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Friday, March 30, 2007

Microeconomics quiz of the week

From ProfessorJournal.com:
As we teach our microeconomics students, prices depend on cost (actually marginal cost in the short run) and demand (price elasticity for the firm's product, which of course depends on the type of competition). The profit markup rule, p/(p-mc) = - 1/(price elasticity) incorporates marginal cost and price elasticity. In reality, however, many conservative firms continue to price by calculating average variable cost and then adding a percentage markup. This article is a nice case in a firm's movement from cost-plus pricing to prices that account for both cost and demand characteristics. "In early 2001, shortly after Donald Washkewicz took over as chief executive of Parker Hannifin Corp., he came to an unnerving conclusion. The big industrial-parts maker's pricing scheme was crazy. For as long as anyone at the 89-year-old company could recall, Parker used the same simple formula to determine prices of its 800,000 parts -- from heat-resistant seals for jet engines to steel valves that hoist buckets on cherry pickers. Company managers would calculate how much it cost to make and deliver each product and add a flat percentage on top, usually aiming for about 35%. Many managers liked the method because it was straightforward and gave them broad authority to negotiate deals. But Mr. Washkewicz thought that Parker, which had revenues of $9.4 billion last year, had stuck itself in a profit-margin rut. No matter how much a product improved, the company often ended up charging the same premium it would for a more standard item. And if the company found a way to make a product less expensively, it ultimately cut the product's price as well.... While touring the company's 225 facilities in 2001, Mr. Washkewicz had an epiphany: Parker had to stop thinking like a widget maker and start thinking like a retailer, determining prices by what a customer is willing to pay rather than what a product costs to make. Such "strategic" pricing schemes are used by many different industries. Airlines know they can get away charging more for a seat to Florida in January than in August. Sports teams raise ticket prices if they're playing a well-known opponent. Why shouldn't Parker do the same, Mr. Washkewicz reasoned." One interesting point in the article is that Parker Hannifin's new pricing mechanism takes into account the type of competition. Specifically, the profit margin is greater for the products in which Parker Hannifin does not have close competition.

QUESTIONS:
1.) In economics models, do profit-maximizing prices account for a firm's costs as well as the demands for its products?

2.) How does the demand for a firm's product affect its optimal prices?

3.) With market demand in place, how does the type of competition (i.e., perfect competition, oligopoly or monopoly) affect the demand for a single firm's product?

4.) To determine prices, why do some firms calculate the variable cost of a product and then add a fixed percentage (for example 35 percent)?
There is a typo in the review, the optimal condition for profit maximization is (p-mc)/p = -1/e, where p = price, mc = marginal cost, and e = price elasticity of demand. The condition is known as the Lerner Condition which describes the optimal markup over cost consistent with profit maximization. Often the left side of the equation is called the Lerner Index.

In short, if price elasticity is infinity in absolute value, i.e., the firm is perfectly competitive, the firm charges price equal to marginal cost. If the firm has some market power, in which case the price elasticity of demand is lower in absolute value, there is introduced a wedge between price and marginal cost. The problem of cost-plus pricing is that consumers might be willing to pay more for a product, as reflected in the price elasticity of demand on the right side of the Lerner condition, than a simple cost-plus pricing scheme would suggest.

Original WSJ article (sub req'd)
More on the Lerner Condition
More on firms and profit maximizing behavior
More on firms and profit maximizing behavior

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