Average Cost Pricing Rule: What it Means, How it Works

What Is the Average Cost Pricing Rule?

The average cost pricing rule is a standardized pricing strategy that regulators impose on certain businesses to limit what those companies are able to charge their 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. This rule usually applies to legal monopolies such as regulated public utilities.

Key Takeaways

  • The average cost pricing rule is a regulatory requirement that a business charge its customers a maximum amount based on the average unit cost of production.
  • The rule is usually applied only to natural or legal monopolies, such as public utilities, in order to prevent price-fixing or other types of monopolistic advantage.
  • Because of competition among firms in free market situations, prices offered by producers will tend to fall to their average cost of production over time as one company competes for the market share of the others by offering the lowest cost product.

How the Average Cost Pricing Rule Works

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.