PRICES AND TARIFFS

Topic 1. PRICE CONCEPT, ESSENCE AND ROLE IN ECONOMY

1.1. Approaches of price concept in economic theory.
1.2. Price functions.
1.3. Price system and its categories.
1.4. Factors that influence the process of price formation.

Key-Terms: exchange, marketing, sale and purchase, freight, economic good, service, value, currency,
price, tariff, labor, productivity, production cost, utility, marginal utility, scarcity, demand, supply, state
regulation, competition, distribution revenue, balancing, stimulating, economic and financial leverage, price
system, sales price level.
Price is an amount of money expected, required, or given in payment for something.
Marketing consists of four key elements: the product, its promotion, its placement or distribution, and its
price.
The first three elements - product, promotion, and placement - comprise a firm’s effort to create
value in the market place.
The last element pricing differs essentially from the other three: It represents the firm’s attempt to
capture some of the value in the profit it earns.
If effective product development, promotion, and placement sow the seeds of business success,
effective pricing is the harvest.

Although effective pricing can never compensate for poor execution of the first three elements,
ineffective pricing can surely prevent those efforts from resulting in financial success.
Price is the one element of the marketing mix that produces revenue, the other elements produce
costs.
Price also communicates to the market the company’s intended value positioning of its product or
brand.
A well-designed and marketed product can command a price premium and reap big profits.
Pricing decisions are clearly complex and difficult. Holistic marketers must take into account many
factors in making pricing decisions - the company, the customers, the competition, and the marketing
environment.
Pricing decisions must be consistent with the firm’s marketing strategy and its target markets and
brand positioning.

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 1.1. Approaches of price concept in economic theory
As “creation” of goods’ exchange, prices have become a primary economic category from the
perspective of complexity and interdependence with other categories and economic processes, with global
dynamics of economic and social development of a country.
Prices can be seen everywhere, anywhere and anytime, more frequently than any other economic
terms.
Any person or economic entity has to pay or receive numerous prices every day.
Generally, price represents an amount of money that the buyer has to pay in exchange for a unit of
an economic good, the amount paid for the transfer of ownership title on goods from one person to another.
In terms of economic content, the price economic category represents the monetary expression of
value of goods and services exchanged on the market through sale.
As well, price expresses the financial relationships which are formed and developed among the
participants in goods’ and services’ trading.
A price is the quantity of payment or compensation given by one party to another in return for one
unit of goods or services. A price is influenced by production costs, supply of the desired item, and demand
for the product. A price may be determined by a monopolist or may be imposed on the firm by market
conditions.
In modern economies, prices are generally expressed in units of some form of currency. (For
commodities, they are expressed as currency per unit weight of the commodity, e.g. euros per kilogram)
Although prices could be quoted as quantities of other goods or services, this sort of barter exchange
is rarely seen. Prices are sometimes quoted in terms of vouchers such as trading stamps and air miles. In
some circumstances, cigarettes have been used as currency, for example in prisons, in times of
hyperinflation, and in some places during World War II.
In a black market economy, barter is also relatively common.
In many financial transactions, it is customary to quote prices in other ways.
The most obvious example is in pricing a loan, when the cost will be expressed as the percentage rate
of interest.
The total amount of interest payable depends upon credit risk, the loan amount and the period of the
loan.
Other examples can be found in pricing financial derivatives and other financial assets.
For instance, the price of inflation-linked government securities in several countries is quoted as the
actual price divided by a factor representing inflation since the security was issued.
"Price" sometimes refers to the quantity of payment requested by a seller of goods or services, rather
than the eventual payment amount.
This requested amount is often called the asking price or selling price, while the actual payment may
be called the transaction price or traded price.
Likewise, the bid price or buying price is the quantity of payment offered by a buyer of goods or
services, although this meaning is more common in asset or financial markets than in consumer markets.
Economic price theory asserts that in a free market economy the market price reflects interaction
between supply and demand: the price is set so as to equate the quantity being supplied and that being
demanded.
In turn these quantities are determined by the marginal utility of the asset to different buyers and to
different sellers.
Supply and demand, and hence price, may be influenced by other factors, such as government
subsidy or manipulation through industry collusion.
Understanding the complex relationship between price and value naturally asserts an incursion
into the variety of theories that explain the determinants of the goods’ and services’ value.
Starting from the content of the ideas issued according to the laws governing the process of value
obtaining, two major economic thinking currents have shaped in science: the theory of value based on labor
and theory of value based on utility.
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 The Labor Theory of Value
Early works regarding the labor theory of value (also called objective theory of value) have been
made by Xenophon and Aristotle, famous economic thinkers of ancient Greece, who defined for the first
time the use value and the exchange value of economic goods.
The first economist who concluded that the source of the goods’ value is given by the human labor
was William Petty (1623-1687).
He parts between “natural price” determined by human labor and “political price” by which he
means “market price”.
The summary of other visions of economic thinkers, proponents of the objective theory of value is
shown in the table 1.1.1.

The labor theory of value (LTV) was an early attempt by economists to explain why goods were
exchanged for certain relative prices on the market.
It suggested that the value of a commodity was determined by and could be measured objectively by
the average number of labor hours necessary to produce it.
In the labor theory of value, the amount of labor that goes into producing an economic good is the
source of that good's value. The best-known advocates of the labor theory were Adam Smith, David Ricardo,
and Karl Marx.
Since the 19th century, the labor theory of value has fallen out of favor among most mainstream
economists.

KEY TAKEAWAYS
 The labor theory of value (LTV) states that the value of economic goods derives from the amount of
labor necessary to produce them.

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  In the labor theory of value, relative prices between goods are explained by and expected to tend
toward a "natural price," which reflects the relative amount of labor that goes into producing them.
 In economics, the labor theory of value became dominant over the subjective theory of value during
the 18th to 19th centuries but was then replaced by it during the Subjectivist Revolution.
The labor theory of value suggested that two commodities will trade for the same price if they embody
the same amount of labor time, or else they will exchange at a ratio fixed by the relative differences in the
two labor times.
For instance, if it takes 10 hours to hunt a deer and 20 hours to trap a beaver, then the exchange ratio would
be two beavers for one deer.
Problems with the Labor Theory of Value
The labor theory of value leads to obvious problems theoretically and in practice.
Firstly, it is clearly possible to expend a large quantity of labor time on producing a good that ends
up having little or no value, such as mud pies or unfunny jokes. Marx's concept of socially necessary labor
time was an attempt to get around this problem.
Secondly, goods that require the same amount of labor time to produce often have widely different
market prices on a regular basis. According to the labor theory of value, this should be impossible, yet it is
an easily observed, daily norm.
Thirdly, the observed relative prices of goods fluctuate greatly over time, regardless of the amount of
labor time expended upon their production, and often do not maintain or tend toward any stable ratio (or
natural price).
Utility Theory of Value
The value-utility theory (also called the subjective theory of value) emerged as a necessity to explain
the influence of the market over prices and, in particular, of the consumers’ preferences and the utility level
assigned to economic goods.
Aristotle has contributed to the foundation of the subjective theory of value, being followed later by
Anne Robert Jacques Turgot (1727-1981), who stated that value reflects the degree of appreciation that a
human being assigns to the various objects of his desires, being determined, therefore, by subjective aspects.

Summarizing the ideas underlying the subjective theory of value, note the following:
a) If a good does not have utility, its value is equal to zero;
b) The value of economic goods is determined not only by their utility, but by their scarcity as well.
This is how some seemingly paradoxical situations regarding goods with high utility, but low
exchange value, or goods with a low utility level, but high exchange value, are explained (e.g.
diamond-water paradox);
c) The value of a good is given by the size of its marginal utility which decreases as consumption
continues.

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 1.2. Price functions
In a free-enterprise exchange economy characterized by private ownership of the means of production,
prices serve five functions:
 they are a means of transmitting information about changes in relative importance of goods and
factors of production;
 they provide an incentive to enterprises to produce those products that are valued most highly by
the market and to use methods of production that economize relatively scarce factors of production;
 they provide an incentive to owners of resources to direct them into the most highly remunerated
uses;
 they distribute output among the owners of production;
 they ration fixed supplies of goods among consumers.
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 The price of goods plays a crucial role in determining an efficient distribution of resources in a
market system.
Price acts as a signal for shortages and surpluses which help firms and consumers respond to
changing market conditions.
If a good is in shortage – price will tend to rise. Rising prices discourage demand, and encourage
firms to try and increase supply.
If a good is in surplus – price will tend to fall. Falling price encourage people to buy, and cause firms
to try and cut back on supply.
Prices help to redistribute resources from goods with little demand to goods and services which
people value more.
Adam Smith talked about ‘the invisible hand‘ of the market. This ‘invisible hand’ relies on the
fluctuation of prices to shift resources to where it is needed.
The major functions of price include:
 Distributive function: for whom to produce, where to produce. Goods and resources are limited, but
needs and wants are unlimited; so price will determine affordability and those with the buying power
will have the limited.
 Allocative function: what, when, for whom to produce.
 Signalling function: Prices signal the demand and supply situations. Shortages are reflected in high
prices, and surpluses are reflected in lower prices.
 Equilibrating function: prices facilitate matching of demand and supply therefore clearing the
market.
 Rationing function: Again a question of limited resources vs. unlimited wants.
 Transmission function: Prices transmit information to various actors in the market thus enabling
them to make informed decision on what and when to buy and sell.
 Provision of incentive: prices act as incentives/disincentives to consumers and producers.
The major functions of price include:
 Enhancing marketing efficiency and performance: correct price signals will oil the marketing
machine. However wrong signals on price will hinder smooth functioning of the market thus
resulting in poor performance.
Determining decision making with respect to the following aspects:
 Production system: what to produce, by whom, and where to produce.
 Industrial location.
 Product market areas and market boundaries.
 Arbitrage and patterns of trade (Spatial trade patterns).
 Temporal arbitrage transportation and processing. However facilitating functions are composed of
standardization, financing, risk bearing and market intelligence.
Within the economic-financial mechanism, prices also perform the following functions:
1. Measurement tool;
2. Production, sale and consumption stimulation;
3. Balancing supply and demand;
4. Distribution and redistribution of revenues;
5. Economic and financial leverage.
According to the measurement tool price function, price, first of all, measures the value of
economic goods, which may result from production costs and producers’ profits, the volume of supply and
demand, the degree of utility assigned by consumers, the correlation between quality and price parameters
assigned etc.
A true measure of value resides in the price formed within a pure competitive market, while its size
reflects both the producers’ interests represented by aggregate supply, as well as consumers’ interests
according to aggregate demand.

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 The competition expression strength requires a certain level of cost and profit to be achieved by the
economic agents, the consumers getting the possibility to purchase products and services at an optimal price.
Secondly, price acts as a measurement tool for the assessment of costs of production of goods, which
are subject to exchange.
Prices of different resources involved in the operational process are reflected in the composition of
production costs, which would be impossible to assess without the involvement of price, taking into
consideration the heterogeneity of production factors used (shape, unit of measurement, etc.).
Thirdly, the price function of the measurement tool gives price the opportunity to evaluate results of
the financial and economic activity of enterprises. When the economic agent plays the role of the buyer,
purchasing raw materials, materials, resources or when he benefits of certain services, the purchasing prices
(tariffs) affect certain indicators, such as:
- Current assets’ value;
- Current assets ratio;
- Goods and materials stocks’ value;
- Solvency ratio;
- Liquidity ratio, etc.

Increasing the price level on technical and material resources determines the immediate cost growth.
Businesses, which are unable to pay suppliers for the resources, have to resort to credit.
Therefore, the list of indicators named above should be completed with net working capital, financial
autonomy ratio, rate of overall indebtedness, etc.
As the seller of final good, when setting the price, the economic agent is expecting the costs recoup
and achievement of a profit appropriate to efforts made and risk taken.
The sales volume, rate of return and other indicators characterizing economic and financial
performances of the enterprise depend on the decisions taken at this stage.
At the macroeconomic level, through this function price serves as the calculus basis for the
estimation of quantitative and qualitative indicators, such as GDP, GNP, NI, investments’ volume, the
volume of production, profitability, labor productivity, return on funds employed, etc.
The production, sale and consumption stimulation function imposes the value creation process
directioning towards a more rational and complete usage of resources.
Price stimulates production through the level of costs, profit, profitability level etc.. As a result,
encouraging, redirecting or surcease of certain activities takes place.
In the same vein, consumers, regardless of the nature of existence, the organizational form and
ownership, face the necessity to take purchasing decisions.
Depending on certain conditions they do or do not accept the supply price, influencing, in such a
way, the dynamics of the sales volumes and of other outcome indicators.

Balancing supply and demand function reveals the link between production and consumption, a
link that can exist only by means of price. In case of appearance of disproportions in economic development,
the first alert is given by prices.
Within an administrative control system, this function was completely carried out by the state which
named the quantities supplied, demanded, as well as the price level that should be exercised.
Within a free economy, price limits or stops the production for which there is no demand, and
encourages the supplies of goods characterized by high degree of utility.

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 The following function highlights prices’ participation within the processes of income distribution
and redistribution.
At the production stage, the distribution function is manifested by the transfer of the value of raw
materials, materials, and all resources used onto the final good.
This mechanism represents the cost of production determination, and, by means of the profit
included in the price, primary revenues are formed.

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 At the sales stage the transfer of value of finished goods and money collection, consequently being
obtained financial resources which will further be distributed among the economic agent, beneficiaries and
state.
Formation of financial resources at the macroeconomic level depends directly on the price system
while both state revenues and expenditures shall be sized according to the level and dynamics of prices in
the economy.
Thus, price participates in the formation of budget revenues, which, in their turn, reflect the relations
of distribution and redistribution of the national income between branches, between regions, between
different forms of ownership, between savings and consumption funds, between social classes and others.
This mechanism is carried out through inclusion in the price structure of taxes (VAT, excise duties,
customs duties), through differentiated pricing of the same product for certain categories of consumers (the
tariffs for electricity used by households and businesses) or price differentiation for goods / services for
public and private sector.
In this way the regulation of the income of the state, branches, businesses and households takes
place.
The continuation of this chain adds up to the fact that the distribution function acts in parallel with
the production optimization and rationalization function.
Substantial capital flows are generally directed towards profitable industries, where related risks are
minimal and there is a high current demand for a particular good.

The function of economic and financial leverage is based on the following arguments:

a) Within their structure, prices comprise many valuable elements, such as wages, taxes, fees, levies,
interest, profit, trade margin, etc. Each of these structural elements is, in its turn, a separate economic
leverage with specific functions and effects;
b) The price of a product is based on other prices and tariffs, respectively prices on raw materials,
materials, energy resources and tariffs on services supplied by third parties.

All these categories of prices (tariffs) are part of the price system of an economy. Their existence and
functioning is manifested through interdependence and mutual influence;

c) Prices are present both in the economic field and in the social sphere.

Macroeconomic revenues collected through prices (taxes and duties) are aimed at economic and social
problems’ solving;

d) Prices affect directly the economic and financial situation of the economic agents through the
relationship between the purchase and sales prices.

Another approach presumes that, through this function, prices are meant to direct enterprises’ activity
towards the efficient use of material, human and financial resources.

Frequently, this function is performed by the state (setting differentiated tariffs on utilities, charging
consumption tax rates, etc.).

1.3. Price system and its categories

Price System represents the totality of prices on the basis of which goods and services are
exchanged on the domestic and international markets, as well as the totality of relations between them.
The relationships between prices express the connections between different categories of price on the
same product, in terms of structural elements.
The price system and its components depend on the level of production, labor productivity, GDP
evolution and structure and other factors, but particularly by the form of economic organization.
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The main types of price systems:
- Regulated price system;
- Free prices system;
- Mixed price system.

Regulated price system is based on unitary and coordinated prices’ setting by the state.
The market does not influence in any way prices’ level and dynamics.
As a consequence, significant distortions in the economy are born, that may trigger inflation and
unrealistic prices.
Free prices system means that free prices are formed under the influence of market factors. The pricing
decision is taken by producers, and the final price is set by negotiations between consumers and producers.
The essential difference between centralized and free setting of prices is that in the first case the
justification process takes place during the production process and in the second case – during sales under
the influence of market factors.
The right to make decisions on price belongs to the producer, and final price shall be set by negotiations.
Given the impossibility to organize and operate a purely free or regulated price system, the mixed price
system functions in modern economies.
Mixed price system means that price is formed by the interaction of supply and demand under the
influence of market conditions, while the state intervenes in case of imbalance, or danger of inflation.
In the Republic of Moldova, the creation of the free prices system has begun with the Presidential Decree
Nr. 256 of 26 December 1991 “on prices’ and tariffs’ liberalization and the protection of the domestic
market”.

The price system in the Republic of Moldova includes the following categories of prices:
1) According to the method of formation:
a) Free prices;
b) Regulated prices.
2) According to the area of application:
a) Wholesale prices (en-gross);
b) Purchase prices on agricultural products for necessities of the state;
c) Consumer prices on food, non-food products, prices on services;
d) Prices on capital constructions;
e) Interest (price on capital);
f) Salary (price on labor);
g) Prices on land and natural resources.
Overall, prices can be grouped into separate homogeneous categories according to various criteria:
1. Criterion: formation:
a) Free prices negotiated between economic entities;
b) Prices regulated by authorities with the right to make pricing decisions.
2. Criterion: area of application:

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 3. Criterion: by the way they react to changes of certain factors:
a) Variable prices – change easily under the influence of factors;
b) Fixed prices - remain (by decision of authorities) at the same level over a longer period of time;
c) Semi-variable – fixed price limits are set, within which prices can either grow or fall.

4. Criterion: geographic area and time period:

a) Unified prices – prices in force throughout the country and during the entire year;
b) Differentiated prices - are set at different levels in different areas, or during different seasons.

5. Criterion: according to the way of Value Added Tax Calculation:

a) Prices including VAT;
b) Prices without VAT.

1.4. Factors that influence the process of price formation

There are four basic factors influence on pricing:
1. Demand (consumer behavior, price elasticity of demand);
2. Supply (amount of supplied goods, competition between manufacturers, production costs, labor
productivity, price elasticity of supply);
3. Competition (dominant market position, monopoly);
4. State regulation (inflation, taxes etc.)
5. Cost
6. Pricing Objectives

Demand represents the aggregate amount of an economic good that can be purchased, as a function
of its price, in a certain period of time.
Demand represents the quantity of goods and services which consumers or users are willing to buy at
a certain price at a given moment.
The demand for a certain good depends on the choice or will to purchase that good, taking into
consideration its utility for the consumer and his purchasing power.
The will to purchase is given not only by the goods’ utility (as an objective element) for the
consumer, but also by the intensity and emergency of necessities’ satisfaction, as well as of the probable
evolution in goods’ prices and consumers’ revenues.
For example, the expectation of a future increase in goods’ prices, and of revenues, might lead to an
increase in current demand, and the possibility of their decrease reduces current demand.
The preference for certain goods (as a subjective element) represents the relationship between the
quantity demanded of goods, and their rate of importance, and it might be influenced by advertising or other
promotional means.
The second factor of demand – the purchasing power, depends on various factors as well:
consumers’ income and their fiscal liabilities, crediting conditions, prices’ levels etc.
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 There are interdependence relations between demand and price, while demand sets the price, as
well as price sets demand.
The first relation can be evidenced on the market, within the exchange process, and it is linked to the
evolution of the relation between demand and supply.
Regarding the second relation, the idea that within a free market the purchased quantities will depend
on the prices of the exchanged goods can be highlighted.
The higher the price level of the demanded good – the smaller is the quantity that consumers are
willing to buy, and vice versa. This statement is true in the condition that all other factors do not change.

Another factors comprise:

 The price of related products, whether they are substitutes or complementary.
 The consumer expectations about whether the price will go up. If they are concerned about future
inflation they will stock up now, thus driving current demand.
The demand curve results from the combination of various possible prices (Pi) of a good, and quantities (Qi)
which could be purchased at each price level

The elasticity of demand reflects the degree of interdependence between the quantity sold of the
product “i” and the price level of the product “i”.

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 Supply reflects the aggregate amount of goods or services that a producer (seller) is willing to sell on
the market at a given price.
The relation of the influence of supply on price can be marked in the process of exchange on the
market, and is linked to the evolution of the relation between demand and supply.
Price can influence supply through its level being in a directly proportional relationship.
Thus, at the moment when price level is high, supply tends to increase, and conversely.
These relations are showed by the supply curve which expresses the links established between price
level on the market for a good or service, and the quantities of that good or service that the suppliers agree to
sell at the given prices.
Price influences the physical quantity of the products sold, altogether influencing the amount of
revenues. This fact also is reflected upon production costs and company’s profit. Respectively, the relation
between price and supply is the following: price → quantity of goods produced (supply) → production cost
→ profit.

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 The formula for price elasticity of supply is:
Percentage change in quantity supplied divided by the percentage change in price
When Pes > 1, then supply is price elastic
When Pes < 1, then supply is price inelastic
When Pes = 0, supply is perfectly inelastic
When Pes = infinity, supply is perfectly elastic following a change in demand

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 Competition represents the natural way of market economy emergence, the situation where for the
same good there are several suppliers and customers.

State regulation is an attempt to influence the mechanism of price formation through various
legislative and administrative means and various financial levers in order to ensure stability for the
economic system as a whole.

The main purposes of regulation of the price formation process embodies in:
- Non-admission of inflationary increases in prices, increase in prices on raw materials and energy
resources;
- Regulation of monopolistic economic agents’ activity;
- Creation of a sound competitive environment;
- Increasing of living standards and social protection of population.

The costs of the product—its inputs—including the amount spent on product development, testing,
and packaging required have to be taken into account when a pricing decision is made. So do the costs
related to promotion and distribution.
For example, when a new offering is launched, its promotion costs can be very high because people
need to be made aware that it exists.
The point at which total costs equal total revenue is known as the breakeven point (BEP).
For a company to be profitable, a company’s revenue must be greater than its total costs. If total
costs exceed total revenue, the company suffers a loss.
Total costs include both fixed costs and variable costs.
Fixed costs, or overhead expenses, are costs that a company must pay regardless of its level of
production or level of sales.
A company’s fixed costs include items such as rent, leasing fees for equipment, contracted
advertising costs, and insurance.
Variable costs are costs that change with a company’s level of production and sales.
Raw materials, labor, and commissions on units sold are examples of variable costs.

Pricing Objectives
Following are the pricing objectives of any business:
(a) Profit Maximisation: Usually the objective of any business is to maximise the profit. During short
run, a firm can earn maximum profit by charging high price. However, during long run, a firm
reduces price per unit to capture bigger share of the market and hence earn high profits through
increased sales.
(b) Obtaining Market Share Leadership: If the firm’s objective is to obtain a big market share, it
keeps the price per unit low so that there is an increase in sales.

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 (c) Surviving in a Competitive Market: If a firm is not able to face the competition and is finding
difficulties in surviving, it may resort to free offer, discount or may try to liquidate its stock even at
BOP (Best Obtainable Price).
(d) Attaining Product Quality Leadership: Generally, firm charges higher prices to cover high quality
and high cost if it’s backed by above objective.

Other important factors are:

Seasonal Effect:
Certain products have seasonal demand. In peak season, demand is high; while in slack season, demand
reduces considerably. To balance the demand or to minimize the seasonal-demand fluctuations, the company
changes its price level and pricing policies.
For example, during a peak season, price may be kept high and vice versa. Discount, credit sales, and price
allowances are important issues related to seasonal factor.
Economic Condition:
This is an important factor affecting pricing decisions. Inflationary or deflationary condition, depression,
recovery or prosperity condition influences the demand to a great extent. The overall health of economy has
tremendous impact on price level and degree of variation in price of the product. For example, price is kept
high during inflationary conditions. A manager should keep in mind the macro picture of economy while
setting price for the product.

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