The Monopoly Markup
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0:00 - 0:06♪ [music] ♪
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0:09 - 0:12- [Alex] In a competitive market,
we know that price is equal -
0:12 - 0:14to marginal cost and equilibrium.
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0:14 - 0:17In a market with a monopoly,
we now know the price -
0:17 - 0:20will be greater than marginal cost.
-
0:20 - 0:23But how much greater?
What determines the markup? -
0:23 - 0:25What we're going
to show in this talk -
0:25 - 0:28is that the monopoly markup
depends upon -
0:28 - 0:30the elasticity of demand.
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0:35 - 0:38Okay, let's do a very brief review
where we ended up last time. -
0:39 - 0:41Everything on this diagram
should now be familiar. -
0:41 - 0:43We know how to find
the marginal revenue curve -
0:43 - 0:46as a curve starting out
on the vertical axis -
0:46 - 0:47at the same point
as the demand curve -
0:47 - 0:49with twice the slope.
-
0:49 - 0:51We know that the profit
maximizing quantity is found -
0:51 - 0:54where marginal revenue
is equal to marginal cost. -
0:54 - 0:57And we know that we read
the profit maximizing price -
0:57 - 1:00as the highest price
that people are willing to pay -
1:00 - 1:03per unit for that quantity,
in this case that's $12.50. -
1:04 - 1:07The monopoly markup
is the difference between price -
1:07 - 1:09and marginal cost.
-
1:09 - 1:11We know that
in a competitive market, -
1:11 - 1:13price would be equal
to marginal cost. -
1:13 - 1:16Here in equilibrium
we have price is much greater -
1:16 - 1:19than marginal cost,
that's a monopoly markup. -
1:19 - 1:22And we can also read
off this diagram, -
1:22 - 1:26total profits for the monopolist
which are above normal profits. -
1:26 - 1:30And profits are the difference
between price and average cost -
1:30 - 1:32times the quantity,
which is this shaded area. -
1:32 - 1:34Okay, that's a review.
-
1:34 - 1:39Now let's give some intuition
for what determines the size -
1:39 - 1:41of the monopoly markup.
-
1:43 - 1:46For intuition, let's go
to our case of a pharmaceutical. -
1:46 - 1:50Two effects are going to increase
the monopoly markup in this case. -
1:50 - 1:53First, the "you can't take it
with you" effect. -
1:53 - 1:55Namely, people
with serious illnesses -
1:55 - 2:00are going to be relatively
insensitive to the price -
2:00 - 2:02of life saving medicine.
-
2:02 - 2:04You can't take it with you
so may as well spend all you have -
2:04 - 2:06trying to save your life.
-
2:06 - 2:09If the price of a life saving
medicine goes up, -
2:09 - 2:14the quantity demanded
isn't going to go down very much. -
2:15 - 2:18Since the customers
are insensitive to the price, -
2:18 - 2:21the monopolist is going to say,
"Hey, I can increase the price -
2:21 - 2:25and they're still going to buy,
so I should increase the price. -
2:25 - 2:28It would be profit maximizing
for me to increase the price." -
2:29 - 2:32Another effect,
the "other people's money" effect. -
2:32 - 2:35If somebody else is paying
for the medicine, -
2:35 - 2:38the user, the consumer is going
to be less sensitive to the price. -
2:38 - 2:41And we know for pharmaceuticals
often the insurance company -
2:41 - 2:44or Medicaid or Medicare
or a government program, -
2:44 - 2:46they're going to be paying
for the pharmaceutical, -
2:46 - 2:49so that the person who
is demanding the pharmaceutical -- -
2:49 - 2:51they're not paying the price.
-
2:51 - 2:54So even when the price goes up
they're still going to ask -
2:54 - 2:56for the pharmaceutical --
the quantity demanded -
2:56 - 2:58isn't going to go down very much.
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2:58 - 3:00So the conclusion here
-
3:00 - 3:06is that the less sensitive
quantity demanded is to price, -
3:06 - 3:08the higher the markup
is going to be. -
3:08 - 3:10If people aren't sensitive
to the price, -
3:10 - 3:13the monopolist is going to say,
"Great. I can jack up the price -
3:13 - 3:17and still sell almost as much
as I did before." -
3:17 - 3:22In other words, the more inelastic
the demand curve, -
3:22 - 3:25the higher the markup,
and that's our basic lesson. -
3:26 - 3:29Now that we have the intuition,
let's test it with some diagrams, -
3:29 - 3:30some demand curves.
-
3:30 - 3:32We have two demand curves.
-
3:32 - 3:34Which is more elastic,
the demand curve on the right -
3:34 - 3:36or on the left?
-
3:37 - 3:41The demand curve
on the left is more elastic. -
3:41 - 3:45The demand curve
on the right is more inelastic. -
3:45 - 3:50So going by our intuition,
we should expect a low markup -
3:50 - 3:53on the left and a high markup
on the right. -
3:54 - 3:57We know how to find
the profit maximizing prices -
3:57 - 3:59and quantities so let's do that.
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3:59 - 4:01First, starting on the left.
-
4:01 - 4:03What we see is that
when the demand curve -
4:03 - 4:08is relatively elastic,
we get a small markup of price -
4:08 - 4:10over marginal cost.
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4:10 - 4:12What about on the right?
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4:12 - 4:16Well now we have
a relatively inelastic demand curve -
4:16 - 4:21and what we see is that price rises
well above marginal cost. -
4:21 - 4:23We have a relatively
inelastic demand -
4:23 - 4:25and we get a big markup.
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4:25 - 4:30Notice the marginal cost
for these two markets is the same. -
4:31 - 4:35What differs is that the demand
curve over here on the right -
4:35 - 4:37is more inelastic.
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4:37 - 4:41Remember the logic:
the monopolist sees the consumers -
4:41 - 4:43are insensitive to price.
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4:43 - 4:47So it knows
that if it raises price, -
4:47 - 4:50the quantity demanded
will fall by only a little. -
4:50 - 4:53Therefore, an increase
in price will increase -
4:53 - 4:56the monopolist's profits,
that's what it wants, -
4:56 - 4:58so the monopolist
will increase the price -
4:58 - 5:02and you get a big markup
of price over marginal cost. -
5:02 - 5:06Remember also
that for a competitive firm, -
5:06 - 5:10the demand for its product
is perfectly elastic -
5:10 - 5:14and in that case price
is equal to marginal cost. -
5:14 - 5:15So it makes sense
-
5:15 - 5:18that the more elastic
the demand curve is -
5:18 - 5:21for a monopolist,
the closer the pricing decision -
5:21 - 5:24of the monopolist is
to that of a competitive firm. -
5:25 - 5:27So when the demand curve
for the monopolist -
5:27 - 5:30is relatively elastic,
price is going to be close -
5:30 - 5:32to marginal cost.
-
5:32 - 5:35The more elastic
the demand curve gets -
5:35 - 5:36for the monopolist,
-
5:36 - 5:41the closer the monopolist's profit
maximizing output is -
5:41 - 5:43to that of a competitive firm.
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5:43 - 5:45Price gets closer to marginal cost.
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5:45 - 5:46Okay, very good.
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5:46 - 5:50Again remember, big lesson,
the more inelastic demand, -
5:50 - 5:51the bigger the markup.
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5:52 - 5:55Let's now try to see
if we can use our theory -
5:55 - 5:57to solve a pricing puzzle.
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5:58 - 6:00I recently looked at some flights
on American Airlines -
6:00 - 6:04and what I found was that a flight
from Washington to Dallas -
6:04 - 6:09was more expensive than a flight
from Washington to San Francisco. -
6:09 - 6:12Now, there's two things
which are puzzling about that. -
6:12 - 6:16First, San Francisco is obviously
much farther from Washington -
6:16 - 6:18than is Dallas,
so you'd expect the cost, -
6:18 - 6:21fuel cost and so forth,
to be higher. -
6:21 - 6:25Second, the puzzle is even deeper
because the flight from Washington -
6:25 - 6:29to San Francisco
ran through Dallas. -
6:29 - 6:33In fact, the Washington
to Dallas segment -
6:33 - 6:36of the Washington
to San Francisco flight -
6:36 - 6:40was exactly the same flight
as the Washington to Dallas flight. -
6:41 - 6:44So why would one segment
of the Washington -
6:44 - 6:48to San Francisco flight
be more expensive -
6:48 - 6:49than the entire flight?
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6:50 - 6:54The answer requires knowing
something about how airlines -
6:54 - 6:56are structured
in the United States. -
6:56 - 6:59Most of the airlines
have a hub airport, -
6:59 - 7:01often near the center
of the country, -
7:01 - 7:03that's dominated
by one particular airline. -
7:04 - 7:06In the case
of American Airlines, it's Dallas. -
7:06 - 7:08In the case of United,
it's Chicago. -
7:08 - 7:12Northwest dominates Minnesota,
St. Paul, and so forth. -
7:12 - 7:15What this means is that if you
want to fly to Dallas -
7:15 - 7:18at a convenient time,
you're much more likely to find -
7:18 - 7:23a good flight on American Airlines
than on another airline. -
7:23 - 7:25And if you want to fly
to Minneapolis, St. Paul, -
7:25 - 7:27it's going to be
much more convenient -
7:27 - 7:29to fly Northwest and so forth.
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7:30 - 7:34Okay, does that give you any ideas
about solving the puzzle? -
7:35 - 7:38Think about someone flying
from Washington to Dallas, -
7:38 - 7:40what options do they have?
-
7:40 - 7:43Not many.
There are few substitutes. -
7:43 - 7:47And few substitutes
means inelastic demand. -
7:48 - 7:52Now think about someone flying
from Washington to San Francisco. -
7:52 - 7:55What options do they have?
Well, they have lots. -
7:55 - 8:00They could fly through Chicago
or they could fly through Denver -
8:00 - 8:03or Minneapolis, St. Paul
or they could fly direct. -
8:03 - 8:06There are many more
good options of flying -
8:06 - 8:09from Washington to San Francisco,
since San Francisco -
8:09 - 8:12isn't a hub city.
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8:12 - 8:14So what do we see?
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8:14 - 8:16Well, we see that the demand
for the Washington -
8:16 - 8:20to San Francisco flight
is going to be relatively elastic -
8:20 - 8:23and the demand
for the Washington to Dallas flight -
8:23 - 8:25is relatively inelastic.
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8:25 - 8:29And what our theory tells us
is that with the elastic demand, -
8:29 - 8:32we get a low markup.
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8:32 - 8:35With the inelastic demand,
we get a high markup. -
8:36 - 8:38So the theory
is completely consistent -
8:38 - 8:41with this pricing puzzle
and it explains the puzzle. -
8:42 - 8:44- [Narrator] If you want
to test yourself, -
8:44 - 8:46click "Practice Questions."
-
8:46 - 8:50Or if you're ready to move on,
just click "Next Video." -
8:50 - 8:54♪ [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
Ask a question about the video: http://mruniversity.com/courses/principles-economics-microeconomics/monopoly-markup-elasticity#QandA
Next video: http://mruniversity.com/courses/principles-economics-microeconomics/costs-benefits-monopoly-pharmaceutical-companies
- Video Language:
- English
- Team:
- Marginal Revolution University
- Project:
- Micro
- Duration:
- 08:55
Martel Espiritu edited English subtitles for The Monopoly Markup | ||
Martel Espiritu edited English subtitles for The Monopoly Markup | ||
Martel Espiritu edited English subtitles for The Monopoly Markup | ||
MRU2 edited English subtitles for The Monopoly Markup | ||
MRU2 edited English subtitles for The Monopoly Markup |