Solved Business Cases
The following is an excerpt from one of our solutions, each of which is in dialog format between a client / executive and a consultant / strategist. Some familiarity with basic economics is assumed to comprehend the matter below...
Excerpt begins ...
Client: Interesting. You introduced two concepts, which are related to each other. Let us go slowly. Can you explain how Dell can gain customers by charging a price below the price point where marginal revenue equals marginal cost? We can take up the idea of new product introductions later, once we are clear on this. In fact, why don't you draw how Dell's marginal revenue and marginal cost curves look like, and what the price points currently are, and what you recommend that Dell do?
Consultant: Yes. it can be argued that Dell enjoys some market power, however feeble, because of the "Dell" brand. Also, as I mentioned earlier, with advertising similar to HP's "Compaq" brand advertising, it is reasonable to assume that Dell's market power by virtue of an increasingly recognizable "Dell" brand will only increase over time, over the next few years. So, I would like to start by drawing a downward sloping demand curve which Dell faces. This curve is almost horizontal, since prices are fairly elastic. However, unlike perfect competition where a firm faces an infinitely elastic demand curve which is horizontal, here the demand curve is downward sloping, which signfies Dell's market power, however feeble.
Can I proceed with this reasonable hypothesis about Dell's market power in the highly elastic consumer market segment in Asia Pacific - Japan?
Client: Yes, you may.
Consultant: Now, let me draw out the Marginal Revenue (MR) and Marginal Cost (MC) curves as shown below.
As per the normal formula for price maximization or MR = MC, the two curves intersect at Q0, and from the demand curve, the corresponding price is P0. So, P0 is the price that Dell should be charging to maximize profit, as per MR = MC.
However, if Dell charges price P0, consumers who would buy the same good at P1 will be out of the market, since the market price P0 is higher than their reservation price of P1. So, in effect, these potential customers will be locked out of the market, if P0 is the only price charged to customers. P1, as a price point, is still higher than the corresponding marginal cost point, though. So, selling to these customers at P1 will still earn Dell a profit, and this profit will not be available if the simple profit maximization formula of MR = MC is always used.
Client: So, you are suggesting that the same desktop / laptop which is sold to a few customers at P0 should be sold to others at P1, so that the P1 level customers enjoy a little consumer surplus?
Consultant: Yes, and I understand that you can't charge different prices for the same product. That is why I mentioned introducing new products with some software pruned, for example, which we can take up next. Other options like offering discount coupons, mail-in-rebates will also help attract customers who are at the cusp of reservation. Similarly, customers who are sitting at P2 and P3 price points as per the demand curve above should be charged these differentiated prices as well, if Dell wants higher-profits. I mentioned this concept of charging higher for higher value-added services for the corporate segment a little earlier. The same can be explored for the consumer segment as well.