Week 4 - Pricing Strategy Flashcards
What should a firm do in a market with inelastic demand?
Firms should increase price as quantity will not drop substantially
What should a firm do in a market with elastic demand?
Firms should drop price and increase quantity
What is PED and what occurs when price is changed at the three different forms?
PED: how much demand changes with a change in price
Elastic > 1 = up price = down rev
Inelastic <1 = up price = up revenue
Unit elastic =1 => up price = down Q but
rev unchanged
How is PED calculated?
(%change in QD) / (% change Price)
or
(change QD / QD) / (change P / P )
Or
(change QD / change P) * ( P/QD)
What are the three determinates of PED
- number of close substitutes
(more subs = more elastic) - Proportion of income spent on good
(higher spending = more elastic) - Time period
Short-run: inelastic
Long-run: elastic
How is P* calculated using PED?
P* = MC/(1-(1/PED))
How is profit maximised using PED?
MR = MC = P(1-(1/PED))
What is the Lerner Index and how is it calculated?
Lerner Index:
measurement of market power: Difference between P and MC
Calc:
(P-MC)/P or 1/PED
What is income elasticity?
Why is it important to firms?
What determines YED?
Defined:
How much demand changes with a change in income
Importance:
- Large shifts in economy effect demand
- Perception of product to consumers
- Repositioning of product
Determinates:
The degree of necessity of the good
How is income elasticity (YED) calculated?
(%change in QD) / (% change Y)
or
(change QD / QD) / (change Y / Y )
Or
(change QD / change Y) * ( Y/QD)
What is the YED for:
1. inferior goods
2. Normal goods
Normal goods:
positive YED => Y up, QD up
inferior goods:
negative YED = Y up, QD down
What is Cross Price elasticity and how is it calculated?
Defined:
Change in demand for a good due to the change in price of another good
CEDab = (%change QDa) / (%change Pb)
What is the relationship between CEDab and substitutes?
If product A price increases, Product B demand increases
CEDab >0
What is the relationship between CEDab and compliments?
If product A price decreases, Product B demand increases
CEDad < 0
What is the importance of CEDab for firms?
- Allows for analysis of competitors
- Pricing strategies
- Allows for development of less CEDab products
What is advertising elasticity of demand?
Percentage change in Qd relative to percentage change in advertisement expenditure
What is Promotion elasticity of demand?
Percentage change in Qd relative to percentage change in promotional expenditure
What is sales force elasticity of demand?
Percentage change in Qd relative to percentage change in sales force expenditure
What is supply elasticity of demand?
How is it calculated?
Defined:
How much supply changes in relation to changes in price
Calculation:
(change Qd / change P) * (P/Qd)
What determines SED?
- Costs
- Capacity to produce
- Access to inputs
- Ability to start/stop production of alternative products
- Time
- inelastic in short-run
- Elastic in long-run
What does a perfectly elastic supply curve look like?
Directly horizontal line
What does a perfectly inelastic supply curve look like?
Directly vertical line
What is first-degree price discrimination?
What is it’s assumption?
Firms charge a different price to each customer based on their maximum willingness to pay
Assumption:
Firms know a customers maximum willingness to pay.
What is second-degree price discrimination?
What is it’s assumption?
Firms charge different prices to consumers depending on the quantity they purchase
What is third-degree price discrimination?
What is it’s assumption?
Consumers are grouped into different markets and charged different prices
What are the three conditions of price discrimination?
- Market Power
- No opportunity to resell product
- Consumers must have different PED
What is cost-based / markup pricing
What are its pros and cons?
Pricing dependant on short-run costs
P = (AFC+AVC)*markup%
or
P=MC(1+%)
Pros
Does require research to determine customers willingness to pay
Cons
Can cause surplus or shortage without knowing customer demand curves
How is optimal markup calculated?
(1/(1-(1/ped)))-1
