Pure mark-ups and mark-downs in bilateral trade

This essay studies a bilateral trading market where a single seller and a single buyer interact using simple heuristics: pure (i.e. linear) mark-up and mark-down rules. We show that the distribution of surplus between buyer and seller as well as the overall level of efficiency is crucially affected by the way mark-up and mark-down are computed. In particular, the common "cost-plus mark-up" rule often adopted by real world sellers is dominated by another pure mark-up rule, computed with respect to the value of the good to the seller. However, overall efficiency is maximized when both the seller and the buyer compute their mark-up/mark-down with respect to their costs.