The optimal price is a function of only two variables:
- Price-Sensitivity: The rate at which customers leave as price is raised. This is elaborated below.
- Marginal Cost: The cost paid by the firm to deliver the additional item to the customer. This can usually be calculated by carefully tabulating costs. This should typically include:
- Cost of Goods sold
- shipping and handling: Shipping should include the costs of raw materials such as packaging, postage, and the cost of time to package goods.
- Taxes: This must include the sales tax and any tariffs.
Notice that the fixed costs don’t enter the calculation of the optimal price because it doesn’t change with price or quantity.
The figure shows a case of underpricing. When price is raised, the green shaded region of profit gained from price increase is larger for the existing customer base than the blue shaded region of profit sacrificed per lost customer.
The converse is true in a case of overpricing. When price is lowered, a larger gain is realized from increasing customer base than the reduction in profit from the existing customer base.
At the optimal price, the profit sacrificed matches the profit gained for small price and volume changes.