Week 11: Profitability and Pricing 2 - Pricing Strategy
Reservation price and Consumer surplus
Reservation price
maximum price that a customer will buy the product
represents the maximum willingness to pay of a customer
Consumer surplus = Reservation price - price paid by customers
example: page 5
Maximum Reservation Price (MRP): least price at which demand is 0
Maximum Willingness to Buy (MWB): expected demand when the product is free
Price elasticity
Price elasticity = % change in quantity/ % change in price
Price elasticity is negative for all products except Giffen and Veblen (status- seeking) goods
3 categories
| PE | = 1 => unitary elastic
| PE | > 1 => price elastic
| PE | < 1 => price inelastic
example: page 9
% change at current price
Linear Demand
Q = MWB x ( 1 - P/ MRP) => diagram on page 11
linear equation
a = MWB (intercept)
b = - (MWB/ MRP) (slope) => downward sloping
page 12 for more details
MWB = Q1 - [(Q2 - Q1)/ (P2 - P1)]P1 (example: p.13)
MRP = P1 - [(P2 - P1)/ (Q2 - Q1)]Q1 (example: p.13)
price elasticity
elasticity = slope x (P1/Q1) = -(MWB/ MRP)(P1/Q1)
more detail on page 14
example: p.15
optimal price
the relationship between total contribution and price is an inverse U- shape
optimal price = (MRP + variable cost)/ 2
Gross Margin (%) at optimal = -1/ elasticity at P*
Contribution = (MWB/ MRP) (P* - VC)^2 ???
page 18
Constant elasticity demand
elasticity is constant while the slope changes at every point
elasticity = ln(Q2/ Q1)/ ln(P2/ P1)
Model: Q = A*P^(ELAS)
A: scaling factor
graph: p.19
Q2 = (P2/P1)^(ELAS) x Q1 (example: p.20)
optimal pricing
optimal P = variable cost x (ELAS/ 1 + ELAS)
Residual price elasticity
Residual elasticity = E1 + E2*E3
E1 = Own price elasticity
E2 = Competitor Reaction Elasticity = % change in competitor's price = % change in own price
E3 = Cross elasticity = % change in quantity sold/ %change in competitor's price
Change in sales (%) = Own price change (%) x Residual price elasticity (example: p.24)
Using regression: p.25
MWB = -slope x MRP (where slope is elasticity of demand)