But some monopolies are not very profitable Price and Output Determination: Monopoly and Dominant Firms Chapter 11 "Monopoly" conjures images of huge profits, great wealth, and indiscriminate power. These monopolists are labeled robber barons. But some monopolies are not very profitable Others dominate their industry Still others are regulated by State Public Service or Utility Commissions, and may have very low rates of return on invested capital. Regulated monopolies are known as utilities. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1

The Mickey Mouse Monopoly Disneyland in Anaheim was unique, a theme park monopoly Eventually competition in terms of Six Flags and others entered Disney World, built in Orlando, FL attracted Sea World & Universal Studios But there is a negative cross-price elasticity with them. They are complements. Lower price on Sea World, means that there are more trips to Disney World. Their existence encouraged repeat business and longer vacations in the area.

Sources of Market Power for a Monopolist Legal restrictions – through copyrights & patents. Control of critical resources creates market power. Government-authorized franchises, such as provided to cable TV companies. Economies of scale allow larger firms to produce at lower cost than smaller firms. Increasing returns from network effects -- compatibilities increase market penetration. Once a critical level of acceptance is achieved, the cost of marketing the next adoption decreases. S-shaped Sales Penetration Curve 2

Sales Penetration Curve Figure 11.1 Frequency of adoption by next target customer Diminish returns in Region 0-30% and in Region above 85%. Increasing returns in Region between 30% & 85%. 30% 85% Time path of market share %

What Went Right ∙ What Went Wrong Pilot Error at Palm In 2000, Palm Pilot had 80% market share of PDAs (personal digital assistants) Grew so fast, bottlenecks developed. When product introductions were delayed, customers switched to Handspring, Sony, and Blackberry.

An Unregulated Monopoly Monopoly is a single seller where entry is prohibited and there are no close substitutes 1. FIRM = INDUSTRY 2. MR < P The demand curve: P = 100 - Q 60 59 D TR1 = 60•40 = 2400 TR2 = 59•41 = 2419 40 41 Q 19 So. MR = 19 where MR < P 3

3. At output where MR = MC, profit is maximized MC PM D QM Proof: Max  = TR – TC Find where dP/dQ = 0 d/dQ = dTR/dQ - dTC/dQ = 0 MR – MC = 0 So: MR = MC D PM QM 4. Charge highest price that the market will bear, PM MR 4

If P = a - b•Q, then TR = aQ - bQ2 so This is twice as steep If we use a linear demand curve: MARGINAL REVENUE is twice as steep as a linear demand curve If P = a - b•Q, then TR = aQ - bQ2 so MR = a - 2b•Q This is twice as steep 5

A MONOPOLY PROBLEM Find the monopoly quantity if: P = 100 - Q, and where MC = 20. Answer this by starting where MR = MC TR = P•Q = 100•Q - Q2 MR = 100 - 2•Q = 20 80 = 2•Q QM = 40 Find Monopoly Price: PM = 100 - 40 = 60 The highest price that the market will bear. 6

The Importance of Price Elasticity of Demand for a Monopoly MONOPOLY has MR = MC TR = Q•P(Q) dTR/dQ = MR = P + (dP/dQ)Q = P [ 1 + (dP/dQ)(Q/P) ] = P[ 1 + 1/ EP ] As EP goes to negative infinity, MR approaches P P [ 1 + 1/ EP ] = MC Equation 11.2 Marginal Revenue 7

Optimal Markups The optimal markup can be found using this same formula. P = [ED /( ED+1)]•MC. The optimal markup m is: (1+m) = [ED /( ED+1)] Hence: m = - 1 / ( ED + 1) For example, if ED = -3, the markup is 50%, since = [-1/( -3 +1)] = .50 If ED = -4, the markup is 33.3%, since his is where [-1/( -4 +1)] = .333. If the price elasticity is infinite, the markup is zero. This occurs in competition, where m = -1/(- + 1) = 0.

Find the Monopoly Price in these Problems ANSWER P[ 1 + 1/( - 3) ] = 100 P[ 2/3 ] = 100 So, P = $150. If EP = -5, then optimal monopoly price falls to $125. The more elastic is the demand, the closer is price to MC. If EP = - 3 & MC = 100 What’s PM ? 8

A Monopoly Pricing Problem Regression results for Land’s End Women’s light-weight coats: Log Q = - .4 -1.7 Log P + 1.2 Log Y ( 3 . 2) ( 4. 5) Let MC of imported women’s light-weight coats be $19.50. Find the Monopoly Price for a Land’s End light-weight coats. ANSWER: P( 1 + 1/EP ) = MC P ( 1 + 1/(-1.7) ) = 19.50 P = $47.36 11

Components of Gross Profit Margin Sometimes it is shortened to Profit Margin and is also called Direct Cost of Goods Sold (DCOGS). It is defined as: Gross Profit Margin = Revenue – Variable Cost – Direct Fixed Cost Suppose a carpet firm makes 20 varieties, the Gross Profit Margin of one of them is the Revenue earned, minus the cost of time and materials to make it, minus the setup costs to produce that type of carpet. The last is the “direct” fixed cost associated with that product. Gross Profit Margin varies across industries: Because industries vary in capital intensity. Typically highly capital intensive industries have larger gross profit margins Because industries vary in selling costs such as advertising and promotional expenses. Typically high selling costs lead to high gross profit margins. Because industries vary in their overhead expense. Often high overhead expense leads to high gross profit margins

Value Creation in a Strategy Map Figure 11.4 Cost Structure: Value Model: Financial Value Lower Unit Cost + Increase Asset Utilization Enhance Price Premiums + Boost Unit Sales Attributes: Relationships: Image: Customer Value Quality + Availability + Selection +Reliability + Post-Sale Services Brand Proposition Functionality + Partnerships + Communications Internal Process Value Operations Management Customer Service Culture of Innovation Regulatory Incentives

Limit Pricing An established firm considers the possibility of new entrants with distaste. Suppose a new entrant would have a U-shaped average cost curves. Suppose also that the established firm has created some brand loyalty, such that entrants must under-price them to take away their customers. AC

Profit Profiles ACPC PL II I D time The potential competitor (PC) has no demand at limit price PL as DPC is below ACPC Profit Profiles ACPC PL II I D ACestablished Q time DPC Which profit profile (I or II) represents profit maximization? Would a stockholder prefer profile I or II? The profit profile of limit pricing is more like II than I.

Regulated Monopolies Electric Power Companies Natural Gas Companies Communication Companies (telephone, cable, radio, TV, etc.) Often, Municipal Water Companies All are examples of regulated companies or Public Utilities. They are all “naturally monopolistic” as they all have significant declining cost curves. Suppose we examine railroads before regulation as an example of a nature monopoly. 12

Natural Monopolies AC Declining Cost Industries economies in distribution economies of scale Without Regulation they face Cyclical Competition with prices gyrating between PM and PC. railroad history includes periods of huge profits then bankruptcies DEMAND P M AC MC PR = AC PC = MC QR QC QM MR 12

Solutions to the Problem of Natural Monopolies REGULATE, prevent entry, & set P = AC common in US for electricity, water FRANCHISE through a bidding war, likely P = AC Cable T.V. concessions at various stadiums PREVENT ENTRY, set P = MC and subsidize. subsidies require some form of taxation, which will tend to distort work effort. subsidies to AMTRAK NATIONALIZE, prevent entry, set price typically low governments find that changing its price is a highly political event once popular solution in Europe 13