Hall and Hitch Full Cost Pricing Theory

1 year ago

Atiqur Rahman

9 minutes

Introduction

In 1939, two Oxford Economists, Hall and Hitch, published some results of research undertaken at Oxford University aimed at the investigation of the decision process of businessmen in relation to government measures.

The study that was conducted in Oxford covered 38 firms, out of which 33 were manufacturing firms, 3 were retail trading firms, and 2 were building firms. Out of 33 manufacturing firms, 15 produced consumer goods, 4 intermediate products, 7 capital goods, and 7 textiles.

The sample was not random but included firms which may well be expected to belong to ‘efficiently managed enterprises’. They empirically found that firms instead of equating marginal revenue with marginal cost, many firms engage themselves in full-cost pricing.

To quote them, “the way in which businessmen decide what price to charge for their products and what output to produce, casts doubt on the general applicability of conventional analysis of price and output policy in terms of marginal cost and marginal revenue and suggests a mode of entrepreneurial behaviour of which current economic doctrine tends to ignore”.

It is clear from the quotation that firms while fixing prices, do not maximize profits by equating marginal revenue with marginal cost.

According to them, businessmen are not using the right approach to profit maximization for product pricing. They further pointed out that in the real world, business firms tried to seek satisfactory profits or a normal or conventional rate of profit.

Thus, according to them, prices are fixed on the basis of full cost pricing theory, i.e. average variable direct cost plus average overhead cost plus a margin for profit.

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡 𝑃𝑟𝑖𝑐𝑖𝑛𝑔 = 𝐴𝑉𝐶 + 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝐶𝑜𝑠𝑡 + 𝑁𝑜𝑟𝑚𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖n

Here Hall and Hitch call the average variable cost as an average direct cost. The average direct cost and the average overhead cost are calculated on the basis of expected output in a period. There were several reasons given by entrepreneurs as to why they favour full-cost pricing over profit maximization as the basis of fixing prices.

(i) The entrepreneurs pointed out that if the price is set above the average cost then firms are earning supernormal profits. These supernormal profits would attract other firms to enter the market if entry is not restricted. Thus, there is a threat of competing away these profits with potential competitors.

(ii) They also expressed the ignorance of marginal revenue and marginal costs concepts because of the absence of any data. This is so because firms do not know the taste and preferences of the consumers, and so are not aware of their demand functions and marginal cost.

(iii) Firms believe that full cost price is the right price as it covers normal profit over the cost of production when the plant is normally utilized and

(iv) It was also pointed out by Hall and Hitch that the prices of manufacturers were sticky, i.e. there are no frequent changes in prices despite changes in demand and cost conditions.

According to Hall and Hitch, Average Cost Pricing is a result of-

(a) Collusion: tacit or open
(b) Long-run demand and cost considerations
(c) Moral convictions of firms and
(d) Uncertain effects of change in price.

Hall and Hitch Full Cost Pricing Theory

Hall and Hitch combined the average cost pricing with the kinked demand curve analysis. According to them, oligopolistic firms face a kinked demand curve. The most important feature of oligopolistic firms is price rigidity. Price rigidity implies that firms would not like to change the price of its product.

This is so because each oligopolistic firm believes that if it lowers the price below the prevailing level, its competitors will follow him and will lower their prices, but on the other hand, if it raises the price above the market prevailing price, its competitors will not follow him.

The kinked demand curve with a kink at the current price is formed on the assumption that an increase in the price by an oligopolistic firm will not be matched by its rivals but any decrease in the price will be immediately followed by its rival. The portion on the kinked demand curve above the current price is highly elastic, and the portion on the demand curve below the current price is less elastic.

Hall and Hitch fixed the current price on the basis of average cost, and at this price, a kink in the demand curve is formed. It is shown in the figure below. In the figure below, price is measured on Y-axis and Quantity is measured on X-axis.

Hall and Hitch Full Cost Pricing Theory Diagram — Hall and Hitch Full Cost Pricing Theory

Suppose a firm wants to produce OQ units of output. This OQ unit of output is fixed on the basis of expected sales in the period. After deciding the units of output to be produced, the firm then calculates the average direct cost incurred on acquiring resources and the average overhead cost incurred on capital equipment etc.

After calculating the average direct cost and average overhead cost, the firm adds a conventional margin for profit to it. Addition of average direct cost, average overhead cost and conventional margin for profit yields average cost. Suppose the average cost is EQ to produce OQ units of output, then the firm will set the price OP, which is equal to EQ average cost. The kink in the demand curve DD is formed at this price OP.

Hall and Hitch used the average cost pricing with the kinked demand curve to provide the explanation for the stability of prices in the short run under an oligopoly. Any change in demand shifts the kinked demand curve keeping the price unchanged. Any increase in demand shifts the kinked demand curve to the right, and any decrease in demand shifts the kinked demand curve to the left without any change in price.

But Hall and Hitch have given two exceptions where the price of the product changes-

(i) If there is a large decrease in demand and demand remains at a low level for some time, then there is a likelihood that the price has to be reduced so as to maintain output. Hall and Hitch explained this reduction in price in the context of depressed demand. According to them, the irrational behaviour of anyone entrepreneur forces other entrepreneurs to reduce their prices as well.

(ii) If the average cost of all firms increased by a similar amount due to changes in the factor price, raw materials, technology etc., then this is likely to lead to a revaluation of the full cost price. So according to Hall and Hitch, there will not be any tendency for the price to either fall or rise more than the factor cost and raw material costs.

The important point to be noted here is that if the average cost falls for a large range of output, then according to average cost pricing, there exists a negative relationship between price and output. This implies that a smaller level of output is associated with a high cost per unit, and thus high prices need to be set. On the other hand, a large level of output is associated with low cost per unit and thus, low prices need to be set.

According to Hall and Hitch, oligopolistic firms are producing a large level of output and thus charge higher prices for their products. The reason behind this was oligopolistic firms prefer-

(i) Price stability
(ii) They have the capacity to produce a large level of output and
(iii) They are prevented by the kink on the demand curve from raising prices.

Hall and Hitch Full Cost Pricing Theory

Introduction

According to Hall and Hitch, Average Cost Pricing is a result of-

Hall and Hitch Full Cost Pricing Theory

But Hall and Hitch have given two exceptions where the price of the product changes-

Read More- Microeconomics

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Introduction

According to Hall and Hitch, Average Cost Pricing is a result of-

Hall and Hitch Full Cost Pricing Theory

But Hall and Hitch have given two exceptions where the price of the product changes-

Read More- Microeconomics

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