How to set prices
Many believe the best way to increase profits is to increase
prices. This misconception represents a mathematical
approach to business whereas business is not about
mathematics – it is about economics. In mathematics one
plus one always equals two but in economics one plus one
could equal one, two or three depending on the dynamics of
the situation. Maximizing profits requires an understanding
of price elasticity.

Price elasticity is the analytical artwork of those seeking to
maximize profits by finding the price at which a company
can make the largest profits. It is a business strategy with
roots in a supply and demand curve and is flavored with the
cost of delivery to the customer.

With few exceptions, as price increases demand
decreases. Therefore an increased retail could result in
higher delivery cost. This is particularly true in retail where
lower sales can inhibit volume discounts from suppliers.
Failure to order and truckload, pallet or layer quantities can
drive up costs even if discounts for such orders were not
negotiated when the volume level was attained.

Here is an example of price elasticity from In
exploring the most profitable price for electronic book they
discovered that at $9.99 the typical book sells 1.74 copies
of the same book priced at $14.99. They extrapolated out to
100,000 copies of a particular book. At the higher price
revenue would be $1,499,000. By reducing the price to just
$9.99 they are offering the book below the $10 threshold,
which is often a psychological barrier. The result is that at
the lower price revenue would be $1,738,000.

In the case of Amazon the cost to deliver an e-book does not
change based on volume so the math is simple once the
economics are applied. This is rare among products and
services to help is needed from marketing and logistics. The
marketing role is to ensure customers are aware of the 33%
decrease in price so that the 74% increase in volume is
achieved. Logistics needs to evaluate the shelf landed cost
of the products as merchants work to gain price
concessions for the increased logistical efficiencies.

The Strategy and Tactics of Pricing authors Thomas
Nagel, John Hogan, and Joseph Zale destroy the concept of
using standard markups to set prices. The authors have
included a chapter on value creation which look at subjective
psychological drivers as opposed to tangible monetary
drivers would marketing products for increased price
elasticity. They conclude that properly marketing a product
will increase the value proposition thereby influencing price

Like Amazon, companies that invest their energy exploring
price elasticity in light of cost and marketing are finding the
investment and time make a heavy contribution to the
bottom line while, contrary to the standard logic, lower prices
will increase top line sales.

Related resources:
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