Managerial Economics - Pricing Decision Lecture 1

MANAGERIAL ECONOMICS
MBAPEM 103
UNIT III - PRICING
DECISIONS
Kalipada Adhikary
Manager/Corp Comp
Service/NLC
1

Pricing : It’s Importance
 Important component of Revenue.
 Very sensitive w.r.t. common goods.
 Much more important for poor and lower-
middle class income group people.
 Change in price has very sharp impact on
profitability.
 Recently, Price is getting more tricky.
3

Pricing : It’s Importance
Pricing and its impact on profitability
Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing
Management 33 (2004) 765– 778
4

Learning Objectives
 Basic Concepts of Pricing
 Four market/competition
structures
 Pure competition and Perfect
competition
 Pricing in Perfect Competition
5

Pricing Timeline : Short-run
pricing
 time horizon of less than one year
 Pricing a one-time-only order
 This include decisions such as:
Adjusting product mix and output
volume in a competitive market
High return aim
Variable Component changes
6

Pricing Timeline : Long-run
pricing
 one year or longer time span
 include decisions such as:
All factor including fixed costs can be
altered
Profit margin is set to earn a reasonable
return on investment
7

Pricing Approaches
Market-Based:
 price charged is based on what customers want
and how competitors react. Starts with a target
price.
 Estimated on customers’ perceived value and
how competitors price competing
products/services
Cost-Based:
 price charged is based on what it cost to
produce, coupled with the ability to recoup the
costs and achieve a required rate of return.
8

Markets and Pricing
Approach
 Competitive Markets – use the market-
based approach
 Less-Competitive Markets – can use
either the market-based or cost-based
approach
 Non-competitive Markets – use cost-
based approaches
What pricing model NLC uses ?
9

Pricing Factors
 Pricing ultimately depends on it’s demand
and supply
 Factors those influences the Price
 Customers – their demand for product/service,
based on factors such as quality and product
features.
 Competitors – their pricing schemes, based
on product features, production volume etc
10

Pricing Factors
Costs – they affect supply (the lower the
cost, the greater the quantity a firm is
willing to supply)
Regulatory environment/ Govt Policy –
Taxes/Subisdies
More Tax on some items
Less Tax on some other items
11

Price Elasticity
 price changes impact sales volume
 Demand is elastic if a price increase has a
large negative impact on sales volume.
 Demand is inelastic if a price increase has
little or no impact on sales volume.
𝑃𝐸𝐷 =
Δ𝑄
Δ𝑃
Factors:
Availability of substitute, income level,
Necessity, Duration, Brand loyalty, Who pays!!
For Electricity, Rice & Exceptions ?
12

Who determines the price?
 Price takers – company in competitive
market has no influence on price
 As competition increase, the price becomes
squeezed between the cost of the product
and the lowest price of a competitor.
 Price makers - companies that influence the
price
 Organizations that compete by offering
innovative products/services have a more
difficult pricing decision.
13

Types of Competition/Market
 Perfect competition
large number of relatively small buyers and
sellers
standardized product
very easy market entry and exit
No non-price competition
Most Free Market Economist advocate for
this type, WHY ?
14

Imperfect Markets
 Monopoly (absolute market power)
one firm, firm is the industry
unique product or no close substitutes
market entry and exit difficult or legally
impossible
non-price competition not necessary
15

Imperfect Markets
 Monopolistic competition
large number of small firms acting
independently
differentiated product
market entry and exit relatively easy
non-price competition very important
16

Imperfect Markets
 Oligopoly
 small number of large mutually
interdependent firms
 each firm is affected by the decisions of its
rival
 differentiated or standardized product
 market entry and exit difficult
 non-price competition important
17

18

 Examples: perfect competition
 agricultural products
 financial instruments
 commodities
19

 Examples: monopoly
 pharmaceuticals with patents
 regulated utilities (although this is changing)
 Indian Railway
20

 Examples: monopolistic competition
 Saloon
 restaurants
 Repair/service shops
21

 Examples: oligopoly
 oil refining
 airlines
 internet access and cell phone service
22

What about NLC ?
PSU ?
e-commerce ?
23

UNIT TOPICS
Pure Competition
AND
Perfect Competition
24

Pure competition
 Large no. of firms each produce a tiny
fraction of market supply.
Important Characteristics
 large number of independent sellers
 homogeneous product.
Examples: farm commodities (wheat,
soybean, strawberries, milo)
25

Perfect Competition
 large number of independent, relatively
small sellers and buyers as compared to
the market size,
 no individual buyer or seller has any
influence over the price.
 economic forces operate to full extent
 allows best allocation of resources to
maximize efficiency
26

Perfect Competition
Important Characteristics
 large number of independent sellers
 identical product
 No barriers to entry and exit : no need of
patents, very high capital expenditure,
regulated market, licencing
 complete information, absence of
transport cost, perfect mobility of factors.
stock market, and the foreign exchange
market
27

Pure and Perfect Competition
Basic Difference
 Only two conditions in Pure Competition,
which ensures no question of monopoly
control
 Four condition in Perfect competition
Buyers and sellers are price takers in both
cases.
28

Price & Output Decision :
business decision questions
 What to Produce and How much to
produce?
 How much profit will be earned?
 If a loss is incurred, will it be worthwhile to
continue in this market in the long run or
should exit ?
29

Perfect Competition
Key assumptions
 Firm is a price taker
 Firm makes the distinction between the short
run and the long run
 Firm’s objective – profit maximization (or
loss minimization) in the short run
 Firm includes its opportunity cost of
operations in its total cost of production
30

Perfect Competition
Demand Curve
 Perfectly elastic demand curve: consumers are
willing to buy as much as the firm is willing to
sell at the going market price
 The firm receives the same MR from the sale
of each additional unit of product = P
 No limit to the total revenue that the firm can
gain in a perfectly competitive market
31

Perfect Competition
Demand Curve
32

Perfect Competition
 Only the industry as a whole, which determines the
market demand curve, can affect price by
changing industry output.
33

Pricing Mechanism: Some Basic
Concepts
 Total revenue (TR) - total amount received by a
firm from the sale of a product.
TR = P x Q
 Average revenue (AR) - total revenue from the sale
of a product divided by the quantity of that product
sold.
AR = TR ÷ Q
 Marginal revenue (MR) – the change in total
revenue that results from selling 1 more unit of
output.
MR = ( change in TR) ÷ (change in Q)
34

Pricing Mechanism: Some Basic
Concepts
 If MR is constant, each additional unit of
output sold adds the same amount to TR.
35

Pricing Mechanism
 Total revenue/Total cost approach:
Compare the TR and TC schedules, find the level of
output that
maximizes the firm’s profits or minimizes its loss.
 Marginal revenue/Marginal cost approach:
Level of output at which the additional revenue received
from
the last unit is equal to the additional cost of producing
that unit
(at MR=MC)
 Both the TR/TC and MR=MC approach lead to the same
price/output decision
36

Production Levels
Case A: economic
profit
The point where
P=MR=MC
is optimal output (Q*)
Profit = TR – TC
37

Production Levels
Case B: economic loss
The firm incurs a loss.
At optimum
output(MR=MC),
P < AC
If P > AVC, the firm
is better off producing in
the short run, b’coz of
fixed costs incurred.
38

Production Levels
Case C: Shutdown point: the lowest price at
which the firm would still produce
 At this point, P = the minimum point on the AVC.
 Price below this point, revenues fail to cover the
fixed costs and the variable costs. The firm
would be better off if it shut down.
39

Production Levels in Short run :
Competitive Market
Profit maximizing output
 individual firm cannot influence the market price,
 horizontal demand curve i.e. perfectly elastic – its
elasticity is infinity at all levels of output.
 Marginal Revenue (MR) curve horizontal and
coincides with AR curve. AR and MR are constant
and equal at all output.
 MR = MC rule
 The firm can adjust its variable resources (but not
fixed resources) to achieve the output level that
maximizes profit.
40

Production Levels in Long run :
Competitive Market
 In long run, Price in the competitive market
settle where firms earn a normal profit.
 Economic profit
 Entry of new firms
 Shifts the supply curve to the right
 Puts downward pressure on price
 Reduces profits to normal levels
 Economic loss
 Opposite effect of the above
41

Perfectly competitive markets in
action
 the earlier the firm enters - better chances
of earning above-normal profit – for longer
period
 new firms must find lowest possible
production cost
 Otherwise try competing by product
differentiation
 All firms in the industry have identical cost
curves
42

Perfectly competitive markets in
action
 At long-run equilibrium, firms earn zero
economic profit and earn a normal profit.
P (=MR) = MC = minimum ATC
 Firms use the limited resources in a way to
maximize the satisfaction of consumers.
 This leads to higher efficient resource
allocation, more productivity, innovation and
altogether more business.
That’s Why Most Free Market Economist
advocate for Market type.
43

Managerial Economics - Pricing Decision Lecture 1

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