How Sellers Calculate The Price That Will Earn Them The Highest Profit
By David Grace (www.DavidGraceAuthor.com)
The mechanisms and forces that determine price are the heart of the capitalist system.
Generally, prices range from a “cost + overhead + minimal profit percentage” for products in a fiercely competitive market on the low end to the Maximum Revenue Price for products in a non-competitive market on the high end.
In extreme situations, e.g. a bumper crop of agricultural products, especially when coupled with sales of those products at auction, prices can be less than the cost of production. In those cases, sellers would be well advised to all refuse to participate in auctions but rather set up a cooperative distribution organization with a floor price equal to the costs of production and with a pro-rata allocation of each sale among the participating farmers or ranchers.
In a previous column, Supply & Demand Don’t Affect Price The Way Most People Think They Do, I discussed the factors that determine price in a competitive market.
This column is about how sellers calculate the most profitable prices in a substantially non-competitive market.
The Initially Asked Or Offered Price
For every product there is a price either initially asked by the seller or initially offered by the buyer.
The initial price is proposed by the least populous side of the transaction, the buyer or the seller.
There are fewer manufacturers of physical products than there are customers for physical products so the sellers set the initial price for most physical products and the buyers generally accept or reject them.
There are fewer sellers of professional services (doctors, lawyers, etc.) than there are buyers of professional services so the sellers of professional services set the initial price.
There are fewer buyers of hourly labor services (employers) than there are sellers of hourly labor services (workers) so the employers set the initial price for hourly labor services.
The party — buyer or seller — that sets the initial price picks a price that is most advantageous to themselves given what they know about the market for that product.
Monopoly and cartel sellers almost always ask a price that will generate maximum profits, the Maximum Revenue Price.
This column is concerned with the factors that determine how a seller in a noncompetitive market picks that price.
Sellers Whose Goals Are Higher Sales Rather Than Higher Prices
While almost all sellers want to set a price that will generate the maximum amount of net revenue, there are a few sellers who set a price designed to achieve a different goal, namely, either
- Maximum sales volume, or.
- Maximum market share
Maximum Sales Volume
Every product incurs costs per unit sold. Up to a certain point, costs per unit decrease as the number of units sold increases because of the economies of scale.
The most important goal for some businesses can be to increase sales volume to the point where the company can reduce its per-unit costs through the economies of scale. To do that, the company may initially price its products as cheaply as possible in order to gain as high a number of unit sales as quickly as possible.
Amazon needed to have a high volume of sales to support the creation of a large and sophisticated warehouse and fulfillment infrastructure.
Verizon’s business requires that it have tens of millions to hundreds of millions of customers to support the overhead costs of the installation and operation of its network.
Maximum Market Share
Some companies have a business model that includes a base product and ancillary products. Those companies want to make maximum sales of the base product, e.g. razors or ink-jet printers, so that they will have maximum sales of very profitable ancillary products, e.g. razor blades and ink.
It’s in Keurig’s interest to sell its coffee makers relatively cheaply in order to gain a huge number of customers so it can profit from the patented coffee pods that its machines require.
The Ultimate Goal Is Always More Profit
If the immediate goal is to sell more units, the long-term goal is always to eventually earn higher profits by lowering costs/unit through the economies of scale.
If the immediate goal is to sell more units because each unit sold will require the customer to purchase expensive ancillary products, the long-term goal is always to earn higher profits through the sale of those expensive ancillary products.
However they get there, the primary goal of all sellers is to earn more net profits.
Sellers Whose Goal Is Maximum Net Revenue
Almost all sellers will happily accept fewer customers and a lower sales volume in exchange for higher profits. Their primary question is not:
“How do I price my product so that it generates the maximum number of units sold?” but rather:
“How do I price my product so that it generates the maximum level of net profits?”
A low unit price that generates the most sales volume is not necessarily the price that generates the highest net profits.
Except when higher unit sales are needed either to get the benefit of economies of scale or to drive the sale of ancillary products, in a low-competition market, sellers will not choose to reduce a price to sell more units if that lower price results in lower net profits.
Sellers in a low competition market will only voluntarily reduce an existing price if they determine that reducing the price will make them more money.
In order to determine if a low-competition seller will choose to raise a price, maintain an existing price, or lower a price we have to understand when raising a price will make the seller more money and when lowering a price will make the seller more money.
Price Elasticity
A price is said to be “elastic” when raising it or lowering it will make the seller more money.
A price is said to be “inelastic” when raising it or lowering it will make the seller less money.
For a reduction in price:
Price Elasticity = The Percentage Increase in The Quantity Sold/The Percentage Decrease in Price per Unit
If the result of the calculation is greater than 1 then the price is elastic and the seller will make more money by lowering the price than by leaving the price where it is.
For an increase in price:
Price Elasticity = The Percentage Increase in Price/The Percentage Decrease in The Quantity Sold
If the ratio is greater than 1 then the price is elastic and the seller will make more money by raising the price than by leaving the price where it is.
If the ratio of price increase to sales decline or price decrease to sales increase is exactly 1, that is called “Unit Elasticity” and it is the point where the price generates the maximum sales revenue.
Sellers always want to raise a low price to the point of Unit Elasticity and lower a high price to the point of Unit Elasticity.
The Unit Elasticity Price is the Maximum Revenue Price, the price where the seller will earn the most gross revenue, and it is the same as the monopoly price, that is, the price a monopoly seller will charge for the product.
It should be noted that the elasticity formulas above assume that all of the seller’s costs are variable costs which increase or decrease in direct proportion to the number of units sold, but in the real world sellers have both variable costs and fixed costs.
Because selling fewer units will not reduce fixed costs the profits from the sale of fewer units will be lower than those predicted by the elasticity formula.
In the real world, the calculations need to be adjusted to reflect increases or decreases in net revenues in the event of increases or decreases in sales volume rather than increases and decreases in gross revenues because of the necessity of taking into account both fixed and variable costs at varying levels of sales.
**To see simple examples of how raising and lowering prices can generate increased gross sales or decreased gross sales, go to the end of this column.
How Changes In Price Affect Changes In Sales Volume
The amount by which changes in price affect sales volume depends on several factors:
How broad is the product’s demographic?
Bottled water has a very wide demographic, meaning that every human is a potential customer for really cheap, really good water. A drop in the price of really good bottled water has the potential to greatly expand the number of purchasers of bottled water.
Blood-pressure medication has a very narrow demographic. Most people don’t need it and no one who has normal blood pressure will buy it no matter how cheap it is. And those who do buy it will not buy more of it if it is cheaper .
How price-sensitive is the quantity the average consumer buys?
People who like steak will buy more of it if the price goes down and less of it if the price goes up.
No matter how cheap toilet paper is, if you use one roll per week you are not going to buy two rolls per week.
How Vital Is The Product?
People buy vital products like water, gasoline, electricity, medications, etc. because they need them, not because they are cheap. Sellers do not need to lower the prices of vital products to lure buyers into purchasing them.
Because people are already strongly motivated to buy vital products, the prices are highly elastic for a price increase and inelastic for a price decrease.
The more vital the product is, the higher is its Maximum Revenue Price.
The more trivial a product is, the lower is its Maximum Revenue Price.
Put differently, sellers can get away with raising the price of insulin far higher than they can get away with raising the price of chocolate-covered cherries.
The Graph Of Prices Charged Vs. Quantities Sold
Let’s do a thought experiment. Let’s pretend that in a certain market two huge meat processing companies operate as an informal cartel. They control over 95% of the market for steak. Their total cost is $3 per pound, including all overhead.
For example, selling 10,000 pounds of steak at $10/pound will generate $100,000 gross revenue — $30,000 costs = $70,000 net profit.
These sellers want to know the price, someplace between $3/pound and $100/pound, that will earn them the maximum amount of profit.
The first thing they need to do is estimate the number of pounds of steak that will be sold at each price point in that $3/pound to $100/pound price range. While vegetarians will never buy their steak, they still have a wide demographic of people who will buy it if the price is “right.”
Also, the people who do buy steak will buy more of it if it is cheaper. The question is, How many pounds of steak can they sell each week at each price?
In the graph below price is on the vertical axis and quantity sold is on the horizontal axis.
If the price of steak was $100/pound very few people would buy it, but there will always be some people who have so much money that paying $100 for a one-pound steak is a trivial expense.
At $50/pound steak is still very expensive but there are more people who are rich enough to consider that a trivial expense and volume increases from 10,000 pounds/week at $100/pound to 30,000 pounds/week at $50/pound.
Until steak reaches around $20/pound, Point A, the price drops faster than the quantity increases. Put differently, the line goes down faster than it increases horizontally — the line’s angle is greater than 45 degrees which means that the price is inelastic — the seller loses more money from the drop in price than the seller gains from the increased volume of sales.
From $18/pound down to about $8/pound, Area B, the price drops more slowly than sales increase, the line’s angle is less than 45 degrees, and the price is elastic. The seller loses less money from each drop in price than the seller gains from the greater volume of sales.
Below $6/pound, Area C, the price is inelastic and the line’s angle is again greater than 45 degrees.
This graph gives the sellers an idea of how many pounds of steak will likely be sold at each price point. Using these numbers they generate a second graph which shows price on the vertical axis and net profit on the horizontal axis.
Graph Of Price Vs. Net Profits
As price increases from $3/pound net profits increase until they hit the maximum level between $10/pound and $15/pound. Any of the prices in that range will generate about the same level of net profits.
Any price between about $10/pound and $15/pound is the Unit Elasticity Price, the Maximum Revenue Price, the Monopoly Price.
An increase in price above $15/pound reduces net profits.
In a highly competitive market, price competition would force prices down to some level equal to all costs including overhead + some percentage of profit. If the minimum profit percentage that companies in this market sector would accept was 33% of total costs including overhead, then the price for steak in an extremely competitive market would be the $3 total cost/pound + $1 profit = $4/pound.
So, depending on how competitive the market is, the price for steak would be someplace between the “Total Cost + Profit Price” of about $4/pound and the “Maximum Revenue Price” of somewhere between $10 to $15 per pound.
Selling Fewer Units At The Same Level Of Profits Is Better
If a seller can make as much profit selling fewer units at a higher price as it can by selling more units at a lower price then the seller will generally choose to sell fewer units at a higher price because producing fewer units means lower capital costs, labor costs, financial costs, customer support costs, warranty costs, etc.
Also, setting the standard price at the higher range gives the seller the opportunity for increased profits through seasonal sales.
In this example, a seller with market control through control of distribution channels, technology licenses, raw materials, trade name dominance, etc. will price its steak at $15/pound with seasonal sales at $11 or $12 per pound to get a temporary surge in sales volume at a price that would generate an equal level of net profits without the expected increase in sales volume.
Maximum Revenue Price Depends On The Wealth Of The Buyers
The Unit Elasticity Price, the maximum revenue price, will be higher if the core buyers of the product are richer and it will be lower if the demographic of the principal buyers is poorer.
If the product is Rolex watches, those buyers are so wealthy that they are far less sensitive to price increases. Rolex prices would have to increase by a very large amount before sales of Rolexes declined faster than the price increased.
Drugs that are expensive in the U.S. are cheaper in third-world countries because the customers for those drugs in those countries are poorer. That means that the maximum amount of money that the pharmaceutical companies can collect from patients in third-world countries is less so the price that will generate the maximum revenue is lower.
Summary
All sellers want to maximize profits. All buyers want to minimize costs.
A fiercely competitive market where the buyers/consumers have greater bargaining power than the sellers, will drive down prices and encourage innovation and higher quality products.
This is what we all say we want, but really only consumers want that.
Sellers, producers, and manufacturers never want that.
Sellers want higher prices (for their own products, not for the products they purchase), less or no competition, as little investment in new products as possible (unless the re-designed product will make them even more money).
They can’t get away with that in a highly competitive market but the less competitive the market, the more they can.
The more a seller’s bargaining power exceeds the buyer’s bargaining power the closer the price will approach the maximum revenue price and the less the seller will be motivated to innovate or increase quality.
If they can, sellers will act (or refuse to act) so as to reduce supplies in order to reduce competition and increase prices.
We saw this when
- energy companies shut down power plants in order to drive up energy prices.
- airlines reduced flights or dropped routes.
- Oil companies closed oil refineries ;
*[The last new operating U.S. oil refinery was built in 1977. In 1980 the U.S, refining capacity was 17,998 barrels per day. In 2019, almost forty years later, the U.S. operating refineries’ capacity was 18,800 barrels per day. In 1980 there were 319 operating oil refineries in the U.S. In 2019 there were 135.]
When the number of sellers is small enough and anti-trust enforcement weak enough, sellers will act to restrict supply in order to reduce competition and raise their bargaining power so that they can raise prices, reduce quality, and restrict innovation, all in the service of higher profits.
It is as pointless to criticize them for doing this as it is to criticize wolves for eating sheep. It’s what they’re designed to do.
The point is not to criticize sellers for reducing competition and, as much as possible, charging maximum revenue prices.
The point is to adopt systems and policies that prevent them from doing it.
— David Grace (www.DavidGraceAuthor.com)
Examples Of Elastic & Inelastic Prices
Lowering The Price — Elastic
If by lowering the price by 10% the seller will sell 15% more units (15%/10% = 1.5) the seller will make more money by lowering the price and the price is elastic.
The price was $10 and sales were 1,000 units for gross sales of $10,000.
If the price was reduced to $9 and sales went up to 1,150 units, gross sales revenue would increase to $10,350.
Lowering The Price — Inelastic
If by lowering the price by 10% the seller will sell 5% more units (5%/10% = .5) the seller will make less money by lowering the price and the price is inelastic.
If the price goes down to $9 and sales go up to 1,050, gross sales would decrease to $9,450.
Raising The Price — Elastic
If by raising the price by 10% the seller will sell 5% fewer units (10%/5% = 2) the seller will make more money by raising the price and selling fewer units and the price is elastic.
If the price increases from $10 to $11 and sales fall from 1,000 units to 950 units, sales revenue increases from $10,000 to $10,450
Raising The Price — Inelastic
If by raising the price by 10% the seller will sell 15% fewer units (10%/15% = .667) the seller will make less money by raising the price and the price is inelastic.
If the price increases from $10 to $11 and sales fall from 1,000 units to 850 units, revenues will decline from $10,000 to $9,350
