BBA I Semester Managerial Economics Pricing Methods Study Material Notes

BBA I Semester Managerial Economics Pricing Methods Study Material Notes:  Pricing methods Pricing a new Product Skimming pricing Penetration Pricing Transfer price Deterrmiation Objectives Transfer pricing presence of an External Market Cost Plus or faul cost Pricing Determination fo cost plus price Marginal Cost Pricing Criticisms Going rate pricing targ

MCom I Semester Analysis Statistical Quality Control Study Material Notes

PRICING METHODS AND PRICE-OUTPUT DECISIONS UNDER DIFFERENT MARKET STRUCTURES PRICING METHODS

PRICING METHODS

There are a number of pricing Methods or strategies which are normally adopted by firms. A few important are explained as under:

1 Pricing a New Product

New products may be original products, improved products, modified products and new brands. In pricing a new product, there is lack of information regarding cost, demand and market. So there is uncertainty about its sales. The price fixed for the new product must:

(i) earn good profits for the firm over the life of the product;

(ii) provide better quality at a cheaper price and at a faster speed than competitors;

(iii) face rising R&D, manufacturing and marketing costs and

(iv) satisfy public criteria such as consumer safety and ecological compatibility. The firm can select two types of strategies :

(A) Skimming Pricing (B) Penetration Pricing

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(A) Skimming Pricing

In skimming pricing a high price is set in the initial stage to cover large unit costs of a new product. When demand is either unknown or more inelastic at this stage, the firm charges a monopoly price. It attempts to skin the cream of the market by charging a high initial price to maximise its profit from the sale of the new product. Later on, it starts lowering the price when competition arises from other producers. This is a short period device for pricing.

This policy is shown in Fig. 1, where the manufacturer of a new product initially determines OP price and sells OQ quantity. Thus he receives KPMN abnormal profit. Under this policy, consumers are distinguished by the producers on the basis of their intensity of desire for a commodity. For example, in the beginning the prices of computers, TVs, electronic calculators, etc., were very high but now they are declining every year. A high initial price together with heavy promotional expenditure may be used to launch a new product if conditions are appropriate. These conditions are:

(i) Demand is likely to be less price elastic in the early stage than later. The cross elasticity demand is low because there are no rivals.

(ii) Launching a new product with a high price is an efficient device for breaking the market into segments that differ in price elasticity of demand.

(iii) High initial price under a skimming policy means a lower growth rate of sales.

(iv) High initial price helps to finance the high cost of production and distribution of the MR product in the early stage.

(B) Penetration Pricing

In penetration pricing, the price for the new product is set low to enter the market against existing competitors. This is aimed at increasing sales, capture market share, utilise full capacity and economies of scale in production and keep the competitors away from the market. In the initial stage, the penetration price is set low to attract comsumers to the new product and gain a share in the market. Consequently, there is very rapid spread of the product in the market and its price is raised gradually. As output increases, unit costs fall and profit is maximised in the long run. Thus it is a long-term pricing policy.

The following conditions are required for the success of penetration policy.

(i) There is very high price elasticity of demand.

(ii) There are substantial cost savings due to increased production and economies of scale.

(iii) The product is acceptable to the mass of consumers.

(iv) There is no strong patent protection.

(v) There is threat of possible competition.

(vi) The market for the product is expected to be large in the future.

(vii) For the initial low price to be effective, there should be high cross elasticity of demand in relation to similar products in the market.

Penetration price is a long term pricing strategy and should be adopted with great caution. Penetration pricing is successful also when there is no elite market. When a firm adopts a penetrating pricing policy, adjustments to price throughout the product life cycle are OP minimal. Since this policy prevents competition, it is also referred to as ‘Stay-out’ price policy.

where market price is OP, and quantity demanded is 09.. Now the producer of a new product fixes the price less than the market price i.e., OP, and sells og, more quantity. Obviously, Quantity it has a wide potential market.

The comparison between skimming pricing and penetration pricing is that high skimming price policy needs vigorous and costly promotional effort to back it but low penetration price would require low promotional expenditures.

But the policy is inappropriate where

(i) the total market is expected to stay small, and

(ii) the new product calls for capital recovery over a long period.

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2. Pricing Over the Life Cycle of a Product

The cycle begins with the invention of the new product. The innovation of a new product and its degeneration to a common product is termed as the life cycle of a product. It is an important concept in marketing that provides insights into a product’s competitive dynamics. The life cycle of a product portrays distinct stages in the sales history of a product. Corresponding to these stages are distinct opportunities and problems with respect to market strategy and profit potential. By identifying the stage that a product is in, or maybe headed toward, Time – companies can formulate better Product Life Cycle marketing plans. The figure depicts the life cycle of a product.

Every product moves through a life cycle having five phases as shown in the figure and they are:

(i) Introduction. This is the first stage in the life cycle of a product. This is an infant stage. The product is a new one. The product is put on the market, awareness and acceptance are minimal. There are high promotional costs. Therefore, the profit may be low. The firm can use two types of pricing policy, i.e., skimming price policy or centralising price policy in this stage.

(ii) Growth. In this stage, a product gains acceptance on the part of consumers and businessmen. The product begins to make rapid sales gains because of the cumulative effects of introductory promotion, distribution work or mouth influence. The product satisfies the market. For the purpose of pricing, there is not much difference between growth and maturity stages.

(iii) Maturity. At this stage, keen competition increases. Sales growth continues, but at a diminishing rate, because of the declining number of potential customers. Competitors go for mark-down price. Additional expenses are involved in the product’s modification and improvement, thus profit margin slips. This period is useful because it gives out signals for taking precaution in pricing policy.

(iv) Saturation. In this stage, the sales are at the peak and further increase is not possible. The demand for the product is stable. The rise and fall of sale depend upon supply and demand. little additional demand to be stimulated, it happens to be its replacement demand. Therefore, the product pricing in are the product pricing in the saturation stage is full cost plus normal mark-up.

 (v) Decline. Sales begin to diminish absolutely as the customers begin to tire of a product. The competitors have entered the market with substitutes and imitations. Price becomes the competitive weapon. The product should be reformulated to suit the consumers preferences, it is possible in the case of few commodities.

Throughout the cycle, changes take place in price and promotional elasticity of demand as also in the production and distribution costs of the product. Therefore, pricing policy must be adjusted over the various phases of the cycle.

3. Transfer Pricing

Transfer pricing is one of the most complex problems in pricing. The growth of large scale organizations has given rise to the problem of pricing commodities that are transferred internally from one division to another. The divisional organisations are preferred due to the following reasons:

(I) t provides a systematic way of delegation and decision making.

(ii) for proper evaluation of contribution, and

(iii) for the precise evaluation of manager’s performance. The transfer price must satisfy the following two criteria:

(iv) It should help establish the profitability of each division or department.

(v) It should permit and encourage maximization of the profits of the company as a whole.

For determining the transfer price there are three alternative methods. They are explained as follows:

(i) Market Price Basis. The suitable system of transfer of goods from one division to another under the same management to another company, is the market price basis. The market price should be the transfer price. Wherever a market price exists for a product, the inter-divisional transfer price should equal the market price to avoid sub-optimization. This method definitely avoids the possibility of passing the inefficiencies of one department to the other departments.

(ii) Cost Basis. In case the product produced by a division of the firm can be sold only to another division of the firm, the inter-divisional transfer should be priced at the level of the actual cost of production. Here transfer prices will be useful to achieve the best joint level of output. It will maximise profits.

(iii) Cost Plus Basis. Under this method the goods and services of each department are charged on the basis of actual cost plus a margin by way of profit. The major defect of this method is that the transferring department may add a high margin so as to raise the profit of the department. It may result in setting the ultimate price unduly high thereby affecting sales.

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Transfer Price Determination

Objectives

Firms have the following objectives while determining the transfer price.

1 The aim of the firm is to ensure that its goal coincides with that of the related divisions.

2. The price of the transferred product should be so determined that the profitability of each division could be ensured.

3. The price should be such that it could induce profit-maximization of the company as a whole rather than of a particular division.

Large firms often divide their operations into various divisions or departments. One division uses the product of the other division. In such a situation, firms are faced with the problem of determining an appropriate price for the product transferred from one division or sub-division to the other. Thus transfer pricing refers to the price determination of goods transferred among interdependent units or divisions within the organization. It is necessary to consider various situations while determining transfer price.

(A) Transfer Pricing: Absence of an External Market

If an intermediate product has no external market, transfer pricing will be according to the marginal cost of the producer.

Suppose that a firm has two independent divisions : production division and marketing division. The production division produces one product that is sold to the marketing division of the same firm. The price at which it sells is called transfer price. Further, the marketing division presents that product as a final product by packaging it and sells it to the public. We also assume that the product manufactured by the production division has no market outside the firm. In other words, the marketing division completely depends upon the production division for the supply of the product and the production division depends on the marketing division for its demand. Therefore, the total quantity of the product manufactured by the production division must be equal to the amount sold by the marketing division.

In Fig. 4 MC, and MC, are the cost curves of production division and marketing division respectively and MC is the firm’s cost curve. This curve is the summation of MC, and MC curves. D. is the firm’s demand curve and MR is the marginal revenue curve for the final product. The firm will be in equilibrium at point E where its MC curve cuts its MR curve. The firm will be selling OQ quantity of the product Now, the question is how much price the production division should charge for

Output its product from the marketing division?

The transfer price is equal to the marginal revenue of the production division. The transfer price once determined is always stable because the demand curve of production division is horizontal on which the marginal revenue of production division is equal to the transfer price, i.e., DEMR=P, The production division will earn the maximum profit for its intermediate product at that point where the transfer price (P.) which is also its marginal revenue (MR.). is equal to its marginal cost (MCp), i.e., P =MR =MC. This situation is at E, point where the MC curve cuts the. D=MR =P, curve from below.

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(B) Transfer Pricing: Presence of an External Market

If there is an external market for the intermediate product, the production division may produce more product than the marketing division needs and may sell the surplus product in the external market. On the other hand, it may produce less than the needs of the marketing division and the marketing division can obtain the rest of its requirements from the external market. Thus, it is more free for maximising its profit.

(1) Transfer Pricing : In a Perfectly Competitive External Market. In the case of a perfectly competitive external market, where the intermediate product can be sold or bought from the perfectly competitive outside market by the firm, the quantity produced by the production division may not be equal to the required quantity for the marketing division. In such situation transfer price of inter mediate product is the market price of that product. The firm can be in the maximum profit situation only when all its divisions operate at Output their related MR = MC points. In these conditions, we explain transfer pricing in terms of Figure 5.

In the figure, D is the demand curve of intermediate product which is a horizontal line. This curve shows marginal revenue (MR), average revenue (AR,) and price (P) of the production division. According to the figure, the production division will receive the maximum profit at 09, output level because at this level marginal cost of production (MC) is equal to its marginal revenue (MR) which determines OP, price. Here the equilibrium is at point E where the MC, curve cuts the D=AR,= MR, curve from below.

To maximize total profit of the firm in the perfectly competitive market, it will be appropriate to keep transfer price at OP, level. It is at this price that the production division will sell its intermediate product to the marketing division or to outside customers, and the marketing division will also give only OP price for the intermediate product to the production division.

The marginal cost curve of the marketing division is MC, which is the summation of marginal marketing cost and transfer price P. To maximise its profit, marketing division will have to purchase OQ, quantity where its marginal cost MC, is equal to its marginal revenue MR, at point E. In the figure, the maximum profitable quantity for the production division will be 00, and that for the marketing division 0 . Hence, the production division will sell 00-00,= 2,2 portion of its output in the external market.

(2) Transfer Pricing : In Imperfectly Competitive External Market. Here we discuss transfer pricing in that market situation where the production division sells its product in imperfectly competitive external market as well as to the marketing division. In such a situation, an important problem of price differentiation arises in different markets. The production division will get the maximum profit, when the marginal revenue in each market is equal to marginal revenue for the total market, and total market marginal revenue is equal to marginal cost. In other words, transfer price for the marketing division should be equal to the marginal cost of production division. Transfer price determination in the case of imperfectly competitive external market is shown is Fig. 6.

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Panel (A) of the figure is related to an imperfectly competitive external market in which D is its demand curve and MR is its marginal revenue curve. Panel (B) is related to the marketing division in which MR, is the net marginal revenue curve of the marketing division. In other words, MR =(P=MC). Here, transfer price (PC) is equal to the marginal cost of the production division (MC). Panel (C) is related to the production division. Its marginal revenue curve MR is the summation of marginal revenue of the marketing division within the firm (MR) and marginal revenue of the external market (MR). The optimum production level of the production division is OQ when MR, curve is equal to MC curve at point E and the transfer price is OP. The marketing division will buy Om quantity of output at OP transfer price from the production division and the production division can sell OQ units of its production at OP price in the external market.

4. Cost-Plus or Full-Cost Pricing

Cost-plus is a shortcut method in pricing a product. It means the addition of a certain percentage of the costs as profits to the cost of production to arrive at the price. This is known as a mark-up on the cost or as a profit margin on the price. This method suggests that the price of a product should cover its full cost and generate the returns as investments at a fixed mark-up percentage. Full cost is full average cost which includes average variable cost (AVC) plus average fixed costs (AFC) plus a normal margin for profit:

P= AVC + AFC + profit margin or mark-up.

Thus, of the two elements of cost-plus price, one is the cost and the other is mark-up.

Determination of Cost-Plus Price

The determination of cost-plus price is explained below in terms of Prof. Andrews’s version.

Prof. Andrews in his study, Manufacturing Business, 1949, explains how a manufacturing firm actually fixes the selling price of its product on the basis of the full-cost or average cost. The firm finds out the average direct costs (AVC) by dividing the current total costs by current total output. These are the average variable costs which are assumed to be constant over a wide range of output. In other words, the AVC curve is a straight line parallel to the output axis over a part of its length if the prices of direct cost factors are given.

The price which a firm will normally quote for a particular product will equal the estimated average direct costs of production plus a costing-margin or mark-up. The costing-margin will normally tend to cover the costs of the indirect factors of production (inputs) and provide a normal level of net profit, looking at the industry as a whole.

Once this price is chosen by the firm, the costing-margin will remain constant, given its organisation, whatever the level of its output. But it will tend to change with any general permanent changes in the prices of the indirect factors of production.

Depending upon the firm’s capacity and given the prices of the direct factors of production (i.e., wages and raw materials), price will tend to remain unchanged, whatever the level of output. At that price, the firm will have a more or less clearly defined market and will sell the amount which its customers demand from it.

But how is the level of output determined? It is determined in either of the three ways: (a) as a percentage of capacity output; or (b) as the output sold in the preceding production period; or (c) as the minimum or average output that the firm expects to sell in the future. If the firm is a new one, or if it is an existing firm introducing a new product, then only the first and third of these interpretations will be relevant. In these circumstances, indeed, it is likely that the first will coincide roughly with the third, for the capacity of the plant will depend on the expected future sales.

The Andrews version of full-cost pricing is illustrated in Figure 7 where AC is the average variable or direct costs curve which is shown as a horizontal straight line over a wide range of output. MC is its corresponding marginal cost curve. Suppose the firm chooses 09 level of output. At this level of output, QC is the full-cost of the firm made up of average direct cost QV plus the costing-margin VC. Its selling price OP will, therefore, equal QC. The firm will continue to charge the same price OP but it might sell more depending upon the demand for its

Output product, as represented by the curve DD. In this situation, it will sell og, output. “This price will not be altered in response to changes in demand, but only in response to changes in the prices of the direct and indirect factors.”

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Advantages

The main advantages of cost-plus pricing are:

1 When costs are sufficiently stable for long periods, there is price stability which is both cheaper administratively and less irritating to retailers and customers.

2. The cost-plus formula is simple and easy to calculate.

3. The cost-plus method offers a guarantee against loss-making by a firm. If it finds that costs are rising, it can take appropriate steps by variations in output and price.

4. When the firm is unable to forecast the demand for its product, the cost-plus method can be used.

5. When it is not possible to gather market information for the product or it is expensive, cost-plus pricing is an appropriate method.

6. Cost-plus pricing is suitable in such cases where the nature and extent of competition is unpredictable.

Criticisms

The cost-plus pricing theory has been criticised on the following grounds:

1 This method is based on costs and ignores the demand of the product which is an important variable in pricing.

2. It is not possible to accurately ascertain total costs in all cases.

3. This pricing method seems naive because it does not explicitly take into account the elasticity of demand. In fact, where the price elasticity of demand of a product is low, the cost-plus price may be too low, and vice versa.

4. If fixed costs of a firm form a large proportion of its total cost, a circular relationship may arise in which the price would rise in a falling market and fall in an expanding market. This happens because average fixed cost per unit of output is low when output is large and when output is small, average fixed cost per unit of output is low.

1 The cost-plus pricing method is based on accounting data for total cost and not the opportunity cost that the sale of product incurs.

2. This method cannot be used for price determination of perishable goods because it relates to long period.

3. The full-cost pricing theory is criticized for its adherence to a rigid price. Firms often lower the price to clear their stocks during a recession. They also raise the price when costs rise during a boom. Therefore, firms often follow an independent price policy rather than a rigid price policy.

4. Moreover, the term ‘profit margin’ or ‘costing margin’ is vague. The theory does not clarify how this costing margin is determined and charged in the full cost by a firm. The firm may charge more or less as the just profit margin depending on its cost and demand conditions.

5. Empirical studies in England and the U.S. on the pricing process of industries reveal that the exact methods followed by firms do not adhere strictly to the full-cost principle. The calculation of both the average cost and the margin is a much less mechanical process than is usually thought.

6. Prof. Earle’s study of the 110 ‘excellently managed companies’ in the U.S. does not support the principle of full-cost pricing. Earley found a widespread distrust of full-cost principle among these firms. He reported that the firms followed marginal accounting and costing principles, and the majority of them followed pricing, marketing and new product policies.

5. Marginal Cost Pricing

Marginal cost pricing implies that the price of the product is set at the marginal cost of production which determines the amount produced by the firm. Unlike the full-cost pricing which is based on average cost, the marginal cost pricing is based on the average variable cost only.

Therefore it is a short-run phenomenon whereas full cost pricing is a long-run phenomenon. The aim of a firm is to maximize its profits. In a perfectly competitive market, a firm maximises its profits at the output level

where marginal cost equals marginal revenue, MC = MR. In such a market, the price charged by a firm in the industry is identical to the prices charged by all the firms. Therefore, the firm faces a perfectly elastic demand curve, AR coinciding with the MR curve, i.e. AR = MR which is a 8 horizontal line. Therefore, the profit-maximizing condition MC = MR results in price being set equal to marginal cost. This is shown in

where the MC curve cuts Output the AR= MR curve and AVC curve at point and determines OP price and OQ output. When price falls below the average variable cost the firm will shut down and S is the shutdown point.

Its Advantages. Marginal cost pricing has the following

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advantages:

1 This strategy allows a firm to develop a very aggressive pricing policy than full-cost pricing. Such a policy leads to more sales and reduced marginal costs through increased marginal productivity and lower input factor prices.

2. It is more useful for pricing over the life cycle of a product which requires short-run marginal cost.

3. In the case of multi-product, multi-process and multi-market firms, the full-cost pricing is not logical and satisfactory because different products, processes and markets are always changing during the short-run. So marginal cost pricing is the most suitable technique.

4. Ealey’s study of 110 American firms revealed that the firms followed marginal costing principle in their decision-making rather than full-cost pricing.

Its Limitations. The marginal cost pricing has the following limitations.

1 Marginal cost pricing being short-period pricing can be applied only on a temporary basis. It does not provide a long-period stable price policy.

2. It does not guarantee that the firms will operate at the break-even point and earn profits.

3. In a business recession, firms using marginal cost technique may lower costs and prices in order to maintain sales. This may lead other firms to reduce prices, thus leading to cut-throat competition.

4. Empirical evidence by Hall and Hitch shows that business firms do not bother about the calculation of MR and MC and businessmen have not even heard about them.

6. Incremental Cost Pricing

Incremental cost pricing is a form of marginal cost-pricing. Incremental cost is not the same as marginal cost. Whereas marginal cost is the additional cost from a very small (1 unit) increase in output, incremental cost is the additional cost from an output increase that is very large. It deals with the impact of large changes in revenues, costs and profit due to managerial decisions. In fact, it is more suitable for such decision making where there is large uncertainty and it is costly to obtain necessary information. Incremental cost pricing is based on the following guidelines for managerial decisions:

(a) If a pricing decision increases revenues more than costs, it should be made.

(b) If a pricing decision decreases revenues more than costs, it should not be made.

(c) If a pricing decision increases costs more than revenues, it should not be made.

(d) If a pricing decision reduces costs more than revenues, it should be made.

These guidelines suggest that it is always advisable to compare large changes in costs and revenues while making any change in the price of a product.

In making a decision in incremental cost pricing, changes in total revenues and total costs are considered and not average variable cost as in marginal cost pricing.

Fixed costs are not relevant to both marginal cost and incremental cost pricing because these are sunk costs that do not change with output. Therefore, incremental cost pricing relates to short-run production as in marginal cost pricing.

The difference between marginal cost pricing and incremental cost pricing is explained in fig. 8. In the case of marginal cost pricing, the equilibrium of the firm is at point S where SMC=AR=MR=AVC. If the price falls below OP, the firm will shut-down. But in the case of incremental cost pricing, the firm must cover its average costs (-average variable and average fixed costs). Since it does not cover full fixed costs, it may or may not operate at the breakeven point, B by producing OQ,, output and selling it at OP price. But it will not shut-down at point S because at this level, it is covering AVC and a portion of average fixed cost (AFC). As long as the price of a product exceeds its incremental cost, total profit can be increased by selling the product.

7 Target (or Rate of Return) Pricing

This method of pricing is only a refinement of the full-cost pricing. According to this method, the manufacturer considers a pre-determined target rate of return on capital invested. In the case of full-cost pricing, the percentage of profit is marked-up arbitrarily. In the case of rate of return method, the companies determine the average mark-up on costs necessary to produce a desired rate of return on the company’s investment. In this case, the company stimates future sales, future costs and arrives at a mark-up price that will achieve a target moon company’s investments. Davies and Hughes have used the following formula to calculate the desired rate of return when a mark-up is applied on cost:

In any business, price policy has to be profit-oriented. Once the mark-up is decided on the basis of capital employed, the firm just cannot follow it blindly. Sometimes, the changes may occur and compel the firm to revise the prices to changing costs. To overcome this problem, three different methods are followed.

(a) Revising the prices to maintain constant percentage of mark-up over costs.

(b) Revising the prices to achieve estimated sales to maintain percentage of profit.

(c) Revising the prices to achieve a constant rate of return on capital invested. Changed percentages may be computed as below:

American firms start with a rate of return they consider satisfactory, and then set a price that will allow them to earn 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 rate of profit over the long run.

The rate of return pricing is a refined variant of full-cost pricing. Naturally, it has the same limitations: (a) it fails to reflect competition, (b) it tends to ignore demand, and (c) 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.

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8. Going-Rate Pricing

The going-rate pricing is opposite to full-cost pricing. In the case of full-cost pricing, the emphasis is on cost of production, while in the case of going-rate pricing, the emphasis is on the market situation. This approach to pricing is known as “price minus theory of cost”. A study by Brooklings Institute reveals that this approach of going-rate pricing is followed even in some large firms besides the medium and small ones in USA.

This method of pricing conforms with the system of pricing in oligopoly where a firm initiates price changes and the other firms in the industry merely follow the pattern set by the leader. Other firms accept the leadership. Firms may also follow a market determined price which means a price prevailing in the market due to market forces. The emphasis here is on the market. Firms make necessary price adjustments to suit the general price structure in the industry. Hence going-rate pricing method is also called “acceptance pricing”. Normally under this method, the industry tries to determine the lowest price that the seller can afford to accept considering various alternatives.

Examples of going-rate pricing include industries like clothing, automobiles, electronic goods, long playing records etc., where products have reached the stage of maturity (on their own development and where customers and rival producers have become accustomed to stable price-relationship. When products are idential, unique selling price will rule. When they are differentiated, prices will form a series, set at discrete intervals.

Its Advantages. This pricing method has the following advantages:

(a) It helps in avoiding cut-throat competition among the firms. (b) It is a rational pricing method when costs are difficult to measure. (c) Going-rate or acceptance pricing is less troublesome and less costly since exact calculation of costs and demand is not necessary. (d) It is suitable to avoid hazards in oligopoly market.

It should, however, be noted that ‘going-rate pricing’ or ‘acceptance pricing’ is not the same as accepting the market price impersonally, as in the case of perfect market. In the case of perfect market, the firms are only price-takers. But in this case, the firm has some power to set its own price and could be a price-maker if it chooses to face all the consequences. It prefers, however, to take the safe course and conform to the policy of others. Hence it is also called imitative pricing.

9. Customary Pricing

Prices of certain goods get more or less fixed because they have prevailed over a long period of time. Any change in costs for such goods is reflected in the quality or quantity of the good rather than its price. For example, the price of a cup of tea is customarily fixed in the market. A change in the cost of production may lead to either change in quality or a small quantity cup. Only when the costs change significantly, customary prices of these goods are changed. While changing the customary price, it is necessary to study the pricing policies and practices adopted by the competing firms. If a new firm enters the market and has lower costs, it will also sell at the customary price because any reduction in price by it will lead to a price war which no firm will like. So a new firm must consider the effect on price. With its entry in the market, the total supply and the demand for the product of the existing firms will be affected. If the customary price does not cover his cost, it will leave the market for having taken a wrong decision. Another approach is to effect price change only in a limited market segment and know the customer reaction to decide whether any change would be accepted by the market.

Customary prices may be maintained even when products are changed. For example, the new model of a radio may be priced at the same level as the discontinued model. This is usually so even in the face of lower costs. A lower price may cause an adverse reaction on the competitors leading them to a price war as also on the consumers who may think that the quality of the new model is inferior. Hence, going along with the old price is the easiest thing to do. Whatever be the reason, the maintenance of existing prices, as long as possible, is a factor in the pricing of many products.

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EXERCISES

1 What is market penetration?

2. Briefly explain market skimming.

3. Explain the pricing policy of a new product.

4. Explain the pricing over the life cycle of a product. What is transfer pricing?

5. Explain the different alternative methods for determining the transfer price.

6. Explain the cost-plus pricing method.

7. Explain marginal cost pricing.

8. Explain incremental cost pricing.

9. Distinguish between marginal cost and incremental cost pricing.

10. Write notes on:

(a) Target Pricing

(b) Going rate Pricing

(c) Customary Pricing

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