Learning Objectives
By the end of this section, you will be able to:
- Explain the concepts of costing, depreciation, going concerns, and pricing
- Identify the basic pricing methods of full cost pricing and target rate of return pricing
- Calculate prices according to these methods
- Discuss the implications of planning, costing, and pricing for the existence of a supply curve
The empirical findings presented in the previous section suggest that our standard models of how firms behave and what determines prices are not appropriate for understanding today’s economies. Choosing the profit maximizing level of output does not appear to be relevant to firm behavior in the short run. Likewise, frequent price adjustments ‘in the market’ are not characteristic of most real-world markets, in which prices are clearly determined by producers and maintained over relatively long periods of time. All of this suggests that a deeper look into the actual nature of firms’ costs and the actual manner in which prices are determined is necessary. Fortunately, ample information about these processes is available, and it comes from the costing practices of accountants and the pricing practices of management.
Costing is the process of estimating the costs of production before production actually takes place–and, hence, before the actual costs of production are known with certainty. To do this, of course, it would be necessary to have some idea of how much output the business will be producing and the direct and indirect expenses that will be involved at that level of production. Making such calculations may involve a simple, educated guess or a sophisticated process of research, experiment, and forecast. What is important, from a theoretical standpoint, is that it is a fundamentally uncertain task which takes place before exchanges occur in the market. This view is consistent with what was suggested above, that firms plan their production processes before, a topic discussed further in chapter “The Megacorp.”
Depreciation and the Going Concern
A complete review of cost accounting isn’t necessary here, but one particular type of cost, depreciation, is of particular historical and conceptual significance. Depreciation is a way of accounting for the expense of an asset–say, a machine press–over the life of the asset. For instance, suppose your machine shop purchases a press (a machine that does exactly what it sounds like it does) for $20,000. If you expect that the press will be in use for the next 10 years you might account for a depreciation expense of $2,000 per year for the next decade.
To understand the significance of depreciation, consider how businesses usually calculated income before the late 1800s. Before then, business enterprise was often treated as a terminal venture, having a clearly defined beginning and end date. Investors would pool money to start a business, purchase materials and capital (say, a ship and local goods to be traded abroad), and hire workers (the ship’s crew). At some predetermined date (perhaps when the ship returned to port) the business would be liquidated: its crew would be paid and any remaining assets would be sold off. The resulting profit to the investors would, in essence, simply be whatever money was leftover. In this approach, what was the relationship between the productive asset (the ship) and profit?
Profits were simply decreased by the cost of the ship, but increased by whatever price could be fetched by selling the ship at the end of the venture.
But, accountants in the late 1800s asked, is that an appropriate way to think of, say, a railroad company? Will a railroad lay thousands of miles of line, run trains across it for some predetermined number of years, and then pull up the line to be sold for scrap metal? Clearly not. Instead, fixed assets like a railroad’s line, or an airline’s planes, or a law firm’s office building are depreciated over the course of their useful life. Conceptually, this is simply the recognition of the role those assets play in allowing these businesses to generate an income into the foreseeable future. Most importantly, this accounting method reflects the fact that these businesses are not treated as terminal ventures. Rather, they, as nearly all businesses today, are considered going concerns: organizations which are expected to continue to exist into the foreseeable future.
Prices from Pricing
Similar to costing, pricing refers to procedures businesses use to determine, beforehand, the price at which they will sell their product once production is up and running and sales can be made. While modern pricing procedures can be complex and will vary widely across different businesses and industries, two basic methods should be understood: full cost pricing and target rate of return pricing. Both are instances of markup (or cost-plus) pricing: setting the price of a business enterprise’s product by adding some dollar amount over and above average costs of production.
Full cost pricing (sometimes called normal cost pricing) is the simpler of the two methods. It can be written as
[latex]P = (ATC)(1+r)[/latex]
Where:
P is the price at which the business plans to sell its product
ATC is the average total (or per-unit) cost determined in the costing process
r is the predetermined markup
Target rate of return pricing is similar, but a bit more complicated. Here the price is being set, not to achieve a particular percentage profit above costs, but to earn a desired return on the money invested into the business. The formula can be written as
[latex]P = ATC + \frac{ROI(IC)}{Q}[/latex]
Where:
ROI is desired return on invested capital
IC is invested capital–that is, money invested into producing the product
Q is the expected quantity of output sold
Calculating Prices
To illustrate both approaches, consider a business that invests $10 million into a plant designed to manufacture inexpensive steak knives. It expects that over some relevant period it will be able to produce and sell 2 million knives; and, at that level of production, its per-unit costs will be $1.80 per knife. The calculated prices using our two pricing procedures are given below (assuming that in the first case the desired markup is 10% (or 0.1), and in the second the desired return on invested capital is also 10%).
Full cost price: [latex]P = (1.80)(1+0.1) = \$1.98[/latex]
Target rate of return price: [latex]P = (1.80) + \frac{(0.1)(10,000,000)}{2,000,000} = \$2.30[/latex]
Notice also that, even though the markup and desired return on invested capital are both 0.1 (10%), the resulting markups and hence the prices are not the same. This is because, although both procedures are essentially marking the price up over costs, the treatment of the costs being marked up are different.
It is worth reflecting on the significance of these insights into cost accounting and markup pricing, as they represent important general concepts in heterodox economics which are usually neglected in standard neoclassical theory. First, they suggest that business enterprises are making decisions before anything is even produced, let alone ‘brought to market’. In particular, pricing practices (and the intended quantity of output and corresponding cost estimates on which pricing is based) are a component of the planning process which takes place within the business enterprise. Contrary to the axiom that firms cannot recover fixed costs in the short run and therefore should ignore them in making short run decisions, it is long run planning driving short run behavior that is most important for understanding what determines prices.
Second, to acknowledge costing and pricing as it actually occurs is to acknowledge that the future is fundamentally unknowable. While standard (neoclassical) models assume that firms know their production costs and, typically, also the amount they can sell and the resulting revenues they can expect to take in, actual firms face uncertainty in how their plans will work out. A particular implication of this reality: since firms set prices based on estimated average total costs at an expected level of output, a change in the actual quantity of production/sales is unlikely to affect the predetermined price. This suggests that price and quantity supplied are determined completely separately, which in turn means that there is no such thing as a supply curve.
The Illusory Supply Curve
Recall from the basics of the neoclassical market model that a supply schedule (and its corresponding supply curve) simply shows the relationship between how much a firm (or firms) would be willing to supply at various market prices. That is, supply simply refers to the functional relationship between quantity supplied and the market price, with the market price determining the quantity supplied. If, however, the two are determined separately then there’s no way around the implication: quantity supplied is not functionally related to the market price–that is, there is no supply curve.
The astute reader may have already realized the impossibility of supply curves under certain conditions from the failed hypotheses discussed earlier in this chapter. Referring back to chapter “Perfect Competition,” specifically the section titled “Marginal Cost and the Firm’s Supply Curve,” you’ll recall that a firm’s marginal cost curve (above minimum average variable cost) is its supply curve. (This is because quantity supplied is determined where MC = MR and, under competitive conditions, MR = P. Hence, quantity supplied is determined by P = MC.) Now, as was shown with the test of hypothesis 2 above, firms simply couldn’t determine their quantity supplied this way–at least not under competitive conditions and having the empirically typical average total cost curves. This, of course, means that the neoclassical theory of supply must be rejected for these cases.
This doesn’t mean that the basic ideas of supply–higher prices leading to higher output and vice versa, for instance–are completely absent in the real world. Some industries–particularly, those related to mining and agriculture–do in fact see diminishing returns. In these (albeit limited) parts of modern economies upward-sloping supply curves may be found. However, as our examination of the cost structures of actual firms suggested earlier in this chapter, this relegates what is considered the normal case in neoclassical economics to a special–and pretty rare–case.
Third and finally, a review of the evidence and history of actual businesses reveals an anachronism within the neoclassical theory of the firm. As you learned in chapter “Perfect Competition,” the firm chooses the most profitable line of business (and appropriate production technique) in the long run, and the profit maximizing quantity to produce in the short run. If, in the short run, the firm is making a loss it will choose to shut down (if its fixed cost losses would be lower than the losses on continuing production). In an abstract, but important way the business enterprise this theory is describing is a terminal venture. Yet, beyond the halls and offices of economics departments, firms are generally seen as going concerns. This is reflected, for instance, in the accounting practices discussed above, as well as in the relationships firms maintain with customers. Blinder et al. (1998, pp. 96-7) found that 85% of all sales in the economy are made to regular customers whom the business expects to sell to in the future. In manufacturing and wholesale trade that number is over 90%.
As will be explored in more depth in the chapter “The Megacorp,” the idea that businesses are organized and run as going concerns is a significant theoretical innovation over the standard neoclassical theory of the firm. For now, we only need to consider what it means for prices. The role of the price mechanism–the ‘invisible hand of the market’–in neoclassical economics cannot be overstated. It is the process by which self-interested people (consumers, workers, entrepreneurs, landlords, and all the rest) are brought together in exchange for their mutual benefit. It is the mechanism that allows economists to believe in a (potentially) optimal equilibrium state–in an individual market, and in a capitalist economy as a whole.
In contrast, what is being argued in this section is that prices–at least those prices not actually determined through an auction–are set by businesses themselves as part of their planning process. The reader may have noticed that in the markup pricing introduced above a glaring question was ignored: namely, what determines the markup? A succinct, if incomplete answer can now be given: if the firm is to be a going concern, the markup, as well as the procedures that determined costs, will reflect the needs of the firm to continue to do business into the foreseeable future. For most firms there will also be plans to grow. Hence, from this view, prices are not exchange-based, market clearing values at all. They are, rather, reproduction prices–allowing the firm to reproduce itself through time–and, typically, also growth prices–ensuring the firm brings in the earnings necessary to expand. To use a now-familiar term, the vast majority of the prices we see in actual capitalist economies today might best be called going concern prices.