Chapter 3

Simple Pricing

The most business focuses on cost reduction rather than a review of the prices of their products. In
accounting, we priced our product based on cost (Price = cost + mark-up) but there are other ways to
price our product not just based on cost especially on products that cost is hard to compute: example in
a coffee shop different flavors have different cost depending on the ingredients yet most of them have
the same price and the computation of cost for them is often costly as ingredients are purchased in bulk
amount.

Consumer Values and Demand Curves

The more units the customer has the less they value our products. For example, choji from naruto
values his chips based on the units left, he values the last chips more than the first chips because there
is only one chip left.
Consumer Value
Table 3.1
Units Marginal Value (P) Total Value (P)
1 5 4
2 4 9
3 3 12
4 2 14
5 1 15

In table 3.1 it shows the marginal value and total value for the various quantities. The consumer uses
marginal analysis to decide how much to consume because it is an extent decision. If the marginal
value of consuming another unit is above the price, the consumer consumes another unit. For example,
at a price of P5 the consumer purchases only 1 unit because the second unit has a value of P4 which is
below the price. Note that the marginal value is the consumer value (how the customers value our
products). If the customer values our product more than the price he will make a purchase.

Demand Schedule
Table 3.2
Price Units Purchased
5 1
4 2
3 3
2 4
1 5

A demand curve tells you how much consumers will purchase at a given price. For example: if you
price your product P3 he/she will purchase 3 units, if it is priced at P2 he/she will purchase 4 units. The
first law of demand tells us that the consumer purchases more as the price falls.
 Consumer Surplus
Table 3.3
Price (P) Units Purchased Total Amount Paid (P) Total Value (P) Surplus (P)
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

Table 3.3 shows how much surplus consumers get at product purchases. As the price declines,
consumer surplus, the difference between the total value and amount paid increases. Since customers
have different buying capacities, for example, customer A might be willing to pay P7, customer B is
only willing to pay P6, and costumer C is only willing to pay P5, this means that if the product is priced
at P7 only A will make the purchase but if it priced at P5, A, B and C will make a purchase. 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 3.1 we can plot this demand curve.

6
To

3
Price

0
1 2 3 4
Quantity

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. For four, the buyers demand two units.

Marginal Analysis of Pricing

Demand curves present sellers with a dilemma. Sellers can raise the prices 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 trade-off is at the heart of pricing decisions.

We use demand curves to change the pricing decision into a quantity decision using marginal analysis.

Example:
Price (P) Quantity Revenue (P) MR (P) MC (P) Profit (P)
7 1 7 7 1.50 5.50
6 2 12 5 1.50 9.00
5 3 15 3 1.50 10.50
4 4 16 1 1.50 10.00
3 5 15 -1 1.50 7.50
2 6 12 -3 1.50 3.00
1 7 7 -5 1.50 -3.50
MR = Marginal Revenue
MC = Marginal Cost

So the price that will yield the highest profit is P5.00. Note that there are times that MC is not stable, as
discussed in chapter 2, MC sometimes increases as quantity increases.

12

10
Highest profit, best price
8

4
Profit

0
7 6 5 4 3 2 1
-2

-4

-6
Price
Price Elasticity and Marginal Revenue
Unfortunately, the companies have a hard time getting their demand curve, it is difficult to get
information since customers are often unstable. Getting the demand curve takes a lot of time and
resources and even if it is computed the information is already obsolete because customers purchasing
capacity and behavior already changes because of this the best price for a single product can only be
computed theoretically but never in practice what is used instead is If MR>MC, reduce price; if the
MR<MC increase price, as what was discussed in chapter 2 wherein if MR>MC sell more and if
MR<MC sell less. In the law in demand if we reduce the price we will sell more and if they increase
the price we sell less.

The marginal cost could be easily computed by there might be a problem with the computation of
marginal revenue. The computation of marginal revenue is based on experiments but you can change
the price of your product too often as it annoys some customers. Example: you’ve decided to get the
best price for your product (soimai), yesterday it is priced at P5.00 per piece then today it is at P6.00
then tomorrow P4.00. Potential and current consumers are surveyed to see how they would respond to
price change note that in a survey the answers might not represent the actual behavior. If reliable
information is somehow surveyed the price elasticity is computed.

e = %ΔQuantity Demanded / %ΔPrice

Price elasticity measures how sensitive demand is to change in 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. Price elasticity is
always negative

If |e| > 1, demand is elastic; if |e| < 1, demand is insensitive.

If the price elasticity of demand is = zero, demand is perfectly inelastic i.e. demand does not vary from
the price meaning the company could freely increase the price of its product.

If the price elasticity is = infinity, demand for a product is perfectly elastic, a change in market supply
will not lead to any change in the equilibrium price. This demand curve applies to highly competitive
markets where no supplier has any “pricing power”

If the price elasticity is = 1, the total spending by consumers on the product will remain the same at
each price level.

Suppose that the price of apples falls by 6% from P20.0 a piece to P18.8 a piece. In response, grocery
shoppers increase their apple purchases by 20%. The elasticity of apples would thus be: 0.20/0.06 =
3.33 indicating that apples are quite elastic in terms of their demand.

Often homogeneous products (example orange) and products with alternatives are highly elastic while
the heterogeneous products (example iPhone)

We can express the revenue change as the sum of quantity and price changes:
%Δrevenue ≈ %ΔQuantity Demanded / %ΔPrice

If the demand is elastic:

Price increase = Revenue decrease
Price decrease = Revenue increase

If the demand is inelastic

Price increase = Revenue increase
Price decrease = Revenue decrease

Example:
A milk tea shop was qualified for vat for the year and was required by the Bureau of Internal Revenue
to collect VAT the following year, because of this there is an increase of 12% on the selling price the
shop determines that there would be a decrease in the quantity sold by 40%. the price elasticity is:
e = 40% / 12%
e = -3.33.
Note that price elasticity is always negative. Since |-3.33| > 1; the demand is elastic.

To determine the best price for the product using elasticity. We use this formula to express the marginal
analysis rule using price elasticity and margins place of MR and MC.
MC = (1/|e|) = desired margin
MR = P (1 – 1) = actual margin
e
Best price is where the desired margin = actual margin

Two methods of computing elasticity

1. Midpoint Method of Elasticity

The advantage of the midpoint method is that we get the same elasticity between two price
points whether there is a price increase or decrease. This is because the formula uses the same base for
both cases. The midpoint method is referred to as the arc elasticity.

2. Point Elasticity

A drawback of the midpoint method is that as the two points get farther apart, the elasticity
value loses its meaning. For this reason, some economists prefer to use the point elasticity method. In
this method, you need to know what values represent the initial values and what values represent the
new values.

For example, after XYZ RMT sells face masks at P20 each during the day he sold 10pcs. he is trying
to determine the price elasticity of his product based on the following prices:
Price (P) Quantity
1 25 7
 2 30 4.5

Using the Midpoint Method of Elasticity:

1.
e = %ΔQuantity Demanded / %ΔPrice
e = [(Q1 – Q2)/ (Q1 + Q2)] ÷ [(P1 – P2)/ (P1 + P2)]
2 2
e = [(10 – 7)/ 10 + 7)] ÷ [20-25)/(20+25)]
2 2
e = 0.3529411764705882 ÷-0.2222222222222

e =-1.58823529
2.
e = [(10 – 4.5)/10 + 4.5)] ÷ [(20 – 30)/ (20+30)]
2 2
e = 0.7586206896551724 ÷-0.40

e =-1.896551724137931

Using Point Elasticity:

1.
e = %ΔQuantity Demanded / %ΔPrice
e = [(Q1 – Q2)/ (Q1 )] ÷ [(P1 – P2)/ (P1)]
e = [(10 – 7)/ 10] ÷ [(20-25)/20]
e = 0.30 / 0.25
e =-1.20
2.
e = [(10 – 4.5)/ 10] ÷ [(20-30)/20]
e = 0.55 / 0.50
e =-1.10

on the example, the elasticity of the product is not constant and elasticity is computed per price.

Determining profit-maximizing price when marginal cost and elasticity are constant:
Formula:
P = MC ( e )
(e+1)

Example: Your company produces a good at a constant marginal cost of P6.00. The price elasticity of
demand for the good is –4.0.

P = 6 ( -4 )
(-3+1)

P = P8.00
Unfortunately, both elasticity and marginal cost depend on your price, because elasticity varies along
the demand curve and marginal cost varies with your level of output. This formula is only effective if
the elasticity of demand and marginal cost is constant.

What makes demand more elastic

1. Products with close substitutes have more elastic demand
2. Demand for an individual brand is more elastic than industry aggregate demand.
As an estimate, demand price elasticity is approximately equal to industry price
elasticity divided by the brand share e=(and ÷ Si)
For example: if the elasticity demand for all running shoes is -0.4%, and the market
share of Nike running shoes is 20%, the price elasticity of demand for Nike running
shoes is -0.4/0.20 = -2.
3. Product 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 (generally or theoretically)

Computation of expected increase in quantity due to decrease in price

Formula:
% change in Quantity = % change in price x price elasticity

For example, an online seller sells 250 face masks at an average of P8 each. It estimates that the price
elasticity of demand for tickets is (-) 1.6. If they reduce their price to P7 each how many units will be
sold.

% change in Quantity = (8-7)/8 x 1.6

% change in Quantity = 20%

Increase in units sold = 250 units x 20% = 50 units

Units sold = 250 units + 50 units = 300 units

https://www.khanacademy.org/economics-finance-domain/microeconomics/elasticity-tutorial/
price-elasticity-tutorial/a/price-elasticity-of-demand-and-price-elasticity-of-supply-cnx
Cross Elasticity of Demand
measures the responsiveness of one product due to the changes in price for another product

0 cross elasticity of demand means the items are not related to each other. Substitute products always
have high positive elasticity of demand while Complementary products always have high negative
elasticity of demand
Stay-even Analysis
Stay-even analysis tells you how many unit sales you can lose before a price increase becomes
unprofitable. it shows whether an increase or decrease in price is profitable.
Formula:
Stay-even quantity = %ΔP ___
(%ΔP + Contribution Margin)
Contribution Margin = (P-MC)_________
P

Comparing the stay-even analysis and the predicted Δ in quantity (using elasticity)

Decision is:
If the predicted quantity is less than the stay-even quantity, then the price increase will likely be
profitable, and vice versa
If:
e(%ΔPrice) < %ΔP _ = change in price is profitable
(%ΔP + Contribution Margin)
in comparing:
decrease in quantity = positive
increase in quantity = negative

The stay even quantity for a 5% price increase for a firm with a 40% contribution margin and elasticity
is -2.
Stay-even quantity = 5% ___
(5% + 40%)
Stay-even Quantity = 11.1% decrease;
11.1 = no change in profit

Predicted Quantity = -2(5%)

Predicted Quanitity = 10% decrease

Since
11.1% > 10% = the change in price is profitable

The stay even quantity for a 5% price increase for a firm with a 40% contribution margin and elasticity
is -2.
Stay-even quantity = 11.1% increase
Predicted Quantity = 10% increase
(11.1%) < (10%) = the change is not profitable

Cost-based Pricing
one of the disadvantages of pricing based on demand and supply is it doesn’t consider the cost of the
item being sold and loss might incur to the company because the item is priced below cost. Cost-based
pricing is often used by companies having a hard time determining their demand and could easily
determine their cost per unit. In this method, price is determined by adding a mark-up to the cost.

Price = Cost + Mark-up

Mark-up could be determined by the following:

1. Mark-up on cost: Mark-up = Cost x % of mark-up
Cost may be based on the following: Variable cost, product cost, total cost
Example: Product A has a cost of P80, the company decided to put a 20% mark-up on cost to
get the selling price:
Price = 80 + (80 x 20%)
Price = 96

2. Mark-up on sale: Mark-up = (Cost x % of mark-up)

1 - % of markup
Example: Product A has a cost of P80, the company decided to put a 20% mark-up on sale to
get the selling price:
Price = 80 + (80 x 20%)
1 – 20%
Price = 80 + 20
Price = 100

Problems:
1. Jim has estimated the elasticity of demand for gasoline to be -0.70 in the short run and -1.80 in the
long run. A decrease in taxes on gasoline would
a) lower tax revenue in both the short and long run.
b) raise tax revenue in both the short and long run.
c) Raise tax revenue in the short run but lower tax revenue in the long run
d) lower tax revenue in the short run but raise tax revenue in the long run.
2. It’s lunchtime, you are hungry and would like to have some pizza. By the law of diminishing
marginal value.
a) You would pay more for your first slice of pizza than your second.
b) You would pay more for your second slice of pizza than your first.
c) You would pay an equal amount of money for both the slices since they are identical
d) none of the above.
3. Jim recently graduated from college. His income increased tremendously from P5,000 a year to
P60,000 a year Jim decided that instead of renting he will buy a house. This implies that.
a) Houses are normal goods for Jim
 b) houses are inferior goods for Jim
c) Renting and owning are complementary for Jim
d) need the information on the price of houses.
4. Which of the following goods has a negative income elasticity of demand? (negative income
elasticity of demand means that increasing price will lead to a drop in demand which will decrease
profit)
a) Cars
b) Items from Dollar stores
c) Shoes
d) Bread
5. An economist estimated the cross-price elasticity for peanut butter and jelly have 1.5. Based on this
information, we know the goods are
a) inferior goods
b) complements
c) inelastic
d) substitutes
6. Christine has purchased five bananas and is considering the purchase of a sixt. It is likely she will
purchase the sixth banana if
a) The marginal value she gets from the sixth banana is lower than its price
b) The marginal benefit of the sixth banana exceeds the price
c) The average value of the sixth banana exceeds the price
d) The total personal value of six bananas exceeds the total expenditure to purchase six bananas.
7. Buyers consider cigarettes and beer to complement. If due to taxes cigarette price increases, What
would you expect to occur in the beer market?
a) Demand would rise and would reduce the price.
b) Demand would fall and would reduce the price
c) Demand would fall and would increase the price
d) Demand would rise and would increase supply
8. Which of the following is the reason for the existence of consumer surplus?
a) Consumers can purchase goods that they want in addition to what they need
b) Consumers can occasionally purchase products for less than their production cost
c) Some consumers receive temporary discounts that result in below-market prices
d) Some consumers are willing to pay more than the price.
9. A bakery currently sells chocolate chip cookies at a price of P16dozen. The MC is P8/dozen. The
cookies are becoming more popular with customers, and so the bakery owner is considering raising the
price to P20/dozen. What percentage of customers must be retained to ensure that the price increase is
profitable?
a) 28.0%
b) 33.3%
c) 66.6%
d) 72.0%
10 Suppose your firm adopts a technology that allows you to increase your output by 15%. If the
elasticity of demand is -3, how should you adjust the price if you want to sell all your output?
a) 5% lower
b) 0.5% lower
c) 15% higher
d) 15% lower
11. George has been selling 5,000 shirts per mount for P850. When he increased the price to P950, he
sold only 4,000 T-shirts. What is demand elasticity? If his MC is P400 per short, what is his desired
markup and initial markup based on cost? Was raising the price profitable?

12. To experiment, AMC increased movie ticket prices from 90 to 100 and measured the change in
ticket sales. Using the data over the following month, they concluded that the increase was profitable.
However, over the subsequent months, they changed their minds and discontinued the experiment.
How did the timing affect their conclusion about the profitability of increasing prices?

13. An end-of-aisle price promotion changes the price elasticity of a product from -2 to -3 If the normal
price is P10, what should the promotional price be?