Monopoly

2 (c) , I.P.L. Png & D.E. Lehman Eli Lilly: Prozac  US Court of Appeals limited patent to August 2001  Lilly market value dropped by $36 bill.  Barr market value rose by $1.1 bill.  How should Lilly adjust  Pricing: $2.63, 90% margin of profit  advertising: ONLY 151,000 OF DIRECT CONSUMER AD, (THE SALES REVENUE: 2.6 BILLION)

3 (c) , I.P.L. Png & D.E. Lehman Seller side Market power Seller side  Pure competition – least freedom in pricing  Monopolistic competition  Medical clinic  Skin care product  Oligopoly  Hospital  anti-virus software, microcomputer operating system, mobile phone service  Monopoly – single supplier of good or a service with no close substitute: most freedom in pricing

4 (c) , I.P.L. Png & D.E. Lehman  Monopsony – single buyer  Oligopsony – few buyers Buyer side Market power Buyer side

5 (c) , I.P.L. Png & D.E. Lehman Outline  sources of market power  operating scale  Advertising and R&D  limiting competition  buyer market power

6 (c) , I.P.L. Png & D.E. Lehman Sources of Market Power  unique resources  Human: super pop star : Wongfei and Advertisement  Natural: Norilsk Nickel

7 (c) , I.P.L. Png & D.E. Lehman

8  intellectual property  patent : for R&D inventions. E.g., new drugs  Copyright: property right on published expressions, e.g., software, movies, songs, drawings, books

9 (c) , I.P.L. Png & D.E. Lehman Sources of Market Power  economies of scale / scope: electricity distribution; cable television service and local telephone service; natural gas; water service; postal service  product differentiation  government regulation: award exclusive franchise to a single provider; example: China Telecom, China Mobile, China Unicom

10 (c) , I.P.L. Png & D.E. Lehman Market power exists in some industries in China  Electricity  Petroleum and Chemical  Telecommunication (China Telecom, China Mobile, China Unicom)  Railway  Tobacco  Financial services (banking/securities/ insurance)  Water  Natural gas  Postal service

11 (c) , I.P.L. Png & D.E. Lehman Sinopec Group (state –owned)  employment ： （ 2010 ）  revenues ： in million’s of U.S. dollar  ranking among the world top 500 enterprises ： #5 （ 2011 ） #7 （ 2010 ）  Scope: prospecting, exploration, extraction, refining, transportation, production of petroleum chemical products, production and installation of machinery equipment, construction (vertically integrated)

12 (c) , I.P.L. Png & D.E. Lehman Open question: the future of 3G services in China  In 2009, the government grants 3 G permits to China Mobile, China Telecom and Unicom.  Not enough competition.  Should China do 3G license auction as U.S. and India did?

13 (c) , I.P.L. Png & D.E. Lehman Monopoly Money Machine US Federal Reserve: Monopoly Money Machine Currency in circulation, Dec $719 bill. Revenue, 2004 $23.5 bill. Earnings, 2004 $21.3 bill.

14 (c) , I.P.L. Png & D.E. Lehman HHI (Herfindahl Index)=Sum(s_i*s_i))  where s_i is the market share of firm i in the market, and N is the number of firms. Thus, in a market with two firms that each have 50 percent market share, the Herfindahl index equals 0.5* *0.5 = 1 / 2.  The Herfindahl Index (H) ranges from 1 / N to one, where N is the number of firms in the market. A HHI index below 0.01 (or 100) indicates a highly competitive index. A HHI index below 0.15 indicates an unconcentrated index. A HHI index between 0.15 to 0.25 indicates moderate concentration. A HHI index above 0.25 indicates high concentration [1].[1]

15 (c) , I.P.L. Png & D.E. Lehman Outline  sources of market power  operating scale  Advertising and R&D  limiting competition  buyer market power

16 (c) , I.P.L. Png & D.E. Lehman Marginal Revenue and Price Operating Scale: Marginal Revenue and Price demand (marginal benefit ) marginal revenue Quantity (Million units a year) Price ($ per unit) infra-marginal units

17 (c) , I.P.L. Png & D.E. Lehman Revenue, Cost, and Profit Operating Scale: Revenue, Cost, and Profit

18 (c) , I.P.L. Png & D.E. Lehman Profit Maximum Operating Scale: Profit Maximum  To maximize profit, 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.

19 (c) , I.P.L. Png & D.E. Lehman Profit Maximum Operating Scale: Profit Maximum

20 (c) , I.P.L. Png & D.E. Lehman Life-and-Death Monopoly Glaxo: Life-and-Death Monopoly “Once its products were approved, a big drug firm such as Glaxo could sell them at almost whatever price it wanted” (Economist, Jan. 28, 1995) True or false?

21 (c) , I.P.L. Png & D.E. Lehman Demand Operating Scale: Demand set  price, or  sales

22 (c) , I.P.L. Png & D.E. Lehman Demand Change Operating Scale: Demand Change Find new scale where marginal revenue = marginal cost  should change price  new scale and price depend on both new demand and costs

23 (c) , I.P.L. Png & D.E. Lehman Prozac: Demand Reduction marginal cost new demand original demand new marginal revenue Quantity (Million units a year) Price ($ per unit)

24 (c) , I.P.L. Png & D.E. Lehman Cost Change Operating Scale: 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

25 (c) , I.P.L. Png & D.E. Lehman Reduction in Marginal Cost Operating Scale: Reduction in Marginal Cost

26 (c) , I.P.L. Png & D.E. Lehman Moore’s Law and cost of computing Technological advances  increase in fixed cost  reduction in marginal cost ($ per unit of computing power)

27 (c) , I.P.L. Png & D.E. Lehman 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?  What about annual fee based on percentage of revenue?

28 (c) , I.P.L. Png & D.E. Lehman Outline  sources of market power  operating scale  advertising and R&D  limiting competition  buyer market power

29 (c) , I.P.L. Png & D.E. Lehman Advertising  benefit of advertising -- increment in contribution margin  advertising elasticity = % increase in demand from 1% increase in advertising

30 (c) , I.P.L. Png & D.E. Lehman Profit Maximum- >additional profit =additional Ad. expenditure Advertising: Profit Maximum- >additional profit =additional Ad. expenditure  Profit-maximizing advertising/sales = incremental margin percentage x advertising elasticity  incremental margin percentage= (price - MC)/price  Raise advertising/sales if higher incremental margin or higher advertising elasticity  The optimal rule is: advertisement expenditure/total sales revenue=((p-mc)/price)*ad. elasticity

31 (c) , I.P.L. Png & D.E. Lehman Prozac: Advertising Competition from generics would  reduce incremental margin  raise advertising elasticity

32 (c) , I.P.L. Png & D.E. Lehman Dollar General (1998) Advertising: Dollar General (1998) “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

33 (c) , I.P.L. Png & D.E. Lehman Why?  incremental margin of Dollar store is low  Advertising elasticity is low

34 (c) , I.P.L. Png & D.E. Lehman Advertising Industry/CompanyCurr.SalesAdvertgRatio IBMUSD89,1311,4061.6% Anheuser BuschUSD15, % FostersAUD3, % MicrosoftUSD32,1871,0603.3% General MillsUSD11, % KelloggUSD10, % SAPEUR7, % UnileverEUR39,6724, % Units: millions

35 (c) , I.P.L. Png & D.E. Lehman 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

36 (c) , I.P.L. Png & D.E. Lehman R&D Sales Ratios (2005) CompanyUnits (million) Sales RevR&D expR&D/sales General Mills USD11, % KelloggUSD10, % UnileverEUR39, % IBMUSD91,1345,8426.4% MicrosoftUSD39,7886, % SAPEUR8,5121, %

37 (c) , I.P.L. Png & D.E. Lehman Outline  sources of market power  operating scale  advertising and R&D  limiting competition  buyer market power

38 (c) , I.P.L. Png & D.E. Lehman Market Structure Limiting Competition: Market Structure

39 (c) , I.P.L. Png & D.E. Lehman Limiting Competition Relative to competitive market, monopoly  sets higher price  produces less  earns higher profit

40 (c) , I.P.L. Png & D.E. Lehman Prozac: Generic competition Why was Barr’s gain less than Lilly’s loss?  production expands beyond monopoly level  lower price  higher production and lower price benefit consumers

41 (c) , I.P.L. Png & D.E. Lehman Limiting Competition  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

42 (c) , I.P.L. Png & D.E. Lehman Limiting Competition  implicit agreement  cartel (explicit agreement)  horizontal integration

43 (c) , I.P.L. Png & D.E. Lehman Cartel Limiting Competition: Cartel effectiveness depends on  number of sellers in the market  industry capacity vs market demand  extent of sunk costs  extent of entry and exit barriers  nature (homogeneity) of product

44 (c) , I.P.L. Png & D.E. Lehman Vitamins, Inc., Limiting Competition: Vitamins, Inc., world’s top three manufacturers -- Roche (40%), BASF (20%), Rhone-Poulenc (15%)  allocated market shares  fixed prices  rigged bids

45 (c) , I.P.L. Png & D.E. Lehman Outline  sources of market power  operating scale  advertising and R&D  limiting competition  buyer market power

46 (c) , I.P.L. Png & D.E. Lehman Buyer market power  buyer with market power restricts purchases to depress price  trades off  marginal expenditure  marginal benefit

47 (c) , I.P.L. Png & D.E. Lehman Operating Scale Buyer market power: Operating Scale

48 (c) , I.P.L. Png & D.E. Lehman Restricting Competition Buyer market power: Restricting Competition  implicit agreement  cartel  horizontal integration

49 (c) , I.P.L. Png & D.E. Lehman  national collective bargaining  employers’ federation, Gesamtmetall  workers’ union, IG Metall  March, 1995, agreed to 3.5% wage rise and cut working hours to 35/week

50 (c) , I.P.L. Png & D.E. Lehman Summary  Sources of market power  Responding to changes in demand and costs  Advertising and R&D  Limiting competition  Buyer market power