1.

Ramsey Pricing Rule - derivation

The derivation of the Ramsey (1927) pricing rule makes use of simple constrained op-
timization techniques (Simon and Blume 1994). Consider a single product monopolist.The
goal is to maximize total surplus, defined as the area under the inverse demand function
p(q) minus total cost (TC), subject to the constraint that total revenue p(q) · q equals total
cost.
To solve this constrained optimization problem, we first define the Lagrangian function:
Z q
L= p(q) dq − TC(q) + λ[p(q) · q − TC(q)]
0
where λ is the Lagrange multiplier. The first-order conditions are
 
∂L ∂p
= p − MC + λ p + q − MC = 0,
∂q ∂q

∂L TC
= p(q) · q − TC(q) = 0 ⇔ p = ≡ AC.
∂λ q
The second equation implies that price must equal average cost, TC/q, which guarantees
zero profit. The first equation can be rearranged as follows:
   
p − MC ∂p q
= −λ p 1 + − MC /p,
p ∂q p
   
p − MC 1
= −λ p 1 − − MC /p
p η
 
p − MC 1
(1 + λ) = λ ,
p η
 
p − MC λ 1 k
= = ,
p 1+λ η η
where k ≡ λ/(1 + λ) . Note that if the profit constraint is not binding, k = λ = 0 and price
equals marginal cost. Otherwise, λ and k are both positive and price exceeds marginal cost.