Pricing with Limited Knowledge of Demand
35 Pages Posted: 15 Oct 2015 Last revised: 14 Oct 2018
Date Written: October 12, 2015
We propose a simple and practical pricing rule for new products where demand information is limited. This research confirms the strength of the widely-used linear demand model. The pricing rule we propose is simple: Set the price as though the demand curve were linear. Our pricing rule relies on the maximum price the firm can charge and still expect to sell some units. The firm need not plan in advance the quantity it will sell. Furthermore, we assume that the marginal cost is known and constant. We show that if the true demand curve is one of many commonly-used demand functions, or even a more complex (randomly generated) function, the firm can expect its profit earned by our pricing rule to be close to what it would earn if it knew the true demand curve. We derive analytical performance bounds for a variety of demand functions, calculate expected profit performance for randomly generated demand curves, and evaluate the welfare implications of our pricing rule. We show that with very limited demand information (maximum price and marginal cost), our simple pricing rule can be used for new products while often achieving a performance not far from optimal. We also discuss the limitations of our method by identifying cases where our pricing rule does not perform well.
Keywords: Pricing, new products, unknown demand, pricing heuristics, linear demand approximation
JEL Classification: D80, D40, D81
Suggested Citation: Suggested Citation