Economic Foundations for Pricing

Pricing, like most business decisions, is an art. This is not, however, a justification for basing pricing decisions purely on the hunch of a talented manager. Art is beyond neither critical judgment nor scientific analysis. And talent is rarely by itself sufficient for artistic success. An architect's exceptional creativity, for example, could hardly compensate for an ignorance of structural engineering. No less important are the principles of economics to the successful study and practice of the art of pricing. Yet, if one approaches economics expecting too much, one may well come away with too little. Economic models are not designed to describe realistically the way firms make pricing decisions or the way consumers respond to those decisions.1 Economic models are abstractions; Understanding the economic environment in which pricing decisions are made is an important first step toward making them effectively. This paper reviews the theoretical literature in economics that is most helpful in furthering that understanding. It explains the implications for pricing of three general areas of research: the economics of information, the economics of spatial competition, and the economics of segmented pricing. It also reviews a number of papers that deal with specific pricing problems. *1 am indebted for helpful comments to Mark Albion, Terry Elrod, Abel Jeuland, Roger Kormendi, Chakravarthi Narasimhan, Kenneth Novak, Ram Rao, Subrata Sen, and to an anonymous reviewer. 1. Because of this lack of realism, some marketers approach economics with hostility. They, in effect, judge economics by the standards of good psychology, which it is not. Economic theorists do not claim to describe the processes by which people actually make decisions; they claim rather to explain why certain decisions persist. Economic theory assumes that persistent and widespread behavior, whatever the underlying psychological process leading to it, must somehow be reinforced by success at furthering economic wellbeing. Such reinforcement encourages people, on average, to act as if' they understood and responded rationally to the economic process that rewards their behavior (Alchian 1950; Friedman 1953).