Monopoly Markup and Elasticity of Demand

Key Concepts

• In a competitive market, price equals marginal cost at equilibrium.
• In a monopoly, price is greater than marginal cost due to monopoly markup.
• Monopoly markup depends on the elasticity of demand.

Review of Previous Lecture

• Marginal Revenue Curve: Starts at the same point as the demand curve on the vertical axis with twice the slope.
• Profit Maximizing Quantity: Where marginal revenue equals marginal cost.
• Profit Maximizing Price: Highest price consumers are willing to pay for that quantity.
• Monopoly Markup: Difference between price and marginal cost.
• Total Profits for the Monopolist: Difference between price and average cost times the quantity.

Intuition for Monopoly Markup

• "You Can't Take It With You" Effect:

  • People are less sensitive to price in life-saving situations.
  • Monopolists can increase price without reducing demand significantly.

• "Other People's Money" Effect:

  • When someone else (insurance, government) pays, consumers are less price-sensitive.
  • Monopolist can increase price without reducing demand significantly.

Elasticity and Markup

• Inelastic Demand: Leads to higher monopoly markup.
• Elastic Demand: Leads to lower monopoly markup.
• More Inelastic Demand: Monopolists can increase prices significantly without reducing demand.
• More Elastic Demand: Prices are closer to marginal cost, similar to competitive firms.

Diagrams and Demand Curves

• Elastic Demand Curve (Left): Smaller markup.
• Inelastic Demand Curve (Right): Larger markup.
• Marginal Cost: Same for both markets; the difference in elasticity affects markup.

Airline Pricing Puzzle

• Example: American Airlines pricing from Washington to Dallas vs. Washington to San Francisco.
• Hub Dominance: Airlines base pricing on hub locations.
• Washington to Dallas: Inelastic demand due to fewer alternatives, thus higher price.
• Washington to San Francisco: More elastic demand due to more alternatives, thus lower price.
• Consistent Theory: Elastic demand results in lower markups and inelastic demand results in higher markups.

Conclusion

• The elasticity of demand directly influences monopoly pricing strategies and markups.
• Real-world examples, such as airline pricing, illustrate these economic principles effectively.