Pricing practices in very small businesses.
There are many well-established principles that economists rely on when explaining the optimal behavior of large firms regarding their goals, pricing strategies and other decisions. Pricing policy is treated slightly differently, though not inconsistently, in the field of marketing. While economists traditionally assume that consumers and business people have perfect knowledge of the market place, in the actual marketplace the lack of perfect knowledge by both consumers and businesses requires the establishment of a pricing policy. Although most large businesses follow these general pricing guidelines, the question raised is do very small businesses use similar pricing guidelines? This study will exam the behavior of small businesses in northeast Louisiana to ascertain if small businesses follow the same principles in pricing their products and services that are generally followed by large businesses.
Large businesses use well-established economic principles to guide them in developing goals, pricing strategies and other similar decisions. From microeconomics textbooks such as Hyman (2010) and Parkin (2012) to managerial economics textbooks such as Keat & Young (2009) and Thomas & Maurice (2011), the basic principles of price theory are well documented and thoroughly explained. General economic theory suggests that :
a. The objective of the firm is to maximize profits.
b. Optimal prices are chosen based on the demand the firm faces in order to at least cover variable costs and to meet the goal of profit maximization.
c. Changes in the optimal price will occur in response to changes in costs or market conditions.
d. Competition can be undertaken in ways other than price changes.
More specifically, for example, Hyman (2010) states " ... models based on the assumption that those who operate firms seek to maximize profits have proved to be very fruitful. These models have consistently yielded hypotheses that empirical evidence has supported." (Chapter 8, page 7) Parkin (2012) further describes the pricing decision as "It (the firm) produces the quantity at which marginal revenue equals marginal cost and then charges the price that buyers are willing to pay for that quantity ... " (p. 327). Thomas and Maurice (2011) describe in great detail how firms would respond to changes in costs (pp. 404-415) and changes in demand (pp. 476-477). They conclude that if costs increase, firms should respond by reducing output and increasing price. If demand increases, firms should respond by raising output and raising price. Keat and Young (2009) postulate different ways in which firms can compete rather than through price. These forms include "(1) advertising, (2) promotion, (3) location and distribution channels, (4) market segmentation, (5) loyalty programs, (6) product extensions and new product development, (7) special customer services, (8) product "lock-in" or "tie-in", and (9) preemptive new product announcements." (pp 367-368).
These principles, as noted above, are generally used by most large businesses. The question is whether these principles that guide the behavior of large businesses are applicable to small businesses and do small businesses recognize these principles and follow them? Haynes (1964) conducted a study of 88 small firms using an intensive interview process to determine the pricing process of small businesses. He finds that many managers in the study group did not attempt to profit maximize, but rather had "ethical objections" to charging "what the market will bear" (p. 323). Costs of production play a major role in the pricing decision, but not in a simple "cost-plus" mechanical way. Managers also indicate considerable adjustments based on market structure or competition. In another study using interviews of 20 small business owner-managers, 10 of which operated manufacturing facilities and 10 other were in the service sector, Curran (1997) concludes that although costs do form the basis for pricing decisions, the additions to costs vary widely and are determined by many different objectives, not just profit maximization.
The teaching of price policy in business school marketing classes is treated slightly differently, though not inconsistently, from the teaching of price policy in economics classes. Economists traditionally assume that consumers and business people have perfect knowledge of the market place. In that case, price will be set in order to sell the optimum quantity. If set higher, the firm will be unable to sell the quantity it wants to; if set lower, the firm will find it beneficial to raise the price.
[FIGURE 1 OMITTED]
In the actual administration of price policy by business people (see above Figure 1), the lack of knowledge by both consumers and business people allow for a price policy. In that case, there is a band of ignorance around the demand, marginal revenue and marginal cost curves. The price and quantity magnitudes will then be expressed as a band depending on the level of ignorance. Less ignorance will result in a narrower band. As a result, a price policy becomes possible.
Most marketing textbooks discuss price policy (strategy) from the point of objectives, levels, and methods. The typical objectives include profit maximization, satisfactory profits, volume, meeting competition, and others. Levels discussions revolve around pricing above, with or below competitors. Methods involve how to set price specifically, cost plus and demand based. See Boone and Kurtz, 2006; Lamb, Hair, and McDaniel, 2009; and Lascu and Clow, 2008. Entrepreneurship and Small Business textbooks follow this basic model, though in more abbreviated form, for discussing pricing, Carland and Carland,, 1998; Ibrahim and Ellis, 1993; Baumbeck, Lawyer and Kelly, 1973; Scarborough, 2011; Longenecker, Moore and Petty, 2000; and Hodgetts and Kuratko, 1995.
PURPOSE OF STUDY
The purpose of this study is to determine if small firms use established economic principles that economists rely on when explaining the behavior of large firms regarding pricing objectives and strategies.
Although the economic principles used to explain pricing behavior are well accepted as accurate when describing large firms, the question remains whether they are appropriate for small businesses. In other words, do small businesses follow the model? Thus, the general hypothesis of this study is:
Hypothesis: Small businesses generally following the basic principles of economic theory in setting and maintaining prices for their products and services.
Consideration of the general hypothesis resulted in the development of questions revolving around four basic decisions. First, is the entrepreneur looking to maximize profits, just make a satisfactory living, maintain a particular market share, or all of the above to some extent? Second, are initial prices set in order to match competitors' prices, be a little above them or a little below them, or be determined independently of what competitors are doing? Third, should the initial price be based on a cost-plus pricing model, a customer demand model, or a competitors' prices model? Fourth, do changes in price result due to changes in cost, customer demand, or what competitors did? Fifth, are other options for competing being used? Thus, five sub-hypothesis are developed to help test our general hypothesis. These are:
Hypothesis 1: Small businesses set their prices to maximize their profits.
Hypothesis 2: Small businesses' prices are strongly influenced by competitors' pricing.
Hypothesis 3: Small businesses' prices are strongly influenced by cost factors.
Hypothesis 4: Small businesses change their prices in response to changes in costs or market conditions.
Hypothesis 5: Small businesses use ways other than price changes to impact their sales.
In order to attempt to shed light on the above hypotheses, a questionnaire was designed specifically to ascertain the basic price decision-making rules of very small businesses in northeast Louisiana. A series of questions were developed to shed light on the attitudes of owners and managers of small businesses toward pricing their products and services. Respondents were asked to indicate whether they agreed or disagreed with a number of general statements concerning pricing decisions in their business. The questionnaire was reviewed by faculty knowledgeable in questionnaire development and distributed to a convenience sample of owners and managers of very small businesses in northeast Louisiana by students enrolled in an Entrepreneurship class.
Questionnaires were hand delivered by students in an entrepreneurship class to the owners and managers of very small businesses in northeast Louisiana. Since the students waited for the completion of the questionnaires, the return rate was 100%. That is, 100 questionnaires were distributed and 100 questionnaires were completed and returned. Table 1 shows the sample characteristics of the sample.
The study was targeted to very small businesses resulting in a sample of 100 respondents, 68 respondents (75.6% of the sample) were involved in businesses employing five or fewer employees; 9 respondents (10%) in businesses employing six to ten employees; and 13 respondents (14.4%) in businesses employing over eleven employees. As expected in very small businesses, most of the businesses were either retail (39.4%) or service (54.5%). Also as expected in northeast Louisiana, two thirds of the respondents (66.3%) claimed a rural location for their business and the other one-third (33.7%) claimed an urban location. All of the small businesses felt the impact of competition on their day-by-day activities. Only 12.6% of the businesses claimed a market share of over 50%, while 21.1% perceived a market share of under 10%, 25.3% perceived a market share of 11-25%, and 37.9% perceived a market share of 2650%.
Respondents in the sample were mostly (60%) male. The racial demographics followed the general pattern of small businesses in northeast Louisiana with 75.3% of the sample white, 19.6% African American, and 5.1% Asian or Hispanic. The age of the sample mirrored other studies in northeast Louisiana that suggested the decision to open a small business was generally made later rather than early in life. Only 6.2% of the respondents were under 30 years of age while 59.8% were between 30 and 50 years of age, and 34% were over 50 years of age. Almost four-fifths of the respondents in the sample (78.9%) were married. Interestingly, over one-half of the respondents had a college degree (36%) or higher (16%) while 25% only graduated from high school and 23% had some college education.
Analysis of the data reflects the attitudes of respondents concerning general statements involving the five basic decisions outlined above. First, what is the objective of the entrepreneur? Second, what are initial prices based on? Third, what causes price changes? And fourth, do the small businesses try to compete in ways other than price?
Objectives of pricing
As can be seen in Table 2, the entrepreneurs in the sample did not agree on a single basic pricing objective. In responding to the question, "When setting prices, I always try to maximize profits, get a satisfactory profit, cover my variable costs, or maintain or increase my market share," a large majority of respondents selected them all as important elements in their decision. While almost 83 percent of the entrepreneurs believed that making at least a satisfactory profit was important in pricing their products or services, only 65 percent believed in maximization of profits. In the area of non-profit based objectives, only 59 percent of entrepreneurs were concerned with maintaining market share while over 80 percent felt that pricing must cover variable costs Although small business men and women make their pricing decisions more on profitability than upon maintaining market share, making a "satisfactory" profit is more important to them than profit maximization. Thus, it appears Hypothesis 1 cannot be supported by this study.
Price relative to competitors
Respondents were asked how prices were set relative to their competitors. As can be seen in Table 3, about one-half of the entrepreneurs in the sample (52.1%) felt that they should match their competitors' prices. While almost an equal number of entrepreneurs disagreed or agreed with the concept of pricing below their competitors' prices (38.8% and 33.6 respectively), an overwhelming numbers of entrepreneurs disagreed rather than agreed to pricing above their competitors prices (54.2% and 17.5% respectively). Thus, it seems that the majority of entrepreneurs in this sample usually set their prices to match competitors' prices and lean heavily toward not being above their competitors' prices. Thus, there is some evidence in this sample to support Hypothesis 2.
Determinants of price
Should price be cost based, customer based, or competitor based? As reflected in Table 4, most entrepreneurs consider all of these factors in the initial price-setting decision. Interestingly, costs appear to have the most influence in setting prices with almost 82 percent of the respondents feeling that costs of goods sold are important factors in price setting and almost 78 percent feeling that overhead costs are also important in price setting. Over 72 percent of the respondents feel that a customers' willingness or ability to pay is an important factor in price setting and over one-half of the respondents (54.6%) are willing to make special pricing decisions for special customers. Although competitors' prices are important in price setting--with almost 63 percent of the respondents feeling it is an important element in determining prices--it appears to have the lowest impact on price setting than any of the other factors. Thus, there is strong evidence in support of Hypothesis 3.
Factors considered in changing prices
Once prices are set, when and how should the entrepreneurs change these prices? Tables 5 through 9 indicate the attitudes of entrepreneurs toward price changing. Factors that influence an entrepreneur to consider changing prices are shown in Table 5. The most significant factor leading to a price change appears to be costs with 83.2% of respondents feeling costs of goods sold and 82.8% feeling that overhead costs are important factors in initiating a price change. Although competitors' pricing is important, only about 50 percent (51.5%) of the respondents indicated it as an important factor in deciding whether or not to change prices. Customers appear to have only a minimum influence on initiating a price change with only about 40 percent (39.8%) of the respondents considering it an important factor in changing prices.
Table 6 suggests entrepreneurs actually change prices to offset costs changes with 53 percent agreeing with the statement that "I always change prices when costs change" and 42.7 percent agreeing to the statement that "I always change prices when inflation changes". Only 35.1 percent of the respondents agreed they change prices to match competitors' prices and very few had a periodic system of price changes--19.5% changed prices annually and 7.3% change prices every few months.
When the question of price changing was more narrowly focused to keeping up with price changes of competitors, a similar result was found. That is, this sample of entrepreneurs does not appear to be greatly concerned with competitor pricing. As can be seen in Tables 7 and 8, only 9.3 percent of the entrepreneurs would always change their prices when one of their competitors changed prices and only 32.6 percent would always change their prices when most of their competitors changed prices. The entrepreneurs in the sample did, however, express a strong sentiment toward thinking about changing prices when one of their competitors or most of their competitors changed prices, 52% and 60.9% respectively.
As can be seen in Table 9, individual customers received very little consideration when they raised concern over the pricing of products or services. A large majority of the entrepreneurs disagreed with adjusting prices for a single customer (59.1%) or adjusting prices for all customers (67%) based upon customers' objections to prices. Thus, the data presented in Tables 5 through 9 indicate strong support for Hypothesis 4.
Previous analysis was concerned primarily with the factors of costs, customers and competitors on pricing decisions. We also asked our sample if they tried to compete in ways other than through price such as with their product, location, etc. The overwhelming majority of respondents (77%) said that they tried to compete in ways other than through price. Thus, Hypothesis 5 is strongly supported.
Interestingly, although the large majority of respondents said they tried to compete on the basis of something other than price, when asked about a few selected actions, there wasn't much expectation that they would matter. As presented in Table 10, our sample of small business owners/managers did not believe strongly that short-term price reductions or advertising on the radio or television or in the newspaper would have much of a positive impact on sales. Short term price reductions were believed to have a positive impact on sales by only 39.4% of the respondents; radio advertising by 34.7%; TV advertising by 32.0%; and newspaper advertising by 31.3%.
We can conclude from this study that very small businesses in northeastern Louisiana generally follow the basic principles of economic theory in setting and maintaining prices for their products and services. Four of the five sub-hypothesis have been supported in this study. In setting prices, small businesses appear to be strongly influenced by competitors pricing and costs factors. In changing prices they continue to be strongly influenced by changes in costs or market conditions. And an overwhelming majority of the small businesses try to compete in ways other than pricing.
The only exception to following the basic principles of economic theory on price setting was found in the sub-hypothesis of profit maximization. Although 65% our sample of small businesses agreed to the statement "When setting prices I always try to maximize profits," when asked about making satisfactory profits or covering variable costs, these other factors were more important. Over 82% of the respondents agreed with the statement of always trying to make satisfactory profits while 80% agreed with the statement of always trying to cover variable costs. Thus, although it appears that small businesses generally following the basic principles of economic theory on pricing, they are more concerned with covering variable costs and making a satisfactory profit than in maximizing profits.
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Paul Dunn, University of Louisiana at Monroe
Carl A. Kogut, University of Louisiana at Monroe
Larry E. Short, Northwestern State University
Table 1. Entrepreneurial Characteristics Sex Frequency Percent Female 41 6.0 Male 59 8.6 Total 100 14.6 Race NR 3 3.0 White 73 73.0 African American 19 19.0 Asian 4 4.0 Hispanic 1 1.0 Total 100 100.0 Education Level High School 25 25.0 Some College 23 23.0 College Degree 36 36.0 Masters Degree 4 4.0 Graduated/Professional 12 12.0 Total 100 100.0 Marital Status Frequency Percent NR 5 5.0 Single 12 12.0 Single/children 4 4.0 Married/children 67 67.0 Married wo chil 8 8.0 divorced/separated 4 4.0 Total 100 100.0 Age NR 3 3.0 under 30 years 6 6.0 30-50 years old 58 58.0 Over 50 33 33.0 Total 100 100.0 Line Experience Yes 50 50.0 No 50 50.0 Total 100 100.0 Business Characteristics Type Business Frequency Percent NR 1 1.0 Retail 39 39.0 Service 54 54.0 Distribution 3 3.0 Contractor 3 3.0 Total 100 100.0 Rural or Urban NR 2 2.0 Rural 33 33.0 urban 65 65.0 Total 100 100.0 Market Share NR 5 5.1 Under 10% 20 20.4 11-25% 24 24.5 26-50% 36 36.7 over 50% 13 13.3 Total 98 100.0 Full-time Employees Frequency Percent NR 10 10.0 0-5 68 68.0 6-10 9 9.0 11 and over 13 13.0 Total 100 100.0 Part-Time Employees Frequency Percent NR 40 39.6 0-5 46 45.5 6-10 7 6.9 11 and over 8 7.9 Total 101 100.0 * Percentages are computed without non-responses included in the total. ** Data on part-time employees was gathered but 40% of the sample failed to respond to the question. Table 2" Percent of Respondents Indicating Agreement With the Statement When setting prices I always try to Disagree Neutral Agree Maximize Profits 7.3 27.8 65.0 Make Satisfactory Profits 5.0 12.1 82.8 Maintain Market Share 13.6 27.1 59.4 Cover Variable Costs 6.3 13.5 80.2 Table 3: Percent of Respondents Indicating Agreement With the Statement "When setting prices for my products or Disagree Neutral Agree services, I usually set my prices...." Below My Competitors 38.8 27.6 33.6 With My Competitors 12.3 35.7 52.1 Above My Competitors 54.2 34.4 11.4 Table 4: Percent of Respondents Indicating Agreement With the Statement "When setting the price initially Disagree Neutral Agree on my products or services, I carefully consider my ..." Cost of Goods Sold 7.4 10.5 81.9 Overhead Costs 5.1 17.3 77.5 Competitors' Price 23.7 13.4 62.8 Customers Willingness to Pay 9.1 18.4 72.4 Special Customers * 22.7 22.7 54.6 * Individual or special customers such as senior citizens, students, large quantity customers, etc. Table 5: Percent of Respondents Indicating Agreement With the Statement "Before changing prices I carefully Disagree Neutral Agree consider my...." Cost of Goods Sold 8.5 8.4 83.2 Overhead Costs 9.1 8.1 82.8 Competitors' Price 27.9 20.6 51.5 Customers Willingness Income/Lifestyle 37.8 22.4 39.8 Table 6: Percent of Respondents Indicating Agreement With the Statement "I always change prices when...." Disagree Neutral Agree Costs Change 23.4 23.5 53.0 Competitors' Price Change 46.4 18.6 35.1 Inflation Changes 32.3 25.0 42.7 Every Few Months 83.5 9.3 7.2 Once a Year 65.0 15.5 19.5 Table 7: Percent of Respondents Indicating Agreement With the Statement "If one of my competitors change Disagree Neutral Agree prices, I...." Always Adjust My Price 68.1 22.7 9.3 Always Think About What I Should Do 24.5 23.5 52.0 Never Worry About It 64.6 17.2 18.2 Table 8: Percent of Respondents Indicating Agreement With the Statement "If most of my competitors change Disagree Neutral Agree prices, I...." Always Adjust My Price 35.7 31.6 32.6 Always Think About What I Should Do 15.5 23.7 60.9 Never Worry About It 64.6 17.2 18.2 Table 9: Percent of Respondents Indicating Agreement With the Statement "If or when a customer objects to Disagree Neutral Agree my price, I...." Always Adjust My Price 59.1 11.2 29.6 Always Think About What I Should Do 67 21.6 11.3 Never Worry About It 63.3 17.3 19.4 Table 10: Percent of Respondents Indicating Agreement With the Statement "I believe that the following actions Disagree Neutral Agree will have a positive impact on my sales" Reducing Prices * 42.2 18.2 39.4 Advertising on Radio 37.8 27.6 34.7 Advertising on TV 40.2 27.8 32.0 Advertising in Newspapers 36.4 32.3 31.2 * Reducing prices for a short period of time such as a sale