Before a firm develops a pricing strategy it should analyze the outside factors affecting decisions. Price decisions depend heavily on elements external to the firm, which are described next.

Consumers
A marketer should understand the relationship between price and consumer purchases and perceptions. This relationship is explained by two economic principles : the law of demand and price elasticity of demand and market segmentation.

The law of demand states that consumers usually purchase more units at a low price than at a high price. The price elasticity of demand defines the sensitivity of buyers to price changes in terms of the quantities they will purchase.

Elastic demand occurs if relatively small changes in price result in large changes in quantity demanded. Numerically, price elasticity is greater than 1. With elastic demand, total revenue goes up when prices are decreased and goes down when prices rise.

Inelastic demand takes place if price changes have little impact on quantity demanded. Price elasticity is less than 1. With inelastic demand, total revenue goes up when prices are raised and goes down when prices decline.

Unitary demand exists if changes in price are exactly offset by changes in quantity demanded, so that total sales revenue remains constant. Price elasticity is 1.

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Competition
Another element contributing to the degree of control a firm has over prices is the competitive environment within which it operates. A market-controlled price environment is characterized by a high level of com¬petition, similar goods and services, and little control over price by individual companies.

A company-controlled price environment is characterized by moderate competition, well-differentiated goods and services, and strong control over price by individual firms. Companies may succeed with high prices because consumers view their offerings as unique. Differentiation may be based on brand image, features, associated services, assortment, or other factors.

A government-controlled price environment is characterized by prices set by the government. Examples are public utilities, buses, taxis, and state universities. In each of these cases, government bodies determine prices after obtaining input from the affected companies, institutions, or industries as well as other interested parties (such as consumer groups).

PRICE STRATEGY
A price strategy may be cost-based, demand-based, or competition-based. With a cost-based price strategy, the marketer sets prices by computing merchandise, service, and overhead costs, and then adding the desired profit to these figures. Demand is not analyzed. The price floor is the lowest acceptable price the firm can charge and attain its profit goal.

In a demand-based price strategy, the marketer sets prices after researching con¬sumer desires and ascertaining the range of prices acceptable to the target market. For example, if the firm finds that its customers will pay $10 for an item and it needs a $3 margin to cover profit and selling expenses, production costs must not exceed $7.

Demand-based pricing is used by marketers who believe that price is a key factor in consumer decision making. These marketers identify the price ceiling, which is the maximum amount consumers will pay for a given good or service. If the ceiling is exceeded, consumers will not make purchases. Its level depends on the elasticity of demand (availability of substitutes and urgency of need).

Under a competition-based price strategy, the marketer sets prices in accordance with competitors. Prices may be below the market, at the market, or above the market, depending on customer loyalty, services provided, image, real or perceived differences between brands or stores, and the competitive environment. Competition-based pricing is applied by firms that face competitors selling similar items.

Source of Reference:
Joel R. Evans and Barry Berman, Marketing in the 21st Century, Atomic Dog Publishing. You can obtain this excellent book here

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