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Pricing Strategies and Method

Managerial Economics

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Introduction

Pricing policies are policies involving longterm decisions regarding prices of the

products of the firm taking various factors

into consideration - economic, social and political. It is a crucial problem and there is no short -

cut formula. Again, prices once fixed needreview and revision from time to time tomake them suitable according to the

changed conditions.

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Objectives of Pricing Policies I. To maximize profits - Exploiting consumers will not pay - The

firm should take a long time view. II. Price Stability - To generate confidence and goodwill among

consumers. III. Facing Competitive Situation - Should avoid potential

competitors. IV. Capturing the Market - In price-sensitive markets, a producer

may fix a comparatively lower price while introducing his product - to capture a lion's share of the market (Market Penetration).

V. Achieving a Target-return - Prices of products so calculated asto earn the target return on cost of production/sale/investment.

Different target - returns may be fixed for different products/brands/markets, but such returns should be related to a

single over - all rate of return target.

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VI. Ability to Pay - Price decisions often hinge onthe customer's ability to pay eg lawyers,

doctors, Governments.VII. Long run Welfare of the Firm - Keeping the bestinterests of the firm in the long run.

F actors aff ecting Price Policy - There are externaland internal factors.

External factors are elasticity of demand/supply, goodwill of the firm, purchasing power of consumers,

trend of the market etc. Internal Factors include cost considerations and

management policy.

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COST PLUS PRICINGUnder this method, (Mark up Pricing) the price is set tocover all costs (material, labour and overhead) and a

predetermined percentage for profit.This percentage is never alike among various units within

the industry and even products of the same concern.This is due to difference in competitive intensity, cost base,

turn - over rate with risk. It shows some vague idea of just profit. Limitations: (i) Demand is ignored : there is noreciprocity between cost and demand for goods. Itignores demand totally.

(ii) Failure to show the forces of competition(ill) Exaggeration of the precision of allocated costs(iv) Based on cost concept - This may not be relevant for

the decision of the price.

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Suitable in the Following Cases:(I) Ideal Method: It is an ideal, fair and just method of

pricing. Prices can be fixed very easily and with

speed. Prices are defensible on moral grounds.(II) Uncertainty of Demand : Firms are often uncertain oftheir demand and probable response to any pricechange. This method is fool-proof that way.

(III) Stability : In cases where costs of getting informationon market situations are high with process of trialand error, they stick to it so that the cost of decisionmaking is reduced to the minimum.

(IV) Managements tend to know more about product coststhan other factors relevant to pricing.

(V) Major Uncertainty in Cost Setting: Rival's prices couldnot be known. Hence, it is difficult to set the priceaccordingly.

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(VI) Product Tailoring: When the selling priceis determined, the product design can bedetermined easily.

(VII) Pricing of Products : When they aremanufactured on the orders of a singlebuyer as per specifications.

(VIII) Monopoly Buying: Buyers know ofthe supplier's costs - if price charged ishigh they will prepare the product themselves.

(IX) Public Utility Pricing.(X) Useful in Times of Depression.

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MARGINAL COST PRICING In the first method, i.e., ful l-cost pr icing and the rate

of return pr icing prices are fixed on the basis of totalcosts comprising fixed costs and variable costs.Under Marginal Pricing method, the price of a product

is determined on the basis of the marginal or variable

costs. In this method, fixed costs are totally ignoredand only variable costs are taken into account.This is done on the assumption that fixed costs are

caused by outlays which are historical and sunk.Their relevance to pricing decision is limited, as

pricing decision requires planning the future.Under marginal cost pricing, the objective of the firm is

to maximize its total contribution to fixed costs and profit.

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Advantages of Marginal Cost Pricing

I. Marginal cost pricing method is highly useful for public utilityundertakings. It helps them in maximising out-put or better capacityutilisation. This is possible only when lowest possible price is charged. The lowest limit is set by marginal cost of the product. When publicutility concerns adopt marginal cost pricing, it helps in maximising

social welfare.

II. This method enables the firms to face competition. This is the reasonwhy export prices are based on marginal costs since internationalmarket is highly competitive.

III.This method helps in optimum allocation of resources and as such it isthe most efficient and effective pricing technique. It is useful when

demand conditions are slack. IV. Marginal cost pricing is suitable for pricing over the life-cycle of a

product. Each stage of the life- cycle has separate fixed cost and short-run marginal cost.

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M arginal cost pricing method is more effective than ful l costpricing because of two character istics of modern business:

(a) The prevalence of multi-process and multi-market concernsmakes the absorption of fixed costs into product costsabsurd.

The total costs of the separate products can never be estimated perfectly and satisfactorily, and the optimal relationshipbetween costs and prices will vary substantially both amongdifferent products and between different markets.

In this type of business, proposals to changing the prices interms of sales and segmentation of the market can be

profitably employed only with short-run problems andmarginal pricing is the most suitable method of short-run

pricing.(b) In business, the dominant force is innovation combined with

constant technology. The long-run situation is often

unpredictable. Hence, short-run marginal cost pricing is most suitable.

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Limitations of Marginal Cost Pricing:

(i) Firms may find it difficult to cover up costs and earn a fair return oncapital employed when they follow marginal cost principle in times ofrecession when demand is slack and price reduction becomesinevitable to retain business.

(ii)When production takes place under decreasing costs, marginal cost pricing is unsuitable since MC curve will be below the AC curve and

marginal cost pricing is bound to lead to deficits.(iii)Marginal cost pricing requires a better understanding of marginal

cost technique. Some accountants are not fully conversant with themarginal techniques themselves. Therefore, they are not capable ofexplaining their use to the management.

In spite of its advantages, marginal pricing has not been adoptedextensively, due to its inherent weakness of not ensuring the coverageof fixed costs. It is confined to cases of special orders only.

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GOING -RATE PRICINGThis method of pricing conforms to the system of pricing in oligopolywhere a firm initiates price changes and the other firms in the industry

merely follow the pattern set by the leader. Other firms accept theleadership.The emphasis here is on the market. Firms make necessary price

adjustment to suit the general price structure in the industry. Hencethis going-rate pricing method is also called Acceptance-Pricing.

Normally, under this method, the industry tries to determine the lowest price that the seller can afford to accept considering variousalternatives.

Examples of Going - Rate Pricing include industries like clothing,

automobiles, CDs, etc., where the products have reached a stage ofmaturity (on their own development) and where both customers andrival producers have become accustomed to stable price-relationship.

When products are identical, unique selling price will rule. When theyare differentiated, prices will form a series set at discrete intervals.

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Advantages of this method of Pricing : (a) It helps inavoiding cut-throat competition among firms

(b) It is a rational pricing method when costs are difficult to

measure .(c) Going - Rate or Acceptance Pricing is less costly sinceexact calculation of costs and demand is not necessary.

(d) It is suitable to avoid price hazards in oligopoly market.

It should however be noted that Going - Rate Pricing or Acceptance Pricing' is not the same as accepting the market price impersonally, as in the case of a perfect market.

In the case of a perfect market, the firms are only price-takers. But in this case, the firm has some power to set its own price and could be a price maker if it chooses to face all theconsequences.

It prefers, however, to take the safe course and confirm to the policy of others. Hence, this is also called Imitative Pricing.

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PRICING IN PUBLIC UTILITIES

The term Public Utilities in the economic sense refers to services such as water-supply, gas supply, electricity,telephone services, communication and all forms oftransport.

In a legal sense, public utilities refer to those group ofindustries which are run with a public interest. Thecommodity or service supplied is so essential to theeconomic life of the community that they should be

regarded as a public necessity.T.C.Bonbright defined public utilities (or naturalmonopolies) as "any enterprise subject to regulation,including price regulation, of a type designed primarily

to protect consumers."

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Peculiarities of Public Utilities:Generally, public utility services are monopolistic in character.

Economies of large scale operation would be available to public

utility industries because of the mass production for the entire population.Since most of the public utility services and commodities areessential for the public, they have inelastic demand.The operation of public utility undertakings involves huge outlayand investment on fixed assets.The cost of construction, the maintenance cost, etc., will be veryhigh.

Further, in all public utility services, some unused plant capacity

will be maintained in order to meet occasional 'Peak Demand'. Because of the surplus capacity of the plant, the service will beoperating under decreasing cost conditions.When the output is increased, the cost per unit will come down.Generally, in all public utility services, price discrimination will be

practiced.

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Different charges will be levied from different types of consumers.The railways will have different fares for different class of

passengers. Above all, the basic objective of a public utility service is the welfareof the community.

Because of these peculiarities and features, public utility servicescannot be producers under competitive conditions which will bewasteful and irregular.Utility services should be made available to the masses at a cheaperrate.

In times of scarcity, they have to be distributed equitably andrationally.

In India, all public utility services are monopolies of either theCentral Government or the State Government or the Local Bodies. In foreign countries, utility services are rendered by privateorganizations as monopolies and they are under the full control of theGovernment.

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Transfer pricing

Transfer Price is:the internal price charged by one segment of a firm for a

product or service supplied to another segment of the same firm

Such as: Internal charge paid by final assembly division for

components produced by other divisions Service fees to operating departments for

telecommunications, maintenance, and services by support services departments

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Transfer Pricing

The transfer price creates revenues forthe selling subunit and purchase costs for

the buying subunit, affecting each subunits operating income Intermediate Product the product or

service transferred between subunits ofan organization

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Effects of Transfer Prices

Performance measurement: Reallocate total company profits among business

segments Influence decision making by purchasing, production,

marketing, and investment managers

Rewards and punishments: Compensation for divisional managers

Partitioning decision rights: Disputes over determining transfer prices

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Three Transfer Pricing Methods

1. Market-based Transfer Prices2. Cost-based Transfer Prices

3. Negotiated Transfer Prices

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Other Methods of Product Pricing

Price Skimming Charging the highest possible price that buyers

who desire the product will pay Penetration Pricing

Setting prices below those of competing brands to penetrate a market and gain a significant market

share quickly

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Psychological Pricing Pricing that attempts to influence a customers

perception of price to make a products price moreattractive

Strategy Action

Reference pricing Pricing a product at a moderate level andpositioning it next to a more expensivemodel or brand

Bundle pricing Packaging together two or more comple-mentary products and selling them for asingle price

Multiple-unit pricing Packaging together two or more identicalproducts and selling them for a single price

Everyday low prices(EDLP)

Setting a low price for products on a consis-tent basis

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Psychological Pricing (contd) Strategy Action

Odd-even pricing Ending the price with certain numbers toinfluence buyers perceptions of the price orproduct

Customary pricing Pricing on the basis of tradition

Prestige pricing Setting prices at an artificially high level toconvey prestige or a quality image

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Price Leadership

When the firms are of same size and same cost structure, it becomes difficult for the firms to decidethe market leader. In such a situation, firms arrive ata consensus and choose a leader. The leader is

supposed to have good knowledge of the market. Leader acts as a barometer for all the other firms inthe industry.

Barometric Price Leadership One firm in an industry will initiate a price change in

response to economic conditions. The other firms may or may not follow this leader. Leader may change.

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Price Leadership

Here a firm with large market share sets the priceand the others follow it. The dominant firm is supposed to know the market demand. Whateverthe price that the dominant firm sets, the others

follow it. Dominant firm sets the price byequating marginal revenue with marginal cost.

Dominant Price Leadership One firm is recognized as the industry leader. Dominant firm sets price with the realization that the

smaller firms will follow and charge the same price.

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Price leadership by a low cost firm

In this type of price leadership firms follow the prices set by the low cost firm.

A firm with low cost structure will be able to

charge a lower price to the customer. But the firmwith a higher cost structure may not be able to do so with the same profit ratio.

Hence the firm with high cost structure followsthe firm with low cost structure. But the later

sacrifices a portion of its profit in order tomaintain the market share.