Blogging about

The Bottom Line

Evan Davis gets to the heart of the big finance stories at The Bottom Line.

In the current economic climate, companies must ‘optimise’ their decision-making, including pricing decisions. The economist’s prescription for profit maximisation is to set selling prices at a level which equates marginal cost and marginal revenue.

Pricing decisions should therefore be based on an analysis of incremental revenues and costs across a range of possible prices.

The evidence available, however suggests that very few companies adopt this approach, most favouring one of two ‘sub-optimal’ alternatives:

• ‘what the market will bear’ with cost playing no role - neglecting the fact that there is seldom a single price that the ‘market will bear’ but a range of possible selling prices, each with its associated demand level.

• ‘cost plus’ (including a normal profit mark-up) with market demand conditions playing no role. The ‘cost’ figure usually includes various overheads, allocated in an arbitrary way, and has little if any economic meaning.

Reasons given by companies for non-optimising behaviour include:

• lack of information concerning the relationship between price and quantity demanded

• the fact that competitors will match any price reduction and so the company is locked into its current prices regardless of how they were arrived at

• changes in prices being costly to implement (new price lists etc.), a nuisance to sales personnel and disliked by distributors and consumers - whereas profit maximising behaviour implies prices changing whenever there is a change in demand or cost.

In addition, many companies’ cost accounting systems are geared up to providing information for external financial reporting purposes (which require that stock be valued at full production cost) and do not readily provide marginal (incremental) cost information.

Over time, pricing approaches tend to become institutionalised as ‘the way we do things around here’. So there’s a risk of insufficient questioning of current approaches. When times are good, companies can afford to sub-optimise; in the current economic climate, the status quo may not be an option!

Find out more

The Open University Business School offers a range of courses that can help you understanding pricing, including the certificate in accounting and the certificate in management.

Thinking of starting a small business? Here's some top tips for pricing.

Video: Evan Davis asks if the price of commercial property is a bellweather for the economy.

Blogging about

Money Programme

Get the facts behind the big business and finance stories from around the world – and down your street, in The Money Programme.

Many of us have ideas for new gadgets or business services that would solve a particular problem or fulfil an unmet need, but, for better or worse, most of these remain unfulfilled ideas. Even those ideas that reach the stage of being protected by a patent of copyright may remain undeveloped – indeed across Europe around a third of all patents are never exploited.

However some entrepreneurial people take their ideas forward and convert them into a reality. This entrepreneurial activity is characterised by risk and uncertainty, and while ideas are free, their realisation will require a commitment of time and money. For small start-up businesses in the UK, the initial financial investment in most cases comes from the individual and their families, and the risk can often involve their life savings and loans secured on their house. The stakes therefore are high, as are the failure rates for start-up companies.

But risks can be managed. As ideas get closer to fruition, risk and uncertainty can be reduced by product development, market research and financial projections. At the same time the level of investment escalates. The entrepreneur needs to have a strong belief in the viability of their idea, but be prepared to cut their losses at the optimum time if for example market testing shows that the market is unlikely to sustain viable levels of demand or the price required to cover costs.

risk-taking entrepreneurs who innovate create higher than normal profits

Intuitively we might think that entrepreneurs are rare or special people. That indeed was the view of Joseph Schumpeter, the economist who more than any other emphasised the key role of the entrepreneur. Working in the early 20^th century Schumpeter placed the individual entrepreneur right at the centre of global economic activity. He argued that risk-taking entrepreneurs who innovate create higher than normal profits, and this drives economic growth. For Schumpeter, the leading entrepreneurs in any field were very special people with almost superhuman qualities of vision and risk-taking. Once they had blazed a trail, others saw the opportunities for profits and jumped on the bandwagon, thus causing widespread economic upswings that could lift economies out of recession.

In his later work Schumpeter acknowledged the importance of large companies that could invest huge sums in research and development (R&D) and organise for innovation on an industrial scale, reducing the opportunities for individual entrepreneurs to compete. Whilst this remains partly true for many sectors, history has subsequently shown that innovation depends on both large and small companies. Indeed, in many areas of the economy innovation thrives on an interdependence between large and small firms. In part, this is linked to the cycle of technological change. Whereas the basic research and long-term development that lays the groundwork for a new technology such as microelectronics or new materials can only be achieved by university research labs and large corporations, small entrepreneurial companies have the flexibility to develop the opportunities offered by the technology in a myriad of niches across the economy.

An exception to this pattern is biotechnology. Here small companies, that are often university spin-offs, are able to conduct R&D over extended periods because they are backed by investors who take a longer than normal view on their investment, in the expectation of larger than normal profits in the future. And again we find a symbiosis between these small firms and the large pharmaceutical companies who can exploit the outcomes on a large scale.

Though the risks remain, there are currently unprecedented opportunities for entrepreneurial activity to exploit the technological platform provided by, in particular, information and communications technologies including the world wide web, new materials and biotechnology. These platforms can support the creation of new service-based businesses as well as entrepreneurial firms developing products, hardware and software. On the horizon, the next potential technological platform – nanotechnology – remains at an early a stage, but, no doubt in future it too will provide the basis for thousands of entrepreneurs to come up with brilliant ideas to exploit market niches.

Find out more

• Join the discussion - how do you get creative? What can your company do to help?
• What makes an inventor tick? - Sir James Dyson and Professor James Fleck shed light on the creative process, in our video extras
• Radical innovation - sometimes a new idea changes the landscape, and even well-established companies struggle to cope
• Managing innovation - how do companies get the creative juices flowing?
• Innovation and Entrepreneurship by John Bessant and Joe Tidd, published by Wiley
• The Journal of Entrepreneurship, published by Sage
• The Open University has a range of courses, and free course material, about creativity and innovation

About the author

Paul Quintas is Professor of Knowledge Management at the OU Business School. He has been researching, teaching and advising in the area of the management of knowledge and innovation for over 20 years.

Subscribe to Paul Quintas's posts