Pricing and Profit Maximization - Essay Example

Pricing and profit Pricing and Profit Maximization Introduction Profit is at the heart of a firm. If there are no profits, the firm ceases to exist, literally. Profits provide the basis for setting up of a business, its survival and growth. In a free market economy profits are legitimate, while profiteering is not. Obviously, profits are a function of the costs and prices, but not necessarily the only two elements. Prices are determined by a variety of factors, not all of which are within the control of a firm, but at the same time these factors also provide the tantalizing opportunity to earn ‘extra normal’ profits. This essay deals with the issues of profits, briefly identifying how they arise, costs and prices, and the influence of market conditions / other factors on pricing decisions for profit maximization. Profits – classical view Profit is the difference between the total revenue and total costs of a business enterprise. Profits are considered to arise either as rewards for risk taking or due to the imperfections in the economy or as reward for innovations, according to economic theories (Dean 1977, pp. 5 – 9). Rewards for risk taking: Entrepreneurs are essentially people with the ability to take risks. The risk involved is, to be prepared to accept as their share of the (monetary) value of the enterprise activities, after all costs have been provided for. What is left may be losses or minimal profits or more than reasonable profits. It is this risk that entitles the entrepreneur to keep for himself whatever is left at the end of the day. This is his profit. A good example of the reward for risk taking is photocopying business. When the plain paper photocopying technique was invented, it was a risky business to invest in, as the future would be that of ‘computerized Pricing and profit 2 paperless offices’. Rank Xerox Corporation, on the other hand, was willing to accept the risk and acquired the technology and patent rights. The stupendous success of this decision and the great revenues that it brought to Rank Xerox, are legendary (www.xerox.com). Imperfections in economy: According to this view, profits arise due to ‘…the imperfections in the adjustment of economy to change’ (Dean 1977, p.8). Imperfection refers to the competitive situation. There is a time lag between the occurrence of a change and the return of the market to near-perfect competitive position or equilibrium, and it is during this time of absorbing the change that profits accrue. An example of this type of opportunity is the occasional shortage in supply of food grains due to bad weather or crop failure and the time lag before a government takes corrective actions for increasing supplies through imports etc. Reward for innovation: In this third view on how profits arise, it is postulated that profits are what the entrepreneur is entitled to, for putting his business ideas into practice by organizing the activities for realizing the innovation. In the process of organizing, he capitalizes his enterprise through own / borrowed funds, hires people, sets up the physical infrastructure and supplies products or services to the market. All his costs are incurred at the market-determined rates and whatever surplus he generates after providing for his costs, is the reward for his innovation – his profit. His innovation upsets the market equilibrium and continues to give him profits until the equilibrium is restored or till such time as he is able to create barriers preventing others to follow him through intellectual and other property rights, such as patents, trade marks and secret formulas. Mobile telecommunication equipment and services are the recent examples of profits through innovation. While the mobile companies reaped huge profits based on high Pricing and profit 3 volumes / low charges / high quality / novelty, the staid fixed line operators suffered huge erosion of their market share and revenues, and were forced to reduce tariffs. Profits and competitive advantage – contemporary view The above three paragraphs briefly summarize the classical theory of profits. Michael Porter’s view, which is contemporary, is not out of place. Instead of talking about profits directly, he analyses the activities of a firm as a ‘value chain’. To the seller, the net balance left in the value chain after providing for all costs of the activities, is his margin. The buyer has his own chain of activities, whose value is enhanced or reduced by the seller’s product; when it is enhanced, the buyer is willing to pay a higher price, and when it is reduced he will pay a lower price or even may change the supplier! Thus, the price commanded by a seller and consequently, the profit that he can achieve, has a direct link to the value that the product can pass on to the buyer. This is an element of the ‘competitive advantage’ as described by Porter (Porter, 2004, pp.320-328). Profit maximization and pricing Profit maximization: Profit maximization, either openly or in a subtle manner, is the goal of all firms. Several factors moderate this aspiration. These are the factors in the environment in which the firm has to operate: competition, public response, demands for higher wages, customer good will, maintaining control over the business etc. (Dean, 1977, p.29). After these factors are considered, the entrepreneur is left to decide on the pricing. Classical or contemporary view, it is clear that the entrepreneur passes on to the buyer, the value he creates (by taking risk, by exploiting the market imperfections or by innovation) by Pricing and profit 4 pricing the products in such a manner that all his costs are adequately covered and a surplus is left for himself. His products are traded in the market place, the arena for putting his wits against the competitors and buyers. Markets operate in a dynamic manner all the time and this dynamism, of which the entrepreneur himself is a factor, limits his ability to price his products at free will. A higher price will bring in higher profit, but will drive down demand and invite competition as well; a lower price will reduce profit per unit, but will fuel the demand thus expanding the market. Similarly, a higher output will reduce the cost per unit, if other factors of production can be maintained at constant value, and vice versa. Thus, market dynamics determine the prices, which in turn determine the profits that can be earned (Whittaker, Classroom lectures). Costs and revenues – total, average and marginal For the purpose of this essay, costs are considered in relation to units of products. Costs comprise of the two basic types viz., fixed costs of an enterprise and variable costs that happen with a change in the output volumes. Total cost equals to the sum of fixed and variable costs (for a given volume of output); average cost equals to the total cost divided by the corresponding numbers of units produced; and the marginal cost is the additional cost for producing an extra unit of the product. Total, average and marginal revenues can be described in a similar manner. These definitions help one to arrive at the proper pricing decisions for profit maximization in different market situations (Sloman, 2003, Ch. 5, 6 & 7). Market dynamics and pricing for profit maximization in theory Markets are classified into three basic types viz., competitive, monopoly and oligopoly markets and they influence the product pricing decisions. Pricing and profit 5 Competitive market: Large number of buyers and sellers, and free movement of people and goods (unrestricted entry and exit) characterize a competitive market. In this situation, neither the buyer nor the seller is able to exert undue influence. Products and their substitutes are available in plenty. Businesses have to operate at the highest possible levels of efficiency to remain competitive in the market and to retain their market share. Profits are minimal and are nearly equal for all players. Items of common consumption like food grains, processed food, milk and beverages etc. are examples of products in a competitive market. In a competitive market, the marginal revenue equals the price of the goods, since the seller is in no position to sell at a differentiated price, irrespective of his production volumes. Hence, he looks to the costs angle. Fixed costs being what they are, it is the variable cost element that comes into play with the changing volume of sales. In order to maximize his profits, he has to find the point (in quantity of sales) at which the marginal cost equals or exceeds the marginal revenue. The following graph depicts this situation: Source: Mankiw NG, 2004, Principles of Economics, p.294 Pricing and profit 6 Monopoly market: A single dominant supplier dictates the market, controlling supplies and prices as he pleases. If a buyer considers the item(s) irreplaceable, he will pay the price demanded by the supplier, whether he likes it or not. Monopoly markets, for all practical purposes, are theoretical or exist for short periods of time only. Legislation like the antitrust law ensures that monopolies do not exploit. However, businesses are always looking to create monopoly situations, even if the gains are for a short period of time. De Beers, which had controlled the world trade in raw and polished diamonds until recently, is a prime example of a monopoly. Microsoft’s packaging of the Windows operating system with the Internet Explorer, created the other widely debated monopoly. In a monopoly market, the supplier is in control of the price and in order to maximize his profits, he increases it. However, increase in price brings about a reduction in demand with the result that with each increase, the total sales and therefore the total revenue reduces. Marginal revenue is always less than the price of the product. In order to maximize his profits, the monopolist has to identify the quantity of output where the marginal revenue and the marginal cost are equal as can be seen in the figure below: Source: Mankiw NG, 2004, Principles of Economics, p.322 Pricing and profit 7 Oligopoly market: Oligopoly exists for items of mass consumption like cosmetics, ready-mades, electronic products etc. A few suppliers, offering competing and differentiated products within a narrow price band, characterize this market. No supplier dominates the market and product features, distribution efficiency and promotion dictate the prices. But since there are only a few suppliers, any decision by one supplier (to increase / decrease production or prices) affects the entire market and impacts the other suppliers as well. This situation leads to the formation of a cartel, which is an association of colluding suppliers. Cartels decide the volumes of production and price levels. “When firms in an oligopoly individually choose production to maximize profit, they produce a quantity of output greater than the level produced by monopoly and less than the level produced by competition. The oligopoly price is less than the monopoly price but greater than the competitive price...(Mankiw, 2004, p.352).” The oil cartel represented by the Organization of Petroleum Exporting Countries (OPEC) is a classic example of an oligopoly cartel. Firms operating under oligopoly, reach market equilibrium for profit maximization when the production volumes and prices are jointly decided and acted upon in case they are able to collude with each other. In other cases where such collusion is not possible due to antitrust laws (Sherman Act) or any other reason, then profit maximization is difficult to achieve with each player constantly trying to improve his market share by product differentiation, pricing and promotion. Profits under these circumstances approach those that can be expected under competitive market conditions. Pricing and profit 8 Pricing for profit maximization in practice Having seen the theoretical concepts of profits, costs and market dynamics for profit maximization, we can now consider the typical pricing practices such as markup pricing, limit pricing, discrimination pricing, bundling, market penetration pricing etc. Mark up pricing is the most common type used since a large number of firms do not have adequate information on supply / demand dynamics of the market. Mark up price or cost plus pricing produces different prices for different firms, depending the % mark up value, or whether the average fixed and variable costs are included or not, and whether costing is done for optimum output levels. A targeted profit volume determines the production volumes and the % of mark up. Elasticity of demand comes into play to moderate mark up pricing decisions. The relation P = MC x 1/ (1 – 1/Ed.) gives the price for profit maximization (where P is the price, MC is the marginal cost and Ed. is elasticity of demand) (Whittaker, 2007). For a given value of elasticity demand, the mark up over and above marginal cost (P-MC) can be easily calculated, from the above formula. Market conditions of supply and demand (i.e., elasticity of demand) play a key role in pricing. Multi product companies take into account cross elasticity of prices, and hence consider all costs of all products while determining prices for individual products. They may offer some products at a lower price to attract customers, who are then expected to buy other products at premium prices, thus helping profit maximization for the business as a whole. Monopolies and oligopolies often resort to ‘limit pricing’ in the short run, which is lower than the profit maximizing price, with a view to discourage potential new entrants to the market. Other methods of pricing for profit maximization are price discrimination based on auctioning or Pricing and profit 9 quantities bought or different markets, and product bundling. Often, firms resort to supply goods at low prices with a view to penetrate a market, which is already being served by the existing suppliers. However, this is a short-term strategy and will not lead to profit maximization even in the longer term. Guidance for developing pricing strategy Many entrepreneurs have a gut sense of market conditions and pricing strategy. As a firm’s operations and competition increase, its management must pay attention to the principles of business economics, instead of relying on gut sense alone. This would involve systematic assessment of the internal and external situations. Internal situation analysis would focus upon product features and costs. Costs in turn are incurred on land, labor and materials. For every business, there is an ideal combination of these factors and the costs associated with them. External situation analysis would focus on the customers and the competitors, collectively called the market. External analysis impacts the internal operations of the firm and its pricing strategy. Depending upon whether the firm is operating in a competitive market or an oligopoly market or in a monopoly market, the levels of investment on the factors of production and the planned output will be determined. Significantly, the market dynamics as discussed in the foregoing paragraphs help to decide the pricing strategy for profit maximization. Pricing strategy alone will not suffice in the long run. Competition will force it to have a review of products or prices or both. In order to remain in business in a profitable way, it has have ideas that will keep it ahead of competition. Expansion of the existing lines of business or Pricing and profit 10 venturing into related or even unrelated products or services is one sure way to survive in the market. Synergistic diversification, involving expansion of business activity into newer but relatively compatible products is a factor to be considered along with pricing strategies, especially if the competition in those new products is less intense. Conclusion Profits levels are determined by what the customers are willing to pay for a product or service. Profit maximization is the aim of all businesses. But this aspiration is moderated by several factors, most important of which are - how efficiently the business is organized and how competitive the market conditions are. Efficiency of operations decides the costs and revenues. Market conditions decide the prices, sales volumes and hence the total revenues. Business economics helps one to appreciate the interplay of the internal and external environment of a firm and to plan for profit maximization under different market conditions. When the situation demands, a firm also has to look for diversification, especially into related areas of business in order to maximize profits on its levels of investment and operations. References Dean J, 1977, Managerial economics, Prentice Hall, New Delhi. Dept. of economics, finance and international business (2005), Module booklet EC1002CN, Introduction to microeconomics, London Metropolitan University. Mankiw NG, 2004, Principles of economics, South-Western Educational Publishing. Porter ME, 2004, Competitive advantage, Free Press, New York. Sloman J, Economics, Prentice Hall, New York. Whittaker J (2007), Economics for business, BEMM321, University of Exeter. Wiens EG (2006), Egwald economics: Macroeconomics, Available: http://www.egwald.com/macroeconomics/keynesian.php [10 May 2006]. Wikipedia (2007), Profit maximization, Available: http://en.wikipedia.org/wiki/Profit_maximization [9 March 2007] Worthington I, Britton C, Rees A (2001), Economics for business: Blending theory & practice – Ch.9: Pricing in theory and practice, FT Prentice Hall. Read More