A capitalist economy is a form of economic organisation

in which means of production viz., land and capital are

owned by private people. Capitalistic economy is also
known as free market economy and Laissez faire
economy.
Features of Capitalist Economy:
The main features of a capitalist economy are as follows:
(a) Factors of production are owned by the individuals.
(b) Every individual has freedom to start business of his
own choice.
(c) All economic activities are guided by the motive of
profit.
(d) Individuals are the owners and acquire property and
pass it on to next heir after death.
(e) Government has little role to play in the functioning of
the economy. (/) Prices of goods and services are
determined by the market forces of demand and supply.
Features of the Market Economic System
A market economy, also known as a free enterprise
system or capitalism, is an economic system wherein
goods and services are exchanged freely on an open
market. A market system characterizes the economy of
the United States and most parts of the world as of 2010.
As a small business owner, an understanding of some of
the main features of a market economy can help you in
the operation of your enterprise.

Supply and Demand

The concept of supply and demand plays a role in
determining your pricing structure. Generally, the larger
the available supply of goods or services in relation to
their demand, the lower the price you can charge.
Conversely, if demand is high but the supply is low, the
price charged goes higher. This is an important
consideration for small business owners in which supply
or demand fluctuates widely, such as the operator of a
gas station.
Competition
A market economy encourages competition. Regardless
of the type of small business you operate, you likely face
competition in some form. The more competition you
encounter, the more you have to monitor your pricing in
relation to your competitors. You also need to develop
some form of marketing campaign to differentiate
yourself from your competition and to carve out your own
niche in the marketplace.
Profit
Business owners in a market economy are usually
motivated by how much money they make. One
measuring stick of the success of a business enterprise is
the "bottom line," or how much
revenue it generates in relation to its expenses. Thus, an
overall goal of businesses in a market economy is to
attract customers who will buy their products at a price
that earns them the highest profits. In turn, consumers
seek products that offer the highest quality for the lowest
price.

Less Government Intervention

In a market economy, the government does not dictate
economic policy as it does in a planned or social
economic structure. In theory, the
government's role is to help maintain market
stability, such as when the Federal Reserve Board raises
or lowers interest rates. This means that components
such as prices are set by market conditions with minimal
government intervention.
A market economy has seven main characteristics: l)
people buy what they want, but only if they can pay for it;
2) thus, money becomes necessary for life; 3) people are
forced to do anything and to sell anything in order to get
money; 4) maximizing profit rather than satisfying social
needs is the aim of all production and investment; 5)
discipline over those who produce the wealth of society is
no longer exercised by other people (as in slavery and
feudalism) but by money and the conditions of work that
one must accept in order to earn money; 6) rationing of
scarce goods takes place through money (based on who
has more than others) rather than through coupons
(based on who has worked harder or longer or has a
greater need for the good); and 7) since no one is kept
from trying to get rich and everyone is paid for what they
do, people acquire a sense that each person gets (and
has gotten) what he deserves economically, in short, that
both the rich and the poor are responsible for their fates.
Whether the society is developed or underdeveloped, a
market economy has several important advantages and
several major disadvantages: Among the advantages, we
find the following:

1. Competition between different firms leads to

increased efficiency, as firms do whatever is
necessaryincluding laying off workersto lower
their costs;
2. Most people work harder (the threat of losing one's
job is a great motivator);
3. There is more innovation as firms look for new
products to sell and cheaper ways to do their work;
4. Foreign investment is attracted as word gets out
about the new opportunities for earning profit;
5. The size, power, and cost of the state bureaucracy is
correspondingly reduced as various activities that are
usually associated with the public sector are taken
over by private enterprises;
6. The forces of production, or at least those involved in
making those things people with money at home or
abroad want to buy, undergo rapid development;
7. Many people quickly acquire the technical and social
skills and knowledge needed to function in this new
economy;
8. A great variety of consumer goods become available
for those who have the money to buy them; and
9. Large parts of the society take on a bright, merry and
colorful air as everyone busies himself trying to sell
something to someone else.

Among the disadvantages, we find the following:

1. Distorted investment priorities, as wealth gets

directed into what will earn the largest profit and not
into what most people really need (so public health,
public education, and even dikes for periodically
swollen rivers receive little attention);
2. Worsening exploitation of workers, since the harder,
faster, and longer people workjust as the less they
get paidthe more profit is earned by their employer
(with this incentive and driven by the competition,
employers are forever finding new ways to intensify
exploitation);
3. Overproduction of goods, since workers as a class are
never paid enough to buy back, in their role as
consumers, the ever growing amount of goods that
they produce (in the era of automation,
computerization and robotization, the gap between
what workers produceand can produceand what
their low wage allows them to consume has
increased enormously);
4. Unused industrial capacity (the mountain of unsold
goods has resulted in a large percentage of
machinery of all kinds lying idle, while many pressing
needsbut needs that the people who have them
can't pay forgo unmet);

5. Growing unemployment (machines and raw materials

are available, but using them to satisfy the needs of
the people who don't have the money to pay for
what could be made would not make profits for those
who own the machines and raw materialsand in a
market economy profits are what matters);
6. Growing social and economic inequality (the rich get
richer and everyone else gets poorer, many
absolutely and the rest in relation to the rapidly
growing wealth of the rich);
7. With such a gap between the rich and the poor,
egalitarian social relations become impossible
(people with a lot of money begin to think of
themselves as a better kind of human being and to
view the poor with contempt, while the poor feel a
mixture of hatred, envy and queasy respect for the
rich);
8. Those with the most money also begin to exercise a
disproportional political influence, which they use to
help themselves make still more money;
9. Increase in corruption in all sectors of society, which
further increases the power of those with a lot of
money and puts those without the money to bribe
officials at a severe disadvantage;
10.
Increase in all kinds of economic crimes, with
people trying to acquire money illegally when legal
means are not available (and sometimes even when
they are);

11.
Reduced social benefits and welfare (since such
benefits are financed at least in part by taxes,
extended benefits generally means reduced profits
for the rich; furthermore, any social safety net makes
workers less fearful of losing their jobs and
consequently less willing to do anything to keep
them);
12.
Worsening ecological degradation (since any
effort to improve the quality of the air and of the
water costs the owners of industry money and
reduces profits, our natural home becomes
increasingly unlivable);
13.
With all this, people of all classes begin to
misunderstand the new social relations and powers
that arise through the operations of a market
economy as natural phenomena with a life and will of
their own (money, for example, gets taken as an
almost supernatural power that stands above people
and orders their lives, rather than a material vehicle
into which people through their alienated relations
with their productive activity and its products have
poured their own power and potential; and the
market itself, which is just one possible way in which
social wealth can be distributed, is taken as the way
nature itself intended human beings to relate to each
other, as more in keeping with basic human nature
than any other possibility. As part of this, people no
longer believe in a future that could be qualitatively
different or in their ability, either individually or

collectively, to help bring it about. In short, what

Marx called "ideological thinking" becomes general);
14.
The same market experiences develop a set of
anti-social attitudes and emotions (people become
egotistical, concerned only with themselves. "Me
first", "anything for money", "winning in competition
no matter what the human costs" become what
drives them in all areas of life. They also become
very anxious and economically insecure, afraid of
losing their job, their home, their sale, etc.; and they
worry about money all the time. In this situation,
feelings as well as ideas of cooperation and mutual
concern are seriously weakened, where they don't
disappear altogether, for in a market economy it is
against one's personal interest to cooperate with
others);
15.
With people's thoughts and emotions effected in
these ways by their life in a market economy, it
becomes very difficult for the government, any
government, to give them a true picture of the
country's problems (it is more conducive to stability
to feed people illusions of unending economic growth
and fairy tales of how they too can get rich.
Exaggerating the positive achievements of society
and seldom if ever mentioning its negative features
is also the best means of attracting foreign
investment. With so much of the economy depending
on "favorable market psychology", the government
simply cannot afford to be completely honest either

with its own people or the rest of the world on what

is really happening in the country);
16.
Finally, the market economy leads to periodic
economic crises, where all these disadvantages
develop to a point that most of the advantages I
mentioned earlier simply dry up the economy stops
growing, fewer things are made, development of the
forces of production slows down, investment drops
off, etc. (a close look at the trends apparent in the
disadvantages of the market should make clear why
such crises are inevitable in a market economy).
Until an economic crisis occurs, it is possible to take
the position that the advantages of a market
economy outweigh its disadvantages, or the opposite
position, and to develop a political strategy that
accords with one's view, whatever it is. But if a crisis
does away with most of the important advantages
associated with the market, this is no longer possible.
It simply makes no sense to continue arguing that we
must give priority to the advantages of the market
when they are in the process of disappearing.

The main differences between Product Market and Factor

Market are as follows:
Product Market:
A product refers to an arrangement for buying and
selling of commodities

 The examples of product market are Rice market, Fish

market, etc.
In the product market the households are the buyer.
The demand for product is a direct demand.
The price of the product is determined by the
interaction of demand and supply of product.
This market facilitates exchange of goods and
services in the society.
Factor Market:
It refers to arrangement for buying and selling of
factors of production.
The examples of factor market is labor market.
They have a derived demand.
The price of factors is determined by the interaction
of demand and supply of the factors.
The market facilitates the distribution of income to
the factors of production.
In economics, a productionpossibility frontier (PPF),
sometimes called a productionpossibility
curve, production-possibility boundary or product

transformation curve, is a graph representing

production tradeoffs of an economy given fixed resources.
In its microeconomic applications the graph shows the
various combinations of amounts of two commodities that
an economy can produce per unit of time (e.g., number of
guns vs kilos of butter) using a fixed amount of each of
the factors of production, given the
production technologies available. At
the macroeconomic level it can be used to depict other
rivalrous trade-offs like production of fixed capital versus
production of consumer goods. Graphically bounding
the production set for fixed input quantities, the PPF
curve shows the maximum possible production level of
one commodity for any given production level of the
other, given the existing state of technology. By doing so,
it defines productive efficiency in the context of that
production set: a point on the frontier indicates efficient
use of the available inputs, while a point beneath the
curve indicates inefficiency. The commodities compared
can either be goods or services. The combination
represented by the point on the PPF where an efficient
economy operates shows the priorities or choices of the
economy, such as the choice of producing more capital
goods and fewer consumer goods or vice versa.
PPFs are normally drawn as bulging upwards ("concave")
from the origin but can also be represented as bulging
downward or linear (straight), depending on a number of
factors. A PPF illustrates a number of economic concepts,
such as scarcity of resources (i.e., the fundamental
economic problem that all societies face), opportunity
cost (or marginal rate of transformation), productive
efficiency, allocative efficiency, and economies of scale.

An outward shift of the PPF results from growth of the

availability of inputs such as physical capital or labour,
or technological progress in our knowledge of how to
transform inputs into outputs. Such a shift
reflects economic growth of an economy already
operating at its full productivity (on the PPF), which
means that more of both outputs can be produced during
the specified period of time without sacrificing the output
of either good. Conversely, the PPF will shift inward if the
labor force shrinks, the supply of raw materials is
depleted, or a natural disaster decreases the stock of
physical capital.
However, most economic contractions reflect not that
less can be produced, but that the economy has started
operating below the frontiertypically both labor and
physical capital are underemployed.

Efficiency[edit]

An example PPF with illustrative points marked

See also: Productive efficiency and Pareto efficiency

A PPF (production possibility frontier) typically takes the

form of the curve illustrated on the right. An economy
that is operating on the PPF is said to be efficient,
meaning that it would be impossible to produce more of
one good without decreasing production of the other
good. In contrast, if the economy is operating below the
curve, it is said to be operating inefficiently because it
could reallocate resources in order to produce more of
both goods, or because some resources such as labor or
capital are sitting idle and could be fully employed to
produce more of both goods.
For example, assuming that the economy's available
quantities of factors of production do not change over
time and that technological progress does not occur, then
if the economy is operating on the PPF production of guns
would need to be sacrificed in order to produce more
butter.[1] If production is efficient, the economy can
choose between combinations (i.e., points) on the
PPF: B if guns are of interest,C if more butter is
needed, D if an equal mix of butter and guns is required.
[1]

In the PPF, all points on the curve are points of

maximum productive efficiency (i.e., no more output of
any good can be achieved from the given inputs without
sacrificing output of some good); all points inside the
frontier (such as A) can be produced but are
productivelyinefficient; all points outside the curve (such
as X) cannot be produced with the given, existing
resources.[2] Not all points on the curve arePareto
efficient, however; only in the case where the marginal
rate of transformation is equal to all consumers' marginal
rate of substitution and hence equal to the ratio of prices

will it be impossible to find any trade that will make no

consumer worse off.[3]
Any point that lies either on the production possibilities
curve or to the left of it is said to be an attainable
point, meaning that it can be produced with currently
available resources. Points that lie to the right of the
production possibilities curve are said to
be unattainable because they cannot be produced using
currently available resources. Points that lie strictly to the
left of the curve are said to be inefficient, because
existing resources would allow for production of more of
at least one good without sacrificing the production of
any other good. An efficient point is one that lies on the
production possibilities curve. At any such point, more of
one good can be produced only by producing less of the
other. [4]
Such a two-good world is a theoretical simplification, due
to the difficulty of graphical analysis of multiple goods. If
we are interested in one good, a composite score of the
other goods can be generated using different techniques.
[5][6]
Furthermore, the production model can be
generalised using higher-dimensional techniques such
as Principal Component Analysis (PCA) and others.[7]

The circular flow of income is a simple model to explain

basic economic transactions.
To start off, consider 2 groups of people

Households people like yourself

Firms companies like BMW, Vodafone e.t.c.

Householders (people like you or me) could get a job in a
factory making cars. This leads to an output of goods.
In return workers get income (wages) from the firm.
With this income we can buy the goods firms are
producing. This is Expenditure.
Thus in a closed economy with no saving, tax or imports.
Total Output should be the same as Total Income and
Total Expenditure.

Note: Factor markets is markets like labour markets.

Product markets are the production of goods like cars

Therefore, this is the very basic circular flow of income.
To this circular flow you could add a government which
collects taxes from firms and households and spends
money in the form of benefits and subsidies.
Also you could add a foreign dimension.

Goods and services could be exported Money

comes into economy

Goods and services could be imported Money

leaves the economy

Diagram to Show Circular Flow of Income

Circular
Flow
Also, we dont spend all the money we receive, but will
save some in banks. Firms could borrow from banks to
invest.
CIRCULAR FLOW OF ECONOMIC ACTIVITY

The basic tenet of the circular flow of economic activity is,

"What goes around comes around." The circular flow
begins with the spending habits of consumers. How much

and how fast consumers spend then drives the amount of

investments that businesses make in resources to
produce goods. These investments in turn affect the
number of jobs that are available and the general
economic health of a region. As more jobs become
available, consumers have more money to spend.
Conversely, as employment levels drop, consumers have
less money to spend on goods and services. Consumer
spending also determines the kinds and quantities of
products that businesses produce.
The circular flow theory was first advanced by the
physiocrats, a school of economics in the 1700s. The
major proponent of the physiocratic view, Francois
Quesnay (16941774), wrote in 1758 that the circular
flow was a natural order in economics and self-sustaining.
Quesnay proposed that the flow had an inherent selfcorrecting mechanism and therefore did not need to be
directed by government. The circular flow created a
balance by automatically decreasing and increasing
consumer spending levels and business investments
when needed.

Objectives of price policy

Pricing Policies: Considerations, Objectives and
Factors involved in Formulating the Pricing Policy!
Contents

1. Considerations Involved in Formulating the Pricing

Policy
2. Objectives of Pricing Policy
3. Factors involved in pricing Policy
A pricing policy is a standing answer to recurring
question. A systematic approach to pricing requires the
decision that an individual pricing situation be
generalised and codified into policy coverage of all the
principal pricing problems. Policies can and should be
tailored to various competitive situations. A policy
approach which is becoming normal for sales activities is
comparatively rare in pricing.
Most well managed manufacturing enterprises have a
clear cut advertising policy, product customer policy and
distribution-channel policy. But pricing decision remains a
patchwork of ad hoc decisions. In many, otherwise well
managed firms, price policy have been dealt with on a
crisis basis. This kind of price management by
catastrophe discourages the kind of systematic analysis
needed for clear cut pricing policies.

1. Considerations Involved in Formulating the

Pricing Policy:
The following considerations involve in formulating
the pricing policy:
(i) Competitive Situation:
Pricing policy is to be set in the light of competitive
situation in the market. We have to know whether the
firm is facing perfect competition or imperfect
competition. In perfect competition, the producers have
no control over the price. Pricing policy has special significance only under imperfect competition.
(ii) Goal of Profit and Sales:
The businessmen use the pricing device for the purpose
of maximising profits. They should also stimulate
profitable combination sales. In any case, the sales
should bring more profit to the firm.
(iii) Long Range Welfare of the Firm:
Generally, businessmen are reluctant to charge a high
price for the product because this might result in bringing
more producers into the industry. In real life, firms want to
prevent the entry of rivals. Pricing should take care of the
long run welfare of the company.

(iv) Flexibility:
Pricing policies should be flexible enough to meet
changes in economic conditions of various customer
industries. If a firm is selling its product in a highly
competitive market, it will have little scope for pricing
discretion. Prices should also be flexible to take care of
cyclical variations.
(v) Government Policy:
The government may prevent the firms in forming
combinations to set a high price. Often the government
prefers to control the prices of essential commodities with
a view to prevent the exploitation of the consumers. The
entry of the government into the pricing process tends to
inject politics into price fixation.
(vi) Overall Goals of Business:
Pricing is not an end in itself but a means to an end. The
fundamental guides to pricing, therefore, are the firms
overall goals. The broadest of them is survival. On a more
specific level, objectives relate to rate of growth, market
share, maintenance of control and finally profit. The
various objectives may not always be compatible. A
pricing policy should never be established without
consideration as to its impact on the other policies and
practices.

(vii) Price Sensitivity:

The various factors which may generate insensitivity to
price changes are variability in consumer behaviour,
variation in the effectiveness of marketing effort, nature
of the product. Importance of service after sales, etc.
Businessmen often tend to exaggerate the importance of
price sensitivity and ignore many identifiable factors
which tend to minimise it.
(viii) Routinisation of Pricing:
A firm may have to take many pricing decisions. If the
data on demand and cost are highly conjectural, the firm
has to rely on some mechanical formula. If a firm is
selling its product in a highly competitive market, it will
have little scope for price discretion. This will have the
way for routinised pricing.
2. Objectives of Pricing Policy:
The pricing policy of the firm may vary from firm to firm
depending on its objective. In practice, we find many
prices for a product of a firm such as wholesale price,
retail price, published price, quoted price, actual price
and so on. Special discounts, special offers, methods of
payment, amounts bought and transportation charges,

trade-in values, etc., are some sources of variations in the

price of the product.
For pricing decision, one has to define the price of the
product very carefully. Pricing decision of a firm in general
will have considerable repercussions on its marketing
strategies. This implies that when the firm makes a
decision about the price, it has to consider its entire
marketing efforts. Pricing decisions are usually considered
a part of the general strategy for achieving a broadly
defined goal.
While setting the price, the firm may aim at the
following objectives:
(i) Price-Profit Satisfaction:
The firms are interested in keeping their prices stable
within certain period of time irrespective of changes in
demand and costs, so that they may get the expected
profit.
(ii) Sales Maximisation and Growth:
A firm has to set a price which assures maximum sales of
the product. Firms set a price which would enhance the
sale of the entire product line. It is only then, it can
achieve growth.

(iii) Making Money:

Some firms want to use their special position in the
industry by selling product at a premium and make quick
profit as much as possible.
(iv) Preventing Competition:
Unrestricted competition and lack of planning can result
in wasteful duplication of resources. The price system in a
competitive economy might not reflect societys real
needs. By adopting a suitable price policy the firm can
restrict the entry of rivals.
(v) Market Share:
The firm wants to secure a large share in the market by
following a suitable price policy. It wants to acquire a
dominating leadership position in the market. Many
managers believe that revenue maximisation will lead to
long run profit maximisation and market share growth.
(vi) Survival:
In these days of severe competition and business
uncertainties, the firm must set a price which would
safeguard the welfare of the firm. A firm is always in its
survival stage. For the sake of its continued existence, it
must tolerate all kinds of obstacles and challenges from
the rivals.

(vii) Market Penetration:

Some companies want to maximise unit sales. They
believe that a higher sales volume will lead to lower unit
costs and higher long run profit. They set the lowest
price, assuming the market is price sensitive. This is
called market penetration pricing.
(viii) Marketing Skimming:
Many companies favour setting high prices to skim the
market. DuPont is a prime practitioner of market
skimming pricing. With each innovation, it estimates the
highest price it can charge given the comparative
benefits of its new product versus the available
substitutes.
(ix) Early Cash Recovery:
Some firms set a price which will create a mad rush for
the product and recover cash early. They may also set a
low price as a caution against uncertainty of the future.
(x) Satisfactory Rate of Return:
Many companies try to set the price that will maximise
current profits. To estimate the demand and costs
associated with alternative prices, they choose the price
that produces maximum current profit, cash flow or rate
of return on investment.

3. Factors involved in pricing Policy:

The pricing of the product involves consideration
of the following factors:
(i) Cost Data
(ii) Demand Factor
(iii) Consumer Psychology
(iv) Competition
(v) Profit
(vi) Government Policy
(i) Cost Data in Pricing:
Cost data occupy an important place in the price setting
processes. There are different types of costs incurred in
the production and marketing of the product. There are
production costs, promotional expenses like advertising
or personal selling as well as taxation, etc. They may
necessitate an upward fixing of price. For example, the
prices of petrol and gas are rising due to rise in the cost
of raw materials, such as crude transportation, refining,
etc.

If costs go up, price rise can be quite justified. However,

their relevance to the pricing decision must neither be
underestimated nor exaggerated. For setting prices apart
from costs, a number of other factors have to be taken
into consideration. They are demand and competition.
Costs are of two types: fixed costs and variable costs. In
the short period, that is, the period in which a firm wants
to establish itself, the firm may not cover the fixed costs
but it must cover the variable cost. But in the long run, all
costs must be covered. If the entire costs are not covered
the producer stops production. Subsequently, the supply
is reduced which, in turn, may lead to higher prices.
If costs are not covered, the producer stops production.
Subsequently, the supply is reduced which in turn, may
lead to higher prices. If costs were to determine prices
why do so many companies report losses. There are
marked differences in costs as between one producer and
another. Yet the fact remains that the prices are very
close for a somewhat similar product. This is the very
best evidence of the fact that costs are not the
determining factors in pricing.
In fact, pricing is like a tripod. It has three legs. In
addition to costs, there are two other legs of market
demand and competition. It is no more possible to say
that one or another of these factors determines price

than it is to assert that one leg rather than either of the

other two supports a tripod.
Price decisions cannot be based merely on cost
accounting data which only contribute to history while
prices have to work in the future. Again it is very difficult
to measure costs accurately. Costs are affected by
volume, and volume is affected by price.
The management has to assume some desired pricevolume relationship for determining costs. That is why
costs play even a less important role in connection with
new products than with the older ones. Until the market is
decided and some idea is obtained about volume, it is not
possible to determine costs.
Regarding the role of costs in pricing, Nickerson observes
that the cost may be regarded only as an indicator of
demand and price. He further says that the cost at any
given time represents a resistance point to the lowering
of price. Again, costs determine profit margins at various
levels of output.
Cost calculation may also help in determining whether
the product whose price is determined by its demand, is
to be included in the product line or not. What costs
determine is not the price, but whether the production
can be profitably produced or not is very important.

Relevant Costs:
The question naturally arises: What then are the
relevant costs for pricing decision? Though in the long
run, all costs have to be covered, for managerial
decisions in the short run, direct costs are relevant. In a
single product firm, the management would try to cover
all the costs.
In a multi-product firm, problems are more complex. For
pricing decision, relevant costs are those costs that are
directly traceable to an individual product. Ordinarily, the
selling price must cover a direct costs that are
attributable to a product. In addition, it must contribute to
the common cost and to the realisation of profit. If the
price, in the short run, is lower than the cost, the question
arises, whether this price covers the variable cost. If it
covers the variable cost, the low price can be accepted.
But in the long run, the firm cannot sell at a price lower
than the cost. Product pricing decision should be lower
than the cost. Product pricing decision should, therefore,
be made with a view to maximise companys profits in
the long run.
(ii) Demand Factor in Pricing:
In pricing of a product, demand occupies a very important
place. In fact, demand is more important for effective

sales. The elasticity of demand is to be recognised in

determining the price of the product. If the demand for
the product is inelastic, the firm can fix a high price. On
the other hand, it the demand is elastic, it has to fix a
lower price.
In the very short term, the chief influence on price is
normally demand. Manufacturers of durable goods always
set a high price, even though sales are affected. If the
price is too high, it may also affect the demand for the
product. They wait for arrival of a rival product with
competitive price. Therefore, demand for product is very
sensitive to price changes.
(iii) Consumer Psychology in Pricing:
Demand for the product depends upon the psychology of
the consumers. Sensitivity to price change will vary from
consumer to consumer. In a particular situation, the
behaviour of one individual may not be the same as that
of the other. In fact, the pricing decision ought to rest on
a more incisive rationale than simple elasticity.
There are consumers who buy a product provided its
quality is high. Generally, product quality, product image,
customer service and promotion activity influence many
consumers more than the price. These factors are

qualitative and ambiguous. From the point of view of

consumers, prices are quantitative and unambiguous.
Price constitutes a barrier to demand when is too low, just
as much as where it is too high. Above a particular price,
the product is regarded as too expensive and below
another price, as constituting a risk of not giving
adequate value. If the price is too low, consumers will
tend to think that a product of inferior quality is being
offered.
With an improvement in incomes, the average consumer
becomes quality conscious. This may lead to an increase
in the demand for durable goods. People of high incomes
buy products even though their prices are high. In the
affluent societies, price is the indicator of quality.
Advertisement and sales promotion also contribute very
much in increasing the demand for advertised products.
Because he consumer thinks that the advertised products
are of good quality. The income of the consumer, the
standard of living and the price factor influence the
demand for various products in the society.
(iv) Competition Factor in Pricing:
Market situation plays an effective role in pricing. Pricing
policy has some managerial discretion where there is a
considerable degree of imperfection in competition. In

perfect competition, the individual producers have no

discretion in pricing. They have to accept the price fixed
by demand and supply.
In monopoly, the producer fixes a high price for his
product. In other market situations like oligopoly and
monopolistic competition, the individual producers take
the prices of the rival products in determining their price.
If the primary determinant of price changes in the
competitive condition is the market place, the pricing
policy can least be categorised as competition based
pricing.
(v) Profit Factor in Pricing:
In fixing the price for products, the producers consider
mainly the profit aspect. Each producer has his aim of
profit maximisation. If the objective is profit
maximisation, the critical rule is to select the price at
which MR = MC. Generally, the pricing policy is based on
the goal of obtaining a reasonable profit. Most of the
businessmen want to hold the price at constant level.
They do not desire frequent price fluctuation.
The profit maximisation approach to price setting is
logical because it forces decision makers to focus their
attention on the changes in production, cost, revenue and
profit associated with any contemplated change in price.

The price rigidity is the practice of many producers.

Rigidity does not mean inflexibility. It means that prices
are stable over a given period.
(vi) Government Policy in Pricing:
In market economy, the government generally does not
interfere in the economic decisions of the economy. It is
only in planned economies, the governments
interference is very much. According to conventional
economic theory, the buyers and sellers only determine
the price. In reality, certain other parties are also involved
in the pricing process. They are the competition and the
government. The government s practical regulatory price
techniques are ceiling on prices, minimum prices and
dual pricing.
In a mixed economy like India, the government resorts to
price control. The business establishments have to adopt
the governments price policies to control relative prices
to achieve certain targets, to prevent inflationary price
rise and to prevent abnormal increase in prices.
Methods of Pricing: Cost-Oriented Method and MarketOriented Method
The two methods of pricing are as follows: A. Costoriented Method B. Market-oriented Methods.

There are several methods of pricing products in the

market. While selecting the method of fixing prices, a
marketer must consider the factors affecting pricing. The
pricing methods can be broadly divided into two groups
cost-oriented method and market-oriented method.
A. Cost-oriented Method:
Because cost provides the base for a possible price
range, some firms may consider cost-oriented methods to
fix the price.
Cost-oriented methods or pricing are as follows:
1. Cost plus pricing:
Cost plus pricing involves adding a certain percentage to
cost in order to fix the price. For instance, if the cost of a
product is Rs. 200 per unit and the marketer expects 10
per cent profit on costs, then the selling price will be Rs.
220. The difference between the selling price and the
cost is the profit. This method is simpler as marketers can
easily determine the costs and add a certain percentage
to arrive at the selling price.
2. Mark-up pricing:
Mark-up pricing is a variation of cost pricing. In this case,
mark-ups are calculated as a percentage of the selling

price and not as a percentage of the cost price. Firms that

use cost-oriented methods use mark-up pricing.
Since only the cost and the desired percentage
markup on the selling price are known, the
following formula is used to determine the selling
price:
Average unit cost/Selling price
3. Break-even pricing:
In this case, the firm determines the level of sales needed
to cover all the relevant fixed and variable costs. The
break-even price is the price at which the sales revenue is
equal to the cost of goods sold. In other words, there is
neither profit nor loss.
For instance, if the fixed cost is Rs. 2, 00,000, the variable
cost per unit is Rs. 10, and the selling price is Rs. 15, then
the firm needs to sell 40,000 units to break even.
Therefore, the firm will plan to sell more than 40,000
units to make a profit. If the firm is not in a position to sell
40,000 limits, then it has to increase the selling price.
The following formula is used to calculate the
break-even point:
Contribution = Selling price Variable cost per unit

4. Target return pricing:

In this case, the firm sets prices in order to achieve a
particular level of return on investment (ROI).
The target return price can be calculated by the
following formula:
Target return price = Total costs + (Desired % ROI
investment)/ Total sales in units
For instance, if the total investment is Rs. 10,000,
the desired ROI is 20 per cent, the total cost is
Rs.5000, and total sales expected are 1,000 units,
then the target return price will be Rs. 7 per unit
as shown below:
5000 + (20% X 10,000)/ 7000
Target return price = 7
The limitation of this method (like other cost-oriented
methods) is that prices are derived from costs without
considering market factors such as competition, demand
and consumers perceived value. However, this method
helps to ensure that prices exceed all costs and therefore
contribute to profit.

5. Early cash recovery pricing:

Some firms may fix a price to realize early recovery of
investment involved, when market forecasts suggest that
the life of the market is likely to be short, such as in the
case of fashion-related products or technology-sensitive
products.
Such pricing can also be used when a firm anticipates
that a large firm may enter the market in the near future
with its lower prices, forcing existing firms to exit. In such
situations, firms may fix a price level, which would
maximize short-term revenues and reduce the firms
medium-term risk.
B. Market-oriented Methods:
1. Perceived value pricing:
A good number of firms fix the price of their goods and
services on the basis of customers perceived value. They
consider customers perceived value as the primary
factor for fixing prices, and the firms costs as the
secondary.
The customers perception can be influenced by several
factors, such as advertising, sales on techniques,
effective sales force and after-sale-service staff. If
customers perceive a higher value, then the price fixed
will be high and vice versa. Market research is needed to

establish the customers perceived value as a guide to

effective pricing.
2. Going-rate pricing:
In this case, the benchmark for setting prices is the price
set by major competitors. If a major competitor changes
its price, then the smaller firms may also change their
price, irrespective of their costs or demand.
The going-rate pricing can be further divided into
three sub-methods:
a. Competitors parity method:
A firm may set the same price as that of the major
competitor.
b. Premium pricing:
A firm may charge a little higher if its products have some
additional special features as compared to major
competitors.
c. Discount pricing:
A firm may charge a little lower price if its products lack
certain features as compared to major competitors.
The going-rate method is very popular because it tends to
reduce the likelihood of price wars emerging in the

market. It also reflects the industrys coactive wisdom

relating to the price that would generate a fair return.
3. Sealed-bid pricing:
This pricing is adopted in the case of large orders or
contracts, especially those of industrial buyers or
government departments. The firms submit sealed bids
for jobs in response to an advertisement.
In this case, the buyer expects the lowest possible price
and the seller is expected to provide the best possible
quotation or tender. If a firm wants to win a contract, then
it has to submit a lower price bid. For this purpose, the
firm has to anticipate the pricing policy of the competitors
and decide the price offer.
4. Differentiated pricing:
Firms may charge different prices for the same product or
service.
The following are some the types of differentiated
pricing:
a. Customer segment pricing:
Here different customer groups are charged different
prices for the same product or service depending on the
size of the order, payment terms, and so on.

b. Time pricing:
Here different prices are charged for the same product or
service at different timings or season. It includes off-peak
pricing, where low prices are charged during low-demand
tunings or season.
c. Area pricing:
Here different prices are charged for the same product in
different market areas. For instance, a firm may charge a
lower price in a new market to attract customers.
d. Product form pricing:
Here different versions of the product are priced
differently but not proportionately to their respective
costs. For instance, soft drinks of 200,300, 500 ml, etc.,
are priced according to this strategy.
What Are the Five Determinants of Demand?
The five determinants of demand are:
1.
2.

1.

Price of the good or service.

Prices of related goods or services. These are either
complementary, which are things that are usually bought
along with the product in demand. They could also be
substitutes for the product in demand.
Income of those with the demand.

2.
3.

Tastes or preferences of those with the demand.

Expectations. These are usually about whether the
price will go up.
For aggregate demand, the number of buyers in the
market is a sixth determinant.
Demand Equation or Function
The relationship between the five determinants and
demand is expressed as this equation:
qD = f (price, income, prices of related goods, tastes,
expectations)
It says that the quantity demanded of a product is a
function of its price, the income of the buyer, the price of
related goods (substitutes or complements), the tastes of
the consumer, and any expectation the consumer has of
future supply, prices, etc.
How Each Determinant Affects Demand
You can understand how each determinant affects
demand if you first assume that all of the other
determinants don't change. That's the principle known
as ceteris paribus -- all other things being equal. So,
ceteris paribus, here's how each element affects demand.
Price - The law of demand states that when prices rise,
the quantity demanded falls.
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Quantity Demanded
This also means that, when prices drop, demand will rise.
People base their purchasing decisions on price, if all
other things are equal. The exact quantity bought for
each price level is described in the Demand Schedule. It's
then plotted graphically to show the Demand Curve.
If the quantity demanded responds a lot to price, then it's
known as elastic demand. If the quantity doesn't change
much, regardless of price, that's inelastic demand.
However, the demand curve can only show the
relationship between the price and quantity. If one of the
other determinants changes, the entire demand curve
shifts.
Income - When income rises, so will the quantity
demanded. When income falls, so will demand. However,
even if your income doubles, you won't necessarily buy
twice as much of a particular good or service. There's
only so many pints of ice cream you'd want to eat, no
matter how rich you are. That's where the concept
of marginal utility comes into the picture. The first pint of
ice cream tastes delicious. You might have another. But
after that the marginal utility starts to decrease to the
point where you don't want any more. (At least until
tomorrow.)
Prices of related goods or services - The price of
complementary goods or services raises the overall cost
of using the good you demand, so you'll want less. For
example, when gas prices rose to $4 a gallon in 2008, the
demand for Hummers fell. Gas is a complementary good

to Hummers. The overall cost of driving a Hummer rose

along withgas prices.
The opposite reaction occurs when the price of a
substitute rises. When that happens, people will want less
of the good or service. That's why Apple constantly
innovates with its iPhones and iPods. As soon as a
substitute, such as the Droid, appears at a lower price,
Apple comes out with a better product, so now the Droid
isn't really a substitute.
Tastes - This is the desire, emotion, or preference for a
good or service. When tastes rise, so does the quantity
demanded. Likewise, when tastes fall, it will depress the
quantity demanded. This is what brand advertising is all
about. Buick spent millions to make you think its not only
for older people.
Expectations - When people expect that the value of
something will rise, then they demand more of it. This
explains the housing asset bubble of 2005. Housing
prices rose, but people bought more because they
expected the price to continue to go up. This drove prices
even further, until the bubble burst in 2006. Between
2007 and 2011, housing prices fell 30%. However, the
quantity demanded didn't really improve. Why? People
expected prices to continue falling, thanks to record
levels of foreclosures entering the market. Demand didn't
improve until people expected future prices would, too.
For more, see Subprime Mortgage Crisis Explained.
Number of buyers in the market - The number of
buyers affects overall, or aggregate, demand. As more
buyers enter the market rises, so does the quantity
demanded -- even if prices don't change. This

was another reason for the housing bubble. Low-cost

and sub-prime mortgages increased the number of
people who were told they could afford a house. The
number of buyers actually increased, driving up the
demand for housing. When they found they really
couldn't afford the mortgage, especially when housing
prices started to fall, they foreclosed. This reduced the
number of buyers, and demand also fell.
The demand curve graphically shows how many units of a
good or service will be bought at each price. It plots the
relationship between quantity and price that's been
calculated on the demand schedule. That's a table that
shows exactly how many units of a good or service will be
purchased at various prices.
As you can see in the chart, the price is on the vertical (y)
axis and the quantity is on the horizontal (x) axis.

This chart plots the conventional relationship between

price and quantity -- the lower the price, the higher the
quantity. As the price decreases from p0 to p1, the
quantity increases from q0 to q1.

This relationship, as portrayed on the demand curve,

follows the law of demand. It states that the quantity
demanded will drop as the price rises, ceteris
paribus -- meaning "all other things being equal").
Those other things that must remain equal are
the determinants of demand: price of related goods,
income, tastes, and expectations. There's an additional
determinant for aggregate demand: the number of
potential buyers in the market.
If those other determinants change, it shifts the entire
demand curve. That's because a whole new demand
schedule will need to be created, to show the new
relationship between price and quantity. For more,
seeDemand Curve Shift.
Types of Demand Curves
The demand curve simply plots the demand schedule on
a graph. This is helpful because you can easily look at the
shape of the curve and quickly determine how much price
affects demand for your product.
If a drop in price causes a huge increase in quantities
bought, the curve looks low and flat. This is known
as elastic demandbecause, like a stretchy rubber band,
the quantity demanded moves easily with just a little
change in prices. An example of this would be ground
beef. If prices drop just 25%, you might buy three times
as much as you normally would, because you know you'll
use it and you'll just put the extra in the freezer.
If the curve looks steep and narrow, then demand is
inelastic. That's because a drop in price isn't able to
increase the quantities purchased. This is more like a

rope, since it takes a lot of effort to get it to change. An

example of this is bananas. No matter how cheap they
are, there's only so many you can eat at one time, and
they go bad in about a week. You can't really freeze or
preserve them, so you won't buy three bunches even if
the price falls 25%.
By the way, the reason you react more to a sale in ground
beef than bananas is because of the marginal utility of
each additional unit. Marginal utility means the
usefulness (utility) of each additional unit the further out
on the margin you go. Because you can freeze ground
beef, the third package is just as good to you as the first.
The marginal utility of ground beef is high. However, that
third bunch of bananas won't be very appealing, so its
marginal utility is low.
Again, these curves assume all other determinants of
demand remain the same. If they change, and the
demand curve shifts, then the entire curve will move to
the right, if demand increases. This means that larger
quantities will be demanded at every price. If the entire
curve shifts to the left, it means total demand has
dropped for all price levels. For example, if you just lost
your job, you might not buy that third package of ground
beef, even if it is on sale. You might just buy the one
package, and be glad it's 25% off.
Aggregate or Market Demand Curve
The market demand curve describes the quantity
demanded by the entire market for a category of goods
or services. An example of this is gasoline prices overall.
When the cost of oil goes up, all gas stations must raise
their prices to cover their costs. Even if the price drops

50%, drivers aren't going to increase the amount bought

by that much. That's why, when the price skyrockets from
$3.20 - $4.00 a gallon, people get very upset. They can't
cut back their driving to work, school and the grocery
store very easily, and so they are forced to pay more for
gas.
By the way, this lowers their incomes for things other
than gas. Income is another determinant of demand, so
that means the demand curve for other things they would
like to buy, like ice cream, will drop. This is called a
demand shift. In this case, the entire demand curve for
ice cream shifts to the left. Since buyers have less
income, they will purchase a lower quantity of ice cream
even at the same price.
Inflation is when the prices of goods and services
increase. There are four main types of inflation,
categorized by their speed: creeping, walking, galloping,
and hyperinflation. There are also many types of asset
inflation and, of course, wage inflation. Many experts
consider demand-pull and cost-push to be types of
inflation, but they are actually causes of inflation, as is
expansion of the money supply.
1. Creeping Inflation
Creeping or mild inflation is when prices rise 3% a year or
less. According to the U.S. Federal Reserve, when prices
rise 2% or less, it's actually beneficial to economic
growth. That's because this mild inflation sets
expectations that prices will continue to rise. As a result,
it sparks increased demand as consumers decide to buy

now before prices rise in the future. By increasing

demand, mild inflationdrives economic expansion.
2. Walking Inflation
This type of strong, or pernicious, inflation is between 310% a year. It is harmful to the economy because it heats
upeconomic growth too fast. People start to buy more
than they need, just to avoid tomorrow's much higher
prices. This drives demand even further, so that suppliers
can't keep up. More important, neither can wages. As a
result, common goods and services are priced out of the
reach of most people.

3. Galloping Inflation
When inflation rises to ten percent or greater, it wreaks
absolute havoc on the economy. Money loses value so
fast that business and employee income can't keep up
with costs and prices. Foreign investors avoid the
country, depriving it of needed capital. The economy
becomes unstable, and government leaders lose
credibility. Galloping inflation must be prevented.

Hyperinflation is when the prices of most goods and

services skyrocket, usually more than 50% a month. It
usually starts when a country's Federal government
begins printing money to pay for fiscal spending. As
themoney supply increases, prices creep up as in
regularinflation.

However, instead of tightening the money supply to lower

inflation, the government keeps printing more money to
pay for spending. Once consumers realize what is
happening, they expect inflation. This causes them to buy
more now to avoid paying a higher price later. When this
accelerates, it artificially boosts demand out of control,
which causes inflation to spiral into hyperinflation. For
more, see Demand-Pull Inflation.

5. Stagflation
Stagflation is just like its name says: when economic
growth is stagnant, but there still is price inflation. This
seems contradictory, if not impossible. Why would prices
go up when there isn't enough demand to stoke economic
growth? It happened in the 1970s when the U.S. went off
the gold standard. Once the dollar's value was no longer
tied to gold, the number of dollars in circulation
skyrocketed. This increase in the money supply was one
of the causes of inflation. Stagflation didn't end until
then-Federal Reserve Chairman Paul Volcker raised
the Fed funds rate to the double-digits -- and kept it there
long enough to dispel expectations of further inflation.
Because it was such an unusual situation, it probably
won't happen again

Definition: The core inflationrate is the measurement of

inflation without food and energy prices. The core
inflation rate is measured by both the core Consumer
Price Index, or core CPI, and the core Personal

Consumption Expenditures price index, or core PCE price

index.
Why would you want to measure inflation without food
and energy prices? Those prices fluctuate daily along with
the price of oil, which is traded on
the commoditiesmarket.

Oil prices are highly volatile, because commodities

traders can bid up oil prices if they suspect actual
oil supply or demand will change in the future. They are
volatile because they based on quick-changing emotions,
not slow-changing supply and demand.
Gas prices are directly tied into oil prices, and change
every week or sometimes even every day. That's because
people must buy gas every day to get to work, so
demand is inelastic. The same is true with food. When
you're out of gas or food, you can't delay the purchase
until prices fall. Food prices rise along with gas prices
because transportation is dependent on trucking, which
consumes a lot of gas. When oil prices rise, you'll see the
effect about a week later in gas prices. If gas prices stay
up, you'll see the effect in food prices a little later.

7. Deflation
Deflation is the opposite of inflation -- it's when prices fall.
It's caused when an asset bubble bursts. That's what
happened in housing in 2006. Deflation in housing prices

trapped those who bought their homes in 2005. In fact,

the Fed was worried about overall deflation during the
recession. That's because deflation can turn a recession
into a depression. During the Great Depression of 1929,
prices dropped 10% -- a year.

8. Wage Inflation
Wage inflation is when workers' pay rises faster than
the cost of living. This occurs when there is a shortage of
workers, when labor unions negotiate ever-higher wages,
or when workers effectively control their own pay. A
worker shortage occurs whenever unemployment is
below 4%. Labor unions negotiated higher pay for auto
workers in the 90s. CEOs effectively control their own pay
by sitting on many corporate boards, especially their own.
All of these situations created wage inflation. Of course,
everyone thinks their wage increases are justified.
However, higher wages are one element of cost-push
inflation, and can cause prices of the company's goods
and services to rise.

9. Asset Inflation
An asset bubble, or asset inflation, occurs in one asset
class, such as housing, oil orgold. It is often overlooked by
the Federal Reserve and other inflation-watchers when
the overall rate of inflation is low. However, as we saw in
the subprime mortgage crisis and subsequent global

financial crisis, asset inflation can be very damaging if left

unchecked.