The main factors affecting product pricing in UK
The main factors affecting product pricing in UK lie mainly on the market structure and firms’ behaviour. Considering the three main market structures (perfect completion, monopoly and oligopoly) we can get a first image of how firms in each market will set its prices and output. Furthermore price (affected by output produced) may vary depending on each firm’s aims.
Perfect competition markets have three characteristics: they are consisted by many firms with low market share, there are no barriers of entry or exit and all firms are price takers. The fact that in these markets firms exist in a great number is because of the lack of barriers of entry and exit like high sunk costs (advertisement), high investments and special permissions. Thus anyone can enter or exit the market. The price in these markets is not a subject to a firm’s individual objective since firms in these markets have low market share and any change in their output would not affect price. The price in these markets is equal to demand, thus the price which consumers are able and willing to pay.
The opposite extreme of perfect competition is a monopoly. Thus a firm which dominates a certain market. In this market entry to other firms might be restricted. The monopolist firm is expected to set price in the long-run where marginal cost is equal to marginal revenue (where profit maximisation is achieved). The fact that it is the only firm in the market, it allows the firm to set price and output based on its objectives which I examine later on.
A most common market structure is oligopoly. Oligopoly market’s share is distributed between some firms. Each of this firm has enough market share to influence market’s price. These firms tend to collude and form cartels in a formal or tacit way. In these joint cartels firms set price and output in their effort to maximize their joint profit.
However how price is influence in a monopoly or in an oligopoly is mainly based on what objectives each firm has. The main common assumption is that a firm will have as an objective Profit Maximisation. This is achieved when the firm manages to match the additional cost for the last unit of output with the additional revenue made by that unit. Thus where Marginal Cost is equal to Marginal Revenue. This means that the firm will produce at a certain output and price where profits are maximised (maximum difference between Total Cost and Total Revenue).
£ Total Cost(TC)
However Profit Maximisation takes place only under two specific assumptions: first and most important that owners are in control of the day to day management and second that their primary objective is profit maximisation. Thus these firms are not likely to be PLCs where shareholders (owners) do not control the management of the firm. If profit maximisation takes place then we expect that output will be less with a higher price per unit rather than any other objective.
Sales maximisation is the main managerial objective. When ownership is divorced from management, owners hire directors by giving them salary or commission on sales revenue. Managers, in their effort to maximise their personal revenue, will aim to maximise sales. Another explanation why sales maximisation takes place when the firm is under managerial control is that directors seeking to increase their prestige, tend to want greater output and greater expenditure. As suggested by Williamson (1963) funds for this expenditure in staff levels and projects can come from sales revenue. Sales maximisation is achieved when Total Revenue is maximised. This will produce a higher number of output at a lower price.
Sales maximisation however is often constrained by shareholders in their effort to achieve a minimum profit level. This was recognised by Baumol and Williamson. They seperated this profit constraint into two categories: binding and non-binding. Binding profit constraint means that owners will demand a level of profit which is achieved by a higher price and a lower output than sales maximisation. Non-binding profit constraint is achieved at a lower level of price and a higher level of output than sales maximisation. Baumol demonstrated this in the following diagram:
Min profit constraint
Max profit constraint
As we see at sales maximisation output Q1 is achieved where at maximum profit Q2 is achieved and at minimum profit target Q4 is achieved. If shareholders demanded maximum profit the price would be higher and output lower and sales maximisation could not take place. This is binding profit constraint. However if shareholders demanded minimum profit target, the output for that to be achieved would be higher and the price lower than sales maximisation. This is non-binding profit constraint.
A very different aim is Growth Maximisation. In contrast with the other two objectives, this optimisation goal could be described as common between managers and shareholders. As Marris (1964) suggested, growth of the firm is aimed by managers to raise their status and by shareholders to increase their personal wealth. If managers try to distribute less profits then capital expenditure will be more feasible but shareholders will not be satisfied resulting to a lower share price and a possible takeover of the firm. However if managers distribute more profits then less funding will remain for capital expenditure but shareholders will be more content. In effect Growth maximisation takes place when ‘balanced growth’ is achieved. This takes place when a firm maximises its capital expenditure according to an acceptable rate of distribution of profits. This results to a balanced price between profit maximisation and sales maximisation.
A firm however is a complex combination of various groups of people with different aims and concerns. As resulted from many studies, a small percentage in the UK can be described as profit maximisers. The Shipley study (1981) showed that only 15.9% of the UK firms can be considered as profit maximisers. In the same study the majority of the UK firms (52.3%) proved to be ‘satisficers’. (Lecture slides, Topic 1).
‘Satishicing’ was first pointed out by Simon (1959) as a firm behavioural theory. A firm is an organisation of many groups of people: owners, managers, workers, customers, suppliers. Each of this group has a different aim (e.g. owners are concerned about profits where customers are concerned about wide range of products at a good quality and low price). Satisficing is said when managers set minimum acceptable levels from all of each of these groups and this level is achieved. If the managers meet their first target, they set a new higher objective (special case of optimisation). This management technique might eventually lead to maximize their objectives.
Market structure allows us to divide firms based on their market power and behaviour. Objectives and aims in a firm of various groups and more specifically of owners and managers vary. Based on which aim a firm will have as its main objective, price and output varies. Firms, in their effort to reach different aims, may change the volume of their production. In this sense, firms’ output is altered and thus price is affected.
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