Average Cost Pricing Rule - Explained
What is the Average Cost Pricing Rule?
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Table of ContentsWhat is the Average Cost Pricing Rule?How does the Average Cost Pricing Rule Work? Average-Cost Pricing vs. Marginal-Cost PricingAcademics Research on Average Cost Pricing Rule
What is the Average Cost Pricing Rule?
The average cost pricing rule is a policy used by regulators to set prices of goods and services equal or close to the average cost of manufacturing the product. This pricing rule is sometimes used by the government or regulators to mandate a monopoly to charge prices equal to the average cost of production. When regulators impose price limits on certain businesses, it means such businesses will change the unit price of a product to match the average cost of producing it.
How does the Average Cost Pricing Rule Work?
The average cost pricing rule is a pricing strategy that helps regulators and governments impose a limit on what businesses can charge for their goods and services. This rule helps to maintain normal prices on goods and services without causing any shortfall to business owners. This pricing rule is otherwise referred to as sales maximization because it guarantees maximum sales of goods and services and also helps businesses maintain normal profits. The average cost pricing rule is mostly used in perfect competition, where companies can make normal profits. It is also a pricing strategy imposed on legal monopolies given that economies of scale can be attained. Companies that want to increase their market share without necessarily making maximum profits can also use the average cost pricing method. Many economists and studies have shown support for the implementation of average cost pricing strategies. This pricing strategy can be imposed on businesses, whether large, medium or small scale. When an average cost pricing rule is implemented, it means that businesses must set prices close to the marginal cost of products or the average cost of producing goods and services. The average cost pricing strategy is often used as a regulatory policy for legal monopolies and sometimes oligopoly. It is used in oligopoly only then the price set enhances sales maximization and the company is not at a loss. In this strategy, the price set for goods and services is equal or close to the average total cost of production. This pricing method guarantees normal profits for organizations and also increase sales margin.
Average-Cost Pricing vs. Marginal-Cost Pricing
When the price set for goods and services equals the marginal cost of producing the goods, a marginal cost pricing strategy is in place. Similar to an average cost pricing rule, a marginal cost pricing rule is also a regulatory policy imposed on business. The distinguishing factor between the two pricing strategies is that the average cost pricing guarantees a normal profit for businesses, especially natural monopolies, while the marginal cost pricing does not.
Academics Research on Average Cost Pricing Rule
- Average cost pricing versus serial cost sharing: an axiomatic comparison, Moulin, H., & Shenker, S. (1994). Average cost pricing versus serial cost sharing: an axiomatic comparison.Journal of Economic Theory,64(1), 178-201. A finite group of agents share a (one output) production function. A cost sharing rule allocates the total cost among the users for every conceivable profile of output demands. We investigate the space of possible cost sharing rules from an axiomatic perspective. We provide two characterizations of average cost pricing, one based on the axioms of Additivity and Monotonicity (both with respect to the cost function), and the other based on the axioms of Additivity and a version of Consistency. We also provide a characterization of serial cost sharing based, essentially, on Additivity and a Free Lunch axiom.Journal of Economic LiteratureClassification Numbers: D63, D78, C79.
- Using cost observation to regulate firms, Laffont, J. J., & Tirole, J. (1986). Using cost observation to regulate firms.Journal of political Economy,94(3, Part 1), 614-641. The paper emphasizes the use of accounting data in regulatory or procurement contracts when the supplier (1) has superior information about the cost of the project and (2) invests in cost reduction. The main result states that, under risk neutrality, the supplier announces an expected cost and is given an incentive contract linear in cost overruns. This (optimal) contract moves toward a fixed-price contract as the announced cost decreases. An investment choice is then introduced and the use of a rate-of-return regulation is studied
- Incentive pricing and utility regulation, Cross, J. G. (1970). Incentive pricing and utility regulation.The Quarterly Journal of Economics, 236-253.
- Multi-product serial cost sharing: an incompatibility with the additivity axiom, Kolpin, V. (1996). Multi-product serial cost sharing: an incompatibility with the additivity axiom.Journal of Economic Theory,69(1), 227-233. Previous literature has shown that the serial cost sharing rule is endowed with a variety of desirable incentive and equity features. By definition, applications of this mechanism are essentially constrained to single service facilities. We investigate difficulties that emerge when attempting to extend serial cost sharing to multi-product environments. In particular, we show that such an extension is incompatible with the additivity axiom.Journal of Economic LiteratureClassification Numbers: D63, C71.
- Ramsey prices, average cost prices and price sustainability, Mirman, L. J., Tauman, Y., & Zang, I. (1986). Ramsey prices, average cost prices and price sustainability.International Journal of Industrial Organization,4(2), 123-140. We study the relationship between sustainable and average cost prices in the multiproduct case. It is shown that for the case where costs are separable only average cost prices can be sustainable even if demands are interdependent. As for the non-separable cost case the notion of average cost prices is axiomatically defined as an extension of the average cost concept of the single product case. We then use this extension to derive necessary as well as sufficient conditions for the extended average cost prices to be sustainable.