What Is a Firm and How Do Firms Set Prices - Literature review Example

WHAT IS A FIRM AND HOW DO FIRM SET PRICES College: What Is a Firm and How Do Firms Set Prices Introduction The questionof what a firm means has been a controversial issue among scholars of economics. Early scholars such as Adam Smith who saw firms as black boxes have been criticized and new definitions have emerged. However, it is clear that the definition of the firm is complex and surrounded by a wide range of factors that makes it difficult to give an accurate definition. Particularly, the way firms set prices is of particular concern to the economist as this is what determines the way the organizations operate. Price is crucial factor in the business environment and the way firm respond to market prices, maintain flexibility and readjust prices is of great significance to the organizations. Understanding prices thus is one way of understanding how firms operate and what role the management play in influencing organization performances and prices. In the contemporary business environment where price determines the marketability of a company, it crucial to comprehend the way pricing strategies can be modelled to suit the demands of the modern market conditions. This paper will define the meaning of a firm, and provide a close analysis of economic theories that define a firm and evaluate how firms set their prices. Economic Theories In the history of economic, a wide range of theories of the firm have been developed in an effort to clarify the concept of the firm and to provide the answer why firms exist. Early scholars such as Adam Smith developed the idea of the firm as a “black box” and associated it with the concept of profit maximization (Penrose, 1995: Dietrich, 2012: Fabiani, 2007). . Adam Smith had a monopolistic perception of the firm as units that aim at maximizing profit by taking advantage of the consumer behaviour. In the evolution of the market structure and the criticism of the monopolistic structures, modern scholars have come up with new ideas concerning the firm. Braendle (n.d.) is one of the scholars that have evaluated the theories of the firm as one way of deducing sense out of them. The theories of firm have studied the supply of goods by profit maximising agents, and the role of the firm in the free market. Braendle particularly pays attention to the theory developed by Coase and later developed by Williamson. Collectively, the two scholars visualize the firm as avenues of economic exchange that are subject to transactional costs. Unlike previous theories that only considered the production costs, it is widely appreciated that transactional costs play a great role in the firm. This idea has revolutionized the concept of firms as profit maximising entities. Powell (1990) refers to the concept of the firms as governance structures that are meant to change from time to time. He visualized firms as networks that are dependent on formal relationships, mutual interests and structure of authority. The author seems to define the business as an entity that is dependent of human organization in a hierarchical order. The idea of this scholar can be seen to refer to the hierarchical nature of the organizational structures that is dependent on the power levels and responsibilities within an organization. Powell (1990) was particularly concerned on the difference between the nature of market and the firm, and states that the difference is that in a firm exists within inside boundaries where competition is non-existent but managers have to exercise authority and curb opportunistic behaviour. In the market, each firm is opportunistic and this breeds the force of competition within the market. On this ground, Powell (1990) feels that the firm is a network that is surrounded by complex organizational factors that cannot be accurately figured out. This notion of the market as a governance structure seems to be concerned with the role of the human resource that plays a key input role in business. Mcteer (n.d) is among the scholars who discussed the idea of Coase on why firms exist and the factors that determine the size of the firm. Coase strived to provide a reason why firms exist and argued that the main reason why firms exist is because there is a price for cost of using the price mechanism, as a coordinating instrument. By price mechanism, this scholar refers to the control of prices with an organization that is the basic role of an entrepreneur. On this ground, Coase introduces the role of the entrepreneur as the person who is solely responsible for creating business contracts and controlling the factors that surround them. To Coase, therefore, the reason why firms exist is because the entrepreneur intends to garner profits by taking advantage of the price mechanisms. On the size of the firm, the scholar points out that the size of the firm is larger if the entrepreneur minimizes the cost of organizing, mistakes and the supply prices are relatively high. The role of business mistakes in the firm is particularly important in the concept of the firm (Kaplan et al, 2005). Mistakes may refer to wrong management decisions or even possible market failures within an organization. These new factors of the firm, as Coase sees, influence the aim of starting a firm. How Firms Set Prices The fact that theories of a firm point to price as one crucial aspect of business, it is crucial to examine how firms set up their prices. In the recent past, a wide range of research has been conducted to identify the factors that underpin the variation of prices in the business environment. As Greenslade and Parker (2008) point out, business managers review their product prices from time to time to keep up with market trends and optimize their sales. Importantly, it is crucial to consider the factors that organizations consider while they adjust their product prices within a particular market. A close analysis of the various factors that influence pricing strategies shows that organization depend on both internal and external business factors to set up their prices. Internal business factors refer to a wide range of factors that emanate from the operations of the organization that impact on the product prices. On the other hand, external factors refer to business factors that exist within the immediate business market that contribute to variation of product prices. Internal Business Factors A wide range of internal business factors influence the way firms set up their prices in the market. Keeney et al (2010) point out that organization set their production prices by measuring their production cost. The production cost involves the cost of raw materials, labour, transaction and other cost overheads that are incurred in getting the products to the selling point. The higher the production cost, the higher will be the prices of products. Another factor that influences the price of firm products is the self-determined profit margins. Every organization aims at optimizing its profits and hence has a limit for the minimum prices. To accomplish this objective, organization set up predetermined profit margins that are added to the total cost of production to determine the cost of products (Hall et al, 1996). The setting up of profit margins is a subjective aspect of the business and varies from one organization to the next as managers are responsible for this decision. On the other hand, the price of production is fixed and is major determiner of the prices of products in the market. In a nutshell, the price of products depends on the cost of production and the self-determined profit margins that organization set up. External Business Factors On the other hand, external business environment factors impact on the product prices in the market. The aim of a firm to maximize their business profits by optimizing sales units in the market. A research by Park et al (2010) reveals that market demand is one the most important factors that determine the way firms set their prices. Market demand is a parameter that is dependent on the consumer behaviour, nature of competition and the bargaining power of the consumers as well as the firm. If the consumers demand a product in large quantities, then high prices would not deter them from purchasing it as this product has a great value on their life. In the event that similar products are available in the market, the forces of competition set in changing the stakeholders bargaining power. As competition sets in, the consumer bargaining power increases and the firm bargaining power decreases. As such, organizations are forced to reduce their prices as demands declines to ensure that they survive in the market. In the recent past, product pricing strategies have emerged due to the increase in competition within the business environment, forcing organization to reduce the prices of their products. In brief, the firm prices of their products depending on the market forces that influence the demand of their products. Stick Prices However, the concept of “sticky prices” points out there is incidence when firm prices remain constant no matter the changes in the external environment. Small and Yates (n.d.) points define stickiness as the tendency of prices to remain constant despite the varying market factors. One instance when prices remain stick is when the customer demand is growing at an equal rate as the rate of force of competition. As competitors enter in the market, the demand for products is expected to go down as the consumers have a wide variety of products to choose from. However, in certain occasions, the market demand for certain products continues to grow (Armstrong and Huck, 2010). This may be as a result of the increase in consumer buying power or the growth in population in the country. This customer behaviour trends keeps the demand constant, allowing the firms to fix their prices to suit the demand. In that case, market prices remain arbitrary constant or vary at a relatively fixed point. Another reason why prices may remain sticky is due to the existence of government policies. In any given country, the government has a role in regulating the prices of products in their strategy to protect the consumer rights. In this case, the government sets the maximum and minimum prices of products and prevent organization from going beyond these points. In the UK, this is common for basic consumer products such as food products. In this situation, the organizations are limited from increasing their prices beyond the maximum or decreasing them below the minimum (Namakura and Steinsson, 2008). As such, the prices of product in subject of such pricing law oscillate within a certain maximum or minimum, preventing dramatic variations. In certain market competitions, organizations fix their prices due to the fact decreasing their prices does not increase their competitiveness in the market (Vermeluen, 2007). For instance, when one organization reduces its prices, the other makes the same reduction and hence this competition strategy does not yield profits for either organization. In monopolistic competitions, the dominant organization sets the prices and has the liberty to fix prices at the optimal profit levels. From this point of view, firms may be force to fix their product prices in view of the market forces. Conclusion In conclusion, the concept of a firm is a complex matter that has challenged the mind of many scholars. Many scholars feel that the reason why forms exist is because they earn profit by manipulate price mechanism in the market. Organizations are hierarchical networks in which entrepreneur establish complex contracts with their employees and customers for the benefit of both. The price of products in the organization determines the profitability of a firm and guarantees the survival of firms within the market. Firms consider both external and internal environment factors while setting up prices for their products. In the internal environment, the cost of production and the predetermined profit margins determine the prices of products. On the other hand, the external environment is a source of pressure that forces the organization to fix their prices at certain level. The demand, consumer and firm bargaining power determine the prices of products in the market environment. Market competition particularly determines the pricing of products it dictates the organisation competitiveness in the market. However, at times, the prices may be stick owing to constant demand, government laws and nature of market competition. In this light, the firms have to observe many factors that influence the prices of their products in the market before setting up prices. Bibliography Armstrong, M., and Huck, S., 2010, Behavioral Economics as Applied Forms: A Primer. Office of Trading. Braendle, U., n.d., Theories of the Firm. Strategy, Economic Policy and Legal Affairs. Dietrich, M. (2012). Handbook on the economics and theory of the firm. Cheltenham: Edward Elgar. Fabiani, S. (2007). Pricing decisions in the euro area: How firms set prices and why. Oxford: Oxford University Press. Greenslade, J., and Parker, M., 2008, Price Setting Behaviour in the United Kingdom. Quartetly Bulletin. Hall, S,Walsh, M and Yates, A (1996), ‘How do UK companies set prices?’, Bank of England Quarterly Bulletin, Vol 36(2), pages 180–92. Kaplan, S., Sensoy, B., and Stromberg, P., 2005, What Are the Firms? Evolution from Bright To Public companies. National Bureau of Economic Research. Massachusetts; Cambridge. Keeney, M., Lawless, M., and Murphy, A., 2010, How Do Firms Set Prices? Survey Evidence from Ireland. Economic Analysis and Research Department. McTeer, B., n.d., Ronald Coase: The Nature of Firms and Their Costs. Federal Reserve Bank of Dallas, 8(3). Namakura, E., abd Steinsson, J., 2008, Five Facts About Prices: A Re-evaluation of Menu Cost Models. Quarterly Journal of Economics. Park, A., Rayner, V., and D’Arcy, P., 2010, Price Setting Behaviour; Insight from Australian Firms, Bulletin Quarterly. Penrose, E. T. (1995). The theory of the growth of the firm. Oxford [u.a.: Oxford Univ. Press. Powell, W., 1990, Neither Market nor Hierarchy: Network Forms of Organizations. Research in the Organizational Behaviour, 12, Pp. 295-336. Small, I., and Yates, T., n.d., What Makes Prices Sticky? Some Survey Evidence for the United Kingdom. Vermeluen, P., 2007, The Euro-system Inflation Persistence Network. Eurosystem Central bank. Read More