Chapter 7: pricing Flashcards
Why is pricing important?
Contributes to profit maximisation- aim of most businesses
How is price determined?
By the market they operate in
What happens in a perfect market
each buyer/ seller is a ‘price taker’
No participant influences the price of the product it buys/ sells
No entry/ exit barriers
Perfect information- prices & quality are assumed to be known to all consumers & producers
Companies aim to maximise profits
Homogenous products- characteristics of given market goods don’t vary
What imperfect competition
Monopoly
Oligopoly
Monopolistic competition
What is a monopoly
1 seller of a good
uses market power to set the price
e.g Microsoft
What is an oligopoly
few companies dominate the market
Firms look at competition to price goods
e.g UK supermarketsq
What is monopolistic competition
products are similar but not identical
many producers (price setters) and consumers
no business has total control
What are the 3 pricing approaches
1) Demand- based approaches
2) cost- based approaches
3) marketing- based approaches
What is a demand based approach
analysing the relationship between a selling price & demand to find the optimum price to max profits
It’s an inverse linear relationship- as price decrease demand increases
2 methods of investigating the relationship - algebraic or tabular
What is the algebraic approach
For demand based approaches
When marginal cost= marginal revenue –> monopolistic max profit
What is the procedure of establishing the optimum price of a product?
1) establish the linear equation between price and quantity. P= a-bQ
A=intercept (max price where demand falls to 0)
b= gradient (amount the price has to change to change demand of 1 unit- usually a negative value to show inverse relationship and shows elasticity)
2) Double the gradient = marginal rev
MR= a-2bQ
3) Establish marginal cost (variable cost per unit)
4) To max profit MC=MR and solve to find Q
5)Sub Q into the price equation to find optimum price
6) Might need to calc max profit
What is price elasticity
How responsive demand is to change in price in % (proportional changes)
Calculation for price elasticity
Change in quantity demanded (as % of demand)/ change in price (as % of the price)
Ignore any negative signs
What is elastic demand
% change in demand > % change in price
PED>1 = very responsive to changes in price
Total rev increases when price is reduced and vice versa
Price increases aren’t recommended but price cuts are
What is inelastic demand
% change in demand< % change in price
PED < 1= not responsive to changes in price
Total rev decreases when price decreases and vice versa
price increases recommended but cuts aren’t
e.g petrol
What is the tabular approach
different prices & volumes of sales being presented in a table- choose highest profit amount
Good for in the exam when there’s no a data table and no indication about demand function/ no simple linear relationship between output & profit
What is the equation for total cost function
Y= a + bx
A= fixed cost per period (y intercept)
B= variable cost per unit (gradient)
x= activity level (independent variable)
y= total cost= fixed cost + variable cost
How do volume based discounts work
E.g economies of scale. Buy more pay less per unit
Total cost equation is derived for each volume range
What do you need to know when increasing sales & production levels
will the increased contribution generated by the increased sales > additional Fixed costs from the increased sales?
If yes= pursue
What is the price in cost plus pricing
Price= cost per unit + chosen margin or mark up
What is a mark-up
Profit expressed as a % of the cost
What is a margin
profit expressed as a % of the sales price
What are the 3 costs that can be used
1) Actual or standard cost
2)Marginal or full cost
3) Relevant costs
What are actual or standard costs
Ad of standard costing: price set in advance and fixed for that period
therefore marketing is simpler and customers know exactly how much they’ll pay
Disad of standard costing: if there are sig variances the price can be too low= losses
Ad of actual costing: profit is guaranteed although less incentive to control costs as inefficiencies are passed onto customers
Disad of actual costing: some customers may not want to deal with them e.g military contracts, trademan where markup is incorporated in price
What are marginal or full costs
MC= simpler (don’t need absorption or fixed OH), more consistent using contribution in decision making.
Difficult to set appropriate margins/ mark-ups to ensure FC are covered
Useful for ST decisions with excess capacity or 1 off contracts
Full cost= all costs incorporated into pricing decision to ensure a profit is made if target volume is achieved
Criticism= to determine FC per unit it depends on volume, price and cost per unit. Method of absorbing OH is arbitrary. Prices may not be realistic compared to what customers want to pay
What are relevant costs
Min tender price for a 1 off tender or contract
Min price= total of all relevant cash flows
Only suitable for 1 off decisions because:
FC may become relevant in the LT
Problems estimating the incremental cash flow
Conflict between accounting measures e.g profit & this approach
Advantages of cost plus pricing
1) Widely used & accepted
2) Simple to calculate if costs are known
3) Selling price decision may be delegated to junior management
4) justification for price increases
5) may encourage price stability- if all competitor have similar cost structures and use similar mark-up
Disadvantages of cost-plus pricing
1) Ignores the economic relationship between price& demand
2) No attempt to establish optimum price
3) Different absorption methods give rise to difficult costs and selling prices
4) Doesn’t guarantee profit- if sales volumes are low- FC may not be recovered
5) Decide between full cost, marginal or manufacturing cost
6) structured method doesn’t recognise the manager’s need for flexibility in pricing
7) circular reasoning- price increase can reduce volume, increase cost per unit, and pressure to increase price further
What is customer based pricing
Customers perception of the benefits of the products
price reflect the benefits
Small regard to cost. The greater the benefit of understanding the customer the better placed to price the products
What is competition based pricing
set a price based on competing products
Competing products:
1) same type of product not easily distinguishable e.g petrol so price changes of competitors have a serious impact
2) Sub products which are different but fulfill the same need e.g ice cream instead of cold drink on hot day
impact of price changes depend on relative price/ performance of substitute
What are the 8 pricing strategies
1) cost plus pricing
2) Market skimming
3) Penetration pricing
4) Complementary product pricing
5) Productline pricing
6) volume discounting
7) price discrimination
8) relevant cost pricing
What is market skimming
charging a higher price when product is first launched to max ST profitability =. Take advantage of the novelty appeal of new products when demand is initially inelastic
When the market becomes saturated the price is reduced to attract the part of market which is untouched
What are the suitable conditions for market skimming
1) product is new & different w/ little competition (most common)
2) products have a short life cycle. Recover R&D quickly and make profit
3) strength and sensitivity of demand to price is unknown. Better to start high and go lower if demand isn’t there
4) Firm has liquidity problems- generate high cash flows early on
Market conditions for entry
If products are selling at a high price= high demand to join this market
To contain this demand there must be 1+ significant barriers e.g patent protection, strong brand loyalty
What is penetration pricing strategy
charging low prices at product launch to gain market share & rapid acceptance of product
When market share is achieved - prices are increased
Opposite of market skimming
Conditions to favour a penetration pricing strategy
1) firms wishes to increase market share
2 ) firm wants to discourage new entrants from entering the market
3) If there’s sig economies of scale to be achieved from high volume output- quick penetration is desirable
4) if demand is highly elastic and respond well to low prices
What is complementary product pricing
normally used with another product e.g razors & razor blades, games consoles & games etc
Complementary goods give the supplier additional power over the consumer
What are the 2 forms of complementary product pricing?
1) major product priced low = encourages the purchases and locks them into subsequent purchases at a high price e.g printers/cameras
2) major product priced high = barrier to entry/ exit and consumer locked into subsequent purchases at low price e.g high end sports centres & cheap green fees
What is a product line pricing strategy
product line= range of products related to eachother/ price differences between upgrades of a product or service
Set the price steps between various products in a product line based on:
Cost differences between products
Customer evaluations of different features
competitors prices
What is volume discounting
offering customers a lower price per unit if they purchase a particular quantity of a product
1) Quantity discounts- for customers that order larger quantities
2) Cumulative quantity discounts - discount increases as cumulative total ordered increases. Ideal for people who don’t want to place large individual orders but purchase large quantities
What are the benefits of using a volume discounting strategy
1) increased customer loyalty- they’re locked in so further purchases can be made a lower price per unit
2) attracts new customers- exceptional discount on 1 off basis. Supplier can get their feet in the door
3) Lower sales processing costs- increased proportion of sales is bulk of orders
4) lower purchasing costs - discounts from suppliers
5) discounts help sell items bought primarily on price
6) clearance of surplus stock/ unpopular item through use of discounts
7) discounts geared to particular off peak periods
What are the conditions suitable for volume discounting pricing strategy
1) substantial sales margin so profits still made after discounting
2) product bought on price so difficult to distinguish it from competing products
3) products with limited shelf life can be discounted to shift them (e.g clothes)
What is a price discrimination strategy
Company sells the same product/ service at different prices in different markets for reasons not associated with costs
What are the conditions for price-discrimination strategies
1) seller has some monopoly power or price will be driven down
2) customers can be segregated into different market
3) customers can’t buy at lower price in 1 market and sell at higher in another
4) price discrimination strategies are effective for services
5) must be different price elasticities of demand in each market so prices can be raised in 1 and lowered in another
What are the dangers of price discrimination as a strategy
1) black market can develop so those in a lower priced segment can resell in a higher priced segment
2) competitors join the market and undercut the firm’s prices
3) customers in the higher priced brackets look for alternatives and demand becomes more elastic over time
