Subject Name : Managerial Economics

Unit 4: Pricing Decisions

Pricing Decision

2 Business Communication
Factors Influencing Pricing Decisions

• External Factors:

i. Total demand for product or service and its elasticity

ii. Number of competing products or services
iii. Quality of competing products or services
iv. Current prices of competing products or services
v. Customer’s preferences for quality versus price
vi. Sole source versus heavy competition (Number of suppliers in the market)
vii. Seasonal demand or continual demand
viii. Life of product or service
ix. Economic and political climate and trends and likely changes in them in future.
x. Type of industry to which the product belongs and future outlook of the industry.
xi. Governmental guidelines, if any.

3 Business Communication
Factors Influencing Pricing Decisions

• Internal Factors:
a. Cost of product or service
i. Variable costs
ii. Full absorption costs
iii. Total costs
iv. Replacements, Standard or any other cost base
b. Price geared toward return on investment
c. Loss leader or main product
d. Quality of materials and labour inputs
e. Labour intensive or automated process
f. Markup percentage updated
g. Usage of scarce resources
h. Firm’s profit and other objectives
i. Pricing decision as a long-run decision or short term decision or a onetime spare capacity decision
Factors Influencing Pricing Decisions

• Customers: Managers examine pricing problems through the eyes of their customers. Increasing prices may
cause the loss of a customer to a competitor or it may cause a customer to choose a less expensive substitute
product.

• Competitors: No business operates in a vacuum. Competitors’ reactions also influence pricing decisions. A
competitor’s aggressive pricing may force a business to lower its prices to be competitive. On the other hand, a
business without a competitor can set higher prices.

• Costs: Costs influence prices because they affect supply. The lower the cost relative to the price, the greater the
quantity of product the company is willing to supply. A product that is consistently priced below its cost can drain
large amounts of resources from an organisation.
Pricing Methods

• Total Cost Plus or Full Cost Plus Pricing: Total cost plus or full cost plus pricing involves all costs
plus a profit margin. It includes not only the product’s direct costs but also the indirect costs incurred
by the overall company which have to be allocated to different products.
• Marginal Cost Plus Pricing: This method, also known as contribution approach, uses only variable
costs as the basis for pricing. Fixed costs are not added to the product, service or contract. This
pricing method emphasises the relationship between prices and costs that vary directly with sales. It
ignores fixed costs altogether.
• Differential Cost Plus Pricing: This method involves adding a markup on differential cost which is
the increase in total cost resulting from the production of additional units. Differential cost pricing
differs from variable cost pricing in which a mark up on variable cost is added, whereas both variable
costs and fixed costs are included in the differential costs on which a markup is determined.
• Standard Costs: Standard costs represent the costs that should be attained under efficient operating
conditions at a normal capacity. The cost-based methods have some adverse implications and include
costs due to inefficient manufacturing, wasteful operations etc.
Total Cost Plus or Full Cost Plus Pricing: Advantages

(1) It is simple to operate if cost structures of products are known.

(2) The pricing decision under full cost approach becomes standardised and such decisions can easily be delegated to lower
management.

(3) It ensures recovery of total costs and also provides a reasonable rate of return to the firm.

(4) It helps a business firm to predict the selling prices of other competitive firms, especially of those firms who are having
similar cost structures.

(5) This pricing method is important in contracting industries where price of the contracts needs to be determined considering
fixed costs also.

(6) This method does not require estimating demand of products before fixing the selling prices. Instead, a standard profit
margin on total cost can be used.
Total Cost Plus or Full Cost Plus Pricing: Advantages

(7) This brings stability in the pricing policy and selling price can be justified to customers. On the other
hand, prices based on less than total cost such as marginal cost may prompt the customers to believe
that the low price will prevail, in absence of which consumers will be dissatisfied and the firm can face
serious problem.

(8) Full cost pricing is consistent with absorption costing system.

(9) If similar technologies and techniques are employed within an industry, such that there is likely to be
broad comparability of cost structures between different firms operating in the industry, then
widespread use of cost-plus methods can lead to a high degree of price stability.
Total Cost Plus or Full Cost Plus Pricing: Disadvantages

(1) It ignores demand and competition and may result into under-pricing or over-pricing of products.

(2) Fixed costs are likely to be distributed on some arbitrary basis as there are different methods of
apportionment and thus total costs of different products will be different depending on which
apportionment method is used.

(3) In full cost pricing, the choice of volume or capacity base is very important. There are different
concepts of capacity starting from maximum to normal or lower, or expected and different unit product
costs will emerge under these concepts. It means selling prices will be subject to wider fluctuations.
Total Cost Plus or Full Cost Plus Pricing: Disadvantages

(4) This method does not distinguish between relevant costs (e.g., variable costs and incremental fixed
costs) and irrelevant costs (fixed costs).

(5) The proper treatment of fixed cost presents a problem in full costs pricing. As volume increases, the
fixed cost and full cost per unit decreases. If price follows cost, price goes down and further spurs
demand. Unfortunately, the opposite is more distressing.

(6) This method cannot always shield the firm from a loss. When the product is priced higher the unit
cost (considering the fixed costs as well) and sales demand falls below the volume level used to
calculate the fixed cost per unit, the total sales revenue will be inadequate to cover the total fixed
costs.
Total Cost Plus or Full Cost Plus Pricing: Types

• Manufacturing Cost plus Pricing: Manufacturing cost (or product cost) plus pricing includes cost
incurred specifically for manufacturing the product plus a profit margin. The profit margin added to this
cost must cover all operating expenses and generate a satisfactory level of profit.

• Conversion Cost plus Pricing: Conversion cost plus pricing uses conversion cost for determining
the selling price and to this cost a profit margin is added. This pricing method is generally followed
when the customer provides the materials.
Short-Run Pricing Decisions

• Short-run decisions include pricing for a one-time-only special order with no long term implications.

• It is likely that most of the resources required to fill the order have already been acquired and the cost of these
resources will be incurred whether or not the bid is accepted by the customer.

In manufacturing companies, incremental costs of one-time special order will include:

(i) Additional materials required to comply with the order.

(ii) Additional labour, overtime and other labour costs.

(iii) Power, fuel and maintenance costs for the machinery and equipment required to fulfill the order.
Long-Run Pricing Decisions

• Most firms use full cost information while setting long-run pricing decisions. In the long-run, firms can
adjust the supply of virtually all of their activity resources.

• If a firm is unable to generate sufficient revenues to cover the long run costs of all its products and its
business sustaining costs, then it will make losses and will not be able to survive.

• There is a need for determining accurately the long-run or full costs of individual products or services
so that product pricing decisions for the long-run can be made satisfactorily.
Target Pricing

Developing target prices and target costs requires the following four steps:

Step 1: Develop a product that satisfies the needs of potential customers.

Step 2: Choose a target price based on customers’ perceived value for the product and the prices competitors
charge.

Step 3: Derive a target cost by subtracting the desired profit margin from the target price.

Step 4: Estimate the actual cost of the product.

Step 5: If estimated actual cost exceeds the target cost, investigate ways of driving down the actual cost to
the target cost. As stated earlier, managers generally use a cost-based approach for long-term pricing
decision and in this cost-based approach a markup is added to the cost base.
Life Cycle Product Costing and Pricing

•Business firms need to consider how to cost and price a product over a multiyear product life cycle.

•Life cycle costing tracks costs attributable to each product from start to finish.

•Life cycle budgeting is related closely to target pricing and target costing.

•Customer life cycle costs focus on the total costs incurred by a customer to acquire and use a product
or service until it is replaced.
Pareto Analysis in Pricing Decisions

• Vilfredo, an Italian economist, has propounded that 70% – 80% of value represents 20% – 30% of
volume.

• This proposition can be noticed in many business areas such as the following:

(i) Stock Control

(ii) Customer profitability

(iii) Quality control

(iv) Pricing of a product in a multiproduct situation

(v) Activity-Based Costing (20% cost drivers are responsible for 80% of total cost)
Economic Approach to Pricing

• In economics, the basic assumption is that a firm will attempt to set the selling price at a level where
profits are maximised.

• Increase in production causes an increase in marginal cost.

• In economic theory, profits are maximised at the sales volume where marginal revenues equal
marginal costs.

• Economists argue that pricing should be set with a recognition of demand considerations not just of
costs.
Limitations of Economist’s pricing model

1. Difficulty in estimating the demand curve

2. Difficulty in estimating the cost curve

• Economic theory assumes that only price influences the quantity demanded

• Any theory which uses only price factor to determine customer demand would not be able to measure it correctly

• Economic models assume that a firm can estimate a demand curve for its products
Price Indifference Point

• A price indifference point is the sales level at which a firm’s net income is same between two pricing
alternatives.

• The price indifference point indicates the volume of sales at which the new price gives a profit equal
to the profit of old sales volume and price.

• In contrary to this, if expected sales volume with price increase is greater than the price indifference
point, profit will increase
Understanding Price Discrimination

• Price discrimination is practiced based on the seller's belief that customers in certain groups can be asked to pay
more or less based on certain demographics or on how they value the product or service in question.

• Price discrimination is most valuable when the profit that is earned as a result of separating the markets is greater
than the profit that is earned as a result of keeping the markets combined.

• Consumers in a relatively inelastic submarket pay a higher price, while those in a relatively elastic sub-market pay
a lower price.
How Price Discrimination Works

• Markets must be kept separate by time, physical distance, and nature of use.

• With price discrimination, the company looking to make the sales identifies different market segments, such as
domestic and industrial users, with different price elasticities.

• For example, Microsoft Office Schools edition is available for a lower price to educational institutions than to other
users. The markets cannot overlap so that consumers who purchase at a lower price in the elastic sub-market
could resell at a higher price in the inelastic sub-market.
Types of Discriminating Monopoly

• Personal Price Discrimination: Personal price discrimination refers to the charging of different prices from different
customers for the same product.

• Geographical Price Discrimination: Under geographical price discrimination, the monopolist charges different prices
in different markets for the same product.

• Price Discrimination according to Use: When the monopolist charges different prices for the different uses of the
same commodity is called the price discrimination according to use.
Conditions for Price Discrimination

• Difference in Elasticity of Demand: Price discrimination is possible only when elasticity of demand will be different
in different markets.

• Market Imperfections: Generally, price discrimination is possible only when there is some degree of market
imperfections.

• Differentiated Product: Price discrimination is possible when buyers need the same service in connection with
differentiated products.

• Legal Sanction: In some cases price discrimination is legally sanctioned. Just like the electricity board charges
lowest for electricity for domestic use and highest for commercial houses.

• Monopoly Existence: Price discrimination is also called discrimination monopoly. It is evident that price
discrimination is possible only under conditions of monopoly.
Price and Output Decisions under Perfect Competition

• Perfect competition refers to a market situation where there are a large number of buyers and sellers dealing in
homogenous products.

• Under perfect competition, the buyers and sellers cannot influence the market price by increasing or decreasing
their purchases or output, respectively.

• In perfect competition, the price of a product is determined at a point at which the demand and supply curve
intersect each other. This point is known as equilibrium point as well as the price is known as equilibrium price.
Price and Output Decision as per Monopoly

• Monopoly refers to a market structure in which there is a single producer or seller that has a control on the entire market.

• This single seller deals in the products that have no close substitutes and has a direct demand, supply, and prices of a
product.

• The producer under monopoly is called monopolist. If the monopolist wants to sell more, he/she can reduce the price of a
product.

• As we know, there is no difference between organization and industry under monopoly. Accordingly, the demand curve of
the organization constitutes the demand curve of the entire industry.
Price and Output decision under Oligopoly

• A diversity of specific market situations works against the development of a single, generalized explanation of how
an oligopoly determines price and output.

• Pure monopoly, monopolistic competition and perfect competition, all refer to rather clear cut market arrangements;
oligopoly does not.

• In-spite of these difficulties, two interrelated characteristics of oligopolistic pricing stand out:

1. Oligopolistic prices tend to be inflexible or Sticky Price change less frequently in Oligopoly than they happen under
other competitions like perfect, competition, monopoly and monopolistic competition.

2. When oligopolistic prices change, firms are likely to change their prices together they act in collusion in setting and
changing prices.
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