Pricing decisions

How have the syllabus learning outcomes been examined?

Syllabus learning
outcomes

How syllabus outcomes are

examined

Example past paper

questions

Derive and manipulate a straight line

demand equation. Derive an equation
for the total cost function (including
volume-based discounts).

The total cost function is covered in

Chapter 10a

Heat Co

Calculate the optimum selling price

and quantity for an organisation
equating marginal cost and marginal
revenue

Calculation could be followed by

discussion here

Heat Co

Evaluate a decision to increase

production and sales levels,
considering incremental costs,
incremental revenues and other
factors.

This links to short-term decisions in

Chapter 6

Determine prices and output levels for

profit maximisation using the demand
based approach to pricing (both
tabular and algebraic methods.

Calculation followed by discussion is

likely here

Explain different pricing strategies.

This has been examined via a

discussion of whether discounting and
promotions are a good idea for a
particular business.

Bits and Pieces

Explanation of the various pricing

policies may also be required.

December 09, part (b), 4 marks

Explain the factors that influence the

pricing of a product or service.
Explain the price elasticity of demand.
June 2011, part (a), 3 marks

June 2011, part (a), 3 marks

June 09, part (c), 4 marks

Stay Clean
Brick by Brick
June 2010, part (c), 6 marks
Heat Co
June 2011, part (b), 8marks

Calculate a price from a given strategy

using cost-plus and relevant costing.

This calculation requirement links with

chapter 6.

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Hammer
June 2010, parts (a) & (b), 10 marks

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Overview

Pricing
decisions

Demand
Total cost function
Y = a + bx

Price elasticity
% Q
% P

Demand function
P = a bQ

Optimal pricing
MR = MC

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Pricing strategies
Cost plus

o
o
o
o

Full cost
Marginal cost
Relevant cost
Standard cost

Market penetration
Market skimming
Premium pricing
Price discrimination
Product bundling
Psychological pricing
Product line pricing
Complementary
products
Loss leaders
Controlled pricing
Volume discounting

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Introduction

1.1

Historically the cost of a product would have had a large influence on the selling price set for
that product. Today there are many factors that will influence that price.
These factors include:
(a)
(b)
(c)
(d)
(e)
(f)
(g)

Variables which
influence demand

Demand
Quality
Competitors
Substitutes
Inflation
Age of product
Disposable incomes

Demand

2.1

Economic theory is that the higher the price charged the less demand there will be for
normal goods.

Price elasticity
2.2

Price elasticity of demand (PED) is a measure of the responsiveness of demand to changes

in price. Some products are more responsive than others.

2.3

PED is calculated

% Q % change in Q
=
% P % change in P

When PED > 1:

The product is described as having elastic demand. This means that a small change in
price will cause a proportionately greater change in quantity demanded.
When PED < 1:
The opposite applies. The product has inelastic demand and prices can be changed
greatly without creating large changes in demand.

Demand and the

individual firm

2.4

An awareness of the PED of a product will assist companies when setting price.

2.5

Where demand is inelastic prices can be raised.

2.6

If demand is elastic a decrease in price will result in an increase in volume.

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Lecture example 1

Exam standard for 2 marks

A football club charges $12 per ticket for home games. Average attendance at these regular
games is 16,000.
When prices were increased by $1 per ticket, attendance fell by 2,500.
Required
Determine the PED if ticket price increases from $12 to $13.

Solution

Demand function
2.7

Price will affect the quantity demanded for a product. Output considerations will alter the
price to be charged. If the demand function is known, and the desired output has been
calculated, the appropriate price can be determined for the product.

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5: PRICING DECISIONS

2.8

Demand functions are usually downward sloping demand falls when price rises and vice
versa.
($) P

Q (units)

2.9

If a downward sloping demand curve becomes steeper demand is becoming more inelastic.
If it becomes shallower it is more elastic.

2.10 The demand function will be in the form P = a bQ.

P

Selling price

Quantity demanded at that price

Theoretical maximum price. If price is set at 'a' or above, demand will be zero

change in price
change in quantity

Gradient of line. Represents the change in price required to

change demand by 1 unit
Exam standard for 5 marks

Lecture example 2

A football club charges $12 per ticket for home games. Average attendance at these regular
games is 16,000.
When prices were increased by $1 per ticket, attendance fell by 2,500.
Required
Assuming attendance to be purely price dependent, what should be the ticket price to ensure a full
house with capacity being 25,000?

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Solution

Optimal pricing

3.1

The desired level of output can be determined graphically by plotting total cost and total
revenue lines. This is another breakeven chart, as used by economists.

TC
MR
Profit

TR
MC

Optimal output

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3.2

The gradient of the total revenue line is known as the marginal revenue (MR). It is the
increase in total revenue from selling one more unit.

3.3 The marginal revenue will be MR = a 2bQ

3.4

The gradient of the total cost line is known as the marginal cost (MC). It is the increase in
total cost from producing one more unit.

3.5

This analysis can be used to ensure the company reaches its objective.

3.6

Profit is maximised where the gradients are equal, ie where marginal revenue = marginal
cost.

Optimal pricing approach

Step 1

Determine the demand function.

Step 2

Make the MR equation given equal to the value of MC

Step 3

Substitute the values found for a and b in step 1 into the MR formulae and solve.

Step 4

Take the quantity found in step 3 and put this into the demand function to find the
price that should be charged.

Lecture example 3

Preparation question

A firm charges $12 per unit for its product. At this price it sells 16,000 units.
Research has shown that when prices were changed by $1 per unit sales changed by 2,500 units.
The product has a constant variable cost per unit of $5.
The demand function is given by P = a bQ. The marginal revenue will be MR = a 2bQ
Required
(a)
(b)
(c)

Determine the demand function

Determine the output level to maximise profit
Determine the price to be charged to maximise profit

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Solution

Tabular approach
3.7

One approach to determining the profit maximising production plan is to calculate the extra
(marginal) costs and revenues at different combinations of output and selling price.

Lecture example 4

Preparation question

Output
(Units)
10

Total
Cost
$
10

20

25

4.50

30

45

4.00

40

70

3.50

50

100

3.00

60

135

2.50

MC
$

Selling
Price
$
5.00

Total
Revenue
$

Required
Determine the output level and selling price that will maximise profit.

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MR
$

Profit
$

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Solution

3.8

A tabular approach assumes that only discrete variables exist, ie that either 30 or 40 units
can be sold, not, say, 35. The use of equations can solve this problem.

Pricing strategies

Cost plus
Cost plus pricing
examples

4.1

The price of the product is calculated by adding an appropriate profit mark up to the
product's cost. This cost could be:

Absorption/full cost (including ABC)

Marginal cost
Relevant cost (Chapter 6)
Standard cost

Advantages
4.2

(a)
(b)
(c)

Readily understood/easy to apply.

Readily determined.
Doesn't require/assume a linear and stable price/quantity relationship.

Disadvantages
4.3

(a)

Because it ignores the impact that the price will have on quantity demanded, it will not
maximise profit.

(b)

If the basis of absorbing overheads changes, the price of the product will change.
Thus absorption costing methods require accurate overhead and activity levels.

(c)

Price may need to be adjusted to reflect market conditions.

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Market penetration
4.4

A policy of low prices when the product is first launched to obtain sales volume and market
share.

4.5

Useful if:
(a)
(b)
(c)

the firm wants to discourage new entrants into the market

the firm wishes to shorten the initial period of the product's life cycle
there are significant economies of scale to be achieved.

Market skimming

Case Study 2
Pricing strategy
leaves room for
discounts later

4.6

Involves charging high prices when a product is first launched and spending heavily on
advertising and sales promotion to obtain sales. As the product moves into the later stages
of its life cycle (growth, maturity and decline) progressively lower prices will be charged. The
aim of market skimming is to gain high unit profits early in the product's life.

4.7

Useful if:
(a)

the product is new and different, so that customers are prepared to pay high prices to
be 'one up' on people who do not own it,

(b)

the product has a short life cycle and needs to recover development costs and make
a profit quickly.

Premium pricing
4.8

Making a product appear 'different' so as to justify a premium price. The product may be
different in terms of quality, reliability, durability, after-sales service or extended warranties.
Heavy advertising can establish brand loyalty which can help to sustain a premium.

Price discrimination
Case Study 3
New laws to stop
British Internet
price rip-offs

4.9

When a company can sell into two or more separate markets, it might be able to charge a
different price in each market. To be successful the company must prevent the transfer of
goods from the cheap market to the more expensive one.

Product bundling
4.10 Selling a number of products or services as a package at a price lower than the aggregate
of their individual prices.

Psychological pricing
4.11 Psychological pricing strategies include pricing a product at 19.99 instead of 20.
4.12 Another example would be withdrawing an unsuccessful product from the market and then
relaunching it at a higher price, the customer having equated the lower price with lower
quality (which was not the seller's intention).

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Productline pricing
4.13 Most organisations sell not just one product but a range of products. Focus is placed on the
profit from the whole range rather than the profit on each single product.

Complementary product pricing

4.14 These products are sold separately but are used together. One product would tend to be
priced competitively which attracts demand for the complementary product.

Loss leaders
4.15 Particularly useful in retailing, a very low price is charged for one product, which is intended
to make consumers buy additional products in the range that carry higher profit margins.

Controlled pricing
4.16 Monopolies have the potential power to charge very high prices for their goods/services as
demand is inelastic. Frequently monopolies are regulated to ensure customers receive value
for money.

Volume discounts
4.17 These are given in order to increase sales volume without reducing prices permanently.
They also allow differentiation between customers ie wholesale v retail.

Other considerations

5.1

Bear in mind decisions should not just be based on financial factors. Non financial
considerations should also be made.
These might include:

Company objectives profit, sales, revenue, market share, long term or short term
Competition and markets competing products and reaction of competitors
Production capacity demand may exceed supply
Product lifecycle introduction, growth, maturity, decline
Superior innovation, technology or quality may set higher prices
Customer's buying power
Other products in range displacing or supplementary
Availability of resources
Impact on staff
Impact on customers
Competitors' reactions
Opportunity costs
Impact on other products

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Lecture example 5

Exam standard for 10 marks

Recently company X has developed a new portable DVD recorder and wonders what price it
should charge for a product which is at the leading edge of technology.
Required
Explain the relevance of the product life cycle when considering which pricing policies could be
adopted.

Solution

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Chapter summary
Section
2

Topic

Summary

Demand

PED measures the responsiveness of demand to a

change in price. PED >1 = elastic demand. PED <1 =
inelastic demand
Price can be determined using the demand function:
P= a bQ

Optimal pricing

The output level to maximise profit is found when MR =

MC.
The output level to maximise revenue is where MR = 0.
Prices at these output levels can then be determined
from the demand function.

Pricing
strategies

There are several strategies that can be applied to a

product. These strategies may be changed depending
upon the stage in the product life cycle.

Other
considerations

The pricing strategy should be chosen bearing in mind

both financial and non-financial factors.

END OF CHAPTER
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