Theories of Pricing | Suitability | Merits | Limitations

Theories of Pricing

The pricing of a product of the public sector enterprise is a controversial issue, because different authors have put forth a variety of theories and principles of pricing. Besides, it is not also possible to lay down a uniform policy suitable to all public undertakings. This is because, the nature of goods or services they produce or provide, and the production function, their size and the market situation are not uniform.

Moreover, no statutes governing public enterprises have laid down clearcut guidelines for the determination of product pricing. No ideal price policy suitable to the public sector is so far evolved. The above are the basic issues in public sector pricing. An understanding would make some of these issues more clear.

Scholars for public sector pricing have put various theories forth. Of them, the following are very important.

  1. Marginal Cost Pricing.
  2. Average Cost Pricing.
  3. No-profit and No-loss pricing.
  4. Profit making pricing.
  5. Discriminatory pricing.

1. Marginal Cost Pricing

Marginal Cost Pricing
Marginal Cost Pricing – Suitability, Limitations

Marginal cost pricing refers to the methods of setting prices in which price is made equal to the marginal cost of production. Professor Herald Hotalling first advocated the marginal cost pricing for the public sector.

According to Hotalling, even public utilities, which are running at a loss and financed by lump sum payments of the Government should adopt the marginal cost pricing to increase the total economic welfare of the community.

Suitability of Marginal Cost Pricing

There are three situations in which marginal cost pricing may be applied. They are:

1. Decreasing cost industries – when production is subject to the law of decreasing costs and if marginal cost pricing is adopted, the total revenue will be less than the total cost. In spite of this, public utilities should follow this Price policy, as social returns are more significant than the monetary returns. But this situation involves permanent subsidization from the public exchequer.

2. Within the given capacities, which are likely to be fully commissioned within a short period.

3. Under conditions of excess capacity, which cannot be equaled by demand over a foreseeable period.

The first situation is not common in all countries. Even the public utilities like railways and the electricity board do not follow this method of pricing. However, the other two situations are quite common.

For example, In India, many enterprises are under utilized such as the Heavy Electrical, Heavy Engineering Corporation, Neyveli Lignite Corporation.

Limitations of Marginal Cost Pricing

Marginal cost pricing method is subject to a number of limitations. They are:

1. The marginal cost cannot be accurately measured. There are several difficulties in measuring the marginal costs, which make the measurement of cost arbitrary especially where an industry produces a number of items.

2. Marginal cost implies optimum utilization of output, which cannot always be achieved. Marginal cost would be high at points when capacity is exhausted. Therefore, for additional production, new plants should be set up and costs incurred for this purpose shall be abnormally high.

3. When production is subject to law of decreasing costs, and the marginal cost pricing is adopted, the total revenue created will be less than the total cost. It will result in a loss and this deficit should be made good by drawing the Government funds further. This would finally result in additional taxation.

4. In India, especially at early stages of industrial development, the marginal cost in the short run period is bound to be different from the long run cost. The difference that may occur in future cannot be estimated precisely.

5. Even in cases where production is subject to law of increasing returns, this policy shall not work. This is because in such case, the total revenue shall be more than the total cost. It implies a higher price and attracts adverse public criticism. Besides, the surplus earned by such units shall also give rise to a demand for higher wages and bonus.

6. If the price were equal to the marginal cost, fluctuations in demand and supply would lead to frequent fluctuations in the prices, which are always undesirable.

Thus, marginal cost principle cannot be followed without creating difficulties, troubles and problems on all round.

2. Average Cost Pricing

Average Cost Pricing
Average Cost Pricing – Merits, Limitations

Average cost pricing refers to the method of setting prices in which price is equal to the average cost of production. Under Average cost pricing, the total revenue will be equal to the total cost. Average cost pricing, thus, ensures the absorption of full cost of production plus a reasonable profit into the price.

Merits of Average Cost Pricing

The average cost pricing is more valid as a price theory for developing the economy like India. Prof. Thiemeyer considers this policy as fair and just due to the following reasons.

1. The public undertakings are expected primarily to meet the public needs that are to provide an optimum volume of supplies cheaply without seeking any profit.

2. Every buyer pays the entire cost of the unit or units consumed by him instead of paying only the additional cost of producing these units.

3. Since nobody is required to pay more for the goods they purchase than the amount actually costs to produce these goods, there is no exploitation.

4. The average cost is a reliable criterion for investment decisions.

5. The average cost principle ensures that the entire expenditure of the undertaking is covered and thereby secures the viability and autonomy of the enterprise. Public units, which are in deficit, shall attract the attention of the parliament. Consequently, ministerial control shall become excessive which will finally affect the autonomy of the enterprises.

Limitations of Average Cost Pricing

Average Cost Pricing theory is also criticized on various grounds. Some of them are as follows.

1. Under conditions of decreasing costs, the average cost will be more than the marginal cost price. The price will also be higher and the demand will be low. The higher prices would affect the interest of the consumers.

2. It is also difficult to allocate costs on the basis of inputs. Hence, the average costs as calculated will not be real.

Thus, average cost pricing is not a practicable theory.

3. No-profit and No-loss Pricing

No-Profit and No-Loss Pricing
No-Profit and No-Loss Pricing – Merits, Suitability

As the name indicates, the no-profit and no-loss theory holds that the price should be fixed in such a way that there would be neither any profit nor any loss. In other words, price should cover all the costs of production.

The average cost price usually includes the normal profit also. But the no-profit and no-loss price does not provide for normal profit. It is argued by the advocates of this policy that the public undertakings established for public good should recover only the cost of production in full including the cost of the capital employed but should not aim at profit making.

Merits of No-profit and No-loss Price Policy

1. Unlike the marginal cost price, this pricing policy shall not involve payment of subsidy to the public units to recoup its deficiency. To that extent, further taxation is avoided.

2. Consumers are given a fair deal, as they bear nothing more than the actual cost of their consumption.

3. It will also prevent over-expansion or under-expansion of the industries concerned and will avoid the inflationary or deflationary tendencies.

Suitability of No-profit and No-loss Price Policy

Traditionally, it was thought that this method of pricing was one of the important ways by which the public undertakings were distinguished from private enterprise. But those days have gone. It seems to be fairly well settled today that investments in public sector should prove profitable working.

This theory may hold good for public utilities in advanced countries. Even in countries like India, it can be adopted only in the earlier stages of working of some public enterprises. But it should not be the permanent policy of the undertakings.

4. Profit Making Pricing

Profit Making Pricing
Profit Making Pricing

It is already stated that the Government is firm on the issue that public undertakings should raise revenue for the state. Various study groups and the parliamentary committees urged the need for producing profit.

In India, where they are committed to the socialistic pattern of society and the public enterprise is a part of the whole Governmental frame work, its profitability must be considered along with several other factors making for the general welfare of the society as a whole.

Maximization of profit in a private enterprise means that the price should be equal to the marginal cost of production. Such a situation can be applied to a public enterprise only if the overhead costs are completely met by the taxation and hence do not enter into pricing. Moreover, maximization of profit implies maximization of output and maximum utilization of output, which can be rarely achieved.

5. Discriminatory Pricing Policy

Discriminatory Pricing
Discriminatory Pricing – Limitations

Another policy often suggested is to charge discriminatory prices for goods. This should be based on a classification of the consumer goods, and capital goods or on a classification of the consumers or users. Since the policy of the Government in a developing economy should be to encourage investments and to discourage consumption, a policy of discriminating prices can be applied to achieve these results.

For instance, coal, mineral oil and electricity are all industrial as well as consumption goods. If the prices were so arranged as to charge less for production purposes and more for consumption purposes, the Government’s policy would become effective.

Prices may be discriminatory as between customers; those who are able to pay more have to pay a higher price for the same commodity. This is followed in the Railways. This has proved to be a useful method for earning surpluses for the public undertakings, which can be reinvested for the further developmental activities of the Government.

Limitations of Discriminatory Price Policy

1. Distinction between capital goods and consumer goods (as the basis of a price theory) may lead to confusion and undesirable situations.

2. The Indian Public Sector has not yet entered in a sufficiently large way into the production of consumer goods even though this is desirable and over due. Therefore, for the time being, there is not enough scope to earn a surplus by charging a higher price to the consumer goods.