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Fine Tuning Prices

by Patrick on September 7, 2011

Getting the most for your money is all about efficiency. Taking the long way to work isn’t going to save gas. Buying a big meal and only eating half of it is spending more than you have to for something that you’re not going to fully enjoy. Selling a product at a non-optimum price to a non-optimum number of people is leaving money on the table.  There is in fact, a best price to charge to maximize profits.

If you aren’t familiar with the demand curve, this is what it looks like. Figure 1 illustrates that the more something costs, the fewer are going to sell.

Empty demand curve

Figure 1

We can draw a demand curve after recording data for previous sales numbers at various prices or by predicting it based on the data for a similar product.  Many accomplish this by having sales or coupons and recording the demand at those prices.

When we set a price, the demand curve shows us how many we can expect to sell.

Demand curve 1

Figure 2

This creates lines on the X and Y axis. The area inside those lines tells us what our expected revenue is.  In this example, we  set the price at $7, and it looks like about 15 people will want to buy it for that much. That gives us $7 x 15 people = $105.

Demand Curve 2

Figure 3

 As I said earlier, there is a best price to charge, but we don’t know what it is yet. Let’s experiment. In Figure 4, we’ll set the price at $6. Twenty five people would buy it at $6, giving us revenue of $150.

Demand Curve 3

Figure 4

What if we set the price really low? Then everyone will want it, right? At $1.50 we can sell to 70 people. Unfortunately, that only gives us $105, and we’ve gone through the trouble of making 70 units.

Demand Curve 4

Figure 5

SPOILER ALERT: It turns out that the ideal price is exactly halfway up the line. This makes the profit box into a square. This is selling to a relatively large amount of people at a relatively large amount. Here, we’re selling 42 units at about $4.25. This gives us $4.25 x 42 = $178.50, our biggest profit yet.

Demand Curve 5

Figure 6

This example has so far occurred in a world where you can make these units for free. If for some reason it costs you money to do business, the graph is adjusted up so that the profit box is sitting on the cost box.  The square is maintained, but it is pushed up and is a little smaller. In Figure 7, it costs $1 to make each unit. Charging less than $1 each would sell a lot, but lose money on each sale.

Demand Curve 6

Figure 7

Parting advice: keep good sales records and try out new pricing from time to time.

 

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