Wine markups at top New York restaurants

This week, my ECONS101 class has been covering elasticity. One aspect of that topic is the observation that firms with market power (such as firms in monopolistic competition, like restaurants) price their products with a markup over their marginal cost [*] (my class will build on this insight next week, when we look at pricing in more detail).

The optimal size of the markup depends on the consumers' price elasticity of demand. When demand is relatively more elastic (that is, when consumers are more price sensitive), the optimal size of the markup is relatively small, and the resulting price will be quite low. When demand is relatively more inelastic (that is, when consumers are less price sensitive), the optimal size of the markup is larger, and the resulting price will be quite high.

To see how this works, consider two firms, as shown in the diagram below. Firm 0 (black lines) has relatively inelastic demand for the good, so its demand curve D0 is relatively steep. That means that it also has a relatively steep marginal revenue curve (MR0). Firm 1 (red lines) has relatively elastic demand for the good, so its demand curve D1 is relatively flat. That means that it also has a relatively steep marginal revenue curve (MR1). Both firms are constant-cost firms, and both have the same costs of production (MC=AC). The condition for profit maximisation is that the firm will want to sell the quantity where marginal revenue is exactly equal to marginal cost. For both firms, this happens to be the quantity Q*. To determine the profit-maximising price, each firm needs to set its price so that the quantity of the product that consumers want to buy is exactly equal to Q*. For Firm 0, that is the price P0, while for Firm 1, that is the price P1. Notice that Firm 0 sets a much higher price than Firm 1. Firm 0 has a larger markup than Firm 1 (the markup is the difference between each firm's price, P0 or P1, and the marginal cost line MC).

How big can markups get? When demand is very inelastic, markups can get very high. Many luxury goods have quite inelastic demand (when they are not the target of conspicuous consumption). That's because, even though the price may be high, for the high-income consumers that buy luxury goods, their spending on the product is only a small proportion of their income. As one example, consider wines at top New York restaurants, as described in this Punch article. They interviewed a number of wine buyers for restaurants, and here are a few quotes from their responses:

Across the board at Four Horsemen, we almost always do a 3x markup, which is generally the standard...

Currently, the markup on our wine list at Roscioli is 2.5x the cost we pay for the bottle. The markup at most restaurants is 3.5x, so we’re trying hard to keep things more approachable...  

I generally stick with the norm as far as markups go: 3x to 3.5x...

Those markups are quite high, but not dissimilar to the markups many years ago when I worked in hospitality (albeit briefly). High-end restaurants know that their patrons who are looking to buy wines have relatively inelastic demand, so they can set a relatively high price (and a high markup). And so, that's what they do.

[HT: Marginal Revolution]