What is 'Average Cost Pricing Rule'

The average cost pricing rule is a pricing strategy that regulators impose on certain businesses to limit what they are able to charge consumers for its products or services to a price equal to the costs necessary to create the product or service. This implies that businesses will set the unit price of a product relatively close to the average cost needed to produce it.

BREAKING DOWN 'Average Cost Pricing Rule'

This pricing method is often imposed on natural, or legal, monopolies. Certain industries (such as power plants) benefit from monopolization, since large economies of scale can be achieved.

However, allowing monopolies to be unregulated can produce economically harmful effects, such as price fixing. Since regulators usually allows the monopoly to charge a small price increase amount above of cost, average cost pricing looks to remedy this situation by allowing the monopoly to operate and earn a normal profit.

Average-cost pricing practices have been widely supported by empirical studies, and the pricing practice is adopted by a large number of small and large companies in most industries.

Utilizing an average-cost pricing strategy, a producer charges, for each product or service unit sold, only the addition to total cost resulting from materials and direct labor. Businesses will often set prices close to marginal cost if sales are suffering. If, for example, an item has a marginal cost of $1 and a normal selling price is $2, the firm selling the item might wish to lower the price to $1.10, if demand has waned. The business would choose this approach because the incremental profit of 10 cents from the transaction is better than no sale at all.

Average-cost pricing is well used as the basis for a regulatory policy for public utilities (especially those that are natural monopolies) in which the price received by a firm is set equal to the average total cost of production. The great thing about average-cost pricing is that a regulated public utility is guaranteed a normal profit, usually termed a fair rate of return. One bad thing about average-cost pricing is that marginal cost is less than average total cost meaning that price is greater than marginal cost. 

Average-Cost Pricing vs. Marginal-Cost Pricing

By contrast, marginal-cost pricing happens when the price received by a firm is equal to the marginal cost of production. It is commonly used for comparison of other regulatory policies, such as average-cost pricing, that are used for public utilities (especially those that are natural monopolies). However, a normal profit is not guaranteed for natural monopolies, which may be why average-cost pricing is more applicable to natural monopolies.

RELATED TERMS
  1. Monopoly

    A monopoly is a situation in which one corporation, firm or entity ...
  2. Franchised Monopoly

    A franchised monopoly is a company sheltered from competition ...
  3. Monopolist

    A monopolist is an individual, group or company that controls ...
  4. Rate Of Return Regulation

    Rate of return regulation is a form of price setting regulation ...
  5. Discriminating Monopoly

    A discriminating monopoly is a market-dominating company that ...
  6. Cost of Revenue

    The cost of revenue is the total cost of manufacturing and delivering ...
Related Articles
  1. Insights

    How and Why Companies Become Monopolies

    Without competition, monopolies can raise prices and lower quality, leaving consumers little choice. But monopolies can benefit consumers as well.
  2. Investing

    Understanding Marginal Cost of Production

    Marginal cost of production is an economics term that refers to the change in production costs resulting from producing one more unit.
  3. Investing

    Hasbro's Monopoly Revamps 1930s Game Pieces

    Hasbro's new Monopoly Token Madness Campaign introduces hashtags, emojis as replacements.
  4. Small Business

    How Gross Margin Can Make or Break Your Startup

    Find out how your startup's gross margin can impact your business, including why a mediocre margin may spell disaster for a budding business.
  5. Investing

    A Look At Corporate Profit Margins

    Take a deeper look at a company's profitability with the help of profit margin ratios.
  6. Investing

    Industries that tend to have high EBITDA margins

    Find out what industries typically have the highest EBITDA margins. Learn what factors influence how EBITDA margin differs from operating margin.
  7. Investing

    It's Not Illegal If The Government Does It

    The government allows itself the leeway to do many things that would be illegal for a private citizen or corporation.
  8. Insights

    Trust In Utilities

    Even in times of economic turmoil, utilities can be a good investment.
RELATED FAQS
  1. Are monopolies always bad?

    Learn why governments sanction some monopolies, such as monopolies over public utilities, and why these monopolies are good ... Read Answer >>
  2. How does a monopoly contribute to market failure?

    Read a simple overview of the theory of market monopoly, where it originated and some contemporary challenges to the classical ... Read Answer >>
  3. What factors influence competition in microeconomics?

    Find out what influences competition in microeconomics and how perfect competition, monopoly and oligopoly vary in their ... Read Answer >>
  4. What is a utility stock?

    Investing in difficult economic conditions requires knowledge of different stock classes. Utility stocks are one vehicle ... Read Answer >>
  5. How is marginal revenue related to the marginal cost of production?

    Learn about the marginal cost of production and marginal revenue and how the two measures are used together to determine ... Read Answer >>
  6. What's the difference between a monopoly and a monopsony?

    A monopoly exists when a single organization is the sole supplier of a commodity, whereas a monopsony controls the market ... Read Answer >>
Trading Center