How to consider marginal cost in determining price of commodities

Author: Iloka Benneth  Chiemelie
Published: 15t-October-2014

1.      Introduction

In the business setting, determining the price of commodities is very necessary because price does have an influence on the perception and purchase of goods. As past researches have noted, price can lead consumers to perceive goods to be of high quality but in the same sense, it can also lead to boycotts especially in cases where there are more affordable and reliable alternatives (Binkley and Bejnarowicz, 2003; Dolan, 1995; Mesak and Clelland, 1979; Monroe, 1973, 1992; Shapiro, 1968; Simon, 1989; Turley and Cabaniss, 1995; Vanhuele and Dre`ze, 2002). On that note, this paper seeks to explore pricing strategy in terms of how they influence profit.

2.      Does selling products at the highest price ensure maximization of profit?

For every business, the goal is to maximize profit through increased sales. It is virtually impossible to generate profit without sales because in the economic setting, production is only considered complete once the final goods have reached the final consumption – that is when consumption has already taken place. So how do businesses determine the price of their goods? This is a difficult question for all businesses. However, one thing that is certain is that selling goods at the highest prices doesn’t always guarantee maximum profit as a number of literatures have noted (Sheth et al., 1991; Ambler, 1997; Bhat and Reddy, 1998; Long and Schiffman, 2000).

In a very competitive market, selling goods at the maximum price will likely bring about decreased sales especially if competing brands are selling at lower price (Brown, 1971; Hirn, 1986; Kujala and Johnson, 1993; McGoldrick and Marks, 1987), or offering better value.

However, innovative or marketing brands can afford to sale goods at the highest price (such as Apple in computing, Rolls-Royce in cars, Chelsea FC in football, University of Liverpool in Education etc.) because they have proven to offer better value than their competitors and the market is willing to pay higher for such value. Although they can still maximize profit by doing so, it is important to understand that the main focus of any given business should be turnover in sales. For instance, while Apple can sale one laptop for $2,000 while Samsung is selling for $1,000, Apple will be considered to have taken the right decision only in cases where it generates higher revenue than Samsung. Apple might end up selling only 10 piece per day (or $20,000), while Samsung might sale 50 pieces per day (or $50,000) which implies that the Samsung brand is making higher profit at the end of the day. Thus, pricing should be based on expected turnover, not on maximizing cost of ownership for customers.

3.      How should marginal costs be considered when determining prices?

Marginal cost can be defined as the estimate of how economic cost could change if changes are experienced in the output (Ralph, 2000). It could be very confusing to describe a term with another term, thus it is necessary to understanding what economic cost is – and it is basically the value of the sacrificed alternative (opportunity cost), which is what should be done with an asset if the asset is not to be used for production (Ralph, 2000). Thus, marginal cost is the cost of not using an asset for production as a result of decrease in demand or cost of overusing an asset for production as a result of increased demand.

Considering marginal cost can be very difficult depending on whether the marginal cost is due to increased demand (which mean increased sales) or decreased demand (which means deceased sales). Marginal cost refers to the first derivative, but in actual practice, it is as a result of indivisibility in the size of plants that forces businesses to be focused on the per unit change in cost that will result due to substantial change in future output, and not on a one unit change (Ralph, 2000). Thus considering marginal cost in determining price should reflect on demand in terms of forecasted change.

For instance, if a company produces 1,000 units per month of a given product X, and it is forecasted that demand will increase to 1,500 units of the same product, the company can decide to increase price of X slightly in order to maximize sales because increase in demand implies overall value and perception of the brand. However, if demand is forecasted to decrease, the company should focus on maintaining or reducing price in order to persuade consumers to order more of product X - as such is the only way to remain competitive. Thus, marginal cost should be considered in determining price of a given product with respect to changes in the demand curve where the higher the demand, the higher the production cost and the higher the price should be and vice versa.

4.      Conclusion

From the above analysis, it has been demonstrated that production cost have huge influence on actual price of a given product. However, one thing is certain and that is that the purpose of any brand when it comes to determining the price of a given product should not be to increase in order to maximize profit, but instead to determine price based on market factors such as demand, competitors price, and overall value of the product.

5.      References

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