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# Evaluate some pricing approaches such as costs plus, market penetration, and skimming

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### Evaluate some pricing approaches such as costs plus, market penetration, and skimming

After this lecture, you should be able to:

Evaluate some pricing approaches such as costs plus, market penetration, and skimming

Define demand elasticities by price and income

Define and evaluate profit maximization strategy and other business motives

Explain participation and incentive constraints in optimal contract

2

In class-exercise:

Make a list of 5 aims that a manager of a high street department store might have.

Identify some conflicts that might arise between these aims.

If you are a manager in a department store, how would you set a price in that store?

Do you think that higher revenues/profits are always in a manager’s personal interest?

The “Cost plus” Pricing Suicide Spiral

-Firms often price own products as P = Costs + Margin (% of Costs)

-But drops in sales lead to higher prices due to higher fixed costs per sold unit of production, which, in turn, leads to even higher drop in sales – the firm “Suicide Costing Spiral”.

-Alternative pricing principle through profit maximization is more flexible

Profit: the classical capitalist view

-For Nobel Prize wiener in economics (Chicago Uni)

Friedman (1970) the social responsibility of business is to make profit. Anything else is a tax on the owner

-This is the classical capitalist perspective of the firm.

Firms maximise profits given constraints

-In perfectly competitive markets firms can only make

‘normal’ profits to cover opportunity costs of labour, capital, and entrepreneurial talent

-However, firms can make ‘supernormal’ profits because they have market power or due to information imperfections

Profit maximisation: simple calculus

• Π = Profit (q) = Revenue(q) – Costs(q), q – quantity produced

To find the point of profit maximization, just differentiate by q and the maximum is achieved at the first order condition:

 = − = 0

= Profit’(q) = π’ = 0 = Revenue’(q) – Costs’(q) = MR - MC

Second order condition: Profit’’(q)

shows increase in revenue by

selling one additional unit of production, i.e. price of that unit

Marginal costs shows costs of production of an

additional unit. Recall that marginal costs represent Supply curve.6

The rule for profit maximization:

Marginal revenue (MR) = Marginal costs (MC)

 Does Fixed Costs affect profit maximization output? =
 No! Fixed Costs are fixed and do not change with output q Consider the logic of this equality: IF selling 1 additional good brings more than its costs MR > MC. Increasing output by one unit and selling that one unit would raise profit, hence, this quantity cannot maximise profit Suppose MR < MC, then decreasing output by one unit and reducing sales by that one unit would raise profit - again, hence, not a maximum 7

Finding maximum profit using total

revenue (TR) and total costs (TC) curves

TR, TC, T(£)

 24 TC 20 d 16 12 e TR 8 4 f 0 1 2 3 4 5 6 7 Quantity -4 -8 TP

8

Finding the profit maximising

output using marginal curves

MC

16

 (£) 12 revenue 8
 and 4 e Profit maximising output Costs 0 1 2 3 4 5 6 7 -4 Quantity MR

9

Exercise: explain the strange pricing

A. Price of Gillette Mach 3 Razor is £6.63

Gillette Mach3 Razor Blades - Pack of 8 - £14.49 or £1.81 per blade cartridge

Gillette Mach3 Razor Blades - Pack of 12 - £20.37 or £1.70 per blade cartridge

Why “30% off your first order”?

B. Water Filter Jug price £8.45

Water Filter, 6 pack filters - £21.99

C. Why do you see prices like .99?

How to link demand with prices?

10

percent change in demand

Demand elasticity ep = percent change in price

11

12

13

Price elasticity by consumer income

Consumer income is another important factor of price changes

Income may shift due to macroeconomic changes (economic growth/recession) or regional shifts in unemployment or particular income sources

Income elasticity of demand for some goods tend to be more stable than price elasticity

 • Income Elasticity = Percent change in Demand Percent change in Consumer Income

If income elasticity >1 – such goods are defined as luxury goods such as jewellery, fashion cars, etc.

14

In brief, price elasticity of demand:

Is typically negative as higher price usually leads to lower demand, but we care about its absolute value

Some Giffen goods show lower demand with lower price, e.g. margarine, low cost substitutes

We considered the elasticity of demand with respect to the good`s own price, but you can also consider changes in demand with respect to prices of substitutes (coffee-tea) and complements (gas-cars)

The elasticity varies at different points along the

 demand curve – it is elastic at high prices and inelastic at low prices 15

A car plant dispute: an application

A few years ago in a country U one car producer decided to fire several hundred workers due to falling demand (about 11%) right after the financial crisis of 2007-08

Trade union was against this and offered instead to reduce wages by 20%. Wages accounted for 30% in the final car price

Trade union argued that the proposed decrease in wages would reduce car price by 20%*0.3 = 6%. Given the Union estimated elasticity of demand for cars at 2.2, this should increase output by 6%*2.2 = 13.2% >11% and nobody needs to be fired

Car plant owners argued that the elasticity of demand for cars was inelastic at 0.8, so that the Trade Union offer would increase revenue only by 6%*0.8 = 0.48%, at best

16

Do firms maximise profit?

Difficulties in maximising profit

Opportunity costs are not normally recorded in financial statements, which reflect nominal expenditures

Difficulties in identifying demand

Difficulties in deciding the time period for maximising profit, e.g. a start-up may have other development targets

Bonuses (payroll costs) are usually issued in form of call options and other derivatives related to company stock prices and such prices are difficult to predict

Is a firm market value affected only by company profits?!

Prices also reflect ‘position’ to competitors’ products, i.e. should reflect strategic interaction with rivals

17

Other market pricing strategies

Penetration: set initial prices low to attract customers. This builds market share and discourages competition (left graph)

Skimming: set initial prices very high and then lower them as product life cycle (fashion) declines. It helps to recoup product development and launch costs, but encourages competition

Which of these pricing strategies are typical for pharmaceutical, mobile phone, textbook industries?

18

Evidence on profit maximisation

motives from the UK company surveys

Shipley (1981)

Concluded that only 16% of his sample of 728 firms state profit maximisation as the main target

Jobber and Hooley (1987)

Found nearly 40% of their 1775 firms had profit maximisation as their primary objective

But the objective pursued varied according to the product life cycle, which goes through emergence, growth, maturity and decline of demand for a product

19

Evidence on profit maximisation in the UK

Hornby (1994)

Showed that 28.6% of 77 Scottish firms looked to profit maximisation as the overriding objective

Most firms had multiple goals, perhaps with a minimum profit requirement

There was no direct link between owner controlled firms and profit maximisation

Stronger evidence for the goal of long termprofit maximisation

E.g. Shipley (1981) and Hornby (1994)

There is also intuitive appeal for this argument in high tech industries, e.g. computers, game consoles.

20

It is difficult to predict the long-run demand and price

of a long-run profit-maximising firm

The firm needs to make strategic decisions, the outcome of which is bound to be uncertain in complex businesses

Revenue curves are likely to shift over the long term

The behaviour of rivals is hard to predict over the long term

Market opportunities are likely to change. Technologies may shift unexpectedly (e.g. faxes vs. emails, IBM vs. Apple in personal computers, photo films vs. digital cameras)

Leading companies exit the market (about half of Fortune 500 companies disappeared in the last century)

Predicting the future (“Back to the future 2”)…

 Source: http://www.vox.com/2015/10/21/9581539/back-to-the-future-day-2015- predictions-hoax 22

A modern view of the classical capitalist perspective

-The classical view of the firm has come under scrutiny for some time as the empirical foundations are mixing

-Practical view of Warren Buffet for investment: Look at business that (1) you can understand, (2) with excellent long- term prospects, (3) operated by competent people, (4) available at attractive share price

-However, this has also given rise to a critical revision of the classical perspective which envisages the firms as a ‘nexus of contracts’ employers-employees as well as suppliers and consumers

-A firm owners (Principals) must establish appropriate reward systems that maximise the effort level of other stakeholders (Agents), especially between owners and managers (CEOs)

23

The Agency problem: conflicting objectives

Agents might not perform for the Principals because they have conflicting objectives and different information

Examples

Managers may be interested in satisfying their own objectives such as expansion, “empire building”, using a company jet to play golf, or embarking on ‘pet projects’ to bolster own prestige

Employees may be interested in minimum effort (shirking)

The information asymmetry between the parties potentially gives rise to a ‘moral hazard’ problem, or post-contractopportunism if employees’ effort is not observable

Principals can only observe outcomes and these might be the result of luck rather than great decisions of Agents

For instance, in a “bull” market of 2005-07, majority of firms’ stock prices grew well on optimistic investors’ expectations despite arguably not the best decisions of some CEOs

24

A solution for individual agents

Thus, the principal must create contracts that induce the agent to engage in high levels of performance in order that their objectives are met

This problem is considered in contract theory that sets optimal constraints and incentives for performance based payoffs

Usually this is via payment systems with two elements:

>make the individual participate in the contract given the uncertain state of the environment: the participation constraint, i.e. pay an agent opportunity costs of taking a contract, e.g. a wage

>give the agent the incentive to engage in high levels of effort vs. low effort: the incentive compatibility constraint (as effort is a cost to an agent)

Note, though, that money alone cannot always induce agents to act in the interests of the principal(s). You need corporate governance

Empirically, there is a mixed evidence on the relationship between company performance and CEO compensation

25

Moral Hazard: An Example with a shopping mall kiosk

The kiosk is owned by Molly (the principal), who hires a single employee (Joe, the agent) to work in Molly’s kiosk

If Joe works hard, the kiosk earns a weekly profit of £1000 with 80% probability, and £500 with 20% probability, depending on customers’ demand, with expected high profit of £900

If Joe applies low effort (shirks), the probabilities are reversed – kiosk gets expected low profit of £600 = £500*0.8 + £1000*0.2

Molly’s expected net profit is £900-£150 = £750 with high Joe’s effort and £600 - £150 = £450 with low Joe’s effort

Joe does not like to work hard, he requires at least £150 per week compensation, and Molly cannot observe Joe’s effort

Molly pays Joe a flat going market wage rate of £150 per week in hope he works hard

As she cannot observe his effort, Joe mostly likely to shirk and

 blame low customers’ demand for low profits 26

How can Molly incentivize Joe to work hard?

Rather than paying Joe a flat rate, Molly can instead pay Joe a wage that varies in proportion with kiosk’s profits

For example, Joe will be paid £250, if weekly profits are high (£1000), and nothing when profits are low (£500)

If Joe works hard, the 80% probability of high profits yields an expected wage of £200 = 0.8*£250+0.2*£0>£150

If Joe shirks, his expected pay will be 0.8*£0+0.2*£250 = £50

Joe will now prefer to work hard if he values his effort lower than expected payoff of £200*0.8+£50*0.2 = £170>£150

Notice that expected payoff for Joe with this contract is

£170- more than his flat expected payoff of £150 per week

Molly is better off too with higher profit!

27

The Principal–Agent Problem as a Sequential Game

 Molly does not know if Joe shirks If Molly pays a flat £150, the with Low Effort (LE) or work hard interests of Joe and Molly do with High Effort (HE) not align. Joe earns more by shirking as Low Effort (LE) is Agent ( 750 , 150 -HE) (HE) for the same payoff £150 . Work hard better for him than High Effort (Worker: Joe) B Shirk Flat wage P ( 450 , 150-LE ) If Molly links Joe’s pay to profit, Joe’s and Molly’s Principal interests align. Now, Joe (Owner: Molly) A P (900-250, 250-HE ) will choose to work hard, Wage tied to earning him £200 and kiosk’s profit Work hard Molly £696. As a result, Agent C Shirk Molly chooses to link (Worker: Joe) (600-50, 50) Joe’s pay to the kiosk’s profit.

28

The Principal–Agent Relationship as a Game

This example (and most principal–agentrelationships) can be thought of as a sequential game

In the first stage, the principal chooses between a set of

contracts

In the second stage, the agent chooses a level of effort resulting in payoffs to the principal and agent

The goal for the principal is to choose a contract structure that induces the agent to choose a high level of effort

An introduction to game theory will follow in the next lectures. An interesting intuition is offered by Covey

29

7 habits of highly effective people by

Stephen Covey

Covey’s “7 habits” through lens of the contract theory 1 “BE PROACTIVE” – design a contract

2 “BEGIN WITH THE END IN MIND” – plan outcomes

3 “PUT FIRST THINGS FIRST” – focus on key outcomes &payoffs

4 “SEEK TO UNDERSTAND, THEN BE UNDERSTOOD” – understand work incentives

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