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How have the syllabus learning outcomes been examined? Syllabus learning outcomes

How syllabus outcomes are examined

Example past paper questions

Explain the factors that influence the pricing of a product or service.

Explain the price elasticity of demand. Derive and manipulate a straight line demand equation. Derive an equation for the total cost function (including volume-based discounts).

The total cost function is covered in Chapter 10a

Heat Co June 2011, part (a), 3 marks

Calculate the optimum selling price and quantity for an organisation equating marginal cost and marginal revenue

Calculation could be followed by discussion here

Heat Co June 2011, part (a), 3 marks

Evaluate a decision to increase production and sales levels, considering incremental costs, incremental revenues and other factors.

This links to short-term decisions in Chapter 6

Determine prices and output levels for profit maximisation using the demand based approach to pricing (both tabular and algebraic methods.

Calculation followed by discussion is likely here

Explain different pricing strategies. This has been examined via a discussion of whether discounting and promotions are a good idea for a particular business. Explanation of the various pricing policies may also be required.

Bits and Pieces June 09, part (c), 4 marks Stay Clean December 09, part (b), 4 marks Brick by Brick June 2010, part (c), 6 marks Heat Co June 2011, part (b), 8marks

Calculate a price from a given strategy using cost-plus and relevant costing.

This calculation requirement links with chapter 6.

Hammer June 2010, parts (a) & (b), 10 marks

Pricing decisions

5: PRICING DECISIONS

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Overview

Pricing decisions

Price elasticity

P%Q%

Total cost function Y = a + bx

Pricing strategies Cost plus

o Full cost o Marginal cost o Relevant cost o Standard cost

Market penetration Market skimming Premium pricing Price discrimination Product bundling Psychological pricing Product line pricing Complementary

products Loss leaders Controlled pricing Volume discounting

Demand function P = a bQ

Demand

Optimal pricing MR = MC


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1 Introduction 1.1 Historically the cost of a product would have had a large influence on the selling price set for

that product. Today there are many factors that will influence that price. These factors include: (a) Demand (b) Quality (c) Competitors (d) Substitutes (e) Inflation (f) Age of product (g) Disposable incomes

2 Demand 2.1 Economic theory is that the higher the price charged the less demand there will be for

normal goods.

Price elasticity 2.2 Price elasticity of demand (PED) is a measure of the responsiveness of demand to changes

in price. Some products are more responsive than others.

2.3 PED is calculated P%Q%

=

Pinchange%Qinchange%

When PED > 1: The product is described as having elastic demand. This means that a small change in price will cause a proportionately greater change in quantity demanded. When PED < 1: The opposite applies. The product has inelastic demand and prices can be changed greatly without creating large changes in demand.

2.4 An awareness of the PED of a product will assist companies when setting price.

2.5 Where demand is inelastic prices can be raised.

2.6 If demand is elastic a decrease in price will result in an increase in volume.

Variables which

influence demand

Demand and the

individual firm


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Lecture example 1 Exam standard for 2 marks A football club charges $12 per ticket for home games. Average attendance at these regular games is 16,000. When prices were increased by $1 per ticket, attendance fell by 2,500. Required

Determine the PED if ticket price increases from $12 to $13.

Solution

Demand function 2.7 Price will affect the quantity demanded for a product. Output considerations will alter the

price to be charged. If the demand function is known, and the desired output has been calculated, the appropriate price can be determined for the product.


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2.8 Demand functions are usually downward sloping demand falls when price rises and vice versa. ($) P

Q (units)

2.9 If a downward sloping demand curve becomes steeper demand is becoming more inelastic. If it becomes shallower it is more elastic.

2.10 The demand function will be in the form P = a bQ. P = Selling price Q = Quantity demanded at that price a = Theoretical maximum price. If price is set at 'a' or above, demand will be zero

b = quantity in change

price in change

Lecture example 2 Exam standard for 5 marks

A football club charges $12 per ticket for home games. Average attendance at these regular games is 16,000. When prices were increased by $1 per ticket, attendance fell by 2,500. Required

Assuming attendance to be purely price dependent, what should be the ticket price to ensure a full house with capacity being 25,000?

Gradient of line. Represents the change in price required to change demand by 1 unit


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Solution

3 Optimal pricing 3.1 The desired level of output can be determined graphically by plotting total cost and total

revenue lines. This is another breakeven chart, as used by economists.

$ TC MR Profit TR MC

Optimal output X


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3.2 The gradient of the total revenue line is known as the marginal revenue (MR). It is the increase in total revenue from selling one more unit.

3.3 The marginal revenue will be MR = a 2bQ

3.4 The gradient of the total cost line is known as the marginal cost (MC). It is the increase in total cost from producing one more unit.

3.5 This analysis can be used to ensure the company reaches its objective.

3.6 Profit is maximised where the gradients are equal, ie where marginal revenue = marginal cost.

Optimal pricing approach Step 1 Determine the demand function. Step 2 Make the MR equation given equal to the value of MC Step 3 Substitute the values found for a and b in step 1 into the MR formulae and solve. Step 4 Take the quantity found in step 3 and put this into the demand function to find the

price that should be charged.

Lecture example 3 Preparation question

A firm charges $12 per unit for its product. At this price it sells 16,000 units. Research has shown that when prices were changed by $1 per unit sales changed by 2,500 units. The product has a constant variable cost per unit of $5. The demand function is given by P = a bQ. The marginal revenue will be MR = a 2bQ Required (a) Determine the demand function (b) Determine the output level to maximise profit (c) Determine the price to be charged to maximise profit


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Solution

Tabular approach 3.7 One approach to determining the profit maximising production plan is to calculate the extra

(marginal) costs and revenues at different combinations of output and selling price.

Lecture example 4 Preparation question

Total Selling Total Output Cost MC Price Revenue MR Profit (Units) $ $ $ $ $ $ 10 10 5.00 20 25 4.50 30 45 4.00 40 70 3.50 50 100 3.00 60 135 2.50

Required Determine the output level and selling price that will maximise profit.


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Solution

3.8 A tabular approach assumes that only discrete variables exist, ie that either 30 or 40 units can be sold, not, say, 35. The use of equations can solve this problem.

4 Pricing strategies

Cost plus 4.1 The price of the product is calculated by adding an appropriate profit mark up to the

product's cost. This cost could be: Absorption/full cost (including ABC) Marginal cost Relevant cost (Chapter 6) Standard cost

Advantages 4.2 (a) Readily understood/easy to apply.

(b) Readily determined. (c) Doesn't require/assume a linear and stable price/quantity relationship.

Disadvantages 4.3 (a) Because it ignores the impact that the price will have on quantity demanded, it will not

maximise profit. (b) If the basis of absorbing overheads changes, the price of the product will change.

Thus absorption costing methods require accurate overhead and activity levels. (c) Price may need to be adjusted to reflect market conditions.

Cost plus pricing

examples


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Market penetration 4.4 A policy of low prices when the product is first launched to obtain sales volume and market

share.

4.5 Useful if: (a) the firm wants to discourage new entrants into the market (b) the firm wishes to shorten the initial period of the product's life cycle (c) there are significant economies of scale to be achieved.

Market skimming 4.6 Involves charging high prices when a product is first launched and spending heavily on

advertising and sales promotion to obtain sales. As the product moves into the later stages of its life cycle (growth, maturity and decline) progressively lower prices will be charged. The aim of market skimming is to gain high unit profits early in the product's life.

4.7 Useful if: (a) the product is new and different, so that customers are prepared to pay high prices to

be 'one up' on people who do not own it, (b) the product has a short life cycle and needs to recover development costs and make

a profit quickly.

Premium pricing 4.8 Making a product appear 'different' so as to justify a premium price. The product may be

different in terms of quality, reliability, durability, after-sales service or extended warranties. Heavy advertising can establish brand loyalty which can help to sustain a premium.

Price discrimination 4.9 When a company can sell into two or more separate markets, it might be able to charge a

different price in each market. To be successful the company must prevent the transfer of goods from the cheap market to the more expensive one.

Product bundling 4.10 Selling a number of products or services as a package at a price lower than the aggregate

of their individual prices.

Psychological pricing 4.11 Psychological pricing strategies include pricing a product at 19.99 instead of 20.

4.12 Another example would be withdrawing an unsuccessful product from the market and then relaunching it at a higher price, the customer having equated the lower price with lower quality (which was not the seller's intention).

Case Study 3

New laws to stop British Internet

price rip-offs

Case Study 2Pricing strategy leaves room for discounts later


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Productline pricing 4.13 Most organisations sell not just one product but a range of products. Focus is placed on the

profit from the whole range rather than the profit on each single product.

Complementary product pricing 4.14 These products are sold separately but are used together. One product would tend to be

priced competitively which attracts demand for the complementary product.

Loss leaders 4.15 Particularly useful in retailing, a very low price is charged for one product, which is intended

to make consumers buy additional products in the range that carry higher profit margins.

Controlled pricing 4.16 Monopolies have the potential power to charge very high prices for their goods/services as

demand is inelastic. Frequently monopolies are regulated to ensure customers receive value for money.

Volume discounts 4.17 These are given in order to increase sales volume without reducing prices permanently.

They also allow differentiation between customers ie wholesale v retail.

5 Other considerations 5.1 Bear in mind decisions should not just be based on financial factors. Non financial

considerations should also be made. These might include: Company objectives profit, sales, revenue, market share, long term or short term Competition and markets competing products and reaction of competitors Production capacity demand may exceed supply Product lifecycle introduction, growth, maturity, decline Superior innovation, technology or quality may set higher prices Customer's buying power Other products in range displacing or supplementary Availability of resources Impact on staff Impact on customers Competitors' reactions Opportunity costs Impact on other products


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Lecture example 5 Exam standard for 10 marks

Recently company X has developed a new portable DVD recorder and wonders what price it should charge for a product which is at the leading edge of technology. Required Explain the relevance of the product life cycle when considering which pricing policies could be adopted.

Solution


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6 Chapter summary Section Topic Summary 2 Demand PED measures the responsiveness of demand to a

change in price. PED >1 = elastic demand. PED


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