Monopoly The definition of monopoly The definition of monopoly –From the Latin: “single seller” A structural view A structural view –Unique product/service –Large relative to market A theoretical view A theoretical view –Must lower price to sell more units –Must find best price for output, so better name is “price searcher” or “price maker”

Sources of monopoly Unique talent Unique talent –LeBron James Patent or copyright Patent or copyright –Intel chip Location Location –McDonald’s in airport Regulation Regulation –Professions Collusion Collusion –OPEC

Consider this Price Maker Market You think so hard in econ class you have a headache! You go to buy a bottle of 100 generic aspirin. Consider these options: Wal-Mart Grocery Store Grocery Store Convenience store Convenience store Which is highest price and lowest price? Is the market competitive? What does monopoly mean in practice?

Marginal Revenue schedule Marginal revenue (MR) is the change in total revenue (TR) when there is a change in quantity (Q) sold. To sell more, you must cut price (P) – move down the demand curve – so MR is always less than P. Price to the seller is the revenue received. Marginal revenue (MR) is the change in total revenue (TR) when there is a change in quantity (Q) sold. To sell more, you must cut price (P) – move down the demand curve – so MR is always less than P. Price to the seller is the revenue received. Because a price cut to sell more units reduces revenue on “earlier” units, extra revenue (the marginal revenue) is less than price. Assuming all sales at the same price — P is Average Revenue — measured by the Demand Curve. Because a price cut to sell more units reduces revenue on “earlier” units, extra revenue (the marginal revenue) is less than price. Assuming all sales at the same price — P is Average Revenue — measured by the Demand Curve.

Anatomy of a Demand Curve Demand reflects what consumers pay for a good. They pay a price, P’, which is Average Revenue to the seller (AR). Total revenue in a given time period is P’ x Q’ = TR. Marginal Revenue (MR) is the change in TR given a change in Q sold, which requires P to change. Q $ MR D = AR P’P’ Q’Q’

Madonna’s problem: How many songs? TC Q Price TR MC TC Q Price TR MC $10m/song $10m/song At each price, recording company demands (will buy) the number of songs shown, Q -- Price-quantity combinations shown are points on demand curve What is the best price; or how many songs? Is maximum total revenue the best solution?

Marginal revenue is less than price TC MR Q Price TR MC TC MR Q Price TR MC $10m/song $10m/song What is the most profitable P and Q? New

The solution: marginal revenue = marginal cost TC Profit MR Q Price/song TR MC TC Profit MR Q Price/song TR MC $10m $10m Find the price that maximizes profits for Madonna (the seller) The solution: Choose Q such that MR = MC Note that P > MC at best Q New

The solution graphically The profit-maximizing price is the one that induces demanders to choose Q such that MR = MC At any higher price, MR > MC MR > MC  lost profits At any lower price, MR < MC  lost profits Only at P* is MR = MC  maximum profits MC = S D MR MC=3.5 P*=7 Quantity $

The Price Maker: Common in Highly Competitive Markets Setting price at movie theater that has 1,000 seats in it. that has 1,000 seats in it. Assume fixed costs of $2,000 for movie rental, $250 for labor, & $250 for building per night. You know your customers from experience—what price do you charge if only one price can be set? Highly competitive market for entertainment dollars. $ D Q MR $6 $5 $

Setting Prices What is Marginal Cost in this situation? All costs are fixed, so MC = $0 At what quantity does MC = MR? 500 seats What price can be charged? $5 (price is Average Revenue—Demand Curve) What is Total Revenue? TR = P * Q = $5 x 500 = $2500

Can we do better? There are unsold seats — and it costs $0 to serve another customer (MC=$0) — so should we cut the price to $4 to fill more seats? Cut price to $4, add 100 customers, but TR falls $100, so MR per extra customer is -$1. Some customers value the movie at more than $5. Should we charge a higher price, say $6? We go from TR = $2500 to TR = $2400, so TR falls $100, or -$1 as customer base falls from 500 to 400. Nothing beats the golden rule of MC = MR

Same example with positive MC Now presume movie distributor charges a rental fee of $2 per customer let into the theater, so MC=$2 per customer let in. Building cost of $250 and labor cost Of $250 per night are still fixed. $6x400=$2400 is where MC=MR Compare to $5 price (TR=$2500), for 100 more customers, $100 more TR or MR = $1 per customer. MC = $2 for each customer (TC=$1500), so net loss of $100. D Q $ $6 $2 MR MC 400

A “monopolist” has competition This is called the monopoly pricing model or price maker model. The market for movie theaters is competitive —between theaters as well as with substitutes such as DVDs. The market is competitive, but firms act as if they are a monopoly.

Trying to apply model in real world— where do you have ability to set price? Parker Hannifin: Industrial parts maker: $9.4 billion revenue 2006; 800,000 parts sold. Traditional policy: “cost” plus 35% (the “strategy” used by ~ 60% US manufacturers) Net income in 2002: $130 million Net income in 2006: $673 million Return on invested capital up from 7% to 21% in same time. How: Be a “monopolist” when possible

Some things are “monopolistic,” some are not, from same seller New Strategy: 4 Basic Categories of products A. Ones in highly competitive markets—charge the market price; no price changes B. Partially differentiated products—common products changed a bit for a customer; prices up 0-9% C. Differentiated products—engineered for a customer; up 0-25% D. Specials—custom designed; no close substitutes; prices up over 25%