Basic Marketing: A Global Managerial Approach

Perreault−McCarthy: Basic

Marketing: A

Global−Managerial

Approach, 14/e

18. Price Setting in the
    Business World

Text © The McGraw−Hill

Companies, 2002

522 Chapter 18

Exhibit 18-5 shows the three average cost curves from Exhibit 18-4. Notice

that average fixed cost goes down steadily as the quantity increases. Although the

average variable cost remains the same, average cost decreases continually too.

This is because average fixed cost is decreasing. With these relations in mind, let’s

reconsider the problem with average-cost pricing.

Average-cost pricing works well if the firm actually sells the quantity it used to

set the average-cost price. Losses may result, however, if actual sales are much lower

than expected. On the other hand, if sales are much higher than expected, then

profits may be very good. But this will only happen by luck—because the firm’s

demand is much larger than expected.

To use average-cost pricing, a marketing manager must make some estimate of

the quantity to be sold in the coming period. Without a quantity estimate, it isn’t

possible to compute average cost. But unless this quantity is related to price—

that is, unless the firm’s demand curve is considered—the marketing manager may

set a price that doesn’t even cover a firm’s total cost! You saw this happen in

Exhibit 18-3B, when the firm’s price of $2.00 resulted in demand for only 20,000

units and a loss of $6,000.

The demand curve is still important even if management doesn’t take time to

think about it. For example, Exhibit 18-6 shows the demand curve for the firm we’re

discussing. This demand curve shows whythe firm lost money when it tried to use

average-cost pricing. At the $2.00 price, quantity demanded is only 20,000. With

this demand curve and the costs in Exhibit 18-4, the firm will incur a loss whether

management sets the price at a high $3 or a low $1.20. At $3, the firm will sell

only 10,000 units for a total revenue of $30,000. But total cost will be $38,000—

for a loss of $8,000. At the $1.20 price, it will sell 60,000 units—at a loss of $6,000.

However, the curve suggests that at a price of $1.65 consumers will demand about

40,000 units, producing a profit of about $4,000.

In short, average-cost pricing is simple in theory but often fails in practice. In

stable situations, prices set by this method may yield profits but not necessarily max-

imum profits. And note that such cost-based prices may be higher than a price that

would be more profitable for the firm, as shown in Exhibit 18-6. When demand

conditions are changing, average-cost pricing is even more risky.

Exhibit 18-7 summarizes the relationships discussed above. Cost-oriented pricing

requires an estimate of the total number of units to be sold. That estimate deter-

mines the average fixed cost per unit and thus the average total cost. Then the firm

adds the desired profit per unit to the average total cost to get the cost-oriented sell-

ing price. How customers react to that price determines the actual quantity the firm

will be able to sell. But that quantity may not be the quantity used to compute the

Ignoring demand is the
major weakness of
average-cost pricing

Cost per unit Average cost

Average variable cost

Average fixed cost

Quantity (000)

0 2040 6080100

1.00

2.00

1.40

1.18

3.00

$4.00

Exhibit 18-5
Typical Shape of Cost
(per unit) Curves When
Average Variable Cost
per Unit Is Constant