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Chapter 6 Where Do Prices Come From?

The Price of a Pill

If you walk down the aisles of a supermarket, you will see thousands of different goods for sale. Each one will have a price displayed, telling you how much money you must give up if you want the good in question. On the Internet, you can find out how much it would cost you to stay in a hotel in Lima, Peru, or how much you would have to pay to rent a four-wheel drive vehicle in Nairobi, Kenya. On your television every evening, you can see the price that you would have to pay to buy a share of Microsoft Corporation or other companies.

Prices don’t appear by magic. Every price posted in the supermarket or on the Internet is the result of a decision made by one or more individuals. In the future, you may find yourself trying to make exactly such a decision. Many students of economics have jobs in the marketing departments of firms or work for consulting companies that provide advice on what prices firms should charge. To learn about how managers make such decisions, we look at a real-life pricing decision.

In 2003, a major pharmaceutical company was evaluating the performance of one of its most important drugs—a medication for treating high blood pressure—in a Southeast Asian country. (For reasons of confidentiality, we do not reveal the name of the company or the country; other than simplifying the numbers slightly, the story is true.) Its product was known as one of the best in the market and was being sold for $0.50 per pill. The company had good market share and income in the country. There was one major competing drug in the market that was selling at a higher price and a few less important drugs.

In pharmaceutical companies, one individual often leads the team for each major drug that the company sells. In this company, the head of the product team—we will call her Ellie—was happy with the performance of the drug. Nonetheless, she wondered whether her company could make higher profits by setting a higher or lower price. In many countries, the prices of pharmaceutical products are heavily regulated. In this particular country, however, pharmaceutical companies were largely free to set whatever price they chose. Together with her team, therefore, Ellie decided to review the pricing strategy for her product. In this chapter, we therefore tackle the following question:

How should a firm set its price?

Road Map

Price-setting in retail markets typically takes the form of a take-it-or-leave-it offer. The seller posts a price, and prospective customers either buy or don’t buy at that price. The prices you encounter every day in a supermarket, a coffee shop, or a fast-food restaurant, for example, are all take-it-or-leave-it offers that the retailer makes to you and other customers.Chapter 5 "eBay and craigslist" has more discussion.

In this chapter, we put you in the place of a marketing manager who has been given the job of determining the price that a firm should charge for its product. We first discuss the goals of this manager: what is she trying to achieve? We then show what information she needs to make a good decision. Finally, we derive some principles that allow her to set the right price. The chapter is built around two ideas:This chapter and Chapter 5 "eBay and craigslist" are linked because they are both about mechanisms that allocate goods and services. In Chapter 5 "eBay and craigslist" we explain how eBay, craigslist, and newspapers are ways in which individuals exchange goods and services. In this chapter, we study how goods and services are allocated from firms to households. At the end of this chapter, we show that the supply-and-demand framework introduced in Chapter 5 "eBay and craigslist" is also a useful framework when the same product is produced by a large number of firms. In particular, we show that our ideas about pricing also allow us to understand the foundations of supply.

  1. The law of demand. Each firm faces a demand curve for its product. This demand curve obeys the law of demand: if a firm sets a higher price, it must be willing to sell a smaller quantity; if a firm wishes to sell a larger quantity, it must set a lower price.
  2. Profit accounting. Firms earn income from selling their goods and services, but they also incur costs from producing those goods and services. These costs include the costs of raw materials, the wages paid to the firm’s workers, and so on. The difference between a firm’s revenues and its costs is the firm’s profits.

The choice of price, via the demand curve, determines the amount of output a firm sells. The amount of output determines a firm’s revenues and costs. Together, revenues and costs determine the profits of a firm.