Cost-Plus Pricing

Abstract

In a classical world of pricing, where information is costless and firms know everything with certainty, only marginal cost (MC) pricing maximizes profits. Most firms, however, ignore this fact and use cost-plus (CP) pricing or some heuristic, cost-based variant. This apparent disconnect is, of course, because actual prices are set in non-classical environments, where information is incomplete, uncertain and costly, environments therefore that do not inevitably lead to a profit-maximizing, optimal MC choice. One such environment, considered here, assumes an n-product monopoly that simplifies its pricing decision with a linear approximation of its actual costs. If these costs are also increasing, then the approximation can easily lead to underpricing for a firm using MC pricing. A firm using CP pricing may also underprice but to a lesser extent because prices can be adjusted by increasing the cost basis and/or markup. We show that if there is sufficient nonlinearity in the firm’s underlying costs, then the CP advantage of mitigating underpricing will result in profits that are higher than they would otherwise be under MC pricing.