Pricing Flashcards
What is a perfectly competitive market and how does it operate?
- In this type of market sellers are “price takers” - where prices are not set by individual sellers but by the supply and demand levels in the market place.
- This is possible where products are homogeneous, meaning that the item with the same characteristics can be purchased from a variety of sellers.
- The level of competitiveness makes it easy for businesses to enter or exit the market (no monopoly)
- It is assumed that consumers are aware of the differing price and quality of all products.
- In this type of market businesses will aim to generate the most profit by selling where marginal costs meet marginal revenue.
What is imperfect competition and how does it function in a market place?
This type of market place is further broken down in to three types
Monopoly - Goods only sold by one company who can set pricing at a level that maximises profit, great for the company not so great for the consumer. E.g. Microsoft.
Oligopoly - A small number of interdependent companies dominate the market, they are inter dependent in terms of price, output and non-price competition. e.g. Games consoles.
Monopolistic Competition - Where products are similar but not identical, a large number of price setters and consumers but no business has overall control of the market place.
What are the two methods that can be applied to investigating the relationship between price and demand for a product?
- Marginal Revenue = additional revenue from selling 1 extra unit*
- Marginal Cost = cost from making 1 more unit (usually variable cost)*
Profit is maximised when Marginal Cost = Marginal Revenue
Algebraic Approach - P = a-bQ, based on linear relationship between price and demand.
How can we establish the marginal revenue for increasing sales by 1 unit?
MR is defined as the increased revenue from selling one extra unit so:
If revenue from selling one unit is $70, and revenue from selling 2 units is $120 then the MR to sell the extra unit is $50 (120-70)
It follows then that if revenue from selling 3 units is $150, then the MR is $30.
In order to maximise profit marginal revenue must exceed marginal cost.
Marginal costs are assumed to be the same as variable cost so should remain constant until the point where demand results in scarce resource.
What are the steps to identifying the optimum price using the algebraic method?
- Establish the linear relationship between price and demand using P = a - bQ
- Double the gradient to find marginal revenue - MR = a - 2bQ
- Establish the marginal cost (MC) This will be the variable cost per unit.
- Knowing that MC must equal MR to maximise profit we can say: MC = a - 2bQ, rearrange this to find Q
- Use the value of Q calculated above in P = a - bQ to find optimum price.
- If maximum profit is required deduct fixed cost total from contribution calculated.
How is the Tabular approach applied and analyses for demand based pricing?
Revenue, Demand, MR, Cost, MC and Profit are set out in tabular format.
Remember that MR = increase in revenue for one extra unit, and MC = increase in cost for one extra unit.
Profit will be revenue less cost.
The table should show a point where MR becomes less than MC and at this point total profit will also start to decrease.
What is the equation for total cost?
Y = a + bx
Where:
- Y = Total cost, this is known as the dependant variable
- a = fixed cost in the period (intercept)
- b = variable cost per unit (gradient)
- X = activity level (independent variable)
NOTE - there may be factors, such as bulk purchase discounts, which cause variable costs to act in a stepped manner. In this situation the differing values of b should be applied at the corresponding activity levels.
With cost plus pricing how do we determine the most appropriate unit price to use?
Standard Cost - Price can be set and advertised in advance, however if the standard is incorrect product may not make a profit.
Actual Cost - profit is guaranteed, however inefficiencies affecting cost would be passed to the customer instead of resolved.
Marginal Costs - useful in short term decisions but can be difficult to identify margin/mark up needed to cover fixed costs.
Full Costs - requires allocation of fixed costs to units, so all cost will be covered. Absorption may be seen as arbitrary and may drive a price that is not reflective of what consumers are willing to pay.
Relevant costs - only suited to one off decisions as ignore fixed costs.
What different pricing strategies may businesses apply?
Market Skimming - Product launched at high price (maximising short term profitability) taking advantage of novelty or early adopters, price reduces as the market becomes saturated. Also applied to products with short lifecycles.
Penetration pricing - launching a new product to market at a price lower than competitors in order to differentiate in a market of very similar or identical products. increasing market share or if demand is highly price elastic.
Complementary product pricing - a product which is usually used with another, initial product is priced keenly (loss leader) to attract consumers, profit is made on sales of the subsequent complementary product.
Product line pricing - essentially the step up in pricing between basic and supper within a product line. I.e. Bronze, Silver & Gold bookkeeping services.
Volume discounting - applied either to individual orders or as a cumulative total. Builds customer loyalty and can serve to attract new customers. May also help with market differentiation.
Price discrimination - Selling same products/services at different prices depending on the market place. This will be for reasons not related to costs. This will need the seller to be operating some degree of monopoly power.
How is PED (Price elasticity of Demand) calculated?
PED = % change in quantity demanded/% change in price.
if < 1 demand is inelastic, meaning not very responsive to changes in price.
greater than 1 demand is elastic so will respond to changes in price.
