Posted by Alex M Thomas on 31st January 2011
Recently, Indians have witnessed an escalation in onion prices followed by a hike in fuel prices. Price rise is a phenomenon which affects all sections of the society in varying degrees. Earlier, through the work of Michal Kalecki, a Russian economist, this blog showed the difference between cost-determined and demand-determined prices. The current post examines how products are priced. Majority of the arguments in this post is taken from the book Smart Pricing, authored by Jagmohan Raju and Z. John Zhang published in 2010.
Textbook economics teaches us that it is demand and supply which determine prices. Are the prices of vegetables, rice, chicken, train travel, milk, bread, toothpaste, parathas, etc determined in a similar way? When price changes are attributed to demand and supply, it means that prices are taking their “normal course”. In other words, price movements arising from demand and supply are considered as normal as the law of gravitation. Economic theory ascribes the term ‘invisible hand’ to denote demand and supply factors which cause prices to alter. However, as repeatedly pointed out in this blog, manufactured goods and producer/consumer services are not priced in the market via bargaining. As Raju and Zhang rightly point out, “Price setting is a tangible process with a tangible outcome – a dollar figure. The process of arriving at that number might not be tidy, but it cannot be so mysterious that it does not involve any human intervention. Someone, somewhere must make a concrete, numerical decision about the price of a product or service” (2010, p 2). Further, they argue that “the market does not set prices. Marketers do. All the prices we observe in the marketplace do not just spring out of an autonomous, impersonal market. The managers’ hands in setting those prices are entirely “visible,” regardless of whether such interventions are acts of expediency or strategy” (Ibid, p 11-12).
According to Raju and Zhang products are usually priced based on three approaches: (1) cost-plus based, (2) competition based and (3) consumer based. An overwhelming majority of U.S. Companies use this approach to set prices. Here, the mark-up is determined by the company’s targeted internal rate of return on investment or by some vaguely defined industry convention. Competition based pricing is the second most popular approach and is considered to be strategic. In this approach, the prices are fixed taking into account the prices of similar products in the market. In the case of consumer based pricing, the company tries to determine how much each consumer is willing to pay and then accordingly fixes a price. All the above mentioned approaches indicate that price fixing is a conscious and deliberate action carried out by the company or individual producer.
In microeconomics textbooks and in the media we find statements which ascribe price rise to demand-supply factors. The group of individuals – the capitalists, the brokers, the intermediaries etc – who cause the prices to rise with their actions are completely absent in this account. The book by Raju and Zhang therefore is a must read for all economists who wish to understand how products are actually priced in today’s consumerist society.
Raju, Jagmohan and Zhang, John (2010), Smart Pricing: How Google, Priceline, and Leading Businesses Use Pricing Innovation for Profitability, Pearson Education: New Jersey.