ECONOMIC ANALYSIS POLICY - I

LECTURE 15

PRICING POLICIES
Pricing policies are policies involving long
term 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 need review and revision from time
to time to make them suitable according to
the changed conditions.
 Objectives of Pricing Policies
I. To maximise 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 as
to 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.
VI. Ability to Pay - Price decisions often hinge on
the customer's ability to pay eg lawyers,
doctors, Governments.
VII. Long run Welfare of the Firm - Keeping the
best interests of the firm in the long run.

Factors affecting Price Policy - There are

external and 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. A
suitable Pricing Policy should have the following
general considerations :
I. Objectives of Business : The Pricing Policy should
conform to the objectives, as discussed above.
II. Cost of the Product : Costs and prices are closely
related. Normally, prices cannot be below costs
including administration and selling costs. In the long
run, price also determines costs.
III. Competitor's Price : Factors such as the number of
competitors, their prices, quality differences, substitutes
etc affect pricing.
IV. Market Position of the Firm: eg. Goodwill for quality
products. A reputed firm may fix a higher price for its
product because of faith of customers in the company's
products.
V. Distribution Channel Policy : Nature of distribution
channels, trade discounts allowed to them and
distribution expenses influence prices.
VI. Price Elasticity of Demand : A high price may be fixed for inelastic
goods and low price for elastic goods. A price reduction policy may
suit highly elastic goods.
VII. Product's Stage in the Life Cycle : In the introductory stages,
prices are fixed lower (to increase the demand for the product) or
higher (to earn maximum profit) considering the competitive
situations in the market. In the maturity stage, penetrating price may
be followed.
VIII. Product Differentiation: When products have different sizes,
colours, quality etc. prices vary. Customers are willing to pay higher
prices for a new style, fashion, quality or packaging etc. (Market
Skimming)
IX. Buying Patterns of Consumers : If the buying frequency of the
product is higher, lower prices should be fixed - low profit margin,
higher turn - over and profit. All consumer products have higher
frequency. But consumer durables such as TV, Fridges have low
frequency and therefore priced higher.
X. Economic Environment : Higher prices are charged during boom,
reduced prices during recession.
XI. Govt. Policy: If prices are much higher, Govt will intervene. (Market
Intervention)
XII. Social and Ethical Considerations :
a) Fair Price b) Fear of labour leaders c) Consumers' reactions to
higher prices
 Role of Costs in Pricing
Important element - There are two other factors - demand and
competition - often it is the price that determines cost - given
the price, the producer arrives at the cost working backwards
from the price consumer can afford to pay. Quality of the
product can be improved only if consumers are willing to pay
higher prices.

If costs were to determine price, why do firms report loss?

Different producers have different costs of production. But in
the market prices are close together for somewhat similiar
product. It is also difficult to measure costs accurately. Costs
are affected by volume and volume is affected by price. The
management has to assume some desired price and volume
relationship for determining costs.

Thus, costs have to be taken into account like other factors. In

the long run if costs are not covered, manufacturers will
withdraw, supply will be curtailed and prices will be raised. All
these show that cost is not the only factor in setting prices .
 PRICING METHODS
Generally, businessmen prefer a pricing
procedure which is easy to implement and
requires only very few assumptions on
demand. The various pricing methods
usually employed by businessmen are: (i)
Cost Plus or Full Cost Pricing (ii) Target
Pricing or Pricing for a Rate of Return (iii)
Marginal Pricing (iv) Going Rate Pricing
and (v) Customary Pricing.
 (I) COST PLUS PRICING
Under this method, (also known as Margin Pricing or
Mark up Pricing) the price is set to cover 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 no
reciprocity between cost and demand for goods. It
ignores 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.
 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 of their demand and
probable response to any price change. This method is fool-proof that
way.
(III) Stability : In cases where costs of getting information on market
situations are high with process of trial and error, they stick to it so that
the cost of decision making is reduced to the minimum.
(IV) Managements tend to know more about product costs than other
factors relevant to pricing.
(V) Major Uncertainty in Cost Setting: Rival's prices could not be known.
Hence, it is difficult to set the price accordingly.
(VI) Product Tailoring: When the selling price is determined, the product
design can be determined easily.
(VII) Pricing of Products : When they are manufactured on the orders of a
single buyer as per specifications.
(VIIT) Monopoly Buying: Buyers know of the supplier's costs - if price charged
is high they will prepare the product themselves.
(IX) Public Utility Pricing.
(X) Useful in Times of Depression.
 (2) TARGET PRICING

PRICING FOR A RATE OF RETURN

This method of pricing is only a refinement of the full- cost
pricing. According to this method, the manufacturer considers a
pre--determined target rate of return on capital invested. In
the case of full cost pricing, the percentage of profit is marked
up arbitarily. In the case of the rate of return method, the
companies determine the average mark-up on costs necessary
to produce a desired rate of return on the company's
investment. In this case, the company estimates future sales,
future costs and arrives at a mark up that will achieve a target
return on the company's investment.

Davies and Hughes have used the following formula to

calculate the desired rate of return when a mark up is applied in
cost:
Percentage mark up on cost

Capital employed
= ------------------------ X Planned rate of return
Total annual cost
Suppose the capital employed by a firm is Rs 6 lakhs and total annaul
cost is Rs 12 lakhs with a planned rate of return of 20 per cent. The
percentage mark-up, therefore, is according to the formula

Capital employed
--------------------------- X Planned rate of return = 6 x 20 = 10 %
Total Annual Cost 12

Now suppose the total cost per unit in the firm is Rs 20 with 10 per
cent mark-up, the selling price would be Rs 22 /-.

In any business, the price policy has to be profit - oriented. Once the
mark up is decided on the basis of capital employed, the firm just
cannot follow it blindly. Sometimes, changes may occur and compel
the firm to revise the prices to changing costs. To overcome this
problem, three different methods are followed :
a) Revising the prices to maintain constant percentage
mark-up over costs.
b) Revising the prices to achieve estimated sales to
maintain percentage of profit.
c) Revising the prices to achieve a constant rate of
return on capital invested.
Changed percentages may be compiled as below:

Profits
(i) Percentage over Costs = ----------­
Costs
Profits
(ii) Percentage on Sales = -----------------------­-----
Earnings from Sales
Profits
(iii) Percentage on Capital employed = ---------------------­
Capital employed
The major drawback of this procedure is
that it ignores demand conditions.
Advantages and Disadvantages of COST -
PLUS Pricing are relevant to this method
also.
(3) MARGINAL COST PRICING
In the first method, i.e., full-cost pricing and the
rate of return pricing prices are fixed on the
basis of total costs 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 ignored and 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 maximise its
total contribution to fixed costs and profit.
 Advantages of Marginal Cost Pricing
I. Marginal cost pricing method is highly useful for public
utility undertakings. It helps them in maximising out-put or
better capacity utilisation. This is possible only when lowest
possible price is charged . The lowest limit is set by
marginal cost of the product. When public utility concerns
adopt marginal cost pricing, it helps in maximising social
welfare.
II. This method enables the firms to face competition. This is
the reason why export prices are based on marginal costs
since international market is highly competitive.
III. This method helps in optimum allocation of resources and
as such it is the most efficient anf 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.
 Marginal cost pricing method is more effective than full
cost pricing because of two characteristics of modern
business:

(a) The prevalance of multi-process and multi-market

concerns makes the absorbtion of fixed costs into
product costs absurd. The total costs of the separate
products can never be estimated perfectly and
satisfactorily, and the optimal relationship between costs
and prices will vary substantially both among
different products and between different markets. In
this type of business, proposals to changing the prices
in terms of sales and segmentation of the market can
be profitably employed only with short-run problems
and marginal 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.
 Limitations of Marginal Cost Pricing:
(i) Firms may find it difficult to cover up costs and earn a fair
return on capital employed when they follow marginal cost
principle in times of recession when demand is slack and
price reduction becomes inevitable 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 the marginal techniques themselves.
Therefore, they are not capable of explaining their use to the
management.
In spite of its advantages, marginal pricing has not been
adopted extensively, due to its inherent weakness of not
ensuring the coverage of fixed costs. It is confined to cases
of special orders only.
 (4) GOING -RATE PRICING
This method of pricing conforms to the system of pricing in
oligopoly where a firm initiates price changes and the other
firms in the industry merely follow the pattern set by the leader.
Other firms accept the leadership. The emphasis here is on the
market. Firms make necessary price adjustment to suit the
general price structure in the industry. Hence this 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 various
alternatives.

Examples of Going - Rate Pricing include industries like

clothing, automobiles, CDs, etc., where the products have
reached a stage of maturity (on their own development) and
where both customers and rival producers have become
accustomed to stable price-relationship. When products are
identical, unique selling price will rule. When they are
differentiated, prices will form a series set at discrete intervals.
Advantages of this method of Pricing : (a) It helps
in avoiding 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 since exact calculation of costs and
demand is not necesary. (d) It is suitable to avoid price
hazards in oilgopoly 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 the consequences.
It prefers, however, to take the safe course and
confirm to the policy of others. Hence, this is also
called Imitative Pricing.
 (5) CUSTOMARY PRICING
Prices of certain goods become more or less fixed for a
considerable period of time, not by deliberate action on the
seller's part, but as a result of their having prevailed for a
considerable period of time. Only when the costs change
significantly, the customary prices of these goods are changed.
While changing the customary price, it is necessary to study the
pricing policies and practices adopted by the competing firms.
Another approach is to effect a price change only in a limited
market segment and know the customer reaction to decide
whether any change would be digested by the market.

Customary Prices may be maintained even when products are

changed. For example, the new model of a radio may be priced
at the same level as the discontinued model. This is usually so
even in the face of lower costs. A lower price may cause an
adverse reaction on the competitors leading them to a price war
as also on the consumers who may think that the quality of the
new model is inferior. Hence, going along with the old price is
the easiest thing to do. Whatever be the reason, the
maintenance of existing prices as long as possible is a factor in
the pricing of many products.
 (6) DIFFERENTIAL PRICING
An important aspect of price differential is price discrimination.
The producer will have various goals in adopting differential
prices : (i) Implementation of a marketing strategy to reach a
particular sector of the market through price differentials. (ii)
Market differential prices help in achieving profitable market
segmentation when legal and competitive considerations permit
price discrimination. (iii) Market expansion : Differential pricing
may be designed to encourage new uses or to attract new
customers. (iv) Competitive adaptation: Differential prices are
major devices for selective adjustment to competitive situations.
When there are standardised products in the industry,
differential prices help to achieve competitive parity with
customers of different backgrounds. (v) Reduction of production
costs: allowing seasonal discounts and the like reduce the
overall production costs by encouraging off-season purchases.
 LEGAL CONSTRAINTS IN PRICING
In fixing the price of a commodity there are certain legal
constraints and restrictions. In the case of certain commodities,
firms are not allowed to fix a price more than what is statutorily
fixed by the Government. In India, statutory price fixation has
been done by the Tariff Commission (formerly Tariff Board) and
Special Committees appointed for the purpose. Thus, prices of
commodities such as motor cars, iron and steel, cotton textiles,
sugar, paper and paper pulp, matches, salt, heavy chemicals,
plantation rubber, sericulture, magnesium chloride, gold thread,
etc. have been fixed by the Tariff Commission at one time or
the other.
The Commission, in fixing the prices of these commodities
generally follow the principle of Cost-plus method of pricing. All
items of works' cost, overheads, administration and bonus to
employees were allowed. The profit element would be fixed as
a percentage of the capital employed. This would be contrived
to cover taxation, dividends and reserves. Managing agent's
remuneration would be separately added to the profit element.
The problem of selection of units for cost study by the
Tariff Commission poses some problems. There are
no objective criteria in selecting the representative unit
for cost study. It may be the most efficient unit or
marginal unit.

Depreciation allowance would be generally

determined on the scales prescribed for income-tax
purpose. Depreciation would be allowed on the basis
of historical cost and not replacement costs.

The return allowed on capital varies from time to time

and from industry to industry. The practice is to allow a
rate of return varying from 8 to 12 percent on the
gross block. i.e., the original value of the fixed assets.
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 of
transport. In a legal sense, public utilities refer to those
group of industries which are run with a public interest.
The commodity or service supplied is so essential to the
economic life of the community that they should be
regarded as a public necessity. T.C.Bonbright defined
public utilities (or natural monopolies) as "any enterprise
subject to regulation, including price regulation, of a type
designed primarily to protect consumers."
 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 are essential for the public, they have inelastic
demand. The operation of public utility undertakings involves huge outlay and
investment on fixed assets. The cost of construction, the maintenance cost,
etc., will be very high. 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 be operating 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
practised. 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 welfare of the community.
Because of these peculiarities and features, public utility services cannot be
producers under competitive conditions which will be wasteful and irregular.
Utility services should be made available to the masses at a cheaper rate. In
times of scarcity, they have to be distributed equitably and rationally. In India,
all public utility services are monopolies of either the Central Government or the
State Government or the Local Bodies. In foreign countries, utility services are
rendered by private organisations as monopolies and they are under the full
control of the Government.

Let us discuss about the pricing policy and methods in public utility services:
 (a) Marginal Cost Pricing:
Hotelling, Montgomery and Lerner advocate the principle of Marginal Cost
Pricing in determining the prices of public utility services. According to this
principle, the marginal cost should be equal to the price. The utility firm
produces the maximum output when its marginal cost is equal to the price of
service. Here, the principle of equating marginal cost with marginal revenues of
a monopolistic firm should not be confused. A non-utility monopolistic form
equates MR to MC and thereby it maximises its monopoly gain. But in a
monopolistic utility undertaking, the MC is equated to the price of the service
i.e., marginal cost is equated to the average revenue. In this case, the utility
firm will be producing more making lesser profit than a monopolistic non­utility
firm.
But the marginal cost principle in pricing public utilities is severely criticised.
Firstly, the principle ignores the long run problem and the theory of maximum
output is applicable more to the short period. Secondly, in a very big
monopolistic firm, the marginal cost will be very negligible or almost nil when it
produces on a large scale. On this score, no public utility service can supply the
service free of cost, as the marginal cost is very low. Thirdly, it is very difficult to
calculate the marginal cost due to the complicated factors involved in it.
Fourthly, in marginal cost pricing principle, overhead costs or fixed costs are
ignored. Hence, this principle will not be accepted. Finally, when the utility firm
is working under deficits, the gap has to be met through taxation of the entire
community, even though every member of the community may not necessarily
use the particular utility services.
 (b) Average Cost Pricing:
In this, the principle of equating average cost
with price is adopted. Instead of equating the
price with marginal cost, the principle of equating
price and average cost is advocated. But this will
lead to some complications. When the utility firm
is working under increasing cost, the equality of
AC with price will be beneficial. When the firm is
working under decreasing cost conditions,
equality of AC and price will result in lesser
output. By this, the principle of maximisation of
public welfare will be defeated. Further there will
be arbitrariness in calculating costs.
 (c) Fair Return Principle:
Generally, for public utility services, the maximum rates are fixed by
public regulatory commissions. It is customary to relate prices to a
fair return on the firm's capital. A return of 6 to 9 percent is
considered as a fair return for public utility services. The Fair Return
principle is adopted in order to make the utility concern cost-
conscious and to make it work efficiently. If this principle is adopted
the problem of deciding the capital value of the utility firm arises.
Then only a fair rate of return could be calculated. What is fair
capital value of the firm for making decisions regarding fair capital
return? There are three methods: (i) Original cost less depreciation
(ii) Current replacement or reproduction cost less depreciation and
(iii) Capitalised market value of the utility firm's assets. If there is no
change in the price level, the first two methods mean the same
thing. If the prices go upwards, according to the second method the
reproduction cost will be higher and the rate of fair return will be
higher. The third method does not appear to be reasonable. The
second method is considered more suitable.
 (d) Actual Pricing:
“What The Traffic Can Bear.” Many practical considerations weigh heavily in
formulating pricing policies for public utilities. The price fixing authorities use a
lot of descretion in fixing the price for the service. They also adopt lot of
discrimination in fixing up the price for different categories of customers. The
principle of WHAT THE TRAFFIC CAN BEAR is adopted. This principle is
commonly known as Value of Service Principle. Each class of customers is
charged a price that it is able to pay according to its demand for the service.
The consumers are divided on the basis of elasticity of demand and charges
are levied on the basis of elasticity of demand. The highest price will be
charged from the sector or the market where the demand for the service is very
inelastic. Lowest price will be charged where the demand is highly elastic. Thus
the discrimination of a true monopolitic organisaton is practised in the public
utility pricing.

The commissions and tribunals fixing the prices of utilities take into
consideration various factors like production costs, administrative expenses,
depreciation, taxes to be paid, development expenditure, fair return on capital
etc. Further, they take into consideration the promotional aspect, the prices
should be kept low so as to be demanded by larger sections of the community.
(Example: Electricity for rural areas). In the social aspect, the price should be
fixed considering the essentiality of the service to weaker sections. In practice,
the pricing of utility services will be not only discriminatory, but also arbitrary.