Activity-Based Pricing in a Monopoly

This paper studies 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. The paper considers two pricing mechanisms–Activity-Based Pricing (ABP) and traditional pricing, and two cost-accounting systems–Activity-Based Costing (ABC) and traditional costing. Under traditional pricing, only the base product is priced while 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 information is available for each customer. Likewise, under traditional costing, the firm knows only the distribution of the cost-driver rates for the base product and support services while under ABC the firm knows the actual cost-driver rates for the base product and support services. The paper compares 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. The paper shows that ABP helps reduce control problems, such as moral hazard and adverse selection problems, for the supplier and increases its ability to engage in price discrimination. We show that firms would adopt ABP when their customer base is very diverse and the variable costs of providing customer support is high. Firms adopt ABC when their priors on cost-driver rates under traditional costing are very diffuse. The paper also shows that cost-driver rate information and cost-driver volume information are complements. While prior literature has viewed ABC and Activity-Based Management (ABM) as facilitating better decision-making, this paper shows that ABC and ABP (a form of ABM) are useful tools for addressing control problems in supply chains. ∗I thank Professors Srikant Datar, Bjorn Jorgensen, Susan Kulp and the seminar participants at the University of Washington and Stanford summer camp for their comments.