Pricing in practice in consumer markets

Abstract

This article offers a theory of pricing in consumer markets that relates cost-plus pricing and value-based pricing to price competition and price leadership, including, in particular, competitive price leadership as defined by Kenneth Boulding. It also argues that the basic question in Keynesian economics is why firms choose prices such that production is restricted by sales, not why prices, once chosen, can be “sticky.” And finally it shows that a firm’s labor demand depends on its sales at the price it sets and not on its “real wage.”

Keywords:

• Pricing
• cost-plus pricing
• value-based pricing
• price competition
• price leadership
• price stickiness
• labor demand

JEL classification :

• D43
• L13

How are prices set in practice? It is an empirical fact that cost-plus pricing is a common pricing procedure in a market economy.¹ It is also an empirical fact that value-based pricing exists for at least some products.² However, neither cost-plus pricing nor value-based pricing can explain the formation of a market price when there is price competition. But a special form of price leadership can, namely competitive price leadership as defined by Kenneth Boulding (1941), at least in markets where buyers take prices as given and prices are set by sellers, as in most consumer markets. I will argue that these pricing procedures are complements and not alternatives: They apply to different situations.

It is indeed true, as argued, for example, by Lavoie (2014, pp. 127–128), that “competition occurs mainly through non-pricing means,” like advertising, product differentiation, or innovation, taking the market price as given. But how is the market price determined? Of course, not all firms can take the market price as given, as in “perfect competition.” But all firms but one can, implying price leadership. But how will the price leader set the price? This issue is not addressed in Lavoie (2014) until on pp. 164–165, under the rubric of Complications:

At this stage of the discussion, we need to distinguish between the price leader, who sets prices, and the price-taker, who follows the lead of the price-leader. The price-leader may be the biggest firm of the industry (the dominant firm), the most innovative one, or firms may take turns. The price-leader may also be a ‘barometric’ firm, that is, a firm that is representative of the costs of the industry and is convenient for others to follow.

The section on market price, price competition, and price leadership makes these ideas precise by relating them to price leadership, as defined by Boulding (1941). When rereading the classical paper on pricing by Hall and Hitch (1939), I now also see that Kenneth Boulding, who graduated from Oxford University, must have based his approach on the findings of the Oxford Economists’ Research Group.

Assumptions

We assume that a firm’s marginal cost is constant up to a certain level of production—its capacity—where it becomes so strongly increasing that its potential output of goods or services can be approximated by its capacity even for high prices. A firm’s marginal-cost function is then characterized by two parameters: marginal cost (c) and capacity (k). This is probably not only a useful first approximation but also rather realistic.³

Wages and indirect costs normally change at most once a year, although the prices of raw materials and other intermediate goods may sometimes change at short notice. If such a change is large, a firm will adjust its output prices to the new input price. However, if changes are small, the firm may find “fine tuning” of its prices to current input prices unnecessary, particularly if input prices fluctuate with no trend. In such cases the firm may choose “normal costs” instead of actual costs as input in its pricing process, where “normal costs” are defined for other inputs than labor as an estimated average in the near future.

Moreover, in markets where buyers take prices as given, prices are set by firms before trade takes place. In markets where sales precede production (production to orders) firms only produce what they can sell at the prices they set.⁴ However, in many markets production precedes sales, especially in consumer markets. And then a firm has to anticipate its sales at the price it sets. In this case production will in general differ from sales and the difference will change the firm’s inventories. But we can often assume that such changes are negligible, so that production equals sales at prices set by firms even in markets with production before sales (production to stock), at least as a first approximation.

Cost-plus pricing

A firm set prices to cover costs and obtain some profits. To cover not only variable (direct) costs but also fixed (indirect) costs, a firm must set prices above marginal cost, which means that firms in practice always set prices as markups on marginal costs. More precisely, the cost-plus price p is determined by (1) $$p=c+\mathit{mc},$$(1) where c is marginal cost and the markup m is determined so that the firm can cover fixed costs f and obtain some “normal” profits ${\pi }_n$ for its estimated or normal sales $q_n,$ (2) $$p{q}_n\hspace{0.17em}-\hspace{0.17em}c{q}_n\hspace{0.17em}-\hspace{0.17em}f={\pi }_n.$$(2)

Cost-plus pricing also implies that indirect costs and normal profits are allocated to a firm’s products in proportion to their direct costs.

It follows from (1) and (2) that (3) $$m=\left(f/c{q}_n\right)+\left({\pi }_n/c{q}_n\right).$$(3)

Thus, the markup is obtained by summing two ratios, namely the ratio of indirect costs to direct costs for estimated sales, and the ratio of normal profits to direct costs for estimated sales. But while the first ratio is determined by fixed costs (and estimated sales), the second ratio defines a “normal rate of return on variable capital.” Assuming this to be $r_n,$ for example 10%, as for many firms examined by Hall and Hitch (1939, p. 19), normal profits will be determined by the “markup for profits” ($r_n$) and direct costs for normal sales, ${\pi }_n=r_{n}c{q}_n.$

Actual profitability is often measured by the profit margin, defined as profits $\pi$ divided by revenues pq, where q denotes actual sales. Note that (4) $$\pi =\left(p-c\right)q\hspace{0.17em}-\hspace{0.17em}f=\mathit{mcq}\hspace{0.17em}-\hspace{0.17em}f=\left(f+{\pi }_n\right)\left(q/q_n\right)-\hspace{0.17em}f=\left(q/q_n\right){\pi }_n+\left(q/q_n-1\right)f,$$(4) and hence that (5) $$\pi /\mathit{pq}=r_n/\left(1+m\right)+\left(q/q_n-1\right)\left(f/\mathit{pq}\right),$$(5) showing how the profit margin $\pi /\mathit{pq}$ depends on the markup for profits ($r_n$), the complete markup (m), but also, in general, actual sales and fixed costs (as measured by $q/q_n$ and $f/\mathit{pq}$). Actual profitability is also often measured by return on capital $\pi /K,$ where K is the firm’s capital; obviously this is proportional to the profit margin, $\pi /K=\left(\mathit{pq}/K\right)\left(\pi /\mathit{pq}\right).$ Of course, the return on capital is sensitive to the definition and measurement of capital as “equity capital” (including equity and retained profits) or “total capital” (also including debt).

Note that the markup m depends not only on “normal profits” but also on the relation between fixed costs and variable costs. Suppose, for example, that fixed costs increase less than variable costs when output increases between firms in an industry. Then a big firm will have a smaller markup than a small firm, other things equal. Note also that direct costs include the costs of intermediate goods and direct labor, whereas the costs of indirect labor (managers, supervisors, administrators, etc.) are included in indirect costs, together with costs for real capital like premises and machines.

Actual sales will be equal to estimated sales if $D\left(p\right)=q_n,$ where D is the firm’s demand function. This can happen if the firm’s customers are insensitive to its price (demand is inelastic) over a certain range.⁵ In this case actual profits will also be equal to normal profits. In general, suppose that $p^m$ maximizes profits and that ${\pi }^m=\left(p^m-c\right)D\left(p^m\right)\hspace{0.17em}-\hspace{0.17em}f.$ Then normal profits are attainable only if ${\pi }_n\le {\pi }^m$ and are obtained only if $p=c+\mathit{mc}$ is sufficiently close to $p^m.$ And if ${\pi }_n={\pi }^m$ normal profits can only be obtained if $c+\mathit{mc}=p^m.$

But what happens if a firm’s production is restricted by its capacity k and not its sales at its choice of markup? To begin with, a queue of customers will develop, making it tempting for the firm to set a price $p^k$ which clears the market, $D\left(p^k\right)=k.$ In practice, however, a firm may hesitate to raise its price if it expects queues to be only temporary, or if it fears that customers facing higher prices than first announced will turn to other firms. Moreover, a firm can avoid problems like these by adjusting its capacity to the variability of its sales. And it seems to be an empirical fact that firms plan some excess capacity in order to avoid losing or antagonizing customers.⁶

Sales may vary over the business cycle, and if a fall in sales is expected to last more than a year, then normal output in the denominator of Equation 3(3) $$m=\left(f/c{q}_n\right)+\left({\pi }_n/c{q}_n\right).$$(3) will also fall and the price will rise, whereas a rise in sales during an upturn will imply a lower price. Thus, a fall in demand implies rising prices, whereas an increase in demand implies falling prices, according to cost-plus pricing. One way of avoiding this anomaly is simply to postulate that price-setting firms keep “normal output” constant during a business cycle. Or, even if cost-plus pricing is a convenient rule of thumb, firms will sometimes find it rational to deviate from it, as also reported by Hall and Hitch (1939, p. 19), either by charging more in periods of “exceptionally high demand” or less in periods of “exceptionally depressed demand.”

Cost-plus pricing has been interpreted as “tacit collusion,”⁷ in spite of the fact that cost-plus prices are not necessarily profit-maximizing. Perhaps cost-plus pricing should be interpreted instead as tacit coordination, but only if firms have similar cost structures. If costs are so different that the corresponding price differentials cannot be sustained in a market, it remains to explain why and how prices are adjusted. Thus, cost-plus pricing cannot explain the formation of a market price in an industry unless all firms have similar costs.

Note finally that there are many variants of cost-plus pricing, as discussed by Lavoie (2014, pp. 157–162) and, in particular, by Lee (2006). Variants differ because of different systems of cost accounting, different definitions of normal profits, and different markup techniques. Cost accounting includes not only direct but also indirect costs, but exactly what to include as indirect costs may vary. And markups for indirect costs depend on the complexity of production and the sophistication of the accounting system.

If all costs for plant and equipment have already been paid for by equity, then these costs are sunk costs and may therefore be ignored by the firm, at least for some time. Perhaps the Kaleckian markup pricing (see e.g. Lavoie 2014, p. 157) can be interpreted in this way, but note that profit-maximizing prices are also independent of fixed costs, as we shall now see.

Monopoly pricing and value-based pricing

Cost-plus pricing can be dismissed as a “delusion” in modern management literature, leading to “overpricing in weak markets and underpricing in strong markets” (Nagle and Hogan 2006, p. 3). What is advocated instead is pricing based on “how products and services create value for customers” (Nagle and Hogan 2006, p. 27) or, in modern terminology, “value-based” pricing or, in other words, profit maximization. And it is easy to see that the profit-maximizing price ($p^m$) solves the equation (6) $$\frac{p\hspace{0.17em}-\hspace{0.17em}c}{p}=\frac{1}{\eta \left(p\right)}, \text{where }\eta \left(p\right)=-p{D}^{\prime }\left(p\right)/D\left(p\right)$$(6)

This equation is often used to guide modern price management in practice (see, e.g. Simon 1989 or Nagel and Hogan 2006). If, for example, the contribution margin $\left(p-c\right)/p$ is 50%, then this margin is also profit maximizing if changing price by 1% is estimated to change sales by 2%. Alternatively, and according to the kinked demand curve introduced by Hall and Hitch (1939, pp. 22–23), a firm can estimate the profit-maximizing price directly if it believes that demand is inelastic for prices below a certain ceiling$\widehat{p}$ but elastic for prices above $\widehat{p}.$ Note also that $d=\left(p-c\right)/p=\left(\mathit{pq}-\mathit{cq}\right)/\mathit{pq}$ is the share of gross profits in sales at p and hence the “degree of monopoly” as defined by Kalecki (see, e.g., Lavoie 2014, p. 158). And with $p=c+\mathit{mc}$ it is easy to see that $d=m/\left(1+m\right)$ or, equivalently, $m=d/\left(1-d\right).$ Of course, pricing according to Equation 6(6) $$\frac{p\hspace{0.17em}-\hspace{0.17em}c}{p}=\frac{1}{\eta \left(p\right)}, \text{where }\eta \left(p\right)=-p{D}^{\prime }\left(p\right)/D\left(p\right)$$(6) only applies to a monopoly (perhaps supported by a patent) or a small firm assuming that its price revisions will affect only its customers and not its competitors. Moreover, estimating product demand, and in particular the price elasticity of product demand, is a difficult problem, particularly for a firm with many products, as in retail. Yet a profit-seeking firm will sometimes exploit an inelastic demand for its products if it can, as the pricing of life-saving drugs sometimes vividly illustrates.

However, as long as profits are at least normal it may be rational for a firm to be satisfied with cost-plus pricing—if further information on demand is too costly. A lower price may appear too risky because the firm doesn’t know if demand is sufficiently elastic, and a higher price may also appear too risky because the firm doesn’t know if demand is inelastic.

In fact, if cost-plus prices—whose definition includes “normal profits”—also yield “normal profits,” then the distinction between cost-plus pricing and value-based pricing is immaterial. After all, it is making profit—not maximizing profit—which is the basic objective for a firm. The distinction matters, however, when cost-plus prices yield less than normal profits, for in this case a firm may be inclined to hope for and exploit an inelastic demand for its output to increase its profits. Attempting to increase profits is also what “profit maximization” means in practice, suggesting that “profit seeking” may be used instead to characterize a firm’s relation to profits in a world of uncertainty.

The distinction also matters if cost-plus pricing yields normal profits while a profit-maximizing price would yield excessive profits. In this case it can be argued that excessive profits in the short run, by attracting new firms to the industry or antagonizing customers, will encroach upon the firm’s profits in the long run. And then a firm may abstain from short-term profit maximization, assuming that the firm’s ultimate goal is to increase its profits over time, which is but a more general formulation of “profit maximization”.

Finally, if value-based prices differ so much between firms in a market that the corresponding price differentials cannot be sustained, it remains to explain why and how prices are adjusted. In other words, not even value-based pricing can always explain the formation of a market price.

Market price, price competition, and price leadership

Most markets are inhabited by more than one business enterprise. Consequently, co-ordination is required among the enterprises if destructive price competition is to be avoided and an acceptable, single market price established. Business enterprises have therefore utilized a range of private market institutions, such as cartels and price leadership arrangements, buttressed by an array of ancillary conventions, traditions, and restrictive trade agreements to establish an orderly market with a single market price. (Lee 2006, p. 297)

If costs differ so much between firms in an industry that the corresponding differences between cost-plus prices (or value-based prices) cannot be sustained, it remains to explain why and how prices are adjusted. Thus, cost-plus pricing cannot explain the formation of a market price in an industry unless all firms have similar costs. Of course, in markets with product differentiation some price differentials may persist, but deviations from a common price level cannot be large in equilibrium, after price adjustment (the law of one price), as noted, for example, by Lavoie (2014, p. 165): “in both competitive and oligopolistic surroundings, all firms will tend to set a similar price for a given product.”

Moreover, we cannot always exclude “price competition” in a market, even if “destructive” price competition can be excluded. It consequently remains to explain how a market price is established in markets with “more than one business enterprise” and, in particular, how price competition can arise and affect the adjustment process. And the key to a complete theory of pricing in practice is co-ordination by a “price leader.”

Price leadership means that all firms but one take the price as given or, more precisely, that one of the firms sets a price that the other firms match. And although setting the same price as another firm suggests collusion in markets with sealed bidding, it is both possible and legal in markets where firms are free to observe and revise their prices at any time, as in most consumer markets.

Collusive price leadership, maximizing an industry’s profits, presupposes a possibility for firms to jointly fix market prices or market shares. This is usually illegal, but because secret cartels are sometimes exposed we cannot exclude this market form, which is emphasized, for example, by Eichner (2008 [1976], p. 47). However, the formation of a market price in this case may introduce bargaining and hence indeterminacy. More importantly, collusive price leadership excludes the possibility of price competition. And to allow for price competition, I will here also consider markets where a competition authority can prevent binding agreements on market prices and market shares.

Now, firms accepting the validity of the law of one price, and operating in a market with a competition authority, will ask what market price (price level) they prefer, where a firm’s preferred market price is that market price that maximizes its individual profits. If all firms prefer the same market price, the choice of price leader among these is immaterial and may be expected to vary randomly or depend on which firm is assumed to have the best information on market conditions. A price leader may in this case also be called a barometric price leader, following Stigler (1947).

If firms prefer different market prices, because of differences in costs, capacities, or market shares, then the market price will be determined by a competitive price leader, that is, a firm preferring the lowest market price, an idea that goes back at least to Boulding (1941, pp. 607–613). And if there is only one firm preferring the lowest market price, it may be called a dominant price leader. Note that such a firm can implement its preferred market price simply by announcing it, while firms preferring a higher market price are forced to follow suit, at least if the price leader has excess capacity. In terms of price adjustment, the market price goes down if and only if a price cut appears profitable to a firm even if its competitors follow suit. Thus, even if competitive price leadership admits of price competition, it excludes price competition that reduces profits for every firm.

In a market with competitive price leadership the problem of a price taker is simple: It sets the same price as the price leader and produces what it can sell at this price or, if its production is not restricted by what it can sell, what it wants to sell. The problem of a price leader is partly the same as it is for a monopolist, that is, estimating the industry’s product demand and especially its price elasticity. In addition, however, a price leader has to estimate its market share at different market prices, including market prices above the market-clearing level (where demand equals total capacity). And then a firm with a large capacity will sometimes find that not only its market share but also its profits will increase as the market price decreases, particularly if there are many small firms, as elaborated in Farm (2017).

Note that a price taker in a market with competitive price leadership has a markup which is determined by the market price p set by the price leader and the price taker’s direct cost c, so that in this case $m=\left(p-c\right)/c,$ as also suggested by Hall and Hitch (1939, p. 19) and emphasized by Lee (2006, p. 208). The price leader, on the other hand, may stick to its cost-plus price, at least to begin with, until it is convinced that a lower market price will increase not only its market share but also its profits. Note also that the market clears endogenously if—and only if—a higher market price would reduce profits for at least one firm.⁸

Note finally that competitive price leadership includes, as a special case, “real competition” as defined and discussed by Shaikh (2016), based on the findings by the Oxford Economists’ Research Group.⁹ Shaikh saw competition as a form of warfare, where “a firm with lower unit costs can always drive out its competitors by cutting price to the point where their profit rates are lower than its own” (pp. 262–263). Competitive price leadership also implies that a price leader will focus on its individual profits, but it does not necessarily imply elimination of competitors. More precisely, a competitive price leader will cut its price as long as this increases its individual profits even if its competitors follow suit.

Of course, the price leader’s profits will increase even more if some of its competitors leave the market after a price cut, and this may also happen after a while if some competitors find their profits being reduced too much. This will also change the structure of the industry and it may even happen that the price leader finds it profitable to raise its price again.¹⁰ Thus, what may appear as price cutting, which reduces profits in the short run to increase profits in the long run, may in practice be a succession of moves which increases profits not only in the long run but also in the short run at every step towards the long-term goal.

Note, however, that collusive price leadership cannot always be excluded, as emphasized in the beginning of this section. It can probably be excluded in markets where a strong competition authority can prevent the fixing of market shares or prices. But what happens in a completely deregulated market, without an effective competition authority? This seems to me to be an open empirical question.

Stability

Firms revise their prices if – and only if – “market conditions” change. Note first that cost-plus prices depend on marginal cost and markup, where marginal cost depends on wages, costs of intermediate goods and Labor productivity, while markups depend on fixed costs, normal profits and expected sales. Thus, cost-plus prices will typically be revised when wages are revised, usually at most once a year, or when prices of important raw materials or other inputs change (unless compensated by changes in Labor productivity).

Minor changes of input prices do not necessarily cause adjustment, particularly not if they are expected to be temporary. Markups are revised only when the relation between fixed costs and variable costs changes (e.g. because of investment in real capital), or when requirements for profitability are revised, or when expected sales change. Changes of expected sales during the business cycle may be ignored by firms being afraid to loose profits in the future by antagonizing customers. And short-term fluctuations in sales during a year are, of course, not a reason for adjusting prices repeatedly.

“Price stickiness” is often thought to be a necessary prerequisite for Keynesian economics.¹¹ It is also obvious that cost-plus pricing, supplemented by price leadership, predicts sticky market prices, because wages, prices of other inputs, labor productivity, markups, and other market conditions (including market structure) do not change that often. The stability of prices in consumer markets and industrial markets are by now also well documented, for example in Blinder et al. (1998) and Fabiani et al. (2007).

Of course, “price stickiness” implies that prices move more slowly than prices in financial markets or commodity markets, suggesting that prices are not market-clearing. But if production is restricted by sales, then capacity (or supply) has no influence on market prices, although increasing demand will increase production and employment but not market prices. Thus, the basic question in Keynesian economics is why firms choose prices such that production is restricted by sales, not why prices, once chosen, can be “sticky.” And the answer offered in this paper is simply that it is profitable for firms to do so.

Labor demand

Firms set prices before trade can start in consumer markets, a fact with important consequences for labor demand. To see this, note first that (7) $$c=\left(\mathit{wN}+H\right)/q,$$(7) where w denotes the wage level in a firm, N its employment, H direct costs other than Labor costs, and q output. Hence we can write (8) $$c=\left(1+h\right)\mathit{wN}/q=\left(1+h\right)w/a,$$(8) where h is direct costs other than labor costs, measured as a share of labor costs ($h=H/\mathit{wN}$), and a is labor productivity ($a=q/N$).

It follows that, unless a firm’s output q and employment N are restricted by capacity k and labor productivity a (so that $q=k$ and $N=k/a$) at the price the firm sets, employment is determined by (9) $$N=D\left(p\right)/a,$$(9) where $D\left(p\right)$ is the demand for the firm’s output at the price p set by the firm, (10) $$p=\left(1+m\right)c=\left(1+m\right)\left(1+h\right)w/a,$$(10) where m is a markup on direct costs chosen by a firm in order to cover indirect (fixed) costs or maximize profits or adjust to price competition, as discussed in sections 3 – 5. Thus, unless restricted by capacity (and Labor productivity), a firm’s employment depends on its sales at the price it sets. It does not depend on the “real wage” $w/p,$ as in neoclassical models.

The intuition is as follows. The traditional motivation for the neoclassical model of labor demand is that a profit-maximizing firm increases employment until the value of the marginal product of labor is equal to the wage rate. However, in practice a firm does not chose employment but the price of its output before trade can start. And then it adjusts its production to its sales and its employment to its production. This applies to every firm, including not only a monopoly or a price leader but also a price-taking firm. Note, in particular, that a firm that takes the price as given only produces what it can sell at this price, unless, of course, its production is restricted by its capacity.

Conclusions

In a market where all firms have (approximately) the same cost-plus prices (or value-based prices), not only individual prices but also the market price (price level) will depend on the same factors. And if wages and input prices change for one firm, they will usually change in the same way for all other firms in the industry, and not only individual prices but also the market price (price level) will change in the same way, as if governed by an “invisible hand.”

But the “invisible hand” may sometimes be replaced by a “visible hand,” particularly during the innovation phase of an industry’s product cycle, when an industry often is dominated by a big firm acting as a price leader. In this case, the market price will be determined by the cost-plus price (or value-based price) of the dominant firm, which, however, may be modified if the dominant firm estimates that decreasing the market price will increase not only its market share (because of its excess capacity and the limited capacity of its competitors) but also its profits.

Additional information

Notes on contributors

Ante Farm

Ante Farm is Associate Professor of Economics emeritus at SOFI, Stockholm University, Sweden.

Notes

1 Cost-based pricing was first described by Hall and Hitch (1939), reporting results from a survey of industrial pricing. This paper introduced pricing based on both indirect and direct costs in the economics literature. See also Scherer (1980, p. 185), Okun (1981, p. 153), Simon (1989, p. 48), Lee (2006), Nagle and Hogan (2006, p. 2), and Lavoie (2014, pp. 156–175).

2 According to the management literature; see, for example, Simon (1989) and Nagle and Hogan (2006).

3 See, for example, Lavoie (2014, pp. 147–156).

4 According to Blinder et al. (1998, p. 104), on average, 46 percent of output is produced to order in the United States, whereas 54 percent is produced to stock.

5 Note also that firms that sell about 40 percent of gross domestic product in the United States believe that their demand is totally insensitive to price, according to Blinder et al. (1998, p. 99).

6 See, for example, Lavoie (2014, pp. 150–154).

7 See, for example, Stigler (1947, p. 433) and Simon (1989, p. 79).

8 Thus, I don’t exclude the possibility of market clearing even if the management literature on cost-plus pricing or value-based pricing implicitly assumes that a firm’s production always is restricted by sales (and not capacity) at the price it sets, suggesting that this is a stylized fact for most firms most of the time.

 9 In fact, Hall and Hitch (1939, p. 19) both observed and emphasized the relation between competition, price leadership, and the formation of a market price.

10 See Section 4 in Farm (2017) for technical details.

11 See, for example, Blinder et al. (1998). However, Melmies (2010, p. 455) argued that Keynesian results do not depend on price stickiness but on the absence of an auctioneer in markets where prices are set by firms, an approach I pursue here.

Appendix: Observing pricing in practice

How can price leadership be observed? It is sufficient to note that, when wages or other market conditions change in an industry, price adjustment is initiated by one of the industry’s firms and followed by the other firms in the market. If firms simultaneously announce new list prices, price leadership is also obvious if some firms adjust their prices to another firm’s price after the initial announcement.

But what if firms simultaneously announce new list prices and there is no adjustment at all? Because firms are free to adjust their prices if they want to, price differentials must be not only small (because of the law of one price) but also acceptable to every firm. This means that we can interpret the outcome “as if” the market price (price level) is determined by a barometric price leader when all firms prefer the same market price. But we can also interpret it as the outcome of cost-plus pricing or value-based pricing in a market where firms have similar costs and markups.

Asking trade associations about pricing

But how can we observe price leadership in an industry? By asking the industry’s trade association or by asking a sample of firms in the industry? Usually a trade association has a lot of basic information on its industry, including the number of firms and their market shares. If there is only one big firm in the industry, it may be easy to conclude that it also is a price leader. If there are several big firms it may be possible to ask if one of them is price leader. However, a direct question about price leadership presupposes (a) that the question is meaningful, and (b) that price leadership is legal.

A question on price leadership is not meaningful in industries where firms produce commodities sold in exchanges. Price leadership is not legal in industries with sealed bidding, as in construction. In markets where buyers take prices as given and prices are set by firms, however, it is not only possible but also legal for firms to set the same price as another firm. Emphasizing that price leadership only means that all firms but one matches the price level set by the leader, a direct question about price leadership is possible. Asking trade associations about price leadership should consequently be possible in consumer markets but perhaps also in some producer markets (business-to-business markets) dominated by a few big firms selling standardized producer goods at well-known list prices.

Moreover, it should be meaningful to ask all trade associations about the system of cost accounting used in the industry, including industries producing commodities and industries dominated by sealed bidding, particularly when a trade association is organizing courses in cost accounting for its member firms. For, even if pricing is not administered by sellers but by exchanges or sealed biding, all firms will relate prices to costs. For example, price offers in sealed bidding may be cost-plus prices or they may deviate from such prices for strategic reasons. Market-clearing prices in commodity markets will be evaluated by firms in relation to their costs: Prices must cover not only direct but also indirect costs and some profits, at least in the long run; otherwise the firm will leave the market.

Finally, if there is no price leader we can conclude that all firms are price makers in the sense that they independently set approximately the same prices (the same price level). In other words, when revising prices according to some principles, there is no need for price adjustment to establish a common price level, that is, a market price, in the industry. It should then be possible to ask a trade association about the principles used by their member firms when revising prices, particularly when the association organizes courses not only in cost accounting but also in pricing.

Asking firms about pricing

Can price leadership also be observed by asking (a sample of) individual firms? Note first that price-taking behavior does not imply “perfect competition” but price leadership. Thus, if, when asked about principles for revising prices, a firm answers that it “sets the same price as its competitors,” this is indirect proof of price leadership in the firm’s industry. Direct information from an industry’s price leader may be more difficult to obtain, particularly if the survey only includes a small random sample of the industry’s firms.

How can value-based pricing be identified? First, it can be excluded in some industries, like retail. Second, firms that have been identified as price-takers can be excluded. Third, a question about value-based pricing presupposes estimation of price elasticities and a firm can be expected do this only for one or a few of its main products. An interviewer may consequently ask if the firm applies value-based pricing to one or more of its main products or services. Note that pricing managers may be expected to know what value-based pricing is, at least in large companies, unless the management literature is completely out of touch with reality. We can also assume that all price setters in an industry know what cost-plus pricing is, particularly in an industry with detailed manuals on cost-plus pricing published by the industry’s trade association.

When asking about a firm’s pricing principles for a particular good or service, there are consequently only four possible answers, namely cost-plus pricing, value-based pricing, price-taking behavior, or price leadership. In an industry without price leadership (and price-taking behavior), variants of cost-plus pricing must be the rule with value-based pricing as a possible exception for one or a few important products or services.

Surveys on pricing

The main objective of the survey on pricing in the United States in 1990–1992 by Blinder et al., reported in detail in Blinder et al. (1998), was to “gather the opinions of real-world decision makers on the validity of economist’s theories of price stickiness” (Blinder et al. 1998, p. 107). But the survey also provides basic facts on pricing, for example that the great majority of sales are made not to consumers but to other businesses (p. 96); that expected inflation is irrelevant for individual pricing (p. 98); that marginal cost is constant (p. 102); that about 50 percent of output is produced to order (p. 104); that firms often believe that their customers are insensitive to price (p. 99); and that quantity rationing does not appear to be common (p. 95), although it is common to vary delivery lags (p. 286). The survey also contains information on price adjustment, including frequency of price changes, with a median of 1.4 times a year (p. 84) and mean lag to price adjustment after change in demand or cost of about 3 months (p. 86). Moreover, prices do not adjust more rapidly upward than downward (p. 87).

However, the main topic of the survey is “price stickiness,” which means that the survey is designed to answer questions like, “Why do nominal wages and prices react so slowly to business cycle developments? In short, why are wages and prices so ‘sticky’?” (p. 3). Or more precisely, “Why do not prices respond more vigorously (and hence real output respond less vigorously) to cyclical changes in demand?” (p. 114). Moreover, “When we say that wages or prices are ‘sticky,’ we generally mean that they move more slowly than would Walrasian market-clearing prices” (p. 4). Also, “if cost and demand shocks occur infrequently, then Walrasian prices would adjust infrequently too. We would not want to call that price rigidity.” (p.86).

Thus, Walrasian prices are obviously the benchmark against which “price rigidity” is evaluated. In other words, deviations from Walrasian prices are characterized as “stickiness,” suggesting that such deviations are something of a mystery (and probably only applicable in the short run). However, although deviations from Walrasian prices in markets for commodities or securities would indeed be mysterious, there is nothing mysterious about production being restricted by sales at prices set by firms. And realizing this, a survey on pricing should ask for other things than price stickiness and include, in particular, a question on whether a firm’s production is restricted by sales or capacity. In fact, information on the degree of capacity utilization in important industries is collected by statistical agencies in most countries.

There are no questions on price leadership in the survey by Blinder et al. in 1990–1992 for the United States or in the survey by the Inflation Persistence Network in 2003–2004 for the euro area, as reported in Fabiani et al. (2007). Price leadership is mentioned in Blinder et al. (1998, p. 32) as a possible solution to coordination problems but is immediately dismissed. Of course, questions on collusion are difficult in interviews, even when anonymity is guaranteed. But price leadership is not always collusive. There is also indirect evidence on price leadership in these surveys, because there is some information on price takers in them or, more precisely, information on firms that “set the same price as the competitors.” In this case firms set the same price as another firm and are consequently price takers, but because not all firms can be a price taker, the existence of price takers is an indirect proof of the existence of a price leader. Note, in particular, that price-taking behavior does not imply “perfect competition” but price leadership. Thus, if, when asked about principles for revising prices, a firm answers that it “sets the same price as its competitors,” this is indirect proof of price leadership, as noted in Fabiani et al. (2007, p. 39), and certainly not, as also suggested in Fabiani et al. (2007, p. 238), an indication of “perfect competition.”