10.7 Pricing and the marketing mix*
So far we have ignored the other elements of the marketing mix in discussing pricing. Intuitively this would not appear to be sensible; if product quality is high, we would expect the price to be high, and a higher price might necessitate more spending on advertising and distribution. Thus we would generally expect there to be some interaction between the marketing mix variables. This interaction now needs to be examined.
10.7.1 An approach to marketing mix optimization
Let us assume that a firm has a marketing mix demand function of the following general form:
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This is essentially (3.15) repeated. The firm’s cost function can be expressed as follows:
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where unit production cost c¼g(Q, L), meaning that unit cost is a function of output and product quality; A and D are discretionary costs of advertising (or promotion) and distribution, and F is a non-discretionary fixed cost. The profit function can now be expressed as follows:
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This clumsy-looking expression shows how much profit depends on all the different aspects of the marketing mix; both revenues and costs are affected by the levels of the marketing mix variables.
The necessary condition for finding the levels of these variables which optimize the marketing mix is obtained by partially differentiating the profit function with respect to each of the variables and setting the partial derivatives equal to zero:
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The mathematics involved in solving these equations is omitted for the sake of brevity, but can be found in an advanced marketing text, such as that by Kotler 9 The resulting conditions for optimization can be expressed in terms of the different elasticities, as follows:
This is one form of the Dorfman–Steiner theorem,10 and it shows the relation-ships in optimality between the elasticities of the various marketing mix instruments. However, because the functions are only stated in general terms, the theorem does not directly give the optimal values of the variables. In order to see this more clearly we must be more specific regarding the form of the
demand and cost functions, and this is the subject of the next subsection. We will then be able to see how an optimal ratio of advertising to sales revenue can be derived in terms of the ratio of the price and advertising elasticities (10.39).
In the following models, only three marketing mix instruments are considered: price, advertising and distribution. Product quality is omitted because its measurement is more complex, and in practice it is often estimated as a function of unit cost, as discussed in Chapter 3. Thus the concept "L in (10.31)
relating to product quality elasticity can be understood as referring to the percentage change in demand caused by a 1 per cent change in quality, as measured in terms of unit cost.