Pricing Policy in British Industry - Literature review Example

Pricing Policy in British Industry With the British Industry officially entering a recession in 2008, it has become evident to economists that the nation is far from the rhetoric of the 1980s proclaiming a supply-side miracle and a return to the global prowess of an earlier period of time. Price levels under an oligopoly market are implicit in the discussion of profitability. Within short-run profit maximization, the price is understood to be a mark-up over marginal cost. This mark-up is predicated upon the elasticity of demand, the level of concentration, and the level of interdependence between businesses (Sawyer 2005, pg 99). Under limit pricing, the mark-up of price of average cost is decided by the height of barriers to entry in a market (Sawyer 2005, pg 99). In both cases, companies do not achieve prices that are predicted by pricing theories due to a lack of information. Instead, predicted prices may be viewed as the desired state that businesses seek to attain due to the fact that such prices would further their objectives for profit maximization. It follows then that actual prices are occasionally above and below the corresponding predicted prices (Sawyer 2005, pg 99). In his study, Skinner (1970) posited that it was clear that cost-plus pricing is fairly widely used in the British industry. Though the question remains regarding whether the mark-up is modified for changes in demand and in the actions of competitors (Skinner 1970). He argued that although 70 percent of companies claimed to use cost-plus pricing, there was significant emphasis on fixing prices to competition and demand (Skinner 1970). In their study, Coutts, Godley and Nordhaus (1978) studied six two-digit level manufacturing industries in Britain and found that a predicted price predicated upon a constant mark-up over normalised costs was highly correlated with actual prices. Though they found that demand factors did not have a significant impact on prices, there was strong evidence that the profit margin declined during the time of the study (Coutts, Godley and Nordhaus 1978). In a later study, Sawyer (1983) associated changes in price to cost changes of material inputs and of labour and toward demand factors for 40 three-digit industries in the UK. His results suggested that price changes that are relative to cost changes are not significantly influenced by short-run fluctuations in demand (Sawyer 1983). These studies suggest that output price changes are strongly correlated with changes in input price (Sawyer 2005, pg 101). Within the British industry, the controversy has principally encompassed the level to which the mark-up associated to average costs is shaped by demand factors and by the degree of competition (Sawyer 2005, pg 101). Though case studies of the British industry do not show influences of demand and competition, studies at the company level do suggest demand influences (Sawyer 2005, pg 101). An airline company that sought profit maximization, with a given schedule and fleet would likely maximize its revenue via its route network (Johnson 1988, pg. 295). The company would occasionally carry passengers whose fares only cover marginal network traffic costs. In order to maximize revenue, companies will utilize price discrimination between groups of passengers with various elasticity of price (Johnson 1988, pg. 295). Companies normally attain such discrimination by attaching different restrictions to tickets. An example of this occurs when BMA offers key and standby fares aside from the typical economy fare on its domestic services. The former fare is available on specific routes and the customer is obliged to pay the full cost at the time of booking (Johnson 1988, pg. 295). In addition to this, there are significant cancellation charges and the standby fare can only be used if there is extra capacity on a flight (Johnson 1988, pg. 295). If a customer is willing to accept more restrictions, they have higher price elasticity. There are two principal restrictions on price discrimination. First, if an airline company formulates a price structure that is too involved, the result may be that potential customers become disaffected (Johnson 1988, pg. 295). Second, a company may not be able to discriminate between customers without sustaining a degree of revenue dilution (Johnson 1988, pg. 295). The freedom of the airline company may be limited by the presence of a competing enterprise. In the British airline industry, head-to-head competition typically creates a similar range of fare prices (Johnson 1988, pg. 295). These companies have attempted to avoid price wars for two reasons. First, such wars may attract regulatory intervention and prohibition and second, in markets that have low price elasticity, a price war would be self-defeating (Johnson 1988, pg. 295). An example of this occurred in 1982 when BMA came onto the Heathrow-Glasgow route. British Airways was clear that it intended to avoid a price war with BMA (Johnson 1988, pg. 295). It is possible that an airline may utilize its aircraft for other purposes when not operated for scheduled passenger services. An example of this occurred when Loganair was contracted to supply night mail services in Scotland (Johnson 1988, pg. 296). From the perspective of the airline company, any price above marginal cost for such endeavours would be beneficial (Johnson 1988, pg. 296). The National Health System of Britain upholds its monopoly position due to the benefit it has that results from its method of finance (Johnson 1988, pg 340). A patient is obliged to use this service and there is no way by which they may opt out of such health care (Johnson 1988, pg 340). Therefore the individual pays the cost for private medical care in addition to the sum that they have paid the National Health System. This contrasts the cases in most other industries in which the individual would pay only the former cost (Johnson 1988, pg 340). The advantages held by the National Health System have been strengthened by an increase in their standards of services. An example of this would be the shift toward smaller wards that has resulted in an increase of patients’ privacy (Johnson 1988, pg 340). In this manner, the operations that the National Health Service conducts, in addition to those of the private sector, have been more homogenous and the incentive to go into the private sector has been diminished (Johnson 1988, pg 340). Almost no queues exist in the private sector and it may take up to two years for a patient to attain a minor operation in the National Health Service. Due to this fact, patients are willing to pay in order to obtain secure treatment during more convenient times for them (Johnson 1988, pg 340). This ‘queue jumping’ by patients has caused a significant political dilemma and has resulted in moves to remove private accommodations from National Health Service hospitals (Johnson 1988, pg 340). The point of contention in such political arguments has centred on the fact that the abolition of private accommodations would drastically reduce waiting lists for patients. In their study, Culyer and Cullis (1974) posited that, centred upon average cost pricing, private patients do not pay the full capital costs of their accommodations in National Health Service hospitals. It follows then that the elimination of private accommodations from National Health Service hospitals would increase the cost for private patients who would consequently have to be treated in private institutions (Culyer and Cullis 1974). Increased costs in this case would result in a decrease of private practice (Culyer and Cullis 1974). In his study, Beresford (1972) used data from the British industry and analysed the behaviour of costs per patient-week and costs per case as a function of the number of cases per occupied bed per week. He defined this function as throughput and calculated the value by multiplying the reciprocal of throughput by seven in order to calculate the average length of stay per day (Beresford 1972). The results from the study showed that costs per patient-week rise with throughput (Beresford 1972). He found that the outset of treatment of patients is usually costly and due to the fact that rising throughput increases the number of early days, this relationship is to be expected (Beresford 1972). He found that costs per case initially decrease sharply with rises in throughput and subsequently reach a plateau at a value of approximately 0.7 (Beresford 1972). Hospitals can reduce costs per case by increasing the rate of throughput in order that the average length of a patient’s stay is less than 10 days (Beresford 1972). In a later study, Steele and Gray (1982) analyzed data from maternity hospitals in the UK. They found that the marginal costs of specialist maternity wars were constant whether output was measured in terms of deliveries or bed-days (Steele and Gray 1982). They also found evidence that GP units were ambiguous (Steele and Gray 1982). In his study, Feldstein (1967) found that the optimal size of hospital was valued at either 310 or 900 beds. The discrepancy in sizes lied in the fact that the latter figure was relevant if the larger hospitals could achieve a similar level of throughput as smaller institutions (Feldstein, 1967). There are three distinct approaches that economists utilize when analyzing the determination of prices. The first principle states that companies in pursuit of profit maximization decide prices relative to costs. In this case, companies are price-makers and establish prices at levels that will achieve their goals. This approach is subject to restrictions that arise from conditions of demand and cost (Sawyer 2005, pg 99). The second principle states that companies are in fact price-takers and the relationship between demand and supply in the market effectively sets prices (Sawyer 2005, pg 99). In a study, Arrow (1959) argued that the problem with this method is that the process of price-determination is not discussed. Under the theory of perfect competition, companies are regarded as price-takers, and therefore are not in a position to set prices (Arrow 1959). The third principle is predicated upon the idea of observing the process of price decision-making and attempting to deduce from such analysis inferences on the process of price determination (Sawyer 2005, pg 99). In a study, Hall and Hitch (1939) posited that price is predicated upon full average cost that includes a conventional allowance for profit. In addition to this, full average cost is equated as direct cost per unit and is taken as the base and a percentage addition is calculated in order to cover overhead cost (Hall and Hitch 1939). Usually, an additional 10 percent is made for profit with selling costs common and interest on capital rare when included in overheads (Hall and Hitch 1939). To compare the first and third principles, the researcher will utilize a profit-maximising monopolist in order to exemplify the first approach and a full-cost pricing in order to exemplify the third approach (Sawyer 2005, pg 100). The profit-maximising monopolist would charge a price calculated by the following equation in which e is the elasticity of demand and mc is marginal cost: p= (e/(e- 1)) * mc= (1+ 1/(e- 1)) * mc Figure 1: (Sawyer 2005, pg 100) The full-cost pricing firm would calculate the price with the following equation with m as the mark-up set and adc as average direct cost: p= (1+m) * adc Figure 2: (Sawyer 2005, pg 100) The primary contrast between the two approaches occurs from the determination of the mark-up. The profit-maximising approach is equated from 1/(e- 1) (Sawyer 2005, pg 100). Regarding the full-cost pricing method, the mark-up is illustrated though the forces that decide that mark-up are not stated (Sawyer 2005, pg 100). This approach is set by convention and yields consistent prices. Under the profit-maximising approach, the mark-up would continue to be consistent as long as the firm’s perceptions of elasticises of demand remain unaltered (Sawyer 2005, pg 100). If a company determines a mark-up of price over marginal costs, it is to be expected that it will maintain that mark-up (Sawyer 2005, pg 100). Another difference between the aforementioned approaches is that marginal costs appear in the first equation and average direct costs appear in the second equation. It is argued that average direct costs are approximately constant regarding output and it follows then that marginal direct costs are also constant and equivalent to average direct costs (Sawyer 2005, pg 100). The full cost pricing approach suggests that prices have minimal fluctuation with changes in output due to the fact that mark-up and average direct costs are taken as constant (Sawyer 2005, pg 100). The third distinction between the two approaches is that the first provides a theory of the determination of prices relative to costs based on the hypothesized objectives of companies while the second approach supplies a generalised account regarding the process of price decision-making (Sawyer 2005, pg 100). There are two primary reasons that are put forward to explain the infrequent price changes under conditions in an oligopoly. The first explanation states that when prices are established, there are costs of changing price (Sawyer 2005, pg 102). The second explanation was developed by Sweezy (1939) and relies on the kinked demand curve theory. He argued that gains from a price change of a company are predicated upon whether or not the other companies make similar price changes. He argued that companies believe that their competitors will not follow a price increase but would match a price increase (Sweezy 1939). This results in a kinked demand curve with a corresponding gap in the marginal revenue curve. Each company faces a demand curve that is more elastic above a price p*, compared to when it is below that price as illustrated in the following kinked demand curve: Figure 3: (Sweezy 1939) Within conditions of general inflation, as input costs rise, the marginal cost curve tends to shift upwards (Sweezy 1939). If other companies are believed to raise prices by removing the kink in the demand curve, the gap in the marginal revenue curve is removed and this arranges the means for a price increase. The kinked demand curve indicates the relatively intermittent price changes (Sweezy 1939). In their study, Stigler and Kindahl (1970) analysed the behaviour of prices during times of contraction and expansion. They argued that their results supported the conventional perspective that prices fall in periods of falling demand and rise in periods of rising demand. Their results indicating price reductions by administered price industries during recoveries do not support the administered price thesis (Stigler and Kindahl 1970). In a later study, Shipley (2006) analyzed pricing flexibility among a sample of 728 companies in the British industry during a time of severe business adversity. He formulated three main conclusions from his study. First, pricing flexibility is extensive and is likely more so than in the past (Shipley 2006). Second, the extent of flexibility is not influenced significantly by the degree of commitment to cost-plus pricing techniques (Shipley 2006). Finally, pricing flexibility differs widely and systematically with firm size but not with numbers of serious competitors (Shipley 2006). References Arrow, KJ 1959, ‘On the stability of the competitive equilibrium, II’, Econometrica, retrieved on February 15, 2009 from Beresford, MW 1972, ‘Use of hospital costs in planning’, The Economics of Medical Care. Coutts, K, Godley, W & Nordhaus, W 1978, ‘Industrial pricing in the UK’, Cambridge University Press. Culyer, AJ & Cullis, JG 1974, ‘A review of polices and problems in the last year’, Poverty Report 1974. Feldstein, MS 1967, ‘Conomic analysis for health service efficiency’, North-Holland Amersterdam. Hall, RL & Hitch, CJ 1939, ‘Price theory and business behaviour’, Oxford Economic Papers. Johnson, PS 1988, The structure of British industry, Routledge, London. Sawyer, A 1983, ‘The significance of statistical significance tests in marketing research’, Journal of Marketing Research, retrieved on February 15, 2009 from JSTOR database. Sawyer, MC 2005, The economics of industries and firms: theories, evidence and policy, Taylor and Francis, New York. Shipley, DD 2006, ‘Pricing flexibility in British manufacturing industry’, Managerial and Decision Economics, vol. 4, no. 4, Retrieved on February 16, 2009 from Interscience database. Skinner, R 1970, ‘The determination of selling prices’, Journal of Industrial Economics, no. 18. Steele, R & Gray A 1982, ‘Statistical cost analysis: the hospital case’, Applied Economics, vol. 14, no. 5. Stigler, G & Kindahl, J 1970, ‘The behaviour of industrial prices’, Review of Economic Studies, no. 56, retrieved on February 15, 2009 from Linkinghub database. Sweezy, PM 1939, ‘Demand under conditions of oligopoly’, The Journal of Political Economy, vol. 47, no. 4, retrieved on February 15, 2009 from JSTOR database. Read More