Demand and Pricing

a) Upper management is unsatisfied with the past year’s profit growth. The SVP of Finance has suggested that you should cut prices by 5% to grow market share and, hence, profits. Given your expertise in pricing, do you agree with this suggestion? Explain.

The suggestion from the SVP finance is not backed up any available data. Reducing the price by 5% may increase the market share, but not necessarily the profits. In fact, reducing the price can erode the profits. The chemicals company has differentiated itself by providing superior customer service, 24 x 7 access to the systems, etc, and hence is able to charge a price with higher contribution margin than the industry standards. Decreasing the price, will impact the contribution margins and hence will directly impact the profitability of the organization. As suggested by the SVP of finance, decreasing the price will gain market share only if the demand is within the elastic region, which we don't know at this stage.

b) Subsequent to your discussions with the SVP of Finance, you commissioned an internal study of your historic sales and price data. Regression analysis generated an estimate of the own-price elasticity of demand of -0.65 (with a standard error of 0.01). The study concludes with an enthusiastic recommendation to increase the contribution margin to 45%. How do you react to this recommendation? What questions might you ask the team in charge of the study?

Since the estimated demand is in the inelastic region, it is less sensitive to the price changes.

The recommendation from the internal study to increase the contribution margin to 45% from the current 8% needs to be approached with caution. The result seems to be incorrect. Based on the calculated elasticity,

P(new) = (0.65)/(1+0.65) x 92% P(old)

P(new) = 36.24% P(old)

This is point elasticity only, and elasticity changes as we progress on the demand curve. Hence, it is recommended that we do step increase of the price, rather...