Economic Theorists Approach to Pricing

Subject: Finance
Pages: 9
Words: 2740
Reading time:
10 min
Study level: PhD

Introduction

Pricing is one of the major goals of the firm. Every firm needs to determine the price at which they will sell their product s in the market. Almost all the goals of the firm are dependent on the pricing objectives of the firm. For example, the profit maximization goal of the organization depends on the price at which the products are sold. Economic theorists have attempted to come up with many approaches that a firm can use while pricing its products (Boehm, 2002, 209). The economic theorists approach to pricing is largely used in pricing in practice. Most firms have multiple pricing objectives and they must apply the most appropriate pricing approach in order to achieve those objectives. The short run and long run profit maximization is a major pricing goal of every profit oriented firm and the price is set so as to realize the profitability level set by the firm (McKenzie& Dwight, 2010). Every profit making organization pursues the goal of maximizing the profit subject to the cost it incurs in producing goods and services. The firm determines the profit maximization level of out put and then determines the price for those outputs. The firm determines both the cost and revenues functions which are used to come up with the profit function. Calculus method may be used in order to come up with the level of output that will give the firm the maximum profit.

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The firms also seek to increase the sales volume through pricing. The firm tries to offer the most competitive price in the market in order to attract most customers in the market and attain the sales target. Increase in sales volume also increases the monetary sale of the firm. The other objective is to maintain price leadership in the market by offering the best price for quality products in the market (Langlois & Robertson, 1995). The firm may set a price slightly lower than that of the competitors so that they can get the biggest market share. The price set in this case depends on the sales volume targeted and the prices that are offered by competitors.

Pricing is also aimed at matching competitors’ prices where the firm tries to set the price so that it does not differ much with the competitors. The price may be set slightly below or slightly above that of the competitors so as to attract the customers to buy the product. Company growth could also be achieved through pricing because growth is dependent on the pricing strategies. The firms’ growth could be with respect to the number of customers that the company has or the amount of profit they make.. Pricing is therefore the main goals of the organization because all the other goals cannot be met if pricing objectives are not met.

This essay explores the role of economic theorists’ approach to pricing to pricing in practice. It tries to answe5r the following question: “What light does the economic theorist’s approach to pricing shed on pricing in practice?”

Economic theory of pricing

Economic theory of pricing claims that the amount of demand of a good in the market plays a big role in determining the price of the commodity. Economists in this case argue that the price of a commodity in the market is dependent on the market forced of demand and supply. The theory of demand and supply can therefore used to explain pricing of commodities in the market. According to Beach & Carpenter (1931, 5), the theory of demand and supply are commonly refereed to as price theory because their forces affect the price of a commodity. Demand theory argues that the price of a commodity is dependent on the prevailing demand of that commodity in the market. The most useful concept in this theory is demand quantity of a commodity. Quantity demand is the number of units of a commodity that the consumer goes for in the market which may vary depending on the price charged in the market. The amount demanded relates inversely to price changes such that it goes up as price reduces and reduces as price goes up (Ricketts, 2003). When the demand of a commodity is high, its price tends to increase because there are many consumers that are chasing few commodities in the market. The reason for the increase in price is because the consumers are willing to buy the commodity even at higher prices. The suppliers on the other hand are taking advantage of the excess demand in order to increase their volume of sale.

Supply theory could also be used to explain pricing of commodities in the market. Supply refers to what the willingness of the suppliers to take their commodities to the market at the prevailing prices (Kenwood & Lougheed, 2002). Quantity supplied is the amount of a commodity that the suppliers are ready to take to the, market for sale at the price that the consumers are offering in the market. According to the University of Michigan (2007). As more and more units of a commodity are supplied in that market, their price tends to decrease because the demand of the commodity will also decrease. There are few consumers chasing excess demand in the market. The supplier will have to reduce their price in order to sell more of their product in that market. Consumers will go for the lowest price of a commodity when the commodity is in ample supply but when the commodity is scarce, the consumer will still buy it at what ever the price that is being offered.

Firms may set their prices in the market depending on the forces of demand and supply in the market. When demand of a commodity is very high in the marker, firms will charge a high price for the commodity. This is because the consumers are willing to buy the commodity at that high price. The short run profit maximization objective could easily be achieved during the seasons of high demand. When the demand of a commodity is low in the market on the other hand, the firms will charge relatively low price in order to increase the sales volume (Hornsby, 2001). Therefore, the firms pricing in practice is largely dependent on the theory of demand. When the supply of goods in the market is very high, the firms will have to reduce their prices in order to attract customers. When the supply is low, it means that the demand is high and the firms will increase their prices because the consumers will still buy at that high price.

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Since the supply and demand of a commodity are affected by many factors, the pricing strategy of the firm is therefore partly dependent of these factors. For instance, if the cost of production of a commodity increases, the price of that commodity will be higher in the market. This is because the producers want to meet their cost of production and also make profit. The firm will therefore charge a price that will reflect the cost of production and the profit markup that the firms targets (Khanna & Jain, 2006). Some of the pricing approaches adopted by the firms are directly or indirectly influenced by the theory of demand and supply in the market.

Factors affecting pricing and common pricing approaches used by firms in actual pricing

Firms applied different approaches in setting the prices of their commodities. The setting of prices by firms is dependent on several factors which actually determine the amount of price to be charged in the market. The factors that affect the pricing decision of the firm are categorized in to internal and external factors depending on whether they are within or without the firm. Marketing or pricing objectives has a significant influence on pricing and determines the price to be charged in the market. These objectives include profit maximization and market share leadership among others (Madura, 2006). The other factor that affects pricing is the costs incurred by the firms in producing the product. The product price must meet the cost that was used in producing it. If the cost of production is high, the firms must charge relatively high prices in order to meet the cost. Relatively Low prices will be charged when the cost of production is high.

The other factor that affects pricing is the marketing mix strategies of the firm. Price is one of the elements of the marketing mix and should therefore be well coordinated with them. For instance, the target costing of the firm is used to support positioning strategies of the firm based on the price charged by the firm. The other elements of the marketing mix like product, promotion and place also determine the price to be charged in the market. Pricing is also directly affected by the costs incurred in production. The types of costs that are considered in this case include variable costs, fixed costs and total costs. These costs vary depending on the production level of the firm and this influence the price setting. The experience or learning curve of these costs affects the price of the commodity.

The other factor that influences price setting is the organizational considerations where the price setter is different in different firms. For example, where in small companies the CEO or the top management are involved in setting of prices or in large companies where the prices are set by the product line, managers. There are also other organizations that allow for price negotiation especially in industrial settings and this affects the pricing strategy of the firm.

Market structures and demand also play a big role in the pricing strategies of the firm and the amount of price to be set by the firm. The common theoretical market structures are pure competition, monopoly market and oligopoly market among others depending on their nature of competition and the 0pricing strategy they adopt. The price setting by these markets are different depending on the nature of the market. For instance, for pure competition market, all firms are price taker and therefore the price is fixed and determined by the market. For a pure monopoly market, the firm sets the price but not the market forces. The price and demand relationship also affect price as discussed earlier.

Competitors’ costs and price is also a pricing factor because the firm setting prices must consider the competitors costs, prices and their possible reactions on the prices set. A firm may decide to benchmark costs against the competition in order to be able to set competitive prices. Economists argue that if firms adopt a low-price low margin-strategy, they will inhibit competition in the market and therefore setting of prices will not be a major concern of the firms. High-price high-margin strategy on the other hand increases competition in the market.

The other factor that is likely to affect pricing is other environmental elements. These may include the economic conditions prevailing in a country or region. The economic conditions affect the production costs of the firms. Production costs have direct influence on the pricing strategy of the firm. They may also affect the buyer perceptions of price and value of the commodity. The government may also restrict or limit the pricing strategies that are available to the firms.

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All these factors that affect pricing strategy of the firm are based on the economic theorists approach to pricing are a vital in actual pricing by the firm. The economic theorists to pricing therefore are very useful to the firms while pricing their products (Griffithys & Ison 2001, 16). Firms must take into consideration the effects of all these factors to pricing. Most of the actual pricing strategies s adopted by the firms are based on these factors are as discussed below.

Approaches used by firms in actual pricing

Based on the factors discussed above, there are several approaches that firms use while pricing their products. One of the major pricing approaches is called cost-plus mark up. This is a cost-based pricing which considers the cost of production as the major basis of pricing. The method involves adding a standard markup to cost of production in order to come up with the selling price of the commodity (Hornsby, 2001). The mark up is the profit that the firm wishes to realize form each unit of output and is determined by the firm. One of the disadvantages of the cost-plus markup method is that it ignores the market demand and competition in the market while setting price. This is the commonly used method of pricing because it is simple, minimizes price competition and is also perceived as being fairer to both the buyers and the sellers.

Te other pricing approach is Break-Even Analysis and Target Profit Pricing which is also a cost-based pricing. Price setting in this case is based on the break-even point of the firm. The firm’s total cost and total revenue are at par at this point and any more units of product beyond this point constitute the profit of the firm (Macleod, 200). The firm that wishes to make profit must produce commodities that exceed the break-even unit volume. The targeted profit is therefore set over and above the break-even of the firm.

The other pricing method is the value-based pricing. Price charged by the suppliers is dependent on the value that the consumers attach to the product depending on the satisfaction they obtain. This method is limited by the fact that it is not possible to measure the perceived value of the consumers (Harvey, 1983). The other pricing approach is Competition-Based Pricing where a firm sets its price with respect to that of the competitors. The price may be set at the same level, above or below that of the competitors.

Market structures theory and pricing

Economists argue that different markets may exist depending on the level of competition that is prevailing in the market. There are different market structures the major ones being perfect competitive market, oligopoly market, monopoly Markey among others. Each of these markets is believed to have a unique pricing strategy depending on its nature. These markets may not exist in real world but they form the basis for understanding the pricing strategies applied by firms.

For a perfect competitive market, the price is fixed for all firms and all firms are price takers. This kind of market does not exist in real world because their features are not realizable in real sense. For instance, he market is said to have many buyers and sellers, many small firms, firms are price takers, products are homogenous and perfect substitutes of each other and there is no barrier to entry and exit to the market (Anderson, 2008, 76). These features are not realistic in real sense. For a monopoly firm, the firm is the price setter and there is only one firm in the market selling one product (American bar Association, 2005, 29). The firm enjoys monopoly power and can set high prices because there is no competition in the market. This market structure does not exist in real sense but may help one identify the firm that is enjoying some monopoly powers.

In the oligopoly market, the market is dominated by a small number of seller called oligopolists which come together to set prices of their products. The product in this market is differentiated, firms are the price makers and there is high barrier to trade. There is stiff price competition in the case of oligopoly market.

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Price discrimination theory and pricing

There are situations where identical goods and services by the same provider are charged different prices in the market. This situation is called price discrimination and is an economic theory that is used to explain pricing. This condition is practically possible in case of monopoly and oligopoly market but it is not always possible in case of perfect competitive market. It can only be exercised by firms with some market powers. However, it may also occur in case of a competitive market where there is product heterogeneity, market frictions or high fixed costs which may give room for such discrimination.

Conclusion

With respect to the above discussion, it is vivid that economic theorists approach to pricing plays a big role in enabling the firm set prices in practice. The demand and supply theory, price discrimination theory, market structures among others are economic theories that determine pricing by different firms.

Reference List

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