Pricing Strategies and Method

Managerial Economics
Introduction
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 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 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.
COST PLUS PRICING
Under this method, (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.
(VIII) 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.
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 maximize 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 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.
Marginal cost pricing method is more effective than full cost
pricing because of two characteristics of modern business:

(a) The prevalence of multi-process and multi-market concerns
makes the absorption 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.
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 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 the
consequences.
It prefers, however, to take the safe course and confirm to the
policy of others. Hence, this is also called Imitative Pricing.
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
practiced.

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
organizations as monopolies and they are under the full control of the
Government.

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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 for
the selling subunit and purchase costs for
the buying subunit, affecting each
subunits operating income
Intermediate Product the product or
service transferred between subunits of
an 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 Prices
2. Cost-based Transfer Prices
3. Negotiated Transfer Prices
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

Psychological Pricing
Pricing that attempts to influence a customers
perception of price to make a products price more
attractive
Strategy Action
Reference pricing Pricing a product at a moderate level and
positioning it next to a more expensive
model or brand
Bundle pricing Packaging together two or more comple-
mentary products and selling them for a
single price
Multiple-unit pricing Packaging together two or more identical
products and selling them for a single price
Everyday low prices
(EDLP)
Setting a low price for products on a consis-
tent basis

Psychological Pricing (contd)
Strategy Action
Odd-even pricing Ending the price with certain numbers to
influence buyers perceptions of the price or
product
Customary pricing Pricing on the basis of tradition
Prestige pricing Setting prices at an artificially high level to
convey prestige or a quality image


Price Leadership
When the firms are of same size and same cost
structure, it becomes difficult for the firms to decide
the market leader. In such a situation, firms arrive at
a 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 in
the 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.
Price Leadership
Here a firm with large market share sets the price
and the others follow it. The dominant firm is
supposed to know the market demand. Whatever
the price that the dominant firm sets, the others
follow it. Dominant firm sets the price by
equating 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.
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 firm
with a higher cost structure may not be able to do
so with the same profit ratio.
Hence the firm with high cost structure follows
the firm with low cost structure. But the later
sacrifices a portion of its profit in order to
maintain the market share.