GSBS6410

Economics of Competitive Advantage

Week 3
Pricing & Elasticity
 OUTLINE
1. Readings and Introduction
2. Simple Pricing
3. Price Elasticity of Demand
4. Other Analysis
5. Questions for Discussion

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 GSBS6410
Readings for this lecture
• Froeb Luke M., Brian T. McCann, Michael R. Ward and Mike
Shor (FMWS) 2018, Managerial Economics, Fifth edition,
Cengage Learning US, Chapter 6, and any intermediate
microeconomic textbook, especially one of the following
1. Arnold, Roger A., (2016) Microeconomics, 12th Edition,
Cengage. Chapter 6 Elasticity (if you think our text is too
simple).
2. Layton A, Robinson T, and Tucker I. (2016) Economics
For Today, Fifth Asia Pacific Edition, Cengage Learning
Australia, Melbourne. Chapter 5, Elasticity of Demand &
Supply (if you think our text is too hard).
 Simple Pricing
Simple pricing:
• A single firm selling a single product at a single price
• Most firms sell: in competition with rivals; multiple
products, and at different prices, so this is rare
• Important to understand simple pricing first though
• Simple pricing has become part of business
vernacular
– When your boss says that “demand is elastic,” she often
means that price is too high.

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 Background: Consumer Surplus and Demand Curves

• First Law of Demand - consumers demand more

(purchase more) as price falls, assuming other factors
are held constant.
• Consumers make consumption decisions using marginal
analysis, consume more if marginal value > price
• But, the marginal value of consuming each subsequent
unit diminishes the more you consume.
• Consumer surplus = value to consumer - price paid
• Definition: Demand curves are functions that relate
the price of a product to the quantity demanded by
consumers
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 Consumer Surplus and Demand Curves Example

Pizza consumer
• Values first slice at $5, next at $4 . . . fifth at $1
Pizza Demand Schedule

● Note that if pizza slice price is $3, consumer will

purchase 3 slices
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 Pizza Example (cont.)
• For the first slice, the total and marginal value
are the same at $5
• For the second, the marginal value is $4, while
the total value is $9 = $5 + $4
Pizza Value Table

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 Background: Market Demand
• Market Demand: the buying behavior of a
group of consumers; a total of all the individual
demand curves.
• To construct demand, sort by value.
Pizza Consumer Surplus

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 Market Demand
• Demand curves describe buyer behavior and tell you how
much they will buy at a given price.

● If something other than price causes an increase in demand, we

say that “demand shifts” to the right or “demand increases” such
that consumers purchase more at the same prices
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 Market Demand
• Market demand is the total number of units that will
be purchased by a group of consumers at a given
price.
• Pricing is an extent decision. Reduce price (increase
quantity) if MR > MC. Increase price (reduce quantity)
if MR < MC.
• The optimal price is where MR = MC.
• Because at the point where MR=MC, profit is
maximized.
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 The concept of elasticity

• Elasticity explains the sensitivity of one

variable to changes in another variable.
• Useful for business decision-making (e.g.
pricing, marketing) and policy-making.
• The Elasticity Coefficient (Ed) is used to
measure the degree of elasticity.

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 Price elasticity of demand

• The ratio of the percentage change in the

quantity demanded of a product to a
percentage change in its price.
• The price elasticity of demand formula is:

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 Price elasticity of demand
What is the Ed if a concert raises ticket prices from
$25 to $30, and the number of seats sold falls from
20 000 to 10 000 (ceteris paribus)?

When price increases by 1%, quantity demand

falls by 2.5%.

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 Price elasticity of demand
What is the Ed if the concert decreases its ticket
prices from $30 to $25, and quantity demanded
rises from 10 000 to 20 000 seats (ceteris paribus)?

When price decreases by 1%, quantity demand

increases by 5.9%.

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 Why are there
different price elasticities on a demand curve?

• When we move along a demand curve

between two points, we get different
answers for the elasticity, because of the
slope.
• The elasticity coefficient changes if we move
along the demand curve.

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 The midpoint formula

• To address this problem we use the

midpoint formula:

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 The midpoint formula
• It does not matter if Q1 or P1 is the first number
in each term as the midpoint method uses
averages.

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 Elasticity coefficients
• Elasticity coefficients are negative because of the
demand curve slope.
• Ignore the minus sign derived from calculations.

The • Elastic (Ed > 1)

elasticity • Inelastic (Ed < 1)
coefficient
could be: • Unitary elastic (Ed = 1)

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 The total revenue test
• Total Revenue is the revenue a firm earns from
sales:
TR = Price x Qd
• The elasticity coefficient gives us the effect on Total
Revenue of a decrease in price:
– elastic: increases total revenue
– inelastic: decreases total revenue
– unitary: no change total revenue.

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Impact of a decrease in price on total revenue

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Price elasticity of demand: The range

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 Variations of elasticity along a
straight-line demand curve

• Price elasticity of demand for a downward-

sloping straight-line demand curve varies as
we move along the curve.
• Any straight line demand curve has three
ranges:
– a price elastic range (at high prices)
– a unitary elastic point
– a price inelastic range (at low prices).

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 Variations along a
straight-line demand curve

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 • continued
Price Elasticity of Demand
• %ΔRevenue ≈ %ΔPrice + %ΔQuantity
– With elastic Demand (|e| > 1): Quantity changes more
than price.
– With inelastic Demand (|e| < 1): Quantity changes less
than price.

• MR > MC implies that (P - MC)/P > 1/|e|; in words, if

the actual margin is bigger than the desired margin,
reduce price
– Equivalently, sell more

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 Hot Wheels
• Mattel introduced Hot Wheels in 1968
• They kept price below $1.00 for 40 years, even as
production costs rose
• Finally tested a price increase, experienced profit
increase of 20%
– Why? Profit=(P-C)xQ
– Businesses tend to focus on C and Q, neglect P
• In many instances, companies can make money
by simply raising price
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 Pricing Trade-Off
• Pricing is an extent decision
• Profit= Revenue - Cost
• Demand curves turn pricing decisions into
quantity decisions:
– “what price should I charge?” is equivalent to “how
much should I sell?”
• Fundamental tradeoff:
– Lower priceg sell more, but earn less on each unit sold
– Higher priceg sell less, but earn more on each unit sold
• Tradeoff created by downward sloping demand
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 Marginal analysis of pricing
• Marginal analysis finds the profit increasing
solution to the pricing tradeoff.
– It tells you which direction to go (to raise or lower
price), but not how far to go.
• Definition: marginal revenue (MR) is change in
total revenue from selling another unit.
• If MR>0, then total revenue will increase if you sell
one more.
• If MR>MC, then total profit will increase if you sell
one more.
• Proposition: Profit is maximized when MR = MC
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 Example: Find the Optimal Price
• Once you reach the 4th unit, total profit decreases by
%0.50 because the MR from the 4th unit is only $1,
which is less than $1.50 MC
• Therefore, the profit maximizing quantity is 3 and we
see that the price is $5.00 for 3 units to be sold
Optimal Price

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 How Do We Estimate MR?
• Price elasticity allows us to calculate MR.
• Definition: price elasticity of demand (e)
(%change in quantity demanded)
(%change in price)
– If |e| is less than one, demand is said to be
inelastic.
– If |e| is greater than one, demand is said to be
elastic.

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 Price Elasticity Example
• Mayor Marion Barry increased taxes on gasoline
sales in DC by 6%.
• Before the tax, gas station predicted that the
increase in a sales tax would reduce quantity
demanded by 40%.
• The gas station owners were indirectly arguing
that gasoline revenue, and the taxes collected
out of revenues, would decline because
gasoline sales in DC has a very elastic demand.
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 Estimating elasticities
• Definition: Arc (price) elasticity=
[(q1-q2)/(q1+q2)]
[(p1-p2)/(p1+p2)]
– Discussion: Compute elasticity, when price changes
from $10 to $8, and quantity changes from 1 to 2?
• Example: On a promotion week for Vlasic, the
price of Vlasic pickles drops by 25% and quantity
increases by 300%.
– Is the price elasticity of demand -12?
• HINT: could something other than price be changing?

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 Formula: Elasticity and MR
• Proposition: MR = P(1-1/|e|)
– If |e|>1, MR>0.
– If |e|<1, MR<0.
• Discussion: If demand for Nike sneakers is
inelastic, should Nike raise or lower price?
• Discussion: If demand for Nike sneakers is
elastic, should Nike raise or lower price?

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 Elasticity and Pricing
• MR>MC is equivalent to
– P(1-1/|e|)>MC
– P>MC/(1-1/|e|)
– (P-MC)/P>1/|e|
• MR > MC means that (P-MC)/P > 1/|e|
• The left side of the expression is the current margin = (P-MC)/P
• The right side is the desired margin, or the inverse elasticity = 1/|e|
• If the current margin is greater than the desired margin, reduce the
price because MR>MC and vice versa.
• Intuition: the more elastic demand becomes (1/|e| becomes
smaller), the less you can raise price over MC because you lose too
many customers
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 What Makes Demand More Elastic?
5 factors that affect demand elasticity and optimal
pricing:
1) Products with close substitutes have elastic
demand.
2) Demand for an individual brand is more elastic than
industry aggregate demand.
3) Products with many complements have less elastic
demand.
4) In the long run, demand curves become more
elastic.
5) As price increases, demand becomes more elastic.
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 Factor 1
1. Products with close substitutes have elastic
demand.
• Consumers respond to a price increase by switching to
their next-best alternative.
• If their next-best alternative is a very close substitute,
then it doesn’t take much change in price for them to
switch.
• When Mayor Barry raised the price of gasoline, DC
commuters began buying gasoline in nearby Virginia
and Maryland.
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 Factor 2
2. Demand for an individual brand is more elastic
than industry aggregate demand.
• Rough rule of thumb: brand price elasticity is
approximately equal to industry price elasticity divided
by brand share
• Example:
– elasticity of demand for all running shoes = -0.4
– Market share of Nike running shoes is 20%
– Price elasticity of demand for Nike running shoes is -0.4/.20 = -2
– Using our optimal pricing formula, this would give Nike a desired
margin of 50%

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 Factor 3
3. Products with many complements have less
elastic demand.
• Products that are consumed as a larger bundle of
complementary goods have less elastic demand.
• Example: iPhones have less elastic demand
because of the number of apps run on them
– If the price of an iPhone increases, you are less likely
to substitute to another product due to the
complementary apps

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 Factor 4
4. In the long run, demand curves become
more elastic.
• This can also be explain by the speed at which price
information is spread; or the ability of consumers to find
more substitutes in the long run.
• Example: ATM fees
– At a selected number of ATMs, a bank raised user fees from
$1.50 to $2.00.
– When informed of the fee increase, users typically completed
the current transaction but avoided the higher-priced ATMs in
the future.

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 Factor 5
5. As price increases, demand becomes
more elastic.
• Example: high-fructose corn syrup (HFCS)
– Primary use is a caloric sweetener in soft drinks
– Sugar is the perfect substitute for HCFS
– Import quotas and sugar price supports have raised the US
domestic price of sugar about twice that of HFCS.
• Bottlers have shifted to HFCS.
– Bottlers have no close substitute for low-priced HFCS,
although as the price of HFCS approaches that of sugar,
demand for HFCS becomes very elastic.
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 Other elasticity measures
• Income elasticity, cross-price elasticity, and
advertising elasticity are measures of how
changes in these other factors affect
demand.
• It is possible to use elasticity to forecast
changes in demand:
– %ΔQuantity ≈ (factor elasticity)*(%ΔFactor).

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 Other Elasticities
• Definition: income elasticity measures the change in
demand arising from a change in income
(%change in quantity demanded)  (%change in income)
• Inferior goods (negative): as income increases, demand declines
• normal goods (positive): as income increases, demand increases
• Definition: cross-price elasticity of good one with respect
to the price of good two
(%change in quantity of good one)  (%change in price of good two)
• Substitute (positive): as the price of a substitute increases,
demand increases
• Complement (negative): as the price of a complement increase,
demand decreases

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 Income elasticity of demand

• The ratio of the percentage change in the

quantity demanded of a good or service
to a given percentage change in the
income that brought about this change in
quantity demanded.

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Income elasticity coefficients

• normal good
If Ey is • consumers purchase more
positive:
when their income rises

• inferior good
If Ey is • consumers purchase less
negative:
when their income rises

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 Income elasticity of demand
• Suppose consumers’ incomes increase from $1000 to
$1250 per month, which then results in an increase in
the quantity of cinema tickets demanded from 10 000
to15 000.

• The Ey calculated is positive suggesting that cinema

ticket is a normal good.
• Ticket sales are responsive to a change in income.

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 Cross-elasticity of demand

• The ratio of the percentage change in the

quantity demanded of a good or service
to a given percentage change in the price
of a related good or service.

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 Other Analysis
• Stay-even analysis can be used to determine
the volume required to offset a change in
costs or prices, which is how businesses often
implement marginal analysis.

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 Stay-Even Analysis
• Stay-even analysis tells you how many sales you need when
changing price to maintain the same profit level
– How to implement marginal analysis of pricing using
stay-even quantity:
(%ΔP)
%ΔQ = ----------------------------
(%ΔP + margin)
• E.g., Margin=40%, %ΔP=5%, then %ΔQ = 11.1%
• In other words, a 5% price increase would be profitable if
quantity went down by less than 11.1%.
• Use elasticity estimates or marketing surveys to determine
whether quantity would go down by 11.1%.
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 Cost-Based Pricing
• Our expression for optimal pricing, MR=MC or
(P-MC)/P= 1/|e|, takes into account the firm’s
cost structure and its consumer demand
• Often, the consumer side is ignored in pricing
decisions, leading to cost-based pricing. Why?
• Often, firms do not have the demand picture
• They need to invest in a market research
division to take profitability seriously

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 Extra: Market Share Formula
• Proposition: The individual brand demand
elasticity is approximately equal to the industry
elasticity divided by the brand share.
– Discussion: Suppose that the elasticity of demand for
running shoes is –0.4 and the market share of a
Saucony brand running shoe is 20%. What is the price
elasticity of demand for Saucony running shoes?
• Proposition: Demand for aggregate categories is
less-elastic than demand for the individual brands
in aggregate.
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 A Real Case
• In 1994, the peso devalued by 40% in Mexico
– Interest rates and unemployment shot up
– Overall economy slowed dramatically and consumer income fell
• Concurrently, demand for Sara Lee hot dogs declined
– This surprised managers because they thought demand would hold
steady, or even increase, since hot dogs were more of a consumer
staple than a luxury item.
– Surveys revealed the decline was mostly confined to premium
hot dogs
– And, consumers were using creative substitutes
– Lower priced brands did take off but were priced too low.
• Failure to understand demand and to price accordingly was
costly.
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 Questions for Discussions
1. A firm adjusted its price and found the percentage
change in quantity was larger than the percentage
change in price. If its objective is to increase its revenue,
then explain which direction you would advise it to adjust
its price.
2. If Ford, a US autos manufacturer, decides to sell its
autos to China where disposable personal income
growth rate is about 5% and the income elasticity of
demand for autos is 4, how Ford will expect the growth
rate of sales for its autos in China?

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