Managerial objectives and the Pricing Strategies

University Degree Business and Administrative studies

Managerial objectives and

the Pricing Strategies

Section 1: Managerial Objectives

1.1 The essence of managerial objectives

We assumed that the firm's primary objective is to maximize profit. This assumption underlies the competitive environment, which we mapped out using the frameworks of the perfect competition, monopoly, monopolistic competition and oligopoly market models, and which allowed us to establish benchmarks for the analysis and comparison of price-output decisions under different market structures. This approach, often referred to as the traditional (or 'neoclassical') approach, can readily be criticized, however, on the grounds that it does not provide a satisfactory explanation of real-world production and pricing decisions. By assuming away many complexities, the simplistic assumption of profit maximization enables us to make very clear-cut predictions about the firm's behaviour However, it is one thing to make predictions, but another to say how realistic they are or how accurate they are. The traditional theory of the firm seems to be at its best when analyzing behaviour in perfectly competitive and monopoly market structures. In practice, however, these theoretical extremes are rarely to be found - in reality most firms are confronted with market conditions, which are more readily described as imperfectly competitive with oligopoly being the dominant market form. This is not to say that we should dismiss the analysis presented in the previous chapter - on the contrary, it is essential to the development of a deeper understanding of the fundamental relationships between pricing and production decisions.

Most economists sympathize with the defence of the profit maximization assumption, recognizing its usefulness as a mental, theoretical link to explaining how one gets from the 'cause to the effect'. The market models reviewed in the last topics were developed to predict, not describe, behaviour in markets. Since the 195Os, however, a collection of new, alternative theories of corporate behaviour has been put forward. The purpose of this chapter is to review these theories and to assess their merits in terms of realism alongside the traditional approach. We shall consider these new theories under the following three basic headings:

Agency theory.
Managerial theories.
Behavioural theories.

A fourth area of development has already been discussed last week in the study of oligopoly. There we introduced the concept of 'game theory', which represents a major development in understanding real-world corporate behaviour

The new theories which we shall discuss below stem, in the main, from abandoning one or both of the following assumptions which are central to the traditional approach, namely that:

decisions are made under conditions of perfect knowledge; and
the objective of the firm is to maximize profits.

There are four main reasons which, can be offered as justification for abandoning these two assumptions. These relate to the following:

The growth in oligopoly;
The growth of managerial capitalism;
Difficulties surrounding profit maximization in practice; and
The organizational complexity of firms.

Before examining the alternative theories of corporate behaviour listed above we shall briefly discuss the significance of each of these developments in turn.

1.1.1 The growth in oligopoly

As mentioned above, oligopoly is the most common form of market structure in reality and yet it is the structure to which the traditional assumptions fit least well. Empirical evidence of the growing importance of oligopoly can be found by measuring the degree of concentration across industries using the method outlined in topic 4. When an industry is concentrated, but not a monopoly, it displays the characteristics of oligopoly. Empirical studies of a number of countries have shown a general trend across many industries towards this type of market structure throughout the last century.

There are two reasons why the traditional theory of the firm, based on the assumptions of perfect knowledge and profit-maximizing behaviour, fails to provide a satisfactory explanation of market behaviour under oligopoly. These concern:

the extent to which firms are interdependent; and
the degree of uncertainty that exists in oligopolistic markets.

These issues have already been fully discussed last week. Briefly, mutual interdependence arises in oligopoly because each firm produces a sufficiently large proportion of the industry's total output for its behaviour to affect the market share of its competitors. Uncertainty arises because the behaviour of one firm is conditioned not just by what its rivals are doing but also by what it thinks its rivals might do in response to any initiative of its own. Uncertainty and interdependence are best tackled through a game theory approach to market behaviour

1.1.2 The growth of managerial capitalism

The traditional assumption of profit maximization implies that the 'firm' somehow has a mind of its own, capable of arriving at independent, rational decisions. In reality, of course, firms do not make any decisions - it is entrepreneurs and managers (i.e. individuals) who make business decisions. A 'firm' is nothing more than an abstract concept covering owners, managers and employees.

Over time, the relationship between ownership and control in firms has changed substantially In their earliest form business units or firms were owned and managed by the same people, therefore the assumption of profit maximization did not seem unreasonable. Over time, however, with the growth of large corporations and the dominance of public joint-stock companies, there has emerged a separation of ownership from control. Ownership is in the hands of shareholders who may or may not exercise their voting rights at board meetings. Control, however, is largely in the hands of the managers and directors of the firm. This situation is described as managerial capitalism and has given rise to 'managerial theories' to explain the behaviour of firms (see later). With managers in control it is easy to question the validity of the profit maximization assumption of the traditional theory. Some managers may seek to keep shareholders happy by reporting a certain level of profit while leaving themselves the flexibility to achieve, perhaps personal, objectives (such as business growth, diversification, salary, etc.). Even if profit maximization is stated as the key objective of the firm as a whole, it is unlikely that every individual within the firm, even within senior management, will be pursuing this objective consistently.

There appears, therefore, to be a potential division between the goal of shareholders and the goal of management in the real world. Recently this issue has been approached through agency theory.

1.1.3 Difficulties surrounding profit maximization

In practice, businesses may have insufficient accurate information about demand and cost conditions to be able to use the concepts of marginal revenue and marginal cost as the basis for determining the profit-maximizing output. Pricing policies are often determined by other methods, such as on the basis of a mark-up over average unit costs subject to the achievement of a 'required' profit margin. As much of the output as possible, will then be sold on the market at this price.

Other price guidelines may be followed for different firms in different industries. For example, over the years, two basic-pricing guidelines for state industries have emerged: marginal-cost pricing, and mark-up pricing to achieve a target rate of return. Full details of these and other pricing policies are given later on. The key point to note here, however, is that the traditional theory of the firm does not provide a particularly useful framework for analyzing the behaviour of state firms.

1.1.4 The organizational complexity of firms

A final reason for questioning the validity of the traditional approach to understanding the behaviour of firms relates to the changing organizational structure of firms. As with the growth of managerial capitalism, this reflects the fact that as firms have increased in size, so too they have become much more complex in terms of their organizational structure. This structure will reflect the often conflicting views of owners, managers, workers and consumers. Within each grouping there will be still more complex structures: perhaps different categories of shareholders with different share holdings who are interested in different objectives (short-term versus long-term profits perhaps); different managers at different levels with different aims and aspirations; blue-collar workers and white-collar workers with different career expectations and reward packages, perhaps represented by different unions; finally, there will be different groups of consumers to be satisfied (such as the one-off customer versus the long-term, loyal customer).

Given the degree of complexity of organizational structures today, some economists argue that it is unlikely that a useful theory of business decisions can be based on a single objective and that instead the subject should be approached through a study of the behaviour of individuals or groups within the firm. Also, it is held that such an approach should start from the position that people in firms, including managers, do not aim to maximize anything they simply aim to 'satisfy' a range of objectives. This 'behavioural' approach to the firm will be discussed later.

In summary, therefore, the traditional theory of profit maximization as illustrated in various market models may be criticized because:

it is not readily applicable to oligopoly situations;
it is no longer appropriate in today's environment, where managerial capitalism has taken over from entrepreneurial capitalism and where control has become divorced from ownership;
pricing policies in practice may bear little obvious resemblance to those suggested by the MR = MC principle; and
the complexity of organizational structures today calls into question some of the basic assumptions of the traditional theory.

We turn now to discuss some developments that have taken place in the analysis of the behaviour of firms, starting with the concept of agency theory referred to already. This theory recognizes the growth in managerial capitalism and the complexity of modern organizational structures.

1.2 Agency theory

In many areas of economic activity, people carry out transactions on behalf of others. That is to say, principals appoint agents to undertake economic transactions on their behalf.

The broad thrust of agency theory as a basis for understanding the behaviour of firms is summarized in Figure 1 below which shows the agent-principal relationships that exist in the private and public sectors. In the private sector, the principals are those who ultimately have the rights to the assets or who 'own' the firm. in joint-stock companies these are the shareholders and they appoint directors as agents to manage these assets on their behalf. In theory, the directors should manage the assets in the interests of the principals but in practice this cannot be guaranteed. In practice, therefore, the agent-principal relationship may involve costs in terms of lower efficiency. This is likely to mean that the principals face costs, not least in terms of the time and effort involved in monitoring the work of their agents.

Figure 1 The agent-principal relationship: private V. public sector

There are, however, 'control mechanisms' in the private sector. Shareholders may attend meetings with management and, in particular, company annual general meetings to question and, if necessary, replace the directors. Perhaps more importantly, the shareholders can exercise their right to sell their share holdings altogether Many economists argue that the existence of such a control mechanism acts as a major constraint on private sector management. If management pursues a quiet life or other objectives, which reduce profitability, then shareholders can react by disposing of their hares. This will tend to drive down the share price, making the company vulnerable to a takeover by new management.

On the other hand, some economists question the significance of shareholder power, arguing instead that shareholders are fairly inert to management performance. Most shareholders rarely attend annual general meetings and the existence of transactions costs and capital gains taxation may reinforce a tendency to hold onto shares in the hope that things will get better. If things do get better those who have held on to their shares, benefit and this produces a 'free rider' problem. Shareholders may be reluctant to sell, hoping, however, that other shareholders do sell. Further, it is not obvious that it is necessarily the less profitable firms, which succumb a takeover. Sometimes what appear to be profitable, well-managed firms face hostile takeover bids.

Figure 1 also illustrates the agent-principal relationship, which exists in he public sector. In this case, civil servants and public boards manage industries and services on behalf of the public. Since there are no shares to sell or annual general meetings to attend, the public are unable to indicate directly dissatisfaction with management performance. Voters can express their views on government performance through the ballot box, but this is a crude indicator of satisfaction and dissatisfaction with particular state activities (such as the postal service, police, education, etc.). Votes reflect broad manifesto pledges and not, usually, views about the quality of service from one particular public industry or state sector. For this reason there appears to be greater scope for managerial discretionary behaviour by management in the public sector compared with the private sector. Consequently, there may be a tendency for production costs in the public sector to be higher than in the private sector - an important rationale for the worldwide privatization programme of the 1990s.

Figure 2 Impact of inefficiency on average cost

A further constraint on managerial discretionary behaviour relates to the product market. Firms, whether private or public sector (unless backed by considerable taxpayers' funds), must be efficient to survive in competitive markets. Any inefficiency, which leads to higher prices will be penalized through a loss of market share and eventual bankruptcy. This constraint is illustrated in Figure 2, which shows two average cost curves. Assume that the curve AC1 applies to the firm when it is fully efficient and that AC2, being higher, reflects inefficiency. If the firm was earning only normal profits when operating with the curve AC1, then when costs rise to AC2 losses will be incurred. As a general rule we can conclude, therefore, that non-profit goals which raise costs are likely to be more prevalent in firms operating where product market competition is imperfect (since if the market was perfectly competitive the firm would not be able to afford the luxury of non-profit goals).

1.3 Managerial theories

Once we acknowledge that managers in the private and perhaps more especially in the public sector are able, to some degree, to pursue their own goals rather than that of profit maximization, the question arises as to what are these goals and what is the effect on prices and outputs. We shall consider the following three possible goals:

1. Sales revenue maximization.

2. Managerial utility maximization.

3. Corporate growth maximization.

The common feature of the underlying models concerned with these goals is that they each reject the simple profit maximization assumption, replacing it with an alternative target which management aims to achieve. These targets stem from the study of what motivates different managers where there is a separation of the ownership from the management (control) function, i.e. an agency relationship, which leaves managers with some degree of freedom to pursue non-profit goals, at least in the short term.

1.3.1 Sales revenue maximization

The idea of sales revenue maximization as a management goal was first put forward by William Baumol in 1959. The argument is based on Baumol's own research into managerial behaviour and is couched in terms of oligopolistic industry, in which there is a divorce of ownership and management of resources. Baumol argues that managers are likely to attach a great importance to achieving high sales revenues for the following reasons:

High and expanding sales revenues help to attract external finance to the firm - larger firms generally find it easier to raise capital, while financial institutions may be less willing to deal with a firm suffering from declining sales.
High sales assist the distribution and retailing of products - resulting in economies from selling in bulk.
Consumers may view a firm with falling sales in a less favourable light this may deter consumers from buying and reduce sales even further.
The distributive trade may be less co-operative, for example to extend credit lines, when a firm's sales are declining.
Falling sales may result in reductions in staffing levels, including managerial staff, as costs are cut.
Last, but not least, managers' salaries may well depend on fast growth of sales revenues - managers are rewarded for expanding the business.

Baumol's theory does not ignore profit altogether but is presented in terms of sales revenue maximization subject to a minimum profit constraint. As long as this constraint is met, based on the assumption that this will be sufficient to pacify shareholders, the firm's management will aim to maximize sales revenues. The needs of shareholders cannot be ignored but the minimum profit constraint will usually be less than the maximum profit feasible. Presumably this will especially hold true where shareholders do not know what is the maximum profit that could conceivably be achieved. Lack of information on the part of shareholders may lead them to accept the reported profit. We might expect this to be most prevalent where there are no competitor firms reporting profits to facilitate comparisons.

Figure 3 illustrates the principles of the sales revenue maximization model where the total revenue (TR) and total cost (TC) curves are drawn for a typical firm. The curve ‘ef’ shows the total profit or loss and is derived from the TR and TC curves for each level of sales. It will be seen that the output, which maximizes profit is q3, i.e. where the vertical distance between TR and TC is at its greatest. At outputs q1 and q6 TR = TC and therefore profit is zero. To the left of q1 and to the right of q6, TR is less than TC and therefore losses are being made.

Figure 3 Sales revenue maximization

In the absence of a minimum profit constraint, management could pursue sales revenues by expanding output to q5 where TR is at its maximum (the firm would not wish to increase output beyond this point because total revenue would fall). With the imposition of a minimum profit constraint, such as a level X as shown in Figure 3, sales can now only be expanded up to q4. Expansion beyond this point would lead to a reduction in total profits below the minimum level considered acceptable to shareholders (note that the profit constraint is also met at output q2 but since output q4 provides a higher level of sales revenue, a sales revenue-maximizing management would not choose q2 over q4).

With the pursuit of sales revenue constrained by the required profit level, any increase in this level (shifting the profit constraint line at X upwards) would lead to a reduction in output, whereas any reduction in the required profit would lead to an expansion in output. Note that only if the profit constraint line passes through point A would production be at the level to maximize profits. From this model we can conclude that, in contrast to management which attempts to profit-maximize, a sales revenue-maximizing management will tend to:

Produce at a higher output level.
Set prices lower ...

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Produce at a higher output level.
Set prices lower (since given a normal downward sloping demand curve a higher output can only be sold at a lower price).
Invest more heavily in measures that boost demand, such as advertising (to increase demand without reducing price).

In later formulations of his model Baumol substituted as the objective of management the maximization of the growth of the firm for the maximization of sales revenue. The two goals are, of course, related, though growth maximization is a more dynamic concept. Also, whereas in the sales revenue maximization model the profit constraint could be at any level (whatever keeps the shareholders happy), in the growth model it is set by the 'means for obtaining capital needed to finance expansion plans', i.e. by the need to attract finance for investment. The 'optimal profit stream' is that which is consistent with raising adequate investment funds to achieve the highest rate of growth of output over the firm’s lifetime.

1.3.2 Managerial utility maximization

Baumol's model outlined above implies that management has some choice in the trade-off between profit and sales revenue in business decision making. This recognition has led to the development of other models, which explain firms' behaviour in terms of managerial discretion. An important approach developed by the American economist Oliver Williamson in the 1960s, indicated that managers in large firms have enough discretion to pursue those policies, which give them personally most satisfaction. Whereas shareholders are assumed to equate their level of satisfaction (i.e. 'utility') with profit management is considered to have a utility function, which includes a number of personal goals and personal measures of 'wellbeing'. These goals may include the achievement of a plush office, a large company car, a high salary, etc. In fact, the goal of sales revenue maximization could even be interpreted as a special case where that single goal dominates all other managerial goals or is even the means by which the other managerial goals are realized.

Williamson's model makes allowance for markets not being perfectly competitive and for the agent-principal relationship in firms described by Figure 1. He suggests that managers' self-interest could be seen in terms of the achievement of goals in four particular areas, namely:

High salaries. This includes not just take-home pay but also all other forms of monetary income such as bonuses and share options. The desire for large salaries reflects a desire for a high standard of living, and a high status.
Staff under their control. This refers to both the number and quality of subordinate staff as a measure of status and a measure of power (reflecting the 'I hire them, I fire them' type of management philosophy).
Discretionary investment expenditure. This does not refer to investment that is essential for the success of the firm but rather to any investment over and above this amount. This includes any pet projects of the management that are excused as necessary to the general development of the firm (such as sponsorship, say, of Formula One motor racing in the case of a petrol company). The manager may be able to further his or her own personal interests and hobbies (sponsoring staff golf outings, for example). The extent of the manager's authority over discretionary expenditure may be taken as an indication of his or her status.
Fringe benefits. Managers might strive for an expense account, a lavishly furnished office, a company car, free club memberships, etc. These perks may be part of the 'slack' in the organization - i.e. non-essential expenditures that force up the firm's costs.

Williamson expresses these goals in terms of a utility function. Believing that the first two goals (concerning salaries and staff) are closely related, he combines them under the symbol S. Discretionary investment is represented by 1d while M represents expenditure on managerial perks. Using U to denote utility, which the manager seeks to maximize, Williamson presents the following managerial utility function:

U=f(S, Id, M)

Profits are not ignored by Williamson and like Baumol, he recognizes that a minimum profit must be paid to shareholders but argues that managers will strive to increase their utility as long as this profit constraint is being satisfied. Equally, however, it is possible to conceive of management desiring higher profits because they derive satisfaction from business achievement. Profitability is a measure of business success and buoyant profits provide a fertile environment in which managers can then pursue other goals.

1.3.3 Corporate growth maximization

The third and final variation of the managerial theory of firms' behaviour, which we present here also sees managerial motivation in terms of striving to maximize a target. This time the target is growth. The model is associated with the work of the economist Robin Marris in the 1960s. Again, competition is assumed to be limited, with ownership divorced from management so that there is scope for managerial discretionary behaviour. This theory stems from Marris's view of the institutional framework and organization of the modern corporation. He sees the firm as typically a bureaucratic organization - a self-perpetuating structure where corporate growth and the security that it brings is seen as a desirable end in itself. Managers are expected to see a relationship between the growth of the company and hence profits ploughed back into investment, and their own personal goals (such as increased status, power and salary). At the same time, managers are expected to balance growth against the impact on profits and dividends - they must beware of the danger of low dividends depressing share prices, which may leave the firm vulnerable to a hostile takeover bid. Therefore, growth and security compete as objectives and each requires a different approach to risk in terms of investment and capital raising.

In particular, there may be a trade-off between securing profits to pay dividends and taking risks when investing to increase the growth of the firm. At the same time, while profits provide the retained earnings to help finance new investment, which leads to growth, excessive company liquidity may attract predators. Cash-rich companies attract takeover bids. In the Marris's model this conflict is summarized as management seeking the optimal dividend-to-profit retention ratio.

1.4 Behavioural theories

The approaches to managerial goals considered so far goes well beyond the simple notion of profit maximization. However, they still cling to the idea that management does endeavour to maximize something, whether it be sales revenue, utility or growth, although in a world of uncertainty and large organizations it could be argued that maximizing behaviour of any kind is not relevant. A radically different approach, which is adopted by so-called behaviouralists rejects the whole notion of maximization in favour of a less strong goal of 'satisficing'. Whereas the traditional profit-maximizing model and the alternatives reviewed so far in this chapter have been concerned with how firms should behave to maximize profits, sales revenue, etc., the behaviouralist approach is concerned with how firms actually behave with attention focused on the internal decision-making structure of the firm. The aim is to understand this decision-making process rather than to try to make predictions about price and output.

The idea of 'satisficing' was initially introduced by Professor H. A. Simon in the 1950s where he argued that, faced with incomplete information and uncertainty, individuals are more likely to be content to achieve a satisfactory level of something rather than to strive to maximize goals, and that this level will be revised continuously in the light of experience. This notion was further developed by R. M. Cyert and J. C. March, who established a behaviouralist model of the firm. As noted above, the process of decision-making, ignored in the other models of the firm discussed earlier, is of critical importance. According to Cyert and March, the firm can be thought of as a coalition of various interest groups: different departments, different levels of management, different groups of workers, suppliers and consumers, shareholders, etc. Hence, a complex process of bargaining must take place between these various groups within the firm to determine their collective goals. Some of the goals could be related to the following:

Production. A goal that output must lie within a certain satisfactory range.
Sales. A goal that there must be a satisfactory level of sales.
Market share. A goal indicating a satisfactory size of market share as a measure of comparative success as well as growth.
Profit. Still an important goal, but one amongst many rather than necessarily of overriding importance.

Consequently, there is no single objective of the firm; instead, there are multiple goals, which emerge from the potential for conflict amongst interest groups within the firm. In addition, these goals can be expected to alter over time as circumstances change. Different managers from different departments or sections of the organization will have a strong affiliation for targets in their own areas. For example1 sales personnel will tend to identify with the goals of marketing and sales departments, while the accountants will tend to identify with financial outcomes and the interests of the finance department. There is no necessity that the goals of these different groups should be the same or easily reconcilable. In these circumstances the objectives of the firm are eventually determined by factors such as the following:

Bargaining between groups and the relationship between groups within the firm.
The method by which objectives are formulated within the organization.
How groups and, therefore, the 'firm' react to experiences and make adjustments.

Hence, the various goals set by different departments within the organization may well conflict and it may arise that managers will be prepared to sacrifice some profit to achieve other goals. The way in which such conflicts are resolved draws attention to the process of decision-making within organizations.

The goals may be inconsistent but it is possible to see how they can be reconciled if we introduce the idea of satisficing in the place of maximizing behaviour The aim will be to achieve a satisfactory performance for each of the goals. For example, sales staff might accept what they regard as a 'satisfactory' level of sales growth to maintain an agreed profitability, while finance staff, agree to the firm forgoing some immediate profit by raising spending on advertising. With such compromises within the organization, Cyert and March argue that different groupings can be bought off by 'side payments' when their particular goals are not being met. These side payments can take pecuniary or non-pecuniary forms, such as higher pay for a section of staff or plusher offices for production managers. Similarly, disgruntled shareholders might be bought off by a rise in dividends per share. Naturally, there may be groups who are able to exert a greater influence on objectives from time to time. Psychology plays a key role in the management of the firm in the way just described since people's actions are to a degree a result of their aspirations, which in turn stem from their perception of how well they feel they ought to be doing within the firm.

In summary, the essence of the behaviouralist approach lies in the study of human beings in terms of their relationship with their environment. Within the complex environment of the firm, behaviour can be seen as a compromise between conflicting views and interests. In achieving a compromise so that the firm can function, it is unlikely that any one goal could ever be maximized, at least for long.

Section 2: Pricing Strategies

2.1 The essence of pricing strategies

Choosing the appropriate price to charge for a good or service is one of the most important challenges facing management. Set the price too low and the result will be overwhelming demand and frustrated customers, much as existed in the former Eastern bloc countries where governments kept prices low for social and political reasons in the post-war period. Set the price too high and there will be stockpiles of unsold goods and a probable cash flow crisis. Determining the right price to sell all of the production profitably and to leave no unsatisfied customers - that is to say, customers who wanted to buy at that price - is like trying to balance a set of kitchen scales - too much weight on either side will cause the scales to tilt. Not surprisingly, therefore, economists call the price, which exactly matches the supply and demand for a particular good or service, the equilibrium price.

This section considers the various approaches to pricing that managers might adopt. In particular, we examine the following issues:

∙ Price determination and managerial objectives.

∙ Generic pricing strategies.

∙ Pricing and the competitive environment.

∙ The marketing mix and the product life cycle.

∙ The economics of price discrimination.

∙ Pricing in multi-plant and multi-product firms.

∙ Peak-load pricing.

∙ Pricing policy and the role of government.

In practice, the 'best' or 'correct' price to charge must remain uncertain ahead of actual production and sale. Market conditions are in a constant state of flux, which produces uncertainty and therefore pricing decisions contain no small element of risk. However, so that the basic techniques of optimal pricing strategies can be fully analyzed, the assumption is often made in this chapter that pricing decisions are being made with full or perfect information available to managers about consumer demand, competitors' reactions, supply costs, etc. This is highly unrealistic but it provides a useful starting point for the formulation of best-practice pricing.

2.2 Price determination and managerial objectives

Price serves two broad functions. All managers will be familiar with the first of these - prices raise revenue for the firm. Price multiplied by the quantity sold determines the firm's total revenue and, depending on production costs, ultimately the firm's survival. But the second broad function is of equal importance in that price is a rationing device. It rations out the available production amongst consumers on the basis of their ability and willingness to pay. Topic 2 contained a detailed discussion of consumer demand in which the importance of the demand relationship and of price elasticity were emphasized. At any given time consumers are likely to buy more of a good or service only if its price is reduced (assuming the other conditions of demand such as income and tastes stay unchanged). In stating this, it is not essential to view consumers as always logical and rational, as always achieving maximum satisfaction from their limited income. Economists do not believe that consumers are professional accountants always carrying a portable computer when going about their shopping! All that is essential is that consumers, in general, respond to prices. Not surprisingly, this appears to be borne out in reality. Later in the chapter we will also consider other factors than price that may influence buying decisions, in a discussion of the 'marketing mix'.

Since price is an important determinant of the amount sold, it follows that it also determines the amount supplied. When price is increased or demand rises, the firm will attempt to cash in by increasing supply In turn this means that investment projects are directly dependent on the expected prices of the product concerned. In deciding whether to invest, some judgement must be made regarding likely prices over the lifetime of the investment project (or at least over the period in which cash flows are being discounted to present values). Once the decision has been taken to produce and the investment has been installed, pricing is more tightly constrained. Hence, the greatest freedom in choosing a pricing strategy comes at the planning stage. It must, therefore, be an integral part of investment planning. In general terms, the higher the expected price the bigger the output the firm will want to supply and hence the larger will be the investment in capacity that the firm will be willing to make. Just as demand is a function of price, so too is supply, as we saw earlier in the semester.

2.2.1 Price determination

In a competitive market economy, price is determined by the forces of demand and supply. A good example is the market for colour TVs, where there are a number of suppliers - Sony, Hitachi, National Panasonic, Philips, Toshiba, etc. - each attempting to sell to consumers. The consumer may, of course, not buy on the basis of price alone (though no doubt many do), but for the present we shall concentrate on price as the principal determinant.

Figure 4 The market for Sony TV's

Figure 4 illustrates the general market situation for one of these suppliers, e.g. Sony. The demand curve for Sony TV's is downward sloping, implying that more sets will be sold as the retail price is reduced. The demand curve has also been drawn to suggest that the demand for Sony TV’s is price elastic (price sensitive) around price P1. In practice, Sony's marketing will be aimed at creating 'brand loyalty', but we shall assume that many consumers will still switch to competitors' products if the relative price of a Sony TV is increased. Therefore, when Sony raises its prices, say from P1 to P2 and competitors' prices are unaltered, the expectation is that the demand for Sony TVs will fall from q1 to q2. Equally, if Sony reduces the price of its sets, say from P1 to P3, and its competitors do not follow suit, the demand will rise from q1 to q3.

The supply curve in Figure 4 shows how many TVs Sony will be willing to supply at each price. Provided that price is set at P1 the market will be cleared - hence P1 is the equilibrium price. All consumers wanting to buy Sony TVs at that price are able to obtain them and Sony is left with no unsatisfied demand or unsold stocks. Clearly, if the price is established above P1, Sony will want to sell more TV sets as it is now more profitable to do so, but consumers will be less willing to buy them. The result is unsold sets (i.e. stocks). Equally, if Sony reduces the price below P1 demand will expand, but given that supplying is now less profitable, output will contract, leaving unsatisfied customers.

In practice, the conditions of demand, such as consumer perceptions of the product or competitors' prices, and the conditions of supply, notably costs of production and technology, are likely to change regularly if not continuously. This means that an equilibrium price is likely to be short-lived. Equally, producers usually lack adequate information about the market to predict the equilibrium price precisely Nevertheless, we can usefully view the competitive market as an evolving process in which firms attempt to position their products and set their prices so as to sell their outputs profitably and expand their businesses. Any changes in the conditions of demand and supply must lead to a new equilibrium price in the market which the competitive process leads firms to seek out. The firms most successful at seeking out this price are those most likely to succeed over the long term as they carry fewer stocks of finished products and do not alienate consumers by a failure to supply.

2.2.2 Price and managerial objectives

Pricing is driven by managerial objectives. The precise objectives pursued by management ultimately determine the kind of pricing strategy that is adopted. As we saw in the previous chapter, management might pursue profit maximization, corporate growth maximization, sales revenue maximization, or they might attempt to maximize their own sense of well-being (perhaps subject to a minimum profit requirement to keep shareholders contented). Equally, firms may not maximize anything, preferring instead to achieve a satisfactory outcome to a range of objectives (a satisficing policy). In some industries, notably where there are state-run firms, the target could be breakeven or perhaps involve a negative mark-up. That is to say, the price is set so as to produce a politically acceptable rate of loss, the burden of which is borne by taxpayers. Equally, private sector firms may from time to time adopt for short periods a pricing policy, which leads to no profits or even losses, perhaps to win market share or to protect a brand during a cyclical downturn in the economy or to fight off a competitor in the market place. Occasionally, products may be used as 'loss leaders' (for instance, to attract consumers into the store, some goods could be priced very low and displayed in the shop window). Firms also need to keep a wary eye on important considerations in the market, such as the state of current demand, the market growth rate, the stage in the product's life cycle, its price elasticity, and the prices set by competitors.

Whatever objective is being pursued, however, will have implications for pricing. The firm, which endeavours to maximize its profits will adopt a different price to one which is more concerned with maximizing its market share or sales. This follows from the fact that, in general, firms face downward sloping demand curves. The lower the price the larger the volume of sales and hence the greater the likely market share. By contrast, the more profit-orientated firm may purposely restrict its output to maximize the difference between its sales revenue and supply costs.

2.3 Generic pricing strategies

In this section we consider the generic pricing strategies that firms might adopt. It is possible to perceive of firms adopting different pricing strategies as competition in the market alters over time, or for different products. The implications for pricing of competition, the product life cycle and multi-product firms are considered later.

Four generic pricing strategies are discussed here, namely:

1. Marginal cost pricing.

2. Incremental pricing.

3. Breakeven pricing.

4. Mark-up pricing.

2.3.1 Marginal cost pricing

Marginal cost pricing involves setting prices, and therefore determining the amount produced, according to the marginal costs of production, and is normally associated with a profit-maximizing objective.

A firm maximizes its profits when the difference between total sales revenue and total supply costs is at its greatest. This is equivalent to the output level where marginal cost (MC) equals marginal revenue (MR), as explained earlier in topics 4 and 5.

In a highly competitive market the price charged by a firm in the industry must be identical to the prices charged by the large number of competitors. Hence, the firm faces a perfectly elastic demand curve in the sense that any attempt to price above the market price, even by a very small margin, will result in a total collapse of the firm's sales. This means that when price is set at the market price, the marginal revenue is constant and equal to this price. Therefore, the profit-maximizing condition MR = MC results in price being set equal to marginal cost. This is the essence of a marginal cost-pricing strategy in highly competitive markets.

In an imperfectly competitive market where products are differentiated sufficiently so that firms can charge different prices (e.g. as in the colour TV market), the demand curve faced by the individual firm is downward sloping, as is the marginal revenue curve. The condition of MR=MC still determines the profit-maximizing output but now price is set above marginal cost (refer back to the diagrams in topic 5 which deal with pricing in monopoly situations and imperfect competition). Hence, in such markets price is related to marginal cost rather than equal to it.

2.3.2 Incremental pricing

Marginal cost is the change in total cost from expanding output by one unit, while marginal revenue is the incremental revenue arising from the sale of this extra unit. However, because of indivisibilities in many industries it is not realistic to talk about one unit output changes. Instead, the issue is whether to produce a further batch of output or open another shop or bank branch, etc. Also, in many instances the firm's demand and cost conditions at the margin may not be known precisely and they may be too costly to discover In such cases, a form of marginal cost pricing called incremental pricing might be adopted.

Incremental pricing deals with the relationship between larger changes in revenues and costs associated with managerial decisions. Proper use of incremental analysis requires a wide-ranging examination of the total effect of any decision rather than simply the effect at the margin.

It will be appreciated that fixed costs are irrelevant to both marginal cost and incremental pricing since these costs are 'sunk' and therefore do not change with output (unless the firm is already working at full capacity and therefore output can only be increased by investing, i.e. by incurring more fixed costs). The decision to supply then simply reflects whether the change in total revenue (TR) is greater or less than the change in variable costs (i.e. the marginal or incremental costs from raising output).

A well-known example of incremental pricing involved Continental Airlines in the United States (in the late 195Os) or currently in some of the developing countries where airlines decided whether to add to or cancel flights according to whether the increase in TR from a flight covered the incremental cost of the flight. If fixed costs (the aircraft, management overheads, etc.) were ignored and the costs of keeping a plane parked at an airport were reflected in the opportunity costs of not flying, it made sense to fly a route even where losses resulted. In other words, a smaller loss resulted from flying than not flying. Hence, Continental's operating rule was, in effect, 'does the flight at least cover its incremental costs?' Where a flight more than covered these costs but still operated at an overall loss, it of course made a useful contribution towards the fixed costs.

This example raises the thorny subject of allocation of fixed costs. In modern accounting, rules exist for allocating the costs (notably through a method called absorption costing) so as to minimize distortion of resource allocation. Nevertheless, some firms still cling to broad-brush rules such as allocating overheads according to a product's share in total revenue or total output. This is not an academic issue. The extent to which a product bears fixed costs affects its total costs and hence its viability. Loading higher overhead costs onto high-revenue earners or high-volume products (successful products!), produces smaller margins for these products, and may even lead to their eventual withdrawal from the market. Once these products no longer exist, the overheads then must be allocated to the remaining products, putting their viability in jeopardy. All of the pricing strategies detailed in this chapter rely for their success on sound costing systems.

2.3.3 Breakeven pricing

Breakeven pricing requires that the price of the product is set so that total revenue earned equals the total costs of production.

Using simple arithmetic, we can calculate the breakeven output. For instance, if we are told that the unit sale price of a good is $20 per item and that the variable costs are $9 per unit with fixed costs of $330,000, the breakeven sales level is:

At breakeven:

total revenue (TR) = total costs (TC)

= fixed costs (FC) + variable costs (VC)

Therefore:

$20 X quantity (q) = $330,000 + $9 X q

Hence:

q = 330,000/11

= 30,000 units.

A breakeven point is illustrated in Figure 5. The breakeven, q, output (where TR = TC) is lower than that at which profit is maximized, i.e. q*. Like marginal cost pricing, breakeven pricing requires a detailed knowledge of the firm's cost and demand conditions. In practice, firms may only be able to identify with reasonable accuracy a 'breakeven area' rather than a breakeven point. For multi-product firms, breakeven analysis is much more complicated.

Figure 5 Pricing strategies compared

2.3.4 Mark-up pricing

Mark-up pricing is similar to breakeven pricing, except that a desired rate of profit is built into the price (hence this pricing is also sometimes referred to as cost-plus pricing, full-cost pricing or target-profit pricing).

The particular mark-up will be what management consider appropriate or necessary to achieve a profit, which satisfies the shareholders. This might be equivalent to what the capital could earn if employed elsewhere in its next best alternative use (i.e. a 'normal' profit). For example, if the next best use generates a rate of return of 8%, then the capital would have to earn at least 8% in its current use or it would pay to invest elsewhere. It should be appreciated that mark-up pricing tends to lead to stable prices when costs are not changing much and to large price increases at times of inflation.

When following a mark-up pricing strategy a firm needs to estimate the average variable cost of producing and marketing the product. This requires some view as to the level of output. It is common practice to take a level equivalent to between 70% and 80% of capacity working, unless there are good reasons to choose an alternative. To this average variable cost is then added the average fixed cost to calculate the average total cost. A mark-up figure is then added which represents the required profit margin.

In notation: m=(P-AC)/AC

where m is the mark-up, AC is the fully allocated average cost, and P - AC is the profit margin.

The price, P, is then given by: P = AC(1 + m)

For example, assuming a desired mark-up of 25%, the average variable cost per unit at $10 and the fixed cost per unit at $6, such that AC $16, the selling price, P, is equal to $16(1+0.25)=$20.

A strategy of mark-up pricing tends to be simpler to implement than marginal cost pricing because management do not need to know the relevant marginal revenues and costs. Also, to the unwary it appears to guarantee the desired profit! However, it is unlikely to generate optimal profit-maximizing prices since it ignores demand completely. There is no guarantee that the output produced will all be sold at the particular mark-up price or even that the output is sufficient to satisfy demand. This highlights the risk associated with pricing based on an arbitrary profit margin rule. Prices may not necessarily clear the market and there is the further danger that the price set will be undercut by the competition. Like all cost-based pricing strategies, it could be argued that mark-up pricing starts at the wrong point. It will usually make more sense for management first to discover the maximum price at which the product could be sold (the price set by competitors?) and then work backwards, determining what costs are permissible to leave an adequate profit margin at that price (this is known as 'backward cost pricing').

In practice, most firms, which claim to use a mark-up pricing policy also consider the implications for demand. If they didn't they would not survive for long! Although mark-up pricing is still widely used, since the early 1970s there has been evidence that firms have become much more flexible in their pricing strategies. In an ever increasing competitive environment, mark-ups are being varied to reflect demand conditions. This has led to prices, which are closer to those, which would be determined by a profit-maximizing price. Where firms apply higher mark-ups to products, which are less price-sensitive (i.e. less price elastic), mark-up pricing approximates the profit-maximizing rule.

2.4 Pricing and the competitive environment

The nature of the market in which the product is sold will have a major influence on the pricing policy adopted. As we saw in Topics 4 and 5, markets can be conveniently divided into four broad kinds:

1. Perfectly competitive markets.

2. Monopoly markets.

3. Monopolistically competitive markets.

4. Oligopoly markets.

We discuss briefly below the appropriate approach to pricing in each of these market forms.

2.4.1 Pricing in perfectly competitive markets

In perfectly competitive markets the supplier is a price-taker

That is to say, since each firm's product is indistinguishable from the products of all other competitive firms the consumer buys only on the basis of price. Commodity markets come closest to this type; for instance, tin producers tend to have to accept the going world price for their tin, otherwise they are undercut by other suppliers. Where perfect competition exists, management has no discretion regarding the individual firm's pricing strategy. Survival decrees that the output must be sold at the market price, the price charged by competitors.

2.4.2 Pricing in monopoly markets

In a monopoly situation, the firm is a price-maker

Thus as markets become less competitive, i.e. as the degree of monopoly power of the firm increases suppliers will have more discretion when setting prices. Raising the price will reduce demand but not completely destroy it. Price elasticity of demand now becomes an important consideration in price setting. The less price elastic (i.e. the more insensitive) the demand for the product the greater will be the firm's market power and the greater the management's freedom to set prices. Hence, the monopolist has more freedom than a firm in a competitive market to determine its price. The actual price set by the monopolist will depend upon what objective is being pursued. For example a sales maximization strategy, perhaps to preserve the monopoly position by deterring new competitors, implies a lower price than a short-term profit maximization goal. This type of strategy is commonly referred to as entry-limit pricing.

2.4.3 Pricing in monopolistically competitive markets

Perfectly competitive and pure monopoly markets are rarely found - most firms are subject to some competition but to a lesser extent than would arise under perfect competition. More commonly, most firms are faced with a large number of competitors producing highly substitutable products, such that an attempt to achieve product differentiation is a dominant feature of the market place. This situation, referred to as monopolistic competition, means that firms still have some control over the price of their output. Firms cannot sell all they want at a fixed price, nor would they lose all their sales if they raised prices slightly. In other words, most firms face downward sloping demand curves.

In monopolistically competitive markets, firms put considerable marketing effort into segmenting their markets and thereby reducing competition.

2.4.4 Pricing in oligopoly markets

When markets are monopolistically competitive, firms may make pricing decisions without explicitly taking into consideration competitive reactions. While this may be appropriate for some industries, it is less applicable in an oligopoly market where an individual firm's actions are very likely to provoke a competitive reaction.

For example, when Ford raises the price of its popular Escort range of cars, it knows that demand will be affected but it can also be confident that because of brand loyalty sales (hopefully) will not collapse. Also, firms in oligopolistic industries may price to forestall new entrants. For instance, if Mazda suspects that competitors will be able to supply the 323-type market at a unit cost of $20,000, this will set a limit to the price of the Mazda Astina (another form of entry-limit pricing).

In oligopoly markets it is crucial to know how competitors are likely to react to a price change. Will they follow suit or not? Or will they react in some other way, for example with an extensive advertising budget to preserve their market share? Oligopoly markets, therefore, reflect various competitive strategies in which price may or may not be a critical variable. As also observed in Topic 5, they are also prone to collusion and the formation of cartels (if firms co-operated in setting their prices uncertainty faced by firms would be reduced) and to price leadership. In markets where there is a price leader, pricing policy may have some similarities to pricing in highly competitive markets with the going rate set by one leading firm, but with less attention paid by competing firms to their own demand and cost functions.

2.5 The marketing mix and the product life cycle

2.5.1 The marketing mix

Pricing strategies require the integration of pricing into a wider marketing mix, which takes into account other factors than price, which determine demand. Some firms may be reluctant to change price because of the uncertain effects on rivals' actions, so the other marketing variables take on added importance. At the same time, research suggests that consumers may only have a vague idea of the price of products they buy, which appears to relegate the importance of price in demand, though it does not remove it altogether At the very least, pricing should complement the other factors in the marketing mix.

In developing an effective marketing strategy, marketing professionals draw attention to the importance of the following 'four Ps':

1. Product 2. Place 3 Promotion 4 Price.

Together the four Ps determine what is called the 'offer' to the consumer.

2.5.1.1 Product

The product raises the issue of consumers' perceptions of the product's characteristics. The perceived value or utility to the consumer rather than the supplier's costs of provision becomes the key to pricing strategy, with non-price factors used to increase the perceived value. Whereas breakeven and mark-up pricing emphasize costs as the basis of price, attention to the marketing mix places the emphasis more squarely on demand, with products perceived to be of higher quality or status than the nearest competition attracting 'premium prices'. When the founder of Revlon cosmetics proclaimed that, 'In the factory we make cosmetics, in the store we sell hope!', he was well aware that his marketing success had opened the road to high profit margins.

The economist Kelvin Lancaster has argued that it is the characteristics or attributes of a product (or brand), which gives utility to the consumer and not the product itself. For example, different cars are similar in many respects but each model has unique characteristics, such as fuel economy, acceleration, internal space, etc. Lancaster's approach to consumer demand suggests that the consumer's choice between products is best analyzed in terms of the utility derived from the individual characteristics the products possess, rather than in terms of the products themselves.

2.5.1.2 Place

Place relates to the distribution of the product. How well a product is distributed is important to its success. Hence, successful suppliers put considerable time and resources into distributing the product effectively. can the product be moved quickly from warehouse stores to retail outlets? Is the product best displayed in supermarkets? Are distribution costs controlled to enable competitive pricing? A complicating factor for producers of a consumer good lies in the growing power of the retailer A market trend of the post-war period has been the manufacturer's loss of control over his or her own product's marketing at the point of sale.

2.5.1.3 Promotion

Product promotion involves effective marketing including the provision of adequate credit (very important for consumer durables) and advertising. Brands with intrinsically average quality but high advertising budgets may achieve premium prices. Advertising shapes consumers' perceptions of the product and increases consumer demand at all prices. Thus more can be sold at a constant price or the same amount at a higher price, leading to healthier margins (i.e. there is scope for margin management). There is also some evidence that successful advertising by increasing market segmentation reduces price sensitivity. It therefore enables suppliers to gain a differential advantage by distinguishing themselves from the competition. In effect, the firm gains a 'quasi-monopoly' position. Segmentation and differential advantage involve aspects of product positioning, in which price is just one variable contributing to that positioning.

2.5.1.4 Price

Product, place and promotion all leave their mark on both a firm's demand and cost relationships. Price has to fit with the remainder of the marketing plan because together they determine the product's 'positioning' in the market place. For instance, BMW and Lada both produce cars but if their cars were perceived to be the same by consumers, competition would centre on price and Lada would gain market share at the expense of BMW. The fact that this does not occur is in part a tribute to the marketing of the BMW cars. BMW is popularly perceived to produce cars of high quality and high status. By contrast, the Lada is judged to be of poor quality and low status, hence it sells very largely on price alone. There are no prizes for guessing where the highest profit margin is earned. Over the years, BMW has successfully cultivated an image, which gives it 'brand loyalty'. The brand loyalty relating to Lada is almost certainly much smaller and more vulnerable to competition. Lada distributors in Europe therefore face a threat from brand switching and must price very competitively in order to retain customers.

In the motor industry, price has become a leading indicator to consumers of supposed quality. This is also especially true for services, where what is being bought cannot be easily inspected before purchase. For example, in the marketing of management training courses, high-priced courses are positioned by their providers as high-quality, elitist events. Consumers believe that it is more worthwhile to participate in a highly priced course provided by a leading business school than a cheaper alternative at the local technical college - rightly or wrongly!

The positioning of a good or service in the market has major implications for pricing policy. There is no point in marketing a high-quality product and then selling it at a down-market price. Equally, a product perceived to be of low value must be priced accordingly. Where a firm is competing for consumers and wants to earn high profit margins, it must try to ensure that its and its competitors' 'offers' as far as possible are not compared on price alone.

2.5.2 The product life cycle

A further important factor in pricing strategy is the product life cycle. Products usually undergo life cycles covering the period from their inception in the market to their eventual withdrawal. A typical life cycle is illustrated in Figure 6.

Figure 6 Phases of the product life cycle

The notion of the product life cycle raises important issues for pricing since it implies that there may be a case for adopting different strategies at each stage of the cycle. Notably, when a product is launched the following two broad pricing strategies can be adopted.

1. 'Promotional' or 'penetration pricing' in which the price is set low to enter the market against existing competitors, attract consumers to the new product, and gain market share.

Consequently, there is a more rapid diffusion of the product in the market and as output rises unit costs fall. Penetration pricing makes most sense where unit costs fall dramatically and quickly as output rises due to economies of scale and experience curve effects.

At the early stage of the product life cycle initial losses from pricing low might be financed in multi-product firms by mature cash-generating products ('cash cows'). In single-product firms the strategy requires sympathetic and strong-nerved investors and bankers.

By contrast, in the growth stage of the product life cycle, price may have ceased to be a primary consideration for consumers, other aspects of the marketing mix having taken over in promoting the product. In the maturity stage, there is little point in pricing to gain market share and the emphasis instead is likely to be on profit contribution. Lastly, in the final stage of the product life cycle, as the product declines in popularity, prices may have to be cut to maintain demand and hence margins shrink.

2. A 'skimming policy' arises when price is set high initially to cover large unit costs in the early stage of the product life.

This policy will be attractive where a new product has a monopoly position in the market for a short period. Producers attempt to maximize the present value of the future profit stream by charging a monopoly price in the early years of the product's life and a lower price later, once competitive pressures begin to emerge. The high initial price under a skimming policy implies a lower rate of growth of sales than under a penetration pricing strategy Hence, it will be more appropriate where unit production costs do not decline significantly as output rises.

Whichever pricing strategy is adopted for a new product, it is important to recognize that the price set at the outset will have implications for longer- term pricing, especially in the case of consumer products. Consumers may relate their perceptions of the product to the initial price.

In the same way as there are product life cycles, there are also market-power life cycles with a firm's ability to price high varying over time depending upon its competitive position in the market for its entire production range. When a firm is fighting to survive, prices will reflect this and be aimed at increasing immediate cash flow. This may also be so in the recession period of a trade cycle.

2.6 The economics of price discrimination

Many producers sell their products at different prices to different customer groups for various reasons. For example, quantity discounts may be given for bulk purchases or to retain a valued customer Prices may reflect differences in transport costs to different markets. Also, where demand fluctuates with seasons or time of day, marginal supply costs may justify some form of peak-load pricing (considered fully later in the chapter). In all these cases price varies essentially because the costs of supplying different consumers vary. However, economists reserve the term price discrimination specifically to identify only those circumstances where different consumers exhibit different responses to prices; i.e. where there are different price elasticities. Such a situation justifies differential pricing for the same product.

2.6.1 Definition of price discrimination

Price discrimination represents the practice of charging different prices for various units of a single product when the price differences are not justified by differences in production/supply costs.

The critical factor for successful price discrimination is the ability of the firm to control its own prices. In other words, there must be imperfect competition such that an effective barrier exists to stop consumers from being able to buy the product at a low price and to on-sell at a higher price (hence the reason why low-priced airline tickets are usually non-transferable). Also, there must be different price elasticities of demand in the various markets. These differing elasticities may reflect different preferences, information and perceptions of the product, and incomes and tastes. Where different price elasticities exist there is scope for price discrimination. An obvious example is the pricing of seats on public transport. The cost of transporting a child is the same as transporting an adult but the demand elasticities are likely to differ.

Price discrimination, in practice, is a matter of degree. Thus, three possible strategies may be identified. These are referred to as follows:

First-degree price discrimination.
Second-degree price discrimination.
Third-degree price discrimination.

We briefly comment on each below.

2.6.1.1 First-degree price discrimination

At the extreme, it is possible to conceive of a producer who sells each unit of output separately, charging a different price for each unit according to the consumer's demand function. Imagine a situation where, if a consumer is willing to pay 60p for a chocolate bar then that is what he or she is charged. Another consumer willing to pay only 30p would be charged that amount and so on. Since all consumers pay for each unit of consumption a price, which just reflects the marginal utility (i.e. satisfaction) they get from the product, the result is the transfer of all of the consumer surplus to the producer (for an explanation of consumer surplus see Topic 3). Although attractive to the producer, price discrimination of this intensity would require the producer to have a detailed knowledge of each consumer's demand function. Hence, what is known as first-degree price discrimination is of theoretical interest rather than practical value.

2.6.1.2 Second-degree price discrimination

A more useful approximation, second-degree price discrimination, involves charging a uniform price per unit for a specific quantity or block of output sold to each consumer This policy extracts part but not all of the consumer surplus and is found where demand can be metered, as in the pricing of gas, water and electricity, or usage monitored, for example where computer time or xerox machines are rented.

2.6.1.3 Third-degree price discrimination

Most frequently found is third-degree price discrimination, which simply involves charging different prices for the same product in different segments of the market.

The markets may be separated in the following number of ways:

By geography as when an exporter charges a different price overseas than at home.
By type of demand as in the market for, say, butter where demand by households differs from the bulk purchase demand of large catering firms.
By time with a lower price charged for off-peak periods (as in the case of the electricity and telephone sectors).
By the nature of the product - as with private dental care with differential pricing where if one patient is treated he or she is unable to resell that treatment to someone else.

By charging differential prices to the various market segments for the same product the so-called price discriminator will be able to increase his total profits above the level that would have existed in the case of uniform pricing. This is because he is soaking up as much consumer surplus as possible (and hence transforming it into producer surplus - i.e. higher profit margins for himself!).

Figure 7 Third-degree price discrimination

The economics of third-degree price discrimination are illustrated in Figure 7. Here, two sub-markets for a product are shown, market A and market B. For convenience, the demand curves are shown as straight lines. The demand elasticities are different in the two markets. If the firm wishes to profit-maximize, then it will sell each unit of output it produces in that sub-market where the revenue added (the marginal revenue) is greatest. In other words, it will allocate its output between the sub-markets until the marginal revenue earned in both is equal. This gives rise to a price of PA in market A and PB in market B. There is then no further incentive to reallocate production between the sub-markets.

The combined marginal revenues in the two sub-markets is shown in segment C of the figure, along with the marginal cost curve which relates to the production of the total output and the total market demand curve. As usual profit is maximized where MR = MC, which in this case is at an output Q(qA + qB). This output is allocated across the sub-markets so that the marginal revenue is equal in both. Hence, qA is sold in market A at a price PA per unit and qB is sold in market B at a price PB per unit. No other allocation of the total output between the sub-markets will achieve a higher profit than that which is earned here.

For all forms of price discrimination to be successful it is essential that arbitrage cannot occur Otherwise, consumers buying the product at a lower price could capitalize by selling it in the higher-priced market. This would boost the supply in this market and reduce prices until they were eventually equal in the two markets and the scope for arbitrage ceased to exist. We can now understand why car manufacturers are keen to prevent the re-import of cars sent to foreign markets for sale at lower prices!

Before adopting a price discrimination policy it is important to consider wider effects. The practice of Australian motor manufacturers (like Wheat and Sugar boards) selling cars (wheat and sugar) cheaper on the world market than at home has led to consumer resentment in some circles. Firms contemplating price discrimination need to consider not only whether it is technically feasible, but also its wider impact on both their image and the threat of state intervention.

2.7 Pricing in multi-plant and multi-product firms

So far we have been primarily concerned with the pricing of one product by a firm, which appears to produce its output in one location. In practice, however, most firms of any real size produce a range of products and on more than one site. This raises interesting questions for pricing and for the resulting distribution of production across the firm. The existence of more than one production point also facilitates price discrimination between different geographic areas served. This will be especially so where the production occurs in different countries and national markets are protected by import controls.

2.7.1 The multi-plant firm

Where a firm's output of the same product is produced on more than one site, the profit-maximizing output rule that marginal supply costs must equal marginal revenue, is unchanged, but in this case this marginal cost is the sum of the separate plants' marginal costs and production must be allocated between the plants so that the marginal supply cost at each plant is identical.

Figure 8 Pricing in a multi-plant firm

This situation is illustrated in Figure 8, where the firm is assumed to have two plants, A and B, which both produce an identical product. Profit maximizing occurs where the firm's total output QT is divided between the two plants in the proportions qA in plant A and qB in plant B. This follows since profit maximization requires cost minimization and if MCA did not equal MCB, costs could be further reduced by shifting some output from the higher-cost to the lower-cost plant.

Where the firm produces multi-products on different sites the production and pricing problem is more complicated.

2.7.2 The multi-product firm

When producing and pricing a product, the multi-product firm has to take into consideration not only the impact on the demand for that product of a price change (its own price elasticity of demand) but the impact on the demand for the other products in the firm's range (the relevant cross-price elasticities). In other words, pricing now involves obtaining the desired rate of return from the full product range rather than individual products.

Such full-range pricing means that the firm may be content to earn little or no profit on certain products, preferring to use them as 'loss leaders' to attract consumers who then (hopefully) buy the higher-profit items. This has been for a long time the strategy of some supermarkets. They make very slim margins on basic goods such as bread and potatoes, which because they are widely sold in other shops have a relatively high price elasticity, making their profits on higher-margin (i.e. lower-demand elasticity) goods, such as items sold at the delicatessen counter. Contrast this with the attitude to pricing in the post-war Australian Footwear and textile industry where the objective was to earn healthy profits from each item, and the price was set accordingly. The Australian industry's market disappeared as Asian competitors undercut the Australian producers' prices. The Asian goal initially was market share or longer-term profits from selling a full product range.

In multi-product firms the products can be complementary, such as Kodak, which sells cameras and film, or substitutes, such as Arnotts' biscuits. In both cases demand for the products is interrelated. This means that profit maximization requires that the output levels and prices of the products produced are determined jointly (in some firms the marketing departments of the various products may compete to increase efficiency and drive down costs, but this risks ignoring the high cross-price elasticities with damaging results for overall profitability).

In addition to demand interdependencies, multi-product firms may have production interdependencies. The most obvious example relates to the production of by-products. In such cases, complex joint-costing' rules must be introduced and economies of scope recognized (cost reductions resulting from supplying together two or more products). Products can be produced jointly in fixed or variable proportions. The classic example of production in fixed proportions is beef and hides, which are produced equally. Hence, the costs of supply cannot be meaningfully apportioned between the two outputs.

Where joint products can be produced in variable proportions, then the profit maximization rule requires that the marginal revenue from each output is equated with its own marginal cost, with due cognizance given to any demand interdependencies.

2.7.3 Transfer pricing

Large-scale multi-product, multinational firms are often decentralized by being split into semi-autonomous divisions, with each responsible for its own price and output decisions as well as profit performance. However, decentralization brings with it problems of resource allocation, one aspect of which is the pricing of products which are transferred between divisions. This gives rise to the need for transfer pricing and the problem of determining the transfer price, which maximizes overall company profits. For example, it may be possible for one division to raise its own reported profits by raising the transfer price but this may be at the expense of profits made by the receiving division. In such situations the general answer to the transfer-pricing problem is that the product being transferred between divisions should be priced at marginal cost.

Furthermore, when divisions are located in different countries with different tax systems, transfer pricing can be used to redistribute profits between countries in order to minimize the overall tax liability. This could be achieved, for example, in situations where one country, A, has a high profits tax relative to another country, B. By setting the transfer price artificially low in country A, the profits could be realized in country B. It should be noted, however, that under fiscal regulations such arrangements are usually illegal - though they are also difficult to police.

2.8 Peak-load pricing

Where the demand for a product varies over time it can pay to introduce a form of discriminatory pricing called peak-load pricing. In this case, the major factor leading to differentiated prices is the differences in supply costs over time, i.e. the marginal cost of supplying the product or service is much lower at off-peak times when there is spare capacity, and much higher at peak times when there is congestion. The higher peak-time costs may be due to several factors as follows:

Diminishing returns and hence higher short-run marginal costs;
The need to use more expensive inputs to satisfy peak-time demand;
The whole of the capital costs of the additional capacity needed to satisfy peak-time demand being attributable to the peak users; and
Externalities: for example, rush-hour traffic congestion imposes external costs on other travellers such that the marginal cost to society as a whole rises.

Peak-load pricing is used extensively not only in public transport, but also in electricity and gas supply, the postal system and telecommunications, and by travel companies and hotels which charge much less for the same holiday or room 'out of season', e.g. the pricing of 'winter weekend breaks'.

When differentiated pricing is introduced in this way some consumers will alter their demand pattern. For example, they may change to travelling off-peak or they might install an off-peak electricity meter This is desirable as it smooths out demand thus reducing congestion in peak periods. However, if peak-load pricing causes such a shift in consumer behaviour that the previous off-peak period now becomes a peak period, prices will have to be adjusted further and this may mean less differentiated pricing with off-peak users also bearing some of the capital costs.

2.9 Pricing policy and the role of government

All market economies have some state intervention in pricing in the form of taxation and subsidies, and direct controls, such as regulations and licensing. Also, in many countries state-owned industries exist at central and local government levels and some decision must be taken on the pricing of their outputs.

2.9.1 Taxes and subsidies

In a private market the price consumers are willing to pay reflects the benefits they receive from marginal consumption. However, in some cases the price consumers are willing to pay may not accurately reflect the true social benefits and costs of the consumption - i.e. there are externalities - in which case the price could be altered through taxes and subsidies. For example, coal-fired power generation causes major pollution, so it could be discouraged by imposing a pollution tax (based on the principle that the polluter should pay). Equally, in so far as public transport has wider social benefits by reducing congestion on the roads, demand for it can be encouraged by state subsidies to keep prices low.

It is important to appreciate, however, that only some forms of taxation have an effect on the pricing decision. For example, for a profit-maximizing monopoly a tax on corporate profits should not affect price or output because neither marginal revenue nor marginal cost is affected. The tax simply removes some of the monopolist's supernormal or excess profits.

Taxes on products do affect prices and outputs. The price to the consumer is raised, which will affect demand depending on the price elasticity of the product. A subsidy has the opposite with the price reduced, though not necessarily by the full amount of the subsidy. Just as the supplier may have to absorb some of the tax to retain demand, so the producer might absorb some of the subsidy

2.9.2 Direct price controls

Government direct controls on pricing arise out of prices and incomes policies, anti-monopoly and restrictive practices legislation, and other forms of regulation and licensing. The latter has grown in importance in a number of countries in recent years following the privatization of major public utilities, namely, telecommunications, gas, electricity; water and rail industries in some countries. The monopoly suppliers now operate under licences granted by the state, which lay down, amongst other things, price regulations.

Rate-of-return regulation is ultimately an indirect form of price regulation since the price charged is an important variable in determining profits. Where the price is directly or indirectly regulated, competition must centre on some other aspect of the marketing mix. In the airline industry, for example, where prices can be heavily regulated, competition is often focused on the level of service, in-flight catering and movies, speed of the check-in desk, and who flies the most modern aircraft at the peak demand times.

2.9.3 Pricing in the public sector

Although many of the issues raised so far, notably peak-load pricing, are relevant to the public sector, pricing in the public sector raises certain unique issues. To begin with, the public sector may well have different objectives since it is concerned with the wider public interest rather than profits. If this is so, state enterprises should set their prices with an eye to the marginal social benefits (MSB) from the additional output and the marginal social costs (MSC) of producing that output. The MSB reflects the benefits to the immediate consumer plus any external benefits (wider social gains) and the MSC is calculated to reflect not only the normal marginal costs - wages, raw material costs, etc. - but any external (social) costs, such as environmental effects. By pricing in this way, a public utility maximizes the difference between the social benefits of production from the output and the social costs of producing that output. The result, however, may be losses, which have to be met through taxpayer subsidies and taxation, which distorts employment, investment and spending decisions. Also, subsidies imply a welfare transfer between payers of taxes and the recipients of subsidized services. Why should all taxpayers subsidize rail users? Is the implied income redistribution equitable?

On the basis of the 'public interest' rule, the public sector should invest and expand output when the marginal social benefits of expanding output exceed the marginal social costs, and should contract production when the marginal social costs exceed the marginal social benefits. But such pursuit of the 'public interest' through public utility pricing depends upon government correctly assessing the public interest and pursuing it relentlessly. In practice, politicians have tended to interfere with the prices set by state-owned industries to hold down inflation, boost government receipts and preserve jobs even when it has been difficult to perceive a public interest objective. To critics the result has been higher inefficiency in the public sector and lowered managerial morale. A key argument for privatization of state industries has been the removal of damaging political control and the restoration of commercial pricing.

Therefore, the fact that prices may be as likely to reflect political considerations as true marginal social costs is a major weakness of state intervention in pricing. This is likely to be an especially acute problem for government services such as social security, education, health and defence. In such services, usually no price is charged, or it is a nominal charge and all or most funding comes from taxation. For example, in Australia education used to be and now most medical care is relatively free to the user within the Medicare system.

SECTION 3. Concluding remarks

The behaviouralist approach to the firm has won many adherents because it appears to be the most descriptively realistic. Rather than simply assuming some maximization objective (profits, sales, etc.), it seeks to explore the internal decision-making of the firm and the process by which the goals emerge. It allows for and copes with conflicting and changing goals, which the other theories reviewed in this chapter avoid. Also, it is concerned with how firms reach decisions and why. Its main weakness, however, lies in its lack of generality and thus predictive ability. Clearly, maximization of something is easier to model than satisficing behaviour Since every firm is different, we may need a different 'behavioural outcome' for each firm. In truth, economists prefer economic models which are generally applicable and which have predictive ability even when this is gained at the expense of descriptive reality.

The other approaches to the firm discussed in Section 1 provide interesting variations on the traditional profit-maximizing assumption. In the sense that they highlight managerial discretionary behaviour, the choice of goals, goal conflict and the constraints upon management decisions, they have considerable value. However, as with the behavioural theory, most economists regard them as supplements to the profit-maximizing model, at least in relation to the private sector; in the state sector where there is often no profit goal they are clearly appropriate.

The profit-maximizing model, set out in Topic 4, still prevails. Even within the alternative models put forward, profit exists as an important constraint upon management and it is still the case that the profit-maximizing model serves us well in predicting how price and output will change when, for example, product taxes are raised, costs of production increase or market price is lowered. Moreover, some economists stress that profit maximization and the other models of the firms can be reconciled through a more careful definition of profit maximization which stipulates the time period concerned. Sales revenue growth, for example, may be the short-run target set to achieve a greater market share with a view to maximizing profits in the longer term.

The importance of the different theories reviewed in this section arises from the insight they provide into the impact of different managerial objectives on the behaviour of firms and, more specifically, price and output decisions. Determination of the firm's goal or goals is a crucial first step in developing an effective competitive strategy. Only once we clearly define where we want to go can we begin to decide how to get there. The next chapter focuses on the different pricing policies, which can be adopted. The precise policy chosen will, of course, amongst other things, reflect management's precise objectives.

Section 2 has been concerned with pricing policies under differing market conditions. As we have seen, optimal pricing requires a full consideration of both demand and cost conditions. Prices based solely on supply costs (with a fixed profit margin) are unlikely to reflect sufficiently the state of consumer demand and hence are likely to lead either to oversupply and thus unsold stocks, or excess demand and unsatisfied consumers. We have also seen that there is a case for a more flexible approach to pricing where markets with different price elasticities are supplied or where a peak-load problem exists. The pricing formula also becomes more complex in multi-plant and multi-product firms; while pricing in the public sector raises its own peculiar problems associated with the inevitable political pressures public sector managers face. Nevertheless, one common theme has run through the chapter - successful firms are those which gain competitive advantage and price remains an important variable in achieving this advantage. In the next chapter we turn to consider another crucial factor in competition, profitable investment.

SECTION 4. Key learning points

The traditional theory of the firm, based on the assumptions of perfect knowledge and profit-maximizing behaviour, may not be readily applicable, given the complexity of organizational structures today.
Agency theory recognizes the growth in managerial capitalism and the complexity of modern organizational structures based on the agent-principal relationship which separates the role of management (the agents) from the principals (the owners of the business).
Baumol concludes that management, which attempts to maximize sales revenue will tend to produce at a higher output level, set lower prices and invest more heavily in measures that boost demand than management which attempts to maximize profits.
Williamson's managerial utility maximization model argues that managers seek to maximize their own self-interest based on the achievement of goals such as high salaries, authority over staffing, discretionary investment expenditure decisions and fringe benefits.
Marris's corporate growth maximization model suggests that management seek to maximize the growth of the firm subject to an optimal dividend-to-profit retention ratio in order to safeguard the firm from a hostile takeover bid.
The satisficing explanation of managerial behaviour argues that there is no single objective of the firm; instead, there are multiple goals. These emerge from the potential for conflict amongst interest groups within the firm, such that the aim will be to achieve a satisfactory performance for each of the goals without any single, maximization objective.
Equilibrium pricing is likely to be short-lived since the conditions of demand and supply are likely to change regularly if not continuously. In addition, producers usually lack adequate information about the market to predict the equilibrium price precisely
Pricing, in practice, is driven by managerial objectives relating to factors such as profitability, corporate growth, sales revenue, managerial satisfaction, etc.
Generic pricing strategies may be based on marginal cost, incremental cost, breakeven or mark-up pricing.
Marginal cost pricing involves setting prices, and therefore determining the amount produced, according to the marginal costs of production, and is normally associated with a profit-maximizing objective.
Incremental pricing deals with the relationship between larger changes in revenues and costs associated with managerial decisions.
Breakeven pricing requires that the price of the product is set so that total revenue earned equals the total costs of production.
Mark-up pricing is similar to breakeven pricing, except that a desired rate of profit is built into the price (therefore this pricing is also sometimes referred to as cost-plus, full-cost or target-profit pricing).
In perfectly competitive markets, the supplier is a price-taker
In a monopoly situation, the firm is a price-maker
In developing an effective marketing strategy, marketing professionals draw attention to the importance of the four Ps: product, place, promotion and price.
With respect to the product life cycle, promotional or penetration pricing sets the price low to enter the market against existing competitors in order to attract customers to the new product and gain market share.
A skimming policy arises when price is initially set high perhaps to cover large unit costs in the early stage of the product life cycle.
Price discrimination represents the practice of charging different prices for various units of a single product when the price differences are not justified by differences in production/supply costs. Successful price discrimination requires an absence of arbitrage opportunities and differing elasticities of demand in the various markets.
First-degree price discrimination arises in the case of a producer selling each unit of output separately, charging a different price for each unit according to the consumer's demand function. This results in the transfer of all consumer surplus to the producer
Second-degree price discrimination involves charging a uniform price per unit for a specific quantity or block of output sold to each consumer
Third-degree price discrimination involves charging different prices for the same product in different segments of the market. The market may be segmented by geography, by type of demand, by time, or by the nature of the product itself.
In the case of a product produced by a multi-plant firm, the profit maximizing output rule (MR = MC) is unchanged, but in this case the marginal cost is the sum of the separate plants' marginal costs and production must be allocated between the plants so that marginal supply cost at each plant is identical.
The multi-product firm has to take into consideration not only the impact of a price change on the demand for the product, but also the impact on the demand for the other products in the firm's range. Pricing policy, therefore, involves obtaining the desired rate of return from the full product range rather than individual products.
Decentralization of firms brings with it problems of resource allocation, one aspect of which is the pricing of products which are transferred between divisions. This gives rise to the need for transfer pricing and the problem of determining the transfer price, which maximizes overall company profits.
Peak-load pricing involves differentiated pricing, which reflects differences in supply costs, given variations in demand for the product over time.
On the basis of the public interest rule, state enterprises should set prices in order to reflect the marginal social benefits from the additional output and the marginal social costs of producing that output.