ECONOMIC ANALYSIS POLICY - IECONOMIC ANALYSIS POLICY - I

LECTURE 15LECTURE 15

PRICING POLICIESPRICING POLICIES

Pricing policies are policies involving long Pricing policies are policies involving long term decisions regarding prices of the term decisions regarding prices of the products of the firm taking various factors products of the firm taking various factors into consideration - economic, social and into consideration - economic, social and political. It is a crucial problem and there is political. It is a crucial problem and there is no short - cut formula. Again, prices once no short - cut formula. Again, prices once fixed need review and revision from time fixed need review and revision from time to time to make them suitable according to to time to make them suitable according to the changed conditions.the changed conditions.

Objectives of Pricing PoliciesObjectives of Pricing Policies

I. I. To maximise profits To maximise profits - Exploiting consumers will not pay - The - Exploiting consumers will not pay - The firm should take a long time view.firm should take a long time view.

II. II. Price Stability Price Stability - To generate confidence and goodwill among - To generate confidence and goodwill among consumers.consumers.

III.III.Facing Competitive Situation Facing Competitive Situation - Should avoid potential - Should avoid potential competitors.competitors.

IV. IV. Capturing the MarketCapturing the Market - In price-sensitive markets, a producer - In price-sensitive markets, a producer may fix a comparatively lower price while introducing his may fix a comparatively lower price while introducing his product - to capture a lion's share of the market (Market product - to capture a lion's share of the market (Market Penetration).Penetration).

V. V. Achieving a Target-return Achieving a Target-return - Prices of products so calculated as - Prices of products so calculated as to earn the target return on cost of production/sale/investment. to earn the target return on cost of production/sale/investment. Different target - returns may be fixed for different Different target - returns may be fixed for different products/brands/markets, but such returns should be related to products/brands/markets, but such returns should be related to a single over - all rate of return target.a single over - all rate of return target.

VI. VI. Ability to Pay Ability to Pay - Price decisions often hinge - Price decisions often hinge on on the customer's ability to pay eg the customer's ability to pay eg lawyers, lawyers,

doctors, Governments.doctors, Governments.

VII.VII. Long run Welfare of the Firm Long run Welfare of the Firm - Keeping the - Keeping the best interests of the firm in the long run.best interests of the firm in the long run.

Factors affecting Price PolicyFactors affecting Price Policy - There are - There are external and internal factors. external and internal factors. External factors External factors are are elasticity of demand/supply, goodwill of the firm, elasticity of demand/supply, goodwill of the firm, purchasing power of consumers, trend of the purchasing power of consumers, trend of the market etc. market etc. Internal Factors Internal Factors include cost include cost considerations and management policy. A considerations and management policy. A suitable Pricing Policy should have the following suitable Pricing Policy should have the following general considerations :general considerations :

I. I. Objectives of Business : Objectives of Business : The Pricing Policy should The Pricing Policy should conform to the objectives, as discussed above.conform to the objectives, as discussed above.

II. II. Cost of the Product : Cost of the Product : Costs and prices are closely Costs and prices are closely related. Normally, prices cannot be below costs related. Normally, prices cannot be below costs including administration and selling costs. In the long including administration and selling costs. In the long run, price also determines costs.run, price also determines costs.

III. III. Competitor's Price : Competitor's Price : Factors such as the number Factors such as the number of competitors, their prices, quality differences, of competitors, their prices, quality differences, substitutes etc affect pricing.substitutes etc affect pricing.

IV. IV. Market Position of the Firm: Market Position of the Firm: eg. Goodwill for quality eg. Goodwill for quality products. A reputed firm may fix a higher price for its products. A reputed firm may fix a higher price for its product because of faith of customers in the company's product because of faith of customers in the company's products.products.

V. V. Distribution Channel Policy : Distribution Channel Policy : Nature of distribution Nature of distribution channels, trade discountschannels, trade discounts allowed to them and allowed to them and distribution expenses influence prices.distribution expenses influence prices.

VI. VI. Price Elasticity of Demand : Price Elasticity of Demand : A high price may be fixed for inelastic A high price may be fixed for inelastic goods and low price for elastic goods. A price reduction policy may goods and low price for elastic goods. A price reduction policy may suit highly elastic goods.suit highly elastic goods.

VII.VII. Product's Stage in the Life Cycle : Product's Stage in the Life Cycle : In the introductory stages, In the introductory stages, prices are fixed lower (to increase the demand for the product) or prices are fixed lower (to increase the demand for the product) or higher (to earn maximum profit) considering the competitive higher (to earn maximum profit) considering the competitive situations in the market. In the maturity stage, penetrating price may situations in the market. In the maturity stage, penetrating price may be followed.be followed.

VIII.VIII. Product Differentiation: Product Differentiation: When products have different sizes, When products have different sizes, colours, quality etc. prices vary. Customers are willing to pay higher colours, quality etc. prices vary. Customers are willing to pay higher prices for a new style, fashion, quality or packaging etc. (Market prices for a new style, fashion, quality or packaging etc. (Market Skimming)Skimming)

IX. IX. Buying Patterns of Consumers : Buying Patterns of Consumers : If the buying frequency of the If the buying frequency of the product is higher, lower prices should be fixed - low profit margin, product is higher, lower prices should be fixed - low profit margin, higher turn - over and profit. All consumer products have higher higher turn - over and profit. All consumer products have higher frequency. But consumer durables such as TV, Fridges have low frequency. But consumer durables such as TV, Fridges have low frequency and therefore priced higher.frequency and therefore priced higher.

X. X. Economic Environment :Economic Environment : Higher prices are charged during boom, Higher prices are charged during boom, reduced prices during recession.reduced prices during recession.

XI. XI. Govt. Policy: Govt. Policy: If prices are much higher, Govt will intervene. (Market If prices are much higher, Govt will intervene. (Market Intervention)Intervention)

XII.XII. Social and Ethical Considerations :Social and Ethical Considerations :a) Fair Price b) Fear of labour leaders c) Consumers' reactions to a) Fair Price b) Fear of labour leaders c) Consumers' reactions to higher priceshigher prices

Role of Costs in PricingRole of Costs in PricingImportant element - There are two other factors - demand and Important element - There are two other factors - demand and competition - often it is the price that determines cost - given competition - often it is the price that determines cost - given the price, the producer arrives at the cost working backwards the price, the producer arrives at the cost working backwards from the price consumer can afford to pay. Quality of the from the price consumer can afford to pay. Quality of the product can be improved only if consumers are willing to pay product can be improved only if consumers are willing to pay higher prices.higher prices.

If costs were to determine price, why do firms report loss? If costs were to determine price, why do firms report loss? Different producers have different costs of production. But in Different producers have different costs of production. But in the market prices are close together for somewhat similiar the market prices are close together for somewhat similiar product. It is also difficult to measure costs accurately. Costs product. It is also difficult to measure costs accurately. Costs are affected by volume and volume is affected by price. The are affected by volume and volume is affected by price. The management has to assume some desired price and volume management has to assume some desired price and volume relationship for determining costs.relationship for determining costs.

Thus, costs have to be taken into account like other factors. In Thus, costs have to be taken into account like other factors. In the long run if costs are not covered, manufacturers will the long run if costs are not covered, manufacturers will withdraw, supply will be curtailed and prices will be raised. All withdraw, supply will be curtailed and prices will be raised. All these show that cost is not the only factor in setting prices .these show that cost is not the only factor in setting prices .

PRICING METHODSPRICING METHODS

Generally, businessmen prefer a pricing Generally, businessmen prefer a pricing procedure which is easy to implement and procedure which is easy to implement and requires only very few assumptions on requires only very few assumptions on demand. The various pricing methods demand. The various pricing methods usually employed by businessmen are: (i) usually employed by businessmen are: (i) Cost Plus or Full Cost Pricing (ii) Target Cost Plus or Full Cost Pricing (ii) Target Pricing or Pricing for a Rate of Return (iii) Pricing or Pricing for a Rate of Return (iii) Marginal Pricing (iv) Going Rate Pricing Marginal Pricing (iv) Going Rate Pricing and (v) Customary Pricing.and (v) Customary Pricing.

(I) COST PLUS PRICING(I) COST PLUS PRICING

Under this method, (also known as Margin Pricing or Under this method, (also known as Margin Pricing or Mark up Pricing) the price is set to cover all costs Mark up Pricing) the price is set to cover all costs (material, labour and overhead) and a predetermined (material, labour and overhead) and a predetermined percentage for profit. This percentage is never alike percentage for profit. This percentage is never alike among various units within the industry and even among various units within the industry and even products of the same concern. This is due to difference products of the same concern. This is due to difference in competitive intensity, cost base, turn - over rate with in competitive intensity, cost base, turn - over rate with risk. It shows some vague idea of just profit.risk. It shows some vague idea of just profit.Limitations: Limitations: (i) (i) Demand is ignored Demand is ignored : there is no : there is no reciprocity between cost and demand for goods. It reciprocity between cost and demand for goods. It ignores demand totally. (ii) Failure to show the forces of ignores demand totally. (ii) Failure to show the forces of competition (ill) Exaggeration of the precision of competition (ill) Exaggeration of the precision of allocated costs (iv) Based on cost concept - This may allocated costs (iv) Based on cost concept - This may not be relevant for the decision of the price.not be relevant for the decision of the price.

Suitable in the Following Cases:Suitable in the Following Cases:(I) (I) Ideal Method: Ideal Method: It is an ideal, fair and just method of pricing. Prices It is an ideal, fair and just method of pricing. Prices

can can be fixed very easily and with speed. Prices are defensible on moral be fixed very easily and with speed. Prices are defensible on moral grounds.grounds.

(II) (II) Uncertainty of Demand : Uncertainty of Demand : Firms are often uncertain of their demand Firms are often uncertain of their demand and and probable response to any price change. This method is fool-proof probable response to any price change. This method is fool-proof that that way.way.

(III) (III) Stability Stability : In cases where costs of getting information on market : In cases where costs of getting information on market situations are high with process of trial and error, they stick to it so that situations are high with process of trial and error, they stick to it so that the the cost of decision making is reduced to the minimum.cost of decision making is reduced to the minimum.

(IV) (IV) Managements Managements tend to know more about product costs than other tend to know more about product costs than other factors relevant to pricing.factors relevant to pricing.

(V) (V) Major Uncertainty in Cost Setting: Major Uncertainty in Cost Setting: Rival's prices could not be known. Rival's prices could not be known. Hence, it isHence, it is difficult to set the price accordingly.difficult to set the price accordingly.

(VI) (VI) Product Tailoring: Product Tailoring: When the selling price is determined, the product When the selling price is determined, the product design can be determined easily.design can be determined easily.

(VII) (VII) Pricing of Products Pricing of Products : When they are manufactured on the orders of a : When they are manufactured on the orders of a single buyer as per specifications.single buyer as per specifications.

(VIIT) (VIIT) Monopoly Buying: Monopoly Buying: Buyers know of the supplier's costs - if price Buyers know of the supplier's costs - if price charged charged is high they will prepare the product themselves.is high they will prepare the product themselves.

(IX) (IX) Public Utility Pricing.Public Utility Pricing.(X) (X) Useful in Times of Depression. Useful in Times of Depression.

(2) TARGET PRICING (2) TARGET PRICING

PRICING FOR A RATE OF RETURNPRICING FOR A RATE OF RETURN

This method of pricing is only a refinement of the full- cost This method of pricing is only a refinement of the full- cost pricing. According to this method, the manufacturer considers a pricing. According to this method, the manufacturer considers a pre--determined target rate of return on capital investedpre--determined target rate of return on capital invested. In . In the case of full cost pricing, the percentage of profit is marked the case of full cost pricing, the percentage of profit is marked up arbitarily. In the case of the rate of return method, the up arbitarily. In the case of the rate of return method, the companies determine the average mark-up on costs necessary companies determine the average mark-up on costs necessary to produce a desired rate of return on the company's to produce a desired rate of return on the company's investment. In this case, the company estimates future sales, investment. In this case, the company estimates future sales, future costs and arrives at a mark up that will achieve a target future costs and arrives at a mark up that will achieve a target return on the company's investment.return on the company's investment.

Davies and Hughes have used the following formula to Davies and Hughes have used the following formula to calculate the desired rate of return when a mark up is applied in calculate the desired rate of return when a mark up is applied in cost:cost:

Percentage mark up on costPercentage mark up on cost

Capital employed Capital employed == ------------------------ X Planned rate of return------------------------ X Planned rate of return

Total annual costTotal annual costSuppose the capital employed by a firm is Rs 6 lakhs and total annaul Suppose the capital employed by a firm is Rs 6 lakhs and total annaul cost is Rs 12 lakhs with a planned rate of return of 20 per cent. The cost is Rs 12 lakhs with a planned rate of return of 20 per cent. The percentage mark-up, therefore, is according to the formulapercentage mark-up, therefore, is according to the formula

Capital employed Capital employed --------------------------- X Planned rate of return = --------------------------- X Planned rate of return = 66 x 20 = 10 % x 20 = 10 %Total Annual CostTotal Annual Cost 12 12

Now suppose the total cost per unit in the firm is Rs 20 with 10 per Now suppose the total cost per unit in the firm is Rs 20 with 10 per cent mark-up, the selling price would be Rs 22 /-.cent mark-up, the selling price would be Rs 22 /-.

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

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

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

c)c) Revising the prices to achieve a constant rate of Revising the prices to achieve a constant rate of return on capital invested. return on capital invested.

Changed percentages may be compiled as below:Changed percentages may be compiled as below:

ProfitsProfits(i) Percentage over Costs(i) Percentage over Costs = = ---------- ----------

CostsCosts ProfitsProfits

(ii) Percentage on Sales(ii) Percentage on Sales = = ----------------------- ----- ----------------------- ----- Earnings from SalesEarnings from Sales

ProfitsProfits(iii) Percentage on Capital employed = (iii) Percentage on Capital employed = --------------------- --------------------- Capital Capital

employed employed

The major drawback of this procedure is The major drawback of this procedure is that it ignores demand conditions. that it ignores demand conditions. Advantages and Disadvantages of COST - Advantages and Disadvantages of COST - PLUS Pricing are relevant to this method PLUS Pricing are relevant to this method also.also.

(3) MARGINAL COST PRICING(3) MARGINAL COST PRICING

In the first method, i.e., In the first method, i.e., full-cost pricing full-cost pricing and the and the rate of return pricingrate of return pricing prices are fixed on the prices are fixed on the basis of total costs comprising fixed costs and basis of total costs comprising fixed costs and variable costs. Under Marginal Pricing method, the variable costs. Under Marginal Pricing method, the price of a product is determined on the basis of the price of a product is determined on the basis of the marginal or variable costs. In this method, fixed marginal or variable costs. In this method, fixed costs are totally ignored and only variable costs costs are totally ignored and only variable costs are taken into account. This is done on the are taken into account. This is done on the assumption that fixed costs are caused by outlays assumption that fixed costs are caused by outlays which are historical and sunk. Their relevance to which are historical and sunk. Their relevance to pricing decision is limited, as pricing decision pricing decision is limited, as pricing decision requires planning the future. Under marginal cost requires planning the future. Under marginal cost pricing, the objective of the firm is to maximise its pricing, the objective of the firm is to maximise its total contribution to fixed costs and profit.total contribution to fixed costs and profit.

Advantages of Marginal Cost PricingAdvantages of Marginal Cost Pricing

I.I. Marginal cost pricing method is highly useful for public Marginal cost pricing method is highly useful for public utility undertakings. It helps them in maximising out-put utility undertakings. It helps them in maximising out-put

or or better capacity utilisation. This is possible only when better capacity utilisation. This is possible only when lowest lowest possible price is charged . The lowest limit is set possible price is charged . The lowest limit is set by by marginal cost of the product. When public utility marginal cost of the product. When public utility concerns concerns adopt marginal cost pricing, it helps in maximising adopt marginal cost pricing, it helps in maximising social social welfare.welfare.

II.II. This method enables the firms to face competition. This This method enables the firms to face competition. This is is the reason why export prices are based on marginal the reason why export prices are based on marginal costs costs since international market is highly competitive.since international market is highly competitive.

III.III. This method helps in optimum allocation of resources This method helps in optimum allocation of resources and and as such it is the most efficient anf effective pricing as such it is the most efficient anf effective pricing technique. It is useful when demand conditions are slack.technique. It is useful when demand conditions are slack.

IV. IV. Marginal cost pricing is suitable for pricing over the life-Marginal cost pricing is suitable for pricing over the life-cycle of a product. Each stage of the life- cycle has cycle of a product. Each stage of the life- cycle has

separate fixed cost and short-run marginal cost.separate fixed cost and short-run marginal cost.

Marginal cost pricing method is more effective than full Marginal cost pricing method is more effective than full cost pricing because of two characteristics of modern cost pricing because of two characteristics of modern business:business:

(a) (a) The prevalance of multi-process and multi-market The prevalance of multi-process and multi-market concerns makes the absorbtion of fixed costs into concerns makes the absorbtion of fixed costs into product costs absurd. The total costs of the product costs absurd. The total costs of the

separate separate products can never be estimated perfectly products can never be estimated perfectly and and satisfactorily, and the optimal relationship between satisfactorily, and the optimal relationship between

costs and prices will vary substantially both among costs and prices will vary substantially both among different products and between different markets. In different products and between different markets. In this type of business, proposals to changing the this type of business, proposals to changing the

prices prices in terms of sales and segmentation of the market in terms of sales and segmentation of the market can can be profitably employed only with short-run problems be profitably employed only with short-run problems

and marginal pricing is the most suitable method of and marginal pricing is the most suitable method of short-run pricing.short-run pricing.

(b) (b) In business, the dominant force is innovation In business, the dominant force is innovation combined with constant technology. The long-run combined with constant technology. The long-run situation is often unpredictable. Hence, short-run situation is often unpredictable. Hence, short-run marginal cost pricing is most suitable.marginal cost pricing is most suitable.

Limitations of Marginal Cost Pricing:Limitations of Marginal Cost Pricing:

(i)(i) Firms may find it difficult to cover up costs and earn a Firms may find it difficult to cover up costs and earn a fair fair return on capital employed when they follow marginal return on capital employed when they follow marginal cost cost principle in times of recession when demand is slack and principle in times of recession when demand is slack and

price reduction becomes inevitable to retain business.price reduction becomes inevitable to retain business.(ii)(ii) When production takes place under decreasing costs, When production takes place under decreasing costs,

marginal cost pricing is unsuitable since marginal cost pricing is unsuitable since MC MC curve will be curve will be below the below the AC AC curve and marginal cost pricing is bound to curve and marginal cost pricing is bound to lead to deficits.lead to deficits.

(iii)(iii) Marginal cost pricing requires a better understanding of Marginal cost pricing requires a better understanding of marginal cost technique. Some accountants are not fully marginal cost technique. Some accountants are not fully conversant with the marginal techniques themselves. conversant with the marginal techniques themselves.

Therefore, they are not capable of explaining their use to Therefore, they are not capable of explaining their use to the management.the management.

In spite of its advantages, marginal pricing has not been In spite of its advantages, marginal pricing has not been adopted extensively, due to its inherent weakness of not adopted extensively, due to its inherent weakness of not ensuring the coverage of fixed costs. It is confined to ensuring the coverage of fixed costs. It is confined to

cases cases of special orders only.of special orders only.

(4) GOING -RATE PRICING(4) GOING -RATE PRICINGThis method of pricing conforms to the system of pricing in This method of pricing conforms to the system of pricing in oligopoly where a firm initiates price changes and the other oligopoly where a firm initiates price changes and the other firms in the industry merely follow the pattern set by the leader. firms in the industry merely follow the pattern set by the leader. Other firms accept the leadership. The emphasis here is on the Other firms accept the leadership. The emphasis here is on the market. Firms make necessary price adjustment to suit the market. Firms make necessary price adjustment to suit the general price structure in the industry. Hence this going-rate general price structure in the industry. Hence this going-rate pricing method is also called Acceptance-Pricing. Normally, pricing method is also called Acceptance-Pricing. Normally, under this method, the industry tries to determine the lowest under this method, the industry tries to determine the lowest price that the seller can afford to accept considering various price that the seller can afford to accept considering various alternatives.alternatives.

Examples of Going - Rate Pricing include industries like Examples of Going - Rate Pricing include industries like clothing, automobiles, CDs, etc., where the products have clothing, automobiles, CDs, etc., where the products have reached a stage of maturity (on their own development) and reached a stage of maturity (on their own development) and where both customers and rival producers have become where both customers and rival producers have become accustomed to stable price-relationship. When products are accustomed to stable price-relationship. When products are identical, unique selling price will rule. When they are identical, unique selling price will rule. When they are differentiated, prices will form a series set at discrete intervals.differentiated, prices will form a series set at discrete intervals.

Advantages of this method of Pricing :Advantages of this method of Pricing : (a) It helps (a) It helps in avoiding cut-throat competition among firms (b) It is in avoiding cut-throat competition among firms (b) It is a rational pricing method when costs are difficult to a rational pricing method when costs are difficult to measure . (c) Going - Rate or Acceptance Pricing is measure . (c) Going - Rate or Acceptance Pricing is less costly since exact calculation of costs and less costly since exact calculation of costs and demand is not necesary. (d) It is suitable to avoid price demand is not necesary. (d) It is suitable to avoid price hazards in oilgopoly market.hazards in oilgopoly market.

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

(5) CUSTOMARY PRICING(5) CUSTOMARY PRICINGPrices of certain goods become more or less fixed for a Prices of certain goods become more or less fixed for a considerable period of time, not by deliberate action on the considerable period of time, not by deliberate action on the seller's part, but as a result of their having prevailed for a seller's part, but as a result of their having prevailed for a considerable period of time. Only when the costs change considerable period of time. Only when the costs change significantly, the customary prices of these goods are changed. significantly, the customary prices of these goods are changed. While changing the customary price, it is necessary to study the While changing the customary price, it is necessary to study the pricing policies and practices adopted by the competing firms. pricing policies and practices adopted by the competing firms. Another approach is to effect a price change only in a limited Another approach is to effect a price change only in a limited market segment and know the customer reaction to decide market segment and know the customer reaction to decide whether any change would be digested by the market.whether any change would be digested by the market.

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

(6) DIFFERENTIAL PRICING(6) DIFFERENTIAL PRICING

An important aspect of price differential is price discrimination. An important aspect of price differential is price discrimination. The producer will have various goals in adopting differential The producer will have various goals in adopting differential prices : (i) Implementation of a marketing strategy to reach a prices : (i) Implementation of a marketing strategy to reach a particular sector of the market through price differentials. (ii) particular sector of the market through price differentials. (ii) Market differential prices help in achieving profitable market Market differential prices help in achieving profitable market segmentation when legal and competitive considerations permit segmentation when legal and competitive considerations permit price discrimination. (iii) Market expansion : Differential pricing price discrimination. (iii) Market expansion : Differential pricing may be designed to encourage new uses or to attract new may be designed to encourage new uses or to attract new customers. (iv) Competitive adaptation: Differential prices are customers. (iv) Competitive adaptation: Differential prices are major devices for selective adjustment to competitive situations. major devices for selective adjustment to competitive situations. When there are standardised products in the industry, When there are standardised products in the industry, differential prices help to achieve competitive parity with differential prices help to achieve competitive parity with customers of different backgrounds. (v) Reduction of production customers of different backgrounds. (v) Reduction of production costs: allowing seasonal discounts and the like reduce the costs: allowing seasonal discounts and the like reduce the overall production costs by encouraging off-season purchases.overall production costs by encouraging off-season purchases.

LEGAL CONSTRAINTS IN PRICINGLEGAL CONSTRAINTS IN PRICING

In fixing the price of a commodity there are certain legal In fixing the price of a commodity there are certain legal constraints and restrictions. In the case of certain commodities, constraints and restrictions. In the case of certain commodities, firms are not allowed to fix a price more than what is statutorily firms are not allowed to fix a price more than what is statutorily fixed by the Government. In India, statutory price fixation has fixed by the Government. In India, statutory price fixation has been done by the Tariff Commission (formerly Tariff Board) and been done by the Tariff Commission (formerly Tariff Board) and Special Committees appointed for the purpose. Thus, prices of Special Committees appointed for the purpose. Thus, prices of commodities such as motor cars, iron and steel, cotton textiles, commodities such as motor cars, iron and steel, cotton textiles, sugar, paper and paper pulp, matches, salt, heavy chemicals, sugar, paper and paper pulp, matches, salt, heavy chemicals, plantation rubber, sericulture, magnesium chloride, gold thread, plantation rubber, sericulture, magnesium chloride, gold thread, etc. have been fixed by the Tariff Commission at one time or etc. have been fixed by the Tariff Commission at one time or the other.the other.The Commission, in fixing the prices of these commodities The Commission, in fixing the prices of these commodities generally follow the principle of Cost-plus method of pricing. All generally follow the principle of Cost-plus method of pricing. All items of works' cost, overheads, administration and bonus to items of works' cost, overheads, administration and bonus to employees were allowed. The profit element would be fixed as employees were allowed. The profit element would be fixed as a percentage of the capital employed. This would be contrived a percentage of the capital employed. This would be contrived to cover taxation, dividends and reserves. Managing agent's to cover taxation, dividends and reserves. Managing agent's remuneration would be separately added to the profit element.remuneration would be separately added to the profit element.

The problem of selection of units for cost study by the The problem of selection of units for cost study by the Tariff Commission poses some problems. There are Tariff Commission poses some problems. There are no objective criteria in selecting the representative unit no objective criteria in selecting the representative unit for cost study. It may be the most efficient unit or for cost study. It may be the most efficient unit or marginal unit.marginal unit.

Depreciation allowance would be generally Depreciation allowance would be generally determined on the scales prescribed for income-tax determined on the scales prescribed for income-tax purpose. Depreciation would be allowed on the basis purpose. Depreciation would be allowed on the basis of historical cost and not replacement costs.of historical cost and not replacement costs.

The return allowed on capital varies from time to time The return allowed on capital varies from time to time and from industry to industry. The practice is to allow a and from industry to industry. The practice is to allow a rate of return varying from 8 to 12 percent on the rate of return varying from 8 to 12 percent on the gross block. i.e., the original value of the fixed assets.gross block. i.e., the original value of the fixed assets.

PRICING IN PUBLIC UTILITIESPRICING IN PUBLIC UTILITIES

The term Public Utilities in the economic sense refers to The term Public Utilities in the economic sense refers to services such as water-supply, gas supply, electricity, services such as water-supply, gas supply, electricity, telephone services, communication and all forms of telephone services, communication and all forms of transport. In a legal sense, public utilities refer to those transport. In a legal sense, public utilities refer to those group of industries which are run with a public interest. group of industries which are run with a public interest. The commodity or service supplied is so essential to the The commodity or service supplied is so essential to the economic life of the community that they should be economic life of the community that they should be regarded as a public necessity. T.C.Bonbright defined regarded as a public necessity. T.C.Bonbright defined public utilities (or natural monopolies) as "any enterprise public utilities (or natural monopolies) as "any enterprise subject to regulation, including price regulation, of a type subject to regulation, including price regulation, of a type designed primarily to protect consumers."designed primarily to protect consumers."

Peculiarities of Public Utilities:Peculiarities of Public Utilities:Generally, public utility services are monopolistic in character. Economies of Generally, public utility services are monopolistic in character. Economies of large scale operation would be available to public utility industries because of large scale operation would be available to public utility industries because of the mass production for the entire population. Since most of the public utility the mass production for the entire population. Since most of the public utility services and commodities are essential for the public, they have inelastic services and commodities are essential for the public, they have inelastic demand. The operation of public utility undertakings involves huge outlay and demand. The operation of public utility undertakings involves huge outlay and investment on fixed assets. The cost of construction, the maintenance cost, investment on fixed assets. The cost of construction, the maintenance cost, etc., will be very high. Further, in all public utility services, some unused plant etc., will be very high. Further, in all public utility services, some unused plant capacity will be maintained in order to meet occasional 'Peak Demand'. capacity will be maintained in order to meet occasional 'Peak Demand'. Because of the surplus capacity of the plant, the service will be operating under Because of the surplus capacity of the plant, the service will be operating under decreasing cost conditions. When the output is increased, the cost per unit will decreasing cost conditions. When the output is increased, the cost per unit will come down. Generally, in all public utility services, price discrimination will be come down. Generally, in all public utility services, price discrimination will be practised. Different charges will be levied from different types of consumers. practised. Different charges will be levied from different types of consumers. The railways will have different fares for different class of passengers. Above The railways will have different fares for different class of passengers. Above all, the basic objective of a public utility service is the welfare of the community. all, the basic objective of a public utility service is the welfare of the community. Because of these peculiarities and features, public utility services cannot be Because of these peculiarities and features, public utility services cannot be producers under competitive conditions which will be wasteful and irregular. producers under competitive conditions which will be wasteful and irregular. Utility services should be made available to the masses at a cheaper rate. In Utility services should be made available to the masses at a cheaper rate. In times of scarcity, they have to be distributed equitably and rationally. In India, times of scarcity, they have to be distributed equitably and rationally. In India, all public utility services are monopolies of either the Central Government or the all public utility services are monopolies of either the Central Government or the State Government or the Local Bodies. In foreign countries, utility services are State Government or the Local Bodies. In foreign countries, utility services are rendered by private organisations as monopolies and they are under the full rendered by private organisations as monopolies and they are under the full control of the Government.control of the Government.

Let us discuss about the pricing policy and methods in public utility services:Let us discuss about the pricing policy and methods in public utility services:

(a) Marginal Cost Pricing:(a) Marginal Cost Pricing:Hotelling, Montgomery and Lerner advocate the principle of Marginal Cost Hotelling, Montgomery and Lerner advocate the principle of Marginal Cost Pricing in determining the prices of public utility services. According to this Pricing in determining the prices of public utility services. According to this principle, the marginal cost should be equal to the price. The utility firm principle, the marginal cost should be equal to the price. The utility firm produces the maximum output when its marginal cost is equal to the price of produces the maximum output when its marginal cost is equal to the price of service. Here, the principle of equating marginal cost with marginal revenues of service. Here, the principle of equating marginal cost with marginal revenues of a monopolistic firm should not be confused. A non-utility monopolistic form a monopolistic firm should not be confused. A non-utility monopolistic form equates MR to MC and thereby it maximises its monopoly gain. But in a equates MR to MC and thereby it maximises its monopoly gain. But in a monopolistic utility undertaking, the MC is equated to the price of the service monopolistic utility undertaking, the MC is equated to the price of the service i.e., marginal cost is equated to the average revenue. In this case, the utility i.e., marginal cost is equated to the average revenue. In this case, the utility firm will be producing more making lesser profit than a monopolistic non utility firm will be producing more making lesser profit than a monopolistic non utility firm.firm.But the marginal cost principle in pricing public utilities is severely criticised. But the marginal cost principle in pricing public utilities is severely criticised. Firstly, the principle ignores the long run problem and the theory of maximum Firstly, the principle ignores the long run problem and the theory of maximum output is applicable more to the short period. Secondly, in a very big output is applicable more to the short period. Secondly, in a very big monopolistic firm, the marginal cost will be very negligible or almost nil when it monopolistic firm, the marginal cost will be very negligible or almost nil when it produces on a large scale. On this score, no public utility service can supply the produces on a large scale. On this score, no public utility service can supply the service free of cost, as the marginal cost is very low. Thirdly, it is very difficult to service free of cost, as the marginal cost is very low. Thirdly, it is very difficult to calculate the marginal cost due to the complicated factors involved in it. calculate the marginal cost due to the complicated factors involved in it. Fourthly, in marginal cost pricing principle, overhead costs or fixed costs are Fourthly, in marginal cost pricing principle, overhead costs or fixed costs are ignored. Hence, this principle will not be accepted. Finally, when the utility firm ignored. Hence, this principle will not be accepted. Finally, when the utility firm is working under deficits, the gap has to be met through taxation of the entire is working under deficits, the gap has to be met through taxation of the entire community, even though every member of the community may not necessarily community, even though every member of the community may not necessarily use the particular utility services.use the particular utility services.

(b) Average Cost Pricing:(b) Average Cost Pricing:

In this, the principle of equating average cost In this, the principle of equating average cost with price is adopted. Instead of equating the with price is adopted. Instead of equating the price with marginal cost, the principle of equating price with marginal cost, the principle of equating price and average cost is advocated. But this will price and average cost is advocated. But this will lead to some complications. When the utility firm lead to some complications. When the utility firm is working under increasing cost, the equality of is working under increasing cost, the equality of AC with price will be beneficial. When the firm is AC with price will be beneficial. When the firm is working under decreasing cost conditions, working under decreasing cost conditions, equality of AC and price will result in lesser equality of AC and price will result in lesser output. By this, the principle of maximisation of output. By this, the principle of maximisation of public welfare will be defeated. Further there will public welfare will be defeated. Further there will be arbitrariness in calculating costs.be arbitrariness in calculating costs.

(c) Fair Return Principle:(c) Fair Return Principle:

Generally, for public utility services, the maximum rates are fixed by Generally, for public utility services, the maximum rates are fixed by public regulatory commissions. It is customary to relate prices to a public regulatory commissions. It is customary to relate prices to a fair return on the firm's capital. A return of 6 to 9 percent is fair return on the firm's capital. A return of 6 to 9 percent is considered as a fair return for public utility services. The Fair Return considered as a fair return for public utility services. The Fair Return principle is adopted in order to make the utility concern cost-principle is adopted in order to make the utility concern cost-conscious and to make it work efficiently. If this principle is adopted conscious and to make it work efficiently. If this principle is adopted the problem of deciding the capital value of the utility firm arises. the problem of deciding the capital value of the utility firm arises. Then only a fair rate of return could be calculated. What is fair Then only a fair rate of return could be calculated. What is fair capital value of the firm for making decisions regarding fair capital capital value of the firm for making decisions regarding fair capital return? There are three methods: (i) Original cost less depreciation return? There are three methods: (i) Original cost less depreciation (ii) Current replacement or reproduction cost less depreciation and (ii) Current replacement or reproduction cost less depreciation and (iii) Capitalised market value of the utility firm's assets. If there is no (iii) Capitalised market value of the utility firm's assets. If there is no change in the price level, the first two methods mean the same change in the price level, the first two methods mean the same thing. If the prices go upwards, according to the second method the thing. If the prices go upwards, according to the second method the reproduction cost will be higher and the rate of fair return will be reproduction cost will be higher and the rate of fair return will be higher. The third method does not appear to be reasonable. The higher. The third method does not appear to be reasonable. The second method is considered more suitable.second method is considered more suitable.

(d) Actual Pricing:(d) Actual Pricing:““What The Traffic Can Bear.” Many practical considerations weigh heavily in What The Traffic Can Bear.” Many practical considerations weigh heavily in formulating pricing policies for public utilities. The price fixing authorities use a formulating pricing policies for public utilities. The price fixing authorities use a lot of descretion in fixing the price for the service. They also adopt lot of lot of descretion in fixing the price for the service. They also adopt lot of discrimination in fixing up the price for different categories of customers. The discrimination in fixing up the price for different categories of customers. The principle of WHAT THE TRAFFIC CAN BEAR is adopted. This principle is principle of WHAT THE TRAFFIC CAN BEAR is adopted. This principle is commonly known as Value of Service Principle. Each class of customers is commonly known as Value of Service Principle. Each class of customers is charged a price that it is able to pay according to its demand for the service. charged a price that it is able to pay according to its demand for the service. The consumers are divided on the basis of elasticity of demand and charges The consumers are divided on the basis of elasticity of demand and charges are levied on the basis of elasticity of demand. The highest price will be are levied on the basis of elasticity of demand. The highest price will be charged from the sector or the market where the demand for the service is very charged from the sector or the market where the demand for the service is very inelastic. Lowest price will be charged where the demand is highly elastic. Thus inelastic. Lowest price will be charged where the demand is highly elastic. Thus the discrimination of a true monopolitic organisaton is practised in the public the discrimination of a true monopolitic organisaton is practised in the public utility pricing.utility pricing.

The commissions and tribunals fixing the prices of utilities take into The commissions and tribunals fixing the prices of utilities take into consideration various factors like production costs, administrative expenses, consideration various factors like production costs, administrative expenses, depreciation, taxes to be paid, development expenditure, fair return on capital depreciation, taxes to be paid, development expenditure, fair return on capital etc. Further, they take into consideration the promotional aspect, the prices etc. Further, they take into consideration the promotional aspect, the prices should be kept low so as to be demanded by larger sections of the community. should be kept low so as to be demanded by larger sections of the community. (Example: Electricity for rural areas). In the social aspect, the price should be (Example: Electricity for rural areas). In the social aspect, the price should be fixed considering the essentiality of the service to weaker sections. In practice, fixed considering the essentiality of the service to weaker sections. In practice, the pricing of utility services will be not only discriminatory, but also arbitrary.the pricing of utility services will be not only discriminatory, but also arbitrary.