Monday, July 29, 2013

"Cut the price and you will sell more!!" is a common statement from students when studying Supply and Demand dynamics. This has more stretch to it than an Elastic band...

I produce widgets.  Under current market conditions, I produce and sell 1,000 widgets a day for $10.00 each. My daily revenue therefore is $10,000 (1,000 X $10).

Students often say "Cut the price so you can sell more and make more money!"  On its face, it makes sense BUT you have to consider (1) what your competition will do and (2) how many additional units will you sell as a result of the price cut.

If I cut my price 10% to $9.00 with the expectation that I will sell and additional 20% more widgets (200) then my revenue will be $10,800.  SWEET! I increased my revenues $800.  Hold on.  What will my competition think about this?  They won't want to lose existing customers, so they will match my price decrease to maintain their customer base.  If I end up gaining no new customers then my revenues will be $9.00 X 1,000 widgets = $9,000.  I am worse off.

Let's assume I am the only producer of widgets.  If I cut my price to increase revenues, I need to know not only my existing customers buying habits but my potential customers as well.  I need to ask myself 2 questions:

(1) How sensitive are my existing customers to a change in price relative to how many ADDITIONAL widgets they will buy from me?

(2)  How sensitive are potential customers to a change in price relative to how may widgets they will buy in the first place.

If I reduce my price 10% and increase the quantity demanded for widgets by 5%, then my new revenues will be $9.00 X 1050 = $9,450. I am worse off.

If I reduce my price 10% and increase the quantity demanded by 15%, then my new revenues will be $9.00 X 1,150 = $10,350.  I am better off.

Changes in Prices tend to induce changes in Quantity Demanded (on the demand side) of a good and/or service.  How responsive the demand side is to changes in prices determines the good or services relative "Elasticity".

Elasticity is a concept in Microeconomics we will cover in depth in class.

The purpose of this blog entry is to eliminate the bias you might have towards the simplistic statement that established our premise "Cut the price so you can sell more and make more money!".

Now you know... :)
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