Our 

formula for optimal pricing tells us that p* = c - q / (dq/dp). Here, marginal costs are a bit

sneaky — they enter directly, through the c, but also indirectly because a change in marginal cost
will change prices which in turn changes both q and dq/dp

rms use price discounts, specials, coupons, and rebate programs to measure the price
sensitivity of demand for their products. Armed with such knowledge, and detailed unit cost
information, firms have all the tools necessary for setting optimal prices.

Price Elasticity and Revenue Relations: A Numerical Example

Optimal Price Formula

As a practical matter, firms devote enormous resources to obtain current and detailed
information concerning the price elasticity of demand for their products. Price elasticity
estimates represent vital information because these data, along with relevant unit cost
information, are essential inputs for setting a pricing policy that is consistent with value
maximization. This stems from the fact that there is a relatively simple mathematical
relation between marginal revenue, price, and the point price elasticity of demand.

Given any point price elasticity estimate, relevant marginal revenues can be determined
easily. When this marginal revenue information is combined with pertinent marginal cost
data, the basis for an optimal pricing policy is created.
The relation between marginal revenue, price, and the point price elasticity of demand
follows directly from the mathematical definition of a marginal relation.2 In equation form,
the link between marginal revenue, price, and the point price elasticity of demand is

Because _P  < 0, the number contained within brackets in Equation 5.10 is always less than
one. This means that MR< P, and the gap between MRand P  will fall as the price elasticity of
demand increases (in absolute value terms). For example, when P  = $8 and _P  = –1.5, MR  =
$2.67. Thus, when price elasticity is relatively low, the optimal price is much greater than
marginal revenue.
Conversely, when P  = $8 and _P  = –10, MR  = $7.20. When the quantity demanded is highly
elastic with respect to price, the optimal price is close to marginal revenue.
Optimal Pricing Policy Example
The simple relation between marginal revenue, price, and the point price elasticity is very
useful in the setting of pricing policy. To see the usefulness of Equation in practical pricing
policy, consider the pricing problem faced by a profit-maximizing firm. Recall that profit
maximization requires operating at the activity level where marginal cost equals marginal
revenue.

Most firms have extensive cost information and can estimate marginal cost reasonably
well. By equating marginal costs with marginal revenue as identified by Equation, the profit-
maximizing price level can be easily determined. Using Equation, set marginal cost equal to
marginal revenue, where

MC  = MR
and, therefore,

which implies that the optimal or profit-maximizing price, P*, equals

This simple relation between price, marginal cost, and the point price elasticity of demand is
the most useful pricing tool offered by managerial economics.

To illustrate the usefulness of Equation, suppose that manager George Stevens notes a 2
percent increase in weekly sales following a 1 percent price discount on The
Kingfish  fishing reels. The point price elasticity of demand for The Kingfish  fishing reels is

What is the optimal retail price for The Kingfish  fishing reels if the company’s wholesale
cost per reel plus display and marketing expenses—or relevant marginal costs—total $25
per unit?
With marginal costs of $25 and _P  = –2, the profit-maximizing price is

Therefore, the profit-maximizing price on The Kingfish  fishing reels is $50. To see how
Equation can be used for planning purposes, suppose Stevens can order reels through a
different distributor at a wholesale price that reduces marginal costs by $1 to $24 per unit.
Under these circumstances, the new optimal retail price is

Thus, the optimal retail price would fall by $2 following a $1 reduction in The
Kingfish’s  relevant marginal costs.
Equation can serve as the basis for calculating profit-maximizing prices under current cost
and market-demand conditions, as well as under a variety of circumstances. Table shows
how profit-maximizing prices vary for a product with a $25 marginal cost as the point price
elasticity of demand varies. Note that the less elastic the demand, the greater the difference
between the optimal price and marginal cost. Conversely, as the absolute value of the price
elasticity of demand increases (that is, as demand becomes more price elastic), the profit-
maximizing price gets closer and closer to marginal cost.

Determinants of Price Elasticity

There are three major influences on price elasticities: (1) the extent to which a good is
considered to be a necessity; (2) the availability of substitute goods to satisfy a given need;
and (3) the proportion of income spent on the product. Arelatively constant quantity of a
service such as electricity for residential lighting will be purchased almost irrespective of
price, at least in the short run and within price ranges customarily encountered. There is no
close substitute for electric service. However, goods such as men’s and women’s clothing
face considerably more competition, and their demand depends more on price.

Similarly, the demand for “big ticket” items such as automobiles, homes, and vacation travel
accounts for a large share of consumer income and will be relatively sensitive to price.
Demand for less expensive products, such as soft drinks, movies, and candy, can be
relatively insensitive to price. Given the low percentage of income spent on “small ticket”
items, consumers often find that searching for the best deal available is not worth the time
and effort. Accordingly, the elasticity of demand is typically higher for major purchases than
for small ones. The price elasticity of demand for compact disc players, for example, is
higher than that for compact discs.

Price elasticity for an individual firm is seldom the same as that for the entire industry. In
pure monopoly, the firm demand curve is also the industry demand curve, so obviously the
elasticity of demand faced by the firm at any output level is the same as that faced by the
industry. Consider the other extreme—pure competition, as approximated by wheat farming.
The industry demand curve for wheat is downward sloping: the lower its price, the greater
the quantity of wheat that will be demanded. However, the demand curve facing any
individual wheat farmer is essentially horizontal. Afarmer can sell any amount of wheat at
the going price, but if the farmer raises price by the smallest fraction of a cent, sales
collapse to zero. The wheat farmer’s demand curve—or that of any firm operating under
pure competition—is perfectly elastic. Figure illustrates such a demand curve.

The demand for producer goods and services is indirect, or derived from their value in use.
Because the demand for all inputs is derived from their usefulness in producing other
products, their demand is derived from the demand for final products. In contrast to the
terms final product  or consumer demand, the term derived demand  describes the demand
for all producer goods and services. Although the demand for producer goods and services
is related to the demand for the final products that they are used to make, this relation is not
always as close as one might suspect.
Price Elasticity and Optimal Pricing Policy

In some instances, the demand for intermediate goods is less price sensitive than demand
for the resulting final product. This is because intermediate goods sometimes represent
only a small portion of the cost of producing the final product. For example, suppose the
total cost to build a small manufacturing plant is $1 million, and $25,000 of this cost
represents the cost of electrical fixtures and wiring. Even a doubling in electrical costs from
$25,000 to $50,000 would have only a modest effect on the overall costs of the plant—
which would increase by only 2.5 percent from $1 million to $1,025,000. Rather than being
highly price sensitive, the firm might select its electrical contractor based on the timeliness
and quality of service provided. In such an instance, the firm’s price elasticity of demand for
electrical fixtures and wiring is quite low, even if its price elasticity of demand for the overall
project is quite high.
In other situations, the reverse might hold. Continuing with our previous example, suppose
that steel costs represent $250,000 of the total $1 million cost of building the plant.
Because of its relative importance, a substantial increase in steel costs has a significant
influence on the total costs of the overall project. As a result, the price sensitivity of the
demand for steel will be close to that for the overall plant. If the firm’s demand for plant
construction is highly price elastic, the demand for steel is also likely to be highly price
elastic.

Although the derived demand for producer goods and services is obviously related to the
demand for resulting final products, this relation is not always close. When intermediate
goods or services represent only a small share of overall costs, the price elasticity of
demand for such inputs can be much different from that for the resulting final product. The
price elasticity of demand for a given input and the resulting final product must be similar in
magnitude only when the costs of that input represent a significant share of overall costs.

Price Elasticity of Demand for Airline Passenger Service

Southwest Airlines likes to call itself the Texas state bird. It must be some bird, because the
U.S. Transportation Department regards Southwest as a dominant carrier. Fares are cut in
half and traffic doubles, triples, or even quadruples whenever Southwest enters a new
market. Airport authorities rake in millions of extra dollars in landing fees, parking and
concession fees soar, and added business is attracted to the local area—all because
Southwest has arrived! Could it be that Southwest has discovered what many airline
passengers already know? Customers absolutely crave cut-rate prices that are combined
with friendly service, plus arrival and departure times that are convenient and reliable. The
once-little upstart airline from Texas is growing by leaps and bounds because nobody
knows how to meet the demand for regional airline service like Southwest Airlines.

Table shows information that can be used to infer the industry arc price elasticity of
demand in selected regional markets served by Southwest. In the early 1990s, Southwest
saw an opportunity because airfares out of San Francisco were high, and the nearby
Oakland airport was underused. By offering cut-rate fares out of Oakland to Burbank, a
similarly underused airport in southern California, Southwest was able to spur dramatic
traffic gains and revenue growth. During the first 12 months of operation, Southwest
induced a growth in airport traffic on the Oakland–Burbank route from 246,555 to 1,053,139
passengers, an increase of 806,584 passengers, following an average one-way fare cut
from $86.50 to $44.69. Using the arc price elasticity formula, an arc price elasticity of
demand of _P  = –1.95 for the Oakland–Burbank market is suggested. Given elastic demand
in the Oakland–Burbank market, city-pair annual revenue grew from $21.3 to $47.1 million
over this period.
A very different picture of the price elasticity of demand for regional airline passenger
service is portrayed by Southwest’s experience on the Kansas City–St. Louis route. In 1992,
Southwest began offering cut-rate fares between Kansas City and St. Louis and was, once
again, able to spur dramatic traffic growth. However, in the Kansas City–St. Louis market,
traffic growth was not sufficient to generate added revenue. During the first 12 months of
Southwest’s operation in this market, traffic growth in the Kansas City–St. Louis route was
from 428,711 to 722,425 passengers, an increase of 293,714 passengers, following an
average one-way fare cut from $154.42 to $45.82. Again using the arc price elasticity
formula, a market arc price elasticity of demand of only _P  = –0.47 is suggested.
With inelastic demand, Kansas City–St. Louis market revenue fell from $66.2 to $33.1
million over this period. In considering these arc price elasticity estimates, remember that
they correspond to each market rather than to Southwest Airlines itself. If Southwest were
the single carrier or monopolist in the Kansas City–St. Louis market, it could gain revenues
and cut variable costs by raising fares and reducing the number of daily departures. As a
monopolist, such a fare increase would lead to higher revenues and profits. However, given
the fact that other airlines operate in each market, Southwest’s own demand is likely to be
much more price elastic than the market demand elasticity estimates shown in Table. To
judge the profitability of any fare, it is necessary to consider Southwest’s revenue and  cost
structure in each market. For example, service in the Kansas City–St. Louis market might
allow Southwest to more efficiently use aircraft and personnel used to serve the Dallas–
Chicago market and thus be highly profitable even when bargain-basement fares are
charged.
The importance of price elasticity information is examined further in later chapters. At this
point, it becomes useful to consider other important demand elasticities.

How Prices Plunge and Traffic Soars When Southwest Airlines Enters a Market

« Previous Topics Next Topics »

 Price Elasticity And Marginal Revenue  Cross-price Elasticity Of Demand

 Price Elasticity Of Demand  Income Elasticity Of Demand

 Demand Sensitivity Analysis: Elasticity  Additional Demand Elasticity Concepts

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