The business price setting of a firm is to do with the policy a firm adopt that determines the price of its goods and services. Traditionally it was believed that the firms set their business objectives, including price, using a profit maximising concept where price was set at MC=MR. However non maximising objectives and other maximising objectives exist and in reality firms may not be actually setting prices to maximise profits. My essay looks into the theory and evidence on business price setting objectives.
It was believed that price changes were costless to the company according to early theory however, the Bank Of England study on ‘how do UK companies set prices’ has stated that price change affect the company in more then one way. The Bank of England study was carried out to ‘throw light on how monetary policy, the control of inflation affects the economy. Never the less it provides evidence into company’s price setting behaviour.
The price a business sets also depends on the demand and cost factors of the firm according to Table D of the Bank Of England’s study ‘How are prices affected’ the top preference (40%) of respondents said that they price their products at the highest level the market could bear, hence the highest the demand curve could handle before it changes. However demand and cost related issues may affect the price in different ways for firms in dissimilar market structures. Therefore the market structure and the firm’s own objective affects the price.
The traditional theory that all business seek only to maximise profit can be correct if the market structure and the firm’s objective are to affect the pricing policy of the firm. The traditional theory of the firm states that under the market structure of Perfectly competitive, Monopolistic, Oligopolistic and Monopoly the price and output is set where MC=MR. However there is also theory that firms, according to the Applied Economics book chapter three, have non-maximising and other maximising objectives contradicting the traditional theory of the firm.
The perfectly competitive firm, according to theory sets its price where MC=MR. My diagrams demonstrate this. Although the perfectly competitive firm sets its price at MC=MR the price set is determined by market demand and supply and therefore allocative efficient. The perfectly competitive firm will not be able to set prices higher then market equilibrium, setting below the market equilibrium would lead to the company making a loss and therefore it would not.
In conclusion the perfectly competitive firm’s theory on price setting coincides with the theory of profit maximisation as there are no other alternative price strategies it can adopt to stay in business. The market structure that has the ability to affect price setting is the monopoly market structure. The traditional theory of the firm states that monopolies use their market dominance to set the price at MC=MR which is not what demand and supply determine in the market. My diagram shows that the monopoly firms, unlike, the perfectly competitive firm is able to charge an abnormal price.
Hence the monopoly is a price maker whereas the perfectly competitive firm is a price taker. If the monopoly firm was not a profit maxi- miser then the price it would change will decrease. These diagrams demonstrate this: Economic theory also states that monopolies that are seen to be in a contestable market, a market with relatively low barriers to entry may limit price their products. Limit pricing is when a firm is able to charge its customers a high price but opts out to charges its customers a lower price in fear of competition is a company limit pricing.
This goes against the traditional theory of the firm that companies profit maximise. The monopoly firm is thinking of long term profits and not short term by limit pricing. The oligopoly market structures as well as the monopolistic market structure differ from the monopoly and the perfectly competitive firm. The oligopolies theory on price setting states that, taking a five firm concentration ratio, a concentration ratio measures the proportion of output or employment in an industry, hence the degree of oligopoly.
Price therefore is not set according to demand and supply but rather firm’s act as one firm and try to ‘price make’. My diagrams demonstrate this interdependency by making the supply curve much more inelastic. My diagrams show that if firms with a 5 firm concentration were actually price competitive, then the price it would charge to its customers will be lower then if the firms acted as interdependent. The price it would charge its customers would be higher then market price.
In conclusion to the oligopoly theory on price setting it has to be said that in practise barriers such as the principle agent problem may get in the way of controllers seeking their business objectives. This problem I will discuss further later on. The monopolistic firm according to economic theory, just like the oligopoly, tries to influence the price it can charge for its goods and services. However the monopolistic firm is unable to do this by becoming interdependent as the market share it holds is small compared to the overall market share.
Therefore monopolistic firms according to theory, differentiate their goods and services to have some influence over price. This theory like the theories above takes the owner of the firm also as the controller of the firm. However, as I have stated for the oligopoly market structure that there may be a case where the owner and the controller of the firm are different people with different objectives. If this was to be the case then the price setting behaviour may also be different.
The evidence in the real world of business price setting for all four markets that I have described may not coincide with the theory of business price setting. The four market structures may be influenced by other objectives like the growth maximisation or sales maximisation theory. I have also demonstrated that even a monopoly firm may decide to limit price rather then profit maximise. Again this demonstrates that short term profit is less desired then long term profit.