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Micro Economics

Notes 4. In practice, firms are uncertain about the shape of their demand curve and about the
probable response to any price change. This makes it too risky to move away from full-
cost pricing.
5. It is difficult, except ex-post, to identify and compute direct costs.

6. Fixed cost must be covered in the long run and firms feel that if they are not covered in the
short run, they will not be covered in the long run either.
7. A major uncertainty in setting a price is the unknown reaction of rivals to that price. When
products and production processes are similar, cost-plus pricing may offer a source of
competitive stability by setting a price that is more likely to yield acceptable profit to most

other members of the industry also.
8. Management tends to know more about product costs than other factors, which are
relevant to pricing.

Disadvantages of Cost-plus Pricing Method

Following are the commonly observed disadvantages of cost plus or full cost pricing method. A

firm should be sensitive to these issues before deciding in favor of such a method.
1. It ignores demand - there is no necessary relationship between cost and what people will
pay for a product.

2. It falls to reflect the forces of competition adequately. Regardless of the margin of profi t

added, no profit is made unless what is produced is actually sold.
3. Any method of allocating overheads is arbitrary and may be unrealistic given the nature of
the product and the market in which it is being sold. Insofar as different prices would give
rise to different sales volumes, units costs are a function of price, and, therefore, cannot
provide a suitable basis for fixing prices. The situation becomes more difficult in multi-

product fi rms.
4. It may be based on a concept of cost, which may not be relevant for the pricing decision.
Full cost pricing ignores marginal or incremental costs and uses average costs instead.
Cost-plus pricing is especially useful while deciding prices for public utility and for tailored or
customized products. Situations in which cost plus pricing is useful:

1. Product tailoring involves determining the product design after the selling price is
determined. By working back from this price, the product design and the permissible cost
is decided upon.
2. This approach takes into account the market realities, by looking from the viewpoint of the
buyer in terms of what he wants and what he will pay.

3. Cost plus pricing is also helpful for pricing products that are designed to the specifi cation
of a single buyer. The basis of pricing is the estimated cost plus gross margin that the fi rm
could have got by using facilities otherwise.

4. It is also possible for monopoly buying, where the buyers know a great deal about
suppliers’ costs. They may make the products themselves if they do not like the price. The
more relevant cost is the cost that the buying company would incur if it made the product
by itself.
These reasons provide some explanation but do not justify it as the logical approach to pricing.

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