Assuming a constant marginal cost, a lower price elasticity of demand would call for a relatively lower mark-up ration.
To understand why a lower price elasticity of demand would call for a relatively lower mark-up ratio, let's break it down step by step.
1. Price Elasticity of Demand: Price elasticity of demand measures how responsive the quantity demanded of a product is to changes in its price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price.
- If the price elasticity of demand is high (elastic demand), it means that a small change in price will result in a proportionately larger change in quantity demanded. In such cases, consumers are very sensitive to price changes, and small price changes can have a significant impact on demand.
- If the price elasticity of demand is low (inelastic demand), it means that a change in price will result in a proportionately smaller change in quantity demanded. In such cases, consumers are less sensitive to price changes, and price fluctuations have a relatively smaller effect on demand.
2. Marginal Cost: Marginal cost refers to the cost of producing one additional unit of a product. It includes the variable costs (such as direct materials and labor) associated with producing that additional unit.
- Assuming a constant marginal cost means that the cost of producing each additional unit of the product remains the same, regardless of the level of output. In other words, each unit is produced at the same cost.
3. Markup Ratio: The markup ratio, also known as the price markup, is a measure of the difference between the selling price and the cost of production (including the cost of producing each additional unit).
- A higher markup ratio indicates that the selling price is significantly higher than the cost of production. This can result in higher profit margins for the seller.
Now, let's tie it all together. If the price elasticity of demand is lower (inelastic demand), it means that consumers are less sensitive to price changes. In this scenario, a decrease in price would have a relatively smaller effect on the demand for the product. Therefore, sellers can afford to set a higher markup ratio to maximize their profits.
Conversely, if the price elasticity of demand is higher (elastic demand), consumers are more sensitive to price changes. In this case, even a small increase in price could result in a significant decrease in demand. To remain competitive and avoid pricing themselves out of the market, sellers may need to set a lower markup ratio.
In summary, assuming a constant marginal cost, a lower price elasticity of demand would call for a relatively lower markup ratio because sellers have more pricing power and can set higher prices without significantly impacting demand.