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- 15 Marks
Question
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)
b) Calculate the price to charge in each market, and the quantity to produce (and sell) each month, to maximise profit. (4 marks)
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)
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)
Answer
a) Price Discrimination Explanation:
Price discrimination is a pricing strategy where a company sells the same product at different prices in different markets or segments. The strategy involves charging each customer the maximum price they are willing to pay.
Conditions necessary for successful price discrimination:
- Market Power: The firm must have some control over prices. Oliso Ltd has a monopoly, making this condition satisfied.
- Market Segmentation: The firm must be able to segment the market into distinct groups that have different price elasticities of demand.
- Prevention of Resale: It must not be possible for customers in a lower-priced market to resell the product in a higher-priced market.
(5 marks)
b) Profit Maximization through Price Discrimination:
Market 1:
- Marginal Revenue (MR) = 55 – 0.1X1
- Setting MR equal to marginal cost (MC = GH¢40):
55−0.1X1=40⇒X1=150
- Price P1 = 55 – 0.05(150) = GH¢47.50
Market 2:
- Marginal Revenue (MR) = 200 – 0.4X2
- Setting MR equal to marginal cost (MC = GH¢40):
200−0.4X2=40⇒X2=400
- Price P2 = 200 – 0.2(400) = GH¢120
The company should produce and sell 150 units in Market 1 at GH¢47.50 each and 400 units in Market 2 at GH¢120 each.
(4 marks)
c) Contribution and Profit Calculation:
Market 1:
- Contribution per unit = (GH¢47.50 – GH¢40) = GH¢7.50
- Total Contribution = GH¢7.50 * 150 units = GH¢1,125
Market 2:
- Contribution per unit = (GH¢120 – GH¢40) = GH¢80
- Total Contribution = GH¢80 * 400 units = GH¢32,000
Total Monthly Profit:
- Total Contribution = GH¢1,125 + GH¢32,000 = GH¢33,125
- Fixed Costs = GH¢20,000
- Net Profit = GH¢33,125 – GH¢20,000 = GH¢13,125
(3 marks)
d) Impact of New Competitors and Alternative Strategies:
- If new competitors enter the market, Oliso Ltd may need to reduce prices or offer additional value to maintain market share. Price discrimination may become less effective if competitors can undercut prices.
- Other pricing strategies that may be considered include:
- Penetration Pricing: Setting lower prices to gain market share quickly.
- Skimming Pricing: Charging a high price initially and then lowering it over time.
- Competitive Pricing: Matching or beating the prices set by new competitors to maintain market position.
Competitors might use aggressive pricing strategies, such as penetration pricing, to capture market share, potentially forcing Oliso Ltd to adopt a more competitive pricing approach.
(3 marks)
- Topic: Cost-Volume-Profit (CVP) Analysis
- Series: NOV 2018
- Uploader: Joseph