Pricing and Costing Midterm Lesson 2

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Value Exchange and Profit Capture
• Price is the value that the firm captures in a
mutually beneficial exchange with its customers
Firm’s reason for existence is to produce
value for customers, value which they
exchange for cash
Customers purchase because they gain value
from the product in excess of the price they
pay

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Profit Formula
Profit = Quantity X (Price – Variable Costs) – Fixed Costs
p = Q (P – V) – F
Variable Costs (V)
Fixed Costs (F)
Volume or Quantity Sold (hence the Q)
Price (P)
Profit (p)

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Marginal Improvement – Price Has Impact
• Consider a firm that improves one
of the levers in the profit equation
by 1%, holding all else constant
• Example:
– P = $5.00
– Q = 200,000
– V = $3.00
– F = $325,000
– Improve either P, Q, V, or F by 1%
– How does this affect profit?
• Initial Profitability
p = 200,000 ($5.00-$3.00) - $325,00
p = $75,000
• Fixed Cost Reduction
– New Fixed Cost = $321,750
– New Profit = $78,250
– Improvement of 4%
• Variable Cost Reduction
– New Variable Cost = $2.97
– New Profit = $81,000
– Improvement of 5%
• Quantity Sold Increase
– New Quantity = 202,000
– New Profit = $79,000
– Improvement of 4%
• Price Increase
– New Price = $5.05
– New Profit = $85,000
– Improvement of 13%

9. Chapter 1
Boundaries of a Good Price
Using Exchange Value Models to
Understand Price Competition and
Define Your Value Add
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Boundaries of Price
• There is a range of “right prices”
 Range implies boundaries, upper and lower
• Extremes from standard economics:
 Marginal Cost is the Extreme Lower Boundary
 Consumer Utility is the Extreme Upper
Boundary

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Marginal Cost = Extreme Lower Bound
Marginal costs are the sellers bottom line.
• Any price below marginal costs leave the
seller worse off then they would be
without the transaction.
• Any price above it leaves the seller better
off.
• Thus, marginal costs is the extreme lower
boundary of the “right” price.

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Consumer Utility = Extreme Upper Bound
Consumer utility are the buyers bottom
line.
• The customer would be worse off if they
paid more for a product than they gained
in utility.
• Any price below consumer utility would
be leave the customer better off than
going without.

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Marginal Costs and Consumer Utility
Extreme Boundaries
• From this example, we know only two
extreme boundaries,
– Bottom boundary of marginal cost
generously estimated $325
– Upper boundary of consumer utility
frugally estimated at $500,000
• Clearly, $325 and $500,000 is a wide
range, with the upper bound a factor of
1000 above the lower bound.
– $400
– $4,000
– $40,000
– $400,000
• Managers need a tighter bound than
this for decision making.
• Blunt force economics of producer cost
and consumer utility alone is
insufficient.
Consumer Utility
$500,000
Marginal
Costs
Price Floor
$325
Range of
Potential Prices
lies between the
Extreme
Boundaries