The Monopoly Markup

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).

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- [Alex] In a competitive market, we know that
price is equal to marginal cost and

equilibrium. In a market where the
monopoly we now know that 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 if
obviously much farther from Washington

than is Dallas, so you'd expect that 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 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.

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