P2 Chapter 7

• Profit

  Made by selling products at a price higher than the cost price
• When volume increases

  Fixed cost per unit decreases
• Lower selling price

  Leads to even higher volume
• Higher volume

  Leads to increased profits
• Price elasticity of demand

  Measures the change in demand in response to a change in price

  
• Perfectly elastic demand

  • Infinite change in demand with change in price

  
• Perfectly inelastic demand

  • No change in demand, whatever the price

  
• Negative price elasticity to demand

  • Decreased prices lead to increased demand

  
• Product A

  • For a fall in price, the corresponding rise in demand is bigger. Hence it is elastic.
• Product B

  • For a fall in price, the rise in demand is smaller, hence it is inelastic.

  
• Even though the price fall between P1, P2, P3 and P4 is equal


  The effect on demand keeps increasing

  
• Elastic demand

  PED>1, change in demand > change in price, Total revenue increases when price reduced and vice versa

  
• Inelastic demand

  PED<1, change in demand < change in price, Total revenue decreases when price reduced and vice versa

  
• Elasticity differs at different points of prices
• When price elasticity is high (i.e. more than 1) and cost inflation is higher than price inflation, putting up prices in line with costs will cause a disproportionately large reduction in demand, and total revenues will decline

  
• In times of inflation it is better to put up prices frequently by a small amount each time, as customers do not appear to notice the increases – or certainly do not react to them
• If prices are held and then substantially increased in a single price rise, demand is likely to fall off sharply

  
• The same product of different companies in the market have different price elasticities due to market conditions, hence elasticity has to be looked at with reference to competitor's reactions too, apart from just the effect on demand
• If price is increased from P1 to PA and competitors do not follow suit, the demand will fall away sharply, since consumers will have the option of substitutes
• In practice few organisations attempt to set prices by calculating demand and elasticity. This is probably because it is exceptionally hard to determine demand under different circumstances with any certainty

  
• Most organisations will have some idea of the elasticity of their products and this will have some bearing on the way prices are set
• Factors affecting demand

  • Scope of market
  • Information in market
  • Availability of substitutes
  • Complementary products
  • Disposable income
  • Necessities
  • Habit items
• Perfect competition

  • Buyer is price taker
  • No entry/ exit barrier
  • Perfect information
  • Companies aim to maximise profit
  • Homogenous products
• Imperfect competition

  • Monopoly: only one seller
  • Monopolistic competition: Limited producers, similar but non identical products
  • Oligopoly: Few companies dominate the market and are inter-dependent
• Profit maximisation model

  1. Profit is maximised when marginal cost = marginal revenue

  2. It is worthwhile a firm producing and selling further units where the increase in revenue gained from the sale of the next unit exceeds the cost of making it (i.e. the marginal revenue exceeds the marginal cost)

  3. If the cost of the next unit outweighs the revenue that could be earned from it (i.e. the marginal cost exceeds the marginal revenue), production would not be worthwhile

  4. A firm should therefore produce units up to the point where the marginal revenue equals the marginal cost: MR = MC
• Algebraic approach to profit maximisation

  Set the price equation

  2. Double b to get MR= a+2bx

  3. Establish MC, which is variable cost per unit

  4. Equate MR and MC to find Q

  5. Substitute Q in price equation to find P

  6. It may be necessary to find maximum profit

  
• Tabular approach to profit maximisation

  Fill in the table with details like units sold, selling price, variable cost, fixed cost

  2. Choose the quantity and price with the maximum profit

  
• Limitations of pricing models

  • Demand not always calculatable
  • Objective is achieving target profit, rather than theoretical max. profit
  • Finding marginal cost not easy
  • Often, quantity determines cost
  • There are a lot of other factors effecting demand

  
• Total cost plus pricing

  Adding a markup to the total cost, more used by government contractors
• Advantages of total cost plus pricing

  • Required profit will be made if budgeted sales achieved

  2. Useful for contract costing

  3. If cost structures are known, cost plus model is simple and cheap

  4. Useful in justifying price to customers
• Problems with total cost plus pricing

  • There may be variation in apportionment of fixed costs, hence varied prices

  2. Costs are apportioned on basis of normal volume, then if lower actual volume achieved, fixed costs are not recovered

  3. No account of competitor activity

  4. No flexibility in different stages of product life cycle

  
• Marginal cost plus pricing

  Adding markup to marginal cost. Higher markup needs to be added to recover fixed costs and profit both.
• Advantages of marginal cost plus pricing

  • In bad market conditions, markup can be reduced to not cover fixed costs

  2. Useful for pricing one off contracts by only considering relevant costs

  3. Contribution per limiting resource can be maximised
• Problems with marginal cost plus pricing

  • Companies in a competitive market may reduce their margins below their total cost to gain market share. Companies may keep lowering their prices until one is forced out of business and then it is difficult for the other company to raise back prices.
• Premium pricing

  Pricing above competitors permanently to position product as superior
• Market skimming

  Keeping high prices initially so that only keen customers buy it. Then prices are lowered. Again customers keen to buy it come in and then prices are lowered again. This maximises revenue.

  
• Penetration pricing

  Pricing products very low (below total cost) temporarily to gain market share and create entry barriers
• Price differentiation

  Market is split into different segments and each segment is charged different prices. Segments can be on the basis of time, quantity, function, type of customer, location, etc
• Loss leader pricing

  Setting low price for main product and charging high for add ons or extras
• Discount pricing

  Products priced lower than market norms but presented as being of same quality. Posing a low cost, high volume and low margins model.