Managerial Application 121

10$ for a Gallon of Gas in Dayton, Ohio

In every state, retail gasoline prices must be clearly visible to passing motorists. At the same time, octane content is regulated so that the gas available for sale meets minimum standards as a clean-burning fuel. With prominently displayed prices, and consistently high gas quality, the groundwork is in place for vicious price competition.

Price-conscious drivers commonly bypass high-price stations in the effort to save as little as 2i or 3i per gallon. As a result, profit margins on gasoline are notoriously low. Margins are typically so low that convenience stores see gasoline as a "loss leader" for other high-margin products. Although the typical driver will go out of the way to save no more than 50i on a tank of gas, that same driver will see nothing wrong with going inside the convenience store and paying $1.29 for a large cup of soda, 89i for a candy bar, or $3.49 for a pack of cigarettes. In no small way, convenience stores offer gasoline as a means of generating traffic for soda, candy, and cigarettes.

For example, in November 2001, Cincinnati-based Kroger Co., which has about 180 grocery stores with gas stations, opened a new store and gas station in Dayton, Ohio. During a 3-day grand opening period, Kroger decided to price its gasoline 10i per gallon below local market norms as a means for generating favorable customer interest and publicity. Competitors took notice, too. Just down the street, the Meijer superstore/gas station, owned by closely held Meijer Inc. of Grand Rapids, Michigan, decided to cut its price. An all-out price war developed. Within hours, gasoline prices in Dayton fell from $1.08 (the Midwest market average) to 50i per gallon, and briefly all the way down to 10i per gallon! In commenting on the situation, Kroger officials said that such prices were not part of the company's "everyday price strategy," but "we intend to be competitive."

See: Maxwell Murphy, "Kroger Versus Meijer: Gasoline Price War Rages in Dayton/'T^e Wall Street Journal Online, November 30, 2001 (http://online.wsj.com).

by Post and Kellogg's competing with a variety of local store brands. Cheerios and Wheaties, both offered only by General Mills, Inc., enjoy a markup on cost of 15 percent to 20 percent. Thus, availability of substitutes directly affects the markups on various cereals. It is interesting to note that among the wide variety of items sold in a typical grocery store, the highest margins are charged on spices. Apparently, consumer demand for nutmeg, cloves, thyme, bay leaves, and other spices is quite insensitive to price. The manager interviewed said that in more than 20 years in the grocery business, he could not recall a single store coupon or special offered on spices.

This retail grocery store pricing example provides valuable insight into how markup pricing rules can be used in setting an efficient pricing policy. It is clear that the price elasticity concept plays a key role in the firm's pricing decisions. To examine those decisions further, it is necessary to develop a method for determining optimal markups in practical pricing policy.

There is a simple inverse relation between the optimal markup and the price sensitivity of demand. The optimal markup is large when the underlying price elasticity of demand is low; the optimal markup is small when the underlying price elasticity of demand is high.

There is a simple inverse relation between the optimal markup and the price sensitivity of demand. The optimal markup is large when the underlying price elasticity of demand is low; the optimal markup is small when the underlying price elasticity of demand is high.

Optimal Markup on Cost

Recall from Chapter 4 that there is a direct relation among marginal revenue, price elasticity of demand, and the profit-maximizing price for a product. This relation was expressed as

To maximize profit, a firm must operate at the activity level at which marginal revenue equals marginal cost. Because marginal revenue always equals the right side of Equation 12.6, at the profit-maximizing output level, it follows that MR = MC and

Equation 12.8 provides a formula for the profit-maximizing price for any product in terms of its price elasticity of demand. The equation states that the profit-maximizing price is found by multiplying marginal cost by the term

To derive the optimal markup-on-cost formula, recall from Equation 12.2 that the price established by a cost-plus method equals cost multiplied by the expression (1 + Markup on Cost). Equation 12.7 implies that marginal cost is the appropriate cost basis for cost-plus pricing and that

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