setting prices

Pricing is vital to business decision-making in markets and price decisions are also important to the government when it wants to control the rate of inflation.

Price setting power

Not all firms have the ability to set their own market price. In perfectly competitive markets firms are said to be price takers. They control only a very small percentage of total market supply and produce an output identical to that of other sellers in the market. Each firm is assumed to be a price-taker. The ruling market price is determined by the interaction of market demand and supply.

Firms in imperfect competition can choose the price or output that they want - although they are constrained by the demand curve. 

Monopolists may choose to price at an output which maximises profits (see below) although a range of other objectives are possible.

Pricing rules

Profit maximisation: price and output where marginal revenue = marginal cost

Break-even pricing: price and output where average revenue = average total cost. At price P3, the firm in the diagram below is making normal profits only

Allocatively efficient pricing: where price  = marginal cost. Total economic welfare is maximised and no one can be made better off without making someone else at least as worse off.

Revenue maximisation: price and output where marginal revenue = zero (this is also the price where the elasticity of demand equals unity)

Price discrimination: when a firm charges different prices to different sub-groups of consumers for the same good and service for reasons related to the willingness of the consumer to pay for a particular product.