Firms and price setting

Firms ultimately want to make economic profits, ie they want their revenues to exceed their costs. This isn’t always possible – if they are in a competitive market and are price takers then they have to accept the price the market dictates. In the real world however, most firms have at least some element of market power because they can differentiate their products from their rivals. If a firm has some market power it has the ability to have some control over the prices it charges.

This gives us the price-setting relation:

This is basically saying that firms charge some form of ‘mark-up’ (denoted by ) over the wages they pay. The wages, which are determined by wage-bargaining, represent part of a firm’s costs, but they are unlikely to be the only costs they face.

So we can think of the ‘mark-up’ as including two elements, it includes the other input costs that firms face apart from labour costs, and also it includes the element of market power that the firm has to charge a price above its marginal cost (ie its Lerner Index).

The mark-up in this model is pretty useful because we can use it to model what will happen if we have other supply shocks, eg a rise in the price of oil, will mean firms have to put the costs up independently of wages (so we represent this with an increase in the mark-up), and we can also capture a change in the market structure which would give a firm more power (forming a cartel, legislation which makes it harder for new firms to enter, an increase in advertising or R&D which makes it harder for new firms to enter etc) – again this can be represented with an increase in the mark-up.