KEY ECONOMIC FACTOR TO DETERMINE PRICE OF GOOD OR SERVICE AND CIRCUMSTANCES THAT WILL ENABLE THE COMPANY TO PASS ON COST INCREASE TO CUSTOMER AND PROTECT PROFIT MARGIN (1750 words)
Price determination depends equally on demand and supply; it is truly a balance of two market component. This essay will first explain key economic price determinant factors such as demand and supply drives and relationship between demand and supply. Secondly, essay will demonstrate the disequilibrium created by recent surge in cotton price and also explains how price discrimination, product differentiation and advertising can enable a company to maintain the profit margin by passing on cost increase to the customer.
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The law of demand states that larger quantity will be purchased when price decreases, similarly smaller quantity will be purchased when price increases (ceteris paribus). Perfect example will be discount offer provided for luxurious items; in Bahrain during al hawaj mega clearance sale demand for the perfume will be high due to low price.
Price= Marginal cost
Price > marginal cost(Price Makers)
Elasticity of Demand
Demand is perfectly Elastic, as shown in Figure 1.1
Negative relationship between the Demand and the price of the product. Depending on the total revenue curve and demand curve shown in Figure 1.2 elasticity and inelasticity range can be determined.
Elasticity of demand across different market structure:
Table 1.1: Comparison Perfect and Imperfect market
Source: Roger LeRoy Miller & Raymond P.H. Fishe (Microeconomics price theory in practice) (Check how to site adaptation)
A larger quantity will be offered for sale when price increases (other things equal); similarly, a smaller quantity will be offered for sale when price decreases (other things equal). It states that there is a positive relationship between quantity supplied and price. There are various factors such as price of resources; price of related outputs, technology and expectations shifts the supply curve.
DEMAND AND SUPPLY RELATIONSHIP: MARKET EQUILLIBRIUM
It occurs at the price where consumer willingness to demand exactly matches with that of firm willingness to supply. Thus intersection of both demand and supply curve generates the equilibrium price and equilibrium quantity. Setting market equilibrium price is considered to be one of the key factors.
Source: Began ward
FACTORS TO DETERMINE PRICE OF THE PRODUCT:
Quality speaks for itself in the product. Thus quality coupled with reasonable price, offers positive economic growth for the firm producing a high-quality product. Infact a firm producing high quality products expands new customer base due to customer referrals and amplification of positive word of mouth. This will in turn multiply overtime as the business grows and also will lead to increase in demand for the product or service. For example, in sensitive fields such as medical, the Heart Specialist / Neurosurgeon in the beginning of their medical practice usually do not overcharge their patients, but over a period of time as they gain experience and expand their clientele, they increase their service cost substantially. We can also pick up another instance from a different field such as share market. If you take the example of Google, a company which came into existence only in 1998, was listed in NYSE in 2004 and the IPO kicked off with just $84. Due to its innovation & various marketing tactics, the company has grown into a huge internet empire & a blue-chip company. This is purely because of share traders who see the potential in company due to its raising quarterly profit, apart from regular announcements on innovations and hence are now pricing its share at a whopping $566 as on 15Nov2010s.
CHANGE IN TASTE AND PREFERENCES OF CONSUMER:
Taste of the consumer affects the demand for the particular product. Obviously, if you are in diet you will buy less butter than someone who does like butter. If you once liked butter later on changed your preferences then, it causes demand for butter to shift and finally affect the price of the product. Thus decline in the preference for the good or service will shift the demand curve inward as shown in below figure. The effect on price can be either short run or long run depending upon the goods, for luxury good there will be short term shift in demand due to change in life style while necessity good tend to have stable or long run demand curve.
Source: Began ward
Consumer income is one of the main factors affecting the demand and the price of the product. The disposable income increases when income increases and it changes the consumption pattern. Demand of normal products is more during boom when consumer income increases, whereas during recession the income falls, resulting customers opting for inferior or less superior products. This change in consumption pattern which rises due to the consumer income affects the demand of the product and its price. But then there are exceptions, where certain products which fall under the autonomous consumption demand are always high.
PRICE OF COMPETITOR:
For instance in Bradford, NOMI SIM card was widely used by expatriate students to make cheap calls (3p per min) to India and it also allowed call charge of 1p per min between 6AM and 6PM. But later on Lyca SIM provided competitive price of 1p for international calls and this attracted students to choose the substitute product. In large market structure knowing the price of competitor is important while determining the price of the product. Thus the availability and the price of complements affect the demand and finally drive the prices.
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PRODUCT LIFE CYCLE:
The demand of the Product varies over the different stages of the Product Life cycle. As the demand varies the prices also changes accordingly. At each stage of the product life cycle the number of competitors is different, so this leads to substitutability and differing elasticity’s of demand. During the Launch, Growth the demand of the product constantly increases and in the latter stage of maturity and during decline stage the demand falls and hence the prices will also follow the demand.
Source: Call & Hollahgan, 2008
Innovation markets emergence is a larger phenomenon than innovation creation. In addition to a new product, breakthrough innovation creates new markets as well (Crawford 1992). Technology can affect the supply; infact supply curves are drawn assuming a given technology. Over time, technology available may change, so if good manufacturing technique is followed then supply curve will always shift towards higher production. For example the supply for Walkman’s were high during the mid-nineties and even in the early 2000 but at the advent of MP3 Players and i-Pods the demand for them dropped as well the prices of those products and supply eventually wiped them out of the market.
Taxes have significant effect on shifting supply and demand curves, which changes the market equilibrium price and quantity. Usually when the government places taxes on a product, companies find themselves unable to produce the product as quickly for the same cost. Because of this, the supply goes down in correlation with the size and impact of the tax. For example in below graph supply shift to upward, thus increasing the price of apple and reducing the product quantity.
Supply shift: Graph predicts how the market equilibrium price and market quantity of the apple varies due to change in tax.
DEPENDING ON THE SUPPLIER PRICE:
In Middle East price of petrol is cheap compare to that of India it is because of the easy availability raw material crude oil in Middle East. (Any idea what is the current petrol price in Bahrain? It will add more value to my answer).
Current petrol price in Bahrain is 100Fills and in India you can check it from website. Pls note we have four metros in India and each of them have their own petrol price. Only Union territories such as Pondicherry the fuel prices are less due to less tax on Fuel.
Demand Curve: Fig. a price change causes movement along the demand curve. Fig.b tells what happens to demand when the variables such as income, the price of complement or expectations changes. Thus the shift in demand curve indicates willingness to pay either a higher or lower price for a given quantity of the good.
Impact of cotton price rise:
RON LAWSON – MD, Logic advisor from California during his interview in NDTV (Aug 24, 2010) commented that consumption outpaced production of the cotton. Due to the imbalance between the cotton production and consumption, cotton stock was reduced to the lowest levels which lead to increase in price of cotton. As world cotton acreage has declined, production has fallen to 15.3% in 2009/2010 crop year compare to 2004/05.
Market Disequilibrium: Supply Shortage
Due to decline in cotton production, predicted cotton supply is far below than actual demand, below trend shows decrease in cotton stocks as a % of consumption during the year 2010/2011.
Low cotton prices caused production to fall for the past three years, but the higher prices are expected to drive a substantial increase in cotton production in 2010/11. Once production is realigned with demand, cotton prices should move back towards their long-term averages.
Below trend shows fluctuations in demand for cotton material during the current period, major factor that cause for fluctuation is due to global and local demand & supply, irrigation and farming facilities due to government policies & subsidies.
Presented by Prabhjot Kaur (Vardhman Group is a leading textile conglomerate in India having a turnover of $700mn) On September 2010.
However for cotton, the most important price driver is a supply shortage in China, which exceeded the actual expectations figures. (www.usda.gov/oce/commodity/wasde — Explanation of Changes to USDA’s Cotton Supply and Demand Estimates for China, November 2010). Thus demand for cotton among retailer outpaced cotton production which resulted in demand and supply shortage. This shortage can be overcome by increasing the price of cotton which in turn accelerates the cotton production and increases supply to match with market demand and creates market equilibrium.
Click to Enlarge
Source: Micro economic (Price Theory in Practice)
Soaring cotton price builds up pressure on fashion retailer market and as a result of which, NEXT warns the increase in price of garment between 5% and 8% and it was predicted to hit the total sales by 1-2 per cent. As illustrated below, this situation creates inelastic demand and results in increase in total revenue.
During price rise most of the consumer will cut down their expenditure by reducing the number of quanity they afford to buy without compromising on the quality of product. So retailer when increasing their price they must focus on products differentiation which increases the demand for their product in the consumer market and also to grade consumer depending on their taste and preference through price discrimination strategy.
If NEXT increases its price by 8%, then there must be certain group of customer who would still prefer to buy NEXT products so, in this situation retailer can generate revenue by increasing the sales of such branded product by discriminating the price across low income and high income generating customers. This can be done by varing the fixed and variable cost of the goods sold. Price discrimination allows the firm to extract consumer surplus and also helps them to maintain the profit margin. Below graph illustrates the situation where demand for product in market A(low income consumer) is elastic whereas in market B demand for the product remain inelastic(high income consumer). Profit Maximisation occurs when MC=MR.
During price rise, retailer should differentiate their products from that of other competitors in order increase demand for the product and maximize profit. In figure 1.1 it says company will generate the profit by selling 200 shirts at $25 for differentiating their product by changing the design of shirt, but in monopolistic competition other firms try to compete by bringing new design to the market, in such situation demand curve will shift left and touches the Average Total Cost as shown in figure 1.2 thus firm in this case will not generate any profit. Though product differentiation is a key to revenue generation, advertising is another factor which most of the fashion retailer use to acquire some degree of market control and increase demand and reduce the elasticity of the demand. But during recession it is always important to consider whether the advertising is worth the expense? Any revenue generated due to advertising must be measured against the expense of advertising.