W2 - Pricing Flashcards
Short-term pricing decisions - Accept a deal or not?
Only take into account relevant/incremental costs, that being costs that would change with this order being accepted. E.g. (from lecture 1, week2)
Company has capacity of 50,000, but expected sales and production is 35,000. Company has decided to pay and retain all of its current labour force.
Competitor offers to buy 15,000 at £20 per pot, + £1 delivery per pot to be paid by seller.
Costs are as follows:
Selling price: £40
Direct material cost per unit: £8
Direct labour cost per unit: £12
Total fixed overheads: £280,000
The only INCREMENTAL COST here is material cost, as company has chose to pay all staff, and overheads are fixed. So, from calculating relevant costs:
15,000 x £20,0000 = £300,000 revenue
Direct materials: £8 x 15,000 = £120,000
Delivery costs: £1 x 15,000 = £15,000
So total benefit from the deal is £300k - £135k = £165k
BE CAREFUL, if it isnt mentioned that staff are being retained, labour costs per unit become RELEVANT costs. Fixed overheads are not
When can we use this short-run pricing method?
3
One-off contract, not to be repeated
Contract does not affect other business
Sufficient unutilised production capacity is available
Other factors to take into account with short-run pricing
4
Prestige/reputation
Relationships with customers
Staff morale
Is it consistent with long-term strategy
Long-run pricing decisions - two approaches
Accountants approach:
Cost-based, aims to recover these costs and generate profit
Cost plus selling price = Cost + Cost x Mark Up %
Economists approach:
Demand based, aims to find an optimal, profit maximising price and output level
Commonly uses Marginal Revenue and Cost
Economic pricing decisions: Demand Curve
Formula and how to calculate
Demand curve formula: P = a - bQ
To find it from a question, we do this:
P1 = a - bQ1
P2 = a - bQ2
The question will give you P1, P2, Q1 and Q2.
e.g. (from lecture 2, week 2)
Company currently sells at £600 per unit at which monthly demand is 10,000 units
Research suggests increasing price to £650 will reduce demand to 9,000
So, P1 = £600, Q1 = 10,000.
P2 = £650, Q1 = 9,000
Plug into equations to get two equations, then solve for A and B.
Get A isolated on one side of both equations, then make it a double-sided equation.
e.g. £600 = A - B X 10,000
A = £600 + b x 10,000
Repeat for P2 Q2 and combine, giving us:
£600 + b x 10,000 = £650 + b x 9,000
£600 + 10,000b = £650 + 9,000b
£600 + 1,000b = £650
1,000b = £50
b = £0.05
Solve this for B, which can then be plugged into the previous equation to give us A
i.e. a = £600 + b x 10,000
a = £600 + 0.05 x 10,000
a = 1,100
Demand curve: P = 1,100 - 0.05Q
SEE RECORDED LECTURE 2, WEEK 2 FOR DETAILS
Drawing the demand curve
Following on from calculating the final formula in the previous flashcard, now have to draw the graph
P vertical axis, Q horizontal
Put the two points from question i.e. (P1, Q1) and (P2, Q2)
Draw line between the points, and label them on the axes
Economic theory: finding Profit Maximising Point
5 Steps
Step 1: find the demand curve: P = a - bQ and calculate it
Step 2: Calculate Total Revenue and Marginal Revenue
TR = P x Q (P being our demand curve formula)
MR = a - 2bQ or ‘dTR/dQ’ ( d being differentiation)
Step 3: Calculate Total Cost and Marginal Cost
TC = VCu x Q + FC
MC = dTC/dQ or VC. We can assume that MC is same as the variable cost listed in the question
Simply put, Marginal revenue is just Total Revenue differentiated, and Marginal Cost is just Total Cost differentiated!!!
Step 4: Find the optimal Output: Qmax is at MR = MC
Plug in previous values for these (most likely will be equations) and solve for Qmax
Step 5: Find the optimal Price: Pmax = a - bQmax
Differentiation
Times and Take
e.g. 5x^3 + 4x^2 - 8x + 3
15x^2 + 8x - 8
In the context of finding Optimal Output, we differentiate to get Marginal Revenue, which is dTR/dQ. Using the example from W2 Lecture 2:
= d(200Q - 0.02Q^2)/dQ
MR = 200 - 0.04Q
Finding Total Costs and Total Revenues at the Optimal Output
Continuing from the previous card on finding optimum output.
Plug in Qmax (optimum output) to the TC and TR equations
TC = Plug Qmax into the TC formula given in question
TR = Plug Qmax into the previously calculated TR formula
Total profit is just TR - TC
Issues with Profit Maximising 2
May have spare capacity
Some customers may not be able to buy it as demand is being limited, which may make some unhappy
If Profit Maximising, what do we do if there is an extra question (e.g. part c) where Marginal Cost and Fixed Costs change
Marginal Cost Change:
Redo MR=MC with the new MC. MR is obviously still the same. This gives new Qmax and thus Pmax
Fixed costs Change:
Same as MC change. So same answer for both. This is because Fixed Costs are removed during the differentiation for MC, thus its value has no impact on MC
7 Alternative Pricing Policies and when you would use them
Cost-plus pricing: Cost + Cost x Mark-up %
Price Skimming: Start off expensive then gradually lower. Works for high market share products with high quality e.g. apple. Takes advantage of the part of the market where demand is inelastic, willing to pay very high prices. Needs inelastic demand
Price penetration: Offer cheap price initially, or one month free etc., then raise to standard price once customers are hooked. Helps gain market share quickly, requires elastic market and prevents competition as the initial price is so low its hard for competitors to compete e.g. new broadband or subscription service
Product line pricing: Different pricing for complimentary products
e.g. printers where printer is relatively cheap but most of the money is made on ink. Can’t use one without the other
Perceived Value: Look from customers eyes and how much they’d be willing to pay. Done through market research. Typically done by luxury companies
Going-rate: Match price to industry average, like commodity products such as milk, bread. Works well in established perfectly competitive markets
Price discrimination: One product, but different prices for this product for different markets and customers. e.g. train tickets off peak and peak, or home and export market pricing differences. Requires a degree of monopoly
