A Reconsideration of Full-Cost Pricing Methodological Aspects of Marginalism and Theoretical Explanations of Pricing Behaviour Inaugural-Dissertation zur Erlangung des Grades Doctor oeconomiae publicae (Dr. oec. publ.) an der Ludwig-Maximilians-Universität München 2010 vorgelegt von Elmar Nubbemeyer Referent: Ekkehart Schlicht Korreferent: Kenneth Coutts Datum der mündlichen Prüfung: 8. November 2010 Promotionsabschlussberatung: 17. November 2010 Acknowledgements This thesis was written in the years 2007-2010 during my time as a research and teaching assistant at the Seminar für Theorie und Politik der Einkom- mensverteilung at the Ludwig-Maximilians-Universität München and my stay at the University of Cambridge, UK. First and foremost, I would like to thank my supervisor Ekkehart Schlicht. His trust, universal support and strong interest in my research ideas were cru- cial for the success of this project. He always took time for my requests, in- spired me with countless suggestions and was a great mentor in matters both academic and not. Furthermore, I thank Ken Coutts, who invited me to a re- search visit at the University of Cambridge, UK and later agreed to act as my secondary supervisor. I am very grateful for his generous hospitality and his interest in my work. I also want to thank Florian Englmaier, who kindly agreed to act as my third examiner. Many friends and co-workers supported me in the course of this work. My dear colleagues and friends Roberto Cruccolini and Christoph Stoeckle helped me in many ways and contributed to a great working atmosphere. Maria Mor- genroth took care of all administrative tasks and often provided good advice. I am also indebted to the student helpers at our chair, who did an excellent job with the oftentimes laborious literature search and related tasks: Regina Burghart, Fabian Lutz, Sabrina Martin, Veronika Martini and Felix Ward. Jon Frost did a remarkable job proofreading the manuscript. My friends Tina Hechinger, Alexander Mahle and Patrick Schenk also helped me, each in their own way. I am also very grateful to Selwyn College, Cambridge, and in par- ticular the members of its Middle Combination Room for their kindness and hospitality during my stay. I also thank my brother Andreas Limoser, my grandmother Herta Limoser, and Susi Alt for their support and patience during my eight years of university education. This work is dedicated to my beloved parents. 2 Contents Preface 8 1 Marginalist Price Theory and Full-Cost Pricing 13 1.1 Introduction . 13 1.2 On Terminology . 14 1.2.1 Marginalism and Neoclassical Price Theory . 15 1.2.2 A Typology of Cost-Plus Pricing . 16 1.3 The Full-Cost Doctrine and the Marginalist Controversy . 20 1.3.1 The Beginnings of the Full-Cost Controversy . 20 1.3.2 The Marginalist Defence . 25 1.3.3 The Absorption Strategy in Greater Detail . 28 1.3.4 The End of the Full-Cost Pricing Debate . 36 1.4 Further Research on Full-Cost Pricing . 37 1.5 Issues Related to Marginalist Price Theory . 40 1.5.1 The Realistic Understanding of Marginalist Price Theory . 41 1.5.2 Implicit Marginalism and Friedman’s Defence . 43 1.5.3 Further Problematic Aspects of Marginalist Price Theory . 53 1.6 Methodological Aspects of Marginalist Price Theory . 60 1.7 Conclusion . 63 2 On the Persistence of Absorption Costing 66 2.1 Introduction . 66 2.2 An Overview on Contemporary Cost Accounting Practices . 68 2.2.1 Internal and External Accounting Systems . 68 2.2.2 Accounting Cost Classifications . 69 2.2.3 Some Stylized Facts on Cost Structures . 72 2.2.4 A Typology of Management Accounting Systems . 72 2.2.5 Empirical Evidence on Costing and Pricing . 78 3 Contents 2.3 The Historical Development of Cost Allocation Practices . 81 2.3.1 Cost Accounting Before World War I . 81 2.3.2 Government Control and Cost Allocation During World War I and II . 82 2.3.3 The Dissemination and Institutionalization of Cost Allo- cation Practices . 84 2.3.4 Diverging Developments of Management Accounting in the 20th Century . 86 2.4 The Persistence of Absorption Costing in Management Accounting 90 2.4.1 An Institutional Framework of Management Accounting Change . 90 2.4.2 Institutional Stabilizers of Cost Allocation Methods . 98 2.4.3 Summary and Outlook . 109 2.5 Conclusion . 111 3 Cost-Plus Pricing and Uncertainty 114 3.1 Introduction . 114 3.1.1 Cost-Plus Pricing in Economics and Management Ac- counting Research . 115 3.1.2 Uncertainty, Pricing and Cost-Plus Methods . 120 3.2 The Choice of Cost-Plus Pricing Methods in Monopoly . 121 3.2.1 The Neoclassical Approach to Demand Uncertainty . 122 3.2.2 A Behavioural Approach to Pricing and Uncertainty . 130 3.3 Choice of Costing Systems under Uncertainty and Competition . 140 3.3.1 The Neoclassical Approach to Demand Uncertainty un- der Competition . 141 3.3.2 The Behavioural Approach to Pricing and Uncertainty under Competition . 147 3.4 Summary and Conclusion . 152 4 Price Dispersion, Ination and Cost-Plus Pricing Heuristics 154 4.1 Introduction . 154 4.2 Previous Research on Inflation and Price Dispersion . 156 4.2.1 Empirical Evidence . 156 4.2.2 Theoretical Explanations . 158 4 Contents 4.3 A Monopoly Model of Cost-Plus Pricing with Inflation . 162 4.3.1 Model Setup . 162 4.3.2 Optimal Pricing . 164 4.3.3 Price Dispersion under Mark-Up Pricing on Historical Costs . 167 4.3.4 Pricing Using a Nearly-Optimal Cost-Plus Heuristic . 172 4.3.5 Overview and Interpretation of Results . 182 4.4 A Model of Imperfect Competition . 186 4.4.1 Model Setup . 186 4.4.2 Pricing Using a Nearly-Optimal Cost-Plus Heuristic . 187 4.5 Conclusion . 197 4.A Appendix . 199 Epilogue 202 Bibliography 205 5 List of Figures 3.1 The Probability Density Function of u for Different Values of b . 126 3.2 Prices and Distortions z . 138 3.3 Profits and Distortions z . 139 3.4 Expected Profits and b . 140 4.1 Staggered Cost-Based Prices . 169 4.2 Absolute and Relative Price Variances and Rates of Inflation . 171 4.3 The Probability Density Function of z for Different Values of b . 174 4.4 Expected Prices, Costs and Profit Mark-Ups against Inflation . 183 4.5 Absolute Price Variances . 184 4.6 Coefficients of Price Variation . 185 4.7 Absolute Variances of Individual and Aggregated Prices . 195 4.8 Standard Price Deviations and Rates of Inflation . 199 6 List of Tables 1.1 Shares of Full Costing Firms . 38 2.1 Categories of Unit Costs in Mangement Accounting . 70 2.2 Diffusion Rates of Activity-Based Costing . 80 7 Preface When I first learned about the phenomenon that most firms set their prices by applying a profit mark-up on full costs, I was sceptical if this topic would lend itself to a fruitful research question. My doubts were not grounded in my conviction that the issue was not highly interesting, let alone important. Rather, I expected that such a vast body of ideas and economic research had already been done on the subject that there would hardly be any “new land to conquer”. With patience, my supervisor Ekkehart Schlicht repeatedly asserted to me that by and large, there barely exists any mainstream economic research on why firms use this pricing method and not another, and what economic implications are entailed by this pricing behaviour. I found it hard to believe him. Given the importance of a thorough understanding of pricing behaviour for economic research in many areas of the field, how could this phenomenon not have been subject to extensive research? I believe I have, in the course of this project, found some answers to this question, having greatly benefited from working with Kenneth Coutts, a lead- ing expert in the field. Yet a part of me is still puzzled by the fact that something so fundamental to economic theory as the pricing decision has not been stud- ied to an appropriate extent. Contemporary mainstream economists rely on the principles of marginalist price theory whenever pricing behaviour needs to be modelled in micro- or macroeconomic settings. Firms are assumed to be profit maximizers, and thus equate marginal revenues and marginal costs to find the price/output combination which yields optimal profits. This neoclas- sical framework can be extended to incorporate various other scenarios such as costly information, specific market settings or assumptions on growth and innovation. While optimal strategies under these extensions are studied quite rigorously in mainstream economics, these models are generally treated as if they generated reliable positive predictions for reality. In this sense, economists 8 Preface rest on the general validity of the postulates of marginalist price theory. Yet as I will argue, this faith is not grounded in empirical confirmation, but rather in questionable theoretical reasoning and probably the lack of an alternative that is as easily and generally applicable. That economists rely blindly on marginal- ist theory has not always been the case. In the first half of the 20th century, evidence of actual pricing behaviour of firms was discussed to a significant ex- tent among economists and the validity of marginalist price theory was called into question. After a fierce debate, proponents of marginalism were success- ful with their defence strategy and a generalized version of neoclassical eco- nomics emerged as the victor of the controversy. This approach has since then been the exclusive theoretical framework for industrial pricing in mainstream economics. Since the controversy ended, empirical research has continued to provide ev- idence for cost-plus pricing behaviour. Most firms set their prices by adding a profit mark-up to a full-cost base that includes fixed overheads which should be, according to neoclassical postulates, disregarded for the pricing decision.