(53).---PRICING.

Introduction.

Historically price was the single most important decision made by the sales department but in modern marketing philosophy price, whilst important, is not necessarily the predominant factor. Modern businesses seek to interpret and satisfy consumer wants and needs by modifying existing products or introducing new products to the range. This contrasts with earlier production-oriented times when the typical reaction was to cut prices in order to sell more of an organization’s product.
Notwithstanding this change in emphasis, pricing is very important. Proper pricing of an organization’s products or services is essential to its profitability and hence its survival and price has an important role to play as a competitive tool which can be used to differentiate a product and an organization and thus exploit market opportunities.

Demand.
The economic analysis of demand.

There are to extremes in the relationship between price and demand. A supplier can either sell a certain quantity, Q at any price (as in graph (a) ). Demand is totally unresponsive to changes in price and is said to be completely inelastic. Alternatively, demand might be limitless at a certain price P and there would be little point in dropping the price below P. in such circumstances demand is said to be completely elastic.

Price elasticity demand (n).

Price elasticity of demand is a measure of the extent of change in market demand for a good in response to a change in its price.

The change in quantity demanded, as a % of demand/the change in price, as a % of the price

since the demand goes up when the price falls, and goes down when the price rises, the elasticity has a negative value, but it is usual to ignore the minus sign.

Elastic and inelastic demand.

The value of demand elasticity may be anything from zero to infinity.
Demand is referred to as inelastic if the absolute value is less than I had elastic if the absolute value is greater than 1.

• Where demand is inelastic, the quantity demanded falls by a smaller percentage than the percentage increase in price.
• Where demand is elastic, demand falls by a larger percentage than the percentage rise in price.

Price elasticity and the slope of the demand curve
Generally, demand curves slope downwards. Consumers are willing to buy more at lower prices than at higher prices. In general, elasticity will very in value along the length of a demand curve.

• If a downward sloping demand curve becomes steeper over a particular range of quantity, than demand is becoming more inelastic.
• A shallower demand curve over a particular range indicates more elastic demand.

The ranges of price elasticity at different points on a downward sloping straight line demand curve are illustrated in the diagram below.

• At higher prices on a straight line demand curve (the top of the demand curve ), small percentage price reductions can bring large percentage increases in quantity demanded. This means that demand is elastic over these ranges, and price reductions bring increases in total expenditure by consumers on the commodity in question.
• At lower prices on a straight line demand curve (the bottom of the demand curve), large percentage price reductions can bring small percentage increases in quantity . this means that demand is inelastic over these price ranges, and price increases result in increase in total expenditure.

Special values of price elasticity.

There are two special values of price elasticity of demand,

• Demand is perfectly inelastic. There is no change in quantity demanded. Regardless of the change in price. The demand curve is a vertical straight line.
• Perfectly elastic demand. Consumers will want to buy an infinite amount, but only up to a particular level. Any price increase above this level reduces demand to zero. The demand curve is a horizontal straight line.

Elasticity and the pricing decision.

In practice, organizations will have only a rough idea of the shape of their demand curve there will only be a limited amount of data about quantities sold at certain prices over a period of time and, of course, factors other than price might affect demand. Because any conclusions drawn from such data can only give an indication of likely future behavior, management skill and expertise are also needed. Despite this limitation, an awareness of the concept of elasticity can assist management with pricing decisions.

• In circumstances of inelastic demand, prices should be increased because revenues will increase and total costs will reduce (because quantities sold will reduce.)
• In circumstances of elastic demand, increases in prices will bring decreases is revenue and decreases in price will bring increases in revenue. Management therefore have to decide whether the increase /decrease in costs will be less than /greater than the increases /decreases in revenue.
• In situations of very elastic demand, overpricing can lead to a massive drop in quantity sold and hence a massive drop in profits whereas under pricing can lead to costly stock outs and, again, significant drop in profits. Elasticity must therefore be reduced by creating a customer preference which is unrelated to price (through advertising and promotional activities).

Determining factors.

Factors that determine the degree of elasticity are as follows.

• The price of the good .
• The price of other goods. For some goods the market demand is interconnected. Goods are of two types.
  · Substitutes, so that an increase in demand for one version of a good is likely a cause a decrease in demand for others. Common examples are rival brands of the same commodity (like coca –cola and Pepsi-cola)
  · Complements, so that an increase in demand for one is likely to cause an increase in demand for the other. Examples are cups and saucers, cars and components.
• Income. A rise in income gives households more to spend and they will want to buy more goods. However this phenomenon does not affect all goods in the same way,
  · Normal goods are those for which a rise in income increases the demand.
  · Inferior goods are those for which demand falls as income rises, such as cheap wine.
  · For some goods demand rises up to a certain point and then remains unchanged,because there is a limit to which consumers can or want to consume. Examples are basic foodstuffs such as salt and bread.
• Tastes and fashions. A change in fashion will alter the demand for a good, or a particular variety of a good changes in taste may stem from psychological, social or economic causes. There is an argument that tastes and fashions are created by the producers of products and services. There is undeniably some truth in this, but the modern focus on responding to customer’s need and wants suggests otherwise.
• Expectations. Where consumers believe that prices will rise or that shortages will occur they will attempt to stock up on the product, thereby creating excess demand in the short term.
• Obsolescence. Many products and services have to be replaced periodically.
  · Physical goods are literally ‘consumed’ carpets become threadbare, glasses get broken, foodstuffs get eaten, children grow out of clothes.
  · Technological developments render some goods obsolete. Manual office equipment has been largely replaced by electronic equipment, because it does a better job, more quickly , efficiently and effectively.

(52).---Summary of EMH.

Summary of EMH

• Definition – market where prices respond rapidly to new information, such that expected returns equal required returns for all investors.
• Requirements for an efficient market.
  - Competing investors react to information quickly.
  - Large number of analysts competing
  - Random information
• Weak from – prices reflect all available market information. Empirical evidence supports this form generally, indicating that it is not possible to achieve superior returns after transaction cost.
• Semi-strong form – prices reflect all publicly available information. Tests suggest that there may be return anomalies that disprove this level.
• Strong form – prices reflect all information, both public and private. Tests indicate that, apart from specialists and directors, other insiders do not earn consistently superior returns.
• Implications for technical analysis – the weak form suggest that technical analysis is invalid.
• Implications for fundamental analysis – it is not possible to earn superior returns just by processing past information. An analyst must be superior at estimating how key variables will change in the future.
• Testes of the weak form.
  - Statistical tests of independence, based on auto correlation and runs tests.
  - Tests of specific trading rules.
• Tests of the semi-strong form
  - Statistical tests of independence, based on auto correlation and runs tests
  - Tests of specific trading rules.
• tests of the semi-strong form
  - aiming to predict future returns based on currently available information, based either on time series data
  - aiming to use new information to make superior returns on stocks(event studies.)
• Market anomalies – these are where there are predictable returns form the market. If this is the case, it suggests that the EMH is invalid. Examples include the following.
  - High dividend yield stocks have given high returns
  - High default spreads have been followed by high returns.
  - Positive earning surprises have been followed by high returns.
  - The January effect where stocks earn low returns in December and high returns in January
  - Small companies have given higher returns (size effect).
  - Neglected stocks have given higher returns.
  - High book to price (low price to book )stocks have given higher returns.
• Overall conclusion on efficient markets. _ most tests of market efficiency support the theory, in its weak and semi – strong forms. There appear to be some stock market and semi-strong forms. There appear to be some stock market anomalies that may refute the EMH. However, it is usually the case that anomalies may earn superior risk adjusted returns before transaction costs but will not after transaction costs.
• Performance of securities analysts – although some analysis appear to have the ability to earn superior risk adjusted returns, the majority are unable to outperform a buy and hold strategy.
• Use of index funds – if markets are efficient then it is not a good idea to try and beat the market. Instead, investors should use index funds that track a particular index, reducing costs to a minimum.
• Role of portfolio manager in efficient markets
  - Identify risk preferences of the client.
  - Select a portfolio based on risky and risk-free assets that matches the client’s needs.
  - Fully diversify the portfolio of risky assets.
  - Minimize transaction costs. This is done by tax efficient investment, reducing trading turnover and minimizing liquidity costs by trading in liquid securities.