Managerial economics 3rd by froeb ch06

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Simple Pricing

1

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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)

• E stimated price elasticity = [(Q 1 - Q 2 )/(Q 1 + Q 2 )] ÷ [(P 1 - P 2 )/(P 1 + P 2 )] 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.

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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.

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Introductory anecdote: Hot

Wheels

below $1.00 for 40 years, even as production costs rose

increase of 20%

simply raising prices

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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

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Background: consumer surplus

and demand curves (cont.)

• Values first slice at $5, next at $4 fifth at $1

• Note that if pizza slice price is $3, consumer will purchase 3 slices

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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?

Price Quantity Revenue

Marginal Revenue

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Pricing trade-off

quantity decisions: “what price should I charge?” is equivalent to “how much should

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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

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

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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

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How do we estimate MR?

• Price elasticity is a factor in calculating MR.

(%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

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Estimating elasticities

[(q 1 -q 2 )/(q 1 +q 2 )] ÷ [(p 1 -p 2 )/(p 1 +p 2 )].

• Discussion: Why, when price changes from $10 to

$8, does quantity changes from 1 to 2?

price of Vlasic pickles dropped by 25% and

quantity increased by 300%.

changing?

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Estimating elasticities

(cont.)

meet Wal-Mart promotion)

• Compute price elasticity of 3 liter coke; cross price elasticity of 2 liter coke with respect to 3 liter price;

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Intuition: MR and price

• 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?

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Formula: elasticity and MR

• If |e|>1, MR>0

• If |e|<1, MR<0

inelastic, should Nike raise or lower price?

should Nike raise or lower price?

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Elasticity and pricing

you raise prices?

Should you raise the price?

MR>MC

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What makes demand more

elastic?

demand.

than industry aggregate demand

demand.

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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.

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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.

Sugar Price

HFCS Quantity

HFCS Price

HFCS Demand

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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

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Stay-even analysis

when changing price to maintain the same profit level

• Q 1 = Q 0 *(P 0 -VC 0 )/(P 1 -VC 0 )

demand, the analysis gives a quick answer to the

question of whether or not changing price makes

sense.

we can draw a stay-even curve that shows the required quantities at a variety of price levels.

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Stay-even curve example

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Extra: quick and dirty

estimators

brand have to go before you would switch

to another brand of running shoes?

running shoes have to go before you should

switch to a different type of shoe?

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Extra: market share formula

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?

is less-elastic than demand for the individual brands in aggregate

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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

• 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

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