Shark Tank Markups

For an economist, one of the most educational and entertaining shows on TV these days is Shark Tankwhich lies squarely in the intersection between venture capital and reality TV. The judges, called "sharks” are shown as choosing whether or not to invest their own money in ventures on the spot as entrepreneurs make their pitch during the taping of the show. There are also some follow-up segments about how ventures one or more of the sharks invested in previously have been doing.  

It is well worth hearing the incisive questions and opinions given by the sharks. Among the inevitable questions are “How much do you sell it for?” and “How much does it cost to make and deliver?” or in the case of a service “How much does it cost you to do it?” The intriguing thing to me about that is being able to get a measure of the actual markup ratio

Actual Markup Ratio = Price/Marginal Cost

for a wide variety of goods and services. I think a great undergraduate economics thesis could be written by watching all of the episodes of Shark Tank, compiling all the data on price and marginal cost and then analyzing the determinants of the markup ratio (such as sector and how different the product is from competing products–something that could be coded up systematically from the televised discussion in the show).

Once price has had a chance to adjust optimally, the markup ratio should equal the target markup ratio

Target Markup Ratio = Price/Marginal Revenue = ε / (ε - 1)

where ε is the price elasticity of demand seen by the firm. The price elasticity of demand seen by a typical firm (or a typical firm’s target markup ratio) is a key parameter for macroeconomics as well as for industrial organization. For example, the value of ε tells how close things are to perfect competition. and ε is important for optimal monetary policy, as you can see in my discussion of Michael Woodford and Vasco Curdia’s paper at a conference at the Bank of Japan. Macroeconomists typically assume a value of 1.1 for the markup ratio, which implies ε = 11. To me, that seems too low a markup ratio and correspondingly, too high a firm-level price elasticity of demand. In any case, the value of typical markup ratios is a central issue that should be disputed in the light of as many different types of relevant information as we can get hold of.

Sometimes the sharks also ask about marketing costs. It is important to recognize that marketing costs (for example, “customer acquisition costs”) should not be included in marginal cost. They are a different animal. When price is above marginal cost, then there is a reward to marketing that pushes out the demand curve the firm faces. If a firm is optimizing, then it should be true that 

Marginal Cost to Make and Deliver + Marginal Marketing Cost of Raising Demand by 1 Unit at the Going Price = Price

So if one (in my view mistakenly) includes marginal marketing cost as part of “marginal cost” then the markup ratio should always look like 1 for an optimizing firm. This obscures the key forces arising from a markup of price over the marginal cost of making and delivering a product.