4.4 Price

What are the four main measures of elasticity of demand?

- Price elasticity of demand (PED); - Income elasticity of demand (YED); - Cross-price elasticity of demand (CED); - Advertising elasticity of demand (AED).

Advantages of marginal cost pricing.

- allows to set different prices on different products based on contribution; - more flexible than cost-plus pricing.

Advantages of psychological pricing.

- attract customers as they feel they're getting a good deal; - widely used method and can work for almost any product; - works well when selling the same product in larger quantities.

Advantages of loss leader pricing.

- attract customers with cheap price - attract customers to the store whom may buy other firm's products (with higher price) - can be used to increase brand loyalty

Advantages of promotional pricing.

- can get rid of excess stocks or renew interest in a falling business; - boosts sales and/or market share.

State five determinants of the level of demand.

- consumer income levels; - price and availability of substitutes; - price and availability of complements; - quality; - marketing; - fashions, habits and tastes; - utility; - speculation; - state of the economy; - perceived level of value for money; - others e.g. weather, religious beliefs etc.

Disadvantages of psychological pricing.

- doesn't work for all businesses e.g. taxi firms; - rounded or whole figures may be more suitable for some products.

Three conditions in order to achieve successful price discrimination.

- have some degree of monopoly and power; - customers have different price elasticities of demand; - market must be kept separate to prevent resale.

Identify two uses of price elasticity of demand.

- helps firms to decide on their pricing policy; - determines which products are most affected by the downturn in the economy; - helps predict the effects of a change in the exchange rate on the country's international trade balance; - helps governments to determine the optimum level of taxes to place on certain products in order to maximise their tax revenues.

Disadvantages of predatory pricing.

- illegal in some parts of the world.

Uses of CED:

- knowledge and application allows a business to devise appropriate pricing strategies - they can predict their sales following a price change in a competitor's products - firms aims to reduce the CED value in relation to substitute products (usually done by branding strategies) receiving repeat purchases from loyal customers

Disadvantages of full cost pricing.

- least accurate in apportioning overheads or fixed costs; - criterion used may be misleading to unrepresentative; - some may feel that indirect costs have been unfairly distributed.

Disadvantages of absorption cost pricing.

- not all indirect costs can be divided accurately; - more complex, thus more time-consuming; - relative benefits of absorption cost pricing may not be significant to justify its use.

Disadvantages of marginal cost pricing.

- not easy to classify some costs as direct or indirect.

Outline two exceptions to the general law of demand.

- ostentatious consumption i.e. the purchase of expensive products which impress and make the customers feel good about themselves; - conspicuous consumption i.e. the lavish spending of some customers for the purpose of upholding their social status rather than serving the real needs; - expectations of future prices e.g. stock values; - giffen goods e.g. price of bread rose, still buys bread because other substitutes (such as meat) were more expensive, whereas if price decreases the reverse happens.

Disadvantages of skimming pricing?

- potential profits may attract competition.

State five determinants of the level of supply.

- price of raw materials; - barriers to entry; - technology (production methods); - taxes; - subsidies; - price of related goods; - climate; - time.

What are the four types of monopolies?

- pure monopolies (100% market share); - natural monopolies (market sustains one supplier); - legal monopolies (no competition by law); - regional monopolies (power in specific location).

Disadvantages of loss leader pricing.

- quality can be perceived as poor - quite risky as they may not be profitable

Disadvantages of cost-plus pricing

- relies too much on intuitive decision-making; - may forget the needs of their customers.

Advantages of full cost pricing.

- simplest method of allocating overheads; - relatively inexpensive as it is simple to use, especially for single-product firms; - more accurate and less time-consuming; - managers have great cost control.

Advantages of cost-plus pricing

- simplistic and easy to calculate

Advantages of skimming pricing?

- strategy can create a unique, high quality or prestigious images for the product; - most likely to have substitutes in the market; - high prices can be chosen to maximise profits before competitors.

State three factors affecting price elasticity of demand.

- substitution; - income; - time; - durability; - fashion, additions, habits and tastes; - necessity.

Disadvantages of promotional pricing.

- suitable for the beginning or end of a product's life cycle.

Advantages of predatory pricing.

- the firm will benefit from being in a more dominant position; - can be used as a barrier to entry.

Advantages of absorption cost pricing.

- using a single criterion is too simple for multiproduct firms; - managers are more aware of the total costs of a product; - fairer method of allocating costs to different departments; - the profitability of each product line or department can be examined.

Define 'monopolist'.

A monopolist is the only business in which supplies for a specific product, thereby has the ability to set its own prices.

Formula for AED.

AED = %Δ in quantity demanded ÷ %Δ in advertising expenditure

What does AED measure?

Advertising elasticity of demand (AED) measures the degree of responsiveness of demand for a product following a change in the advertising expenditure fort that product.

What is 'absorption cost pricing'?

An extension of full cost pricing which involves allocating overheads by working out which department has incurred what proportion of each of the indirect costs.

State the relationship between price and quantity of supply.

As price of a product increase, its supply will tend to rise.

Formula for CED.

CED = %Δ in quantity demanded for Good A ÷ %Δ in price for Good B

Define 'complements'.

Complements are products that are in joint demand i.e. the goods complement each other

Example of Giffen goods:

Consumer has $5.00 to spend Buys 3kg of potatoes (at $1.20 each) and 1kg of sausages (at $1.40) = $3.60 + $1.40 = $5.00 Price of potatoes drop to $1.00 Consumer now buys 2kg of potatoes (at $1.00 each) and 2kg of sausages (at $1.40 each) = $2.00 + $2.80 = $4.80 As price falls the demand for potatoes (the Giffen good) falls.

Formula for marginal cost pricing.

Contribution* = Selling price - Direct costs *contribution is the money contributed towards paying its fixed costs of production

Cost-based Pricing Strategies

Cost-based pricing strategies are based on using costs of production to determine an appropriate price.

What is 'cost-plus pricing'?

Cost-plus pricing, also known as mark-up price, takes place when a firm calculates its unit costs and then adds a percentage profit to determine price.

Example:

Costs of production = $6 (per unit) Mark-up percentage = 50% Price = $6 x (0.5 + 1) = $9 (per unit)

What does CED measure?

Cross-price elasticity of demand measures the degree of responsiveness if demand for one product due to a change in the price of another product, such as substitutes or complements.

What does it indicate when AED is more than 1. Give a product example.

Customers are highly responsive to the changed spending on advertising (where managers aim to achieve AED) e.g. new technology

Define 'demand'.

Demand is the amount of products that customers are willing and able to buy at each price level for the vast majority of products.

Elasticity

Elasticity of demand refers to the technique of measuring the degree of responsiveness of quantity demanded due to a change in a specific factor that affects demand.

What is 'full cost pricing'?

Full cost pricing requires the business to allocate the total fixed costs between all the products that are sold using a single criterion to allocate the indirect costs.

What does YED measure?

Income elasticity of demand measures the degree of responsiveness of demand for a product following a change in the income level of consumers.

Discuss the relationship between PED and total revenue.

Inelastic - P↑ TR↑, P↓ TR↓ Unitary - no change in TR Elastic - P↑ TR↓, P↓ TR↑

What is 'going rate pricing'?

It is a pricing method whereby a firm charges a similar price to that of competitors for their goods or services, based on the market's 'going rate'.

What is penetration pricing suitable for?

It is highly suitable for products that have a high price elasticity of demand whereby lowering price will lead to proportionately higher sales volumes.

What is 'loss leader'?

Loss leader pricing involves selling a product at or below its cost value and is usually short-term.

What is 'marginal cost pricing'?

Marginal cost pricing, also known as contribution pricing, calculates the costs of supplying an extra unit of output in order to determine a suitable price. Only direct costs are apportioned since fixed costs do not affect the marginal output.

Market-led Pricing Strategies

Market-led strategies are based on the level of customer demand for a firm's products or the level of demand in the industry in which the firm operates.

What is the difference between a 'price taker' and a 'price maker'?

Monopolists have a higher degree in market power, thereby are said to be price makers or price setters. Price takers is vice versa, they 'take' the price given by others in the market.

Formula for PED.

PED = %Δ in quantity demanded ÷ %Δ in price

What is 'penetration pricing'?

Penetration pricing involves setting a relatively low price in order to grain market share and brand awareness. Then over time, the price can be raised.

What is 'predatory pricing'?

Predatory pricing is a strategy that involves temporarily reducing price in an attempt to force rivals out of the industry since they cannot compete profitably.

Formula for cost-plus pricing.

Price = Costs of production x (Mark-up decimal* + 1) *the mark-up percentage ÷ 100

What is 'price discrimination'?

Price discrimination occurs when the same product, usually a service, is sold in different markets at different prices. It is usually referred to as 'variable pricing'.

What is 'price leadership'?

Price leadership is a strategy that is often used for best-selling products or brands, setting their own prices.

What is 'skimming pricing'?

Price skimming is a strategy that tends to be used for technologically advanced and innovative productions. A high selling price is initially set to recoup the costs of research and development.

Define 'price war'.

Price war is a less aggressive version of predatory pricing whereby firms compete by a series of intensive price cuts.

What is 'promotional pricing'?

Promotional pricing is often used when marketing new products by charging a low price to entice customers to try the product and to build brand awareness.

What is 'psychological pricing'?

Psychological pricing is a strategy that involves using numbers to make them seem lower e.g. $9.99

Competition-based Pricing Strategies

Refers to a firm's pricing strategies that are based on the prices being charged by its competitors.

What if the price is too high?

Setting too high a price will put off customers, leading to low levels of demand and potential finance for the firm.

What if the price is too low?

Setting too low a price could lead to an undesirable image for the product which could prove difficult to put right.

Define 'substitutes'.

Substitutes are products in competitive demand i.e. they can be used in place of one another.

Define 'supply'.

Supply if the amount of product that firms are willing and able to provide at each price level.

What does it indicate when YED is positive. Give a product example.

The demand for normal goods rises as incomes increase e.g. normal goods such as necessities.

What does it indicate when YED is negative. Give a product example.

The demand for these products falls as income levels rise e.g. inferior goods such as pencils, hairclips etc.

What does it indicate when YED is more than 1. Give a product example.

The demand is income elastic e.g. luxuries.

What does it indicate when AED is between 0 and 1. Give a product example.

The demand is not so responsive to changes in advertising expenditure e.g. cigarettes

What does it indicate when PED is equal to 1.

The demand is of unitary price elasticity.

What does it indicate when PED is greater than 1. Give a product example.

The demand is price elastic i.e. shoes, eletronics.

What does it indicate when PED is between 0 and 1. Give a product example.

The demand is price inelastic i.e. cigarettes, rice.

What does PED measure?

The extent to which demand for a product changes due to change in its price.

State the relationship between price and quantity of demand.

The higher the price of a product, the lower the demand tends to be.

Explain the link between the price of a product and its perceived quality.

The more expensive, the better the quality. The less expensive, the lower the quality.

What is the 'equilibrium'?

The point at which the amount of a product demanded equals the amount supplied is known as the equilibrium (graphs of Supply and Demand against Price intersects).

State why the price decision is such a difficult task.

The price of a product must be set at a competitive level yet profitable.

What does it indicate when CED is negative. Give a product example.

The products are complements e.g. cameras and camera films.

What does it indicate when CED is positive. Give a product example.

The products are substitutes e.g. iPad and Galaxy Tab.

What does it indicate when AED is negative.

The rise in advertising expenditure leads to a fall in demand: it is possible to increase sales without always having to advertise.

Example:

Total fixed costs = $500 Selling price = $8 (per unit) Direct costs = $3 (per unit) Contribution = $8 - $3 = $5 (per unit) This means that the firm will make profit once it has sold more than 100 units ($5 x 100 units)

Formula for YED.

YED = %Δ in quantity demanded ÷ %Δ in income

What are the four cost-based pricing strategies?

[C]ome [M]eet [F]unny [A]liens Cost-plus pricing (or mark-up) Marginal cost pricing (or contribution) Full cost pricing Absorption cost pricing

What are the six market-led pricing strategies?

[P]lease [S]it and [P]rovide [L]aura with [P]retty [P]earls Penetration pricing Skimming pricing Price discrimination Loss leader Psychological pricing Promotional pricing

What are the three competition-based pricing strategies?

[P]ower [P]uff [G]irls Price leadership Predatory pricing Going rate pricing