Assume you have been hired to advise two different firms, A and B, regarding the price each firm should charge for its product, focusing on the amount each firm should mark up price over marginal cost
While both firms are price setters, the product produced by firm A is extremely unique and enjoys widespread appeal. In contrast, firm B sells a fairly standard product for which there are are several good, but not perfect, substitutes. How would your advice to each firm differ? How does the price elasticity of demand influence your recommendations?
The profit-maximizing price-setting firm is able to mark up price above the marginal costs of production at the profit-maximizing level of output. That being said, firm A would be able to apply a larger markup factor than would firm B. This is because the optimal mark up is inversely related to the price elasticity of demand. As demand for the price-setter's output becomes more inelastic, the size of the mark up increases. Based on the information in the question, demand for firm A's output is more inelastic than is demand for firm B's product. It then follows that firm A should use a larger markup, all else constant.
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