The Economic Model of Pricing

The economic model of pricing, marginal cost pricing, clearly identifies a pricing strategy that will maximize profits. This strategy also identifies the information needed to set prices.

The economic model of pricing is simple. First, find out what your incremental costs are. (Remember, incremental costs are the same as marginal costs.) Second, estimate the price elasticity of demand facing your organiza- tion’s product. (Demand for the products of your organization will usually be much more elastic than the overall demand for the product. See chapter 8 for more information about elasticity.) Third, calculate the appropriate markup, which will equal ε/(1 + ε). (Here, ε represents the price elasticity of demand for your organization’s product.) Multiplying this markup by your organization’s incremental cost gives you the profit-maximizing price. The profit-maximizing price will equal [ε/(1 + ε)] × MC, where MC represents the incremental cost. So, if the price elasticity of demand is −2.5 and the incremental cost is $3.00, the profit-maximizing price would be [−2.5/(1 − 2.5)] × 3.00, or $5.00.

By now you may have noted that the pricing rule is just a restatement of the profit maximization rule from chapter 11, which states that marginal revenue equals marginal cost. The formula for marginal revenue is Price × (1 + ε)/ε, so MC = Price × (1 + ε)/ε. Solve this formula for Price by dividing both sides by (1 + ε)/ε, and you end up with Price = MC/[(1 + ε)/ε], which is the same as [ε/(1 + ε)] × MC.

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