Pricing Policies for New Products

by Joel Dean

Harvard Business Review

Reprint 76604

NOVEMBER–DECEMBERHBR 1976

Pricing Policies for New Products

by Joel Dean

ow to price a new product is a top manage- 1. Technical maturity, indicated by declining rate ment puzzle that is too often solved by cost- of product development, increasing standard- Htheology and hunch. This article suggests a ization among brands, and increasing stability of pricing policy geared to the dynamic nature of a new manufacturing processes and knowledge about them. product’s competitive status. Today’s high rate of 2. Market maturity, indicated by consumer accep- innovation makes the economic evolution of a new tance of the basic service idea, by widespread product a strategic guide to practical pricing. belief that the products of most manufacturers New products have a protected distinctiveness which will perform satisfactorily, and by enough fa- is doomed to progressive degeneration from competi- miliarity and sophistication to permit consum- tive inroads. The invention of a new marketable spe- ers to compare brands competently. cialty is usually followed by a period of patent protec- tion when markets are still hesitant and unexplored HBR first published this article in November 1950 as a and when product design is fluid. Then comes a practical guide to the problems involved in pricing new period of rapid expansion of sales as market accep- products. Particularly in the early stages of competition, it tance is gained. is necessary to estimate demand, anticipate the effect of Next the product becomes a target for competitive various possible combinations of prices, and choose the most suitable promotion policy. Then as the product’s encroachment. New competitors enter the field, and market status matures, policy revisions become necessary. innovations narrow the gap of distinctiveness be- Joel Dean outlines the possible price strategies for each tween the product and its substitutes. The seller’s stage of a product’s market evolution and the various zone of pricing discretion narrows as his or her dis- grounds for making a choice. To update his original state- tinctive “specialty” fades into a pedestrian “comment, Mr. Dean has written a retrospective comment, modity” which is so little differentiated from other which appears at the end of this article. He amplifies his products that the seller has limited independence in earlier article with insights from intervening years and in pricing, even if rivals are few. light of such developments as inflation. Throughout the cycle, continual changes occur in Now president of Joel Dean Associates and professor of promotional and price elasticity and in costs of pro- business economics at Columbia University, Mr. Dean duction and distribution. These changes call for ad- was formerly on the faculty of the University of Chicago. During World War II, he was head of machinery price justments in price policy. control and later of fuel rationing. Books he has written Appropriate pricing over the cycle depends on the include Managerial Economics (Prentice-Hall, 1951), Capi- development of three different aspects of maturity, tal Budgeting (Columbia University Press, 1951) and Sta- which usually move in almost parallel time paths: tistical Cost Estimation (Indiana University Press, 1976).

3. Competitive maturity, indicated by increasing novelty to a 49-cent “price football,” partly because stability of market shares and price structures. entry barriers of patents and techniques were ineffec- tive. Frozen orange juice, which started as a protected Of course, interaction among these components specialty of Minute Maid, sped through its competi- tends to make them move together. That is, intrusion tive cycle, with competing brands crowding into the by new competitors helps to develop the market, but market. entrance is most tempting when the new product At the outset innovators can control the rate of appears to be establishing market acceptance. competitive deterioration to an important degree by The rate at which the cycle of degeneration pro- nonprice as well as by price strategies. Through suc- gresses varies widely among products. What are the cessful research in product improvement innovators factors that set its pace? An overriding determinant can protect their specialty position both by extending is technical—the extent to which the economic en- the life of their basic patents and by keeping ahead of vironment must be reorganized to use the innovation competitors in product development. The record of effectively. The scale of plant investment and techni- IBM punch-card equipment is one illustration. Ease cal research called forth by the telephone, electric of entry is also affected by a policy of stay-out pricing power, the automobile, or air transport makes for a (so low as to make the prospects look uninviting), long gestation period, as compared with even such which under some circumstances may slow down the major innovations as cellophane or frozen foods. process of competitive encroachment. Development comes fastest when the new gadget fills a new vacuum made to order for it. Electric stoves, as one example, rose to 50% market satura- STEPS IN PIONEER PRICING tion in the fast-growing Pacific Northwest, where electric power had become the lowest-cost energy. Pricing problems start when a company finds a prod- Products still in early developmental stages also uct that is a radical departure from existing ways of provide rich opportunities for product differentiation, performing a service and that is temporarily pro- which with heavy research costs holds off competi- tected from competition by patents, secrets of pro- tive degeneration. duction, control at the point of a scarce resource, or But aside from technical factors, the rate of degen- by other barriers. The seller here has a wide range of eration is controlled by economic forces that can be pricing discretion resulting from extreme product dif- subsumed under rate of market acceptance and ease ferentiation. of competitive entry. A good example of pricing latitude conferred by Market acceptance means the extent to which protected superiority of product was provided by the buyers consider the product a serious alternative to McGraw Electric Company’s “Toastmaster,” which, other ways of performing the same service. Market both initially and over a period of years, was able to acceptance is a frictional factor. The effect of cultural command a very substantial price premium over com- lags may endure for some time after quality and costs petitive toasters. Apparently this advan-tage resulted make products technically useful. The slow catch-on from (1) a good product that was distinctive and superior of the garbage-disposal unit is an example. and (2) substantial and skillful sales promotion. On the other hand, the attitude of acceptance may Similarly, Sunbeam priced its electric iron $2 above exist long before any workable model can be devel- comparable models of major firms with considerable oped; then the final appearance of the product will success. And Sunbeam courageously priced its new produce an explosive growth curve in sales. The metal coffeemaker at $32, much above competitive antihistamine cold tablet, a spectacular example, re- makes of glass coffeemakers, but it was highly suc- flected the national faith in chemistry’s ability to van- cessful. quish the common cold. And, of course, low unit price To get a picture of how a manufacturer should go may speed market acceptance of an innovation; ball- about setting a price in the pioneer stage, let me point pens and all-steel houses started at about the same describe the main steps of the process (of course the time, but look at the difference in their sales curves. classification is arbitrary and the steps are interre- Ease of competitive entry is a major determinant lated): (1) estimate of demand, (2) decision on market of the speed of degeneration of a specialty. An illus- targets, (3) design of promotional strategy, and (4) tration is found in the washing machine business choice of distribution channels. before the war, where with little basic patent protec- tion the Maytag position was quickly eroded by small Estimate of Demand manufacturers who performed essentially an assem- The problem at the pioneer stage differs from that in bly operation. The ball-point pen cascaded from a $12 a relatively stable monopoly because the product is

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beyond the experience of buyers and because the “practical” range of prices. Manufacturers of electri- perishability of its distinctiveness must be reckoned cal equipment often explore the economic as well as with. How can demand for new products be explored? the technical feasibility of a new product by sending How can we find out how much people will pay for a engineers with blueprints and models to see custom- product that has never before been seen or used? ers, such as technical and operating executives. There are several levels of refinement to this analysis. In guessing the price range of a radically new con- The initial problem of estimating demand for a new sumers’ product of small unit value, the concept of product can be broken into a series of subproblems: barter equivalent can be a useful research guide. (1) whether the product will go at all (assuming price For example, a manufacturer of paper specialties is in a competitive range), (2) what range of price will tested a dramatic new product in the following fash- make the product economically attractive to buyers, ion: A wide variety of consumer products totally (3) what sales volumes can be expected at various unlike the new product were purchased and spread points in this price range, and (4) what reaction will out on a big table. Consumers selected the products price produce in manufacturers and sellers of dis- they would swap for the new product. By finding out placed substitutes. whether the product would trade evenly for a dish The first step is an exploration of the preferences pan, a towel, or a hairpin, the executives got a rough and educability of consumers, always, of course, in idea of what range of prices might strike the typical the light of the technical feasibility of the new prod- consumer as reasonable in the light of the values uct. How many potential buyers are there? Is the received for his or her money in totally different kinds product a practical device for meeting their needs? of expenditures. How can it be improved to meet their needs better? But asking prospective consumers how much they What proportion of the potential buyers would prefer, think they would be willing to pay for a new product, or could be induced to prefer, this product to already even by such indirect or disguised methods, may existing products (prices being equal)? often fail to give a reliable indication of the demand Sometimes it is feasible to start with the assump- schedule. Most times people just do not know what tion that all vulnerable substitutes will be fully dis- they would pay. It depends partly on their income and placed. For example, to get some idea of the maxi- on future alternatives. Early in the postwar period a mum limits of demand for a new type of reflecting-sign manufacturer of television sets tried this method and material, a company started with estimates of the got highly erratic and obviously unreliable results aggregate number and area of auto license plates, because the distortion of war shortages kept pros- highway markers, railroad operational signs, and name pects from fully visualizing the multiple ways of signs for streets and homes. Next, the proportion of spending their money. each category needing night-light reflection was Another deficiency, which may, however, be less guessed. For example, it was assumed that only rural serious than it appears, is that responses are biased by and suburban homes could benefit by this kind of the consumer’s confused notion that he or she is name sign, and the estimate of need in this category bargaining for a good price. Not until techniques of was made accordingly. depth interviewing are more refined than they are It is not uncommon and possibly not unrealistic for now can this crude and direct method of exploring a a manufacturer to make the blithe assumption at this new product’s demand schedule hold much promise stage that the product price will be “within a com- of being accurate. petitive range” without having much idea of what One appliance manufacturer tried out new prod- that range is. For example, in developing a new type ucts on a sample of employees by selling to them at of camera equipment, one of the electrical companies deep discounts, with the stipulation that they could judged its acceptability to professional photographers if they wished return the products at the end of the by technical performance without making any in- experiment period and get a refund of their low pur- quiry into its economic value. When the equipment chase price. Demand for foreign orange juice was was later placed in an economic setting, the indica- tested by placing it in several markets at three differ- tions were that sales would be negligible. ent prices, ranging around the price of fresh fruit; the The second step is marking out this competitive result showed rather low price elasticity. range of price. Vicarious pricing experience can be While inquiries of this sort are often much too secured by interviewing selected distributors who short-run to give any real indication of consumer have enough comparative knowledge of customers’ tastes, the relevant point here is that even such rough alternatives and preferences to judge what price range probing often yields broad impressions of price elas- would make the new product “a good value.” Direct ticity, particularly in relation to product variations discussions with representative experienced indus- such as styling, placing of controls, and use of auto- trial users have produced reliable estimates of the matic features. It may show, for example, that $5 of

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cost put into streamlining or chromium stripping can some basic strategic decisions on market targets and add $50 to the price. promotional plans. To decide on market objectives The third step, a more definite inquiry into the requires answers to several questions: What ultimate probable sales from several possible prices, starts market share is wanted for the new product? How with an investigation of the prices of substitutes. does it fit into the present product line? What about Usually the buyer has a choice of existing ways of production methods? What are the possible distribu- having the same service performed; an analysis of the tion channels? costs of these choices serves as a guide in setting the These are questions of joint costs in production and price for a new way. distribution, of plant expansion outlays, and of poten- Comparisons are easy and significant for industrial tial competition. If entry is easy, the company may customers who have a costing system to tell them the not be eager to disrupt its present production and exact value, say, of a forklift truck in terms of ware- selling operations to capture and hold a large slice of house labor saved. Indeed, chemical companies set- the new market. But if the prospective profits shape ting up a research project to displace an existing up to a substantial new income source, it will be material often know from the start the top price that worthwhile to make the capital expenditures on can be charged for the new substitute in terms of cost plant needed to reap the full harvest. of the present material. A basic factor in answering all these questions is But in most cases the comparison is obfuscated by the expected behavior of production and distribution the presence of quality differences that may be im- costs. The relevant data here are all the production portant bases for price premiums. This is most true outlays that will be made after the decision day—the of household appliances, where the alternative is an capital expenditures as well as the variable costs. A unknown amount of labor of a mysterious value. In go-ahead decision will hardly be made without some pricing a cargo parachute the choices are: (1) free fall assurance that these costs can be recovered before the in a padded box from a plane flown close to the product becomes a football in the market. Many ground, (2) landing the plane, (3) back shipment by different projections of costs will be made, depending land from the next air terminal, or (4) land shipment on the alternative scales of output, rate of market all the way. These options differ widely in their serv- expansion, threats of potential competition, and ice value and are not very useful pricing guides. measures to meet that competition that are under Thus it is particularly hard to know how much consideration. But these factors and the decision that good will be done by making the new product cheaper is made on promotional strategy are interdependent. than the old by various amounts, or how much the The fact is that this is a circular problem that in market will be restricted by making the new product theory can only be solved by simultaneous equations. more expensive. The answers usually come from Fortunately, it is possible to make some approxi- experiment or research. mations that can break the circle: scale economies The fourth step in estimating demand is to consider become significantly different only with broad changes the possibility of retaliation by manufacturers of in the size of plant and the type of production meth- displaced substitutes in the form of price cutting. ods. This narrows the range of cost projections to This development may not occur at all if the new workable proportions. The effects of using different product displaces only a small market segment. If old distribution channels can be guessed fairly well with- industries do fight it out, however, their incremental out meshing the choices in with all the production costs provide a floor to the resulting price competi- and selling possibilities. The most vulnerable point tion and should be brought into price plans. of the circle is probably the decision on promotional For example, a manufacturer of black-and-white strategy. The choices here are broad and produce a sensitized paper studied the possibility that lowering variety of results. The next step in the pricing process its price would displace blueprint paper substantially. is therefore a plan for promotion. Not only did the manufacturer investigate the prices of blueprint paper, but it also felt it necessary to estimate the out-of-pocket cost of making blueprint Design of Promotional Strategy paper because of the probability that manufacturers Initial promotion outlays are an investment in the already in the market would fight back by reducing product that cannot be recovered until some kind of prices toward the level of their incremental costs. market has been established. The innovator shoul- ders the burden of creating a market—educating con- Decision on Market Targets sumers to the existence and uses of the product. Later When the company has developed some idea of the imitators will never have to do this job; so if the range of demand and the range of prices that are innovator does not want to be simply a benefactor to feasible for the new product, it is in a position to make future competitors, he or she must make pricing

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plans to recover initial outlays before his or her pric- POLICIES FOR PIONEER PRICING ing discretion evaporates. The innovator’s basic strategic problem is to find The strategic decision in pricing a new product is the the right mixture of price and promotion to maximize choice between (1) a policy of high initial prices that long-run profits. He or she can choose a relatively skim the cream of demand and (2) a policy of low high price in pioneering stages, together with extrava- prices from the outset serving as an active agent for gant advertising and dealer discounts, and plan to market penetration. Although the actual range of recover promotion costs early; or he or she can use choice is much wider than this, a sharp dichotomy low prices and lean margins from the very outset in clarifies the issues for consideration. order to discourage potential competition when the barriers of patents, distribution channels, or produc- Skimming Price tion techniques become inadequate. This question is For products that represent a drastic departure from discussed further later on. accepted ways of performing a service, a policy of Choice of Distribution Channels relatively high prices coupled with heavy promotional expenditures in the early stages of market Estimation of the costs of moving the new product development (and lower prices at later stages) has through the channels of distribution to the final con- proved successful for many products. There are sev- sumer must enter into the pricing procedure, since eral reasons for the success of this policy: these costs govern the factory price that will result in a specified consumer price and since it is the con- 1. Demand is likely to be more inelastic with sumer price that matters for volume. Distributive respect to price in the early stages than it is margins are partly pure promotional costs and partly when the product is full grown. This is particu- physical distribution costs. Margins must at least larly true for consumers’ goods. A novel product, cover the distributors’ costs of warehousing, han- such as the electric blanket when it first came dling, and order taking. These costs are similar to out, was not accepted early on as a part of the factory production costs in being related to physical expenditure pattern. Consumers remained ig- capacity and its utilization, i.e., fluctuations in pro- norant about its value compared with the value duction or sales volume. of conventional alternatives. Moreover, at least Hence these set a floor to trade-channel discounts. in the early stages, the product had so few But distributors usually also contribute promotional close rivals that cross-elasticity of demand was effort—in point-of-sale pushing, local advertising, low. and display—when it is made worth their while. Promotional elasticity is, on the other hand, These pure promotional costs are more optional. quite high, particu-larly for products with high Unlike physical handling costs they have no neces- unit prices such as television sets. Since it is sary functional relation to sales volume. An added difficult for customers to value the service of layer of margin in trade discounts to produce this the product in a way to price it intelligently, localized sales effort (with retail price fixed) is an they are by default principally inter-ested in optional way for manufacturers to spend their pros- how well it will work. pecting money in putting over a new product. 2. Launching a new product with a high price is an In establishing promotional costs, manufacturers efficient device for breaking the market up into must decide on the extent to which the selling effort segments that differ in price elasticity of de- will be delegated to members of the distribution mand. The initial high price serves to skim the chain. Indeed, some distribution channels, such as cream of the market that is relatively insensi- house-to-house selling and retail store selling supple- tive to price. Subsequent price reductions tap mented by home demonstrators, represent a substan- successively more elastic sectors of the market. tial delegation of the manufacturers’ promotional This pricing strategy is exemplified by the sys- efforts, and these usually involve much higher distri- tematic succession of editions of a book, start- bution-channel costs than do conventional methods. ing with a very expensive limited personal edi- Rich distributor margins are an appropriate use of tion and ending up with a much lower-priced promotion funds only when the producer thinks a paperback. high price plus promotion is a better expansion policy 3. This policy is safer, or at least appears so. Facing in the specialty than low price by itself. Thus there an unknown elasticity of demand, a high initial is an intimate interaction between the pricing of a price serves as a “refusal” price during the stage new product and the costs and the problems of float- of exploration. It is difficult to predict how ing it down the distribution channels to the final much costs can be reduced as the market ex- consumer. pands and as the design of the product is im-

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proved by increasing production efficiency with considerations and differences in equipment and new techniques. When an electrical company service cloud the picture, it is pretty clear that the introduced a new lamp bulb at a comparatively bargain-rate coach fares of scheduled airlines were high initial price, it made the announcement adopted in reaction to the cut rates of nonscheduled that the price would be reduced as the company airlines. This competitive response has apparently found ways of cutting its costs. established a new pattern of traffic growth for the 4. Many companies are not in a position to finance scheduled airlines. the product flotation out of distant future reve- An example of penetration pricing at the initial nues. High cash outlays in the early stages result stage of the product’s market life—again from the from heavy costs of production and distributor book field—occurred when Simon & Schuster organizing, in addition to the promotional in- adopted the policy of bringing out new titles in a vestment in the pioneer product. High prices are low-priced, paper-bound edition simultaneously a reasonable financing technique for shoulder- with the conventional higher-priced, cloth-bound ing these burdens in the light of the many un- edition. certainties about the future. What conditions warrant aggressive pricing for market penetration? This question cannot be an- Penetration Price swered categorically, but it may be helpful to gener- The alternative policy is to use low prices as the alize that the following conditions indicate the desir- principal instrument for penetrating mass markets ability of an early low-price policy: early. This policy is the reverse of the skimming A high price-elasticity of demand in the short policy in which the price is lowered only as short-run . run, i.e., a high degree of responsiveness of sales competition forces it. to reductions in price. The passive skimming policy has the virtue of Substantial savings in production costs as the safeguarding some profits at every stage of market . result of greater volume—not a necessary condi- penetration. But it prevents quick sales to the many tion, however, since if elasticity of demand is buyers who are at the lower end of the income scale high enough, pricing for market expansion may or the lower end of the preference scale and who be profitable without realizing production therefore are unwilling to pay any substantial pre- economies. mium for product or reputation superiority. The ac- Product characteristics such that it will not tive approach in probing possibilities for market ex- . seem bizarre when it is first fitted into the con- pansion by early penetration pricing requires sumers’ expenditure pattern. research, forecasting, and courage. A strong threat of potential competition. A decision to price for market expansion can be . reached at various stages in a product’s life cycle: This threat of potential competition is a highly per- before birth, at birth, in childhood, in adulthood, or suasive reason for penetration pricing. One of the in senescence. The chances for large-volume sales major objectives of most low-pricing policies in the should at least be explored in the early stages of pioneering stages of market development is to raise product development research, even before the pilot entry barriers to prospective competitors. This is stage, perhaps with a more definitive exploration appropriate when entrants must make large-scale when the product goes into production and the price investments to reach minimum costs and they can- and distribution plans are decided upon. And the not slip into an established market by selling at question of pricing to expand the market, if not an- substantial discounts. swered earlier, will probably arise once more after the In many industries, however, the important poten- product has established an elite market. tial competitor is a large, multiple-product firm op- Quite a few products have been rescued from pre- erating as well in other fields than that represented mature senescence by being priced low enough to tap by the product in question. For a firm, the most new markets. The reissues of important books as important consideration for entry is not existing mar- lower-priced paperbacks illustrate this point particu- gins but the prospect of large and growing volume of larly well. These have produced not only commercial sales. Present margins over costs are not the domi- but intellectual renascence as well to many authors. nant consideration because such firms are normally The patterns of sales growth of a product that had confident that they can get their costs down as low reached stability in a high-price market have under- as competitors’ costs if the volume of production is gone sharp changes when it was suddenly priced low large. enough to tap new markets. Therefore, when total industry sales are not ex- A contrasting illustration of passive policy is the pected to amount to much, a high-margin policy can pricing experience of the airlines. Although safety be followed because entry is improbable in view of

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the expectation of low volume and because it does tion were explored. Calculating in terms of antici- not matter too much to potential competitors if the pated dollars of profit rather than in terms of percent- new product is introduced. age margin, the company reduced the price of asbes- The fact remains that for products whose market tos shingles and brought the annual cost down close potential appears big, a policy of stayout pricing from to the cost of the cheapest asphalt roof. This reduc- the outset makes much more sense. When a leading tion produced a greatly expanded volume and secured soap manufacturer developed an additive that whit- a substantial share of the mass market. ened clothes and enhanced the brilliance of colors, the company chose to take its gains in a larger share of the market rather than in a temporary price pre- PRICING IN MATURITY mium. Such a decision was sound, since the company’s competitors could be expected to match or To determine what pricing policies are appropriate for better the product improvement fairly promptly. Un- later stages in the cycle of market and competitive der these circumstances, the price premium would maturity, the manufacturer must be able to tell when have been short-lived, whereas the gains in market a product is approaching maturity. Some of the symp- share were more likely to be retained. toms of degeneration of competitive status toward Of course, any decision to start out with lower the commodity level are: prices must take into account the fact that if the new Weakening in brand preference. This may be product calls for capital recovery over a long period, . evidenced by a higher cross-elasticity of demand the risk may be great that later entrants will be able among leading products, the leading brand not to exploit new production techniques which can un- being able to continue demanding as much price dercut the pioneer’s original cost structure. In such premium as initially without losing position. cases, the low-price pattern should be adopted with a Narrowing physical variation among products view to long-run rather than to short-run profits, with . as the best designs are developed and stand- recognition that it usually takes time to attain the ardized. This has been dramatically demon- volume potentialities of the market. strated in automobiles and is still in process in It is sound to calculate profits in dollar terms rather television receivers. than in percentage margins, and to think in terms of The entry in force of private-label competitors. percentage return on the investment required to pro- . This is exemplified by the mail-order houses’ duce and sell the expanded volume rather than in sale of own-label refrigerators and paint spray- terms of percentage markup. Profit calculation ers. should also recognize the contributions that market- Market saturation. The ratio of replacement development pricing can make to the sale of other . sales to new equipment sales serves as an indi- products and to the long-run future of the company. cator of the competitive degeneration of durable Often a decision to use development pricing will turn goods, but in general it must be kept in mind that on these considerations of long-term impacts upon both market size and degree of saturation are the firm’s total operation strategy rather than on the hard to define (e.g., saturation of the radio mar- profits directly attributable to the individual product. ket, which was initially thought to be one radio An example of market-expansion pricing is found per home and later had to be expanded to one in the experience of a producer of asbestos shingles, radio per room). which had a limited sale in the high-price house The stabilization of production methods. A dra- market. The company wanted to broaden the market . matic innovation that slashes costs (e.g., prefab- in order to compete effectively with other roofing ricated houses) may disrupt what appears to be products for the inexpensive home. It tried to find the a well-stabilized oligopoly market. price of asphalt shingles that would make the annual cost per unit of roof over a period of years as low as The first step for the manufacturer whose specialty the cheaper roofing that was currently commanding is about to slip into the commodity category is to the mass market. Indications were that the price reduce real prices promptly as soon as symptoms of would have to be at least this low before volume sales deterioration appear. This step is essential if the would come. manufacturer is to forestall the entry of private-label Next, the company explored the relationship be- competitors. Examples of failure to make such a tween production costs and volume, far beyond the reduction are abundant. range of its own volume experience. Variable costs By and large, private-label competition has speeded and overhead costs were estimated separately, and up the inevitable evolution of high specialities into the possibilities of a different organization of produc- commodities and has tended to force margins down

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by making price reductions more open and more demand will warrant further exploration. The second universal than they would otherwise be. From one step is to mark out a range of prices that will make standpoint, the rapid growth of the private-label share the product economically attractive to buyers. The in the market is a symptom of unwise pricing on the third step is to estimate the probable sales that will part of the national-brand sector of the industry. result from alternative prices. This does not mean that manufacturers should If these initial explorations are encouraging, the declare open price war in the industry. When they next move is to make decisions on promotional strat- move into mature competitive stages they enter oli- egy and distribution channels. The policy of rela- gopoly relationships where price slashing is pecu- tively high prices in the pioneering stage has much liarly dangerous and unpopular. But, with active com- to commend it, particularly when sales seem to be petition in prices precluded, competitive efforts may comparatively unresponsive to price but quite re- move in other directions, particularly toward product sponsive to educational promotion. improvement and market segmentation. On the other hand, the policy of relatively low Product improvement at this stage, where most of prices in the pioneering stage, in anticipation of the the important developments have been put into all cost savings resulting from an expanding market, has brands, practically amounts to market segmentation. been strikingly successful under the right conditions. For it means adding refinements and quality extras Low prices look to long-run rather than short-run that put the brand in the elite category, with an appeal profits and discourage potential competitors. only to the top-income brackets. This is a common Pricing in the mature stages of a product’s life cycle tactic in food marketing, and in the tire industry it requires a technique for recognizing when a product was the response of the General Tire Company to the is approaching maturity. Pricing problems in this competitive conditions of the 1930s. stage border closely on those of oligopoly. As the product matures and as its distinctiveness narrows, a choice must sometimes be made by the company concerning the rung of the competitive RETROSPECTIVE COMMENTARY price ladder it should occupy—roughly, the choice between a low and a not-so-low relative price. Twenty-five years have brought important changes A price at the low end of the array of the industry’s and have taught us much, but the basics of pricing real prices is usually associated with a product mix- pioneer products are the same, only clearer. New ture showing a lean element of services and reputa- product pricing, if the product is truly novel, is in tion (the product being physically similar to competi- essence monopoly pricing— modified only because tive brands, however) and a company having a lower the monopoly power of the new product is (1) re- gross margin than the other industry members (al- stricted because buyers have alternatives, (2) ephem- though not necessarily a lower net margin). The eral because it is subject to inevitable erosion as choice of such a low-price policy may be dictated by competitors equal or better it, and (3) controllable technical or market inferiorities of the product, or it because actions of the seller can affect the amount may be adopted because the company has faith in the and the durability of the new product’s market power. long-run price elasticity of demand and the ability of In pricing, the buyers’ viewpoint should be control- low prices to penetrate an important segment of the ling. For example, buyer’s-rate-of-return pricing of market not tapped by higher prices. The classic ex- new capital equipment looks at your price through ample is Henry Ford’s pricing decision in the 1920s. the eyes of the customer. It recognizes that the upper limit is the price that will produce the minimum acceptable rate of return on the investment of a IN SUMMARY sufficiently large number of prospects. This return has a broad range for two reasons. First, the added In pricing products of perishable distinctiveness, a profits obtainable from the use of your equipment company must study the cycle of competitive degen- will differ among customers and among applications eration in order to determine its major causes, its for the same customer. Second, prospective custom- probable speed, and the chances of slowing it down. ers also differ in the minimum rate of return that will Pricing in the pioneering stage of the cycle involves induce them to invest in your product. difficult problems of projecting potential demand and This capital-budgeting approach opens a new kind of guessing the relation of price to sales. of demand analysis, which involves inquiry into: (1) The first step in this process is to explore consumer the costs of buyers from displaceable alternative preferences and to establish the feasibility of the ways of doing the job, (2) the cost-saving and profit- product, in order to get a rough idea of whether producing capability of your equipment, and (3) the

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capital management policies of your customers, par- the whole life cycle of the new product. Its profitabil- ticularly their cost of capital and cutoff criteria. ity and investment return are meaningless for any shorter period. Role of Cost A second decision is “birth control.” The commer- Cost should play a role in new product pricing quite cialization decision calls for a similar concept of cost different from that in traditional cost-plus pricing. To and discounted cash-flow investment analysis, but use cost wisely requires answers to some questions one that is confined to incremental investment be- of theory: Whose cost? Which cost? What role? yond product birth. As to whose cost, three persons are important: Another role of cost is to establish a price floor that prospective buyers, existent and potential competi- is also the threshold for selecting from candidate tors, and the producer of the new product. For each of prices those that will maximize return on a new the three, cost should play a different role, and the product investment at different stages of its life. The concept of cost should differ accordingly. relevant concept here is future short-run incremental The role of prospective buyers’ costs is to forecast cost. their response to alternative prices by determining what your product will do to the costs of your buyers. Segmentation Pricing Rate-of-return pricing of capital goods illustrates this Particularly for new products, an important tactic is buyer’s-cost approach, which is applicable in princi- differential pricing for separated market segments. To ple to all new products. enhance profits, we split the market into sectors that Cost is usually the crucial estimate in appraising differ in price sensitivity, charging higher prices to competitors’ capabilities. Two kinds of competitor those who are impervious and lower prices to the costs need to be forecasted. The first is for products more sensitive souls. already in the marketplace. One purpose is to predict One requisite is the ability to identify and seal off staying power; for this the cost concept is competi- groups of prospects who differ in sensitivity of sales tors’ long-run incremental cost. Another purpose to price or differ in the effectiveness of competition may be to guess the floor of retaliation pricing; for this (cross-elasticity of demand). Another is that leakage we need competitors’ short-run incremental cost. from the low price segment must be small and costs The second kind is the cost of a competitive prod- of segregation low enough to make it worthwhile. uct that is unborn but that could eventually displace One device is time segmentation: a skimming price yours. Time-spotted prediction of the performance strategy at the outset followed by penetration pricing characteristics, the costs, and the probable prices of as the product matures. Another device is price- future new products is both essential and possible. shaped modification of a basic product to enhance Such a prediction is essential because it determines traits for which one group of customers will pay the economic life expectancy of your product and the dearly (e.g., reliability for the military). shape of its competitiveness cycle. A similar device is product-configuration differen- This prediction is possible, first, because the pace tials (notably extras: the roof of the Stanley Steamer of technical advance in product design is persistent was an extra when it was a new product). Another is and can usually be determined by statistical study of afterlife pricing (e.g., repair parts, expendable compo- past progress. It is possible, second, because the rate nents, and auxiliary services). Also, trade channel at which competitors’ cost will slide down the cost discounts commonly achieve profitable price dis- compression curve that results from cost-saving in- crimination (as with original equipment discounts). vestments in manufacturing equipment, methods, and worker learning is usually a logarithmic function Cost Compression Curve of cumulative output. Thus this rate can be ascer- Cost forecasting for pricing new products should be tained and projected. based on the cost compression curve, which relates The producer’s cost should play several different real manufacturing cost per unit of value added to the roles in pricing a new product, depending on the cumulative quantity produced. This cost function decision involved. The first decision concerns capital (sometimes labeled “learning curve” or “experience control. A new product must be priced before any curve”) is mainly the consequence of cost cutting significant investment is made in research and must investments (largely intangible) to discover and achieve be periodically repriced when more money is in- internal substitutions, automation, worker learning, vested as its development progresses toward market. scale economies, and technological advances. Usu- The concept of cost that is relevant for this decision ally these move together as a logarithmic function of is the predicted full cost, which should include im- accumulated output. puted cost of capital on intangible investment over Cost compression curve pricing of technically ad-

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vanced products (for example, a microprocessor) should be to maximize the present worth, dis- epitomizes penetration pricing. It condenses the time counted at the corporation’s cost of capital, of span of the process of cutting prices ahead of fore- the future stream of real (purchasing-power) casted cost savings in order to beat competitors to the dividends, including a terminal dividend or bigger market and the resulting manufacturing econo- capital gain. The Wall Street traditional objec- mies that are opened up because of creative pricing. tive— maximizing the size or the growth of This cost compression curve pricing strategy, which book earnings per share—is an inferior master took two decades for the Model T’s life span, is con- goal that is made obsolete by inflation. densed into a few months for the integrated circuit. 2. The unit for making decisions and for measuring But though the speed and the sources of saving are return on investment is the entire economic different, the principle is the same: a steep cost com- life of the new product. Reported annual prof- pression curve suggests penetration pricing of a new its on a new product have little economic product. Such pricing is most attractive when the significance. The pricing implications of product superiority over rivals is small and ephem- the new product’s changing competitive eral and when entry and expansion by competitors is status as it passes through its life cycle from easy and probable. birth to obsolescence are intricate but compelling. Impacts of Inflation 3. Pricing of a new product should begin long before Continuous high-speed inflation has important im- its birth, and repricing should continue over its pacts on new product pricing. It changes the goal. It life cycle. Prospective prices coupled with fore- renders obsolete accounted earnings per share as the casted costs should control the decision to in- corporation’s overriding goal—replacing it with maxi- vest in its development, the determination to mization of the present worth (discounted at the launch it commercially, and the decision to kill corporation’s cost of capital) of the future stream of it. real purchasing power dividends (including a termi- 4. A new product should be viewed through the nal dividend or capital gain). Real earnings in terms eyes of the buyer. Rate of return on customers’ of cash-flow buying power alone determine the power investment should be the main consideration in to pay real dividends. pricing a pioneering capital good: the buyers’ Inflation raises the buyers’ benchmark costs of the savings (and added earnings), expressed as re- new products’ competitive alternatives. Thus it lifts turn on their investment in the new product, the buyer benefits obtainable from the new products’ are the key to both estimating price sensitivity protected distinctiveness (for example, it saves more of demand and pricing profitably. wage dollars). 5. Costs can supply useful guidance in new product It raises the seller’s required return on the invest- pricing, but not by the conventional wisdom of ment to create and to launch the new product. Why? cost-plus pricing. Costs of three persons are Because the cost of equity capital and of debt capital pertinent: the buyer, the competitor, and the will be made higher to compensate for anticipated producer. The role of cost differs among the inflation. For the same reason, inflation raises the three, as does the concept of cost that is perti- customer’s cutoff point of minimum acceptable re- nent to that role: different costs for different turn. It also intensifies the rivalry for scarce invest- decisions. ment dollars among the seller’s new product candi- 6. A strategy of price skimming can be distin- dates. Hence it probably tends to increase stillbirths, guished from a strategy of penetration pricing. but may lower subsequent infant mortality. For these Skimming is appropriate at the outset for some reasons, perennial inflation will make an economic pioneering products, particularly when followed attack on the problem of pricing new products even by penetration pricing (for example, the price more compelling. cascade of a new book). In contrast, a policy of Pricing of new products remains an art. But the penetration pricing from the outset, in anticipa- experienced judgment required to price and reprice tion of the cost compression curve for manufac- the product over its life cycle to fit its changing turing costs, is usually best when this curve competitive environment may be improved by con- falls steeply and projectably, and is buttressed sidering seven pricing precepts suggested by this by economies of scale and of advancing technol- analysis. ogy, and when demand is price sensitive and invasion is threatened. 1. Pricing a new product is an occasion for rethink- 7. Penetration and skimming pricing can be used at ing the overriding corporate goal. This goal the same time in different sectors of the market.

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Creating opportunities to split the market into low to elastic sectors, can produce extra profits segments that differ in price sensitivity and in and faster cost-compression for a new product. competitiveness, so as to simultaneously charge Devices are legion. higher prices in insensitive segments and price

12 HARVARD BUSINESS REVIEW November–December 1976