Module 6 – Simple Pricing

Learning Objectives
1. Discuss simple pricing and its importance;
2. Illustrate and describe demand curves;
3. Explain marginal analysis of pricing;
4. Explain price elasticity and marginal revenue;
5. Identify and explain the factors that affect demand elasticity;
6. Discuss income elasticity and cross-price elasticity;
7. Differentiate cost-based pricing and mark-up pricing.

OUTLINE
SIMPLE PRICING
CONSUMER VALUES AND DEMAND CURVES
MARGINAL ANALYSIS OF PRICING
PRICE ELASTICITY AND MARGINAL REVENUE
WHAT MAKES DEMAND MORE ELASTIC
FORECASTING USING DEMAND ELASTICITY
COST-BASED PRICING
SUMMARY
REVIEW QUESTIONS
REFERENCES
2 Managerial Economics

SIMPLE PRICING Back to top

In 1968, Mattel introduced the inexpensive and wildly popular Hot Wheels line of toy cars. Forty
years and four billion cars later, the suggested retail price of the classic Hot Wheels car had never
budged above $1 even as production costs continued to climb, squeezing margins. Eventually,
some interns working for Mattel suggested that they double both the wholesale price and suggested
retail price of the cars.
Initially, Mattel executives balked, reportedly claiming that a price increase could devastate sales.
Eventually, Mattel did increase its prices slightly to test the waters and evaluate the wisdom of
price adjustments. Shortly following the move, Mattel reported one of its most successful quarters,
with revenues unchanged from a year earlier but profits rising by 20%.
Pricing is a powerful but oft-neglected tool. We all know that Profit = (P – C) x Q, but many
businesses seem to focus on Q or C and forget about P. Think about companies that spent most of
their time thinking about how to sell more or how to reduce costs and not much time thinking
about how to raise price. This is a mistake. According to Roger Brinner, Chief Economist at The
Parthenon Group, most companies can make money simply by raising price.

In this chapter, we consider "simple pricing," the case of a single firm, selling a single product, at
a single price. Although this kind of pricing is rare because most firms sell multiple products, at
different prices, and in competition with rivals, it is important to understand simple pricing before
moving on to more complex settings. In addition, this simple pricing model has become part of the
business language, and it is important to understand it if you are to communicate well with your
co-workers. Topics include the introduction of demand curves, using marginal analysis to choose
the most profitable price, and then talk about how firms price in practice.

CONSUMER VALUES AND DEMAND CURVES Back to top

Let's consider a simplified relationship between price and quantity purchased by a single
consumer, using some good, like a slice of pizza. Table 6.1 shows the number of slices the will
purchase at various prices.
It’s easy to see from the table that, as price falls, the consumer purchases more slices, reflecting
the First Law of Demand: consumers demand (purchase) more as price fall. This makes intuitive
sense. Consider the value you, a hungry consumer, receive from the first pizza slice you purchase
and consume it's likely to be substantial. The additional value you get from consuming the second
slice is a bit less, and by the time you're chowing down on your fifth slice, the additional value is
fairly small. The marginal, or additional value of consuming each subsequent slice diminishes the
more you consume.

Suppose the consumer values that first slice at $5, the second at $4, the third at $3, and so on.
Knowing the value our consumer places on each subsequent slice allows us to con struct Table
6.2, which shows marginal value and total value for the various quantities. For the first slice, the
total and marginal values are the same, both equal to $5. For the second slice, the marginal value
3 Module 6 Simple Pricing

is $4, while the total value of consuming two slices is $9 = $5 + $4. For the third slice, the marginal
value is $3, and the total value is $12 = $5 + $4 + $3, and so on.

Table 6.1 Pizza Demand Schedule

Slice Price Slices Purchased

$5 1
$4 2
$3 3
$2 4
$1 5

Because how much to buy is an extent decision, thinking in marginal terms is critical. For example,
suppose you just looked at the fact that five slices have a total value of $15. You might be tempted
to conclude that if slices were priced at $3, the consumer would purchase five slices since 5 x $3
= $15. Thinking in marginal terms, however, shows us that the marginal value of the fourth slice
is only $2, less than the price of $3, so the consumer will not purchase it. If consumers behave
optimally, they will try to maximize the surplus they get from consuming slices, the difference
between their value and the price they pay. Purchasing three slices at $3 each leads to consumer
surplus of $3 (total value of $12 less expenditure of $9). Purchasing five slices at $3 each would
lead to consumer surplus of zero.

Table 6.2 Pizza Value Table

Slices Purchased Marginal Total Value
Value

1 $5 $5
2 $4 $9
3 $3 $12
4 $2 $14
5 $1 $15

We can link our two tables to get a measure of how our consumer gains from eating pizza slices.
If the consumer pays less than the total value of the slices, he or she has consumer surplus. Table
6.3 shows the amount of consumers surplus for different numbers of slices consumed.
To describe how consumers will respond to price, economists use demand curves, which tell you
how much a single consumer or a group of consumers will consume as a function of price. Recall
from the First Law of Demand that we should expect demand curves to slope downward because
consumers purchase more as prices fall.
4 Managerial Economics

Table 6.3 Pizza Consumer Surplus

Slice Price Slices Purchased Total Price Paid Total Value Surplus

$5 1 $5 $5 $0
$4 2 $8 $9 $1
$3 3 $9 $12 $3
$2 4 $8 $14 $6
$1 5 $5 $15 $10

Demand curves describe buyer behavior and tell you how much consumers will buy at a given
price.
To describe the buying behavior of a group of consumers, we add up all the individual demand
curves to get an aggregate demand curve. The simplest way to show this is to consider the case
where each consumer wants only a single item (i.e., the marginal value of a second unit is zero).
To construct a demand curve that describes the behavior of five buyers, we simply arrange the
buyers by what they are willing to pay (e.g., $5, $4, $3, $2, and $1). At a price of $5, one buyer
will purchase; at a price of $4, two buyers will purchase; at $3, three buyers; and so on. At a price
of $1, all five buyers will purchase the good. An aggregate or market demand curve is the
relationship between the price and the number of purchases made by this group of consumers. In
Figure 6.1, we plot this demand curve.

Figure 6.1 Demand Curve

$5 a

4 b
Price per pizza

3 c

2 d

1 e

D
Quantity
0 1 2 3 4 5
5 Module 6 Simple Pricing

Note that the price – the independent variable – is on the wrong axis. There are good reasons for
this that will become apparent, but for now, just accept that economists like to do things a little
differently. Note also that economists have special jargon describing the response of demand to
price. We say that as price decreases, "quantity demanded" increases. If something other than price
causes an increase in demand, we instead say that the "demand shifts" to the right, or "demand
increases," such that consumers purchase more at the same prices.
To determine the quantity demanded at each price using the demand curve, look for the quantity
on the horizontal axis corresponding to a price on the vertical axis. At a price of $5, buyers demand
one unit; at a price of $4, two units; and so on. As price falls, quantity demanded increases.

MARGINAL ANALYSIS OF PRICING Back to top

Demand curves present sellers with a dilemma. Sellers can raise price and sell fewer units, but
earn more on each unit sold. Or they can reduce price and sell more, but earn less on each unit
sold. This fundamental trade-off is at the heart of pricing decisions. We resolve it by using marginal
analysis. We use demand curves to change the pricing decision ("what price should I charge") into
a quantity decision ("how much should I sell?") that we already know how to solve using marginal
analysis. If marginal revenue (MR) is greater than marginal cost (MC), sell more, and you do this
by reducing price.
Reduce price (sell more) if MR > MC. Increase price (sell less) if MR < MC.
Recall that consumers and sellers are both using marginal analysis. But consumers are using
marginal analysis to maximize consumer surplus (make all purchases so that marginal value
exceeds price), while sellers use it to maximize profit.

To see how to use marginal analysis to maximize profit, examine Table 6.4. The columns list the
Price, Quantity, Revenue, MR, MC, and total Profit. Suppose that the product costs $1.50 to make.
At a price of $7, one consumer would purchase, so revenue would be $7. Cost would be $1.50, so
marginal profit on the first sale would be $5.50.
If we reduce price to $6, two consumers purchase, so revenue goes up from $7 to $12, an increase
of $5. We say that the MR of the second unit is $5. If we reduce price further to $5, revenue
increases to $15, so that the MR of the third unit is $3.
So far, all of these changes have been profitable because the increase in revenue (MR) has been
greater than the increase in cost (MC). We earned $5.50 on the first unit, $3.50 on the second unit,
and $1.50 on the third unit. These marginal profits sum to a total profit of $10.50, as indicated in
the last column of Table 6.4.
However, if we sell a fourth unit, total profit would go down because the marginal revenue from
selling the fourth unit is only $1, which is less than the $1.50 marginal cost. So we don't sell the
fourth unit. The optimal quantity is three; and to sell this amount, we look at the demand curve to
tell us how much to charge: at a price of $5, we sell three units.
6 Managerial Economics

Table 6.4 Optimal Price

PRICE QUANTITY REVENUE MR MC PROFIT

$7.00 1 $7.00 $7.00 $1.50 $5.50

$6.00 2 $12.00 $5.00 $1.50 $9.00

$5.00 3 $15.00 $3.00 $1.50 $10.50

$4.00 4 $16.00 $1.00 $1.50 $10.00

$3.00 5 $15.00 $-1.00 $1.50 $7.50

$2.00 6 $12.00 $-3.00 $1.50 $3.00

$1.00 7 $7.00 $-5.00 $1.50 $-3.50

After going through your analysis to compute the optimal price, suppose your boss looks at you
and says, "This is the stupidest thing I've ever seen! Since the price is $5, and the cost of producing
another good is only $1.50, we're leaving money on the table." What do you tell her?

Your boss has confused average revenue or price to marginal revenue. They’re easy to confuse.
Here’s why. As long as price is greater than average cost, it appears that an increase in quantity
would increase profit. However, this reasoning is incorrect because it doesn’t recognize the
dependence of Q on P – you cannot sell more without decreasing price. Put another way, you can
say that to sell more, you have to reduce price for all customers, not just the additional customers
who would be attracted by the reduced price.

Tell your boss that you are already making all profitable sales – those for which marginal revenue
exceeds marginal cost. Marginal analysis, not average analysis, tells you where to price or,
equivalently, how many to sell.

PRICE ELASTICITY AND MARGINAL REVENUE Back to top

Unfortunately, you're never going to see a demand curve like the one in Figure 6.1. In general, it
is very difficult to get information about demand at prices above or below the current price. In fact,
if anyone-particularly an economic consultant-ever tries to show you a complete demand curve,
don't trust it, the consultant has only a very rough guess as to what demand looks like away from
current prices.
At this point you may be shaking your head and wondering why you have to learn about things
you will never see. The point of Figure 6.1 and the associated analysis that you don't need the
entire demand curve to know how to price – all you need is information on MR and MC. If MR >
MC, reduce price, if MR < MC, increase price. As we saw earlier, marginal analysis points you in
7 Module 6 Simple Pricing

the right direction, but it doesn't tell you how far to go. You get to the best price by taking steps
and then by recomputing MR and MC to see whether you should take another step.
So how do we estimate marginal revenue? The answer involves measuring quantity responses to
past price changes, "experimenting” with price changes, or surveying potential consumers to see
how quantity would change in response to a price change. If you do get any useful information
about demand away from the current price, it's likely to come in the form of information about
price elasticity of demand, which we denote by e.

Price elasticity of demand (e) = (% change in quantity demanded) / (% change in price)

Price elasticity measures the sensitivity of quantity to price. A demand curve for which quantity
changes more than price is said to be elastic, or sensitive to price, and a demand curve for which
quantity changes less than price is said to be inelastic, or insensitive to price. A demand curve for
which the changes of quantity and price is proportional, it is said to be unitary elastic.
if |e| > 1, demand is elastic; if |e| < 1, demand is inelastic; if |e| = 1, demand is unitary elastic
Since price and quantity move in opposite directions-as price goes up, quantity goes down, and
vice versa-price elasticity is negative, that is, e < 0. However, people often refer to elasticity
without the minus sign, resulting in confusion. To keep things clear, whenever we use price
elasticity, as we do here, we will refer to its absolute value, represented by |e|. To show how you
might be able to estimate elasticity, consider this 1999 "natural experiment” at MidSouth, a
medium-sized retail grocery store. The store's managers decreased the price of three-liter Coke
(diet, caffeine-free, and classic) from $1.79 to $1.50 because they wanted to match a price offered
at a nearby Wal-Mart. In response to the price drop, the quantity sold doubled, from 210 to 420
units per week
To compute elasticity, simply take the percentage quantity increase and divide by the percentage
price decrease. Some confusion inevitably occurs because we can compute percentage changes in
several different ways, depending on whether we divide the price or quantity change by initial or
final prices and quantities. The most accurate estimate comes from dividing by the midpoint of
price (P1 + P2)/2 and the midpoint of quantity (Q1 + Q2)/2.

Price elasticity estimator: [(Q1-Q2) / (Q1+Q2)] ÷ [(P1-P2) / (P1+P2)]

In the three-liter Coke example, the calculation works like this

[(210-420) / (210+420)] ÷ [1.79-1.50) / (1.79+1.50)]

In this case, the estimated price elasticity is -3.8, indicating that a 1% decrease in price of three-
liter Coke leads to a 3.8% increase in quantity. The change in revenue associated with the change
is
($1.50x420) – ($1.79x210) = $630 – $375.90 = $254.10

What this experiment shows is that for elastic demand, if you reduce price, revenue goes up.
8 Managerial Economics

Elasticity is important because it tells you how revenue changes as you change price. All this says
is that whichever change in bigger (price vs. quantity) determines whether revenue goes up or
down. And elasticity tells you this. Tables 6.5 and 6.6 follow from this equation.

Table 6.5 Elastic Demand |e| > 1

Price increase = Revenue decrease (decrease in Q is bigger than increase in P)
Price decrease = Revenue increase (increase in Q is bigger than decrease in P)

Table 6.6 Inelastic Demand |e| < 1

Price increase = Revenue increase (decrease in Q is smaller than increase in P)
Price decrease = Revenue decrease (increase in Q is smaller than decrease in P)

When demand is elastic, quantity changes by a greater percentage than price, so revenue will rise
following a price decrease and fall following a price increase. If you increase price when demand
is elastic, revenue will go down (top row of Table 6.5) and a decrease in price when demand is
elastic, revenue will rise (bottom row of Table 6.5).

On the other hand, when the demand is inelastic, quantity changes by a lesser percentage than
price, so revenue will fall following a price decrease and will rise following a price increase. If
you increase price when demand is inelastic, revenue will go up (top row of Table 6.6) and a
decrease in price when demand is inelastic, revenue will go down (bottom row of Table 6.6).

However, if the demand is unitary elastic (|e| = 1), changes in quantity and price is proportional,
so neither an increase nor a decrease in price will affect the revenue.
The exact numerical relationship between marginal revenue (change in revenue) and elasticity is
MR = P(1 – 1 / |e|). We can use this formula to express the marginal analysis rule – reduce price if
MR > MC, and increase price if MR < MC – using price elasticity in place of marginal revenue:
MR > MC means that (P – MC) / P > 1 / |e|.
This expression is an intuitive interpretation. The left side of the expression is the current margin
of price over marginal cost, (P – MC) / P, whereas the right side is the desired margin, which is
the inverse elasticity, 1 / |e|. If the current margin is greater than the desired margin, reduce price
because MR > MC, and vice versa. Intuitively, the more elastic demand becomes (1 / |e| becomes
smaller), the less you can raise price over marginal cost because you lose too many customers.

WHAT MAKES DEMAND MORE ELASTIC Back to top

Given the importance of elasticity (price elasticity of demand) to pricing – the more elastic demand
is the lower the profit-maximining price is – it’s worthwhile to gain an understanding for what
would make demand more or less elastic. In this section, we list five factors that affect demand
elasticity and optimal pricing.
Products with close substitutes have more elastic demand.
9 Module 6 Simple Pricing

Consumers respond to a price increase by switching to their next-best alternative. If their next-best
alternative is a very close substitute, then it doesn't take much of a prior is crease to induce them
to switch. This is why revenues tell when Mayor Barry raised the price of gasoline by 6%. Since
DC has many commuters, they began purchasing gasoline in nearby Virginia and Maryland.
In a similar vein, we see that individual brands, such as Nike, have close substitutes (other brands)
than do aggregate product categories that include the brands, such as shoes. This leads to our next
factor.
Demand for an individual brand is more elastic than industry aggregate demand.
As a rough rule of thumb, we can say that brand price elasticity is approximately equal to industry
price elasticity divided by the brand share. For example, if the elasticity of demand for all running
shoes is -0.4, and the market share of Nike running shoes is 20%, price elasticity of demand for
Nike running shoes is (-0.4/0.20) = -2 Using our optimal pricing formula, this would give Nike a
desired margin of 50%.
If you search the Internet, you'll easily find industry price elasticity estimates that you can combine
with market share estimates to get an estimate of brand elasticity. And you can use this estimate
to gain a general idea of whether your brand price is too high or too low.
Products with many complements have less elastic demand.
Products that are consumed as part of a larger bundle of complementary goods-say, shoe laces and
shoes-have less elastic demand. This becomes an important consideration for goods that are
typically purchased with other goods, like computers, operating systems, and applications. One of
the reasons that the demand for iPhones is less elastic is due to the number of applications that can
run on them. If the price of an iPhone increases, you are less likely to substitute to another product,
due to the complementary apps.
Another factor affecting elasticity is time. Given more time, consumers are more responsive to
price changes. They have more time to find more substitutes when price goes up and more time to
find novel uses for a good when price goes down. This leads to our fourth factor:
In the long run, demand curves become more elastic.
This phenomenon could also be explained by the speed at which price information is disseminated.
As time passes, information about a new price becomes more widely known, so more consumers
react to the change.
As an example, consider automatic teller machine (ATM) fees. In 1997, a bank in Evanston,
Indiana, ran an experiment to determine elasticity of demand for ATMs with respect to ATM fees.
At a selected number of ATMs, the bank raised user fees from $1.50 to $2.00. When informed of
the fee increase, users typically completed the current transaction (short run) but avoided the
higher-priced ATMs in the future (long run).
10 Managerial Economics

Our final factor relates elasticity to the price level. As price increases, consumers find more
alternatives to the good whose price has gone up. And with more substitutes, demand becomes
more elastic.
As price increases, demand becomes more elastic.
For example, high-fructose corn syrup (HFCS) is a caloric sweetener used in soft drinks. For this
application, sugar is a perfect substitute for HFCS. However, impots quotas and sugar price
supports have raised the U.S. domestic price of sugar to about twice that of HFCS. All soft drink
bottlers now use HFCS instead of sugar. And because bottlers have no close substitutes for low-
priced HFCS, its demand is less elastic. But if the price of HFCS were to rise to that of sugar, sugar
would become a good substitute for HFCS. In other words, demand for high-priced HFCS would
become very elastic.

FORECASTING DEMAND USING ELASTICITY Back to top

We can also use elasticity as a forecasting tool. With an elasticity and a percentage change in price,
you can predict the corresponding change in quantity:
%Δ Quantity ≈ e(%Δ Price)
For example, if the price elasticity of demand is -2, and price goes up by 10%, then quantity is
forecast to decrease by 20%.
Remember that price is only one of many factors that affect demand. Income, prices of substitutes
and complements, advertising, and tastes all affect demand. To measure the effects of these other
variables on demand, we define a factor elasticity of demand:
Factor elasticity of demand = (% change in quantity) ÷ (% change in factor)
For example, demand for bottled water, iced tea, and carbonated drinks is strongly influenced by
temperature. If the temperature elasticity of demand for beverages is 0.25, then a 1% increase in
temperature will lead to a 0.25% increase in quantity demanded.
Income elasticity of demand measures the change in demand arising from changes in income.
An income elasticity > 1 means that the good is normal; that is, as income increases, demand
increases. An income elasticity < 1 means that the good is inferior; that is, as income increases,
demand declines. A study for income elasticity for food was made by Ernest Engel (Engel’s Law)
states that:
• When income increases, the percentage that is spent on food tends to decrease.
• The resulting coefficient is less than one because food is a necessity.
• When income increases, the increase goes mostly to the purchase of luxury items,
education, travel and leisure.

Income elasticity = (% change in quantity demanded) / (% change in income)

11 Module 6 Simple Pricing

Cross-price elasticity of demand for Good A with respect to the price of Good B measures the
change in demand of A owing to a change in the price of B. Positive cross-price elasticity means
that Good B is a substitute for Good A: As the price of a substitute increases, demand increases.
For example, two-liter Coke is a good substitute for one-liter Coke.

Negative cross price elasticity means that Good B is a complement to Good A: As the price of a
complement increases, demand decreases. Computers, for example, are complements to operating
systems that run on them. We can trace part of Microsoft's success to its strategy of licensing its
operating system to competing computer manufacturers. That strategy helped keep the price of
computers low which stimulated demand for Microsoft's operating system.

Cross-Price elasticity = (%change in Quantity of Good A) ÷ (%change in Price of Good B)

COST-BASED PRICING Back to top

Our expressions for optimal pricing, MR = MC or (P – MC)/P = 1 / |e|, take into account both a
firm's cost structure and its consumers' demand to obtain the optimal price. Yet, many companies
set prices based only on the cost component, ignoring consumer demand entirely. For example,
cost-plus pricing arrives at a price by adding a fixed dollar margin to the cost of each product,
while mark-up pricing multiples the cost by a fixed number greater than 1. It doesn't take much
analysis to see that ignoring consumer demand leads to suboptimal pricing-just imagine cost-based
pricing applied to diamonds, wine, movie tickets, or bottled water. Without comparing costs to
demand, we cannot know if goods are priced optimally.
To understand why cost-based pricing persists, we apply the second question in our problem-
solving paradigm: Does the decision maker have enough information to make a good decision? In
one survey of managers, most reported that they are well informed about their own costs, but much
fewer than half reported being well-informed about demand. Part of the reason for this is historical
accident. Tax compliance required firms to have cost accountants, and since these cost data were
there anyway (though using accounting not economic-costs), pricing managers used them. A firm
that takes its profitability (and pricing) seriously needs a "demand accounting" (market research)
division, too.

SUMMARY Back to top

• Aggregate demand, or market demand, is the total number of units that will be purchased
by a group of consumers at a given price.
• Pricing is an extent decision. Reduce price (increase quantity) if MR > MC. Increase price
(reduce quantity) if MR < MC. The optimal price is where MR = MC.
• Price elasticity of demand, e = (% change in quantity demanded) ÷ (% change in price).
1. Estimated price elasticity = [(Q1-Q2) / (Q1+Q2)] ÷ [(P1-P2) / (P1+P2)] is used to
estimate demand from a price and quantity change.
12 Managerial Economics

2. If |e| > 1, demand is elastic; if |e| < 1, demand is inelastic; if |e| = 1, demand is unitary
elastic.
• Elastic demand (|e| > 1): Quantity changes more than price.
Price increase = Revenue decrease
Price decrease = Revenue increase
• Inelastic demand (|e| < 1): Quantity changes less than price.
Price increase = Revenue increase
Price decrease = Revenue decrease
• Unitary elastic (|e| = 1): Changes of quantity and price is proportional.
Neither an increase nor a decrease in price will affect the revenue.
• MR > MC implies that (P – MC) / P > 1 / |e|; that is, the more elastic is demand, the lower
the optimal price.
• Five factors that affect elasticity:
1. Products with close substitutes have more elastic demand.
2. Demand for an individual brand is more elastic than industry aggregate demand.
3. Products with many complements have less elastic demand.
4. In the long run, demand curves become more elastic.
5. As price increases, demand becomes more elastic.
• Income elasticity, cross-price elasticity and advertising elasticity are some measures of
how changes in these other factors affect demand.
• It is possible to use elasticity to forecast changes in demand.
• %Δ Quantity = (Factor elasticity) (%Δ Factor).
• Income elasticity = (% change in quantity demanded) / (% change in income).
• Cross-Price elasticity = (%change in Quantity of Good A) ÷ (%change in Price of Good B)

REVIEW QUESTIONS Back to top

1. What is elasticity? What is the significance of knowing a good’s elasticity?
2. State and explain the First Law of Demand.
3. Other than the price, give at least five (5) factors that affect demand.
4. Differentiate price elasticity from income elasticity.
5. Taster’s Choice coffee lovers consider Carnation Coffeemate as its complement. If Taster’s Choice
increased its prices, what would you expect to happen in the market for Carnation Coffeemate and
what would you consider?
6. If a particular good has a price elasticity of 1.5 and a 5% price markdown, how much would you
predict to the good’s demand
7. Why do you think pricing based on cost is commonly used?
13 Module 6 Simple Pricing

References
Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mikael Shor. (2014). Managerial Economics Third
Edition. Cengage Learning Asia Pte Ltd.

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