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Pricing Methods

Pricing Methods

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Published by: yasheshgaglani on Oct 06, 2011
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Pricing methods: (10 marks)
Today the management (of the firms) has more objectives than one (profit maximization). Hencedifferent pricing methods are adopted. They are:a.
Cost oriented pricingb.
Competition oriented pricingc.
Pricing based on other economic considerationsCost oriented pricing: Most firms prefer this method because:a.
It is easy to calculateb.
It is very satisfactory as it takes care of uncertainties and ignorancec.
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 unlikethe full cost pricing which is based on average cost, the incremental or marginal cost pricing is basedon the variable cost only (The difference between the two being fixed cost only). While the full costpricing 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 costpricing.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 marketsb.
When a firm faces stiff competition or when it has unutilized capacityWhen a firm equates MC with MR at that level of output it maximizes its profits. An additional unitproduced over and above this may increase the cost hence profit maximization is affected. Todayfirms have better objectives than profit maximization. It is sales promotion, maximization of growthetc. 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 So the MC pricing has become outdated.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, thefirms 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 thatfirms set a price to cover the average variable cost, the average fixed cost and normal profit margin(NPM)P = AVC + AFC + NPMWhy was the marginalist principle abandoned?According to Hall and Hitch, the firms in practice never know their demand curve. They also do notknow their marginal costs. So due to lack of relevant information, the firms find it difficult to followthe 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 anddemand.Uncertainty makes it difficult for the firms to have accurate information about the future demand andcost conditions. So it is reasonable to charge a price which recovers the full cost inclusive of a marginof profit.Even in the long run due to continuous change in the economic environment, demand cannot beestimated 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 asit may provoke undesirable reactions from the rival firms.
It is a rather simple and easy to use method since much less information is needed incomparison to the marginalist method.
This principle provides a legitimate reason for price increases. A firm can increase its pricepointing to an increase in the cost of production.Price/CostDA P ACD1O Q OutputOA price is fixed on the full cost principle.
Limitations of full cost principle:
It ignores consumer’s 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 costconditions.
Price discrimination:
A monopolist who adopts the policy of discrimination is called a discriminating monopoly. This impliesthe 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 thecommodity, size etc.A monopoly producer tries to sell his commodity in different sub markets at different prices dependingon the demand elasticities. A monopolist divides the total market into two or more submarkets. Eachsubmarket assumes a separate identity. The consumers have no inclination to move from onesubmarket to another. There is no resale possible because the distance between the two sub marketsis quite considerable. One of the main conditions for price discrimination to succeed in each markethas different elasticities. So a market with inelastic demand quotes a higher price and a market withmore elastic demand quotes a lower price. Whatever is the loss to the producer due to low prices in asub market is compensated by the gain the other sub market.
It is a special case of price discrimination. This happens when a monopolist charges high prices in thehome market (in his capacity as a monopolist) and a lower price in the world market in his capacity asa competitor. He practices price discrimination policy between the markets of his own country and themarkets of a foreign country.Why dumping: A monopolist may resort to dumping to dispose off the surplus stock of the commoditywhich he has produced or to develop new trade connections or to eliminate the competitors from theforeign market or even to reap the benefits of large scale production.The following diagram explains dumping:Price MCPHPW ARW = MRWMRH ARHQ Q1 OutputThe total output sold is OQ1 out of which OQ is sold at home at a high price of OP. the monopolist athome sells less quantity (OQ) while he sells more qty QQ1 at a less price outside home. A monopolistsells a commodity in a foreign country (faces cut throat competition) at a price which is less than themarginal cost.

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