Pricing | ICSE Class 10 Commercial Studies Notes

This note covers the meaning and objectives of pricing in marketing: what price is, why pricing matters, the objectives a firm pursues through its pricing decisions, and how price objectives differ in the short run and the long run.

What is price and why does pricing matter?

When a product is bought, some money is paid for it. This money represents the sum of values that consumers exchange for the benefit of having or using the product, and it is called the price of the product.

Money paid for services works the same way: the fare for a transport service, the premium for an insurance policy, and the fee to a doctor for medical advice all represent the price of those services.

Definition: price. Price is the amount of money paid by a buyer (or received by a seller) in consideration of the purchase of a product or a service.

The law uses the same idea. Under the Sale of Goods Act, 1930, price means the money consideration for a sale of goods. Goods exchanged for other goods, as in barter, therefore have no price in this legal sense.

Pricing occupies an important place in the marketing of goods and services by a firm. No product can be launched without a price tag or at least some guidelines for pricing.

Pricing is often used as a regulator of the demand of a product: generally, if the price of a product is increased, its demand comes down, and vice-versa.

Pricing is also considered to be an effective competitive weapon. Where many firms sell similar products, they compete with each other mainly on price.

It is also the single most important factor affecting the revenue and profits of a firm. For these reasons, most marketing firms give high importance to the fixation of price for their products and services.

Price is one of the four elements of the marketing mix, the others being product, place and promotion. The price element of the mix covers the price level, margins, the pricing policy, pricing strategies and price change.

What are the objectives of pricing?

Pricing objectives are an important factor affecting the fixation of the price of a product or a service. Generally the objective is stated to be profit maximisation. But there is a difference between maximising profit in the short run and in the long run.

If the firm decides to maximise profits in the short run, it would tend to charge the maximum price for its products.

But if it is to maximise its total profit in the long run, it would opt for a lower per unit price so that it can capture a larger share of the market and earn greater profits through increased sales.

Apart from profit maximisation, the pricing objectives of a firm may include the following:

1. Obtaining market share leadership: if a firm's objective is to obtain a larger share of the market, it will keep the price of its products at lower levels so that a greater number of people are attracted to purchase the products.
2. Surviving in a competitive market: if a firm is facing difficulties in surviving in the market because of intense competition or the introduction of a more efficient substitute by a competitor, it may resort to discounting its products or running a promotion campaign to liquidate its stock.
3. Attaining product quality leadership: in this case, normally higher prices are charged to cover high quality and the high cost of research and development.
4. Earning a target return: the firm sets a price that is expected to earn a planned rate of return, say 15 per cent a year, on the capital invested in the business.
5. Keeping prices stable: the firm aims at a steady price over a long period, so that buyers and dealers can plan and price wars are avoided.
6. Meeting or preventing competition: the firm sets its price at the level of its rivals to meet competition, or keeps it low enough to discourage new firms from entering the market.

Thus, the price of a firm's products and services is affected by the pricing objective of the firm. The same product may carry a low price when the aim is market share and a high price when the aim is a quality image.

How do short-run and long-run profit objectives differ?

The choice between short-run and long-run profit maximisation is the clearest illustration of how a pricing objective shapes price. A firm that wants the largest profit this year will push the price as high as the buyer will bear.

A firm that wants the largest total profit over many years will hold the price down, sell more units, and earn its profit on volume.

This is why the pricing objective must be settled before the price is fixed. The objective decides whether the firm is aiming at a high margin on a few units or a small margin on many units.

It also decides how the firm will react when a competitor cuts prices: a firm aiming at market share leadership may match the cut, while a firm aiming at quality leadership may hold its price and defend its quality instead.

The pricing objective also links pricing to the other elements of the marketing mix. A firm that wants to be seen as a quality leader must spend on quality and on research and development, and its higher price is what covers that spending.

A firm that wants market share leadership must keep its price low, and it must therefore keep its costs low enough to earn a profit at that price.

Worked example 1. A firm can sell a pen at ₹50 or at ₹40. The cost of each pen is ₹30 at either price. At ₹50 it expects to sell 10,000 pens a year; at ₹40 it expects to sell 25,000 pens a year. Which price should a firm aiming at long-run profit and market share choose?

Answer: Profit at ₹50 = (₹50 − ₹30) × 10,000 = ₹2,00,000. Profit at ₹40 = (₹40 − ₹30) × 25,000 = ₹2,50,000. The lower price earns ₹50,000 more and wins more buyers, so the firm should choose ₹40. A firm that wanted only a high margin on each unit would choose ₹50.

What factors affect the price of a product?

A number of factors affect the fixation of the price of a product. The important ones are set out below.

Product cost

One of the most important factors affecting the price of a product or service is its cost. This includes the cost of producing, distributing and selling the product.

The cost sets the minimum level, or the floor price, at which the product may be sold.

Generally all marketing firms strive to cover all their costs, at least in the long run, and in addition aim at earning a margin of profit over and above the costs.

In certain circumstances, for example at the time of introducing a new product or while entering a new market, products may be sold at a price which does not cover all the costs.

But in the long run, a firm cannot survive unless at least all its costs are covered.

There are broadly three types of costs. Fixed costs are those costs which do not vary with the level of activity of a firm, say with the volume of production or sale; the rent of a building or the salary of a sales manager remains the same whether 1000 units or 10 units are produced in a week.

Variable costs are those costs which vary in direct proportion with the level of activity, such as the cost of raw material, labour and power.

Semi-variable costs are those costs which vary with the level of activity but not in direct proportion with it; the compensation of a sales person may include a fixed salary of, say, ₹10,000 plus a commission of 5 per cent on sales.

Total costs are the sum total of the fixed, variable and semi-variable costs for the specific level of activity.

Worked example 2. A salesperson is paid a fixed salary of ₹10,000 a month plus a commission of 5 per cent on sales. Work out the pay when monthly sales are ₹2,00,000 and when they are ₹4,00,000, and decide which type of cost this pay is.

Answer: At sales of ₹2,00,000, pay = ₹10,000 + 5 per cent of ₹2,00,000 = ₹10,000 + ₹10,000 = ₹20,000. At sales of ₹4,00,000, pay = ₹10,000 + ₹20,000 = ₹30,000. Sales doubled but pay rose only by half, so the firm should classify this pay as a semi-variable cost.

The utility and demand

While product costs set the lower limit of the price, the utility provided by the product and the intensity of demand of the buyer set the upper limit of price which a buyer would be prepared to pay.

The price must reflect the interest of both parties to the transaction, the buyer and the seller.

The buyer may be ready to pay up to the point where the utility from the product is at least equal to the sacrifice made in terms of the price paid.

The seller, however, would try to at least cover the costs. According to the law of demand, consumers usually purchase more units at a low price than at a high price.

Extent of competition in the market

Between the lower limit and the upper limit, where the price settles down is affected by the nature and the degree of competition.

The price will tend to reach the upper limit where there is a lesser degree of competition, while under conditions of free competition the price will tend to be set at the lowest level.

Competitors' prices and their anticipated reactions must be considered before fixing the price of a product. Not only the price but the quality and the features of the competitive products must be examined carefully before fixing the price.

Government and legal regulations

In order to protect the interest of the public against unfair practices in the field of price fixing, the government can intervene and regulate the price of commodities.

The government can declare a product an essential product and regulate its price. For example, the cost of a drug manufactured by a company having a monopoly in its production may come to ₹20 per strip of ten, and the buyer may be prepared to pay any amount for it, say ₹200.

In the absence of any competitor, the seller may be tempted to extort the maximum amount of ₹200 for the drug.

Usually in such a case the government does not allow the firm to charge such a high price and intervenes to regulate the price of the drug, by declaring the drug an essential commodity and regulating its price.

In India this is done under the Essential Commodities Act, 1955. The Drugs (Prices Control) Order, 2013, issued under that Act, lets the National Pharmaceutical Pricing Authority (NPPA) fix ceiling prices for the medicines in the National List of Essential Medicines.

Other laws also bear on price. Under the Legal Metrology Act, 2009, every pre-packed product must show its Maximum Retail Price (MRP), inclusive of all taxes, and no seller may charge more than the MRP. The tax inside the MRP, the GST, is levied under the Central Goods and Services Tax Act, 2017 and the matching state laws.

The Consumer Protection Act, 2019 treats a misleading claim about price, such as a false sale price, as an unfair trade practice. It also lets a consumer complain against a seller who charges more than the price fixed by law or displayed on the pack.

Worked example 3. A firm is the only maker of a drug. The cost of a strip of ten tablets is ₹20, and patients would pay up to ₹200. Suppose the government fixes a ceiling price of ₹35 a strip. Work out the firm's margin per strip with and without the ceiling, and recommend the price it should charge.

Answer: Without the ceiling, margin = ₹200 − ₹20 = ₹180 a strip. With the ceiling, margin = ₹35 − ₹20 = ₹15 a strip. The firm should charge no more than ₹35: at that price it still covers its cost and earns ₹15 a strip, while a higher price would break the price control order.

Pricing objectives

As explained above, the pricing objective of the firm affects the price it sets: profit maximisation in the short run or the long run, market share leadership, survival in a competitive market, product quality leadership, a target return, stable prices, or meeting competition.

Marketing methods used

The price fixation process is also affected by other elements of marketing such as the distribution system, the quality of salesmen employed, the quality and amount of advertising, sales promotion efforts, the type of packaging, product differentiation, credit facility and customer services provided.

For example, if a company provides free home delivery, it has some flexibility in fixing prices. Similarly, uniqueness of any of these elements gives the company a competitive freedom in fixing the prices of its products.

How do costs set the floor and demand set the ceiling of price?

Price has to sit between two limits. The lower limit is set by cost: a firm cannot survive in the long run unless at least all its costs are covered.

The upper limit is set by the utility the buyer expects and the intensity of the buyer's demand.

Within these two limits, competition decides where the price actually settles. Where competition is weak, the price tends to move towards the upper limit. Where competition is free and intense, the price tends to be set at the lowest level.

This is why the same product can carry very different prices in different markets.

The floor is found by spreading the fixed costs over the units the firm expects to sell and adding the variable cost of each unit.

Cost per unit = Variable cost per unit + Fixed costs ÷ Number of units

Worked example 4. A firm making school bags has fixed costs of ₹2,00,000 a month and a variable cost of ₹150 a bag. It expects to sell 4,000 bags a month and wants a profit of 25 per cent on cost. Find the floor price and the price it should charge.

Answer: Cost per unit = ₹150 + ₹2,00,000 ÷ 4,000 = ₹150 + ₹50 = ₹200, which is the floor price. Profit = 25 per cent of ₹200 = ₹50, so the firm should charge ₹250 a bag, provided buyers value the bag at least that much and rivals' prices allow it.

Why is pricing called a competitive weapon?

Price is the marketing tool that rivals notice first and can answer fastest. That is why pricing is called an effective competitive weapon.

Because price is so visible and so easy to change, it is the first tool a firm reaches for when a rival brings out a cheaper or better product.

A well-known Indian example is the entry of Reliance Jio into mobile telephony in September 2016. It offered free voice calls and very cheap data, and within about three years it had become India's largest mobile operator by number of subscribers. Rival operators had to cut their own data prices sharply. This was a low price used for the objective of market share leadership.

Price also carries a message about quality, so a firm that wants to be seen as a quality leader usually defends its higher price instead of matching every cut.

Cutting the price too far can therefore damage the image the firm has built, even while it wins sales.

The weapon also has legal limits. Under the Competition Act, 2002, rival firms may not agree among themselves to fix prices, and a dominant firm may not charge predatory prices, set below cost to drive rivals out of the market. The Competition Commission of India enforces these rules.

How is price related to the other elements of the marketing mix?

Price is one of the four Ps of the marketing mix, the others being product, place and promotion. The success of a market offer depends on how well these ingredients are mixed to create superior value for customers and at the same time achieve the firm's sale and profit objectives.

Price is tied to product because the features, quality, packaging, labelling and branding of a product all cost money, and the price must recover that money.

It is tied to place because the distribution system, the dealers used and services such as free home delivery all add to cost and also give the firm flexibility in fixing prices.

It is tied to promotion because the quality and amount of advertising and sales promotion affect both the cost of the product and the demand for it.

The price decision is therefore never taken in isolation; it is taken along with the other three elements of the mix.

What decisions does a firm take about price?

Price is the amount of money customers have to pay to obtain the product. In the case of most products, the level of price affects the level of their demand.

The marketers have not only to decide about the objectives of price setting but to analyse the factors determining the price and fix a price for the firm's products.

The decisions a firm takes about price can be grouped as follows:

1. Setting the pricing objectives, that is, deciding whether the aim is short-run profit, long-run profit, market share leadership, survival or quality leadership.
2. Analysing the factors determining the price, namely cost, utility and demand, competition, government regulation, pricing objectives and the marketing methods used.
3. Determining the pricing strategies, that is, the approach the firm will follow in setting the price.
4. Determining the price itself, that is, fixing the amount the customer will pay.
5. Deciding on discounts to customers, traders and credit terms, so that customers perceive the price to be in line with the value of the product.
6. Changing the prices when costs, demand or competition change.

These decisions are taken together, because a change in one affects the others. A decision to give a larger discount to traders, for example, changes the price the customer finally pays and the margin the firm keeps.

How does price regulate demand?

Because demand responds to price, a firm can use price to manage demand. According to the law of demand, consumers usually purchase more units at a low price than at a high price.

This relationship gives the firm a simple lever. If demand is more than the firm can handle, it can raise the price and bring demand down. If demand is weak, it can lower the price and attract more buyers.

Indian Railways has used flexi fares on some premium trains such as the Rajdhani and Shatabdi expresses, under which the fare rises as more berths are sold. The price itself then rations the seats that are in heavy demand.

The strength of the response to a price change is not the same for every product.

For some products, buyers are willing to spend a lot of time and effort on the purchase and remain loyal to a brand; for such speciality products, even if the price is increased, demand falls only a little, because it is relatively inelastic.

For ordinary products bought frequently, a rise in price usually reduces demand.

What is the difference between price and the other marketing decisions?

Price differs from the other marketing decisions in one clear way: it is the only element of the marketing mix that brings money in.

Product, place and promotion all involve spending; price is what recovers that spending and earns the profit. This is why price is the single most important factor affecting the revenue and profits of a firm.

Price is also the easiest element to change. A new product design or a new distribution network takes time to build, but a price can be changed overnight. That speed is what makes price an effective competitive weapon, and it is also what makes a careless price change dangerous.

The table below sets out the main pricing decisions alongside the other elements of the marketing mix.

What are the advantages and limitations of using price as a competitive tool?

Advantages

• Price is the single most important factor affecting the revenue and profits of a firm, so a correct price decision has the largest effect on profit.
• Price can be changed quickly, which makes it an effective competitive weapon when a rival brings out a cheaper or better product.
• Price regulates demand: raising it brings demand down and lowering it attracts more buyers.
• A low price helps a firm obtain market share leadership, because a greater number of people are attracted to purchase the product.
• A high price supports product quality leadership, because it covers high quality and the high cost of research and development.
• Discounts and credit terms can be adjusted so that customers perceive the price to be in line with the value of the product.

Limitations

• Cost sets a floor below which the firm cannot survive in the long run, so price cannot be cut without limit.
• Buyer utility and the intensity of demand set a ceiling above which the buyer will not go.
• Under conditions of free competition the price tends to be set at the lowest level, leaving little room for margin.
• The government can declare a product an essential commodity and regulate its price, so the firm may not be free to charge what the market would bear.
• Competitors' prices and their anticipated reactions must be considered before fixing a price, which limits the firm's freedom.
• A price that is too low can damage the quality image the firm has built, even while it wins sales.

Glossary

• Price: the amount of money paid by a buyer, or received by a seller, in consideration of the purchase of a product or a service.
• Pricing: the process of setting the price of a product or service, covering objectives, strategies, the price itself and price changes.
• Pricing objective: the aim a firm pursues through its price, such as profit, market share, survival or quality leadership.
• Floor price: the minimum level at which a product may be sold, set by the cost of producing, distributing and selling it.
• Fixed cost: a cost that does not vary with the level of activity of a firm, such as rent of a building.
• Variable cost: a cost that varies in direct proportion with the level of activity, such as the cost of raw material.
• Semi-variable cost: a cost that varies with the level of activity but not in direct proportion with it.
• Total cost: the sum total of the fixed, variable and semi-variable costs for a specific level of activity.
• Utility: the satisfaction a buyer expects from a product, which sets the upper limit of the price the buyer will pay.
• Law of demand: the rule that consumers usually purchase more units at a low price than at a high price.
• Market share leadership: a pricing objective in which the firm keeps prices low to attract a greater number of buyers.
• Essential commodity: a product which the government declares essential and whose price it therefore regulates.
• Marketing mix: the combination of product, price, place and promotion used to create superior value for customers.

Common errors and misconceptions

• Misconception: Price is the same as cost. Correct: Cost is what the firm spends to produce, distribute and sell the product; price is what the buyer pays. Cost sets the floor, price sits above it.
• Misconception: A firm should always charge the highest price it can get. Correct: A firm aiming at long-run profit charges a lower per unit price so that it captures a larger share of the market.
• Misconception: Price has nothing to do with demand. Correct: Pricing is often used as a regulator of demand; generally, if the price is increased, demand comes down.
• Misconception: Under free competition a firm can charge whatever it likes. Correct: Under conditions of free competition the price tends to be set at the lowest level.
• Misconception: The government never interferes in pricing. Correct: The government can declare a product an essential commodity and regulate its price.
• Misconception: All costs behave in the same way when output changes. Correct: Fixed costs do not vary with activity, variable costs vary in direct proportion, and semi-variable costs vary but not in direct proportion.
• Misconception: A higher price always means a higher profit. Correct: A higher price may reduce demand and sales, and so reduce total profit.

Exam-style questions with model answers

Q1. Define price. [2 marks]

1. Price is the amount of money paid by a buyer, or received by a seller, in consideration of the purchase of a product or a service. Money paid as transport fare, an insurance premium or a doctor's fee is also price.

Q2. State any two objectives of pricing other than profit maximisation. [2 marks]

1. Obtaining market share leadership, in which the firm keeps prices at lower levels so that a greater number of people are attracted to purchase the products.
2. Surviving in a competitive market, in which a firm facing intense competition or a more efficient substitute may resort to discounting its products or running a promotion campaign to liquidate its stock.

Q3. Explain how product cost sets the floor price of a product. [3 marks]

1. Product cost includes the cost of producing, distributing and selling the product, and it sets the minimum level at which the product may be sold.
2. Generally all marketing firms strive to cover all their costs, at least in the long run, and aim at earning a margin of profit over and above the costs.
3. In certain circumstances, such as introducing a new product or entering a new market, products may be sold at a price which does not cover all the costs, but in the long run a firm cannot survive unless at least all its costs are covered.

Q4. Distinguish between fixed costs and variable costs, with one example of each. [3 marks]

1. Fixed costs do not vary with the level of activity of a firm, say with the volume of production or sale; the rent of a building or the salary of a sales manager remains the same whether 1000 units or 10 units are produced in a week.
2. Variable costs vary in direct proportion with the level of activity; the costs of raw material, labour and power are directly related with the quantity of goods produced.
3. If the cost of wood for one chair is ₹100, the cost of wood for 10 chairs is ₹1,000, and there is no cost of wood if no chair is produced.

Q5. Explain how the extent of competition and government regulation affect the price of a product. [4 marks]

1. Between the lower limit set by cost and the upper limit set by utility and demand, the price settles according to the nature and degree of competition.
2. The price tends to reach the upper limit where there is a lesser degree of competition, while under conditions of free competition the price tends to be set at the lowest level. Competitors' prices and their anticipated reactions must be considered before fixing a price.
3. The government can intervene to protect the public against unfair practices in price fixing, and can declare a product an essential commodity and regulate its price.
4. For example, if a drug costs ₹20 per strip of ten and the buyer is prepared to pay ₹200, a monopolist seller may be tempted to extort ₹200; the government then usually intervenes and regulates the price of the drug.

Q6. Explain the difference between maximising profit in the short run and in the long run, and state two other pricing objectives a firm may have. [5 marks]

1. If a firm decides to maximise profits in the short run, it would tend to charge the maximum price for its products.
2. If it is to maximise its total profit in the long run, it would opt for a lower per unit price so that it can capture a larger share of the market and earn greater profits through increased sales.
3. One other objective is obtaining market share leadership: the firm keeps the price of its products at lower levels so that a greater number of people are attracted to purchase the products.
4. A second other objective is attaining product quality leadership: normally higher prices are charged to cover high quality and the high cost of research and development.
5. A third is surviving in a competitive market: a firm facing intense competition or a more efficient substitute may resort to discounting its products or running a promotion campaign to liquidate its stock.

Q7. "Pricing is considered to be an effective competitive weapon." Explain this statement, and state how price regulates demand. [5 marks]

1. Where many firms sell similar products, they compete with each other mainly on price, which makes it an effective competitive weapon.
2. Price is also the single most important factor affecting the revenue and profits of a firm, so most marketing firms give high importance to fixing the price of their products and services.
3. A firm facing the introduction of a more efficient substitute by a competitor may resort to discounting its products or running a promotion campaign to liquidate its stock.
4. Pricing is often used as a regulator of the demand of a product: generally, if the price of a product is increased, its demand comes down, and vice-versa.
5. According to the law of demand, consumers usually purchase more units at a low price than at a high price, so a firm can raise or lower demand by adjusting its price.

Key takeaways

• Price is the amount of money paid by a buyer or received by a seller in consideration of the purchase of a product or service.
• No product can be launched without a price tag or at least some guidelines for pricing.
• Pricing objectives include short-run and long-run profit, market share leadership, survival and quality leadership.
• Cost sets the floor price; utility and the intensity of demand set the upper limit of price.
• Between the two limits, competition decides where the price settles, with free competition pushing it to the lowest level.
• The government can declare a product an essential commodity and regulate its price.
• Pricing regulates demand: generally a higher price brings demand down and a lower price raises it.
• Price is the single most important factor affecting the revenue and profits of a firm.

Test yourself

What is meant by the floor price?

The floor price is the minimum level at which a product may be sold. It is set by the cost of producing, distributing and selling the product, and a firm cannot survive in the long run unless at least all its costs are covered.

Give one example of a semi-variable cost.

The compensation of a sales person may include a fixed salary of, say, ₹10,000 plus a commission of 5 per cent on sales. With an increase in the volume of sales the total compensation increases, but not in direct proportion.

What sets the upper limit of the price a buyer will pay?

The utility provided by the product and the intensity of the buyer's demand set the upper limit. The buyer may be ready to pay up to the point where the utility from the product is at least equal to the sacrifice made in terms of the price paid.

Why does a firm aiming at long-run profit charge a lower price?

A lower per unit price lets the firm capture a larger share of the market and earn greater profits through increased sales, which gives a larger total profit in the long run than a high price on a few units.

Name the four elements of the marketing mix.

The four elements, popularly known as the four Ps of marketing, are product, price, place and promotion. Price is the element that covers the price level, margins, pricing policy, pricing strategies and price change.

How can the government control the price of a drug sold by a monopolist?

The government can declare the drug an essential commodity and regulate its price, so that a firm with a monopoly is not able to extort the maximum amount the buyer is prepared to pay.

State two marketing methods that give a firm flexibility in fixing prices.

Providing free home delivery gives a firm some flexibility in fixing prices. Similarly, uniqueness in elements such as packaging, product differentiation or customer services gives the company a competitive freedom in fixing prices.