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Economics Analysis
MBA 103

WRITTEN REPORT

PRICING STRATEGY FOR THE FIRM

Submitted by:
Vanely F. Mendoza
Master in Business Administration

Submitted to:
Prof. Benigno Andres

July 3, 2021
 I. ROLE OF MARKUP PRICING

Markup pricing also called cost-plus pricing. It is calculating the price of a product by
determining the average cost of producing the product and then setting the price a given
percentage above the cost.

Under this procedure:

• Firms establish production costs, then apply a markup to the average cost to
determine price.

• From a manager’s perspective, markup pricing is considered a means of dealing with

uncertainty in demand estimation.

A method that is “fair” to both customers and firms, and a simplified approach to
the pricing of large numbers of products, as the procedure involves only determining
a product’s average cost of production and then applying a percentage markup to
that cost to determine the product price.

• There has been much discussion about whether using a simplified rule of thumb,
such as markup pricing, is consistent with the firm’s goal of profit maximization
Applying uniform markup to all products would not be profit maximizing strategy for
a firm because this approach considers only the cost of production and does not
incorporate information on demand and consumer preferences.

However, many studies of managerial pricing decisions have shown that firms do not use
a uniform markup for all products. According to Philip Kotler, common markups in
supermarkets are:

Common markups in supermarkets are:

• 9% on Baby Products
• 14% on Tobacco Products
• 20% on Bakery Products
• 27% on Dried Foods and Vegetables
• 37% on Spices and Extracts
• 50% on Greeting Cards.

In many of these cases, it appears that the size of the markup is related to what managers
believe the market will bear, or, in economic terms, the price elasticity of demand.

II. PROCESS OF APPLYING MARK-UP

In the following discussion, we show why a policy of applying larger markups to

products that have less elastic demand helps firms maximize their profits. This
discussion will proceed in three steps:
 1. We establish a mathematical relationship between marginal revenue and the
price elasticity of demand.
2. We review the profit maximizing role of equating marginal revenue and marginal
cost.
3. We show how marking up price above the above cost of production, where the
markup is inversely related to the price elasticity of demand, it’s equivalent to
pricing according to the profit-maximizing rule from economic theory (marginal
revenue equals marginal cost). Thus, even though markup pricing is often
considered a rule of thumb, applying it as described here is a profit-maximizing
strategy for managers.

III. MARGINAL REVENUE AND THE PRICE ELASTICITY OF DEMAND

Equations 10.1 to 10.7 present a derivation of the relationship between marginal

revenue—the change in total revenue from producing an additional unit of output—and
the price elasticity of demand.

1 MR = (ΔTR)
ΔQ

2 ΔTR = (P) * ( ΔQ) + (Q) * (ΔP)

ΔQ + Q * ΔP
3 MR = P * ΔQ
ΔQ
ΔP
4 MR = P + Q *
ΔQ
ΔP P
5 MR = [P + Q ]
ΔQ P

6 MR = P 1 + ΔP * Q
ΔQ P

MR = P 1 + 1
7 e
p

Equation 1 - is simply the definition of marginal revenue (MR)—the change in total

revenue (TR) divided by the change in output or quantity (ΔQ)

Equation 2 - describes the change in total revenue, which is the numerator of Equation
1. When lowering price and moving down a demand curve, total revenue changes because
additional units of output are now sold at the lower price. This change in revenue is
represented by the first right-hand term in Equation 10.2, (P)∗(ΔQ). Total revenue also
changes because the previous quantity demanded is now sold at a lower price. This
change is represented by the second right-hand term in Equation 10.2, (Q)∗(ΔP). Thus,
 Equation 10.2 is simply expressing the change in total revenue as price is lowered along
a demand curve.

Equation 3 - again presents the full definition of marginal revenue, using the definition
of change in total revenue (ΔTR) from Equation 2.

Equation 4 - is a simplified version of Equation 3.

Equation 5 - the last term of Equation 4 is multiplied by the term (P/P). Because this
term equals 1, the value of the equation is not changed.

Equation 6 - simplifies Equation 5 by taking the price term outside the brackets and
rearranging the other terms. The last term in Equation 6 is the inverse of the price
elasticity of demand. This is expressed in Equation 7.

Equation 7 - which shows the formal relationship between marginal revenue and price
elasticity: MR = P [1 + (1/eP)].

The implications of this relationship are shown in Table 10.1. When demand is elastic,
marginal revenue is positive; when demand is inelastic, marginal revenue is negative; and
when demand is unit elastic, marginal revenue is zero. The numerical examples in Table
10.1 illustrate this relationship for different elasticity values.

IV. PROFIT-MAXIMIZING RULE

The second step of price elasticity and optimal pricing is to review the rule for profit
maximization used in all of our market structure models. To maximize profit, a firm needs
to produce that level of output at which marginal revenue equals marginal cost. We now
show how this rule, derived from economic theory and the mathematics of optimization,
is consistent with the commonly used managerial technique of markup pricing, when the
size of the markup is inversely related to the price elasticity of demand.
V. PROFIT MAXIMIZATION AND MARK-UP PRICING

We begin by relating markup pricing to the profit-maximizing rule by reprinting Equation

7 and adding the profit-maximizing rule in Equation 8

1
7 MR = P 1 + e
p

8 MR = MC

We now substitute the definition of marginal revenue from Equation 7 into Equation 8 and
rearrange terms, as shown below in Equations 9 to 11.

1 = MC
9 P 1+
e
p

10 P = _MC__ = _MC_
1 e
1+ p+ 1
e
p e
p

11 e
P= p
MC
1+ e
p

Equation 11 - shows that the optimal price, which maximizes profits for the firm, depends
on marginal cost and price elasticity of demand. Holding the marginal cost constant, the
optimal price is inversely related to the price elasticity of demand. Firms usually base the
price markups for their products on the average variable cost (variable cost per unit of
output), not the marginal cost (the additional cost of producing an additional unit of
output). Marginal cost equals average variable cost if average variable cost is constant,
which may be the case over a given range of output for many firms. Given this assumption
and drawing on Equation 11, we derive the formula for the optimal markup, m, in
Equations 12 and 13 by substituting average variable cost for marginal cost in Equation
11; defining m, the markup procedure, in Equation 12; and solving for m in terms of the
price elasticity of demand by relating Equations 11 and 12. The end result is presented in
Equation 13. The implications of the formula in Equation 13 are shown in Table 10.2
below.

12 P = average variable cost + (m) (average variable cost)

= ( 1 + m) average variable cost

e
p -1
13 (1+m) = or m =
(1+ e ) (1+ e )
p p
 The upper limit for the size of price elasticity is infinitely or perfectly elastic demand, which, as
shown in Table 10.2, results in no markup above the average cost of production. This is the case
of the perfectly competitive firm that faces the horizontal or perfectly elastic demand curve.
Perfectly competitive firms are price takers, which cannot influence the price of the product.
Therefore, perfectly competitive firms have no ability to mark up the price above cost.

VI. BUSINESS PRICING STRATEGIES AND PROFIT MAXIMIZATION

• In 1950’s and 60’s, markup pricing generated debate about whether firms pursued
goal or profit maximization.
• Goas was to earn a pre-determined target rate of return.
• Prices were “administered” to achieve this goal.
• In 1980’s Elzinga found most firms earned lower rate of return in subsequent years
compared with original study period.
• Several of the original companies filed for bankruptcy or underwent reorganization.
• Fog notes that prices can be determined along a continuum.

VII. MARGINAL RULE OF THUMB:

Markup Pricing

Managers may use a simple cost-based pricing method to achieve an acceptable outcome,
even if they do not earn the maximum amount of profits. However, most managers appear
to explicitly or implicitly use some type of inverse price elasticity rule, which involves both
demand and cost factors, in calculating their markups. This strategy will bring them closer
to earning the maximum amount of profit possible.

Price Discrimination

Is the practice of charging different prices to various groups of customers that are not
based on differences in the costs of production. This can entail charging different prices
to different groups when the costs of production do not vary or charging the same price
to different groups when there are differences in the costs of production.
 The following are three basic requirements for successful price discrimination:

1. Firms must possess some degree of monopoly or market power that enables them
to charge a price in excess of the costs of production. Thus, price discrimination can
be used by firms in all the market structures where the individual firm has no
influence on price. Successful price discrimination results when competitors cannot
undersell the price-discriminating firm in its high-priced market.

2. Firms must be able to separate customers into different groups that have varying
price elasticities of demand. The costs of segmenting and policing the individual
markets must not exceed the additional revenue earned from price discrimination.

3. Firms must be able to prevent resale among the different groups of customers.
Otherwise, consumers who are charged a low price could resell their product to
customers who are charged a much higher price. Price discrimination also should
not generate substantial consumer resentment at the differential prices or be illegal.

VIII. THEORITICAL MODELS OF PRICE DISCRIMINATION

Economists focus on three models of price discrimination—first-, second-, and third-

degree—that illustrate the relationship of this strategy with demand and price elasticity.
Before discussing each of these models and their implications, we describe how a demand
curve illustrates consumer willingness to pay for a product and provides a rationale for
price discrimination.

Demand and Willingness to Pay

The standard assumption with a demand curve is that all units of a good are sold at
whatever price exists in the market. In Figure 10.1, suppose that P1 is the price of the
good and Q1 is the quantity demanded at that price. The amount of money spent on the
good is price times quantity, or the area 0P1BQ1. However, this area does not represent
the total amount that consumers would be willing to pay for the good rather than go
without it. That total willingness to pay is represented by the area underneath the demand
curve up to quantity Q1, or area 0ABQ1. This difference between the amount actually paid
when purchasing all units at price P1 and the total amount consumers would be willing to
pay results from the fact that the prices measured along a demand curve represent
consumers’ marginal benefit or valuation, the dollar value they attach to each additional
unit of the product.
First-Degree Price Discrimination

• A pricing strategy under which firms with market power are able to charge
individuals the maximum amount they are willing to pay for each unit of the
product.
• Firms with market power can charge maximum amount consumers are willing to
pay for each unit of product.
• Largely theory because firms usually can’t charge maximum price consumers
would be willing to pay.

Profit maximization where MR = MC results in P = $7, Q = 5, TR = 35, TC =

$10, and π = $25. Under first degree price discrimination, the consumer surplus
or the area of the triangle under the demand curve above a price of $7 is turned
into revenue for the firm. This adds $12.50 to revenue and profit.

Second-Degree Price Discrimination

• A pricing strategy under which firms with market power charge different prices
for different blocks of output.
• It is often called nonlinear pricing because prices depend on the number of units
bought instead of varying by customer. Each customer faces the same price
schedule, but customers pay different prices depending on the quantity
purchased
• Quantity discounts are an example of second- degree price discrimination.
 Under second-degree price discrimination, firms charge the maximum price
consumers are willing to pay for different blocks of output. Revenue to the firm
equals area 0P3CQ3 plus area Q3EDQ2 plus area Q2FBQ1.

Third-Degree Price Discrimination

• A pricing strategy under which firms with market power separate markets
according to the price elasticity of demand and charge a higher price (relative to
cost) in the market with the more inelastic demand.
• Under third-degree price discrimination, firms separate markets according to the
price elasticity of demand and charge a higher price (relative to cost) in the
market with the more inelastic demand.
• Optimal price in each market is the price on the demand curve that corresponds
to profit-maximizing level of output.

This shows a relatively inelastic demand curve, D1, with its marginal revenue
curve, MR1, and a relatively more elastic demand curve, D2, with its marginal
revenue curve, MR2. Quantity Q1 maximizes profits for Market 1, while Q2
maximizes profits for Market 2, as MR = MC in each market at these output levels.
The optimal price in each market is that price on the demand curve that
corresponds to the profit-maximizing level of output, P1 in Market 1 and P2 in
Market 2. As you see the optimal price in Market 1, P1, is higher than the optimal
price in Market 2, P2. Third-degree price discrimination results in a higher price
being charged in the market with the relatively more inelastic demand. Charging
the same price in both markets would result in lower profit because marginal
revenue would not equal marginal cost in both markets at the levels of output
corresponding to that common price
IX. PRICE DISCRIMINATION AND MANAGERIAL DECISION MAKING

1. Personalize Pricing
Another name for first-degree price discrimination, in which the strategy is to
determine how much each individual customer is willing to pay for the product and
to charge him or her accordingly.

2. Group Pricing
Another name for third-degree price discrimination, in which different prices are
charged to different groups of customers based on their underlying price elasticity of
demand.

Rationale for Group Pricing

• Lock In - Achieving brand loyalty and a stable consumer base by making
Product expensive for consumers to switch to a substitute product.
• Network Externalities - Result when the value an individual places on a good
function of how many other people also use that good.

3. Versioning
Where different version of products are offered to different groups of customers at
various prices, targeted to meet specific needs.

4. Bundling
Selling multiple products as a bundle where the price of the bundle is less than the
sum of the prices of the individual products.

5. Coupon and Sales Promotional Pricing

Using coupons and sales to lower prices for those willing to pay cost of these devices
as opposed to lowering the price of products for all customers.

6. Two-Part Pricing
Charging customers, a fixed fee for right to purchase product, then a variable fee
that is a function of the number of units purchased.

X. MARKETING AND PRICE DISCRIMINATION

• Managers must be careful when using price discrimination
• Price discrimination based on observation may also be counterproductive.
• Analysis can build on economics of markup pricing and price discrimination to
develop effective strategies and avoid either fog zone profits on noncompetitive
prices.

XI. MACROECONOMICS AND PRICING POLICIES

• Overall economic conditions influence markup and price discrimination.
• Periods of long-run economic expansion make consumers less cost-conscious and
more value-conscious (demand is more price inelastic)
• However, ability to raise prices differs among sectors of the economy.
• Firms become rigid when they think other firms will not follow price increases.