AP® Business with Personal Finance review sheet from Aim for Five (aimforfive.com/business-finance/units/2/2-5)
Unit 2 · Topic 2.5
2.5 Price
Price is the only one of the four Ps that brings money in. This topic covers four pricing strategies, why some businesses can raise prices and others can't (pricing power), and the laws that limit how businesses set prices.
Key terms
- pricing strategy
- value-based pricing
- cost-based pricing
- penetration pricing
- pricing power
- price elasticity of demand
Price must beat per-unit cost
A pricing strategy is a business's method for deciding what to charge. Price matters because it affects how many customers come and stay, and how much revenue and profit the business earns.
Start with per-unit cost, what it costs to make and deliver one unit. Per-unit profit = price − per-unit cost. A low price can win market share, but if the price is at or below per-unit cost, each sale earns nothing or loses money.
Four pricing strategies
With competitive pricing, a business that thinks its product is clearly better may charge more than rivals. One whose product is about the same may price at or below rivals to win market share, accepting a smaller profit on each unit.
| Strategy | How the price is set | Who tends to use it |
|---|---|---|
| Value-based | What customers believe the product is worth | Businesses with very different or unique products |
| Competitive | Based on rivals' prices (price matching), a premium above them, or a price at or below them | Businesses in crowded markets |
| Cost-based | Per-unit cost plus the desired profit per unit | Businesses with clear costs they can explain, like construction contractors |
| Penetration | Start low, maybe even below cost, and raise the price later | New entrants trying to pull price-sensitive customers from rivals fast |
Pricing power
Pricing power is the ability to raise prices without losing market share. Businesses in highly competitive markets with similar products have little; they may be forced to keep prices as low as possible. Businesses in less competitive markets, or with very differentiated products, have more and can use more profitable strategies.
Pricing power also depends on how strongly customers react to price changes, which economists measure as price elasticity of demand. When demand is elastic (customers are very responsive), a price increase can make sales fall so much that revenue drops. A price cut might raise sales, but not always enough to make up for the lower price. When demand is inelastic (customers barely react), a business can raise prices more easily.
You need the idea of elasticity, but you won't be asked to calculate it on this exam. That's AP Microeconomics.
Legal limits on pricing
- Price fixing: rivals agreeing on a price, usually to keep it higher than competition would. It's illegal in the U.S. and many other countries.
- Price gouging: raising prices sharply on a product that people suddenly need during a crisis, like bottled water after a hurricane. It's illegal in many U.S. states and countries.
- Price discrimination: charging different customer groups different prices for the same product. It's illegal when based on race, nationality, sex or another protected status. (Student discounts are generally legal, because being a student isn't a protected status.)
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
Cost-based price
A carpenter's per-unit cost to build a bookshelf is $18 in wood and hardware plus $42 in labor. She wants a $25 profit on each. What price does cost-based pricing give?
Show the solutionHide the solution
- Step 1: Per-unit cost = $18 + $42 = $60.
- Step 2: Price = per-unit cost + desired per-unit profit = $60 + $25 = $85.
Answer: $85 per bookshelf.
- Example 2Calculator allowed
When a price increase lowers revenue but raises profit
A company sells 1,000 phone stands a month at $20. Per-unit cost is $12. It raises the price to $24 and sales fall to 750. Find revenue and profit before and after. Did the price increase help?
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- Step 1: Revenue = price × quantity. Before: $20 × 1,000 = $20,000. After: $24 × 750 = $18,000. Revenue fell by $2,000, so these customers are fairly responsive to price.
- Step 2: Profit = (price − per-unit cost) × quantity. Before: ($20 − $12) × 1,000 = $8,000. After: ($24 − $12) × 750 = $9,000.
- Step 3: The trap: lower revenue doesn't always mean lower profit. Selling 250 fewer units also cut costs by 250 × $12 = $3,000, which more than covered the $2,000 drop in revenue.
Answer: Revenue fell from $20,000 to $18,000, but profit rose from $8,000 to $9,000. The increase helped profit, though it lost customers and market share, which could hurt later.
Common mistakes
- Confusing revenue and profit. Revenue is price × quantity; profit subtracts costs.
- Thinking price discrimination is always illegal. It's illegal when based on protected traits like race or sex.
- Describing penetration pricing as permanently low prices. The plan is to raise the price once market share is won.
On the exam
- Expect to calculate per-unit profit, revenue or profit at different prices, and to say which pricing strategy a business is using from a description.
- When you explain pricing power, mention competition, differentiation and how responsive customers are to price. Don't calculate elasticity.
Connected topics
Videos
Check yourself: 2.5 Price
4 questions on 2.5 Price. Pick an answer to see if you got it, and why.
Four businesses describe how they set prices.
Deck builder: "I add up the materials and labor for each deck and then add $2,000 for my profit."
New streaming service: "We charge $2 a month for the first year. Once we have lots of subscribers, we'll raise it."
Gas station: "Every morning I check the three stations on my corner and match the lowest price."
Portrait artist: "I price each custom painting based on what it's worth to the client, not what it costs me."
Hypothetical business descriptions
The deck builder uses which pricing strategy?
The streaming service is using penetration pricing mainly to
Which pairing correctly identifies the strategies of the gas station and the portrait artist?
During a hurricane, the gas station triples its price for bottled water. In many states, this practice is
0 of 4 answered