. ., - : ...i .i_-t:.

- ,1.]'.
:::1

.'.'.,::,,i,i.1':

i¡'Ji' cé '.,.
''1¡,,nj
,,i
:¡
.:--:;:d
..
;:f$
i'..1:

What is cL cynic? A mant wlto knows the price of

everytling and. tlrc ttolue of rtotlting.

Oscal Wilde (I 854- I 900), Irish author

Key topics
. The pricing decision
.
Pricing policies: cost-based, competition-based and market-led
Higher Level extension
. Supply and demand
Note: Diagrams ate not required. (O IBO 2007)
. Price, income, cross and advertising elasticities of demand
Note: Elasticity formulae will be provided in the examination. (O IBO 2007)
. Relationship between elasticities and the product life cycle
. Relationship between price eiasticity and sales revenüe
O-

.ar
Ul'lli 4.4 Pr-ice

$lHTffiStrU€3"8*$üj

The price decision is a crucial pait of anv marketins canrpaien. Deciding on the 'right' plice for a
piodLrct is not an easy task. In fact. research has shcn'n tliat manv pfedlicts fail due to poof pnci;,rv
Jecrrion.. The dilcnillra 1'rcill_q ltlan¡o:r. i-. to set a price thai i. cornpetitire r.et i).o p|ofitab)e.
S.etring roo high a price rvill pLrt off customels. This u'lll lead to lower levels of demand and
potentiai flnancial problems for the ñrm. However. settins too lo*' a price could lead to an
undesirrrble jmase for thc product thjch couid prore difficult to pur right.

Thrs then means that prices affect the irnage of a business or its ploducts. Producers and suppliers
of luxur¡' br-ands, such as \¡ersace or Gucci, might benefit fi'om some price cuts in the short terr¡r
brit sustainirl_s lo\\cf pJ'jres itr lhe lung terrll ir i]l drrlla,:e thrir lcputation. pe rhaps irrcvocrbl¡.
Tl're price decision r.vill also have a dilect impact on the level of sales revenues. Marketers
therefore need to fi¿ys ¡ eleelrn¡le,'ctrndino ^f the link between the price and the demand for
theii products.
This Unit examjnes the valious forms of pricing that a¡e used in businesses and how different
plicing decisions affect the re\/enue and plofitability of firms.

rT¡{E pRge¡NG DEClSlOlll: trRlGE RñAKERS AruE PRTCE

T'ÍTKERS
Some firms are in a better position than others to set prices. A monopolist (single sr-rpplier of a
ploduct) will heve a higlr deer:e ol'nrarket powel and the¡'efore has tlre lbiliry io set irs owr)
plrces (within reason). Monopolists are thereiore said to be price makers or price setters.
Box 4.4a outlines the various types of monopolists. At the other extreüle a¡e the firms that operate
in higltly competitive rnarkets, where balriers to entry are low. They do not have mr-rch, if any,
power o\/er the selting of prices. Such firms are therefore refelTed to as price takers. Tl-rey 'take'
the price given by othels in the n.iarket.

Inespective of rts degr-ee of market lower. a tlrn needs to foi'lnulate an effective pricing strateg)'
in ordel to meet its marketing objectives. Wrthin its chosen pricing strategy. different pricing
methods (ol tactics) are used. It is comrron for differe¡t pricing tactics to be used for different
Dloducts of llre orsanization.

Box 4.4a Types of monopolies

Pure monopolies - A pure monopolist is a ñrm that has l00vo markefshare, i:e. it is '
the sole ,r-,ppti", of a pioduct- Periraps the nearest exq.rnple to a pure monopoly might,
be Microsoft, which has over 957o of the market share in the peisonal computer l. .
opbrating system market:
Natural monopolies These exist when the market can only sustain one:súpplier. For.:
example, it is regarded aS wastefui to have more- than one supplier of telephone. cables,
gas pipes or rail tracks since a monopolist could provide these at huge savings in
companqon to many smaller firrns who would not benefit from economi,es of scale to .
the same exl-ent.
Legal monopolies * These are -firms rhat are protected frorn competition by law in
order to prevgnt )va!tefr:.I competition or in order for an essential service to be provided I

tothegeneiai.puuiic'é.g.poitalsérvicesorpub1ictransport.
I

FI
 R:gi,,¡31 fil{-rit¡,p,,li:i - T _r:: -.-: _,:-:,.
L.:: :

l. :r,:,n¡pcii¡S. ,.', j]:¡-.. -r tjte i¡ fcrnt. are S-'io tr'r be acting

against the interests of the
'i:r.:¿r'al pubiic rp:rhaps bl de lib,era¡elv
restrictine conrpetirion or b¡, price flxin,e).
{ir\ -rltment mal step in io break up the po\\ cri oj-rhe tire
moltnpnüsrs.

€{}ST-BASED Pffig€IM¡G STRATEGTES

cost-based pricing st|ategies are based on usin-l crsrs pt'otrLtcr¡o, fo cletel-mjne an approllrate
o.f
prlce.

Cost-plus pricing (rnark-up pricing)

This prici'g strategy involVes adding a percenfctge ot'predefernínecl
a¡rou,fof profit to the
average cost of productic'rn to deter¡¡ine the selling price. Both f-ixed and
va¡iable costs afe
included iil this calcrrlation. The percentage or specified amount
is known as the mark-up or
prollt rnargin' For example, if a ploduct is estirnatecl to
harrean average cosi of $6 per unit ancl
the producer wishes to have a 5a7o profit rnargin,
the price will be set at $g. Alternatir¡ely,
fi¡m wanted ro make $4 profit on each item sold, the if the
sllling price would be $10. Boeing uses this
pricittg meihod to sell its 14f lunbo Jets to cijents
such as"Japan Airl,,,., and British Air.ways.
The price cl.rarged is approximately $230 rnillion
which helps? .o".. ir, huge pr.o¿ucrio, cosis
of the'741 aircrafi.
The advantage in,sing tliis methocl is that it is srnrplistic;rnd easy to calculate.
However, cost-
relies too ;¡uch on intuitive clecision-i¡aking
,.ath.. rhan focusing o,
:i:Ti:t:t}r"ften rire neerts

A simila. strategy is floor pricing rvhich is used

for econotr\, brand.c (see unit 4.3). A verli
prtce is set to appeal to the price-sensitive low
custorrer. It is a suitable strategy fbr businesses
can survive on very low profit margins that
by selling in huge volu¡nes.
Marginal cost pricing (contribution pricing) (Higher
r_ever extension)
Marginal cost refers to the acjditional costs
of producing an extra unit of output. In other
considers the direct o'variable costs rvords. rt
of uny .*t.u ortput. Afte¡ all, fixed or indirect
change as output levels change (see costs do nor ..,]:
unit s.z;. Marg;nal cost pricing is similar to cost-plus
except that this pricing method involves pricing . ,,:-

' .,r
looking at the contribution nade from the sale
product' i'e the amount left from .f each ,,; l,
the seliing price after all direct costs of production 't¡:l
accounted for' The surplus is then used have been
as a contribution tou,ards poy;ng the
fixed or indirect costs '.;,,
of production (see Unir 5.2).
,''!
..,. :::1
for exarnple, suppose a firm had a sellin-g price of $g and clirect r ,t:
costs ar.e g3 per unit. This means ,.4.a
that the cor.rtribution per unit :.:: I
is $5 (sellirig plice minus unit variable costs).
Hence. each item sold
enables the firm to contribute
$5 towards paying its frxed costs of productio'. .I
costs alnount to $500 per tinre period, If the total fixed .,1
then this means the firm wili r¡ake a pr.ofit !
rl::
once it has solcl ::,,f
more rhan i00 units ($5 x 100 units).
'i:!
;.i
This nlethod allows a trusjness to
set diffe¡ent pr-ices for different products
,.l
,a
cont¡ibution' Hence there is'rore based on its level of
fleribility than usrng the cost-plus approach. one
using this metho..i is that it is not lirnitation irr
always easy to classify ,o,.,.r" .o.,, as elther
direct or jn.i¡ect.

527
 UlrilT 4.4 Price

¡ Exan¡ TiP!
É Worked ex6mple
'' 1\ The costs incurred by a firnr that produces h¿ndm¿de leaiher shoes are
as follows:

Cost (per pair of shoes) $

It{ateri als 1-5

Di¡ect iabour 20
Iildirect costs l0
Total cost (per pair)

Question: Calculate the marginal cost of producing an extra pair of shoes.

Answer: The marginal cost refers the extra costs incurred by producing an
extra pair of shoes. Indirect and fixed costs are excluded since they do
not relate directly to the actual output of the shoes. Hence, the marginal
cost would be $15 + $20 = $35. This means that the shoes must be sold
for at least this price for the firm to make any contribution towards
paying its Indirect and fixed costs.
Full cost pr¡c¡ng (Higher Level extension)
Full cost pdcing requires the business to allocate the total fixed costs between all the products
that are sold. This helps to ensure that the price covers all costs of ploduction. The method is
siinplistic in that it uses a single criterion to allocate the iudirect costs.
The method can be explained through an example. Suppose for instance that a toy factory
produces three ploducts: Alpha, Beta and Gamma. Its total indirect costs are $12,000 per month.
Full cost pricin,q would r-equile the firn'i to allocate the $12,000 using a single criterion. For
jnstance, the criterion can be based on the sales level o1- each product or the nul¡ber
of employees
jn each departntent. Even sinrpler-, the criterion could be to split the indirect costs équally
between
all three ploducts.
In order to allocate the ilidirect costs, frrst consider the information beiow:

Product (Departrnent) AIpha Beta Gamma

Di¡ect costs (per unit) $8 $5 $6
Floor space (square metres) 600 550 350
Output per rronth 500 800 600

In this instance, there are several criteria that can be used to allocate the $12.000 flxed costs.
 Criirrir,;n 1: .'\;rrci-tir;n inciirect clsrs er¡::aiir,

Titis is ¡ht ¡lL:iesL lllclilod ta) Ll:4. E¿1alr oi-tir¡ ti ii.': rl-t:rt-tltr!.ilis \.,,.r,.11r] bc allc,c.,_i¡;,-i iliii;.i..i.,,
of S_i,00rl rj e . il:.1)00 i -1 pr.ocluct lir,.rs)
LI-ring ihi,c ilti¡rr-nr¡ticrn. ilre in-¡ininlunr)ilice f¡,r'e¡rch i¡el'l ran liren be rleier.n-rinecl:

Prodr-rct ¡Departmeni) Alnha Beta Lramma

L)ir-cf cosr-\ (per Llni¡) SÓ

f)utput per ntonth 6C)0

Total dilec¡ costs _c

j.0r.j0

lnJilect c"sr xl lu.iltion

Totel costs si.600
Cost per-Lrnrr 5i i 6 t-rCr .s I 0 t)f_) 5i i2 ó7

Hence, charsing ito less th¿n fhe cost pel'unjt sliould help ihe tlrnr to at leest bre¿tk-eve¡. If. for
instance, the desirecl trark-up was sornething in the region of 100?á. the pr-ices mightbe $j2
(Alpha). $20 (Beta) and $25 (Ganrma.).
Criterion ?: Apportion indirect costs according to floor space
In this case, bear-ing in ntincl th¡,t the total f'acioi'',' l'locrr space i-c l._500 scluare r.ireti.es, ihe
allocation of inclil'ec¡ cost,s to each pi-odLrct js caltullteJ as follu.,i,:

Alpha: (600 / 1,500) x S12.0410 = $4.300

Beta: (,550/ l,-500) x $12,000 = 54,-100

Gamrna:(350/ I,500) r S12.000 = $2,800

Taking thls one step lulthei-, we can then cletenline the r¡rni¡nuir.r plice rirat neecls to be chltr-gecl
lbr each pr-odr-rct:

Prod uct (Dcparin'rent) Alpha Beta Camnra

Total cli¡'ect costs $4.000 $,1 000 5^ 3. ó00
Lrdirect cost allocation $+.800 $r1.100 s2.800
Total costs $s,800 Og.1rr0 s6,100
OLrtput per trontit -500 't00 600
Cost per Lrnit i $ 17.6t1 $ 10.50 $1067

By r-rsing this critelion, Alpha and Beta have higher costs per u¡rit than before aud therefor-e prices
rvill need to be set at a relatively higher level. By contr-ast, tliis r¡ethocl means that the price of
Gamma is l'elativel)¡ loiver.

Advantages of fuii costing

' Full costing is the simplest method of allocatin-s overheacls (indirect costs). It is a sirnpler
version of cLb.sor¡ttiotl co.erít1g (see 'Absor-ption cost pricin-u' on page 530).
' It is a relatively inexpensive exercise as it is simple to use, especially for sir.r-9le-product fi¡¡s.
Conplex methods of costing (such as absorption pricing) can still be somewhat inaccurate yet
are rlore time consumin_u to calcuiate.
' Managers have greater cost control by allocating a1l costs of production to determine an
appropriate pricé. Departrnents ale also held more accountability for their contribution
towards a flrm's indirect cosls.

529
UNIT 4.4 Price

Limitations of full cosiing

. irLrli cosi ¡.ncin,r is tite least aactLr¿tte llethod c,f ¿rpl-.ortionittq oYet'herd-- oi i-i"ctl tUsts.
" fltc cr-j¡el,i.n useci ic.r ¡rllocaie indir-ect costs ma\/ eive tltisleading or unr-presL-llL;ltive
irli.r.rario¡. Change rhe cr-il¿rion used to allocate costs anLl the r¿sults u'ill ¿tiso chrrnge.
r,,,ith.ur ,rry funci:rilenral shif¡ ln the productivitv or effrciencv of a departnienl.
, The ¿rllocaiion of indjreci costs i,. r-lLthe¡ arbitrar\'. Solre cleplt'tneuts-s'i1l feel that indi|ect
costs hale been r-rnfairl¡- distribirted. This call be a huge concerrr if the departi'nents are run as

plotit cetrtres tsee Llnit 5.21.

AbsonptÉon €ost p¡'r€¡ü'!g {Highen Level extensioni
Absorprion c.rsi pricins is an exteusion of full cosi pricing. It i¡l,olves allocatiir-s oveiireads by
u,orking out u,l.rich departrrent has incnrred u,hat propottion of each of the indirect costs. For
exl¡1ple, the rental costs of ¿i conr¡nerciiil bLrilding nray be split up bascd on hou' i-l'tttclr f'loor
space is irsed b¡, each prodlrct )ine or-depalt¡lent. Similarly, indirect labour costs can be allocatetl
accordin_u to lhe nlintber of ernplovees iri each departn-ient. Hence. absorption costing does not
apportion costs based on a single cliterion. 'fhis makes cost allocation mLtch fairer as departurents
acccru¡ti¡g for a larcer proportion ofoverheads are appoftioned a qt'eater share of the cosis. Price
is then defelmined from the tolal costs allocated to each depat ttnetlt.

Coilriiiiti,rg [to¡l llre lllcvit-)lr, exrrrrple. qlrpl)ose tlrrl the to) fri(to1 y') ore|lrelds cun-ist o1'Íhr
followine:
Rent $8,000

Marketing $2,000

Depreciation $2.000

lbtal $i 2.000

Tire cr-iie¡ion used to allocate the $8,000 r'ent could be tlie floor'alea occr-rpied by each
department. For example. Alpha takes up 40ch of the lloor area of tl.re factorl,
(600 rrr2/ 1,500 rr2). so it is allocafecl 40o/c of the rental costs, i.e. $3,200. Malketing costs coukl
be split accolding to the sales volLrrne of e¿rch prodllct. Final)y, depreciatiort costs could be
allocated based on the value trf nachinely used in each depirrtnrent. Using the following
infornation, absoiption cost plicing can then be calculated.
 Cosl f ,¿seJ nr;a ..) ,,:r:-c_-t;35

lnh¡ -fotal
Produci (Department) A Beta Gamma

f'lc,ois¡lce { squJre n,Érr..s ) 600 _i50 ,1,i0 1.500

Rent aliocation s3.200 st qt3 s r.867 s8.000

OLrtput (units per month) i00 s00 600 r.900

lvlarketing allocation $526 $8.12 $ó32 s2,000

li4achinely (7c orvned per 30 40 30 100

Department)
Depreciation $600 $800 $600 "q2.000

Total indirect cost allocation $,1.32ó $4.-s75 $3,099 $ 12"000

Total direct costs $4,000 $4,000 $3,600

Total costs $8,326 $8,57s $6,699

ñrtnrt' ner mnnth 500 800 '

600

Cost per unit $ 16.65 $ 10,72 $11 17

Thel'efore, the price of each product rnust be set above its cost per unit in oldel fol tl.re business to
make any profit.

Advantages of absorption costing

Absorption costing shares many of thebenefits of full costing. In addition, there are other beneflts
of this method.
. The method acknowleriges tbat using a single criterion to allocate ail indirect costs rnight be
too sinplistic for multiproduct fifms.
. It makes managers more aware of the total costs of a product. This helps to ensure that an
appropriate price is set to cover all costs of production.
" It is seeil as a fairer method of allocating costs to different'departments since it tal<es into
account differer-rt rates of contributioir towards differeilt indirect costs.
. The profitabiiity of each ploduct line or department can be examined.

Limitations of absorption costing

" Not all indirect costs can be divided accurately. For example, it might be dilficult to apporlion
the costs of insurance or stationery. Ar-ry criterion used i.s likeiy to be rather subjective.
" This ruethod is more complex to calculate than full cost pr-icing, and hence it is more time
consuming.
' The relative benefits of absorption cost pricing may not be significant to justify its use. This is
especially the case in smaller frrms that may lack the time and resources to use this method.
Finally, i?is important to ¡emember that whatever criteria are used, it is impossible to accurately
allocate all indirect costs due to the rather subjective nature of absorption costing. More
importantly, the indirect costs must be paid irrespective of whether a particular product is
rranufactured or sold.

531
 Ul'.li; 4 :1 Pr ¡r ¿

Question ffiffi
, , r.roIEs-it-Us
l;¡lis-R-Us is a rranufacturel of toy clol1s, 1,,'it]-r three ploduct l',ires: Penn\'. J¿L¡les and Lori th-
.i:,i. lts riirli¡-!iil li\t.1 r()sii iti SSi.000 ceursist of the follou ins:
R-ent Slti.000
-l,drrinistr¡tion S2-í.0[)0
Depleciation S1l.C0ii

5
üthe r 5i1l.00ti

* InfLri ni.rti(,n oil fhe Lhree plc,rlLrcts is sliou'n belou,:

R
rl
F Pennl, James Lori
&
fl -!clling ¡:.rice '5 t+ .s l0 "\t0
n. Dir-ect costs (per unit¡ 5i1 S3 $5
E Ditect ialrt.r-u- cosls (per unit) $3 ca
$5
in
é. Sales volLrnle (tinitsl r.i.000 l -5.00{) 15,000
\, Nrrmber of errylr:yee s 2 3
ñ..
Fui
-l

ll:r'.ir¡l
FJ.iur'':p,,¡,' ls-11llrt, rndlres ] 3,000 3,000 4.000
i':i ,r;:,.:
$30.000 $2s.000 $35.000
:ljirt:' I I I

. ::'
1...,¡, a Outliile th,-'eridcnce thlr. slrsgcsts Dolls-R-Us has used a cost-basecl prícing
' stt'ltleq\'. [2 marks]
, l:,: i¿ C¿rlculate the Lrnil contlibution for-each of the tht'ee products. [3 morks]
c Er¡ririr, tlrn'c cliit'r'ir, tlllt i,r,ould hi approirrinte in allocrrillg thc firrtr's lixed
,.,lt. cosfs to eacl.i ol'the three products. [6 mcu'ks]
,
:,¡,1 d l]sc'. ),our ¿rns\ver lo Question Lc to a]locate tire tot¿rl frxed costs. Prepare an
.., iinal¡,si5 of the tot¿rl cr¡sts. total revenues ancl prolit for each plocluct. [9 mcu'ks]

€@FW PffiTHTEffi fi1$.ffiASEM PMEüSR¡G sTffiAFffi GEES

(',rr11.¡titi.il bi:r'tl¡'r i.irr3rrl:r¡krrr,r.rxsrotnllet!tioi¡-orientateclplicingrlcJel'stoafirm's
l.riicinc stfategies tir¿it ut'e based on the ¡rrices being chalged by its competitols. Prices can be set
cclLral to. lor¡,er tirau ol higher thrn those cirelged by othel firn-is iu tl.re industly. This strategy does
rrol 1.ri'inlrrily talie inlo consideration the costs of production of the level of denraltd for the fir'ltr's
plociucts. Thei e al-e several categories of cor.npetition-based pt'icing rnethods:

Frñee !eadersFrúg:
Pr.ice le¡clership is lt strateq)/ that Is often used for best-selling products or brands. Tl1el'e are ferv
sLrbstitlrtes. rn the e,ve of the custonrer', fol sr-rch products so the dominant firm cau set its own
p;-ices. Cotrpetitors lhen 'follow the leacler-' by establishing their prices based on the price set by
th¿ mal'ket (ol price) ieader.
 l,4a itl?.a ii:i; 1t:.iiiI E si.¡t.j,i i aj j

FredatorSr pr¡cirTg (*igher- Leve! exier.¡s;sn)

Pl'¡tllior-t piictnr: is sli,tlJ,ql that iir.,.ol',,es ¡anlpoffiill\/ r¡,lLlcing ¡tnil: trr 1lt iLLic;¡l,t iv trrr-c
Ll
t';i:rl,s ortt c,f the irtriustr'\ since tll-v cilnltoi corrpete proiitabl_r,. Due Lo rit* ;rgeressi.,,.- nzl,Llr.i r..ri
tilrs strat.g\'. it is sc,ilelinie:. referred tc as c!esír:c1 er pricing. fltLi -str¡tegy ofter sien-is fi.crr ai,r
c\t-ilsjoll of a price ua¡-. iir-rrts crrntpel¡1 lrr'á series c.Í' jntensive pj-ice cLlt5. This rnighi
-\'ell mesr'l s¿jline ¡rroditcts"'.herel-¡i
Jt Lrelc\.,, clii . lf the st¡are.rv js sr,¡ccessfirl. ti¡e Ílrii^r u'ill bene
iti-ice i.ri
iionl ili a I.l-iol-e clomi¡lant position. and c¡Ln therefbl"e iarse its prices to recoup:rny iosses
bein,q
incrirrecl rlhiisr usin,e predatorl pr.ices. This lietbod is likel¡'¡o be usetl u,hen an eristine firnr is
tl']reltclled v'ith neir.'compe¡j¡¡6¡i uhich rL beiier'¿s u'ould h¡tnt'i its nrar-ket sh¿rre and protitabiliti,
,{lthou.-sh pt'ice wlrls can brins sonr: benet-its ro customer-s in tire short tenr. predatorv pricrng
i¡self js ille-sal jn sonre parrs of rhe *orrir rsLrch as rhe USA ancr the l-ÍK) since it is r.esar-clecl ¿s ¡Ln
:rnti-conrpetitir e practice.

A sinlil¿rr pricing stratesv js c¡rile.i !ir:rit pricing ol pre-e*r¡riive pricing. l-his nrethr¡cl inyolves
setting pr.ices.iLrst low enouqh to discoura"e potential ¡ivals tl-om enterinq the ntar-ket. l,inrit
Lrrlcing the¡e1bre acts as a barrier.to enrr),and is especiall¡r suiteci to mat.kets u,lrere eilirv bar-i.iel.s
at'e iorv Howevel', both predatory pricing and limit pricing are anti-conrpetitive and nr¡tv dr-aw
the
atiention of the autliorities ovc-l-seeing r-estr.ictive tracie pr¡as¡icss.
ii

Golng nate prEcing (FEigher Leve! extens¡on) i;

The 'goirrg rate' I'efers to the ai'erase price being chalged bv cornpetito¡s in the inclr-rstry. Going ir;

|ate pricing therefore.is a pricing method whereby e firnr charges r sinrilar price to that of *E
competltors for their goods or servjces.
ti.
u
Question ffi
The price of price wars
The rvorld's largest supermarket chains (such as ¡,Val-Mari, Cari-efour and Tesco) haye huge
marketpovver to reduce prices. Price reductions are a key technique used by supermarkets. For
erarnple, the UK collsuüler has grown accustorned to supermaiket price v,ars, rvith over
€l llion ($2 billion) of price ¡eductioirs each yenr. Price u,ar' rre also in..reasinslv cornnrorl
bi
in the airline aud mobile phone industries.
a Describe what is meant by a price war. !2 nmrk.tJ
b Exaurine the winners and lose¡s of a price war in the short run and the
long run. t6 tnarksl
c Justify two forms of non-price coilpetition that supermarkets miglit use to
increase their cornpetitiveness.
[g nnrks]

trIAffiKET.LÉEP PMACÉEUG STffiATEGFtrS

Unlike competition-based pricing methods that rely on the actror.ls of conrpetitor-s, nrarket-lerl
strategies are based on the level of custome¡ demand for a finn's proclucts o¡ the level
of der¡antl
in the industry in which tlre firm opérates.
Penetration pr¡c¡ng
Penelr3tion pricing is a strategy used for a new product to help establish itseifin the industry.
This
method involves setting a relatively low price in o¡der to gain market share and brand awareness
Over time, as the product establishes itself, the plice can be raised (see Fi-qure 4.4a). This
strare-sv
is sLritable for mass market ploclucts that sell in large enough volumes to sustain
low profit
mar,qlns. sttch as fast mrlving consurler goods (see Unit.1.3). It also applies to new
firms trl,ing 1e

533
 UNI'f 4.4 Pnce

enler rt'ell-established marliels. It is lrighlv suitable for pr-crducts thn ha¡,'e tthizh ltnce elcLstici^.of
c!entat¡cl (see 'Price eiasticit',, of denland' on ilase ,5.12 ) ri,herel¡r, Jo*'er ing pr-ice ir jll jead tr.;
propor¡ionltúli, irieher sales voluires. For exarnpie. Brilliance Autonlobiles of China launchec.l
irs
ca¡s in Europe in 2007 at erotr nd 1 i l¿ lower than the prices of rival Korean rranufacturer.s such
as
Hyundeii. One potential dmgel u'jth this ntethod rs that setting prices tcro lou,could n.lean thatthe
mrrket 1¡3v perceir e the pr,rduct rs inlsljor anJ tlf poor- qurliti.

Tll.ne

Figure 4.4a Penetration pricing

SkimrninE pr¡e¡ng
Price skimming (or skimming price) is a strategy that tends to be used for tech¡ologically
advanced and innovative products. Since ¡zev., prodtLcf developntent can be very expensive (see
Unit 4.3), a high selling pr:ice is initially setto recoup fhe costs of research arrd developnre¡r. Tl"ie
strategy can also create a unique, high quality or pr:estigious image for the procluct. In addition,
sitlce there ar.e unlikely to be n'rany, if any, substitutes on the market, the finn can charge a lrigh
price to maximize profits before competitors afe attracted to the industry. Games consoles,
mobile plrones and flat-screen televisions have all been plicecl using this strategy.
Due to the higit potential profits that can be made, it is likely that other finns wili be attracted to
enter the industry. When this happens, the original firn-i will skim, or gradually reduce, its prices
(see Figure 4.4b).rt is inrpoltant to remenrber, however, that marketin-q, b), its very natur-e, is
int.egrated. Skimning price can only be successful if it is sr:pported by other elements of the
marketing rrix, especially promotion. Brandin-9, for example, is vital to ensure that pr-ice
skimnline is profitable fbr a business.

Ti¡.ne

Figure 4.4b Skimming price

An alternative strategy to skimming is prestige pricing. prestige pricing jnvolves a firm
permanently setting a high price because of the irnage, reputation or status associated with its
product. The method would be appropriate for pricing products such as designer- clothes, luxury
cars-and liigh-class jerveller-y. For customers of such products, the price itself would not be of
ma.¡tr concern.
 Lr¡,1 a,_l_l p-i..i-,q . -,-,¡¿ ,,-.,

Fr! ee d iseri rl.t¡ nat¡Gn {l-li g her !-eve! extens¡ cn}

l-:-jr.: cljscril¡tnttir-rn o;.r-Lts $lrcll
i'
LIle.)Jini pl.'.iii¿t. r-tsrtell-r ¿r sei\'ia:i. solcl in dilf¡rcrrt lll:rllci\
acr. Fo| e":aiirple . chilcren ¿rnd adults pal'clii'i'ert:nt
ai jilTer-e.¡tt pii,,es. TlIs i-i a pelfecrl,r'1egal
t., s¿Ln.ie cillel1la. ilreme prrk or hairdi'essel's
eitie ri¡,-S the The p¡od¡ct the5' pa¡ for i:;
1..rI.., ciiscrinrina¡ion is someli¡ie:
beinv cha|gecl ae ciiffel'ent. Pr-ice
essentiailY rire sainebur the pr-ices
r¿l'et't'etl io as r ariable pricing

Businesses are likel¡, to raise pr-ices

duling peak periods. For erai-nple. airiine companies incre¡se
th.irpri.", durin-l the chl"isinlas an.l summerholiclav peliods. This is partly because there is
incl.eased demand and iai-gel.r,because
firns knolv that tl'le price elasticitv of demand (the degree
of ..rponsi,,.ness of demand to cl.iitilges
in price) during peak pe|iods is lower'. so custolners are
alld ate less sensitive to p¡ice variatioi.ls'
more willing to pa,v higher-prices
price discrinination is not only about settine higi-rel. plices to those cllstomei's that can affbrd to
p¿r),. Statistically. i-estau¡a¡ts anci
cinem¿rs throughout tlie rvorld face theil quieiest trading day of
rhe week on a Tuesclay allcl that is u'il)¡ ina¡v
of these Lrusillesses offer discounted prices to cliners
ancl cinem¿L goers on TuesdaYs'

Thei.e are three contlitioils that urust be met in

order to achieve successful price disc|itr-iinalion:
in
. Tlie must hat,e sonle clegl'ee of monopoly and price-setting porvel's' Hence, firms
fi.n
hi-ehly cornpetitile m¿rrkets would be unr,vise to use il-lis
pricing stl-ateg)r'
. (degrees of willingness to pay)
Custoners must have different price elasticities of demand
otherq,ise the firm cartnot set ciiffelent plices to different customels'
a child callnot sel1 his or her
" Mar.kets must be kept sepalate to prevent l-esale. For erampie,
ci;le ma or bLrs iitker to all r.ittlt'

A sir¡.rilar strategy to pr.rc:e discrin-rin¡ttion tiiat is used by r.t.iany lalge

nlltltirlationals is trallsfel'
pricing. This refer-s to the use of internal p|ices beiirg charged to otl'ier divisions of
the same
to coutrol tl're organization's costs. l¿lultinationals also use trarrsler p|icing to
.o,',prny. This helps
rer_luce tax liabilitjes by charging higl-r interi.ral
prices to sections o1 the business located in
co'utries with irigh tax rates. This, thelefofe, artificially but legally recitices pro11ts, ther.eby
ctitting the conlplrny's tax bili.
Loss !eader (Flig*'ler E-evel extension)
l-oss leacler pricing involves selling a product at or below its cost
value. This is a sliort-term
products at the same time as buyittg
strateg)/ that aiuis to enlice custorners to buy nore profitable
the loss leader. Retaijers, s¡ch as supermalkets, oftett use this strategy by
heavily lnarketin-q the
loss ieacler in the hope of attractin-{ customers. it is unlikely for cl,lstomers
to simply 1:r-trchase
can attract
only the loss leaclei. rvheir visiting a supermarket, but the exisience of loss le¿rdel's
used to iucrease brand loyalty,
lutany clrstomers to visit the supemrarket. Loss leaders can also be
which in the long te¡¡ cau ¡rake up for any losses incurt'ed whilst the product was priced at a

los s.

console ¡takers, such as Sony, Nintendo and lv{icrosofi, often sell their hardware
at a loss
G¿rrnes
the Sony Playstation 3 costs $800 pel urnit to make. br-rt is sold for
to attract buyers. For example,
berween $499 and $599 (see Question 4.4.3). The aim is to lecoup the loss by sales
of
cornplenrcntary goocl.s, such as gaming software. and collecting royalty payments from games

rnanufactulers.

535
ur\r 4.4 l-'¡'ta€

Question ffi
Sony Play5tation 3

Sonl' iaunched the Pla¡'Station 3 in late 2006. It rvas quick

to u'in positile revieu s. althou-sh analysts questioned the
price which \r,;as set at o\ier Sl00 nrore thaii the Xbox-360
liom Microsof¡. its main rival. Sony said its state-of-the-art
ss¡s¡rle rvith a built-in Blu-r'ay DVD player made the
premium price value for monel'.
Despite tile h jsher prices clrarged by Son¡. the Jrpanese
r¡anufacturer loses money on each games console sold. It
ruakes up for this \\hen customers br-ry several games and
other softrvare proclucts fo¡ the duration of the PS3's
oroduct life cvcle.
i:1,fi ;*";iüit jil'.lliilii, :';[: iil::: :fl
"

a Define rhe tenr premium price. [2 marks]

b In the context of the case sfudy, examine the ¡elationship between a product's
cash florv position and its life cycle. [6 nnrks]

Fsychological pricing (FNigher Level extension)

Psychological plicing is a strate-sy that involves using numbers, such as $9.99 or'$14,995, to
make prices seem lower (than $10.00 or $15,000). Hence. customers psycholo-qically feel that
they are gettilg a balgrin or better price fol the product. This niethod is widely used and cau r¡'ork
l'or ulnrosl lny produc{. from elocerics sold in n supellnarket to expensive r¡lotol velricles or
lesiclential plopefty. Psychological pricing also works well when selling tlre sar¡e product in
larger.quantities. Forexample. supermarkets rnay sell a product at l;4.99 for one or $14.97 for
three (the price is exactly the sar¡e per unit but it can be deceiving to some cnstomers). It does not
wor-k rveil for some businesses, such as taxi fir'ms, since rounded or whole number figures are
more suitable for the customer and the service provider.
Fros, rotional pricing (Fllgher l-evel extension)
Pronrotional pricing is often used rvhen marketing new products by chalging a low price to entice
cllstoiners to tly the product and to build brand awareness. It is comr.nonly used for products suclr
as food itenrs sold in supernrarkets. Promotional pricing is also used to get rid ofexcess stocks or
to renew intel'est in the business if sales have been falling. Promotional pricing has two key
charactelistics: it focuses on pricing being the most important part of the marketing mix and it is
only used as a shoft-tenn measure to boost sales or market share. However, critics ar_eue that
plomotional pricing is limited in effectiveness since rivals can simply copy the technique.
Promotional pricing is very similar to discount pricing in that both attempt to raise malket share
by lowering prices. However, pronotional pricing tends to be used at the beginning of a product's
life cycle wlrereas discount pricing is often used later in a product's iife cycie, perhaps as an
extension strategy (see Unit 4.3).
Pricing stlategies are summarized in Table 4.4a

a
 HL: Supply anc' Ce.n¿ncj

Table -1.-Xa Sumnrar.v table oi pr!cing sti"ategies

Cost-based I Competition-based
Cost-plus Plice leadership Penetration
I'lurgittal cost Pretlaron ¡:ticiitg I JKlmmt¡_c
Full co.sr Ooinq i ate P ri t e d isc ñ minitti t,n

A b.s o t'¡t t i tL ii c' o.r t L0,t.c le0clei

P,st' t' I t o I o g i c' a I p ri t i nB

P ro nt oti on a / ¡: ti cí tt g

Note: Pricing strategies tn iralics appjy to Hisher Level stude nts onlv-

Question re
Virgin Blue
Virgin Blue is the creation of Sk Richard Branson, founder and CEO
of the Vi¡-ein Group. The airline carrier was launched in 2000 by
Sir Richard Branson and Virgin Blue CEO Brett Godfrey. to enter the
Australian market. Initially set up as a low fare carrier, the company
only flew between Brisbane and Sydney. Siuce then. it has becolne
Australia's second largest airljne. catering for all major cities ilt
{,*W-u E

E
E
AustraIa. Customers pay for their in-flight meals and drinks. To
further cut'costs, Virgin Blue uses a system of eticketing (a telephone F

and inlernet-based tickering systenl). E

a Describe three potential pricing strategies that airline coripanies can adopt &

when entering a new market. [6 nrarks]

n
6

b Evaluate two possible plicing strategies that aL'line carriers such ts E

E
Virgin Blué could use to increase their sales revenLle. [8 nmrks] s

t{lG}lER LEVtrL EKT'EruSlOlü; StrppLV AruB f}EfutAtUtl

Econonrists define demand as the )evel r:f abilitv an.d wíllüryne,es to pay a pafiicular price for a
product, per period of time. The theory of dernand states that the liigher tlre price of a ploduct, the
lower the demand (abiJity and willingness to pay) tends to be, i.e. there is an inverse relationship
between price and the quantity dernanded (see Figure 4.4c). The vast majority of products
conforn-r to this rule, and are therefore known as normal goods.

Price In general, as the price ofa product

($) falls, i¡ore people are able ar.rd
willing to purchase the product.
Hence, as price falls, detrand telds
to rise.

Quantity dernanded

Figure 4.4c The negative relationship between price and demand

537
 UtrllT 4.4 pri:e
. Deterrnlnan,ts of tl-¡e f eroe! of
den¡a¡-¡d
price i-<.'¡ttheo.li'irtc¡oi'rhrr¡aiiecrsrhelerel.idenrendior.apr..clucr.oLher.l¡Lcr.¡.
i|.'1::i::''
' cr¡nsul'e¡' itlconle levels
- The hi3herdre le'el of incoine. the hiqire r der.¿rnci
pLrr':hasj,r-t tends to be
i'61i¡'. This wiu s.".;;,, i;,;rl.r. ,r.," te'el as
ir-"".1';.:]il:,:fe3ter of dernand ior
" P.ice and ar''ailabilit'v of substitutes
atailrble' the lowe¡ theprice of - Generall-v,
the higber the number of substirutes
a proouct tends to be. F'ier-ce thar a¡e
i ind,strl has' lb¡ exarnple' teducei conrpetition in the air-rine
p.o-, of aiirine rr-aver throushout the
' orcomplements rhere rs
-
w,or.rd.

li :;,ff11:;:'l;:""'' " ".;.,'";,=;ir'onrr,ip berween the p¡ice oI

fori¡s complement Forerainple.
of printers.,i,.,rt'lt"""d
:ntand for ink cartr.idges is
irin"r. is an increase in theprice
likelv to fall.
' Qualitl'-The c¡ualit¡'of aprocluctcanret-ertoanvconrbinationof.irsrreqio,.
reliabitiry. r'earui-es and funitions h,.irr ^. ,.
¡r-. un,r 5.:r). Sporrs cais a'd:j.::::.::':-l:buird-qLrali¡,,
ef [l'lr't certlilt c]ieitts -vcn ar rrp,.,, r.i^r _
i*',o,r, ##.o ñ'J H: ffiT ill'rLlf
"
ra c r o r sen e

N{arketing - The successful

ra,. o ;'l':',.;;;,"j m H j:.' "'' ""
_n o

use of persuasii'e aud/or

of advertising or celebritv informative n.rarketing, such as the use
"ttoot"rtinirlun uoo* demanr.l ro. ...ruin prodLrcts. similarry,
to dcrer.:rnokin,q arrd dri,kjng
;i,J:lJ::]|j1):l,l::1""'s .u,' .m..' the den,end ro,
" Fashions' habits and tastes
- Trends and changes in fashion will also alTect de*and.
coverage or marketing activjties Media
can arter fashio"n ,"¿ ,"ri".
i''espective of the price revei. r", ,u.t, popuru. products,
The n;0. r;;;;,üiioro," diet has h"..,.,"á mrny
Irisir poraro farmers who have
..." ál;;;"r,j,:^1,ki",
drop in demand fbr rháir crop.
. Utility (or level of satisf-action) _
Custome;rs are more wilJiitg
thejr level of satisfaction to pay for products that inc¡ease
cieriveci fi.om the
,,vho is ra'aric abour a parricura^o",,
' speculatio'- Expectations a'd forecasts "i,,iii;'Jiñ"}ii:Jff:,,jiili}T,".1T|"tJil*
can also influence the lever
of dernancl. For
ilT5lT;1i,,'1,il?:i';,::l}.|ii::,"J::;;jl'1es are expecred ro rise sread'v, rhar rajse the
. 'igrrr
State ol f he econolnv _ Whether.
the econo
just inciividuar income
revers b'r ,'r"
'or
::,;:f::""rclence
in rhe economy jr'i;;,""!.rritr"tlffi::i::r1:::iifi::?TiJ
;, cá' trigger.o"". u"i,r*
ffi";:
and a tack of consumer
' Perceived rever of varue fbr
money - Demand ten!¡ to rise if proclucrs are seen to be of
Ait hotels' ro'exampie, orrer
:,T:!",.] ;iHiL:T"ev buffet rrears (breakfasr, runch
. o,,rers _ rhere...
and/or

weather, different seasot.ls, ".ii:,'l,:ff;:ilT::J",l:*.,;,":^_

age of customers, peet'
rbr a produ* rhe
and religious beliefs are ' influence or pressure, rivalry
some exarnples. and cultural
There are, however, several
exceptions to the
. -qeneral law of demand:
Ostentatious con¡
makerhe.,,,"*.,iil1,',;üifi:Jil::,::[:n]:..Jfi
knowin-e the higrr :il?il:.*T,x.li:::TlTi],:x
'/ Rorex watches, Nike trainers,
,": trr. p.oJu.t Exampr.Jinirro"'cnr,r,,rn
i:::r:r: Dior perfumes,
Armani s,its and veia \\rang
*..d;i;g d¡esses. Demand wourd
lii,llt::ffi:,'i::J::.'""uur 'i,,uiio,,j,in.. the prestile anl*excrusiuity associared with

538
 H L: rl._.¡ppl), anal demand
. L.o¡tSptcU()¡r-s C(¡nS¿tinptiOti refer_s to the laViSh spenciinr of sr¡me {r,r_¡i,
the purlrr.,se crf Lrpholijin-e l.ich) cusronr¡rs lirr
th¡ir social starus
rser enes1i,. -1 .r -i r rhere is c,iie n a
,,-Ji'i'-,ii'JJ,,'*J'i;*".]i:J::|:'.:Í:li"'i;; l:'J,-.
.. irstentatjous c.tl-sitl'l.tptiott. but the larre=,.,"
r is aJso boLight rrr, p.of i. iu'no are noi
ren'1righ incon.ie relers. Conspjcucus consunrption necessar.ijr o ,

i.s a te,-,r, coined b,, ihe f9;-c_;;;;

'{ill-ncai.r econor.uist Tho|siein Ve bren. Erirmples ol \éblen g"oá.
-xl-r¿¡51rt' Iuruil'cars (suclt
in.tro. ..u.,"_ir-
Rolls-Royce. Bentle,r ana ltri,racnr.,rj
as
as original paínrin.s i.onr picasso
.-o1t-.,.r1 ,'*n-,r,ru.n
and \hn co-eh oiunique u.,y expensr'e
stalrps). corns ancl
",ra
' Erpectations of fiitLrre prices ha'e an i'porrant
i-ole in the cle'aricl fbr cer-tain products.
as stocks' shares' propertv ancl forei.-en currencies. sirch
when pi-rces r-rse but people believe ihat
thele will be further jncl.eases. der¡a-nd nrry also rise. Stock and property
lai'gel1' by speculirtion of higher der.tancl bootls are caused
fo. shares and propertv clue ro expecta¡rons that
pnces r.i,ill r.ise in the luture.

' Giffen goods ar-e goods named after 19rh centurv

economist. Srr Robel.t Giffen. q,ho
discovered that whell tire price of bread
lose, people (particular-ly poor.farnilies)
money on bread (an inferiol'eood) because spe'trnorz
otheriL,bstitut. p.oauJrs r,,.h os meat
were still relatively more.expensive. The and fruit
opposite rvould happen when prrces
fo¡ Giffen goods wourd drop as prices feil (see fell. i.e. cler.nancr
Box 4.4b fo. o nr,.,.,..,.aI exarrpre).
eramples ol Giffen goods might include otr.rer
basicf_oods such a.s poruro., anci rice.
In reality, it is
rhere are anv Girfen goocrs. However,
tr,,";,rtn"o."¡;.ar possibility has stood
[rjlj]tb:?:'l:ther
F1

Box 4.4b Numerical example of Giffen goods

,El
A co¡lstuner has $5.00 to spend.
E
' Consunrer buys 3 kilos of potatoes at $1.20 each- plus
r -" -I .\1rv
kilo vr
of Jdurdr
sausages at $1.40 f=
I ($3.60 + $1.40). ll
r Assume the price of potatoes subsequently
falls to g 1 .00. q
I The consumer now buys 2 kilos of potaroes (g2.00)
plus 2 kilos of sausa_{es ($2.g0). \t
H
'Hence,aspricefai1sthedemandforpotatoes(theGilfengood)fa1ls' HJ

-- '- ' ,.-

-'_. ---]
Question
ffi
Sony PSp
Fans of Sony's hand-held galnes con-sole
can personalize theirmachines by
rhe various
:::::j::: 1l"t]10,t"
oeparrmenr srore
on rrre ma,.ker. if they *"'y
*""i1";;;;;J rhe ;;;;;
crowd, ruxury
Har:rod:. ir] uK. sell thq ultimare
!oid_o: púat, so,ry Fse .over. The exclusive
offering is f'om uS fashion iabel Baby witn a gold anri jewel-enc.¡sted case,
staggering {20,000 ($3 9,200) I priced at a

. Explain.why anyone wo,uld want to pay such

a high price for a pS^ l

that is charged ur'ou., r:o ti-.-¡'Á.'ü." t rhe psp

*o-", "onrol"accessory [4 marks]

539
 Ui\iiT 4.4 Piice -
Supply
to piL-,\ ld¡ i-'r.t,'L'::-. ::l gr', i-
Econontists cl..fine su¡lpl¡. ¡.s tlre u illlngness rn¡1 abilii'r' oí fl|nts
nric... l:r ¿l¡. ¡re i. l)ei-ruLl of time . U,<iral11', the hief ier ihe tnarket price oi a pr-o.1uct. lhe m¡¡i: '.,, i,r:-.
.'n¡ i¡]. produ.-r' ef¿ Ltl sLlppi)'pr:oducis io tile lllafket (see Figr-rr':4:id,l 1-h:r-e 3i3 t\t.o
beiiveen prjc¿ 3nd tir¿ level of sLrppl-r'. Filst. erist-iirg fi¡rns can "utt't.
maf:t
fcr this posiri'e r-elarionsl.rip
higher so \vill suppi¡' moie. Seconcl. ne\! fll ills r"'ill be attlactid io
,,,or- prtf,, ri,hen price-s are
enter th. ¡¡aiket r/llen prices are hi-cher-

lrr seneral, as tlre nrice of a p:'oduct

rises. ilore L¡usinesses are r.villing
anC ¡ble to suppli the producr.
j...',, Hence. as plices rise. supply a)so
,j. ::: t¡nds to rise.

:;;' :

..ii::
+"tl

,l:,t l, Quantitl, suPPlied

'l::.
.

ii.tt Figure 4'4d The positive relationship between price and supply
i:ji';,i
Determinants of the level of supply
:::1,::
:;n:
U;:.:
a:,i . price of r-au' materials - Il the price of a raw material, such as oi1, increases it will shift its
+,Ét
[t sLrpply curve to rhe left (a11 other things being equal). Since costs of production subsequenily
'.!:','
3i'.., increase, this neans that less will be supplied at each and every price level (vice versa).
É.]¡:i
, Barriers to entry - The nature of entry barriers to rviil deter|nirle the number of
a mai'ket
producers in the industry. The higher the entry barr^iers, tlre smaller the nul¡ber of producers
X,
iia;:
g.'.a,:: ancl hence the lower the level of supply tends to be. Due to the extremely high costs of airline
luauufactllring, Boein-e and Airbus dominate the industry. At tin.res, finns may deliberately
ij.
ti.a erect llarriers to entl-y to detel new finns fi'orn entering the market. This therefol-e limits the
!¿"
1:t,
srrpply in lhe rnrlkct.
¡ir'l
" Technology (production rnethods) - Advances in technology will shift the supply curve to
*¡,: the rigl-rt. If improved production techniques become a\/ailable, a larger output can be supplied
I;;:ii..
at each and every price level clue to higher productivity and lower Lll')it costs of production.

"-r&
r¿,H!i
. Taxes - These compulsory charges by the governlrent cause hi-eher production costs, and
therefore redllce the supply at each price level. Hence, a sales tax wouid shjft the supply cun'e
É*::Í
Éi+i:
tifi
J"6 of a product to the left. Products that cause additional costs to society, such as tobacco alid
fá$ alcohol, tend to be taxed heavilY.
Egll
ÉE:
,J:fr . Subsidies These have the opposite effect to taxes. Subsidies, such as business grants from
-
,"+,ui
ütr
'dtJ the government, are a means of financial aid to reduce a producer's costs. This should then
lead to higher levels of supply in the market. Products that yield additional benefits to society,
j"i+, such as education and healtlfcare. may well quaiify for subsidies f¡om the governlnent.
S¡¡l
ft91
!Lj!
. Price of related goods - Thele are two types of related goods: substittLtes and conqtlenterús'
É,i1 In terms of suppiy, some goods are in competitive supply, i.e . one good can be produced
f¡$ quite easily as an alternative to another good. An example wouid be Coca-Cola which
If¡l
itíi¡ produces Coke and other drinks such as Fanta and Sprite. The ploduct with the higher relative
?+i profitabiliry will be produced and supplied in larger volumes. In the case of joint supply. an
f.ri:* tin.r.or.
$i;: in the production of one product necessarily increases the supply of another (joint)
¡¿íl
*,i$ product, such as cows and nrilk or chickens and eggs.
ELÉ
fu:i
Ff
R]
E*
tr
 HL: Supply and de¡rani

. C_'limate (or weatlier c(rnditions) - Fol agricullural pro.lrcts. such as fruits and veg¿t¡rbles. th¿
clit11ate can ha\,e a lar'_qe irrrpact on the qLr¿1niit¡'suppliecl. Faroura,ble \/eatitercc-rnclitions',',ill
l¡oost suppl¡'. D|oughts. floods anci otherunfa\/ou|abie ty'pes of
;,ield a good return. i.e.
..$,eather rl,ill result in poor han'ests and therefore reduce strppl¡'.
. Time In rhe inmediate o¡ shorl tenn. it can be very difficult to alter the level of suppiv. For
-
instance. a_ericultural prodlrcts take time to hart,esl. Aircraft take a verv long time to
lnanllfactufe. Over time, prodllcels can adjust their supply to suit ma'rket changes.
Funl1e¡more, new resources and supplies may be discovered in the futui'e. thereb¡r tncreasing
rite level of supply.

Question ffi
Hurricane Katrina
In 2005 Hur¡icane Katrina caused a síx-month halt to oil operations near America's Gulf
Coast, affecting about a quarter of the USA s oil production. Shell, for exemple, announced a
fall in production of 420,000 barrels of oi1 each day. Subsequently, oil prices soared.
a Identify two deterrninants of the demand for oil. [2 marks]
b Explain how natu¡al disasters, such as Hurricane Katrina, can push up
oil prices. [4 marks]
g
g
a
Al1 markets require buyers (who liave demand) and sellers (who create supply). The point at
which the amount of a product demanded equals tl-re amount supplied is known as the
&
equilibrium. At the equilíbriun.r price, the wiliingness and ability of customers to pay lratches
rhat of the suppliers - buyers are able to get all they demand at that price and films are willing ancl
F
v
able to sell that same amount at that exact price. Therefore, both parties are satisfied at tlre
equilibrir-rrr. The interaction of the denrand and supply ctlrves (collectively kuown as market tr

forces) in Figure 4.4e shows the equilibrium price and quantity fraded. t
The folces of delnand and supply will, if lefi to their own devices, clear the market of irny excess
der¡and or excess suppiy. In the case ofshortages (excess denrend). prices will t'ise to deter
excess demand or to encourage nore supply. F,ither rvay, prices continue to rise until there is no
more excess. In the case of surpluses (excess supply), businesses will offload the excess stock of
products by reducing prices until there is no more excess. Hence, unless thele is a change in tlie
coltclitio¡s of clemand or supply, the equilibrium ptice will prevail in the market. Any change in'
dernand or supply will, given time lags, result in a new equilibriuin position.

Price
(s) Ma¡ket forces ensure that an
equilibriun price is esiablished (p.)
where del¡and equals supply. This
will also determjne the equilibriurn
p. quantify traded (q").

Quantify traded
q"

Figure 4.4e Equilibrium price and quantity

541
 Ui,iiT 4 4 Price

Question

,.The socrts industry

Tire summe¡ of 2008 saw n-rajo¡ sporting evenrs such as the olvmpic Garnes in Beijing,
the
\\iimbledon tennis fina1s held in rhe t-iK. ¡he 20C8 Ru_vb;-.Lea-rue R/or1d Cup in Austialia
and
the Euro 2008 foorball chanpionship held in Austria anci sr',itzerland.
. Explain hou,the h¡,pe u,ould affect the market for sports equipms¡¡
and sportsrvear.
[4 marks]

${lGHtrffi LEWgg- EKTffiggSEGffi: ffiLÁgTEeAFv

Elasticity of clen'rand refels to the iechniqLre of measuring the degree of responsive¡ess
of
quantitv demalidecl drre to a change in a specific factor that affects clemand.
Exanrples *,o,lcl
incltlde changes in price, income adr,'ertisin.q ancl the prices of oiher ¡elated pr.oduits
(complements or substitures;. There ere foui' nain measures
--:l': r.:
of elasticrty of demand:
,i:,::l'
:.i,,::
' Price elasticity of demand (PED) measures the de-qree of responsiveness of changes
in
r.-;ri .
: r;' demand due to a (small) chanqe in the product's own price. For this reason, pED
:':,i:i:'
is also
:::ii r': known as o!rr? price ela.rtic.i.h,of clentand.
::li:l.
-i:'
r:j!:
' I¡rcome elasticity of de¡nand (YED) measures the degree of responsiveness
of changes in
r.,.1 detrand due to a (small) change in consumer income levels"
Ii¡
x 1'"
" Cross-price elasticity of demand (CED) measures the cleglee of responsiveness
of changes
g_i in demand for one pr'Oduct dlle to a (small) change in the price of another pr-ocluct (be
q:,: that"a
substitute or a complernent).
t:ir
tt:,
' Advertising elasÉicity of tlernand (AED) rreasures the degree of responsiveness
of changes
r::i' in clema'd due to a change in a fir¡'s adver-tisino expenditure.
A.ri
rl:t
r..-!¡, Frice elasticity of denrand
{'
-:: Pl'ice elasticity of demand (PED) rneasures the extent to rvhich demand
¡'sa
l;.,
tor a product changes d,e
to ii cliarlge in its plice. If there is a lelatively small change in quantity
rÍ:iil. de¡-ianded followine a
change in pr:ice, tlrer.r demand is said to be price inelasfic, i.e. custome.s
:.t!iri are not u".y."rpJnriu.
i¡J:l to changes in p|ice. Denand is said to be price elastic if there is a relatively
lurg..h"ng. jn
demand due to a price change, i.e. customers are highly responsive
to changes in price.ihe
fbr¡¡ula for working out the PED js:
i;*r
Percentage change in quantity demanded
percentage change in price

or in annotation fo¡m, PED equals:

*i¡
"ka!!
OAAP
,<¡ii¡

Note that tire value of PED will almost always be ne,gative because
:i;.iii:: of the lnverse r-eiatio¡ship
between price and quantity dernanded. The calculation of PED
1!-¡i
will give one of three possibilities:
$ " If the calculation of pED is between 0 and 1 (ignoring the minus sign), denrand is price
saJ inelastic. i.e' unresponsive to changes in price as the percentage chánge
rn demand is
=ü lelatively lower than the percentage change in price.
ri:li
laili
{¡l
' tlf the caiculation of PED is equal to 1 (ignor-ing tl.re minus sign), demand is of unitary price
f::: elasticity, i.e. a change in plice leads to a propoltional change in the
quantrty clemanded.
:i-:l:¡
al
.i:.:i
' If the calculation of PED is greater than 1 (ignoring the minus sign), demand price
is elastic,
l.e. demand for the product is relatively responsive to changes
a:-":.
in its pr.ice.
:alt::'

542
 iL: :la:.i.i -_v
Ifi
s
I

¿ Exam TiF!
¿ Worked example of <ale¡.rlati¡.lg pED
suppose at $7 per ticket the demanc for movies at a cinema is 4,000 per
'' ,\ w,eek. lf the cjnema raises its price to $g per ticket and observes tir¿t
demand falls to 3,000 per week, what is the value of pED?
' ' To calculate PED, first work out the percentage change in the level of
demand, i.e. der¡and has f alren by 25% f rom 4,000 to 3,000 tickets per
week.
' Then, calculate the percentage change in price (which caused demand
to fall), i.e. prices rose by 14.28% from g7 per ticket to $8 per ticket.
' Finally, plug the percentage change figures into the pED formula:
25t14.28 = (_) 1.75
This means that since pED is greater than 1.0 (ignoring the minus sign),
then demand for cinema tickets is said to be price elastlc, i.e. customers
.are responsive to the increase in price. This will therefore mean a larger
drop in the level of dernand relative to the increase in price.
lmplications and uses of price elasticity of demand
Knowledge ofPED can sive businesses and other stakeholders vaiuable inforrnation about how
the sales revenue of a product is likely to change if its prices are adjusted. This infornration can be
used ir.r many ways, inciudir.rg:

' Helps firlns to decide on their pricing poiicy. For example, a business with price inelastic
demand fol its ploduct is likely to raise price. il
q
' Determines which products are most affected by a dolvnturn in tl're economy. Luxury é
E1
pr-oducts. for example, will have a high PED value and businesses will know that these tencl trr
E
suffer the most during a recession.
fi&
' Helps pledict the effects of a change in the exchange rate on the couutly's inter.nationai trade
balance. Exporters will generally benefit fi'om lower exchange retes since their prices become 6
more competrtrve, assumiirg the PED fol exports is price elastic (i.e. pED > 1). d
' Helps governments to determine the optimum level of taxes to place on certain products in \ü
E
order to nlaximize their tax revenues. Price inelastic prorlucts. such as petrol and cigarettes, H
d
tend to be lieavily taxed as demand is price inelastic, therefore demand is not significantly
affected by the tax but the govemment manages to raise lalge sums of revenues from taxing
these products.

Question ffi
Price elasticitv of demand
a Explain whether rhe price elasticity of demand for the followine producrs
.';.t:
ls
relatively price elastic or inelastic. Remember to justify you. unr*.rr.
i Perrol.
ii Mobilephones. ,,, ,. ,'., r ,'
iiiBananas. rr: |- .,::, _: , " .. -. , r.:,,
'''.'
iv Tobacco.

¡ analyse the reasons for governments raising the áx on tobacco, alcohol ao¿.
, lll--.
petrol, often annually.

543
 UIJiT 4.4 Price

F{EGF{ER LF!IEttrX?Erusg@ffi : RñtATE&rusH g p BE"w€EEq¡

FRE€E EIASE"EEñTY @F DEMffiAruB AffiM
,r T{FTA[- RElfEruE9E
In Figure'1.4f. the der¡and ctrrve is relativelv price inelastic (rather unresporsive to chan-ees
in
price). The ltrn should. thel'efore. raise prices. The percenta_se increase in price is far g,..aie.
tha,,
the subsequent fall in der¡and. Hence. total revenue will increase. Conversely, a .ecluclo'
i" p;;..
forproducts with price inelastic demand will result in a net loss in total re\¡euLre.

81, r'aising price. the percenta-!¿c

change in price is _ereater than the
llercerrraqe chan-qe in derr,rlrd.
Hence the gain tn total re\renue rs
larger than the loss.

Quantity rraded

Figure 4.4f Relatively price inelastic demand curve

In Figure 4-4g't"he demand curve is relatively price elastic (son.rewl.rat
responslve to cl.ranges in
plice)' The finn slrould therefole ¡educe prices since this rvould leaci
to a net in total revenue.
However, if prices are iucreased, custoirers will simply srvitch to substitutes, -qain
thereby generating a
net loss itr totrl revenue

The relationship berween price elasticity of clemand (PED) anct

total r.evenue ( i'R) js show. in
Table 4.4b.

By reducing price, the resulting

percentage char.rge in derrand ls
greater than the per-centage change
rn price. Hence the gain in total
revenue is iarger t¡tan tire loss

_._-_-'.'_- Quantify traded

Figure 4.4g Relalively price elastic demand curve

Table 4.4b Relationship betrveen pED and TR

Inelastic Unitary Elastic

Value of PED >0<1 >1
Increase price TRT no change in TR TRI
Reduce price TRJ no chan_9e in TR TR'i'
-
544
 l-1L: Fielar onshi¡-. beii,veen pED ancl total rar.ranrrt

Quesiion ffi
Fhe b¡,¡siness of musi{ concerts
I¡ is comn'ion knor¡'led-qe tir"i tne price of e concert ticket keeps goine up. h{adoirna fans in
the
uK paid beh\:een :80 ro tl60 (s160-s310), \\.jrh an addirional €13 bookrng fee for her
'Confessions on a Dance Floor'
toul. The public opinion rvas spiit - some thought the prices
\r;ere an outrage u'hilst othel's tirought it r-epr-esented entertainment value.
-eoorl
Chanses in n'rarket forces hat'e neant that rock and pop stars can make huge arnounts of
l.noney f¡onl each concert thel'clo. Madonna's 200.1 Re-Invention tour grossed
$125 million
u'or-ldrvide - more than any other artist that
¡,-ear. Sone analvsts argue that music artists haye
been forced into doing concerts to combat the decline in their potential earnings caused by
people illegall,v do$,nloadinc lnusjc from the intemet.
a Erplain the renl market forces.
[3 narks]
b Outline {wo reasons rvit¡, 1¡¡ri. fans might be plepared to pay such high
prices for conceñ tickets.
[4 nurks]
c Justify whetl-rer you feel that concert tickets are relatively price elastic or ------- -....-

price inelastic.
[8 ntarks]

Factors affect!ng pr¡€e e!asticity of demand

" Substitution - This is by far the mosi important determinant of price elasticity. In general, tl're &
&
-qreatel the nLllnber and availability of substitutes fol' a product, the greater its pED will be. It ñ
Illust be noted. Irower¡er, tlrat w'hat ís an appropriate or acceptable substi¡ute for one person &
@
does not necessal-ilv rne¡rn tlrat it i,s eqLrally suitable for otherpeople. Examples of pioducts
with relatively 1:rice inelastjc clemencl inclLicle oil. private eclncation ancl medicines. F
tb

* X¡icon¡e - Tile ¡trtl¡rot-tion t-rf incoure spent on a procinc-t wili alsc afibct the r¡¿lue of its pED. If g
the price of ll hox o1'hoLlsehold nratches were [o dcub]e. it rvorilcl discourage very few E
buyers
becaLlse the actLtal change in price is a rrinrite proportion of their overali income.
However, if
the pi'ice of rt I¡tltot.cycle u,ele to rise by -507o fl'om $10,000 to $15.000, it woulclhave a tr
ilr¿rssive inlpact on quaittitv deniandecl; even though the percentage increase in the
pr-ice of
tl]otot'cycies js l¡Lrch lower thri.r that of household r.natches. Therefol-e. the greater tire
¡rt-oportron of i¡lcollre that the price r.eplesents. the higher the value of PED tends to be. On an
individual leve i, peopie on high levels of income al'e less sensitive to chanses in the price tharr
tliose wi¡h low incorrres.
' Time - The periocl of time af'Íbcts tlre value of PED since people's habits and traditions,
u'hich have been established ovel' a long period, may be slow to change. Over time, however.
people will ad.JLrst to altv perntanent price changes and uray seek alternatives if prices
are
increased Parents with children in private education are unlikely to rvithdraw theiroffspring
fl'oul sclrool, partly because this could be very disruptive to their learni¡g. Drivers of motor
vehicles are tinltl<ely, at least in the short to medium term, to get rid of their motor vehicles
sinlply becar¡se of fuel price increases. Given time. however', botl-r parents and drivers may
well seek alternatives. Hence, in general, the shorter the time period in question, the less price
elastic der¡and tends to be.
' Durability - Perishable proclucts may need to be leplaced, even if prices have dsen. However
i? the plice of a consuiner durable (see unir 4.3) is on the r-ise, .urtorr.., may try to make
their existing possessions last a little longer'. Items such as fulniture, niobile phones and cars
can all be up-eladed at a later date. Hence. in general, the more durable a product
is. the sreater
its price elasticity of demancl tends to be.

545
 UNIT 4,4 Price

.
it F¿rshicir, acldictions, habits and tastes - Where a product is hal¡it forming (such as ¡¡,.-¡r-:
trr highlv fasl.rionable. the price elaisticitl'of demand u,ill tend to be low. i.e. relativelr'p¡::
i¡elrrstic. Habits and tastes. \Á'hich ale largeil'aflected by marketing stlateqies. q'i1l also
'. reduce rhe degree of responslveness of dentand due to a rise in price. People u'ho are seric,r_..
devored to a hol.by (be it spoi'ts. music or otherwise) are wiliing io spend a huge ai¡ouni of
lurone\,: so they are therefore less sensilive to cltanges in price.

l:r:; i
. Necessit¡' - The de-qr'ee of neuessity or ur-qency also affects PED. Ploducts tirat are seen as
'essential' (such as fuel and food) tend to be lelativel;r plice inelastic. This is because people
necd thesc ploducrs:o r¡illcontinueJq_plu'clra,e thenr cren if plices ri:e. On tlre orltcrlr¿¡d.
luxury ,eoods and sellices tend to be rnor\r-ice elastic. For instance, tl.re demand for
husiner.-class 3if trr\el is lcsq rc\poirsive to chrnges in price rhan tlle delnalld for econurn\-
class air travel. Sirnilarll,. demand for f¡esh flowers durin,e Valentine's Day and Mothers' Dar
is much less price sensitive than durin,q off-peak periods.

Question fiffi
Toshíba -

Toshjba is one of the world's largest n¡rnufacturers of flash nrcrnory chips used in mobile
phones. digital cameras and dieiial music players. In Apnl 2007, the Japanese electronics giant
annoulrced that its profits increased by almost 7 67o despite a fall in the price of memory chips ,

by son're 607o. Prices of memory chips ar-e expected to fall even further as competition .-
intensifies.
. :._...
a Comment on the price elasticity of demand for Toshiba memory chips. [3 nnris]
b To what extent does knowledge of price elasiicity of demand prove useful
fbr firms, such as Toshiba, that face intense competition? {7 nnrksl

Income elasticity of demand

ILrconre elastie ity of denaud (YED) rrieasures the degree of responsiveness of derland fol a
ploduct follor.l'ing a change iu the incor¡e level of consllmers. Businesses are interested in the
value of YED fol their products so that they can make forecasts of the level of demand as the
ecolloury grows and prospers over time. When income ¡ises. the den-rand for most products also
incleases. Tlie formula for calculatine YED is:

Percentage change in quarÍtity demanded

Percentage change ilr ilrcome

ol in annotation form:
okry!
%LY

There ¡re f llree nossihle outcomes whelr caicul¡tinq the inco:¡e elrsticitv of demand for a

product:

' YED is ¡tositive for normal goods, i.e. the demand for normal goods rises as incomes
increase, One category of normal goods is necessities. In this case, the YED is greater than
zero but less than 1. This means that demand for such products is not highly responsive to
r changes in price. People will not, for instance, purchase significantly more socks or consume
that much more drinking water simply because prices have dropped. Indeed, the demand fo¡
baby foods and nappies (diapers) wiil increase as a result of an inc¡ease in consumer incones,
but not by a great amount.

546
 HL: Relationship bettveen pED and total revenr¡e w
E\
Lururies are the second t¡ipe of normal
-soods. In thjs case. the lalue of YED is grelter than
1.0. i.e. demand is inconle elastic (orhighl¡,responsive ro chanses in income levels). This
treans lhat as income levels incre¡rse ovei lime. the detnand for lurnries sucb as designer
clothing aitd spolrs cars ¡ises by a proportionatelv greater amount.
Inferior Goods a¡e defined as tlrose products ti.iat hai,e a negative YED value, i.e. dentancl for
these products/n1l.s as income leveis rise (see Table 4.4c).If a procluct has a YED figure of
-0.6. this nteans a 107'r price increase causes the demancl for tlre substandard product to fail
b5 67c. This heppens becaure higher lerels of income lllorv the cusromer 1o subsliiute infcrio;:
soods lsuch c.s sausa-qes or supertrarket econoiny brand cola) for superior goods (such as
steak or Coca-Cola). The denland for pLrblic ti-ansport is of¡en cited as an example of inferior
sood
'.
Table 4.4c Relationship between YED and t1'pes of products

Value of YED Type ofProduct

Inferior goods
>0<l Normal goods: necessities
>l Nol-nlal goods: Luxuly / Superior goods

The value of YED is also affected by different segment groups. What is a necessity to one group
ofpeople (e.g. business ail travel for seniol executives) may be regarded as a luxury to others
(such as holiday travellers). Equally, what is regalded as an essential product to one group (such g
as textbooks for high school students) is not necessarily applicable to other groups (such as lr
E
younger children) (see Figure 4.4h). *
Time can also change the value ofYED for a product. Bus ttavel was, for exarrple, once regarded U
E
as a normal good in many developed countries. However, with rising income levels, bus tr-avel is
now seelt as an inferior good in countries such as Get'rnany, USA and the UK where peopie F
ñr
choose to use trains, taxis and private transpoltation as altel'natives. In addition, many products E

that are considered luxury iterrs today u'ill become the necessities of tontonow. Examples E
g

illclude personal computers and mobile phones that have become an integral part of Jif'e in a
mode¡n societies. E
E
Knowledge ancl application of YED can be used by businesses to preciict sales. Thebusiness
cycle of booms and slumps (see Unit 1.5) rneans that the level of income and aggregate demand
in the economy will fluctuate over time. Certain products (such as staple foods or education) are
less income sensitive than other-s (such as expensive food proclucts or pr:ivate tuition) so are leps
prone to changes in demand during a recession. Luxury items on the other hand do well during an
economic upturn but their sales are much more volatile during less prosperous times.

Businesses can use YED figures to plan theirmarketing strategies. Forexample, price
disclimination can take place whereby higherprices are being charged to customers in r¡ore
affluent areas or countries. With lising incomes in China and India, computer firms and car.
manufacturers have located or introduced distribution channels in these countries to nake the
most of the income elastic demand for such products.

547
 uh|T 4.4 Price

,a L Norntal goorls - including l_urun.gootls rnd

Necessities

Price
In coi.:t e

Quantiqv
Quantrry
For nol'nra] soods. rhere is rnlerse relationship between
price and quantity demandecl.
dernand cu.ie ex,srs. inr.ri" .i.e. a normal
rhar as inco,,,e ¡ises so ,;;::flfi::llfi::3.1,ilo.il :ilTulq,0,,íi,, a.'on¡ed rhis neai's
ii. ' Inferior Goods (excluding Giffán
Coods)

Pnce
Incorle

Quantity
Quanriry
For inf'erior goods, there it

j;i::tfu**i'T;:,ili;,".":.,:.ji,,:TlI,:,:,'J..ff,iffi,?:1"1;:::i,í,llll3i1,T;i;I"i,,;".,u,
levels the clemand ror
swrtch ro rnore superior 'ise' intr.iu. goá0, *',, falt
o.:;;.';l:"*" as cons.mers

l1t, Giff"en Goods - a special case

of Inferiol goorl

P¡ice
[¡tcor¡c

Quantify
Qr:antity

since Giffen goods are a type

of infe¡iorgood, there is a negative
coreration berween lncome
levers
:ltii:.H,:,:i iJffif;.fl1;:T;3;:, n,,, o' den an d cu rve, wh ereby rh
if i::*:;, ere is a
Figure 4.4h Diagrammatic
representation of normal
and inferior goods

548
iif
 HL: frielaricns¡lp berir;--en pED al¡l iotal reverue
Cross-priee ef estíeiiy c¡f denle:-¡d
f¡¡s-r-pt'ice eia,s¡ícitl of denl:ind (CEDl rneasui-es the d¡si'ce of r-espo¡siye¡¡ss of ci.eti¡.u¡trli.r.r,.
in ti'te príce oi another prL)Juci. sir;ii :Ls sLrb:ri¡ntes or colxp1cnt-nts. Thr.
tt-rrcirict.due ¡o a cilan.'g¡
i¡inruia for calculri¡i¡g cross-price rl¿isticiir,: of clenrend is:
Perceniage change in quaniity demanded for Good A
percentagecnaffi
or in annotation lbr-rl:

ob-r
0Dl
oio
\ PB

Substitutes are proclucls in competitive demand. i.e. they can be used il-r place of one ano¡her.
Examples include tea and coffee. private education and state eclucation or dourestic ancl overseas
holidav destín¡rtions. All things bein-u eqr-ral. tl.ie demancl for a product will tend to directlt:
u'ith the price of its substitute product. For exanpJe. if the price of a Sar¡sung digital 'ary
carnera
falls' the denrand for Sonv digital cameras is likeiy to t'a1l, oiher things remainingequal. This
relationship suggests that tliere is a positive CED value ibr suirstitutes, i.e. as the price of a
oroduct increases the demand for its substitute will also tencl to rise.

Figule:1.4i illusti'ates this direct relationship for goods that are in competirive clemand, such as
strau,berries and bananas.
ffi
(A) (B) FE
M
Price Price
\
@
($) (s)
F*
tu
rác
!,&
u

FF
qt
Quantity HS
ry
EE
A la t'ke | /b r str att' bet'r í es A,íurket for bctnanas

Figure 4.4i CED for goods in cornpetitive demand

In Figure 4.4t(A), a 1á11 in the supply of strawberies, perhaps due ro a poor harvest,
has caused an
illcrease in its price and reduced the quantity demanded. The higher price of strawber.ries
has
subsequently caused an increase in the demand for bananas as showr.r in Figure 4.4i(B).
In time,
the increased demand for bananas will also cause its equiiibrium price to rise although
the
quantity traded increases. The higher the value of CED for substitutes, the more customers
see the
products as being close substitutes.

Complements are pt"oducts that are in joint demand, such as the demand for personal computers
and computer sofñ.vare. A fall in the price of computers is likely to lead to an increase
in the
demand for computer software products. This rneans that there is a negative CED
for goods that
are in joint demand. For exampie, an increase in the price of tennis racquets
is likely to cause a
f'ali in demand for tennis balis.

Figure 4 4j shows the inverse relationship between complementary goods (those in joint
demand).
A fail in tle price of contact lenses, perhaps due to advances in production technologies, has
lecl
to an expansion in their demand. This then leads to an increase in the demand for
contact lens
solutions.

549
 Ui{lT 4.4 Price

f'r.icc Pri ce
(si lS) )

./

Quantrt,r,

A,lorkel for soft (orlfúcl letl,te,t .\,!url;ei ior confocI Iens -¡oILrtion

Figure 4.4j CED for goods in joint demand

In theoll¡, CED can also equal zero. Thrs sug-sests that there is no relationship between the price
of one product (such as apples) and the demand fol another (such rs helicopters). Hence, the
lower the value of CED, the weaker the relationship betrveen corrplernentary or substitute goods.
Knowledge and application of CED aliows a business to devise appropriate pricin_e strategies.
Firms can forecast the impact on their sales following a change in the price of a ¡ival's producrs.
For exanrple. budset airline opelators such as easyJet and Air Asia have catered well for'
relatively price-sensitive customers who now have an allelnative to using the larger national
airiine carriel-s. Complementary -qoods that have a strong lelationship. such as popcorn and sofr
drinks at the cinema, tend to har¡e at least one of the products sold rvith a high mark-up. Ganres
consoles, for instance, are often sold at a loss but there is a hu-9e mark up on tl-re games
themselves, Sor.ry claim to br.eak-even on their PS3 console once a customer has bought two
'gcmes. Popcorn and soft dlinks are sold at a high (prenrir-rnr) price with the purchase of cinema
tickets (their strong complenrertiry good¡ at the crnerra.
Firms will also aim to reduce the value of their CED in r-elation to substitnte products. This can be
done by branding stfategies (see Unit 4.3) or any other approach that encoulages custotrer
loyalty. Not only does this mean that the business beneflts fronr repeat purchases from its loyal
customers, the falling value of CED in relation to substitute prodlrcts also means that the br-rsiness
can charge a higher price to increase its total revenue and profit.

ouestion Effi
€¡oss-price elasticity of demand ' ,.;i
. I
.ll
Explain how the demand for supermarket own-label cola would change in each of rhe
followingsicuationS:'''l : ::.: _jt1.é

1i.É
price of Coca-Cola falls dramatically due to a special promotion.
a The lr.,l t3 it,arkSIE
t :1.r-::.,
b The price of supermarket own-label cola is affected by an increase in:'its
'proauctioo I t3
,.,.ir,i{
,,.,o,tkiJ-il
"osts. ,...rrfi
c A govemment advertisi,ng carnpaign warns of tooth decay caused by di-inking , .i
fizzy drinks. lJ illarktli;
"''.rr

Advertising elasticity of demand

Advertising elasticity of demand (AED) measures the degree of responsiveness of derrand for a
product following a change in the advertising expenditure for tl'rat product. In other words, it acts
as a measure of the degree of sttccess of an advertising canpaign on the demand for a particular
oood or service.

550
 iil: lel¿:iorsh;l lieLivee¡ elasiiiit;. and pr-cdir:t ilie c,,:le:

l-:,': f¡-,r-r-, r: I :r Ji,r- c,¡ilclr I iL',i n g .LED is :

PerceniaEe change in quaniriy demanCeC

. 'r perüeniaEe chang? in adveriising
expenditure

ij:¿rlly. ittanasers uould u'ant ¿i hiehlr, elastic AED srnce this means that the ciiange in

led to a more than proportionaie chanse tn the l¿r'el oidentarid fo¡ the
:r,l ,er-tisrns spendin-e h¿rs

fir.lucl. An AED value th.rt is above 1.0 sugeests tha[ custor¡els are high]r' responsive ro ihe
:hln-eecl sperrdine on adr.'ertisins. For example. if a business laised its adveltising erpenditure on
i!ri.odLLctfrontSl millionperyearto$l.2millionpervear.andsubsequentl¡,thedemar.rdfo¡the
lroduct also increased fron.1 million unit--c to 5 ntillioit units in iire sar.ue time period. theu the
.AED is l.2i (i e. 25-/c + 207c). This means tliat deirand is elastrc to a chang¿ in adverrising
¿'. nenJltttl'e rild thet Ihe c\iiit spendinu u ould be rnorc thtn compensarcd bv the hi-sller s,rles that
ri'ould foliow. Likeu,ise, an AED figure belorv 1.0 suggests fhat dei'nanci is not so responsive to
changes in advertising exLrenditLrre.

lr rcrlit-'.
iL is ofterr dilfi'Lrlt to rlcrel'nrinc .rhether chrn--.ed rdi.errisiiro e x¡errdiLLrlc is rhc root
cause of a change in denand. This is especially the case for firms that use family branding isee
Unit 4.3) in their adveltiseinents as opposed to advertisrng a sinsle product. Fulthemrore. demand
rnay have cl.ranged due to other reasons. srich as a change in income levels. Marketels do.
however, believe that there is a positive correlalion between advertising expenditule ancl the level
of dem¡urd. Big blockbuster r.novies that do r','ell at the bor offlce, for. exaniple. are backed by
expensive advertising campaiens.
€
It rs possible tha¡ thecalculation of AED gives a negative uumber. This means that a rise in FT
F&
advertising expenditttre u'ould actually bring about a lall in demand. Hence the adverrising
ú,ltltp)3ilrt would be l'egrrded ns bcing ineflective rsi;rce ltigher'flcireltising .pendin.e is sLrpposed #
to Iead to higher levels of demand). Altematrvely, a negative AED figure cau come about by ¿:n

spending less on advertising ii'hich leads to rrore demand. This suggests that it is pcissible to iii
...,.i

increase sales r.vithout alrvays having to spend more nlonev ou acivertising. lii;l
Question ffi ¡, I

Disney Píxar ..i

Disney Pixar's huge trovie hits such as Toy Story, Monsters Inc.,The Increclibles. A Bug's Life,
Finding Nento, RatatouiJl.e and Car,s owe much to their pelsuasive and successful advertising
clnrpaisns. Pixar's success lras also been attributed {o üe sales ol'its movie-reJaied
merclrandise, such as toys and clothing. :

aout1inewhymoviesa¡rdnrerchandisemightbec]assedaScompiementary.
goods. [2 marks]
b with referencero price elasticity of demrnd. explain what is likely to happeu
to the demand curve for movies that have been efrectively malketed . t4 marksl

l*!G FEER E-€V€ L EXTEI1¡SIOIU : RELATtOgUSS¡tp BET!&lEEru

ELASTIC¡TY AruD PRODI'CT LIFE CYC!-85
'Ihe price for a product is not simply set and then attention
turns away to other matters. In many
businesseÍ prices fol existing products are constantl¡, being monitored and compared rvith tliose
offered by competito¡s. As a product passes thror-rgh )ts producr tife cycte (see Unit 4.3) its price
may need to be changed and adapted to each distinct stage. For example, end-of-season stock,
such as Chrtstmas cat'ds or calendars in Jar.ruary, are heavily discounted (using discountpricing)

)f I
 UI,JiI +.4 .prii e

rilrcl s,tl.i ¿l¡ \ -r\, 1ol prices. llhe ¡ole of t¡¿ii,liati jlgr).lAil¡ig-rs jsioc'rlliinLroLlsl\'Ill¿trliiir'-i
i,-lricingstrareg. c,,.,afrroclr,cl'slifecrcle. ,-r,.;-...-

lt- .., j,,, ,l ¡,ED f¡r... ¡r1.nl¡¡..1 uill

r.¡,tj tu j,;. Tt.¡rc.,. it nr,,.rcc
. _
tlnt,,_ if i li¡.-.....¡ .

Launch Since t¡Lr prodL¡ct is nev,,. produclion

,; ,,,."n,
level,; are lor, .r,.il 1;i;.;:]liill:::,,..,_
,r,u,'.oJ;,',* ;;:J;;;; il_.,.::,,ili;
:l:ll:ii:-,::.1: .:f high A smrtt nLrmber
rou'd ihar arounrr iiii
ilJ;,i';:::illii:,',1:"T
Rose.s ;;?ii
,¡ ;;i;;;;;.,',i"',1 :iil: 'Jl:.::: ,,:
,
2.5-it of i.li::,,t:t-:'
tne n,,a.r-t;;i ; ;;il;::'::;j.T;:;,t[::,,il.:.:::
new product con,es fi.om t¡e;ntrial
lf in,,oiarors
of in,oia¡ors (see unir ;.
Unir 5.61. Thevffi;:;i:i.i;iJ:,.a
ar.e ¡isk,ui.r. and are *,itlino r^ ñ^,, r.r-L ,_
-
u'llJing tt'r pa¡' high p.i.., _ --__p
;.;;;;; il ';.;J;";iii i;?ti:l',::
-s
ptrrr r.-,.
erclusi,, ifr,. Hence. the r'¿Lrue of PED
for ., .--.-
,. "nO , ¡*
price 'el¡re
il..ii,l:,?:,lence'
inelastrc
. Grou,fh _ As rhe U:*:"9 for a prodirct gro\Á,s. prodLrction
levels c

IfJ:Ji: ili,:,:?:i::i::1;;Tffjil't'::,:,sca,e p¡ices ;';i;J;;"l:i;i:,lt;J"

this *,,,1,r- .r
stage. e,u no'". co.periro's
producrs) so pr-ices are also
rnav hai,e ñ::;:.'i'ffi;::ilfl ii::;; ;l,t,i:
likery tÁ fat irr order for rhe
value of pED wirl tend to rise fi.m ro be contpeti¡ive Hence,
sri-ehtly,rrrr'ng the,{ror,vth rhe
stage.
have become a,,aj,ab,e
il'üTL;.";j'T':'::?;#'::::r:,ir;"',.:',r::::|j,',j.;:*;,,,|
Tl.ie ñ'm rvirirnaxirnize
rhis
to price differenriars.
econornres ;;"i.;::;"",,,",]'il',l"t:::lll"t
o,
olrrpur is ar irs highesr, rhus
reduced. Firn,s w;ll "f
u*1",;;;.;l:,:,","L.:^?,. pr.ices .rn ¡.....
,ri nini ze,¡ i,,...o,Ti"n'T:\:i
" H :|.iHi::[! ;:#,];.''' "
bran di n g i
" ".J".
Ñ .
. Saturation - Custo:
producr's ife cvcr e are
d fferen ti ar.s
i rn.*,lli'# :t;:;i:::lia r
ve
,;ljy;#il#';;",
raggarcis ("' unit i o).wir, onrv-be r;;;:'ffi;
the'efoi'e likeJy to be hi-eh..p..iully'"r"r,¡r,irri. f*S $"li'
uno

' Decli¡re - As a lroclLrcl

i.oar.,,,,ril. uuo,rru. oir rhe
qo¡1 into clecli'e, prices will contirually 'rarket.
snap Llp tl.re products-rvhicir fal1. Bar.gain hunrer.s will
have been
highly criscouirted i" p,:i.'"li'o.¿..
levers' Cusronrers
wit be exrrenrery r.rrir"; to fhe pr-oduct,s ro recluce srock
price. In fact. price wi'
il:Tl'y.,X:Jf,;::[]':iili::,:'.':,]"" oi it'' n'"'t.ting rnix:,;;;'s this nnar srage berore

PRI€E AruF B{,,sIN¡ESS STRATtrGV

lil,Tiy; i,'ii,'l'i,iji:1li'X?fi;il,::i'.'::::::':: combinarion or rr,e va¡ious pricing n,ethods

prolit otl.tsgy auopled by a buslrless plovicles
;:Ji1';:1# i},.Y",J,Ín;:?l,Ii::l:::tl',j.,:1'TljliiiJ:;'nJlT,:::;,1il:J:'.:;.li*
fol ail products in its portfolio.
l¡ is utro] acleqrra
not destroy pln, the pricing of a new proau.t
,rru.*ins on more eqichri.r.^.r :]ry"|"'that oá.,
;:::H¿il:l;H:?i::1.::t,::-':1:l':1".:;;;;{;:;:'.*iT:ilTfi Li,1:i',;'*1
il:Í:#'::::iJ::"Jilil:?,""',l""l.i.:::t*:*:íili::";il::nJ5ffil'ii$:lH:'iJ:;",,
must be consistent with all
other aspects oirnur:t.ring,
, rrtdl\(

' _ pricing decisions

need ro consider the
{::!.,^'::::"1:t:,:::i,,such
as inco,re reveis anJ
i:m:::l::ldata
sultable prices. #;Tffi,:'JJX,:lTj:::J:iy:'::,,:T*,
can prove useful in settiirg
o Place - The dish-ibu
cosmerics .o,o,n.ou,j,lX,Tirfrir.::e,:,!r^.:jll,1,u) will also affecr prices. For
::: il :J: ;1,1 3,'"";:ll,::l ::i:: :.1':, :
g u., *' r u". ; ;#* #"-"i;,:n T: :Jexampte,
lI l; X'
,?J:::,"JJ"H:T::T:,i]ff
the cosrs and hence the
:J;T,::l;i:j$;;,;:'ff
higher ,rr"pri."i""a, i"i.
;T,'ff:x1J:L::::";::T:,*

552
.ii
 p¡.i¡e ¿r¡C l¡lsiness
straiL.g),

. f';.';!:i¡-r -Fe¡rturesof ritiPl-odLrctsllclt.rsc1ue1iti,anal C3sitn,.-".ill affectrlrel¡r,elLri¡r¡i¡¿.

::l-r,i ulr:rLqecl. I¡n¡r'a!ive Diorructs x iil de r¡and a hi.'ub p:-icc- \\he1-i¿1s ,r¡- too. piodLlcts
.an
. ..1., .r,rr¡r,:rir.i Jc,,i:1
¡¡.i¡¡..
' F¡'it¡i'toíic't: - The t\rpe of promotional methLrds usecl to l¡ail,-et a prcirliict (see
Unil 4.,¡lrvill
¡Liieci its costs. \\rhich in tuilr u,ill in|ruence rfre price of the pi-ocLrct.
l;, :iddiiion to nrliketin,e issues, iher-e are other a.-(pects of a lrusine:;s thai r.r,ill aifect i¡s
l-rricins
slfJ¡-g\':
, .\'ctture c,.f the Proflt marintizin-g f'lr.urs are likelv to use hrsh pr.icing methorls such
LtLr.ríries-r -
ts pr¡i6E cii.scrinlinalionor desirc,rrer-pricing. Bv conirast. cost-basecl r¡ethorls l-nar,,be more
appr opli ate fol not-for-profi t orsairi zatl on s.

' Nct{ttre o¡ brtt'riers to e¡ü^) This ref'ers to rhe dest'ee of corrpetition

within the industr.¡, (high
ent|y barriei's u'il1 limit coinpetitior in an industry). For eranple. f-illns
operatrng in highl¡r-
collllletiti\/e lllarliets u'ili take lnore nolice of the pi'ices being char-eed fl,
theii-riva1s. By
contrast. rilorlopolists have nrlrch nrore power over the setiing of prices
clue to the eristence of
hieh bnli'ic¡'s lo entt-)
, -
Busitte,ss iruu,qe Ot.ganizations with a repr.itable a¡cl presti,tious im:rgs q,
ill chmge relativeiy
higl.rer p'ices. By contrast, firnrs endea'oLrr.ing to be cost leaciers (see
unit 1.7) wili charge
mnclr lrtn'er prices.

; Exam Tip!
ó Questions often ask candidates to suggest and justify suitable pricing
strategies that can be used by a business to enter new markets. Rather
than simpry expraining the various types of pricing methods that can be
usedl it is more imporiant to put tháse into the cátext of the
organization. For example, it may be appropriate to consider a few
issues first, before advisíng suitabre pricing strategies. These
considerations may include the foliowing issues:
e Even though the ma¡'ket is 'new'for the business in question.
there
might be wer-estabrished firms that arready exist irr the market.
However, if the firm is the first entrant to a market, then price
skimming may be appropriate.
" Unless the product is purely original and innovative, customers wjll
already have perceptions about what the correct level of price ought
to be.
" which pricing method is most rikery to attract the attention of
customers? For some items, promotionar pricing is highry suitabre,
whilst prestige pricing works better for other products.
n what sort of image does the business want to portray?
crearry, the
pricing strategy used for high quarity and exclusive products will be
different from that used for mass market products that have prenty of
s u bstitutes.

" Finally, it is important to consider the l¡kely reaction of competitors

to
the pricing strategies used by a firm. rf row prices are used and this
sparks a price war, most businesses will tend to lose.
Despite the huge importance placed on pricing decisions, businesses
are also likeiy to employ
non'pricing strategies to market their products. These may take the form of promotionai
strategies (see Unit 4.5) such as advertising, gift voucher-s and packaging.
Alternatively, non-price
competidof can take the forr¡ of diffelentiaád pi'oducts and blanding
ftee Unit 4.3) orthrough
innovarive ideas (see Unit 5.6) and quality assurance (see unit:.a). If
is evidenr that marketirig is
hi-ehly integrated and no amount of plice discount can sell a product
that cloes not meet tire needs
or wants of the consumer.
 1 Explain uh1'the price decision (decrding on the'r'isht'price) is such a djfficulr task.
2 Explain rlie link between tire price of a p¡odr-rct and its perceived qua1it},.
3 \\¡har is the différence between a'price taker.' and a .price ,,1
makel
4 Wha¡ is 'cost-plus pricing'?
5 Erplain the meaning of 'competition-based pricin-e'.
5 Differentiate between 'price skinimin_e' and 'penetration pricing,.
Higher Level extension
7 \\¡hat is 'n-ralgir.ral cLrst pricing'?
8 Diff-erentiate between full cost pricin,e and absorption cost pricing.
9 Explairr when eech type of pricing would be srrirable for.a business
i going-rate pricin_e.
ii predatory pricine.
10 what are rhe thr-ee conditions necessary for effective price discrimination?
11 What ale 'loss leaders'?
12 What is 'promotional pr-icing'?
f3 State four detem.rinants of demand and four determiuants of supply.

f4 Explain the meaning of 'price elasticity of demand' ancl liow it mighr be of value to a
bLrsiness.

5
'l Explain the relationship between the PED of a product and its sales revenue.
f6 Distinguish between normal, supelior.and inferior goocls.
I7 Horv will changes in the price of each of tl'rese products affect the de mand?
i substitutes.
ii complements.
18 How might the calculation of advertising eiasticity of demancl be of use to marketers?
19 Explain why the pricing strategy for a product will change as it r¡oves through the product
life cycle.
outline three pricing strategies that businesses can use ro enter new markets.

TERMS

Absorption cost pricing is a type of cost-based pricing method that focuses on covering all costs
of production (both direct and indirect costs). Indirect costs are apportioned to diffe¡ent
departments based on a predetermined set of criteria.
Advertising elasticity of demand (AED) measures the impact on the demand for a firrn,s
product following a change in its adverlising expenditure.
rCompetition-based pricing refers to pricing strategies based on the pdces charged by the rivals
in the industry, rather than on the costs of production or the levei of customer demand.
Complements are products that are jointly demanded as they go well together. Examples include
tea and sugar, cars and petrol, or food and drink.

554
 Re,rie,,,v

Cost-ba-sed pricing reiiis t(l settinq piices bastd on the costs ol'pt'iiductiott i-:ttlter tl'rar-r c,lr ii-ie
l-.r ¿l c'f clrr-nand oí i.he price,c sei Lrv corlpetitors.

Qost-pltis pricir:g. knou'n as nrark-up plicing. taltes place then ¡ t-ii.t't'l c¿ilcul¡i{es iis irnrL
¿.lso
;o'srs and th¿n;t,lcis e p:rcenlas- pfoflt to detern.iine tlie piice.
Cross-price elasticit¡'of deila¡id (CED) neasLrres the degiee of te-sprrnsiveness of th¿ levei oi
demand for one prcduci dLre to a change in the price cf a related gooC (either a contpleileni oi
sLrbstitnte l.
Demand is the antount of plodr,rcts that custonters are u'illing ¿Lnd able to blly et each ¡rl'ice leve I
For the vast majorit¡, of ploducts. as the frfice incl'eases. demand rvill tend to fall
Full cost pricing is a pricine ¡rethod based on the appoltionntent of iotal indirect costs b-v using
a single arbitlar.v c¡iterion.
Income elasticitl'of dernand (YED) measures the d¡sr-ee of i'esponsir.eness of changes in
clenr¡rnd due io a chlnge in consuiler incor.ne levels. A positive YED figtire tttearrs tltat the
product is a norntul goocl. Infgríor gttotls have a nesative YED figui'e.
[,oss leader is a rnarket-led pricing strategy that invo]ves setting the plice of a ploduct that is
beiorv iis cosrs of production to entice cuslomers to buy otlrel products with high pl'oflit nlar'-urns.
trlarginal cost pricing (also kr.rorvn as contribution pricing) calculates the cost of supplying an
extt'a uit;t of or-rtput in orclet'to detelrnine a sLritable price. Oiriy ciirect costs are appotttoned since
fixed costs do not affect tl.re narginal olltput.
Nfarket-led pricing strateg;es are based on the level of custotner demand lbl a fii'ln's products,
i.e. the ievel of demand in the indusü-y rather than being based olt costs of ploduction ol the prices
cl.rarged b1, con-rpetito¡s.
Penetration pricing is a nrarket-led pticing strategy that involves a fitm setting low plices to gairt
entry into a new market. Once the pi'odrict has establjshed n-rai-ket share. prices can then be
incr'eased-
Predatory pricing is a conpetition-based pricing stfategy that involves e firrtt setting pt'ice s so
low tliat other colrpetitors, especially srnallei'firrls. cautlr¡t coinpetc at a profitable level.
Price cliscrimination is a pricing strategy that inr,olr,es charging dift'elent ¡rrices lo different
gfoups of custol.ners for the same prodLrct, e.-q. adlllt and child airlille tickets.
Price elasticity of clemand (PED) measures the deglee of tesponsiveness of chartges itt demand
due to a (small) change ir.r the product's own prlce.
Price v'ar is a less agglessive version of predatoly plicing rvheleby fitms cotttpete by a series of
rnlensive ¡rlice cuts.
Skimming is a mar-ket-1ed pricing strategy that involves cho'ging a high price for innovative or
high-tech products for an initial period. As the novelty factor wears off. prices will be gradualiy
reduced (or skimmed).
Substitutes are products in competitive demand, i.e. they can be used in piace of one another.
Supply is the amount of procluct that firms ale willing aud able to pr ovide at each price level. The
law of supply stetes that as the price of a product increases, its supply will tend to rise.