This model is an extension of Hotelling’s model of non-collusive pricing by duopolists located in different places.
Basing-point pricing has been adopted often in practice by oligopolists producing a homogeneous product whose transportation costs are relatively high and whose production requires a large plant if the full economies of scale (minimum production costs) are to be realized.
We will examine two varieties of basing-point pricing, the single basing-point system and the multiple basing-point system.
A. The Single Basing-Point System
In this collusive pricing model the oligopolists agree on a common place as the basing point, and all firms quote as their price the production price (mill price) at the basing point, plus transportation cost from the basing point to the place of destination. Assume that town A is agreed as the basing point for all oligopolists located anywhere. The basing-point production price is AP. Delivered prices increase as the distance from the basing point increases. Assume that the delivered prices change as shown by the curve PT in figure 10.11.
These prices are the same for all oligopolists. For example, a firm located in town E will quote the price EG to its local customers, the price DL to customers in town D, and the price BK to buyers located in town B. Clearly if the production price (mill price) is in town E the same as in the basing point A, the firm in E will be realizing excess profits by selling to buyers located between E and C. For example, if the firm in E sells to a buyer located in D the firm will be making an excess profit equal to D’L per unit of output, since its freight costs are given by the P’R curve. Such excess profits are called ‘phantom freight’.
The firm in E may expand its sales beyond point e in the territory-market of firms located at A, if its marginal costs are less than its mill price EP’ minus the freight it will have to cover. For example, the firm located at E will find it profitable to sell to buyers at B, if its marginal cost is
MC < (EP’ – KM)
The firm located in the basing point A will be covering all its production and transport costs at all places. Thus the oligopolists may find it profitable to sell in each other’s territory-markets. This is known as cross-hauling.
B. Multiple Basing-Point System:
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The excess profits (‘phantom freight’ gains) realized by firms selling at the basing-point price to buyers located at places where this price is higher than their production costs plus transportation cost, may be reduced under a system of multiple basing-point pricing. In such a system several places are agreed as basing points. The delivered price of all oligopolists will be the same for buyers located in a certain place, and will be the lowest-possible delivered price.
To illustrate the multiple basing-point system assume that location A and location E are both agreed as basing points. The delivered price of firms in location A are those on the curve PT, the delivered prices of firms located in E are those on curve P’R (figure 10.11). Only at the point of intersection of PT and PR will the delivered price be identical for firms located in A and E.
To the left of e the delivered price of firms in A are higher than those of firms located in E thus for buyers located to the left of e the delivered prices quoted by all sellers will be the (lower) prices of curve P’e. To the right of point e the delivered prices of firms in A are lower, and these will be quoted by all firms to all buyers.
In this way the relevant delivered prices for buyers located between E and A are the prices on the segment Fe (of FR) and the segment eP(on PT). A firm located in A will charge the delivered price on P’e to buyers located between E and C, without gaining any ‘phantom freight’. If this firm wants to sell to buyers located further than C, it will have to cover itself part of the freight.
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Only firms in between the basing points will have ‘phantom freights’, given that they can produce at the same mill price as firms in A or E. For example, a firm located in D will charge the delivered price Ce to buyers located at C, and will receive ‘phantom freight’ equal to ae. A firm located at C and selling to local customers will receive a greater phantom price (equal to eb) given the two basing- point pricing agreement.
It should be clear that as the number of basing points increases the ‘phantom freights’ are gradually eliminated. In the limit, if sellers were located next to each other and there were as many basing points as sellers, all would quote the same price EP’ = AP, which is the lowest of delivered prices of all sellers.
The basing-point system reduces competition. If firms adhere strictly (without secret price concessions and other forms of cheating) to the basing-point pricing agreement, price competition is avoided. Identical prices prevail in all locations, and the share of
each oligopolist is determined by chance or by non-price competition (advertising, prompt delivery, differentiated product).
Given that open agreements for basing-point pricing are illegal, trade associations and other similar institutions publish detailed data on freights so as to facilitate the member firms to arrive at the same price for buyers in the same location. The firms usually take as a basis the mill price of a tacitly agreed leader who publishes its mill price regularly, and add to this price the freights published by the trade association.
Naturally, there is always the incentive to cheat, and price-chiselling may appear a tentative action. However, in most cases some sort of informal gentlemen’s agreement imposes sanctions against firms who are caught not adhering to the basing-point pricing rules. The basing-point pricing system is sometimes called the ‘Pittsburgh-plus’ pricing system, because it was widely used el industry in the U.S.A. (with Pittsburgh being the basing point) in the 1920s.