Author: Geoff Riley Last updated: Sunday 23 September, 2012
The factors that determine the variety of pricing decisions open to a business nearly always come back to two main driving forces
The market structure in which a business operates.
The objectives that a business may be pursuing at a given time.
“Fixing the price” does not necessarily imply some anti-competitive type of behaviour! It refers to the power that a firm has to use some discretion in the prices it charges to groups of consumers for one or more products.
Most businesses are multi-product firms servicing a variety of different markets. Indeed markets can become highly segmented – each with their own characteristics – so the factors will vary from industry to industry.
Key factors affecting the pricing power of a business
(1) Market Structure
Price–taking firms have no influence over the ruling market price.
Free entry and exist of businesses in the long run – drives down profits towards normal.
Each supplier produces homogeneous products hence the perfectly elastic demand curve.
Contestable markets are markets where the entry and exit costs are low.
Potential for hit and run entry to cream off profits if incumbent firms are being inefficient.
The threat of new entry from new suppliers or new products affects the current behaviour of existing firms (may force them to price more competitively – less scope for monopoly pricing).
There are barriers to contestability– the higher the barriers, the greater the pricing power in the hands of the incumbent firms because the risk of “hit and run entry” is lower.
(2) Price and Cross-price Elasticity of Demand
Elasticity of demand remains a fundamental factor affecting a firm’s pricing power:
When demand is inelastic, a business can raise price without losing a disproportionate level of sales.
When demand is price elastic, the potential to raise price and extract consumer surplus, turning it into higher producer surplus / profit is reduced.
Cross price elasticity of demand is linked to this – i.e. the percentage change in demand for good X resulting from a given percentage change in the price of a related product (in particular the relative price of a substitute)
When the cross-elasticity of demand is low, the “substitution-effect” from changes in relative prices is weak consumers are less likely to switch their demand, giving the firm greater price power.
(3) Product differentiation – moving away from homogeneous products
Some consumers willing to pay premium prices for new products (known as “early-adopters”).
Products towards the end of their life-cycle – more elastic demand, lower prices.
Impact of marketing and advertising on consumer loyalty / brand loyalty.
(4) The Regulatory System
Government appointed regulatory agencies may intervene directly or indirectly in the price-setting process. The regulatory agencies cover privatised utilities such as gas, electricity, telecommunications, the airports and the rail industry – most of these regulators have at times enforced ‘price-capping formulae’ limiting the extent to which the utilities can increase prices year on year. Some of the regulators have now lifted price controls because they believe that there is now sufficient competition in the market (a good example is the gas industry.)
(5) The International Environment
Most businesses face competition either from domestic rivals or from international competitors. Increasingly the pricing decisions of one business are influenced by the strength of competition from overseas suppliers. Globalisation has made this a key factor in many industries
(6) The Economic Cycle
The pricing power of a business (or a group of firms within a market) is also affected by macroeconomic variables including the strength of domestic and global demand at different stages of the economic cycle. When demand is strong and rising (e.g. during the upturn phase of the economic cycle), a business will have more “pricing power” than when demand is much weaker and falling (e.g. during a recession). Often a market may be affected by a demand-side “shock” which takes away the pricing power of suppliers. The airline industry in the wake of the terrorist attacks in 2001 could be considered as an example of this.
Summary of the main factors affecting a firm’s pricing power
Influence on Pricing Policy
In order to make a profit, a business should ensure that its products are priced above their average cost. In the short-term, it may be acceptable to price below AC if this price exceeds marginal cost – so that the sale still produces a positive contribution to fixed costs.
If the business is a monopolist, then it has price-setting power. At the other extreme, if a firm operates under conditions of perfect competition, it has no choice and must accept the market price.
The reality is usually somewhere in between. In such cases the chosen price needs to be considered relative to those of close competitors and with one eye to the likely reaction of rival firms when a business changes its pricing strategy.
Consideration of customer expectations about price must be addressed. Ideally, a business should attempt to quantify its demand curve to estimate what volume of sales will be achieved at given prices and also the price elasticity of demand when prices change
Possible pricing objectives include:
To maximise profits or to achieve a target return on a capital investment project
To achieve a target sales figure in a given time period
To achieve a target market share
To match the competition, rather than lead the market