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

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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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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One could be political-legal which includes all regulations and licenses and restrictions applied to various stages in the production and distribution process. These regulations and restrictions may be motivated by safety reasons, by intentions to protect local industries or other special interest groups. Examples are tariffs, high initial capital requirements, patents.
A second type may have to do with the inevitably unique nature of the value which is being marketed. It is impossible to become a supplier of 19th century symbolist painting because you cannot go back in the 19th century to paint; or to become a producer of Bordeaux wine if the demand is for wine that actually comes from Bordeaux and there is only so much land around Bordeaux to grow grapes.
A third type has to do with the nature of the production process and distribution for a particular product. In the car manufacturing industry there are high startup costs. You need to pool a large amount of investments first. There may be economies of scale which means your business becomes profitable only after you become quite big. Or there may be network effects which favor existing suppliers. Traders go to ebay simply because is larger than a contester trying to establish a new trading place.

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