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Simple Pricing
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Chapter 6 – 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.
Chapter 6 – 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.
Introductory anecdote: Gas prices
• US: From early 2007 to mid 2008 gas prices rose in the US.
• Gas prices caused people to find alternate methods of work and
travel to avoid using gas.
• Some farms began using mules instead of tractors
• India: In Rajasthan, the rising gas prices caused many farmers
to switch from tractors to camels on farms.
• As oil prices rose, demand for camels increased.
• Prices for camels tripled over a two-year period.
• A US company, NNS, that produces potash fertilizer
experienced an increase in input costs due to their use of
petrochemicals.
• NNS doubled the price of the generic fertilizer, and priced it’s
branded fertilizer at a 35% premium above the generic price.
• Costs increased rapidly over the first two quarters combined with
NNS’s policy of quarterly price revision led to stockouts and a price
that ended up being 25% below the generic – NNS could have
earned $13 million but failed to maintain their premium
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 -
Background: consumer surplus and
demand curves (cont.)
• Hot dog consumer
• Values first dog at $5, next at $4 . . . fifth at $1
• Note that if hot dogs price is $3, consumer will purchase 3 hot
dogs
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.
Marginal
Price Quantity Revenue Revenue
$7.00 1 $7.00 $7.00
$6.00 2 $12.00 $5.00
$5.00 3 $15.00 $3.00
$4.00 4 $16.00 $1.00
•$3.00 5
Discussion: $15.00
Why do -$1.00 demand
aggregate curves slope downward?
$2.00 6 $12.00 -$3.00
• Role of heterogeneity?
$1.00 7 $7.00 -$5.00
$8.00
• How to estimate?
$6.00
Price
$4.00
$2.00
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
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 .
HFCS
Price
Sugar Price
HFCS Demand
HFCS Quantity
Other elasticities
• Definition: income elasticity measures the change in demand arising from a
change in income
• (%change in quantity demanded) (%change in income)
demand is $28
revenue $22
$18
increases will
increase revenue $16
300 400 500 600 700 800 900 1000
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?
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.
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
1. Introduction: What this book is about
2. The one lesson of business Managerial Economics -
3. Benefits, costs and decisions Table of contents
4. Extent (how much) decisions
5. Investment decisions: Look ahead and reason back
6. Simple pricing
7. Economies of scale and scope
8. Understanding markets and industry changes
9. Relationships between industries: The forces moving us towards long-run equilibrium
10. Strategy, the quest to slow profit erosion
11. Using supply and demand: Trade, bubbles, market making
12. More realistic and complex pricing
13. Direct price discrimination
14. Indirect price discrimination
15. Strategic games
16. Bargaining
17. Making decisions with uncertainty
18. Auctions
19. The problem of adverse selection
20. The problem of moral hazard
21. Getting employees to work in the best interests of the firm
22. Getting divisions to work in the best interests of the firm
23. Managing vertical relationships
24. You be the consultant
EPILOG: Can those who teach, do?
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