Pricing methods:

(10 marks)

Today the management (of the firms) has more objectives than one (profit maximization). Hence different pricing methods are adopted. They are: a. Cost oriented pricing b. Competition oriented pricing c. Pricing based on other economic considerations Cost oriented pricing: Most firms prefer this method because: a. It is easy to calculate b. It is very satisfactory as it takes care of uncertainties and ignorance c. It is scientific and there is no doubt in this method The marginal cost pricing (Direct cost pricing): This method implies that the price of the product is based on the incremental cost of production unlike the full cost pricing which is based on average cost, the incremental or marginal cost pricing is based on the variable cost only (The difference between the two being fixed cost only). While the full cost pricing is a long period phenomenon, the incremental cost pricing is a short period phenomenon. This method allows a firm to develop a far more aggressive pricing policy than does the full cost pricing. This method does not provide a long period stable pricing policy. Many people are not even aware of marginal cost pricing methods. When is the marginal cost pricing method used? a. When the firm wants to introduce its products into the new markets b. When a firm faces stiff competition or when it has unutilized capacity When a firm equates MC with MR at that level of output it maximizes its profits. An additional unit produced over and above this may increase the cost hence profit maximization is affected. Today firms have better objectives than profit maximization. It is sales promotion, maximization of growth etc. Long term survival and growth is the aim of the firms. So the MC pricing has become outdated. Average Cost or Full cost pricing: This principle is used by a large number of firms both small and large. According to Hall and Hitch, the firms usually oligopolistic in nature did not use the marginal rule i.e. MC = MR to determine the price. So these firms did not attempt to maximize their profits. Firms aim at long run profit maximization. Firms determine their price by applying the full cost principle. The full cost principle suggests that firms set a price to cover the average variable cost, the average fixed cost and normal profit margin (NPM) P = AVC + AFC + NPM Why was the marginalist principle abandoned? According to Hall and Hitch, the firms in practice never know their demand curve. They also do not know their marginal costs. So due to lack of relevant information, the firms find it difficult to follow the marginalist principle.

The firms believed that the full cost principle is the appropriate price since it included the full cost (AVC + AFC) and also a margin of profit say 10% or 20%. The real business world is very complex. There are always too many factors which determine cost and demand. Uncertainty makes it difficult for the firms to have accurate information about the future demand and cost conditions. So it is reasonable to charge a price which recovers the full cost inclusive of a margin of profit. Even in the long run due to continuous change in the economic environment, demand cannot be estimated accurately. Full cost pricing at least ensures a fair amount of profit to the firm. Merits of full cost pricing: It normally leads to price stability. Since frequent price changes can be counterproductive as it may provoke undesirable reactions from the rival firms. It is a rather simple and easy to use method since much less information is needed in comparison to the marginalist method. This principle provides a legitimate reason for price increases. A firm can increase its price pointing to an increase in the cost of production. Price/Cost D A P AC

D1 O Q Output

OA price is fixed on the full cost principle. Limitations of full cost principle: It ignores consumers preferences and demand It ignores the effects of competition In case of wide fluctuations in the variables costs, such pricing is difficult This method cannot be used in industries producing perishable goods This leads to overpricing under decreasing cost and under pricing under increasing cost conditions.

Price discrimination: A monopolist who adopts the policy of discrimination is called a discriminating monopoly. This implies the act of selling the output of the same product at different prices in different markets to different

people. Price discrimination can be on the basis of time, age, sex, quality, location, use, nature of the commodity, size etc. A monopoly producer tries to sell his commodity in different sub markets at different prices depending on the demand elasticities. A monopolist divides the total market into two or more submarkets. Each submarket assumes a separate identity. The consumers have no inclination to move from one submarket to another. There is no resale possible because the distance between the two sub markets is quite considerable. One of the main conditions for price discrimination to succeed in each market has different elasticities. So a market with inelastic demand quotes a higher price and a market with more elastic demand quotes a lower price. Whatever is the loss to the producer due to low prices in a sub market is compensated by the gain the other sub market. Dumping: It is a special case of price discrimination. This happens when a monopolist charges high prices in the home market (in his capacity as a monopolist) and a lower price in the world market in his capacity as a competitor. He practices price discrimination policy between the markets of his own country and the markets of a foreign country. Why dumping: A monopolist may resort to dumping to dispose off the surplus stock of the commodity which he has produced or to develop new trade connections or to eliminate the competitors from the foreign market or even to reap the benefits of large scale production. The following diagram explains dumping:

Price

MC

PH

PW

ARW = MRW

MRH

ARH

Q1

Output

The total output sold is OQ1 out of which OQ is sold at home at a high price of OP. the monopolist at home sells less quantity (OQ) while he sells more qty QQ1 at a less price outside home. A monopolist sells a commodity in a foreign country (faces cut throat competition) at a price which is less than the marginal cost.

Dumping can be persistent where at home he charges more and in a foreign land less price or it can be predatory where the seller will initially charge a lesser price to cut down his rivals and then once he gets established he will charge a higher price or it can be sporadic where due to wrong estimation fo demand he might have produced more and so will like to dispose off the excess quantity at a lower price. Any how he charges a price which is less than MC. This is dumping. Transfer pricing: It refers to the valuation of the intermediate goods within the firm. Transfer prices are internal prices at which intermediate goods from upstream division are sold to downstream divisions. A firm is vertically integrated when it contains several divisions. Some divisions produce the components which the other divisions use to produce the final product. For eg: each of the major automobile companies in different countries has upstream divisions that produce engine brakes radiators and other components etc that the downstream divisions use for producing motor vehicles which is the finished product. The components used to make the motor car are called intermediate goods. These are the inputs needed to make a car. In a vertically integrated firm an inappropriate price set for an intermediate good can affect the overall profit of the firm. There are guidelines for determining transfer prices. For eg: let us assume that there are only two stages of production. In the first, the cotton cloth is manufactured as an intermediate product. In the other, cloth is used for manufacturing shirts which are sold to consumers. If an external market exists for cloth, then the division selling cloth can sell its output to buyers outside the firm and the division requiring cloth to make the shirts has outside sources of supply. Let us assume in the second case that there does not exist an external market. In this case, cloth can be bought and sold only between the two divisions of the firm. In the first case there is a market determined price but not in the latter. In the external market there is perfect competition. So the firm has no role in determining the price of the cloth. So the cloth manufacturing division like any other competitive firm faces a horizontal demand curve at the market determined price. So they will expand production. So as to maximize profit upto the point where price AR equals marginal cost. When MC = MR (at pt E), the firm will produce OQ qty of output at price OP where P = MC. Price/cost per unit MC

AR = MR

Output

If the cloth making unit tries to set a price in excess of the market price, the shirt making division would purchase cloth from outside suppliers. If there is an excess supply of cloth it can be sold to other users of cloth in the open market due to the existence of an external market. It there is no external market and if the divisions are not allowed to trade with other firms, a conflict will develop regarding the price to be charged for the cloth by the cloth manufacturing division. The cloth manufacturing division would like to fix a higher price while the shirt making division will benefit from a lower price. The vertically integrated firm will like to determine such a transfer price for cloth that maximizes the overall profit of the firm. Administered prices: In a free enterprise or market economy, prices are determined by market forces viz demand and supply. Govt does not interfere in price determination. In modern economies, prices are regulated or controlled and sometimes even fixed by the government. This is also due to the ownership of different enterprises passing into the hands of the government. The price fixed by the government is called the administered price. So they have legal sanction while the govt fixes the price, the equality between MC and MR is not relied upon. The government considers the AC plus a margin of profit while fixing the price. The purpose is to control the price of essential goods like fertilizers, cement, steel, coal etc. The objectives for the government are: a. Free market price may not do justice to the customer especially with regard to poor or relatively poor sections of the community. Such administered prices ensure stability in prices. b. Sometimes it is desirable to increase the price of certain goods to reduce their consumption. Govt of India has been increasing the price of petroleum products from time to time since 1974. c. Now-a-days it is also used as a tool to raise revenue. So prices of goods and services supplied by the public enterprises are raised from time to time to mobilize resources. d. They are imposed to achieve some egalitarian (larger benefit to larger sections of the society) goals. It may supply such goods at subsidized prices or at prices which cover the cost of production only. This will encourage the people to consume such goods. For eg: supply of milk at subsidized prices by the Maharashtra government. Problems faced in fixing administered prices: These prices control only specific goods and services leaving bulk of commodities outside the purview of administered prices. So there are lots of problems arising due to this. i. ii. iii. iv. The authorities have to decide the specific commodities whose prices are to be fixed by the government. Administered prices include the cost of production plus a margin of profit. So it is necessary to determine the cost first. It is very difficult to compare the cost of production If we talk about the average cost, the problem is whose average cost of production to be taken. Whether it is the cost of a small or medium or a large business. The price fixed by the government may not sometimes be just to the producers. Usually the government fixes a low price which reduces the profit margin of the producers.

So care should be taken while fixing the price to include the cost of inputs supplied by the firms also.

A good majority of industries that are subject to administered prices are found ultimately turning into sick units. Such industries do not attract fresh investments so their growth is disturbed. Dual pricing: A market where a commodity is covered simultaneously under the administered price as well as market price is called dual pricing. A part of the firms product is subjected to administered prices while the rest of the output is sold in the free market. Administered prices are fixed by the government. Generally the administered price is lower than what would have prevailed in the free market. So there are two separate demand and supply curves for the product. An example of dual pricing in India has been sugar. A major portion of the production of sugar reaches the public through public distribution system (PDS). The purpose of introducing dual pricing is that the essential goods should reach the poorer and weaker sections of the society. The major problem in this method of pricing is the possibility of misuse. Some economically weaker sections buy the commodities (say sugar) at lower price under the PDS and sell it to others at a higher price. This happens in chemical fertilizers also. This defeats the very purpose of the government selling it at a lower price in the ration shops. Customary pricing: Incase of some commodities the prices get fixed because they have prevailed over a long period of time. Any change in costs of such products gets reflected in quality and quantity of the product rather than its price. For eg: the price of a cup of tea or coffee in the market is customarily fixed. Changes in cost of production lead to either quality change or smaller quantity per cup. It is only when costs change quite significantly that the customary prices change. It must be noted that if a new firm enters the market and has lower costs than the existing firms, still it may sell at the customary price as any reduction in price of the new entrant will trigger off a price war which no firm will like to enter into. Cyclical pricing: There are considerations other than market structure that operate to influence the pricing decisions viz seasonal and cyclical fluctuations in economic activity. While the seasonal factors operate on short term basis, upto a year, the cyclical fluctuations influence the economic activity for a longer time. When the pricing of a firm is based on the assessment of general economic environment, it is known as cyclical pricing. When ther eis depression in the market, the firm has to reduce the price to continue in the market in a condition of boom, the firm will be foolish to not take the benefit of rising prices in the market. So even if the cost of production remains unchanged, the firm has to make these adjustments. Imitative pricing and suggested prices: This is used in retail business under oligopoly where the firms follow a price leader. But in non oligopoly situation also it is considered very beneficial to imitate the price set by other firms. So decision making becomes quite easy because the firm need not take the cost demand analysis.

Suggested price is one that the manufacturer or the wholesaler has found feasible given the market conditions. It suggests to the retailer to change this price from the customers. So the management of the retail trade from undertaking its own individual analysis of the market and cost conditions. This enables many managements to devote their spare time for other purposes. However this method protects the retailer from an unfair competition from the larger ones. Zone pricing: Many a times a seller instead of charging a uniform price throughout the country divides the economy into several zones. Within a zone there is a uniform price but between the zones prices differ. Skimming price: There are a variety of other pricing strategies adopted by the firms, depending on market conditions and the image the firm wishes to project for its product. In the skimming price method, the initial price will be high, it may be continued along with the promotional expenditure for different periods of time. In the earlier stages the product has less competitors thus it commands a better price. This policy aims at skimming the cream by taking advantage of the target segments willingness to pay a high price. The preconditions for introducing skimming prices are: A sufficiently large segment whose demand is relatively inelastic and not sensitive to a high price. High price unlikely to attract competition Unit cost unlikely to be affected by small volume, high ration of variable to fixed costs.

The advantage of such a policy is that it enhances the quality image thereby providing the needed adjustment if the initial price is too high. The skimming price may cover the heavy costs of introducing a new product. After sometime the benefits of falling prices can be passed on to the customers. For eg: penicillin was introduced at a high initial price. Now it is reasonably priced. Same is the case with electronic items like computers, calculators, TV sets etc. Penetration price: This refers to the initial price of the new product. It believes that if the initial price is properly set it can be successful in expanding markets. When competition develops, the firm has to make only minor adjustments. The policy or strategy involved is to charge a low price. So as to stimulate demand for the product of the firm and capture a large share of the market. A low penetration price creates a barrier to the entry of new firms. Stay out pricing: When a firm is not certain about the price at which it will be able to sell its products it starts with a very high price. If at the high price quotation it is not able to sell, it then lowers the price of its products. It will keep on lowering the price till it is able to sell the targeted amount of the product. This approach helps the firm to ascertain the maximum possible price it can charge from its customers. Price lining:

Prices of one product in the total range of products is fixed. Prices of the rest of the commodities is automatically determined by the relationship between the commodity whose price has been fixed and the rest of the commodities in the range. For eg: if a firm producing shirts fixes up the price of one particular size of shirt and the prices for the rest of the shirt sizes is fixed automatically on the absis of the differences in their sizes. This is also a method of price tagging. A firm fixes the price of its product in a manner which gives the impression of being low. For eg: if the price of a particular product is fixed at Rs 89.90/- rather than Rs 90/- it will have the psychological impact on the consumers that the prices are in the range of Rs 80/- and not Rs 90/- and above. The shoe companies have been following this policy with some success. Sometimes they round their prices to the next higher amount to keep their accounts intact.

Super normal versus normal profits: Profit in the ordinary sense is the excess of a firms earning over and above its cost. P=RC where P = profit, C = total cost, R = total revenue. Here cost includes both implicit and explicit costs. Normal profits: it refers to that amount of earning which is just sufficient to induce the firm to stay in the industry. Normal profit is thus the minimum reasonable level of profit which the entrepreneur must get in the long run. If he fails to get this he will quit the industry and shift his resources elsewhere. It is the least possible reward which should be earned in the long run as compensation for the organizational services as well as for bearing the insurable risks of business. Incidentally when R = C, it is believed that there is no profit in the economic sense. Short run under perf comp Price SMC SAC Price Long run under perf comp LMC LAC

P P E2 AR = MR

E3 AR = MR

Q2

output

output

When the firm is in equilibrium at E2, the firms Mc = MR = AC = AR. So the firm earns normal profit. But under perfect competition in the short run some firms may earn super normal profits also while some may incur losses too. So the industry is in an unstable equilibrium in the short run under perfect competition. But in the long run all the firms earn only normal profits due to free entry and exit. This is the full equilibrium where P = AR = AC = MR = MC in the long run E3 is the equilibrium point. However in the short run, under perfect competition, some firms do earn super normal profits. At this point MC = MR but AR > AC i.e. when P > AC there is super normal profit. MC AC P S Q R AR > AC AR= MR

AR = QM. AC = RM. The difference is profit per unit. Profit per unit * OM qty = super normal profit Fixed versus variable costs: While engaging in productive activity, the producer always has to incur some expenditure which remains fixed whatever be the level of output. So much so that even if the producer stops production altogether these costs have to be incurred. For eg: interest paid by the producer on the capital borrowed for purchasing the plant and machinery rent of the factory building, depreciation of the machinery etc. As the producer produces more and more these fixed costs get spread over the units. So the per unit fixed cost (AFC) falls. So fixed costs are those costs that do not vary with the output. Therefore even if the output is zero these fixed costs have to be borne by the producer. This is because the firm has to honour its commitments for payments such as wages/ salaries to permanent staff, property tax , building depreciation etc. They are referred to as overhead costs or supplementary costs. These are also the unavoidable costs. Variable costs on the contrary vary with the level of output. They vary directly with the output. This varies as output increases and falls when less is produced when the output is zero, variable cost is also zero. These costs include the cost of raw materials, labour costs etc. According to Prof Samuelson, variable costs represent all items of total cost except the fixed costs. These are referred to as prime costs. The short run variable costs include fuel and power charges, transport expenditure, prices of raw materials, sales tax, excise duties etc. to give an example:

This can be shown in a diagram also as follows: TC Cost TVC

TFC

Output

However this distinction between the prime and supplementary costs is not always significant. In the long run all factors become variable so all costs are variable as well. In the long run, all factors of production become adjustable. In the short run, this distinction is very significant because it influences the average cost behavior of the product of the firm. Moreover it is a necessity that in the short run a firm should cover its variable costs atleast if it has to continue in business. This will minimize the losses.