Markup rule

A markup rule is the pricing practice of a producer with market power, where a firm charges a fixed mark-up over its marginal cost.

[1][page needed][2][page needed] Mathematically, the markup rule can be derived for a firm with price-setting power by maximizing the following expression for profit: Profit maximization means that the derivative of

this means that a firm with market power will charge a price above marginal cost and thus earn a monopoly rent.

On the other hand, a competitive firm by definition faces a perfectly elastic demand; hence it has

which means that it sets the quantity such that marginal cost equals the price.

The rule also implies that, absent menu costs, a firm with market power will never choose a point on the inelastic portion of its demand curve (where

Intuitively, this is because starting from such a point, a reduction in quantity and the associated increase in price along the demand curve would yield both an increase in revenues (because demand is inelastic at the starting point) and a decrease in costs (because output has decreased); thus the original point was not profit-maximizing.