How do firms set prices?

By John Dudovskiy

This article critically evaluates the notion of firm and transaction costs and explores how do firms set prices. The article starts with setting context for discussions and this is followed by critical evaluation of firms from the perspective of transaction costs. Moreover, the article contains critical analysis of price setting practices of firms by referring to set of relevant studies and theoretical frameworks.


How do firms set prices?

Although the range of issues discussed in this paper are not new and they have been previously addressed by many economists in varying levels of depth, importance of firms, evaluation of transaction costs approach and the nature of price-setting strategies engaged by firms may be greater than ever before.

In other words, recent global economic crisis of 2007 – 2009 has revealed significant shortcomings of liberal market economy at multiple levels, and from this perspective reassessment of the core notion of firms, relevance of transaction costs and price setting practices of modern businesses may provide valuable data in terms of developing macroeconomic policies to minimise chances of economic crises in the future.

The most popular price setting techniques include market level pricing, competition pricing, variable and fixed mark-up pricing, pricing set by government regulatory agency, and customer-set pricing (Anderton, 2008). Each of these price setting techniques has its own advantages and disadvantages and selection of any particular technique depends on a wide range of factors such as the nature of products and services, intensity of competition, customer purchasing power etc.

Additionally, pricing strategies can be divided into new-product pricing, differential pricing, psychological pricing, product-line pricing and promotional pricing categories (Pride et al, 2010: 386). The choice of a pricing strategy according to this particular categorisation depends on the business strategy of the company. For example, the level of effectiveness of the use of psychological pricing strategy by Tesco, one of the major supermarket chains in the UK is increased by the brand’s slogan ‘Every Little Helps’. This slogan is formulated to affect consumer behaviour in psychological level by associating shopping at Tesco with the sense of being cost-effective and sensible.

Pricing techniques discussed above are broad categories and these techniques can be further divided a wide range of sub-categories such as negotiated pricing, odd-number pricing, captive pricing, special-event pricing, reference pricing and others (Pride et al., 2010).

Each of these techniques is associated with unique advantages and disadvantages and these need to be studied in a comprehensive manner before selection of any particular technique by firms. For example, odd-number pricing involves price formulation with the use of odd-numbers a little below the whole amount such as can of drink being offered for GBP 0.99 and intended to impact on consumer behaviour on a psychological level. A high level of effectiveness of this particular pricing technique has been confirmed by a study conducted by Ingenbleek and Lans (2013).

A survey conducted by Bank of England in 1995 revealed that type of pricing strategies employed by businesses in the UK in relation to their main product varied throughout the year. For example, market level pricing was used by 39 per cent of businesses participating in the survey during the first quarter of the year; however, this number has declined to 12 per cent by the end of the third quarter.

Moreover, the study mentioned above shed a light into the factors that caused price fluctuations. Major factors causing price increases were found to include rising costs of materials, changes in price levels offered by competition, increase of demand, increases of interest rates, gaining more market share, and attempts to address decline in productivity.

Main factors causing prices to decline, on the other hand, were found to include reduction of material costs, reaction to cost-cutting initiatives by competitors, decline of demand, reduction of interest rates, and enhancement of productivity.

At the same time, it has to be acknowledged that this particular study was conducted almost two decades ago and relevance of its findings in relation to modern markets may be compromised to a certain extent taking into account dramatic changes in global economy since that time such as increased role of globalisation and increased impact of information technology and internet in various aspects of life.

According to findings of another study conducted by The Bank of England that is based on the responses of 693 business entities in the UK, manufacturing and hotels and restaurants are industries with the highest frequency of price changes and almost 45 per cent of businesses in these industries were found to change their prices annually (Greenslade and Parker, 2008).

As it is illustrated in Figure 1, about 42 per cent of UK firms do conduct price reviews in regular intervals, while around 15 per cent of businesses do engage in price reviews in response to specific events.

Such events may include but not limited to price changes introduced by competitors, major technological breakthroughs in the industry, changes in government rules and regulations related to the industry and a wide range of other political, economical, social, technological and other factors.

Around 45 per cent of firms reported engaging in price reviews in regular intervals, as well as, when addressing implications of specific events as discussed above.

How do firms set prices

Figure 1 How Companies in the UK Review their Price

Adapted from Greenslade and Parker (2008)

Moreover, findings of the same study indicate that constant mark-up pricing is assessed as ‘very important’ by 25 per cent of business entities in the UK, whereas 33 per cent of businesses participating in the survey were found to be engaged in variable mark-up pricing. At the same time, reported focusing on competitors’ prices when engaging in price setting activities.

Comparison of findings of surveys conducted in1995 and 2008 by Bank of England mentioned above leads to interesting observations. Specifically, the role of cost of labour as the trigger to increase prices has increased during the last two decades, whereas actual decline of demand emerged as the most significant reason behind price reductions in the UK during the same period of time.

Moreover, price-setting practices of firms can be explained in a greater level of depth with the use of The Structure Conduct Performance Paradigm. The model focuses on inferring performance of a firm using a set of market structure indicators. For example, application of The Structure Conduct Performance Paradigm to a service industry identifies specific variables under market structure as number of sellers, and buyers, product differentiation, entry barriers, cost structure, vertical integration and diversification (Lei, 2006).

At the same time, market conditions interact with other variables under basic conditions, conduct, performance, and public policy. It is important for the nature of these interactions to be taken into account when engaging in price setting practices.

It has to be mentioned that The Structure Conduct Performance Paradigm has been criticised for neglecting a set of important issues such as impact of mergers on firm’s size and distribution practices, formation of entry barriers through advertising, and the use of predatory pricing strategy in order to force competition out of the business (Lei, 2006:)

 Porter’s Five Forces is a strategic model that specifies individual forces that jointly determine the level of intensity of competition in a given industry. These forces are threat of new entrants, bargaining power of buyers, bargaining power of suppliers, threat of substitute products or services and rivalry among existing firms (Figure 2).

How do firms set prices

Figure 2 Porter’s Five Forces

Adapted from Porter (1980)

The level of competitiveness of an industry determined by Porter’s Five Forces affects price-setting practices for businesses within the industry in a direct manner. Importantly, each individual factor within the framework of Porter’s Five Forces effects prices in the industry and the prices are also affected by overall competitive environment in the industry resulted from interaction of these forces.

When analysing the frequency of price change in the US economy in in-depth manner in a secondary study Nakamura and Steinsson (2008) find highly seasonal nature of the frequency of price changes. Specifically, Nakamura and Steinsson (2008) find that prices tend to be the highest in the first quarter of the year and then tend to decline in consequent quarters. Possible explanation for this tendency may relate to attempt by business management to increase the volume of annual sales, and thus decrease prices for products and services towards the later periods of the year.

Intensifying levels of global competition has increased the levels popularity of competition-based pricing for a wide range of industries. For example, competition-based pricing strategy is extensively used by McDonald’s, the largest global fast-food chain. Specifically, in the global marketplace McDonald’s competes with other fast-food chains such as KFC, Subway, Pizza Hut, Burger King and others, as well as, many local fast food outlets. Accordingly, competition-based pricing strategy is exercised by McDonald’s in a way that the company closely monitors price levels of its major direct competitors in order to avoid major price disparities.

Concluding thoughts on how do firms set price

Major geo-political events, increasing levels of competition, globalisation and interaction of a number of other related factors are increasing the levels of complexity of various branches of economics, both theoretically and practically.

As a result, various branches of managerial economics such as new product development decision-making, pricing strategies, supply-chain management, risk management and others need to be studied in much greater levels of depth and new theoretical frameworks reflecting relevant aspects of present realities need to be developed.

This article has focused on the notion of firms from transaction cost perspective and analysed price setting practices of firms by referring to relevant studies, models and theoretical frameworks.

Transaction cost economics deals with the alignment between governance structure of firms and transactions. Accordingly, the level of appropriateness of firm’s governance structure plays greater role in transaction cost economics, whereas neo-classical economics is focused upon production capabilities of the firm.

As one of the critically important aspects of firm’s business practices pricing has indirect implications on the levels of national economy and the standard of life of people. Contrary to its appearance pricing aspect of businesses is not a straightforward issue and a wide range of factors need to be taken into account when developing and implementing firm’s pricing strategy. Currently, a wide range of price setting techniques used by firms are categorised under the groups of product-line pricing, new-product pricing, differential pricing, psychological pricing, promotional pricing and others and selection of a specific pricing method depends on firm’s business strategy, as well as, a set of other factors discussed throughout this report.

To summarise discussions it can be stated that the area of economics is highly dynamic and macroeconomic changes partially impacted by technological breakthroughs may result in emergence of new perspectives on current economic issues including pricing strategies.


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Category: Economics