Welcome back. What we'll do in this section, it look, is look at the relationship between monopoly price and elasticity demand. This week's material covers chapter 11 for those of you that are following in the text, and the first three sections of chapter 12. And the math behind the relationship between a monopoly price and elasticity demand is a little more complex, so their details in the text how to arrive at the rules that we're going to spell out and look at more closely in this session. So take my word for it, if you want to, if you don't want to delve further. Bottom line, there's an inverse relationship between elasticity demand and the markup of price to marginal cost in a monopoly setting. And this relationship holds importantly at the profit maximizing level of output chosen by the monopolist. One way to express it is the way it is on this first equation, where we look at the mark up of price to marginal cost relative to price in the denominator. This mark up ratio is inversely related to the elasticity demand. Now to test this out, and this applies in competitive settings or monopoly settings. In competitive settings, remember the elasticity demand for an individual firm is infinite. You're stuck. Everybody will run away if you try to raise your price just a little bit over the price prevailing in the marketplace. So, in this particular case, say the elasticity demand, you're in a perfectly competitive setting, and the right-hand side of this equation, 1 over the elasticity demand. If the elasticity is infinity, then the markup you can charge over marginal cost is zero. If the elasticity demand isn't infinite and we will see as it gets lower than infinite then you can charge some markup over price, some markup over marginal cost. Another way to express this formula is to say look the price you want to charge the profit maximizing level of output is marginal cost divided by, in brackets, 1 minus 1 over the elasticity demand. Okay. Let's test this out. Say the marginal cost was $3. We're going to apply this second formula. Let's say you're retailing gasoline, and you know the marginal cost is a flat $3. And what if the elasticity demand... Was 20. More competitive setting. numerous gas stations around. It's not perfectly competitive because there's some locational advantages to where you're located in particular. If you were stuck in that setting and if you do the math, what you'll find out is the price you should charge, is $3.16 at the competitive level, [UNKNOWN] sorry at the, at the profit maximizing level. So the markup of priced marginal costs is $0.16 over marginal cost is 5.33% over marginal cost, or roughly 5% of the price being charged of $316. Now what if elasticity demand, instead of 20, what if it was equal to 3? Consumers were less responsive to the price charged. What would be the price you could charge at the profit maximizing level? If you do the math, this works out to $4.50. Okay. Or $1.50 above marginal cost. So a 50% markup over marginal costs, and relative to the price, it's 33% over the prevailing price. Let's see if that intuition makes sense, where elasticity demand's lower, you can charge a higher markup. Consumers can't run away as easily. So it's easier to stick them with a higher price marginal cost markup. Let's look at a particular setting and this got mentioned a few weeks ago [UNKNOWN], [UNKNOWN] question to think about as part of the announcement for the week. Stations around airports, gasoline stations, usually charge a higher price marginal cost markup than stations that aren't located around airports. Why? Because when you're at airports, a lot of the business revolves around people returning rental cars. And if you're in a hurry to catch a flight, you don't have as much time to look for alternatives. And again, elasticity demand one of the components is how much time you have to look for substitutes. So if elasticity demand is lower, let's assume three like in the calculations we just did. And let's look at what happens for an airport setting, the demand curve, where demand is more inelastic, lower elasticity of 3, same marginal cost of $3 per unit. So the firm will look to where marginal revenue equals marginal cost, and then charge a higher price, up to the demand curve at that quantity Q1, $450, $4.50 per gallon at airport stations. Non-airport stations elasticity demand people have more time to look for substitutes on average. The elasticity demand is associated with the demand non-airport. It has its associated marginal revenue curve. Same marginal cost of $3, and at non-airport locations at that same quantity, we end up with a price at a price marginal cost markup that's lower. Consumers are more sensitive So suppliers can get away with a lower markup of price over marginal cost. Now one other example of this phenomenon. Cowboy Stadium where they play football in the National Football League in the United States. On February 11, 2011 there was a Jack in the Box parking lot, a fast food restaurant, right across the street from Cowboy Stadium. The cost to park your car for a few hours on that particular day in February was $990. Why? Because that particular day happened to be when the Super Bowl was played in Cowboy Stadium. The elasticity demand, what people are willing to pay, especially those that wanted to go and have a convenient spot to attend the Super Bowl, was a lot lower. And that's why this particular fast food restaurant could charge a much higher markup. For typical Dallas Cowboys home games, by contrast, parking spots sold for $50 per day. So a lot less than for Super Bowls. Demand was more elastic in cases where it was a regular Cowboy's football game. And when there was no football game, there was practically no charge for those parking spots for the Jack in the Box. So, for that one particular Super Bowl, when elasticity demand was low, people couldn't run if they wanted to attend the Super Bowl. Jack in the Box was able to charge the equivalent of what they charge for 248 Jumbo Jack hamburgers, or 496 tacos, or 4,960 16-ounce sodas, or roughly 9,000 fries. Same rule between elasticity demand and the markup you can charge over marginal costs.
