An introduction to the two most common types of demand curves (linear and power), which can be used to estimate the price for a product or service that maximizes profit margins. Includes hands-on real-world examples using Excel.

Published on: **Mar 4, 2016**

Published in:
Data & Analytics

- 1. PRICING ANALYTICS Creating Linear & Power Demand Curves
- 2. Demand Curve 0 200 400 600 800 1000 1200 1400 $0 $5 $10 $15 $20 $25 Demand Curve describing how many units of product the market demands for every possible price point
- 3. Demand Curves •Used to estimate price that should be charged for maximum profits •The best price for a product maximizes margins – not unit sales 12 units * $5 = $60 50 units * $1 = $50
- 4. Estimating Best Price •Need two things to estimate best price: •Variable cost to produce one unit of product •Product’s demand curve
- 5. Estimating Best Price •COG: variable cost to produce one unit of product •p: price we charge customers for 1 unit of product •D(p): customer demand, in units of product, at price p •Profit margin formula: Margin = (p – COG) * D(p) Profit margin per unit Demand for product
- 6. Demand Curves •Demand curves are subject to frequent change •Affected by: •Competitive pressures •Customer sentiment •Macroeconomic factors
- 7. Price Elasticity •The amount demand decreases if prices increased by 1% •Product is price elastic if its elasticity > 1 •Decreasing price of product will increase revenue •Product is price inelastic if its elasticity < 1 •Decreasing price of product will decrease revenue
- 8. Price Elasticity •Examples of price elasticity values in Boston MSA: •Good pricing decisions require understanding of products’ price elasticity Product/Service Elasticity Salt 0.09 Coffee 0.20 Beer 0.95 LCD monitors 1.73 Restaurant meals 2.90 Travel to Ireland 5.27
- 9. Demand Curves •Two most popular types of demand curves: •Linear demand curves •Power demand curves
- 10. Linear Demand Curves •Straight-line relationship between price and demand D = a – bp •D: units of product demanded by customers •p: per-unit price •a and b: adjust curve to fit product’s price elasticity •Excel can auto-calculate a and b for us
- 11. Power Demand Curves •Arc that shows relationship between price and demand, when product’s price elasticity isn’t affected by product’s price D = apb •D: units of product demanded by customers •p: per-unit price •a and b: adjust curve to fit product’s price elasticity •b is additive inverse of price elasticity (ex: b = -2 if elasticity = 2) •Excel can auto-calculate a for us
- 12. Which Curve to Use? •Price elasticity properties tell us which curve is appropriate •Linear demand curve: if product’s price elasticity changes as price changes •Power demand curve: if product’s price elasticity remains constant as price changes
- 13. Constructing Linear Demand Curves •Scenario: •We’re selling polo shirts for Ralph Lauren •Current price per unit p = $90 •Current demand D = 1,000 shirts •Price elasticity of product: 2.0 •We need two points to construct our line: •We already know ($90, 1000) is on the curve •Increase price by 1% ($0.90), demand will decrease by 2% (20 shirts) •Calculated point on curve: ($90.90, 980)
- 14. Enter our data points
- 15. Select data points by dragging the mouse over them
- 16. Insert “Scatter with only Markers” chart
- 17. Incorrect upwards- sloping demand curve
- 18. Switch Row/Column to fix slope of line
- 19. Correct slope for demand curve
- 20. Right-click a data point, and choose “Add Trendline…”
- 21. Choose “Linear” type Check “Display Equation on chart” Click “Close”
- 22. Demand curve Equation of demand curve
- 23. Value of a Value of b
- 24. Constructing Linear Demand Curves •Linear demand curve equation for this example: D = 3000 – 22.2p •Implication: Every $0.90 increase in shirt price is going to cost demand for ~22 shirts •Error rate for linear demand curves increases with distance from current price point •Pretty good approximation +/- 5% of current price
- 25. Constructing Power Demand Curves •Use power demand curves when product’s price elasticity doesn’t change when price changes •Same scenario: •We’re selling polo shirts for Ralph Lauren •Current price per unit p = $90 •Current demand D = 1,000 shirts •Price elasticity of product: 2.0 •Price elasticity doesn’t change when price changes •Excel’s Goal Seek function calculates value of a for us
- 26. Starting guess for value of a
- 27. Current per-unit price
- 28. Enter Excel formula for demand: =B1*B2^-2 Power Demand Curve Formula: D = apb
- 29. Accept formula
- 30. Demand at this price should be 1,000 units – our guess for a was way off
- 31. Goal Seek will change this value… …until our formula yields the correct value here
- 32. Start Goal Seek
- 33. We want to set the cell containing our customer demand…
- 34. …to our known value of 1000…
- 35. …by changing the value of a Click “OK” to run Goal Seek
- 36. Goal Seek sets correct value for a Click “OK” to exit Goal Seek
- 37. Enter prices in increments of $10 between $50 and $140
- 38. Enter Excel power demand curve formula using correct value for a: =$B$1*C6^-2
- 39. Right-click cell containing formula, and choose “Copy”
- 40. Select other “Demand” cells, right-click, and choose “Paste as Formula”
- 41. Verify formula is correct by checking demand/price value we know
- 42. Select data cells from table Insert “Scatter with only Markers” chart
- 43. Chart of points in demand curve
- 44. Right-click any data point, then choose “Add Trendline…”
- 45. Select “Power” radio button Click “Close”
- 46. Power demand curve
- 47. Constructing Power Demand Curves •Value of a determined to be 8,100,000 D = 8,100,000p-2 •Price elasticity remains constant for every price on the demand curve