Econ 330 Lecture 8 Wednesday, October 9

Webpage : https://ais.ku.edu.tr/course/22582/Default.html Read Tyco Rules Plastic-Hangers Market Through Aggressive Acquisitions, from the WSJ, Feb 15 2000 http://online.wsj.com/article/SB950573052395979151.html Old exams (2011 and 2012) are posted (Announcements section)

This is the first Biro ballpoint pen made by the Miles-Martin Pen Company Ltd - with its 'folded' copper refill unit (England 1945) from http://www.ballpointpen.co.uk/Biro_page_1.htm

Ladislav Biro, (Bíró László József) 1899 – 1985 Ladislav Biro, (Bíró László József) 1899 – 1985. Inventor of the … He presented the first production of the ballpoint pen at the Budapest International Fair in 1931! Bíró patented the invention in Paris in 1938. Emigrated to Argentina in 1943. ballpoint pen

At left, an authentic Birome made in Argentina by Bíró & Meyne At left, an authentic Birome made in Argentina by Bíró & Meyne. At right, Birome advertisement in Argentine magazine Leoplán, 1945

A monopoly in ballpoint pens Reynolds International Pen Corporation In 1945 Milton Reynolds acquired a patent on a revolutionary new type of pen that used a ball bearing in place of a conventional point. He formed the Reynolds International Pen company, capitalised at $26,000 and began production on 6th, October 1945. The production was 70 pens the first day!

The pen was introduced with a good deal of fanfare by the famous New York department Store, Gimbels. (Now long gone!) Gimbels guaranteed that the pen would write for two years without refilling. The price was set at $12.50. They sold 10,000 pens on 29th October 1945, the first day they were on sale... In the early stages of production the cost of production was estimated to be around 80¢ per pen.

In the spring of 1946 the firm was producing 30,000 pens daily and had a profit of 1.5 million dollars. By December 1946 100 new firms had entered the market and prices had dropped to 3 dollars. By the end of the 40’s a pen was sold at 0.39 cents! 1951: Reynolds closed the firm!

Definitions… A firm is a monopoly if it is the only supplier of a product for which there is no close substitute.

It is not always easy to find examples of the classic monopoly behavior described in economics textbooks.

However, Tyco International's control of the plastic hanger market in the late 1990s may have come pretty close.

A coat hanger monopoly

How much do they cost? 6 to 25 cents (2000 prices, US) Who buys them?

Retail firms such as J. C. Penny and K-Mart use only plastic hangers to display their clothing goods.

What is the size of the market? About $400 million (2000 prices, US)

Initially there were two major producers: A&E, part of a large plastics company based in Phoenix, and Batts, a family owned firm in Michigan. Each firm had a market share of about 35% and there was a sharp rivalry between the two. As a result prices were down by 15-20% during the 1990s.

Tyco entered the market by buying A&E’s parent company in 1996 Tyco entered the market by buying A&E’s parent company in 1996. Then they also acquired Batts, eliminating most of the competition Immediately thereafter, Tyco raised prices by 10 percent to all its customers. Some clients complained but most accepted the higher prices.

Tyco bought the WAF corporation. Others firms, such as K-Mart and VF (makers of Lee and Wrangler jeans) informed Tyco that they had an alternative hanger supplier, a company called WAF. For a brief moment, Tyco appears to have backed off raising the price. Then in the fall of 1999… Tyco bought the WAF corporation. Within a few months, it not only raised prices to all its customers again but, this time, it also added in a new delivery charge. Read more at http://online.wsj.com/article/SB950573052395979151.html

Lets go back to the formal definitions

A firm is a monopoly if it is the only supplier of a product for which there is no close substitute. A monopoly faces a demand curve that is not “infinitely elastic”.

Unlike a firm in a competitive market… The monopoly firm will not lose all its customers if it raises its price a little bit (above marginal cost!). But … unless the demand is completely inelastic, even a monopoly firm will lose some of its customers as it gradually increases the price.

Today’s lecture Monopoly equilibrium Inefficiency (DWL) of monopoly

After the Bayram break Estimating DWL for real world markets The dominant firm model

The mathematics of monopoly equilibrium

Profit maximization STEP #1: always start with writing out the profit function as… Profit = revenue – cost π(Q) = TR(Q) – TC(Q) Revenue is price times quantity, cost is cost! = P(Q)·Q – C(Q) Yes But what exactly is this P(Q), price as a function of Q?

P(Q) is… The “inverse demand”: P as a function of Q This function P(Q) tells us the (maximum) price at which a given level of output can be sold. Put differently, P(Q) is the price at which a given Q is the quantity demanded.

Demand - Inverse demand: what’s the difference? p demand function inverse demand function Q

So, back to profit maximization! How do we do it?

When in doubt, differentiate, set equal to 0! Profit = P(Q)∙Q – C(Q) STEP #2: Differentiate the profit function (with respect to Q). The derivative of the total revenue TR(Q) = P(Q)∙Q with respect to Q is [dP/dQ]∙Q + P This is called the marginal revenue, denoted by MR(Q), also computed as ΔTR/ΔQ. Most popular definition: Marginal revenue is the additional revenue from selling one more unit of output.

We have used the “product rule” of differentiation: Two functions f(x), and g(x). Consider the product of the two: f(x) ∙ g(x) The derivative of f(x) ∙ g(x) with respect to x is f’ ∙ g + f ∙ g’ , where f’ is the derivative of f(x) with respect to x, and g’ is the derivative of g(x) with respect to x.

Profit = P(Q)∙Q – C(Q) The derivative of the cost function C(Q) with respect to Q is MC(Q) (marginal cost)

Profit = P(Q)∙Q – C(Q) So when we take the derivative of the profit function with respect to Q and set equal to 0 we obtain the following condition: [dP/dQ]∙Q + P – MC = 0

[dP/dQ]∙Q + P – MC = 0 MARGINAL Revenue. MARGINAL Cost [dP/dQ]∙Q + P – MC = 0 MARGINAL Revenue. MARGINAL Cost. SO, the condition says: The monopoly firm maximizes profits by choosing the output level Q at which MR equals MC.

With some algebra we can rearrange the condition MR = MC as (P – MC)/P = –1/EP where EP is the price elasticity of demand

[dP/dQ]∙Q + P – MC = 0 P – MC = –[dP/dQ]∙Q (P – MC)/P = –[dP/dQ]∙(Q/P) Note that [dP/dQ]∙Q/P is 1/EP ! The Price elasticity formula EP = [ΔQ/ΔP]∙[P/Q], or [dQ/dP]∙(P/Q) So, MR = MC is equivalent to (P – MC)/P = –1/EP

The profit maximization condition for the monopolist is MR = MC, which we can also write as (P – MC)/P = –1/EP

MR = MC is the same as (P – MC)/P = –1/EP

Interpreting (P – MC)/P = –1/EP The degree of monopoly power depends (inversely) on the demand elasticity. A monopoly firm that faces a highly elastic demand (say, EP = -5) cannot raise price much above MC. If MC = 10, the (profit maximizing) price will be 12.5 A monopoly firm that faces a less elastic demand (say, EP = -2) can significantly raise price above MC. If MC = 10, the (profit maximizing) price will be 20

An example

More mathematics: An example with linear demand The inverse demand is p(Q) = a – bQ , a and b are positive numbers, for example a = 10, b = 1. The total revenue is TR(Q) = p(Q)xQ = (a – bQ)xQ = aQ – bQ2 MR is the derivative of TR with respect to Q MR(Q) = a – 2bQ

Marginal revenue curve with linear demand p(Q) = a – bQ Q a/2b a/b MR(Q) = a – 2bQ

Costs The total cost function is TC(Q) = F + αQ + βQ2 F, α, and β are positive numbers. The marginal cost MC is the derivative of TC with respect to Q MC(Q) = α + 2βQ

Total Cost Marginal Cost $ TC(Q) = F + αQ + β Q2 F Q $ MC(Q) = α + 2βQ

Finding the Q* At the profit-maximizing output level Q*, MR(Q*) = MC(Q*). We have MR and MC: MR = a – 2bQ MC = α + 2βQ The profit maximizing output level is defined by a – 2bQ = α + 2βQ  Q* = (a–α)/2(b+β)

The monopoly equilibrium on the graph Price p(Q) = a - bQ MC(Q) = α + 2βQ y MR(Q) = a - 2bQ

A short exercise: why is MR different than P? (not even close) We are selling Q = 500 units per week at price P = $5. We can sell Q =550 units if we reduce our price by 10 cents. Please compute the MR. (MR is defined as ΔTR/ΔQ) ANSWER: Revenue now (at P = $5) = $2,500 Revenue at lower price higher quantity (P = $4.90) = $2,695 ΔTR = $195 MR = ΔTR/ΔQ = 195/50 = $3.90

Short cut for MR ΔTR = ΔQxMR = ΔQxP – QxΔP  MR = $5 – 500x$0.10/50 = $4

The inefficiency of monopoly Now… The inefficiency of monopoly

The monopoly equilibrium and the DWL 6 = DWL 2 = 4 = 8 =

The Dead Weight Loss of Monopoly The in-class exercise The Dead Weight Loss of Monopoly

There are three different groups of potential readers. A well known publishing company has bought the rights to the latest Orhan Pamuk novel at a neat sum of 250,000 TL. There are three different groups of potential readers. A group of 10,000 Pamuk-crazy individuals will pay up to 20 TL for the book. A second group of 30,000 people will buy the book if its price is not higher than 15 TL. In addition, there are 50,000 readers who will pay only up to 9 TL. It costs 5 TL to print and distribute a book. What price will maximize profits? Compute the deadweight loss when profits are maximized.

Suggested answers

There are 3 candidates for profit maximizing price 20 (so that only group 1 buy) profit (20 – 5)x 10,000 = 150,000 15 (so that both group 1 and 2 buy) profit (15 – 5)x40,000 = 400,000 9 (so that all three groups buy) profit (9 – 5)x 90,000 = 360,000 So, the profit maximizing price is 15, only the first two groups buy. Consumer Surplus Group 1 CS is 10,000x(20 – 15) = 50,000, Group 2 CS is 0 total CS is 50,000 Producer Surplus (excluding the 250,000 TL payment to the author) (15 – 5)x40,000 = 400,000 Social welfare = 450,000

DWL = 50,000x(9 – 5) = 200,000 This is the surplus that could be realized by selling the book to the third group at any price between 5 and 9. Consider a low price, say P = 8, so that all three groups can buy Redo the CS and PS Consumer Surplus Group 1 CS is 10,000x(20 – 8) = 120,000, Group 2 CS is 30,000x(15 – 8) = 210,000, and Group 3 CS is 50,000x(9 – 8) = 50,000. The total CS is 380,000 Producer Surplus (excluding the 250,000 TL payment to the author) (8– 5)x90,000 = 270,000 Social welfare = 650,000 This is 200,000 more than the social welfare wit the monopoly price

Monopoly quantity DWL

If you have time think about the following What price will maximize the number of books sold while at the same time giving the company a 5% profit on total cost, which includes the 250,000 TL payment to Mr. Pamuk?

Everyone have a nice Bayram break End of the lecture