Evaluation of Cost Plus Pricing
Cost plus pricing may contribute to price stability and it is simple and easy to use. It provides justification for price changes. Despite these merits, it is criticized for not taking demand conditions into account. It is also criticized for relying on historical or accounting data instead of incremental or opportunity costs.
If applied properly, cost plus pricing may result in firms coming close to maximum profits. Though it appears to be inconsistent with profit maximization as it does not takes elasticity of demand or marginal costs explicitly. As one may ask in the example, why 50 per cent mark-up was taken. Why not 25 per cent or 150 per cent? Though average cost is a basis of price determination, it is close approximation of marginal cost decision making. The mark-up is determined by price elasticity of demand for the book. To understand why this is true, recall that
MR = P[1+1/ep]
Since profit is maximised when MR = MC, we can rewrite the equation as
MC = P[1+1/ep]
Further under certain conditions MC = AC. Thus the equation is rewritten as
AC = P[1+1/ep]
or AC= P[ep+1/ep]
By rearranging the equation we get
P=AC (ep/1+ep)
Under conditions of cost plus pricing
P = AC (1 + mark-up)
If we compare the previous two equations
(1+mark-up)=ep/1+ep
The equation clearly shows that, a firm's maximum profit depends on the products' price elasticity of demand. The optimal mark-up goes up as the price elasticity of demand for the prod.uct goes down. If the quantity demanded of a product is not very sensitive to its price, a high price can be set to make maximum profits.
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