Elasticity based pricing rules: a cautionary note

Abstract

The inverse elasticity rule is all too often described in a way that implies a myopic application, sometimes with a numerical example with input values for price elasticity of demand and marginal cost thus determining profit maximizing price. Conversely, the rule's shortcomings are not given deserved attention. This is unfortunate, as the rule may be adopted at face value, which will lead to erroneous pricing. If marginal cost and price elasticity depend on price, as is usually the case, a myopic application of the rule will, in most cases, lead to a bypassing of optimal price; if the initial price were too low, then the prescribed price would be too high, and vice versa. Continued myopic use may even lead to divergence from the profit maximizing price. Only if both price elasticity of demand and marginal cost are constant, which is rarely the case, will the rule return the optimal price.