16.10.19 Economics for Management
Pricing decisions with simple and complex costs
Consumer surplus, demand curves and average revenue
o Pricing is an extent decision – it has an effect on both marginal revenue and marginal costs,
hence profits.
o In business, you may have an idea of current marginal costs, but you may not know how costs
will change at different levels of output.
o Consumers make consumption decisions using marginal analysis.
o They will consume more if marginal value (the value of buying one more) is greater than
price
o The marginal value however, of consuming each subsequent unit diminishes the more you
consume.
o Consumer surplus = value to consumer – price paid.
o What you would be willing to pay compared to the actual price.
o Demand curve: the average revenue curve. It is a function that relates the price of a product to
the quantity demanded by consumers.
o To increase profit, a company could increase production and lower prices to spread fixed
costs over a greater outfit.
Aggregate demand
o Aggregate demand: the buying behaviour of a group of consumers; a total of all individual
demand curves.
Marginal
Price Quantity Revenue Revenue
$7.00 1 $7.00 $7.00
$6.00 2 $12.00 $5.00
$5.00 3 $15.00 $3.00
$4.00 4 $16.00 $1.00
$3.00 5 $15.00 -$1.00
$2.00 6 $12.00 -$3.00
$1.00 7 $7.00 -$5.00
$8.00
o Marginal revenue: The difference between the current and previous revenue figure.
o Marginal revenue is less than the price in this example – thus is slopes down.
$6.00
$4.00
$2.00
, 16.10.19 Economics for Management
o Aggregate demand slopes down because for a low expense item, the lower the price the
person may buy.
Pricing trade-off
o Pricing is an extent decision
o Demand curves turn pricing decisions into quantity decisions: ‘what price should I charge?’ is
equivalent to ‘how much should I sell’
o Fundamental trade off:
o Lower price: sell more, earn less on each unit sold
o Higher price: sell less, earn more on each unit sold
o Trade-off created by downward sloping demand.
o Finding optimal price: if MR>MC, reduce price and sell one more unit.
o Continue until, for the next price cut (additional sale) MR<MC
o Marginal profit = MR-MC and is the extra profit from selling one more unit.
Price Elasticity of Demand and MR
o Used to calculate marginal revenue
o PED: The percentage change in quantity demanded divided by the percentage change in
price.
o If ‘e’ is <1: demand is inelastic. Demand isn’t overly responsive to a change in price
o If ‘e’ is >1, demand is elastic
o Inelastic demand due to availability of substitutes, brand loyalty, a complimentary good, if the
product is a necessity/habit forming.
o Estimating elasticities:
o Based on either initial or final prices and quantities.
o Use average prices and quantities:
((q1-q2))/(q1+q2)) / ((p1-p2)/(p1+p2))
MR and Price Elasticity
o Revenue (Price X Quantity) and PED are related
o %Rev ≈ %P + %Q
o If demand is elastic:
o If P↑ then ↑ %P < %Q ↓ and so, Rev↓
o If P↓ then ↓ %P < %Q ↑ and so, Rev↑
Pricing decisions with simple and complex costs
Consumer surplus, demand curves and average revenue
o Pricing is an extent decision – it has an effect on both marginal revenue and marginal costs,
hence profits.
o In business, you may have an idea of current marginal costs, but you may not know how costs
will change at different levels of output.
o Consumers make consumption decisions using marginal analysis.
o They will consume more if marginal value (the value of buying one more) is greater than
price
o The marginal value however, of consuming each subsequent unit diminishes the more you
consume.
o Consumer surplus = value to consumer – price paid.
o What you would be willing to pay compared to the actual price.
o Demand curve: the average revenue curve. It is a function that relates the price of a product to
the quantity demanded by consumers.
o To increase profit, a company could increase production and lower prices to spread fixed
costs over a greater outfit.
Aggregate demand
o Aggregate demand: the buying behaviour of a group of consumers; a total of all individual
demand curves.
Marginal
Price Quantity Revenue Revenue
$7.00 1 $7.00 $7.00
$6.00 2 $12.00 $5.00
$5.00 3 $15.00 $3.00
$4.00 4 $16.00 $1.00
$3.00 5 $15.00 -$1.00
$2.00 6 $12.00 -$3.00
$1.00 7 $7.00 -$5.00
$8.00
o Marginal revenue: The difference between the current and previous revenue figure.
o Marginal revenue is less than the price in this example – thus is slopes down.
$6.00
$4.00
$2.00
, 16.10.19 Economics for Management
o Aggregate demand slopes down because for a low expense item, the lower the price the
person may buy.
Pricing trade-off
o Pricing is an extent decision
o Demand curves turn pricing decisions into quantity decisions: ‘what price should I charge?’ is
equivalent to ‘how much should I sell’
o Fundamental trade off:
o Lower price: sell more, earn less on each unit sold
o Higher price: sell less, earn more on each unit sold
o Trade-off created by downward sloping demand.
o Finding optimal price: if MR>MC, reduce price and sell one more unit.
o Continue until, for the next price cut (additional sale) MR<MC
o Marginal profit = MR-MC and is the extra profit from selling one more unit.
Price Elasticity of Demand and MR
o Used to calculate marginal revenue
o PED: The percentage change in quantity demanded divided by the percentage change in
price.
o If ‘e’ is <1: demand is inelastic. Demand isn’t overly responsive to a change in price
o If ‘e’ is >1, demand is elastic
o Inelastic demand due to availability of substitutes, brand loyalty, a complimentary good, if the
product is a necessity/habit forming.
o Estimating elasticities:
o Based on either initial or final prices and quantities.
o Use average prices and quantities:
((q1-q2))/(q1+q2)) / ((p1-p2)/(p1+p2))
MR and Price Elasticity
o Revenue (Price X Quantity) and PED are related
o %Rev ≈ %P + %Q
o If demand is elastic:
o If P↑ then ↑ %P < %Q ↓ and so, Rev↓
o If P↓ then ↓ %P < %Q ↑ and so, Rev↑
