Average Cost Pricing Theory

Introduction

In industrial economy it is assume that the major goal of the firm is profit maximisation and the equilibrium price and output is determined by the conditions: MC=MR and MC curve cuts MR curve from below. But during the great depressions of 1930's and afterwards, the economists found that the actual behaviour of the firm in price determination, has not at all so. Marginal analysis of the firm was challenged by empirical analysis of the behaviour of the firm. This sets some economists thinking about the need for building a realistic theory of pricing. Two investigations of pricing behaviour have been made in England, one by a group at Oxford University who interviewed thirty eight business tycoons,mainly engaged in the manufacturing sector and concluded that : It casts doubts on the general applicability of the conventional analysis
of price and output policy in terms of marginal cost and marginal revenue, and suggests a mode of entrepreneurial behaviour which current economic doctrine tends to ignore. This is the basis of price what we shall call the ‘full-cost’
principle.

AVERAGE-COST PRICING PRINCIPLE

We have discussed above that a number of economists have developed Average cost pricing models. The basic characteristic of model is that the price of the product is determined as :

P=AVC + GPM = AC

Where AVC = Average Variable Cost and GPM = Gross Profit Margin In other words, the firm sets a price equal to its total average cost which includes a certain net profit margin.

AVERAGE-COST PRICING AND GOAL OF PROFIT MAXIMISATION

In average-cost pricing model it is assumed, explicitly and implicitly, that the goal of the firm is long-run profit maximisation. However, the profit maximisation goal is not achieved by maximising profits in each one period within the time horizon of the firm. It has been established that short run profit maximisation attained by marginal analysis (MC=MR) in each period does not lead to long-run profit maximisation as postulated by traditional theory. It is mainly because of the Fact that the individual time periods (short run and a long run) are not independent of each other. Decisions taken in anyone period are influenced by decisions in earlier periods and will affect decision in future period. Therefore, marginal analysis does not correctly describe businessman's behaviour. Instead long run profit- maximisation is attained by equating price to the average cost of the firm.

DEMAND SCHEDULE

For analysing long run behaviour of the firm, we would require knowledge of its long run demand and cost schedules. In the wake of uncertainty it is difficult to prepare these schedules. The uncertainty is caused by the fact that tastes of the consumers are continuously changing in the market and the reaction of the competitors is difficult to predict. Past experience do not help much in reducing the uncertainty in this dynamic and continuously changing world. Therefore, A-C-pricing theorists reject the demand schedule as a tool of analysis. However, in the traditional theory of the firm, demand schedule is one of the most important tools of analysis.

Average-Cost-Pricing and Cost Schedule

Long run costs of the firm are also uncertain. Rapid technological change and changes in factor prices make it impossible to obtain reliable estimates of the long run cost schedule. Thus average cost pricing theories take into consideration short-run average cost.

It is assumed that the short-run average variable cost has saucer-type shape. This is mainly because of the fact that firms build into their some ‘reserve capacity’ which is required for various reasons, For example (a) to meet seasonal fluctuations in demand; (b) to allow a smooth flow of production when break-down to plant occurs; (c) to meet a growing demand until further expansion of scale is realised; and (d) to allow for making minor changes in the design of the product whenever there is a change in the tastes of the consumers. The shape of the average variable cost and other costs are shown in the figure 1. The decrease in short-run average variable cost (SAVC) is due to the better utilization of some of the fixed factors. So far the SAVC is falling the SMC is also falling.

The increasing part of SAVC reflects of the wastage of raw material, the higher repair charges and overtime payment to the labour force. When SAVC is rising the SMC lies about it. Over the flat stretch of the SAVC, the SMC is equal to the average variable cost. Pricing is based on the flat stretch of the SAVC. When firms producing the output at a level less than the normal capacity, they will have high costs. But they will not charge a high price in order to cover their costs because they expect to eventually reach the normalange  of output. Similarly when due to increasing demand pressure firms produce at increasing part of their average cost, they will not change a higher price to cover such costs because they are afraid of losing their goodwill.

PRICE DETERMINATION : 'THE MARK-UP RULE'

The determination of A-C pricing involves two stages :
(1) The firm defines the desired price (P) in order to cover its total cost when its plant is operating its optimal range of capacity and earn a reasonable' profit.

(2) The firm compares its estimated price with the level of price at which entry would occur, and sets the price at a level (P*) which would effectively discourage entry.
Subjective Estimate of the ‘Desired Price’ For determining the desired price the firm used the mark-up or cost-plus pricing rule. According to this rule :

P = AVC + GPM

AVC is cost-plus :- It is assumed that average variable cost (AVC) is known to the firms with certainty. The flat stretch of the SAVC curve represents normal utilisation of the plant capacity of the firm. The aim of the firm is long-run profit maximisation. However, given the uncertainty in the environment, the firm bases its price decision on the short-run average variable cost (SAVC).

It is because of the fact that the firm believes that its cost will not increase even if it expands its scale in the long-run (rather cost may fall in the long-run due to economies of large scale). Thus the short-run average-cost is thought to be a good approximation to the long-run average-cost.

The ‘Plus’ in A-C Pricing :- The mark-up or gross profit margin (GPM) may be added to average variable cost. This GPM will cover the average fixed cost (AFC) and yield a normal profit :

GPM = AFC + NPM

AFC is calculated by dividing total fixed cost (TFC) with the ‘planned’ or ‘budgeted’ or the ‘normal’ output (X*). Thus AFC = TFC/X*.
The net profit margin (NPM) is known to the established firms as a matter of experience. The firms should yield a ‘fair’ return on capital so that capital keeps flowing regularly in the industry for investment in the long run. For a new product the firm is assumed to add the NPM which is ‘safe’ in the sense that it does not attract the entrants.

Actual Price Setting Actual Price Setting

It is not necessary that the ‘desired’ or ‘standard’ price (as experienced above) will, actually be charged. The ‘desired’ price may be taken as the initial basis of the actual price. The level of actual price depends upon the threat of potential entry. Actual competition by existing firms may be resolved by tacit collusion or price leadership. Tacit collusion takes various forms. The  calculations of the actual price of the product are on the basis of average-cost data published by trade associations.

When the firms in an industry are having widely different costs, pricing on the basis of average-cost by each firm indepdently may result in market instability and price wars. For the smooth functioning of the industry, the firm with the lowest cost will be considered as the leader. The less efficient firms will be price takers. Although the price leader calculates the price of the product on the basis of average-cost rule, yet the leader will charge the actual price (P*) depending on two factors. (a) on potential competition; and (b) on
general economic condition (Prosperity and depression). If the entry of new firms is restricted, actual price (P*) will be higher than the leader's normal price (P) who will be earning just normal profits. Thus GPM is competitively—determined by the threat of potential entrants. In other words the average—cost—pricing has a strong link with entry-preventing behaviour.

Let we explain the determination of price in our ‘representative’ average-cost pricing model with the help of Figure-2. The horizontal lines are not demand curves, but show the price that would be charged under certain conditions.In Fig. 2 the SATC curve includes the net profit margin. The price leader would normally desire to charge the price P (or OP) which is equal to short-run average cost (aX*) and his ‘gross profit margin’ (ab). At OP price the price leader would sell the budgeted output (X*).

However, if barriers to entry exist (or their is booming business) the leader would charge the price P*. It is evident from the figure that the effective GPM at P* is ac which is greater than ab (ac > ab). If the threat to entry is strong (or there is depressed business) the leader would charge the price P*. Which is lower than the ‘initial’ or ‘normal’ price P. In this case, effective GPM would be ad<ab.

CRITICAL EVALUATION OF AVERAGE-COST PRICING

Most of the models of the A-C Pricing and based on empirical tests with the help of survey method. The finding of many of these surveys have come under attack on the following grounds :

(a) Small and non-random business survey using questionnaire and interviews are unreliable method of obtaining data on price determination ;

(b) The results of such surveys have been misinterpreted and

(c) The marginalist explanation of price determination has been incorrectly presented and therefore unduly criticised.

Other criticisms of A-C pricing principle are :

1. The average-cost pricing theory is not different from other known theories of the firm. For example, average costing rule of pricing are compatiable with Baumol's sales maximisation hypothesis, Cyert and March's satisficing behavioural model, with short-run marginalistic profit-maximisation behaviour and with long-run profit maximisation.

2. If should be clear that the ‘mark-up’ margin would be different, depending on the goals of the firm, and hence the price level would be different. Thus, unless we know what the goals of the firm are, it is not possible to come to know from the pricing rules of thumb whether it is a sales maximiser, or a satisficer, or a firm aiming at the long run profit maximisation because all these motivations may bet attained by applying an average-cost routine in price setting. However, the empirical evidence regarding the goals of the firm is far from conclusive. However there are certain merits of average-cost princing principle :

(a) Average cost pricing is easier to apply, because the concepts it involves are familiar to business persons and accountants, while the concept of
elasticity is not perhaps understood by the average business person.

(b) Average-cost pricing rule facilitates price setting in multi-product firms. In these firms acquisition of information on price elaticities for all products is both difficult and costly.

(c) Trade associations publicise information of costs of individual product lines. These informations can be very well utilised in calculating the average-cost pricing.