What are the Sources of Pricing Power?
The factors that can influence pricing power are specific to each industry considering the different target customer markets, degree of competition, and behavioral patterns in purchases, among other considerations.
From a high-level perspective, the following are the most typical sources of pricing power.
- Product Differentiation (Value Proposition) → Companies that offer differentiated products or services with regard to quality, unique features, or capabilities often face limited competition in the market. In particular, technical products protected by patents or intellectual property (IP) create a legal barrier against competition. The more technical a product is, the stronger the barrier to entry is for new entrants and the more pricing power afforded to the company over the end markets it serves, all else being equal. Thus, companies must constantly improve the value offered to their customer base to sustain pricing power.
- Limited Market Competition → The absence of close competitors in a market or substitutes can provide companies with more leeway to set prices based on their self-interest, rather than consumers in the market naturally determining price (i.e. supply and demand).
- Strong Branding and Reputation → Establishing the intended branding and reputation among consumers in the market is easier said than done, but companies that do, in fact, become perceived by consumers as reliable and of higher quality can reap long-term benefits from the trust attached to their brand name.
- High Switching Costs → If the process of switching to a different competitor’s product or service is costly or inconvenient, the original provider is likely to possess more pricing power. The decision to switch to a different provider – assuming there are high switching costs – should cause customers to be more reluctant to move to a competitor. The incentive to move to a different provider cannot be a marginal improvement relative to the current provider because the switching costs raise the “hurdle” that the competitor must bypass to steal market share, i.e. the switching costs outweigh the marginal benefits of moving to a different provider.
- Economies of Scale (Cost Advantage) → Given an expansion in the scale of operations, a business can obtain cost advantages wherein the average cost per unit of production declines from the increase in production volume. The favorable unit economics from more efficient production processes can contribute towards an expansion in profit margins, resulting in more flexibility to adjust prices. For instance, an existing market leader could incur far less costs in the process of manufacturing its products, which provides the optionality to offer its products at lower price points that would not be economically viable for new entrants, i.e. the pricing functions as a deterrent to new entrants.
- Inelastic Market Demand → If a product or service is in high demand, or if demand is relatively insensitive to price changes (referred to as inelastic demand), a company can often charge higher prices. A company’s pricing power is directly tied to the price elasticity of demand for its product. If there are a limited number of competing products, companies will have strong pricing power (and vice versa for those with plenty of competing products).
- Favorable Regulatory Environment and Patents → In certain industries, regulations can function as a constraint on competition by reducing the number of market players or setting pricing floors or ceilings. The pre-determined pricing of the products and services of a given industry can disproportionally benefit certain companies while serving as a barrier to others. Moreover, patents, copyrights, and related legal factors can reduce competition and contribute to more pricing power.
- Mission-Critical Product Offerings (or Contractual Revenue) → The types of products or services with high pricing power are often essential to the end markets of the company. While more applicable to B2B companies, the discontinuance of such products or services would be detrimental to business continuity, i.e. the customer should be unable to function because of how deeply embedded the product is in its operations, or the adjustment period should cause a notable drop-off in quality to their customers. Furthermore, multi-year contractual agreements are another method to secure long-term customers and more recurring revenue.
How to Measure Pricing Power
Pricing power can be gauged using quantitative and qualitative metrics, but the top two leading indicators that reflect pricing power are the following:
- Profit Margin (%) → The profit margins of a company with stronger pricing power are on the higher end relative to comparable companies. In particular, the gross margin, contribution margin, and operating margin will each stand out because of the favorable unit economics that benefit the profitability of the company.
- Margin Stability → Pricing power also enables a company to maintain its current profit margins amidst an economic downturn (or recessionary period). In fact, a company will not only be capable of exhibiting long-term stability in its margin profile but might be able to improve its profit margins by raising prices.
While there is no exact formulaic method to quantify the pricing power belonging to a company, a practical question to ask is, “If the company raised prices by ~20%, what would the impact on customer retention (and churn) be?”
On that note, minimal attrition in customers following a hike in pricing implies the company possesses pricing power.
If a company has pricing power, it can raise prices and not see a substantial increase in customer churn.
In short, the pricing power of a company is determined by how essential the product or service is to the end market, the unique value proposition offered, and the availability of (or more specifically, the absence of) other alternatives in the market.
Learn More → Exploring Pricing Power (Source: Morgan Stanley)
What are the Benefits of Pricing Power?
There are a multitude of benefits of pricing power:
- Profit Margin Expansion (“Lever”) → Companies that possess pricing power can raise prices without significantly affecting the demand for their products or services, enabling them to maintain (or benefit from margin expansion), even if costs were to rise or the near-term economic outlook appears unfavorable.
- Resilience to Inflationary Periods → In periods of high inflation, where the pricing of raw materials and labor costs rise, companies with pricing power typically exhibit more resilience. The option to raise prices is a critical trait of the company that enables its profit margins to remain in line with historical trends and ultimately withstand challenging market conditions.
- Capital Markets Access → Investors in the capital markets that provide financing in the form of either debt or equity often perceive pricing power as a positive attribute that improves the likelihood of the company meeting its necessary capital raise target, including favorable terms in the case of debt lenders (e.g. better interest rates). The strength of the company and its competitive advantage implies more predictable revenue and stability in operating performance, which practically all investors view positively.
- Business Model Flexibility → Pricing power offers companies a greater degree of flexibility with regard to implementing various strategies, irrespective of the market conditions. For instance, the company can raise prices to increase profits, or lower prices to gain more market share in periods where competitors are currently facing margin compression.
How Does Inflation Impact Pricing Power?
The economic concept of inflation describes the widespread increase in the prices of goods and services that affects consumers and businesses. The rise in pricing in the broader market directly causes a decline in purchasing power over time.
In inflationary periods, where most companies are struggling to implement strategies for cost reduction, market leaders with pricing power can pass increased costs from inflation onto their customers by raising prices.
Therefore, a company with pricing power can maintain (or even improve) its profit margins in adverse economic conditions, while others are incurring margin erosion.
With that said, companies with higher pricing power are generally better positioned to withstand inflationary pressures than their competitors with less pricing power, which enables them to retain or even gain market share, i.e. capitalize on the opportunity.
Pricing power is a critical attribute of a business with a sustainable moat, in which the business can continue to benefit from consistent profit margins over the long run and less cyclical performance, even if the economy were to undergo a downturn.
Real-Life Example of Pricing Power: Apple (AAPL)
An example of a real-world company with strong pricing power is Apple Inc. (AAPL).
- Brand Strength → The branding of Apple is second to none, because the brand is recognized globally and associated with high-quality, premium products with features at the forefront of innovation. The strong brand provides Apple with the option to price its products at premium prices relative to its competitors.
- Differentiated, Innovative Product Line → The product offerings of Apple are also highly differentiated with innovative features such as iOS, iMessages, App Store, iCloud, MagSafe, and FaceTime, including a user experience where each product is strategically connected to be complementary to one another.
- Interconnected Product Offerings→ The seamless integration of Apple products, often called the “Apple Ecosystem”, functions as an incentive for customers to be more likely to purchase other Apple products, i.e. customer loyalty, resulting in more recurring revenue and repeat purchases. In effect, once a consumer purchases one product from Apple, there is a high probability that future purchases of adjacent products will also be from Apple, as the customer is now part of the Apple ecosystem.
- High Switching Costs → Apple benefits from high switching costs, both in monetary terms and the convenience factor, where switching to a competitor is inconvenient (and causes the value of existing Apple products to decline, e.g. using a Windows laptop with Apple AirPods is less convenient as using a MacBook Pro with AirPods). Hence, Apple has consistently been able to raise the prices of its flagship products, namely the iPhone, without experiencing significant drops in demand.
- Cost Advantage → Apple commands control over its value chain – both on the hardware components and software development side – which allows Apple to negotiate more favorable terms with suppliers, although there have been more recent initiatives annouced to bring production in-house (with less reliance on outsourcing).
The unique combination of brand strength, product differentiation, high switching costs, and product connectivity each contribute towards Apple’s demonstrated pricing power.
Apple Ecosystem – Product Line (Source: Apple Store)
The pricing power of Apple is evident in its ability to regularly release new versions of its products at higher prices without seeing a significant drop in demand, which can be confirmed by Apple’s historical profit margins.
In conclusion, the pricing power of Apple is often viewed as one of its primary strengths and a major contributor to its past and continued success.
