Question

If a monopoly charges $2.00 and its marginal cost of producing the good is $1.50, what explanation can be given about the elasticity of demand for the product? If a monopoly in another firm charges $2.00 and the marginal cost of producing the good is $1.00, what explanation can be given about the elasticity of demand for the product? What conclusion can be given about the mark-up of price over marginal cost and the elasticity of demand for the product?

Answer 1

Answer to the above question is worked out and can be found in the snapshot attached below.

In equation 1, the LHS is the Price (P) Markup over the Marginal Cost (MC) and the RHS is the inverse of the price elasticity of demand. Note that there is an inverse relation between markup and the elasticity. This means, higher the elasticity, the lower the markup the monopolist can charge, because, it is more likely that the consumer will demand less, by stopping consumption altogether or consuming a substitute commodity.

Using equation 1 and the price and marginal cost information provided in the problem we can see:

In the case of the first monopolist, the markup is $0.5 and the elasticity = (-) 4. However, for the other monopolist, the markup is $1 and the elasticity = (-) 2. Since, the price elasticity of demand for the first monopolist = |(-)4| > the price elasticity of demand for the first monopolist = |(-)2|, demand is more elastic for his good and hence he/ she is able to charge a lower markup, compared to the other monopolist.