A reconsideration of full-cost pricing [Elektronische Ressource] : methodological aspects of marginalism and theoretical explanations of pricing behaviour / vorgelegt von Elmar Nubbemeyer

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AReconsiderationofFull-CostPricingMethodologicalAspectsofMarginalismandTheoreticalExplanationsofPricingBehaviourInaugural-DissertationzurErlangungdesGradesDoctoroeconomiaepublicae(Dr.oec.publ.)anderLudwig-Maximilians-UniversitätMünchen2010vorgelegtvonElmarNubbemeyerReferent: EkkehartSchlichtKorreferent: KennethCouttsDatumdermündlichenPrüfung: 8.November2010Promotionsabschlussberatung: 17.2010cknoAwledgementsThis thesis was written in the years 2007-2010 during my time as a researchand teaching assistant at the Seminar für Theorie und Politik der Einkom-mensverteilung at the Ludwig-Maximilians-Universität München and my stayat 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 bothacademic 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 mysecondary supervisor. I am very grateful for his generous hospitality and hisinterest in my work. I also want to thank Florian Englmaier, who kindly agreedto act as my third examiner.Many friends and co-workers supported me in the course of this work.

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AReconsiderationofFull-CostPricing
MethodologicalAspectsofMarginalismand
TheoreticalExplanationsofPricingBehaviour
Inaugural-Dissertation
zurErlangungdesGrades
Doctoroeconomiaepublicae(Dr.oec.publ.)
anderLudwig-Maximilians-UniversitätMünchen
2010
vorgelegtvon
ElmarNubbemeyer
Referent: EkkehartSchlicht
Korreferent: KennethCoutts
DatumdermündlichenPrüfung: 8.November2010
Promotionsabschlussberatung: 17.2010This 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
cknowledgementsA1.1 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 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
2.1 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
Maull-CosttPricingryCosting866PriceF2hPrefacee1PrginalistersistenceTheoofandAbsoOnrptionContents13Contents
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
Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
2.4.2 Institutional Stabilizers of Cost Allocation Methods . . . . 98
2.4.3 Summary and Outlook . . . . . . . . . . . . . . . . . . . . . 109
2.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
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 . . . 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
4.1 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
3PInationandCost-PlusricingDisp4Pricing114andyersion,UncertaintPrice154HeuristicsCost-PlusContents
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
5
Bibliography205202Epilogue3.1 The Probability Density Function of u for Different Values of b . . 126
3.2 Prices and Distortions z . . . . . . . . . . . . . . . . . . . . . . . . 138
3.3 Profits and 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
ListFiguresof1.1 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
ofTListablesWhen 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
PrefacePreface
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.
These cost estimates are often derived by traditional costing systems that
crudely allocate common and joint costs to individual products and have been
criticized for leading to distorted cost measures. As will be shown in this work,
these aspects of pricing behaviour have implications both for the profitability
of individual firms and the aggregate behaviour of prices in the market. The
motivation if this research project is thus threefold.
Firstly, I seek to reassess the aforementioned controversy on marginalist price
theory to determine whether the loss of interest in studying the details of the
pricing decision due to a reliance on the validity of marginalist price theory is
justified. As I will discuss in Chapter 1, entitled “Marginalist Price Theory and
Full-Cost Pricing”, the debate on cost-plus pricing, and with it the concern for
the development of fitting theoretical approaches to accurately represent the
pricing decision, ended prematurely. Not only have supporters of marginalist
price theory failed to put forward convincing empirical evidence for the valid-
ity of their approach, but also remain their theoretical justifications incomplete
and unsatisfactory in several respects. Furthermore, empirical and theoretical
investigations regarding the foundations of the marginalist approach fortify the
view that economists should have little reason to exclusively resort to marginal-
ist pricing theory for conducting research. In the discussion of the problematic
9Preface
aspects of the prevailing theoretical framework, some alternative possibilities
are outlined regarding research strategies that may lead to a price theory that
is more coherent and consistent with reality.
The second motivation for this work is to shed light on some of the aspects
that are responsible for the wide use of full-cost pricing, and the related preva-
lence of cost allocation techniques in management accounting. In Chapter 2
and 3, prevailing pricing methods are studied using two different approaches.
Chapter 2, entitled “On the Persistence of Absorption Costing”, examines the
pricing and costing behaviour of firms within a framework of institutional eco-
nomics. It is shown that full-cost pricing techniques have been institutionalized
due to historical, political and economical reasons during the end of the 19th
and the early 20th century. Up to the present day, institutional factors stabilize
its persistence against pressures for change despite apparent economic ineffi-
ciencies. Yet it will be shown that an obvious argument along the lines of path
dependency and institutional lock-in effects does not suffice to explain why
firms continue to use supposedly inefficient costing systems when more ad-
vanced systems such as Activity-Based Costing are widely available and have
been heavily propagated during the last 20 years. Instead, it will be argued
that a range of institutional stabilizers, namely psychological fallacies, auxil-
iary functions of cost allocations and the external effect of financial accounting
regulations deter management accounting change towards more modern ap-
proaches. Through this investigation, it will become clear that pricing is gov-
erned by many other aspects besides purely economic forces, a fact that is not
recognised in the marginalist approach.
Chapter 3, entitled “Cost-Plus Pricing and Uncertainty”, investigates the
pricing decision in the context of demand uncertainty. For this purpose a model
is developed that, at first glance, resembles a pure neoclassical formulation of
cost-plus pricing. Yet in the course of the chapter, a theoretical approach of
modelling the pricing decision is introduced that aims at an actual description
of firm behaviour, rather than resorting to instrumentalist as-if justifications.
The model distinguishes between the two most common forms of cost-plus
methods, namely variable and full costing. It is recognised that firms are char-
acterized by incomplete knowledge about their market environment and thus
rely on rules of thumb. In this setting, a justification for the wide use of full-
cost pricing emerges. It is shown that under settings of both monopoly and
10