Why Do Companies Offer ‘Buy One, Free One’ Offers?

Jackie Phoong Kah Wai (0312734) - Section 9 - Second Article

Why Do Companies Offer 'Buy One, Free One' Offers?

            Based on the article ‘Buy one free one- A price experiment?’ in Economics for Business by Fraser I. and Mc.Graw, I have decided to write on how big companies price their products based on the price elasticity of demand for their product.

Credits to Veley, Bradford.

            How does a firm indicate a pricing plan that offers the best price in the interest of achieving the firm’s objectives and what are the factors that are involved in this decision making? A firm can maximize the amount of profit made, maximize the market share for the firm’s product or maximize the firm’s total revenue. These objectives cannot be achieved simultaneously as there is often a trade off. For example, a firm may wants to maximize market share for a product by attracting a larger customer base by reducing the price of the product. The firm could be sacrificing profit by lowering its price. Therefore, we would assume that the best price is achieved when the firm meets its preferred objective.

Simple diagram of equilibrium price determination.

            How exactly is the price determined? We often use demand and supply curves to determine the equilibrium price which is the point at which both the curves meet. Is the equilibrium price the best price in the interest of the firm and consumers? Many may think that equilibrium price is the price that both parties agree on but then the equilibrium price is not often the best price if the objective of the firm is not achieved. 

            When a national supermarket is selling wide range of products from household items to beverages, a small change in price can generate huge changes in total revenue. Firms are expected to price items relative to their cost structures. If a firm wished to make profit, then the price must certainly be greater than the costs. If the firm is optimizing for market shares which is to increase quantity sold in the market, then the price set cannot fall below the cost of making product or a loss is incurred.

            To understand consumer behavior, a demand curve is used to represent the quantity demanded by the market force. According to the law of demand, the higher the price of the product, the lesser is the quantity demanded while everything remains unchanged (ceterus paribus). On the other hand, while price falls, ceteris paribus, the quantity of the product demanded by consumers will increase. 

            This negative relationship between price and quantity demanded is often a key factor in price determination. Why do firms use offer such as ‘buy one get one free’? They do so as they are reluctant to reduce the price of their product. Reducing price of a product will likely to induce a retaliatory price war from rivals thus making the market more and more competitive and loss may incurred for all firms in the market itself. As society is more materialistic and brand-aware, lower prices may be a signal to the market that the product is of inferior quality. A ‘buy one get one free’ offer allows the price to be maintained but the effective price for consumers is halved. Under this offer, consumers are more willing to demand for the product thus boosting sales which in turn increasing market shares even if there is no profit maximization.

Relationship between price elasticity of demand and total revenue.

            Does this ‘buy one get one free’ offer always work? To clarify this, we need to be able to measure the price elasticity of the product. Price elasticity measures the response of demand to a change in price. There are three types of price elasticity which are elastic, inelastic and unit price elastic. When the price elasticity is elastic, a small change in the price will lead to a large response in the quantity demanded. The price and the quantity demanded always have a negative relationship. For inelastic price elasticity, a small change in price will result in a smaller response in quantity demanded. With unit elasticity, the portion of increase in price will be equal to the portion of decrease in quantity demanded and vice versa.

            To calculate total revenue, the price of a product is multiplied by the number of units sold. So, when should we increase or decrease the price in order to maximize revenue? When the demand is elastic, we should opt to decrease the price of the product because a small drop in price results in a large increase in quantity demanded. Even if the price of an individual good has been lowered, the total revenue increases as there is more quantity demanded. For example, we cut price of product by a 10% but there is an increase in 30% for quantity demanded, the total revenue will increase. If we were to increase price for a product that is price elastic, a slight drop in price will induce a sharp drop in quantity demanded thus lowering total revenue. On the other hand for demand inelastic product, we should increase price if we were to maximize revenue. A large increase in price will only results a small drop in quantity demanded. Although the firm loses some market shares, each product is generating higher revenue contributing to higher total revenue. When the firm decrease price of the product that is demand inelastic, a sharp decrease in price only attract a small amount of new customers thus total revenue is less than before. To put it simply, dropping prices raises total revenue if demand is inelastic while prices should be increased in order to increase total revenues if demand is inelastic. The best price occurs when price elasticity is unitary which is exactly in between the elastic and inelastic region. With unit elasticity, total revenue does not change as either increase or decrease in price will affect the total revenue as the change in quantity demanded is always proportional.

            Depending on the firm’s objective, firms may not always target price elasticity equal to 1 as they may not have revenue maximization as their objective. They may wish to maximize market shares or profits. Changing of price involves planning of new pricing plans and the communication of price changes to retailers of the product. As a result, change can be costly as a reduction in price could lead to price war from competitors. Furthermore, price elasticity of demand of a product may be wrongly interpreted thus making a wrong decision having total revenue falling. Therefore, it is important to understand fully on how to measure the elasticity of demand for a product.