Timothy Van Zandt - Insead

Chapter 9
How Pricing Depends on the
Demand Curve
9.1 Motives and objectives
Broadly
A firm’s demand curve may shift when (for example) a rival firm changes its price, there
is a news report about the firm’s product, or the firm engages in an advertising campaign.
How does or should a firm adjust its price following such a shift?
If we have all the data—complete demand curves and cost curves—needed to calculate
optimal prices before and after the shift, then the answer to this question just gives the
“before” and “after” prices. However, we would like to be able to say something even
when we lack such data. For example, under what easily verifiable conditions can we say
that the firm should raise its price following a shift in its demand curve?
We will show, for example, that a firm should raise its price in response to an increase
in the price of a rival firm’s substitute good. However, it should lower its price if the price
of a complementary good goes up. The effect of an advertising campaign on price depends
on the nature of the campaign. However, typically it will be raise demand for the good and
differentiate the good so that consumers are less price sensitive. Then the firm should raise
its price following the campaign.
More specifically
A shift in the demand curve has two effects on pricing.
• Volume effect. Suppose that a firm has increasing marginal cost. If the demand curve
shifts outward (so that, at any price, the firm would sell more) then the extra volume
of sales pushes the firm to a region of higher marginal cost and causes the firm to raise
its price.
• Price-sensitivity effect. Even with constant marginal cost, a firm should raise its price
if demand becomes less price sensitive.
These two effects are typically both present. To understand each effect, we will isolate
them. We first isolate the price-sensitivity effect by studying a firm with constant marginal
cost. The main step in our analysis is to measure price sensitivity correctly—as elasticity—
Firms, Prices, and Markets ©August 2012 Timothy Van Zandt