Editing Cost-plus pricing (section)

==Elasticity considerations==
Although this method of pricing has limited application as mentioned above, it is used commonly for the purpose of ensuring a business covers its costs by "breaking even" and not operating at a loss whilst generating at least a minimum rate of profit.<ref>{{Cite web |last=Marn |first=Michael V. |last2=Roegner |first2=Eric V. |last3=Zawada |first3=Craig C. |date=2003-08-01 |title=Pricing new products |url=https://www.mckinsey.com/capabilities/growth-marketing-and-sales/our-insights/pricing-new-products |access-date=2025-03-18 |website=[[McKinsey Quarterly]]}} </ref> In spite of its ubiquity, economists rightly point out that it has serious flaws. Specifically, the strategy requires little market research hence it does not account for external factors such as consumer [[demand]] and competitor's prices when determining an appropriate selling price.<ref name=":1" /> There is no way in advance of determining if potential customers will purchase the [[product (business)|product]] at the calculated price. Regardless of which pricing strategy a company chooses, [[Price elasticity of demand|price elasticity]] (sensitivity of demand to price) is a vital component to examine.<ref>{{Cite web|date=2014-12-16|title=Pricing Strategies & Elasticity|url=https://julieaskewblog.wordpress.com/marketing-principles/pricing-strategies-elasticity/|access-date=2021-04-26|website=Fundamentals of Marketing|language=en}}</ref> To compensate for this, some economists have tried to apply the principles of [[price elasticity of demand|price elasticity]] to cost-plus pricing.<ref>[https://www.talkcosts.co.uk/ Talkcosts - Cost Guides]</ref>

We know that:<blockquote>MR = P + ((dP / dQ) * Q)</blockquote>
where: <blockquote>
MR = marginal revenue<BR>
P = price<br />
(dP / dQ) = the derivative of price with respect to quantity<BR>
Q = quantity</blockquote>

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:<blockquote>MC = P + ((dP / dQ) * Q)</blockquote>

Dividing by P and rearranging yields:<blockquote>MC / P = 1 +((dP / dQ) * (Q / P))</blockquote>

And since (P / MC) is a form of markup, we can calculate the appropriate markup for any given market elasticity by:<blockquote>(P / MC) = (1 / (1 – (1/E)))</blockquote> where:<blockquote>(P / MC) = markup on marginal costs<BR>E = price elasticity of demand</blockquote>

In the extreme case where elasticity is infinite:<blockquote>(P / MC) = (1 / (1 – (1/999999999999999)))<BR>   (P / MC) = (1 / 1)</blockquote>Price is equal to marginal cost. There is no markup.

At the other extreme, where elasticity is equal to unity:<blockquote>(P /MC) = (1 / (1 – (1/1)))<BR> (P / MC) = (1 / 0) </blockquote>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):<blockquote> (P / AVC) = (1 / (1 – (1/E)))</blockquote> 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.