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- [Alex] In a competitive market, we know that price is equal
to marginal cost and equilibrium.
In a market with a monopoly, we now know the price
will be greater than marginal cost.
But how much greater? What determines the markup?
What we're going to show in this talk
is that the monopoly markup depends upon
the elasticity of demand.
Okay, let's do a very brief review where we ended up last time.
Everything on this diagram should now be familiar.
We know how to find the marginal revenue curve
as a curve starting out on the vertical axis
at the same point as the demand curve
with twice the slope.
We know that the profit maximizing quantity is found
where marginal revenue is equal to marginal cost.
And we know that we read the profit maximizing price
as the highest price that people are willing to pay
per unit for that quantity, in this case that's $12.50.
The monopoly markup is the difference between price
and marginal cost.
We know that in a competitive market,
price would be equal to marginal cost.
Here in equilibrium we have price is much greater
than marginal cost, that's a monopoly markup.
And we can also read off this diagram,
total profits for the monopolist which are above normal profits.
And profits are the difference between price and average cost
times the quantity, which is this shaded area.
Okay, that's a review.
Now let's give some intuition for what determines the size
of the monopoly markup.
For intuition, let's go to our case of a pharmaceutical.
Two effects are going to increase the monopoly markup in this case.
First, the "you can't take it with you" effect.
Namely, people with serious illnesses
are going to be relatively insensitive to the price
of life saving medicine.
You can't take it with you so may as well spend all you have
trying to save your life.
If the price of a life saving medicine goes up,
the quantity demanded isn't going to go down very much.
Since the customers are insensitive to the price,
the monopolist is going to say, "Hey, I can increase the price
and they're still going to buy, so I should increase the price.
It would be profit maximizing for me to increase the price."
Another effect, the "other people's money" effect.
If somebody else is paying for the medicine,
the user, the consumer is going to be less sensitive to the price.
And we know for pharmaceuticals often the insurance company
or Medicaid or Medicare or a government program,
they're going to be paying for the pharmaceutical,
so that the person who is demanding the pharmaceutical --
they're not paying the price.
So even when the price goes up they're still going to ask
for the pharmaceutical -- the quantity demanded
isn't going to go down very much.
So the conclusion here
is that the less sensitive quantity demanded is to price,
the higher the markup is going to be.
If people aren't sensitive to the price,
the monopolist is going to say, "Great. I can jack up the price
and still sell almost as much as I did before."
In other words, the more inelastic the demand curve,
the higher the markup, and that's our basic lesson.
Now that we have the intuition, let's test it with some diagrams,
some demand curves.
We have two demand curves.
Which is more elastic, the demand curve on the right
or on the left?
The demand curve on the left is more elastic.
The demand curve on the right is more inelastic.
So going by our intuition, we should expect a low markup
on the left and a high markup on the right.
We know how to find the profit maximizing prices
and quantities so let's do that.
First, starting on the left.
What we see is that when the demand curve
is relatively elastic, we get a small markup of price
over marginal cost.
What about on the right?
Well now we have a relatively inelastic demand curve
and what we see is that price rises well above marginal cost.
We have a relatively inelastic demand
and we get a big markup.
Notice the marginal cost for these two markets is the same.
What differs is that the demand curve over here on the right
is more inelastic.
Remember the logic: the monopolist sees the consumers
are insensitive to price.
So it knows that if it raises price,
the quantity demanded will fall by only a little.
Therefore, an increase in price will increase
the monopolist's profits, that's what it wants,
so the monopolist will increase the price
and you get a big markup of price over marginal cost.
Remember also that for a competitive firm,
the demand for its product is perfectly elastic
and in that case price is equal to marginal cost.
So it makes sense
that the more elastic the demand curve is
for a monopolist, the closer the pricing decision
of the monopolist is to that of a competitive firm.
So when the demand curve for the monopolist
is relatively elastic, price is going to be close
to marginal cost.
The more elastic the demand curve gets
for the monopolist,
the closer the monopolist's profit maximizing output is
to that of a competitive firm.
Price gets closer to marginal cost.
Okay, very good.
Again remember, big lesson, the more inelastic demand,
the bigger the markup.
Let's now try to see if we can use our theory
to solve a pricing puzzle.
I recently looked at some flights on American Airlines
and what I found was that a flight from Washington to Dallas
was more expensive than a flight from Washington to San Francisco.
Now, there's two things which are puzzling about that.
First, San Francisco is obviously much farther from Washington
than is Dallas, so you'd expect the cost,
fuel cost and so forth, to be higher.
Second, the puzzle is even deeper because the flight from Washington
to San Francisco ran through Dallas.
In fact, the Washington to Dallas segment
of the Washington to San Francisco flight
was exactly the same flight as the Washington to Dallas flight.
So why would one segment of the Washington
to San Francisco flight be more expensive
than the entire flight?
The answer requires knowing something about how airlines
are structured in the United States.
Most of the airlines have a hub airport,
often near the center of the country,
that's dominated by one particular airline.
In the case of American Airlines, it's Dallas.
In the case of United, it's Chicago.
Northwest dominates Minnesota, St. Paul, and so forth.
What this means is that if you want to fly to Dallas
at a convenient time, you're much more likely to find
a good flight on American Airlines than on another airline.
And if you want to fly to Minneapolis, St. Paul,
it's going to be much more convenient
to fly Northwest and so forth.
Okay, does that give you any ideas about solving the puzzle?
Think about someone flying from Washington to Dallas,
what options do they have?
Not many. There are few substitutes.
And few substitutes means inelastic demand.
Now think about someone flying from Washington to San Francisco.
What options do they have? Well, they have lots.
They could fly through Chicago or they could fly through Denver
or Minneapolis, St. Paul or they could fly direct.
There are many more good options of flying
from Washington to San Francisco, since San Francisco
isn't a hub city.
So what do we see?
Well, we see that the demand for the Washington
to San Francisco flight is going to be relatively elastic
and the demand for the Washington to Dallas flight
is relatively inelastic.
And what our theory tells us is that with the elastic demand,
we get a low markup.
With the inelastic demand, we get a high markup.
So the theory is completely consistent
with this pricing puzzle and it explains the puzzle.
- [Narrator] If you want to test yourself,
click "Practice Questions."
Or if you're ready to move on, just click "Next Video."
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