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. r a construction firm might take an estimator!s calculation of
construction costs, and multiply by "."# to determine what price to bid for a $ob.
%he &uestion that this practice raises is whether the fairly common practice of markup
pricing contradicts the M' ( M) types of rules that we ha*e shown to be profit
maximi+ing. %he answer is that the two approaches to pricing can be completely
consistent. In fact, it is possible to show that there are optimal markup rules, and the
optimal rule is exactly consistent with M' ( M) pricing.
Mathematically, a markup price is computed as follows,
- ( ./M', where - is the price charged, M' is marginal cost and . is the markup
constant. ur pro$ect is to show that there is a . that is exactly consistent with - ( M'
pricing.
0et %) be total re*enue. %hen %) ( -1&2&.
Marginal re*enue is the deri*ati*e of total re*enue with respect to &. 3ow recall our
deri*ation of marginal re*enue,
dQ
dP
q q P
dq
dTR
MR . 2 1 + = =
3ow, factoring out -1&2, we get

+ =
dQ
dP
q P
q
q P MR
2 1
" 2 1
3otice that the second term inside the brackets is the in*erse of price elasticity of
demand. So now we can write

+ =

"
" 2 1q P MR

where is the price elasticity of demand. 3ow, we use the condition for profit
maximi+ation that M'(M) and we write

+ =

"
" 2 1q P MC
3ow we can rearrange terms to get

+ =

"
"
2 1q P
MC
'ombining the bracketed term o*er a common denominator and in*erting both sides we
get,

+
=

"
2 1
MC
q P
%hat gi*es us the desired ., the ratio of price to marginal cost, or the markup constant
that is discussed abo*e.
4 couple of easy examples illustrate how the elasticity of demand relates to the markup
coefficient. 5or an elasticity of demand of 67, the markup coefficient is 6789", or $ust 7,
so that a profit maximi+ing price would be twice marginal cost. 4 much more elastic
demand, such as 6# would yield a markup of 6#89:, or $ust ".7#, so that the profit
maximi+ing price would be 7#; greater than cost. <hat would be the profit maximi+ing
markup if the firm faced an elasticity of 9".#=