Simple Pricing PDF

CHAPTER 6 Simple Pricing ©2018 Cengage Learning. ©Kamira/Shutte rstock Ima ges  Aggregate demand or market demand is the total number of units that wil be purchased by a group of consumers at a given price. Pricing is an extent decision. Reduce pr...

CHAPTER 6 Simple Pricing ©2018 Cengage Learning. ©Kamira/Shutte rstock Ima ges  Aggregate demand or market demand is the total number of units that wil be purchased by a group of consumers at a given price. Pricing is an extent decision. Reduce price (increase quantity) if MR > MC. Increase price (reduce quantity) if MR < MC. The optimal price is where MR = MC. Price elasticity of demand: e = (% change in quantity demanded) ÷ (% change in price) [(Q1 - Q2)/(Q1 + Q2)] ÷ [(P1 - P2)/(P1 + P2)] ©2018 Cengage Learning. ©Kamira/Shutter stock Images 2  continued %ΔRevenue ≈ %ΔPrice + %ΔQuantity MR > MC implies that (P - MC)/P > 1/|e|; in words, if the actual margin is bigger than the desired margin, reduce price Four factors make demand more elastic: ©2018 Cengage Learning. ©Kamira/Shutter stock Images 3  continued Income elasticity, cross-price elasticity, and advertising elasticity are measures of how changes in these other factors affect demand. It is possible to use elasticity to forecast changes in demand: Stay-even analysis can be used to determine the volume required to offset a change in costs or prices, which is how businesses often implement marginal analysis. ©2018 Cengage Learning. ©Kamira/Shutter stock Images 4  Hot Wheels Mattel introduced Hot Wheels in 1968 They kept price below $1.00 for 40 years, even as production costs rose Finally tested a price increase, experienced profit increase of 20% In many instances, companies can make money by simply raising price ©2018 Cengage Learning. ©Kamira/Shutter stock Images 5  Mattel Hot Wheels ©2018 Cengage Learning. ©Kamira/Shutter stock Images 6  Simple Pricing In this chapter, we consider “simple pricing”: A single firm selling a single product at a single price Most firms sell: in competition with rivals; multiple products, and at different prices, so this is rare Important to understand simple pricing first though Simple pricing has become part of business vernacular ©2018 Cengage Learning. ©Kamira/Shutter stock Images 7  Background: Consumer Surplus and Demand Curves First Law of Demand - consumers demand more (purchase more) as price falls, assuming other factors are held constant. Consumers make consumption decisions using marginal analysis, consume more if marginal value > price But, the marginal value of consuming each subsequent unit diminishes the more you consume. Consumer surplus = value to consumer - price paid Definition: are functions that relate the price of a product to the quantity demanded by consumers ©2018 Cengage Learning. ©Kamira/Shutter stock Images 8  Consumer Surplus and Demand Curves Example Pizza consumer Values first slice at $5, next at $4... fifth at $1 Pizza Demand Schedule Note that if pizza slice price is $3, consumer will purchase 3 slices ©2018 Cengage Learning. ©Kamira/Shutter stock Images 9  Pizza Example For the first slice, the total and marginal value are the same at $5 For the second, the marginal value is $4, while the total value is $9 = $5 + $4 Pizza Value Table ©2018 Cengage Learning. ©Kamira/Shutter stock Images 10  Background: Aggregate Demand Aggregate Demand: the buying behavior of a group of consumers; a total of all the individual demand curves. To construct demand, sort by value. ©2018 Cengage Learning. ©Kamira/Shutter stock Images 11  Aggregate Demand Demand curves describe buyer behavior and tell you how much they wil buy at a given price. If something other than price causes an increase in demand, we say that “demand shifts” to the right or “demand increases” such that consumers purchase more at the same prices ©2018 Cengage Learning. ©Kamira/Shutter stock Images 12  Pricing Trade-Off Pricing is an extent decision Profit= Revenue - Cost Demand curves turn pricing decisions into quantity decisions: Fundamental tradeoff: Tradeoff created by downward sloping demand ©2018 Cengage Learning. ©Kamira/Shutter stock Images 13  Marginal analysis of pricing Marginal analysis finds the profit increasing solution to the pricing tradeoff. Definition: is change in total revenue from selling another unit. If MR>0, then will increase if you sell one more. If MR>MC, then wil increase if you sell one more. Proposition: Profit is maximized when MR = MC ©2018 Cengage Learning. ©Kamira/Shutter stock Images 14  Example: Find the Optimal Price Once you reach the 4th unit, total profit decreases by 0.50 because the MR from the 4th unit is only $1, which is less than $1.50 MC Therefore, the profit maximizing quantity is 3 and we see that the price is $5.00 for 3 units to be sold Optimal Price ©2018 Cengage Learning. ©Kamira/Shutter stock Images 15  Optimal Price Profit is maximized when MR = MC Price Quantity Revenue MR MC Profit ₱7.00 1 ₱7.00 ₱7.00 ₱1.00 ₱6.00 ₱6.00 2 ₱12.00 ₱5.00 ₱1.00 ₱10.00 ₱5.00 3 ₱15.00 ₱3.00 ₱1.00 ₱12.00 ₱4.00 4 ₱16.00 ₱1.00 ₱1.00 ₱12.00 ₱3.00 5 ₱15.00 -₱1.00 ₱1.00 ₱10.00 ₱2.00 6 ₱12.00 -₱3.00 ₱1.00 ₱6.00 ₱1.00 7 ₱7.00 -₱5.00 ₱1.00 ₱0.00 ©2018 Cengage Learning. ©Kamira/Shutter stock Images 16  How Do We Estimate MR? Price elasticity allows us to calculate MR. Definition: price elasticity of demand (e) (%change in quantity demanded) (%change in price) ©2018 Cengage Learning. ©Kamira/Shutter stock Images 17  Mistake in 3rd Edition The Correct Answer Elastic Demand [| |> 1] Inelastic Demand [| | < 1] ©2018 Cengage Learning. ©Kamira/Shutter stock Images 18  Price Elasticity Example Mayor Marion Barry increased taxes on gasoline sales in DC by 6%. Before the tax, gas station predicted that the increase in a sales tax would reduce quantity demanded by 40%. The gas station owners were indirectly arguing that gasoline revenue, and the taxes collected out of revenues, would decline because gasoline sales in DC has a very elastic demand. ©2018 Cengage Learning. ©Kamira/Shutter stock Images 19  Estimating elasticities Definition: Arc (price) elasticity= [(q1-q2)/(q1+q2)] [(p1-p2)/(p1+p2)] Example: On a promotion week for Vlasic, the price of Vlasic pickles drops by 25% and quantity increases by 300%. HINT: could something other than price be changing? ©2018 Cengage Learning. ©Kamira/Shutter stock Images 20  Intuition: MR and Price Elasticity Revenue and price elasticity are related by the following approximation. % Rev ≈ % P + % Q Elasticity tells you the size of |% P| relative to |% Q| If demand is elastic P P P P ©2018 Cengage Learning. ©Kamira/Shutter stock Images 21  Formula: Elasticity and MR Proposition: MR = P(1-1/|e|) Discussion: If demand for Nike sneakers is , should Nike raise or lower price? Discussion: If demand for Nike sneakers is , should Nike raise or lower price? ©2018 Cengage Learning. ©Kamira/Shutter stock Images 22  Elasticity and Pricing MR>MC is equivalent to MR > MC means that (P-MC)/P > 1/|e| The left side of the expression is the current margin = (P-MC)/P The right side is the desired margin, or the inverse elasticity = 1/|e| If the current margin is greater than the desired margin, reduce the price because MR>MC and vice versa. Intuition: the more elastic demand becomes (1/|e| becomes smaller), the less you can raise price over MC because you lose too many customers ©2018 Cengage Learning. ©Kamira/Shutter stock Images 23  What Makes Demand More Elastic? 5 factors that affect demand elasticity and optimal pricing: 1) Products with close substitutes have elastic demand. 2) Demand for an individual brand is more elastic than industry aggregate demand. 3) Products with many complements have less elastic demand. 4) In the long run, demand curves become more elastic. 5) As price increases, demand becomes more elastic. ©2018 Cengage Learning. ©Kamira/Shutter stock Images 24  Factor 1 1. Products with close substitutes have elastic demand. Consumers respond to a price increase by switching to their next-best alternative. If their next-best alternative is a very close substitute, then it doesn’t take much change in price for them to switch. When Mayor Barry raised the price of gasoline, DC commuters began buying gasoline in nearby Virginia and Maryland. ©2018 Cengage Learning. ©Kamira/Shutter stock Images 25  Factor 2 2. Demand for an individual brand is more elastic than industry aggregate demand. Rough rule of thumb: brand price elasticity is approximately equal to industry price elasticity divided by brand share Example: ©2018 Cengage Learning. ©Kamira/Shutter stock Images 26  Factor 3 3. Products with many complements have less elastic demand. Products that are consumed as a larger bundle of complementary goods have less elastic demand. Example: iPhones have less elastic demand because of the number of apps run on them ©2018 Cengage Learning. ©Kamira/Shutter stock Images 27  Factor 4 4. In the long run, demand curves become more elastic. This can also be explain by the speed at which price information is spread; or the ability of consumers to find more substitutes in the long run. Example: ATM fees ©2018 Cengage Learning. ©Kamira/Shutter stock Images 28  Factor 5 5. As price increases, demand becomes more elastic. Example: high-fructose corn syrup (HFCS) Bottlers have shifted to HFCS. ©2018 Cengage Learning. ©Kamira/Shutter stock Images 29  Other Elasticities Definition: measures the change in demand arising from a change in income (%change in quantity demanded) / (%change in income) Inferior goods (negative): as income increases, demand declines normal goods (positive): as income increases, demand increases Definition: cross-price elasticity of good one with respect to the price of good two (%change in quantity of good one) /(%change in price of good two) Substitute (positive): as the price of a substitute increases, demand increases Complement (negative): as the price of a complement increase, demand decreases ©2018 Cengage Learning. ©Kamira/Shutter stock Images 30  Stay-Even Analysis Stay-even analysis tells you how many sales you need when changing price to maintain the same profit level Margin=40%, %ΔP=5%, then %ΔQ = 11.11%.05/(.05+.40) =.1111 In other words, a 5% price increase would be profitable if quantity went down by less than 11.11%. Use elasticity estimates or marketing surveys to determine whether quantity would go down by 11.11%. ©2018 Cengage Learning. ©Kamira/Shutter stock Images 31  Cost-Based Pricing Our expression for optimal pricing, MR=MC or (P-MC)/P= 1/|e|, takes into account the firm’s cost structure and its consumer demand Often, the consumer side is ignored in pricing decisions, leading to cost-based pricing. Why? Often, firms do not have the demand picture They need to invest in a market research division to take profitability seriously ©2018 Cengage Learning. ©Kamira/Shutter stock Images 32  Extra: Quick and Dirty estimators Linear Demand Curve Formula: e= p / (pmax-p) Discussion: How high would the price of the brand have to go before you would Discussion: How high would the price of all running shoes have to go before you should ©2018 Cengage Learning. ©Kamira/Shutter stock Images 33  Extra: Market Share Formula Proposition: The individual brand demand elasticity is approximately equal to the industry elasticity divided by the brand share. Proposition: Demand for aggregate categories is less-elastic than demand for the individual brands in aggregate. ©2018 Cengage Learning. ©Kamira/Shutter stock Images 34 ©2018 Cengage Learning. ©Kamira/Shutter stock Images 35  Title? In 1994, the peso devalued by 40% in Mexico Concurrently, demand for Sara Lee hot dogs declined Failure to understand demand and to price accordingly was costly. ©2018 Cengage Learning. ©Kamira/Shutter stock Images 36  Stay-even curve example Note that if demand is , price increase revenue When demand is , price will increase revenue