Full-Cost or Mark-up Pricing and Sales Maximisation Models

• After discussing theoretical models of price and output determination under oligopoly and duopoly based on the assumption of profit maximisation, attention shifts to two models that are claimed to reflect actual pricing practices followed by firms in the real world.

• The first model is Mark-up Pricing, jointly developed by Hall and Hitch of Oxford University, and is also known as Cost-plus Pricing or Full-cost Pricing.

• Hall and Hitch argue that firms in practice do not determine price and output through marginal analysis, that is, they do not fix price where marginal cost (MC) equals marginal revenue (MR).

• According to the Mark-up Pricing approach, firms determine price by adding a margin (mark-up)—generally expressed as a percentage of average variable cost (AVC)—to the average variable cost of production.

• The second model, proposed by Baumol, is also presented as being based on the actual behaviour of firms in real-world markets.

• Baumol rejects the assumption that firms primarily seek profit maximisation and argues that firms aim at sales maximisation.

• By sales maximisation, Baumol means the maximisation of total revenue (TR) earned by a firm from selling its output, where sales revenue equals quantity sold multiplied by price (TR = Q × P).

• According to Baumol, firms determine the price of their products on the basis of the sales-maximising level of output and revenue, rather than on the basis of profit-maximising conditions.

Full-Cost or Mark-Up Pricing

• Mark-up pricing theory (also called full-cost pricing, cost-plus pricing, or average-cost pricing) emerged as an important alternative to the marginalist explanation of profit maximization based on marginal revenue (MR) and marginal cost (MC). It does not assume that firms are rational profit maximizers; instead, prices are fixed by adding a mark-up to average cost at an expected or normal capacity level of output.

• Hall and Hitch of Oxford University strongly criticized marginal analysis and the profit-maximization assumption. They argued that actual business behaviour does not conform to the conventional rule of equating MR = MC for determining price and output, and that economic theory ignores an important pattern of entrepreneurial behaviour observed in practice.

• Their conclusions were based on an empirical study of 38 entrepreneurs:

  • 33 manufacturers,

  • 3 retailers,

  • 2 builders.

  • Interviews revealed that firms generally do not calculate prices through marginal analysis and do not consciously maximize profits in the conventional sense.

• According to Hall and Hitch, firms seek satisfactory, normal, or conventional profits rather than maximum profits. Prices are therefore determined on a full-cost basis, consisting of:

  • Average variable (direct) cost.

  • Average overhead cost.

  • Normal/satisfactory profit margin.

• Both average direct cost and average overhead cost are calculated with reference to:

  • Expected output during a period, or

  • A conventional/normal level of output.

  • Price is then fixed by adding a profit margin to this calculated full cost.

• The theory predicts that when the average cost of producing normal output rises significantly—for example due to:

  • A new wage agreement with labour unions, or

  • A sharp increase in raw-material prices,

  • Firms will raise prices accordingly because full-cost pricing is cost-based.

• In contrast, changes in demand are expected to cause mainly changes in output rather than changes in price, since prices are tied to costs rather than to demand fluctuations.

• Entrepreneurs offered several reasons for adopting full-cost pricing:

  • Charging prices substantially above average cost and earning abnormal profits could attract actual or potential competitors, who would erode those profits.

  • Businessmen generally lacked knowledge of marginal revenue and marginal cost concepts.

  • Reliable data on MC and MR were usually unavailable, making marginalist pricing impractical.

  • Full-cost pricing was therefore viewed as a more workable and realistic method.

• Hall and Hitch further argued that entrepreneurs are guided by a moral principle that there exists a price that ought to be charged, namely the full-cost price including normal profit. They regard this as the fair or proper price irrespective of business conditions.

• Because of this moral conviction, firms tend to maintain the same pricing principle during both:

  • Booms, and

  • Depressions,

  • leading to relatively infrequent price changes and a preference for price stability.

• According to Hall and Hitch, full-cost pricing arises from a combination of:

  • Tacit or open collusion among firms.

  • Consideration of long-run demand and cost conditions.

  • Firms’ moral conviction regarding the proper price.

  • Uncertainty about the consequences of increasing or decreasing prices.

• A potential implication of mark-up pricing is that when the average cost curve declines over a wide range of output, price should vary inversely with output:

  • Lower output → higher average cost → higher price.

  • Higher output → lower average cost → lower price.

• Hall and Hitch argued that oligopolists generally do not respond by producing small outputs and charging higher prices because:

  • They prefer price stability.

  • The kinked demand curve prevents profitable price increases.

  • They have a strong tendency to keep production high and maintain plant utilization; in their words, firms desire to “keep plant running as full as possible,” creating a general inclination toward price concessions rather than higher prices.