Introduction
The full-cost pricing principle, also known as cost-plus pricing, is a method where firms set the selling price of a product by adding a specific markup to the total cost of production. It is a widely used pricing strategy in practice, especially among monopolistic and oligopolistic firms. However, this approach raises questions regarding production efficiency and market outcomes.
Understanding Full-Cost Pricing
Under this method, price is determined using the following formula:
Price = Average Total Cost (ATC) + Markup
Here, the markup covers profit expectations, overheads, and contingencies. Full-cost pricing assumes that firms cover all costs, including fixed and variable, and earn a reasonable return.
Features of Full-Cost Pricing
- Stability: Prices remain relatively stable, even if demand fluctuates.
- Simplicity: Easy to apply without needing complex market data.
- Predictability: Ensures cost recovery and consistent profitability.
Implications for Production Levels
One key critique of full-cost pricing is that it might not lead to optimum output. Let’s examine how:
1. Demand Ignorance
This method ignores consumer demand and elasticity. If the price is set too high, demand could fall below the optimal level, leading to underproduction.
2. Inefficiency
Firms may become complacent about controlling costs, knowing they can simply add a markup, resulting in inefficiency and higher-than-necessary prices.
3. Output Decisions
Optimal output occurs where marginal cost equals marginal revenue. Full-cost pricing bypasses this condition, potentially leading to either under or overproduction compared to socially optimal levels.
4. Monopolistic Behavior
Firms with market power may use full-cost pricing to justify prices that exceed competitive levels, leading to deadweight losses and inefficiencies.
Conclusion
While full-cost pricing is practical and widely used, it doesn’t ensure that firms produce at the socially or economically optimal output level. By focusing on costs rather than consumer demand and marginal analysis, it can lead to inefficient resource allocation and either under- or overproduction.