UNIT-2
Estimating Demand Curves: Estimating
Linear and Power Demand Curves
Demand curve estimation refers to the exercise of estimating the demand
curve, typically the market demand curve (as opposed to the individual demand
curve) for a good. Demand curve estimation is typically done for the following
purposes:
·
It may be done by sellers (and in some cases buyers) with
significant market power, so that they can decide the appropriate price to set.
Note that buyers or sellers who do not have market power simply set the price
as the market price and know that whatever quantity they produce will get sold.
In contrast, in the extreme case of a monopoly, the seller chooses both the
price and quantity but is not guaranteed to sell everything. In order to be so
guaranteed, the seller needs to have a plot of the market demand curve so that
the (price, quantity) pair can be chosen as a point on the demand curve.
·
It may be done by buyers or sellers in order to better estimate
prices and quantities to buy or sell for the future. Note that this is
advantageous even in a perfectly competitive market: with knowledge of the
future demand and supply curves, sellers can estimate future prices, and
therefore optimize their long-run choices (i.e., make appropriate fixed cost
investments).
·
Linear
Demand Curve
·
Understanding
linear demand curves is critical to learning the basics of how a market works
and running a successful business. Being able to use a demand is almost like
telling the future, because it predicts consumer behavior. However, in the real
world, most curves are nonlinear, so you constantly need to analyze demand for
your products.
·
Identification
of Linear Demand Curve
·
A linear
demand curve is the graphical representation of the relationship between the
price of a good and the quantity of that good consumers are willing to pay at a
certain price at a point in time. The slope, or rate that the line rises or
falls, is equal to the difference between two quantities of a product — usually
represented on the horizontal axis on the graph — divided by the difference
price of two points of the graph — usually on the vertical axis.
·
Features of
Linear Demand Curve
·
Linear
curves rarely exist in the real world because demand depends in large part on
elasticity of demand, or how consumers react to a change in price. Also, the
relationship between demand and price is not always constant. Some products are
in demand regardless of price. For instance, customers probably use about the
same amount of electricity regardless of price because it is essential to
living. On the other hand, televisions are a luxury, so consumers usually
become exponentially more willing to buy a unit as the price drops.
·
Tip for
Linear Demand Curve
·
Look at
data from your past sales to graph a demand curve. You may want to hire a
market research firm to help you set the price on your goods or calculate
production level if you do not have sales data. You may also need to use your
own estimation skills and to factor in the economic environment. For instance, Christmas
decorations and new toys usually spike in price right before the holidays but
fall during the beginning of the year because demand plummets. In the world of
supply and demand, price increases as demand increases, and vice versa.
Optimize Pricing
Price optimization is using data from customers and the market to understand
how you should most effectively be pricing your product. The optimal price
point is the price where companies can best meet their objectives, whether that
means increased profit margins, customer growth, or a blend.
Information used in
price optimization includes things like:
·
Customer survey data
·
Demographic and psychographic data
·
Historic sales data
·
Operating costs
·
Inventories
·
Machine learning outputs
·
Subscription lifetime value and churn data (for subscription
business models)
·
Pricing
optimization is a similar process to dynamic pricing strategies used in
hospitality, travel, ecommerce, and other industries, although dynamic pricing
tends to change much more rapidly as companies tweak pricing to match real-time
demand.
·
Finding the
right price for your product—a price that maximizes value for customers and
profit for you—starts with gaining a deep understanding of your customers. You
need to understand who your best customers are, what features they like, and
what features they need. Once you understand that, you can align your pricing
with what they value, tracking the results of the price changes you make and
improving over time.
(i)
Get to know your
customers
Optimizing
your pricing is all about the data—both qualitative and quantitative. Hard data
is the only way to find out how much customers are willing to pay for your
product, and it’s the key to breaking free from the guessing cycle.
Quantitative
data, like transactional data, customer reviews, supply and demand data, churn
rate, MRR, and more show you how you’re doing and what needs to be changed.
Software like Price Intelligently can help you make sense of those metrics and
turn them into pricing insights by slicing and dicing your data based on
demographic, psychographic, and customer preferences.
Just
as helpful, qualitative data comes from talking to customers. Surveys are
great, but they’re no match for picking up the phone and actually talking to
customers, asking them about topics such as their price sensitivity and what
features or benefits they value most in your product.
(ii) Quantify value
Once
you’ve collected all your customer data, it’s time to work out what “value”
actually means to your customers. That means working out your value metric.
Your value metric is essentially what and how you’re charging for your
product—identifying and pricing along your proper value metric is the
difference between surviving and thriving.
(iii) Analyze the data
You’ve
collected some customer data and worked out what your customers value—now it’s
time to look for patterns in the features, benefits, price points, and value
metrics that drive or detract from value. You’ll also find out how willing
different segments and personas are to pay different prices for your products.
Use
your findings to create tiers and proper packages for your product or services.
Each tier should be priced along your value metric, and should align with your
different buyer personas so that you’re offering the right amount of product or
service to each customer segment.
(iv) Adjust pricing and monitor
Even
once you’ve set your prices, you’re still not done—the value you provide versus
your competitors’ is constantly changing, so you need to be constantly
monitoring and adjusting your pricing.
Pricing
is an ongoing process. You should use your pricing strategy to eliminate as
much doubt as possible. Think back to our dartboard example from
earlier—adjusting your pricing helps eliminate sections of the dartboard,
focusing in on the right region for your dart to land as you learn more about
what works.
You
need to continually collect data and analyze the value customers are getting
from your product to make sure that what you’re offering still meets your
customers’ needs and pricing desires. Make sure you keep a very close eye on
your pricing, and see how customers respond. If need be, re-evaluate and change
things up—but don’t be too quick to switch, since you might alienate potential
or existing customers.
Need to optimize for
The
goal of pricing optimization is to find that perfect balance of profit, value,
and desire. Since you can’t control which products and features customers want,
and adding valuable product features takes time and effort, most companies
start finding that balance by setting two things: the starting price of their
product or services, and any discounts or promotions they might offer.
(i) Starting prices
Your
starting price, or base price, is important since it lets customers know
whether your product or service is worth their time and investment. Starting
prices should be optimized to match the baseline demand for your product before
any discounts or promotions are applied. Optimizing the starting price works
well for companies with products and services that remain fairly stable over
time, like groceries, office supplies, or even SaaS products.
(ii) Discounted prices
If
you’re in sales, you need to know what works best to pull in new customers.
Offering your product at a discount—or, in some cases, even offering a freemium
version—is a great way to bring in new customers (customers acquired through
freemium offerings cost nearly half as much to acquire as those who sign up for
paid offerings directly).
(iii) Promotional prices
What
promotional offers would serve you and your customers best? Will markdowns
create any additional profit, or are you better off charging the starting
price? How big of a discount should you offer below your starting prices? How
long will something take to sell at a specific price point? Optimizing your
promotional prices can help boost sales for newly introduced products and
promotional bundles—for example, a SaaS company launching a new product, or
bundling multiple products.
Why many companies fail at pricing?
To
make a long story short, most companies aren’t willing to put in the effort to
optimize their pricing decisions. All the customer research needed to figure
out the right valuations takes time and effort. Surprisingly, the average
company only spends less than ten hours per year on their pricing strategy,
which is not enough.
Instead,
companies turn to strategies like guessing, relying on discounts, and not
pricing based on value.
(i)
Guessing
Many
companies simply guess what an optimal price point would be instead of using
analytics and metrics that their customers have given them. It’s an insidious
cycle. With the right positioning and promotion, even guessing at your prices
will work to some extent—it’s easy to take that as a sign that your pricing is
“good enough.” Ultimately, though, you are leaving money on the table.
(ii)
Misunderstanding tiers
Many
companies don’t know how many different pricing tiers or levels they should
incorporate into their pricing structure. It’s a common misconception that more
tiers equals more conversions. Data shows that too many or too few options
pushes away potential customers, with a clear decrease in conversion rates as
the number of tiers gets higher.
(iii)
Relying heavily on discounts
The
problem with discounting is that many companies wield discounting like a
sledgehammer instead of a scalpel. Yes, it juices your acquisition metrics in
the short term, but over time discounting can reduce your SaaS lifetime value
by over 30%. Discounted customers have just over double the churn rate of those
who pay full price—they’ve either been trained to devalue the product, or they
just weren’t the right customers in the first place.
(iv)
Not pricing for value
Value-based
pricing is the best price optimization model since it includes both you and
your customer’s optimal prices. The goal with value-based pricing is to figure
out how much each customer is willing to pay for your product, so you can
maximize revenue by charging each customer exactly what they’re willing to pay.
Figuring out what that price should be, though, isn’t easy.
(v)
Target
That’s
why so many companies lose out on revenue by setting their prices based on
those of their competitors or on their costs—they don’t want to put in the
effort.
Incorporating
Incorporation is the legal process used to form a
corporate entity or company. A corporation is the resulting legal entity that
separates the firm’s assets and income from its owners and investors.
Corporations can be created in nearly all countries in the
world and are usually identified as such by the use of terms such as “Inc.” or
“Limited (Ltd.)” in their names. It is the process of legally declaring a
corporate entity as separate from its owners.
Incorporation
has many advantages for a business and its owners, including:
·
Protects the owner’s assets against the company’s liabilities
·
Allows for easy transfer of ownership to another party
·
Achieves a lower tax rate than on personal income
·
Receives more lenient tax restrictions on loss carry forwards
·
Can raise capital through the sale of stock
Throughout
the world, corporations are the most widely used legal vehicle for operating a
business. While the legal details of a corporation’s formation and organization
differ from jurisdiction to jurisdiction, most have certain elements in common.
The Creation and
Organization of Corporations
Incorporation involves drafting “articles of
incorporation,” which lists the primary purpose of the business and its
location, along with the number of shares and class of stock being issued if
any. A closed corporation, for instance, would not issue stock. Companies are
owned by their shareholders. Small companies can have a single shareholder, while
very large and often publicly traded companies can have several thousand
shareholders.
As a rule, the shareholders are only responsible for the
payment of their own shares. As owners, the shareholders are entitled to
receive the profits of the company, usually in the form of dividends. The
shareholders also elect the directors of the company.
The directors of the company are responsible for day-to-day
activities. They owe a duty of care to the company and must act in its best
interest. They are usually elected annually. Smaller companies can have a
single director, while larger ones often have a board comprised of a dozen or
more directors. Except in cases of fraud or specific tax statutes, the
directors do not have personal liability for the company’s debts.
Other Advantages of Incorporation
Incorporation
effectively creates a protective bubble of limited liability, often called a
corporate veil, around a company’s shareholders and directors. As such,
incorporated businesses can take the risks that make growth possible without
exposing the shareholders, owners, and directors to personal financial
liability outside of their original investments in the company.
·
Incorporation is the legal process by which a business entity is
organized and brought into existence.
·
The process of incorporation involves writing up a document known
as the articles of incorporation and enumerating the firm’s shareholders.
·
In a corporation, the assets and cash flows of the business entity
are kept separate from those of the owners and investors, which is called
limited liability.
Complementary Products
A
complement refers to a complementary product or service used in conjunction
with another product or service. Usually, the complementary product has little
to no value when consumed alone, but when combined with another product or
service, it adds to the overall value of the offering. A product can be
considered a compliment when it shares a beneficial relationship with another
product offering, for example, an iPhone complements an app.
Complementary Products
The
joint demand nature of complementary products causes an interplay between the
consumer need for the second product as the price of the first product
fluctuates. In economics, this connection is called negative cross-elasticity
of demand. So, as the cost of a product increase, the user’s demand for the
complement product decreases. Further, as consumer demand weakens, the market
price of the complementary product or service may fall. For example, when the
price of a product rise, the demand for its complement falls because consumers
are unlikely to use the complement product alone.
Examples
For
example, should the price of hot dogs increase, it can cause a decrease in the
demand for hot dog buns. Since the cost of hot dogs has an inverse relationship
with the demand for hot dog buns, they are considered complementary products.
Consumers may substitute hamburgers for their picnic, and weak complementary
mustard and ketchup products will see little impact on the rising price of the
hot dog.
Additionally, complementary pairs are not two-sided and often
have one-sided effects. Using another example, if the price of car tires
decreases, it will not necessarily increase the demand for cars. However, if
the price of automobiles decreases, it will increase the demand for car tires
as more are sold.
Real World Example
Complements
are often used by merchants to increase sales. Supermarkets place related food
products next to each other, such as tortillas next to refried beans, to
increase sales of each. Merchants might also sell a product at a low price but
charge more for add-on items that complement the first item.
Complementary
products are often more lucrative for producers versus a substitute product.
Netflix, Inc.(NFLX) could be considered an alternative product for traditional
cable. However, with the potential unbundling of cable channels, financial
analysts believe that Netflix may move from a substitute product to a
complementary product.
The
unbundling of channels refers to consumers’ ability to pick and choose which
cable channels they pay for rather than being required to purchase an entire
cable package. The belief that Netflix may become a complementary product to
cable once it decides to unbundle has caused analysts like those at CNBC to
estimate that the company will add 70 million subscribers by the end of 2020.
Unbundling reduces the overall cost of cable, and more users are expected to
subscribe to Netflix in addition to their chosen cable channels.
Complements and Elasticity
There
are weak complementary products and strong complementary products. Weak
complements have a low cross-elasticity of demand. For example, if the price of
coffee increases it will only have a marginal impact on reducing the
consumption of cream. In the case of Apple increasing the price for iPhones,
this would reduce sales of iPhones and the demand for iOS apps.
Complementary
products differ from substitute products, which are different products or
services that satisfy the same consumer need. The Apple iPhone is a substitute
for Samsung phones. These two products can, therefore, replace each. So, rather
than complement each other they become substitute products. For this reason, if
the price of the iPhone increases, the consumer demand for a substitute will
also increase.
·
A complementary product is one used in conjunction with another
product or service.
·
Such a product may have little value without its complement.
·
When the price of a particular product rises the demand for its
complement drops because consumers are unlikely to use the complement alone.
Using Pricing Subjectively to Estimate
Demand Curves
Suppose due to changes in
income, population and other factors, the theoretical demand curve shifts from
D1 to D2, D2 to
D3 to D4 in
Figure 1. The corresponding supply curve at each of these points occupies
positions S1 to
S4. The price-quantity observation which is
recorded in period 1 (say, 1981) is given by the intersection of D1 to
S1, namely, A. The next one is determined by
the intersection of D2 and
S2 at B (in 1982).
Thus we get a series of
observations A to D for four years, viz., 1981, 1982,1983 and 1984. These
together trace out a demand curve DD. But this is not the same demand curve
discussed in theory. More specifically, it is not reversible. It is improbable
that we can move back from C to B and B to A.
It is unlikely that the
precise combination of conditions which prevailed at these points will be
repeated. In practice, the demand and supply curves may not move consistently
in the same direction, as is assumed in this diagram. They may move up or down
rather erratically.
In Figure 11.1, points A, B and C are not three
points on a single demand curve for, say, product X. Each point is on a
different demand curve — one that is shifting over a period of time. So just by
connecting them we cannot trace out the product demand curve.
A firm may interpret the
line dd (which is a Iocus
of points A, B, C and D) as the demand curve by mistake. Thus it might assume
that a reduction in price from P1 to
P2 increases sales from Q1 to
Q2. An expansion of demand may well justify the
price reduction.
But, in practice, such a
price cut will result in a much smaller increase in demand. The true demand
curve (D1) is much less elastic than the line dd.
Thus, a price cut is much less desirable than it appeared at the first sight.
Simultaneous
Relationship
So there is interrelationship between demand and
supply curves.
Now, data
on prices and quantities purchased can be used to estimate a demand curve only
under two sets of conditions:
(1) The demand curve has
not shifted, but the supply curve has shifted; or
(2) We have almost
complete information to determine just how each curve has shifted during the
observation period (which covers four years in this case).
Suppose there is a
technological change in the production of X. So costs in the industry will fall
sharply within a short period but demand conditions are likely to be stable.
The situation is illustrated in Figure 2. Here the demand curve, which
initially was unknown, in now assumed to be stable. The supply curve shifts
from S1 to S2,
S2 to S3 and
S3 to S4.
It is clear that each
price/quantity point represents the intersection of the supply and demand
curves. Since all the demand determinants except price are assumed to be
stable, points A, B, C and D must be on the same demand curve. So the demand
curve DD can be estimated by connecting the four points.
Price Bundling and Nonlinear Pricing: Pure Bundling and
Mixed Bundling
Price bundling is combining several products or services into a single
comprehensive package for an all-inclusive reduced price. Despite the fact that
the items are sold for discounted prices, it can increase profits because it
promotes the purchase of more than one item.
Pricing
Bundling Examples:
·
Detergent and dryer sheets
·
New phone with a data plan
·
Bake at home pizza and a large soda
Deeper Insights
For example, mobile phone
retailers frequently bundle the prices of several products and services
together for their new customers. They offer the phone itself with a package
that also includes the 2-year phone plan, internet access, and phone charger.
This bundle benefits the customer because it provides them with all the tools
they need for their phone all at once and it benefits the mobile phone retailer
because they are selling the customer supplementary products and services other
than just a phone.
The main appeal to sell
things in a bundle is that you can introduce new or complementary products
packaged with a consistent high seller. Many businesses do this to try to
promote new products and get customers intesrested enough to buy more.
Advantages and Disadvantages
Bundle pricing has many
advantages. The most important one is it that it allows companies to sell their
lesser known or unpopular products with the popular ones. It will also help
attract different kinds of buyers: buyers looking for deals, buyers looking for
convenience or buyers looking for advice on items that complement each other.
Some consumers will be spending more than they initially wanted when they see
an offer they like (if you offer the product that they already wanted to buy
with something they wanted to try but never got to it). Product bundles have
lower marketing cost because you are promoting two or more products with an
effort and resources for one.
No matter how great a
strategy is there is always a downside to it. The biggest disadvantage for this
one is that it can lead to cannibalization of your products that can be bought
outside of the bundle. For example, you are selling a laptop and a printer
together, but also separately. Because of this more printers could be sold
through the bundle than on its own. This does cause lower profit for that
particular product. There is also a chance that some consumers won’t buy
something if it can’t be bought separately because they feel forced to buy
more. So it’s crucial to choose the right products for the bundle.
Product bundles are very
popular among customers. They make their lives easier because they save them
time looking all around the store for each product, they help them decided on
products they weren’t sure about trying them, etc. When done right, bundle
pricing strategy drives more sales and profit for the companies, which is why
it’s one of the most used ones.
There are two basic bundle
pricing strategies, which are pure bundling and mixed. Let’s see what each of
them means and how you can apply them.
1.
Pure Bundling
Pure
bundling is when products are only sold together. In some cases, products don’t
exist outside the bundle. The best example for that are TV channels offered by
cable providers. They offer a number of packages and each one has a different
combination of channels. If you want a specific one, that is offered in only
one package, you have to get all of the others from that one. For example, if
you want HBO, you will have to pay for HBO2 and HBO3 too, and other channels
that go with it (depending on the provider). When you think about it, it makes
sense for such products.
Pure
bundling has three subcategories: joint bundling, leader bundling, and
mixed-leader bundling.
·
Joint bundling is when the two products are offered together for
one bundled price.
·
Leader bundling is when a leader product is offered for a discount
if purchased with a non-leader product, accessory, etc.
·
Mixed-leader bundling is a type of leader bundling with the added
possibility of buying the leader product on its own.
2.
Mixed Bundling
Mixed bundling,
also called custom bundling, is when customers are offered to purchase a bundle
or separate products on their own. Consumers are offered complete cable,
internet, and telephone packages. The price will depend on the level of service
that the package provides. If you choose high-speed internet and maximum
channels, it’s going to be much more expensive than getting a package with
low-speed internet and minimum channels. Each of these services can be bought
separately, but it’s just like the restaurant example – it will be more
expensive.
NONLINEAR PRICING
Nonlinear pricing is a broad term that covers any
kind of price structure in which there is a nonlinear relationship between
price and the quantity of goods. An example is affine pricing. A nonlinear
price schedule is a menu of different-sized bundles at different prices, from
which the consumer makes his selection. In such schedules, the larger bundle
generally sells for a higher total price but a lower per-unit price than a
smaller bundle.
Determine Optimal Bundling Pricing
In a bundle pricing, companies sell a package or
set of goods or services for a lower price than they would charge if the
customer bought all of them separately. Common examples include option packages
on new cars, value meals at restaurants and cable TV channel plans. Pursuing a
bundle pricing strategy allows you to increase your profit by giving customers
a discount.
Based on Consumer Surplus
Bundle pricing is built on the idea of consumer
surplus. Every customer has a price that he is willing to pay for a particular
good or service. If the price you set is equal to or lower than what the
customer is willing to pay, the customer will buy, as he considers the price a
bargain. The difference between what the customer pays and what the customer
was willing to pay is known in economics as the consumer surplus. Bundle
pricing is an attempt to capture more of your customers’ consumer surplus.
Personalized Pricing
An example: Your
car wash offers two services, exterior cleaning and interior cleaning. Using
market research and your own experience, you’ve concluded that there are two
primary groups of customers. Those in group A are concerned about appearances
and are willing to pay up to $15 for the exterior package but only $8 for the
interior. Members of group B are less appearance-oriented, but they value
comfort; they’re willing to pay $10 for the exterior package and $9 for the
interior.
If you were able
to charge everyone exactly what they’re willing to pay, you could get $23 from
each customer in group A and $19 from each in group B, for a total of $42 from
a pair of A and B customers. With personalized pricing, there would be no
consumer surplus.
Bundling Benefit
If you have no
reliable way of telling whether customers are in group A or group B when they
come in, personalized pricing is impossible. In a bid to get each customer to
buy both services, you’d charge $10 for exterior and $8 for exterior, as each
group is willing to pay that amount for each service. Each customer would
produce $18 worth of revenue, for a total of $36 from a pair of A and B
customers. The consumer surplus in this case is $6. Look again at what each
customer is willing to pay for the two services: $23 in group A and $19 in
group B. If you set an interior-exterior bundle price of $19, you’d make $38
per A-B pair, capturing $2 of consumer surplus.
Other Advantages of Bundles
Offering
products in bundles provides benefits beyond simply getting more revenue from
each customer. It simplifies production and reduces errors. Think about a
fast-food restaurant where customers can quickly order the No. 3 or No. 7
rather than separately order a sandwich, fries and maybe a drink. It also heads
off pricing disputes with customers. A customer might be perfectly happy to pay
an all-in bundled price, yet be turned off by a laundry list of charges that
add up to the exact same dollar amount.
Nonlinear Pricing
Nonlinear
pricing is used in a situation in which the cost of purchasing q units is not equal
to the unit cost c per
unit times q.
Bundling (discussed in Chapter 5, “Price Bundling”) is a special type of
nonlinear pricing because the price of three items is not equal to the sum of
the individual prices.
Other
common examples of nonlinear pricing strategies include:
· Quantity
discounts: If customers buy ≤CUT units, they pay
high price (HP) per
unit, and if they buy >CUT units,
they pay low price (LP) per
unit. CUT is
simply the “cutoff point at which the charged price changes.” For example, if
customers buy ≤1000 units,
you charge $10 a unit, but if they buy more than 1000 units, you charge $8 per
unit for all units bought. This form of nonlinear pricing is called the nonstandard quantity discount.
Another type of quantity discount strategy is as follows: Charge HP for the
first CUT units
bought, and charge LP for
remaining units bought. For example, you charge $10 per unit for first 1000
units and $8 per unit for remaining units bought. This form of nonlinear
pricing is called the standard quantity discount. In both examples the value
of CUT = 1000.
Two-part
tariff: The cost of buying q units is a fixed
charge K plus $c per unit
purchased. For example, it may cost $500 to join a golf club and $30 per round
of golf.
Many
companies use quantity discounts and two-part tariffs. Microsoft does not
charge twice as much for 200 units, for example, as for 100 units. Supermarkets
charge less per ounce for a 2-pound jar of peanut butter as for a 1-pound jar
of peanut butter. Golf courses often use a two-part tariff by charging an
annual membership fee and a charge for each round of golf.
Just as
in Chapter 5 you used the Evolutionary Solver to find optimal price bundling
strategies, you can use the Evolutionary Solver to find the profit maximizing
parameters of a nonlinear pricing strategy. As in Chapter 5, you can assume the
consumer will choose an option giving her the maximum (non-negative) consumer
surplus. You can see that nonlinear pricing can often significantly increase
your profits, seemingly creating profits out of nothing at all.
In this
chapter you will first learn how a consumer's demand curve yields the
consumer's willingness to pay for each unit of a product. Using this
information you will learn how to use the Evolutionary Solver to determine
profit or revenue maximizing nonlinear pricing strategies.
Profit Maximizing with Nonlinear Pricing Strategies
Throughout this chapter assume a power company
(Atlantis Power and Light, APL for short) wants to determine how to maximize
the profit earned from a customer whose demand in kilowatt hours (kwh) for
power is given by q = 20 – 2p. It costs $2 to produce a unit of
power. Your analysis begins by assuming APL will use linear pricing; that is,
charging the same price for each unit sold. You will find that with linear
pricing the maximum profit that can be obtained is $32. Then you will find the
surprising result that proper use of quantity discounts or a two-part tariff
doubles APL's profit! The work for this chapter is in the file
Powerblockprice.xls. To determine the profit maximizing linear pricing rule,
you simply want to maximize (20 – 2p) × (p – 2).
In the oneprice worksheet from the Powerblockprice.xls file, a price of $6
yields a maximum profit of $32 (see Figure 6.1). The Solver model
simply chooses a non-negative price (changing the cell that maximizes profit
[Cell D12]). Charging $6 per kwh yields a maximum profit of $32.00.
Figure 6-1: Finding the profit maximizing single price
strategy
Price Skimming
Price skimming
is a product pricing strategy by which a firm charges the highest initial price
that customers will pay and then lowers it over time. As the demand of the
first customers is satisfied and competition enters the market, the firm lowers
the price to attract another, more price-sensitive segment of the population.
The skimming strategy gets its name from "skimming" successive layers
of cream, or customer segments, as prices are lowered over time.
How Price Skimming Works
Price skimming is often
used when a new type of product enters the market. The goal is to gather as
much revenue as
possible while consumer demand is high and competition has not entered the
market.
Once those goals are
met, the original product creator can lower prices to attract more cost-conscious
buyers while remaining competitive toward any lower-cost copycat items entering
the market. This stage generally occurs when sales volume begins to decrease at
the highest price the seller is able to charge, forcing them to lower the price
to meet market demand.
Skimming is a useful strategy
in the following contexts:
- There are enough
prospective customers willing to buy the product at a high price.
- The high price does not
attract competitors.
- Lowering the price would
have only a minor effect on increasing sales volume and reducing unit costs.
- The high price is
interpreted as a sign of high quality.
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