Chapter 3: Basic Pricing and Revenue Optimization,Some slides from Robert L. Phillips,Page 2,Roadmap:,The Price-Response Function The Basic Pricing and Revenue Optimization,Page 3,3.1 The price-response function,The price-response function specifies how many demand for a product varies as a function of its price Associated with each combination of the Cube. Demand for the product of a single seller as a function of the price offered by that seller, not the concept of a market demand curve (how an entire market will respond to changing prices),Page 4,Example 3.1 the PRF in a perfectly competitive market,If the seller price above the market price, his demand drops to 0; If he prices below the market price ,his demand is equal to the entire market. The seller in a perfectly competitive market has no need for PRO. However, true commodities are surprisingly rare.,Page 5,General PRF,Those facing most companies most of the time-demonstrate some degree of smooth price response. Such as United Airlines, UPS, and Ford. As price increases, demand declines until it reaches zero at some satiating price.,Page 6,3.1.1 Properties of the PRF,Nonnegative: Continuous: if for every ,there is a price such that Differentiable: Downward sloping:,Page 7,Exception of the three cases,No.1 Giffen goods : (the possibility from the economic theory), whose demand rises as their price rises because of substitution effects .It is almost never encountered in reality-in fact ,many economists doubt whether it has ever existed.,Page 8,No.2 Price as an indicator of quality:,higher prices signal higher quality. Lowering the price for a product may lead consumers to believe that it is of lower quality. Typically some “lazy” buyers who do not have the time or resources to research the relative quality of all the alternatives so that they use price as a proxy. It can be particularly important when a new product enters the market.,Page 9,No.3 Conspicuous consumption:,the situation in which a consumer makes a purchase decision in order to advertise his ability to spend large amounts. It postulates a segment of customers who buy a product simply because it has a high price-and others know it. Dropping the price in this case may cause the product to lose its cachet and decrease demand.,Page 10,3.1.2 Customer Price sensitivity,Relationship between Price Sensitivity and Demand,When increases can decrease as fewer customers feel the product is a good value,sales,price,Page 11,Price Experiment,Page 12,Price sensitivity of customers (demand curve),Page 13,Profit at Different Prices,Page 14,Slope and elasticity of the price-response function,Slope: the slope of the PRF measures how many demand changes in response to a price change. It is equal to the change in demand divided by the difference in prices. A large (highly negative )slope means that demand is more responsive to price than a smaller slope.,Page 15,Example: the measure of the slope,The price of a bulk chemical can be quoted in either cents per pound or dollars per ton. Assume that the demand for the chemical is 50,000 pounds at 10 cents per pound but drops to 40,000 pounds at 11 cents per pound. The slope of the price response function at these two points is The same slope in tons per dollar wound be (25-20)/(0.1-0.11)=-500 tons/dollar. It is also important to realize that the slope depends on the units of measurement being used for both price and demand,Page 16,Price elasticity,Defined as the ratio of the percentage change in the demand to the percentage change in price.,Page 17,Example for elasticity,Assume that a retailer originally priced a private-label DVD play at $90 and raised the price to $100. Prior to raising the price, the retailer was selling 1,500 units a week. When the price was increased, sales dropped to 1,100 units per week. What is the price elasticity of the product? (answer: 2.4005),Page 18,Notice:,Often , a good with a price elasticity greater than 1 is described as elastic, while one with an elasticity less than 1 in described as inelastic. For most products , short-run elasticity is lower than long-run elasticity. The reason is that buyers have more flexibility to adjust to higher prices in the long-run. E.g. gasoline (0.2-0.7) For many durable goods, the long-run price elasticity such as automobiles and washing machines -is lower than the short-run elasticity. Reason: initially postponing the purchase of a new item, but will still purchase at some time in the future. Market elasticity is generally much lower than the price-response elasticity faced by an individual supplier within the market (all suppliers).,Page 19,Estimated price elasticity for various goods and services,Page 20,The point elasticity,It is useful as a local estimate of the change in demand resulting from a small change in price. Unlike slope ,independent of the units being used.,Page 21,3.1.3 Price Response and Willingness to pay,The PRF