4.4. Price

Cost-based strategies

Cost plus Pricing (Core)

Explanation:

Advantages 1. Fair method: It is a fair method of price fixation. The business executives are convinced that the price fixed will cover the cost.

2. Assured Profit: If price is greater than cost, the risk is covered. This is true when normal expected capacity basis of cost estimation is used.

3. Reduced risks and uncertainties: A decision maker has to take decisions in the face of many uncertainties. He may accept a pricing formula that seems reasonable for reducing uncertainty.

4. Considers market factors: This sort of pricing does not mean that market forces are ignored. The mark up added to the cost to make a price reflect the well established customs of trade, which guide the price fixer towards a competitive price.

Disadvantages 1. Ignores demand: It ignores demand. It fails to take into account the buyers’ needs and willingness to pay which govern the sales volume obtainable at each series of prices.

2. Ignores competition: It fails to reflect competition adequately.

3. Arbitrary cost allocation: It takes for granted that the costs have been estimated with exact accuracy which is not often true particularly in multi-product firms because the common costs are allocated arbitrarily.

4. Ignores opportunity cost: For many decisions incremental costs rather than full costs play a vital role in pricing. This aspect is ignored.

5. Price-Volume relationships: Since the fixed overheads are apportioned on the basis of volume of production, the cost will be more if a sales volume is less and cost will be less if sales volume is more. The increase or decrease in sales volume again is dependent of price. Thus it is a vicious circle–cost plus mark up is price based on sales volume and sales volume is based on price.

Question: If a firm is using a cost-based pricing strategy, what other factors in addition to cost should the enterprise factor into the pricing of their product(s)?

1

Marginal cost (HL Extension)

Marginal cost is the addition to the total cost from producing one more unit of output.

Marginal cost focuses on variable or marginal cost (rather than indirect/fixed costs), such as wages and raw material costs. It ignores any indirect/fixed costs in relation to the product, such as rent or interest payments. If the price is set higher than the marginal costs the surplus can be used to pay off the fixed costs. Once the fixed costs are paid, this surplus will become profit, so any price higher than the marginal cost will be profitable for the firm.

Marginal cost pricing is likely to be most appropriate where demand fluctuates considerably - perhaps, for example, where demand is seasonal or varies according to time of day. Marginal cost pricing is frequently used by utilities and public services.

Example

The costs incurred by a firm that produces handmade leather shoes are as follows:

Cost (per pair of shoes) $

Materials 15

Direct labour 20

Indirect Costs 10

Total Cost (per pair) 45

Question: Calculate the marginal cost of producing an extra pair of shoes

Advantages and disadvantages of marginal cost pricing

Advantages It is a relatively simple pricing method - quick to calculate and easy to

implement Can help to smooth fluctuations in demand. It can be very useful where the firm has spare capacity and may not be able to

put its resources to other, perhaps more profitable, uses. Can be a useful way to attract other different market segments into the market

e.g. low peak train travellers may be attracted by lower prices and only travel during the day because of low prices - they may not otherwise have travelled.

Can be a good way to remain in business and price-competitive in a time of difficult trading. Prices can then be raised later when the economic situation improves.

2

Disadvantages Not sustainable as a long-term pricing strategy as the firm will need to recover

the full costs of production. Can result in lower price expectations and make it more difficult to raise

prices again at a later stage. If markets are not fully separated then there can be leakage between the

markets with different prices. Customers who might have paid a higher price may take advantage of the lower marginal cost price.

Contribution pricing (HL Extension)

Contribution pricing is very similar to marginal cost pricing. The direct cost of production for each product is calculated and price is then set at a higher level. The difference between the direct costs per unit and the price is called the contribution, so called because this is NOT PROFIT, but a 'contribution' to the unpaid indirect/fixed costs of production.

No one product will need to account for all the indirect costs, but each product sold will contribute a proportion to the payment of the firm's overall fixed costs.

For example, let's assume that Maze Green Yachts has indirect/fixed costs of $200 000 and faces the following situation:

Product Sales Direct costs per unit ($)

Price ($) Contribution per unit ($)

Total contribution ($)

21i 17 28 000 29 000 1 000 17 000 25i 18 33 000 36 000 3 000 54 000 32i 15 43 000 48 000 5 000 75 000 38i 11 62 000 66 000 4 000 44 000 45i * 11 80 000 88 000 8 000 88 000

Total contribution

$278 000

* Note that the product number refers to the size of the yacht, so the larger the number, the larger the product.

Have a careful look at this data. Why do you think the contribution from each product is different? What factors might lead to these differences? Have a think about these issues and then follow the link below.

Maze Green Yachts - contribution pricing strategy

Question: if the firm’s fixed costs are $200000, what is the net profit for this firm?

3

Advantages and disadvantages of contribution pricing

Advantages Contribution pricing allows flexibility in the pricing of individual products -

low volume or successful products can be priced to give a higher contribution to indirect costs

Demand factors can be taken into account with contribution pricing Pricing can be linked with the nature/position of the product (N.B. Consider

the link with product life cycle and the Boston Matrix - newly introduced products could even be priced with a negative contribution to boost demand and push them into their growth phase while cash cows could command a higher contribution)

Disadvantages It may be difficult to allocate costs accurately or appropriately across the full

product range and so difficult to assess the most appropriate contribution. If costs are difficult to allocate then this may lead to the pricing being

inaccurate It may lead to an excessively product and cost-oriented approach and so not be

sufficiently flexible to customer needs.

4

Absorption cost and full cost pricing (HL Extension)

If a firm produces a range of products, one accounting issue is how it deals with its fixed/indirect costs, such as rent and interest. This is a subject dealt with in greater detail in the operations and management pack.

Absorption cost and full cost pricing are methods used to allocate all the indirect/fixed costs when determining the price.

Full cost pricing is simple, because the same formula is used to allocate all the costs to each of the product. The full-cost pricing formula may, for instance, be based on the area of the factory used to create each product.

For example, if a product takes up 45% of the factory space, then the firm will allocate 45% of all of the indirect costs (rent, security, interest payments and so on) to that product. The price will therefore be made up of the direct costs per unit, 45% of the indirect costs per unit and a profit mark-up.

Example

Take the following information about a toy factory:

Suppose that a toy factory produces three products; Alpha, Beta and Gamma. Its total indirect costs are $12000 per month. These indirect costs can be apportioned to the three products in two different ways

1. Equally across the three products 2. Apportion indirect costs according to a pre-determined variable

Some additional information about the toy factory are given in the table below:

Product (Department)

Alpha Beta Gamma Total

Direct Costs (per unit)

$8 $5 $6

Floor space (metre squared)

600 550 350 1500

Output per month 500 800 600 1900

Criterion A: Apportion indirect costs equally ($12000/3 = $4000)

Product (Department)

Alpha Beta Gamma

Direct Costs Indirect Costs Total Costs Output per month 500 800 600Cost per unit

5

Criterion 2: Apportion indirect costs according to floor space

Since you are given information about the floor space, you can use this variable to allocate your indirect costs to the three different products.

Total Factory floor space = 1500 metres squared

Alpha: (600/1500) x $12000 = $4800

Beta:

Gamma:

Using your calculations above and any other relevant information, fill in the following table:

Product (Department)

Alpha Beta Gamma

Total Direct CostsIndirect cost allocationTotal CostsOutput per monthCost per unit

Compare the cost price of each product under criterion 1 & criterion 2

6

Absorption pricing is a more sophisticated variant on this where costs are allocated more precisely. Each indirect cost will be treated separately and allocated accordingly.

Rent may be allocated according to the factory space used (i.e. the product that takes 45% of the factory space will have 45% of the rent apportioned to it), but other indirect costs may be apportioned differently. Interest payments, however, may be allocated according to the amount of investment in each product. For example, a product where there has been significant investment made in its production, may bear a higher apportionment of the indirect costs than a product where little investment has been made. Marketing costs may also be apportioned according to the products where most marketing effort has been directed.

Example

Here one takes each element of indirect costs separately and apportion them according to a pre-determined variable.

Suppose that from our previous example, indirect costs are made up of three elements:

1. Rent $80002. Marketing $2000

3. Depreciation $2000

For this example we will apportion these indirect costs according to the following cost bases:

Rent – Floor space

Marketing – according to output levels

Depreciation – according to % of machinery owned per department.

a. Alpha = 30%b. Beta = 40%

c. Gamma = 30%

Calculate the relevant costs and fill the results into the table below.

Product (Department)

Alpha Beta Gamma

Rent allocation

Marketing allocation

7

Depreciation allocation

Total direct costs

Total Costs

Cost per unit

Advantages and disadvantages of absorption/full cost pricing

Advantages It recognises the importance of indirect costs as an element of overall cost It allows for more accurate and precise apportionment of costs It offers a more flexible pricing approach than other cost-based pricing

approaches

Disadvantages It may appear to offer an accurate approach, but in some instances it can be

difficult to calculate an accurate apportionment of costs If used in isolation it may focus too much on product and costs and not be

sufficiently flexible to take into account changes in demand and customer needs

8

Competition-based

Price Leadership (Core)

Explanation:

Advantages of Price Leadership

The following is an advantage of the price leadership method:

High profit margin. If a company can set high price points and competitors are willing to follow those price points, then the company can earn inordinately high profits.

Disadvantages of Price Leadership

The following are disadvantages of using the price leadership method:

Defensive effort. There are several reasons why an industry may accept a particular company as its price leader, several of which involve having to monitor competitors and take reactive steps if they do not follow the company's price leadership position.

Complacency. A company that successfully exercises price leadership may become complacent and not keep its cost structure sufficiently lean to allow it to still earn a profit if a price war develops.

Predatory Pricing (HL Extension)

Exaplantion:

Advantages of Predatory Pricing

The following are advantages of using the predatory pricing method:

Entry barrier. If a company communicates its willingness to use predatory pricing again, possible new entrants to the market will be deterred from competing.

Reduces competition. Financially weaker competitors will be driven from the market, or into smaller niches within the market.

9

Market dominance. It is possible to achieve a dominant market position with this strategy, though predatory pricing may have to be used again in the future to drive away new market entrants.

Disadvantages of Predatory Pricing

The following are disadvantages of using the predatory pricing method:

Illegal. It may be illegal, depending upon the government jurisdiction. Questionable actual value. The concept can certainly work in the short term,

but may not be viable in the long term, since new competitors may enter the market place.

Going rate pricing (HL Extension)

Going rate pricing is a pricing strategy where firms examine the prices of their competitors and then set their own prices broadly in line with these.

Going rate pricing is most likely to occur where:

there is a degree of price leadership taking place within a particular market businesses are reluctant to set significantly different prices because of the risk

of setting off a price war, which would reduce profits to all firms there is a degree of collusion taking place between firms

If there is one price leader and firms are tending to follow the prices set by the price leader, then they will often feel frustrated that they are not able to mark themselves out by reducing their prices. To compensate for this, they may try, through their marketing strategy, to establish a strong brand identity. This will enable them to differentiate themselves from the competition.

Question – The price of price wars

‘The world’s largest supermarket chains have huge market power to reduce prices. Price reductions are a key technique used by supermarkets. For example, the British consumer has grown accustomed to supermarket price wars, with over £1 billion of price reductions each year. Price wars are also common in the airline and mobile phone industries’. (Hoang, Paul. Business and Management, IBID Victoria, 2011, p463)

a. Describe what is meant by a price warb. Examine the winners and losers of a price war in the short-term and long-termc. What forms of non-price competition could supermarkets use to increase their

competitiveness?

10

Market-based

Market Penetration (Core)

Explanation:

Amongst the advantages claimed for penetration pricing include:

o Catching the competition off-guard / by surprise o Encouraging word-of-mouth recommendation for the product because of the attractive pricing (making promotion more effective)

o It forces the business to focus on minimising unit costs right from the start (productivity and efficiency are important)

o The low price can act as a barrier to entry to other potential competitors considering a similar strategy

o Sales volumes should be high, so distribution may be easier to obtain

Penetration pricing strategies do have some drawbacks, however:

The low initial price can create an expectation of permanently low prices amongst customers who switch.  It is always harder to increase prices than to lower them Penetration pricing may simply attract customers who are looking for a bargain, rather than customers who will become loyal to the business and its brand (repeat business)

The strategy is likely to result in retaliation from established competitors, who will try to maintain their market share

Price Skimming (Core)

Explanation:

Advantages of Price Skimming

11

The following are advantages of using the price skimming method:

High profit margin. The entire point of price skimming is to generate an outsized profit margin.

Cost recovery. If a company competes in a market where the product life span is short, price skimming may be the only viable method available for ensuring that it recovers the cost of developing products.

Dealer profits. If the price of a product is high, then the percentage earned by distributors will also be high, which makes them happy to carry the product.

Quality image. A company can use this strategy to build a high-quality image for its products, but it must deliver a high-quality product to support the image created by the price.

Disadvantages of Price Skimming

The following are disadvantages of using the price skimming method:

Competition. There will be a continual stream of competitors challenging the seller's extreme price point with lower-priced offerings.

Sales volume. A company that uses price skimming is limiting its sales, which means that it cannot lower costs by building sales volume.

Consumer acceptance. If the price point remains very high for too long, it may defer or entirely prevent acceptance of the product by the general market.

Annoyed customers. Early adopters of the product may be highly annoyed when the company later drops its price for the product, thereby generating bad publicity and a very low level of customer loyalty.

Cost inefficiency. The very high profit margins engendered by this strategy may cause a company to avoid making the cost cuts required to keep it competitive when it eventually lowers its prices.

Psychological Pricing (HL Extension)

Explanation:

Advantages of Psychological Pricing

The following are advantages of using the psychological pricing method:

Price bands. If a customer is accessing information about product prices that are segregated into bands, the use of fractional pricing can shift the price of a product into a lower price band, where customers may be more likely to make a purchase. For example, if a customer only wants to consider automobiles that cost less than $20,000, pricing a vehicle at $19,999 will drop it into the lower price band and potentially increase its sales.

Non-rational pricing. If customers are swayed by the incremental price reductions advocated under psychological pricing (which is a debatable premise) then sales should increase.

12

Control. It is much more difficult for an employee to create a fraudulent sales transaction and remove cash when product prices are set at fractional levels, since it is more difficult to calculate the amount of cash to steal.

Discount pricing. If a company is having a sale on selected goods, it can alter the ending digits of product prices to identify them as being on sale. Thus, any product ending with a ".98" price will receive a 20% discount at the checkout counter.

Disadvantages of Psychological Pricing

The following are disadvantages of using the psychological pricing method:

Calculation. It can be difficult for cashiers to calculate the total amount owed when fractional prices are used, as well as to make change for such purchases. This is less of a problem when credit card and other types of electronic payments are used.

Rational pricing. If customers are more rational than psychological pricing gives them credit for, then they will ignore fractional pricing and instead base their purchases on the value of the underlying products.

Loss Leader Pricing (HL Extension)

Explanation:

Advantages of Loss Leader Pricing

The following are advantages to using the loss leader pricing method:

Sales increase. When buyers purchase other items in addition to the loss leader, the seller can make a larger profit than would have been the case if it had not offered the loss leader.

New stores. Loss leader pricing is an excellent way to attract shoppers to a new location, since they might otherwise never enter the store, but will do so to take advantage of a particular pricing deal. Thus, it can be used to build a customer base.

Merchandise elimination. The strategy can be used to clear out older merchandise, so the seller can restock its warehouse with newer products.

Marketing. Loss leader pricing is an alternative form of marketing, where the seller is essentially paying customers in the amount of any losses sustained on its loss leader products to enter the company store.

Disadvantages of Loss Leader Pricing

The following are disadvantages of using the loss leader pricing method:

Risk of loss. A company may incur a substantial loss from this pricing strategy if it does not closely monitor sales of other items positioned alongside the loss leader; the risk is that customers may buy only the loss leader, and in large quantities.

13

Stockpiling. If the loss leader price is unusually good, and it is for a necessary item that a consumer may use in bulk, it is possible that each buyer will purchase the largest possible quantity of the item, and then stockpile it for later use. A seller can avoid this issue by limiting purchase quantities or only offering products that have a limited shelf life and which therefore cannot be stockpiled.

Pricing perception. Retaining a deep discount for too long can give buyers the impression that a product should have a lower price at all times, which can reduce its unit sales once management stops the loss leader promotion and returns the product to its normal price.

Price Discrimination (HL Extension)

Explanation:

Advantages of Price Discrimination

1. Firms will be able to increase revenue. This will enable some firms to stay in business who otherwise would have made a loss. For example price discrimination is important for train companies who offer different prices for peak and off peak.

2. Increased revenues can be used for research and development which benefit consumers

3. Some consumers will benefit from lower fares. E.G. old people benefit from lower train companies, old people are more likely to be poor.

Disadvantages of Price Discrimination

1. Some consumers will end up paying higher prices. These higher prices are likely to be allocatively inefficient because P > MC.

2. Decline in consumer surplus.

3. Those who pay higher prices may not be the poorest. E.g. adults could be unemployed, OAPs well off.

4. There may be administration costs in separating the markets.

5. Profits from price discrimination could be used to finance predatory pricing.

Promotional pricing (HL Extension)

Promotional pricing is the use of pricing strategies to support specific promotional strategies. This may include the use of offers (buy one, get one free - BOGOF), discounts or perhaps simply offers. These offers will often be associated with a

14

particular promotional campaign or perhaps time-limited. An example may include the sales that most retail stores will have a few times a year.

The aim of these sales is to encourage people to purchase at a time when demand might otherwise have been low and perhaps the firm has excess stock. This discounted policy is likely to happen towards the end of a product's life cycle. It may also be employed when a new outlet opens and the firm wants to create a buzz of excitement and encourage customers to visit the store.

Questions

1: Explain with examples the the idea of a variable pricing strategy

2: ‘Virgin Blue is the creation of Sir Richard Branson, founder and CEO of the Virgin Group. The airline carrier was launched in 2000 by Branson and Virgin Blue CEO Brett Godfrey to enter the Australian market. Initially set up as a low-fare carrier, the company only flew between Brisbane and Sydney. Since then, it has become Australia’s largest airline catering for all major cities in Australia. To cut costs, customers pay for their in-flight meals and drinks and Virgin Blue uses a system of e-ticketing (a telephone and internet-based ticketing system)’ - (Hoang, Paul. Business and Management, IBID Victoria, 2011, p. 465)

(a) Describe three potential pricing strategies that airline companies can adopt when entering a new market

(b) Evaluate two of the pricing strategies mentioned in part (a) that airlines can use to increase their sales revenue.

15

Supply and Demand (HL Extension)

A market is a place where buyers and sellers meet to trade and it is the market that determines the price of the goods and services that we buy. The market price (or equilibrium price) is determined by the levels of demand and supply in the market. Figure 1 below shows a market in equilibrium with an equilibrium market price of P* and an equilibrium quantity being bought and sold of Q*.

Figure 1: Market equilibrium

Though markets aim to reach equilibrium they can record excesses. This can happen both with demand and supply. When this occurs it is called disequilibrium and figure 2 below shows possible excess supply and excess demand.

16

Figure 2 Excess demand and excess supply

Where there is excess demand in a market this will tend to drive the price upwards, whereas excess supply will tend to drive it downwards.

Demand and supply alter because of changes in certain conditions. If the price of the product you are looking at changes there will be a MOVEMENT along its demand or supply curve (see figure 3 for a move along a demand curve and figure 5 for movements along a supply curve), whilst if any other condition, apart from price of the item you are looking at, changes, then you will have to SHIFT either the demand or the supply curve (see figure 4 for shifts in a demand curve and figure 6 for shifts in a supply curve).

A movement along the demand or supply curve is called a contraction or an extension.

Figure 3 Possible movements along a demand curve

A shift in the demand or supply curve is either an Increase or a Decrease.

17

Figure 4 Possible shifts of a demand curve

Figure 5 Possible movements along a supply curve

Figure 6 Possible shifts of a supply curve

Elasticity

Elasticity is a measure of how sensitive demand is to a change in something that affects it. You can think of the relationship in terms of the dependent and the independent value.

The DEMAND for a product is the dependent variable, as it is the variable being influenced. It can be influenced by a number of different or independent variables such as:

Price Income Advertising The prices of other substitute or complementary goods

The dependent variable (the factor being influenced) - in this case, demand - is always placed on the top of the equation as it is being influenced and the independent variable (the factor causing the change in demand) is placed on the bottom of the equation.

18

We will be start by looking at price elasticity of demand with a definition:

Price elasticity of demand

Price elasticity of demand is a measure of the sensitivity of the demand for a product to changes in its own price. In other words, it is a measure of how much demand for a good or service responds to a change in its price.

Price elasticity of demand is calculated and defined as:

The following 'aide memoire' may be of use. You usually put your dinner (demand) on your plate (price). Demand is over price, D over P!

Price and demand are usually in inverse relationship. In other words, as price falls, demand increases; and as price increases, demand falls. The result of any calculation of price elasticity normally results in a negative elasticity. In practice, the negative sign is usually excluded.

The value of the elasticity ranges from zero to infinity, and is given different names over different numerical ranges. The table below gives all these possibilities.

Value Description Explanation O PERFECTLY

INELASTIC Price has no effect on demand at all

Under 1 INELASTIC Price has a small effect on demand. The % change in price is larger than the % change in demand

Exactly 1 UNITARY % Change in price and % change in demand are the same. Remember, though, the signs are different.

Over 1 ELASTIC Demand is very sensitive to price. The % change in price is less than the % change in demand.

Infinity PERFECTLY ELASTIC

Any increase in price kills demand.

It is usual to represent the degree of elasticity graphically. The common shapes for demand curves and their elasticity values are given in the diagrams below.

19

Figure 1 Inelastic demand curve

Figure 2 Elastic demand curve

The special shape that represents a price elasticity of 1 is known as a rectangular hyperbola! This is shown below.

Figure 3 Unit elastic demand curve

Price elasticity of a good or service depends on a range of factors:

The number of close substitutes in the market. The more substitutes available the greater the elasticity.

20

Is the product a luxury or a necessity? Luxuries are more elastic than necessities.

Amount of income spent on the product. Cheap items tend to be inelastic. Is the product habit forming? If so demand will become price inelastic. The stage of the product life cycle.

Elasticity and sales revenue

As we have seen, one of the most important uses of elasticity is to see the impact that a change in price will have on the demand for a good. This will affect the amount of revenue a firm can earn from a good or service. The table below summarises the possibilities:

Price elasticity value

Price change

Impact on firm's revenue

Explanation

Elastic Increase Fall Elastic demand will mean that when price increases, demand will fall by more than the price increased. This means a fall in revenue.

Elastic Decrease Increase Elastic demand will mean that when price falls, demand will increase by more than the price decreased. This means an increase in revenue.

Inelastic Increase Fall Inelastic demand will mean that when price increases, demand will fall by less than the price increased. This means an increase in revenue.

Inelastic Decrease Increase Inelastic demand will mean that when price falls, demand will increase by less than the price decreased. This means a fall in revenue.

Price elasticity and the product life cycle

The price elasticity will tend to vary at each stage of the product life cycle.

21

Figure 4 Product life cycle and elasticity

In the growth phase of the product life cycle, the product will tend to be fairly inelastic. This is because of the nature of the demand. People buying at this stage will tend to be 'innovators' and they are prepared to take risks with new products and are willing to pay a high price to have the latest technology.

However, as the product moves towards maturity, the elasticity will increase. The amount of competition will increase and the increasing number of substitutes will make consumers more price sensitive. The nature of the consumers will also change and they are likely to be more motivated to buy by factors like price, functionality and reliability.

Questions on PED

22

1: If the price of a good or service increased and the total revenue received by the seller declined, is the demand for this good over this segment of the demand curve elastic or inelastic? Explain

2: Suppose the price elasticity of demand for used cars is estimated to be -3.0. What does this mean? What will be the effect on the quantity demanded for used cars if the price rises by 10%?

3: Suppose a university raises its tuition from $3000 to $3500. As a result, student enrolment falls from 5000 to 4500. Calculate the PED. Is demand elastic, inelastic or unitary elastic?

4: Suppose the movie theatre raises the price of popcorn 10%, but customers do not buy any less of it. What does this tell you about the PED, and what will happen to total revenue as a result of the price increase?5: Price of beans per tin Market demand per week€0.40 1000€0.30 1500

(a) Calculate the price elasticity of demand(b) Comment on its value(c) What will the demand curve for beans look like?

6: BreadPrice per loaf Quantity demanded per month€0.25 10000€0.20 10500

DVD recorders

Price per DVD recorder Quantity demanded per month€500 1000€400 1800

(a): In each case calculate the price elasticity of demand and comment on the values.

(b): Calculate the total revenue for bread and for DVD recorders at each price.

(c) Would you advise bread-makers to cut the price of a loaf from €0.25 to €0.20? Explain your answer

(d) Would you advise manufacturers to cut the price of a DVD recorder from €500 to €400? Explain your answer.

Income elasticity of demand (YED)

The income elasticity of demand is a measure of the sensitivity of the quantity demanded to changes in real income.

23

N.B. In economics the abbreviation of Income is 'Y'. This is because 'I' is used for Investment.

Formula:

Normal and inferior goods

Elasticity can be calculated and a range of values found. What do they show? What do they tell an economist?

Income elasticity may be positive or negative. If income elasticity is negative, demand actually falls as real income rises, which is not the normal reaction. Demand will normally increase as incomes increase as consumers can afford to spend more. As a result, goods or services with such elasticity are called inferior goods.

If the income elasticity is positive, demand increases with real income. These goods are known as normal goods.

List some examples of normal goods.

Elasticity ranges from plus infinity to minus infinity. The sign reveals whether the good is inferior or normal.

Question

1: If, when income rises by 5% and other things remain the same, the quantity demanded of good C increases by 1%.

(a) Is good C a normal good or an inferior good? Why?(b) Describe how the demand for good C changes when income increases

(c) Calculate the income elasticity of demand for good C

Cross elasticity of demand

The cross elasticity is a measure of the sensitivity of the demand for one product to changes in the price of another.

24

Formula:

Significance of XED sign

The sign is as important as the numerical value, however.

Some products tend to be bought together, others are purchased in competition to each other.

Products which are in joint demand are called complementary goods. Products which are in competitive demand because customers see them as

interchangeable are called substitute goods.

Examples of complements are strawberries and cream, fish and chips, cars and petrol, printers and printer ink. Complementary goods have negative cross price elasticities. Perfect complements will have a cross price elasticity of infinity.

Examples of substitutes are beef and lamb, gas and heating oil, petrol and diesel fuel. (Note that the substitution may not be possible at once). Substitutes have positive cross price elasticities.

Cross price elasticity can change with time.

Question

1: If the quantity demanded of Good A increases by 5% when the price of good B rises by 10% and other things remain the same:

(a) Are goods A and B complements or substitutes? Why?(b) Describe how the demand for good A changes

(c) Calculate the cross elasticity of demand of good A with respect to good B.

Advertising elasticity of demand

Advertising elasticity of demand is a measure of how much advertising expenditure affects the demand for a good or service.Advertising elasticity of demand (AED) is a useful measure of advertising effectiveness. It measures the percentage change in demand for the product or service compared to the percentage change in the level of advertising expenditure.

25

Formula:

The value that is derived as a result for the advertising elasticity will vary from zero to infinity. As before, the now familiar descriptions are used:

Value Description 0 Perfectly inelastic Under 1 Inelastic 1 Unitary Over 1 Elastic Infinity Perfectly elastic

Significance of AED sign

If the value for AED that is calculated is below one, then the product is said to be inelastic in response to advertising expenditure. This means that an increase in advertising expenditure of, say 20%, has led to a growth in demand for the product of less than 20%. The lower the value of the AED, the less effective advertising expenditure has been at boosting demand.

A value of greater than 1 indicates that the demand for the product is highly responsive to changes in advertising expenditure. This means that an increase in advertising expenditure will generate a greater increase in demand for the product.

Limitations of the AED value

However, while the AED value may be very useful, a simple numerical interpretation of the value may not be entirely appropriate for a number of reasons. These might include:

The purpose of a lot of advertising may not be to directly boost demand, but to help with building a brand image or brand loyalty - the AED value cannot show the effectiveness of this strategy

If dealing with a family of brands, it may be difficult to isolate the effect of the advertising spending on a single product or service and this may distort the apparent effectiveness of the expenditure

It may be difficult to isolate the impact of advertising expenditure to a specific time period - some campaigns are ongoing over a considerable period and other factors may also influence demand over an extended period

Question

Your vending machine company starts a new ad campaign, “Vend for Yourself.” Currently, your company sells soft drinks at $1.50 per bottle, and at that price,

26

customers purchase 2,000 bottles per week. Initially, you spend $400 per week on advertising. After a month, you’re spending $500 per week on advertising and, without changing the price of soft drinks, sales have increased to 3,000 bottles per week.

(a) Calculate the advertising elasticity of demand(b) Comment on the value

27