Power Point Slides Luke M Froeb Vanderbilt

Power. Point Slides © Luke M. Froeb, Vanderbilt 2014 Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

11 Chapter 6 Simple Pricing 2 Copyright © 2014 Cengage Learning. All Rights Reserved.

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 is used to estimate demand from a • price and quantity change. [(Q 1 - Q 2)/(Q 1 + Q 2)] ÷ [(P 1 - P 2)/(P 1 + P 2)] If |e| > 1, demand is elastic; if |e| < 1, demand is inelastic. Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

Chapter 6 – Summary (cont. ) • %ΔRevenue ≈ %ΔPrice + %ΔQuantity • Elastic Demand (|e| > 1): Quantity changes more than price. • Inelastic Demand (|e| < 1): Quantity changes less than price. • MR > MC implies that (P - MC)/P > 1/|e|; in words, if the actual margin is bigger than the desired margin, 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. Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole 4

Chapter 6 – Summary (cont. ) • 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 often implement marginal analysis. Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

Introductory Anecdote: Hot Wheels • Mattel introduced Hot Wheels in 1968 • They kept price below $1. 00 for 40 years, even as production costs rose • Finally tested a price increase, experienced profit increase of 20% • Why? Profit=(P-C)x. Q • Businesses tend to focus on C and Q, neglect P • In many instances, companies can make money by simply raising price Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

Simple Pricing ▮ In this chapter, we consider “simple pricing”: • A single firm selling a single product at a single • • • price Most firms sell: in competition with rivals; multiple products, and at different prices, so this is rare Important to understand simple pricing first though Simple pricing has become part of business vernacular • When your boss says that “demand is elastic, ” she often means that price is too high. Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole 7

Background: Consumer Surplus and Demand Curves • First Law of Demand - consumers demand more (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 Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

Consumer Surplus and Demand Curves Example • 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 Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

Pizza Example Cont. ▮ For the first slice, the total and marginal value are the same at $5 ▮ For the second, the marginal value is $4, while the total value is $9 = $5 + $4 Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole 10

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. Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

Aggregate Demand Cont. ▮ Demand curves describe buyer behavior and tell you how much they will buy at a given price. ▮ If something other than price causes an increase in demand, we say that “demand shifts” to the right or “demand increases” such that consumers purchase more at the same prices Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole 12

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 Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

Marginal analysis of pricing • Marginal analysis finds the profit increasing solution to the pricing tradeoff. • It tells you which direction to go (to raise or lower price), but not how far to go. • Definition: marginal revenue (MR) is change in total revenue from selling another unit. • If MR>0, then total revenue will increase if you sell one more. • If MR>MC, then total profit will increase if you sell one more. • Proposition: Profit is maximized when MR = MC Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

Example: Find the Optimal Price • Once you reach the 4 th unit, total profit decreases by %0. 50 because the MR from the 4 th unit is only $1, which is less than $1. 50 MC • Therefore, the profit maximizing quantity is 3 and we see that the price is $5. 00 for 3 units to be sold Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

How Do We Estimate MR? • Price elasticity allows us to calculate 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. Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

Mistake in 3 rd Edition • The Correct Answer • Elastic Demand implies |e|>1 • Inelastic Demand implies |e|<1 • The following figures are mis-labled (The inequality in parentheses should be reversed) Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

Price Elasticity Example ▮ Mayor Marion Barry increased taxes on gasoline sales in DC by 6%. ▮ Before the tax, gas station predicted that the increase in a sales tax would reduce quantity demanded by 40% ▮ The gas station owners were indirectly arguing that gasoline revenue, and the taxes collected out of revenues, would decline because gasoline sales in DC has a very elastic demand Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole 18

Estimating elasticities • Definition: Arc (price) elasticity= [(q 1 -q 2)/(q 1+q 2)] [(p 1 -p 2)/(p 1+p 2)] • Discussion: Compute elasticity, when price changes from $10 to $8, and quantity changes from 1 to 2? • Example: On a promotion week for Vlasic, the price of Vlasic pickles drops by 25% and quantity increases by 300%. • Is the price elasticity of demand -12? • HINT: could something other than price be changing? Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

Intuition: MR and Price Elasticity • Revenue and price elasticity are related by the following approximation. • % 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↓ Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

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? Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

Elasticity and Pricing • MR>MC is equivalent to • P(1 -1/|e|)>MC • P>MC/(1 -1/|e|) • (P-MC)/P>1/|e| • MR > MC means that (P-MC)/P > 1/|e| • The left side of the expression is the current margin = (P-MC)/P • The right side is the desired margin, or the inverse elasticity = 1/|e| • If the current margin is greater than the desired margin, reduce the price because MR>MC and vice versa. • Intuition: the more elastic demand becomes (1/|e| becomes smaller), the less you can raise price over MC because you lose too many customers Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

What Makes Demand More Elastic? • 5 factors that affect demand elasticity and optimal pricing: 1. Products with close substitutes have elastic demand. 2. Demand for an individual brand is more elastic than 3. 4. 5. industry aggregate demand. Products with many complements have less elastic demand. In the long run, demand curves become more elastic. As price increases, demand becomes more elastic. Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

Factor 1 1. Products with close substitutes have elastic demand. • Consumers respond to a price increase by switching to their next-best alternative. • If their next-best alternative is a very close substitute, then it doesn’t take much change in price for them to switch • When Mayor Barry raised the price of gasoline, DC commuters began buying gasoline in nearby Virginia and Maryland Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole 24

Factor 2 2. Demand for an individual brand is more elastic than industry aggregate demand. • Rough rule of thumb: brand price elasticity is approximately equal to industry price elasticity divided by brand share • Example: elasticity of demand for all running shoes = -0. 4 Market share of Nike running shoes is 20% Price elasticity of demand for Nike running shoes is -0. 4/. 20 = -2 Using our optimal pricing formula, this would give Nike a desired margin of 50% Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole 25

Factor 3 3. Products with many complements have less elastic demand. • Products that are consumed as a larger bundle of complementary goods have less elastic demand. • Example: i. Phones have less elastic demand because of the number of apps run on them If the price of an i. Phone increases, you are less likely to substitute to another product due to the complementary apps Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole 26

Factor 4 4. In the long run, demand curves become more elastic. • This can also be explain by the speed at which price information is spread; or the ability of consumers to find more substitutes in the long run. • Example: ATM fees At a selected number of ATMs, a bank raised user fees from $1. 50 to $2. 00. When informed of the fee increase, users typically completed the current transaction but avoided the higherpriced ATMs in the future. Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole 27

Factor 5 5. As price increases, demand becomes more elastic. • Example: high-fructose corn syrup (HFCS) • Primary use is a caloric sweetener in soft drinks • Sugar is the perfect substitute for HCFS • Import quotas and sugar price supports have raised the US domestic price of sugar about twice that of HFCS. Bottlers have shifted to HFCS. • Bottlers have no close substitute for low-priced HFCS, although as the price of HFCS approaches that of sugar, demand for HFCS becomes very elastic. Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole 28

Other Elasticities • Definition: income elasticity measures the change in demand arising from a change in income • (%change in quantity demanded) (%change in income) • Inferior goods (negative): as income increases, demand declines • normal goods (positive): as income increases, demand increases • 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 (positive): as the price of a substitute increases, demand increases • Complement (negative): as the price of a complement increase, demand decreases Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

Stay-Even Analysis • Stay-even analysis tells you how many sales you need when changing price to maintain the same profit level • How to implement marginal analysis of pricing using stay-even quantity: • %ΔQ = (%ΔP) (%ΔP + margin) • Margin=40%, %ΔP=5%, then %ΔQ = 11. 1% • In other words, a 5% price increase would be profitable if quantity went down by less than 11. 1%. • Use elasticity estimates or marketing surveys to determine whether quantity would go down by 11. 1%. Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

Cost-Based Pricing ▮ Our expression for optimal pricing, MR=MC or (P-MC)/P= 1/|e|, takes into account the firm’s cost structure and its consumer demand ▮ Often, the consumer side is ignored in pricing decisions, leading to cost-based pricing. Why? ▮ Often, firms do not have the demand picture ▮ They need to invest in a market research division to take profitability seriously Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole 31

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? Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

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. Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

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 to price accordingly was costly Copyright © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole