Given the nature of average-cost pricing models one should expect prices to be much more sensitive to changes in cost than to changes in demand.

A change in costs:

If there is a minor change in costs, firms would tend to absorb it by variation in the quantity or quality of their product.

For example, a small increase in factor prices would lead firms to change the appearance of the product (e.g., a new packaging) so as to allow them to reduce the quantity offered at the going price (e.g. sell cigarettes slightly shorter, offer a thinner chocolate bar).

Similarly, if there is a minor decrease of factor prices, firms will not disturb the price, being afraid of triggering a price war, but would rather pass the reduction in costs to customers via improved quality or increased quantity at the given price.


However, if the change in costs is substantial, price will be accordingly changed. A substantial fall in costs, originating from fast technical progress in the industry or a fall in factor prices, will result in a decrease in price, otherwise the excess profits would attract entry and endanger the long-run profitability of the existing firms. Similarly, if there is a substantial increase in factor prices all firms in the industry are similarly affected and the price will be raised eventually to cover the increased costs.

Change in demand:

If demand increases, in the short run firms will usually prefer to adopt a queuing policy (backlog of demand) rather than increase their prices, because they do not know whether the pressure of demand will last for long and they are afraid to damage their reputation by exploiting a ‘temporary sellers’ market’. If the increase in demand persists, firms will install new equipment and expand their capacity, thus moving to a new point on their LRAC, where the cost per unit of output is not expected to be higher, and may probably be lower.

This expectation about the shape of the LRAC deters firms from raising their price, lest they should attract entry and damage permanently their goodwill with dissatisfied customers who would shift their purchases to the new entrants if they charged a price lower than the ‘exploitative’ one of their old suppliers.

If demand declines, in the short run firms would avoid an increase in the price to cover probably higher costs (as they are pushed backwards to levels of output cor­responding to the increasing part of their cost curve); such a policy would almost certainly accelerate the decline of sales. In the short run the firm would, while holding its price unchanged, search for the causes of the decline in sales and act accordingly.


For example, if the fall in demand is due to change in tastes, the firm will improve or alter its product or diversify. However, under conditions of secular decline in demand weaker firms, faced with decreased liquidity, may be led to the desperate action of price- cutting. This would then be generalized in a competitive price-cutting and a price war, in which the most efficient firms would survive and the market would settle to a new equilibrium. In summary, average-cost theories predict that prices would tend to be sticky, changing less than marginalism would imply in the face of changing demand.

Imposition of a tax:

In average-cost theories the imposition of a corporate tax (lump-sum or profit tax) will affect all firms similarly and hence all firms will raise their price concurrently, thus shifting the tax to the customers. Similarly the imposition of a specific tax per unit of output would shift the A VC curve upwards and even with the same GPM, price would increase by the full amount of the tax.

The difference between the corporate tax and the specific tax is that in the first case the AFC will shift upwards and the GPM will be accordingly readjusted, while the tax per unit of output shifts upwards the AVC. However, both types of taxes will be passed on to the buyers.

The prediction of the average-cost theories from the imposition of a corporate tax are thus different from the prediction of marginalism. There is empirical evidence that firms do in fact pass (at least partly), on to their customers corporate taxes via increases in their price.

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