Demand, Pricing, Margin Revenues & Costs

Demand

The demand for a product is the amount of a product that a population is willing to pay money for. The higher the demand is then the less of the product is available (supply), and so the price increases. However, when demand goes up producers will naturally increase supply by attempting to produce more product, and thus driving the price down again over time. So, a demand curve with price on the vertical axis and quantity on the horizontal axis will look as shown in Figure 1, displaying that as price increases that demand will decrease. Conversely as price decreases then demand will go up because people like to pay less for items.

Figure 1. The demand curve

In addition to the basic relationship between price and quantity, other affects on demand include changes, such as a change in the number of demanders (population), consumer preferences changes, systemic income and general economical fluctuations. Changes like these can move the demand curve itself to the right or left, where the demand generally increases or decreases showing the demand curve itself moving across the graph, as shown in Figure 2.

Figure 2. Increasing or decreasing the demand curve irrespective of price and quantity

The steepness or slope of the demand curve can change as well based on price elasticity. Price elasticity is determined by the sensitivity of quantity demand to any price changes. A flatter demand curve, as shown in Figure 3, is elastic because a small change in price will make a big change in demand quantity. For example, examine the original demand curve of price at 20 is quantity 200, and price at 5 is quantity 500. The flatter curve shown in Figure 3 puts price at around 18 for the same quantity of 500, which is a much smaller price change of 2 instead of the original 15, but also retaining the original change in quantity. So obviously if the quantity changes from 200 to 300 to give a price change of 20 to 15 in the original curve, and in the flatter curve the price only changes from 22 to21 with the same 200 to 300 change in quantity, then a small change in price will produce a relatively much large change in quantity.

Figure 3. A flat demand curve is elastic

Conversely a steep demand curve is inelastic because any change in price has much less of an effect on the quantity demanded, as shown in Figure 4.

Figure 4. A steep demand curve is inelastic

It follows that where inelastic goods are concerned that price increases do not affect demand as much as a steeper demand curve (inelastic demand), such as for items that are essential like gasoline, resulting in large seasonal price changes for gasoline in the United States. In fact, entire economies and even countries and continents can be held hostage for essential products with inelastic demand, as shown by the oil crisis and OPEC setting prices much higher than before, without negatively effecting demand.

There are also two special cases of demand curves that generally do not exist. Firstly, the completely flat demand curve, which is a horizontal line where any change in price has no effect on quantity. Secondly, there is also the vertical demand curve where any change in quantity has no effect on price. Again, both of these cases are unrealistic and do not exist in a market economy.

The ideas for this entire section above originate from an online reference at http://uk.answers.yahoo.com/question/index?qid=20110102160459AAErSwa) and Heyne.

Pricing a Product

A price searcher is a person or entity trying to figure out how best to price an item, based on a set of criteria. Profit making companies are in business to make money and do not exist as non-profits or charities. One searches for appropriate pricing based on a number of logical criteria:

  • Maximize income
  • Minimize cost
  • Maximize profit
  • Acquire and retain a good reputation
  • Remain competitive

Consumers by and large are looking for a good deal and for convenience, where convenience is usually related to the time taken to acquire a product that can absorb a certain amount of higher pricing if that higher pricing is not exorbitant.

Price Setting

How can a price be set? The simple method is cost plus markup, which in most cases probably will not work. If prices are too high demand will slack and if prices are too low then there will not be any profit. There would be no point in being in business if the business loses money because of poor demand or because it is selling items at less than cost. So it makes sense that the size of markups will vary. Typically simple staple items such as food in supermarkets is turned over in huge quantities and so their demand is inelastic – a steep demand curve as shown in Figure 4. So changes in demanded quantities should have a big effect on prices but the reason why this is not the case for food is because supply is profligate and competition is intense. However, crisis situations that affect the prices of basic commodities like food and water can have enormous effects on pricing, which is inelastic supply and not inelastic demand, but in this posting only demand is being analyzed and not supply.

Gasoline was already discussed earlier on a macro-cosmic supply scale, but locally different gas stations on different street corners in the United States will compete with each other. However, the center of cities could have higher gas prices where the number of gas stations is limited by statutes and accessibility. Also gas prices are often much higher in different states, not always because of population density and car population, but sometimes because of capacity to pay. For example, New York City is densely populated but there is plenty of public transportation, but prices are still higher than rural areas in the Deep South of the country. California usually has the highest gas prices of all states – is that because California is a wealthy economy?

Prices and markups are set based on costs as well as a company’s ability to sell something at a higher price to a specific demographic; it is a market economy. Discounts in supermarkets are common when one purchases something like a buy-one-get-one-free item, which entails a lower markup based on quantity purchased. Returning customers get better deals by use of customer specific coupon cards, which give access to slightly lower prices for customers who keep coming back.

Price setting encompasses more than one factor issue including costs, building good will, and moving either as little product as possible for the biggest markup, or moving as much product as possible at smaller markups. The objective of price setting is usually higher profits but depends on circumstances and a given situation.

Marginal Revenue and Marginal Cost

Those people who say that in business that bigger is not always better? They are correct! As stated on Investopedia, Marginal revenue is The increase in revenue that results from the sale of one additional unit of output (Marginal Revenue – MR. Filed Under » Business Revenue, Microeconomics. See http://www.investopedia.com/terms/m/marginal-revenue-mr.asp. Or also the revenue obtained from the last unit sold (see http://economics.fundamentalfinance.com/micro_revenue.php). So marginal cost is the increase in cost per item as more quantity is produced. Here is a simple formula for calculating marginal revenue:

marginal revenue = ( price * quantity ) for last unit sold price / quantity

= change in total revenue / change in quantity

According to economics.fundamentalfinance.com, marginal revenue is computed by taking the change in total revenue divided by the change in quantity. Firstly, what is needed are the revenues that can be earned at each price and quantity according to the demand curve as shown in Figure 5, which can be used to start to process of calculation.

Figure 5.Assume a constant $10 marginal cost

The formula above for marginal revenue applied mathematically in a spreadsheet is shown in Figure 6, with marginal price and marginal revenue changing to negative in slightly different places.

Figure 6. Running some numbers to calculate marginal values

Marginal revenue can be deduced from the line drawn between where marginal revenue becomes negative, which is somewhere between 300 and 400, and thus assumed as 350 (see Figure62); it could even be 300 because marginal price is negative at 300. Additionally, a second point can be plotted by using a marginal price plot of $15 at a quantity of 200, resulting in a marginal revenue curve as shown in Figure 7.

Figure 7.Marginal revenue and cost using 1st and last points only

The interesting point to note about Figure 7 and calculating (or estimating) marginal revenues, is that the marginal revenue curve provides very much the same information as the demand curve in that there is a sweet spot where the most revenue is made. That sweet spot can be far more easily found by using the Total Revenue column (Price * Quantity), as shown in Figure 6.

When it comes to marginal cost, one can never assume a marginal cost that is constant with quantity. This is because in many cases, manufacturing a product in quantity can lower the cost of production substantially over the long term, even if the up-front costs for manufacturing are enormous. In reality, in the example shown in Figure 7, the marginal cost is constant for each item produced, but for quantities more than 1 then obviously the total marginal cost changes. If one assumes that for every 700 items manufactured that the cost of production decreases by 50%, then Figure 7 will change as shown in Figure 8, and then production costs and marginal costs will change as well.

Figure 8. Changing marginal costs can flatten out with increasing quantity produced

Manufacturing in quantity can reduce production cost substantially but large scale manufacturing can often involve huge amounts of capital investment. So sometimes revenues do not increase at the same rate as costs do, as revenues go up – and thus bigger is not always better in business.

Price Searching

Price searching is a simple concept of figuring out what is the best price to charge for a product. If the aim is to maximize net revenue as in the case of Figure 6, then the best result will be obtained by selling an expected 300 items at $15 each, maximizing profits. Obviously for a non-profit the break-even point is more appropriate where the marginal revenue and marginal cost meet. In the case of the example used shown in Figure 7, it is required to sell 250 items at $10 each in order to cover the cost of $2500 to manufacture 250 items at $10 each.