Fixed and variable costs are the two major costs in the current business. Variable costs are those that vary with the volume and outcome of the sales. Fixed costs do not depend on the level of sales. Marginal Pricing, also called, Marginal cost-pricing comes under the idea of variable costs.
It bases a product’s selling price on the variable costs of its production and includes a margin and ignores any fixed cost. The selling price can also be a little higher than that of the variable.
Marginal pricing is done in the case of short-term cases like if a company cannot make a sale at a higher price and it has no other choice if it wants to make a sale, or if there is a tiny amount of unused production capacity left which is available for use if the financially healthy company chooses to just to maximize its profit.
The sales are always increment based on these short-term pricing strategies as these prices fall under the lower range. This variable price constitutes the direct materials needed and not direct labour.
The Marginal Pricing is based on this paradigm called the ‘Marginal Transmission Pricing Paradigm’ which says that the new transmission costs because of the new transmission customer will be included in the evaluation of transmission charges for the same customers. It will remain the responsibility of the present customers’ utilities.
Where is Marginal Pricing concept useful?
Marginal Pricing takes care of the manufacturing costs but not the overhead costs. The low prices attract customers benefitting the business. This high demand would bring profits and higher revenues when compared to products of high price range and comparatively low demand. This brings the idea of a short-term revenue boost’ to mind.
Marginal cost pricing is a concept which requires the presence and use of alternate markets. A supplier or company cannot sell its products at the full retail price at one section of the market and the marginal rate at another section of the same market.
This is where alternate markets come into play. Careful marketing has to be performed when the prices are being set for the local market and the import market. The advantage is usually on the exporter’s side as the import market will find it hard to compare the import prices and the exporter’s local market prices. Since it can also be disadvantageous (We will come to that at the end of the article) for the importing market, the export-import business using marginal pricing should be short term, like non-seasonal sales and maybe right after the construction and set up of a new plant.
The entirety of this should be strategized and executed carefully. Research and analysis say that a trade-off occurs between the risk and efficient pricing. Marginal cost pricing seems to be optimal when the marginal utility of the customer does not depend on the price. It says that the tariff’s ‘lump-sum element’ should be greater than that of the fixed cost when the demand is the same as the fixed cost and with unit elasticity.
Examples of Marginal Pricing
Let’s look at examples to understand this concept in a better manner.
- We have been mentioning that this concept works only on a short-term basis and marginal pricing works therefore on a time limit. You can find marginal pricing being employed in year-end sales and seasonal sales where retailers and stores give huge discounts on seasonal clothes or other items that are considered to be outdated. You will find that woollen clothing is cheaper in the summer than in the winter. So, marginal pricing can be viewed as a concept that can add additional tiny revenue and profits to a company.
- Locational Marginal Pricing or just locational pricing is seen in rural areas especially in the electric service sector because of congestion, diminished service and losses are faced due to old generators and power lines that are not maintained leading to their low efficiency. Here, customers pay one price in one location and for the same service pay another price in a different location. This is called locational marginal pricing. One of the prices is the full retail price and the other is the cheaper marginal pricing.
- Marginal pricing is also used by the travel industry. Airlines, resorts and hotels need a minimum number of seats or rooms filled or the minimum number of people checked in to achieve a profit. When they are underbooked, they not only not get in revenue but also face losses due to maintenance costs and employee salaries that have to be fulfilled however the business is running then. There are websites that have bidding facilities so that customers can name the price they would like to pay such that underbooked places can get in some revenue.
- Some companies make the prices such that they are lower for products in lower demand and higher for those in higher demand. This is discrimination in price.
Advantages of Marginal Pricing
As we have already seen, marginal pricing is most optimal for short-term solutions and this makes sure that one need not worry about the effects it will have on fixed costs of maintenance and overhead. It majorly focuses only on what has to be done to achieve profits and to equalize the amount of labour or investment.
Disadvantages of Marginal Pricing
But marginal pricing always reminds you that there is always the risk that you may not recover the total fixed cost price and it will also get difficult to increase the prices as customers get used to the lower price and may not continue with the product once prices increase.
Several products have accessory items. Marginal pricing gives way to accessory sales which is very profitable for a service provider or retailer. It can make these pricing strategies very viable and also boost the margins. The cellphones can be considered as an example. The service can be considered the main accessory and other accessories can be the cellphone charger, earphones, cell phone charger and the USB cord. The cell phone itself can then be sold at a lower price as the summation of the entire cost containing the prices of all the accessory will be profitable in the long run as this offer will appeal to the audience. This will reap them high profits in the future with their products in large demand.
All of this does sound promising, but even this has its minus point. The minus point contradicting the advantage is marginal cost pricing for products that do not have accessory items. The above point would definitely not apply then.
CUSTOMERS WHO ARE PRICE-SENSITIVE
Lower prices usually lead to higher demand and incremental profits. Lower prices can also show a level of increase in the number of units sold. It is said to be a new way to be employed while entering the market promoting a new product.
Customers can be price-sensitive (most are, nowadays) and will mostly not subscribe or buy the product anymore if prices are increased to compensate the rising fixed cost of production.
It is advantageous for short-term benefits. It makes the brand high-quality and high-service when the strategy for pricing is the promotional and short term. It can also help faster entry into the market. But it will lead to the gain of several customers who are price sensitive.
Marginal cost pricing doesn’t consider the market prices. The market rates are not included when the prices are being quoted.
Another perspective of marginal pricing that has been brought up is of the government of the importing country. It is said that this concept of marginal cost pricing may be viewed as dumping. Dumping is the marketing or selling of a product at a lower price in the foreign or importing market when it is being sold at the domestic market for a higher price. The foreign market tends to feel threatened on behalf of their competing industries from unfair competition and seek protection. The exporting companies can face imposition by the importing government. It can be of high countervailing dues to correct the price imbalance.
Another flaw is that the exporting company might shift its focus to the local market as soon as there seems to be an increase in sales in the domestic market itself. This can cause tiffs and mistrust among countries and foreign buyers where their trust will sway even when it comes to other suppliers in the same market. This way, even a tiny careless mistake can cost a part of the nation’s economy.
Hence, companies employ this strategy when they realize they can earn additional revenue by selling excess unsold products. It is not to be included in a long-term plan as it would definitely bring losses to the company by the minimal revenue. Marginal cost pricing is surely opening new doors for combatting periodical revenue issues and for soaring sales.