls: 500,000 euros becomes 484,000 euros. Profit nonetheless improves, because contribution goes from 20 × 10,000 = 200,000 euros to 25 × 8,800 = 220,000 euros. Revenue and profit can move in opposite directions after a price rise.
5. A company has price autonomy only if it offers a positive differentiation value against the next best competitive alternative. Without that, the price is effectively set by the competitor’s price, and the only remaining decision is how far below the reference value the company has to go.
6. Any four of: monopolistic position (utility services such as water and gas, patented pharmaceuticals); premium quality perception (luxury watches, high-end electronics such as Apple); switching barriers (enterprise ERP software, cloud infrastructure); limited quality-price knowledge (complex insurance, specialised consulting); low price-to-income ratio (salt, matches, glue or rivets); low share of total lifecycle cost (industrial HVAC, medical imaging units). Pricing low backfires because in several of these situations the customer cannot judge quality independently and uses price as the proxy, so a low price is read as an admission of low quality and destroys the premium perception you needed.

Revision summary

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The one-minute recap

• Price has direct and indirect effects: it sets revenue per unit directly, moves volume q(p), and through volume moves unit cost c(q). R = p · q(p), C = q(p) · c(q), P = R - C.
• Myth 1: small price changes do not matter. Wrong. Volkswagen at a 3.5 percent operating margin in 2012 gains 28.5 percent of profitability from a 1 percent price rise. Fight for pennies.
• Myth 2: costs are the basis for pricing. Wrong. Pricing has to be based on customer value, which is the Nike position.
• The McKinsey 1,200-company study, for a 1 percent move each: price 11.0, variable costs 7.2, volume 3.7, fixed costs 2.7 percent. The stated assumption is that the price rise costs no volume.
• The three C’s: Company (costs, market objectives, R&D payback, capacity), Competition (next best alternatives and their prices and quality, competitive dynamics, own advantages), Customer (value perception, ability to pay, price sensitivity per segment, plus cost to serve, lifetime value and bargaining power for individual B2B accounts).
• The price corridor: upper limit from willingness and ability to pay, competitors’ prices and quality, and regulation; lower limit from total costs; any price in between is profitable, and corporate objectives decide where you sit.
• Cost is the floor, not the basis. Cost-plus is circular in volume, blind to value and worst exactly where value is highest. Mark-up on cost is not the same as margin on price.
• Total economic customer value = reference value (price of the next best competitive alternative) + positive differentiation value. You have price autonomy only with positive differentiation value.
• In B2B the price is not set by the vendor alone but by tenders and reverse auctions, spot markets, or negotiation, the last being the norm for customised, complex, innovative and high-price goods.
• Price-response functions come in four shapes: linear, multiplicative, attraction and Gutenberg. In the multiplicative form the exponent is the elasticity.
• ε = (dq/q) / (dp/p) = (dq/dp) · (p/q), the percentage change in demand from a 1 percent price rise. Magnitude above 1 is elastic and a price rise cuts revenue; below 1 is inelastic and a price rise raises it. Profit can still improve when revenue does not, because unsold units save their variable cost.
• Six conditions lower elasticity: monopolistic position, premium quality perception, switching barriers, limited quality-price knowledge, low price-to-income ratio, and a low share of total lifecycle cost.
• Price is read as a quality proxy because of past experience, its simplicity as a single pre-purchase number, its status value (snob or Veblen effect) and its credibility against advertising. So a low price can be self-defeating.
• For a new product, hunt for the reference value: the Segway sits at 5,000 to 8,000 dollars while its alternatives span a walking aid at 100 to 6,000, transport at 500 to 10,000, and lifestyle sport at 13,000 to 50,000 dollars. Choosing the segment chooses the anchor.
• Skimming starts high and walks down the adopter curve, which links straight to early adopters with high willingness to pay; penetration starts low to buy the installed base. Both belong to the dynamic pricing chapter next.

Next: Dynamic Pricing & Price Differentiation → - charging different prices to different people, on purpose.