Pricing Done Right

Appendix A Economic Origins of Competitive Advantage

As a simple first-principles thought experiment proves, economic profits derive from widening the gap between the benefits customers receive and the costs the firm incurs over the firm's competitors.

To demonstrate, consider a simple one-product firm serving a simple market and identify the economically optimized price for that firm.

Recall the standard form of the firm's profit equation:

where π stands for the firm's profit, Q stands for the quantity sold, P stands for the price of the product, Vc stands for the variable costs to make the product, and Fc stands for the firm's fixed costs.

According to standard calculus, the profit function for normal products is maximized where the first derivative of the profit with respect to price equals zero. In examining the profit equation of the firm, we see that a price change affects the firm's profit directly through the variable P. We can also expect that a price change influences the quantity sold and so indirectly affects the firm's profit through the variable Q. As for Fc and Vc, fixed and variable costs are constants with respect to a pure price change.

Taking the first derivative of the firm's profit equation with respect to price, and setting this equal to 0 yields

The derivative ...