In imperfect markets where there are a small number of competitors producing di¡erentiated products the firm has a degree of flexibility to make its own prices, tempered by concern for the pricing behaviour of rivals. Economics suggests two competing methodologies for price setting. First, a firm can relate prices to costs of production. At its simplest this represents a desire on the part of a firm to ensure that revenues cover costs and allow the firm to make a product. Such practices are described as cost-plus pricing. At its most sophisticated, it implies that a firm that seeks to maximize products should strive to equate marginal revenue to marginal cost. Second, it can relate price to the conditions of demand and the position and slope of the demand curve. It is the downward slope of the demand curve that gives the firm the ability to set its own prices and the inelasticity of demand its ability to raise prices above marginal cost. Thus, the manager in setting prices should be aware of the cost structure of producing an individual product, its demand curve, the product’s degree of uniqueness and the number of rivals.
STUDIES OF PRICING
Economists have from time to time tried to discover how managers set prices and whether they follow the prescriptions of marginalism. The methods that have been used include investigative interviews, case studies and questionnaires. Studies tend to be old and widely quoted. Among them are Hall and Hitch (1939), Andrews (1949), Andrews et al (1975), Barback (1964), Skinner (1970), Hague (1971), Atkin and Skinner (1975) and Dorward (1987) ^ the latter surveyed the post-war literature. These studies tend to end support for cost-plus pricing using a standard mark-up and full cost pricing. Demand only weakly influenced price setting. Firms tended to use time-honoured rules of thumb in determining the mark-up. These endings were partly confirmed by Hall et al. (1997), who also found an increasing recognition of the role of demand.
Hall et al. (1977) undertook a survey of the price-setting behaviour of 654 UK firms. They found, ‘‘cost-based rather than market-led pricing was widespread and the overwhelming majority of companies indicated that they would be more likely to overtime (working) and capacity than change their price in response to a boom in demand’’ (p. 5). Firms were asked to choose their preferred method or the most in£uential factors in their price formation. Respondents were able to choose more one response as their firrst preference, so that total ¢rst preferences exceed 100%.The results are summarized below in order of preference:
1 Prices are set at the highest level the market would bear (39%).
2 Prices are set in relation to their competitors (25%).
3 Prices are set equal to direct cost per unit plus a variable percentage mark-up (20%).
4 Prices are set equal to direct costs plus a fixed percentage mark-up (17%).
5 Prices are set by customers or buyers (5%).
6 Prices are set by regulators (2%).
The survey showed that 64% of first preferences said they used the market-based process in setting their prices compared with 37% that used cost-plus pricing procedures. Cost-plus mark-up pricing tended to be more important for small companies than for medium and large ones. The report suggests that the cost mark-up rule of thumb is more suitable for small companies that cannot a¡ord expensive market research. The overall conclusions from these studies are that businesses still use cost-plus pricing as their basic approach, but that that there is a growing recognition of the role of market forces in modifying those prices obtained by cost-plus methods (i.e., by modifying the mark-up).
ANALYTICS OF AVERAGE COST PRICING
The empirical evidence suggests that there are two main methods of calculating price based on average variable costs. The first, the full cost method, involves estimating the average variable (or average direct) costs for a chosen or normal output and then adding average fixed or (average indirect) costs and an average product margin. Managers as a matter of experience know the average product margin that is appropriate to any sector. Such a price should yield a ‘‘fair’’ return on capital, so that the firm is in a position to borrow or acquire the necessary capital to fund investment, given the risks particular to the industry. All three elements are treated as costs in the sense that they have to be covered by the price charged. The second method involves estimating the average variable or (average direct) costs for a chosen or normal output and then adding a costing margin to cover indirect costs and deliver the desired product margin.