Chapter 2 comp based pricing

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What Is a Price?:

What Is a Price? Narrowly, price is the amount of money charged for a product or service. Broadly, price is the sum of all the values that consumers exchange for the benefits of having or using the product or service.

Theory of Pricing:

Theory of Pricing Setting price is important for managerial decision making It increases revenue of firm Buyers and sellers Reformulated time to time Low price and high price Strategies depending on the market situation. No specific formula or economic rationale

Criteria for Market Classification:

Criteria for Market Classification Classification by the area : Local, Regional, National and International Classification by nature of transactions : Spot and Future market Classification by the volume of business : Wholesale and retail markets Classification on the basis of time: Very short period, short period, long period and very long period Classification by the status of sellers : Primary, Secondary and Terminal Markets Classification by regulation : Regulated and unregulated Classification on the basis of market structure : Characterized by sellers, buyers, products and conditions of entry and exit.

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Type of Market Definition Pure or Perfect Competition EX: Free software, street vendors, fish market and the vegetable or fruit vendors, stock exchange A market characterized by a large number of independent sellers of st andardized products , free flow of information , and free entry and exit . Each seller is a "price taker" rather than a "price maker". Simple Monopoly Ex: Electricity Dept. Cease Fire (Extinguishers) A situation in which a single company or group owns all or nearly all of the market for a given type of product or service. By definition, monopoly is characterized by an absence of competition - which often results in high prices and inferior products. Discriminating Monopoly Early Bird Specials—Restaurants charge special, lower prices for early diners. Matinees—Theaters charge less for earlier shows. Air Fares—Airlines charge less for flyers willing to fly “off peak,” i.e. early morning and late night. A company able to charge different prices for its output in different markets because it has power to influence prices for its goods

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Type of Market Definition Monopolistic Competition Restaurants , cereal , clothing , shoes and service industries A market structure in which several or many sellers each produce similar, but slightly differentiated products . Each p roducer can set its price and quantity without affecting the marketplace as a whole . Monopsony Ex: Wal-Mart, in the United States, functions as a Monopsony in certain market segments, as its buying power for a given item may dwarf the remaining market. A single-payer health care system, in which the government is the only "buyer" of healthcare services. A market form in which only one buyer faces many sellers. It is an example of imperfect competition, similar to a monopoly. Duopoly Ex: Visa and MasterCard , Canon and Nikon, Pepsi and Coca Cola The number of sellers are only 2 and large number of buyers. Price and Output decisions are interdependent. Oligopoly Ex: OPEC Few Sellers supplying either homogenous (Steel/Aluminum/Copper) or differentiated products (Automobile-Passenger Cars). Blocked entry and exit. Imperfect dissemination of information. Interdependence about fixing Price and determining OP.

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Type of Market Definition Bilateral Monopoly Ex: L abor markets of industrialized nations in the 1800s and the early 20th century. Large companies would essentially monopolize all the jobs in a single town and use their power to drive wages to lower levels. Workers, to increase their bargaining power, formed labor unions with the ability to strike, and became an equal force at the bargaining table with regard to wages paid. A market that has only one supplier and one buyer. The one supplier will tend to act as a monopoly power, and look to charge high prices to the one buyer. The lone buyer will look towards paying a price that is as low as possible. Since both parties have conflicting goals, the two sides must negotiate based on the relative bargaining power of each, with a final price settling in between the two sides’ points of maximum profit. Oligopsony Ex: Cocoa, where three firms (Cargill, Archer Daniels Midland, and Callebaut ) buy the vast majority of world cocoa bean production, mostly from small farmers in third-world countries. American tobacco growers face an oligopsony of cigarette makers, where three companies (Altria, Brown & Williamson, and Lorillard Tobacco Company) buy almost 90% of all tobacco grown in the US. the U.S. fast food industry, in which a small number of large buyers (i.e. McDonald's, Burger King, Wendy's) controls the U.S. meat market. Such control allows these fast food mega-chains to dictate the price they pay to farmers for meat and to influence animal welfare conditions and labor standards. A market form in which the number of buyers is small while the number of sellers in theory could be large. This typically happens in market for inputs where a small number of firms are competing to obtain factors of production. It contrasts with an oligopoly, where there are many buyers but just a few sellers. An Oligopsony is a form of imperfect competition.

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Type of Market Nature of the Product # of Buyers # of Sellers Entry Conditions Pure or Perfect Competition Homogenous for all firms Large Large Free entry, free exit Simple Monopoly Homogenous for all firms Large One Entry Barriers Discriminating Monopoly Homogenous for all firms Large One Entry Barriers Monopolistic Competition Product Differentiation by each firm Large Many Product differentiation acting as Entry Barrier Duopoly Can be homogenous or differentiated Large Two Entry Barriers created by product differentiation and by one of the two firms dominating the market Oligopoly Can be homogenous or differentiated Large A few Entry Barriers due to product differentiation and by a few firms dominating the market Bilateral Monopoly Homogenous One One Entry Barriers Monopsony Homogenous One Large Free Entry Oligopsony Can be homogenous or differentiated A few buyers, while some of them are main buyers Large No Entry Barriers Market Structures

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TYPE OF MARKET PRICE NATURE OF DECISION VARIABLES Pure or Perfect Competition Uniform Everywhere Only Output Simple Monopoly High Both price and output are within control, but decision can be taken only about one of them. Discriminating Monopoly High Discrimination in prices by deciding to charge different prices from different customers. Monopolistic Competition Higher than perfectly competitive firm but lower than a monopolist The nature and extent of product differentiation and therefore the levels of selling expenses and advertisement Duopoly High Price, product differentiation and selling expenses including advertisement, but decision primarily depending upon competitors strategy PRICE POLICY

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TYPE OF MARKET PRICE NATURE OF DECISION VARIABLES Oligopoly High Price, product differentiation and selling expenses, including advertisement, but decision primarily depending upon competitors strategy Bilateral Monopoly Prevailing price depending upon whether the buyer or the seller is more powerful or the seller is more powerful. Price and output Monopsony Tendency of paying lowest possible price Adjusting output according to expected price Oligopsony Large buyers try to push the price as low as possible No single buyer can afford to ignore the reactions of his rivals to policies he might initiate. PRICE POLICY

General Considerations In Formulating A Pricing Policy By A Firm:

General Considerations In Formulating A Pricing Policy By A Firm KIND OF MARKET STRUCTURE Number, size and product differentiation Potential competition Degree of potential market segmentation and chances of price discriminations Richness of the mixture of service, advertisement and sales propaganda and the reputation of the firm. The cross elasticity of demand between differentiated and homogenous products. GOAL OF PROFIT AND SALES Stimulation of profitable combination sales Seeking profit maximization Capturing market Profit oriented

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FLEXIBILITY: To meet the changes in demand pattern and market situation LONG RANGE WELFARE OF THE FIRM: establishment and to discourage entry of rivals BUSINESS OBJECTIVE: Set a Vision Survival Growth MISCELLANEOUS: Prices should be adapted in accordance with the diverse competitive situations encountered by different varieties of products produced by the firm. Predetermined and systematic method of pricing new products Determination of price discount structure Prices in relation to quality and quantity Price based on promotional policies and sales expenditures

FACTORS INVOLVED IN PRICING POLICIES:

FACTORS INVOLVED IN PRICING POLICIES EXTERNAL FACTORS: Elasticity of supply and demand: Pricing policy largely depend on elasticity of demand and consumer preference and psychology. Ex: If demand is inelastic we can follow rising price policy but if demand is elastic decreasing price policy should be followed Degree of competition prevailing in market. Purchasing power of buyers Government policy towards pricing INTERNAL FACTORS Cost of product : Price has to be along the cost (TC,MC AND AC). If price is below cost of production means loss. Economy in cost is essential . Sales turnover Management policy Target rate for profit :In price determination, profit plays a significant role. Pricing policy is based on the goal of obtaining reasonable profit. Conflicts between producer and retailer Trial & error

OBJECTIVES OF PRICING POLICIES:

OBJECTIVES OF PRICING POLICIES Survival: Is Always the underlying objective of the firm. To maximize profits Achieving a target-return Rate of growth and sales maximization Market shares Target return on investment Preventing competition Service motive Regular income Price stabilization Seek anticipated rate of growth Capturing the market

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COST-ORIENTED PRICING: Cost Plus Pricing Marginal Pricing Target Pricing COMPETITION ORIENTED PRICING Going Rate Pricing Loss Leader Customary Pricing Imitative Pricing And Suggested Prices Price Leadership PRICING BASED ON OTHER ECONOMIC CONSIDERATIONS Administered Pricing Dual Pricing Price Discrimination PRICING POLICIES, PRACTICES AND STRATEGIES PRICING OF MULTIPLE PRODUCTS: Product Line Pricing Transfer Pricing Peak Load Pricing OTHER PRICING STRATEGIES : Psychological Pricing Limit Pricing Skimming Pricing Penetration Pricing Premium Pricing

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COST PLUS or FULL COST PRICING Price is determined by adding a fixed markup to the cost of acquiring or producing the product. Most common method. Long Period Phenomenon. COST PLUS PRICING= COST + FAIR PROFIT OR CPP= AVC + GPM (NPM+AFC) GPM=Gross Profit Margin NPM= Net profit margin AFC= Average Fixed cost COST: Based on Average cost (TC/Q). cost refers to full allocated cost. Three different concepts of the cost component used in the formula of cost pricing: Actual Cost Expected Cost Standard Cost

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Actual costs : Historical costs for the latest available period. Covers wage bills, raw material costs and overhead charges at the then current output rate. Expected costs : Forecast for the pricing method on the basis of expected prices, output rates and productivity. Standard costs : Normal cost determination at some normal rate of output at a given level of capacity utilization and productivity at normal level. In practice, cost base is determined form engineering estimates plus cost experience, historical data and projections.

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FAIR PROFIT or Net profit margin Arbitrarily determined. Fair profit is usually meant a fixed percentage of profit mark-up. Typically, it is determined at 10 percent in many cases. Fair profit differs from industry to industry and among the homogenous product firms because- Differences in turnover rate Differences in risks Differences in competitive industry Differences in traditions or customary fixation of profit margin in different business

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The fair profit in cost plus principle in practical business is fundamentally different from the concept of normal profit in economic analysis. Cost pricing is essentially mark-up pricing in practice. It is determined by adding a percentage mark-up to the average variable cost of the product. Thus- P = AVC + M M= mark-up measured as x%(AVC) . It is also referred to as contribution margin. Ex: A firm’s AVC is Rs.50 and contribution margin (X%) is 10%. P=? X%= 10/100(50) = 0.1*50= Rs.5 P= 50+5= Rs.55. Suitable only when producers are uncertain about market demand for their product and want stability when the rival’s price strategy are unknown.

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Shortcomings : Ignores consumer preferences, demand, effect of competition, rival’s reaction, importance of incremental costs, economic tools and overstresses the precision of allocated costs. Advantages : Easy and convenient even in cases of multiple product Fulfills objective of profit maximization Reduces cost of decision making Prices fixed in this manner are considered fair from the point of view of consumers As firms are uncertain about the demand conditions facing them, moving away from cost plus pricing may be too risky. Suitable where price leadership prevails.

INCREMENTAL OR MARGINAL OR DIRECT COST PRICING:

INCREMENTAL OR MARGINAL OR DIRECT COST PRICING Priced is based on incremental cost of production based on variable cost only Short period phenomenon In economics marginal cost of unit. In practice only incremental cost due to business decision is considered in change of Output. Particularly relevant in transport where fixed costs may be relatively high. Allows variable pricing structure. When do they adopt: Introduction of product into the new markets. Faces stiff competition in market Has unutilized capacity.

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Advantages : Helps for more aggressive pricing policy MC pricing – allows flexibility Useful for pricing over the life cycle of the product. In case of multiproduct, multiprocess and multimarket firms as they do not have equal impact on costs, MCP is satisfactory. Limitations : Only SR policy. No long period stable pricing policy Doesn’t guarantee that the firm will operate at the BEP In recession cut throat competition as decrease in prices

Marginal Cost Pricing:

Marginal Cost Pricing Example: On a flight from London to New York – providing the cost of the extra passenger is covered, the price could be varied a good deal to attract customers and fill the aircraft Aircraft flying from Bristol to Edinburgh – Total Cost (including normal profit) = £15,000 of which £13,000 is fixed cost* Number of seats = 160, average price = £93.75 MC of each passenger = 2000/160 = £12.50 If flight not full, better to offer passengers chance of flying at £12.50 and fill the seat than not fill it at all! *All figures are estimates only

Rate of Return or Target Pricing :

Rate of Return or Target Pricing Refined version of CPP Due to certain reasons, if the prices revised, they would allow it to maintain A fixed percentage of mark up over cost. Profit as a fixed percentage of total sales or fixed return on existing investments . ROR Determination: Specify Expected rate of return on investment = Earnings/capital invested. To determine Normal rate of OP by the firm and then to estimate the Full cost on the basis of the normal rate of production. Estimate Cap turnover ratio = Capital Investment/Full Cost Mark Up% = Capital Turnover Ratio X Expected Rare of Return on investment RATE OF RETURN PRICE = FULL COST + MARK-UP ROR changes as costs changes Demand or competition changes MU change Price Change Advantage : Based on planned/expected rate of return on investment. Full Cost based on normal output and cost. MARK-UP = CAPITAL INVESTED X EARNINGS = EARNINGS FULL COST CAPITAL INVESTED FULL COST FULL COST = COST + FAIR PROFIT

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