The Relationship Between Price Indices and Pricing Methods

Introduction

Price, which is the value paid for the change of ownership in the purchase of a good or service, is considered as the factor that determines how much that goods or service will be produced, how much it will be consumed, and which firms will make this production for which consumers. Price is an economic variable of great importance for all market actors as the main determinant of consumer behavior, the source of firms' profit, and the factor that ensures the efficient distribution of resources in the economy. For this reason, pricing which refers to the process of determining the price as a result of the evaluation of the factors affecting the price has gained a very important place in the economic literature. If the markets operating in the economy fulfill the perfectly competitive market assumptions, the price will be taken as given from the market and there will be no such issue as pricing. However, in today's economies, as the imperfect competitive markets are common, each firm has more or less the power to set prices in the market and pricing becomes one of the most important decisions of the firms. Firms prefer various pricing methods in line with targets such as profit maximization, market growth, survival, and leadership depending on multivariable factors such as the structure of the market, life of the goods, production costs, market power, demand for goods, price and demand in complementary and substitute product markets.

Firms mainly use three different pricing methods: cost-based, demand-based, and competition-based pricing. Incumbent firms operating in the markets, potential firms seeking entry, policymakers, and regulatory authorities closely follows the pricing methods used in the markets for their strategies and decisions. While not the pricing method used by each firm in the market, determining the pricing method commonly used in the market is very important for these market actors. There were two basic ways to determine the commonly used pricing method in a market. The first of these is to collect and analyze the private information of all firms in the market. This method is not useful and is not much preferred because the firms are reluctant to share their private data and because it is difficult and costly to compile and analyze the data to be obtained in markets where the number of firms is high. The second method is the determination of the commonly used pricing method in the market with the help of a causality relationship between producer and consumer prices. In the empirical analysis, price indices are used to represent producer and consumer prices. This method is very useful and highly preferred because the available data on the market is sufficient for analysis.

Price indices are the criteria used to analyze the changes in prices of selected goods and services and to compare the changes in average prices. Among price indices, the most used are the consumer prices index (CPI) and the producer prices index (PPI). The existence and direction of the causality relationship between PPI and CPI are highly controversial as empirical studies in the literature have yielded disparate results. There are four types of relationships that can be inferred from previous studies. The first is the one-way causality relationship from the CPI to the PPI, the second is the one-way causality relationship from the PPI to the CPI, the third is the two-way causality relationship between the PPI and the CPI, and the fourth is a state of independence, which means that there is no causality relationship between these two indices. At this point, the leading view is the supply-side approach. According to this approach, there is a causality relationship from producer prices to consumer prices, so producer prices determine consumer prices. On the other hand, it is argued that the demand-side approach may dominate the market. According to this approach, the causality relationship is from consumer prices to producer prices, and therefore consumer prices determine producer prices. Approaches that find the two-way causality relationship between the two indices argue that there are mutual interaction and producer prices and consumer prices cannot be evaluated independently. Studies, which argue that there is no causality relationship between the indices, emphasize that the indices act independently by drawing attention to the differences in the calculation methods. As a result, the causality relationship from producer prices to consumer prices indicates that the supply-side approach is dominant in the relevant market and that the cost-based pricing method is commonly used, if the causality relationship is from consumer prices to producer prices, it indicates that the demand-side approach is dominant and the demand-based pricing method is commonly used.