“A pricing decision is one of the most crucial & difficult decision that a firm has to make. Such a decision affects the long- term survival of any profit-oriented enterprise.” Accounting information is often an important input to pricing decisions. Most firms need to make decision about setting or accepting selling prices for their products or services. In some firms selling price is derived directly from cost information by estimating future product’s cost & adding a suitable profit margin. In others, an established market price is accepted. Generally, pricing decisions are influenced by the pricing policy followed by an organisation. Pricing policies are made taking overall objectives of an organisation into account. Thus, before fixing price of a product, objectives of the organisation must be understood first to achieve the organisation’s goal. Objective of an organisation may be either to maximise the profit or maximise the sales or maximise the output or optimal utilisation of resources etc.
The basic approach in most of the micro-economic theory (theory of the individual firm and its relation to other firms) defines the term optimum price as that price which yields the maximum profits (excess of total revenues over total costs). Thus, the basic assumption of the pricing theory is that the firm’s main objective is to maximise its profits. It also assumes that the firm takes into consideration the position of demand and cost functions and that the firm produces one product.
The determination of optimal price can be considered under the following market structures.
Perfect Competition – Under perfect competitive market, there are large numbers of sellers selling a homogeneous product using identical production process and all of them have perfect information about the market and price. Perfect market allows free entry and exit of firms into and out of the industry. Under this type of market, firm has no pricing policy of its own as the sellers are price takers (i.e., it has to accept the price determined by the market) and sell as much as they are capable of selling at the prevailing market price. Since each firm produces and sells a homogeneous product, it cannot increase its price beyond the market price. If it does so then it has to lose all of its market demand to the competitors. There is no control over market price which will equate the quantities available with the quantities which the buyers are willing to buy. The firm has to take a decision in favour of the quantity to sell. The firm can continue to produce so long as its marginal cost is less than or equal to its selling price, up to the point at which the marginal cost is equal to price, increase in output will add to revenue and thereafter the increase will add to cost.
Monopoly – Monopoly is a market condition where there is only one supplier or producer of a homogeneous product for which there is no close substitute but has many buyers. Under the monopoly, a firm is a price setter i.e., it can fix any price but here also the pricing is done taking elasticity of demand for the product into consideration. That means though the seller/ producer can fix any price but it will go for the price where demand for the product and consequent profit will be maximum.
Monopolistic Competition – The monopolistically competitive market is one in which there are large number of firms producing similar but not identical products. Since there is limit to the growth of competitors the excess profits earned by monopolistic situation attracts new competition. This will have a long – run effect on the excess profits which will tend to diminish because of the price competition with close substitutes. The company will, however, have to compare marginal cost and marginal revenue in maximising its profits. Under monopolistic condition, consumers may buy more at a lower price than at higher price. The profit can be maximised by equating marginal revenue with marginal cost.
Oligopoly – A market structure where there are few firms producing or selling homogenous or identical product. In this type of market structure, the firms are aware of the mutual interdependence of investment, production process, advertising and sales plan of its rival firm. Hence, any change in any variable by a firm is likely to have an equal reaction on the part of other competing firms. It is therefore, clear that the oligopolistic firm, while determining the price for its product, consider not only the demand for the product but also the reactions of the other firms in the industry to any action or decision it may take.
If a firm does not follow or adapt its pricing policy in consonance with its competitor, the shift in the sales will be sensitive. That means demand will shift towards the lower price. Thus, each firm will study the potential reaction before increasing or decreasing the selling price. The firms in oligopolistic market maintain the price of the product either by close analysis of each other’s behaviour or by means of cooperation and collusion.
The pricing policy plays an important role in a business because the long run survival of a business depends upon the firm’s ability to increase its sales and derive the maximum profit from the existing and new capital investment. Although cost is an important aspect of pricing, consumer demand and competitive environment are frequently far more significant in pricing decisions. These are also known as determinants of pricing or market powers. Thus, costs alone do not determine price. Cost is only one of the many complex factors which determine prices. There must however, be some margin in prices over total cost of capital is to be unimpaired and production maximised by the utilisation of internal surplus.