Managerial Economics Jack Wu Monopoly Managerial Economics Jack Wu

Monopoly

MARKET Pure (Perfect) competition – least freedom in pricing Monopolistic competition Medical clinic Oligopoly Hospital anti-virus software, microcomputer operating system Monopoly – single supplier of good or a service with no close substitute: most freedom in pricing [IP] 08mono-ap-wo.ppt

Market Power Definition: ability to influence price monopoly -- single supplier of good or a service with no close substitute oligopoly -- few suppliers monopsony -- single buyer oligopsony – few buyers

Sources of Market Power unique resources human natural intellectual property patent Copyright economies of scale / scope product differentiation government regulation

US Federal Reserve: Monopoly Money Machine Currency in circulation, Dec. 2004 $719 bill. Revenue, 2004 $23.5 bill. Earnings, 2004 $21.3 bill. * Image … source: http://www.acclaimimages.com/_gallery/_pages/0269-0609-0115-4830.html

MONOPOLY: MARGINAL REVENUE AND PRICE 250 infra-marginal units 150 130 demand (marginal benefit) Price ($ per unit) 70 marginal revenue 50 0.4 0.8 1.2 1.4 1.6 2 -50 Quantity (Million units a year)

REVENUE, COST, AND PROFIT

Monopoly: Profit Maximum, I Operate at scale where marginal revenue = marginal cost Justification: If marginal revenue > marginal cost, sell more and increase profit. If marginal revenue < marginal cost, sell less and increase profit.

Operating Scale: Profit Maximum

Monopoly: Profit Maximum, III contribution margin = total revenue less variable cost profit-maximizing scale: selling additional unit does not change the contribution margin

Demand Change Find new scale where marginal revenue = marginal cost should change price new scale and price depend on both new demand and costs

Prozac: Demand Reduction 250 200 Price ($ per unit) 150 marginal cost 100 original demand 50 new demand 0.4 0.8 1.2 1.6 2 new marginal revenue Quantity (Million units a year)

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

REDUCTION IN MARGINAL COST 200 demand 150 marginal revenue original marginal cost Price ($ per unit) 100 new marginal cost k 50 0.4 0.8 1.2 1.6 2 -50 Quantity (Million units a year)

3G Licensing “There’s good and bad in auctioning off spectrum … it may raise costs for telecoms providers” Anthony Wong, Director-General, OFTA, Hong Kong How does one-time license fee affect price and scale of operations?

Advertising benefit of advertising -- increment in contribution margin advertising elasticity = % increase in demand from 1% increase in advertising

Advertising: Profit Maximum Profit-maximizing advertising/sales = incremental margin x advertising elasticity incremental margin = (price - MC)

PROZAC: ADVERTISING Competition from generics would reduce incremental margin raise advertising elasticity

Coke vs Pepsi, Nov. 1999 Coke Pepsi raised prices by 7% increased advertising and other marketing Pepsi raised price by 6.9% what about advertising?

Answer Pepsi should increase advertising expenditure for two reasons: price increase --> increase in incremental margin; Pepsi’s increase in advertising will attract some marginal consumers -- those who are brand- switchers, relatively less loyal to Pepsi/Coke; so Coke’s demand will be more sensitive to advertising (higher advertising elasticity)

Dollar General “Our customer lives within three to five miles of the store, knows we’re there” cut advertising from 3.8% to 0.2% of revenue sales dropped but profit rose

Advertising IBM USD 89,131 1,406 1.6% Anheuser Busch 15,036 850 5.7% Industry/Company Curr. Sales Advertg Ratio IBM USD 89,131 1,406 1.6% Anheuser Busch 15,036 850 5.7% Fosters AUD 3,972 380 9.6% Microsoft 32,187 1,060 3.3% General Mills 11,244 477.0 4.2% Kellogg 10,177 858.0 8.4% SAP EUR 7,025 162 2.3% Unilever 39,672 4,999 12.6% Units: millions * The book, p.210

Research and Development The profit maximizing R&D/sales ratio is the incremental margin percentage x the R&D elasticity of demand R&D/sales should be raised if price is higher, marginal cost is lower, or if the R&D elasticity is higher

R&D Sales Ratios (2005) Company Units (million) Sales Rev R&D exp General Mills USD 11,244 168 1.5% Kellogg 10,177 181 1.8% Unilever EUR 39,672 953 2.4% IBM 91,134 5,842 6.4% Microsoft 39,788 6,184 15.5% SAP 8,512 1,089 12.8%

MARKET STRUCTURE, I (a) Perfect Competition (b) Monopoly demand demand 60 Price (Cents per unit) Price (Cents per unit) marginal cost 30 30 supply marginal revenue 300 150 Quantity (Million units a year) Quantity (Million units a year)

Market Structure, II Relative to competitive market, monopoly sets higher price produces less earns higher profit

Competitiveness entry and exit barriers perfectly contestable market -- sellers can enter and exit at no cost Lerner Index (incremental margin percentage) -- measures the degree of actual and potential competition

Monopsony marginal expenditure marginal benefit buyer with market power restricts purchases to depress price trades off marginal expenditure marginal benefit

MONOPSONY SCALE marginal expenditure supply Price ($ per ton) 400 supply 350 Price ($ per ton) 273 marginal benefit 6 8 Quantity (Thousand tons a year)

DISCUSSION The National Collegiate Athletic Association (NCAA) aims to “govern competition in a fair, safe, equitable and sportsmanlike manner, and to integrate intercollegiate athletics into higher education so that the educational experience of the student-athlete is paramount” (Source: NCAA website). The NCAA restricts the amounts that member colleges and universities may pay their student athletes (generally limited to the full cost of their education) and requires student athletes to attend full-time programs of study.  

DISCUSSION a. What market power does the NCAA have, and what are its source(s)? b. If the U.S. government were to forbid the NCAA from such restrictive practices, what would happen to: (i) each athlete’s earnings, and (ii) the number of athletes?