Let's Talk Price: An Economist's Method

When buying something, PRICE is a big deal. You can't escape the fact that all people, customers, companies, Governments, are stingy and don't want to part with their precious dough when paying for something, but at the same time everyone wants to charge the most when selling something (negotiating salaries, eBay auctions, etc). You must consider that raising prices to $XYZ limits your appeal to the amount of possible consumers that can afford to part with $XYZ, regardless of how valuable, fashionable or delicious your widget is.

So consider the following graph:

The red, downward-sloping line represents a typical demand curve. On the Y-axis (up and down) is Price, and the X-axis (left to right) are the units sold. So imagine you price your product somewhere on this demand curve; will you price low to attract the masses of consumers or price high to achieve an attractive profit margin on each unit sold?

Hopefully you're thinking to yourself, "Maybe somewhere in the middle where I can get a decent margin from a fair sized customer base."

A gold sticker if you were thinking this, no points for second place.

The optimal sacrifice of high prices and high customers occurs when the projected revenue curve is at its apex (highest). In the case above, it is at $20, with 6000 units being sold. Any price above or below this will offer less revenue. Ok great, but is revenue our objective? Sure boasting a revenue report doubling your closest competitor may put a feather in your cap, until your accountants tell you that you've sold everything under cost and you've got the financial head hunters sharpening their blades for a clean scalping.

This is hardly the case but it can happen. Revenue is a myopic approach to pricing goals. The goal should be to maximise profits not revenue.

Profit = Revenue - Cost of Goods Sold

A+ if you were already on this train of thought when I was discussing revenue, again, no points for second place.

Total cost can be expressed as the summation of an overhead or fixed costs (costs that are independent of how much or little you produce, such as rent, interest on debt, salaries of full-time employees) and variable costs (costs that are dependent of production like raw materials and labour) which forms an upward sloping cost curve. But to ascertain the most efficient level of production, average cost must be quantified.

Total Cost = Fixed Costs + Variable Costs

Average Cost = Total Cost ÷ Units Produced

So let's assume you're production plant for widgets is fitted out to reflect the following average cost curve:

The average cost curve takes this shape because it is most efficient at producing your widget in a certain zone inbetween declining economies of scale and increasing diseconomies of scale. So in this instance, this plant should aim to produce at most [5600 to] 7400 units.

Ok so I've been going on about COST, but what we really want to know is how to maximise PROFIT. So just subtracting the Total Cost Curve from the Total Revenue curve will represent a Total Profit curve. From this stage, you should only produce at the point where profit is the highest, which is 5000 units.

This level of production is actually below the production plant's optimal range and also lower than the maximum potential revenue. So as a medium-long term goal for capitalising on profit, you may look at (i) adjusting the plant's production capabilities to become optimal at a lower range, or (ii) chemically brainwash consumers to encourage them that they need more widgets. I'd go for the second option.

Now here's the trouble when you do this in the real world: You don't know what the demand curves are like, and only have some idea or control of your production capabilities and efficiencies. What you have to do is try to achieve the best results from whatever hunches or incomplete information you have available.