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CH 2CH 2 The Economics of Price Determination Kent B. Monroe (2007). Pricing: Making Profitable Decisions. 3 rd Edition (Singapore: McGraw-Hill).

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Presentation on theme: "CH 2CH 2 The Economics of Price Determination Kent B. Monroe (2007). Pricing: Making Profitable Decisions. 3 rd Edition (Singapore: McGraw-Hill)."— Presentation transcript:

1 CH 2CH 2 The Economics of Price Determination Kent B. Monroe (2007). Pricing: Making Profitable Decisions. 3 rd Edition (Singapore: McGraw-Hill).

2 02 Chapter Objectives Chapter Objectives (P.26) 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.

3 03 Price Determination Theory Price Determination Theory (P.26-27) The firm Minimize input cost Maximize profit Economic theory is more concerned with the behavior of aggregates or markets, particularly how persistent and widespread behavior leads to stable results called Equilibrium.

4 04 Price Determination Theory Price Determination Theory (P.26-27) 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.

5 05 The Profit-Maximizing Firm The Profit-Maximizing Firm (P. 28) 0 Q1Q1 Q*Q* Q Fixed costs Revenues or Costs $ Units Total Revenue Maximum Profits Total Costs Figure 2.1 Output Determination for Profit-Maximizing Firm – Short Run (Constant Prices) : Aggregate Analysis Price

6 06 The Profit-Maximizing Firm The Profit-Maximizing Firm (P. 28) 0 Q*Q* Q Costs $ Units Price Average costMarginal cost (Marginal revenue) Figure 2.2 Output Determination for Profit-Maximizing Firm – Short Run (Constant Prices) : Marginal Analysis

7 07 0 Q*Q* Q Price $ Units Demand Marginal cost (Marginal revenue) P*P* Figure 2.3 Output Determination for Profit-Maximizing Firm – Short Run (Varying Prices) The Profit-Maximizing Firm The Profit-Maximizing Firm (P. 29)

8 08 Challenges to the Profit Maximization Obj. Challenges to the Profit Maximization Obj. (P. 29) Profits are not the only objective of managers of the firm. The actual objectives of the organization are determined by a wide range of … personal objectives pressures constraints from the external environment The goal of some managers may be to simply attain satisfactory profits.

9 10 Corporate and Pricing Objective Corporate and Pricing Objective (P. 30) The organizations specific marketing objectives are based on those corporate objectives. Setting objectives for one element of the marketing mix. Pricing objectives should be consistent with & should advance corporate & marketing objectives

10 11 3 Classifications of Pricing Objectives 3 Classifications of Pricing Objectives (P. 30) PROFITABILITY Objectives VOLUME-BASED Objectives COMPETITIVE Objectives

11 12 Profitability Objectives Profitability Objectives (P. 30) 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.

12 13 Elements of Profitability Elements of Profitability (P ) PiPi VC i FC QiQi Monetary sales mix P i = Price per unit of each product or service offering. VC i = Variable costs per unit of each offering. FC = Fixed costs per period. Q i = Volume produced and sold of each offering. Monetary sales mix of the offering sold.

13 14 Profit Maximization Profit Maximization (P. 31) Low pricesHigh prices Low unit profit marginsHigh unit profit margins High unit salesLow unit sales High inventory turnoverLow inventory turnover Depending on the marketing situation, maximum profits over a planning period may be obtained by either pricing the firms 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.

14 15 Target Return on Investment Target Return on Investment (P. 31) 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 Wholesalers & Retailers Inventory Buildings WHAT DO THEY INVEST ON ? Manufacturers Capital Machinery Buildings Land Inventory A firm with $10 million in capital assets, seeking a 15% ROI, would seek to achieve net contribution to profits of___________for the planning period. Example $1.5 million

15 16 Volume-Based Objectives Volume-Based Objectives (P. 32) Customer Demand Creation 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. Sales Volume

16 17 Competitive Objectives Competitive Objectives (P. 32) 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.

17 18 Establishing Relevant Pricing Objectives Establishing Relevant Pricing Objectives (P ) Profitability ObjectivesVolume-Based ObjectivesCompetition Objectives The firm is the low-cost supplier The firm is low-cost supplier The firm is the low-cost supplier The firm is the price leader The market is price sensitive There are no perceived value differences across sellers in the minds of buyers There is an internal required rate of return for new product introductions Cost decline as volume increases Market share could be captured using non-price marketing efforts 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 19 Summary Summary (P. 34) 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.

19 20 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 Boeings current pricing objective? Seat Work 1 Seat Work 1 (P. 35)

20 21 Market Structure : Degree of Competition Market Structure : Degree of Competition (P. 35) Perfect (Pure) Monopoly Perfect (Pure) Competition Imperfect Competition Monopolistic Competition Oligopoly Depending on the structure of competitors within a market, firms may have considerable discretion to determine prices. Table 2.1 Characteristics of Market Structure

21 22 Market Structure : Degree of Competition Market Structure : Degree of Competition (P. 36) Perfect Monopoly Only one seller supplies the product or service Considerable degree of power over price/Government regulations

22 23 Perfect Competition Many sellers offer many buyers an identical (homogeneous) product; no seller can influence price Market Structure : Degree of Competition Market Structure : Degree of Competition (P. 36)

23 24 Imperfect Competition 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 Market Structure : Degree of Competition Market Structure : Degree of Competition (P. 36) Year 2008

24 25 Monopolistic Competition Market Structure : Degree of Competition Market Structure : Degree of Competition (P. 37) 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

25 26 Oligopoly Market Structure : Degree of Competition Market Structure : Degree of Competition (P. 37) 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

26 27 The Laws of Supply and Demand The Laws of Supply and Demand (P. 38) 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.

27 28 The Laws of Demand The Laws of Demand (P. 38) 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.

28 29 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 Factors Affecting Laws of Demand

29 30 The Laws of Supply The Laws of Supply (P. 38) 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.

30 31 Equilibrium Equilibrium (P. 39) 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.

31 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 Price Elasticity of Demand Price Elasticity of Demand (P. 43) E d = price elasticity of demand Δ Q = quantity change in demand Δ P = quantity change in demand Q 1, P 1 = original quantity demanded and price, respectively

32 33 Income Elasticity of Demand Income Elasticity of Demand (P. 44) Income elasticity of demand: responsiveness of the quantity demanded of a product or service to a change in personal income If E I is negative, the product is an inferior good Income goes up fewer units are demanded (switch to steak, less hamburger) If E I is positive, the product is a normal good Demand increases as income increases If 0< E I <1, the product becomes less important in households consumption plan If E I >1, the product becomes more important as income increases.

33 34 Cross-Price Elasticity of Demand 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 If E C is negative, the two products are complementary If E C is positive, the two products are substitutes

34 35 Consumers Surplus Consumers Surplus (P. 50) 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

35 36 Sellers Surplus 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


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