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The pricing of industrial goods
THE PRICING OF INDUSTRIAL GOODS A departure from conventional wisdom REED MOYER AND ROBERT J. BOEWADT
Both authors are faculty members, Mr, Moyer at Michigan State University and Mr. Boewadt at the University o f Florida.
Convention has it that producers o f industrial goods are unable to measure buyer responses to price changes. This article challenges conventional wisdom, and proposes a number o f market factors that can be considered in deciding whether to raise or lower prices to reach an optimum. The author divides the problem into demand-and-supply components and discusses the applications o f the response o f consumers, competitors, and measurements in the fringe markets. He suggests the possibility o f test marketing the price variable for industrial products and the use o f simulation techniques as a tool for analyzing price responses in oligopolistic markets.
One of the most difficult tasks facing m o d e r n management is learning the shapes of its products' demand curves. Ultimately, profits depend upon the relationship between a firm's costs and revenues at various levels of output. Projecting cost levels for different output rates--though often c o m p l e x - i s a
JUNE, 1971
manageable engineering task that most firms perform with reasonable adequacy. Measuring the sensitivity of demand, on the other hand, is a perplexing chore, one calling for abundant skills on the part of market researchers to w h o m this job usually falls. Conventional wisdom holds that producers of consumer goods have an advantage over industrial goods manufacturers in their ability to measure buyers' responses to price changes. To some extent this statement is true. For example, m a n y consumer goods lend themselves to test marketing which permits the seller to measure the key marketing variables of price, promotion, advertising, and packaging. This article challenges conventional wisdom. It examines the varying characteristics of industrial products and prescribes ways to analyze the effect of price changes on the quantity demanded and on the level of profits. Briefly, the paper emphasizes the need to analyze end-user markets as well as the cost structures of intermediate users of industrial products; delineates several measures of demand elasticity and indicates
27
REED MOYER AND ROBERT J. BOEWADT
the market strategies necessary to take advantage of each; suggests the possibility of test marketing the price variable for industrial products; and investigates the use of simulation techniques as a tool for analyzing price responses in oligopolistic markets. The proper price for a product, whether industrial or consumer, is one which maximizes long-run profits for the firm within the financial, personnel, and other constraints within which the firm operates. The optimum price is not fixed, but changes in response to different demand and cost conditions. A number of market factors can be considered in deciding whether to raise or lower prices to reach an optimum. Under the usual analysis, they boil down to two questions: how will customers respond to a change in price, and what will be the reaction of competitors? These two factors must be examined separately. 28 CUSTOMER REACTION A necessary first step is to divide the problem into its demand and supply components. Conventional wisdom again holds that the demand for consumer products is more elastic than for industrial products. That is, a reduction in the price of a consumer good will bring about a greater proportionate increase in the amount of that product demanded than is the case with producer goods. This is particularly true with nonessential consumer goods. The reasoning is that the consumer has a bundle of discretionary income to spend and is free to choose among an array of products. He is free not only to choose among various brands of a given product, but to forego the purchase of one product altogether and to substitute another if the satisfaction he derives from the substitute is greater per dollar of expenditure than the satisfaction derived from the product given up. Substantial price changes alone will, in many cases, bring about such a transfer of buyer loyalty.
With most industrial goods products, however, the situation is different. Many industrial products serve as inputs for industrial processes which, in the short run, are fixed. These inputs, along with labor, capital, and other inputs, combine in the short run in more or less fixed proportions to produce a plant's output. Purchasing agents are able to alter demand for the industrial product inputs slightly by ordering hand-tomouth and postponing major blanket-order commitments. However, in the main, they are unable to alter substantially demand for industrial product inputs, except as the derived demand for the plant's end-product fluctuates. This analysis is accurate as far as it goes; however, market researchers in an industrial products industry should carry the analysis several steps further. The first step is to compute the proportion that the industrial product input bears to the total cost of production of the end-product. This should be done for as many industrial goods inputs as is feasible; feasibility here is measured by the dollar volume involved. In many instances, the results of this analysis will show that the cost of the input is an insignificant part of the final product's total cost. In this case, demand is probably inelastic, which should discourage the industrial goods supplier from reducing prices. For example, a manufacturer of precision transistors was contemplating an across-theboard price decrease to increase sales. However, an item analysis of the product line revealed that some of its low volume transistors were used in exotic applications by the firm's customers. A technical customer used the component in an ultrasonic testing apparatus which was sold for $8,000 a unit. This fact prompted the transistor manufacturer to raise the price of the item. Ironically, the firm then experienced a temporary surge of demand for the item as purchasing agents stocked up in anticipation of future price increases.
BUSINESS HORIZONS
The Pricing of Industrial Goods
Another point should be noted with regard to the foregoing example. Often when an industrial input is vital to the manufacturing process and, in addition, represents a minimal portion of the total cost, price assumes secondary importance to the purchasing agent. Given these conditions, the purchasing agent is more interested in consistency of quality and reliability of delivery. In another case, the industrial goods product may represent a fairly substantial share of the finished product's total cost. As in the other instance, demand for the input will reflect the derived demand for the product of which it is a component part. But, unlike the first case, since the industrial goods component represents a large share of the end-product's total costs, price changes may have an important effect on the amount demanded, both of the final product and of the industrial product input. For example, a reduction in the price of a chemical product used as an input in an industrial process may permit the customer to reduce the price of the end product proportionately more than the reduction in price of the input. Under this circumstance, the chemical firm's demand studies should be moved one step forward to the final consumer. The market research job of measuring demand elasticity in the finial consumer market can be done individually or on a cooperative basis with the firm's customers. Numerous applications of this principle of analyzing end-user markets suggest themselves. For example, in the apparel industry it is feasible, though admittedly not easy, to measure price elasticity. A fiber producer, interested in measuring the elasticity of demand for his product used as an input by an apparel manufacturer, could follow the approach suggested above by working out a test marketing arrangement at the final consumer level with its customers on a costsharing basis. The fruits of this research would benefit both the apparel producer and the
JUNE, 1971
fiber manufacturer. The end result might show that the garments in question are highly price elastic, which might dictate a substantially lower price for the fiber input. The result would be a more than proportionate increase in demand for that input when used in the manufacture of the apparel item. Another example can be drawn from the color television tube industry. Because the color picture tube is a major component of the receiver, it was not until mass production technologies allowed tube manufacturers to reduce their selling price that the mass market for color television could be truly exploited. The end market for receivers was found to be highly price elastic. By passing on cost savings to set manufacturers, who in turn reduced prices of receivers, the tube manufacturers substantially increased sales.
COMPETITOR REACTION The preceding analysis has focused on the consumers' reactions to price changes; we will now analyze the reactions of a firm's competitors to price adjustments. Here it is useful to delineate several measures of demand elasticity and indicate the market strategies necessary to take advantage of each. Heretofore, we have used the term "demand" in the usual sense, indicating price-output relationships for the entire industry. Two other product demand measurements, however, need to be considered: the elasticity of demand for the firm's o u t p u t - a s opposed to the industry's o u t p u t - a n d the elasticity in fringe markets. In many markets, the reactions of competitors to price changes deter each firm from making price adjustments. Although a firm may gain a temporary sales increase by price cutting, this move is not likely to cause a major shift in market shares since competitors soon meet the lower prices. This is particularly true when demand for the products is inelastic. Each industrial producer
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30
simply ends up selling virtually the same output at lower prices. Manufacturers of industrial goods whose products have been involved in price wars know the disastrous results of this pricing condition. The deterrent effect of price cutting, however, should not discourage an industrial product firm from adjusting prices under all conditions. A major function of the marketing research department in an industrial products field should be to measure the conditions which influence reactions of competitors and customers to price adjustments. Such investigations may take the form of the analyses cited earlier. Alternatively, industrial product market researchers can analyze another factor in price determination: the general level of prosperity in its customers' industries. Too often industrial producers gauge the efficacy of price increases solely on the intensity of demand for the firm's products without considering the competitive pressures in the users' markets. All things being equal, an industrial supplier will have more success in passing on a price increase to customers who are prospering than to customers who are hard-pressed. This being true, an industrial firm's marketing research department should devote some of its resources to analyzing prosperity conditions in user industries. These measurements can take a number of forms and are easily gathered. The most obvious is the record of earnings and sales in the user industries. Another guide which may serve as a useful predictor of prosperity in user industries is the capacity indices (for example, operating rates) compiled by the government and private research organizations. A similar analysis of the industrial producer's own industry will help measure the response of competitors to a proposed price change. Frey has termed this procedure "walking through the competitor's mind. ''1 When the industry is operating at a relatively low rate, each firm is faced with what economists refer to as a kinked demand curve;
prices below the existing market price are met by competitors' downward price reactions with price increases resulting in substantial losses of markets for the firm rash enough to raise prices. 2 When operating rates are high, however, the kink tends to disappear, and price increases are more readily made without fear of losing market position. The risks of experimenting with higher prices in this situation are reduced, and the rewards for the venturesome may be substantial.
DEMAND IN FRINGE MARKETS The third conception of demand elasticity referred to is the elasticity of demand in fringe markets, which lie outside of the normal market area. These markets may be separated from the normal market area either geographically or in terms of customer types. Geographically remote markets may exist within the United States but outside the normal market area or they may be export markets. In either case, the firm is free to measure demand elasticity in a crude way by altering prices and measuring market responses. The Canadian market, in some cases, offers a useful testing ground for price elasticity measurements since in many respects it is a microcosm of the American market. There may be some Robinson-Patman implications if this price experimentation approach is used in the United States. However, this danger can be minimized by carefully seeking market segments isolated from competitive interaction with other markets served by the vendor. 3 The obvious 1. Theodore D. Frey, "Forecasting Prices for Industrial Commodity Markets," Journal of Marketing, XXXIV (April, 1970), p. 3O. 2. Paul M. Sweezy, "Demand Under Conditions of Oligopoly," Journal of Political Economy, XLVII (August, 1939), pp. 568-73. 3. Albert G. Seidman, "Some Aspects of the Law Concerning Pricing," in Competitive Pricing (Report No. 17; New York: American Management Association, 1958).
BUSINESS HORIZONS
The Pricing of Industrial Goods
drawback to this approach is that what one firm can do, others m a y copy. Excessive use of this technique can result in general price deterioration in all markets. Often, one of the indicators of a weak market for a particular product is the level of prices in such fringe markets. An example of this situation may be drawn from the coal industry. Because of this product's great bulk, transportation costs play a key role in pricing strategy. Market areas are defined approximately b y concentric circles centered about the point of production. In markets where competing producers' areas overlap, stiff price competition drives d o w n the general level of prices. All of the foregoing has ignored the possibility of the substitution of industrial goods for one another. An example of such a situation was the copper shortage in the United States created by the Vietnam war. Copper producers could n o t adequately serve m a n y of their traditional industrial markets. As a result, m a n y customers turned to other metals, such as aluminum, and to other processes (for example, copper-aluminum electric wiring), which minimized their copper consumption. 4 As the shortage eased, the producers found their customers reluctant to return to their former usage patterns. How should the possibility of substitution be treated b y the industrial goods producer? Here, industrial marketing researchers should devote more effort to analyzing competitors such as the producers of potential substitutes. Knowing in as m u c h detail as is feasible the cost structures of substitute products at current and predicted future levels of o u t p u t will aid management in its pricing decisions. If, on the other hand, an industrial goods manufacturer is foreclosed from a market as a result of competition from a substitute material, a detailed knowledge of that material's cost structure might open up 4. Bernard A. Lietaer, "Prepare Your Company for Inflation," Harvard Business Review, XLVIII (SeptemberOctober, 1970), p. 117.
JUNE, 1971
tactical pricing possibilities for the threatened firm to drive a wedge into that market. Boom periods, when there is little excess capacity, call for another kind of market analysis in the pricing of industrial products. This is an analysis of conditions calling for what has been referred to as " b o t t l e n e c k " pricing, that is, pricing for m a x i m u m returns in situations in which there are bottlenecks in one or more of the inputs used in the production process, s Often firms will deemphasize low margin products and concentrate on high margin products in an effort to maximize total returns. For m a n y industrial producers this approach m a y have merit, b u t under forced draft conditions a different approach might be called for. The following case occurred during World War II: . . . the activities of non-essential consumer industries were sharply curtailed by government decree. In the candy industry, for example, the volume of its basic raw material, sugar, was restricted to a fraction of normal requirements. Candy companies found an eager market for every ounce they could produce. In analysing the profit potentials for one candy company, a consultant found that the firm had been specializing in the production of candies which yielded the greatest contribution per dollar sold. Investigation also revealed that those items with the greatest contribution per sales dollar also used much more critical sugar than the lower contribution lines. To get the maximum profit stretch per pound of sugar consumed, the firm's profit strategy was reoriented to feature those products which earned the greatest contribution per unit of sugar. By adopting this policy the firm's profits quadrupled during a period when com6petitor's profits no more than doubled on the average. Other producers today might analyze the availability of their products' inputs to see whether similar opportunities exist. In m a n y industries, such an investigation might first focus on the cost of labor in the production process. During periods of escalating union demands and shortages of skilled workers,
5. Albert J. Bergfield,James S. Earley, and William R. Knobloch, Pricing for Profit and Growth (New York: McGraw-HillBook Company,Inc., 1957), p. 77. 6. Pricingfor Profit and Growth, p. 77.
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many firms are likely to find themselves in a situation directly parallel t o the candy manufacturer described above. If, indeed, this is the case those manufacturers might be welladvised to emphasize those products in their product line which result from capitalintensive processes rather than labor-intensive processes. Despite brief periods of labor surplus, it seems safe to assume that shortages of skills will persist in the future and that the cost of labor inputs in the production process will develop at least as rapidly as they have in the past.
TEST MARKETING AND SIMULATION It is generally accepted that producers of consumer goods command an advantage over industrial goods manufacturers in their ability to measure buyers' responses to price changes. Of the several tools available to them, the most important is test marketing. What are the characteristics of a product which permit it to be test marketed? If prices are being tested, the product should have a weight-price ratio that prevents speculators from buying the product in one market and selling in another. It should have a fairly fast turnover
to permit an analysis of the repeat purchase pattern. It should be sold to a fairly large number of users, and its sales pattern should be more or less normal to permit extrapolating test market results to other markets. Moreover, communications between markets in which the product is sold should be weak enough to prevent the leakage of price information from one market to another. Finally, its sales should be easily counted to permit quantification of results. Most high ticket industrial goods or those sold to a limited number of customers do not meet these specifications and, therefore, are not suitable for test marketing. However, such products as industrial paints and cleaning compounds would appear to lend themselves well to such experimentation. Herein lies the challenge for industrial marketing researchers. The absence of favorable conditions for test marketing in some product lines should not obscure the existence of products which, in fact, do meet these specifications. Opportunities exist in a great many industries which produce predominantly industrial goods. The need here is for market analysts to assess the purchase characteristics of the firm's entire product line, and, rather than divide them
BUSINESS HORIZONS
Changing ManagerialPhilosophies
into consumer and industrial products, separate out those possessing the characteristics appropriate for test marketing. Simulation is a final tool with interesting potential, available to industrial producers for testing price reactions. A realistic management game can be constructed, which simulates, as nearly as possible, conditions existing in a branch of a particular industry. This simulation would differ in several respects from management games typically used as educational tools. Management games, played in business schools and in management seminars, subject each team or player to c o m m o n conditions. Each usually begins the game with identical financial resources. These simulations also e m b o d y cost and demand functions which affect the play of each participant equally. The functions may or may not typify those which actually prevail in a given industry. Usually the functions' parameters assume values which give the cost and demand curves " n o r m a l " shapes. These and other relevant functions may make the games serviceable, but they do not necessarily simulate particular industries' conditions accurately. 7 The simulations which we propose would recreate, as nearly as possible, an industry's market structure. It would allocate to each c o m p a n y team financial resources equal to those the firm possesses in the real world. Through regression analysis, the builder of the simulation would construct industry demand functions with realistic parameters. Ideally, each team should operate with a cost function which represents his firm's actual cost conditions. If the industry's t r a d e association builds the simulation, it migh t have access to each company's cost data in the normal course of its work, or, alternatively, the m e m b e r firms might supply the association cost data on an ad hoc basis for use in construction of the simulation.
7. Readers familiar with INTOP know that this otherwise excellent simulation can produce inordinately high profits for modestly skillful participants.
JUNE, 1971
The game would incorporate other data and functions based, as nearly as possible, on actual industry conditions. Thus participating teams would begin the simulation with advertising budgets and sales force expenses resembling those then in existence in their firms. The game would inevitably postulate an o p t i m u m marketing mix which, o f necessity, would be based as much on the game builder's intuition and perspicacity as on hard facts w h i c h - i n this a r e a - a r e , unhappily, sparse. Once the game is built, marketing executives responsible for pricing decisions would compete against each other. The game's administrator would change parameters to simulate real-life occurrences as a way of testing the participants' reactions to change and, more important, to dramatize the effects of their decisions on price levels,
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REED MOYER AND ROBERT J. BOEWADT
market shares and profit levels. Changes may be real or rumored. A real change could involve a reduction in GNP, an influx of low price imports, or a strike in a major user industry. Industry gossip indicating that a firm had developed a new, low-cost production process is an example of a rumored change. The game should provide for the creation of new productive capacity with appropriate time lags. It would not be surprising in an industrial market simulation for the participants to go through a cycle of higher prices, increased profits, a surge of new capacity followed by price-cutting, consolidation, and a renewal of the cycle. By playing the game and jointly analyzing results, participants ought to develop a deeper understanding of the industry's price-making forces, and do so in a safer environment than the marketplace__ where price wars in many industrial goods markets wreak periodic havoc. This is especially true in markets for undifferentiated
commodities, but producers of differentiated industrial goods also ought to benefit from the simulation. ~--I#ll#ll~]l'll'][l'[ A fresh approach is needed to the analysis of industrial product pricing. We suggest breaking away from the conventional consumer goods--industrial goods ,dichotomy which leads typically to the despair of market analysts in industrial goods firms over their inability to measure responses to price changes. As a substitute it calls for bolder action to emulate analysts and managers who use techniques coveted by industrial goods market analysts, especially the technique of test marketing. Second, we p l e a d for more in-depth analysis of both cost and demand conditions closer to the market at both the user industry level and at the final consumer demand level. Finally, we recommend more imaginative use of market simulation models to test competitive price reactions.
34
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Now why is it that the prices of goods in the heavily concentrated industrial sector of the economy are relatively stable or inflexible both in the upswing and the downswing of the cycle? It would be impossible to answer this question in satisfactory fashion without examining the structure of particular industrial markets, b u t there are certain characteristics common to all or most of the industries here under consideration that go far toward explaining this phenomenon. Among these characteristics the following have special importance: the tendency of variable costs .per unit of output to be stable with respect to changes in the volume of output; the existence of possibilities of expanding sales through advertising or product changes without resort to price inducements; price policies which of necessity take account of the probable price reaction of rival firms; a traditional concern with antitrust policy which forms part of the peculiar sensitiveness of large firms to adverse public reaction. --Edward S. Mason in J ules Backman, ed. Price Practices and Price Policies
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BUSINESS HORIZONS
Both authors are faculty members, Mr, Moyer at Michigan State University and Mr. Boewadt at the University o f Florida.
Convention has it that producers o f industrial goods are unable to measure buyer responses to price changes. This article challenges conventional wisdom, and proposes a number o f market factors that can be considered in deciding whether to raise or lower prices to reach an optimum. The author divides the problem into demand-and-supply components and discusses the applications o f the response o f consumers, competitors, and measurements in the fringe markets. He suggests the possibility o f test marketing the price variable for industrial products and the use o f simulation techniques as a tool for analyzing price responses in oligopolistic markets.
One of the most difficult tasks facing m o d e r n management is learning the shapes of its products' demand curves. Ultimately, profits depend upon the relationship between a firm's costs and revenues at various levels of output. Projecting cost levels for different output rates--though often c o m p l e x - i s a
JUNE, 1971
manageable engineering task that most firms perform with reasonable adequacy. Measuring the sensitivity of demand, on the other hand, is a perplexing chore, one calling for abundant skills on the part of market researchers to w h o m this job usually falls. Conventional wisdom holds that producers of consumer goods have an advantage over industrial goods manufacturers in their ability to measure buyers' responses to price changes. To some extent this statement is true. For example, m a n y consumer goods lend themselves to test marketing which permits the seller to measure the key marketing variables of price, promotion, advertising, and packaging. This article challenges conventional wisdom. It examines the varying characteristics of industrial products and prescribes ways to analyze the effect of price changes on the quantity demanded and on the level of profits. Briefly, the paper emphasizes the need to analyze end-user markets as well as the cost structures of intermediate users of industrial products; delineates several measures of demand elasticity and indicates
27
REED MOYER AND ROBERT J. BOEWADT
the market strategies necessary to take advantage of each; suggests the possibility of test marketing the price variable for industrial products; and investigates the use of simulation techniques as a tool for analyzing price responses in oligopolistic markets. The proper price for a product, whether industrial or consumer, is one which maximizes long-run profits for the firm within the financial, personnel, and other constraints within which the firm operates. The optimum price is not fixed, but changes in response to different demand and cost conditions. A number of market factors can be considered in deciding whether to raise or lower prices to reach an optimum. Under the usual analysis, they boil down to two questions: how will customers respond to a change in price, and what will be the reaction of competitors? These two factors must be examined separately. 28 CUSTOMER REACTION A necessary first step is to divide the problem into its demand and supply components. Conventional wisdom again holds that the demand for consumer products is more elastic than for industrial products. That is, a reduction in the price of a consumer good will bring about a greater proportionate increase in the amount of that product demanded than is the case with producer goods. This is particularly true with nonessential consumer goods. The reasoning is that the consumer has a bundle of discretionary income to spend and is free to choose among an array of products. He is free not only to choose among various brands of a given product, but to forego the purchase of one product altogether and to substitute another if the satisfaction he derives from the substitute is greater per dollar of expenditure than the satisfaction derived from the product given up. Substantial price changes alone will, in many cases, bring about such a transfer of buyer loyalty.
With most industrial goods products, however, the situation is different. Many industrial products serve as inputs for industrial processes which, in the short run, are fixed. These inputs, along with labor, capital, and other inputs, combine in the short run in more or less fixed proportions to produce a plant's output. Purchasing agents are able to alter demand for the industrial product inputs slightly by ordering hand-tomouth and postponing major blanket-order commitments. However, in the main, they are unable to alter substantially demand for industrial product inputs, except as the derived demand for the plant's end-product fluctuates. This analysis is accurate as far as it goes; however, market researchers in an industrial products industry should carry the analysis several steps further. The first step is to compute the proportion that the industrial product input bears to the total cost of production of the end-product. This should be done for as many industrial goods inputs as is feasible; feasibility here is measured by the dollar volume involved. In many instances, the results of this analysis will show that the cost of the input is an insignificant part of the final product's total cost. In this case, demand is probably inelastic, which should discourage the industrial goods supplier from reducing prices. For example, a manufacturer of precision transistors was contemplating an across-theboard price decrease to increase sales. However, an item analysis of the product line revealed that some of its low volume transistors were used in exotic applications by the firm's customers. A technical customer used the component in an ultrasonic testing apparatus which was sold for $8,000 a unit. This fact prompted the transistor manufacturer to raise the price of the item. Ironically, the firm then experienced a temporary surge of demand for the item as purchasing agents stocked up in anticipation of future price increases.
BUSINESS HORIZONS
The Pricing of Industrial Goods
Another point should be noted with regard to the foregoing example. Often when an industrial input is vital to the manufacturing process and, in addition, represents a minimal portion of the total cost, price assumes secondary importance to the purchasing agent. Given these conditions, the purchasing agent is more interested in consistency of quality and reliability of delivery. In another case, the industrial goods product may represent a fairly substantial share of the finished product's total cost. As in the other instance, demand for the input will reflect the derived demand for the product of which it is a component part. But, unlike the first case, since the industrial goods component represents a large share of the end-product's total costs, price changes may have an important effect on the amount demanded, both of the final product and of the industrial product input. For example, a reduction in the price of a chemical product used as an input in an industrial process may permit the customer to reduce the price of the end product proportionately more than the reduction in price of the input. Under this circumstance, the chemical firm's demand studies should be moved one step forward to the final consumer. The market research job of measuring demand elasticity in the finial consumer market can be done individually or on a cooperative basis with the firm's customers. Numerous applications of this principle of analyzing end-user markets suggest themselves. For example, in the apparel industry it is feasible, though admittedly not easy, to measure price elasticity. A fiber producer, interested in measuring the elasticity of demand for his product used as an input by an apparel manufacturer, could follow the approach suggested above by working out a test marketing arrangement at the final consumer level with its customers on a costsharing basis. The fruits of this research would benefit both the apparel producer and the
JUNE, 1971
fiber manufacturer. The end result might show that the garments in question are highly price elastic, which might dictate a substantially lower price for the fiber input. The result would be a more than proportionate increase in demand for that input when used in the manufacture of the apparel item. Another example can be drawn from the color television tube industry. Because the color picture tube is a major component of the receiver, it was not until mass production technologies allowed tube manufacturers to reduce their selling price that the mass market for color television could be truly exploited. The end market for receivers was found to be highly price elastic. By passing on cost savings to set manufacturers, who in turn reduced prices of receivers, the tube manufacturers substantially increased sales.
COMPETITOR REACTION The preceding analysis has focused on the consumers' reactions to price changes; we will now analyze the reactions of a firm's competitors to price adjustments. Here it is useful to delineate several measures of demand elasticity and indicate the market strategies necessary to take advantage of each. Heretofore, we have used the term "demand" in the usual sense, indicating price-output relationships for the entire industry. Two other product demand measurements, however, need to be considered: the elasticity of demand for the firm's o u t p u t - a s opposed to the industry's o u t p u t - a n d the elasticity in fringe markets. In many markets, the reactions of competitors to price changes deter each firm from making price adjustments. Although a firm may gain a temporary sales increase by price cutting, this move is not likely to cause a major shift in market shares since competitors soon meet the lower prices. This is particularly true when demand for the products is inelastic. Each industrial producer
29
REED MOYER AND ROBERT J. BOEWADT
30
simply ends up selling virtually the same output at lower prices. Manufacturers of industrial goods whose products have been involved in price wars know the disastrous results of this pricing condition. The deterrent effect of price cutting, however, should not discourage an industrial product firm from adjusting prices under all conditions. A major function of the marketing research department in an industrial products field should be to measure the conditions which influence reactions of competitors and customers to price adjustments. Such investigations may take the form of the analyses cited earlier. Alternatively, industrial product market researchers can analyze another factor in price determination: the general level of prosperity in its customers' industries. Too often industrial producers gauge the efficacy of price increases solely on the intensity of demand for the firm's products without considering the competitive pressures in the users' markets. All things being equal, an industrial supplier will have more success in passing on a price increase to customers who are prospering than to customers who are hard-pressed. This being true, an industrial firm's marketing research department should devote some of its resources to analyzing prosperity conditions in user industries. These measurements can take a number of forms and are easily gathered. The most obvious is the record of earnings and sales in the user industries. Another guide which may serve as a useful predictor of prosperity in user industries is the capacity indices (for example, operating rates) compiled by the government and private research organizations. A similar analysis of the industrial producer's own industry will help measure the response of competitors to a proposed price change. Frey has termed this procedure "walking through the competitor's mind. ''1 When the industry is operating at a relatively low rate, each firm is faced with what economists refer to as a kinked demand curve;
prices below the existing market price are met by competitors' downward price reactions with price increases resulting in substantial losses of markets for the firm rash enough to raise prices. 2 When operating rates are high, however, the kink tends to disappear, and price increases are more readily made without fear of losing market position. The risks of experimenting with higher prices in this situation are reduced, and the rewards for the venturesome may be substantial.
DEMAND IN FRINGE MARKETS The third conception of demand elasticity referred to is the elasticity of demand in fringe markets, which lie outside of the normal market area. These markets may be separated from the normal market area either geographically or in terms of customer types. Geographically remote markets may exist within the United States but outside the normal market area or they may be export markets. In either case, the firm is free to measure demand elasticity in a crude way by altering prices and measuring market responses. The Canadian market, in some cases, offers a useful testing ground for price elasticity measurements since in many respects it is a microcosm of the American market. There may be some Robinson-Patman implications if this price experimentation approach is used in the United States. However, this danger can be minimized by carefully seeking market segments isolated from competitive interaction with other markets served by the vendor. 3 The obvious 1. Theodore D. Frey, "Forecasting Prices for Industrial Commodity Markets," Journal of Marketing, XXXIV (April, 1970), p. 3O. 2. Paul M. Sweezy, "Demand Under Conditions of Oligopoly," Journal of Political Economy, XLVII (August, 1939), pp. 568-73. 3. Albert G. Seidman, "Some Aspects of the Law Concerning Pricing," in Competitive Pricing (Report No. 17; New York: American Management Association, 1958).
BUSINESS HORIZONS
The Pricing of Industrial Goods
drawback to this approach is that what one firm can do, others m a y copy. Excessive use of this technique can result in general price deterioration in all markets. Often, one of the indicators of a weak market for a particular product is the level of prices in such fringe markets. An example of this situation may be drawn from the coal industry. Because of this product's great bulk, transportation costs play a key role in pricing strategy. Market areas are defined approximately b y concentric circles centered about the point of production. In markets where competing producers' areas overlap, stiff price competition drives d o w n the general level of prices. All of the foregoing has ignored the possibility of the substitution of industrial goods for one another. An example of such a situation was the copper shortage in the United States created by the Vietnam war. Copper producers could n o t adequately serve m a n y of their traditional industrial markets. As a result, m a n y customers turned to other metals, such as aluminum, and to other processes (for example, copper-aluminum electric wiring), which minimized their copper consumption. 4 As the shortage eased, the producers found their customers reluctant to return to their former usage patterns. How should the possibility of substitution be treated b y the industrial goods producer? Here, industrial marketing researchers should devote more effort to analyzing competitors such as the producers of potential substitutes. Knowing in as m u c h detail as is feasible the cost structures of substitute products at current and predicted future levels of o u t p u t will aid management in its pricing decisions. If, on the other hand, an industrial goods manufacturer is foreclosed from a market as a result of competition from a substitute material, a detailed knowledge of that material's cost structure might open up 4. Bernard A. Lietaer, "Prepare Your Company for Inflation," Harvard Business Review, XLVIII (SeptemberOctober, 1970), p. 117.
JUNE, 1971
tactical pricing possibilities for the threatened firm to drive a wedge into that market. Boom periods, when there is little excess capacity, call for another kind of market analysis in the pricing of industrial products. This is an analysis of conditions calling for what has been referred to as " b o t t l e n e c k " pricing, that is, pricing for m a x i m u m returns in situations in which there are bottlenecks in one or more of the inputs used in the production process, s Often firms will deemphasize low margin products and concentrate on high margin products in an effort to maximize total returns. For m a n y industrial producers this approach m a y have merit, b u t under forced draft conditions a different approach might be called for. The following case occurred during World War II: . . . the activities of non-essential consumer industries were sharply curtailed by government decree. In the candy industry, for example, the volume of its basic raw material, sugar, was restricted to a fraction of normal requirements. Candy companies found an eager market for every ounce they could produce. In analysing the profit potentials for one candy company, a consultant found that the firm had been specializing in the production of candies which yielded the greatest contribution per dollar sold. Investigation also revealed that those items with the greatest contribution per sales dollar also used much more critical sugar than the lower contribution lines. To get the maximum profit stretch per pound of sugar consumed, the firm's profit strategy was reoriented to feature those products which earned the greatest contribution per unit of sugar. By adopting this policy the firm's profits quadrupled during a period when com6petitor's profits no more than doubled on the average. Other producers today might analyze the availability of their products' inputs to see whether similar opportunities exist. In m a n y industries, such an investigation might first focus on the cost of labor in the production process. During periods of escalating union demands and shortages of skilled workers,
5. Albert J. Bergfield,James S. Earley, and William R. Knobloch, Pricing for Profit and Growth (New York: McGraw-HillBook Company,Inc., 1957), p. 77. 6. Pricingfor Profit and Growth, p. 77.
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REED MOYERAND ROBERTJ. BOEWADT
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many firms are likely to find themselves in a situation directly parallel t o the candy manufacturer described above. If, indeed, this is the case those manufacturers might be welladvised to emphasize those products in their product line which result from capitalintensive processes rather than labor-intensive processes. Despite brief periods of labor surplus, it seems safe to assume that shortages of skills will persist in the future and that the cost of labor inputs in the production process will develop at least as rapidly as they have in the past.
TEST MARKETING AND SIMULATION It is generally accepted that producers of consumer goods command an advantage over industrial goods manufacturers in their ability to measure buyers' responses to price changes. Of the several tools available to them, the most important is test marketing. What are the characteristics of a product which permit it to be test marketed? If prices are being tested, the product should have a weight-price ratio that prevents speculators from buying the product in one market and selling in another. It should have a fairly fast turnover
to permit an analysis of the repeat purchase pattern. It should be sold to a fairly large number of users, and its sales pattern should be more or less normal to permit extrapolating test market results to other markets. Moreover, communications between markets in which the product is sold should be weak enough to prevent the leakage of price information from one market to another. Finally, its sales should be easily counted to permit quantification of results. Most high ticket industrial goods or those sold to a limited number of customers do not meet these specifications and, therefore, are not suitable for test marketing. However, such products as industrial paints and cleaning compounds would appear to lend themselves well to such experimentation. Herein lies the challenge for industrial marketing researchers. The absence of favorable conditions for test marketing in some product lines should not obscure the existence of products which, in fact, do meet these specifications. Opportunities exist in a great many industries which produce predominantly industrial goods. The need here is for market analysts to assess the purchase characteristics of the firm's entire product line, and, rather than divide them
BUSINESS HORIZONS
Changing ManagerialPhilosophies
into consumer and industrial products, separate out those possessing the characteristics appropriate for test marketing. Simulation is a final tool with interesting potential, available to industrial producers for testing price reactions. A realistic management game can be constructed, which simulates, as nearly as possible, conditions existing in a branch of a particular industry. This simulation would differ in several respects from management games typically used as educational tools. Management games, played in business schools and in management seminars, subject each team or player to c o m m o n conditions. Each usually begins the game with identical financial resources. These simulations also e m b o d y cost and demand functions which affect the play of each participant equally. The functions may or may not typify those which actually prevail in a given industry. Usually the functions' parameters assume values which give the cost and demand curves " n o r m a l " shapes. These and other relevant functions may make the games serviceable, but they do not necessarily simulate particular industries' conditions accurately. 7 The simulations which we propose would recreate, as nearly as possible, an industry's market structure. It would allocate to each c o m p a n y team financial resources equal to those the firm possesses in the real world. Through regression analysis, the builder of the simulation would construct industry demand functions with realistic parameters. Ideally, each team should operate with a cost function which represents his firm's actual cost conditions. If the industry's t r a d e association builds the simulation, it migh t have access to each company's cost data in the normal course of its work, or, alternatively, the m e m b e r firms might supply the association cost data on an ad hoc basis for use in construction of the simulation.
7. Readers familiar with INTOP know that this otherwise excellent simulation can produce inordinately high profits for modestly skillful participants.
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The game would incorporate other data and functions based, as nearly as possible, on actual industry conditions. Thus participating teams would begin the simulation with advertising budgets and sales force expenses resembling those then in existence in their firms. The game would inevitably postulate an o p t i m u m marketing mix which, o f necessity, would be based as much on the game builder's intuition and perspicacity as on hard facts w h i c h - i n this a r e a - a r e , unhappily, sparse. Once the game is built, marketing executives responsible for pricing decisions would compete against each other. The game's administrator would change parameters to simulate real-life occurrences as a way of testing the participants' reactions to change and, more important, to dramatize the effects of their decisions on price levels,
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REED MOYER AND ROBERT J. BOEWADT
market shares and profit levels. Changes may be real or rumored. A real change could involve a reduction in GNP, an influx of low price imports, or a strike in a major user industry. Industry gossip indicating that a firm had developed a new, low-cost production process is an example of a rumored change. The game should provide for the creation of new productive capacity with appropriate time lags. It would not be surprising in an industrial market simulation for the participants to go through a cycle of higher prices, increased profits, a surge of new capacity followed by price-cutting, consolidation, and a renewal of the cycle. By playing the game and jointly analyzing results, participants ought to develop a deeper understanding of the industry's price-making forces, and do so in a safer environment than the marketplace__ where price wars in many industrial goods markets wreak periodic havoc. This is especially true in markets for undifferentiated
commodities, but producers of differentiated industrial goods also ought to benefit from the simulation. ~--I#ll#ll~]l'll'][l'[ A fresh approach is needed to the analysis of industrial product pricing. We suggest breaking away from the conventional consumer goods--industrial goods ,dichotomy which leads typically to the despair of market analysts in industrial goods firms over their inability to measure responses to price changes. As a substitute it calls for bolder action to emulate analysts and managers who use techniques coveted by industrial goods market analysts, especially the technique of test marketing. Second, we p l e a d for more in-depth analysis of both cost and demand conditions closer to the market at both the user industry level and at the final consumer demand level. Finally, we recommend more imaginative use of market simulation models to test competitive price reactions.
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Now why is it that the prices of goods in the heavily concentrated industrial sector of the economy are relatively stable or inflexible both in the upswing and the downswing of the cycle? It would be impossible to answer this question in satisfactory fashion without examining the structure of particular industrial markets, b u t there are certain characteristics common to all or most of the industries here under consideration that go far toward explaining this phenomenon. Among these characteristics the following have special importance: the tendency of variable costs .per unit of output to be stable with respect to changes in the volume of output; the existence of possibilities of expanding sales through advertising or product changes without resort to price inducements; price policies which of necessity take account of the probable price reaction of rival firms; a traditional concern with antitrust policy which forms part of the peculiar sensitiveness of large firms to adverse public reaction. --Edward S. Mason in J ules Backman, ed. Price Practices and Price Policies
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BUSINESS HORIZONS