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Learning Objectives
To be able to analyse different pricing strategies: cost – based, competition – based, market - based
To be able to analyse the appropriateness of different pricing strategies
HL – To evaluate the impact of changes in the conditions of supply and demand
HL – To calculate and interpret price, income, cross and advertising elasticity and the product life cycle
HL – To be able to analyse the relationship between price elasticity and sales revenue
Price
• Factors determining the pricing decision for a product1. Costs of production2. Competitive conditions in the market3. Competitors’ prices4. Marketing objectives5. Price elasticity of demand6. Whether it is a new or an existing product
PRICING STRATEGIESCOST BASED PRICING
Cost plus pricing
• Mark up pricing
• In a competitive market the profit margin may be small e.g. 5%, while in non-competitive the mark up might be over 100%
• Example– Cost of bought in materials: $40– 50% mark up on cost: $20– Selling price: $60
Marginal Cost Pricing• Marginal cost – the cost of producing ONE extra or ONE fewer item of
production• MC pricing – allows flexibility • It bases the price on the extra cost of making the additional unit of output• Particularly relevant in transport where fixed costs may be relatively high
• Allows variable pricing structure – e.g. on a flight from London to New York – providing the cost of the extra passenger is covered, the price could be varied a good deal to attract customers and fill the aircraft
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Marginal Cost Pricing• Example:
Aircraft flying from Bristol to Edinburgh – Total Cost (including normal profit) = £15,000 of which £13,000 is fixed cost*
Number of seats = 160, average price = £93.75
MC of each passenger = 2000/160 = £12.50
If flight not full, better to offer passengers chance of flying at £12.50 and fill the seat than not fill it at all! *All figures are estimates only
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Contribution Pricing• Contribution = Selling Price – Variable (direct costs)
• Prices set to ensure coverage of variable costs and a ‘contribution’ to the fixed costs
• Similar in principle to marginal cost pricing• Break-even analysis might be useful in such circumstances
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Absorption/Full Cost Pricing• Full Cost Pricing – attempting to set price to cover both fixed
and variable costs• Absorption Cost Pricing – Price set to ‘absorb’ some of the
fixed costs of production• Example
– DVD company• Overheads \ fixed costs per year = $10 000• Variable cost of each DVD = $5• Currently producing 5000 units per year• Total costs are:
$10000 + ($5000 X $5) = $35000Average or unit cost of making each DVD are$35000 / 5000 = $7
The business needs to charge at least $7 in order to break even on each unit. If the business adds 300% mark up the price becomes $28
Competition-Based Pricing
• A firm will base its price upon the price set by its competitors
• Price leadership – one dominant firm in a market sets a price and other firms simply change a price based upon that
Destroyer/Predatory Pricing• Deliberate price cutting or offer
of ‘free gifts/products’ to force rivals (normally smaller and weaker) out of business or prevent new entrants
• Anti-competitive and illegal if it can be proved
Microsoft – have been accused of predatory pricing strategies in offering ‘free’ software as part of their operating system – Internet Explorer and Windows Media Player - forcing competitors like Netscape and Real Player out of the market.Title: Bill Gates speaks at UNIX convention. Copyright: Getty Images, available from Education Image Gallery
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Going Rate (Price Leadership)
• In case of price leader, rivals have difficulty in competing on price – too high and they lose market share, too low and the price leader would match price and force smaller rival out of market
• May follow pricing leads of rivals especially where those rivals have a clear dominance of market share
• Where competition is limited, ‘going rate’ pricing may be applicable – banks, petrol, supermarkets, electrical goods – find very similar prices in all outlets
Methods Advantages Disadvantages
Full-cost pricing (Also applies to cost-plus)
• Price set will cover all costs of production
• East to calculate for single product firms where there is no doubt about fixed cost allocation
• Suitable for firms that are ‘price makers’
• Not necessarily accurate for firms with several products where there is doubt about fixed cost allocation
• Doesn’t take market \ competitive conditions into account
• Tends to be inflexible • If sales fall, costs increase, could
lead to price being raised
Contribution-cost pricing • All variable costs covered and a contribution to fixed costs
• Suitable for firms producing several products
• Flexible with price
• Fixed costs may not be covered • If prices vary too much regular
customers may not be happy
Competition–based and going–rate pricing
• Almost essential for firms with little power – ‘price takers’
• Flexible to market and competitive conditions
• Price set may not cover all costs of production
• May have to vary price frequently due to changing market and competitive conditions
Price discrimination (Market based pricing strategy) HL
• Uses price elasticity knowledge to charge different prices in order to increase total revenue
• Admin costs of having different pricing levels
• Customers may switch to lower priced market
• Customers paying higher prices may object and look for alternatives
PRICING STRATEGIES MARKET BASED
Penetration Pricing• Price set to ‘penetrate the market’
• ‘Low’ price to secure high volumes
• Typical in mass market products – chocolate bars, food stuffs, household goods, etc.
• Suitable for products with long anticipated life cycles• May be useful if launching into a new market
Market Skimming• High price, Low volumes
• Skim the profit from the market
• Suitable for products that have short life cycles or which will face competition at some point in the future (e.g. after a patent runs out)
• Examples include: Playstation, jewellery, digital technology, new DVDs, etc.
Plasma screens: Currently athigh prices but for how long?
Title: Thin-shaped television. Copyright: Getty Images, available from Education Image Gallery
Price Discrimination• Charging a different price for
the same good/service in different markets
• Requires each market to be impenetrable (fully saturated)
• Requires different price elasticity of demand in each market
Prices for rail travel differ for the same journey at different times of the day
Title: Inter-City 125. Copyright: Getty Images, available from Education Image Gallery
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Loss Leader• Goods/services deliberately sold below cost to encourage
sales elsewhere in the store
• Typical in supermarkets, e.g. at Christmas, selling bottles of gin at £3 in the hope that people will be attracted to the store and buy other things
• Purchases of other items more than covers ‘loss’ on item sold• e.g. ‘Free’ mobile phone when taking on contract package
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Psychological Pricing
• Used to play on consumer perceptions
• Classic example - £9.99 instead of £10.99!
• Links with value pricing – high value goods priced according to what consumers THINK should be the price
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Promotional Pricing
• Special low prices to gain market share or sell off excess stock
• Widely used• Tends to operate for limited periods to boost
sales
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Supply and Demand
Babysitter Required
• How many of you would be interested in babysitting for the following wages:
• £1 per hour• £3 per hour• £5 per hour• £10 per hour• £15 per hour
Definition of Supply
• “ The amount offered for sale, at each given price level over a period of time.”
• The theory explains how firms (suppliers) behave, with regard to decisions about how much they plan to produce.
• Economists make 2 key assumptions here:– That firms have one main objective – to maximise profits.– That the costs of production increase, as output increases
(this is known as rising marginal cost)
The Supply Curve
• A rise in price leads to a rise in the quantity supplied (& vice versa).
• Suppliers increase supply when prices rise, to take advantage of the higher profits now available (and vice versa).
• ie, Supply and Price have a positive correlation.
Supply and PriceP
Q
Supply
P1
P2
Q1 Q2
As prices rise, from P1 to P2,the quantity supplied by firmsincreases from Q1 to Q2, causinga movement along the SupplyCurve, from P1Q1 to P2Q2.
Supply and PriceP
Q
S
P2
P1
Q2 Q1
As prices fall from P1 to P2,some firms will cut back on unprofitable production, whilst others may stop producing altogether. Some firms may even go bankrupt, if unable to cover their costs of production from the price received.
Supply & Other Factors
• Changes in Costs of Production eg, wage costs• New Technology, leading to improved/increased
productivity.• The Price of other goods.• Other Factors:
– Changes in Market dynamics– Changes in Government Legislation– Firms’ Expectations for the Future
These non-price factors (known as ‘the conditions of supply’) lead to a Shift in the Supply Curve.
Costs of Production/New TechnologyP
Q
S1P1
P2
Q1
If costs of production increase, suppliers will attempt to pass these costs on, in the form of higher prices.For any given quantity supplied eg, Q1 - firms want a higher price, to compensate for their increased costs ie, P1 to P2. This increase is true for any point on the supply curve - so, the supply curve shifts, upwards & to the left, to S2 – ie, in this example there has been a reduction in Supply at each price point.
S2
Other Factors affecting Supply• Changes in Market Dynamics
– Any change in the market which affects profit levels eg, the number of competitors in the market, will affect supply.
• Government Legislation– Anti-pollution controls; legal barriers to market entry; subsidies; tax
changes – these can all affect supply.• Expectations for the Future
– If firms expect prices to rise in future, they may stockpile goods and restrict supply; if they expect prices to fall they may increase supply, to get rid of stock quickly whilst prices are high.
• The Weather– Weather plays a crucial role in determining Supply in agricultural
markets – ie, bad weather causing a shortage of supply; good weather leading to excess supply.
Determinants of Demand
Definition of Demand
• Demand for a good/service is “the quantity of a good or service that will be bought over a period of time, at any given price”.
• The Demand Curve shows the quantity of a good demanded, at any given price.
• When price changes, there is said to be a “movement along the curve”.
Demand & Price
P
Q
D
P1
P2
Q2Q1
As price decreases, from P1 to P2, thequantity demanded increases, fromQ1 to Q2. This is shown by a movement along the Demand Curve from P1Q1 to P2Q2.
Demand and Price
• Assuming “ceteris paribus” (all other things being equal) if the price of a product increases, then the quantity demanded will fall – and conversely – if the price of a product falls, then the quantity demanded increases (-ve correlation). So:-
when Price ↑ / Demand ↓and when Price↓ / Demand ↑
Variables Affecting Demand
Complements/Substitutes
Size ofPopulation
Legislation Income
Advertising& Promotion
Taste orFashion
Price
Factors AffectingDemand
Other Variables
• Demand for goods/services will also rise or fall if there are changes in other variables, other than price.
• Changes in these ‘other variables’ cause an increase or decrease in demand – shown by a shift of the entire Demand Curve (ie, at any given price point, the quantity demanded will change).
Demand & Income
P
QD1
Q1 Q2
As income increases, the demand fora normal good increases, from Q1 to Q2.This is shown here by a shift of the Demand Curve to the right, from D1 to D2.
D2
P1
Demand for Other Goods
• A more general model or ‘real model’ of the market system shows how events in one market (or product) lead to changes in other markets (or products).
• We call these Complements & Substitutes.
Complements
• COMPLEMENTS – goods which are purchased with another good, to satisfy a want. Examples:– Tennis rackets & tennis balls– Washing machines & soap powder– Porridge & milk– DVD players & DVD’s
• Demand for 1st → Demand for 2nd
• Demand for 1st → Demand for 2nd
Demand for Tennis Rackets
Price
Quantity
P1
P2
Q1 Q2
A fall in the price of Tennis Rackets from P1 to P2, causes a movement along the demand curve, resulting in an increase in the quantity of tennis rackets demanded, from Q1 to Q2.
Demand Curve for Tennis Rackets
D
Demand for Tennis Balls
Price
Quantity
P1
Q1 Q2
The fall in the price of Tennis Rackets means that people also need more Tennis Balls (the complementary product). This causes an increase in demand for tennis balls, from Q1 to Q2. The demand curve shifts to the right, from D1 to D2.
D1D2
Demand Curve for Tennis Balls
Substitutes
• A SUBSTITUTE is a good which can be replaced by an alternative good, to satisfy a want.
• Examples include:– Beef instead of Lamb– Coca-Cola instead of Pepsi-Cola– White Bread instead of Brown Bread– Gas instead of Oil (in the long term)
• Price of one → Demand for the other• Price of one → Demand for the other
Demand for Beef
Price
Quantity
P2
P1
Q2 Q1
A rise in the price of Beef from P1 to P2 causes a decrease in the quantity of Beef demanded from Q1 to Q2. This causes a movement along the demand curve, from P1Q1 to P2Q2.
D
Demand Curve for Beef
Demand for Lamb
Price
Quantity
P1
Q1 Q2
The rise in the price of Beef means that people look for alternatives. This causes people to switch to buying Lamb, and the demand curve for Lamb increases from Q1 to Q2. The Demand Curve shifts to the right, from D1 to D2.
D1
D2
Demand Curve for Lamb
Practice
1. Show with diagrams what happens to the demand for battery chicken if the price of organic chicken drops rapidly.
2. Show what happens to the demand for automatic washing powder if the price of washing machines decreases.
3. Show what happens to the demand for iPod’s if the price of music downloads was to increase dramatically.
Elasticity…..how much do consumer’s react?
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The concept of elasticity
• Has the London congestion charge reduced traffic flows and congestion?
• Will most people still fly if there is a new aviation fuel tax?
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Price elasticity of demand
• Why is elasticity of demand important for Stelios?
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Elasticity of Demand
– Why do hotels lower room-rates at weekends and why do car rental firms charge lower prices at weekend?
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Cut-throat competition?
Gillette – the manufacturers of the Mach 3 razor - controls over 70 per cent of the world's wet shave razor market and takes 90 per cent of the $1.5 billion annual global profits
If the price of Mach3 razors went up by 20% - would you still buy them?
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Elasticity – the concept
• Elasticity is the responsiveness of one variable to changes in another
• E.g. When price rises what happens to demand?
BUT….
By how much does demand
fall?
Demand falls
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Elasticity – the concept
• If price rises by 10% - what happens to demand?
We know demand will fall• By more than 10%?• By less than 10%?• Elasticity measures the extent to which demand
will change
Elastic
Inelastic
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There are 5 types of elasticity
• Price elasticity of demand (PED)
• Price elasticity of supply (not so important)
• Income elasticity of demand (YED)
• Cross elasticity of demand (XED)
• Advertising elasticity of demand (AED)
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Price Elasticity of Demand
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Elasticity
Price (£)
Quantity Demanded
The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded.
They all have
differing levels of elasticity
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Elastic V Inelastic
• Price Elasticity of Demand
• The responsiveness of demand to changes in price– Where % change in demand is greater than %
change in price – elastic– Where % change in demand is less than % change
in price - inelastic
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To your work sheet & calculators!
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Your worksheet…. Use a calculator!
Question % change in Price % change in Qty Demanded
Elasticity Type of elasticity
A 10 20 =20/10 =
B 50 25 =25/50 =
C 7 28
D 9 3
E 5 10
F 20 60
G 8 4
H 9 9
I 7 5
J 11 8
K 15 0
% change in D > % change in P = elastic
% change in D < % change in P = inelastic
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The ANSWERS…
Question % change in Price
% change in Qty Demanded
Elasticity Type of elasticity
A 10 20 =20/10 = 2 Elastic
B 50 25 =25/50 = 0.5 Inelastic
C 7 28 4 Elastic
D 9 3 0.33 Inelastic
E 5 10 2 Elastic
F 20 60 3 Elastic
G 8 4 0.5 Inelastic
H 9 9 1 ???
I 7 5 0.71 Inelastic
J 11 8 0.73 Inelastic
K 15 0 0 ???
UNITARY
PERFECT INELASTIC
What do you notice about the numbers and the type of elasticity?
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Elasticity
The Formula:
Ped =% Change in Quantity Demanded___________________________
% Change in Price
If answer is between 0 and -1: the relationship is inelastic
If the answer is between -1 and infinity: the relationship is elastic
Note: PED has – sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)
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Values for elasticity of demand
• If Ped = 0 then demand is perfectly inelastic - demand does not change when the price changes
• If Ped is between 0 and 1 then demand is inelastic
• If Ped = 1 then demand is said to unit elastic
• If Ped > 1, then demand responds more than proportionately to a change in price – i.e. demand is elastic
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Elasticity through demand curves
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An inelastic demand
Quantity Demanded
Price
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An inelastic demand
Quantity Demanded
Price
£200
400
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An inelastic demand
Quantity Demanded
Price
£200
400
Total revenue
= price x quantity
= £80,000
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An inelastic demand
Quantity Demanded
Price
£200
400
Total revenue
= price x quantity
350
£400
= £140,000
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An inelastic demand
Quantity Demanded
Price
£200
400
% change in demand =
Was 350 and is now 400
= 50 / 350 x 100
= 0.14 x 100 = 14%
350
£400
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An inelastic demand
Quantity Demanded
Price
£200
400
% change in demand = 14%
% change in price =
£200 - £400 = 200/200 = 1
1x100 = 100% change in price
350
£400
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An inelastic demand
Quantity Demanded
Price
£200
400
% change in demand = 14%
% change in price = 100%
Price elasticity of demand =14 / 100.0=0.14 (inelastic)
350
£400
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An elastic demand curve
Quantity Demanded
Price
£200
400
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An elastic demand curve
Price
£200
400
£100
1200
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An elastic demand curve
Price
£200
400
£100
1200
Total revenue when price = £200 =
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An elastic demand curve
Price
£200
400
£100
1200
Total revenue when price = £200 = £80,000
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An elastic demand curve
Price
£200
400
£100
1200
Total revenue when price = £200 = £80,000
Total revenue when price = £100 = £120,000
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An elastic demand curve
Price
£200
400
£100
1200
Price elasticity of demand
% change in demand =
% change in price =
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An elastic demand curve
Price
£200
400
£100
1200
Price elasticity of demand
% change in demand = 200%
% change in price = 100%
Formula = 200 100
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An elastic demand curve
Price
£200
400
£100
1200
Price elasticity of demand = -2 (elastic)
% change in demand = 200%
% change in price = 100%
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Perfectly inelastic demand curve
Quantity Demanded
Price
£200
600
£300
£400
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Perfectly elastic demand curve
Price
400 1200
£200
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Elastic = customers will react more to a change in priceInelastic = customers will react less to a change in price
Your go again…
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Elastic or inelastic demand?
A Sony portable PlayStation
Household electricity
What would happen to demand if prices went up
by 25%?
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Elastic or inelastic demand?
A tall latte from Costa Coffee from a railway station vendor
A pound of pork sausages from a local market
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Elastic or inelastic demand?
A new kitchen bought from B&Q
Precision steel used in the construction of new office developments
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Elasticity Questions…are these products Price Elastic or Inelastic?
Gateway cuts the price of their desktop PCs by 10%
A fall in the price of Euro-star tickets
An increase in the price of the Financial Times
A taxi home from a night-club on a Friday night
A rise in average car insurance premiums
Motorway petrol prices rise by 5% after the budget
Vodafone cuts their mobile phone charges
The price of central heating oil rises by 20% due to a rise in world oil prices
A local leisure club decreases monthly charges by 15% in a bid to increase the number of members
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What factors will affect price elasticity of demand?
• How necessary the product is• The number of similar competing products or
brands• The level of consumer loyalty to the brand• The price of the product as a proportion of
consumers’ income
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Plenary - Elastic or Inelastic ?
• Price increase by 10% and demand falls by 30%... Price elasticity of demand is ??????
Elastic
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Plenary - Elastic or Inelastic ?
• Price increase by 10% and demand falls by 8%..... Price elasticity of demand is ??????
Inelastic
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Plenary - Elastic or Inelastic ?
• Price increase by 10% and demand falls by 10%... Price elasticity of demand is ??????
Unitary Elastic
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Plenary - Elastic or Inelastic ?
• Price increase by 10% and demand falls by 0%... Price elasticity of demand is ??????
Perfectly Inelastic
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