Lecture Notes: Monopoly Markup and Elasticity of Demand

Key Concepts

• Competitive Market vs. Monopoly
  • In competitive markets, price equals marginal cost at equilibrium.
  • In monopolies, price is greater than marginal cost, known as the monopoly markup.

Monopoly Markup

• Definition: The difference between the monopoly price and marginal cost.
• Profit Maximization:
  • Quantity is where marginal revenue equals marginal cost.
  • Price is the highest consumers are willing to pay for that quantity.
• Profit Calculation: Total profits are the difference between price and average cost times the quantity.

Determinants of Monopoly Markup

• Elasticity of Demand: A key determinant of how much greater the price is compared to marginal cost.
  • Inelastic Demand: Leads to a higher markup.
  • Elastic Demand: Leads to a lower markup.

Intuition Behind Elasticity and Markup

• "You Can't Take It With You" Effect:
  • Life-saving medication is less sensitive to price changes as consumers must purchase regardless of costs.
  • Results in higher prices as demand does not significantly decrease with price hikes.
• "Other People's Money" Effect:
  • If insurance or government programs cover costs, consumers are less sensitive to price increases, allowing monopolists to raise prices.

Relationship Between Demand Elasticity and Markup

• More Inelastic Demand:
  • Monopolists can raise prices significantly without losing much demand.
  • Results in a larger markup of price over marginal cost.
• More Elastic Demand:
  • Closer pricing to competitive market prices where price is near marginal cost.
  • Lower markup.

Case Study: Airline Pricing Puzzle

• Scenario: Higher price for a shorter flight (Washington to Dallas) compared to a longer flight (Washington to San Francisco).
  • Explanation:
    • Dallas is a hub for American Airlines, leading to fewer alternative options (inelastic demand).
    • San Francisco offers more flight options (elastic demand).
  • Conclusion:
    • Inelastic demand (fewer substitutes) results in higher markups.
    • Elastic demand (more substitutes) results in lower markups.

Conclusion

• Main Lesson: The inelasticity of demand leads to higher monopoly markups.
• Application: Understanding elasticity helps explain pricing strategies in monopolies and competitive scenarios.

Practice questions and further exploration can help solidify understanding of these concepts.