In economics textbooks, the profit-maximizing optimum price policy depends upon the effect of the price elasticity on the marginal revenue and marginal cost. See Mansfield (1996), and Hirschey and Pappas (1996). The problem is that the relationship between the price elasticity and the marginal cost is not precisely assessed, since usually a hypothetical marginal cost curve is assumed in economics literature, e.g., a monotone increasing cost function in quantity demanded. In this paper, the order of the income statement entries is followed to evaluate how the price elasticity may affect the revenue and cost, because this procedure is actually taken in the real world to measure the profit for the stockholders.

  Additionally this paper addresses the impact of a price reduction on the (net) profit margin. The general consensus is that a low profit margin is an indication of operating inefficiency resulting from low sales, high costs,or both (Brigham, 1995; Brigham and Gapenski, 1997; and Pinches, 1996), and that a high profit margin serves the stockholders (Lazere, 1996; Sullivan, 1996; and Esquivel, 1996). However, a low profit margin is not necessarily bad for the stockholders, because, even if a reduction in price may result in a low profit margin, the net income may increase due to the increased demand for the product. The direction and magnitude of the change in profit margin also depends upon the price elasticity of the product.

  The purpose of this paper is two-fold. First, it derives the condition, under which the net income rises after a price cut, to help practitioners decide whether or not to reduce the price. Second, it identifies the condition, under which a price cut increases the profit margin, to convince the readers that a low profit margin does not always hurt the stockholders. Additionally, the optimum price cut, that maximizes stockholders’ wealth, is also shown. Numerical examples are provided to verify the results of the study.

PROFIT MAXIMIZATION VERSUS WEALTH MAXIMIZATION

  For a public corporation, the profit maximization criterion supported by economists is inappropriate as the firm’s objective, because it ignores the time value of money and the degree of risk. The kinds of risk that matters include,but are not limited to, business, financial, and operating risks. The degree of business risk depends on the line of business that the company is engaged in. For example, the business risk of an airline company is higher than that of a grocery chain. Financial risk increases as the firm uses more long-term debt, that produces fixed financial commitments. The operating risk of a firm is measured by the types of capital assets that the company uses. A labor intensive capital asset has a low operating risk; a capital intensive capital asset creates more operating risk.

  Wealth maximization is more appropriate for the stockholders of a public corporation, because both the time value of money and the degree of risk are accounted for in the efficient stock market. In this paper, however, net income maximization is chosen in place of wealth maximization for three valid reasons. First, net income, which is the measure of profit for the stockholders, is the main interest of financial practitioners as in Greenwald (1996), and Hensley (1997). Second, net income after a price reduction is easier to project, thereby providing an analytical edge and expositional conveniences. Third, net income maximization is usually consistent with wealth maximization, because the three kinds of risks mentioned earlier do not change drastically.1

PRICE ELASTICITY

  To measure how a price cut may change the quantity demanded, and consequently net income and profit margin,the price elasticity of demand of the following equation is examined in this section:

Equation 1



  where is the price elasticity, Q is the original quantity, and P is the original price. The numerator of this equation is the percentage increase in quantity; the denominator is the percentage cut in the price.