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How to Create a Competitive Pricing Strategy

August 1, 2012
URL: http://www.entrepreneur.com/article/223816

Sticker Shock

Q: What's the best way to price competitively?

A: In business, it's not the glint in your eye that's the tip-off to your competitive ways--it's the price you charge.

Professor Richard Gilbert, chair of the Competition Policy Center at the University of California at Berkeley, tells us that the economics of competition comes down to the gap between price and costs. "The closer together these are, the greater the competition," he says. Businesses prefer a larger margin in order to increase profits, so there is a natural desire to find ways to limit competition. In a healthy market, this happens by introducing better products and services, not by cutting prices.

Given time, the forces of the free market will uncover the "right" price for a given item. That's all well and good--but not much help when setting prices for a new offering. For most businesses, pricing is a combination of covering costs and tacking on a reasonable profit, then determining what the competition is able to charge. If the market is perfectly competitive, all companies will charge the same price for a similar product. Price above the average, and customers will go elsewhere; price below it, and you can't afford to stay in business. Beyond that, there are strategic decisions that could affect your price point.

First, businesses may want to start with low introductory prices. "It's a common strategy to do promotional pricing to tell the world who you are and what you do," Gilbert says. If costs are likely to fall as more goods are produced and sold, then a low price that attracts sales can help a business reach greater profits more quickly.

If a product has network effects--if it becomes more valuable the more people use it--then a low price can get it into the hands of more people and help your business set the standard. On the other hand, a high price can enhance the positioning of a product as a unique or luxury item.

Companies that sell directly to consumers can set prices as high as they like, but those that work with distributors need to know a few things. "Often, firms that sell prestige products don't want their distributors to cut their price," Gilbert points out, but it is illegal to dictate a price as a requirement for carrying an item. The solution is to explain the advantages of using the suggested retail price. "You might have to help your distributor help you," he says. A high price that carries a good margin may encourage distributors to stock your product over that of the competition.

But what about antitrust laws? "For a new entrepreneur, most of antitrust is a nonissue," Gilbert says. However, there are always ways to get into trouble.

"Any business--big or small--can set its prices as it deems prudent," says William Markham, an antitrust lawyer at San Diego-based Maldonado & Markham. He says businesses can raise prices if higher margins offset the reduced demand. Alternatively, setting prices low in order to entice customers is fine, but doing so in order to force a competitor out of business is not.

Markham also says two direct competitors can never agree among themselves how much they will charge. "The offenders are exposed to criminal punishment, including even prison sentences and massive fines, and they are further exposed to civil litigation and administrative proceedings," he warns. 

Price fixing doesn't always involve top-level executives at smoky, secret meetings. In 2008, the FTC charged a physician's group in Boulder, Colo., with encouraging members to collude in their negotiations with health insurance companies. In 1998, hotels in the South Lake Tahoe Lodging Association ran afoul of the law when they collectively agreed not to post signs advertising room rates.

Now that you've been warned against getting too cozy with the competition, keep in mind that you also have to be careful about going head-to-head with them. Though acknowledging that it's "always nice to know what your competitors are up to," Berkeley's Gilbert says to avoid veering into industrial espionage. Checking out prices in stores is fine; stealing a competitor's sales documents is not. In sum, he tells us, "You're not supposed to break the law, even if it's in the service of good old capitalism."