Learning Note 11.1: Economic Theory of Pricing

Size: px
Start display at page:

Download "Learning Note 11.1: Economic Theory of Pricing"

Transcription

1 Learning Note 11.1: Economic Theory of Pricing The central feature of the economic model is the assumption that the firm will attempt to set the selling price at a level where profits are maximized. For monopolistic/imperfect competition the model assumes that the lower the price, the larger will be the volume of sales. This relationship is depicted in Figure LN11.1, which is known as a demand curve. Points A and B represent two of many possible price/quantity combinations. You will see that at a price P a, the quantity demanded will be Q a, while at the lower price of P b the quantity demanded will increase to Q b. The economist describes the sensitivity of demand to changes in price as the price elasticity of demand. Demand is elastic when there are substitutes for a product, or when customers do not value the product very highly; the result is that a small increase/decrease in price causes a large decrease/increase in the quantity demanded. Alternatively, demand is inelastic when customers place a high value on the product, or when no close substitutes exist; the result is that a small increase/decrease in price causes only a small decrease/increase in the quantity demanded (see Figure LN11.2). If you compare the two graphs in Figure LN11.2, you will see that in (a) an increase in price from to results in only a small reduction in the quantity demanded, whereas in (b) the same increase in price results in a large reduction in the quantity demanded. Establishing the optimum selling price The precise quantification of the relationship between the selling price and the quantity demanded is very difficult in practice, but let us assume here that management has produced an estimate of the sales demand at various selling prices, as shown in Exhibit LN11.1. You will note that if the price is reduced from 40 to 38 the total revenue will increase by 18, and that each successive price reduction causes incremental or marginal revenue to increase by successively smaller amounts. This process eventually results in a decline in total revenue when the price per unit is reduced from 30 to 28. To determine the optimum selling price (i.e. the price at which total profits are maximized), it is also necessary for management to estimate the total costs for each of the sales levels given in Exhibit LN11.1; this cost information is set out in Exhibit LN11.2. The final stage is to calculate the profit for each sales level and select the most profitable price volume combination. The profit calculations are obtained by combining the information given in Exhibits LN11.1 and LN11.2 (see Exhibit LN11.3). You can see from Exhibit LN11.3 that profits are maximized at a selling price of 34 when 13 units are sold.

2 FIGURE LN11.1 A demand curve A B Possible price quantity combinations 0 Q A Q B Quantity demanded FIGURE LN11.2 elasticity of demand: (a) inelastic demand; (b) elastic demand (a) (b) 0 Q B Q A Demand 0 Q B Q A Demand EXHIBIT LN11.1 Estimate of sales demand at different price levels Unit of Total Marginal sales demand revenue revenue ( ) ( ) ( )

3 Demand and Total Marginal output costs cost ( ) ( ) ( ) EXHIBIT LN11.2 Estimate of total costs at different volume levels Units Total Total sold revenue cost Profit ( ) ( ) ( ) ( ) EXHIBIT LN11.3 Estimate of profits at different output levels Graphical presentation Economic theory would normally present the information contained in Exhibits LN11.1 to LN11.3 in graphical form as shown in Figure LN11.3. The shape of the graphs for the total revenue and the total cost lines is based on the explanations outlined in Chapter 8. If you refer to the top diagram in Figure LN11.3, you will see that it indicates that the difference between total revenue and total cost increases as long as total revenue is climbing more rapidly than total cost. When total cost is climbing more rapidly than total revenue (i.e. unit marginal cost exceeds unit marginal revenue), a decision to increase the number of units sold will actually reduce the total profit. The difference between total cost and total revenue is the greatest at a volume level of 13 units; the price required to generate this demand is 34 and this is the optimum selling price. The lower part of Figure LN11.3 shows the cost and revenue information in terms of marginal revenue and marginal cost. Marginal revenue represents the increase in total revenue from the sale of one additional unit, and marginal cost represents the increase in total cost when output is increased by one additional unit. Note that the marginal revenue line slopes downwards to the right as demand increases, reflecting the fact that the slope of the total revenue line decreases as demand increases. Similarly, the marginal cost line slopes upwards because of the assumption that total cost increases as output increases. Exhibit LN11.1 and the demand/price curve in the lower part of Figure LN11.3 indicates that to increase sales demand from 10 units to 11 units it is necessary to

4 FIGURE LN Economist s model for establishing optimum price. MC, marginal cost; MR, marginal revenue; TC, total cost; TR, total revenue TR Profit TC 360 Optimum volume Optimum price Units demand and output Optimum price quantity combination MC 10 MC=MR Optimum quantity MR Demand and output reduce the selling price from 40 to 38. This increases total revenue from 400 to 418, the difference of 18 being the marginal revenue of the eleventh unit (shown in the graph as the height of the marginal revenue line at that point). The marginal revenues for the 12th, 13th and 14th units are 14, 10 and 6 respectively. The marginal cost is calculated by assessing the cost of one extra unit (or batch, etc.), and this information is presented in Exhibit LN11.2. For example, the marginal cost is 4 for the eleventh unit and 6 for the twelfth unit. The marginal cost is plotted in Figure LN11.3, and the optimum price is determined by the intersection of the marginal revenue and marginal cost curves; this is at a price of 34, when sales demand will be 13 units. Note that the intersection of the graphs occurs at a demand just in excess of 13 units. Clearly, we must work in whole units demanded, and therefore the optimal output is 13 units. The demand curve is also included in the lower part of Figure LN11.3, and to obtain the optimum price it is necessary to extend a vertical line upwards from the intersection of the marginal cost and marginal revenue curves. The point where this line cuts the demand curve provides us with the optimum selling price. Note that if the vertical line at the point of intersection of the marginal cost and marginal revenue curve is extended further upwards into the top part of the graph, it will cut the total cost and the total revenue curves at the point where the difference

5 between these two lines is the greatest. In other words, it cuts the total cost and total revenue curves at the points where the profits are maximized. The graphs in the lower and upper sections of Figure LN11.3 are therefore related, and this dual presentation clearly indicates that the point where the difference between total cost and total revenue is the greatest is where marginal revenue is equal to marginal cost. The selling price that causes marginal revenue to be equal to marginal cost represents the optimum selling price. Difficulties with applying economic theory Economic theory is extremely difficult to apply in practice. The difficulties can be grouped into three categories. First, economic theory assumes that a firm can estimate a demand curve for its products. Techniques have been developed for estimating demand curves at the industry, or aggregate level for undifferentiated products such as automobiles, coffee and crude oil but consider the difficulties of estimating demand curves below the aggregate level. Most firms have hundreds of different products and varieties, some with complex inter-relationships, and it is therefore an extremely difficult task to estimate demand curves at the individual product level. The problem becomes even more complex when competitive reactions are taken into account since these are likely to impact on the price/demand estimates that have been incorporated in the demand curve. Secondly, the basic model of economic theory assumes only price influences the quantity demanded. In practice, product quality and packaging, advertising and promotion, the credit terms offered and the after-sales service provided all have an important influence on price. Thus a model that includes only price will fail to capture all of the factors that determine customer demand. Thirdly, the marginal cost curve for each individual product can only be determined after considerable analysis and the final result may only represent an approximation of the true marginal cost function particularly where significant joint product costs exist. However, whilst an approximation of the cost function may suffice for the application of economic theory the estimation of demand curves for each major product represents the major reason why many firms do not directly apply economic theory in practice. Nevertheless, economic theory does provide useful insights and stresses the need for managers to think about price/demand relationships, even if the relationships cannot be precisely measured. For example, we shall see that many firms add a profit margin to a product s cost. If managers can identify products or customers where demand is inelastic they can add higher margins to a product s costs. Alternatively, where demand is elastic price changes are likely to be crucial and accurate cost measurement becomes vital. There is a danger where profit margins are reduced to minimal percentage figures that any undercosting of products may result in acceptance of unprofitable business whereas overcosting may result in the loss of profitable business to competitors.