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Pricing is more than a numbers game: Pricing models shape businesses and markets, and have ripple effects across societies. Boston Consulting Group partners Jean-Manuel Izaret and Arnab Sinha make the case for approaching pricing strategically, looking beyond value extraction and zero-sum assumptions. Viewing pricing as an opportunity to share value with customers, the authors describe seven pricing models – or “games” – defining how that value gets shared and, in turn, how companies acquire and retain customers. The book includes interesting accounts of how major players like Tesla and Amazon have shaped their industries by adopting innovative pricing models
- By adopting a strategic approach to pricing, business leaders can drive growth and performance.
- In the Value Game, businesses deliver unique products or services whose prices reflect the value to the customer.
- In the Uniform Game, companies set a single, optimal price for all buyers.
- The Cost Game occurs in commoditized markets, where efficiency determines pricing.
- Companies play the Power Game in concentrated markets where buyers and sellers negotiate high-stakes deals.
- In the Custom Game, a few sellers compete for the business of heterogeneous buyers by offering customized solutions and discounts.
- Companies playing the Choice Game seek to shape buyers’ behavior by segmenting their offers.
- In the Dynamic Game, sellers adjust prices in real-time to reflect supply and demand.
- Innovative pricing models could help solve important societal challenges, such as access to life-saving medications.
By adopting a strategic approach to pricing, business leaders can drive growth and performance.
Many people view pricing as a dry, mathematical exercise in which a company seeks simply to extract the maximum value from transactions. The underlying assumptions of this view include that business transactions are zero-sum – that is, what one party gains, the other loses – and that drivers such as demand, willingness to pay and competition represent givens that don’t change. But this view of pricing has serious flaws. It doesn’t recognize the reality that the inputs to price move dynamically, and that sellers can approach pricing as an opportunity to collaborate with buyers, share value and foster loyalty.
Sellers that take a different approach to pricing can escape the constraints of zero-sum and transform their businesses and entire markets. For example, in the early 1900s Henry Ford reshaped the automobile industry – and dominated global production – by dispensing with the practice of charging what the market would bear and instead innovating ways to reduce prices.
“Pricing strategies express intention and offer guidance and direction. They are subjective and require astute judgment.”
The three classic pricing methods – based on cost, the competition or value – force businesses into a straitjacket that rarely fits well. Businesses differ, and costs, competitors and value vary over time and across location, occasion, and other drivers. Instead of leaping directly from these inputs to price, decision-makers need to step back and consider pricing strategically. Leaders can define a strategy that’s right for the business by considering three factors:
- How the business creates value and shares value with customers.
- Which of seven “games” – approaches to pricing decisions – best aligns with the business’s market, competitive advantages, and other considerations.
- Which pricing model fits the business’s strategy for value creation.
Markets are constantly changing, and companies need to monitor their business environment so they can remain aware of the game being played. But companies don’t always have to accept the pricing game of their industries – many have benefited, and even transformed their markets, by changing their game unilaterally.
In the Value Game, businesses deliver unique products or services whose prices reflect the value to the customer.
Apple exemplifies a company playing and winning the Value Game. In the Value Game, a seller offers a product or service that offers far greater value than other options, serving a large, fragmented customer base. Apple gained market leadership for MP3 players and smartphones by introducing products competitors couldn’t touch, in terms of both functional and emotional value: the iPod in 2001 and the iPhone in 2007. The fragmentation of its customer base meant Apple could set prices almost unilaterally.
“Companies succeed when they express their differentiation convincingly and match it with a pricing model that reinforces the value.”
By creating products that deliver high levels of customer value, companies can share value with buyers and thereby gain a strong market position. But to maintain that position amid emerging competition, companies must constantly invest to deliver greater value. Companies can gain significant advantages from sharing value with customers, including customer retention, high sales volumes and rapid market penetration. However, some companies choose to share lower levels of value with buyers. Luxury goods manufacturers, for example, prefer the high unit profit margins they enjoy by charging premium prices.
In the Uniform Game, companies set a single, optimal price for all buyers.
Where markets feature a massive number of buyers, all with similar needs, as well as a large quantity of sellers making comparable offers, the sellers make pricing decisions by employing the elasticity framework. Elasticity refers to customers’ sensitivity to price changes: High elasticity means a change in price will cause many buyers to purchase more or less, depending on the direction of the price change. Hence, in the Uniform Game, sellers seek to maximize profits by observing buyers’ responses to changes in price and then calculating the optimal price point. Prices are transparent, and all customers pay the same price.
“The Uniform Game…sits at the intersection of value and cost, thus requiring balanced consideration of both inputs.”
To determine prices, sellers use analytical tools such as the profit function, a curve that reflects the elasticity and costs associated with a product. The seller finds the optimal price within a narrow range of competitive prices. However, sellers have a degree of agency in that they can influence buyers’ price sensitivity and thereby their elasticity. Companies use promotions, coupons, and other transaction incentives to modify elasticities and boost demand and volume. Sellers need to develop a detailed understanding of their customers’ sensitivity to price and the effects of factors such as available substitutes, household budgets and product differentiation.
The Cost Game occurs in commoditized markets, where efficiency determines pricing.
In markets where buyers can select among many substitutes and have bargaining power, sellers compete mainly on price – they play the Cost Game. Construction companies, for example, win contracts by offering low bids. Typically, Cost Game markets tend to be crowded, featuring a fragmented group of sellers, where no one seller clearly leads, and a group of large buyers who have individual needs. Offers tend to have a high variable-cost component.
“Low-margin businesses need to track even the smallest and irregular cost areas, because in aggregate they can have a material effect on profits.”
To win the Cost Game, leaders need to achieve a tight alignment of prices with costs. This will drive efficiency, lead to differentiation, allow the company to share value with customers and build trust. Playing the Cost Game well can result in cost advantages, higher market share and higher profits. To do so, sellers need to identify and estimate costs accurately. They also need to understand precisely how increases in sales volume will affect unit costs. With this information, a seller can optimize the use of its capacity and select a pricing formula that reflects its cost drivers. They can also partner with buyers to create efficiencies and reduce costs, to the benefit of both parties.
Companies play the Power Game in concentrated markets where buyers and sellers negotiate high-stakes deals.
The hard disk drive industry in the 1990s and 2000s exemplifies the Power Game: A small number of sellers and buyers make high-stakes deals – any one of which can make or break a supplier or upset the delicate balance of the market. In this kind of market, decision-makers turn to game theory to analyze the consequences of potential moves, and success depends on leaders’ ability to maintain market equilibrium. Limited differentiation among offers also characterizes a Power Game market, which often exists where products must meet stringent technical standards.
“Implementing a pricing strategy in this game requires a high level of organizational resolve and operational discipline.”
Because the products in Power Game markets often see explosive growth, prices frequently decline or even go into free fall. To protect revenues and to defend against lower-price competition, sellers need to find ways to take power and control their margins. They can do this by exploiting the asymmetries that can be found in any market. Sellers can always discover competitive advantages: ways to differentiate their products or businesses, such as through supply chain reliability or product features. In negotiations, sellers should avoid considering individual deals in isolation and instead set overall goals that guide decision-making. Companies can use a pricing grid to set target prices and avoid giving in to pressure to reduce price.
In the Custom Game, a few sellers compete for the business of heterogeneous buyers by offering customized solutions and discounts.
The heavy-duty commercial truck industry exemplifies the Custom Game. Here, just a handful of manufacturers sell to a large number of buyers, including individual owner-operators, logistics companies and retailers such as FedEx. In a Custom Game market, sellers offer a wide variety of products, and buyers purchase in a wide variety of volumes. Transactions also vary widely, due to numerous available product options and adjustable terms and conditions. Buyers have difficulty comparing solutions from different sellers. Sellers and buyers arrive at prices through negotiation, and sellers offer discounts as their primary means for price differentiation. The result is a chaotic landscape where price has a complex relationship with sales volume and revenue.
“In the Custom Game, it is critical to control the high level of discretionary discounting very tightly to provide both customers and the sales force with a sense of fairness for the pricing process.”
Companies playing the Custom Game often resort to offering transaction incentives, but this tactic exacerbates the chaos resulting from discretionary discounting used as a panacea. Instead, companies need to see they have alternatives, such as fees and functional discounts – for example, the raw material surcharges used in the heavy-duty truck industry – or the use of option pricing to account for variations in products. A simple analysis tool called the natural volume slope (NVS) can help sellers understand their negotiation power within the Custom Game, as well as in the Choice Game and the Power Game.
Companies playing the Choice Game seek to shape buyers’ behavior by segmenting their offers.
Starbucks grew to become a $32 billion business – and the world’s largest coffee seller – by winning at the Choice Game. In Choice Game markets, a concentrated group of sellers provides their customers – who are fragmented and have diverse needs – a broad lineup of offers. These offers have been carefully designed to meet the value perceptions of certain customer segments or clusters, and the lineup’s structure guides and influences buyers’ choices. Choice Game markets tend to feature products that have low marginal costs – such as coffee.
“Success in the Choice Game depends on a company’s ability to create packages and prices that align to the needs and preferences of customer segments.”
Typically, sellers put forward either a good-better-best lineup, where each successive package comes with higher value and a correspondingly higher price, or a selection of package sizes. Often, some degree of customization is available. Sellers then apply techniques from behavioral science to nudge customers toward certain price and value points. These techniques include the compromise effect, where the offer of a high-end offering makes a less expensive product appear more desirable; the decoy effect, where an inferior offering propels buyers toward a target option; and anchoring mechanisms, where sellers carefully present a selected price first so buyers will adopt it as a reference point.
In the Dynamic Game, sellers adjust prices in real-time to reflect supply and demand.
Airlines started using algorithms to set ticket prices in real-time based on demand and other factors in the late 1970s. Today, artificial intelligence has increased the power of these algorithms to the point that sellers can choose to optimize volumes, revenues, profits or some mix of the three. This is the Dynamic Game, where sellers set prices on the fly, based on real-time data. And any company can play it, if it has access to the requisite data and science. In 2007, the San Francisco Giants baseball team turned to a dynamic ticketing system that adjusted seat prices according to demand. By 2010 the franchise saw ticket revenue grow 7% and was consistently selling out.
“The Dynamic Game is especially well suited to situations when short-term capacity is fixed and offers are perishable.”
Companies playing other games, such as the Cost Game or the Custom Game, can use dynamic pricing to improve margins, for example. But the Dynamic Game involves more than just dynamic pricing: Companies playing the Dynamic Game can transform the market itself. As a result, customers will see changes in their access and options, and the market’s efficiency will improve. Sellers will find themselves obliged to increase their sophistication constantly to maintain a competitive advantage.
Innovative pricing models could help solve important societal challenges, such as access to life-saving medications.
Drugs that target chronic or life-threatening diseases pose a dilemma: They provide enormous value over time – they could even eradicate certain diseases – but their makers need to reap economic rewards in the short term. The pharmaceutical industry predominantly plays a form of the Uniform Game and charges patients on a per-treatment basis at the time of care. But moving to the Value Game would better align the interests of the drug makers, patients and payers.
“An up-front, per-patient pricing basis forces payers to choose between broadening access and incentivizing innovation.”
A pricing model called the payer licensing agreement (PLA) recognizes that the economics of curing a disease differ from those of merely managing a disease – beginning with the fact that disease management focuses on individual patients, and cures benefit entire populations. The PLA gives health care systems a license to provide universal access to a treatment for a number of years. The drug maker receives a fixed fee charged annually. This model makes life-saving drugs more affordable and creates incentives for health care systems to treat large numbers of people quickly. PLAs can keep total health care costs down while allowing pharmaceutical companies to reap the rewards they need. Similar innovations in pricing models could help societies promote sustainability, drive reductions in carbon emissions and help solve problems of social justice.
About the Authors
Jean-Manuel Izaret is a senior partner and global leader of the marketing, sales and pricing practice at the Boston Consulting Group (BCG). Previously, he led BCG’s pricing practice for more than a decade. Arnab Sinha is a senior partner and managing director at BCG, leading the pricing practice in the consumer space and in North America.