Pricing and Revenue Lesson
The Demand Curve
As we’ve seen, good strategic analysis starts with thinking through how your decisions affect average price, average cost, or quantity.

Profits = Revenue - Costs
Profits = (Average Price – Average Cost) ·  Quantity

This can get complicated due to the relationship between average price and quantity. In general, if you want to sell a larger quantity, your average selling price will fall. If you want to raise the average price, your quantity will often decrease. Getting this balance right is essential for maximizing profits.

In this module, we will examine this tradeoff. We will discuss demand, pricing, and differentiation, and will answer the following three questions:

• What is a demand curve?
• What tradeoff does a firm face when making pricing decisions?
• How does product differentiation affect the pricing tradeoff?

• We’ll use the answers to provide insight on how firms can make profitable choices regarding both pricing and product characteristics.

Figuring Out the Demand Curve
How can a firm figure out where its demand curve is? The short answer is you never know for certain.

The longer answer is that the best way to gather information about demand is to charge a price and see what happens. When you set a price and observe a quantity, you have just seen one point on the demand curve for that time and location.

And this means that one of your best sources for information about demand is your past data. Now, in analyzing this data, you need to keep in mind that demand curves move over time; as willingness to pay for our product (or rival products) changes, or as prices of rival products change, demand curves can shift either left or right. As a result, today’s demand curve is not likely to be exactly the same as yesterday’s.

What about for new products, where you don’t have any past history to examine?

With new products, it is harder to determine demand, but one important factor to keep in mind is that demand comes from willingness to pay. If you can somehow estimate consumers’ willingness to pay, then you can construct demand in much the same way we have done.

This is easiest in the b-to-b (business to business) context, where your customers are for-profit firms. A customer’s willingness to pay for your product will be closely linked to the amount of additional profit you generate for your customer.

In the b-to-c (business to consumer) context, it can be difficult to get a handle on willingness-to-pay. There are no rules about what willingness to pay should be, and it’s easy to get tricked.

There’s no formula that would describe a customer’s desire to reduce their environmental impact. And this makes it difficult to sort out what the willingness to pay for a new product like Orbital’s shower system.

In this case, the best option may be small-sample market research. One low-cost approach would be to survey potential customers about their willingness-to-pay for an energy-and-water saving shower system.

Small sample sizes might mean your data will not be representative of the entire mass of consumers. In addition, survey respondents really have little incentive to tell you what they really think. If a customer says “Sure, I’d buy an Orbital shower if the price were \$5000,” that’s less reliable information than actually observing a customer parting with the cash. A survey respondent might be telling you what s/he thinks you want to hear, but an actual customer is putting his/her money where his/her mouth is.

A medium-cost approach would be a small-scale product launch. Imagine opening a showroom an arid, well-to-do area where many residents are concerned about their environmental impact. (Palo Alto, California seems perfect for this!) Such a rollout would allow the firm to set prices and then assess demand using actual data. Here, the concern would be finding a test-market that’s truly representative of broader market conditions.

In general, you have accept the fact that you never know demand with certainty. We think it’s better to analyze the information you have rather than proceeding with guesswork, hunches, or unchecked intuition.

Although Orbital cannot accurately predict the demand, it tries to educate customers in a way that will increase their willingness to pay. On their website, they have an interactive section called Measure Your Savings. Click on either “Commercial” or “Residential” and you will have the opportunity to tailor information such as location, watercost, shower length, and daily showers to your personal experience. The website dynamically displays water savings, energy savings, and estimated cost savings per year as you adjust various factors. Emphasizing the environmental and monetary savings highlights the benefits of the product to the customer.

Test market your product. Click or drag to set a price and see the quantity sold.

As you look at the demand curve, you see that price and quantity have an inverse relationship. There is a tradeoff that occurs - when one increases, the other decreases. In this tradeoff, a company wants to be at the point in the demand curve where revenue is maximized. To explore the connection between demand and revenue in more detail, we will look at the company Scott Turbon Mixer. Scott Turbon Mixer is a small manufacturer in California that makes stainless steel industrial mixing equipment.

Price or Quantity?
There are two ways for a business to grow revenue: (1) Charge a higher price, and (2) produce and sell more output (which makes the firm’s quantity go up). The problem is that it’s often difficult to increase one without reducing the other.

Demand curves, as we have seen, slope downward. And this means any attempt to increase price requires careful thought about how to do so without a dramatic reduction in quantity. Further, any attempt to increase quantity requires careful thought about how to do so without a dramatic reduction in price.

Pricing and Elasticity

As we have seen, demand elasticity is the crucial factor determining how a price increase will affect your business’s revenue.

If consumers are price sensitive (so that demand is elastic), then raising your price will lead to a large reduction in volume. In cases like this, it pays for firms to keep prices low. The benefit (higher margin) of a price increase is outweighed by the cost (smaller volume).

If consumers are not price sensitive (so that demand is inelastic), then raising your price will lead to a small reduction in quantity. In such cases, it can pay to increase price, since the benefit (margin) is smaller than the cost (volume).

Click or drag on the graph below to set a price and see how revenue changes. You can also choose between different types of demand curves and see how the revenue rectangle will change if you add features to the product.

Poll
Our customers would give up breathing before they would give up our product.
We would lose every single customer we have and be bankrupt before lunch.
After you select your company’s strategy, the aggregate results from all submissions will be displayed..

Pricing and Product Differentiation

One way to increase revenue is to raise price. But, as we’ve shown, raising price only makes sense if your demand is inelastic. Which raises the question: How do I make my demand inelastic?

Through choice of product characteristics, a firm can influence how elastic its demand will be, and hence how strong the urge to cut prices will be.

To develop a concrete example, let’s go back to the story of Rosa Brothers Dairy. And let’s begin by thinking about the market for regular milk. Grocery stores everywhere sell milk, and in the US most stores sell multiple brands of gallon-sized plastic jugs of milk.

The packaging is the same, and, well, milk is milk. So consumer willingness-to-pay is unlikely to vary much from one brand to the other. If a consumer has willingness-to-pay of \$4 for a gallon of plastic jug milk with a yellow label, then he’d probably have \$4 willingness-to-pay for a blue-label gallon.

This means that price is likely to be the predominant factor in the purchase decision. Because each consumer likes yellow-label milk as much as blue, they’ll simply select the cheap one.

As a result, if the yellow-label milk price is a bit lower than the blue-label price, then yellow will get a very large market share. But if blue undercuts yellow a little on price, then blue can capture a very large share. This situation --- where small price changes lead to large swings in quantities and market shares --- is a perfect example of elastic demand.

In cases where consumers perceive little difference between competing products, demand is elastic and it pays to cut price… which can make it very difficult to earn profits.

So how can companies avoid this outcome? The key is to identify product characteristics for which willingness-to-pay varies significantly across consumers.

Rosa Brothers entered the milk market with glass bottles, not with a different-color-label plastic jug.

To many consumers, the glass bottle conveys freshness and quality in a way that plastic cannot replicate. For these consumers, willingness to pay for the glass-bottled milk will be considerably higher than that for plastic bottled milk. For such consumers, price will not be the only important factor in the purchase decision, and these customers will stick with Rosa Brothers even in the face of a price increase. Because of this, Rosa Brothers’ demand will be inelastic, which give the company some room to raise prices and boost margin without losing so much quantity.

Other consumers might not much care about glass or plastic, or they might even dislike the hassle of having to return heavy glass bottles to the store. Should Rosa Brothers worry about not serving these customers? Well, perhaps not. Because there are many such brands available, demand in this segment of the market is likely to be elastic. This means margins (and hence profits) are likely to be low. Rosa Brothers is probably best off serving its customers --- those who strongly prefer glass-bottled milk --- well, and leaving the rest of the market to the plastic-jug players.

This discussion suggests that one key to raising prices is to differentiate your product. If consumers perceive your product to be similar to that of rivals, then price will be an important factor in the purchase decision, and demand will be elastic. If consumers think your product is different, then price is less important, and demand can turn inelastic.

An important insight is to pursue features that some consumers like intensely, even if not all consumers do. This can differentiate your product, make demand inelastic, and allow for higher margins. Generating strong loyalty from a subset of the market can often be a more profitable strategy than attempting to please everyone.

Quantity Growth: Shifting Your Demand Curve

A second way to increase revenue is to increase quantity. Here again, however, the interrelation between price and quantity complicates matters. Once you raise your output targets, you can expect your sales staff to come asking for permission to cut price. This pressure comes from the downward movement along your demand curve as you try to increase quantity, and your margins --- and hence profits --- can suffer.

So how can you grow quantity without cutting price?

So, before you ask your sales staff to deliver higher unit volumes, give them the tools to do so without a price cut. To increase willingness to pay and shift demand to the right, you’ll need to improve the product in the mind of your customer. You can do this by adding features, improving quality or ease-of-use, enhancing services, or even by increasing customer awareness of product availability or features. (Yes, marketing counts; a potential customer who doesn’t know you exist has a willingness-to-pay of zero!)

There are three important factors to keep in mind when attempting to grow revenue in this way. First, make sure to prioritize product improvements that have the largest impact on willingness-to-pay. Orbital Systems could perhaps improve “quality” of its product in dozens of ways, but a quality improvement will increase quantity sold to only the extent that consumers notice and value the improvement.

Second, think about involving your sales staff early in this process. Product designers, engineers, and operations specialists might have the technical skills needed to execute on product improvements, but frequently your salespeople will hold the best knowledge about what customers really value. Bill Scott’s primary role at Scott Turbon Mixer is talking to customers and understanding their problems. This allows the company to focus its development resources on insights gathered directly from customers.

Third, make sure to compare cost and benefit, and pursue product innovations with the biggest bang for the buck. A product improvement that shifts your demand curve and nets you a hundred additional customers might be a great idea if the cost is modest, but not if you’ll need to spend millions.

Summary
In this section, we have focused on strategies intended to grow a business’s revenue. Revenue increases can be achieved either by increasing price or by increasing quantity, but the problem of growing revenue is made more difficult by the fact that demand curves slope downward. To manage the interrelationship between price and quantity, it’s essential for managers to understand their demand elasticity, and to recognize that price increases boost revenue only if demand is inelastic. Product differentiation is a leading strategy that can make your demand inelastic, and allow you to grow margins. To grow quantities profitably, it’s useful to identify strategies that shift your demand curve to the right. This can be done with product changes that increase willingness-to-pay.

Stanford's Digital Learning Solutions team prepared this multimedia lesson under the supervision of Professors Mike Mazzeo, Scott Schaefer, and Paul Oyer as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation.