Some companies ignore the ATC of a product and set the price of a product higher (or usually lower) than the ATC. Some other companies use the cash flow of revenue of that product in setting the price. Discuss with use of data examples.
Introduction
For a firm, which operates in the contemporary corporate/economic system, the ultimate objective is profit. A firm enters an industry to earn a profit, for which it develops a strategy and then implements that strategy by employing different resources and instruments. There are some factors, which determine the size of the profit. For instance, the costs of production, price and market types are major factors, which directly influence the profit of a firm. If the market is highly competitive, then a firm earns little profit, as it is not in a position to experiment with prices. Also, it can reduce the cost of production only to a certain extent, especially in competitive and mature industry, where systems of productions have evolved (Mankiw, 2016).
As most of the markets are markets are a mixture of perfectly competitive markets and monopolies; therefore, firms can experiment with a price to alter the size of their profit. Thus, the price is one, of the major factors, that affects revenue and eventual profit. However, the setting price is generally a cumbersome and dicey affair. The study, of Microeconomics, suggests that there are various instruments and parameters that a firm can use to set the price of a product. However, the effectiveness of these parameters mostly depends upon the market type and prevailing economic condition. One of the instruments or parameters, which firms must use to set the price of a product or service, is Average Total Cost.
Average Total Cost
Average Total Cost is obtained by dividing the total cost of total products. Another process of knowing the average total cost is adding summation of variable cost with a fixed cost. Generally, Average Total Cost is time-dependent and its nature differs from short-run to long-run. For instance, in short-run, when businesses can earn abnormal profits, Average Total Cost curves may look distinct from Price. However, in the long run, Average Cost or Average Total Cost may look similar, if not identical. It is because, in the long-run, more firms are operating in the market and the profit, generated by industry, is shared among more such firms (Taylor, 2016).
Idealistically, a firm must charge a price equal to its Average Total Cost. However, this is not always possible, especially when a firm can charge more than its average cost. When a firm set a price more than its AC, then it can earn higher profits, which directly and positively affects its capital structure. Additional funds eventually translate into expansion of operations, capturing more market and thus generating more revenue.
In the monopolistically competitive market, where firms have limited market power and faculty to temper with prices, additional funds (generated by setting price more than Average Cost) are used for distinguishing the product from its closest rivals. One such example is of Coca-Cola and Pepsi, which have invested enormous financial capital in running potent campaigns that aim to distinguish their products from close substitutes.
It is quite apparent that there are different factors, which influence the setting of price. Mostly setting of price is not a discretionary decision, which is not influenced by external factors. For instance, the firm’s decision, about price is strongly affected by the shape of the demand curve. If the demand curve is flat, then it is quite difficult for a firm to increase the price.
Even if the demand curve is not flat and there rightwards shifts in the demand curve, firms are mostly not able to increase the price (price upwards rigidity). In one of the major studies, about the subject of pricing (in the United Kingdom), it was learned that firms opted to increase their production capacity whenever there was a shift (rightwards) in the demand curve, rather than increasing the price of the product. It again suggests that market dynamics are extremely relevant to pricing (Hall, Walsh, & Yates, 1998).
Different Strategies for Setting Price
We have already established that setting price is a cumbersome process, which is risky and may directly affect quantity demanded. However, firms must determine the price of their product, and for that purpose, they have devised different strategies and various instruments.
What The Market Will Bear?
The pricing strategy, which is opted by a considerable number of firms, is quite simple. The arithmetic pertains to short-run, and it dismisses Average Total Cost. If the demand is high, the price is high, and if the demand is low, the price is low. However, for manufacturers or industry firms, which have permanent clients, it is not easy to tamper with prices. Though, a small retailer would not shy from changing prices with demand. A prime example is of a tourist destination, where customers do not share transactions/business history with firms/sellers/service providers. For firms, which intend to use this strategy, it is also essential for segment market to understand what the market will bear true.
Cash Flow of Revenue
Some firms, not many, use Cash Flow Revenue to set their prices. These types of firms also ignore ATC, as their prime focus is a certain size of revenue/profit, which is essential to deliver corporate/industrial/firm’s obligations, such as wages. As these firms have a particular revenue target; therefore, the price is always set above ATC. Apart from corporate obligations, the capital structure of a firm also affects its decision regarding pricing, as capital structure too directly influences the size of the profit.
GMT Pricing Strategy
Gross Marginal Profit Target is another contemporary technique to set the price. This strategy is close to ATC strategy, which is recommended by most of Microeconomics pricing theories and strategies. In such a strategy ((price-cost) /price), profit is targeted in percentage, which automatically sets the price (Kalb, 2013).
ATC Still the Ultimate Instrument for Setting a Price
It is apparent that there are different factors, which affect price setting and among all these factors, market and the cost of production are the major factors. In recent years, there are many products, which prices have fluctuated because of changes in average cost. One of such products is apparel, which price has declined 9%, in the United States, primarily because manufacturing has shifted to labor-intensive economies. Similarly, as the methods, of producing energy and drilling oil/gas, have improved, the average total cost has lowered for the firm, which has affected prices. For instance, the cost of household fuel has declined 9.2% since 2006 (Picchi, 2016).
Ideally, setting price equals to ATC will allocate resources optimally, which will benefit not only the firm but also the entire system. However, for a firm earning profit is also essential; therefore, a firm will charge what a market can bear. For instance, if the demand curve is steep for a product, a firm may increase the price, but that too will have consequences, as higher profit will attract competition.
In the above paragraph, Average Total Cost is equal to the price in two different types of market, indicating an appropriate association of resources. (Note: a firm usually produces at the point, where MC =MR).
Conclusion
In the end, it is concluded that setting a price for a product or service requires a strategy backed by a lot of arithmetic. However, the simplest instrument to set price is Average Total Cost. A firm earns zero economic profit, by setting price equals to ATC, which underestimates its ultimate objective (earning at least normal economic profit). It may keep a firm operational and may allow it to exploit all its resources optimally, but this would not allow it to earn desired or targeted profit/revenue.
Market dynamics usually influence pricing strategy. For instance, sometimes market dynamics push firms to set the price lower than Average Total Cost (loss), other than the market dynamic capital structure to influence price-related decisions. The capital structure may push firms to set a price more than the average total cost, as a firm has to deliver various obligations, such as interest payments and wages. However, microeconomics theory, about cost, and pricing suggests that in the long-run price equals ATC; though, there is substantial evidence of that.
References
Hall, S., Walsh, M., & Yates, A. (1998). How do UK companies set prices? Retrieved from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=114948
Kalb, I. (2013, October 2). Three Ways Companies Decide Price of A Product. Retrieved July 19, 2018, from http://www.businessinsider.com/3-powerful-pricing-strategies-businesses-should-always-consider-2013-10
Mankiw, G. N. (2016). Principles of Microeconomics (8 ed.). Cengage Learning.
Picchi, A. (2016, September 20). A decade of changing prices for 11 basic goods and services. Retrieved July 19, 2018, from https://www.cbsnews.com/media/a-decade-of-changing-prices-for-11-basic-goods-and-services/5/
Taylor, K. (2016, February 13). Coca-Cola and Pepsi are depending on ‘the marketing trick of the century’ to save business. Retrieved July 19, 2018, from http://www.businessinsider.com/coke-and-pepsis-bottled-water-strategy-2016-2
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