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Subject Business Economics

Paper No and Title 1, Microeconomic Analysis

Module No and Title 20, Price Theories: Mark-up Pricing

Module Tag BSE_P1_M20

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 20: PRICE THEORIES: MARK-UP PRICING
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Mark up Pricing
3.1 Calculation of mark up price
3.2 Demand elasticity and mark up price
3.3 Margin and Mark up
3.4 Advantages of mark up pricing
3.5 Disadvantages of mark up pricing
4. Summary

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 20: PRICE THEORIES: MARK-UP PRICING
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1. Learning Outcomes
After studying this module, you will be able to

 Understand the concept of Mark up pricing technique

 Analyze the relationship between demand elasticity and mark up pricing
 Evaluate the difference between the concepts of margin and mark up
 Identify the advantages and disadvantages of the pricing methods

2. Introduction
A number of price-setting methods are available. The particular method used by a firm will
depend in particular on the type of business being operated. Mark up pricing is a commonly
used pricing technique, because it is simple to understand and implement and it appeals to firms
which are risk averse. This approach sets a price that covers the cost of production and provides
sufficient profit margin for the firm to reach its target rate of return.

3. Mark up Pricing
Mark up pricing is a strategy firms use to maximize profits. The firm calculates the average cost
of production and then adds a predetermined (agreed) percentage mark up or profit margin. If
successful this will ensure a certain amount of profit per unit sold. The exact nature of this profit
mark up depends on the market, but as a generalization it is likely that high volume items will
have a relatively low mark up, whereas low volume items are likely to have a higher mark up.
This percentage is often governed by a corporate strategy on what is an acceptable return on the
capital invested to make the product. Ideally the firm will attempt to maximize its profit margin.
Such a pricing strategy ignores the effect of pricing levels on demand patterns and does not take
into account market conditions and the pricing strategies of competitors.

3.1 Calculation of Mark up price

As we know, profit maximization for a competitive firm occurs when price equals marginal cost;
whereas for the firm with monopoly power, it occurs when price exceeds marginal cost.
Therefore, a natural way to measure monopoly power is to examine the extent to which the profit
maximizing price exceeds marginal cost.
The optimal pricing condition for a monopoly is when the marginal revenue (MR) equals
the marginal cost (MC). That is,
MR = MC
We know that MR = ∆R / ∆y, where R is the revenue (P, y), and y is the output.
MR = ∆R / ∆y
= P + y [∆P / ∆y]
= P [1 + (y∆P /P∆y)]

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 20: PRICE THEORIES: MARK-UP PRICING
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Given (p∆y /y∆P) as the elasticity of demand ε, we have

MR = P + P (1/ε)

Now, because the firm’s objective is to maximize profit, we can set marginal revenue equal to
marginal cost:
P + P (1/ ε) = MC
P [1 + (1/ ε)] = MC
Since elasticity is naturally negative, this expression can be written as:
P [1 – (1/ І ε І)] = MC

which can be rearranged to give us

(P – MC) /P = (1/ І ε І) ………………….(1)

The left-hand side, (MC – P)/ P, is the mark up over marginal cost as a percentage of price. The
relationship says that this mark up should equal the negative of the inverse of the elasticity of
demand. Equivalently, this equation can be rearranged to express price directly as a mark up over
marginal cost:
P = MC / [1 – (1/ І ε І)] ………………… (2)

From these equations it is easy to see the connection with the competitive case: in the
competitive case, the firm faces a flat demand curve—an infinitely elastic demand curve. This
means that 1/ І ε І = 1/∞ = 0, so the appropriate version of this equation for a competitive firm is
simply price equals marginal cost. It should be noted that a monopolist will never choose to
operate where the demand curve is inelastic. For if І ε І < 1, then 1/ І ε І > 1, and the marginal
revenue is negative, so it can’t possibly equal marginal cost. The meaning of this becomes clear
when we think of what is implied by an inelastic demand curve: if І ε І < 1, then reducing output
will increase revenue and reducing output must reduce total cost, so profits will necessarily
increase. Thus, any point where І ε І < 1 cannot be a profit maximum for a monopolist since it
could increase its profits by producing less output. It follows that a point that yields maximum
profits can only occur where І ε І ≥ 1.
The formulation (2) indicates that the market price is a mark up over marginal cost,
where the amount of the mark up depends on the elasticity of demand.
The mark up is given by
[1/ 1 – (1/ І ε І)]

Since the monopolist always operates where the demand curve is elastic, it implies that
ІεІ > 1, and thus the mark up is greater than 1.
In the case of a constant elasticity demand curve, this formula is especially simple since ε
is a constant. A monopolist who faces a constant elasticity demand curve will charge a price that
is a constant mark up on marginal cost. This is illustrated in Figure 3.1. The curve labelled MC/
[1− (1/ І ε І)] is a constant fraction higher than the marginal cost curve; the optimal level of
output (y*) occurs where this curve crosses the demand curve. That is,
BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS
ECONOMICS MODULE No. 20: PRICE THEORIES: MARK-UP PRICING
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p = MC/[1 – (1/ І ε І)].

3.2 Demand elasticity and mark up price

As discussed earlier, in a perfectly competitive market, price equals marginal cost. However, a
monopolist charges a price that exceeds marginal cost, by an amount that depends inversely on
the elasticity of demand. As the mark up equation (1) shows, if demand is extremely elastic, price
will be very close to marginal cost. In that case, a monopolized market will look much like a
competitive one. In fact, when demand is very elastic, there is little benefit to being a monopolist.

This is illustrated in Figure 3.2(A). In this case, the firm’s demand curve (AR1) is highly
elastic and flatter. As a result the mark up is smaller and the firm has little monopoly power.
However, if the demand is relatively inelastic, given by AR2 in Figure 3.2(B), the mark
up will be large and the firm will have considerable monopoly power.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 20: PRICE THEORIES: MARK-UP PRICING
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BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 20: PRICE THEORIES: MARK-UP PRICING
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3.3 Margin and Mark up

Margin and mark up are terms used in the derivation of product costs and profits. The two terms
have different meanings, which can lead to confusion when setting product and service prices and
determining profit levels. A mistake in the usage of these terms can lead to price setting that is
substantially too high or low, resulting in lost sales or lost profits, respectively. There can also be
an inadvertent impact on market share, since excessively high or low prices may be well outside
of the prices charged by competitors.
 Margin (also known as gross margin) is sale minus the cost of goods sold. For example,
if a product sells for Rs.100 and costs Rs.70 to manufacture, its margin is Rs.30. Or,
stated as a percentage, the margin percentage is 30% (calculated as the margin divided by
sales).
 Mark up is the amount by which the cost of a product is increased in order to derive the
selling price. To use the preceding example, a markup of Rs.30 from the Rs.70 cost
yields the Rs.100 price. Or, stated as a percentage, the mark up percentage is 42.9%
(calculated as the mark up amount divided by the product cost).
Essentially, if you want to derive a certain margin, you have to mark up a product cost by a
percentage greater than the amount of the margin, since the basis for the mark up calculation is
cost, rather than revenue; since the cost figure should be lower than the revenue figure, the mark
up percentage must be higher than the margin percentage.
The mark up calculation is more likely to result in pricing changes over time than a
margin based price, because the cost upon which the mark up figure is based may vary over time;
or its calculation may vary, resulting in different costs which therefore lead to different prices.
Consider an example. Suppose you bought an item for Rs.50 and could sell it for Rs.100,
doubling your money. In this case your mark up would be (the difference between selling price
and cost price) divided by the cost of the item and multiplied by 100 to bring it to a percentage.
That is (Rs.100 – Rs.50) = Rs.50 (difference). Rs.50 (difference) / Rs.50 (cost) = 1 x 100 =
100%. Your mark up was then 100%.
When you look at the profit margin on that sale, that would be (difference between selling price
and cost price) divided by the selling price and multiplied by 100 to bring it to a percentage.
That is (Rs.100 – Rs.50) = Rs.50 (difference). Rs.50 (difference) / Rs.100 (selling price) = .5 x
100 = 50%
So the difference is that mark up is the profit as a percentage of the cost price and profit
margin is the profit as a percentage of your selling price.

3.4 Advantages of Mark up Pricing

There are several advantages for firms who use this method to arrive at pricing decisions. They
are as follows:
 The mark up method is simple to calculate and uses data that has already been
accumulated.
 Throughout periods of increasing cost, this method helps fight the inflation effects. When
costs decline, this method will also reflect the cost charges.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 20: PRICE THEORIES: MARK-UP PRICING
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 Price increases can be justified when costs rise. Since the price is based upon the product
cost, not the demand, customers will recognize that the company did not raise prices
simply because of increasing demand.
 Price stability may arise if competitors take the same approach (and if they have similar
costs).
 Customers can distrust companies who take advantage of market conditions to raise
prices. These companies are perceived as being unethical. For businesses whose sales
depend on relationship -building between the company and its customers, these actions
will result in lost sales. Keeping prices level by using a cost-plus markup methodology
for pricing will maintain the perception of integrity and high ethics by the company. The
trust that the customers feel for the company will transfer from the pricing details to the
perception of the entire company. Customers will consider the quality and service to be
higher as well and will reward that company with repeat business.

3.5 Disadvantages of Mark up Pricing

However, the mark up pricing technique has various drawbacks, as described below:

 The mark up pricing method ignores the concept of price elasticity of demand - it may be
possible for the business to charge a higher (or lower) price to maximize profits
depending on the responsiveness of customers to a change in price.
 Such a method may leave a business in a vicious circle. For example, if budgeted costs
are over estimated, selling prices may be set too high. This in turn may lead to lower
demand (if the price is set above the level that customers will accept), higher costs (e.g.
surplus stock) and lower profits. When the pricing decision is made for the next year, the
problem may be exacerbated and repeated.
 Provides an incentive for inefficiency to companies with a monopoly, encouraging them
to raise costs. The business has less incentive to cut or control costs - if costs increase,
then selling prices increase. However, this might be making an "inefficient" business
uncompetitive relative to competitor pricing.

4. Summary
 Mark up pricing is often considered a rational approach to maximizing profits. Under this
approach, the price is set by calculating the cost of the product, and then adding a
percentage of the cost as mark up.
 This mark up is inversely related to the elasticity of demand. In order to maximize
profits, a monopolist would find it feasible to produce an output where demand is
elastic.
 This strategy offers numerous benefits in terms of calculation, market stability and
integrity.
 However, there are also some disadvantages of using a mark up pricing technique. This
includes incentive for inefficiency, ignoring the role of consumers and competitors.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 20: PRICE THEORIES: MARK-UP PRICING