My brother Neal just called to say my nephew Doug had a bedtime question. Doug got on the phone and asked, "Is it better for a store to charge low prices and get a lot of customers, or charge high prices and get a small number of customers?"
Now that's a heck of a good question for a kid his age. Actually, it's a good question for an adult, but what really impressed me was the clear understanding of the Law of Demand implicit in the question. I told him the store should pick a point in between, because either extreme (high price and low sales, or low price and high sales) would be a mistake. I was tempted to jump into an explanation of elasticity of demand and marginal pricing... but I thought that might be a bit much for bedtime.
Tuesday, May 23, 2006
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4 comments:
It's a good question, but why did you give him the wrong answer? Where the profit maximizing price is depends on the shape of the demand curve and the cost curves--there is no universal rule requiring it to be in the middle.
I didn't say to pick the point exactly in the middle, I said to pick a point in between the extremes. I could have given a more complicated answer, of course, but I think an explanation of cost curves would have a bit above his head.
You wrote:
"I told him the store should pick a point in between, because either extreme (high price and low sales, or low price and high sales) would be a mistake."
There is no general reason why that should be true, unless what you mean by "low sales" is "zero sales" and "low price" is "below marginal cost," which isn't the natural way for your nephew to interpret it. Given the right curves, the profit maximizing price might be near one extreme or the other.
The right answer to his question is "it depends," plus an explanation of what it depends on.
I stand by my answer on precisely the grounds you state -- that for any plausible demand curve and marginal cost curve, you can find a price too high or too low. If I'd had more time, I would have told him a few of the things it depends on. But this was his bedtime! I probably didn't give him the very best answer I could have in the time I had available, but I don't think I misled him in any serious way.
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