The objective of the firm is very important in determining how they are to set their prices. Their objective could be, for example, to either maximise profit or to raise market share. Whatever their objective there are many factors which can influence the firms when setting their prices for their products. Some of these methods of pricing can have their advantages on the consumer, however there are many occasions where pricing decisions can have negative effects. In what follows, you will be able to see examples of both of these.
Market structure as well as the firm’s objective is very important and often influences firms pricing. For a monopolist, prices will be higher relative to costs than for perfectly competitive markets. In perfect competition prices would be determined by the forces of demand and supply, however in reality a totally perfect market does not exist therefore this pricing level is most often never met, A monopolist can choose to set their own price and output levels, usually being set at a low output level and at a high price, as there is no competition to influence what they should set, thus creating an imperfect market. However a regulating board exists in the UK, called the competition commission (formally known as the monopolies and mergers commission), to keep guard on potential monopoly situations and to check that these monopolies are not abusing their strong dominant power.
The competition commission also watches over collusion, which often takes place in oligopoly situations. This occurs when the firms come together to co-ordinate their prices to achieve maximum profits for the industry as a whole, creating a unique industry price. There are various types of collusion. One example is cartels are one example. This is where a central body is established and given the responsibility for setting the industry price. An example of an industry that was part of an international cartel is the telephone companies, companies such as AT;T, British telecom, Deutche Bundespost and France telecom.
Prices may be reduced to raise the market share of a company or to defend existing market share in the face of greater competition. Jobber and Hooley (1987) found that market share pricing objectives were practised more by larger firms. This brings into consideration competition as aggressive pricing policies have sometimes broken out in attempts to defend the companies’ market share against others. An example would be Esso, who launched its ‘price watch’ campaign in January 1996. This saw prices cut to the extent that its margin on the price per litre fell to 1p (OFT 1998).
A central idea on pricing is that it is not so much the demand side of the market that affects price, but rather the supply side through costs of production. A method called cost-plus pricing is a description given to a number of practices whereby price is closely related to the costs of production. In general most cost-plus pricing strategies add a certain percentage profit mark up to the firms costs, in order to arrive at a final price.
Product differentiation is important when setting prices. If a product is relatively homogenous to that of its competitors, such as petrol. Then prices charged by all the companies has to be set at fairly similar levels, as most people would choose the cheaper alternative if one product was higher then the other. If one company was to drop their prices, they would attract many customers away from their competitors, unless these competitors also lowered their prices.
The position of the product in its life cycle will also influence the price a firm sets for its product. The three main stages of the product life cycle are: growth, maturity and decline. In the growth stage the total market size is increasing. Firms have various choices in how to set their prices. They could adopt a ‘skimming’ strategy charging a high price, which gets rid of a small but lucrative part of the market. Alternatively they can adopt a ‘penetration’ strategy, charging a lower price and raising market expenditure in order to establish a much larger market presence. How much of a role cost plays in the determination of price during the growth phase will depend on the individual firm.
In the maturity phase the pricing decisions will largely depend on the market share which the company has already established during its growth phase and also on the quality of the product maintained. High quality and high market share would suggest that their policy would be to charge relatively high prices.
In the decline phase, manufacturers will try to maintain their high price, however in reality they are often forced to lower their prices or bring out newer designs, otherwise sales might fall drastically, forcing the firm to reduce price, also dramatically.
Firms may set their prices as a strategy to deter entry into their market. This is an act of strategic behaviour. Existing firms will set a price that deters entry but is still profitable for them. Entry deterring strategies are costly for existing firms as they are foregoing part of their profits.
The graph shows an example of what happens when firms when firms take the strategy of limit pricing. The new entrant can’t produce at this new value as the equilibrium lies below the average cost curve, therefore stopping them from entering the market.
Some other factors that may influence a firms pricing are market segmentation and price discrimination.
With price discrimination, different prices are set in different markets. An example would be present in the European commission report on the car industry, cars are more expensive to buy in the UK compared to the rest of the EU.
A firms pricing may be influenced by market segmentation, depending what segment the firm is aiming their product at, e.g. A firm can set very high prices for designer luxuries as these are aimed at a small individual section of the market not just at everyone in general.
A point I have not touched on as yet, but which I will do now, is the elasticity of the product involved. This is a very important factor a firm must consider when making their pricing decisions. Price elasticity of demand is worked out using the formula : percentage change in amount demanded
Percentage change in price
By working out the price elasticity of demand, a firm will then know just how much control it will be able to exert over the price it charges. If the product has a low price elasticity of demand, then a firm is able to make significant price changes without losing a vast part of its market. An example of a product with a low price elasticity is toothpaste, if the price of toothpaste went up, the demand for it would not change much, if at all, as people will still need it. If the price of toothpaste falls, this does not mean that the demand will rise as people will not start using more of it.
If however a product has a high elasticity of demand, then this will mean, even a small change in the price charged for the product will result in a much larger change in the demand. An example of a product with a high elasticity of demand is high street clothing. If the prices rise, the demand will fall as people will start to buy fewer clothes. If the price falls, the demand will increase as people can now afford to buy more clothes.
Many points have been discussed now about the factors which influence the price which a firm charges. As we can see many different situations take place regarding the environment a firm is set in, the main ones being the differing firm objectives and the different market structures. There are many different combinations of these for any given product, therefore the pricing decision made by the firm is often complicated and their decisions are often individual and different to those even in the same market as them.
APPLIED ECONOMICS – ( 9th edition ) edited by Alan Griffiths and Stuart Wall
PRICING IN BUSINESS – D.C. Hague
PRICE THEORY – Townsend
UK ECONOMY NOTES – Dr. David Young and Nick Weaver.