Chapter 6 - Simple Pricing

Managerial
Economics, 6e
Chapter 6: Simple Pricing
Froeb
Froeb etet
al.,al., Managerial
Managerial Economics,
Economics, 6th ©
6th Edition. Edition. © 2023AllCengage.
2023 Cengage. All Rights
Rights Reserved. Reserved.
May not May
be scanned, not be
copied scanned, or
or duplicated, copied
postedor
to a publicly
duplicated, or posted
accessible website, toorainpublicly
in whole part. accessible website, in whole or in part. 1
Icebreaker: Interview Simulation
A bar offers its patrons free nuts with their drinks.
Why do you think it does so?
What impact would it have on consumer thinking and behavior?
Will it play a role in affecting demand if the bar decides to raise the
prices of its drinks?
Froeb et al., Managerial Economics, 6th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly
accessible website, in whole or in part. 2
Chapter Objectives
By the end of this chapter, you should be able to:

• 06.01 Define individual demand and aggregate (or market) demand.
• 06.02 Describe pricing and the steps to arrive at an optimal price.
• 06.03 Estimate the price elasticity of demand using the appropriate formula and
explain the factors affecting elasticity.
• 06.04 Explain how to use different elasticities including income elasticity, cross-
price elasticity, and advertising elasticity to forecast changes in demand.
• 06.05 Use stay-even analysis to determine the quantity change required to
offset a price change.
Introduction
• Pricing is a powerful but oft-neglected tool:

− Many companies focus on selling more or reducing costs.
− Setting a price too low can prove to be costly.
• Simple pricing should be understood before moving on to pricing in
more complex settings.
Individual Demand Curves (1 of 2)
• Consumers use marginal analysis to decide how much to buy.
• A demand curve shows how much consumers will purchase at a given
price.
− First law of demand: consumers buy more as price goes down
• Consumer surplus is the difference of total value and amount paid.
• Changes in quality demanded in response to price
Individual Demand Curves (2 of 2)
• To describe buying behavior of a group, we add individual demand curves

to get the aggregate demand curve.
Knowledge Check Activity 1
Christine has purchased five bananas and is considering the purchase of
a sixth. It is likely she will purchase the sixth banana if:
a) the marginal value she gets from the sixth banana is lower than its
price
b) the marginal benefit of the sixth banana exceeds the price
c) the average value of the sixth banana exceeds the price
d) the total personal value of six bananas exceeds the total expenditure
to purchase six bananas
Knowledge Check Activity 1 - Answers
Correct answer:
b) the marginal benefit of the sixth banana exceeds the price
Marginal Analysis of Pricing
• Trade-off between price and quantity sold is at the heart of pricing

decisions.
• Using marginal analysis for the pricing decision
• Sell at the price at which total profit (sum of marginal profits) is
highest.
• Do not confuse average revenue or price with marginal revenue or
price.
Which of the following is the reason for the existence of consumer
surplus?
a) Consumers can purchase goods that they <want= in addition to what
they <need.=
b) Consumers can occasionally purchase products for less than their
production cost.
c) Some consumers receive temporary discounts that result in below-
market prices.
d) Some consumers are willing to pay more than the price.
Correct answer:
d) Some consumers are willing to pay more than the price.
Discussion Activity 1
A product costs $1.50 to make. The table shows how many units will be
purchased at each price and the MR and MC for each unit. Discuss the
optimal price in this situation. Why should the price not be higher or
lower than this?
Price Quantity Revenue ($) MR ($) MC ($) Profit ($)
7 1 7 7 1.50 5.50
6 2 12 5 1.50 9.00
5 3 15 3 1.50 10.50
4 4 16 1 1.50 10.00
3 5 15 –1 1.50 7.50
2 6 12 –3 1.50 3.00
1 7 7 –5 1.50 –3.50
Price Elasticity and Marginal Revenue
(1 of 4)
• Demand curves are only rough estimates, but not needed to price
optimally if using marginal analysis.
• If �㕀ā > �㕀ÿ, we need to reduce price; if �㕀ā < �㕀ÿ, we need to increase
price.
• Estimating MR by measuring quantity responses to past price changes
• Price elasticity (e) measures how sensitive demand is to price changes.
− Elasticity e = %�㗥Āþ�㕎Āý�㕖ý�㕦 Āÿÿ�㕎Āþÿþ ÷ %�㗥ÿ�㕟�㕖ýÿ
− Elasticity is often referred to using its absolute value, ÿ.

(2 of 4)
• Computing percentage changes:
−ÿ = Ā1 2 Ā2 ÷ Ā1 + Ā2 ÷ ÿ1 2 ÿ2 ÷ ÿ1 + ÿ2
• For an elastic demand, a decrease in price leads to an increase in
revenue.
− %�㗥āÿÿÿĀþÿ j %�㗥Āþ�㕎Āý�㕖ý�㕦 + %�㗥ÿ�㕟�㕖ýÿ
(3 of 4)
• Price increase → Revenue decrease

For Elastic Demand • Price decrease → Revenue increase
• Price increase → Revenue increase

For Inelastic Demand • Price decrease → Revenue decrease
(4 of 4)
• Relationship between price, revenue and elasticity:
121
− �㕀ā = ÿ
|�㕒|
�㕃2�㕀�㔶
− �㕀ā > �㕀ÿ implies that > |ÿ|.
�㕃
− If |ÿ| < 1 , demand is inelastic.

• The more elastic the demand, the less profitably you can raise price.
Case Study Activity 1
Tax Increase on Gasoline Sales in DC
Mayor Marion Berry proposed a tax increase on gasoline sales in the
District of Columbia. Price elasticity of demand for gasoline sold in DC
was estimated to be –6.7. Why were gas station owners against the
proposed 6% price increase? What impact would it have on gasoline
sales and tax revenue? What would have happened had the elasticity
been –0.5?
To conduct an experiment, AMC increased movie ticket prices from
$9.00 to $10.00 and measured the change in ticket sales. Using the data
over the following month, they concluded that the increase
was profitable. However, over the subsequent months, they changed
their minds and discontinued the experiment. How did the timing affect
their conclusion about the profitability of increasing prices?
What Makes Demand More Elastic?
• Products with close substitutes have more elastic demand.

• Demand for an individual brand is more elastic than industry aggregate
demand.
• Products with many complements have less elastic demand.
• In the long run, demand becomes more elastic.
• As price increases, demand becomes more elastic.
High fructose corn syrup (HFCS) is a caloric sweetener used in soft

drinks. Sugar is a perfect substitute for HFCS but import quotas and
price supports have kept its price at about twice that of HFCS.
Discuss the effect of a price increase in HFCS on its elasticity of
demand.
Forecasting Demand Using Elasticity (1 of 2)
• The change in quantity:
− %�㗥Āþ�㕎Āý�㕖ý�㕦 j ÿ %�㗥ÿ�㕟�㕖ýÿ
− Can be predicted by using elasticity and percentage price change.
• Factor elasticity of demand:
− (%�㗥Āþ�㕎Āý�㕖ý�㕦) ÷ %�㗥�㔹�㕎ýýā�㕟
− Can be used to measure the effects of variables other than price on
demand.
Forecasting Demand Using Elasticity (2 of 2)
• Income elasticity of demand measures change in demand arising from
changes in income.
− Positive income elasticity: the good is normal
− Negative income elasticity: the good is inferior
• Cross-price elasticity of demand measures change in demand for a
product caused by a change in price of its substitute or complement.
Which of the following goods has a negative income elasticity of
demand?
a) Cars
b) Items from Dollar stores
c) Shoes
d) Bread
Correct answer:
b) Items from Dollar stores
Stay-Even Analysis, Pricing, and Elasticity
• Stay-even analysis: A price increase will be profitable if the predicted

quantity decrease is less than the stay-even quantity and vice versa.
%�㗥�㕃
− Compute the stay-even quantity: %�㗥Ā =
%�㗥�㕃 + ÿ�㕎�㕟�㕔�㕖Ā
− Predict how much quantity will go down if you raise price

• Experiments like randomized trials can also be used to test the
profitability of pricing strategies.
Written Reflection Activity
Suppose you’re trying to compare the year-to-year performance of one
of your regional salespeople over a period in which income grew by 3%. If
demand for your products has an income elasticity of 2, you would
expect quantity to increase by 6%.
How would you factor this to arrive at a performance measure closely
related to sales effort? Justify your reasoning.
Cost-Based Pricing
• Many companies set prices based on costs, ignoring demand.

− Cost-plus pricing
− Mark-up pricing
• Ignoring demand leads to suboptimal pricing.
• Cost-based pricing persists due to lack of information.
• Firms need market research divisions as much as cost accountants.
Think, Pair Share/Breakout Groups Activity
It costs Mattel $0.50 to produce a Hot Wheels toy car, which it sells for
$0.75.
If Mattel were to double the price, how would the margin be affected?
What percentage of its customers can it afford to lose at the new price
to still earn the same profit?
In what case would the price increase be profitable?
Summary
Click the link to review the objectives for this presentation.

Link to Objectives
Self Assessment Activity
A bakery currently sells chocolate chip cookies at a price of $16/dozen.
The MC is $8/dozen. The cookies are becoming more popular with
customers, and so the bakery owner is considering raising the price to
$20/dozen. What percentage of customers must be retained to ensure
that the price increase is profitable?
a) 28.0%
b) 33.3%
c) 66.6%
d) 72.0%

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Managerial

By the end of this chapter, you should be able to:

• Pricing is a powerful but oft-neglected tool:

• To describe buying behavior of a group, we add individual demand curves

• Trade-off between price and quantity sold is at the heart of pricing

− Elasticity is often referred to using its absolute value, ÿ.

• Price increase → Revenue decrease

• Price increase → Revenue increase

− If |ÿ| < 1 , demand is inelastic.

• Products with close substitutes have more elastic demand.

High fructose corn syrup (HFCS) is a caloric sweetener used in soft

• Stay-even analysis: A price increase will be profitable if the predicted

− Predict how much quantity will go down if you raise price

• Many companies set prices based on costs, ignoring demand.

Click the link to review the objectives for this presentation.

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