Pricing and Framework for Competitive Advantage
Wednesday, June 2nd, 2010By Leslie Pratch
When I was getting my M.B.A., I outlined what I considered most useful to digest the curriculum and to help my classmates preparing to interview for consulting firms. Nearly a decade later, I realize these notes may be helpful to first- and second-year M.B.A. students at Chicago Booth (and elsewhere) who are boning up for interviews with consulting firms. I offer them freely and if they are helpful, encourage your use of them, especially if you are pursuing a leadership position in a consulting firm.
(1) When there are few sellers, monopoly-like pricing can be maintained if the short-term discount rate is low –Folk Theorem
(2) Firm 1 raises price; Firm 2 can follow one period later. Will it? If it doesn’t, Firm 1 will drop price and both firms will be worse off. For Firm 2, the question is how valuable is an extra period of extraordinary profits relative to perpetuity of better but not extraordinary profits? If discount rates are low, it will follow price increase; but if discount rates are high?
In other words, Firm 2 can go for profits: High, Low, Low, Low . . . or profits; Medium, Medium, Medium, Medium if it matches. Which set of cash flow is greater depends on the discount rate. The higher the discount, the more attractive is the former.
(2) Whether an oligopoly can maintain a monopoly-like price depends on communication and coordination and understanding between the players. These depend on:
(a) Market concentration
(b) Speed with which price changes are detected, which depends on a number of factors.
(c) Prices should be set based upon the value created for the purchaser of the product. Value can be created by revenue increases or cost decreases that result from using the product. For pricing technological innovations, look not only at the direct purchaser’s situation, but also at how the innovation increases revenue or decreases cost in other downstream parts of the value chain.
(d) Prices, however, are constrained by the value / price offered by competitors and substitutes and also by their behavior (i.e., competitors and substitutes may bid away any economic profits). In a competitive case, competition ensures that the product seller does not capture all the value created by the product.
(d) In the absence of competitors a producer is a monopolist and maximizes profits by raising prices / restricting output.
(e) Producers can have some monopoly pricing power if their product is differentiated. Commodity producers have no pricing power.
(f) Producers should try to price discriminate by segmenting the market and raising the price for segments with inelastic demand (e.g., business travelers) and lowering prices for segments with elastic demand (e.g., vacationers).
(g) Prices should be varied to react to fluctuations in demand.
(h) A long-term view should be considered when pricing a new product or changing prices in reaction to demand fluctuations
(i) For new products consider network synergies (sell the handle cheap in order to sell the blades) and other loss leader approaches.
(j) For price changes in reaction to demand fluctuations, consumer good will may be important.
(k) Pricing policy should be consistent with desired image and brand.
(l) If you don’t price discriminate, you have to make a choice between appealing to all or many segments at a moderate price or to one or a few segments at a higher price. Multiple the size of the segments by the (price less the variable costs) for each scenario and see which is larger.
(3) Pricing Rivalry
(a) Market concentration.
(b) Lumpiness of orders.
(c) Availability of sales transaction information.
(d) NUMBER AND SIZE OF BUYERS.
(e) Volatility of demand and cost conditions.
(f) Asymmetries among firms (different costs or quality levels).
(g) Multi-market contact.
(4) Time Based Competition
(a) Capability to minimize time in innovation, marketing, production, and logistics is an increasingly important driver of competitive advantage.
(5) Framework for Competitive Advantage
(a) Relative Differentiation.
→ Relative value created
(b) Relative Cost Structure.
→ Firm’s profitability
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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.
