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How do companies set prices?

Updated Friday, 6th March 2009

Mike Lucas explores the problems for companies in maximising their profits and setting their prices

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In the current economic climate, companies must ‘optimise’ their decision-making, including pricing decisions. The economist’s prescription for profit maximisation is to set selling prices at a level which equates marginal cost and marginal revenue.

Pricing decisions should therefore be based on an analysis of incremental revenues and costs across a range of possible prices.

The evidence available, however suggests that very few companies adopt this approach, most favouring one of two ‘sub-optimal’ alternatives:

  • ‘what the market will bear’ with cost playing no role - neglecting the fact that there is seldom a single price that the ‘market will bear’ but a range of possible selling prices, each with its associated demand level.

  • ‘cost plus’ (including a normal profit mark-up) with market demand conditions playing no role. The ‘cost’ figure usually includes various overheads, allocated in an arbitrary way, and has little if any economic meaning.

Reasons given by companies for non-optimising behaviour include:

  • lack of information concerning the relationship between price and quantity demanded

  • the fact that competitors will match any price reduction and so the company is locked into its current prices regardless of how they were arrived at

  • changes in prices being costly to implement (new price lists etc.), a nuisance to sales personnel and disliked by distributors and consumers - whereas profit maximising behaviour implies prices changing whenever there is a change in demand or cost.

In addition, many companies’ cost accounting systems are geared up to providing information for external financial reporting purposes (which require that stock be valued at full production cost) and do not readily provide marginal (incremental) cost information.

Over time, pricing approaches tend to become institutionalised as ‘the way we do things around here’. So there’s a risk of insufficient questioning of current approaches. When times are good, companies can afford to sub-optimise; in the current economic climate, the status quo may not be an option!

Find out more

The Open University Business School offers a range of courses that can help you understanding pricing, including the certificate in accounting and the certificate in management.

Thinking of starting a small business? Here's some top tips for pricing.

Video: Evan Davis asks if the price of commercial property is a bellweather for the economy.

 

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