Reference no: EM131225915

Target Statement for Assignment

When IT procurement managers do business across a transnational border (or choose which borders to negotiate across) it will be helpful for managers to be aware of what restraints or pressures exist on both sides of the border that will affect the negotiated price of the product or service being acquired. The understanding that Garrett’s entire pricing theory depends on the macroeconomic (and hence also political) environment emerges from considering relations between contract pricing and economic theory, specifically, the “reservation price” and “economic calculation problem”.

A fixed-price strategy in Garrett’s account does not mean a price that is fixed legally; it means a price that is determined by negotiation between free parties, such as is described in Ch. 8, pp. 105-106. That is, in Garrett’s pricing theory there is a transaction pricing calculation performed on each side of the transaction. Contract pricing is a decision, about which what matters is not the type of contract but the locus of the decision, that is, who makes the decision, and under what constraints?

Garrett’s Chapter 8 answers: buyer and seller make the decision. In a free-market economy, the pricing decision would be entirely an outcome of their negotiation. In an interventionist economy, the decision is in part an outcome of the buyer-seller negotiation; however, the cost of such interventions as taxes, regulations, currency instability, or contract impairment by monetary inflation, and any price caps or floors are built into or reflected by the seller’s offering price.

In free market economic planning where there is zero central economic planning, a first approximation to a contract price that is freely set by buyer and seller is the reservation price or “walk-away” price for the buyer. The seller, too, has a “walk-away” price. The negotiation can only occur, resulting in a contract, in the interval between the two. Buyer and seller make a decision through a negotiation based on the seller’s estimate of the cost of performance and the buyer’s estimate of what price the market, established by other potential sellers, would bear -- both estimates being a function of history.

According to the economic calculation problem described by the economist Ludwig Von Mises, a freely agreed upon price that reflects the combination of the buyer’s and seller’s needs or desires is based on a calculation of the type that cannot be performed in a condition of central economic planning by a government. Under central economic planning, or socialism, price determination is not a function of trading history, or of the sellers' willingness to sell or the buyers' willingness to buy at a given price, rather it is either an arbitrary or politically-influenced decision. Such central economic planning, Von Mises observes, replaces economic calculation – the statistical aggregate of all individual actions by buyers and sellers who freely set prices by their own transaction pricing calculations.

Under the free market modeled in the theory of Von Mises, contract pricing relies on the absence of such market intervention so that buyer and seller are totally free to set a price that allows a contract to occur in the interval between the seller's and buyer's respective walkaway prices. This decision of both parties to agree on a price in that interval is one component of economic calculation – a component that applies to a single trade or transaction and contributes to the statistical aggregate which, in turn, tends to govern resource allocation so as to bring supply and demand into alignment.

To a lesser extent, contract pricing described by Garrett in Chapter 8 relies largely on the absence of central economic planning. Why? Because when the state intervenes it either substitutes its decision for that of the buyer and seller, or at a minimum imposes price controls that either foster shortages or surpluses or else tend to preclude the contract from ever happening if the controlled price is below the seller’s cost estimate.

Under contract pricing as described by Garrett, the parties to the contract are still able to perform calculations of reservation (walkaway) prices and determine whether they can do the deal at some price in the interval that does not cause either to walk away. However, in a market that is only partially free, interventions such as regulations, taxes, currency exchange fluctuations, or monetary inflation that increase the seller’s cost do alter the pricing calculation and tend to narrow the interval within which the buyer and seller can come to agreement. That still-intact possibility of agreeing on a price sensitive to market conditions is the essence of the relationship between the economic theory of Von Mises and the contract pricing theory of Garrett.