Our study of optimal managerial decisions suggests two points of criticism
about full-cost pricing. First, full-cost pricing uses average cost—the incorrect
measure of relevant cost—as its base. The logic of marginal analysis in general
and the optimal markup rule (Equation 3.13) in particular show that optimal
price and quantity depend on marginal cost. Fixed costs, which are counted in
AC but not in MC, have no effect on the choice of optimal price and quantity.^12
Thus, to the extent that AC differs from MC, the full-cost method can lead to
pricing errors.
Second, the percentage markup should depend on the elasticity of
demand. There is considerable evidence that firms vary their markups in rough
accord with price elasticity.^13 Gourmet frozen foods carry much higher
markups than generic food items. Inexpensive digital watches ($15 and under)
have lower markups than fine Swiss watches or jewelers’ watches. Designer
dresses and wedding dresses carry much higher markups than off-the-rack
dresses. In short, producers’ markups are linked to elasticities, at least in a qual-
itative sense. Nonetheless, it is unlikely that firms’ full-cost markups exactly
duplicate optimal markups. Obviously, a firm that sets a fixed markup irrespec-
tiveof elasticity is needlessly sacrificing profit.^1498 Chapter 3 Demand Analysis and Optimal PricingCHECK
STATION 5The U.S. cigarette industry has negotiated with Congress and government agencies to set-
tle liability claims against it. Under the proposed settlement, cigarette companies will
make fixed annual payments to the government based on their historic market shares.
Suppose a manufacturer estimates its marginal cost at $2.00 per pack, its own price elas-
ticity at2, and sets its price at $4.00. The company’s settlement obligations are
expected to raise its average total cost per pack by about $.80. What effect will this have
on its optimal price?(^12) Fixed costs obviously are important for the decision about whether to produce the good. For
production to be profitable in the long run, price must exceed average cost, P AC. If not, the
firm should cease production and shut down. Chapter 6 provides an extensive discussion of this
so-called shut-down rule for firms producing single and multiple products.
(^13) In evaluating the practice of full-cost pricing, the real issue is how close it comes to duplicat-
ing optimal markup pricing. Even if firms do not apply the optimal markup rule, they may price
as though they did. For instance, a firm that experiments with different full-cost markups may
soon discover the profit-maximizing price (without ever computing an elasticity). In contrast, a
rival firm that retains a suboptimal price will earn a lower profit and ultimately may be driven
from the highly competitive market. So-called natural economic selection (elimination of less
profitable firms) means that the surviving firms are ones that have succeeded in earning maxi-
mum profits.
In some circumstances, full-cost pricing is a lower-cost alternative to the optimal markup rule.
Estimating the price elasticities necessary for setting optimal markups is sometimes quite costly.
Accordingly, the firm may choose to continue its current pricing policy (believing it to be approx-
imately optimal) rather than generating new and costly elasticity estimates and setting a new
markup.
(^14) For an instance of an entrepreneur suboptimally operating on the inelastic portion of the
demand curve, see S. Leavitt, “An Economist Sells Bagels: A Case Study in Profit Maximization,”
Working Paper 12152, National Bureau of Economic Research(March 2006).
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