MANAGERIAL ECONOMICS
An Analysis of Business Issues
Howard Davies
and Pun-Lee Lam
Published by FT Prentice Hall
1
Chapter 15:
Pricing in Practice
Objectives:
To identify the PRICING OBJECTIVES adopted by firms
To describe COST- PLUS PRICING METHODS
To explain the relationship between the evidence on COSTPLUS and the MC=MR model
To briefly review other pricing issues: alternative pricing
methods; transfer pricing, pricing for public enterprise
2
Pricing Objectives



The central objective of pricing is PROFIT MAXIMIZATION
Companies may either express this in a different way, or
have intermediate level objectives for pricing.
Those intermediate level objectives may or may not be
consistent with profit-max
– achieve a target rate of return: might be the maximum, might be a
‘satisficing objective, might be to deter entry
– target market share: might be the share which is consistent with
profit- maximisation or it might be a managers’ target
– stabilize output - keep the factory running and the workers
employed
– match the competition
3
Pricing in Practice

Most firms use some form of COST-PLUS practice to
set prices

CALCULATE average direct cost of production (labour and
materials)
Sometimes just
ADD a margin for overheads
one margin added
ADD a margin for profit
GIVES the price to charge




FIRST RESEARCHED BY AN OXFORD TEAM IN 1938 AND
REPORTED IN A FAMOUS STUDY BY HALL AND HITCH
(1939)
4
A Good Example of the
Theory/Practice Relationship

A simplistic interpretation of the Oxford findings is
that the economic model of pricing is incorrect
– it is clear from the evidence that managers do not describe
their pricing practices in marginalist terms, in terms of
MC=MR or in terms of elasticity and MC
– some analysts (including the original researchers and many
accountants) have concluded that the MC=MR model is
therefore incorrect
5
A Good Example of the
Theory/Practice Relationship



However, the conclusion that the evidence on cost-plus
pricing invalidates the profit-maxing model is a
misunderstanding of the relationship between models and
practice.
This is very important for general understanding and can
be approached in a number of ways
First
– the profit-maxing model can be re-written in cost-plus form
(P-MC) = 1 is the same as P = MC . (Ed)
–
P
Ed
(Ed -1)
– If average variable cost is constant (which is often assumed in
management accounting) then AVC = MC
6
The Marginal Pricing Model is Equivalent to a CostPlus Model in Many Common Circumstances




If AVC is constant , therefore = MC the profit-max model
can be re-written:
P = AVC. (Ed)
Average cost plus a margin
(Ed -1)
Calculate the margin when elasticity takes the following
values
•
•
•
•


1.2
2.5
3
10
(Why can we not find a value if elasticity is less than 1?)
If managers use margins which are consistent with these
values, they are profit-maximising
7
The Marginal Pricing Model is Equivalent to a CostPlus Model in Many Common Circumstances




If AVC is constant , therefore = MC the profit-max model
can be re-written:
P = AVC. (Ed)
Average cost plus a margin
(Ed -1)
Calculate the margin when elasticity takes the following
values
•
•
•
•


1.2
2.5
3
10
P = AVC.1.2/.2 = AVCx6
P = AVC.2.5/1.5 = AVCx1.66 P = AVC.3/2 = AVCx1.5
P = AVC 10/9 = AVCx 1.11
Margin = 500%
Margin = 66%
Margin = 50%
Margin = 11%
(Why can we not find a value if elasticity is less than 1?)
If managers use margins which are consistent with these
values, they are profit-maximising
8
But That Is Not the Most Important Point

Close examination shows that
– rigid cost plus pricing must lead to irrational results.
Managers would be stupid to use it
– in practice, firms do take other factors into account, which
allows them to approximate the profit-maxing solution
9
Why Is Rigid Cost-plus Pricing Irrational?

There is a circularity problem. In many circumstances cost per unit
depends on the volume of output sold. But the volume of output sold
depends upon the price!.
– Unless cost is constant over a very wide range of output a firm does
not know its cost per unit until it knows the price !

Cost-plus pricing completely ignores the demand side and the
behaviour of customers and competitors For instance:
– if my competitors lower their prices, how would a cost-plus price change?
– if demand increases how will my cost plus price change?
10
Why Is Rigid Cost-plus Pricing Irrational?

If my competitors lower their prices, my sales volume will fall. That will
increase my cost per unit.

IF I USE COST-PLUS PRICING, I WILL RAISE MY PRICE!

If demand increases and my sales volume increases, my costs will
usually fall.

IF I USE COST-PLUS PRICING I WILL LOWER MY PRICE!

NOTICE THAT THE PROFIT-MAXING, MC=MR MODEL GIVES
MUCH BETTER PREDICTIONS OF FIRMS’ BEHAVIOUR THAN A
COST-PLUS ‘MODEL’ OF PRICING!
11
How Can We Reconcile the Contradiction Between Cost-plus
Pricing Practice and Rational Behaviour by Managers?


Closer examination of managers’ descriptions of their pricing practice
shows that they do take account of the demand side.
1. The “Cost” which is used as the basis for Cost-Plus is rarely an
actual cost - it is arrived at through discussions which implicitly take the
demand side into account. In Denmark, for instance:
–
–
–
–
–
Fog asked a firm “what is the cost per unit on which you base your price?”
Answer ”cost per unit when the factory is at full capacity”
Fog “do you expect to be at full capacity?”
Answer “no”
Fog “why use an unrealistic figure for cost”
– Answer “for competitive reasons. If we use the real figure our price will be
too high”

2. The margin is flexible in the light of market conditions
12
Issues of Market Demand May be Taken Into Account Early
in the Design Process, with Cost being determined after Price,
not before


FOR EXAMPLE:
The Managing Director of a manufacturer of bathroom equipment in the
North of England explained their pricing process like this:
– The first stage is before production begins. I look at the market and I identify
the price at which a premium product can be sold in enough volume to use
our factory efficiently
– We decide how much margin we expect to make in order to give a profit
which will satisfy the shareholders
– I subtract the margin from the price. The result is the target cost per unit. I
then tell the design department to design a product which can be made for
that cost but which is a premium product. If they can’t do it, we adjust the
price up a bit, but we are very careful not to over-price the extra benefits for
the customer .

This is a “Price-Minus” approach to Cost, the opposite of “Cost-plus”
approach to Price
13
What Can We Conclude on the Cost-Plus Practice
Versus MC=MR Theory?

The theory is not supposed to describe pricing practices. It should be
no surprise that it does not.
– (See the paper by Govindajaran and Anthony 1983 for a good example of
how accountants get confused over this issue)

The purpose of the MC=MR theory is to predict how firms will change
their prices when cost and demand conditions change. The predictions
make more sense, and are more accurate than those derived from a
‘cost-plus’ theory of price.

Managers are not dumb. They do not use cost-plus in a rigid way and
they do not have the accurate information needed to do an MC= MR
calculation. They feed their experience and knowledge into a complex
decision-making process and in the end often behave ‘as if’ they were
fully-informed maximisers.
14
Pricing Methods II:Other
Approaches



Target return pricing - identify target
profit and set the margin equal to that
required to provide the target profit
Going rate pricing - behave as a pricetaker
Sealed bids - for auctions
15
Transfer Pricing

How to set prices for internal transfers so that
divisions taking their own decisions will bring
maximum profit to the firm as a whole?
– If there is no external market for the intermediate product the
amount of that product that the final producing division
wishes to purchase must correspond to the profit-maxing
output for the firm as a whole
– see the graphical analysis on p.321
– if there is an intermediate market for the product the final
production division can buy on the open market as well as
acquire in-house. Transfer price is the market price
16
Pricing in Public Enterprise



The basic rule? Set price equal to
marginal cost?
But which marginal cost - long-run or
short-run?
It doesn’t matter if you have the
appropriate set of plant and equipment
because in that case SMC =LMC (see
p.325)
17
Pricing in Public Enterprise

What about surpluses or deficits?
– If there are scale economies at the optimal level of output,
MC pricing must lead to losses (and vice versa for
diseconomies)
– Some planning theorists hoped that losses and gains would
just balance out!
– If a public enterprise makes losses it might be because of
the pricing rule, or it might be due to inefficiency - difficult to
tell the difference
18
Pricing in Public Enterprise



The second-best problem - if there are ‘n’
conditions for an optimum and 1 cannot be achieved
- the others may be redundant
If MC pricing in all industries is optimal but it is
impossible in one industry - MC pricing may not be
optimal in the others - VERY DESTRUCTIVE OF
THE PRICING RULE
But a partial approach may be possible. If the price of
oil is too high, oil output will be too low and coal and
gas output will be too high. Therefore ‘lean’ against
the distortion by also raising their prices>MC
19