Pricing on marginal cost basis means that the prices should be so set that at least the marginal costs, preferably direct costs, are covered. Ordinarily, the total cost can be divided into two board categories: fixed costs and variable costs. Up to a certain level of output, fixed costs remain unchanged irrespective of the volume of production. Thus, under the marginal cost pricing system the relevant costs are the variable costs or the direct costs.
The use of marginal cost pricing in the case of export markets is advocated on the basis that if the manufacturers are able to realize the direct costs including those involved in export operations specifically, they would be able to export without in any way affecting the overall profitability of their firms. Thus, in export operations, profitability has to be assessed not in elation to average costs but with references to marginal/direct cost which should ordinarily constitute the basis for export pricing. In other words, the profitability should be measured in terms of contribution from exports towards fixed costs.
There are a number of points in support of the use of marginal cost for export pricing:
Export sales are additional sales and, therefore, these need not be burdened with overhead costs which are ordinarily recovered from the domestic markets.
The manufacturer’s product is probably less well known in foreign markets than that of his competitors from developed countries, and therefore, price may have to be used as a technique for securing market acceptance for products newly introduced into the market with established competitors.
The markets for the products of developing countries usually are in countries with low national income. In such cases, high prices may limit the sales to a small segment of the market. Low prices, on the other hand, may serve to widen and create markets. In many of these countries price is still the decisive factor and quality is comparatively less important.
Competition in foreign markets may require quotation of a lower price:
Some domestic costs do not apply to exports, e.g. domestic promotion and market research costs.
The use of direct costs for export pricing would necessarily lead to a differentiation in the domestic price and the price charged to the foreign buyers. But this differentiation is not uncommon even among the developed countries. The team on Techniques of International Trade sponsored by the National Productivity Council pointed out that export prices are set on the basis of what the traffic can bear and often unrelated integrity to domestic prices or even to costs of manufacturer. Here it may be worthwhile to refer to the Japanese practice of marginal cost pricing.
In firms where many of the workers live at the plant, either in dormitories or in other company houses, it would pay a firm to operate if income covered raw material costs, power and relatively little else. Even below this point, the higher cost of paying traditional, contractual, or legal severance wages serves as a bar to disbanding a work force except in the face of a long lived loss of sales.
The question would then arise: How to recover the fixed or overhead costs? There are two possibilities – (1) fixed costs may be recovered from the domestic market, and (2) extra loading may be done on commodities that can bear high costs.
The feasibility of the adaptation of marginal cost pricing would, however, depend upon (1) the existence of a large home market; (2) adoption of mass production techniques which will reduce the gap between the full and the marginal costs, and (3) the capacity of the home market to pay higher prices. Gain, the basic assumption for the use of marginal cost pricing is that additional production for exports is possible without increasing overhead costs.
Operating conditions justifying the use of marginal cost for exports:
(1) When the firm reached the break even point on the basis of domestic costs.
(2) Where overheads are substantial.
(3) Domestic market is not large enough to ensure full capacity utilization
(4) When export incentives are available.