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- [Prof. Alex Tabarrok] Monopoly.[br]It's not just a game.

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In this video[br]we'll talk about how a firm

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uses market power[br]to maximize profit.

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We'll begin with[br]a controversial example.

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This is the AIDS virus.

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Worldwide, it has killed[br]more than 36 million people.

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In the United States, however,

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AIDS is no longer[br]the death sentence that it once was.

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Beginning in the mid-1990s,

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death rates from AIDS[br]began to fall dramatically

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with the introduction[br]of new drugs such as Combivir.

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These new drugs are great,[br]but they're expensive,

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and they're expensive

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not because it costs a lot[br]to manufacture these drugs.

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The per-pill costs of production[br]are actually quite low.

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Instead, these drugs are expensive

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because they're the subject matter[br]of this chapter -- Monopoly.

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GlaxoSmithKline, or GSK,

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owns the patent on Combivir

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and that means that it has[br]the right to exclude competitors.

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Only GSK can legally sell Combivir.

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The patent gives GSK a monopoly,

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or more generally we say[br]it gives them market power.

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Market power is the power[br]to raise price above marginal cost

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without fear that other firms[br]will enter the market.

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Now how do we know the price[br]is above marginal cost?

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Here's a simple test --

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in the United States,

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Combivir costs[br]around $12 to $13 per pill.

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India, however, does not[br]recognize the patent on Combivir.

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So in India,

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there are many producers of Combivir[br]who sell in a competitive market.

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As we know,[br]in a competitive market,

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price will fall to marginal cost

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and in India the price of Combivir[br]is about 50 cents per pill.

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Thus, in the United States,

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the price of Combivir

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is about 25 times higher[br]than the marginal cost.

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Let's say a few words[br]about the sources of market power.

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The basic idea[br]is that a firm has market power

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when it's selling a unique good

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and there are barriers to entry,

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forces which prevent competitors[br]from entering the market.

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Barriers to entry[br]could include patents,

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as we've already discussed.

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There may also be other[br]government regulations

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creating barriers to entry,[br]such as exclusive licenses.

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Economies of scale

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can mean that a single big firm

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can sell at lower cost[br]than any of many small firms,

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making it difficult[br]to establish a competitive market

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even with free entry.

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Exclusive access[br]to an important input.

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Diamonds, for example,

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are found in only[br]a few places in the world.

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If you control a number[br]of these diamond mines,

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you can monopolize[br]the market for diamonds,

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where you will have market power[br]in the market for diamonds.

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Technological innovations

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can give a firm[br]temporary market power.

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A firm with knowledge or abilities[br]that other firms don't yet have

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will have some market power,[br]for example.

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Now we'll say a little bit more[br]about these later.

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What we want to do now

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is to focus on how[br]a firm with market power

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chooses to set its price.

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What is the profit[br]maximizing price?

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So how does a monopolist[br]maximize profit?

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By producing at the level of output

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where marginal revenue[br]is equal to marginal cost.

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Great!

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That's the same rule[br]as for a competitive firm --

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choose a level of output

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where marginal revenue[br]is equal to marginal cost.

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The only difference[br]is that for a competitive firm,

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marginal revenue[br]was the same as price,

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and that's not true[br]for a monopolist.

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A monopolist is not[br]a small share of the market.

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Since it's selling a unique good,

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the monopolist

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faces the entire downward[br]sloping market demand curve.

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As a result,

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marginal revenue[br]is going to be less than price.

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Let's show how to calculate[br]marginal revenue for a monopolist.

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Let's start with the demand curve,

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and suppose that[br]we're initially selling two units.

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We can sell those[br]two units for $16 apiece.

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Total revenue therefore[br]is $16 times 2 units, or $32.

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Now, remember that marginal revenue

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is the change in total revenue[br]from selling an additional unit.

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So suppose[br]that we sell an additional unit --

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three units in total.

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We can sell three units for $14 --

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$14 is the maximum per unit price[br]we can get when selling three units.

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So when the quantity sold is three,

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total revenue[br]is 14 times three, or $42.

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That means marginal revenue,

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the change in revenue[br]from selling that additional unit,

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is $10.

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Now we can actually[br]arrive at the same conclusion

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in another revealing way.

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Marginal revenue[br]can be broken down into two parts.

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First is the revenue gain[br]from selling an additional unit.

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That's just this area right here.

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We can sell an additional unit,[br]the third unit for $14.

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That's the revenue gain.

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But, in order to sell[br]that additional unit,

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we had to lower the price

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on the previous units[br]that we were selling,

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so there's also a revenue loss.

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We were receiving $16 per unit[br]when we sold just two units.

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When we sell three units,[br]we have to lower the price to $14,

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so we lose $2 per unit[br]on these previous units

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or a total loss of $4.

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So marginal revenue[br]is just the revenue gained -- $14,

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minus the revenue loss, $4,[br]or $10 just as before.

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Notice also that the revenue gain

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is just the price of the third unit,

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so since it's the revenue gain[br]minus the revenue loss,

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we can also see right away[br]that for a monopolist,

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marginal revenue[br]must be less than the price.

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Okay, let's remember[br]where we're going.

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We want to find[br]the profit maximizing price,

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which is the level of output

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where marginal revenue[br]is equal to marginal cost.

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But do we need to go through[br]this tedious process

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to find marginal revenue[br]for each unit?

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No.

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There's a shortcut,

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and that's what[br]I'm going to show you next.

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Here's the shortcut[br]for finding marginal revenue,

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and this will work[br]for any linear demand curve,

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and those are the only ones[br]we're really going to be working with

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in this class,[br]so it'll work just fine for us.

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Take a linear demand curve,

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then the marginal revenue curve

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begins at the same point[br]on the vertical axis

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as the demand curve,

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and it has twice the slope.

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So if we were to write[br]the demand curve in inverse form,

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as P is equal to A minus B times Q,

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then the marginal revenue curve[br]is equal to A minus 2B times Q.

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That's it.[br]Pretty simple.

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Let's give a few more examples.

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Let's use our shortcut[br]on these two different demand curves.

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In the first case,[br]the marginal revenue curve

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begins at the same point[br]on the vertical axis.

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It has twice the slope.

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So notice what that means

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is that if the demand curve[br]hits the horizontal axis at 500,

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the marginal revenue curve[br]must hit the horizontal axis at 250.

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More generally,[br]since it has twice the slope,

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the marginal revenue curve[br]splits the distance

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between the vertical axis[br]and the demand curve in half.

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So the distance[br]from the vertical axis

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to the marginal revenue curve

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is half the total distance[br]to the demand curve,

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throughout the length[br]of the marginal revenue curve.

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Okay, what about[br]our second demand curve?

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Notice that it hits[br]the horizontal axis at 200,

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therefore[br]the marginal revenue curve

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must hit[br]the horizontal axis at 100.

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Pretty simple, and again,

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this will work[br]for any linear demand curve,

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any demand curve which[br]we're going to see in this course.

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Great.

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We're now ready[br]for the big payoff --

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how a firm uses market power[br]to maximize profit.

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So here is our demand curve[br]and our marginal revenue curve

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with twice the slope.

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Let's introduce[br]the marginal cost curve.

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We're going to make it flat[br]at 50 cents per pill.

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How does the firm maximize profit?

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Well it compares for each unit

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the revenue[br]for selling that additional unit

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compared to the cost[br]of selling that unit.

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If the marginal revenue[br]is bigger than the marginal cost,

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then that's a profitable unit to sell,

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so the firm keeps producing

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so long as marginal revenue[br]is bigger than marginal cost.

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That is, it produces[br]until marginal revenue

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is equal to marginal cost.

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That point tells us the profit[br]maximizing quantity of output,

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in this case, 80 million pills.

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Now what is[br]the maximum amount per pill

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that we can sell[br]these 80 million pills for?

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Where do we find that?

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We find that by looking up[br]to the demand curve.

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Remember the demand curve tells us

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the maximum willingness to pay.

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So the maximum willingness[br]to pay for a pill is $12.50.

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Eighty million units --

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that's the profit[br]maximizing quantity,

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$12.50 -- that's that profit[br]maximizing price per unit.

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One more curve --

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let's remember[br]our average cost curve.

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If we introduce this curve

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we can now show[br]profits on the diagram,

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just as we did[br]with a competitive firm.

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The profit is the price[br]minus the average cost --

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in this case that's $10 per pill --

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times the quantity --[br]in this case 80 million units --

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so profit is the shaded area[br]given right here.

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So now we've got everything.

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Whenever we have[br]a monopoly question,

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we have a demand curve,[br]we draw the marginal revenue curve,

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we draw a marginal cost curve[br]if it's not given.

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We can then find the profit[br]maximizing output quantity --

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that's given when marginal revenue[br]is equal to marginal cost.

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We go up to the demand curve[br]to find the profit maximizing price.

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The difference between[br]the price and average cost

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gives us the profit per unit,

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times the total number[br]of units gives us total profit.

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Okay.[br]That's our big lesson for today.

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What we're going to do next time[br]is look at --

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how does the difference[br]between price and marginal cost --

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how does the mark-up vary?

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And what we're going to show

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is the mark-up varies[br]with the elasticity of demand.

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Remember, I told you elasticity[br]of demand would come back.

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Well, here we're going to[br]use it again in our next lecture.

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- [Narrator][br]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[br]just click "Next Video."

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