Chapter 6: Estimating demand and revenue relationships

Learning outcomes After this study unit, you should be able to: Describe the demand curve and its influence on pricing Described the supply curve and its influence on pricing Explain price elasticity and discuss why it is important for marketers Explain why customers are price sensitive and discuss how to measure price sensitivity Discuss the different types of costs that need to be taken into account when setting prices Discuss marginal and break-even analysis

Introduction Pricing, despite its importance to marketers, is often mismanaged. Marketers aim to create value for customers by creating a product that meets their needs; by promoting the product to the customers and finally by making sure that the customer can get hold of the product via appropriate distribution. Price is the only element by which marketers attempt to get back some of the value that they created. When the pricing objectives revolve around maximising or increasing sales, marketers need to take the customer into account very early on in the price setting process.

Understanding supply and demand The marketplace consists of buyers and sellers. Organisations that manufacture and sell products and services represent the sellers. Customers who purchase products and services in order to consume them represent the buyers. Buyers want to get the most value at the lowest possible cost. Sellers would like to sell at the highest possible price. This leads to an imbalance in the economic equilibrium and a difference of opinion when it comes to buying and selling.

The supply curve Price Quantity supplied

The demand curve Price Quantity demanded

Price elasticity When it comes to certain types of products, customers tend to be very sensitive about price changes. If the price goes up by a few rands or even cents, the customer demand for the product changes dramatically. In other cases, the price can fluctuate up or down and customers will continue buy the same quantities. Marketers take the customers price sensitivity into account when they set prices by calculating the percentage change in sales for each percentage change in price. This ratio is called price elasticity.

Price elasticity Price elasticity of 1 means that demand is unitary. Unitary demand makes life predictable for marketers because they know that any change in price (up or down) will result in the inverse reaction in quantity demanded. Let us consider a different scenario. Price elasticity of less than 1 is called inelastic demand. Inelastic demand implies that customers are more tolerant of price changes and will continue to purchase the product even at a higher price. Price elasticity of greater than 1 is called elastic demand. This means that for a small change in price the consumer demand will vary by a much larger proportion.

Factors affecting price sensitivity The buyers’ perceptions and preferences. Customers tend to be less price sensitive when it comes to products that they believe they cannot do without or products that they believe have unique benefits. The buyers’ awareness of alternatives or substitutes. If customers are aware that there are alternatives to the product, they tend to be more sensitive to price changes. The buyers’ ability to pay. If customers just cannot afford the higher price, then they will have to purchase less. The proportion of expenditure to income. Customers will be less sensitive about price changes if the expenditure represents a small portion of their income.

Factors affecting price sensitivity cont… Effect Description Impact on price sensitivity Unique value Customers perceive the product to have unique benefits or value to them Lower Perceived substitute Customers believe that substitute products are easily available Higher Difficult comparison It is difficult for customers to make product characteristic, benefits or price comparisons Total expenditure The expenditure on the product represents a large portion of the customer’s total expenditure End benefit Customers believe that the benefit received from the product is unique Shared cost Customer only pay for a part of the cost of the product Sunk investment Customers have already purchased complimentary products that are used in conjunction with the item Price-quality Customers believe that the product is a prestige item of high quality Inventory Customers cannot store the product Source: Adapted from Nagle and Holden12

Methods of measuring price sensitivity Expert judgments Expert judgements involve asking market experts to provide expected sales figures for high potential prices and low potential prices for a specific product. Customer surveys Using customer surveys to measure price sensitivity means asking customers how much they intend to purchase at different prices levels. Price experimentation Price experimentation involves varying the selling price in a store and then carefully monitoring the resultant sales. Historical price data Analysis of historical price data can reveal how demand fluctuated over time in response to changes in price.

Estimating revenue Total revenue is calculated by multiplying the unit price of the product by the quantity sold. Total revenue is therefore: Marginal revenue is the additional revenue that is generated by selling one more unit of the product. Marginal revenue is calculated as follows:

Estimating revenue cont… Average revenue is equal to the total revenue divided by the number of products sold. Average revenue is calculated as:

Costs, marginal analysis and volumes Using costs as a basis for setting prices is one of the oldest and probably the most intuitive of all pricing methods. Fixed costs are those costs that the company will have to pay, regardless of whether they produce a single unit or not. Cost items like salaries, rent and electricity tend to be fixed and payable every month. Some people refer to fixed costs as ‘overheads’. Variable costs are those costs that rise or fall depending on the quantity of products that are produced. Variable costs tend to represent the raw materials that are used on the production process and even additional staff or overtime that may be required when producing more products than usual.

Costs, marginal analysis and volumes cont… Total costs are the sum of all fixed costs and variable costs. Average cost is the total costs divided by the quantity produced. Marginal costs represent the additional cost that would be incurred if additional units (usually one) were to be produced.

Costs, marginal analysis and volumes cont… Break-even analysis Break-even analysis attempts to find the sales volume needed to cover all costs at a specific price and shows the relationship between total revenue and total costs. The break-even point is reached when the company produces just enough units to neither make a profit nor incur any loss at a given price.

Costs, marginal analysis and volumes cont… Break-even analysis

Summary This chapter has illustrated that selecting the correct price is more than simply covering costs or meeting demand, but rather it is a complex balance of multiple variables. Marketers need to take into account what they aim to achieve with the chosen price: do they want to increase sales, increase profitability or simply match the competition. No matter what the ultimate pricing objective, the marketing manager will have to take into account consumer demand, revenue, costs and break-even quantities.