Price and pricing policy in neoclassical economic theory

Demand - The demand function describes the demanded quantity of a certain product at every possible price while holding all other factors constant. At a lower price, buyers demand a larger quantity whereas at a higher price a smaller quantity. This reflects the principle of diminish-ing marginal benefit, which states that each purchased unit provides less benefit to the buyer than the preceding one. The principle of diminish-ing marginal benefit implies that the relationship between price and demanded quantity will be negative and that demand curves slope downwards.

A key interpretation of the demand curve is that it shows the marginal benefit buyers receive from each unit of production, and thus, the maximum price that will be accepted. Because preferences differ be-tween individual buyers, or buyer segments, so does the level of benefit they receive from a particular product. Hence, given that a uniform price is set across the market, buyers with differential preferences re-ceive differential levels of surplus. This phenomenon is captured by the concept of buyer surplus, which equals the total benefit received by buy-ers minus their expenditure (i.e. price).

Instead of setting a uniform price corresponding to the level of benefit received by the marginal buyer (the buyer who values the product the least), an individual seller can set different prices for various units of the same product. This allows the seller to extract a larger surplus from the buyers who receive high levels of benefit from the product (i.e. buyers who would have received a large buyer surplus with a uniform price) and to increase the production rate to include potential buyers for which marginal costs exceed marginal revenues under the uniform pric-ing policy (i.e. buyers who would not have bought the product at the profit maximizing uniform price). The practice of setting different prices (or incremental margins) for various units of the same product in order to reduce buyer surplus and increase the seller’s profit is termed price discrimination.

Elasticity - The own-price elasticity of demand (price elasticity) repre-sents the slope of the demand curve. The definition of price elasticity is the percentage by which demanded quantity will change if price is raised by 1 %. For most products there is a negative relationship be-tween price and demanded quantity (i.e. downward sloping demand curve). If a large percentage change in price causes no change in

de-manded quantity, the price elasticity of demand is 0. If a 1% increase in price leads to more than a 1% decrease in demanded quantity, demand is elastic with respect to price. If a 1% increase in price leads to less than a 1% decrease in demanded quantity, the demand is inelastic with re-spect to price.

Profit maximizing pricing decisions take into account the price elastic-ity within the relevant range of the price change. All other things equal, firms should in order to maximize profits increase the price where the demand is inelastic and decrease the price where the demand is elastic.

The reason for this is the proportionate change in price versus de-manded quantity. A price increase in an inelastic market implies that the demanded quantity will proportionately not decrease as much as the price is increased, while a price decrease in an elastic market implies that, proportionately, the demanded quantity will increase more than the price is lowered.

Supply – Firms maximize profits at the production rate where its mar-ginal revenue equals its marmar-ginal cost. Marmar-ginal revenue shows the rate at which total revenues increase with the sale of an additional unit.

Marginal cost shows the rate at which total costs increase with the pro-duction of one additional unit. Hence, the firm’s marginal cost curve determines how much the firm will produce at any given price. This relationship is represented by the individual supply curve (correspond-ing to the marginal cost curve).

A key interpretation of the individual supply curve is that it describes the minimum price that a seller will accept for each unit of production.

From this perspective it is possible to explain how a seller will be af-fected by a change in price. The concept used to explain this is seller surplus. Seller surplus is the difference between the revenues from a cer-tain production rate and the minimum amount necessary to induce production. In the short-run, the minimum price necessary to induce production is average variable costs. The minimum price to induce a seller to produce in the long run is average total costs. Thus, the short-run seller surplus equals revenues minus total variable costs and the long-run seller surplus equals revenues minus total costs.

A change in price will affect seller surplus (and profits) in two ways: a volume effect and a price effect. Both effects are determined by the cost

structure of the seller’s operations in terms of the marginal cost curve.

For example, when a price taker in a competitive market experiences an increase in (market) price, the seller will be induced to increase produc-tion so that marginal revenue equals marginal cost, thus earning surplus from the additional units sold (volume effect). Further, the higher price would also increase surplus from the production of the original number of sold units (price effect).

There are two main conclusions to be drawn from the discussion of supply. First, the cost structure of a firm determines the minimum price at which a supplier will produce (i.e. break-even restrictions). Sec-ond, the seller’s marginal cost curve determines the proportionate effect that a change in price will have on seller surplus (profits).

Pricing policy - The brief review of basic economic concepts has shown three attributes of firm pricing policy that are desirable for a firm wish-ing to maximize its profits. In addition to providwish-ing a set of pricwish-ing re-lated-objectives, these attributes also posit three dimensions by which firm pricing policy can be described.

• The demand curve facing a firm describes the marginal benefit buyers receive from products, thus determining the maximum amount that individual buyers or buyer segments are willing to pay. Buyer surplus reflects the differential levels of net benefit (total benefit-buyer expenditure) received by different buyers or buyer segments. One objective of a seller’s pricing policy can therefore be said to discriminate prices across buyers or segments so that the price matches the received benefit. This is termed price discrimination.

• Price elasticity of demand reflects the percentage change in de-manded quantity following a 1% increase in price. Demand is elastic if demanded quantity changes proportionately more than price. Demand is inelastic if demanded quantity changes pro-portionately less than price. One objective of a seller’s pricing policy can therefore be said to set a relatively lower price if the demand is elastic and set a relatively higher price if the demand is inelastic. This is termed price elasticity leverage.

• The seller’s marginal cost curve determines the optimal price/production rate and the minimum price at which the firm

will produce (i.e. the short and long run break-even points).

Further, the marginal cost curve determines the financial impact of particular prices or price changes. Generally, profits are more sensitive to changes in volume if marginal costs are low. Further, profits are proportionately more sensitive to price changes if marginal costs are high. Hence, one objective of pricing policy can therefore be said to leverage the financial implications of a certain pricing policy based on the characteristics of the firm’s (marginal-) cost structure. This is termed operating leverage¹⁵.