The term markup pricing assumes that a hypothetical firm when setting a price makes it equal to average costs plus some reasonable profit margin that can be expressed as cost times a markup. There are different theoretical treatments of markup pricing, however. In the neoclassical theory of monopoly, the law of supply and demand is assumed and the markup is thought to be determined by the elasticity of demand. The post-Keynesian theory, on the other hand, assumes some monopolization of markets due to concentration, entry barriers, and collusion within or across industries and does not consider the law of supply and demand a relevant factor—that is, prices are not thought to respond to disequilibria in supply and demand. The markup is assumed to be determined by the degree of monopoly. Since the 1970s, theories of what is called dynamic markup pricing have also been developed.
The neoclassical theory assumes the existence of monopolies or monopolistic competition due to differentiated products. In a market for differentiated products, a large number of firms compete by selling similar products but they are not perfect substitutes for one another. A firm confronts certain limitations imposed by the nature of consumer demand—that is, the fact that consumers are more willing to buy products at lower prices than at higher ones. Thus, the firm’s profit-maximization problem can be written as
where p (y ) is the inverse demand function, and c (y ) the cost function.
The profit-maximizing condition is
where ǀηD ǀ ≡ ǀ(p /y )(dy /dp )ǀ > 1 is the elasticity of demand in absolute value. Because consumer demand is inversely related to the price, ηD is never positive. The elasticity of demand must be greater than 1 in absolute value, or the condition is contradictory to nonnegative marginal cost, c '(y ) ≡ MC > 0.
Rearranging the above, we obtain
The left side of the equation indicates the ratio of profit to price, while the right is the so-called Lerner index, which is inversely proportional to the elasticity of demand. The elasticity of demand ǀηD ǀ is independently determined by consumer behavior. Hence, assuming that ǀηD ǀ = 4, we can see from the first formula that the price is equal to marginal costs times 4/3 times the marginal costs. In this theory, markup pricing is, therefore, an attempt by a firm to guess the market’s elasticity of demand. Higher elasticity leads to a price closer to the competitive price.
Theories of monopolistic and oligopolistic markets in post-Keynesian economics were developed based on the assumption that concentration, entry barriers, and collusion within or across industries prevent prices from responding to disequilibria in supply and demand. The markup is determined by the degree of the monopoly that gives the firm or entrepreneur the power to increase a markup on prime cost by raising price. This position is taken by post-Keynesian economists such as Michal Kalecki (1971), Maurice Dobb (1973), Joan Robinson (1965, 1971), Josef Steindl (1952), Paolo Sylos-Labini (1969), Alfred S. Eichner (1973, 1976, 1980), Adrian Wood (1975), and Athanasios Asimakopulos (1975).
Kalecki (1971) holds the view that the different markups in different industries are determined by the degree of industrial concentration and that the different markups within one industry are determined by the distribution of power among the firms in the industry. This can be expressed as
p = mu + np̄
where u is the variable cost, ̄ the weighted average price of all firms in the industry, and m > 0 and 0 < n < 1 are coefficients that indicate the firm’s position within the industry. The weighted averages, m̄ and n̄, which reflect the degree of industrial concentration, determine the average price in the industry and thus the average markup:
whereby the factor before the ū is the markup.
Target return pricing is a variant of markup pricing that is often found in post-Keynesian economics. Price is set to earn a profit margin that yields a target rate of return on capital at a standard volume of output:
where π is the target rate of return on capital, K the capital stock, xN the normal output, ULCN and UMCN the unit labor and material costs respectively at a normal output, and μ the markup factor. The markup over variable cost μ VC = πK/xN changes either because of changes in the target rate of return or in the capital-output ratio.
Studies by Robert F. Lanzilotti (1958), Wood (1975), and Eichner (1973, 1976, 1980) are concerned particularly with pricing decisions by large corporations. These economists maintain that prices are likely to be set so as to assure the internally generated funds necessary to finance a firm’s desired rate of capital expansion:
where VC is variable cost, FC fixed cost, CL corporate levy (the desired internal funds to finance the investment expenditure), and CUN normal capacity utilization. If variable and fixed costs are held constant, the markup is determined by corporate levy, though it may be limited by substitution, the entry of new firms, and government intervention.
Despite the fact that there are several accounts of the markup within post-Keynesian economics, post-Keynesian theories do nonetheless all share an assumption: that prices change primarily due to a change on the cost side (though this is less due to the law of supply and demand than would be the case for neoclassical theorists).
According to dynamic markup pricing theorists, while firms can decide their own prices and markups, they are nonetheless guided by the need to build up customers in order to expand their future market shares. Firms also have to face competition with a few rivals in the oligopolistic market and threats from potential entrants into the market. Furthermore, customers may leave or switch to other firms. In this sense, the firms have restricted choice since their pricing decisions should be based on considerations of the current and future state of the market. In this dynamic framework, a firm’s markup pricing is greatly dependent on other firms.
Economists such as Joe Staten Bain (1956), Sylos-Labini (1969), Franco Modigliani (1958), and David P. Baron (1973) have long argued that price and markup function as barriers to market entry set up by incumbents who wish to deter potential competition. This version of oligopolistic pricing is called limit pricing or entry-preventing pricing. Prices are set above the costs but below prices at which potential competitors could enter the market and earn positive profits. Pricing depends on many factors such as the degree of concentration, economies of scale, product differentiation, the absolute cost advantages of incumbents, and internal interdependence of oligopolistic firms.
Like other post-Keynesians, Nicholas Kaldor (1985) suggests that prices and markups are cost-determined, but he also takes the importance of customer relationships into account. In his view, a firm determines markup based on two opposing considerations: market-share expansion and capital expansion. On the one hand, each firm will choose a price and a markup as low as possible so that they can build up more customers to improve their market share. On the other hand, they also have an incentive to set their markup as high as possible to increase their own capital by means of internal finance. This is because firms want to prevent a situation in which they become financially constrained through excessive reliance on external finance. Note that the second point was usually neglected in the traditional neoclassical theories, in which internal and external finances are considered as near-perfect substitutes. Kaldor therefore views a markup merely as a residual between the cost and the price chosen after considering the market dynamics.
Edmund S. Phelps and Sidney Winter (1970) have provided the first rigorous theoretical analysis of this type of dynamic markup pricing theory. They point to customerflow dynamics as a barrier to optimal markup pricing:
Here n is the number of a firm’s own customers, p its own price, p̄ the average price of all other firms in the industry, and α a positive constant. Therefore, if a firm charges a high price, it loses customers. They find that equality between marginal cost and price does not generally hold even in a stationary state. Thus an optimal markup is derived as the difference between those two.
More recent developments in oligopolistic pricing theory focus on imperfect information such as “judging quality by price” (Stiglitz 1984), “reputations” (Greenwald, Stiglitz, and Weiss 1984), and “search costs” (Stiglitz 1983) as the source of price rigidities and the markup.
SEE ALSO Competition; Prices; Rate of Profit
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