Mark up pricing: A Derivation

Many firms use a markup rules to determine the prices they will charge for their output.
By a markup rule, I mean that the firm determines price by multiplying marginal cost, or
some proxy for marginal cost, by some constant in order to pick a price. So, for example,
a retailer might use the so called keystone rule by doubling the wholesale price to get
the retail price. Or a construction firm might take an estimators calculation of
construction costs, and multiply by 1.15 to determine what price to bid for a job.

The question that this practice raises is whether the fairly common practice of markup
pricing contradicts the MC = MR types of rules that we have shown to be profit
maximizing. The answer is that the two approaches to pricing can be completely
consistent. In fact, it is possible to show that there are optimal markup rules, and the
optimal rule is exactly consistent with MC = MR pricing.

Mathematically, a markup price is computed as follows:

P = K*MC, where P is the price charged, MC is marginal cost and K is the markup
constant. Our project is to show that there is a K that is exactly consistent with P = MC
pricing.



Let TR be total revenue. Then TR = P(q)q.

Marginal revenue is the derivative of total revenue with respect to q. Now recall our
derivation of marginal revenue:


dQ
dP
q q P
dq
dTR
MR . ) ( + = =


Now, factoring out P(q), we get

(

+ =
dQ
dP
q P
q
q P MR
) (
1 ) (

Notice that the second term inside the brackets is the inverse of price elasticity of
demand. So now we can write

(

+ =
q
1
1 ) (q P MR
where q is the price elasticity of demand. Now, we use the condition for profit
maximization that MC=MR and we write

(

+ =
q
1
1 ) (q P MC

Now we can rearrange terms to get


(

+ =
q
1
1
) (q P
MC


Combining the bracketed term over a common denominator and inverting both sides we
get:


(

+
=
q
q
1
) (
MC
q P


That gives us the desired K, the ratio of price to marginal cost, or the markup constant
that is discussed above.