Week 4 - Pricing Strategy

Question 1

What should a firm do in a market with inelastic demand?

Answer 1

Firms should increase price as quantity will not drop substantially

Question 2

What should a firm do in a market with elastic demand?

Answer 2

Firms should drop price and increase quantity

Question 3

What is PED and what occurs when price is changed at the three different forms?

Answer 3

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

Question 4

How is PED calculated?

Answer 4

(%change in QD) / (% change Price)

or

(change QD / QD) / (change P / P )

Or

(change QD / change P) * ( P/QD)

Question 5

What are the three determinates of PED

Answer 5

1. number of close substitutes
   (more subs = more elastic)
2. Proportion of income spent on good
   (higher spending = more elastic)
3. Time period
   Short-run: inelastic
   Long-run: elastic

Question 6

How is P* calculated using PED?

Answer 6

P* = MC/(1-(1/PED))

Question 7

How is profit maximised using PED?

Answer 7

MR = MC = P(1-(1/PED))

Question 8

What is the Lerner Index and how is it calculated?

Answer 8

Lerner Index:
measurement of market power: Difference between P and MC

Calc:
(P-MC)/P or 1/PED

Question 9

What is income elasticity?
Why is it important to firms?
What determines YED?

Answer 9

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

Question 10

How is income elasticity (YED) calculated?

Answer 10

(%change in QD) / (% change Y)

or

(change QD / QD) / (change Y / Y )

Or

(change QD / change Y) * ( Y/QD)

Question 11

What is the YED for:
1. inferior goods
2. Normal goods

Answer 11

Normal goods:
positive YED => Y up, QD up

inferior goods:
negative YED = Y up, QD down

Question 12

What is Cross Price elasticity and how is it calculated?

Answer 12

Defined:
Change in demand for a good due to the change in price of another good

CEDab = (%change QDa) / (%change Pb)

Question 13

What is the relationship between CEDab and substitutes?

Answer 13

If product A price increases, Product B demand increases

CEDab >0

Question 14

What is the relationship between CEDab and compliments?

Answer 14

If product A price decreases, Product B demand increases

CEDad < 0

Question 15

What is the importance of CEDab for firms?

Answer 15

• Allows for analysis of competitors
• Pricing strategies
• Allows for development of less CEDab products

Question 16

What is advertising elasticity of demand?

Answer 16

Percentage change in Qd relative to percentage change in advertisement expenditure

Question 17

What is Promotion elasticity of demand?

Answer 17

Percentage change in Qd relative to percentage change in promotional expenditure

Question 18

What is sales force elasticity of demand?

Answer 18

Percentage change in Qd relative to percentage change in sales force expenditure

Question 19

What is supply elasticity of demand?
How is it calculated?

Answer 19

Defined:
How much supply changes in relation to changes in price

Calculation:
(change Qd / change P) * (P/Qd)

Question 20

What determines SED?

Answer 20

1. Costs
2. Capacity to produce
3. Access to inputs
4. Ability to start/stop production of alternative products
5. Time
   - inelastic in short-run
   - Elastic in long-run

Question 21

What does a perfectly elastic supply curve look like?

Answer 21

Directly horizontal line

Question 22

What does a perfectly inelastic supply curve look like?

Answer 22

Directly vertical line

Question 23

What is first-degree price discrimination?
What is it’s assumption?

Answer 23

Firms charge a different price to each customer based on their maximum willingness to pay

Assumption:
Firms know a customers maximum willingness to pay.

Question 24

What is second-degree price discrimination?
What is it’s assumption?

Answer 24

Firms charge different prices to consumers depending on the quantity they purchase

Question 25

What is third-degree price discrimination?
What is it’s assumption?

Answer 25

Consumers are grouped into different markets and charged different prices

Question 26

What are the three conditions of price discrimination?

Answer 26

1. Market Power
2. No opportunity to resell product
3. Consumers must have different PED

Question 27

What is cost-based / markup pricing

What are its pros and cons?

Answer 27

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

Question 28

How is optimal markup calculated?

Answer 28

(1/(1-(1/ped)))-1