Firms and Firm Price Setting - Essay Example

What is a Firm and how do Firms Set Prices? By Firms Firms play a central role in the growth and prosperity of the economy of countries, thus it is important to study them. Over the years, the firm has been poorly understood, including its behaviour and organization. Kantarelis (2000) considers a firm to be a need-satisfying machine, as it serves the purpose of satisfying the interests of people in the society. Since Adam Smith’s “An Inquiry Into the Nature and Causes of the Wealth of Nations”, different theories about the firm have been developed, including the Neoclassical Theory, The Transactions Cost Theory, The principal-Agent Theory and the Evolutionary Theory. Coase in his work, “The Nature of the Firm” examined the reasons why firms exist and the determinants of the scale and scope of firms basing on The Transactions Cost Theory (Kay 2005). In economics, it is generally assumed that firms exist and are characterised by production functions, demand curves and cost curves among others, and it is observed that firms are capable of transforming inputs into outputs, have employees and employers and are legal entities. However, some these characteristics are shared by individuals as well as market transactions. It is possible to imagine of production without firms, whereby individual traders exchange capital and labour for payment. Firms are generally understood to embody some sort of institutional structure and coordinate economic activity. Coase observed that there are costs, mainly transaction and marketing costs, to using the price mechanism for coordinating economic activity. However, it is less costly for an institutional arrangement to coordinate economic activity. Therefore, firms exist to serve the purpose of economizing the cost involved in the process of coordinating activities that are economic in nature. Additionally, a lack of price mechanism is an important characteristic of firm, according to Coase (Kay 2005). This is therefore, a transaction-based theory ; since it is less costly to transact under alternative institutions, price mechanism will not be utilised. Increasing the marginal costs of doing additional business within the organization and decreasing returns of management capacity are considered to limit the scope of the firm. This therefore, implies that the margin of the firm determines its scope. Coase perceived the firm as a form of governance structure and argued that markets and firms are alternative means for organizing similar kinds of transaction (Kay 2005). Williamson expanded on Coase’s work and argued that organized firms are more likely to be characterized by operations marked with uncertainty about their outcome, that recur frequently and require substantial transactional-specific investments such as money, time or energy. In addition, such transactions are not easily transferrable while the market interface is more likely to experience exchanges that are more straightforward, non-repetitive and which do not require transaction-specific investment. Additionally, transactions from markets move into hierarchies when knowledge specific to the transaction builds up and this is attributed to the aspects of bounded rationality and opportunism (Holnstrom & Tirole 1987). Opportunism here means the rational pursuit by economic actors of their own advantage with various means at their disposal, including guile and deceit, and which is mitigated by authority relations (Powell 1990). In this regard therefore, firms are perceived as distinct from markets and the larger social context. Outside the firms are competitors and inside them are authoritative mangers that ensure to curb opportunism. Today however, firms are undergoing different dynamics and have been forced to blur their boundaries and engaging in new collaborations that may not resemble market contracts (Powell 1990). The firm is seen as a contract between a multitude of parties, and in this case, implicit and explicit contracts are designed to minimise transaction costs. Williamson argued that problems arising from incomplete contracting are where involved parties engage in irreversible investments. However, transacting in firms helps to protect against opportunism. In a firm, transactions are controlled by the involved authorities if they are incomplete whereas in the market transactions in the case of incomplete contracts, resolution is through negotiations by asset owners (Holnstrom & Tirole 1987). According to Powell (1990), “organization or hierarchy arises when the boundaries of a firm expand to internalize transactions and resource flows that were previously conducted in the market place” and this is characterised by employees that are execute their tasks under heavy administrative and supervisory procedures and generally the system of order becomes highly authoritative. Price Setting The economic environment that companies operate in today has necessitated the optimization of companies’ decision making, including their price setting decisions. The ways firms set their prices is of high significance including in the design and implementation of monetary policy thus an imperative area of focus in any country (Nakamura & Steinsson n.d). Prices can be sticky, meaning that their response to changes in the economic environment is slow; the response of prices to excess demand and supply in the economic environment can be asymmetrical and these are important questions that can tell more about price setting in firms. This is important as it contributes vital knowledge that can inform monetary policy in a country (Amirault, Kwan & Wilkinson 2006). Price setting of firms can be explained using the classical Structure-Conduct-Performance paradigm. Structure has to do with the nature and level of interaction between sellers, buyers and new entrants, and it is a function of products, number of firms and technology while conduct involves the behaviour of firms in a specific market structure and encompasses advertising, competition and price setting whereas performance entails technological, social and dynamic efficiency and encompasses profits, surplus and optimal variety. The characteristics of the structure of the industry in which a firm operates determines the opportunities and challenges a firm will face. Some industries are challenging and highly competitive thus make the firms therein to experience more constraints and fewer opportunities. In such industries, the firms will generate profits that cover only their costs, and in this regard generally, the industry structure influences the conduct and performance of a firm. In the less competitive industries, firms are exposed to fewer constraints and more opportunities thus allowing for competitive advantage. The highly competitive industries are characterised by large numbers of competing firms, homogenous products and cost, and easy entry into and exit out of the industry. An example of this is the crude oil industry. The firms operating in this industry act as price takers in that they respond to changes in demand and supply by adjusting their prices instead of influencing demand and supply (Bridoux n.d). Many countries have adopted the survey approach in studying price setting, and this is important in order to establish the role of price stickiness in effecting changes in monetary policy and other economic variables such as employment. The Bank of England in the year 1995 conducted a survey on price setting by companies in the UK, and this included 1100 companies in the UK (Hall, Walsh & Yates 1997). Results showed that for most UK companies, the prices were set at the highest level the market could sustain while 25 percent of companies set their prices based on the prices of their closest competitors. Retailing and manufacturing companies exhibited a higher level of price rigidity while the construction companies considered market level as the most important determinant of their price setting, and these did not rely on their competitors’ prices. Company specific conditions also played a major role in price setting of UK companies. 20 percent of the companies reported that the price was made up of a direct cost per unit plus a variable percentage mark-up, while a 17 percent based their pricing on costs plus a fixed percentage mark-up. Cost mark-up was more suitable for smaller companies. A larger number of UK companies reviewed their prices annually and time-dependent pricing was more common. More than half of the UK companies reviewed their prices at a specific frequency while 11 percent reviewed their prices after a major event and 10 percent embraced both time and state-dependent mechanisms. Larger companies and those that operated in highly competitive markets were found to review their prices more frequently compared to the smaller companies and those with a greater proportion of long-term customer relationships. In Ireland, Keeney, Lawless & Murphy (2010) found that a greater percentage of the firms interviewed set prices based on costs and self-determined profit margin while the rest based on the prices of their closest competitors. Competition was a significant determinant of prices among Irish firms. Some firms, approximately 11 per cent lacked an autonomous policy for setting their prices, while 5 percent had their main customers set prices. It was noted that the largest firms (with more than 250 employees) did not possess an independent price setting mechanism because these were subsidiaries of international/multinational groups for which the head office made decisions about pricing. The survey found that manufacturing and construction firms were most likely to report that their price setting procedures depended on their costs and profit margin. High or severe competition in the market was reported to result in firms setting their prices based on the prices of their competitors. The firms in Ireland only adopt autonomous price setting in cases where there is no competition in the market. The survey found that only the smaller firms (with less than 50 employees) were most likely to set their own prices not basing on market competition. Most firms (38 percent) reported to changing their prices after every six months. On average, Irish firms were found to change their prices after every 8.5 months. The price flexible firms were found to experience stronger competition as well as greater elasticity of demand as a large proportion of these firms base on their competitors to determine their price. In Australia, the results of RBA survey showed that more than half of the firms surveyed set their prices basing mostly on internal considerations mostly the demand factors. The firms that set their prices based on cost factors reported to set the prices as a fixed mark-up over cost while the others had their price setting determined by cost and margin. Many firms adopted the time-dependent strategy in their price review and most reviewed their prices annually. For most firms in the business service and construction industries, price review was for each transaction and was influenced by a change in costs, thus the cost-focused pricing models in these two industries (Park, Rayner & D’Arcy 2010). Price setting in Australian firms was also found to be influenced by economic conditions. With inflation, more firms raised their prices, but started to lower the prices when there was a decline in inflation. Cost changes were also found to be a major significant of firms raising prices. On the other hand, competitors’ pricing strategies and exchange rate movements significantly influenced Australian firms lowering their prices. Demand conditions were a determinant of both price increases and decreases by Australian firms. The surveys in the Euro area provide important information on different aspects of price setting, including determinants of prices, factors that lead the stickiness of nominal prices, distinctions between price reviews and price changes and whether price treat price increases and decreases symmetrically. Different factors lead to price stickiness in the Euro area, and these include fixed costs of price adjustment, costly information, implicit and explicit contracts, sticky marginal cost, attractive price thresholds, cost-based pricing, and possibility of shocks being temporal among other non-price related factors including judging quality by price, coordination failure and the possibility of changing non-price factors (Fabiani et al 2006). Fabiani et al (2006) in their survey including 11000 firms in the euro area found that most firms in the euro area followed the time-dependent rules in their price reviews. Additionally, most firms in the euro area evaluate their prices based on information sets that include future economic conditions. Firms that experience a high level of competition also were found to review their prices more frequently. Druant et al (2005) found that the dominant price setting strategy among firms in the euro area was the mark-up pricing. However, smaller firms used this strategy as opposed to the larger firms that based on competition in the market. In conclusion, the research on firms is imperative as firms play a major role in the economy of a country. There are different theories of the firm that have been used in the past to explain firms. Coase based his perspective of the nature of the firm on the Transaction Cost Theory. This paper has also focused on the perspective of Williamson, who expounded on the earlier work of Coase on the firm. Overall, there is a distinction between firm, market and organization, and Williamson considered a firm to turn into an organization if it goes beyond the set boundaries of a firm. With regard to price setting, light has been shed on the S-C-P model and how this applies to price setting of a firm. The different surveys in various regions have revealed how firms in the regions set their prices. As in the S-C-P model, the structure of the industry influences the conduct and performance of a firm therein and in return influences the firm’s price setting. Works Cited Amirault, D., Kwan, C. & Wilkinson, G 2006, Survey of Price-Setting Behaviour of Canadian Companies,” Working Paper 2006-35 / Document de travail 2006-35 Bridoux, F n.d, “A Resource-Based Approach to Performance and Competition,” Accessed from https://www.uclouvain.be/cps/ucl/doc/iag/documents/WP_110_Bridoux.pdf, 20 June 2015. Druant, M et al 2005, “The pricing behaviour of firms in the euro area: new survey evidence,” NBB WORKING PAPER No. 76. Fabiani, S et al 2006, “What Firms’ Surveys Tell Us about Price-Setting Behaviour in the Euro Area,” International Journal of Central Banking, 2(3): 1-45. Hall, S., Walsh, M. & Yates, A 1997, “How do UK companies set prices?” Accessed from http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.196.3014&rep=rep1&type=pdf, 20 June 2015. Holnstrom, B. & Tirole, J 1987, “The Theory of the Firm,” Working Paper No. 456, Department of Economics. Kantarelis, D 2000, “Theories of the Firm,” New York, Inderscience Publishers. 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