﻿

# Cost-plus pricing with elasticity considerations

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:

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)))
(P / MC) = (1 / 1)

Price is equal to marginal cost. There is no markup. At the other extreme, where elasticity is equal to unity:

(P /MC) = (1 / (1 - (1/1)))
(P / MC) = (1 / 0)

The markup is infinite. 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, cost-plus pricing, price elasticity of demand, markup, production, costs, and pricing, marketing, microeconomics

Wikimedia Foundation. 2010.

### Look at other dictionaries:

• Pricing — is one of the four p s of the marketing mix. The other three aspects are product, promotion, and place. It is also a key variable in microeconomic price allocation theory.Price is the only revenue generating element amongst the 4ps,the rest being …   Wikipedia

• Outline of industrial organization — For concepts relating to production in macroeconomics, see gross domestic product and measures of national income and output. The following outline is provided as an overview of and topical guide to industrial organization: Industrial… …   Wikipedia

• List of topics in industrial organization — In microeconomics, industrial organization is the field which describes the behavior of firms in the marketplace with regard to production, pricing, employment and other decisions. Topics in this field range from classical issues such as… …   Wikipedia

• List of marketing topics — This is a list of marketing topics. Marketing fundamentals * [ [Marketing] * Consumer * Business Marketing * Core * Customer ** Customer lifetime value (CLV) ** Customer relationship management (CRM) * Marketing mix * Marketing orientation, also… …   Wikipedia

• Topic outline of marketing — For a more comprehensive list, see the List of marketing topics. Marketing refers to the social and managerial processes by which products, services and value are exchanged in order to fulfil individual s or group s needs and wants. These… …   Wikipedia

• Outline of marketing — The following outline is provided as an overview of and topical guide to marketing: Marketing refers to the social and managerial processes by which products, services and value are exchanged in order to fulfil individuals or group s needs and… …   Wikipedia

• Carbon tax — Part of a series on Green economics Concepts …   Wikipedia

• Henry Schultz — Naissance 4 septembre 1893 Szarkowszczyzna (Russie) Décès 26 novembre 1938 Californie (États Unis) Nationalité américaine Champs économétrie …   Wikipédia en Français