Basic Marketing: A Global Managerial Approach

Perreault−McCarthy: Basic
Marketing: A
Global−Managerial
Approach, 14/e

18. Price Setting in the
    Business World

Text © The McGraw−Hill

Companies, 2002

Price Setting in the Business World 529

variable costs increase continually as more and more units are produced. So it’s the

increases in variable cost that explain the increase in total cost. (Technical note: Divid-

ing total variable cost by output equals average variable cost. We do not show average

variable cost in this table because it is not central to the discussion that follows. How-

ever, we should note that in this example average variable cost decreases for a while

and then increases again. This pattern is found in many firms after economies of scale

run out—say, because a firm must pay overtime to be able to sell a higher quantity.)

There is another kind of cost that is vital to marginal analysis. Marginal costis

the change in total cost that results from producing one more unit. In Exhibit 18-9,

you can see that it costs $355 to produce five units of a product but only $344 to

produce four units. Thus the marginal cost for the fifth unit is $11. In other words,

marginal cost is the additional cost of producing one more specific unit.By contrast,

average cost is the average for all units.

The marginal cost column in Exhibit 18-9 shows what each extra unit costs. This

suggests the minimum extra revenue we would like to get for that additional unit. Usu-

ally, however, we’re not interested in just covering costs, we’re shooting for a profit.

In fact, to maximize profit, a manager generally wants to lower the price and

sell more units as long as the marginal revenue from selling them is at least equal

to the marginal cost of the extra units. From this we get the following rule for

maximizing profit:The highest profit is earned at the price where marginal cost is

just less than or equal to marginal revenue.*

You can see this rule operating in Exhibit 18-9. As the price is cut from $140

down to $79, the quantity sold increases to six units and the profit increases to its

maximum level, $106. At that point, marginal revenue and marginal cost are about

equal. However, beyond that point further price cuts result in lower profits, even

though a larger quantity is sold. Note, for example, that at a price of $53, which

would be required to sell eight units, the profit almost disappears. Below that price

there would be losses.

Total profit is at a maximum at the point where marginal revenue (MR) equals

marginal cost (MC). However, marginal profit—the extra profit on the last unit—

is near zero. But that is exactly why the most profitable price is the one where related

quantity sold results in marginal cost and marginal revenue that are equal. Marginal

analysis shows that when the firm is looking for the best price to charge, it should

lower the price—to increase the quantity it will sell—as long as the last unit it sells

will yield extra profit.

You can see the effect of all of these relationships clearly in Exhibit 18-10. It

graphs the total revenue, total cost, and total profit relationships for the numbers

we’ve been working with in Exhibit 18-9. The highest point on the total profit curve

is at a quantity of six units. This is also the quantity where we find the greatest ver-

tical distance between the total revenue curve and the total cost curve. Exhibit 18-9

shows that it is the $79 price that results in selling six units, so $79 is the price

that leads to the highest profit.

A price lower than $79 would result in a higher sales volume. But you can see that

the total profit curve declines beyond a quantity of 6 units. So a profit-maximizing

marketing manager would not be interested in setting a lower price.

In Exhibit 18-10, note that there are two different points where total revenue

equals total cost. These two break-even points show there is a range of profitaround

the price that produces maximum profit. The highest profit is for a price of $79, but

this firm’s strategy would be profitable all the way from a price of $53 to $117.

Profit is largest when

marginal revenue 


marginal cost

Profit maximization

with total revenue and

total cost curves

*This rule applies in the typical situations where the curves are shaped similarly to those discussed here.

As a technical matter, however, we should add the following to the rule for maximizing profit: The marginal

cost must be increasing, or decreasing, at a lesser rate than marginal revenue.

A profit range is

reassuring