2.5 Price

Pricing strategies, pricing power, and the legal constraints that limit it.

Part 1 of 4 What a Pricing Strategy Is

A pricing strategy is a business's rule for deciding how much to charge. Price does three jobs at once: it attracts customers, brings them back, and produces the revenue and profit that keep the business open.

Businesses consider per-unit cost when setting a price: what it costs to produce and distribute one unit. The running example of this unit is a teenager who rebuilds used bikes and sells them at a Saturday market with a signed inspection tag. For his rebuilt commuter bike, $35 for the frame, $18 of parts and $4 of stall fee make $57. A low price can win share, and a product stops being profitable the moment its price falls to or under per-unit cost.

A price line marking per-unit cost at fifty-seven dollars, rival prices from sixty-five to seventy-five, the inspected bike at ninety-five, and a new bike at one hundred ninety. — Example numbers. Three different pricing strategies arrive at the same $95.

Part 2 of 4 Four Pricing Strategies

Four strategies

Strategy	The rule	When
Value-based	Price on the perceived value of the product to the customer	Highly differentiated or uniquely valuable products
Competitive	Price off rival products, often called price matching	A premium when the product is sufficiently differentiated; at or below rivals to gain share at the expense of per-unit profit when it is not
Cost-based	Per-unit cost plus the per-unit profit you want (price minus per-unit cost)	Clearly defined costs that can be shown to customers, such as a construction contractor's
Penetration	A low price, possibly below per-unit cost, with the intent to raise it later	Pulling price-sensitive customers off rivals to grow share fast

Three of the four pricing strategies arrive at $95 for the inspected commuter bike. Value-based pricing gives $95, half the $190 price of a new bike, for a used bike that comes with the certainty of an inspection. Competitive pricing gives $95, a deliberate premium over untagged rival bikes priced at $65 to $75. Cost-based pricing gives $95: $57 of per-unit cost plus $38 of target profit. When independent pricing strategies arrive at the same price, that price is well supported. Penetration pricing fails here. A $45 commuter bike loses $12 per bike now. A business using penetration pricing plans to raise the price later. A durable bike brings its buyer back years later, if at all, so the buyers won at $45 would not pay the higher price for years.

Part 3 of 4 Pricing Power and Elasticity

Pricing power is the ability to raise prices without risking market share. In a highly competitive market with little differentiation, businesses have little pricing power and may be forced to keep prices as low as possible. In a less competitive market, or with a highly differentiated product, they have more pricing power and can run more profitable strategies. Pricing power also depends on the customers. When buyers respond strongly to a price change, a price rise can reduce revenue. When buyers respond weakly, a price cut may not sell enough extra units to make up for the lower price.

One tier, three Saturdays

Price	Bikes sold	Revenue	Per-unit profit
$95	4	$380	$38
$110	2	$220	$53
$80	4	$320	$23

The price rise to $110 lost revenue because customers bought 2 bikes instead of 4. The price cut to $80 sold no extra bikes, because the buyers who wanted a tagged bike were already buying at $95. So the price cut also lost revenue. Price elasticity of demand measures how strongly buyers respond to a price change. Elastic demand is a strong response, so elastic demand limits how far a business can raise its price. Inelastic demand is a weak response, so a business can raise its price with a smaller loss of sales. Classify demand as elastic or inelastic, then work out whether the price change raises or lowers revenue.

Part 4 of 4 Where the Law Draws Lines

Three moves the law limits

Practice	What it is	Where the line is
Collusion	Agreeing a price with competitors, usually above the competitive price	Illegal in many countries, including the U.S.
Price gouging	Raising a price when a crisis drives demand up	Illegal in many U.S. states and many countries
Price discrimination	Charging different customer segments different prices for the same product	Legal for student and senior tickets; illegal when based on race, nationality, sex or another protected status

The law limits how a price is agreed, when it may be raised, and whom it may differ for.

Worked Examples

Per unit cost of one commuter rebuild

Build a per unit cost from direct costs plus an allocated fixed cost, and identify the price floor.

Theo buys a commuter frame for thirty five dollars and spends eighteen dollars on cables, tubes, and brake pads. His stall costs twenty dollars every Saturday, and a good Saturday sells five bikes. Find the per unit cost of one finished commuter bike, then state what happens to profit at a price of fifty seven dollars and at fifty dollars.

Frame purchase price: $35
Parts per rebuild: $18
Saturday stall fee: $20
Bikes sold on a good Saturday: 5

1. Separate direct costs from the fixed cost
The frame and the parts are spent on this specific bike, so they belong to it in full. The stall fee is paid once and serves every bike that sells that day, so it has to be spread before it can be assigned.
2. Allocate the stall fee across the bikes it serves
Twenty dollars divided across five bikes is four dollars of stall fee per bike.
$\frac{$ 20}{5} = $ 4$
3. Add the three components
Thirty five plus eighteen plus four is fifty seven dollars of per unit cost.
$$ 35 + $ 18 + $ 4 = $ 57$
4. Test prices against the floor
At fifty seven dollars, price equals cost and the labor earns nothing. At fifty dollars, the seller loses seven dollars on every sale, so volume makes the problem worse rather than better.
$$ 50 - $ 57 = - $ 7$

Check answer

Answer
$57 per bike. Per unit cost is fifty seven dollars, and that is the price floor: at or below it the product is unprofitable no matter how many sell.

Why it matters
Fixed costs have to be allocated before a per unit figure means anything, and the allocation depends on volume. If a bad Saturday sells only two bikes, the same twenty dollar fee becomes ten dollars per bike and the floor rises to sixty three. A per unit cost is always a per unit cost at an assumed volume.

Setting the price with cost based pricing

Set a price from per unit cost and a target profit, then express the margin as a share of price.

Theo wants thirty eight dollars of profit on every commuter bike he sells, and his per unit cost is fifty seven dollars. Set the price using cost based pricing, express the profit as a share of the selling price, and check the result against the value anchor of about one hundred ninety dollars for a comparable new bike.

Per unit cost: $57
Target per unit profit: $38
Comparable bike new: $190

1. Add the target profit to per unit cost
Cost based pricing starts at the ledger instead of at the customer. Pick the per unit profit you want, then add it to what the unit costs.
$$ 57 + $ 38 = $ 95$
2. Express the profit as a share of the selling price
Thirty eight divided by ninety five is forty percent, which is the figure to quote when a customer asks how the price was built.
$\frac{$ 38}{$ 95} = 0.40$
3. Cross check the number against the value anchor
Ninety five is almost exactly half of one hundred ninety, so the cost based answer also lands on the half of retail claim the value proposition already makes.
$\frac{$ 95}{$ 190} = 0.50$
4. Read the agreement between methods
Cost based pricing, value based pricing, and competitive pricing all point at ninety five here. When independent methods agree the price is strong, and when they disagree the business has to decide which one to trust.

Check answer

Answer
$95. The price is ninety five dollars, giving a forty percent per unit margin and landing at half the price of a comparable new bike.

Why it matters
Do not confuse margin on price with markup on cost. Thirty eight dollars is forty percent of the ninety five dollar price and about sixty seven percent of the fifty seven dollar cost. Free response answers lose points by computing one and labeling it the other, so name the base you divided by.

Three Saturdays of price testing

Compare revenue and total margin across three prices and classify demand as elastic or inelastic.

Theo tests his commuter tier at three prices on three separate Saturdays. At ninety five dollars, four bikes sell. At one hundred ten dollars, two sell. At eighty dollars, four sell. Per unit cost stays fifty seven dollars throughout. Compute revenue and total margin at each price, then classify the demand he is facing.

Per unit cost: $57
Saturday one: $95, 4 sold
Saturday two: $110, 2 sold
Saturday three: $80, 4 sold

1. Compute revenue at each price
Revenue is price times quantity. Four at ninety five is three hundred eighty. Two at one hundred ten is two hundred twenty. Four at eighty is three hundred twenty.
$4 ($ 95) = $ 380, 2 ($ 110) = $ 220, 4 ($ 80) = $ 320$
2. Compute margin per bike at each price
Subtract the fifty seven dollar cost from each price: thirty eight, fifty three, and twenty three dollars.
$$ 95 - $ 57 = $ 38, $ 110 - $ 57 = $ 53, $ 80 - $ 57 = $ 23$
3. Compute total margin at each price
Multiply margin per bike by the number sold: one hundred fifty two, one hundred six, and ninety two dollars.
$4 ($ 38) = $ 152, 2 ($ 53) = $ 106, 4 ($ 23) = $ 92$
4. Classify the demand on the way up
Raising the price about sixteen percent cut quantity in half and cut revenue by one hundred sixty dollars. A price rise that reduces revenue means customers responded strongly, which is elastic demand.
5. Read the price cut correctly
Cutting to eighty dollars did not raise volume at all, because the parents buying on the inspection were already buying at ninety five. Revenue and margin both fell, so a cut only pays when the extra volume more than covers the smaller take per unit.

Check answer

Answer
$95 is the best of the three. Ninety five dollars produced the highest revenue and the highest total margin at one hundred fifty two dollars. Demand is elastic upward and unresponsive downward within this range.

Why it matters
Elasticity is about the revenue consequence, not about a coefficient. This exam asks you to classify demand and reason to what happens to revenue, and the classification can differ in each direction, as it does here: pushing the price up loses customers, and pulling it down wins none.

Key Terms

Practice Questions

6 questions. Nothing here is recorded or scored.

Question 12.5.A.1, 2.5.A.3
Static Groove Records
Wren Castillo owns Static Groove Records, a used-vinyl business run from a spare bedroom and a monthly record-fair table. Wren buys whole crates at estate sales, cleans and grades every record, and lists the playable ones online. Most of her inventory is common pressings that dozens of other sellers list at the same time, so she checks the going online price for each title and matches it, because a common record priced above the crowd sits unsold. A few finds each month are rare first pressings that collectors search for by name, and for those she ignores her cost entirely and prices at what each record is worth to a collector, judging that worth from what buyers pay on the collector forums. This month a new vinyl seller took the table next to hers at the fair, and Wren is weighing a plan: price common records below every other seller for one season to pull the fair's regular browsers to her table, then move prices back up once they shop with her by habit.
Wren's method for pricing the rare first pressings is best described as which of the following?
- A.Cost-based pricing, because a rare record raises the per-unit cost of the crate it came in.
- B.Value-based pricing, because the price is set by what the record is worth to a collector.
- C.Competitive pricing, because Wren reads the prices posted by sellers on collector forums.
- D.Penetration pricing, because collectors will accept steadily higher prices as time passes.
Check answerHide answer
Answer: B
A.
Runs the logic backward. Cost-based pricing builds the price up from per-unit cost, and this price ignores cost on purpose.
B.
Correct. A pricing strategy is a business's method for deciding what to charge, and value-based pricing sets the price on what the customer believes the product is worth, fitting products with strong differentiation or one-of-a-kind appeal. A rare first pressing that collectors hunt by name is exactly that, so Wren prices from the buyer's perception and keeps her own cost out of the decision.
C.
The bait is the word forums. Competitive pricing reads what rival sellers charge, and Wren is reading what buyers actually pay, which is a signal of worth to the customer.
D.
Penetration pricing is a deliberately low introductory price designed to rise later. The rare pressings are priced high from the start, at collector worth, and no later increase is planned; nothing about the strategy is introductory.
Question 22.5.A.4, 2.5.B.1
Which of the following best explains why Wren matches the market price on common pressings instead of charging more?
- A.Common pressings cost Wren more per unit to buy and to clean than her rare pressings do.
- B.Sellers are legally required to match prices whenever many of them list the same record.
- C.Matching the going market price moves each common copy off her list within the same month.
- D.Dozens of sellers list identical copies, so Wren has little power to price above them.
Check answerHide answer
Answer: D
A.
The stimulus gives no per-unit costs, and the reasoning would not follow anyway: Wren prices common pressings by reading the market rather than her cost. What she paid for the crate never enters the decision.
B.
Invents a law. Price matching is a strategy a business chooses, and the real legal lines around pricing are collusion, gouging, and discrimination by protected status.
C.
Matching keeps a record competitive and settles nothing about timing. A common pressing at the going price still sits until a buyer who wants that particular title happens to look.
D.
Correct. Pricing power is the room a business has to raise prices without handing sales to rivals, and it comes from differentiation or from a shortage of competitors. A common pressing is an identical product with dozens of sellers, so Wren has neither, and the market hands her the price. Her rare pressings are the mirror image: a product different enough from its rivals earns the right to price above them.
Question 32.5.A.6
Wren's one-season plan for common records is best identified as which of the following?
- A.Price gouging, because Wren plans to raise her prices once the discount season ends.
- B.Value-based pricing, because browsers will perceive the low season prices as a bargain.
- C.Penetration pricing, a deliberately low price meant to win market share before it is raised.
- D.Collusion, because the plan is aimed at the new vinyl seller at the next fair table.
Check answerHide answer
Answer: C
A.
Gets the direction and the trigger wrong. Gouging is a price increase during a crisis, and a planned increase after a discount season shares nothing with it.
B.
Value-based pricing sets the price on what the product is worth to the buyer, and a below-everyone price is set by reading rivals rather than worth. Browsers noticing a bargain is the strategy working, not the method that produced the number.
C.
Correct. Penetration pricing sets a deliberately low price, sometimes under per-unit cost, planning to raise it later, and its job is to pull price-sensitive customers off rival sellers and build market share fast. Wren's plan has each part: the deliberately low season, the price-sensitive browsers, and the planned increase once the habit forms.
D.
Misreads collusion, which is an agreement with competitors to set a price. Competing hard against one is ordinary, legal business.
Question 42.5.B.2, 2.5.B.3
A smoothie stand shares a food court with five other vendors selling similar drinks. The stand raises its price 10 percent, and its total revenue falls. Which of the following best explains the result?
- A.Demand is elastic, so the sales lost to rivals outweighed the extra dollars per cup.
- B.Demand is inelastic, so the stand's regular customers barely noticed the higher price.
- C.The other five vendors were legally required to hold their own drink prices steady.
- D.A 10 percent price increase reduces revenue at any business selling a similar drink.
Check answerHide answer
Answer: A
A.
Correct. Price elasticity of demand measures how strongly customers respond to a price change. Elastic means highly responsive, and five near-identical substitutes a few steps away make responsiveness close to certain: raise the price and the buyers walk. When the lost sales outweigh the extra dollars per cup, revenue falls.
B.
The paired-concept swap. Inelastic customers barely respond, and a price increase under inelastic demand raises revenue rather than lowering it.
C.
No law holds rival prices steady, and none is needed to explain the result. The other vendors simply kept their prices where they were, and customers walked a few steps to pay them.
D.
Hardens one outcome into a rule. The only coffee cart in an office tower can raise prices 10 percent and watch revenue climb, because what decides the direction is how responsive that cart's customers are.
Question 52.5.A.2, 2.5.A.5
Static Groove Records (Estate-Sale Crate)
Wren Castillo, owner of Static Groove Records, buys one crate of used records at an estate sale. The table shows the numbers.
Figure | Amount Crate price | $60 Records in the crate | 30 Records sellable after cleaning and grading | 20 Cleaning and sleeve supplies for the crate | $20 Target profit per record sold | $2 Which conclusion is supported by the table?
- A.The records cost 2 dollars each, so any price above 2 dollars returns a profit per record.
- B.A 4-dollar price hits the 2-dollar target profit on each of the twenty sellable records.
- C.The crate cannot turn a profit, because ten of its thirty records cannot be sold.
- D.A 6-dollar price meets the target, because each sellable record has a cost of 4 dollars.
Check answerHide answer
Answer: D
A.
Divides the 60-dollar crate by the thirty records and gets 2 dollars, and that average lies twice: it skips the 20 dollars of supplies, and it spreads cost across ten records that will not earn a cent. The duds pay nothing, so the sellable twenty carry the whole 80.
B.
Prices at the true cost itself, and a price equal to per-unit cost earns zero, however many records it moves.
C.
Unsellable units are normal in this business, and the sellable ones can carry them. At any price above the 4-dollar true cost, the twenty playable records earn back the whole 80 dollars and more, so the crate turns a profit even though a third of it goes in the bin.
D.
Correct. Total spending on the crate is 60 plus 20, 80 dollars. Only the twenty sellable records can earn that money back, so the true per-unit cost divides 80 by 20: 4 dollars per sellable record. Cost-based pricing stacks the per-unit profit you want on top of per-unit cost, so 4 dollars of cost plus the 2-dollar target gives a 6-dollar price.
Question 62.5.C.1, 2.5.C.2, 2.5.C.3
Which of the following best identifies a pricing practice that is illegal in many places?
- A.A movie theater charging students a lower ticket price than it charges adult moviegoers.
- B.Two rival gas stations agreeing with each other to raise prices to the same higher level.
- C.A grocery store raising its shelf prices after its own supplier raises the wholesale cost.
- D.A new streaming service pricing below its per-subscriber cost to win early subscribers.
Check answerHide answer
Answer: B
A.
Brushes against price discrimination, and the legal line is precise: charging different customer segments different prices is legal and common, student discounts included, and it turns illegal when the basis is race, nationality, sex, or another protected status.
B.
Correct. An agreement between competitors to set a price is collusion, and it is illegal in the U.S. and many other countries, because the agreed price typically sits above what real competition would allow.
C.
Brushes against price gouging, and the trigger separates them: raising prices because your own costs rose is ordinary business, and gouging raises prices to exploit a crisis-driven demand spike, which is illegal in many U.S. states.
D.
Penetration pricing. Pricing low, even below cost, to attract customers is a legal strategy in this course's framework.

In a class? These questions are not recorded.

Take the same questions as a scored quiz and your teacher will see that you have finished this section.

Take the scored quiz →

7 Common Mistakes on 2.5

The wrong moves students actually make on these questions, why each one is wrong, and what to do instead. Part of the practice tier.

See what is included

CED Codes

2.5.A.1 · 2.5.A.2 · 2.5.A.3 · 2.5.A.4 · 2.5.A.5 · 2.5.A.6 · 2.5.B.1 · 2.5.B.2 · 2.5.B.3 · 2.5.C.1 · 2.5.C.2 · 2.5.C.3