PRICING AND PROFITABILITY ANALYSIS
QUESTIONS FOR WRITING AND DISCUSSION
If demand is relatively elastic, a price
change of X% results in a quantity change
of more than X%. If demand is relatively in-
elastic, a price change of X% results in a
quantity change of less than X%. Housing,
postage for personal letters, and ice cream
bars are examples of products with relatively
elastic demand. Insulin, salt, and laser print-
er toner cartridges are examples of products
with relatively inelastic demand.
Perfectly competitive markets are character-
ized by the following: many buyers and
sellers—no one of which is large enough to
influence the market; a homogeneous
product (one company’s product is virtually
identical to any other company’s product);
and easy entry into and exit from the in-
dustry. Commodity markets for agricultural
products such as wheat, soybeans, and
pork bellies are close to perfectly competit-
ive. Similarly, gas stations in a city face
competitive conditions. A gas station may
try to differentiate itself to move to a more
monopolistically competitive situation. For
example, it might offer car washes, certain
grocery staples, or full service.
The markup percentage on cost of goods
sold is equal to selling and administrative
expense plus desired operating income di-
vided by cost of goods sold. The markup is
not pure profit because it includes selling
and administrative expense.
Target costing is a method of determining
the cost of a product or service based on
the price that customers are willing to pay.
In essence, target costing is price driven.
Once the target price is determined, the cost
is calculated by subtracting desired profit
from price. The remainder is the target cost.
Penetration pricing is the pricing of a new
product at a low initial price, perhaps even
lower than cost, to build market share
quickly. Price skimming is a pricing strategy
in which a higher price is charged at the be-
ginning of a product’s life cycle and then
lowered at later phases of the life cycle.
There are a number of possible reasons;
here are three. First, the price difference
may be cost based. If interstate locations
are more expensive than lots in town, then
the higher cost of operating on the interstate
could result in a higher price. Second, inter-
state highway gas purchasers are often
tourists. They do not have a long-term rela-
tionship with the gas station owner; there-
fore, the price charged may be higher.
Third, the price elasticity of demand for gas-
oline purchased in town may be higher due
to the larger number of competing gas sta-
Price discrimination is the charging of differ-
ent prices to different customers for essen-
tially the same commodity. It is legal in
some instances. For example, if price dis-
crimination is necessary to meet competition
or is based on cost differences in serving
different customers, it is legal.