Chapter 5 - Pricing

Question 0

The optimum price of a product

Answer 0

1. P = a + bQ
   Where a is the intercept, b is the gradient.
2. MR = a - 2bQ
3. Establish the MC. This will be the variable cost per unit.
4. To maximise profit, MC = MR and solve to find Q.
5. Substitute Q into the P = a - bQ to find the optimum price.
6. May be necessary to calculate the maximum profit.

Question 1

The price elasticity of demand

Answer 1

Measures the change in demand as a result of a change in its price.

Price elasticity of demand = Change in quantity demanded, as a % of demand/ Change in price as a % of the price

Question 2

Interpretation of PED

Answer 2

Elastic demand.
If % change in demand > % change in price then price elasticity > 1.

Demand is elastic (very responsive to changes in price).

1. Total revenue increase when price is reduced.
2. Total revenue decreases when price is increased.

Price increases are not recommended but price cuts are recommended.

Inelastic demand.
If % change in demand < % change in price then price elasticity < 1.

Demand is inelastic (not very responsive to changes in price).

1. Total revenue decreases when price is reduced.
2. Total revenue increases when price is increased.

Price increases are recommended but price cuts are not recommended.

Question 3

Equation for the total cost function.

Answer 3

y = a + bx

a is the Fixed cost (intercept).
b is the Variable cost per unit (gradient).
X is the activity level (independent variable).
Total cost = Fixed cost + Variable cost (dependent variable).

Question 4

Profit mark up and profit margin

Answer 4

Profit mark up: The profit is quoted as a percentage of the cost.
e.g. A 25% mark up of $540 would be $540 x 1.25 = $675

Profit margin: The profit is quoted as a percentage of the selling price.
e.g. A 25% profit margin of $540 would be $540 x 100/75 = $720

Question 5

Market skimming pricing strategy

Answer 5

1. Involves charging high prices when a product is first launched in order to maximise short-term profitability.
2. Initially high prices charged to take advantage of the new product when demand is initially inelastic.

Conditions suitable:-

1. Where the product is new and different.
2. Where products have a short life cycle and there is a need to recover costs quickly to make a profit.
3. Where the strength of demand and the sensitivity of demand to price are unknown. Start high then lower price if needed.
4. A firm with liquidity problems may use market skimming in order to generate high cash flows early on.

Question 6

Penetration pricing strategy

Answer 6

1. Involves charging low prices when a new product is initially launched in order to gain rapid acceptance of the product.
2. Once market share is achieved, prices are increased.

Conditions suitable:-

1. If the firm wishes to increase market share.
2. A firm wants to discourage new entrants to enter the market.
3. If there are significant economies of scale to be achieved from high volume output and so a quick penetration into the market is desirable.
4. If demand is highly elastic and so would respond well to low prices.

Question 7

Complementary product pricing

Answer 7

A product which is normally used with another product.
e.g. Razors and razor blades, games consoles and games, printers and printer cartridges.

1. The major product is priced low to lock the consumer into subsequent purchases of high price consumables.
2. The major product is priced high to create a barrier to entry and exit and the consumer is locked into subsequent purchases of low price facilities.

Question 8

Product line pricing strategy

Answer 8

A range of products that are related to one another. All products are related but many vary in terms of style, colour, quality, price etc.

Product line pricing works by:-

1. Capitalising on consumer interest in a number of products within a range.
2. Making the price entry point for the basic product cheap.
3. Pricing other items in the range more highly.

Question 9

Volume-discounting pricing strategy

Answer 9

Offering customers a lower price per unit if they purchase a particular quantity of a product.

The main forms are:

1. Quantity discounts - customers that order large quantities.
2. Cumulative quantity discounts - the discount increases as the cumulative total ordered increases.

Benefits:

1. Increase customer loyalty.
2. Attracting new customers.
3. Lower sales processing costs.
4. Lower purchasing costs.
5. Discounts help to sell items that are bought primarily on price.
6. Clearance of surplus stock or unpopular items through discounts.
7. Discounts can be geared to particular off-peak periods.

Question 10

Price-discrimination pricing strategy

Answer 10

Where a company sells the same product at different prices in different markets.

Conditions required:

1. Seller must have some monopoly power or the price will be driven down.
2. Customers can be segregated into different markets.
3. Customers cannot buy at lower price in one market and sell at higher price in the other market.
4. There must be different price elasticities of demand in each market so that prices can be raised in one and lowered in the other to increase revenue.

Dangers:

1. A black market may develop where those in a lower priced segment resell to those in a higher priced segment.
2. Competitors join the market and undercut the firms prices.
3. Customers in the high bracket look for alternatives and demand becomes more elastic over time.