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Unit 14: Pricing Decisions

limitations of the estimation method. Besides, there is a problem of product interdependence Notes

among rival firms, which is rather significant in an oligopolistic market. Similar problems are
witnessed with regard to the cost function.

There is no unique theory of firm behaviour. Profit is certainly an important variable for which

every firm cares, but maximisation of short run profit is not a popular objective of the fi rm today.

Firms seek maximum profit in the long run. The problem is dynamic and its solution requires
accurate knowledge of demand and cost conditions over time, which may be impossible.
In view of these problems, economic prices are a rare phenomenon. Instead, firms set prices for

their products through several alternative means which we are going to discuss in this unit.
14.1 Cost-based Pricing
Cost-based pricing methods have three types – Full cost pricing, target return pricing and the
marginal cost pricing.

14.1.1 Cost-plus or Full-cost Pricing

This is the most common method used for pricing. Under this method, the price is set to cover

costs (materials, labor and overhead) and pre-determined percentage or profit. The percentage

differs strikingly among industries, among member firms and even among products of the same

firm. This may reflect differences in competitive intensity, differences in cost base and differences
in the rate of turnover and risk. In fact, it denotes some vague notion of a just profi t.
Let us discuss the factors determining the normal profit. Ordinarily margins charged are highly

sensitive to the market situation. They, may, however, tend to be inflexible in the following
cases:
1. They may become merely a matter of common practice.
2. Mark-ups may be determined by trade associations either by means of advisory price lists
or by actual lists of mark-ups distributed to members.
3. Profits sanctioned under price control as the maximum profit margins remain the same

even after the price control is discontinued. These margins are considered ethical as well as

reasonable. Usually profit margins under price controls are set so as to make it possible for

even the least effi cient firms to survive. Thus, the margin of profits tends to be higher than

what would be possible under competitive conditions.
Advantages of Cost-plus Pricing Method
A clear explanation cannot be given for the advantage and widespread use of full cost pricing,
as fi rms vary greatly in size, product characteristics and product range. They also face varying
degrees of competition in markets for their products. However, the following points may explain
its advantages:
1. Full-cost pricing offers a means by which fair and plausible prices can be found with ease
and speed, no matter how many products the fi rm handles.

2. Prices based on full cost look factual and precise and may be more defensible on moral
grounds than prices established by other means.
3. Firms preferring stability use full cost as a guide to pricing in an uncertain market where
knowledge is incomplete. In cases where costs of getting information are high and the
process of trial and error is costly, they use it to reduce the cost of decision making.

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