## The Monopoly Markup

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♪ [music] ♪
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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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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,
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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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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
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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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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
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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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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
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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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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] ♪
Title:
The Monopoly Markup
Description:

Ever wonder why pharmaceuticals are so expensive? In this video, we show how low elasticity of demand results in monopoly markups. This is especially the case with goods that involve the “you can’t take it with you” effect (for example, people with serious medical conditions are relatively insensitive to the price of life-saving drugs) and the “other people’s money” effect (if third parties pay for the medicine, people are less sensitive to price).

Microeconomics Course: http://mruniversity.com/courses/principles-economics-microeconomics

Next video: http://mruniversity.com/courses/principles-economics-microeconomics/costs-benefits-monopoly-pharmaceutical-companies

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Video Language:
English
Team:
Marginal Revolution University
Project:
Micro
Duration:
08:55
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