MANAGERIAL ECONOMICS An Analysis of Business Issues

MANAGERIAL ECONOMICSAn Analysis of Business Issues Howard Davies and Pun-Lee Lam Published by FT Prentice Hall

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 COST-PLUS and the MC=MR model To briefly review other pricing issues: alternative pricing methods; transfer pricing, pricing for public enterprise

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

Pricing in Practice • Most firms use some form of COST-PLUS practice to set prices • CALCULATE average direct cost of production (labour and materials) • ADD a margin for overheads • 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) Sometimes just one margin added

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

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

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 The Marginal Pricing Model is Equivalent to a Cost-Plus 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 P = AVC.1.2/.2 = AVCx6 Margin = 500% 2.5 P = AVC.2.5/1.5 = AVCx1.66 - Margin = 66% 3 P = AVC.3/2 = AVCx1.5 Margin = 50% 10 P = AVC 10/9 = AVCx 1.11 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 The Marginal Pricing Model is Equivalent to a Cost-Plus Model in Many Common Circumstances

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 But That Is Not the Most Important Point

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?

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!

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 competitivereasons. If we use the real figure our price will be too high” • 2. The margin is flexible in the light of market conditions

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

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.

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 price-taker • Sealed bids - for auctions

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

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)

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

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

MANAGERIAL ECONOMICS An Analysis of Business Issues