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Thumbs Price Rule

Economics Theory >> Microeconomics Assignments

Larne’s index of monopoly power according to which degree of monopoly Is given by

P – MC / P = 1/e

Where P – MC / P is the mark- up over marginal cost as a proportion of price, according to the above equation this mark-up over price is equal to inverse of the absolute value of the price elasticity of demand for the product. It follows from above that there are following relations of mark – up over marginal cost with price elasticity of demand.

(a) The lower the price elasticity of demand the greater the mark – up as a proportion of pried and greater the monopoly power.

(b) The greater the price elasticity of demand the smaller the mark up as a proportion of price and less the monopoly power.

For example if marginal cost of production at the equilibrium output is 9 and price elasticity of demand is 4. What will be the price? Note that absolute value of price elasticity of demand is 4. Therefore

Mark up = P – MC / P = P – 9 / P = 1 / 4

P = 4P – 36 3P = 36

Thus price or P = 36 / 3 = 12

Now if at the equilibrium output with MC = 9 price elasticity of demand is 2 then

P – MC / P = P – 9 / P = ½

P = 2 P – 18

2 P – P = 18

P = 18

It follows from above that given the marginal cost the lower absolute value of price elasticity f demand, the greater the mark – up over marginal cost and therefore higher the level of price fixed by the producer.

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