Principles of Pricing

Because management is not an exact science, several approaches that appear obvious turn out to have little value. In a book published this year—and particularly in a chapter devoted to pricing and competition—Kellogg School of Management professors Rakesh Vohra and Lakshman Krishnamurthi outline why many preconceived ideas can be wrong. “We intentionally focused on things that are counterintuitive,” Vohra says. “The added value of the book is pointing out that, if you think carefully about certain things, some intuitions about how prices should behave are incorrect.”

Vohra emphasizes that the book’s insights stem from ideas and concepts that are familiar to academics and business practitioners but possibly surprising to individuals thinking about pricing for the first time. “The novelty is that we have taken basic economic principles and used them to think about pricing; that’s something that other books don’t do,” he says. “We have organized the principles in a way that I hope will be useful and have added our own experiences to the book.” Readers will need a little mathematical savvy. “Our audience is really managers who are willing to look at equations,” Vohra adds.

Vohra became interested in the broad issue of pricing largely by accident. “There was a course called ‘Pricing’ with nobody interested in doing it,” he recalls. “I started teaching it and then realized that the materials available were not good. For me, doing this right meant starting from first principles. A portion of pricing dovetails with my research on auction theory and mechanism design. The framework of that research informs the design of the book.”

The book’s chapter on pricing and competition illustrates, with examples, the complexities of pricing in a competitive business environment. Vohra and Krishnamurthi focus on five specific issues—the pricing dilemma, repetition, capacities, differentiation, and inferior entrants—through a series of thought experiments. “The advantage of these experiments is that every variable within them can be controlled,” they write. “This allows one to precisely isolate how each aspect of the competitive environment affects prices.”

The Pricing Dilemma

The thought experiment for the pricing dilemma involves two firms selling identical widgets to a small short-term market. The issue: What price should each firm charge, given that the experiment does not allow them to adjust their prices and that neither firm knows what its competitor plans to charge? “The fundamental difficulty is that one’s profit depends not just on one’s own price but the rival’s price as well,” the pair writes. But game theory reveals that the only way to guarantee sales is to price the widgets at cost and hence forgo profit.

That simple example illustrates a reality of modern business: intense price competition. “The pricing dilemma sets up the simplest possible situation you can imagine,” Vohra says. “We take readers through what can happen there and then ask what forces drive the firms to cost—forces that you can change.”

The beneficiaries in this simple situation are the buyers, who can take advantage of competition even between just two sellers to reduce the prices they need to pay. “Farsighted buyers recognize this and engage in dual sourcing to keep competition going,” the pair writes.

But what if the rules of the game give the sellers some flexibility in their pricing through repetition, by permitting them to change their prices during the game? “Many people have an intuition that if you have more than one chance to change your price, you can signal to your competitor that he should keep the price high,” Vohra says. (Indeed, it is possible—if potentially illegal—for firms to signal their way to higher prices. In the 1990s, for example, the eight largest American airlines settled a suit brought by the United States Department of Justice for colluding to maintain higher prices through a common computerized reservation system.)

But, says Vohra, “we emphasize why [signaling] might be impractical in certain situations. That’s a fairly new emphasis.” The impracticality arises from the fact that often price cuts are easily disguised. Typically, a firm signals by dropping its own prices whenever its rival does. Eventually the rival should realize that it is better off keeping its prices high. But, in order to signal in this manner, a firm must first be able to detect that its rival has cut prices: no simple matter.

Capacity, Differentiation, and the Inferior Entrant

Another potential escape route from the price dilemma involves limited supplies. “If firms could limit their capacities, prices would be higher,” Vohra and Krishnamurthi write. “So why don’t firms do this? Greed.” Individual firms’ temptation to increase their own capacity to take advantage of high prices almost inevitably leads to excess capacity and lower prices. Vohra’s advice in that situation: “If you’re expanding capacity, you want to be the first to do so.”

In the real business world, of course, widgets or other goods and services sold by different vendors are not uniform in quality. Companies work hard to differentiate their offerings from those of their competition in ways that allow them to charge premium prices. But here again the benefit is not so simple. “Everyone has the idea that differentiation should push prices up,” Vohra says. “We say this is correct only if you do not simultaneously indulge in price discrimination,” where identical products are priced differently for different sets of customers. Lowering prices for just your rival’s customers will force your rival to lower its prices, thereby making its product more attractive to your customers. “When you do that,” says Vohra, “you essentially destroy the benefits you get from differentiation.”

Finally, the chapter examines the ability of an inferior entrant— that is, a company with higher costs and/or a poorer product—to move into a market with at least one established incumbent. The two researchers describe a game that gives the incumbent the choice between accommodating the entrant (by giving up the market segment that the entrant targets) or fighting the move (by, for example, cutting its prices). The counterintuitive result of the game: It is sometimes better to accommodate than to fight.

Shell, BP, and Esso, the main retailers of petrol in the early 1990s, learned that lesson when supermarkets began to sell petrol. In response to a forecast that its market share would fall from 21 percent to 18 percent, Esso (now Exxon) decided to cut its prices in areas that faced direct competition from supermarkets. But Shell and BP interpreted the move as the start of a price war and cut their prices at all locations. Once margins fell, the big three backed off. But by then the supermarkets had captured 20 percent of the market, and Esso’s share had fallen to just 16 percent.

The Take-away Message

As Vohra sees it, the chapter has a simple take-away message. “If you’re going to think seriously about pricing in competitive environments, you need information about costs, capacity, the size of the market, and a sense of how much people are willing to pay,” he says. “The flip side is that with this information alone you get a lot of mileage. Things such as the CEO’s personality are second order. There’s a lot you can learn from just knowing supply and demand.”

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