But in the actual world it is impossible for businessmen to make exact calculations because they do not have exact knowledge. So it is not surprising to see some divergence between normative theory and actual business practice.
Secondly, some divergence between economic theory and business practice is due to the fact that profit maximisation is not the only or major objective pursued by management.
Herbert Simon has pointed out that in the face of uncertainty; management may abandon its goal of profit maximisation and seek only a satisfying or satisfactory level of performance which ensures survival and acceptable profits.
Oliver Williamson, Richard Cyert, James March and others argue that profitability is only one of several goals which management can follow.
Other goals include production goals, market-share goals, sales goal, professional status and firm survival which management can pursue.
All firms need a pricing policy. But a firm which operates in a competitive environment, managers has option to set prices.
They simply adopt prevailing market prices. However, if competition is limited as in the case of monopolistic competition, monopoly or oligopoly, firms enjoy some control over price-setting.
The question is, how does the businessman actually set the selling price of his product? Two Oxford economists, R.L. Hall and C.J. Hitch, have given the answer.
On the basis of a sample survey of 38 firms, mostly oligopolists, Hall and Hitch argued that in their pricing and output policy, firms do not aim at the maximisation of profits by equating MR and MC.
Instead they were using a principle which they called “full cost” i.e., charging a price based upon full average cost of production, plus a conventional allowance for profit.
Full cost or cost-plus pricing is a fairly common method of fixing the selling prices of products. The method here is to estimate the full cost per unit of the product and then add some mark up or margin of profit considered reasonable by the manager. The cost plus pricing is also known as mark up pricing or margin pricing.
If a firm operates under competitive environment, the full cost or cost plus concept has only limited utility.
There a firm’s supply is conditioned by marginal costs, not by average costs. Other firms might enter or leave the industry so as to force price towards average cost, but the single competitive firm has no reason to think in terms of average cost.
The theory of the equilibrium of the firm which runs in terms of MC and MR breaks down in oligopoly because the price and output policies of the firms are interdependent.
Thus the rationale why firms base prices on full cost is that producers cannot know their demand curves (hence marginal revenue curves) because they do not know consumers’ preferences and being oligopolists, they do not know what would be the reactions of consumers to a change in their price.
We have already noted that kinked demand curve does not explain how price is determined. Under such oligopolistic conditions price will be equal to the full cost of the ‘representative firm’. Price set at full cost level has a tendency to be stable over a long period of time.
It will change only when there is a significant change in labour costs or material costs, but not in response to small shifts in demand.
The business world employs different systems of cost plus or full cost pricing. They range from simple rules of thumb to sophisticated formulas.
The simple rule of adding a customary mark up appears to be common. With a sophisticated formula, a firm estimates future sales, future costs, and adopts a markup that will achieve a “target return” on the firm’s investment.
The path breaking empirical analysis of Hall and Hitch was further extended by P.W.S. Andrews.
According to him, the price which a firm normally charges for a product is equal to the estimated average direct cost of production plus a costing margin.
The costing margin will normally tend to cover the costs of the indirect factors of production and provide a normal level of net profit. With the help of a diagram let us compare the full cost theory with the marginal analysis.
If the firm has got some control over price, it will produce OM and fix the price at MP. The firm chooses this price by taking its average direct costs of production and adding a costing margin. It has been assumed that average direct cost remain constant over the relevant output range. In the full cost analysis, the costing margin will be PS.
If the costing margin differs from PS, that will be due to the fact that the firm does not know exactly its cost and demand for the product or it is pursuing an objective other than profit maximisation.
If a firm seeks to maximise its net revenue, the addition of costing margin to the price would approximate the price suggested-by the relationship between MC and MR.
The main advantages of cost plus pricing is that it is simple to operate, particularly when little is known about demand conditions. With this system prices respond to changes in production costs and not to demand.
Although this may be acceptable to buyers who understand the logic of price increase based on cost increases, its failure to emphasise the importance of demand conditions is its main weakness.
Flexible mark-up pricing is a slightly more sophisticated variant which permits the firm to adapt its mark up to market changes to some extent.
From the administrative point of view it may be expensive if frequent demand estimates are required and many firms restrict the use of flexible mark ups to products sold to well known customers.
Intuitive pricing is fairly common which is based on some vague notion of the market. This method is helpful only to people with a great deal of experience. Experimental pricing may be useful in the market testing of new products.
It is quite clear that full cost pricing violates the marginal pricing rules of traditional theory, since fixed costs enter explicitly in the price determination process.
However, as we have noted, when average costs remain nearly constant over the relevant output range and when price elasticity remains fairly constant over time, the use of cost plus pricing may lead to nearly optimal decisions. In other words, cost plus pricing need not be inconsistent with maximum profits.
According to R.F. Lanzillotti, the mark-up percentage is frequently set so as to achieve a “target return on investment”.
Under target return on investment pricing the firm chooses an acceptable profit rate on investment.
This is defined as earnings before interest and depreciation divided by total
gross operating assets. Then this return is prorated over the number of units to be produced. Target pricing rules may be expressed in the form of an equation as follows:
Many advantages are claimed for the use of target return- on-investment pricing. First, it leads to price stability since it is based on standard costs which vary much less than actual costs. Price stability is advantageous for many reasons.
Price changes are expensive. New price lists have to be prepared and salesmen have to be informed. In an oligopolistic environment price changes will invite competition. Second, target return on investment is well suited for an industry where price leadership is prevalent. Lastly, it is said that target pricing enables the firm to plan and manage its profits.
Lanzillotti draws the distinction between those firms which use target return as a rigid guide to pricing and those using it as a benchmark. New products are most frequently chosen for target return pricing.
Since they have no close rivals, they are expected to produce a predetermined level of profit on the investment undertaken and usually over a shorter period than established products. The price is gradually reduced as new competitors enter the market.
This practice is known as skimming. Alternatively a firm may initially set a low price for a new product in order to develop mass markets through relatively low prices, with the hope of raising prices and generating higher profits later on. This is known as penetration price policy.
Full cost and target pricing are not the only pricing strategies followed by business firms. Some firms place major emphasis on maintenance of market share.
Here market share is a determinant of price policy. If a firm suffers losses as a result of price war, it hopes to regain it over the long run once the market share is increased.
The whole conflict between what businessmen say and what economic theory suggests arises partly from economists’ use of marginalist terminology.
The full cost theory merely describes the method by which firms seek to set their prices at the levels which would be suggested by marginal analysis.
Their method might not be that of equating MC and MR, but they also seek to maximise net revenue by varying the size of the costing margin in the light of their expectations of demand.
In India which has introduced industrial licensing to restrict entry or import controls in order to encourage indigenous producers, full cost pricing is widely practiced. In a seller’s market firms are likely to add a profit margin keeping in view what the market can bear.
Margins or mark-ups can be suitably adjusted in order to minimise imbalance between demand and supply. Conventional break-even analysis is an example of a tool which firms use to determine the level of output or sale at which full costs of production are recovered.
The intersection of the total cost and total revenue functions in the breakeven chart indicates the critical level of output below which the firm would not fall.
After the mid-sixties when recession was set in our economy, many Indian firms found that full cost pricing does not work. There was a sharp fall in demand and at the prevailing prices demand was inadequate to match the supply of goods in many industries.
Under the changed circumstances, firms began to reduce their prices and set it at marginal cost. This trend towards marginal cost pricing is usually noticed only when demand conditions are slack.
Marginal cost pricing implies the practice of setting the price just to cover the variable cost (MC does not include fixed costs) involved and not the full costs.