Question

What role does the price elasticity of demand play in markup pricing, i.e., how does it affect the firm's ability to mark up price over marginal cost?

Answer 1

In order to answer this question, we need to consider firm's profit maximization problem.

Suppose inverse demand is given as:

P(Q)

Total cost = TC = a + cQ

where, c = marginal cost.

Profit = P(Q)Q - (a + cQ)

To maximize profit, we get:

Dividing whole equation by P, we get:

We can use elasticity formula here, we get:

This is the lerner index which shows relation between price-cost markup and price elasticity of demand.

Effect: When elasticity rises in absolute value, markup falls and vice versa.

• Perfect competition case: Infinite elasticity gives Zero markup: P = c