0:00:00.000,0:00:05.676
♪ [music] ♪

0:00:08.886,0:00:11.557
- [Alex] In a competitive market,[br]we know that price is equal

0:00:11.557,0:00:13.933
to marginal cost and equilibrium.

0:00:13.933,0:00:16.767
In a market with a monopoly,[br]we now know the price

0:00:16.767,0:00:19.506
will be greater than marginal cost.

0:00:19.506,0:00:23.292
But how much greater?[br]What determines the markup?

0:00:23.292,0:00:24.854
What we're going[br]to show in this talk

0:00:24.854,0:00:27.525
is that the monopoly markup[br]depends upon

0:00:27.525,0:00:29.741
the elasticity of demand.

0:00:34.647,0:00:38.141
Okay, let's do a very brief review[br]where we ended up last time.

0:00:38.345,0:00:41.160
Everything on this diagram[br]should now be familiar.

0:00:41.160,0:00:43.325
We know how to find[br]the marginal revenue curve

0:00:43.325,0:00:45.568
as a curve starting out[br]on the vertical axis

0:00:45.568,0:00:47.100
at the same point[br]as the demand curve

0:00:47.100,0:00:48.579
with twice the slope.

0:00:48.579,0:00:50.855
We know that the profit[br]maximizing quantity is found

0:00:50.855,0:00:53.357
where marginal revenue[br]is equal to marginal cost.

0:00:53.357,0:00:56.642
And we know that we read[br]the profit maximizing price

0:00:56.642,0:00:59.662
as the highest price[br]that people are willing to pay

0:00:59.662,0:01:03.154
per unit for that quantity,[br]in this case that's $12.50.

0:01:03.606,0:01:07.009
The monopoly markup[br]is the difference between price

0:01:07.009,0:01:08.690
and marginal cost.

0:01:08.984,0:01:10.797
We know that[br]in a competitive market,

0:01:10.797,0:01:12.773
price would be equal[br]to marginal cost.

0:01:12.773,0:01:15.915
Here in equilibrium[br]we have price is much greater

0:01:15.915,0:01:18.729
than marginal cost,[br]that's a monopoly markup.

0:01:18.729,0:01:21.733
And we can also read[br]off this diagram,

0:01:22.233,0:01:26.010
total profits for the monopolist[br]which are above normal profits.

0:01:26.010,0:01:29.420
And profits are the difference[br]between price and average cost

0:01:29.420,0:01:32.181
times the quantity,[br]which is this shaded area.

0:01:32.181,0:01:34.268
Okay, that's a review.

0:01:34.268,0:01:39.082
Now let's give some intuition[br]for what determines the size

0:01:39.082,0:01:41.302
of the monopoly markup.

0:01:43.184,0:01:46.269
For intuition, let's go[br]to our case of a pharmaceutical.

0:01:46.269,0:01:50.078
Two effects are going to increase[br]the monopoly markup in this case.

0:01:50.078,0:01:52.980
First, the "you can't take it[br]with you" effect.

0:01:52.980,0:01:55.477
Namely, people[br]with serious illnesses

0:01:55.477,0:01:59.599
are going to be relatively[br]insensitive to the price

0:01:59.599,0:02:01.732
of life saving medicine.

0:02:01.732,0:02:04.359
You can't take it with you[br]so may as well spend all you have

0:02:04.359,0:02:05.823
trying to save your life.

0:02:05.823,0:02:09.242
If the price of a life saving[br]medicine goes up,

0:02:09.242,0:02:13.886
the quantity demanded[br]isn't going to go down very much.

0:02:14.698,0:02:18.114
Since the customers[br]are insensitive to the price,

0:02:18.114,0:02:21.285
the monopolist is going to say,[br]"Hey, I can increase the price

0:02:21.285,0:02:24.490
and they're still going to buy,[br]so I should increase the price.

0:02:24.490,0:02:28.080
It would be profit maximizing[br]for me to increase the price."

0:02:28.972,0:02:32.368
Another effect,[br]the "other people's money" effect.

0:02:32.368,0:02:34.783
If somebody else is paying [br]for the medicine,

0:02:34.783,0:02:38.201
the user, the consumer is going[br]to be less sensitive to the price.

0:02:38.201,0:02:40.927
And we know for pharmaceuticals[br]often the insurance company

0:02:40.927,0:02:43.612
or Medicaid or Medicare[br]or a government program,

0:02:43.612,0:02:45.669
they're going to be paying[br]for the pharmaceutical,

0:02:45.669,0:02:48.971
so that the person who[br]is demanding the pharmaceutical --

0:02:48.971,0:02:50.494
they're not paying the price.

0:02:50.494,0:02:53.579
So even when the price goes up[br]they're still going to ask

0:02:53.579,0:02:56.004
for the pharmaceutical --[br]the quantity demanded

0:02:56.004,0:02:58.198
isn't going to go down very much.

0:02:58.429,0:03:00.186
So the conclusion here

0:03:00.186,0:03:05.493
is that the less sensitive[br]quantity demanded is to price,

0:03:05.493,0:03:07.963
the higher the markup[br]is going to be.

0:03:07.963,0:03:09.867
If people aren't sensitive[br]to the price,

0:03:09.867,0:03:13.121
the monopolist is going to say,[br]"Great. I can jack up the price

0:03:13.121,0:03:16.703
and still sell almost as much[br]as I did before."

0:03:17.277,0:03:21.678
In other words, the more inelastic[br]the demand curve,

0:03:21.678,0:03:24.957
the higher the markup,[br]and that's our basic lesson.

0:03:25.945,0:03:29.016
Now that we have the intuition,[br]let's test it with some diagrams,

0:03:29.016,0:03:30.242
some demand curves.

0:03:30.242,0:03:31.616
We have two demand curves.

0:03:31.616,0:03:34.266
Which is more elastic,[br]the demand curve on the right

0:03:34.266,0:03:36.038
or on the left?

0:03:36.798,0:03:40.593
The demand curve[br]on the left is more elastic.

0:03:41.022,0:03:44.974
The demand curve[br]on the right is more inelastic.

0:03:44.974,0:03:49.668
So going by our intuition,[br]we should expect a low markup

0:03:49.668,0:03:53.382
on the left and a high markup[br]on the right.

0:03:54.124,0:03:56.436
We know how to find[br]the profit maximizing prices

0:03:56.436,0:03:58.725
and quantities so let's do that.

0:03:58.725,0:04:00.773
First, starting on the left.

0:04:00.773,0:04:03.041
What we see is that[br]when the demand curve

0:04:03.041,0:04:07.845
is relatively elastic,[br]we get a small markup of price

0:04:07.845,0:04:09.949
over marginal cost.

0:04:09.949,0:04:11.952
What about on the right?

0:04:11.952,0:04:15.886
Well now we have[br]a relatively inelastic demand curve

0:04:15.886,0:04:20.400
and what we see is that price rises[br]well above marginal cost.

0:04:20.400,0:04:22.468
We have a relatively[br]inelastic demand

0:04:22.468,0:04:25.129
and we get a big markup.

0:04:25.129,0:04:30.356
Notice the marginal cost[br]for these two markets is the same.

0:04:30.715,0:04:34.708
What differs is that the demand[br]curve over here on the right

0:04:34.708,0:04:36.507
is more inelastic.

0:04:36.507,0:04:40.957
Remember the logic:[br]the monopolist sees the consumers

0:04:40.957,0:04:43.355
are insensitive to price.

0:04:43.355,0:04:46.509
So it knows[br]that if it raises price,

0:04:46.509,0:04:50.029
the quantity demanded[br]will fall by only a little.

0:04:50.039,0:04:52.847
Therefore, an increase[br]in price will increase

0:04:52.847,0:04:55.639
the monopolist's profits,[br]that's what it wants,

0:04:55.639,0:04:58.191
so the monopolist[br]will increase the price

0:04:58.191,0:05:01.571
and you get a big markup[br]of price over marginal cost.

0:05:02.035,0:05:05.849
Remember also[br]that for a competitive firm,

0:05:05.849,0:05:10.377
the demand for its product[br]is perfectly elastic

0:05:10.377,0:05:13.676
and in that case price[br]is equal to marginal cost.

0:05:13.676,0:05:14.835
So it makes sense

0:05:14.835,0:05:17.638
that the more elastic[br]the demand curve is

0:05:17.638,0:05:21.013
for a monopolist,[br]the closer the pricing decision

0:05:21.013,0:05:24.298
of the monopolist is[br]to that of a competitive firm.

0:05:24.704,0:05:26.519
So when the demand curve[br]for the monopolist

0:05:26.519,0:05:30.165
is relatively elastic,[br]price is going to be close

0:05:30.165,0:05:31.674
to marginal cost.

0:05:31.674,0:05:34.830
The more elastic[br]the demand curve gets

0:05:34.830,0:05:36.360
for the monopolist,

0:05:36.360,0:05:40.822
the closer the monopolist's profit[br]maximizing output is

0:05:40.822,0:05:42.609
to that of a competitive firm.

0:05:42.609,0:05:44.832
Price gets closer to marginal cost.

0:05:44.832,0:05:45.999
Okay, very good.

0:05:45.999,0:05:49.769
Again remember, big lesson,[br]the more inelastic demand,

0:05:49.769,0:05:51.441
the bigger the markup.

0:05:51.904,0:05:54.913
Let's now try to see[br]if we can use our theory

0:05:54.913,0:05:57.096
to solve a pricing puzzle.

0:05:57.375,0:06:00.147
I recently looked at some flights[br]on American Airlines

0:06:00.147,0:06:03.656
and what I found was that a flight[br]from Washington to Dallas

0:06:03.656,0:06:08.878
was more expensive than a flight[br]from Washington to San Francisco.

0:06:09.108,0:06:11.654
Now, there's two things[br]which are puzzling about that.

0:06:11.654,0:06:15.792
First, San Francisco is obviously[br]much farther from Washington

0:06:15.792,0:06:18.048
than is Dallas,[br]so you'd expect the cost,

0:06:18.048,0:06:20.718
fuel cost and so forth,[br]to be higher.

0:06:21.129,0:06:25.412
Second, the puzzle is even deeper[br]because the flight from Washington

0:06:25.412,0:06:29.006
to San Francisco[br]ran through Dallas.

0:06:29.367,0:06:32.993
In fact, the Washington[br]to Dallas segment

0:06:32.993,0:06:35.433
of the Washington[br]to San Francisco flight

0:06:35.433,0:06:40.188
was exactly the same flight[br]as the Washington to Dallas flight.

0:06:41.022,0:06:44.074
So why would one segment[br]of the Washington

0:06:44.074,0:06:47.428
to San Francisco flight[br]be more expensive

0:06:47.428,0:06:49.182
than the entire flight?

0:06:50.234,0:06:53.652
The answer requires knowing[br]something about how airlines

0:06:53.652,0:06:55.535
are structured[br]in the United States.

0:06:56.127,0:06:58.770
Most of the airlines[br]have a hub airport,

0:06:58.770,0:07:00.722
often near the center[br]of the country,

0:07:00.722,0:07:03.288
that's dominated[br]by one particular airline.

0:07:03.606,0:07:06.228
In the case[br]of American Airlines, it's Dallas.

0:07:06.228,0:07:08.090
In the case of United,[br]it's Chicago.

0:07:08.090,0:07:12.166
Northwest dominates Minnesota,[br]St. Paul, and so forth.

0:07:12.172,0:07:15.083
What this means is that if you[br]want to fly to Dallas

0:07:15.083,0:07:18.440
at a convenient time,[br]you're much more likely to find

0:07:18.440,0:07:22.660
a good flight on American Airlines[br]than on another airline.

0:07:22.660,0:07:25.152
And if you want to fly[br]to Minneapolis, St. Paul,

0:07:25.152,0:07:26.819
it's going to be[br]much more convenient

0:07:26.819,0:07:29.179
to fly Northwest and so forth.

0:07:29.477,0:07:33.540
Okay, does that give you any ideas[br]about solving the puzzle?

0:07:34.717,0:07:37.499
Think about someone flying[br]from Washington to Dallas,

0:07:37.499,0:07:39.644
what options do they have?

0:07:39.644,0:07:42.726
Not many.[br]There are few substitutes.

0:07:42.726,0:07:47.274
And few substitutes[br]means inelastic demand.

0:07:48.307,0:07:51.666
Now think about someone flying[br]from Washington to San Francisco.

0:07:51.666,0:07:55.222
What options do they have?[br]Well, they have lots.

0:07:55.222,0:07:59.350
They could fly through Chicago[br]or they could fly through Denver

0:07:59.350,0:08:03.104
or Minneapolis, St. Paul[br]or they could fly direct.

0:08:03.104,0:08:06.081
There are many more[br]good options of flying

0:08:06.081,0:08:09.330
from Washington to San Francisco,[br]since San Francisco

0:08:09.330,0:08:11.572
isn't a hub city.

0:08:12.207,0:08:13.486
So what do we see?

0:08:13.486,0:08:16.419
Well, we see that the demand[br]for the Washington

0:08:16.419,0:08:20.108
to San Francisco flight[br]is going to be relatively elastic

0:08:20.108,0:08:22.632
and the demand[br]for the Washington to Dallas flight

0:08:22.632,0:08:25.016
is relatively inelastic.

0:08:25.016,0:08:29.378
And what our theory tells us[br]is that with the elastic demand,

0:08:29.378,0:08:31.569
we get a low markup.

0:08:31.569,0:08:35.513
With the inelastic demand,[br]we get a high markup.

0:08:35.513,0:08:37.775
So the theory[br]is completely consistent

0:08:37.775,0:08:40.896
with this pricing puzzle[br]and it explains the puzzle.

0:08:42.028,0:08:43.660
- [Narrator] If you want[br]to test yourself,

0:08:43.660,0:08:45.781
click "Practice Questions."

0:08:45.781,0:08:49.592
Or if you're ready to move on,[br]just click "Next Video."

0:08:49.592,0:08:53.802
♪ [music] ♪