Cost-plus pricing with elasticity considerations
Encyclopedia
One of the most common pricing
methods used by firms is cost-plus pricing
. In spite of its ubiquity, economists rightly point out that it has serious methodological flaws. It takes no account of demand
. There is no way of determining if potential customers will purchase the product
at the calculated price. To compensate for this, some economists have tried to apply the principles of price elasticity
to cost-plus pricing.
We know that:
where:
Since we know that a profit maximizer, sets quantity at the point that marginal revenue is equal to marginal cost (MR = MC), the formula can be written as:
Dividing by P and rearranging yields:
And since (P / MC) is a form of markup, we can calculate the appropriate markup for any given market elasticity by:
In the extreme case where elasticity is infinite:
At the other extreme, where elasticity is equal to unity:
Most business people do not do marginal cost calculations, but one can arrive at the same conclusion using average variable costs (AVC):
When business people choose the markup that they apply to costs when doing cost-plus pricing, they should be, and often are, considering the price elasticity of demand, whether consciously or not.
See also : pricing
, cost-plus pricing
, price elasticity of demand
, markup
, production, costs, and pricing
, marketing
, microeconomics
Pricing
Pricing is the process of determining what a company will receive in exchange for its products. Pricing factors are manufacturing cost, market place, competition, market condition, and quality of product. Pricing is also a key variable in microeconomic price allocation theory. Pricing is a...
methods used by firms is cost-plus pricing
Cost-plus pricing
Cost-plus pricing is a pricing method used by companies to maximize their profits.The firms accomplish their objective of profit maximization by increasing their production until marginal revenue equals marginal cost, and then charging a price which is determined by the demand curve. However, in...
. In spite of its ubiquity, economists rightly point out that it has serious methodological flaws. It takes no account of demand
Demand
- Economics :*Demand , the desire to own something and the ability to pay for it*Demand curve, a graphic representation of a demand schedule*Demand deposit, the money in checking accounts...
. There is no way of determining if potential customers will purchase the product
Product (business)
In general, the product is defined as a "thing produced by labor or effort" or the "result of an act or a process", and stems from the verb produce, from the Latin prōdūce ' lead or bring forth'. Since 1575, the word "product" has referred to anything produced...
at the calculated price. To compensate for this, some economists have tried to apply the principles of price elasticity
Price elasticity of demand
Price elasticity of demand is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price...
to cost-plus pricing.
We know that:
MR = P + ((dP / dQ) * Q)
where:
MR = marginal revenue
P = price
(dP / dQ) = the derivative of price with respect to quantity
Q = quantity
Since we know that a profit maximizer, sets quantity at the point that marginal revenue is equal to marginal cost (MR = MC), the formula can be written as:
MC = P + ((dP / dQ) * Q)
Dividing by P and rearranging yields:
MC / P = 1 +((dP / dQ) * (Q / P))
And since (P / MC) is a form of markup, we can calculate the appropriate markup for any given market elasticity by:
(P / MC) = (1 / (1 - (1/E)))where:
(P / MC) = markup on marginal costs
E = price elasticity of demand
In the extreme case where elasticity is infinite:
(P / MC) = (1 / (1 - (1/999999999999999)))Price is equal to marginal cost. There is no markup.
(P / MC) = (1 / 1)
At the other extreme, where elasticity is equal to unity:
(P /MC) = (1 / (1 - (1/1)))The markup is infinite.
(P / MC) = (1 / 0)
Most business people do not do marginal cost calculations, but one can arrive at the same conclusion using average variable costs (AVC):
(P / AVC) = (1 / (1 - (1/E)))Technically, AVC is a valid substitute for MC only in situations of constant returns to scale (LVC = LAC = LMC).
When business people choose the markup that they apply to costs when doing cost-plus pricing, they should be, and often are, considering the price elasticity of demand, whether consciously or not.
See also : pricing
Pricing
Pricing is the process of determining what a company will receive in exchange for its products. Pricing factors are manufacturing cost, market place, competition, market condition, and quality of product. Pricing is also a key variable in microeconomic price allocation theory. Pricing is a...
, cost-plus pricing
Cost-plus pricing
Cost-plus pricing is a pricing method used by companies to maximize their profits.The firms accomplish their objective of profit maximization by increasing their production until marginal revenue equals marginal cost, and then charging a price which is determined by the demand curve. However, in...
, price elasticity of demand
Price elasticity of demand
Price elasticity of demand is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price...
, markup
Markup (business)
Markup is the difference between the cost of a good or service and its selling price. A markup is added on to the total cost incurred by the producer of a good or service in order to create a profit. The total cost reflects the total amount of both fixed and variable expenses to produce and...
, production, costs, and pricing
Production, costs, and pricing
The following outline is provided as an overview of and topical guide to industrial organization:Industrial organization – describes the behavior of firms in the marketplace with regard to production, pricing, employment and other decisions...
, marketing
Marketing
Marketing is the process used to determine what products or services may be of interest to customers, and the strategy to use in sales, communications and business development. It generates the strategy that underlies sales techniques, business communication, and business developments...
, microeconomics
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...