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CH 2 The Economics of Price Determination Kent B. Monroe (2007). Pricing: Making Profitable Decisions. 3rd Edition (Singapore: McGraw-Hill) . Chapter Objectives (P.26) 02 1. To summarize the traditional neoclassical economic theory of price determination 2. To introduce some useful concepts for actual pricing decisions such as revenue, elasticity, marginal revenue, marginal costs etc. Price Determination Theory (P.26-27) 03 • Minimize input cost • Maximize profit The firm Economic theory is more concerned with the behavior of aggregates or markets, particularly how persistent and widespread behavior leads to stable results called “Equilibrium”. Price Determination Theory (P.26-27) 04 Economic Perspective • The firm is a pricetaker, not the pricemaker • Management determines the quantity to produce • The market sets price through the forces of supply and demand Marketing Perspective • Price is a decision variable. 05 The Profit-Maximizing Firm (P. 28) $ Revenues or Costs Maximum Profits Total Costs Total Revenue Price Fixed costs 0 Q1 Q* Q Units Figure 2.1 Output Determination for Profit-Maximizing Firm – Short Run (Constant Prices) : Aggregate Analysis 06 The Profit-Maximizing Firm (P. 28) $ Costs Marginal cost Average cost Price (Marginal revenue) 0 Q* Q Units Figure 2.2 Output Determination for Profit-Maximizing Firm – Short Run (Constant Prices) : Marginal Analysis 07 The Profit-Maximizing Firm (P. 29) $ Price Marginal cost P* Demand (Marginal revenue) 0 Q* Q Units Figure 2.3 Output Determination for Profit-Maximizing Firm – Short Run (Varying Prices) Corporate and Pricing Objective (P. 30) 10 Pricing objectives should be consistent with & should advance corporate & marketing objectives The organization’s specific marketing objectives are based on those corporate objectives. Setting objectives for one element of the marketing mix. 3 Classifications of Pricing Objectives (P. 30) PROFITABILITY Objectives VOLUME-BASED Objectives 11 COMPETITIVE Objectives Profitability Objectives (P. 30) 12 • Realizing maximum profits in the business. • Pricing objectives need to be measured precisely in order to be able to assess performance • Profitability objectives are measured and expressed in specific $ or % • $1.1 million for 3 years • 10% increase in revenue before tax, etc. 13 Elements of Profitability (P. 30-31) Monetary sales mix Qi Pi VCi FC Pi = Price per unit of each product or service offering. VCi = Variable costs per unit of each offering. FC = Fixed costs per period. Qi = Volume produced and sold of each offering. Monetary sales mix of the offering sold. 14 Profit Maximization (P. 31) Low prices High prices Low unit profit margins High unit profit margins High unit sales Low unit sales High inventory turnover Low inventory turnover Depending on the marketing situation, maximum profits over a planning period may be obtained by either pricing the firm’s offerings relatively low or relatively high. Which pricing strategy to follow if you want to maximize profit? Depending on the nature of market demand and competition. Target Return on Investment (P. 31) WHAT DO THEY INVEST ON ? Wholesalers & Retailers Manufacturers • Inventory • Capital • Buildings • Machinery • Buildings • Land • Inventory 15 • The ratio of profits to investments • An ROI objective can be expressed as a specific % of the investment • A variation is target return on sales Example A firm with $10 million in capital assets, seeking a 15% ROI, would seek to achieve net contribution to profits of___________for the $1.5 million planning period. Volume-Based Objectives (P. 32) Sales Volume • Revenue (sales) growth - prices are set to demand and unit sales. • Market share - prices are set to sales faster than competition; or to a sales decline to be slower than competition. Customer Demand Creation 16 Competitive Objectives (P. 32) 17 Price stability - as a market leader, the firm attempts to keep prices from declining (usually found in mature markets); usually leads to non-price competition. Aggressive pricing - price below competition to take advantage of market changes, when market demand is growing, or when opportunities to grow market share. Establishing Relevant Pricing Objectives (P. 33-34) Profitability Objectives The firm is the low-cost supplier The firm is the price leader Volume-Based Objectives The firm is low-cost supplier The market is price sensitive There is an internal required rate of return for new product introductions Cost decline as volume increases There is a short lead time for new products before competitors will likely to enter the market. There is a strong “captive” aftermarket for replacement supplies There is a growth market segment There is little differential perceived value in the offerings of firms in the market To limit competitive entry 18 Competition Objectives The firm is the low-cost supplier There are no perceived value differences across sellers in the minds of buyers Market share could be captured using non-price marketing efforts Summary (P. 34) 19 • There is no one apparent pricing objective for a specific set of market conditions. • A profitability objective does not specify either a high- or low- price strategy. • Using low price to pursue a volume objective must be viewed as an investment over several years. • The significance of being the low-cost supplier is … • it allows the firm to invest in non-price marketing efforts. • it is not a license to use price as a key competitive tool. Seat Work 1 (P. 35) Read the case given at Box 2.1 and answer the questions carefully. 1.What was Boeing Pricing Objective in the beginning of the case? 2. What was the result of their change in pricing objective? 3. How did they resolve the losses incurred to Boeing in 1997? 4. What is Boeing’s current pricing objective? 20 Market Structure : Degree of Competition (P. 35) 21 Depending on the structure of competitors within a market, firms may have considerable discretion to determine prices. Table 2.1 Characteristics of Market Structure • Perfect (Pure) Monopoly • Perfect (Pure) Competition • Imperfect Competition − Monopolistic Competition − Oligopoly Market Structure : Degree of Competition (P. 36) 22 Perfect Monopoly ตลาดผูกขาดแท้จริง • Only one seller supplies the product or service • Considerable degree of power over price/Government regulations Market Structure : Degree of Competition (P. 36) 23 Perfect Competition ตลาดแข่งขันสมบูรณ์ • Many sellers offer many buyers an identical (homogeneous) product; no seller can influence price Market Structure : Degree of Competition (P. 36) 24 Imperfect Competition ตลาดแข่งขันไม่สมบูรณ์ • Large number of sellers and buyers • Few sellers, some sellers may hold relatively large market shares and thus be able to influence the prices of products they sell. • Monopolistic Competition • Oligopoly Year 2008 Market Structure : Degree of Competition (P. 37) 25 Monopolistic Competition ตลาดกึง่ แข่งขัน กึง่ ผูกขาด • Large number of firms market heterogeneous (dissimilar) products • The greater the degree of product differentiation perceived by buyers, the greater is the opportunity for competing firms to set different prices Market Structure : Degree of Competition (P. 37) 26 Oligopoly ตลาดผูข้ ายน้อยราย • Few sellers dominate the marketplace and thus have substantial influence over price. • The greater the degree of product differentiation perceived by buyers, the greater is the opportunity for competing firms to set different prices The Laws of Supply and Demand (P. 38) 27 Whether one, a few, or many sellers are operating in marketplace, their pricing decisions are influenced to some degree by the economic laws affecting supply and demand. The Laws of Demand (P. 38) 28 • Demand is a relation among various amounts of a product that buyers would be willing and able to purchase at possible alternative prices during a given time, all other things remaining the same • If supply is held constant… • an increase in demand leads to and increased market price, • a decrease in demand leads to a decreased market price. Demand Factors Affecting Laws of Demand • Price • Income of households • Price and availability of substitute goods • Price and availability of complement goods • Expectations about future prices • The size and composition of the population 29 The Laws of Supply (P. 38) 30 • Supply is a relation showing the various amounts of a product that a seller would make available for sale at possible alternative prices during a given period of time, all other things remaining the same • When the price of a good is raised, more will be produced • If demand is held constant… • an increase in supply leads to a decreased in price. • a decrease in supply leads to an increased price. Supply Equilibrium (P. 39) 31 • In well-behaved markets, the supply and demand curves will intersect at some point. • An equilibrium between supply and demand is established, producing an equilibrium price • The market price at which the supply of an item equals the quantity demanded. P Equilibrium Price Q Price Elasticity of Demand (P. 43) 32 Price elasticity of demand measures the responsiveness of the quantity demanded for a product or service to a change in the price of the product or service (Q1 Q2) / Q1 Q / Q1 Ed % Q % P ( P1 P2) / P1 P / P1 Ed ΔQ ΔP Q1, P1 = price elasticity of demand = quantity change in demand = quantity change in demand = original quantity demanded and price, respectively Income Elasticity of Demand (P. 44) 33 • Income elasticity of demand: responsiveness of the quantity demanded of a product or service to a change in personal income ( Q) ( I ) EI I Q • If EI is negative, the product is an inferior good Income goes up fewer units are demanded (switch to steak, less hamburger) • If EI is positive, the product is a normal good Demand increases as income increases • If 0<EI<1, the product becomes less important in households’ consumption plan • If EI >1, the product becomes more important as income increases. Cross-Price Elasticity of Demand (P. 45) • Cross price elasticity of demand: responsiveness of demand for a product to a change in the price of another product QA PB Ec PB QA • If EC is negative, the two products are complementary • If EC is positive, the two products are substitutes 34 Consumers’ Surplus (P. 50) 35 • The difference between the maximum amount consumers are willing to pay for a product (known as the reservation price) and the amount they actually pay Sellers’ Surplus (P. 51) •The seller also enjoys a sellers' surplus, which we may define as the difference between his minimum price and the market price. 36 37 END OF CHAPTER II