9781118041581

Demand Analysis and Optimal Pricing 97

The markup rule is intuitively appealing and is the most commonly noted

form of the optimal pricing rule. Nonetheless, to make computations easier, it

is useful to rearrange the rule to read

[3.13]

Using this formula, Table 3.2 lists optimal prices by elasticity. Again, we see that

greater elasticities imply lower prices.

CAUTION The markup rule is applicable only in the case of elasticdemand.

Why not inelastic demand? The simple fact is that the firm’s current price cannot

be profit maximizing if demand is inelastic.Under inelastic demand, the firm could

raise its price and increase its revenue. Because it would sell less output at the

higher price, it also would lower its production cost at the same time. Thus,

profit would increase. In short, the firm should never operate on the inelastic

portion of its demand curve. It should increase profit by raising price and mov-

ing to the elastic portion; the optimal markup rule tells it exactly how far it

should move into the elastic region of demand.

Pa

EP

1 EP

bMC.

TABLE 3.2

Elasticities and

Optimal Prices

The markup of price

above marginal cost

varies inversely with

the elasticity of

demand.

Markup Factor

Elasticity EP/ MC Price

1.5 3.0 100 300

2.0 2.0 100 200

3.0 1.5 100 150

5.0 1.25 100 125

11.0 1.1 100 110

    1.0 100 100

11 EP 2

The markup rule is a formal expression of the conventional wisdom that price

should depend on both demand and cost.The rule prescribes how prices should be

determined in principle. In practice, managers often adopt other pricing

policies. The most common practice is to use full-cost pricing. With this method,

price is

[3.14]

where AC denotes total average cost (defined as total cost divided by total out-

put) and m denotes the markup of price above average cost.

P(1m)AC,

Business Behavior:

Pricing in

Practice

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