Pricing Methods in Managerial Economics: Top 7 Methods

The following points highlight the seven main methods of pricing policies. The methods are:- 1. Marginal Cost Pricing 2. Limit Pricing 3. Market Skimming Pricing 4. Penetration Pricing 5. Bundling Pricing 6. Peak Load Pricing 7. Internet Pricing Models.

Policy # 1. Marginal Cost Pricing:

Social welfare is maximum or, in other words, economic efficiency in resource allocation is achieved when price is set equal to marginal cost. It has been suggested that non-profit enterprises should pursue marginal cost pricing policy so as to achieve economic efficiency in resource allocation. However, marginal cost pricing does not ensure positive profits when the enterprise is enjoying very large economies of scale.

To induce the enterprise to continue producing the product as it is socially beneficial, subsidies should be paid to the enterprise or else the government should itself undertake the production of the product and meet its losses from the budgetary resources. Thus, in such enterprises where large economies of scale occur, marginal cost pricing is non-viable.

Policy # 2. Limit Pricing:

Limit pricing refers to the pricing by incumbent firm(s) to deter or inhibit the entry or the expansion of fringe firms.

Limit pricing implies that firms sacrifice current profits in order to deter entry of new firms and earn future profits. It is not clear whether this strategy is always superior to one where current prices (and profits) are higher, but decline over time as an entry occurs.

Limit pricing thus involves charging prices below the monopoly price in order to make entry appear unattractive (to limit entry). A low price would discourage entry if prices had a commitment value. But they do not, because prices can be changed quickly. Hence, if a potential entrant has complete information about the incumbent, limit pricing would be useless.

It is the policy adopted by firms already in a market to reduce their prices so as to make it unprofitable for other firms to try to enter the market. The price so established is called an entry forestalling price.

Policy # 3. Market Skimming Pricing:

Skimming is adopted where a new product is launched and the seller has little information on the acceptable price in the market. The seller, therefore, starts by setting a high price on the launch of the product and then, over a period of time, lowers the price to meet the varying price elasticities of demand.

This enables gradual expansion in capacity by the seller. This practice is followed in the consumer durables market. The seller chooses to start by setting at a high price to avoid the risk of losing on customers who are willing to pay a high price.

Policy # 4. Penetration Pricing:

Penetration pricing is a strategy employed by businesses introducing new goods or services into the marketplace. With this policy, the initial price of the good or service is set relatively low in hopes of ‘penetrating’ into the marketplace quickly and securing significant market share.

A penetration policy is even more attractive if selling larger quantities results in lower costs because of economies of scale. Penetration pricing may be wise if the firm expects strong competition very soon after introduction. A low penetration price may be called a ‘stay out’ price. It discourages competitors from entering the market. Once the product has secured a desired market share, its producers can then review business conditions and decide whether to gradually increase the price.

Penetration pricing involves the setting of lower, rather than higher prices in order to achieve a large, if not dominant, market share.

This strategy is most often used in businesses wishing to enter a new market or build on a relatively small market share.

This will only be possible where demand for the product is believed to be highly elastic, i.e., demand is price-sensitive and either new buyers will be attracted or existing buyers will buy more of the product as a result of a low price.

A successful penetration pricing strategy may lead to large sales volumes/market shares and therefore lower costs per unit. The effects of economies of both scale and experience lead to lower production costs, which justify the use of penetration pricing strategies to gain market share. Penetration strategies are often used by businesses that need to use up spare resources (e.g., factory capacity).

A penetration pricing strategy may also promote complementary and captive products. The main product may be priced with a low mark-up to attract sales (it may even be a loss-leader). Customers are then sold accessories (which often only fit the manufacturer’s main product) which are sold at higher mark-ups.

The most obvious potential disadvantage of implementing a penetration pricing strategy is the likelihood of competing suppliers following suit by reducing their prices also, thus nullifying any advantage of the reduced price (if prices are sufficiently differentiated the impact of this disadvantage may be diminished).

A second potential disadvantage is the impact of the reduced price on the image of the offering, particularly where buyers associate price with quality.

Policy # 5. Bundling Pricing:

It is a pricing practice when two or more products are sold as bundle. Also, the constituent products of the bundle are not sold individually.

Price bundling is a strategy whereby a seller bundles together many different goods/items being sold and offers the entire bundle at a single price.

There are two forms of price bundling—pure bundling, where the seller does not offer buyers the option of buying the items separately, and mixed bundling, where the seller offers the items separately at higher individual prices. Mixed bundling is usually preferable to pure bundling, both because there are fewer legal regulations forbidding it, and because the reference price effect makes it appear even more attractive to buyers.

Suppose there are two buyers, A and B, and two products, X and Y. Suppose buyer A values product X at 20 units above the cost of production, and values 7 at 15 units above the cost of production. Suppose buyer B values Y at 20 units above the cost of production, and X at 15 units above the cost of production.

The ideal thing for the seller would be to practice price discrimination: charge each buyer the maximum that buyer is willing to pay. However, this may be forbidden by law or otherwise difficult to implement.

Instead, the seller can pursue the following bundling strategy- charge slightly under 35 units above production cost for the combination of X and Y. Since both buyers value the combination at 35 units, this deal appeals to both buyers. This allows the seller to obtain the entire social surplus as producer surplus.

The seller can even make this a mixed bundling strategy – offer both X and Y individually for 20 units, and offer the combination for slightly less than 35 units.

Policy # 6. Peak Load Pricing:

It is a pricing practice where price varies with time of the day. When demand for a commodity or service varies at different periods of time, it has been generally suggested that higher price of a commodity or service be charged for the peak period when demand is greater and lower price be charged for off-peak period when demand is lower. This dual pricing, that is higher price for peak period and lower price for off-peak period is known as peak-load pricing.

It may be noted that peak-load pricing is suggested when not only the demand varies between peak and off-peak periods but also cost of production is different in the two time periods. In the peak period when capacity is strained marginal cost is higher as compared to the off-peak period. Thus, different prices of a commodity for two periods also reflect the different costs of production of the commodity in the two periods.

Various examples of peak load pricing can be given. In India charges for trunk or STD calls during day time which is the peak period is higher and charges for the off-peak period from 9 P.M. to 6 A.M. are lower. In many countries, electric companies are permitted to charge higher rates during the day time which is the peak period for the use of electricity and lower rates for the night which is off-peak period for the use of electricity. Similarly, airlines often follow peak-load pricing; in off season they often lower their rates as compared to the peak periods of travel.

Policy # 7. Internet Pricing Models:

The traditional pricing scheme of putting a postage stamp on every letter does not work with Internet.

The pricing models relevant in the context of the new economy in general and the Internet in particular are described as follows:

i. Flat-Rate Pricing:

The Internet user is required to pay a fee to ‘connect’ for a fixed period during which one is not charged on the basis of the ‘bits’ sent or received each time.

ii. Usage-Sensitive Pricing:

This model looks like a two-part tariff that utilities have—a part of the bill is for the connection and the other part is a price per unit of bit sent or received. We could have the peak user paying both parts and the off peak user paying only one part. The variable part could also be based on connection time, speed of connection, etc.

Pricing based on the number of minutes of connection is a popular basis of pricing and assumes that usage, in terms of packets sent and connection time are correlated, but they need not be. The only disadvantage of basing price on packets sent is that the cost of implementing such a system is very high.

iii. Transaction-Based Pricing:

This model is a variant of the usage-sensitive pricing. In this model, the pricing is ‘transaction’ based and not usage based. The advantage of this pricing model is its efficient administering. However, we cannot distinguish between different qualities of service (quality of service being gauged by band width).

iv. Priority Pricing:

In this model, the users pay according to the quality of service chosen by them. This comes close to the price-discrimination model of the old economy. Another variant of this is the increasing block tariff used in electricity pricing, wherein the user pays a fixed amount for the first block of units, a higher amount for the next block, and so on.

v. Charging on the Basis of Social Cost:

This is similar in principle to the rationale behind peak-load pricing. The users during the peak period pay for imposing a congestion cost on the network. This system of pricing, paradoxically, makes the congestion actually happen because it is in the interest of the ISPs to create shortage by reducing capacities, where ISPs are private parties, this congestion will be created in all likelihood.

vi. Precedence Model:

Under the precedence model, the existing users are protected by determining the priority of different applications. The criteria that determine the priority will be reflected in the precedence field of the different data packets. Network priority would be assigned to packets based on their precedence numbers.

When there is congestion, the sequence of sending the packets is decided by the priority assigned. This model was developed by Bohn (1994). Under this model, the role of the authority who sets the priority is critical.

vii. Smarty Market Mechanism Model:

Varian and Mackie-Mason (1995) proposed the smart market mechanism model, wherein there is a dynamic bidding system whereby the price changes by the minute depending on the degree of network congestion. Each user specifies the bit price on each packet and at the time of congestion, the highest bidder will get the top priority.

This model is a form of congestion pricing and is, therefore, subject to the abuse of the service, by the ISPs that can artificially create congestion. This necessitates the creation of an objective and powerful regulatory authority.

All pricing models require e-commerce to be pervasive on the Internet. Unless this happens, procedures of billing and settlement processes cannot be developed; without this, no pricing model can be implemented.