First of all, any business man or a firm or a company must know a few basic things:
What type of competition it has to face?
What will be the demand for the product?
For example, if the product is homogeneous by nature, say vegetables, there is a thick competition and the firm virtually has no market power in its hand. So, the firm must be a price taker (i.e. it has to accept the market determined price).
Again, if the product is differentiated one (may be a fancied one) in nature, say bath soap, it is a situation of non-price competition. In that case, the business itself has to decide its own pricing strategy, because it has to incur a lot on advertisement in order to create “BRAND LOYALITY “
Another big question may arise——how much to produce or supply? What will be the potential market share for the firm?
Perhaps the most urgent question is: what is price elasticity of demand of the potential market?
If the product is a homogeneous one—just fuck off this problem, but if the firm faces an imperfect competition from either side (i.e. from buyer’s side or from seller’s side), than price elasticity of demand for the market is a vital deciding factor, because the firm should adopt different tactics, in order to snatch consumer surplus, i.e. the firm will charge comparatively low price to an elastic market and higher price for an inelastic market.
Even though, we imagine for a free price mechanism, but it reality, what we find is a collusive one.
Sellers often decrease supply to create an artificial scarcity to make more profit (rather profiteering).
Today, business is much more complex in nature. Producer has to pay attention on social costs and psychic costs while deciding the pricing strategy.
Then, there is the question of Inflation; pricing strategies are completely different in different situations like DEMAND PULL INFLATION or COST PUSH INFLATION or a situation like STAGFLATION.
WHAT IS LAW OF DEMAND
In simple words, it states the relationship between price of the commodity and quantity demanded for the commodity.
Now, according to this law, other factors remain constant (the situation is known as, ceteris Paribus assumption), price and quantity demanded both are inversely related.
Demand for the product largely depends on the determinants of demand like, price of the product, price of the related products, income of the consumer, taste and preference pattern of the consumer etc. The real life problem is that, the determinants may influence individual demand or the market demand jointly. A parametric change (i.e. keeping Price of the product constant) may shift the market demand line/curve upward or downward.
Again, if the market competition is perfectly competitive in nature, a little increase in price will drop the market demand to zero. So, the producer or seller should be fully aware about the price elasticity of demand in the prevailing market.
Let me explain to you the relation between total revenue (TR), marginal revenue (MR) and price elasticity of demand.
WHAT IS LAW OF SUPPLY
In this case, price and quantity supplied are in a positive co-relationship, keeping other determinants remain constant i.e.citeris peribus).
There is a basic difference between ‘STOCKS’ and “SUPPLY’.
As far as STOCK is concern, its quantity remains fixed at a given period of time, whereas, SUPPLY means various quantities offered by the producer /seller at different prices within that given period of time.
The quantity supplied basically depends on its determinants like, price of the product, prices of the related products, prices of inputs, state of technology, goal of the producer etc. In a real life situation, they may jointly influence supply of a commodity.
A parametric change (keeping price of the commodity constant) like an increase in state of technology or a tax imposed on the commodity by the Government may shift the supply line/curve.
For a rare type of commodity (like classical paintings) price elasticity of supply will be perfectly inelastic. Again supply curve of labor may be backward bending.
MARKET MECHANISM AND MARKET FAILURE
Price/market mechanism is defined as the mechanism in which prices play the most important role in deciding the activity of the producers. It guides and coordinates the decisions of the producers and the buyers through a system of prices and markets. It has two major components: price and market.
It is the essence of market mechanism. Market mechanism works through prices in the private sector. Prices are determined by the market forces of demand and supply.
You see, market is a system or an institution, where buyers and sellers of a commodity or service are able to interact and communicate to each other to strike a deal.
In his book “An inquiry into the nature and causes of the wealth of nations” in 1776, economist Adam Smith made the most famous observation in all of economies: households and Firms interacting in markets act as if they are guided by an “INVISIBLE HAND OF THE GOD” that leads them to desirable market outcomes.
Prices reflect both the value of a commodity to society and the cost to society of making commodities. Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social benefits and costs of their actions. As a result, prices guide these individual decisions makers to reach outcomes that in many cases maximize the welfare of the society as a whole.
Producers or sellers must exactly know the price elasticity of demand and supply for their commodities in the market to survive.
Joseph Schumpeter’s view on innovation and entrepreneurship in relation to market is quite relevant. He said:
- Lunch a new product or a new species of already known product;
- Applications of new methods of production or sales of a product (not yet proven in the industry) ;
- Opening of a new market ( the market for which a branch of the industry was not yet represented );
- Acquiring of new sources of supply of raw-materials or semi-finished goods;
- New industry structure such as the creation or destruction of monopoly position.
Schumpeter argued that anyone seeking profits must be innovative. (Ref: Schumpeter’s view on innovation and entrepreneurship by Karol Siedzik).
Although markets are usually a good way to organize economic activity, this rule has some important exceptions. When the price mechanism fails to take into account all the costs and/ or benefits in providing and/ or consuming the commodities, the market will fail to supply the society optimal amount.
The competitive forces of supply and demand will not produce quantities of commodities where the prices reflect the marginal benefits (utility) of consumption—this in turn, leads to over/ under consumption of the commodities i.e. allocative inefficiency. So most markets are not efficient and as a result, the Government intervenes to some degree.
The possible reasons for market failure are:
- Externalities ( pollution for example);
- Market power (monopoly power/ collusive power).
A firm /seller is said to be in equilibrium when:
- When MR=MC ( exceptions are there, for example oligopoly market competition)
- In case of perfectly competitive market, movement of MC should be greater than MR, and in case of imperfect competition MC should cut MR from below etc.
MARK UP PRICING
You see, in a real life situation, it is very difficult for the producer to identify the MCor MR or the equality of MC or MR. So, what we find to determine the selling price is the mark-up pricing. Actually, mark- up pricing method is used to determine the selling price. It is a method of adding a certain percentage of a mark-up to the cost of production.
Thus, in order to apply this method, the firm/ seller must determine the cost of the product and has to decide the percentage of profit to be earned over and above it and then add that much mark-up in the cost.
Let’s site an example to understand the mark-up pricing policy.
Suppose, Adam is a furniture manufacturer. His cost of production and expected sales are given below:
Variable Cost per unit = $20
Fixed Cost = $400000
Sales (in units) = 250000
Therefore, per unit cost = 20 + 400000/25000 = $36
Now, Adam decided to add a 25% mark-up on sales.
Mark-up price = unit cost / 1 – desired return on sales.
Therefore, mark-up price = 36/ 1 – 0.25 = $48.
Hence, we may conclude, Adam must charge $48 to earn a profit of ($48 -$36) or $12.
However, mark-up pricing method also has some limitations, because this method overlooks the demand for the commodity, perceived demand price of the buyer, and the nature of market competition etc.