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How Managers Made Pricing Decisions in 1939
We take a deep dive into the classic Hall and Hitch (1939) paper, "Price Theory and Business Behaviour" to explore how pricing decisions were made 85 years ago.
“In staples, price is related to what market will bear. In fancy lines, cost is the basis of price.” - 1930s manager explaining his company’s pricing policy.
In pricing, as in other life domains, there’s value hidden in the past that we often overlook and fail to appreciate. Sellers have been setting prices for millennia. How they set prices then can inform our thinking on how to set prices now.
In this spirit of looking back, in this post, I want to explore how managers made pricing decisions in the middle of the last century by taking a deep dive into a classic paper by Hall and Hitch (1939) titled “Price Theory and Economic Behaviour.”1
A note before we dig in. One focus of the authors was to compare managers’ pricing decisions to the prevailing economic doctrine (“expand production to the point that marginal revenue and marginal cost are equal”). In this post, I am going to bypass most of the comparisons, instead focusing on Hall and Hitch’s core practical question of how managers set prices.
The paper’s goal
Let’s begin with the paper’s purpose, which the authors laid out clearly on the very first page.
“The purpose of the paper is to examine…. the way in which business men decide what price to charge for their products and what output to produce. It casts doubt on the general applicability of the conventional analysis of price and output policy in terms of marginal cost and marginal revenue, and suggests a mode of entrepreneurial behaviour which current economic doctrine tends to ignore. This is the basing of price upon what we shall call the 'full cost' principle, to be explained in detail below.” (p. 12).
Eighty-five years on, the descriptive plus comparative set of questions Hall and Hitch were trying to answer still interests us. We spend a lot of time and effort today to understand exactly what they were interested in: how managers make pricing decisions and how they deviate from economic and, over the past few decades, psychological doctrine. Our answer, like their answer, still tends to be that how managers actually make pricing decisions is nowhere close to theoretical frameworks and models specifying how they should make them.
Next, Hall and Hitch (1939) describe the method they used for the study.
The research method
“The method followed has been to submit the questionnaire to business men who were willing to answer it, and to discuss the questions and answers at length in an interview. We considered the evidence of only 38 of the entrepreneurs interviewed, which is far too small a sample to warrant any final conclusions. Of these, 33 were manufacturers of a wide variety of products, 3 were retailers, and 2 builders. The sample is thus strongly biased in favour of manufacturers, and any conclusions relate particularly to this type of entrepreneur.” (13)
This method is imminently reasonable and would not seem out of place in a paper published in many journals today. Hall and Hitch essentially used convenience sampling, followed by a survey, followed by a sit-down interview with the respondents to probe into their survey responses in depth.
Late last year, a research team led by Federal Reserve Bank of New York economists (Dongra, et al. 2023)2 studied “what factors were most important to firms in setting their prices … and to what extent were firms passing along changes in costs to their prices.” They used essentially the same method that Hall and Hitch used eighty-five years earlier3.
The full-cost pricing method
A vast majority of the managers surveyed by Hall and Hitch used full-cost pricing to set prices for their products and services. They observed:
“The most striking feature of the answers was the number of firms which apparently do not aim, in their pricing policy, at what appeared to us to be the maximization of profits by the equation of marginal revenue and marginal cost…that in pricing they try to apply a rule of thumb which we shall call 'full cost', and that maximum profits, if they result at all from the application of this rule, do so as an accidental (or possibly evolutionary) by-product.” (18-19)
What exactly did full-cost mean to these managers?
Full-cost pricing is cost-based pricing. When costs are used as the main inputs into pricing decisions, the decision-maker must make choices about which costs to include, how they are to be estimated (if they are prospective), and how they will be combined to arrive at the final price. This was true in 1939, just as it is true today.
“An overwhelming majority of the entrepreneurs thought that a price based on full average cost (including a conventional allowance for profit) was the 'right' price, the one which 'ought' to be charged.' In some cases this meant computing the full cost of a 'given' commodity, and charging a price equal to cost. In others it meant working from some traditional or convenient price, which had been proved acceptable to consumers, and adjusting the quality of the article until its full cost equalled the 'given' price. A large majority of the entrepreneurs explained that they did actually charge the 'full cost' price, a few admitting that they might charge more in periods of exceptionally high demand, and a greater number that they might charge less in periods of exceptionally depressed demand.” (19)
Luckily for us, the authors provided verbatim answers given by their respondents to the question of how they calculated full costs. Here are some of the more specific responses from their surveyed managers (34-42):
Net cost of labor + materials + overhead proportional to direct labor + 10% for profit, if possible.
(Labor & materials) x 2.2 to 2.3; i.e., assumes that overheads will be covered by this. Actually this gives 10 to 15% profit.
Total cost + 10%. Overheads are very small.
Materials + labour + overheads + intended profit. Overhead split to departments, then spread ‘evenly.’
They start from a conventional price, and produce an article whose full cost equals this price. Overheads determined on basis of full working. The selling department then adds ‘something’ for selling costs, risk, and profit. Allowance for risk varies from line to line.
Overheads (about 65% of total cost) distributed on the basis of forecast output. There was a range of 40% between the highest and lowest prices on an article, depending on the size of the order.
Manufacturing cost + transport cost + ‘reasonable profit’ gives wholesale price. This is usually doubled to get retail price.
Direct cost + overheads + a variable percentage (depending on whether the line is standard or ephemeral) for profits. Overheads distributed on actual output, except that where expansion of sales is expected, estimated output may be taken.
Overheads computed on basis of of forecast output, mainly in light of recent experience. Overheads vary from 60% to 400% of works cost in different lines. Distribution expenses taken as a percentage of selling price.
(Direct costs + overheads) + 5% for profits. Overheads based on estimated turnover.
Material cost + weaver’s wage + a percentage of this wage to cover overheads, &c. Overheads on the basis of the past six months.
While there is obvious overlap in these responses, there are also some interesting differences. All responses have direct costs, overhead, and a markup factor at the heart of their full-cost pricing calculation. However, what is considered direct cost, what is considered overhead and how it is calculated, what markup factor is used, and how it is chosen differ quite a bit from one response to the next.
The most striking thing is how prevalent the very approaches described by the managers in 1939 are today. For instance, here’s a quote in the Dogra et al. (2023) paper from one of their respondents about how they set prices:
“We look at what’s been the evolution on labor rates, raw material rates, and so on…. We look at the cost to produce. All that is factored in and then we basically come up with a price based on that.” -- Wood container and pallet manufacturer, August 2021.
I could have easily moved this quote to the 1939 list, and it would have fit right in! Reading Hall and Hitch’s work makes us realize how little pricing has changed in many industries in 85 years.
The role of competition
While Hall and Hitch didn’t ask directly about competition, the respondents brought it up quite often. Hall and Hitch summarized what they found in this way:
“What, then, was the effect of 'competition'? In the main it seemed to be to induce firms to modify the margin for profits which could be added to direct costs and overheads so that approximately the same prices for similar products would rule within the 'group' of competing producers. One common procedure was the setting of a price by a strong firm at its own full cost level, and the acceptance of this price by other firms in the 'group'; another was the reaching of a price by what was in effect an agreement, though an unconscious one, in which all the firms in the group, acting on the same principle of 'full cost', sought independently to reach a similar result.” (19)
Essentially, considering competitors made prices more homogeneous and stable within the category and conferred pricing power on the market leader. The market leader decided what markup factor should be used, and other category members followed.
Why did managers use the full-cost method?
Hall and Hitch looked at the rationale behind the popularity of full-cost pricing. They found that both personal beliefs (e.g., “This is the best way to price, this has worked for us in the past, this method will lead to the “right” price) and group beliefs (e.g., endorsed by trade associations, used by competitors) played a role. The tables below provide insights into the significance of full-cost pricing for these managers.
As you can see, most of the reasons listed for favoring the full-cost method instead of pricing higher or lower are those that managers use today. A price higher than the “regular” cost-plus price will lead to lost market share if competitors don’t match the raise or push back from customers who are “technically informed regarding costs.” A price lower than the cost-plus price may lead to lost profit if sales don’t increase, would make it hard to raise prices in the future, or lead to prices spiraling down if competitors match it enthusiastically. One reason mentioned we likely wouldn’t see today is “quasi-moral objections to selling below cost,” based on a concern about being fair to their competitors.
The knowledge of underlying pricing inputs
Hall and Hitch (1939) considered how the knowledge (or lack thereof) of pricing decision-makers affected their use of the full-cost pricing method. They concluded that managers’ reliance on full-cost pricing was driven by their perceived lack of knowledge and concerns about how doing anything different would affect the status quo. Hall and Hitch listed six factors contributing to the heavy reliance that I’ve edited lightly (22):
A lack of understanding of the demand or marginal revenue curves for their product because (a) they don’t know their customers’ preferences, and (b) they don’t know how their competitors will react to their price change.
Fear their competitors would cut prices if they cut.
Fear their competitors wouldn’t raise prices if they did.
Are convinced that “the elasticity of demand for the group of products [i.e., category demand] is insufficient to make this course pay.”
Raising prices will make it easier for new entrants to enter the market.
Changes in price are frequently very costly, a nuisance to salesmen, and are disliked by merchants and consumers. There are conventional prices to which customers are attached.
These arguments are valid, and like other findings in the paper, would also apply to many companies that use cost-based pricing today. Even with the infusion of optimization, display, and price surveillance technologies that have drastically reduced menu costs and allowed prices to be changed instantaneously, Hall and Hitch’s list still serves as a warning from the past to today’s managers. They should be deliberate when changing prices frequently and when adopting a variable pricing policy. Varying prices affect sales, competitors’ responses, employees, and customers, and not necessarily in a good way.
Hall and Hitch’s (1939) conclusions
In the paper’s recapitulation, Hall and Hitch (1939) listed their main findings.
If our sample is at all representative of business conditions, we suggest that the following conclusions may be drawn:
A large proportion of businesses make no attempt to equate marginal revenue and marginal cost in the sense in which economists have asserted that this is typical behaviour.
An element of oligopoly is extremely common in markets for manufactured products; most businesses take into account in their pricing the probable reaction of competitors and potential competitors to their prices.
Where this element of oligopoly is present, and in many cases where it is absent, there is a strong tendency among business men to fix prices directly at a level which they regard as their 'full cost'.
Prices so fixed have a tendency to be stable. They will be changed if there is a significant change in wage or raw material costs, but not in response to moderate or temporary shifts in demand.
There is usually some element in the prices ruling at any time which can only be explained in the light of the history of the industry.”
What can we conclude from Hall and Hitch’s influential work? A number of things. First, cost-based pricing in the form we know it today has an established history. Businesses have been using it widely and successfully for at least 85 years (a lot longer, actually, but that’s a different post).
Second, as Hall and Hitch discovered from their respondents, there’s a compelling case to be made for using full cost for setting prices. I would add that these reasons are as valid today as they were in 1939. (See my post, “A balanced assessment of cost-based pricing” for a detailed discussion).
Third, business academics have been trying for a long time to find an overlap between what their theories suggest managers should do and what they actually do. Hall and Hitch found a vast gap in 1939 between theory and practice, just as Dogra and his colleagues did in 2023.
Finally, perhaps one of Hall and Hitch’s most penetrating insights is the last point on the list, which is that no specific theoretical method or prevailing best practice can fully explain the pricing method in a specific industry. Tradition and industry norms within a particular industry often have an outsize influence. Prices can be set in idiosyncratic ways, even when they are clearly not the most optimal or effective. Today, for instance, variable pricing means very different things for pricing concert tickets than it does for pricing tomato ketchup.
The upshot is that to make effective pricing decisions, it pays to be informed about both the current state of academic thinking and the current state of best practice. For setting prices, there has been, and continues to be, considerable divergence between what is published in the journals and what happens in the real world.
Hall, R. L., & Hitch, C. J. (1939). Price theory and business behaviour. Oxford Economic Papers, 2, 12-45.
Dogra, K., Heise, S., Knotek II, E. S., Meyer, B, H., Rich, R. W., Schoenle, R. S., Topa, G., van der Klaauw, W., & Bruine de Bruin, W. (2023). Estimates of cost-price pass-through from business survey data, Federal Reserve Bank of New York Staff Reports, no. 1062, June.
It should be acknowledged that Dongra et al. (2023) reversed Hall and Hitch’s (1939) quantitative-qualitative sequence in their study’s implementation. They conducted interviews first to get “a deeper look at pricing in an unstructured setting” and then used insights from the interviews to design and administer a survey to “700 business contacts from the networks of the Federal Reserve Banks of Atlanta, Cleveland, and New York during December 2022 and January 2023.”