Understand that price serves three functions: (a) as the basis on which firms generate revenue; (b) as a rationing device in markets; and (c) as a signal to producers to alter supply.
Identify how price is determined in a competitive market economy through the interaction of demand and supply.
Realise that pricing decisions are driven by particular managerial objectives (such as profit maximisation, sales revenue maximisation, etc.).
Distinguish between different generic pricing strategies adopted by firms, namely: marginal cost pricin g, incremental pricin g, breakeven pricing and mark-up pricin g.
Appreciate the nature of various pricing strategies in markets with differing degrees of competition.
Recognise that pricing strategies require the integration of pricing decisions into a wider marketing mi x, taking into account non-price as well as price factors that affect demand.
Appreciate how pricing decisions may vary over the life cycle of a product or service in the market.
Understand the economics of price discriminatio n.
Grasp the complexities introduced into pricing decisions where multi-plant or multi-product production occurs and the nature of transfer pricin g.
Identify when peak-load pricing and two-part tariff pricing may be appropriate.
Recognise the ways in which government affects prices in market economies today.
OHT 12.2B Learning outcomes
Prices serve three broad functions.
Prices raise revenue for the firm.
Prices act as a rationing device.
Prices indicate changes in the wants of consumers and induce suppliers to alter product accordingly.
Price determination and managerial objectives OHT 12.3
OHT 12.4 Figure 12.1 The market for Sony TVs
Marginal cost pricing.
Generic pricing strategies OHT 12.5
Marginal cost pricing Marginal cost pricing involves setting prices, and therefore determining the amount produced, according to the marginal costs of production, and is normally associated with a profit-maximising objective. Incremental pricing Incremental pricing deals with the relationship between larger changes in revenues and costs associated with managerial decisions.Proper use of incremental analysis requires a wide-ranging examination of the total effect of any decision rather than simply the effect at the margin. Breakeven pricing Breakeven pricing requires that the price of the product is set so that total revenue earned equals the total costs of production. OHT 12.6
OHT 12.7 Figure 12.2 Pricing strategies compared
Mark-up pricing Mark-up pricing is similar to breakeven pricing, except that a desired rate of profit is built into the price (hence this pricing is associated with terms such as cost-plus pricing,full-cost pricing and target-profit pricing). OHT 12.8 M = (P - AC)/AC where m is the mark-up, AC is the average total cost, and P - AC is the profit margin. The price, P, is then given by: P = AC (1 + m )
Perfectly competitive markets.
Monopolistically competitive markets.
The nature of the market in which the product is sold will have a major influence on the pricing policy adopted. As we saw earlier markets can be conveniently divided into four broad kinds: Pricing and the competitive environment OHT 12.9
Pricing in perfectly competitive markets In perfectly competitive markets the firm is a price-taker . Pricing in monopoly markets In a monopoly situation, the firm is a price-maker . OHT 12.10
The marketing mix and the product life cycle The marketing mix In developing an effective marketing strategy, marketing professionals draw attention to the importance of the following ‘ four Ps’:
Together the four Ps determine what is called the ‘offer’ to the consumer. OHT 12.11
OHT 12.12 Figure 12.3 Product positioning and customers’ perceptions
( 1) ‘Promotional’ or ‘penetration pricing’ occurs when the price is set low to enter the market against existing competitors, attract consumers to the new product and gain market share. (2)A ‘skimming policy ’arises when price is set high initially to earn high profits before competition arrives or to cover large unit costs in the early stage of the product life. The product life cycle OHT 12.13
OHT 12.14 Figure 12.4 Phases of the product life cycle
Definition of price discrimination Price discrimination represents the practice of charging different prices for various units of a single product when the price differences are not justified by differences in production/supply costs.
The markets may be separated in the following ways:
By geography 紡 as when an exporter charges a different price overseas than at home.
By type of demand 紡 as in the market for,say,butter where demand by households differs from the bulk purchase demand of large catering firms.
By time 殆 with a lower price charged for off-peak periods (as in the case of seasonal charges for hotel rooms).
By the nature of the product 紡 as with private dental care with differential pricing, where if one patient is treated he or she is unable to resell that treatment to someone else.
Third-degree price discrimination Most frequently found is third-degree price discrimination, which simply involves charging different prices for the same product in different segments of the market. OHT 12.17
The multi-plant firm Where a firm ’s output of the same product is produced on more than one site, the profit-maximising output rule that marginal supply costs must equal marginal revenue, is unchanged, but in this case this marginal cost is the sum of the separate plants ’marginal costs and production must be allocated between the plants so that the marginal supply cost at each plant is identical. Pricing in multi-plant and multi-product firms OHT 12.19
OHT 12.20 Figure 12.7 Pricing in a multi-plant firm
When producing and pricing a product, the multi-product firm has to take into consideration not only the impact on the demand for that product of a price change (its own price elasticity of demand)but the impact on the demand for the other products in the firm ’s product range (the relevant cross-price elasticities).In other words, pricing now involves obtaining maximum profits from the full product range rather than from the individual products. The multi-product firm Pricing in multi-plant and multi-product firms OHT 12.21
OHT 12.22 Figure 12.8 Peak-load pricing
OHT 12.23 Figure 12.9 Two-part tariffs Two-part tariffs A two-part tariff is concerned with levying a charge according to the number of volume of the units consumed, plus a fixed charge to cover fixed joint or common costs, usually on a quarterly of annual basis.
Pricing policy and the role of government
Taxes and subsidies
Direct price controls
Key learning points
Equilibrium pricing is likely to be short-lived since the conditions of demand and supply are likely to change regularly if not continuously. In addition,producers may lack adequate information about the market to predict the equilibrium price precisely.
Pricing ,in practice,is driven by managerial objectives relating to factors such as profitability,corporate growth,sales revenue, managerial satisfaction,etc.
Generic pricing strategies may be based on marginal cost,incremental cost,break-even or mark-up pricing.
Marginal cost pricing involves setting prices,and therefore determining the amount produced,according to the marginal costs of production,and is normally associated with a profit-maximising objective.
Incremental pricing deals with the relationship between larger changes in revenues and costs associated with managerial decisions.
Breakeven pricing requires that the price of the product is set so that total revenue earned equals the total costs of production.
Mark-up pricing is similar to breakeven pricing,except that a desired rate of profit is built into the price (therefore this pricing is also sometimes referred to as cost-plus, full-cost or target-profit pricing).
In perfectly competitive markets, the supplier is a price-taker.
In a monopoly situation,the firm is a price-maker.
In developing an effective marketing strategy , marketing professionals draw attention to the importance of the four Ps: product, place, promotion and price.
With respect to the product life cycle , promotional or penetration pricing sets the price low to enter the market against existing competitors and in order to attract customers to the new product and gain market share.
OHT 12.25B Key learning points
A skimming policy arises when price is initially set high perhaps to cover large unit costs (e.g.R&D costs)in the early stage of the product life cycle or to make higher profits before competitors can respond.
Price discrimination represents the practice of charging different prices for various units of a single product when the price differences are not justified by differences in production/supply costs.Successful price discrimination requires an absence of arbitrage opportunities and differing elasticities of demand in the various markets.
First-degree price discrimination arises in the case of a producer selling each unit of output separately,charging a different price for each unit according to the consumer 痴 demand function.This results in the transfer of all consumer surplus to the producer.
Second-degree price discrimination involves charging a uniform price per unit for a specific quantity or block of output sold to each consumer.
OHT 12.2C Key learning points
Third-degree price discrimination involves charging different prices for the same product in different segments of the market.The market may be segmented by geography,by type of demand,by time,or by the nature of the product itself.
In the case of a product produced by a multi-plant firm , the profit-maximising output rule (MR =MC)is unchanged,but in this case the marginal cost is the sum of the separate plants 知 marginal costs and production should be allocated between the plants so that the marginal supply cost at each plant is identical.
The multi-product firm has to take into consideration not only the impact of a price change on the demand for the product,but also the impact on the demand for the other products in the firm’s product range.Pricing policy, therefore, involves obtaining the desired rate of return from the full product range rather than from individual products.
OHT 12.25D Key learning points
Decentralisation of large firms brings with it problems of internal resource allocation, one aspect of which is the pricing of products which are transferred between the firm’s divisions.This gives rise to the need for an appropriate transfer pricing policy and the problem of determining the transfer price so as to maximise overall company profits.
Peak-load pricing involves differentiated pricing which reflects differences in supply costs,given variations in demand for the product over time.
A two-part tariff is concerned with levying a charge per unit according to units consumed plus a charge to reflect fixed joint or common costs.
The inverse price elasticity rule ,sometimes referred to as Ramsey pricing,suggests that consumers with the more price inelastic demands should bear a higher proportion of fixed charges than consumers with a higher price elasticity of demand.
OHT 12.25E Key learning points
On the basis of a public interest or economic welfare maximation rule, state enterprises should set prices in order to reflect the marginal social benefits from the additional output and the marginal social costs or producing that output.
Taxes and subsidies should be set so as to minimise the damage to resource allocation in the economy. In practice, state policies are determined by a mixture of political, social and economic criteria so economic welfare maximisation is far from guaranteed.
Key learning points OHT 12.25F
The demand for labour and the concept of the marginal revenue product .
The supply of labour and the concept of the elasticity of labour supply .
The determination of wages in the labour market.
The impact of collective bargaining and trade unions on wages and employment.
Discrimination in labour markets.
Minimum wage legislation.
Taxation and the incentive to work.
The importance of education and training.
CHAPTER 13. Understanding the market for labour OHT 13.1
This chapter will help you to:
Understand how wages and employment levels are determined in competitive labour market s.
Grasp what is meant by the marginal product of labour and the important role that it plays in explaining the demand for labour in market economies.
Identify those factors which influence the supply of labour and the effect of the willingness to work on wages and employment levels.
Appreciate the effects of labour market imperfections on wages and employment levels.
Recognise the ways in which trade unions affect labour markets in terms of their impact on the demand for and supply of labour.
Realise the significance of both negative and positive discrimination in modern labour markets and the resultant economic consequences.
Understand the likely impact of minimum wage legislation on wages and employment.
Recognise the role of taxation in explaining the incentive to work and the implications for the labour market.
Appreciate the importance of education and trainin g, and therefore investment in human capita l, in determining real wages and employment in all economies.
OHT 13.2B Learning outcomes
MVP = MPP x P where MVP is the marginal value product; MPP is the marginal physical product,i.e.the volume of output added by employing one more person;and P is the price at which the output sells in the market place. OHT 13.3 The demand for labour
Table 13.1 Calculation of marginal value product (firm in perfect competition) ($) Quantity produced (units) Number of workers employed Marginal physical product (MPP) x Price (per unit) = Marginal value product (MVP) 550 600 660 710 750 780 800 810 11 12 13 14 15 16 17 18 - 50 60 50 40 30 20 10 X X X X X X X X - 30 30 30 30 30 30 30 = = = = = = = = - 1,500 1,800 1,500 1,200 900 600 300 OHT 13.4
OHT 13.5 Figure 13.1 The marginal value product (MVP) curve
Table 13.2 Calculation of marginal revenue product Quantity produced (units) Number of workers employed Marginal physical product (MPP) x Price (per unit) ($) = Marginal revenue product (MRP) ($) 550 600 660 710 750 780 800 810 11 12 13 14 15 16 17 18 - 50 60 50 40 30 20 10 x x x x x x x x - 30 29 28 27 26 25 24 = = = = = = = = - 1,500 1,740 1,400 1,080 780 500 240 OHT 13.6 Marginal Revenue Product (MRP) = Marginal Physical Product (MPP) x Marginal Revenue (MR) = MPP x MR
OHT 13.7 Figure 13.2 The marginal revenue product (MRP) curve
OHT 13.10 Figure 13.4 The effect of restricting the supply of labour
OHT 13.11 Figure 13.5 Wage determination in a highly competitive labour market Wage determination in the labour market
OHT 13.12 Figure 13.6 Wage determination in a less competitive labour market Wage determination in the labour market
Unions will tend to be at their strongest in wage bargaining if:
The firm currently makes more than a normal profit so higher wages can be paid out of the higher profits.
The employer is a monopsonist and currently the average wage paid is less than the MRP (as in Figure 13.6).
The employer has limited scope to introduce further labour savings.
Labour costs are only a small part of total costs so that a wage rise can be more easily absorbed.
Firms can more easily pass on some or all of a wage increase to consumers through higher prices.This will occur when either the demand for the product is rising (e.g.because incomes are rising)or where consumer choice is restricted and the price elasticity of demand of the product is,therefore,low (e.g.in a monopolistic industry such as water supply).
In state enterprises where wage increases for state employees are funded from compulsory tax payments 勃 unless there is strong public opposition to taxation.
The employer,although not a monopsonist,is currently paying a wage which is less than the MRP of labour (for example,as illustrated in Figure 13.6).
Collective bargaining OHT 13.13
OHT 13.14 Figure 13.7 Illustrating the possible impact of trade unions on wages and employment
Minimum wage legislation.
Taxation and the incentive to work.
The importance of education and training.
Further issues in the labour market OHT 13.15
OHT 13.16 Figure 13.8 Illustrating the effects of discrimination on the labour market
OHT 13.17 Figure 13.9 Impact of minimum wage legislation
OHT 13.18 Figure 13.10 The impact of taxation
OHT 13.19 Figure 13.11 Investment in human capital
Key learning points
The demand for labour is a derived demand,i.e.people are employed for the output they produce.
The marginal value product of labour (MVP) under conditions of perfect competition is the value added to production by employing one more person and is calculated as follows:
MVP =MPP x P
where MPP is the marginal physical product (i.e.the volume of output added by employing one more person)and P is the constant price at which the output sells.
Under conditions of imperfect competition the marginal revenue product of labour (MRP) is affected by MPP and changes in price (i.e.MR),so that
MRP =MPP ﾗ MR
Managers seeking to maximise profits should employ more labour only if the marginal revenue product exceeds or is equal to the marginal cost of employment.
The elasticity of supply of labour is a measure of the responsiveness of the supply of labour to a change in the wage paid, calculated as:
Percentage change in supply of labour
Percentage change in the wage rate
Collective bargaining refers to arrangements between employers and trade unions regarding the setting of wages and conditions of work.
Where trade unions are powerful they are able to raise wages above the levels that would otherwise exist but this may occur at the expense of the number employed resulting in unemployment.
Trade unions can impact on the labour market by both reducing the supply of labour and raising the demand for labour.
Negative discrimination can occur in labour markets,for example on grounds of race,sex,creed,physical disabilities,etc.,leading to a lower demand for labour from these groups.
Positive discrimination can also occur leading to increased demand for labour from particular groups in society.
OHT 13.20C Key learning points
The elasticity of demand for labour measures the responsiveness of employment to a change in wages, calculated as:
Percentage change in number employed
Percentage change in the wage rate
The supply of labour is determined by demographic factors,the wage rate and other employment inducements,barriers to entry into different occupations and labour mobility.
In a highly competitive labour market , the supply curve for labour is horizontal at the industry wage rate W ; the average and marginal costs of employing labour are therefore constant at that wage,so that the optimal level of employment will correspond to the point where MC =MRP.
In a less competitive labour market ,the marginal cost of labour rises more quickly than the average cost of employment. While the profit-maximising condition MC =MRP still holds,the average wage rate will be less than the value of the marginal revenue product.
OHT 13.20B Key learning points
A number of countries have introduced minimum wage legislation ,preventing employers from ‘exploiting 蜘 workers by offering wages at levels which society may consider to be unacceptable 釦 The result may, however, be higher unemployment.
Taxation can reduce the incentive (willingness)to work and,in effect,shift the supply curve of labour leftwards,resulting in lower employment levels.
Higher levels of education and training are an investment that lead to improved human capital with a consequent increase in the marginal revenue product of labour and therefore higher real wages and more employment.
Educational qualifications also act as a screening device in the labour market, thereby reducing the cost imposed on employers in searching for suitably skilled labour to fill job vacancies.
OHT 13.20D Key learning points
CHAPTER 14. Understanding the market for capital
Capital as a resource of the firm.
Capital and profit maximisation.
The investment decision-making process.
Estimating and ranking capital investment projects.
Calculating the cost of capital.
Understanding cost benefit analysis.
This chapter will help you to:
Understand the basis upon which capital investment decisions are made by firms.
Identify the level of capital investment which will be undertaken by a profit maximising firm.
Distinguish between the stock of capital and the flow of new capital (i.e.investment in the capital stock).
Identify the various stages involved in the capital investment decision-making process.
Grasp the importance of estimating the cash flows from a planned capital investment project.
Distinguish between three different methods for evaluating and ranking capital investment projects, namely the payback metho d, the discounted cash flow method and the internal rate of return metho d.
Appreciate the role of the cost of capital in capital investment decisions and why a weighted average cost of capital is calculated when a range of sources of finance is used.
Understand the principles and stages involved in undertaking a cost benefit analysis – CBA takes into account the usual financial returns on an investment and the cost of capital but also the impact of the investment decision on the wider economy (the external or social costs and benefits of the investment).
OHT 14.2B Learning outcomes
The stock of capital is the quantity or value of the total capital invested within the firm, i.e. the total value of buildings, machines, equipment,etc. that are available within the firm.
The fl ow of capital is the increase or reduction in the stock of capital over a given time period, i.e.the net addition to the capital stock arising from purchasing new machines.Investment is the term used for additional capital expenditure that creates new assets.
Capital as a resource of the firm OHT 14.3
Employment of capital to maximise profits requires that: MC K =MRP K This applies irrespective of whether the firm buys or hires its capital inputs. Capital and profit maximisation OHT 14.4
OHT 14.5 Figure 14.1 Employment of capital - under conditions of a perfectly competitive factor market
OHT 14.6 Figure 14.2 Employment of capital - a monopsony factory market
Step 1:Generation of capital investment proposals.
Step 2:Determination of the capital investment budget.
Step 3:Evaluation and selection of capital investment projects.
Step 4:Monitoring of capital investment performance.
Step 5:Post-audit project review.
The investment decision-making process OHT 14.7
OHT 14.8 Figure 14.3 The investment decision process
Estimating capital investment cash flows The following three points should be borne in mind when estimating cash flows:
The role of tax
OHT 14.10 Figure 14.4 Estimating cash flows
Evaluating and ranking capital investment projects
Net present value method.
Internal rate of return method.
Net present value (NPV) where s is the future sum or, more correctly, the incremental after-tax net cash flow in each year; t represents each year in the life of the investment from the present ( t =1)up to a certain number of n years in the future; r is the discount rate;and S denotes summation over the time period concerned. OHT 14.12
where s , t and r are as defined in the earlier net present value formula,and I is the initial investment outlay for the project.Where the investment outlay occurs over more than the current year the value of I would also need discounting. OHT 14.13 Net present value method
Internal rate of return method OHT 14.14
In essence the cost of capital is related to the source of the funds used for the investment. A firm may raise funds in a number of ways, including the following: Calculating the cost of capital
Loan capital,e.g.bank loans and debenture (fixed interest) stock.
New equity issues (issuing shares or stock on which dividends are paid out of profits earned).
OHT 14.16 Figure 14.5 The weighted average cost of capital (WACC)
Cost –benefit analysis is a method for assessing capital projects where it is important to take into account all of the impacts of the investment decision,including the effects on other people,other firms, regions and so on.This involves accounting for the total social costs and benefits of a capital investment project. Undertaking a cost-benefit analysis OHT 14.17
OHT 14.18 Figure 14.6 Stages of a cost-benefit analysis
Key learning points
Capital is a factor of production which includes all physical, manufactured goods that are used in the production of other goods and services 貿 for example, plant, machinery,buildings and business fixtures and fittings.
The stock of capital is the quantity or value of the total capital invested with the firm.
The flow of capital is the increase in the stock of capital over a given time period resulting from new capital investment.
Employment of capital to maximise profits requires that the marginal cost of capital(MC K ) equals the marginal revenue product of capital (MRP K ), i.e.
MC K =MRP K
The marginal cost of capital reflects the cost of financing investment and will vary depending upon the degree of competition for funds in the capital market.
There are five steps in the investment decision-making process: generation of capital investment proposals,determination of the capital investment budget, evaluation and selection of capital investment projects,monitoring of capital investment performance, and post-audit project review.
The payback method for evaluation of an investment project is based on an assessment of how quickly the investment can generate sufficient net cash returns to cover the initial investment outlay.
The net present value and internal rate of return methods for evaluating and ranking investment projects are based on the concept of discounting expected cash flows back to the present day so as to obtain their net present value (PV).
Net present value (NPV) is given by the formula:
where s is the incremental after-tax cash flow in each year t of the life of the project and is the discount rate.
OHT 14.19B Key learning points
If all of the capital outlays for a project occur in the current year, the net present value (NPV) of the stream of future cash flows arising from the project is given by:
where I is the initial investment outlay for the project .In general terms, if the NPV is positive the investment has a positive net return in present value terms and should be accepted;if NPV is negative it should be rejected.
Another measure of the expected profitability of an investment is based on the internal rate of return (IRR)method where the IRR is defined as the rate of interest that equates the present value of a project’s net cash flow to the initial investment outlay.To calculate its value we set the NPV for the project equal to zero and solve the equation below for the value of IRR which produces a zero NPV:
OHT 14.19C Key learning points
The weighted average cost of capital (WACC)is given by the weighted average of the cost of raising the funds for the capital investment project.
If only retained earnings are used,the cost of capital is equal to the return that could have been earned if the internal funds were invested elsewhere (their opportunity cost).
lf only equity finance is used,the return to equity will be the same as the cost of capital.
If a project is financed entirely by a loan ,the cost of capital is the rate of interest paid on the loan.
In practice,projects are often financed by a mixture of debt and equity capital .In this case,the calculation of the cost of capital raises issues concerning the impact of leverage or the gearing ratio (the proportion of debt to equity finance)on the overall WACC.
OHT 14.19D Key learning points
The market for natural resources.
Economic rent verses quasi-economic rent.
CHAPTER 15. Understanding the market for natural resources OHT 15.1
This chapter will help you to:
Understand the role of land and other natural resources in the production of goods and services.
Appreciate how the prices of land and other natural resources are determined by the interaction of demand and supply.
Identify how a resource in finite supply (e.g. land) may earn economic rent or a payment above its transfer earning s.
Distinguish between economic rent and quasi-economic rent.
Grasp the importance of environmental issues in the production process.
Appreciate the implications for social welfare of environmental costs arising from the production of goods and services and how these may be best tackled.
Understand the meaning and importance of property rights in a discussion of environmental issues.
OHT 15. 3 Figure 15.1 The market for land - perfectly inelastic supply The market for natural resources Economic rent represents the earnings to a factor of production over and above its opportunity cost or the minimum payment needed to keep it in its present use, known as the transfer earnings.
OHT 15.4 Figure 15.2 The market for land in a particular use
Economic rent versus quasi-economic rent OHT 15.5 Quasi-economic rents occur when a factor of production earns economic rents that are competed away in the long run as the supply of the factor of production is increased.
Social welfare relates to the well-being of society and reflects both private (internal) and public (external) costs and benefits stemming from the production of goods and services. Property rights in the context of environmental issues are concerned with assets that are over-used because their ownership is not clearly defined or protected in law. OHT 15.6 Environmental issues may be discussed under the two broad headings of :
OHT 15.7 The Environmental Kuznets curve
OHT 15.8 Figure 15.3 Marginal social costs and benefits Social welfare
If MSB is less than MSC, output should be reduced.
If MSB equals MSC, output is at the appropriate level to maximise social welfare.
If MSB exceeds MSC, increased output should be encouraged.
Key learning points
Natural resources including the supply of land are an important input into the production process, alongside labour and capital.
Natural resources ultimately tend to be finite in supply, although there may be many competing alternative uses to which they can be put.
Economic rent represents the earnings to a factor of production over and above its opportunity cost or the minimum payment needed to keep the factor of production in its present use, known as its transfer earnings .
Economic rent tends to arise when a factor of production is inelastic in supply such as land, and the demand for the factor of production increases.
Quasi-economic rents occur when the supply of the factor of production can be increased in the long run and the economic rents are therefore competed away.
From the viewpoint of social welfare , natural resources should be used in productive activities up to the point where the marginal social benefit from their use is equal to the marginal social cost arising from their use; i.e. MSB = MSC represents the condition for a socially efficient level of production.
Governments may become involved in the market process to limit production and consumption where there are appreciable external costs , such as pollution, through taxation, prohibition, regulation and pollution permits.
Where there is no clear ownership or property rights over natural resources (e.g. fish in the sea) then over-production and over-consumption are likely to arise.