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Business-to-Business MarketingPricing Strategies in Industrial Markets

Haas School of BusinessUC Berkeley

Fall 2008Week 3

Zsolt Katona

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Stock prices

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Prediction Market

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Today’s Agenda

• Rohm and Haas – case discussion

• Signode Industries – case discussion

• On pricing – in general

• B2B pricing – three common contract types

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Overview

An overview of pricing strategies• Basics

– Pricing objectives– Common pricing methods– Demand-based pricing

• Advanced pricing– Price discrimination– Bundling– Behavioral pricing– Dynamic pricing– Competitive pricing

Pricing in Business to Business Markets (3 common types)– Most Favored Customer clause– Meet the Competition clause– Take or Pay contracts

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Basics

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Pricing objectives

• Survival• Maximum current profit• Maximum current revenue• Maximum growth• Predatory pricing• Price signaling - image building• Maximum long term profit

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Common pricing methods

• Mark-up pricing• Target return pricing• Perceived value pricing• Going rate pricing• Sealed-bid pricing

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Price pressures

CONSUMER’S WILLINGNESS TO PAY

Competition createsdown pressure

POTENTIAL PERCEIVED VALUE

Marketing communication can raise perceived value

Consumer’s incentive to buy

PRICE

Producer’s reward (contribution to fixed cost)

VARIABLE COST

Feasible price

range

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Demand-based pricing

• Elasticity of demand:

• Optimal elastic pricing: • Local price in-elasticity• Price as a signal of quality• Price response and other

marketing mix• Measuring price response

– Market level (Econometrics)– Individual level (Conjoint)

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Advanced pricing

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Price discrimination(Pigou, 1920)

• First degree: each customer is charged his/her reservation price.

• Second degree: customers self-select between price plans (customers choose products/prices).

• Third degree: customers are discriminated based on observable characteristics (firms choose customers).

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Bundling

• Two movies, two movie theaters At what price should the movies

be sold to the theaters if the sellercannot discriminate?

PA=PB=

What is the optimal bundle?PA+B=

Movies

Theaters

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2

A B

12 3

10 4

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Behavioral pricing

When people process information, they may arrive to different conclusions depending on how theinformation is presented.

Framing or context effects:

- People’s willingness to pay for a product may depend on the price of similar products. Works for goods whose value is hard to evaluate (e.g. fashion item in a boutique).

- People’s attitude towards risk depends on whether the purchase is framed as a loss or a gain compared to status quo.

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Prospect Theory

$

Status Quo

xp

y1-p

E ( (L)) = pf(x)+(1-p)f(y)

(E (L)) = f [px+(1-p)y]

f($)

Lottery, L: (x, y, p)withE(L)=px+(1-p)y

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Dynamic Pricing

Objective:

where T is the time horizon; r is the discount rate

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Basic dynamic pricing strategies

• Penetration:

– Playing on repeat purchases (addiction effects)– Network externalities (technology standard setting

or diffusion effects)– Learning on costs and entry deterrence

• Skimming:

– Inter-temporal price-discrimination and the problem of expectations/commitment

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‘Competitive’ pricing

1. Predatory Pricing to deter entry or to force a competitor to exit (illegal).

2. Substitutes and Complements (see before):– Substitutes: I increase my price and my

competitors’ demands increase (e.g. competing brands in the same category).

– Complements: I increase my price and my competitors’ demands decrease (e.g. tennis balls and rackets).

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Cooperative pricing

Cooperative pricing methods

– Round table collusion (e.g. Telecom)

– “Umbrella pricing” and “price leadership” (e.g. Signode)

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Pricing in Business to Business Markets

• Contracts with customers

– 1. Most Favored Customer clause (MFC)

– 2. Meet the Competition clause (MCC)

• Contracts with suppliers

– 3. Take or Pay contracts

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1. Most-Favored-Customer Clause

• MFC is a contract or formal commitment from the seller that guarantees the customer the best price the company gives to anyone.

• Also called:– Most-favored-nation clause– Best-price provision

• Common in business-to business markets from raw materials to hi-tech products.

• Makes sure customers are treated equally, they are not at a disadvantage vis-à-vis one another.

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Examples of MFCs:

• Federal Election Campaign Act (1971): campaign spot rates for candidates be as low as lowest commercial spots.

• Medicaid Reimbursement Act (1990): Government gets lowest of 88% of average branded drug price or best retail price.

• “Cortes in Mexico…”

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MFC: The seller’s perspective

• Pros:– Seller becomes a tougher negotiator (tiger)

– Reduces the customer’s incentive to negotiate (instead provides customer an incentive to free-ride on other customers’ negotiation efforts)

• Cons:– It only works if seller has considerable monopoly power

• Seller’s rival can get the seller’s customer easier

• It is harder for the seller to get his rival’s customer

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MFC: The buyer’s perspective

• Pros:

– Ensures buyer’s rivals are not at a cost advantage

– Buyer doesn’t look bad if other competitor’s make a better deal

– Buyer can benefit from other buyer’s superior negotiating skills

• Cons:

– Buyer loses incentive to negotiate (pussycat)

– With other buyers having MFCs it is harder to get a special deal

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2. Meet-the-Competition Clause

• MCC is a contract that gives the seller an option to retain the buyer’s business by meeting any rival bids.

• Also called: – Last-look provision– Meet-or-release clause

• Often the un-written rule in business marketing.

• MCC-s work because responding to an RFP is not cheap and it is risky– The process of responding is costly (time, feasibility studies,

etc.)– Low probability to succeed– Profit prospects are questionable– Low bid may trigger a price war even if you win.

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Example of MCC:

Miami Dolphins sold for only $138 million to Huizenga who had an MCC on the team.

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MCC: The seller’s perspective:

• Pros:– Reduces the incentives for competitors to bid– Takes the guess work out of bidding (seller knows the bid he

need to beat)– Lets seller with the final decision to keep/drop customer

• Con:– Allows competitors to bluff (bid w/o delivery), only relevant if

their objective is to explicitly hurt the seller.

• Competition:– Imitation makes MCCs work better - competitors do not

challenge each other’s business. It is a collusion device.

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MCC: The buyer’s perspective

• Pros:– It creates incentives (means) for suppliers to invest in the

relationship

– Suppliers often offer superior service in return.

• Cons:– Leads to higher prices.

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MFC’s and MCC’s supplier-side analogues

• “Most favored supplier clause”– Buyer commits to pay the supplier at least as much as to any other

supplier.

– Example: compensation contracts

• MCC for suppliers:– The supplier commits to continue supplying provided that buyer

matches the best price anyone else offers

– Suppliers typically get paid less when they have granted an MCC

– Example: Professional Sports (basketball, hockey): team owners have an MCC in some of their contracts with athletes.

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3. Take-or-pay contracts with suppliers

• The customer either takes the product from the supplier or pays a penalty up to a ceiling

• Example: I agree to pay $10 for each unit up to a 100 units and if I buy less than a 100 units I pay $8 for each unit I didn’t buy.

• Examples:– commodity inputs (electricity, cable programming)– suppliers with large fixed costs and low variable costs /

products that are hard to store– essentially turns the supplier’s fixed costs into variable costs

(reverse for the buyer). – risk sharing between buyers and sellers

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Take-or-pay contracts: buyer’s perspective

• Pros– Reduces risk to the supplier, in return for which buyer can

ask to pay less– Reduces the incentive of the buyer’s rival to come after the

buyer’s customer (buyer becomes a tiger).

• Con:– Works like nuclear deterrence: price war is devastating if

deterrence fails

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Conclusion

• Pricing is important and easy to make mistakes

• Short term decision, but long term objectives

• R&H: Value pricing

• Signode: Price leadership issues

• Typical B2B pricing contracts