CH 2CH 2

The Economics of Price DeterminationThe Economics of Price Determination

Kent B. Monroe (2007). Pricing: Making Profitable Decisions. 3rd Edition (Singapore: McGraw-Hill) .

0202Chapter Objectives Chapter Objectives (P.26)

1. To summarize the traditional neoclassical economic theory of price determination

2. To introduce some useful concepts for actual pricing decisions such as revenue, elasticity, marginal revenue, marginal costs etc.

0303Price Determination Theory Price Determination Theory (P.26-27)

The firm

• Minimize input cost

• Maximize profit

Economic theory is more concerned with the behaviorof aggregates or markets, particularly how persistent and widespread behavior leads to stable results called“Equilibrium”.

0404Price Determination Theory Price Determination Theory (P.26-27)

Economic Perspective

• The firm is a pricetaker, not the pricemaker

• Management determines the quantity to produce

• The market sets price through the forces of supply and demand

Marketing Perspective • Price is a decision variable.

0505The Profit-Maximizing Firm The Profit-Maximizing Firm (P. 28)

0 Q1 Q* Q

Fixed costs

Revenuesor

Costs

$

Units

Total Revenue

Maximum Profits Total Costs

Figure 2.1 Output Determination for Profit-Maximizing Firm – Short Run (Constant Prices) : Aggregate Analysis

Price

0606The Profit-Maximizing Firm The Profit-Maximizing Firm (P. 28)

0 Q* Q

Costs$

Units

Price

Average costMarginal cost

(Marginal revenue)

Figure 2.2 Output Determination for Profit-Maximizing Firm – Short Run (Constant Prices) : Marginal Analysis

0707

0 Q* Q

Price$

Units

Demand

Marginal cost

(Marginal revenue)

P*

Figure 2.3 Output Determination for Profit-Maximizing Firm – Short Run (Varying Prices)

The Profit-Maximizing Firm The Profit-Maximizing Firm (P. 29)

1010Corporate and Pricing Objective Corporate and Pricing Objective (P. 30)

Pricing objectives should be consistent with & should advance corporate & marketing objectives

11113 Classifications of Pricing Objectives 3 Classifications of Pricing Objectives (P. 30)

PROFITABILITYObjectives

VOLUME-BASEDObjectives

COMPETITIVE Objectives

1212Profitability Objectives Profitability Objectives (P. 30)

• Realizing maximum profits in the business.

• Pricing objectives need to be measured precisely in order to be able to assess performance

• Profitability objectives are measured and expressed in specific $$ or %%

• $$1.1 million for 3 years

• 10%% increase in revenue before tax, etc.

1313Elements of Profitability Elements of Profitability (P. 30-31)

Pi

VCi

FC

Qi

Monetary sales mix

Pi = Price per unit of each product or service offering.VCi = Variable costs per unit of each offering.

FC = Fixed costs per period. Qi = Volume produced and sold of each offering.

Monetary sales mix of the offering sold.

1414Profit Maximization Profit Maximization (P. 31)

Low prices High prices

Low unit profit margins High unit profit margins

High unit sales Low unit sales

High inventory turnover Low inventory turnover

Depending on the marketing situation, maximum profits over a planning period may be obtained by either pricing the firm’s offerings relatively low or relatively high.

Which pricing strategy to follow if you want to maximize profit?

Depending on the nature of market demand and competition.

1515Target Return on Investment Target Return on Investment (P. 31)

• The ratio of profits to investments

• An ROI objective can be expressed as a specific % of the investment

• A variation is target return on sales

Wholesalers & Retailers

• Inventory

• Buildings

WHAT DO THEY INVEST ON ?WHAT DO THEY INVEST ON ?

Manufacturers

• Capital

• Machinery

• Buildings

• Land

• Inventory A firm with $10 million in capital assets, seeking a 15% ROI, would seek to achieve net contribution to profits of___________for the planning period.

Example

$1.5 million

1616Volume-Based Objectives Volume-Based Objectives (P. 32)

CustomerDemandCreation

• Revenue (sales) growth - prices are set

to demand and unit sales.

• Market share - prices are set to sales

faster than competition; or to a sales decline

to be slower than competition.

Sales Volume

1717Competitive Objectives Competitive Objectives (P. 32)

Price stability - as a market leader,

the firm attempts to keep prices from declining

(usually found in mature markets);

usually leads to non-price competition.

Aggressive pricing - price below competition to take advantage of market changes,

when market demand is growing,

or when opportunities to grow market share.

1818Establishing Relevant Pricing Objectives Establishing Relevant Pricing Objectives (P. 33-34)

Profitability Objectives Volume-Based Objectives Competition Objectives

The firm is the low-cost supplier The firm is low-cost supplier

The firm is the low-cost supplier

The firm is the price leaderThe market is price sensitive

There are no perceived value differences across sellers in the minds of buyers

There is an internal required rate of return for new product introductions

Cost decline as volume increasesMarket share could be captured using non-price marketing efforts

There is a short lead time for new products before competitors will likely to enter the market.

There is a strong “captive” aftermarket for replacement supplies

There is a growth market segment

There is little differential perceived value in the offerings of firms in the market

To limit competitive entry

1919Summary Summary (P. 34)

• There is no one apparent pricing objective for a specific set of market conditions.

• A profitability objective does not specify either a high- or low- price strategy.

• Using low price to pursue a volume objective must be viewed as an investment over several years.

• The significance of being the low-cost supplier is … • it allows the firm to invest in non-price marketing efforts. • it is not a license to use price as a key competitive tool.

2020Read the case given at Box 2.1 and answer the questions carefully.

1.What was Boeing Pricing Objective in the beginning of the case?

2. What was the result of their change in pricing objective?

3. How did they resolve the losses incurred to Boeing in 1997?

4. What is Boeing’s current pricing objective?

Seat Work 1 Seat Work 1 (P. 35)

2121Market Structure : Degree of Competition Market Structure : Degree of Competition (P. 35)

• Perfect (Pure) Monopoly

• Perfect (Pure) Competition

• Imperfect Competition

− Monopolistic Competition

− Oligopoly

Depending on the structure of competitors within a market, firms may have considerable discretion to determine prices. Table 2.1 Characteristics of Market Structure

2222Market Structure : Degree of Competition Market Structure : Degree of Competition (P. 36)

Perfect Monopoly ตลาดผู�กขาดแท้�จริ�ง

• Only one seller supplies the product or service• Considerable degree of power over price/Government regulations

2323Perfect Competition ตลาดแข�งข�นสมบู�ริณ์�

• Many sellers offer many buyers an identical (homogeneous) product; no seller can influence price

Market Structure : Degree of Competition Market Structure : Degree of Competition (P. 36)

2424Imperfect Competition ตลาดแข�งข�นไม�สมบู�ริณ์�

• Large number of sellers and buyers

• Few sellers, some sellers may hold relatively large market shares and thus be able to influence the prices of products they sell.

• Monopolistic Competition• Oligopoly

Market Structure : Degree of Competition Market Structure : Degree of Competition (P. 36)

Year 2008

2525Monopolistic Competition ตลาดก��งแข�งข�น ก��งผู�กขาด

Market Structure : Degree of Competition Market Structure : Degree of Competition (P. 37)

• Large number of firms market heterogeneous (dissimilar) products

• The greater the degree of product differentiation perceived by buyers,the greater is the opportunity for competing firms to set different prices

2626Oligopoly ตลาดผู��ขายน�อยริาย

Market Structure : Degree of Competition Market Structure : Degree of Competition (P. 37)

• Few sellers dominate the marketplace and thus have substantial influence over price.

• The greater the degree of product differentiation perceived by buyers,the greater is the opportunity for competing firms to set different prices

2727The Laws of Supply and Demand The Laws of Supply and Demand (P. 38)

Whether one, a few, or many sellers are operating in marketplace, their pricing decisions are influenced to some degree by the economic laws affecting

supply and demand.

2828The Laws of Demand The Laws of Demand (P. 38)

• Demand is a relation among various amounts of a product that buyers would be willing and able to purchase at possible alternative prices during a given time, all other things remaining the same

• If supply is held constant…

• an increase in demand leads to and increased market price,

• a decrease in demand leads to a decreased market price.

Demand

2929

• Price

• Income of households

• Price and availability of substitute goods

• Price and availability of complement goods

• Expectations about future prices

• The size and composition of the population

Factors Affecting Laws of Demand Factors Affecting Laws of Demand

3030The Laws of Supply The Laws of Supply (P. 38)

• Supply is a relation showing the various amounts of a product that a seller would make available for sale at possible alternative prices during a given period of time, all other things remaining the same

• When the price of a good is raised, more will be produced

• If demand is held constant…

• an increase in supply leads to a decreased in price.

• a decrease in supply leads to an increased price.

Supply

3131Equilibrium Equilibrium (P. 39)

• In well-behaved markets, the supply and demand curves will intersect at some point.

• An equilibrium between supply and demand is established, producing an equilibrium price

• The market price at which the supply of an item equals the quantity demanded.

Equilibrium Price

P

Q

3232Price elasticity of demand measures the responsiveness of the quantity demanded for a product or service to a change in the price of the product or service

Price Elasticity of Demand Price Elasticity of Demand (P. 43)

EQ Q Q

P P P

Q Q

P PQ Pd

( ) /

( ) /

/

/% %

1 2 1

1 2 1

1

1

Ed = price elasticity of demand

ΔQ = quantity change in demand

ΔP = quantity change in demand Q1, P1 = original quantity demanded and price, respectively

3333Income Elasticity of Demand Income Elasticity of Demand (P. 44)

• Income elasticity of demand: responsiveness of the quantity demanded of a product or service to a change in personal income

EQ

I

I

QI

( ) ( )

• If EI is negative, the product is an inferior good

Income goes up fewer units are demanded (switch to steak, less hamburger)

• If EI is positive, the product is a normal good

Demand increases as income increases

• If 0<EI<1, the product becomes less important in households’ consumption plan

• If EI >1, the product becomes more important as income increases.

3434Cross-Price Elasticity of Demand Cross-Price Elasticity of Demand (P. 45)

• Cross price elasticity of demand: responsiveness of demand for a product to a change in the price of another product

E cQ A

P B

P B

Q A

• If EC is negative, the two products are complementary

• If EC is positive, the two products are substitutes

3535Consumers’ Surplus Consumers’ Surplus (P. 50)

• The difference between the maximum amount consumers are willing to pay for a product (known as the reservation price) and the amount they actually pay

3636Sellers’ Surplus Sellers’ Surplus (P. 51)

•The seller also enjoys a sellers' surplus, which we may define as the difference between his minimum price and the market price.

3737

END OF CHAPTER IIEND OF CHAPTER II