Ch 8 Monopoly

2 Learning objectives  Appreciate how to gain market power.  For a seller with market power, identify the scale of production/sales that maximizes profit.  Appreciate how to adjust sales to changes in demand and costs.  For a seller with market power, identify the levels of advertising and R&D expenditure that maximize profit.

3 Learning objectives  Appreciate that sellers with market power restrict sales to raise margins and profit.  Apply the incremental margin percentage to measure market power.  For a buyer with market power, identify the scale of purchases that maximize profit.

4 Statins  Pfizer owns the patent of ‘‘Lipitor’’  A branded statin that reduces the level of cholesterol  While Pfizer owns the patent, it faces the competition from other stains, e.g, Merck  How much to spend on R&D?  How much to spend on advertising?  Patent drugs also face competition from generic drugs, such as Ranbaxy from India  How to respond to generic competition?

5 Market power  Definition: The ability of a buyer or seller to influence market conditions  Influence market demand or supply.  Buyer/seller with market power must manage strategy toward competitors  pricing, advertising expenditure, R&D expenditure

6 Market power  Pure competition – least freedom in pricing  Monopolistic competition  many competitors that cannot strategize about each competitor individually  General medical practice  Small-scale systems integration

7  Oligopoly  Hospitals  Search-linked advertising: Google, Yahoo, MSN  Monopoly – single supplier of good or a service with no close substitute  Monopsony – single buyer Market power – Buyer side

8  Monopoly vs monopsony: business that is monopoly in selling an item may be monopsony for inputs into that item.  Intel has market power over suppliers of equipment to fabricate semiconductors  Boeing and Airbus have market power over component suppliers Market power

9 Outline  Sources of market power  Profit maximum  Demand and cost changes  Advertising  Research and development  Market structure  Monopsony

10 Sources of market power  Ingredients  Barriers to competitors  Price elasticity of demand/supply  Need both ingredients:  Even if no competition, but demand is perfectly elastic (many good substitutes), then, no market power.  Sellers can enhance market power in four ways  Product differentiation, intellectual property, economics of scale and scope, regulation

11 Sources of market power: Product differentiation  Means of differentiation  Design: provides first impression  Function: is the benefit of the product  Distribution channel: make products available to buyers  luxury products use exclusive distribution to build brand image  Advertising and promotion: introduce buyers to products  Example: Branded vis-à-vis generic drugs  Simvastatin: Zocor (S$1 per tablet) vis-à-vis generic (S$0.10)

12 Sources of market power: Intellectual property  Intellectual property encompasses  Patents: gives an exclusive right to the owner of an invention  Intel over microprocessor  Copyright: provides exclusivity over published expressions  Microsoft over windows  Trademark: provides exclusivity over words and symbols associated with a good  the basis for branding and advertising  Trade secrets: provide exclusivity over information that is not generally known  Google’s algorithms

13 Sources of market power: Economies of scale, scope, experience  Incumbent has cost advantage over competitors  Larger scale  Larger scope  More experience

14 US search engines 2013

15 Sources of market power: Regulation  The government may limit competition  The firms with government licensing gain market power  Electricity, gas, telecommunications, broadcasting, airline services, gambling

16 Outline  Sources of market power  Profit maximum  Demand and cost changes  Advertising  Research and development  Market structure

Profit maximum (with uniform pricing): Revenue, cost, and profit Price x sales Δ revenue ÷ Δ sales Δ cost ÷ Δ sales 17

18 Profit maximum (with uniform pricing): Marginal revenue and price

19 Profit maximum (with uniform pricing)  To maximize profit, operate at scale where marginal revenue = marginal cost  Justification:  If marginal revenue > marginal cost, then should sell more and increase profit  If marginal revenue < marginal cost, then should sell less and increase profit

Profit maximum (with uniform pricing) Maximize price or profit? 20

21 Profit maximum (with uniform pricing): Break even  Short run  SR revenue > variable costs  Long run  LR revenue > fixed and variable costs (excluding all sunk costs)

22 Pfizer versus Ranbaxy  Pfizer: Branded drug manufacturer  Intensive in R&D => large sunk costs  On forward-looking basis (before commitment to R&D), higher breakeven price/production level  Once R&D is sunk, only avoidable costs matter – costs of production similar to generic manufacturer  Ranbaxy: Generic drug manufacturer  Less intensive in R&D  On forward-looking basis, lower breakeven price/production level

23 Outline  Sources of market power  Profit maximum  Demand and cost changes  Advertising  Research and development  Market structure  Monopsony

Demand change 24

25 Cost change  Find new scale where marginal revenue = marginal cost  change in MC  should change price (but less than change in MC)  change in fixed cost  should not change price or scale

Marginal cost change Do not change price by same proportion as cost 26

Fixed cost change 27

28 Outline  Sources of market power  Profit maximum  Demand and cost changes  Advertising  Research and development  Market structure  Monopsony

29 Advertising  The benefits of advertising  Shifts demand curve outward (higher quantity at all prices)  Renders demand more inelastic  Marginal benefit of advertising = increase in contribution margin (revenue – cost)

30 Advertising: Profit maximum  Profit-maximizing advertising/sales revenue = incremental margin % x advertising elasticity  Incremental margin % = (price – MC) ÷ price  Advertising elasticity = % increase in demand from 1% increase in advertising  Raise advertising relative to sales revenue if  Higher incremental margin %  Higher advertising elasticity

Advertising: Profit maximum  Profit maximizing advertising-sales ratio 31

32 Advertising-sales ratio

33 Outline  Sources of market power  Profit maximum  Demand and cost changes  Advertising  Research and development  Market structure  Monopsony

34 R&D  R&D  Shifts demand curve outward (higher quantity at all prices)  Renders demand more inelastic  Marginal benefit of R&D = increase in contribution margin (revenue – cost)

35 R&D: Profit maximum  Profit-maximizing R&D expenditure / sales revenue = incremental margin % x R&D elasticity  Incremental margin % = (price - MC) ÷ price  R&D elasticity = % increase in demand from 1% increase in R&D expenditure  Raise R&D relative to sales revenue if  Higher incremental margin %  Higher R&D elasticity

36 R&D-sales ratio

37 Outline  Sources of market power  Profit maximum  Demand and cost changes  Advertising  Research and development  Market structure  Monopsony

Market structure 38

39  Relative to competitive market, monopoly  sets higher price  produces less  earns higher profit  Measure of market power: incremental margin percentage (IM%) Market structure

Market structure: Slot machines, Victoria, Australia Opening of competition => Loss in market capitalization: A$2.8 billion 40

41 Outline  Sources of market power  Profit maximum  Demand and cost changes  Advertising  Research and development  Market structure

42 Key takeaways  Gain market power by limiting competition and making demand less price-elastic.  To maximize profit, produce if total revenue covers total cost, and, then, produce at the scale where marginal revenue equals marginal cost.  When demand or costs change, adjust production to the scale where marginal revenue equals marginal cost.  To maximize profit, spend on advertising to the level where the advertising-sales ratio equals the incremental margin percentage multiplied by the advertising elasticity of demand.

43 Key takeaways, cont’d  To maximize profit, spend on R&D to the level where the R&D-sales ratio equals the incremental margin percentage multiplied by the R&D elasticity of demand.  Sellers with market power restrict sales to raise margins and profit.  Measure market power by the incremental margin percentage.  To maximize profit, purchase at the scale where marginal benefit equals marginal expenditure.