IMBA Managerial Economics Jack Wu Monopoly IMBA Managerial Economics Jack Wu

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 suppliers

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

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

Monopoly: Profit Maximum, II 250 demand (marginal benefit) 150 130 Price ($ per unit) 70 marginal revenue 50 marginal cost 0.4 0.8 1.2 1.4 1.6 2 -50 Quantity (Million units a year)

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

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 1 Pfizer owns the patent to Viagra, which at the time of writing, was the only approved drug for erectile dysfunction. Bayer manufactures aspirin, which is not covered by patent and is one of several drugs that relieve the symptoms of the common cold.

Discussion 1: continued Who has relatively more market power: Pfizer over Viagra or Bayer over aspirin? How is the difference between price and marginal revenue related to the price elasticity of demand? Compare the difference between price and marginal revenue for the two drugs, Viagra and aspirin.

Discussion 2 Hong Kong Director-General of Telecommunications Anthony Wong expressed concern about the effect of license auctions on the price of telecommunications: “There’s good and bad in auctioning off spectrum … it may raise costs for telecoms providers” (“Telecoms chief sees further fall in long-distance tariffs”, South China Morning Post, December 31, 1999, Business 1.)

Discussion 2: continued Typically, licenses are transferable, but the one-time license fee, once paid, is not refundable. From an operational standpoint, how does the cost of a license depend on the price, if any, that the owner paid for it? How does the one-time license fee affect the marginal cost of providing telecommunications service? How does it affect the profit-maximizing scale of operations? Suppose that the one-time license fee is changed to an annual charge based on the telecommunications provider’s revenue. How would the new policy affect the service provider’s profit-maximizing scale of operations?

Discussion 3 Discount retailer Dollar General targets low and fixed-income families in the midwest and southeast. The majority of the chain’s 3,200 items are priced at $1 or lower. Shoppers spend an average of $8.06 a trip. The average store size is 6,700 square feet. In 1998, Dollar General discontinued most advertising. While financial analysts worried that sales would drop, the company’s profit rose. Chief Executive Cal Turner, Jr., explained: “Our customer lives within three to five miles of the store, knows we’re there, knows who we are and appreciates the everyday low price,” (“Dollar General Sticks to Plan for Prosperity,” Wall Street Journal, August 16, 1999, page B11E).

Discussion 3: continued How could the cut in advertising raise profit while reducing sales? Explain Mr Turner’s comment in terms of the advertising elasticity of demand. Relate Dollar General’s incremental margin and advertising elasticity of demand to the new advertising policy.