Setting the Price 219
Price elasticity depends on the magnitude and direction of the contemplated
price change. It may be negligible with a small price change and substantial with a
large price change; it may differ for a price cut versus a price increase. Finally, long-
run price elasticity may differ from short-run elasticity. Buyers may continue to buy
from their current supplier after a price increase because they do not notice the
increase, or the increase is small, or they are distracted by other concerns, or they find
that choosing a new supplier takes time. But they may eventually switch suppliers. The
distinction between short-run and long-run elasticity means that sellers will not know
the total effect of a price change until time passes.
Step 3: Estimating Costs
While demand sets a ceiling on the price the company can charge for its product, costs
set the floor. Every company should charge a price that covers its cost of producing,
distributing, and selling the product and provides a fair return for its effort and risk.
Types of Costs and Levels of Production
A company’s costs take two forms—fixed and variable. Fixed costs(also known as over-
head) are costs that do not vary with production or sales revenue, such as payments for
rent, heat, interest, salaries, and other bills that must be paid regardless of output.
In contrast, variable costsvary directly with the level of production. For example,
each calculator produced by Texas Instruments (TI) involves a cost of plastic, micro-
processing chips, packaging, and the like. These costs tend to be constant per unit
produced, but they are called variable because their total varies with the number of
units produced.
Total costsconsist of the sum of the fixed and variable costs for any given level of
production.Average costis the cost per unit at that level of production; it is equal to
total costs divided by production. Management wants to charge a price that will at least
cover the total production costs at a given level of production.
To price intelligently, management needs to know how its costs vary with differ-
ent levels of production. A firm’s cost per unit is high if only a few units are produced
every day, but as production increases, fixed costs are spread over a higher level of pro-
duction results in each unit, bringing the average cost down. At some point, however,
higher production will lead to higher average cost because the plant becomes ineffi-
cient (due to problems such as machines breaking down more often). By calculating
costs for different-sized plants, a company can identify the optimal plant size and pro-
duction level to achieve economies of scale and bring down the average cost.
Accumulated Production
Suppose TI runs a plant that produces 3,000 calculators per day. As TI gains experi-
ence producing calculators, its methods improve. Workers learn shortcuts, materials
flow more smoothly, and procurement costs fall. The result, as Figure 4-10 shows, is
that average cost falls with accumulated production experience. Thus, the average cost
of producing the first 100,000 hand calculators is $10 per calculator. When the com-
pany has produced the first 200,000 calculators, the average cost has fallen to $9. After
its accumulated production experience doubles again to 400,000, the average cost is
$8. This decline in the average cost with accumulated production experience is called
theexperience curveorlearning curve.
Now suppose TI competes against two other firms (A and B) in this industry. TI is
the lowest-cost producer at $8, having produced 400,000 units in the past. If all three
firms sell the calculator for $10, TI makes $2 profit per unit, A makes $1 per unit, and
B breaks even. The smart move for TI would be to lower its price to $9 to drive B out of