Page 229 - DECO101_MICRO_ECONOMICS_ENGLISH

Micro Economics

Notes Most of the American firms start with a rate of return they consider satisfactory, and then set a

price that will allow them to earn that return when their plant utilization is at some ‘standard
rate’ - say, 80 per cent. In other words, they determine standard costs at standard volume and

add the margin necessary to return a target of profit over the long run.

Rate of return pricing is a refined variant of full-cost pricing. Naturally, it has the same

inadequacies, viz. it tends to ignore demand and fails to reflect competition adequately. It is
based upon a concept of cost, which may not be relevant to the pricing decision at hand and
overplays the precision of allocated fixed costs and capital employed.

14.1.3 Marginal Cost Pricing

Both under full-cost pricing and the rate-of-return pricing, prices are based on total costs

comprising fixed and variable costs. Under marginal cost pricing, fixed costs are ignored and
prices are determined on the basis of marginal cost. The firm uses only those costs that are directly

attributable to the output of a specific product. A pricing decision involves planning into the

future, and as such it should deal solely with the anticipated and, therefore, estimated revenues,

expenses, and capital outlays. All past outlays which give rise to fixed costs are historical and
shrunk cost.
With marginal cost pricing, the firm seeks to fix its prices so as to maximize its total contribution

to fixed costs and profit. Unless the manufacturer’s products are in direct competition with each

other, this objective is achieved by considering each product in isolation and fixing its price at a
level which is calculated to maximize its total contribution.
!
Caution There are two assumptions behind use of such a method:

1. The firm is able to segregate its markets so that it is able to charge higher price in
some market
2. Lower price in others, and there are no legal restrictions.
Advantages of Marginal Cost Pricing

1. With marginal cost pricing, prices are never rendered uncompetitive merely because of a

higher fixed overhead structure, or because hypothetical unit fixed costs are higher than

those of the competitors. The firm’s prices will only be rendered uncompetitive by higher

variable costs, and these are controllable in the short run while certain fixed cots are not.

2. Marginal costs more accurately reflect future as distinct from present cost levels and cost
relationship. When making a pricing decision one is more interested in changes in cost
that will result from that decision. Marginal cost represents these changes, while total costs
include fixed costs, which are not incurred as a result of the pricing decision.

3. Marginal cost pricing permits a manufacturer to develop a far more aggressive pricing
policy than does full-cost pricing. An aggressive pricing policy should lead to higher sales
and possibly reduced marginal costs through increased marginal physical productivity
and lower input factor prices. However, before entering into a more differentiated and a
more flexible pricing policy, it would be necessary to consider the impact of unstable prices

on consumer goodwill.
4. Marginal cost pricing is more useful for pricing over the life cycle of a product, which

requires short-run marginal cost and separable fixed cost data relevant to each particular
stage of the cycle, not long-run full-cost data. Marginal cost pricing is more effective than
full-cost pricing because of two characteristics of modern business:

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