Theory # 1. No Profit, No Loss Principle:
For a long time, the ‘no profit no loss’ principle was regarded as the ideal of price-policy of public undertakings. Since public enterprises are operated in public interest, they should follow the policy different from the private enterprises which are actuated by motivation of profit.
The public enterprises should not charge prices higher than the cost. Unlike private enterprises which quote prices beyond the aggregate cost- the difference being their profit margin- public undertakings should not aim at profit and hence should supply goods or services at cost price. This would be equitable.
At the same time they should see that their operations do not slip into a state of losses. If prices do not cover the cost then the loss has to be made good by the Government by other means like taxation.
Commercial principle of fixing prices to cover all the chargeable costs and general overheads with no attempt to earn profit had been considered as the justifiable form of price policy. Therefore, public enterprises should make neither profit nor incur losses after meeting all costs. The prices charged for different services must be based on corresponding costs.
If the price is less than the cost, there would be inflationary tendency because the deficit has to be covered by the State. This would amount to deficit financing. The State will have to tax more and curb the deficit-induced inflation. If the prices are more than the cost, then the profit-oriented price may smack of exploitation and may be politically challenged.
Moreover, higher prices may lead to diversion of demand towards substitutes etc. Hence public undertakings should make neither profit nor incur loss. Costs are to be covered by the prices in order to avoid over-expansion or under-expansion of the enterprise. Prices are also to be related to the elasticity of demand for the respective commodities or services.
In short, price-policy should be governed by the cost of maintaining operational efficiency and elasticity of demand. If there is surplus, relief should be granted to consumers. Prices should not be kept low by paying unfair wages to the workers or by supplying inferior quality of goods, Prices are to be fair as to cover the normal costs of efficiently operating the enterprises.
Exception to this Principle:
The exceptions to this principle of balanced structure cost-price relationship may be accepted.
They are as follows:
(a) If the enterprise is over-capitalised losses become inevitable and in course of time the state should attempt to eliminate the superfluous part of the assets.
(b) If there is sudden change in technology rendering the existing assets or equipment of the enterprise less useful or obsolete, then losses are inescapable till the new method is duly adopted.
(c) Profits are justifiable if they are designed to be accumulated and applied for expansion.
(d) Profits are also permissible as a method of indirect taxation as in U.S.S.R. Profits are also regarded sometimes essential to reverse the deflationary trend.
(e) Profit through higher prices is also justified when the excess consumption of the commodity or service is sought to be discouraged.
(f) Losses are also tolerated in defence industries as well as to save foreign exchange by encouraging consumption of home made goods at subsidised prices.
(g) Losses arising from granting subsidies to encourage consumption, for example, persons in rural areas may get electricity at lesser-prices, electricity at cheap rates for farming, etc.
Except in these circumstances, prices should, by and large, correspond to the costs of operating and supplying the services to the community.
Theory # 2. Marginal Cost:
It is argued that public enterprises should equate that prices with the marginal costs. Theoretically the output will be optimum and profits maximum at the point where prices and marginal costs coincide. But in practice this may not prove to be a feasible principle.
Under pure competition average and marginal cost tend to be the same and prices related to such costs would reflect, the optimum level. But under conditions where competition is almost non-existent, marginal cost tends to be more than average cost subject to the range of production scale. Moreover state enterprises are heavily capitalised and their costs are relatively fixed. They will have some unutilised capacity to meet peak demands.
As the idle capacity is used, and the plant is further expanded, the costs per extra unit will decrease. Hence marginal costs tend to become lower than the average costs. Therefore prices based on marginal costs may not cover all the operating expenses, provision for interest, depreciation, taxation and other overhead costs.
Consequently, there would be losses which will have to be written off by state subsidies. This wholesale subsidisation is not good public, finance. Eventually the state has to levy additional taxes to bridge the gap and thus benefit of lower pricing at marginal cost will be neutralised by additional taxation.
Theory # 3. Average Cost:
Basing the price on average costs is advocated as a plausible policy in underdeveloped countries where enterprises may not be able to operate at the level of full capacity.
Under marginal cost theory, as noted above, all the costs may not be covered in pricing. Hence the public undertakings have to design such a pricing process as would include all the costs (average costs being total cost averaged per unit of output).
But it would be difficult to define the scope of the costs. It is generally agreed that the costs should comprise operational costs, administrative and selling overhead costs, interest and amortisation charges and preferably a normal rate of return on capital employed.
A public enterprise being a monopolist or near-monopolist undertaking can afford to reimburse all these charges out of prices. Prices are to be related not only to current charges but also capital costs.
Demand trends relative to supply position should be weighed in formulation of a price-structure. When all the costs are covered through a higher range of price, the need for additional taxes will be avoided.
Theory # 4. Price Discrimination:
Many public undertakings provide goods or services whose importance to different sections of people differ. There may also be the necessity of diverting the services for particular purpose on priority basis. If different classes or purposes compete for the use of a service or product provided by an undertaking, prices also should vary even though the product or service is the same.
Price discrimination means charging different prices (for the same product) to different users of different purposes, e.g., lower electricity charges for industrial and agricultural operations and higher charges for domestic consumption; different water rates for household use and for commercial purposes. Prices are also fixed according to the well-known principle of what the traffic will bear.
For example. Railways charge higher rates for valuable articles and lower rates for other goods, more for first class passengers and lower rate for ordinary passengers, higher rates for express trains compared to those for ordinary trains.
The intensity of demand for different prices will be taken into amount for differential pricing. If different parts of the service compete with each other the relative prices shall have to correspond to marginal costs.
Each part of the service must be priced in such a manner as to pave its way avoiding losses and if necessary leaving a surplus to be used for contributing to the common overhead costs. Hence price policy should be linked both with the ‘cost of service’ and ‘value of service’. Discriminating prices based on value of service may prove to be socially and financially justifiable in certain circumstances.
Public may grudge the practice of discrimination resorted to by public undertaking but state undertakings have to convince the concerned users of their duty to contribute to the fixed common costs according to their capacity. Those who receive more benefit shall have to pay more and others the normal rate.
Discrimination not based on unreasonable preferences will not be socially resented. It is unwise to charge uniform rates for services provided at different costs or for services whose benefit is more marked for certain classes.
Theory # 5. Profit:
Nowadays public enterprises also are ordained to earn profit through appropriate price adjustments. Prices should not only cover the current and capital costs but yield a normal profit.
Prof. Lewis believes that the financial test is a primary index of efficiency. Profit-earning capacity is the acid test of effective operation of an undertaking. Without charging too high a price the rates should be so fixed as to generate reasonable surplus after meeting all the actual and expected expenses (recurring and non-recurring) including capital costs.
The capacity to create sufficient demand for the products or services at profit- yielding price without disturbing the optimum level of output is the real test of efficiency.
Criteria of Judging Efficiency through Price Policy:
(a) Cost of manufacturing the product or operating a service should be minimum by comparable technical standards.
(b) Capacity to meet the demand of the market.
(c) Durability and suitable quality of the product so as to create maximum response among the consumers.
(d) Rate of return on the capital invested should be reasonable and comparable to rates of profit, dividend or interest that would have been obtained had the capital been invested somewhere else.
Objectives of Profits Earning:
Profit is to be earned by a state enterprise for fulfilling the following objectives:
(i) To pay a specified sum to the state exchequer as a return on the capital provided by the state.
(ii) To repay any subsidies, if granted by the state, to bridge the revenue gap of the enterprise.
(iii) To make provision for replacement or for expansion.
(iv) To plough back the surplus for further investments.
(v) To create a fund for offsetting any losses that may occur in lean years,
(vi) To provide relief to all or some consumers.
(vii) To improve the amenities of workers.
(viii) To contribute surplus to the state for financing part of the investment and maintenance expenditure of the Government, i.e., to generate a surplus as one of the means of financing economic development.
If the state can finance its schemes and balance its general budget through the surplus contribution by public undertakings, the Government will be saved from the unpleasant task of increasing the taxes on personal incomes or on commodities.
Particularly, in developing countries where taxable capacity is less, power to tax is inhibited by political pressures, or the administrative machinery is weak, prices charged by the state enterprises should contain the fiscal element also, i.e., of increasing the Government revenue without direct resort to taxation.
Care should be taken to ensure that profit is not earned by:
(a) Exploiting the labour through unfair wages, bad working conditions, longer hours of work, etc.
(b) Concealment of social costs by destroying any amenity, or causing any disturbance, insanitary conditions etc.
(c) Higher margin on smaller output or higher price not justified by the quality.