Lee on the Three Types of Mark-up Prices

A price that is set by a firm on the basis of average unit costs of production plus a profit mark-up is an “administered price.” These prices are also sometimes called “mark-up prices,” “average cost prices,” “full cost prices,” “normal cost prices,” or “cost-plus prices.”

However, these are all essentially the same type of price, but differences exist mainly in mere accounting conventions used to calculate them.

Lee clarifies these differences and identifies three fundamental types of such prices, as follows:

(1) standard mark-up pricing
This takes average direct/variable costs at actual or estimated output, and then adds to this a mark-up which covers both (1) average “shop expenses” and average “enterprise expenses” (overhead/fixed costs) and (2) an allowance for profit;

(2) normal cost pricing
This begins by calculating average direct/variable costs at a target or expected output level, and adds to this average “shop expenses” and average “enterprise expenses” (overhead/fixed costs). Finally, a mark-up for profit is added to this;

(3) target rate of return pricing
This is calculated by taking normal average total costs (including overhead/fixed costs) and marking this up by a certain percentage to achieve a specific rate of return or profit at projected sales in relation to the firm’s capital assets. (Lee 1998: 204–205).

Now, as has been noted, both “shop expenses” and “enterprise expenses” constitute overhead costs (Lee 1998: 201–202), so that for most businesses it is ultimately total average unit costs – including both (1) direct/variable costs and (2) overhead/fixed costs – that matter and are the basis of the mark-up price. Fundamentally, all involve a mark-up for profit over total average costs, and types (2) and (3) are the most prevalent (Lee 1998: 206).

Why does this matter? First, if you are doing a price setting survey and ask businesses if they set prices based on direct/variable costs, then many will no doubt answer “yes.” However, standard mark-up pricing firms, as in (1) above, are adding a mark-up to this that includes overhead/fixed costs and an allowance for profit. Therefore it is highly misleading and wrong to conclude that firms are generally only using direct/variable costs as their cost base.

For instance, in a recent study of price setting behaviour in the Eurozone, Gaspar et al. (2007: 238) report that about half of Eurozone firms set their prices as a mark-up over average variable costs, but they fail to understand that the mark-ups of many, and probably most, of these firms will include average overhead/fixed costs as well, so that it is total average unit costs that should be the fundamental cost base of interest to economists.

Secondly, while some administered prices can be based only on direct/variable costs, this practice appears to be far less important than the use of total average unit costs. For example, Govindarajan and Anthony (1986: 31) found that 85% of the US companies they surveyed used full cost pricing, and Shim and Sudit (1995: 37) conducted a survey in 1993 of US industrial companies, and found that 69.5% were using full cost pricing.

So, in contrast to conventional marginalist theory, most businesses certainly do take account of fixed/overhead costs. “Sunk costs” can be important in determining the administered price.

As I noted in the last post, the failure to understand these facts causes deep confusion, and the wrong idea that firms generally use average variable/direct unit costs only, and that they are therefore doing this as a good general proxy for marginal cost.

That is why dynamic stochastic general equilibrium (DSGE) models that assume prices are set as a markup over marginal costs are also mistaken, and almost wholly irrelevant models for real world pricing.

And, finally, it appears to be “now well established in the industrial economics literature that the average variable cost data … may be a poor proxy for the theoretical concept of marginal cost,” and it is not irrational for firms to use overhead/fixed costs in calculating price.

All in all, the marginalist theory of prices has severe problems: it simply does not reflect reality.

Addendum
As noted in the comment below, Godley and Lavoie (2007: 263–276) have a good discussion of mark-up pricing, and they note that overhead/fixed costs are the important average unit cost basis (Godley and Lavoie 2007: 266–267, 272). They also argue that costing margins are generally set to include any increase in interest rate costs (Godley and Lavoie 2007: 265).

Godley, Wynne and Marc Lavoie. 2007. Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth. Palgrave Macmillan, New York, N.Y.

BIBLIOGRAPHY
Fabiani, Silvia, Suzanne Loupias, Claire, Monteiro Martins, Fernando Manuel and Roberto Sabbatini. 2007. Pricing Decisions in the Euro Area: How Firms set Prices and Why. Oxford University Press, New York.

Gaspar, Vítor, Levin, Andrew, Martins, Fernando and Frank Smets. 2007. “Policy Lessons and Directions for Ongoing Research,” in S. Fabiani, C. Suzanne Loupias, F. M. Monteiro Martins and Roberto Sabbatini (eds.), Pricing Decisions in the Euro Area: How Firms set Prices and Why. Oxford University Press, New York. 235–249.

Govindarajan, V. and R. Anthony. 1986. “How Firms use Cost Data in Price Decisions,” Management Accounting 65: 30–34.

Lee, Frederic S. 1998. Post Keynesian Price Theory. Cambridge University Press, Cambridge and New York.

Pittman, Russell. 2009. “Who Are You Calling Irrational? Marginal Costs, Variable Costs, and the Pricing Practices of Firms,” Economic Analysis Group Discussion Paper 09-3
http://www.justice.gov/atr/public/eag/248394.htm

Shim, Eunsup, and Ephraim Sudit. 1995. “How Manufacturers Price Products,” Management Accounting 76.8: 37–39.