SIMPLE PRICING

MODULE 6
TOPICS:

• SIMPLE PRICING
• CONSUMER VALUES AND DEMAND CURVES
• MARGINAL ANALYSIS OF PRICING
• PRICE ELASTICITY AND MARGINAL REVENUE
• WHAT MAKES DEMAND MORE ELASTIC
• FORECASTING DEMAND USING ELASTICITY
• COST-BASED PRICING
SIMPLE PRICING

PRICING IS A POWERFUL BUT OFT-NEGLECTED TOOL. MANY

BUSINESSES SEEM TO FOCUS ON SELLING MORE OR THE COST OF
MATERIALS AND FORGET ABOUT THE PRICE.

PROFIT = (P – C) x Q

MARGIN
CONSUMER VALUES AND DEMAND CURVES

DEMAND – THE QUANTITY CONSUMERS ARE WILLING AND ABLE TO

BUY AT EACH PRICE DURING A GIVEN TIME PERIOD, OTHER THINGS
CONSTANT.

THE FIRST LAW OF DEMAND STATES THAT:

“QUANTITY DEMANDED IS INVERSELY PROPORTIONAL WITH PRICE”

“DEMAND CURVES DESCRIBE BUYER BEHAVIOR AND TELL YOU HOW

MUCH CONSUMERS WILL BUY AT A GIVEN PRICE”
Table 6.1
• Market Demand Schedule and Market Demand Curve for Pizza
(a) Market demand schedule (b) Market demand curve

Price Quantity
per Demanded $5 a
pizza

Price per pizza

4 b
a $5 1
3 c
b 4 2
c 3 3
2 d
d 2 4
e 1 5 1 e
•The market demand curve D shows
the quantity of pizza demanded, at D
various prices, by all consumers.
Price and quantity demanded are 0 1 2 3 4 5
inversely related other things
constant, reflecting the law of
demand.
Table 6.2
• Pizza Value Table

TABLE 6.2 SHOWS US MARGINAL VALUE AND

Slices Marginal Total
TOTAL VALUE FOR VARIOUS QUANTITIES. FOR
Purchased Value Value
THE FIRST SLICE, TOTAL AND MARGINAL
VALUES ARE THE SAME. FOR THE SECOND
SLICE, THAT MARGINAL VALUE IS 4 WITH A
TOTAL VALUE OF 9.
1 $5 $5
2 4 9 CONSIDER THE VALUE YOU RECEIVE FROM
3 3 12 THE FIRST PIZZA YOU PURCHASE AND
4 2 14 CONSUME IS LIKELY TO BE SUBSTANTIAL. THE
5 1 15 ADDITIONAL VALUE YOU GET FROM
CONSUMING THE SECOND SLICE IS A BIT LESS.
THE MARGINAL VALUE OF CONSUMING EACH
SUBSEQUENT SLICE DIMINISHES THE MORE
YOU CONSUME.
Table 6.3
• Pizza Consumer Surplus

Slice Slices Total Price Total Surplus

Price Purchased Paid Value THIS TABLE SHOWS HOW MUCH A
CONSUMER GAINS FROM EATING
PIZZA SLICES. IF A CONSUMER PAYS
LESS THAN THE TOTAL VALUE OF
$5 1 $5 $5 $0 THE SLICES, HE OR SHE HAS
4 2 8 9 1 CONSUMER SURPLUS.
3 3 9 12 3
2 4 8 14 6
1 5 5 15 10

BECAUSE HOW MUCH TO BUY IS AN EXTENT DECISION, THINKING IN MARGINAL TERMS IS

CRITICAL.
MARGINAL ANALYSIS OF PRICING

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.

REDUCE PRICE (SELL MORE) IF MR > MC. INCREASE PRICE (SELL LESS)
IF MR < MC.
MARGINAL ANALYSIS OF PRICING

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
PRICE ELASTICITY AND MARGINAL REVENUE

ELASTICITY – THE RESPONSIVENESS OF DEMAND/SUPPLY TO A

CHANGE IN ITS DETERMINANT.

𝑄1 − 𝑄2
% 𝐶𝐻𝐴𝑁𝐺𝐸 𝐼𝑁 𝑄𝑈𝐴𝑁𝑇𝐼𝑇𝑌 (%Δ𝑄) (𝑄1+𝑄2)/2
PRICE ELASTICITY (e) = % 𝐶𝐻𝐴𝑁𝐺𝐸 𝐼𝑁 𝑃𝑅𝐼𝐶𝐸 (%Δ𝑃)
= 𝑃1 − 𝑃2
(𝑃1+𝑃2)/2

IF e > 1, DEMAND IS ELASTIC, IF e < 1, DEMAND IS INELASTIC

PRICE ELASTICITY AND MARGINAL REVENUE

POINT PRICE QUANTITY DEMANDED (IN

KILOS)
A 30 120
B 35 100
C 40 80
D 45 50

FR. PT A TO PT B
% 𝐶𝐻𝐴𝑁𝐺𝐸 𝐼𝑁 𝑄𝑈𝐴𝑁𝑇𝐼𝑇𝑌 (%Δ𝑄)
PRICE ELASTICITY (e) = % 𝐶𝐻𝐴𝑁𝐺𝐸 𝐼𝑁 𝑃𝑅𝐼𝐶𝐸 (%Δ𝑃)
𝑄1 − 𝑄2 120 −100 20
(120+100)/2 0.1818
=
(𝑄1+𝑄2)/2
𝑃1 − 𝑃2 = 30 −35 = 110
−5 = = 1.18
−0.1538
(𝑃1+𝑃2)/2 (30+35)/2 32.5
PRICE ELASTICITY AND MARGINAL REVENUE

BASED ON ELASTICITY COEFFICIENT, THESE GOODS HAVE ELASTICITIES LESS

THAN ONE (INELASTIC):
INFANT MILK ELECTRICITY MEDICINE
SALT RICE SUGAR

GOODS THAT HAVE ELASTICITIES OF GREATER THAN ONE (ELASTIC):

SIGNATURE BAGS CHOCOLATES PERFUMES
IMPORTED SHOES HIGH-END FURNITURES

The less necessity of a good is, the more elastic is the demand for it.
PRICE ELASTICITY AND MARGINAL REVENUE

ELASTICITY IS IMPORTANT BECAUSE IT TELLS YOU HOW REVENUE CHANGES

AS YOU CHANGE PRICE.

ELASTIC DEMAND e > 1

PRICE INCREASE = REVENUE DECREASE
PRICE DECREASE = REVENUE INCREASE

INELASTIC DEMAND e < 1

PRICE INCREASE = REVENUE INCREASE
PRICE DECREASE = REVENUE DECREASE
PRICE ELASTICITY AND MARGINAL REVENUE

If the demand is elastic, an increase in price may not benefit the

seller as shown below. The increase in price has resulted a
significant decrease in demand causing the total revenue to
decrease.
Price Quantity Total Revenue
Original Price P6 Original Qd 2,000 Original TR P12,000
New Price P7 New Qd 1,500 New TR P10,500

A decrease in price will ultimately benefit the seller if demand is

elastic.
Price Quantity Total Revenue
Original Price P6 Original Qd 2,000 Original TR P12,000
New Price P5 New Qd 2,500 New TR P12,500
PRICE ELASTICITY AND MARGINAL REVENUE

A decrease in price may not benefit the seller if demand is inelastic

because it causes a decrease in total revenue.
Price Quantity Total Revenue
Original Price P6 Original Qd 2,000 Original TR P12,000
New Price P5 New Qd 2,100 New TR P10,500

An increase in price will, on the other hand, benefit the producer if

demand is inelastic causing an increase in his total revenue.
Price Quantity Total Revenue
Original Price P6 Original Qd 2,000 Original TR P12,000
New Price P7 New Qd 1,900 New TR P13,300
PRICE ELASTICITY AND MARGINAL REVENUE

If the demand is unitary elastic, neither an increase nor a decrease

in price will affect the seller’s total revenue.

Price Quantity Total Revenue

Original Price P4 Original Qd 5,000 Original TR P20,000
New Price P2 New Qd 10,000 Same TR P20,000

Price Quantity Total Revenue

Original Price P4 Original Qd 5,000 Original TR P20,000
New Price P8 New Qd 2,500 Same TR P20,000
PRICE ELASTICITY AND MARGINAL REVENUE

The exact numerical relationship between marginal revenue (change in

revenue) and elasticity is MR = P(1 – 1 / |e|).

MR > MC means that (P – MC) / P > 1 / |e|.

(P – MC) / P = Current margin
1 / |e| = Desired margin

If the current margin is greater than the desired margin, reduce price
because MR > MC, and vice versa.
WHAT MAKES DEMAND MORE ELASTIC

PRODUCTS WITH CLOSE SUBSTITUTES HAVE MORE ELASTIC DEMAND.

DEMAND FOR AN INDIVIDUAL BRAND IS MORE ELASTIC THAN INDUSTRY

AGGREGATE DEMAND.

PRODUCTS WITH MANY COMPLEMENTS HAVE LESS ELASTIC DEMAND.

IN THE LONG RUN, DEMAND CURVES BECOME MORE ELASTIC.

AS PRICE INCREASES, DEMAND BECOMES MORE ELASTIC.

FORECASTING DEMAND USING ELASTICITY

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%.
FORECASTING DEMAND USING ELASTICITY

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.
FORECASTING DEMAND USING ELASTICITY

INCOME ELASTICITY OF DEMAND MEASURES A PRODUCT’S

PERCENTAGE CHANGE IN DEMAND AS A RATIO OF THE PERCENTAGE
CHANGE IN INCOME WHICH CAUSES A SHIFT IN THE DEMAND CURVE.
𝑄1 − 𝑄2
% 𝐶𝐻𝐴𝑁𝐺𝐸 𝐼𝑁 𝐷𝐸𝑀𝐴𝑁𝐷 (%Δ𝐷) (𝑄1+𝑄2)/2
INCOME ELASTICITY = % 𝐶𝐻𝐴𝑁𝐺𝐸 𝐼𝑁 𝐼𝑁𝐶𝑂𝑀𝐸 (%Δ𝑌)
= 𝑌1 −𝑌2
(𝑌1+𝑌2)/2

> 1 MEANS DEMAND IS ELASTIC AND THE GOOD IS NORMAL.

< 1 MEANS DEMAND IS INELASTIC AND THE GOOD IS INFERIOR.
FORECASTING DEMAND USING ELASTICITY

POINT PRICE QUANTITY

A 60 300
B 80 260

Y1 = 15,000; Y2 = 22,000
𝑄1 − 𝑄2
% 𝐶𝐻𝐴𝑁𝐺𝐸 𝐼𝑁 𝐷𝐸𝑀𝐴𝑁𝐷 (%Δ𝐷) (𝑄1+𝑄2)/2
INCOME ELASTICITY = = 𝑌1 −𝑌2
% 𝐶𝐻𝐴𝑁𝐺𝐸 𝐼𝑁 𝐼𝑁𝐶𝑂𝑀𝐸 (%Δ𝑌)
(𝑌1+𝑌2)/2
60 −80 −20
(60+80)/2 −0.2857
= 15,000 −22,000 = 70
−7,000 = = 0.7550
−0.3784
(15,000+22,000)/2 18,500
FORECASTING DEMAND USING ELASTICITY

An analysis of income elasticity figures are shown below:

Income elasticity Degree of demand Type of good
elasticity
2 Elastic Normal luxury
1.5 Elastic Normal luxury
0.75 Inelastic Normal-necessity
0.5 Inelastic Normal-necessity
0.3 Inelastic Inferior
0.22 Inelastic Inferior
FORECASTING DEMAND USING ELASTICITY

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.
FORECASTING DEMAND USING ELASTICITY

CROSS-PRICE ELASTICITY IS A MEASURE OF CHANGE IN DEMAND OF

GOOD A OWING TO A CHANGE IN THE PRICE OF GOOD B.

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

in Price of Good B)

NEGATIVE CROSS PRICE ELASTICITY – COMPLEMENTS

POSITIVE CROSS PRICE ELASTICITY - SUBSTITUTES
FORECASTING DEMAND USING ELASTICITY

INCOME ELASTICITY ORIGINAL NEW

DEMAND FOR PRICE QUANTITY PRICE QUANTITY
GOOD A 50 30
GOOD B 10 100 15 60
% 𝐶𝐻𝐴𝑁𝐺𝐸 𝐼𝑁 𝑄𝑈𝐴𝑁𝑇𝐼𝑇𝑌 𝐺𝑂𝑂𝐷 𝐴 (%Δ𝑄)
Ce = % 𝐶𝐻𝐴𝑁𝐺𝐸 𝐼𝑁 𝑃𝑅𝐼𝐶𝐸 𝐺𝑂𝑂𝐷 𝐵 (%Δ𝑃)

Δ𝑄𝐴 50−30 20
𝑄𝐴
Ce = Δ𝑃𝐵 = 50
10−15 = 50
−5
𝑃𝐵 10 10

Ce = -0.8

THE NEGATIVE RESULT MEANS GOOD A AND GOOD B COMPLEMENT EACH OTHER.
COST-BASED PRICING

Cost-plus pricing – adding a fixed dollar margin to the cost of each

product.
Cost = P60 + 10 Price P70
Mark-up pricing – multiples the cost by a fixed number greater than
one (1).
Cost = P60 x 25% mark-up Price P75