1. IMBA Managerial Economics Jack Wu
Monopoly
IMBA Managerial Economics
Jack Wu

2. 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

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

4. 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)

5. Revenue, Cost, and Profit

6. Monopoly: Profit Maximum, I
Operate at scale where marginal revenue = marginal cost

7. 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)

8. Monopoly: Profit Maximum, III
contribution margin = total revenue less variable cost
profit-maximizing scale: selling additional unit does not change the contribution margin

9. Demand Change Find new scale where marginal revenue = marginal cost
should change price
new scale and price depend on both new demand and costs

10. 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)

11. 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

12. 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)

13. 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?

14. Advertising benefit of advertising -- increment in contribution margin
advertising elasticity = % increase in demand from 1% increase in advertising

15. Advertising: Profit Maximum
Profit-maximizing advertising/sales = incremental margin x advertising elasticity
incremental margin = (price - MC)

16. Prozac: Advertising Competition from generics would
reduce incremental margin
raise advertising elasticity

17. 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?

18. 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)

19. 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

20. Market Structure, I (a) Perfect Competition (b) Monopoly demand demand60
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)

21. Market Structure, II Relative to competitive market, monopoly
sets higher price
produces less
earns higher profit

22. 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

23. Monopsony marginal expenditure marginal benefit
buyer with market power restricts purchases to depress price
trades off
marginal expenditure
marginal benefit

24. Monopsony Scale marginal expenditure supply Price ($ per ton)
400
supply
350
Price ($ per ton)
273
marginal benefit 6 8
Quantity (Thousand tons a year)

25. 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.

26. 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.

27. 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.)

28. 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?

29. 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).

30. 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.