Gus is set on controlling the market for meth in the Southwest. He has worked hard to eliminate the local drug cartel so that he can be the sole supplier. Being the only supplier of a product gives a firm market power to charge prices greater than marginal cost. While profit maximization still occurs where marginal cost equals marginal revenue, a firm with market power is able to charge a markup on top of the marginal cost. Further, the markup is inversely proportional with the price elasticity of demand coefficient (i.e. the more inelastic the demand, the higher the markup). As the number of substitutes (competitors) decreases, the demand for each firm becomes more inelastic, which, in turn allows the firm to charger higher prices.
Walter tracks down his former student, Jesse, with the intention of collaborating with him in the production of methamphetamine. Walter’s intentions become obvious once he starts revealing that the Drug Enforcement Agency (DEA) has apprehended Jesse’s former business partner. Walter goes further and adds, “But you know the business and I know the chemistry. I’m thinking … maybe you and I could partner up.”
While Jesse has performed both tasks in the past, there is little doubt that Walter, because of his chemistry knowledge and perhaps better task-management skills, is more productive at making methamphetamine as well as distributing it. Even though Walter has absolute advantage in cooking and distributing methamphetamine, the logic of comparative advantage tells us that Walter and Jesse should collaborate. More specifically, Walter should cook while Jesse should distribute/sell the methamphetamine.
Incentives, and how individuals respond to incentives, represent another key economics concept. In this clip, Walter’s offer for a partnership deal comes with a catch:
Jesse: “You wanna cook crystal meth? You. You and me.”
Walter: “That’s right. Either that, or I turn you in.”
Walter threatens to inform the DEA about the methamphetamine business if Jesse chooses not to join the partnership. Here, Walter is encouraging some action (joining him) by issuing a threat (turning Jesse in). Their interaction represents an ultimatum game, in which Walter’s threat is an example of a negative incentive.
This description comes from Duncan, Muchiri, and Paraschiv (Forthcoming).
See more: absolute advantage, comparative advantage, credible threat, credible threat, division of labor, gains from trade, game theory, incentives, opportunity cost, specialization, tradeoffs, ultimatum game