Chapter 6 Simple Pricing

1. Chapter 6Simple Pricing

2. 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.

3. 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, which is how businesses use marginal analysis.

4. 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

5. 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

6. 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 3 slices

7. 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. • Discussion: Why do aggregate demand curves slope downward? • Role of heterogeneity? • How to estimate?

8. 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

9. 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

10. 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 MR<MC

11. How do we estimate MR? • Price elasticity is a factor in calculating MR. • Definition: price elasticity of demand (e) • (%change in quantity demanded)  (%change in price) • If |e| is less than one, demand is said to be inelastic. • If |e| is greater than one, demand is said to be elastic.

12. Estimating elasticities • Definition: Arc (price) elasticity= [(q1-q2)/(q1+q2)]  [(p1-p2)/(p1+p2)]. • Discussion: Why, when price changes from $10 to $8, does quantity changes from 1 to 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 price be changing?

13. Estimating elasticities (cont.) • 3-Liter Coke Promotion (Instituted to meet Wal-Mart promotion) • Compute price elasticity of 3 liter coke; cross price elasticity of 2 liter coke with respect to 3 liter price;

14. Intuition: MR and price elasticity • Revenue and price elasticity are related. • %Rev ≈%P + %Q • Elasticity tells you the size of |%P| relative to |%Q| • If demand is elastic • If P↑ then Rev↓ • If P↓ then Rev↑ • If demand is inelastic • If P↑ then Rev↑ • If P↓ then Rev↓ • Discussion: In 1980, Marion Barry, mayor of the District of Columbia, raised the sales tax on gasoline sold in the District by 6%. What happened to gas sales and availability of gas? Why?

15. Formula: elasticity and MR • Proposition: MR = P(1-1/|e|) • If |e|>1, MR>0. • If |e|<1, MR<0. • Discussion: If demand for Nike sneakers is inelastic, should Nike raise or lower price? • Discussion: If demand for Nike sneakers is elastic, should Nike raise or lower price?

16. Elasticity and pricing • MR>MC is equivalent to • P(1-1/|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.

17. 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.

18. Describing demand with price elasticity • First law of demand: e < 0 ( 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.

19. 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.

20. 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

21. 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.

22. Stay-even curve example • Note that if demand is elastic, price cuts increase revenue • When demand is inelastic, price increases will increase revenue

23. 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?

24. 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.

25. 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