WEEK 2 PROFIT’S SENSITIVITY TO PRICE justified, and the firm should consider alternative

actions.
In more established markets, executives require stronger
guidance in pricing decisions than that provided by PROFIT SENSITIVITY ANALYSIS OF A PRICE REDUCTION
exchange value models.

They will require a clearer understanding of the

customer’s response to price.

PROFIT SENSITIVITY ANALYSIS

Demonstrates the impact of a small change in price on

profits.

It is a straightforward analysis of the expected profits When price gets lowered, the quantity that
earned at two different prices. “theoretically” gets sold gets higher.
PRICE CHANGES HAVE BOTH DIRECT AND INDIRECT DECISION IMPLICATIONS
EFFECTS ON PROFITS
Executives can use the volume in considering either price
DIRECT - Linear relationship between profits and prices. increases or decreases before the price change has
occurred because information is readily available to the
INDIRECT - Influence of price changes on customer
firm internally.
demand.
 The current price and variable costs can be seen
Profit = Q (P – VC) – FC
in the accounting records.
Among the variables that determine profit, a pure price
 The proposed price/s is/are up to the
change influences the quantity sold but not the variable
management’s discretion.
and fixed cost.
Due to the inverse relationship pf price and volume, in a
Pure price change – implies that the price changes
normal market, if there is a:
without changing the product.
Price reduction – volumes are required to increase for
VOLUME HURDLES
the firm to profit the price move.
Define the required demand increase to justify a price
Price increase – volumes can decrease, but only put to a
cut and allowable demand sacrifice to justify a price hike.
point. The smaller the decrease, the more profitable the
It enables the executives to quantify the required selling firm gets.
goals and compare them against their expectations of
The volume hurdle depends on the size of the price
potential demand.
change under consideration.
In tactical pricing decisions, volume hurdles are routine
Larger price changes – require greater volumes to be
procedure in setting sales targets for price promotions
met, and
and discount practices and for evaluating the profitability
of price concessions at the end of promotion. Smaller Price Changes– are associated with smaller
volume hurdles.
Based on the profit motive of the firm, we can state that
the requirement of price changes is to improve profits. Fixed costs play no role in identifying the volume hurdle.
If the firm expects the volume hurdle to be met, then a  While fixed cost must be covered to stay in
price change may be in order. business, it does not affect the optimal price. It’s
just there to decide whether to stay in or exit a
 if the volume hurdle is greater than the expected
business.
change in sales, then the new price cannot be
The volume hurdle is a necessary condition for pricing INELASTIC MARKET
actions to improve the profitability of the firm, but it is
A large change in price has only a small effect on the
not a sufficient condition.
quantity sold.
Volume hurdles do not take into account long-term
Elasticity is less than 1. ( < 1 )
changes in customer demand that may be influenced by
a pricing action. Only a few firms face inelastic demand curves.
 It can reset price expectations. Tend to favor price increases to improve profitability.
 Competitors may match offer. VOLUME HURDLE AND DEMAND CURVE FOR INELASTIC
MARKETS
ELASTICITY OF DEMAND
This shows how in an inelastic market, price increases
Measure of the changes in volume delivered with a
are more favorable.
change in price.

Ratio of the present change in volume to the percentage

change in price.

Numerically, the elasticity of demand is negative for

normal markets, implying fewer goods are sold at higher
prices and most goods are sold at lower prices.

By convention, economists tend to drop the sign

MEASURED ELASTICITY OF DEMAND
(absolute value)
The elasticity of demand can be routinely measured and
ELASTIC MARKET
be used to inform pricing decisions.
A small change in price has a large effect on the quantity
In general, historic metrics of the elasticity of demand
sold.
are better quantified for more commodity-oriented
Elasticity is greater than 1. ( > 1 ) products than they are for branded goods.

Most firms face this situation due to competition. As products become less commodity-oriented and
suppliers offer greater differentiation between
In the short run, elastic markets tend to favor price cuts competing products, there tends to be greater
to improve profitability. uncertainty in the measurements of elasticity of demand.
VOLUME HURDLE AND DEMAND CURVE FOR ELASTIC
MARKETS
Brand choice
This shows how in an elastic market, price decreases are generally have a
more favorable. more elastic
elasticity over
primary demand
markets.

When the price of an individual brand increases,

customers readily switch bands to a lower-cost
alternative.

When the prices on all brands in the category increase,

customers have to reduce their purchases to save money.

In the short term, customers are often locked into a

particular purchasing pattern.
In the long term, customers may uncover substitutes or PRICE OPTIMIZATION
change in their lifestyle to reduce their need for the
At the peak of the profit curve, profits will be maxed.
product.

NECESSARY, BUT INSUFFICIENT

In reviewing the reported elasticities of demand. We also

notice that demand at the firm level is often elastic,
while that at the category level remains inelastic. This
result derives directly from the nature of competition.

Managers should be very cautious of pricing actions that

may reduce the overall industry-level prices. But beware: EPO produces a false sense of accuracy.

Volume hurdles are a necessary condition for evaluating  EPO suffers from a challenge in identifying the
a price change but not a sufficient condition for judging a relevant elasticity of demand and variable cost to
pricing action as healthy. use in calculating the price.

The firm should expect that competitor to react; to
match the firm’s price cut.
All temporary gains in volume will be lost and both the
firm and its competitor will be pricing their product at a
new, lower price point.
Hence, many firms will be better served by seeking to
raise or at least maintain their prices to promote overall
industry health, rather than lowering them to take a
greater share but damage the industry as a whole.
Even if economists have precisely quantified the
elasticity of demand at both the firm level and the
industry level, executives may be uncertain how to
proceed.
 Price optimization using the elasticity of demand
alone would encourage most firms to lower their
prices.
Accepting these challenges, executives may use EPO to
create a range of potential prices.

These quantitative approaches (elasticity of demand and Industry level – identify a higher price that would
volume hurdles) ignore competitive reactions. improve the firm’s and industry’s profit overall.

They also fail to consider the differences between long- Firm level – identify the minimum price to change if all
term changes in consumer behavior and short-term other competitive actions were thwarted and customers
predictability. behaved in a consistent manner.

ECONOMIC PRICE OPTIMIZATION

Method of identifying the price that maximizes profits.

It will rely on quantifying the elasticity of demand.

Any price above the optimum will damage profits by

depressing demand sufficiently to destroy gains created
by improving margins..

Any price below the optimum will damage profits by

decreasing margins more than the gains earned in
improving volumes.