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
M ARKET P OWER 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
S OURCES OF M ARKET P OWER unique resources human natural intellectual property patent Copyright economies of scale / scope product differentiation government regulation
M ONOPOLY M ONEY M ACHINE US F EDERAL R ESERVE : M ONOPOLY M ONEY M ACHINE Currency in circulation, Dec. 2004 $719 bill. Revenue, 2004 $23.5 bill. Earnings, 2004 $21.3 bill.
-50 50 70 130 150 250 0.40.81.21.41.62 demand (marginal benefit ) marginal revenue Quantity (Million units a year) Price ($ per unit) MONOPOLY: MARGINAL REVENUE AND PRICE infra-marginal units
M ONOPOLY : P ROFIT M AXIMUM, 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.
P ROFIT M AXIMUM O PERATING S CALE : P ROFIT M AXIMUM
M ONOPOLY : P ROFIT M AXIMUM, III contribution margin = total revenue less variable cost profit-maximizing scale: selling additional unit does not change the contribution margin
D EMAND C HANGE Find new scale where marginal revenue = marginal cost should change price new scale and price depend on both new demand and costs
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) P ROZAC : D EMAND R EDUCTION
C OST C HANGE 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
-50 50 10 0 150 200 0.40.81.21.62 demand Quantity (Million units a year) Price ($ per unit) k marginal revenue original marginal cost new marginal cost REDUCTION IN MARGINAL COST
3G L ICENSING “ 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?
A DVERTISING benefit of advertising -- increment in contribution margin advertising elasticity = % increase in demand from 1% increase in advertising
A DVERTISING : P ROFIT M AXIMUM 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
C OKE VS P EPSI, N OV. 1999 Coke raised prices by 7% increased advertising and other marketing Pepsi raised price by 6.9% what about advertising?
A NSWER 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)
D OLLAR G ENERAL “ 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
A DVERTISING 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
R ESEARCH AND D EVELOPMENT 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 S ALES R ATIOS (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%
0 30 300 Quantity (Million units a year) Price (Cents per unit) 0 30 Quantity (Million units a year) Price (Cents per unit) supply demand 150 60 marginal revenue marginal cost demand (a) Perfect Competition (b) Monopoly MARKET STRUCTURE, I
M ARKET S TRUCTURE, II Relative to competitive market, monopoly sets higher price produces less earns higher profit
C OMPETITIVENESS 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
M ONOPSONY buyer with market power restricts purchases to depress price trades off marginal expenditure marginal benefit
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?