Activity‐Based Pricing in a Monopoly

Abstract

abstractIn this article, I study the interaction between cost accounting systems and pricing decisions in a setting where a monopolist sells a base product and related support services to customers whose preference for support services is known only to them. I consider two pricing mechanisms—activity‐based pricing (ABP) and traditional pricing—and two cost‐accounting systems—activity‐based costing (ABC) and traditional costing, for support services. Under traditional pricing, only the base product is priced, whereas support services are provided free because detailed cost‐driver volume information on the consumption of support services by each customer is unavailable. Under ABP, customers pay based on the quantities consumed of both the base product and the support services because detailed cost‐driver volume information is available for each customer. Likewise, under traditional costing for support services the firm makes pricing decisions on cost signals that are noisier than they are under ABC. I compare the equilibrium quantities of the base product and support services sold, the information rent paid to the customers, and the expected profits of the monopolist under all four combinations of cost‐driver volume and cost‐driver rate information.I show that ABP helps reduce control problems, such as moral hazard and adverse selection problems, for the supplier and increases the supplier's ability to engage in price discrimination. I show that firms are more likely to adopt ABP when their customer base is more diverse, their customer support costs are more uncertain, their costing system has lower measurement error, and the variable costs of providing customer support are higher. Firms adopt ABC when their cost‐driver rates for support services under traditional costing are noisier measures of actual costs relative to their cost‐driver rates under ABC and when the actual costs of support services are inherently uncertain. I also show that cost‐driver rate information and cost‐driver volume information for support services are complements.Although the prior literature views ABC and activity‐based management (ABM) as facilitating better decision making, I show that ABC and ABP (a form of ABM) are useful tools for addressing control problems in supply chains.