Home > Mathematics, Pricing, Statistical Economics > Some Thoughts On Pricing, Part I

## Some Thoughts On Pricing, Part I

Meyer, a close friend of mine, and I live in a country of unique and colorful beauty, Mexico, and our town Guadalajara additionally inherits a traditional Spanish-colonial and picturesque quaintness. Meyer and I are good pals and you can often find us shopping together: we live close by enough to make it convenient and worthwhile (loading and unloading and placing in the cupboard is easier and faster with a helping hand). From another point of view, it gives us the opportunity to chit-chat and share ideas, and we definitely appreciate each other’s company.

In examining a variety of comparable products the other day, say concentrated apple juice, I noticed that, even across generic brands, there exists a price fluctuation that I simply could not explain. One might cost 7.50 pesos, another might cost 10, and yet another might cost 8. This completely intrigued me. Because I had recently worked in the tequila sector on a consulting project, I moved on the the spirits section. For different, generic, and comparable-in-quality tequila products, again significant fluctuation. The branded products also displayed a not-so-tight price range.

I put myself in the shoes of the supplier of the product. If I am determining what the acquisition price of my product should be to maximize my expected profit, and I am competing against a plethora of other products of comparable quality, I am in effect bidding against the other products for the lowest possible price. I am bidding for the lowest possible price because a rational consumer will always choose the cheapest product across comparable-quality. The bid is a sealed one, in which it is impossible for me the supplier to determine how other products will price (since I cannot know with exactness other suppliers’ cost functions, inventory levels, etc.), although I can get a fair idea by sampling directly from the shelves, say.

These observations, then, can be elevated to the category of axioms: first (C1), that the rational consumer knows that the products that he is offered at the shelf are comparable in quality, and that he will always chose the cheaper of the products, much as I did when I chose the cheapest generic brand of apple juice available; second (S1), that the supplier is bidding for the lowest price in a sealed bid against other comparable products, and this gives rise to price fluctuation of the products; third (S2), that the supplier can inform himself by sampling the shelves of the particular price fluctuation, and can determine by careful methods a general distribution of the prices (or in fact knows a priori the distribution because he is omniscient); fourth (S3), that the supplier knows his cost function.

For example, say I am an apple juice company, *, and competing against me there is a single other company (or many other companies with very tight price center of mass), F1, and our products are comparable-in-quality (S1).  Now let's say there are 1000 different shops or so that can sell our product, but only one rational consumer (C1) per shop is interested in the product and comes in that day.  Let's say that at these shops either you sell the product that day at the time of purchase or it's returned to you, and you must inventory it or destroy it (perhaps the apple juice is no good after 1 day).  Furthermore let's say you can decide what price you'll set for the product, and F1's price can be modeled as the value of a random variable that is uniformly distributed within a range, maybe anywhere between 2 to 15 pesos (S2). I, *, only need to invest 1 peso per product produced (S3).

The probability of me selling at any shop, if I price at $x$, is $\frac{15-x}{13}$ (one minus the cumulative density): if I price at the lower bound 2 I am guaranteed to sell, but if I sell at 15 I am guaranteed not to sell.  My probability of not-selling or failure is $1-\frac{15-x}{13}$, or $\frac{x-2}{13}$ (cumulative density).  Being a profit maximizing company, what should I price my products in order to sell as much as possible and earn as much as possible?  If I do sell, then I earn $x-1$ pesos.  If I don't sell, I have to destroy or inventory my product, and I have lost 1 peso.  I can easily calculate my expected profit as a function of $x$:

$E_p(x) = \underbrace{ \frac{15 - x}{13} \cdot (x-1)}_{success/win/sell} + \underbrace{\Big(1-\frac{15-x}{13}\Big)\cdot (-1)}_{failure/lose/didn't-sell}$

or

$E_p(x) = \frac{15 - x}{13} \cdot (x-1) + \frac{x-2}{13}\cdot (-1)$

or

$E_p(x) = \frac{1}{13} \cdot (-x^2 + 15 x - 13)$

which is, luckily in this particular case, an inverted parabola with maximum that can be readily calculated at:

$-2x + 15 = 0$

or $x=7.5$ pesos.  At this price my expected profit per unit is about 3.33 pesos. For a 1000 shops my expected profit is about 3330 pesos.

I must mention that I based this idea on a bidding problem from Ross's excelent book titled "A First Course in Probability," but the core concept has morphed significantly in this particular application.

Now suppose that, besides me, there are 2 companies (or two tight center-of-masses), F1 and F2, each pricing with the same uniform probability distribution as before (alternatively, one can choose to think the prices of F1 and F2 are two realizations of the known uniform distribution), and each are not influenced by the other (they speculate on their own), and are therefore independent.  To sell product at the shops, now I must be twice successful: I must win against both F1 and F2.  My probability of winning now is: $(\frac{15-x}{13})^2$ by independence (and of losing one minus that), for which the expected profit is:

$E_p(x) = \Big(\frac{15 - x}{13}\Big)^2 \cdot (x-1) + \Big(1-(\frac{15-x}{13})^2\Big)\cdot (-1)$

Further developing the idea, for n companies labeled Fn, my expected profit is:

$E_p(x) = \Big(\frac{15 - x}{13}\Big)^n \cdot (x-1) + \Big(1-(\frac{15-x}{13})^n\Big)\cdot (-1)$

Graphing these functions it is obvious that the break-even points for 2 competing companies, 3 competing companies, and so on (zeroes of expected profit functions) are closer and closer to the lower bound.  Also maximum expected profit can be achieved only at the lower bound for more competition in the market.  Indeed, prices do fall the more competition there exists.

I think using a Gaussian distribution instead of a uniform is much more interesting (probabilities are not constrained to an interval, e.g.) and potentially more realistic, and that is the subject of my next post.

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1. October 8th, 2008 at 04:36 | #1

Hmmm, I think assumption C1 is a problem.

Even rational consumers are not immune to branding. When I was a kid, the two competing cereal brands were Kellogg's (of USA fame) and Maizoro (the National Brand). The quality of the cereal was comparable (it is hard to make corn flakes more special than any other corn flakes). Yet the Kellogg's packaging was brighter, cleaner, and...supposedly came from the US. Maizoro, being national brand, was also a little (but only just slightly) cheaper.

You don't see any more Maizoro on the supermarket shelves, do you?

So either a) consumers are irrational, which makes your assumption C1 not very applicable, or b) rational consumers decide what to buy based on other things that are not only quality and price (I call this other thing "brand recognition"/"cache"/"status by association").

I find this "third factor" also true in Switzerland, with the difference that, while in Mexico, the perception was that "if it is Mexican-made it is crap" (therefore consumers wouldn't buy anything obviously marked "Made in Mexico" even if the product WAS of better quality), here in Switzerland the Swiss prefer to buy Swiss-made, even if it is lower quality, and, amazingly, is tagged at higher price. I guess it is the proverbial bumblebee that keeps the Swiss economy afloat: after all, their economy is dominated by fix-pricing monopolies, there is lack of choice, and the prices are exhorbitant, without justifying the quality. Consumers still choose the pricier (national brand) items, against all dictates of logic. (shrug).

Still, I think I prefer a market where the price varies widely like the Mexican one. At least that one gives me more choice (and surely, as you hint, allows more opportunities for entrepeneurial gains). Here in Switzerland we're stuck all wearing grey jeans and white T-shirts, white Converse or Adidas sneakers, and eating food from the local Migros or Coop, with prices that are within 2 cents of each other. Talk about a way to kill the fun!

By the way, nice to have found your blog. Interesting reads.

2. October 8th, 2008 at 07:06 | #2

Ah... this is a very good point. I have an argument about branding coming up shortly, it seems to fit nicely in a following mathematical description... bear with me! C1 is a problem, I agree, but it also is standard in economic theory to think in this manner, hence why it's included. I am hoping to address several issues you mention. Glad to see you're around, and thank you for your comment!

3. October 20th, 2008 at 18:07 | #3

Hi Elisa,
I've been of course thinking about what you've said in your comment and I hope that some questions are being answered in the "Some Thoughts on Pricing" series. Don't think I dismissed outright your objection of the C1 axiom... the present analysis of course requires it for the sake of crystal clarity, in the sense that we must ignore consumers that are not picking the cheapest-priced product across comparable products in order to exclude a source of noise. There is really no reason why we shouldn't be (more) lax about it, however: we can allow some consumers to be "irrational" or have some people choose according to a different rule... but we must be careful that the amount of people acting this way do not significantly (in the statistical sense) affect the framework I'm trying to build. We could add on flexibility if needed, you see. How many "eccentrics" we can allow into the system without making it break is an analysis onto itself, perhaps something we can explore a little later. But first, I'm concerned with outlining the rational set of criteria by which a company, consumers, and disorganized competition might operate. Then I want to see how an organized competition will affect things (soon-coming part III).

*