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Demand-based Pricing

Every pricing exploration in classical economics starts with demand analysis. Without knowing consumer demand for a product at various price levels, no business can calculate future revenue and profit streams that could be detrimental to its existence. This basic optimization process tells the company the pricing levels that will maximize its revenue. One of the common ways to calculate revenue uses the product’s demand curve. The company’s revenue can change dramatically at different price levels as the quantity demanded will vary accordingly. This is pictured in the first graph of Fig. 4.1.

In Fig. 4.1, various prices and quantities are indicated by the letters A, B, and C. In general, the higher the product’s price, the lower the demand (A), as indicated on the Quantity axis. On the other hand, if the product is priced lower, the demand rises (C) as everybody wants to benefit from the value created by the lower-priced product. Companies try to determine the best price throughout the price-quantity continuum (from A to C). In this context, the company should pick the price or price ranges where the revenue is maximized [Revenue = (Price) x (Quantity)]. The company’s revenue streams can easily be derived from the demand curve. The revenue curve, as indicated in the second graph of Fig. 4.1, can be calculated. The second graph shows a concave down curve (second-degree polynomial) with a maximum point (B). It is clear from this graph that the company’s revenue reaches the highest point at price level B.

The same results can be found using marginal analysis. This analysis helps us to calculate marginal revenue (MR), which is the change in revenue

Demand and revenue curves derived from selling one additional unit at a specific price level

Fig. 4.1 Demand and revenue curves derived from selling one additional unit at a specific price level. MR can be calculated by taking the derivatives of the second degree of the polynomial revenue curve shown in the second graph of Fig. 4.1. Derivation of the revenue curve eventually gives us another linear line ofa similar shape to the demand curve. Thus, if a demand equation (with a negative slope) can be defined as P = a — b * Q, the MR line will be P = a — 2bQ. In other words, the MR equation has the same intercept as the firm’s price equation and twice the slope, as shown by the dotted lines in the first graph of Fig. 4.1. This economic generalization is especially useful for calculating the profit maximization price and pricing levels in marketing.

The company’s exchange value can also be determined by examining the interactions between supply and demand in markets. In general terms, supply represents “seller” or “company,” while demand represents “consumer” in these kinds of analysis. The interplay between supply and demand eventually sets the product’s exchange value in markets where sellers and buyers agree. In other words, price is used as a communication tool. While the buyer or consumer signals their willingness to pay, the seller signals the value of the offerings and their willingness to sell.1 As a result of this negotiation and bargaining, markets determine the true value of products.

If a product is produced in a smaller quantity than demanded, its price will eventually be higher than expected. The scarcity of the demanded product eventually increases its price. On the other hand, if a greater quantity is produced than is needed or demanded in the market, consumers have more and cheaper options available everywhere in the market, eventually making it difficult to sell the product and hence lowering the

Demand-supply and price equilibrium

Fig. 4.2 Demand-supply and price equilibrium

price in the market. Market price reaches equilibrium when supply and demand intercept as pictured in Fig. 4.2.

In other words, market determines the price based on consumer demand and availability of the product in the market, or supply. Companies prefer to operate around the market price equilibrium to attract the right number of consumers. If a company sets its price higher than the price equilibrium, most consumers prefer not to buy it as there are more alternatives available at lower price levels in the market. If the product is not sold because of the higher prices, there will be more products available in the markets (this is called a supply surplus). On the other hand, if a company sets the price lower than the price equilibrium, most consumers will go to this lower price because they profit from the transaction (consumer surplus). Thus the company needs to set its price around price equilibrium so that its loss will be minimized for a long-standing presence in the market.

Another way to determine the product price is by looking at price demand elasticity. Price elasticity tells you how much you can or need to change the price without disturbing consumer demand. In other words, price elasticity (Ep) shows how responsive demand is to price changes; hence it can be said to measure the sensitivity of quantity to price. This, mathematically, can be formulated as follows (where Ep refers to price elasticity):

As explained in Fig. 4.1, price and quantity are negatively correlated, thus price elasticity always comes out as a negative. But, in general, elasticity is referred to without a negative sign in the industry, thus it is wise to use the absolute value of elasticity in formulations as follows:

Thus, if quantity demanded changes more than price changes, the price elasticity of demand can be said to be elastic. On the other hand, if quantity changes less than price changes, it can be said that consumers are insensitive to price changes thus price is inelastic. Finally, if the price change and quantity change is at the same level, the price elasticity equals one and it is called unitary elastic. The various price elasticities are shown in Fig. 4.3.

As illustrated in Fig. 4.3, the demand’s price elasticity is inelastic between points B and C as a price increase from P2 to P3 does not make too big a difference to the quantity demanded; between points C and D as the price increases from P1 to P2 it makes a big difference to the quantity demanded. Demand is infinitely inelastic between points A and B (where Ep = 0); and finally, it is infinitely elastic between points D and E (where Ep = да). At the infinite elasticity level, the company cannot influence the price, whereas the opposite is true in the infinitely inelastic range.

From the marketing point of view, if the company can find where the price is inelastic, then it can increase the price to the limits of elasticity so that it can maximize its profits. In other words, price-inelastic consumers are still willing to buy the product even though the price has increased, which in turn increases the company’s profit. Thus, to make a pricing decision that will maximize profit, the company needs to determine the price levels at which elasticity is high and low. This approach, in fact, can help the company to develop a segmentation strategy based on price elasticity. Furthermore, the product features can influence price elasticity. If there are more substitutes for the product in markets, it may increase consumers’ price sensitivity and hence the price elasticity as consumers can easily replace the product with near-substitutes. On the other hand, a product that requires complements can have price elasticity as the demand for the product depends on the complementary products. For example, the iPhone has low price elasticity as there are many applications required

Price elasticity

Fig. 4.3 Price elasticity

to run in the phone in order to reach efficiency. Thus, if the iPhone’s price increases, users are less likely to switch to another brand because all the information is stored in the complementary apps.2 That eventually keeps the iPhone price inelastic, enabling Apple to easily maximize its profits.

A company’s price changes influence not only consumers’ decisions but also other companies’ sales. In general, when substitute products are in price competition (such as McDonald’s and Burger King), a price change at McDonald’s might also influence demand at Burger King as these two close substitutes compete in the same market. This is called cross-price elasticity. If a company only measures the price elasticity of its own product, it will miss out on competitive reactions and their impacts on price changes. Thus, cross-price elasticity helps a company understand possible changes in competitors’ demand structure as well as market share. This elasticity measure could also be used to understand the level of price competition in the market.

Similarly, among all the various price elasticity measures, a company can use residual price elasticity which takes all the potential changes into account. The residual price elasticity is the combination of the regular price elasticity measure (or the company’s own price elasticity), cross-price elasticity, and finally competitive reaction elasticity, which takes account of competitors’ reactions to the company’s price changes. The calculation of the residual elasticity is also illustrated in Fig. 4.4.

Residual elasticity, in this context, helps marketing managers to understand potential price changes in the markets. Residual price elasticity is the most realistic elasticity measure as it is the combination of all the major market competitiveness measures. Moreover, it is a strong indicator of competitive reactions in the markets.

Overall, price elasticity can change as a result of the availability of substitute and complementary products in the market as well as product durability and the availability of other products. In short, any influences that sit at the heart of consumers’ product or brand switching and searching behaviors eventually affect price and demand elasticity.

Residual elasticity Source

Fig. 4.4 Residual elasticity Source: (Farris et al. (2006)

 
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