Learning how to draw and calculate a demand curve and a cost curve enables managers and entrepreneurs to set a price that results in the highest possible profit. A the optimal price point, a price increase would reduce the demand too strongly while a price reduction would affect the profit margin too strongly.
- In this video, I will show you how to set the price that maximizes your profit. Now, I'm fully aware that in the real world setting prices is not as easy as this example. Nevertheless, it is very important that you understand the basic foundation of profit maximization. In the simplest models, all we need to know is the demand curve for our service of product and the variable costs. Let's assume that you are the pricing manager for Iberia, the national land line of Spain. You fly from Zurich to Barcelona twice a day with an aircraft that has a capacity of 300 passengers.
Your research indicates that at the ticket price of 500 francs you can sell 150 tickets. Let's forget for a moment that airline use dynamic pricing and customer pay very different prices. For the sake of the argument, let's assume that the airline sets a price and the demand reacts accordingly. If Iberia is lowering the price to 300 francs the demand would increase to 210 tickets. If we assume a linear relationship, the Demand Curve looks like this.
We also know that the Variable Costs are 100 francs, therefore every price above the variable costs generates gross profit, and we can actually calculate the estimated gross profit. At the ticket price of 300 francs, the gross profit per ticket is 200 francs. We sell 210 tickets resulting in a total gross profit for this flight of 42,000 francs. But what if we increase the price? Would that not be more profitable? Let's calculate the gross profit at the ticket price of 800 francs.
At that price, we would make 700 francs per ticket. If we sell 60 tickets, the gross profit would be the same, 42,000 francs. If you compared the two charts you see that at the ticket price of 300 we sell a lot of tickets but the margin is small. On the opposite, if we charge 800 francs the margin is high but the volume is low. The easiest way to find the optimal price is to create the worksheet and calculate the profit for each price point.
If you know how to solve a quadratic function you may also use linear algebra to define the optimal price. For the purpose of this video, we'll stick to the spreadsheet. The spreadsheet reveals that the optimal price is 550 francs. The surprise, at least for me, is that at this price more than half of the 300 seats in the plane remain empty, and if we lowered the price to fill those seats the gross profit actually declines.
If you now go back to our chart we can see that at the price of 550 the colored area below the demand curve has reached its maximum size. You may have wondered why we only include variable costs and not fixed costs in this analysis. The logic is quite clear given that the fixed costs are, well fixed. The price point where the gross profit is maximized must also be the price point when net profit is maximized. To conclude, it is important for any entrepreneur and executive to estimate the demand curve and to know the variable costs in order to calculate the optimal price.
It is not necessary that you find the exact price. As long as you are close, in this case, between 450 francs and 650 francs, your profitability is high.
- What are customers buying? (demand theory)
- What should we produce? (production theory)
- Which costs do I need to worry about now? (cost theory)
- What market am I in? (competition theory)
- What should we charge for it? (pricing theory)
To understand what managerial economics looks like in practice, Stefan explains how Google's auction-based advertising system employs the principles of game theory and how understanding this can help decision makers to outmaneuver their competitors.
- Using economics to solve business problems
- Understanding price elasticity
- Demand curve shifts
- Economics of scale vs. scope
- Break-even and what-if analysis
- Profit maximization
- Economics in action