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University of Minnesota
WHAT GOES INTO SETTING A PRICE? Profit, Sales volume, Ethics, Laws, Cost, Promotions,
Price discrimination
First, Second, and Third Order Price discrimination
Charging different prices to different consumersfor the same product
First order: Extract all consumer surplus with multiple prices
Second order: charge different prices for different blocks of sales
Third order: Different consumer demand elasticity in different markets - charge each a different price equating MC to MR in each market.
University of Minnesota
Buyers “valuation” of the product/service
Price
P
Q
revenue
value
Consumer surplus
Price elasticity
University of Minnesota
Price elasticity%change in Q / a % change in P
The slope of the demand curve
Shifts in demand vs. changes in demand
P
Po
Qo
What makes it shift?
• Consumers have an elasticity of demand => price down and quantity up (even for food)
• Economic theory (Utility Maximization) & consumer psychology/behavior => get the most Quantity for the price!
Pricing Strategy
University of Minnesota
I will raise my price to increase my revenue
When will this work? (Necessities, addictive, status, Low % of income, tourist)
% increase in price is 10 and % decrease in volume is 5 e = ??
-5/10 = -.5 => inelastic and revenue will increase
Pricing Strategy
University of Minnesota
Price elasticitye = %change in Q / % change in P
P
Q
Po
Qo
P1
Q1Q1”
Elastic demand: e >1(absolute value)Revenue loss from p increase
Inelastic demand: e <1Revenue gain from p increase
Pricing Strategy
University of Minnesota
I will cut my price and make it up on volume!
When will this work?
% decrease in price is 10% and increase in volume is 20% e = ??
20/-10 = -2 => elastic and revenue will increase
Pricing Strategy
University of Minnesota
Price elasticitye = %change in Q/ % change in P
P
Q
Po
Qo Q2 Q3
Q2= less elastic response
Q3 = more elastic response:Gain more revenue with lower priceP1
Pricing Strategy
University of Minnesota
PromotionLoyalty
Premium Quality
P
Q
more elasticless elasticPrice has less effecton quantity sold.
INCOME EALSTICITY
• Engle’s Law:
As income goes up, the portion of the increase that is spent
on necessities (food) decreases.
Income elasticity: % change in quantity / % change in income
Expenditure elasticity: % change in expenditure on a given food/ % change in income
University of Minnesota
Substitutes and complements:Cross price elasticity:1. % change in quantity of hot dog buns/
% change in price hot dogse is - => complement
2. % change in quantity of bratwurst/ % change in price of hot dogs
e is + => substitute
University of Minnesota
How do we measure profit?
Profit on sales: Revenue - Total cost = Profit
TC = marketing costs+ manuf. Costs + Overhead Costs (2variable + 1fixed)
At retail: COGS not a hard number
Rebates, promotion dollars, slotting fees etc. Questions of where these show up in profits?
University of Minnesota
COGS = $500,000 •Promotion $ from manuf. 5% = $25,000•Rebate based on volume 3% on quantity over 100 cases a week ( sell 200 cases: 100x$25/case = $2500x.03=$75) •Slotting fee if new product: $100,000
•If it is accounted for as a decrease in COGS: •$500,000 – 25,000 -75 -100,000 = $374,925
Label1
University of Minnesota
If it is accounted for as a decrease in COGS: •$500,000 – 25,000 -75 -100,000 = $374,925
#1 Revenue: $1,000,000 - COGS: $500,000 = $500,000 Gross Profit–other costs $400,000 = $100,000 Net Profit
#2 $1,000,000 - $374,925 = $625,075=> more Gross Profit (lower COGS) $625,075 – $400,000 = $225,075 = Net ProfitBUT: tradendollaresnhave to appear somewhere. If add to #1 as revenue,get same net profit as $225,075.
Issue of timing: book promotion $ before received.