Only Exceptional Proff

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The Firm: Pricing and Market Power

I. Price setters and price takers

When viewed from the perspective of pricing behavior, firms can be categorized into two

very broad groups: price takers and price setters. The overwhelming majority of firms, and all

core sector firms, are price setters. These firms have enough control over their environment to

alter the price of their product and thus their profits. The major factor affecting the price of their

product is cost, with price changes being directly related to changes in cost. But, a smaller

proportion of firms are price takers, forced to accept the dictates of the market. These firms have

no control over their environment and are forced to accept the market price regardless of whether

that price is profitable. For these firms, the major factor affecting the price of their product is

demand, with price changes being directly related to changes in demand.

The major characteristic of price taking firms is that they are surrounded by so many

other competitors that they have no control over the price of their product. These firms tend to be

concentrated in the primary sector of the economy and tend to approach the market as

supplicants hoping to capture a good price. The supply of the product tends to be relatively

inelastic and the market price is determined by demand conditions. As a result, each firm ends up

having to accept the going market price, regardless of whether such a price is agreeable. Rather

than there being a range of prices, as is common in virtually all other product markets, there

instead tends to be one common market price.

For example, in the very short-run, a corn farmer is stuck with the amount of corn he or

she has harvested and cannot alter the amount produced. Thus, the revenue that the farmer can

capture depends on the market price of corn. If corn is selling at a relatively high price, that is

high relative to average cost, then the farmer can make a profit, if not, then not. There is little the

farmer can do about all of this. It would not make sense to offer the corn at a lower price because

it could easily be sold at the higher market price. Likewise, the corn could not be sold at a higher

price because no one would willingly pay more than the going market price. Thus, in the very

short-run, price taking firms have little option but to accept the going market price.

Producers caught in these market environments tend to find large variations in their

income flows. This is due to the fact that market demand plays a larger role in the determination

of the price than is the case in virtually any other market context. When the supply of the product

cannot be easily altered in the short-run, as is the case with agricultural products at the time of

harvest, it is demand that determines the price of the product. As a result, the flow of income that

such firms can obtain depends exclusively on the strength of demand. In some years, when

demand, and thus market price, is relatively high, the firms may be bringing in a substantial flow

of profits. In other years when demand is relatively low, firms are losing money and going

bankrupt. In short, price taking firms are at the mercy of the market. As a result, capitalists and

commodity producers are forever trying to circumvent, avoid, or conquer, these types of market

environments.

Most firms and industries are not subject to this kind of uncertainty. This is particularly

true of firms in the core of the economy. But even in the periphery one can find large numbers of

firms with more control over their price than price taking firms. Price setters have enough control

over their environment to set a price that differs, in varying degrees, from that of the

competition. Indeed, in these environments one generally finds a range of prices for the same

commodity, rather than one common market price.

There are two reasons for this. First, firms that find themselves producing and selling a

homogenous commodity, that is a commodity that has the same properties regardless of its

producer, like corn, is more likely to be subject to a price taking environment than firms that

produce and sell differentiated commodities. When confronted by a set of firms selling a

homogeneous commodity, buyers will have no reason, other than price, to prefer one seller over

another. The buyer, given that all the firms are selling the same commodity, will immediately

choose the lowest priced seller, forcing all of the other firms to adopt that same low price. The

competition for buyers among the firms will insure the existence of one common market price.

In contrast, when a buyer is confronted by a set of firms selling similar but differentiated

commodities, such as microwave ovens, the buyer must consider not only the prices of the

commodities, but the various real or imagined differences. Under these circumstances, the buyer

may no longer chose the lowest priced good. He or she may pick a higher priced version of the

same commodity if the higher price is thought as appropriate compensation for a preferred

version of the same good. Moreover, this behavior can be found even in the case of commodities

that are identical in every way except for the context in which they are sold. Thus, it is not

unusual to find different prices for the exact same beverage in different pubs, even though the

establishments may be of the same size and be located on the same block. The ambiance is often

sufficient reason for the price differential.

A second major reason for the difference between price taking firms and price setting

firms is that price setters generally have a greater share of their corresponding market. As a

firm's market share increases, other things equal, its ability to control the price also increases.

The extreme case is that of a pure monopolist - a firm having a 100% share of the market. In this

case the degree of control is as high as it can ever get. While this control diminishes as the firm's

market share falls, it does not vanish to zero. As an example, all of the firms in the core of the

economy, even though they may not be pure monopolists, have enough market share to

manipulate the price of their products. This is true even if the product is homogenous, as in the

case of steel. The firm's price setting ability increases with its market share even if the product is

homogeneous.

In sum, price setting firms have control over the price of their products either because

they are selling a differentiated commodity or because they have enough of a market share, or

both. This covers most of the firms that one encounters in advanced capitalist societies, and

clearly all of the firms in the core of the economy. These firms set the price ahead of time on the

expectation that, given the estimated volume of sales, the target level of profits will be achieved.

General Motors, for example, does not produce a volume of automobiles and then pray they will

sell at an appropriate price. Instead, GM sets the price ahead of time and informs the buyers that

this is the minimal price they are expected to pay. Moreover, while this behavior is characteristic

of large firms with a considerable amount of monopoly power, it is also a feature of the millions

of smaller enterprises that dominate the periphery. In these latter cases, even though the degree

of monopoly power is very small it is sufficient, primarily because of the differentiated nature of

their product, to provide the firm with some price setting ability.

II. Profit maximization for price takers

We’ll start by exploring the behavior of price-taking firms, not because it’s the most

representative example, but because it’s the most common way of introducing the idea of profit

maximization. As already noted, these kind of firms are operating in extremely competitive

markets (called pure or perfectly competitive markets by economists). The case we’ll be

exploring will be that of a representative firm that is a price taker in both the output and input

market; that is, not only is the price of the product given by the competitive market, but so too

are the prices of the inputs. Since the firm has no control over the price of its inputs or output, all

it can do, in an effort to earn as much profit as possible, is to adjust its production levels and

input usage in such a fashion that the gap between revenue and cost is as large as possible.

To keep things simple we’ll be assuming that the firm (establishment) is producing and

selling one product. The firm’s revenue can thus be represented as

and given that, as we saw last week, cost can be represented as

then profits can be represented as the difference between revenue and cost, that is

or, substituting the definitions for TR and TC,

Since the firm has no control over p, w or v, then it will seek to use the minimal amount

of K and L in the production of the greatest amount of Q. But, in the short run, capital (K) is

fixed, so the only variables the firm will be able to control will be output levels, Q, and labor

usage, L. The profits that can be earned from producing and selling different levels of output will

depend on how labor usage varies with changes in production levels. Two possibilities emerge:

either the firm’s production function exhibits diminishing marginal returns, or it exhibits fixed

proportions. If the firm experiences diminishing returns, then the production of greater levels of

output will require increasingly greater amounts of labor, that is the amount of labor needed to

produce each extra batch of output will keep getting greater and greater, causing, of course, cost

to rise at an increasing rate. If instead the firm is experiencing fixed proportions, then the

production of greater levels of output will require greater amounts of labor, but at a fixed rate, so

that the amount of labor needed to produce each extra batch of output remains the same, causing

cost to rise at a constant rate.

Regardless of whether the firm is experiencing diminishing returns or fixed proportions,

it’ll be the case that the firm will be attentive to the extra profit brought in from producing and

selling one extra unit of the product. So long as each extra unit of sales (and thus output)

generates extra profit, then it’s in the best interest of the firm to produce and sell that extra unit.

But, since profit depends on revenue and cost, this is the same thing as saying that so long as the

extra revenue brought in from producing and selling one extra unit of the product exceeds the

€

TR = p⋅ Q

€

TC = w⋅ L + v⋅ K

€

Π = TR −TC

€

Π = p⋅ Q − w⋅ L −v⋅ K

extra cost incurred in producing and selling that extra unit, then it’s in the best interest of the

firm to produce and sell that extra unit.

We can restate the above by rewriting the above profit equation in the following terms ,

which says that extra profits must be the difference between extra revenue and extra cost. If we

divide this equation by the extra output, then we have

MP = MR – MC.

That is, marginal profit is equal to the difference between marginal revenue and marginal cost.

Note that the term marginal means the extra amount of something (profit, revenue, or cost) that’s

generated from producing and selling one extra unit of the product. Thus, marginal profit means

the extra profit that’s generated from producing and selling one more unit; that is, it represents

the extra profit that’s added to whatever profits the firm is already earning. It provides the firm

with information on the amount by which profits will grow if one more unit of the product is

produced and sold.

Now, in a context where the firm is a price taker, marginal revenue (MR) will always be

equal to the market price of the product. If the product is currently selling at $10, then each extra

unit that is produced and sold is generating $10 worth of extra revenue; marginal revenue is $10.

Whenever the firm is a price taker it will always be the case that marginal revenue and price are

the same.

But, what about marginal cost? This will depend on whether the firm is experiencing

diminishing returns or fixed proportions. If the firm is experiencing diminishing returns, then

marginal cost will be increasing with each extra unit of the good that’s produced. But if the firm

is experiencing fixed proportions then marginal cost will remain the same with extra unit of the

good that’s produced.

Let’s explore the case of diminishing returns first. So, long as marginal revenue exceeds

marginal cost, then marginal profit will be positive, and this will induce the firm to produce and

sell that extra unit. Since the price of the product remains unchanged, meaning that marginal

revenue remains unchanged, then marginal profit will depend on what’s happening to marginal

cost. Since marginal cost increases with each new unit of the good that’s produced, this must

€

ΔΠ = ΔTR − ΔTC

€

ΔΠ ΔQ

= ΔTR ΔQ

− ΔTC ΔQ

mean, given a constant marginal revenue, that the firm’s marginal profit is gradually declining.

But notice that a declining marginal profit does mean that the firm’s profits are falling. Instead

what it means is the amount of extra profits which the firm generates from producing and selling

one extra unit is diminishing, but it is nevertheless adding to its profits. Given that the firm wants

the largest possible profits, this means that the firm will continue producing and selling until the

marginal profit that can be generated from producing and selling one extra unit is zero. Once

again, this does not mean that it isn’t making profits, all it means is that it has ceased to ADD

profits to its overall profit position.

We can summarize this idea by noting that the firm will end up making the greatest

possible profit when its marginal profit is zero. But, since marginal profit is the difference

between marginal revenue and marginal cost, another way of saying the same thing is that the

firm will be maximizing its profit when marginal revenue is equal to marginal cost.

This profit maximizing rule can be restated in the following terms:

The following table and graphs provide a numerical and graphic illustration of this idea.

Q p R C π MR MC Mπ

100 $10.00 $1,000.00 $1,000.00 $0.00

101 10.00 1,010.00 1,004.00 6.00 $10.00 $4.00 $6.00

102 10.00 1,020.00 1,010.00 10.00 10.00 6.00 4.00

103 10.00 1,030.00 1,020.00 10.00 10.00 10.00 0.00

104 10.00 1,040.00 1,036.00 4.00 10.00 16.00 -6.00

105 10.00 1,050.00 1,060.00 -10.00 10.00 24.00 -14.00

€

Πmax ⇒ MΠ = 0

€

Πmax ⇒ MR = MC

$990.00%

$1,000.00%

$1,010.00%

$1,020.00%

$1,030.00%

$1,040.00%

$1,050.00%

$1,060.00%

$1,070.00%

99% 100% 101% 102% 103% 104% 105% 106%

Revenue&and&Cost&

!$15.00'

!$10.00'

!$5.00'

$0.00'

$5.00'

$10.00'

$15.00'

99' 100' 101' 102' 103' 104' 105' 106'

Profit&

π'

0.00#

5.00#

10.00#

15.00#

20.00#

25.00#

99# 100# 101# 102# 103# 104# 105# 106#

Marginal(Revenue(and(Marginal(Cost(

MR#

MC#

These four graphs are derived from the data in the above table. Note that profit is at a

maximum when marginal profit is zero or, stated differently, when marginal revenue just

matches marginal cost. In each of these graphs, and in the table, the profit maximizing level of

output occurs when the firm is producing 103 units of output. Note that right at that level of

output, marginal revenue is equal to marginal cost, and marginal profit is zero; exactly the

condition pointed out earlier that would be achieved if the firm were intent on maximizing profit.

A more generalized graphic version of this idea is presented below, depicting all the

relevant unit cost curves for a firm experiencing diminishing returns.

Once again, profit maximization occurs at the point where the firm’s marginal revenue

just equals its marginal cost. Note that in the above example, the firm is shown making above

normal profits. The reason for this is that, in building the cost curves it’s assumed that the

!15.00&

!10.00&

!5.00&

0.00&

5.00&

10.00&

99& 100& 101& 102& 103& 104& 105& 106&

Marginal(Profit(

Mπ&

Output

D o lla rs

mc ac

avc

p = mr

owners have already incorporated the opportunity cost of using their own labor and capital. That

is, built into average variable cost avc) and average cots (ac) is the owner’s opportunity cost of

labor as well as the opportunity cost of having her/his capital tied up in the business instead of in

safe long-term securities. The classical economists would have said that built into the average

cost curve is the normal profit the capitalist is hoping to achieve, where the normal profit would

be equal to the going interest rate incorporated in the cost of capital (the rental rate). Since the

price, in the above graph, is above average cost, this must mean that the owners are receiving not

only the normal flow of profits that are already built into the ac curve, but an extra flow of

profits, over and above that. In short, they are making above normal profits.

For ease of exposition, the above graph was drawn to display a firm making above

normal profits. But it should be underscored that profit maximization does not mean that profits

will always be above normal. Profit maximization can also occur when profits are normal (or in

the language of neoclassicals, when the firm is making zero economic profits), or when profits

are negative (as would occur if the price were momentarily below average cost). The point is that

profit maximization simply means that the owners are earning the best profits they possibly can,

given the circumstances; and under some conditions, the best possible profits might be zero or

negative. If, for example, profits were zero or negative, this would mean that any other level of

production would bring about even lower profits; so, in that sense, profits are at a maximum.

It should also be noted that the above example was set up so that the maximum of profit

would be achieved when marginal revenue just equaled marginal cost. But in more realistic

settings the common scenario would be to find marginal revenue close to marginal cost, but not

exactly equal to it. This more general way of viewing the matter is often expressed by noting that

the profit-maximizing firm will produce at that level where marginal revenue is greater than or

equal the marginal cost of production. Mathematically, this condition is expressed in the

following terms

While this can occur for firms experiencing diminishing returns or fixed proportions, it’s

more appropriate in the case of firms experiencing fixed proportions. Consider the following

graph, which shows the unit cost structure of a firm experiencing fixed proportions and, what’s

more, the firm is a price taker, in a very competitive market.

€

Πmax ⇒ MR ≥ MC

Note that, in this case, the firm’s marginal revenue is consistently above marginal cost,

regardless of how much the firm produces. What this means is that the firm would be motivated

to produce as much as it possibly can, which in the above diagram occurs at the point where

output is at a maximum. Note that, in the short run, this outcome would be true even if the price

were equal to average cost or below average cost but above, or equal to, average variable cost.

So long as the firm’s marginal revenue is above or equal to marginal cost (which in this case is

also average variable cost), the firm would be induced to produce at its maximum capacity.

It should be noted that in the case of both diminishing returns and fixed proportions,

while the firm would be able to arrive at a profit maximizing level of output, this does not mean

that at any moment in time, real firms operating in real competitive environments, are in fact

operating at a maximum of profit. The proper interpretation is to think of the profit maximizing

level of output as the position toward which the firm would move if cost and demand remained

unchanged. Thus, in the above two graphs, it’s quite likely, assuming those graphs represented

real firms in real time, that production levels might be below the profit maximizing point, but the

profit incentive would motivate the firm to eventually get to that point. The usual assumption is

that the firm would get there fairly quickly. But, in reality it depends on the kind of production

taking place and the nature of the industry. In the case of industries where the product can be

produced very quickly, the adjustment can occur within a matter of days. But in the case of

industries, such as agriculture, where it takes a year or longer for production levels to vary, the

adjustment toward the profit maximizing level of output can take years. And since, in the

interim, cost and demand conditions will inevitably change, this means that in such industries the

Output

D o lla rs

p = mr

avc = mc

firms are forever moving toward a target that is, itself, also moving. In those cases, the firms

never reach the profit maximizing equilibrium; they are instead always moving toward an

equilibrium that itself is always moving.

III. Profit Maximization for price setters

Now, in the case of price setting firms, which cover almost all firms, the logic behind

profit maximization would still be the same. That is, the firms will produce and sell that volume

of output that maximize their profits. However, since the firm now has some control over the

price of the product, the firm can alter the price, moving it up or down, in an effort to alter to

volume of output being purchased. A higher price would reduce quantity demanded, and

consequently levels of production, while a lower price would increase quantity demanded, and

thus production. By playing with the price, the firm can induce that volume of customers, and

consequently level of production, which will maximize its profits.

The following graph shows the profit maximizing choice for a price-setting firm

experiencing diminishing marginal returns.

Note that the price setting firm would arrive at the profit maximizing level of output by

manipulating the price. The proper way of thinking about this, in ways similar to the comments

made above regarding the profit maximizing equilibrium for price taking firms, is that the firm

would eventually arrive at that profit maximizing price so long as the cost and demand

conditions remained the same. That is, at any moment in time, the firm’s actual price might be

above or below the profit maximizing level. But self-interest would be enough to motivate the

Output

D o lla rs

mc ac

avc

p = D

firm to keep moving the price until it gets to that one profit-maximizing level. If the price is

currently below the profit maximizing amount, then the firm would move it up; if the price is

currently above the profit maximizing amount, then the firm would move it down. This process

would continue until the equilibrium, profit maximizing, price is achieved.

The same logic applies to firms experiencing fixed proportions. While the graph looks

slightly different, the idea is the same. As with the firm experiencing diminishing marginal

returns, this firm will also play with the price, moving it up or down until that volume of sales,

and thus output, is just enough to maximize profits. Also, as mentioned in the previous cases, the

proper way of thinking about this is not that it represents the price that actually exists at any one

moment in time for a real firm, but rather it represents the profit maximizing price that would

exist if cost and demand conditions remained unchanged. The price charged by the firm would

eventually become the profit maximizing one.

IV. Markup Pricing

The extent to which a firm can manipulate the price of its product depends on the degree

of monopoly power it might possess. Firms with a high degree of monopoly power have a

greater ability to control their price than firms with a smaller degree of monopoly power. The

monopoly power of a firm depends on the share of the market it might control and on the extent

to which the good being sold by the firm is differentiated from the competition. As a firm's

market share increases, other things equal, its monopoly power increases, and so too does its

ability to control the price of its product. Likewise, the more distinct or different the firm's

Output

D o lla rs

p = D ac avc = mc

product is from that of the competition, the greater the firm's ability to control its own price.

Most firms have enough monopoly power to alter the price of their product; they are price

setters.

Regardless of the degree of monopoly power that price setting firms might possess they

all have in common a pricing schema known as markup pricing. While the definition of the

markup varies from one industry to another, the underlying logic is the same and quite

straightforward. Basically, it involves pricing the product in such a fashion that the gap between

the price of the commodity and the firm's average variable cost is sufficient to cover the firm's

overhead plus the target profit.

The firm first determines the average variable cost of production and then adds an

amount that will cover fixed costs plus target profits. The percent by which variable costs should

be increased, to cover fixed costs plus profits, is called the markup. In algebraic terms the

equation determining the price of the product is:

where m represents the markup, the percentage by which average variable costs should be

marked-up.

The markup is estimated by assuming that the firm is operating at some normal level of

capacity which, in turn, is thought to lie below the firm's maximum capacity. This serves the

purpose of providing the firm with enough excess capacity to meet the temporary or seasonal

expansions in demand. The markup that is then chosen will permit the firm to cover all of its

costs plus the target profit, assuming that sales fall within the anticipated normal range. Once the

firm has committed itself to a particular markup, and assuming no change in cost conditions, it

will hold on to that price.

The following graph provides a graphic representation of this idea. The firm's average

total cost and average variable cost are represented by the ac and the avc curves. The firm's

normal level of production is represented by the quantity qn. Given that normal level of output,

the firm picks a markup that is sufficient to cover both fixed costs and target profits. The amount

by which avc is marked up is measured by the vertical distance between the price line, p, and the

avc line. The firm's profit, assuming that qn units are sold, is represented by the shaded rectangle.

avcmavcp ×+=

avcmp ×+= )1(

If quantity demanded happens to exceed qn, the firm will increase production while

holding onto the pre-determined price. If quantity demanded falls short of qn, the firm cuts back

on production without altering the price. Price changes only take place if avc and/or the markup

is changed. Of course, if sales are consistently above or below the anticipated amount then the

firm might alter the size of the markup and thus the price. In this section we will assume that the

demand for the product stays within the anticipated range. The effect that different cost and

demand conditions might have on the markup and/or the price will be considered later. At this

point, it is more important to understand the significance of the markup.

To begin with, the concept of a normal level of production should more appropriately be

referred to as a normal level of capacity utilization. Management assumes a normal amount not

because it can predict the actual level of capacity utilization but because it is the standard by

which the viability of the investment must be judged. Managers and capitalists view the firm as

an investment that is expected to provide the going rate of return. The owners assume a normal

level of capacity utilization, say 85%, not because they know the rate at which the firm will be

operating, but because if the firm could not earn that rate, at a normal level of capacity, then the

investors would be better off selling portions, or all, of the physical capital and using the

proceeds to purchase assets that earn a higher return.

The markup then reflects the rate of return that capitalists expect their firms to earn over

the long-run, assuming the firm is operating at normal levels of capacity. This does not mean,

however, that capitalists know what the demand for the product will be, and thus what sales and

Output

D o lla rs

p = (1+m)*avc

avc = mc

capacity utilization will be. What it instead means is that capitalists know the rate of return they

expect their investments to earn. It is this latter knowledge that determines the size of the

markups. The viability of the firm as an investment is gauged by the extent to which it can earn

the target rate of profit at a normal level of capacity utilization. Since the firm is a long-term

commitment, the rate of return that it is expected to earn will be governed by the interest rate that

can be captured on long-term financial paper. And since the safest, interest earning, investment is

a government bond, investors (and thus owners of firms) will be expecting to earn, at a

minimum, the return that can be captured from these bonds.

Before proceeding let’s break down the component parts of price by using the unit cost

equations we’ve worked with thus far. This will allow us to eventually arrive at an expression

that lays out the component parts of the markup. It will also allow us to explain, in a bit more

detail, the meaning of the rental rate, v, the significance of the capital/labor ratio, and the

productivity of labor We already know that the firm’s average cost can be represented as

but the K/Q ratio is the same thing as the product of the capital to labor ratio and the labor to

output ratio. That is,

where k represents the capital/labor ratio for the firm under normal conditions; it can be thought

of as the long-run capital to labor ratio. Substituting this last expression into the equation for

average cost provides us with the following

Note that this way of representing average cost has the advantage of reducing it to the

influence of the capital/labor ratio and the productivity of labor, given the wage rate and the

rental rate.

The price that the firm chooses will be one that, under normal conditions, allows it to

cover its average cost plus the target profit. We can write this in the following way

where Pt represents the target profit. Since the profit rate can be expressed as a function of the

target rate of profit, we can rewrite the above in the following terms,

€

ac = w apL

+ v⋅ K Q

€

K Q

= K L ⋅ L Q

= k apL

€

ac = w apL

+ v⋅ k apL

= (w + v⋅ k)/apL

€

p = ac + Πt /Q

𝑝 = 𝑎𝑐 + 𝑟' ∙ 𝐾 𝑄

= 𝑎𝑐 + 𝑟' ∙ 𝑘 𝑎𝑝,

where rt represents the target rate of profit. Rearranging the terms and expanding average cost

provides us with,

𝑝 = (𝑤 + (𝑣 + 𝑟') ∙ 𝑘)/𝑎𝑝,

This last equation provides us with the component parts that go into the price of the

product, the wage rate, the target rate of profit, the rental rate, the capital/labor ratio, and the

productivity of labor. If we set this equation equal to the markup pricing equation introduced at

the beginning of this section, and rearrange terms, we end up with the following expression

which helps to highlight the key components of the markup.

𝑚 = (𝑟' + 𝑣) ∙ 𝑘

𝑤

This expression draws attention to the fact that, given the rental rate and the wage rate,

the markup depends on the target rate of profit and the capital labor ratio. The target rate of profit

represents the return on the investment that the capitalist is hoping to earn over the long run,

assuming the firm is operating with the normal, long run, capital to labor ratio, k.

Another way of thinking of this last equation, the markup, is that it represents the profit-

wage ratio, a version of Marx’s rate of surplus value concept. The numerator represents the

surplus that’s generated per worker while the denominator represents the wage per worker.

Now, with a given target rate of profit, wage rate, and input prices, the markup that will

be set by the firm will be affected by its productive technology. The firm's productive technology

is expressed through its capital/labor ratio - k, that is, the amount of productive capacity required

per worker. Other things equal, namely the target profit rate, the wage rate, and input prices, the

markup will vary directly with the firm's capital/labor ratio. A higher capital/labor ratio will

require a higher markup, and vice versa, even if the rate of profit remains unchanged. The reason

for this is that, with a given rate of profit the firm's total profit has to increase as its productive

capacity per worker is increased. Otherwise, the return on investment would be falling as

productive capacity per worker is increased. Thus, with a fixed long-term target rate of profit, the

markup will have to increase as the firm's capital/labor ratio increases.

The importance of this is that, even if all of the firms used the same target rate of profit,

the markups could nevertheless vary from one industry to another. Firms operating in industries

requiring a high capital/labor ratio would use a higher markup than firms operating in industries

with relatively small capital/labor ratios. Thus, even if capital could freely move from one

market to another, insuring a common long-term rate of return, the markups would still vary

from industry to industry. Another way of stating this is that, even though each firm might use

the interest rate that can be captured on long-term financial paper as a measure of the minimally

acceptable target profit rate, the markup will nevertheless be directly related to the capital/labor

ratio.

Of course, in reality the rate of profit varies from one industry to another. Thus, not only

will the markup vary because of differing capital/labor ratios, it will also vary because the rate of

profit that can be captured in different markets also varies. In the case of firms that have already

established their presence in the market, the target rate will generally exceed the rate that can be

earned on long-term government bonds. In this case, the target rate of profit reflects not only the

return that can be earned on long-term financial paper, or the firm's capital/labor ratio, but the

degree of monopoly power that the firm happens to have as well. The greater the degree of

monopoly power, the greater the target profit rate and the higher the markup. Firms that have

established themselves as monopolists will be able to use a higher target profit rate than firms

that have just entered a relatively competitive market environment. Either way, the minimal

return that will be accepted will be the rate that can be earned on long-term paper.

In the case of core sector firms, the markup also reflects the corporation's need to

generate investment funds (not shown in the above equations). At any one moment in time the

firm has a set of investment projects it is currently implementing. These projects are part of the

firm's overall growth strategy. The firm must adjust existing productive capacity to the rate at

which demand is estimated to grow over time. At the same time, the firm is continually investing

in the creation of new products (and thus new capacity) intended to provide the firm with a new

market or a greater share of existing markets. In both cases, the firm must figure out a way of

financing these investment projects.

Some of this investment is financed through borrowed funds. Most of it, however, is

financed through internally generated funds. That is, core sector firms finance most of their

investment through the use of retained profits. The firm plows back a portion of its profits into

the various investment projects that are part of its overall growth strategy. The amount of funds

needed for this purpose will depend on the rate at which productive capacity is expected to grow

over time. This estimate is then incorporated into the target rate of profit and thus the markup

that is used in the pricing of existing product lines. Thus, the markup reflects, in addition to the

degree of monopoly power, the firm's need to generate investment funds.1

V. The sales effort and profit realization2

While the markup is chosen with the hope that the target profit will be attained, there is

no guarantee that it will. Ideally, the quantity purchased will exceed the anticipated normal

amount so that profits end up being greater than expected. But it is also possible for the

purchased amount to fall short of expectations, so that profits end up being less than targeted, or

in the extreme case, less than is minimally acceptable. Given the uncertainty surrounding this

endeavor, management will do everything possible to ensure that quantity demanded be equal to,

or exceed, the normal amount. Management, in other words, will seek to realize the targeted rate

of profit.

This objective is attained through a number of different strategies that have in common

an attempt to manipulate the demand for the product. The first, and most common strategy,

involves the promotion of an aggressive sales effort. In diagrammatic terms, management tries to

get the demand for the product to shift to the right. This idea is depicted in the following graph.

The first demand curve, dd1, represents the demand for the firm's product in the absence of a

sales effort while the second demand curve, dd2, represents the new demand brought about by

the sales effort.

1 The reader should consult Eichner, Alfred S. The Megacorp and Oligopoly: Micro Foundations of Macro

Dynamics. Cambridge: Cambridge University Press, 1976. 2 The classic reference on the impact of the sales effort on the realization of profits is Paul Baran and Paul

Sweezy, Monopoly Capital. New York: Monthly Review Press, 1966.

While management has no way of knowing, with the level of precision suggested by the

graph, the extent to which the sales effort will influence demand, it will nevertheless finance

such an effort as a way of hedging the capital invested in the firm. As can be seen, by examining

the vertical distance between the price line and ac at the two sales levels, q1 and q2, a greater

demand will have the effect of increasing profits. Thus, even if sales are within the normal range

and the targeted profits are realized, it will still be in the best interest of management to finance

the sales effort.

This sales effort involves two components; the creation of a corps of sales agents intent

on pushing the product, and an on-going advertising campaign. The sales agents are the foot

soldiers in the firm's overall sales effort. These individuals do more than simply facilitate a

transaction, they seek out customers, cultivate them, and sell them the company's products. Their

job is to convince potential buyers to purchase the product from their company and not from the

competition.

The work of the sales agent is buttressed by the firm's advertising campaign. The most

obvious and innocuous form of advertising is the type intended to inform potential buyers of the

existence of the firm, its product lines, and the quality and characteristics of its output. In

general, however, advertising involves much more than simply providing information. It also

involves an effort to habituate the consumer into buying the firm's products. This type of

Output

D o lla rs

p = (1+m)*avc

avc = mc

q1 q2

advertising takes on a number of different forms and should more appropriately be viewed as a

form of propaganda.

The most common version of this type of advertising involves repeating the firm's name

or product in so many different contexts and so many times that, when shopping, the consumer

unthinkingly reaches for the product. A variation of this same idea involves associating the

product, or the company, with the various images and cultural symbols that are intended to

induce consumers to feel good about, or desirous of, the product.

Sometimes firms consciously set a higher price as a way of attracting conspicuous

consumers. This tactic is generally carried out as part of an overall strategy pursued by firms

intent on providing an image of exclusivity and affluence. The idea is to give the potential

consumer the impression that the commodity is only available to a few discriminating clients. In

a culture imbued with the acquisitive spirit, where social standing and repute is measured by the

quantity and dollar value of possessions, the purchase of expensive commodities, particularly if

they are useless trinkets, is a way of indicating the relatively high social standing of the

individual. The purchase of such commodities signals to the community the extent to which the

buyer can afford to be careless and wasteful in the use of money. In such an environment firms

will take advantage of these sentiments and continue promoting them by purposefully claiming

to cater to the few discriminating conspicuous consumers.

All of these various tactics are supposed to keep the demand for the product strong and

growing. In the jargon of economics, the idea is to shift the demand for the product outward,

while simultaneously making it relatively inelastic with respect to price (not shown in the above

graph). The consumer is made to feel that the commodity is a necessity. Indeed, if the advertising

campaigns, sales efforts, and pricing policies are successful, the firm's market share will increase

and this will have the effect of making the demand for the product less elastic with respect to

price. The firm will have managed to create an environment that makes it easier to set a higher

markup, and thus a higher price.

The firm's ability to manipulate the demand for its product is not, of course, limitless. It is

constrained by a number of factors, the most prominent being the quality of the product itself and

the fraction of aggregate spending generally spent on the market of which the firm is a part.

Ultimately, the firm's ability to manipulate the demand for its product is dependent on the extent

to which the commodity fulfills its utilitarian promise. If the commodity turns out to be less than

what it had been cracked up to be, sales will quickly diminish even in the face of an extravagant

sales effort. And even if the commodity turns out to be just as good, or better, than advertised,

the firm's ability to increase its sales will eventually be constrained by the amount of income

consumers can allocate towards its purchase. With a given level of national income and a fixed

consumption hierarchy (implicit in the socially determined consumption bundle), the maximum

amount of income that can be spent on any one category of goods will also be fixed, and this will

place an upper limit on the demand for that good.

The various strategies pursued by management in its attempt to realize the targeted

profits cost money. The costs associated with the sales effort, the advertising budget and corps of

sales agents, are a form of fixed cost. In the above examples it was assumed that these

expenditures were already incorporated into the ac curves.3

VI. Monopoly power and price elasticity

One way of measuring the monopoly power of the firm is through the price elasticity of

demand. The price elasticity of demand captures the extent to which the firm can manipulate the

price of the product without significantly altering the quantity demanded. Firms with a relatively

inelastic demand tend to have a greater degree of monopoly power than firms with a relatively

elastic demand. As the degree of monopoly power increases, the firm's ability to set a relatively

high markup also increases.

In general, the price elasticity of demand is dependent on two factors: one, the relative

importance of the commodity to the reproduction of the social order; and two, the structure of

competition within the products market. The first factor measures the relative necessity of the

commodity, that is, the extent to which the commodity is required to maintain the socially

necessary standard of living. It measures the relative standing of the industry in the reproduction

of the social order. For example, in a society that views wine consumption as a necessity, the

demand for wine will tend to be relatively price inelastic, and this inelasticity will allow wine

producers to set relatively higher markups.

3 The commission paid to sales agents is also a fixed cost even though it will vary with the level of sales. In this

case, the ac curve will have more of a U shape, but not because of diminishing returns. This effect however is sufficiently small that it can be ignored.

However, the extent to which any one wine producer can do this depends on the second

factor affecting the price elasticity of demand. This second factor measures the relative standing

of the firm within the market. That is, it reflects the extent to which the firm has managed to

dominate the market. It is the case that firms that have managed to capture a relatively large

share of the market will have a more captive group of customers than firms with a smaller

market share. As a result, firms with a large market share tend to have a more inelastic demand,

and thus a higher markup, than firms with a small market share. Moreover, this is true regardless

of whether the industry of which the firm is a part is viewed as generating a social necessity.

Thus, firms that have managed to capture a relatively large market share in industries

generating an output viewed as a necessity will be able to set a higher markup than firms that

captured the same market share but in industries viewed as superfluous. In the extreme, the

monopolist producing a necessity will have a more inelastic demand than the monopolist

producing a luxury good. This inelastic demand will permit the first monopolist to set a higher

markup than the second.

Obviously, as pointed out in the previous section, the price elasticity of demand is not

beyond the firm's control or influence. Indeed, the firm does everything possible to alter the

elasticity of demand. Thus, the price elasticity of demand can be viewed as a measure of the

extent to which the firm has managed to dominate its environment. Of course, in the short-term

this environment is more or less fixed, but over the long-term the firm seeks to alter it to its

advantage. The sales effort, battles over market share, product differentiation and innovation, the

cultivation of customers, the continual promotion of consumerism, and the buying out

competitors are all various means by which the firm seeks to change its market context. In the

process of altering its environment, the firm alters the price elasticity of demand and thus the

markup it can use in the pricing of its output.

Now, if demand conditions end up being significantly different than anticipated, say that

quantity demanded is far beyond the normal amount, then production levels will of course be

changed. Whether the markup, and thus the price, is changed depends on the context in which

demand conditions changed. If there were a general increase in demand affecting all of the firms

in the market more or less equally, and if, in addition, the direct unit costs of each firm remained

stable, then the relative standing of each firm in the market would remain stable and so too

would the monopoly power of each firm. Since the degree of monopoly power remains

unaffected, the markup, and thus the price, will also remain unchanged. Under these conditions

an increase in demand leads to an increase in output without an increase in the price of the

product.

However, if the demand for the output of one firm grows faster than the demand for the

output of others, then the relative standing of that firm is improved. This would occur even if the

direct unit costs of each firm in the market remained unchanged. The fact that the demand for the

output of one firm is growing faster than the others implies that its demand is becoming

relatively less elastic. In turn, this relatively less elastic demand implies that the firm's degree of

monopoly power is rising, allowing it to use a higher markup and thus charge a higher price. In

this case, an increase in the demand for the product of the firm will cause output and price to

rise.

Similar remarks can be made in the case of cost changes. Whether or not a cost change

will lead to a change in the markup depends on the extent to which the cost change is being

experienced by other firms in the same market. If the cost change is across the board, assuming

no change in demand, then the relative standing of each firm remains unaltered and so too does

each firm's degree of monopoly power. If the cost change is being experienced primarily by one

firm (assuming again no change in demand conditions), then that firm's relative market standing

is affected as is its degree of monopoly power. In the first case the markup remains unaffected.

In the second case the markup is changed.

However, unlike the effect of a change in demand, even if the markup remains unchanged

in the face of a change in costs, prices will change. Thus, if all of the firms in a market

experience an increase in direct unit cost of approximately the same magnitude, then despite the

fact that each firm will hold onto the same markup, the price will nevertheless increase by the

same percentage as the increase in direct unit costs. Of course, if the increase in the direct unit

costs of one firm is greater than the cost increase of others, then that firm's relative standing is

affected. The firm will still increase its price, but in order to maintain its relative standing in the

market, the markup will be reduced, insuring that the price increase will not be as great as it

otherwise could have been.

It should be obvious that both demand and cost conditions can change simultaneously

and that these changes may not be distributed equally across all firms in the same market. Given

the outline already provided, the reader should be able to infer the likely effect on the markup

and price when there is a simultaneous change in demand and cost conditions.

VII. Price elasticity and pricing

The demand for the product of the firm can be represented in the following terms

where q represents quantity demanded, p represents the price of the commodity, which is set by

the firm, d represents the shift factor (that is, those factors that account for a shift in demand,

such as income, consumer preferences, and price and availability of other goods), and ep

represents the price elasticity of demand. The price elasticity of demand is a negative number

and assumed to be a constant.

The demand curve is assumed to have a constant elasticity demand. That is, the price

elasticity of demand remains fixed as the price of the product changes. The price elasticity of

demand can be thought of as a measure of the relative standing of the firm within the market; it

reflects the firm's market share and the relative importance of the commodity to the reproduction

of a socially necessary standard. As long as the firm's standing remains stable, so will the price

elasticity of demand. In the context of a growing economy, the demand for the product will be

growing, that is, the shift factor, d, would be getting larger, even though price elasticity may

remain stable. This could happen if the relative standing of the firm remains stable as the

economy grows over time. Of course, if the firm's market share is altered, or the relative

necessity of the commodity changes, then the price elasticity of demand would also change.

The price elasticity of demand measures the percentage change in quantity demanded due

to a percentage change in the price of the product. This can be expressed in the following terms

where the numerator represents the percentage change in quantity; the denominator represents

the percentage change in price. Rearranging this expression, provides us with the following

definition for price elasticity

This is the version of price elasticity that is more commonly employed in theoretical work.

pd = q e p´

, p/p q/q

=e p D D

. q p

p q

=ep ´ D D

Note that ep is a negative number because price and quantity are inversely related to each

other along any one demand curve. Economists often use the absolute value of ep as a measure of

the price elasticity of demand. The larger the absolute value of ep, the more elastic the demand

for a commodity with respect to its price. If the absolute value of ep is greater than one, the

demand curve is said to be price elastic. If the absolute value of ep is less than one, the demand is

said to be price inelastic.

The firm's revenue is equal to the price of the product times the amount purchased. But

amount purchased depends on the demand for the product. Thus, the firm's revenue function, R,

can be expressed in the following terms

Because marginal revenue is a measure of the amount by which revenue changes due to a

small change in quantity demanded (more formally, it is the derivative of the revenue function),

the firm's marginal revenue function, MR, must be

And since the last term in this equation can be expressed as a function of the price elasticity of

demand (keeping in mind the price elasticity definition), the firm's marginal revenue function

can also be expressed in the following terms

Profit maximization requires that the firm's marginal revenue be equal to its marginal

cost. But in the context of fixed proportions, marginal cost is equal to average variable cost.

Thus, setting marginal revenue equal to average variable cost provides us with the following

relationships,

pd = qp = R )e+(1 p´´

( ) . q p

ped = q R

= MR pep D D

´+´ D D

. e

e p = MR

÷ ÷ ø

ö ç ç è

æ + ´ 1

÷ ÷ ø

ö ç ç è

æ + ´=Þ=

e e

pavcMRMC 1

avc e e

p p

p ´÷ ÷ ø

ö ç ç è

+ = 1

This is nothing other than the profit maximizing price. Of course if the firm experienced

diminishing marginal returns, we would then have to substitute mc for avc in the above

expressions. The underlying pricing logic would still be the same.

If the firm does indeed pick a markup that maximizes its profits, then it must be that the

bracketed portion of above equation is equal to the (1+m) portion of the markup pricing formula

introduced earlier. Setting these two expressions equal to each other and solving for the markup,

provides us with the following expression for the markup

If the firm is a profit maximizer, then this expression means that the size of the markup,

m, is positively related to the price elasticity of demand. Another way of stating this is that the

markup is negatively related to the absolute value of the price elasticity of demand. Since the

absolute value of the price elasticity of demand tends to decrease as the firm's market share is

increased, this implies that firms with a greater market share will set a higher, profit-maximizing,

markup than those that have a smaller market share. Likewise, commodities that are more

important to the reproduction of the system (relatively inelastic with respect to price) will tend to

sell at a higher markup than those that are less important.

Note also that profit maximization requires that demand be relatively price elastic; that is

ep must be less than -1. Stated differently, what this means is that profit maximization is

inconsistent with price inelastic demand curves, (ep > -1). This result has always created a bit of

consternation to economists, since it seems to fly in the face of common sense.

÷ ÷ ø

ö ç ç è

+ -=

pe m

1 1