A pharmaceutical company produces a branded medication at $0.50 per pill and sells it at $300 per pill — a 59,900 percent markup. A supermarket sells the same generic commodity at $0.55 per pill, a 10 percent markup. Both are applying the same economics — price relative to marginal cost — but one faces an inelastic demand curve with no close substitutes while the other competes against dozens of identical alternatives. Markup is the number that captures this difference in market power in a single ratio.
The formula
Markup = (P – MC) / MC
Alternatively expressed as a fraction of price (the Lerner Index):
Lerner Index = (P – MC) / P
For a firm charging $50 with a marginal cost of $30:
- Markup = ($50 – $30) / $30 = 67%
- Lerner Index = ($50 – $30) / $50 = 0.40
The markup and the Lerner Index measure the same thing from different denominators. Either way, the higher the number, the more pricing power the firm has over its specific product.
Reading the result
The markup is mathematically tied to the firm's elasticity of demand:
Optimal markup = 1 / (|ε| – 1)
Where ε is the firm's own-price elasticity of demand.
- If |ε| = 2: optimal markup = 1/(2–1) = 100% above MC
- If |ε| = 5: optimal markup = 1/(5–1) = 25% above MC
- As |ε| → ∞ (perfect competition): optimal markup → 0
This is why firms with inelastic demand (few substitutes, strong brand loyalty) sustain large markups, while firms in competitive markets with elastic demand must price near MC. The markup formula turns demand elasticity directly into optimal pricing strategy.
Worked example
A software company estimates its demand elasticity at –3.5. Optimal markup = 1/(3.5 – 1) = 1/2.5 = 40%. If marginal cost (server costs, support) is $10/month per subscriber, the optimal price is $10 × (1 + 0.40) = $14/month. Setting price at $14 maximizes profit given the demand and cost structure.
The Bureau of Economic Analysis profit share data shows that aggregate markups in the U.S. economy have increased since the 1980s — consistent with rising market concentration and declining competition in many industries. NBER research on markups documents that the average firm's markup has risen from approximately 1.1× cost in 1980 to approximately 1.6× cost by the 2010s — a significant structural shift in the distribution of surplus between firms and consumers.
Where it's used
Markup analysis is used in antitrust (high markups signal market power), monetary economics (rising aggregate markups reduce the pass-through of wage increases into prices), and competitive strategy (identifying the markup ceiling before demand becomes elastic enough to cause volume losses). It is one of the most direct empirical measures of market structure and competitive dynamics.
