Original Article

Pricing nancial services

innovations
Received (in revised form): 24th May 2012

Mohammad G. Nejad*
is Assistant Professor of Marketing at the Graduate School of Business, Fordham University. He received his PhD from the University
of Memphis. His research interests relate to diffusion of innovations, particularly how rms can direct their marketing activities to use
complex interactions among consumers and increase the chances of their new products success in the market. His research has been
published in the European Journal of Operational Research and Services Marketing Quarterly.

Hooman Estelami*
is Professor of Marketing at the Graduate School of Business, Fordham University. He received his PhD in Marketing from Columbia
University and his MBA from McGill University. His areas of research specialization are nancial services marketing, customer service
management, and pricing. He has published over 30 research papers in journals such as the Journal of Retailing, the Journal of the
Academy of Marketing Science, the International Journal of Research in Marketing, the Journal of Business Research, the Journal of
Product and Brand Management, the Journal of Services Marketing, the Journal of Service Research, the Journal of Financial Services
Marketing, Marketing Education Review, and the International Journal of Bank Marketing. Dr Estelami is the associate editor of the
Journal of Product and Brand Management and the author of two books: Marketing Financial Services and Marketing Turnarounds. He
has received multiple awards for his teaching and research and has advised a wide range of nancial institutions on target marketing,
pricing, and service enhancement strategies.
*Both authors contributed equally to this paper

ABSTRACT The number of innovative nancial solutions introduced to markets has grown
considerably in the past decade owing to emerging digital technologies, deregulation and
market fragmentation. Examples are abundant in the worldwide markets for insurance, credit
products and transaction processing services. A question of growing interest is how rms
should price these innovations. The optimal introductory pricing of nancial innovations
may vary as a function of factors such as price sensitivity of the market and competitors
ability to introduce competing nancial solutions. In this article, we examine the role of these
factors in the optimal pricing of a nancial innovation. Using an agent-based simulation
framework, introductory pricing strategies that maximize protability under various market
conditions are identied. Results indicate that lower levels of market price sensitivity and
longer time horizons for competitive entry create pricing opportunities for nancial innovators.
However, the relationship becomes more complex as market price sensitivity increases or
competitive market entry becomes more immediate. Detailed recommendations for optimal
pricing of nancial innovations under various market conditions are provided, and the article
concludes with strategic recommendations for pricing innovative nancial services.
Journal of Financial Services Marketing (2012) 17, 120134. doi:10.1057/fsm.2012.12
Keywords: pricing; innovations; nancial services; diffusion; agent-based modeling and simulation

Correspondence: Mohammad G. Nejad

Graduate School of Business Administration, Fordham University,
113 West 60th Street, New York, NY, USA
E-mail: mnejad@fordham.edu

2012 Macmillan Publishers Ltd. 1363-0539 Journal of Financial Services Marketing Vol. 17, 2, 120134
www.palgrave-journals.com/fsm/

Pricing nancial services innovations

INTRODUCTION
Financial services markets have witnessed
the introduction of a growing number of
innovations during the past decade. Since
the enactment of financial deregulatory
measures in the United States, Europe and
Asia, financial institutions have introduced
a large number of new solutions in order
to address the unique needs of customers
in both corporate and consumer financial
markets. The blending of new digital
technologies into the new product
development process for financial services
has further accelerated the development and
market adoption of new financial solutions.
Examples can be found in markets for
insurance, consumer credit and transaction
processing services.
Firms pricing strategies for introducing
financial innovations must take into account
the market forces that are at work during
and following product launch. The nature of
consumer interactions with each other
through their social networks in the target
market can further influence the diffusion
process. The optimal introductory price of a
financial innovation can also be affected by
the speed with which competitors would be
able to imitate the financial innovation.
Although some financial innovations present
significant entry barriers to competitors
owing to technological hurdles or investment
requirements, other financial innovations can
be easily copied by competitors. The optimal
pricing also impacts the speed of the
diffusion process. Lower prices may lead to
faster diffusion processes and therefore
increase the market penetration of the
innovator in advance of competitive entry
to the market.
The optimal introductory price of a
financial innovation can also be affected
by the degree of price sensitivity evident
in the marketplace. The unique nature of
consumers response patterns to prices in
specific financial services markets may have
strategic pricing implications that need to
be considered when pricing financial

innovations. Empirical studies show that

consumer price knowledge and ability to
comprehend prices can be limited in certain
financial services markets, resulting in
market responses that can challenge the
traditional views of a downward sloping
demand function. The nature of a markets
price response, as captured by the price
elasticity of demand, can therefore influence
the optimal pricing of new financial
services.
In this article, we focus on the pricing of
new-to-the-world financial solutions by
pioneers. We use a simulation-based
approach to examine the effects of various
introductory pricing strategies on firm
profitability under a range of market
conditions. For every condition, we
identify the pricing strategies that maximize
profitability by conducting extensive agentbased simulation experiments. This approach
enables the modeling of the complex social
influences that consumers exert on each
other during the market adoption process of
a financial innovation a social process that
is growing in its significance owing to wide
public access to social media tools. The
results demonstrate that the optimal pricing
strategy should be informed by measures
of market price sensitivity as well as
expectations regarding the timing of
competitive entry. The article concludes
with a discussion of the findings and
directions for future research.

THE MARKET IMPACT OF

FINANCIAL INNOVATIONS
It is estimated that in the past decade alone
the number of new products introduced to
the marketplace outpaced the number of
new product introductions for most of the
previous century (Fortin and Uncles, 2011).
In financial services, this growth can be
partially attributed to deregulatory measures
that came into effect at the turn of the
century in the United States, Europe and
Asia. In the United States, deregulation
under the general umbrella of the Bank

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Nejad and Estelami

Modernization Act of 1999 enabled

financial institutions to participate in
markets from which they were previously
banned. For example, deregulation allowed
commercial banks to participate in the
underwriting of insurance, and it also
enabled insurers to sell deposit and credit
products, which were traditionally sold by
retail banks.
An additional effect of the deregulatory
mindset was the worldwide relaxation of
restrictions on the development of new
financial products. This, in combination
with the explosive growth of the Internet
and leapfrogging advancements in mobile
phone technologies, has resulted in the
introduction of a great number of
pioneering financial solutions to the
marketplace in the past decade. Examples
can be found in insurance markets, where
very well-defined insurance products have
been introduced to address very specific
risk-protection needs. For example, new
insurance products have been introduced
to protect the needs of athletes in certain
high-risk sports (for example, ski-pass
insurance), or to protect event organizers
from the potential risk of event cancellations
due to terrorist activities (Estelami, 2006).
It is important to note however that the
growing number of financial innovations in
recent years has also caused concerns over
the limited ability of consumers to
comprehend the nature of financial offers,
and has put into question the extent of
responsibility and accountability that should
be owned by regulators in assessing the
societal impact of financial innovations
(Warren, 2008; Richards, 2009). Research
indicates that the complexity of financial
services can at times make it difficult for
consumers to evaluate a financial offer
objectively. For example, financial services
prices are often multi-dimensional, difficult
to understand and pose challenges for
consumers in determining the expected
layout of funds associated with their purchase
(Estelami, 2009). As a result, consumer

122

knowledge of prices and their understanding

of the benefits of financial services is limited,
and these limitations can become profound
in cases where no prior consumer exposure
to the financial service exists, as one would
expect in the context of financial
innovations.
Historically, financial innovations have
been fueled by the emergence of market
segments with unique financial needs not
served by conventional financial solutions
available in the marketplace. For example,
Bank of America first introduced the
BankAmericard (eventually renamed Visa)
in 1958 in order to serve the unique
transaction-processing needs of drivers who
are frequent travelers and use specific gas
stations and hotels in their travel paths
(Manning, 2001). By establishing the Visa
payment network at these outlets, the credit
card category came to life. Considered by
some as the most innovative financial
innovation of the twentieth century, it is
argued that this innovation has had more
impact on western society than any other
financial service (Manning, 2001).
The launch pricing of BankAmericard
comprised collecting yearly membership fees
from cardholders and collecting additional
network usage fees from the participating
merchants. These fees were considerably
higher than current credit card fees,
where most cards now no longer charge
membership fees, and network usage fees
for merchants have dropped significantly
due to competition. However, the choice
of how to price an innovative financial
service is not an obvious one. Although
for some financial innovations a high
introductory price may be a reasonable
strategy, it may prove catastrophic for
other innovations or under other market
conditions. The optimal launch price of a
financial innovation may, for example, be
affected by the level of consumer price
sensitivity, the anticipation of competitive
market entry and the nature of the adoption
process in the marketplace.

2012 Macmillan Publishers Ltd. 1363-0539 Journal of Financial Services Marketing Vol. 17, 2, 120134

Pricing nancial services innovations

FACTORS THAT INFLUENCE

INTRODUCTORY PRICING
OF PIONEERING FINANCIAL
SERVICES
Identifying the optimal introductory price for
an innovative financial service has become an
important concern in recent years owing to
evolving market characteristics. Consumers
have become more cost-conscious as a result
of increased competition, a global economic
slowdown and limited household
discretionary spending budgets. The
emerging market environments show signs of
more controlled consumer spending and
increased price sensitivity. In addition, the
growing power of the consumer, resulting
from the mass use of social media, has
influenced the rate at which consumers in
the marketplace adopt innovations, financial
or otherwise. Owing to the use of social
media, information on new products and
services can disseminate through a target
population at speeds that far exceed those
experienced a decade earlier. As a result,
financial innovations that have great appeal
to consumers can reach market acceptance
more quickly with consequences on the
optimal pricing of such innovations. In this
section, we will examine the potential role
of market price sensitivity and the expected
timing of competitive entry in launch pricing
decisions. The possible influence of these
factors will be examined, following which a
simulation-based approach to determining the
optimal launch price will be presented.

The market adoption process

Innovation diffusion is the the spread of an
innovation across markets over time
(Chandrasekaran and Tellis, 2007, p. 40),
which occurs as potential adopters learn
about the new product and make their
adoption decisions. According to diffusion
theory, potential consumers learn about an
innovation through marketing activities of
sellers and the social influence exerted by
other consumers (Rogers, 2003; Muller et al,
2010). During early diffusion stages, some

customers adopt an innovation because they

are influenced by marketing activities or
because they are in touch with the latest
advances. Over time, these adopters will
communicate their experiences to others
through word-of-mouth (WOM) or other
means of social influence, leading to further
adoptions by other consumers over time
(Rogers, 2003).
Consumers communicate with each other
and exchange WOM through their social
ties. Social networks comprise individual
consumers referred to as nodes and
social ties. In a social network, consumers
are connected to each other through their
social ties, which connect them to their peers
(Van den Bulte and Wuyts, 2007). In recent
years, the social networking effect has further
strengthened owing to the growing use of
social media and Internet sites that enable
individuals to connect with each other and
learn from each others experiences. User
reviews posted on the Internet inform the
public on consumers experiences with a new
financial service and can be disseminated
very quickly within the target population.
The social networking effect may have both
positive and negative effects on market
reactions. For example, consumer protests in
reaction to price increases in the retail
banking markets in the United States were
communicated using Facebook, YouTube,
Twitter and other social media sites
(Harrington, 2011). The wide use of social
media quickly resulted in the depletion of
the brand positioning of some of the largest
national banks in the United States and a
reversal of highly contested pricing policies.
In some financial services, the diffusion
process is driven by the accessibility of the
underlying technology that makes the service
possible. This helps create a natural social
network of consumers that further enhances
the adoption rate of the financial innovation
within the target market. For example, in
order for the BankAmericard to be adopted
by the consumer base, a minimum threshold
number of gas stations and hotels had to

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Nejad and Estelami

have adopted the capabilities of transaction

processing through its payment network.
This threshold is often referred to as the
tipping point and reflects the minimum level
of market acceptance needed before the mass
adoption of the innovation can become
possible in the marketplace. Reaching and
exceeding the tipping point was also critical
to the success of PayPal, for which a certain
minimum number of members would have
been needed in order for it to become a
widely accepted means for online financial
payment processing (Gladwell, 2002).

The effects of market price

sensitivity
For an innovative financial service, the
optimal introductory price may be affected
by the way in which individual consumers
interpret the price. Research in behavioral
decision making shows that human financial
decisions and price reaction often do not
follow rational economic models (Lowenstein
and Thaler, 1989). For example, when
evaluating the trade-off decisions between
present and future consumption of financial
assets, most consumers apply discount rates
significantly different from those used in
financial markets. In such decisions, most
consumers pay higher-than-market discount
rates to secure access to immediate
consumption, while demanding only low
discount rates for consumption decisions in
the distant future. This phenomenon, often
referred to as hyperbolic discounting, has
been considered as a primary driver for
massive consumer debt accumulation related
to excessive discretionary spending and the
under-investment of the public in retirement
plans a phenomenon observed in many
advanced economies (Shleifer, 2000; Murthi
et al, 2011). Furthermore, consumer
knowledge of financial services prices has
been shown to be weak, and their ability to
objectively compare financial prices
suboptimal (Estelami, 2005).
The lack of ability to understand financial
services offers and the associated prices has in

124

some markets resulted in low levels of price

sensitivity. Consumers inability to gauge the
quality of some financial services can result
in the use of price as an indicator of quality.
This phenomenon reduces consumer
sensitivity to price, as higher prices can be
considered beneficial as they would be
associated in the consumers mind with
higher levels of quality. This behavior is
more evident in categories of financial
services where objective quality can be
difficult to establish, such as property-andcasualty insurance, life insurance and financial
advisory services (Dusansky and Koc, 2010),
and less evident in commoditized financial
services, such as mortgages or credit products
(Estelami, 2005).
A financial services providers knowledge
of the price sensitivity expected for an
innovative financial service can have
significant effects on the choice of the
introductory price. If the consumer price
sensitivity is low, then a low launch price
strategy may leave potential profits untapped
and also deplete market perceptions of the
innovation by implying low quality. This is
an especially important consideration as
consumers have not seen the new-to-the-world
innovation before and, as a result, they may
have no prior product quality information to
rely on. In such a case, price may serve as
their primary information cue with respect
to quality. On the other hand, if the level
of price sensitivity is high, then a lower
price will attract a larger mass of the target
market. Given this relationship, the optimal
introductory pricing depends on the
balancing point between the financial effects
of a lower price and the possible gains in
customer count. The magnitude of the
price elasticity will determine if the customer
count gains resulting from a low price can
have positive financial effects for the firm.
A low introductory price strategy can also
help the innovator secure a long-term
pioneering advantage for the financial
innovation, such as those resulting from the
establishment of a strong brand name or the

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Pricing nancial services innovations

perception of uniqueness associated with the

innovation. As a result, other financial
services providers may have difficulty
entering the market and establishing their
own market identity, or may choose to
delay their entry to the marketplace.

The effects of the expected timing

of competitive entry
The optimal introductory pricing of a
financial innovation can also be affected by
the length of time it takes for competitors to
introduce their own financial solutions that
match the capabilities of the innovation.
Some financial solutions may be protected
from competitive entry because of entry
barriers. Barriers to entry, such as
technological hurdles, large upfront
investments and patents, may prevent
competitors from entering the market created
through a financial innovation. For example,
developing a payment network infrastructure
to match that of Visa in the 1960s took
competing firms over a decade (Manning,
2001). On the other hand, for some
innovative financial services, entry barriers
may be minimal. In cases where no major
technological leaps are needed or investment
requirements for launching products into a
newly developed market are not high, early
competitive entry is more likely to take
place. Innovations in some sub-categories of
insurance markets would be good examples,
whereby similar insurance policies to those of
the pioneer can be introduced by
competitors who replicate the contractual
terms of the pioneers insurance product.
Variations in the timing of entry of
competitors in a newly developed market
may also result from variations in customer
retention rates. Research indicates that in
financial services markets the tendency of
customers to switch to competitors is
generally low (Panther and Farquhar, 2004;
Dawes et al, 2009). Therefore, even after the
entrance of competitors, adopters of a
financial innovation have a low propensity to
switch to competitors. This further reduces

the financial incentive for the competition

to enter the market. Competitive entry
may be further delayed owing to regulatory
requirements, which prevent a massive influx
of competitors at local, regional or national
levels. For example, in the United States,
where insurance products are regulated at the
state level, specific requirements and
restrictions exist for each state, with respect
to the introduction of new insurance
products.
The expected timing of competitive entry
can affect the overall marketing strategy of
a financial innovation. However, this issue
is not unique to financial services and is a
well-documented concern in many markets,
especially those of a high-technology nature
where the products life cycle can be short.
For some technology firms, a skim-andwithdraw strategy is often adopted in cases
where competitive entry is anticipated within
a short time of the launch of the innovation
(Walker et al, 2010). In this strategy, high
prices are charged upon product introduction
and once competing firms enter the market
a withdrawal market strategy is adopted
whereby prices are dropped, or the pioneer
withdraws from the market altogether. For
some financial innovations, an initial price
skimming strategy may also be an appropriate
approach as barriers to entry may be minimal
and imitation by competitors may occur
within a short period of time. The effects of
the timing of competitive entry will
therefore be examined through the
simulation framework that is discussed in the
next section.

METHODOLOGY
Simulation modeling is a viable approach for
examining diffusion phenomena that are
difficult to examine using other methods,
and has been shown to have a high degree
of internal validity (Davis et al, 2007;
Harrison et al, 2007). In this approach, a
market environment is modeled and the
expected business outcomes, such as profits
and market share, are computed. The process

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Nejad and Estelami

is repeated multiple times, under a variety

of market scenarios, in order to develop an
understanding of variations in the business
outcomes resulting from changes in the
inputs (for example, introductory price, level
of market price sensitivity, timing of
competitive entry) as well as natural
randomness in the underlying market
adoption process (North and Macal, 2007).
We employ an agent-based modeling and
simulation (ABMS) approach (Bass, 2004;
Muller et al, 2010) to explore the research
questions outlined above. ABMS provides a
setting for simulating consumers as
autonomous entities who can interact with
each other through their social ties (North
and Macal, 2007) a phenomenon of
growing significance in light of the explosive
use of social media by the general
population. The methodology also allows for
longitudinal examination of the diffusion
process and the assessment of the impact of
the study factors on diffusion outcomes.
At the heart of the simulation is a
diffusion process reflected in the Bass
diffusion model. The Bass model is popular
because it is parsimonious and has high
predictive capability as supported by over 40
years of empirical research (Bass, 2004). It
uses two parameters for modeling innovation
diffusion: parameter p capturing the overall
effects of the marketing activities of the
innovating firm and parameter q
capturing the influence of adopters on other
consumers (Bass, 1969). The Bass model was
initially introduced to examine the diffusion
of durables but has since been successfully
used for modeling diffusion processes for a
wide range of innovations in various service
industries (for example, Mesak and Darrat,
2002; Bass, 2004; Jiang et al, 2006). Examples
are market adoption of online banking
services (Hogan et al, 2003), Cable TV
(Lilien et al, 2000) and cellular phones
(Krishnan et al, 2000). Whereas the original
Bass model examined the diffusion process
at the aggregate market level, recent
studies have developed individual-level

126

methodologies (for example, Goldenberg

et al, 2002, 2007; Ghoreishi Nejad, 2011).
These individual-level models have provided
new opportunities for studying the diffusion
process because they allow for modeling each
individual customers adoption decision as
well as the effects of the relationships among
customers, which may further influence
adoption rates. We will use this individuallevel approach in simulating the adoption
process. In the next section, we will discuss
the consumer decision-making process and
incorporate the effects of price, competitive
entry timing and price sensitivity on the
performance outcomes of the firm.

Consumer decision process to

adopt a nancial innovation
In modeling the diffusion process, we use a
chronological sequence for individual
consumer decisions in adopting a financial
innovation. When a financial innovation is
first launched (time = 0), all consumers in the
marketplace are in the pool of potential
adopters. During the early diffusion stages,
marketing activities captured by parameter
p of the Bass model are the primary driver
of innovation diffusion and may influence
some consumers to adopt the innovation.
These consumers will leave the pool of
potential adopters and will move to the pool
of actual adopters. They will also initiate
WOM communications with other
consumers in their social network, which
increases the chances of adoption by the
market (Amini et al, 2012). The effect of
WOM is captured by parameter q of the
Bass model. Building on earlier studies
(Goldenberg et al, 2002), we calculated the
probability of a potential consumer i
adopting the product p(i, t) at time period t
using the following formula:
p( i ,t ) = 1 (1 pi )(1 qi )Si ( t )
where pi captures the influence of marketing
activities on each potential consumer, qi
represents the WOM effect, and Si(t) is the

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Pricing nancial services innovations

number of adopters at time period t who have

a social tie with a potential consumer i. The
next step in the model is to incorporate
the impact of price on the probability of
adoption. Previous aggregate-level diffusion
models have assumed a multiplicative impact
for price (for example, Mesak and Darrat,
2002; Lehmann and Esteban-Bravo, 2006).
We incorporate this approach in modeling
consumer adoption decisions by using
exp( b(price 1)) as a multiple of the above
formula, with b capturing the price elasticity
of demand. Therefore, the probability of
adoption by each consumer will be calculated
as:
p( i ,t ) 1 (1 pipr )(1 qipr )Si ( t )
where
pipr = pi exp( b( price 1))
qipr = qi exp( b( price 1))
Thus we have a zero adoption probability
when price is infinite and the base level of
diffusion is at the price of 1. In this study,
the price of 1 is set as the base price that
generates the base level of market diffusion
as a benchmark, to which all other simulated
market and pricing conditions will be
compared. Therefore in establishing the best
pricing strategy (for example, decreasing or
increasing the price from this base level),
financial outcomes will be compared with
simulated outcomes resulting from the base
price of 1. In the base case, a price of 1
denotes that every adoption generates a profit
of 1 unit for the firm, and the unit variable
cost is assumed to be negligible, as is often
the case in most service organizations
(Estelami, 2005; Oliver, 2009). The
parameter values and ranges in the simulation
were chosen based on previous studies. This
was done in order to accurately capture the
effects of real-world market characteristics.
The appendix provides the empirical and
theoretical bases for the choice of parameter
values used in the simulation.

The dependent variable

To compare the performance of different
pricing strategies, the net present value (NPV)
of profits was used as the dependent variable.
The NPV of profits captures both the number
of adopters and the timing of adoption. This
is an important consideration as adoptions that
take place during early stages of the diffusion
process are more valuable to the firm than
those which occur during later stages (Libai
et al, 2010). In line with earlier studies (for
example, Goldenberg et al, 2007; Ghoreishi
Nejad, 2011), the performance of every
pricing strategy is captured by comparing the
NPV of profits resulting from the diffusion
process, where the pricing strategy was
applied, with that of the base case (that is,
price of 1) as calculated using the relative
NPV, referred to as NPVR:
NPVR =

NPVPricing Strategy
NPVBaseCase

For example, an NPVR of 0.7 shows

a 30 per cent drop in NPV of profits
compared to the profits earned in the base
case where price is set to 1. Similarly, an
NPVR of 1.1 indicates a gain of 10 per cent
in the NPV of profits relative to the base
case.

RESULTS
A full-factorial design of price level, market
price elasticity and expected time horizon of
competitive entry was conducted. As shown
in Table 1, price was varied at five levels,
price elasticity was varied at four levels, and
the timing of competitive entry was also
varied at five levels. This resulted in 100 (that
is, 545) experimental conditions. For each
of these conditions, simulation runs were
replicated 20 times to capture the variations
in NPVR that may occur due to stochastic
effects (Ghoreishi Nejad, 2011). Overall,
considering all factorial combinations, the
study comprised 400 experiment replications
and five different expected time horizon levels

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Nejad and Estelami

Table 1: Simulation model parameters

Parameter

Parameter value or
range

Source(s) for chosen parameters

Factor 1: Unit price 4, 0.7, 1, 1.3, 2

Lehmann and Esteban-Bravo (2006); Estelami (1999)

Factor 2: Price
elasticity

Bijmolt et al (2005); Lehmann and Esteban-Bravo (2006); Tellis (1998)

0.2, 0.6, 1, 2

Factor 3: Expected 3, 6, 9, 12, Unlimited

time horizon

Reecting time when approximately 3%, 16%, 50% and 84% of market
adopted in the base case. The unlimited refers to the time when 95% of
the market in each experiment adopted the innovation

Average number
of social ties per
consumer
Discount rate
Market size
p (External
inuences)
q (Internal
inuences)

14

Ghoreishi Nejad (2011); Goldenberg et al (2007); Libai et al (2010)

10%
3000
0.0142

Goldenberg et al (2007); Libai et al (2010)

Ghoreishi Nejad (2011); Goldenberg et al (2007)
Jiang et al (2006); Libai et al (2009); Hogan et al (2003); Sultan et al (1990)

0.545

Jiang et al (2006); Libai et al (2009); Hogan et al (2003); Sultan et al (1990)

Note: Please consult the appendix for more detailed discussion on the choice of parameters used in the simulation study.

Table 2: ANOVA model for the effects of price, price elasticity and expected time horizon
Source
Price
Price elasticity
Expected time horizon
PricePrice elasticity
PriceExpected time horizon
Price elasticityExpected time horizon
PricePrice elasticityExpected time
horizon
Error
Total
Corrected total

Sum of squares

DF

21.207
6.103
9.631
179.720
36.475
14.732
24.087

4
3
4
12
16
12
48

7.221
1896.829
299.177

1900
2000
1999

Mean square

P-value

5.302
2.034
2.408
14.977
2.280
1.228
0.502

1394.988
535.220
633.531
3940.556
599.816
323.015
132.032

0
0
0
0
0
0
0

0.004

Adjusted R 2=0.975.

for each experiment replication, resulting in

a data set of 2000 cases.
In order to examine the effects of various
pricing strategies and market conditions on
profits, we conducted a priceprice elasticity
expected time horizon Analysis of Variance
(ANOVA), with NPVR as the dependent
variable. Table 2 summarizes the findings of
this analysis. The F-ratios for all the main
effects and the interactions were statistically
significant. As Table 2 shows, this is true for
price (F(4,1900) = 1394.99, P < 0.001), price
elasticity (F(3,1900) = 535.22, P < 0.001), and
expected time horizon (F(4,1900) = 633.53,
P < 0.001), which all have significant main
effects on NPVR. Moreover, all two-way

128

interaction effects and the three-way

interaction effect between the study factors
are significant.
The three-way interaction in the ANOVA
results indicates that the best pricing strategy
depends on the combination of price
elasticity and the time horizon for
competitive entry. To help dissect the
complex interaction between the factors,
the effects of various pricing strategies on
NPVR under different levels of price
elasticity were plotted. Figure 1 provides the
associated factorial plots. As can be seen from
Figure 1(a), when the price elasticity is at its
lowest level, a high introductory price
generates the highest NPVR, for all expected

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Pricing nancial services innovations

Figure 1:
Three-way interaction between price, price elasticity and expected time horizon: (a) very low price
elasticity (0.2); (b) low price elasticity (0.6); (c) high price elasticity (1); (d) high price elasticity (2).

time horizons of competitive entry. The

average NPVR ranges from a low of 1.36 to
a high of 1.75, indicating that a high price
strategy can generate anywhere between
36 per cent and 75 per cent higher profits
versus the profits generated from the
base-case price. Furthermore, as the
introductory price decreases, NPVR also
decreases, indicating the negative effects on
profitability of lowering prices, under this
specific market condition. As Figure 1(a)
indicates, when the market is not price
sensitive, regardless of the timing of
competitive market entry, a high price
strategy would be optimal for the
introduction of a financial innovation.
However, the relationship becomes more
complex when price elasticity increases. As
shown in Figure 1(b), with a price elasticity
of 0.6, firms may expect a significant increase

in NPVR only when competitive entry is

expected to take a very long time, perhaps
due to factors such as market entry barriers
or regulations. Under this condition,
charging a high introductory price for a
financial innovation leads to a direct increase
in the value of NPVR, exceeding the
threshold of 1.0, thereby representing a profit
gain versus the profits in the base-case price.
On the other hand, in conditions where a
more restricted time horizon for competitive
entry exists, charging prices different from
the base case can lead to profit changes,
which in most cases may lead to decreases in
the NPVR compared to the base case. The
contrast in the outcomes shown in this
situation versus the ones examined in Figure
1(a) demonstrates the significant effect that
market price elasticity can have on the
introductory pricing of financial innovations,

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Nejad and Estelami

and highlights the importance of conducting

appropriate market research to measure price
elasticity of demand before product launch.
As shown in Figure 1(c), when price
elasticity is 1, and a short time horizon for
competitive entry is expected, a competitive
pricing strategy (below the base-case price)
can lead to gains in NPVR. For example,
a price of 0.7 can result in NPVR values
ranging from 1.03 (for a very short time
horizon) to a peak of 1.19 (for a moderate
time horizon for competitive entry).
However, as competitive entry is delayed,
such a pricing strategy may no longer be
optimal and result in NPVR values below 1.
In fact, when a long time horizon for
competitive entry is expected, a moderately
high price strategy (for example, 1.3)
generates the highest NPVR.
Under conditions of very high price
elasticity (Figure 1(d)), optimal pricing
depends on the time horizon of competitive
entry. When the time horizon is short (3 or
6 periods), a very low introductory price
generates the highest NPVR. However, for
average to long time horizons, a moderately
low price (that is, 0.7) generates the optimal
NPVR. These two scenarios emphasize the
significance of competitive pricing of
financial innovations in highly pricesensitive
markets. The contrast between these results
and those examined in Figures 1(a) and (b)
highlights the complexity that the timing of
competitive entry can introduce to the
optimal pricing of a financial innovation. For
this reason, financial innovators must collect
as much competitive intelligence as possible
to form accurate expectations regarding the
timing of the market entry of potential
competitors, before finalizing launch price
decisions.

DISCUSSION
This research examined the optimal
introductory pricing of financial innovations.
A systematic analysis of what prices would
maximize profitability was conducted, by
examining the effects of variations in price

130

elasticity and the expected timing of

competitive market entry on profitability.
The results demonstrate that the choice of
the pricing strategy for a financial innovation
may lead to significant financial gains or
losses if financial innovators do not carefully
consider the impact of market price elasticity
and the timing of competitive entry. When
high degrees of price sensitivity exist and a
short time horizon for competitive entry is
expected, lowering the introductory price
would be an optimal strategy. On the other
hand, when price sensitivity is low and the
expected time horizon for competitive entry
is long, higher introductory prices for a
financial innovation would be the optimal
choice. As shown in Figure 1, more complex
relationships arise in relationship to the
optimal pricing of a financial innovation, as a
function of market price sensitivity and
expected timing of competitive entry.
These results are consistent with anecdotal
evidence on the launch pricing of wellestablished financial innovations. For
example, the launch of BankAmericard was
not matched by competitive entry for many
years. The product targeted a market
segment that was not highly price sensitive
and valued the unique benefits of the credit
card in facilitating business travel needs.
These market conditions reflect those of
Figure 1(a), in which BankAmericards
optimal strategy was to launch the product at
a high price point. This was done by
charging yearly membership fees, interest
rates on balances from members and
transaction processing fees from merchants
(Manning, 2001). On the other hand, for a
financial innovation where price sensitivity is
high and competitive entry can be easily
achieved, a different pricing strategy would
prove optimal. Variations of mortgage
products, such as flex mortgages and
extended-life (for example, 40-year)
mortgages, introduced in recent years
represent good examples. Mortgage
instruments can be readily replicated by
competitors and market price sensitivity for

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Pricing nancial services innovations

these products is relatively high, representing

scenarios similar to Figure 1(d). In such
markets, a low price strategy has been
adopted by financial innovators who seek to
benefit from the short-term gains they can
realize before competitors enter the market.
It is important to also recognize that the
low-price strategy adopted under this market
condition can also serve as a deterrent for
competitors who may find it difficult to
realize reasonable margins given the level of
price competition, and may therefore choose
to delay their market entry. This delay in
competitive entry may further help the
financial innovator realize incremental profits.
One of the important aspects of the
methodology used in this article is providing
a setting for studying the social effects among
consumers in the process of adopting a
financial innovation. With growing reliance
of the public on various forms of social
media, it is important that in examining
pricing strategies, the possible interactions
that will occur among consumers be
modeled. The diffusion framework used in
this article facilitates such analysis. In
addition, this study expands the existing
agent-based diffusion models by
incorporating price in customer decisions and
applying this model to establish the optimal
price of a financial innovation. This
framework provides extensive flexibility and
power in studying diffusion processes at the
individual level, and the methodology creates
new opportunities by overcoming limitations
of other methodologies. For example, some
of the earlier diffusion studies that have used
closed-form solutions had to limit the number
of diffusion periods owing to computational
limitations associated such models (for
example, Lehmann and Esteban-Bravo, 2006).

LIMITATIONS AND FUTURE

RESEARCH
This study provides insights on optimal
pricing of financial innovations, and
demonstrates the significant impact of market
price sensitivity and timing of competitive

entry. The results show that firms may risk

significant losses by ignoring these two
variables, and highlight the significance of
conducting appropriate levels of market
research and competitive intelligence
gathering before deciding on the launch
price of a financial innovation. Financial
innovators must therefore undertake
sufficient market research to accurately
measure price sensitivity levels among
target consumers before deciding on an
introductory price. Furthermore, research
must be conducted to assess the likely timing
of competitive entry into the market that the
financial innovation will create. This research
may take on the form of examination of
prior cases of competitive entry by
established competitors, interviews with
industry experts or other forms of
intelligence gathering.
Although the study provides important
insights into pricing of financial innovations,
it is important to acknowledge several
limitations and provide direction for future
research. First, the adopted methodology is
based on several assumptions that are
common in studies of diffusion processes
(Goldenberg et al, 2007), whereby only one
type of social influence, namely, WOM
effects, between consumers is considered.
However, this may not represent a major
limitation as consumer-to-consumer
communications for innovations are typically
communicated through WOM activity
(Gounaris et al, 2003; Estelami, 2006; Casalo
et al, 2008). Nevertheless, alternative means
of social influence such as observing others
use of an innovation or social influence
through consumers desire to achieve specific
self-image goals (Chen et al, 2011) may
provide interesting opportunities for
extending this work.
Another limitation of this study is the
focus on optimal launch pricing before
competitive entry. The dynamics of market
competition following competitive entry may
be highly complex and depend on the nature
of competitors who choose to enter a market

2012 Macmillan Publishers Ltd. 1363-0539 Journal of Financial Services Marketing Vol. 17, 2, 120134

131

Nejad and Estelami

established by a financial innovation. Future

research can therefore examine reactive
pricing strategies following competitive entry,
in order to establish how financial
innovators prices should be adjusted to
competitive intrusion into the markets they
helped create. However, it is hoped that this
research has demonstrated the significance of
careful assessment of market price sensitivity
and competitive entry timing on the optimal
pricing of financial innovations, in a world of
growing diffusion effects resulting from mass
use of social media by consumers.

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APPENDIX

categories of adopters as discussed by Rogers

(2003). Furthermore, because increasing
price may lead to slower adoption rates,
and hence longer diffusion patterns, we also
captured the dependent variable at a time
when 95 per cent of the market have
adopted the product. This allowed for
examining conditions where the firm does
not have any concern with the amount of
time it may take for the diffusion process to
complete and the goal is to maximize profits
regardless of the time horizon.

Selection of parameter values for

the simulation model
Price, price elasticity and time
horizon
The simulation examines diffusion processes
resulting from sales prices of 0.4, 0.7, 1 (base
level), 1.3 and 2. In addition, price elasticity
is systematically varied at four levels: 0.2, 0.6,
1 and 2. These values are in line with those
used in previous theoretical studies (for
example, Lehmann and Esteban-Bravo, 2006)
and those found in meta-analysis of empirical
studies (Tellis, 1998; Bijmolt et al, 2005).
To capture the expected time of
competitive entry, we applied the customer
groups discussed by Rogers (2003) in the
base model. Rogers categorizes adopters into
five categories: innovators, early adopters,
early majority, late majority and laggards. We
examined the time horizons of 3, 6, 9 and
12 periods. These numbers represent the
average time when approximately 3 per cent,
16 per cent, 50 per cent and 84 per cent of
the market have adopted the product in the
base case. These values approximately
represent the cumulative adoption of the
four first groups of the aforementioned

Parameters p and q
The values of parameters p and q are based
on the values estimated by previous empirical
research and meta-analyses. As this study
seeks to examine the context of financial
innovations, the choices of values for
parameters p and q represent average values
considered for such an innovation in
previous research. Thus, we fixed the
aggregate-level parameter p to 0.0142 and
the aggregate-level parameter q to 0.545,
values estimated for the diffusion of online
banking (Libai et al, 2009). These values are
in line with those used in earlier studies that
examined online banking (Hogan et al,
2003). Moreover, previous research has
found that consumers perceive greater risk in

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Nejad and Estelami

the adoption of services compared to the

adoption of goods, and thus adoption of
services relies more heavily on WOM and
personal sources of information, and less so
on information from marketers (Murray,
1991). Therefore, the choice of the two
parameters in this study are in line with
the average values estimated in previous
meta-analysis studies (Sultan et al, 1990;
Jiang et al, 2006).
The aggregate-level values of parameters p
and q were converted to the individual-level
parameters pi and qi using the methods
suggested in the literature (Goldenberg et al,
2002; Toubia et al, 2008). The parameter p is
the same at both aggregate and individual
levels. However, the individual-level value of
parameter q is calculated by dividing the
aggregate-level value of parameter q by the
number of individual ties. Therefore, the
overall diffusion process resulting from this
model are comparable to those at the
aggregate level (Goldenberg et al, 2002).

134

Fixed variables
We fixed the average number of one-to-one
connections between one consumer and
other consumers to 14, a value that is in
line with the average number found in
previous studies (Goldenberg et al, 2007;
Libai et al, 2010; Ghoreishi Nejad, 2011).
For the purposes of the simulation, we fixed
the market size number of potential
consumers to 3000, a value that is in
line with earlier studies (for example,
Goldenberg et al, 2007; Ghoreishi Nejad,
2011). Furthermore, because the average
number of connections is used in converting
the aggregate-level value of q into
individual-level values, it is also indirectly
captured in the diffusion process through
the influence of consumers on each other
through qi, the number of social ties does
not significantly alter the results (Ghoreishi
Nejad, 2011). It is important to note that
we further examined values of 4 and 24 and
the results remained the same.

2012 Macmillan Publishers Ltd. 1363-0539 Journal of Financial Services Marketing Vol. 17, 2, 120134

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