Do lower prices create value?

There is a common belief that the determination of lower prices for some products or services would lead to a reduction in total revenue and, therefore, would destroy the economic value that the company generates in the market. However, in many cases, this assumption doesn’t hold and, on the contrary, a good pricing strategy can help attract customers in other segments in such a way that sales and profits are magnified despite the reduction in price. In relation to this, the effectiveness of this tactic consists in knowing which rates are my clients willing to pay?

Also, it is relevant to highlight that a product has a heterogeneous demand. Thus, a product could eventually have as many prices as the number of customerssince each person has a different valuation of the product and, therefore, a different willingness to pay. However, in practice this may be unachievable since the company does not always know exactly the valuation that each client gives to the product and because it would be impractical to discern the prices for two consumers if they intend to purchase the product through the same sales channel.

Furthermore, an heterogeneous demand can be used to establish a good pricing strategy and therefore increase revenue. For this cause, let’s establish an example associated with the car rental market. On this, while there are people willing to pay US$ 120 per day to rent a high-end car, there are also those who would be willing to pay half or a third of that amount. Certainly, these customers would choose to go to the competition or they would look for an alternative mode of transport if the service is not available at a fraction of the original amount. Thus, it is in these cases where Revenue Managementbecomes highly relevant. Hence, there are two approaches by which the situation described could be addressed:

– Strategy 1: reduce the rental price for all consumers to US$ 70. This strategy leads to attracting new customers at that price level, but at the same time it would generate a loss of US$ 50 in some cases since it is the additional amount that frequent customers of high-end cars were willing to pay and are no longer doing it due to the discount. In this case, if it is not possible to attract enough new clients to offset the losses associated with the price reduction (in those who would normally pay US$ 120), the revenue would decrease. This means losing value.

– Strategy 2: create a new rate of US$ 70 with rental conditions that limit in most cases that frequent customers of high-end cars can rent that new lower rate (anticipation, rental days, applicable locations, etc). Thus, unlike the first strategy, as little as possible is lost due to the lower payment of frequent customers who were willing to pay the original amount, while a new market segment is covered. Therefore, these new consumers would generate an increase in sales and revenue. This means creating value.

The difference between both promotional strategies lies in the handling of the dilution concept: the loss for charging a price lower than the one the customer is willing to pay. In the first scenario dilution is US$ 50 per rental vehicle, as an important part of the customers that they lowered the price to US$ 70 were willing to pay US $ 120. Otherwise, in the second scenario, dilution is close to zero since the new rate product of US$ 70 does not apply to them, either due to the anticipation required, the sales channel, the number of rental days required or another factor that links the segment of greater willingness to pay.

In conclusion, lowering prices to the same customers DESTROYS value. Instead, creating different rate products at lower prices to reach new customers or segments CREATES value.

Therefore, when evaluating a promotion, it is necessary to assess to what extent this strategy could reduce the margin charged to consumers with a greater willingness to pay, and whether new customers would compensate for this loss. Given this, a correct segmentation is necessary so that customers with a greater willingness to pay cannot access the offer, since otherwise the money would be diluted in those who valued the product or service even more.

About the author

With over 16 years of leadership experience driving strategic growth, pricing innovation, and transformational change across multiple industries, Daniela León is driven to contribute to the Community by sharing her experience through this blog. 

Her passion for data-driven insights and cross-functional collaboration, positions her to deliver valuable insights for business transformation.