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Chapter15 - MANAGERIAL ECONOMICS An Analysis of Business...

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1 MANAGERIAL ECONOMICS An Analysis of Business Issues Howard Davies and Pun-Lee Lam Published by FT Prentice Hall
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2 Chapter 15: Pricing in Practice Objectives: To identify the PRICING OBJECTIVES adopted by firms To describe COST- PLUS PRICING METHODS To explain the relationship between the evidence on COST- PLUS and the MC=MR model To briefly review other pricing issues: alternative pricing methods; transfer pricing, pricing for public enterprise
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3 Pricing Objectives The central objective of pricing is PROFIT MAXIMIZATION Companies may either express this in a different way, or have intermediate level objectives for pricing. Those intermediate level objectives may or may not be consistent with profit-max achieve a target rate of return : might be the maximum, might be a ‘satisficing objective, might be to deter entry target market share : might be the share which is consistent with profit- maximisation or it might be a managers’ target stabilize output - keep the factory running and the workers employed match the competition
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4 Pricing in Practice Most firms use some form of COST-PLUS practice to set prices CALCULATE average direct cost of production (labour and materials) ADD a margin for overheads ADD a margin for profit GIVES the price to charge FIRST RESEARCHED BY AN OXFORD TEAM IN 1938 AND REPORTED IN A FAMOUS STUDY BY HALL AND HITCH (1939) Sometimes just one margin added
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5 A Good Example of the Theory/Practice Relationship A simplistic interpretation of the Oxford findings is that the economic model of pricing is incorrect it is clear from the evidence that managers do not describe their pricing practices in marginalist terms, in terms of MC=MR or in terms of elasticity and MC some analysts (including the original researchers and many accountants) have concluded that the MC=MR model is therefore incorrect
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6 A Good Example of the Theory/Practice Relationship However, the conclusion that the evidence on cost-plus pricing invalidates the profit-maxing model is a misunderstanding of the relationship between models and practice. This is very important for general understanding and can be approached in a number of ways First the profit-maxing model can be re-written in cost-plus form (P-MC) = 1 is the same as P = MC . (E d ) P E d (E d -1) If average variable cost is constant (which is often assumed in management accounting) then AVC = MC
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