Pricing Concept: Understanding the Difference Between Price Level & Price Structure

A thoughtfully designed complex price structure can increase realized prices and profit without raising asking prices.

Pricing is a complex activity. Managers can approach pricing decisions with different mindsets. When considering a price increase, they can ask, “By how much should we raise our prices?” Or they can frame the challenge as, “How can we improve our (realized) prices without raising our (asking) prices?”

These two questions highlight the distinction between the price level and the price structure. The price level involves thinking in averages, totals, and percentage changes. The price structure is a more sophisticated and powerful approach. It considers assortments, price-benefit combinations, and pricing variations and offers.

The Price Level

In everyday conversations, we often frame our discussions using price levels. For example, a recent story noted that the average price of a wedding in the United States declined from $28,000 in 2019 to $19,000 in 2020 because of the Covid-19 pandemic. Another story reported that despite the declining costs of coffee beans, Starbucks raised its prices by 1% because its labor and rent costs were increasing. These stories are about the price level, defined as “the average price that a company charges for its products.”

The value of the price level lies in quickly providing an overall picture of the company’s prices and pricing performance. It is a helpful, if somewhat crude, tracking variable. However, the price level has at least three serious limitations.

First, it lacks specificity and hides essential information. Saying that Starbucks raised its prices by 1% is not particularly informative. It does not mean that Starbucks raised the prices of every single item it sells by exactly 1%. The company may have raised the prices of some items and lowered the prices of others netting a 1% increase. The price level obscures details of actual prices and price changes.

Second, across-the-board price changes can be shaky. Such increases are readily subject to the penalty of the demand curve. Customers can identify them easily and respond quickly, by negotiating increases down or by buying less. On the flip side, when all prices are decreased equally, customers may not react with enough enthusiasm to make the price cuts worthwhile. Customers have less flexibility to adjust their response to a blanket price change in either direction. 

Third, and perhaps most significantly, relying on price level alone leads to ineffective pricing decisions. The savvy pricing strategist has no leeway to improve price realization. They cannot take advantage of differences in customer valuations or in customer psychology.

The Price Structure

The price structure provides a more nuanced way to approach pricing decisions. The price structure is defined as “the overall assortment of prices, price-benefit combinations, price variations, and price offers provided by the company to its customers.”

The overall assortment of prices acknowledges that few companies sell just one product. The pricing strategy must consider the company’s product lines, making decisions about how many products and different versions of each product to offer, then decide the prices of individual items. These decisions are interrelated due to the substitutability and complementarity of the company’s products.

Price-benefit combinations refer to the correspondence between the features, benefits, and the price of each item in the company’s portfolio. Prices of different products can be set to maximize their distinction from others in the line or to achieve a specific goal like maximizing sales of high-margin products. It requires an understanding of how customers make purchase decisions and the role played by price in the decision making.

Price variations acknowledge that prices change frequently in today’s dynamic pricing and low menu costs-driven environment. Instead of thinking about one price for any product, it is more useful to think of a range of prices. The pricing strategist must establish the range and decide how much, how often, and when each product’s price should change.

Price offers refer to the specific ways in which prices are temporarily reduced or contextualized to influence customer behavior. Common methods include offering discounts, price bundles, using two-part pricing, utilizing the psychological roles of price, and so on. There are virtually unlimited ways to design effective price offers, and there are almost as many reasons to do so.

Making pricing decisions by considering price structure provides the pricing strategist with many opportunities to design an effective pricing strategy.

Simple Versus Complex Price Structures

One way to understand a company’s price structure is by its degree of complexity. Spotify’s price structure in 2018 consisted of two options, Spotify Free, an ad-supported free version, and Spotify Premium at $9.99 per month that was ad-free, and provided shuffle play, offline listening, and higher-quality audio. The Spotify user had a simple binary choice: Use the free service or pay $9.99/month for the premium service. This is an example of a simple price structure. An all-you-can-eat buffet with one standard price, say $15, for everyone all the time is another example.

By 2020, Spotify had changed its price structure. It offered an individual plan for $9.99 per month, a duo plan for $12.99, a family plan for up to 6 accounts for $14.99, and a student plan for $4.99. The plans had different trial periods – the first month free for the student plan and two months free for the other plans. The family plan provided additional features like an app for kids, a family mix playlist, and the ability to block explicit music. The student plan bundled ad-supported Hulu and Showtime for cash-strapped students.

Spotify’s price structure in 2020 was more complex. It considered overall price assortment, price-benefit combinations. and price offers. The offers incorporated price bundling, good-better-best pricing, quantity discounts, trial pricing, and customized pricing. The pricing was now taking advantage of differences in the valuations, willingness-to-pay, and ability-to-pay of different customer segments and differences in the costs to serve them.

How to Improve Realized Prices Without Increasing Asking Prices

A well-designed price structure takes advantage of the four pricing pillars - costs, customer value, reference prices, and the value proposition in a thoughtful and goal-oriented way. It delivers greater total value to customers by recognizing differences between them while concurrently increasing the company’s revenue and profit, all without necessarily changing the price level. This is the fundamental benefit of a price structure. The company can improve its realized prices without raising its asking prices.

Let’s consider two examples to illustrate this counter-intuitive but powerful principle: (1) By focusing on higher-margin sales from an existing product assortment, and (2) By shifting from an everyday low price (EDLP) to a hi-lo pricing strategy.

1) By focusing on higher-margin sales from an existing product assortment.

Consider a company that sells economy and premium versions of a product, A and B. A costs $7 to make and is priced at $10. B costs $10 to make and is priced at $25. The margins on A ($3 or 30%) are lower than the margins on B ($15 or 60%).

In the base case, the company’s management hasn’t considered price structure strategically. The company advertises both products equally. The result is that the company sells more of A (10 units) and less of B (5 units). The company earns a revenue of $225 and a profit of $105 (47%).

The Base case

Thinking strategically, the management makes one change: they focus on selling B by shifting all advertising to B (using the same budget as before). This results in fewer sales of A (5 units) and more sales of B (10 units). With this shift, the company earns a revenue of $225 and a profit of $105 (47%).

An emphasis on sales of B

By emphasizing B, the company’s revenues have increased to $275 from $225, and its profit has increased to $165 from $105. The margin also increases, from 47% to 60%. The asking prices have remained unchanged; but because of the company’s focus on selling the higher-margin product, performance has improved.

Now imagine a third case where customers are more demanding. To achieve the same sales of B as the previous case, the company must not only switch all advertising to B, but also offer a 10% discount to buyers. The customers of B now pay $22.50 instead of $25.

An emphasis on sales of B, with a 10% discount

Comparing this to the base case, we can see that the price level of the company’s products has decreased. But the company still earns higher revenue ($250 vs. $225 in the base case) and higher profit ($140 vs. $105). The customers are paying lower prices, but the company is still making higher revenue and profit. This example illustrates the principle of improving realized prices without raising asking prices or even lowering them.

2) By shifting from EDLP to hi-lo pricing

Everyday low price is a pricing strategy where the company keeps its prices unchanged over time. Hi-lo pricing involves selling the product at its regular, higher price some of the time and offering price promotions at others. Under EDLP, the customer pays the same price no matter when they buy the product. In hi-lo pricing, the price paid depends on purchase timing. EDLP uses a simple price structure, hi-lo pricing uses a more complex price structure.

In the base case, consider a company that sells product A using EDLP. It costs $7 to make and is always priced at $10. The margins on A are $3, and the company is able to sell 10 units of A. In this case, the company will earn revenue of $100 and a profit of $30 (30%).

EDLP pricing

The company now shifts from the simpler EDLP price structure to the more complex Hi-lo price structure. They increase the regular (hi) price of A to $15. From time to time, they run promotions, offering A at the low price of $9. The company still sells 10 units of A, 3 units at the hi price to customers who are not price-sensitive, and 7 units at the low price. The company earns revenue of $108 and a profit of $38 (35%) under hi-lo pricing.

Hi-lo pricing

A majority of customers pay a lower price under hi-lo pricing than they did under EDLP. Still, the company earns higher revenue and profit. This is because hi-lo pricing allows the company to capture greater value from the lower price sensitivity and higher willingness-to-pay of a small minority of customers.

Tools for Designing a Price Structure

As the two examples illustrated, the price structure provides opportunities to develop more customized price offers. It recognizes differences in what customers want and how much they are willing to pay and makes offers that fit these needs. The pricing strategist can use the following pricing tools in designing a price structure:

• Give a free trial or introductory discount.

• Utilize price promotions.

• Offer different prices based on natural or orchestrated fluctuations in demand.

• Charge fees for customer affordances (e.g., change fees, resort fees, surge prices).

• Vary the price at random intervals.

• Use hi–lo pricing, not EDLP.

• Provide good-better-best choices.

• Vary prices for horizontally and vertically differentiated products in the line.

• Use mixed price bundling.

• Avoid all-inclusive prices, partition prices instead. (Example: separate shipping)

• Use loss leaders.

• Use two-part pricing, by requiring a paid membership for access (e.g., Costco)

• Discount complementary products.

• Design a complex loyalty rewards program.

• Use dynamic pricing anchored to demand changes.

Each pricing tool in the list has its own design parameters and considerations for effective use, and each one merits its own in-depth discussion. Plus this is by no means a comprehensive list of available tools. New tools are constantly emerging with technology and a better understanding of buying psychology.

Conclusion

When the pricing strategist makes decisions by thinking about the price structure instead of the price level, they have more flexibility and greater opportunities to improve price performance. As a result, they can pursue the seemingly impossible goals of delivering greater value to customers and concurrently increasing the company’s revenue and profit. They can improve realized prices without raising asking prices, or even by selectively lowering them. A more complex price structure that accounts for differences between customers will result in bigger payoffs for the company.