Pricing Practices

So far we assumed that the firm produced only one

product, sold its product in only one market, was
organized as a centralized entity, and had precise
knowledge of the demand and cost curves it faced.
None of these assumptions is generally true for most
firms today. That is, most firms produce more than
one product,sell products in more than one market,
are organized(at least large corporations) into a
number of decentralized or semiautonomous
divisional profit centers, and have only a general
rather than a precise knowledge of the demand and
cost curves they face.
 Pricing Practices
Thus our discussion of the pricing decision must be
expanded to take into consideration actual pricing
practices as under:
Pricing of Multiple Products:
Pricing of Products with Interrelated Demands
One important reason that firms produce more than
one product is to make fuller use of their plant and
production capacities.Instead of producing a single
product at the point where MR=MC and be left with a
great deal of idle capacity,the firm will introduce new
products(or different varieties of existing products),in
the order of their profitability ,until the marginal
 Pricing Practices
revenue of the least profitable product produced
equals its marginal cost to the firm.The quantity
produced of the more profitable products is then
determined by the point at which their marginal
revenue equals the marginal cost of the last unit of the
least profitable product produced by the firm.The
price of each product is then determined on its
respective demand curve.
Pricing of Products with Interrelated Production
Products can be jointly produced in fixed or variable
proportions.(Example:Sheep Raising yielding wool
and meat and Petroleum Refining which results in
oils,gas etc respectively)
 Pricing Practices
When products are jointly produced in fixed
proportions,they should be thought of as a single
production package.There is then no rational way of
allocating the cost of producing the package to the
individual products in the package.On the other
hand,the jointly produced products may have
independent demands and marginal revenues. The
best level of output of the joint product is then
determined at the point where the vertical summation
of the marginal revenues of the various jointly
produced products equals the single marginal cost of
producing the entire product package.
 Price Discrimination
Price Discrimination(Variously termed as Dynamic
pricing,Targeted pricing,Flexible pricing or Tailored
pricing) This exists when the same product is sold at
different prices to different buyers. The cost of production is
either the same,or it differs but not as much as the
difference in the charged prices.The necessary conditions
which must be fulfilled for the implementation of price
discrimination are the following:
1.The market must be divided into sub-markets with
different price elasticities. 2.There must be effective
separation of the sub-markets, so that no reselling can take
place from a low-price market to a high-price market.Thus
easier to apply with consumable goods and services.
Degrees of Price Discrimination : Third-degree(Two
prices),Second-degree(More than two prices)and First-
degree(Different price for each buyer). Dumping
 Transfer Pricing
The rapid rise of modern large-scale enterprises has
been accompanied by decentralization and the
establishment of semiautonomous profit centers.This
has given rise to the need for transfer pricing which
refers to the price of intermediate products sold by
one semiautonomous division of a large-scale
enterprise and purchased by another semiautonomous
division of the same enterprise.
Transfer Pricing with no External Market for the
Intermediate Product:This one-to-one relationship
implies that the output of the intermediate product
and of the final product are equal.
The correct transfer price in this case would be its
marginal cost.
 Transfer Pricing
Transfer Pricing with a Perfectly Competitive Market
for the Intermediate Product:
The transfer price for intracompany sales is given
here by the external competitive price for the
intermediate product.
Transfer Pricing with a Imperfectly Competitive
Market for the Intermediate Product:
Here the determination of the internal and external
prices of the intermediate product by the production
division of the firm becomes one of third-degree price
discrimination with higher price being charged from
the external market.
 Pricing in Practice
Cost-Plus Pricing
In the real world firms may not be able ( and it
maybe too expensive) to collect precise MR and MC
data to determine the optimal level of output and
price at the point at which MR=MC. The most widely
used of such pricing rules is cost-plus pricing(also
called “mark-up pricing” and “full-cost pricing”.
The usual method is for the firm to first estimate the
average variable cost(AVC) of producing or
purchasing and marketing the product for a normal
or standard level of output(usually taken to be
between 70 and 80 percent of capacity).The firm then
adds to the AVC an average overhead charge(usually
expressed as a percentage of AVC) so as to get the
estimated fully allocated cost. To this the firm then
adds a markup on cost for profits.
 Pricing in Practice
The firm then adds to the AVC an average overhead
charge(usually expressed as a percentage of AVC) so
as to get the estimated fully allocated cost. To this the
firm then adds a markup on cost for profits.
The markup on cost can be expressed as : m=P-C
C
where m is the markup on cost,P is the product price,
and C is the fully allocated average cost of the
product.The numerator is called the profit margin.
Markups of 25% have been traditional in some major
industries such as automobiles etc.
 Pricing in Practice
Incremental Analysis in pricing
Two-Part Tariff
Tying
Bundling
Prestige pricing
Price lining
Skimming
Value pricing
Price matching
Auction pricing
Electronic scanners