Nov 2018 Q4
Oliso Ltd manufactures and sells an executive game for two distinct markets in which it currently has a monopoly. The fixed costs of production per month are GH¢20,000, and variable costs per unit produced, and sold, are GH¢40. The monthly sales can be thought of as X, where X = X1 + X2, with X1 and X2 denoting monthly sales in their respective markets. Detailed market research has revealed the demand functions in the markets are to be as follows, with prices shown as P1 and P2:
Market 1: P1 = 55 − 0.05X1
Market 2: P2 = 200 − 0.2X2
The price is currently GH¢50 per game in both markets and the Management Accountant believes there should be price discrimination.
Required:
a) Explain the term ‘price-discrimination’ and explain THREE (3) conditions that are necessary for the successful operation of this pricing strategy. (5 marks)
View Solution
A price-discrimination strategy is where a company sells the same products at different prices in different markets. In pure price discrimination, the seller charges each customer the maximum price he or she will pay. In more common forms of price discrimination, the seller places customers in groups based on certain attributes and charges each group a different price.
Conditions that are necessary for the successful operation of this pricing strategy:
• The seller must be able to determine the selling price. MOC has a monopoly and therefore this would be possible.
• It must be possible to segregate customers into different markets, e.g. using geographical location or age.
• Customers must not be able to buy at the lower price in one market and sell at the higher price in another market.
b) Calculate the price to charge in each market, and the quantity to produce (and sell) each month, to maximise profit. (4 marks)
View Solution
Profit will be maximised when marginal revenue = marginal costs. In each market, marginal costs = GH¢40
Market 1
MR = 55 – 0.1X1
So that:
55 – 0.1X1 = 40
X1 = 150
P1 = 55 – 0.05X1
when: X1 = 150
P1 = GH¢47.50
Market 2
MR = 200 – 0.4X2
So that:
200 – 0.4X2 = 40
X2 = 400
P2 = 200 – 0.2X2
when: X2 = 400
P2 = GH¢120
The company should sell 150 units for GH¢47.50 each to Market 1, and 400 units at GH¢120 each to Market 2. In total, 550 units should be produced.
c) Calculate the Total Monthly Contribution for each market at the price and quantities calculated in part (a) and the maximum monthly profit in total. (3 marks)
View Solution
Market 1
Total contribution = (GH¢47.50 − GH¢40) × 150 units = GH¢1,12
Market 2
Total contribution = (GH¢120 − GH¢40) × 400 Units = GH¢32,000
Total profit = GH¢1,125 + GH¢32,000 − GH¢20,000 = GH¢13,125
d) Write brief notes to the Management Accountant to explain how this pricing strategy would change if new competitors enter the market and suggest other pricing strategies which the business may have to consider, as well as pricing strategies that a new competitor may use.
(3 marks)
View Solution
- This pricing strategy calculated previously may not be able to be applied if competition was to emerge in the market, as the business would now have to be more aware of the competitors’ prices. We may be forced to use going rate pricing to match the competitors’ prices, in order to remain competitive.
- However, competitors may choose to adopt a penetration pricing strategy, which means that they will start off with as low as possible a price, in order to try and gain some of our market share. Competing at this price will drive down our profit margins.
- However, we may be able to sustain low margins in the short term to try and hold onto our customer base. As we have had such a strong monopoly of the market, we should already have sufficient economies of scale to be able to withstand the lower profit margins for longer than the competitor.
- Furthermore, we may even be able to undercut competitors, so that they cannot gain any market share. Alternatively, as we are already an established name in the market, we may be able to rely on brand loyalty and keep our prices high. By keeping a high price our customer may also perceive our product to be of higher quality. This could work particularly well, because this is an executive game and presumably the customer would be more likely to choose quality over a lower price. (Any 3 points)