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 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 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.

- [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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