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- [Alex] In a competitive market,
we know that price is equal

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to marginal cost and equilibrium.

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In a market with a monopoly,
we now know the price

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will be greater than marginal cost.

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But how much greater?
What determines the markup?

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What we're going
to show in this talk

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is that the monopoly markup
depends upon

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the elasticity of demand.

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Okay, let's do a very brief review
where we ended up last time.

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Everything on this diagram
should now be familiar.

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We know how to find
the marginal revenue curve

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as a curve starting out
on the vertical axis

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at the same point
as the demand curve

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with twice the slope.

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We know that the profit
maximizing quantity is found

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where marginal revenue
is equal to marginal cost.

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And we know that we read
the profit maximizing price

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as the highest price
that people are willing to pay

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per unit for that quantity,
in this case that's $12.50.

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The monopoly markup
is the difference between price

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and marginal cost.

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We know that
in a competitive market,

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price would be equal
to marginal cost.

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Here in equilibrium
we have price is much greater

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than marginal cost,
that's a monopoly markup.

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And we can also read
off this diagram,

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total profits for the monopolist
which are above normal profits.

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And profits are the difference
between price and average cost

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times the quantity,
which is this shaded area.

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Okay, that's a review.

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Now let's give some intuition
for what determines the size

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of the monopoly markup.

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For intuition, let's go
to our case of a pharmaceutical.

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Two effects are going to increase
the monopoly markup in this case.

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First, the "you can't take it
with you" effect.

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Namely, people
with serious illnesses

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are going to be relatively
insensitive to the price

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of life saving medicine.

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You can't take it with you
so may as well spend all you have

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trying to save your life.

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If the price of a life saving
medicine goes up,

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the quantity demanded
isn't going to go down very much.

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Since the customers
are insensitive to the price,

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the monopolist is going to say,
"Hey, I can increase the price

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and they're still going to buy,
so I should increase the price.

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It would be profit maximizing
for me to increase the price."

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Another effect,
the "other people's money" effect.

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If somebody else is paying 
for the medicine,

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the user, the consumer is going
to be less sensitive to the price.

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And we know for pharmaceuticals
often the insurance company

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or Medicaid or Medicare
or a government program,

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they're going to be paying
for the pharmaceutical,

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so that the person who
is demanding the pharmaceutical --

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they're not paying the price.

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So even when the price goes up
they're still going to ask

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for the pharmaceutical --
the quantity demanded

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isn't going to go down very much.

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So the conclusion here

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is that the less sensitive
quantity demanded is to price,

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the higher the markup
is going to be.

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If people aren't sensitive
to the price,

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the monopolist is going to say,
"Great. I can jack up the price

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and still sell almost as much
as I did before."

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In other words, the more inelastic
the demand curve,

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the higher the markup,
and that's our basic lesson.

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Now that we have the intuition,
let's test it with some diagrams,

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some demand curves.

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We have two demand curves.

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Which is more elastic,
the demand curve on the right

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or on the left?

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The demand curve
on the left is more elastic.

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The demand curve
on the right is more inelastic.

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So going by our intuition,
we should expect a low markup

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on the left and a high markup
on the right.

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We know how to find
the profit maximizing prices

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and quantities so let's do that.

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First, starting on the left.

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What we see is that
when the demand curve

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is relatively elastic,
we get a small markup of price

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over marginal cost.

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What about on the right?

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Well now we have
a relatively inelastic demand curve

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and what we see is that price rises
well above marginal cost.

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We have a relatively
inelastic demand

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and we get a big markup.

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Notice the marginal cost
for these two markets is the same.

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What differs is that the demand
curve over here on the right

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is more inelastic.

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Remember the logic:
the monopolist sees the consumers

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are insensitive to price.

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So it knows
that if it raises price,

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the quantity demanded
will fall by only a little.

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Therefore, an increase
in price will increase

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the monopolist's profits,
that's what it wants,

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so the monopolist
will increase the price

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and you get a big markup
of price over marginal cost.

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Remember also
that for a competitive firm,

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the demand for its product
is perfectly elastic

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and in that case price
is equal to marginal cost.

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So it makes sense

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that the more elastic
the demand curve is

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for a monopolist,
the closer the pricing decision

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of the monopolist is
to that of a competitive firm.

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So when the demand curve
for the monopolist

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is relatively elastic,
price is going to be close

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to marginal cost.

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The more elastic
the demand curve gets

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for the monopolist,

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the closer the monopolist's profit
maximizing output is

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to that of a competitive firm.

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Price gets closer to marginal cost.

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Okay, very good.

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Again remember, big lesson,
the more inelastic demand,

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the bigger the markup.

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Let's now try to see
if we can use our theory

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to solve a pricing puzzle.

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I recently looked at some flights
on American Airlines

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and what I found was that a flight
from Washington to Dallas

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was more expensive than a flight
from Washington to San Francisco.

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Now, there's two things
which are puzzling about that.

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First, San Francisco is obviously
much farther from Washington

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than is Dallas,
so you'd expect the cost,

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fuel cost and so forth,
to be higher.

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Second, the puzzle is even deeper
because the flight from Washington

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to San Francisco
ran through Dallas.

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In fact, the Washington
to Dallas segment

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of the Washington
to San Francisco flight

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was exactly the same flight
as the Washington to Dallas flight.

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So why would one segment
of the Washington

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to San Francisco flight
be more expensive

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than the entire flight?

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The answer requires knowing
something about how airlines

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are structured
in the United States.

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Most of the airlines
have a hub airport,

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often near the center
of the country,

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that's dominated
by one particular airline.

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In the case
of American Airlines, it's Dallas.

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In the case of United,
it's Chicago.

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Northwest dominates Minnesota,
St. Paul, and so forth.

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What this means is that if you
want to fly to Dallas

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at a convenient time,
you're much more likely to find

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a good flight on American Airlines
than on another airline.

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And if you want to fly
to Minneapolis, St. Paul,

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it's going to be
much more convenient

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to fly Northwest and so forth.

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Okay, does that give you any ideas
about solving the puzzle?

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Think about someone flying
from Washington to Dallas,

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what options do they have?

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Not many.
There are few substitutes.

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And few substitutes
means inelastic demand.

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Now think about someone flying
from Washington to San Francisco.

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What options do they have?
Well, they have lots.

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They could fly through Chicago
or they could fly through Denver

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or Minneapolis, St. Paul
or they could fly direct.

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There are many more
good options of flying

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from Washington to San Francisco,
since San Francisco

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isn't a hub city.

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So what do we see?

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Well, we see that the demand
for the Washington

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to San Francisco flight
is going to be relatively elastic

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and the demand
for the Washington to Dallas flight

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is relatively inelastic.

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And what our theory tells us
is that with the elastic demand,

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we get a low markup.

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With the inelastic demand,
we get a high markup.

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So the theory
is completely consistent

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with this pricing puzzle
and it explains the puzzle.

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- [Narrator] If you want
to test yourself,

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click "Practice Questions."

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Or if you're ready to move on,
just click "Next Video."

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♪ [music] ♪