The price of a product relative to the prices of its competing products should presumably be set higher or lower depending upon the presence or absence of desirable attributes perceived in that product by consumers in general.
Example: In the market for personal computers there are a variety of computers, and variations of each computer, available at a variety of prices. Those with more memory, two disk drives rather than one, and a better reputation for quality and service, command above-average prices, or a price “premium” over the average price. Conversely, those with less memory, and the absence of other desirable features, command below-average prices, or a “discount” from the average price level. The price premium, or price discount, that a particular firm may add to or subtract from the general, or average, price level will depend upon the market’s appreciation of the value of the total package of attributes involved in that firm’s product relative to the offerings and prices of all competitive products.
How might we determine the value of specific product attributes or the value of a total package of attributes embodied in that product? Market research techniques must be applied to find the value placed upon the presence of certain attributes or groups of attributes in a particular product. If a large sample of consumers were canvassed, their consensus regarding the extra amount they would be prepared to pay for certain features could be used as a guide for pricing variants or new models of an established product.
The maximum amount that a buyer will pay for a product is known as that buyer’s “reservation price.” Similarly a buyer will have reservation prices for attributes perceived to be supplied by the product. The buyer will buy the product only if the reservation price is greater than the seller’s asking price. If an attribute may or may not be included in the product, such as a “luxury package” in an automobile, the
buyer will only buy that attribute along with the basic product if his or her reservation price for that attribute exceeds the seller’s asking price for that attribute. Buyers will be reluctant to divulge their reservation prices, since sellers would use this information to set the price just at or below the buyer’s reservation price, and thus leave the consumer with little or no consumer surplus. (Consumer surplus is the difference between what the consumer had to pay for a product—the seller’s asking price—and the maximum he or she would have been willing to pay rather than go without—the buyer’s reservation price.)
Carefully conducted market research could supply the firm with the reservation prices (of a sample of buyers surveyed) for a particular product and for each attribute that may or may not be included in the product. Putting these in descending order essentially graphs out the sample’s demand curve for that product or the attribute in question. Generalizing this information to the market as a whole, a market demand curve and associated marginal revenue curve could be derived. A profit-maximizing firm would then have a simple pricing decision—namely, price the product or the attribute such that the marginal revenue equals the marginal cost of production. An oligopolist must consider the probable reactions of its rivals if the price indicated by this analysis was significantly above or below the prices of the rivals’ versions of this product or the attribute in question.
Example: One version of a particular brand of personal computer might contain 256K bytes of memory, and another might contain twice that amount. If the computers are otherwise the same, what is the appropriate price premium for the computer with the larger memory? The firm could establish the short-run profit-maximizing price or the long-term profit-maximizing price (proxied by the sales-maximizing price, for example), given information regarding the buyers’ demand curve for the extra 256K bytes of memory and given its own cost data. Alternatively, rather than incur the search costs, the firm might prefer to simply mark up its average variable cost of purchasing and installing the extra 256K memory chip to arrive at the price premium for the 512K model. Should the markup rate be relatively high or low? Ask yourself whether price elasticity is likely to be relatively high or low. In the case where a prospective buyer is considering either the 256K model or the 512K model, we would probably expect relatively elastic demand for the extra 256K, and thus a relatively low markup. But if the buyer already owns a 256K computer and wants an extra 256K- byte chip installed, we would expect relatively inelastic demand and thus a relatively high markup rate for retrofitting the extra 256K. In both cases an oligopolistic seller will wish to be sure that its price premium for the computer with extra 256K, and its price for retrofitting the extra 256K, is not too far different from the prices of its rivals, other things being equal.
In general, the firm will attempt to price its product such that its position in the price range is reflective of its position in the quality range, where the word “quality” is used broadly to mean the presence of desirable attributes. Thus a product with more desirable attributes will command a higher price than one that is lacking some of the attributes desired by some buyers. Buyers will buy the product that gives them the
most consumer surplus for the collection of attributes that they want, namely, the product with the lowest asking price, other things being equal. Since buyers have different preferences, we should expect to see the simultaneous offering of a wide range of “quality” at a similarly wide range of prices. In fact we observe this structure in most oligopoly markets.
Example: In the market for video cassette recorders (VCRs) one can find several basic models (two video heads, twelve or fourteen preset channels, and one or two preselected programs) selling for about $250 at the time of this writing. As additional features are added, the competitive price for the product increases. A wireless remote control commands a premium over the wired type. The next step up is additional channels, and four programs over a two-week period, for which additional premiums are charged. Two more video heads with special-effects capabilities, stereo capability, and a quartz tuner each add another premium, and so on. At each “quality” level there are typically a dozen or more competing brands, and the prices tend to be similar. Each firm must consider the prices of rivals for the similar package of attributes, because buyers are aware of the availability of competing brands.
A more complicated price positioning decision must be made when the firm offers several different models of their product in a market where the “quality” demands of buyers differ. In the markets for automobiles, computers, VCRs, and so on, we find the firms each offering a “product line”—a series of related products. Some of these products are substitutes for each other, being located at different points along the “quality” spectrum, such as small cars and large cars. Other products in the product line are complementary to each other, such as a particular car and spare parts for that car. We turn now to product-line pricing.