Question

The wholesale price of a widget is $p dollars. The widget sells for $r dollars at retail. The manufacturer incurs $c fixed cost (assume no variable cost) and the retailer incurs $z fixed cost. The quantity of units sold is q. Please answer the following questions to explain why there are misaligned incentives:

What is the profit equation for the manufacturer? (i.e. how much profits will the manufacturer make?)

What is the profit equation for the retailer? (i.e. how much profits will the retailer make?)

Does the retailer or the manufacturer prefer a lower retail price $r

Answer 1

(A) MANUFACTURERS PROFIT EQUATION

Number of quantity sold = q (Given)

Wholesale selling price = $p

Fixed cost wholesaler = $c

PROFIT EQUATION => Profit = ($p * q) - $c

(B) RETAILERS PROFIT EQUATION

Number of quantity sold = q

Retail selling price = $r

Fixed cost of retailer = $z

PROFIT EQUATION => Profit = ($r * q) - $z

Generally its the retailers who will not prefer lower retail price because it will reduce their margin earned by them and they will find it difficult to cover their fixed cost.