1. M ONOPOLY IMBA NCCU Managerial Economics Jack Wu

2. CASE: ATORVASTATIN( 降膽固醇藥 )BY PFIZER Pfizer markets atorvastatin under the brand name “Lipitor”. In 2010, Lipitor was Pfizer’s best-selling drug. Even while protected by patent, Lipitor faced competition from other statins- particularly simvastatin. The US patent on simvastatin, owned by Merck, expired in 2006, and Merck cut the price of Zocor, its branded simvastatin. Pfizer’s US patent on atorvastatin expired in June 2011.

3. GENERIC DRUG In 2003, Ranbaxy Lab (Indian generic drug manufacturer) filed for a generic version of atorvastatin. To encourage the manufacture of generic drugs, the H-W Act provides six months of exclusivity to the first generic manufacturer approved by the FDA. The six-month period of generic exclusivity begins immediately after the expiry of the patent of the original drug. Typically, the exclusive generic manufacturer would price its drug at 70-80% of the price of the original patented drug. Once the generic exclusivity expires and open competition ensues, the price may fall to 5% of the price of the patented drug.

4. MANAGERIAL ECONOMICS QUESTIONS Pfizer must decide how to manage the competition. How much should it spend on advertising? At what scale should Pfizer produce the branded drug? How would generic production of atorvastatin affect the market for the ingredients in the production of the drug?

5. 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

6. 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

7. S OURCES OF M ARKET P OWER unique resources human natural intellectual property patent Copyright economies of scale / scope product differentiation government regulation

8. -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

9. REVENUE, COST, AND PROFIT

10. 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.

11. P ROFIT M AXIMUM O PERATING S CALE : P ROFIT M AXIMUM

12. 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

13. 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

14. 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

15. 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?

16. A DVERTISING benefit of advertising -- increment in contribution margin advertising elasticity = % increase in demand from 1% increase in advertising

17. A DVERTISING : P ROFIT M AXIMUM Profit-maximizing advertising/sales = incremental margin x advertising elasticity incremental margin = (price - MC)

18. PROZAC: ADVERTISING Competition from generics would reduce incremental margin raise advertising elasticity

19. 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?

20. 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)

21. 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

22. 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

23. 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

24. 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%

25. 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

26. M ARKET S TRUCTURE, II Relative to competitive market, monopoly sets higher price produces less earns higher profit

27. 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

28. M ONOPSONY buyer with market power restricts purchases to depress price trades off  marginal expenditure  marginal benefit

29. 0 273 350 400 68 marginal expenditure marginal benefit supply Quantity (Thousand tons a year) Price ($ per ton) MONOPSONY SCALE

30. DISCUSSION QUESTION Suppose that Iron Music has the copyright to the latest CD of the heavy Iron band. The market demand curve for the CD is Q=800-100P, where Q represents quantity demanded in thousands and P represents the price in dollars. Production requires a fixed cost of $100,000 and a constant marginal cost of $2 per unit. (A)What price will maximize profits? (B)At that price, how will be the sales? (C)What is the maximum profit? (D)Calculate the Lerner Index at the profit-maximizing scale of production. (E)Suppose that the fixed cost rises to $200,000. How would this affect the profit-maximizing price?