Price Elasticity and Cost Pass-Through in a Competitive Retail Market
Marlow Homewares sells 50,000 units a year at a price of 20. Variable cost is 12 per unit and fixed costs are 300,000 a year, so current profit is 100,000. A supplier cost increase will raise variable cost to 14 per unit. Marlow's market research suggests the price elasticity of demand in its segment is -1.6 in the relevant range. A competitor has announced it will hold prices at 20 and absorb the cost increase. Marlow is considering three options: (a) hold price at 20 and absorb the cost; (b) raise price to 22; (c) raise price to 23.50. The market is in a recession, and consumer confidence is falling.
1. Using the elasticity estimate, quantify the volume effect of each pricing option and compute the resulting profit, then recommend an option.
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Baseline: price 20, volume 50,000, contribution 8 per unit, total contribution 400,000, less fixed 300,000 = profit 100,000.
New variable cost 14. Use elasticity -1.6: % change in quantity = -1.6 x % change in price.
Option (a) hold at 20:
- Price change 0, volume stays 50,000. Contribution per unit = 20 - 14 = 6. Total contribution = 300,000. Profit = 0.
Option (b) raise to 22 (10% increase):
- Volume change = -1.6 x 10% = -16%, so volume = 50,000 x 0.84 = 42,000.
- Contribution per unit = 22 - 14 = 8. Total contribution = 336,000. Profit = 36,000.
Option (c) raise to 23.50 (17.5% increase):
- Volume change = -1.6 x 17.5% = -28%, so volume = 50,000 x 0.72 = 36,000.
- Contribution per unit = 23.50 - 14 = 9.50. Total contribution = 342,000. Profit = 42,000.
Recommendation: Option (c) gives the highest profit of 42,000, but the margin over (b) is thin (6,000) and rests on a linear elasticity assumption over a large price move. Option (b) is the more prudent choice because it preserves 42,000 units of volume and leaves room to respond if the competitor reacts. Holding price (a) is the worst outcome - zero profit - and is only defensible as a temporary share-defence move. Note that demand is elastic (|1.6| > 1), so revenue falls as price rises, but profit rises because the contribution margin improves faster than volume falls within this range.
2. Explain how the recession and the competitor's price hold should modify the recommendation, and identify the risk in relying on the elasticity estimate.
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Recession effect: Falling consumer confidence shifts the demand curve inward at every price, so the volume figures above are optimistic. The elasticity of -1.6 may also understate sensitivity in a downturn: consumers trade down more aggressively, so the true elasticity could be higher (for example -2.0). At -2.0, option (c) volume falls 35% to 32,500, contribution = 308,750, profit = 8,750 - worse than option (b) at 36,000. The recommendation is therefore elasticity-sensitive, and a prudent board should stress-test at -2.0 before committing to the largest price rise.
Competitor's price hold: If the competitor holds at 20, Marlow's price rise makes it the more expensive option, accelerating volume loss beyond the elasticity estimate (which measures movement along a demand curve, not a shift caused by a rival's relative price). This is a cross-price effect not captured by the own-price elasticity. Option (c) becomes riskier; option (b) is more defensible.
Risks in the estimate:
- Elasticity is measured over small changes; extrapolating to a 17.5% rise assumes linearity that may not hold.
- The estimate comes from market research, not observed transactions, and may be biased.
- It assumes competitors' prices and consumer incomes are constant - both are moving.
- It ignores non-price competition (service, brand), which may make demand less elastic than estimated.
Revised recommendation: choose option (b) at 22, with a contingency to reduce to 20 if volumes fall more than 20% within two quarters, and monitor competitor pricing weekly.