ajaz_204_2009_lecture_16

# ajaz_204_2009_lecture_16 - University of Toronto Department...

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University of Toronto Department of Economics ECO 204 2009 2010 Sayed Ajaz Hussain Lecture 16 1 Ajaz Hussain. Department of Economics. University of Toronto (St. George)

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Today ± Optimal Price Rule ² Optimal price: what matters? ² Optimal price and |E| > 1 ² Cost plus rule ² Price and transportation costs ² Segmentation ² Price setting in practice ± Optimal Markup Rule ² Markups and price sensitivity ² Extracting markup from financial statements ² Price setting in practice ± Opportunity Cost Analysis ² MR = MC with and without other opportunities ² Marginal value of multiple activities Ajaz Hussain. Department of Economics. University of Toronto (St. George) 2
Optimal Price and Markup Rules: Motivation From last time, optimal price followed from optimal output that Max = P(q)q – C(q) s.t. q capacity This procedure requires: Demand and Cost functions What if company lacks resources and/or expertise? Use: Optimal Price Rule or Optimal Markup Rule Ajaz Hussain. Department of Economics. University of Toronto (St. George) 3

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Optimal Price Rule (No Capacity Constraint) Choose q to Max = P(q)q C(q) d /dq = (dP/dq)q + P dC/dq = 0 P + q/(dq/dP) = MC P + 1/[ (dq/dP)(1/q) ] = MC P + P/[ (dq/dP)(P/q) ]= MC P + P/ E = MC P = [E/(1 + E)]MC Ajaz Hussain. Department of Economics. University of Toronto (St. George) 4 Point Elasticity E = (dq/dP)(P/q) This condition true at optimal price
Optimal Price Rule: Ingredients Optimal price only depends on price elasticity and MC Optimal Price requires |E| > 1 Example: Suppose MC = \$10 Ajaz Hussain. Department of Economics. University of Toronto (St. George) 5 |E| ↑ → Price Intuition? MC ↑ → Price Intuition? E = 0.5 P = E/(1 + E)]MC P = ( 0.5/0.5) 10 = \$10 E = 2 P = E/(1 + E)]MC P = ( 2/ 1) 10 = \$20

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Optimal Price Rule vs. Cost Plus Rule Accountants set prices by cost plus rule: P = AC + subjective markup*AC P = (1 + m)AC Contrast with optimal price rule P = (E/(1 + E))MC Under what conditions is the cost plus rule correct? Ajaz Hussain. Department of Economics. University of Toronto (St. George) 6
Optimal Price Rule and Transport “The pricing will be a 20% premium above regular beer or more, the latter if exported. When the product is exported it will be higher due to the higher costs of transport” Source : Heineken internal marketing memo on introduction of Buckler (11/11/1987) Ajaz Hussain. Department of Economics.

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## This note was uploaded on 05/02/2011 for the course ECO 204 taught by Professor Hussein during the Fall '08 term at University of Toronto.

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ajaz_204_2009_lecture_16 - University of Toronto Department...

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