11 Chapter Simple Pricing Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter – Summary of main points • Aggregate demand or market demand is the total number of units that will 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) • Estimated price elasticity = [(Q1 - Q2)/(Q1 + Q2)] ÷ [(P1 - P2)/(P1 + P2)] is used to estimate demand from a price and quantity change • If |e| > 1, demand is elastic; if |e| < 1, demand is inelastic • %ΔRevenue ≈ %ΔPrice + %ΔQuantity • Elastic Demand (|e| > 1): Quantity changes more than price • Inelastic Demand (|e| < 1): Quantity changes less than price Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter – Summary (cont.) • • MR > MC implies that (P - MC)/P > 1/|e|; in words, if the actual markup is bigger than the desired markup, reduce price • Equivalently, sell more Four factors make demand more elastic: • Products with close substitutes (or distant complements) have more elastic demand • Demand for brands is more elastic than industry demand • In the long run, demand becomes more elastic • As price increases, demand becomes more elastic • 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: %ΔQuantity ≈ (factor elasticity)*(%ΔFactor) • Stay-even analysis can be used to determine the volume required to offset a change in costs or prices, which is how businesses use marginal analysis Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Introductory anecdote: Hot Wheels • Mattel: introduced Hot Wheels in 1968, kept price below $1.00 for 40 years, even as production costs rose • Finally tested a price increase, experienced profits increase of 20% • Why? Profit=(P-C)xQ • Businesses tend to focus on C and Q, neglect P • In many instances, companies can make money by simply raising prices Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Background: consumer surplus and demand curves • First Law of Demand - consumers demand (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: Demand curves are functions that relate the price of a product to the quantity demanded by consumers Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Background: consumer surplus and demand curves (cont.) • Pizza consumer • Values first slice at $5, next at $4 fifth at $1 • Note that if pizza slice price is $3, consumer will purchase slices Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part • 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 Price $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 Quantity Marginal Revenue Revenue $7.00 $7.00 $12.00 $5.00 $15.00 $3.00 $16.00 $1.00 $15.00 -$1.00 $12.00 -$3.00 $7.00 -$5.00 $8.00 • $6.00 Discussion: Why aggregate demand curves slope downward? P r ic e • Role of heterogeneity? $4.00 • How to estimate? $2.00 Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Pricing trade-off • Pricing is an extent decision • Profit= Revenue - Cost • Demand curves turn pricing decisions into quantity decisions: “what price should I charge?” is equivalent to “how much should I sell?” • Fundamental tradeoff: • Lower price sell more, but earn less on each unit sold • Higher price sell less, but earn more on each unit sold • Tradeoff created by downward sloping demand Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Marginal analysis of pricing • Marginal analysis finds the profit increasing solution to the pricing tradeoff • It tells you only whether to raise or lower price, not • Definition: marginal revenue (MR) is change in total revenue from selling extra unit • If MR>0, then total revenue will increase if you sell one more • If MR>MC, then total profits will increase if you sell one more • Proposition: Profits are maximized when MR = MC Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Example: finding the optimal price • Start from the top • If MR > MC, reduce price (sell one more unit) • Continue until the next price cut (additional sale) until MR1, MR>0 • If |e|MC • P>MC/(1-1/|e|) • (P-MC)/P>1/|e| • Discussion: e= –2, p=$10, mc= $8, should you raise prices? • Discussion: mark-up of 3-liter Coke is 2.7% Should you raise the price? • Discussion: Sales people MR>0 vs marketing MR>MC Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part What makes demand more elastic? • Products with close substitutes have elastic demand • Demand for an individual brand is more elastic than industry aggregate demand • Products with many complements have less elastic demand Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part • Describing demand with price elasticity First law of demand: e < ( as price goes up, quantity goes down) • Discussion: Do all demand curves slope downward? • Second law of demand: in the long run, |e| increases • Discussion: Give an example of the second law of demand Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Describing demand (cont.) • Third law of demand: as price increases, demand curves become more price elastic, | e| increases • Discussion: Give an example of the third law of demand HFCS Price Sugar Price HFCS Demand HFCS Quantity Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Other elasticities • Definition: income elasticity measures the change in demand arising from a change in income • (%change in quantity demanded) ÷ (%change in income) • • Inferior (neg.) vs normal (pos) 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 (pos.) vs complement (neg.) Definition: advertising elasticity; a change in demand arising form a change in advertising • (%change in quantity) ÷ (%change in advertising) • Discussion: The income elasticity of demand for WSJ is 0.50 Real income grew by 3.5% in the United States • Estimate WSJ demand Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Stay-even analysis • Stay-even analysis tells you how many sales you need when changing price to maintain the same profit level • Q1 = Q0*(P0-VC0)/(P1-VC0) • When combined with information about the elasticity of demand, the analysis gives a quick answer to the question of whether or not changing price makes sense • To see the effect of a variety of potential price changes, we can draw a stay-even curve that shows the required quantities at a variety of price levels Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Stay-even curve example • Note that if demand is elastic, price cuts increase revenue • When demand is inelastic, price increases will increase revenue Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 switch to another brand of running shoes? • Discussion: How high would the price of all running shoes have to go before you should switch to a different type of shoe? Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Extra: market share formula • Proposition: The individual brand demand elasticity is approximately equal to the industry elasticity divided by the brand share • Discussion: Suppose that the elasticity of demand for running shoes is –0.4 and the market share of a Saucony brand running shoe is 20% What is the price elasticity of demand for Saucony running shoes? • Proposition: Demand for aggregate categories is less-elastic than demand for the individual brands in aggregate Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Alternate introductory anecdote • In 1994, the peso devalued by 40% in Mexico • Interest rates and unemployment shot up • Overall economy slowed dramatically and consumer income fell • Concurrently, demand for Sara Lee hot dogs declined • This surprised managers because they thought demand would hold steady, or even increase, since hot dogs were more of a consumer staple than a luxury item • Surveys revealed the decline was mostly confined to premium hot dogs • And, consumers were using creative substitutes • Lower priced brands did take off but were priced too low • Failure to understand demand and to price accordingly was costly Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part ... 2? • Example: On a promotion week for Vlasic, the price of Vlasic pickles dropped by 25% and quantity increased by 300% • Is the price elasticity of demand -12? • HINT: could something other than... • Businesses tend to focus on C and Q, neglect P • In many instances, companies can make money by simply raising prices Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned,... Definition: Demand curves are functions that relate the price of a product to the quantity demanded by consumers Copyright ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or