There are many different variations of pricing models and strategies that businesses can use to price their goods and services. We’ll list some of the main types of pricing models that companies use below along with the 9 laws of price sensitivity.
There are lots more variations of all of these pricing strategies and many businesses use hybrid pricing models. Reviewing these will better help you decide which ones are most suitable for your business.
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In addition to these pricing models, learn the essential sales and marketing terms you need to know.
The first of the pricing models to use is Cost-plus. Cost-plus pricing or mark-up pricing is quite a simple pricing strategy often used by retailers of physical products. A fixed percentage is added on top of the product cost and so it becomes ‘marked-up’. For example a product you wish to sell for $20 has a production cost of $10. By selling the $10 item at $20 you have marked-up the item by 100%.
Competition Based Pricing
Competition based pricing is focused on competitor’s pricing and the going rate of products. This strategy is commonly used in highly competitive markets to strategically price their products to remain competitive against similar businesses.
High-low pricing is used to sell an item that was initial priced high at a lower price in future. This is usually after a period of time when an item is no longer as valuable due to loss of relevance or popularity. A common example of this type of pricing is in Black Friday or Christmas sales used by retailers. Retailers offer major markdowns on old stock during sales events as it is a good way for them to clear old inventory. For example a clothing retailer may offer large discounts on last season’s fashion items.
Skimming pricing is sometimes also known as creaming. It is when an initially high priced item is reduced in price gradually over time. This pricing tactic is commonly used with newly launched technology and electronics products such as smartphones. It allows large profit margins to be gained from selling to early adopters. The price will then be lowered as the products popularity or relevance begins to wane and the products investment costs have been recouped.
Premium pricing is when the product price is kept high giving customers the perception of items being high quality and desirable. It is different from price skimming in that premium pricing remains constantly high priced to maintain excessively high profit margins.
Premium pricing is used extensively with luxury goods such as high end fashion, watches and jewelry. An example is Rolex watches – these are purchased more as status symbols to flaunt wealth rather than functional objects. The brand is perceived by customers to be high end and worth paying more for. It is not always the quality or function of the product but more about the brand being perceived by customers as quality, aspirational or exclusive.
Another of the pricing models businesses can use is value pricing. Value-based pricing is based on the value the product has to the customer rather than it’s costs of production. It is based more on the perceived benefits to the customer. If the product is perceived to offer benefits and meet a need then the customer is likely to pay more.
The bundle pricing model is when you offer customers multiple products together in one bundle. This is a great way to up-sell and cross-sell products and services. It is popular in industries such as telecoms and fast food restaurants. For example a telecoms company may offer separate packages for broadband and TV. But a customer can bundle them together with the perception of saving money whilst they spend more.
Dynamic pricing is a flexible strategy that is dependent on market pricing and consumer demand. With dynamic pricing you would constantly adapt your prices to reflect current market conditions such as competitor pricing and demand. Airline tickets and travel are good examples of dynamic pricing strategy.
Penetration pricing is a pricing strategy used with the aim of quickly gaining market share by attracting customers away from competitors. It is effected by setting a price below the usual market price in order to attract more customers. Once market share has been increased the price will then usually be increased. This isn’t a viable long-term strategy but can be effective if used in the short term especially for new businesses entering a highly competitive market.
Freemium pricing models combine elements of free and premium pricing. A basic, limited version of a product or service is offered for free to the customer. Premium features can then be accessed by upgrading to a premium plan. This type of strategy is very common with digital services such as software, apps and plugins.
Differential pricing is when prices are set differently for different types of customer. This is sometimes called discriminatory pricing as it can be affected by the customer’s demographic, country or other variable. For example some businesses may offer discounts to senior citizens, students or military veterans etc.
Hourly based pricing is usually offered by individuals and businesses that offer services. Examples of this are freelancers and consultants that offer their services to clients based on an hourly fee. You can find good examples of this on freelance service marketplaces such as Fiverr.
Project-based pricing is another commonly used pricing strategy used by freelancers, consultants and other service businesses as an alternative to hourly pricing. Instead customers pay an agreed cost for completion of an entire project rather than pay for each hour worked. This may be more attractive to customers with large projects as they know that if the project overruns the costs will not increase as they would with an hourly rate.
The final of the pricing models to use is known as psychological pricing. Psychological pricing is a strategy which entices customers to make a purchase using positive psychology.
The most common tactic is the ‘left digit effect’ sometimes known as the 9 digit effect. This is where a round number is rounded down by one fraction to reduce the left digit by one and end in a 9. E.g a product at $10.00 is sold at $9.99 instead. This tricks the brain into seeing the product as $9 rather than $10 and is a very effective pricing tactic.
The 9 Laws Of Price Sensitivity
What is price sensitivity? Thomas Nagle and Reed Holden outlined the ‘9 Laws of price sensitivity’ in their book The Strategy and Tactics of Pricing. These 9 laws are factors that influence how a consumer perceives a given price and how price-sensitive they are likely to be with respect to different purchase decisions. These should be taken into consideration along with the above pricing models.
The 9 laws are as follows;
1. Reference Price Effect
The buyer’s sensitivity to product price is increased when they can compare your pricing to your competitors. This is why you need to take your competitor’s pricing into consideration but also communicate to customers what differentiates your product from competitors.
2. Price-Quality Effect
Customers give less consideration to the price of a product if it is perceived to be higher quality. Price-quality effect can be seen in businesses that use a premium pricing strategy. The product in question may not be the best but if the customer perceives it to offer exclusivity or uniqueness then they are less sensitive to higher pricing.
3. Expenditure Effect
The expenditure effect takes into account the customer’s budget. Price sensitivity increases when the purchase represents a larger amount of the customer’s budget. Research what income range your target customer fits into, using insights gained from historical customers where applicable. This can help to price your product or service more accordingly.
4. Shared Cost Effect
The smaller the proportion an individual has to pay of the purchase price the less sensitive they will be to price. A good example of this effect is with bundle pricing where the individual elements appears as a smaller cost.
5. End-Benefit Effect
This effect refers to the overall benefit that is achieved from a purchase which can be both economic and psychological. It is important to define exactly what your customers end-benefit is. For instance, somebody taking their partner for a romantic meal is unlikely to pay using discount vouchers. It would be seen as unromantic – the end benefit of this situation is an emotional benefit and not a financial one.
6. Framing Effect
The framing effect also relates to the shared-cost effect. Buyers are more sensitive to price when they perceive something to be negative or seen as a loss. They respond more positively when you communicate the advantages rather than the disadvantages they could gain from a product. A good example is bundle pricing. The benefits of individual items bundled together are communicated to the customer as a positive. You clearly show the advantages of purchasing bundle A rather than the disadvantages of purchasing bundle B.
7. Fairness Effect
Buyers become more sensitive to price when it is perceived to be outside of a fair or reasonable range. This is dependant on what the customer perceives the fair price range to be.
8. Difficult Comparison Effect
Buyers are less price sensitive if they have difficulty comparing pricing or product benefits with a competitor’s. Customers will be less sensitive to the price of well known products if it is difficult to compare alternatives.
9. Switching-Costs Effect
The switching-costs effect refers to the inconvenience to the customer on switching to a competitor’s products or services. It is most commonly applicable to subscription based businesses. A customer is less likely to switch if they perceive you are offering them more value than a competitor. This is not necessarily financial but could be other benefits such as loyalty points or rewards etc.
More Business Resources
We hope you’ve found this list of pricing models and price sensitivity laws useful and you are now able to apply these pricing strategies to your own business.