Price Determination

In discussing demand in the previous chapter it was assumed that prices were in some sense given for the individual firm. This simplifying assumption is now dropped, and the present chapter discusses how prices are determined, first in theory and then in practice. Pricing is an area where behaviour apparently diverges markedly from the norms laid down by economic theory. Frantic attempts are often made to provide theoretical justification for widespread practices which may seem irrational. Economists can be imprisoned by their own simplifying assumptions and fail to recognise the wide diversity of objectives of modern industry and the complexity of large companies. The basic theory assumes that profit maximisation, whether today or in the long run, is the guiding principle of management. It is maximisation of total profits rather than of profit margins or returns on capital that is meant in this context. In practice, profit maximisation is only one objective among many, as Chapter 1 has recognised. The relative importance of each objective helps determine a firm’s approach to pricing policy.