1. Monopoly

2. 2 (c) 1999-2007, 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. 3 (c) 1999-2007, 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. 4 (c) 1999-2007, I.P.L. Png & D.E. Lehman  Monopsony – single buyer  Oligopsony – few buyers Buyer side Market power Buyer side

5. 5 (c) 1999-2007, I.P.L. Png & D.E. Lehman Outline  sources of market power  operating scale  Advertising and R&D  limiting competition  buyer market power

6. 6 (c) 1999-2007, I.P.L. Png & D.E. Lehman Sources of Market Power  unique resources  Human: super pop star : Wongfei and Advertisement  Natural: Norilsk Nickel

7. 7 (c) 1999-2007, I.P.L. Png & D.E. Lehman

8. 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. 9 (c) 1999-2007, 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. 10 (c) 1999-2007, 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. 11 (c) 1999-2007, I.P.L. Png & D.E. Lehman Sinopec Group (state –owned)  employment ： 640535 （ 2010 ）  revenues ： 273421.9 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. 12 (c) 1999-2007, I.P.L. Png & D.E. Lehman Monopoly Money Machine US Federal Reserve: Monopoly Money Machine Currency in circulation, Dec. 2004 $719 bill. Revenue, 2004 $23.5 bill. Earnings, 2004 $21.3 bill.

13. 13 (c) 1999-2007, I.P.L. Png & D.E. Lehman Outline  sources of market power  operating scale  Advertising and R&D  limiting competition  buyer market power

14. 14 (c) 1999-2007, I.P.L. Png & D.E. Lehman Marginal Revenue and Price Operating Scale: Marginal Revenue and Price -50 50 70 130 150 250 0.40.81.21.41.62 demand (marginal benefit ) marginal revenue Quantity (Million units a year) Price ($ per unit) infra-marginal units

15. 15 (c) 1999-2007, I.P.L. Png & D.E. Lehman Revenue, Cost, and Profit Operating Scale: Revenue, Cost, and Profit

16. 16 (c) 1999-2007, 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.

17. 17 (c) 1999-2007, I.P.L. Png & D.E. Lehman Profit Maximum Operating Scale: Profit Maximum

18. 18 (c) 1999-2007, I.P.L. Png & D.E. Lehman Profit Maximum Operating Scale: Profit Maximum  contribution margin = total revenue less variable cost  profit-maximizing scale: selling additional unit does not change the contribution margin

19. 19 (c) 1999-2007, 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?

20. 20 (c) 1999-2007, I.P.L. Png & D.E. Lehman Demand Operating Scale: Demand set  price, or  sales

21. 21 (c) 1999-2007, 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

22. 22 (c) 1999-2007, I.P.L. Png & D.E. Lehman Prozac: Demand Reduction 0 50 100 150 200 250 0.40.81.21.62 marginal cost new demand original demand new marginal revenue Quantity (Million units a year) Price ($ per unit)

23. 23 (c) 1999-2007, 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

24. 24 (c) 1999-2007, I.P.L. Png & D.E. Lehman Reduction in Marginal Cost Operating Scale: Reduction in Marginal Cost

25. 25 (c) 1999-2007, 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)

26. 26 (c) 1999-2007, 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?

27. 27 (c) 1999-2007, I.P.L. Png & D.E. Lehman Outline  sources of market power  operating scale  advertising and R&D  limiting competition  buyer market power

28. 28 (c) 1999-2007, 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

29. 29 (c) 1999-2007, I.P.L. Png & D.E. Lehman Profit Maximum Advertising: Profit Maximum  Profit-maximizing advertising/sales = incremental margin x advertising elasticity  incremental margin percentage= (price - MC)/MC  Raise advertising/sales if higher incremental margin or higher advertising elasticity  The optimal rule is: advertisement expenditure/total sales revenue=((p-mc)/mc)*ad. elasticity

30. 30 (c) 1999-2007, I.P.L. Png & D.E. Lehman Prozac: Advertising Competition from generics would  reduce incremental margin  raise advertising elasticity

31. 31 (c) 1999-2007, 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

32. 32 (c) 1999-2007, I.P.L. Png & D.E. Lehman Why?  incremental margin of Dollar store is low

33. 33 (c) 1999-2007, I.P.L. Png & D.E. Lehman Advertising Industry/CompanyCurr.SalesAdvertgRatio IBMUSD89,1311,4061.6% Anheuser BuschUSD15,036850 5.7% FostersAUD3,972380 9.6% MicrosoftUSD32,1871,0603.3% General MillsUSD11,244477.0 4.2% KelloggUSD10,177858.0 8.4% SAPEUR7,0251622.3% UnileverEUR39,6724,99912.6% Units: millions

34. 34 (c) 1999-2007, 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

35. 35 (c) 1999-2007, I.P.L. Png & D.E. Lehman R&D Sales Ratios (2005) CompanyUnits (million) Sales RevR&D expR&D/sales General Mills USD11,2441681.5% KelloggUSD10,1771811.8% UnileverEUR39,6729532.4% IBMUSD91,1345,8426.4% MicrosoftUSD39,7886,18415.5% SAPEUR8,5121,08912.8%

36. 36 (c) 1999-2007, I.P.L. Png & D.E. Lehman Outline  sources of market power  operating scale  advertising and R&D  limiting competition  buyer market power

37. 37 (c) 1999-2007, I.P.L. Png & D.E. Lehman Market Structure Limiting Competition: Market Structure

38. 38 (c) 1999-2007, I.P.L. Png & D.E. Lehman Limiting Competition Relative to competitive market, monopoly  sets higher price  produces less  earns higher profit

39. 39 (c) 1999-2007, 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

40. 40 (c) 1999-2007, 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

41. 41 (c) 1999-2007, I.P.L. Png & D.E. Lehman Limiting Competition  implicit agreement  cartel  horizontal integration

42. 42 (c) 1999-2007, 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

43. 43 (c) 1999-2007, I.P.L. Png & D.E. Lehman Vitamins, Inc., 1990-99 Limiting Competition: Vitamins, Inc., 1990-99 world’s top three manufacturers -- Roche (40%), BASF (20%), Rhone-Poulenc (15%)  allocated market shares  fixed prices  rigged bids

44. 44 (c) 1999-2007, I.P.L. Png & D.E. Lehman Visa and MasterCard - Competitors or Collaborators? Limiting Competition: Visa and MasterCard - Competitors or Collaborators?  Visa (50%), MasterCard (25%), Amex (18%), Discover (6%)  “automatically terminate.. [if].. issues.. Discover Cards or American Express Cards” (Visa By-Law 2.10(e))  “With the exception of... Visa, members of MasterCard may not participate”

45. 45 (c) 1999-2007, I.P.L. Png & D.E. Lehman Outline  sources of market power  operating scale  advertising and R&D  limiting competition  buyer market power

46. 46 (c) 1999-2007, 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. 47 (c) 1999-2007, I.P.L. Png & D.E. Lehman Operating Scale Buyer market power: Operating Scale

48. 48 (c) 1999-2007, I.P.L. Png & D.E. Lehman Restricting Competition Buyer market power: Restricting Competition  implicit agreement  cartel  horizontal integration

49. 49 (c) 1999-2007, I.P.L. Png & D.E. Lehman Robert Bosch: Cheating on buyer cartel  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  Robert Bosch negotiated better deal

50. 50 (c) 1999-2007, 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