What is the Average Cost Pricing Rule?
Average cost pricing rule is a standardized pricing strategy that regulators impose on certain businesses to limit how well those companies can charge their consumers a price equal to the cost required to make the product or service for their products or services. are capable. This implies that businesses will set the unit price of a product relatively close to the average cost required to produce it. This rule generally applies to legal monopolies such as regulated public utilities.
- Average cost pricing rule is a regulatory requirement that a business charge its customers the maximum amount based on the average unit cost of production.
- The rule to prevent pricing or other forms of monopoly advantage usually only applies to natural or legal monopolies, such as public utilities.
- Because of competition among firms in free market conditions, the prices offered by producers will drop to their average cost of production over time as one company competes for the market share of others by offering the lowest cost product. .
How the Average Cost Pricing Rule Works
This pricing method is often imposed on natural, or legal, monopolies. Some industries (such as power plants) benefit from monopolies because economies of scale can be achieved.
However, allowing monopolies to go unchecked can create economically detrimental effects, such as price fixation. Since regulators usually allow monopolies to charge a small price increase amount above cost, average cost pricing addresses this situation by allowing the monopoly to operate and earn a normal profit.
Average-cost pricing practices are widely supported by empirical studies, and the pricing practice is adopted by a large number of small and large companies in most industries.
Using an average-cost pricing strategy, a manufacturer charges a fee for each product or service unit sold, only in addition to the total cost resulting from materials and direct labor. Businesses will often set prices closer to marginal cost if sales are being affected. If, for example, the marginal cost of a commodity is $1 and the normal selling price is $2, the firm selling the commodity can reduce the price to $1.10 if demand has fallen. The business will choose this approach because an incremental profit of 10 cents from a transaction is better than not making a sale.
Average-cost pricing is well used as the basis for a regulatory policy for public utilities (especially those that are natural monopolies) in which the price received by a firm is determined to be equal to the average total cost of production. goes. The great thing about average-cost pricing is that a regulated public utility is guaranteed a normal profit, usually called a fair rate of return. One bad thing about average cost pricing is that marginal cost is less than average total cost which means the price is higher than marginal cost.
Average-Cost Pricing vs. Marginal-Cost Pricing
In contrast, marginal-cost pricing occurs when the price received by a firm is equal to the marginal cost of production. It is commonly used for comparison to other regulatory policies, such as average-cost pricing, that are used for public utilities (especially those that are natural monopolies). However, a normal profit is not guaranteed for natural monopolies, which is why average cost pricing is more applicable to natural monopolies.