Pricing strategies and practices
- 1. Pricing Strategies and practices We have seen that the firms’ objective is profit maximization. The pricing theory under this hypothesis suggest that, given the demand and cost curves, price and output are so determined that profit ids maximized, i.e. at the level of output where MR=MC. But there are firms that follow a pricing rule other than the one suggested by the marginality rules. Besides, in a complex business world, business firms follow a variety of pricing rules and methods depending on the conditions faced by them. Cost-plus Pricing Cost-plus pricing is also known as mark-up pricing, average cost pricing and full-cost pricing. The cost-plus pricing is the most common method of pricing used by manufacturing firms. The general practice under this method is to add a ‘fair’ percentage of profit margin to the average variable cost (AVC). The formula for setting the price is given as P= AVC + AVC (m) P= AVC (1+m) Where AVC= average variable cost, and m= mark-up percentage. It applies only for market structures where companies have some market power and are, therefore, able to set prices for their products. Advantages of Cost plus Pricing 1. This method is appropriate when it is difficult to forecast the future demand. 2. This method guarantees recovery of cost. Hence it is the safest method. 3. It helps to set the price easily. 4. Both single product and multi product firms can apply this method for pricing. 5. It ensures stability in pricing.
- 2. 6. If this method is adopted by all firms within the industry, the problem of price war can be avoided. 7. It is economical for decision making. Disadvantages of Cost plus Pricing 1. This method ignores the effect of demand. 2. It does not consider the forces of market and competition. 3. This method uses average costs, ignoring marginal or incremental costs. 4. This method gives too much importance for the precision of allocation of costs. Multiple Product Pricing Almost all the firms have more than one product in their line of production. Even the most specialized firms produce a commodity in multiple models, styles and size, each so much differentiated from the other that each model or size of the product may be considered a different products e.g. the various models of television, refrigerators etc produced by the same company may be treated as different product for at least pricing purpose. The various models are so differentiated that consumers view them as different products. Hence each model or product has different average revenue (AR) and Marginal Revenue curves and that one product of the firm concepts against the other product. The pricing under this condition is known as multi-product pricing or product line pricing. In multi-product pricing, each product has a separate demand curve. But, since all of them are produced under one organization by interchangeable production facilities, they have only one inseparable marginal cost curve. That is, while revenue curves, AR and MR, are separate for each product, cost curves AC and MC are inseparable. Therefore, the marginal rule of pricing cannot be applied straightaway to fix the price of each product separately. The problem, however, has been provided with a solution by E.W. Clemens. The solution is similar to the technique employed to illustrate third degree price discrimination under profit maximization assumption. As a discriminating monopoly tries to maximize its revenue in all its market, so does a multi-product firm in respect of each of its products.
- 3. A B C D Dc Dd Da Db Pd Pc Pb Pa EMR MR MRd MRb c MRa MC Cost and Revenue O Qa Qb Qc Qd Quantity demanded per time unit C To illustrate the multiple product pricing, let us suppose that a firm has four different products- A, B, C, and D in its production. The AR and MR curves for the four branded product are shown in four segments of the figure. The marginal cost for all the products taken together is shown by the curve MC, which is the factory marginal cost curve. Let us suppose that when the MRs for the individual products are horizontally summed up, the aggregate MR (not given in the figure) passes through point C on the MC curve. I f a line parallel to the X-axis, is drawn from point C to the Y-axis through the MRs, the intersecting points where MC and MRs are equal for each product, as shown by the line EMR, the Equal Marginal Revenue line. The points of intersection between EMR and MRs determine the output level and price for each product. The outputs of the four products are given as OQa of product A; QaQb of B; QbQc of C; and QcQd of D. The perspective prices for the four products are: PaQa for product A; PbQb for B; PcQc for C and PdQd for D. these price and output combinations maximizes the profit from each product and hence the overall profit of the firm.
- 4. Peak Load Pricing There are certain non storable commodities like electricity, telephone, transport and security services, etc which are demanded in varying measures during the day as well as night. For example, consumption of electricity reaches its peak in day time. It is called ‘peak-load’ time. It reaches its bottom in the night. This is called ‘off-peak’ time. Similarly, consumption of telephone services is at its peak at day time and at its bottom at night. Another example of ‘peak’ and ‘off-peak’ demand is of railways and air services. During festivals, summer holidays, ‘Pooja’ vacations, etc the demand for railway and air travel services rises to its peak. A technical feature of such products is that they cannot be stored. Therefore their production has to be increased in order to meet the ‘peak-load’ demand and reduced to ‘off-peak’ level when demand decreases. Had they been storable, the excess production in ‘off-peak’ could be stored and supplied during the ‘peak-load’ period. But this cannot be done. Besides, given the installed capacity, their production can be increased but at an increasing marginal cost (MC). Pricing of products like electricity is problematic. The nature of the problem in a short-run setting is depicted in the figure. The peak-load and off-load demand curves are shown by DP and DL curves respectively. The short-run supply curve is given by the short-run marginal cost curve, SMC. The problem is ‘how to price electricity’. If electricity price is fixed in accordance with peak-load demand, OP3 will be the price and if it is fixed according to off-load demand, price will be OP1. The problem is: what price should be fixed? If a peak-load price OP3 is charged uniformly in all seasons, it will be unfair because consumers will be charged for what they do not consume. Besides, it may affect business activities adversely. If electricity production is a public monopoly, the government may not find it advisable to charge a uniform peak-load price.
- 5. A D B E C DP DL P3 P2 P1 O Q1 Q2 Q3 Q4 Price Quantity SMC