IMBA Managerial EconomicsJack Wu

Market PowerDefinition: ability to influence pricemonopoly -- single supplier of good or a

service with no close substituteoligopoly -- few suppliersmonopsony -- single buyer oligopsony -- few suppliers

Sources of Market Powerunique resources

human natural

intellectual propertypatentCopyright

economies of scale / scopeproduct differentiationgovernment regulation

-50

50

70

130

150

250

0.4 0.8 1.2 1.4 1.6 2

demand (marginal benefit)

marginal revenue

Quantity (Million units a year)

Pri

ce (

$ p

er

unit

)

Monopoly: Marginal Revenue and Price

infra-marginal units

Price ($)

Sales

Total Revenue

($)

Marginal Revenue

($)

Total Cost ($)

Marginal Cost ($)

Profit ($)

200 0.0 0 50 -50 190 0.2 38 190 52 10 -40 180 0.4 72 170 56 20 16 170 0.6 102 150 62 30 40 160 0.8 128 130 70 40 58 150 1.0 150 110 80 50 70 140 1.2 168 90 92 60 76 130 1.4 182 70 106 70 76 120 1.6 192 50 122 80 70 110 1.8 198 30 140 90 58 100 2.0 200 10 160 100 40 90 2.2 198 -10 182 110 16

Revenue, Cost, and Profit

Monopoly: Profit Maximum, IOperate at scale where marginal revenue = marginal cost

-50

50

70

130

150

250

0.4 0.8 1.2 1.4 1.6 2

demand (marginal benefit)

marginal revenuemarginal cost

Quantity (Million units a year)

Pri

ce (

$ p

er

unit

)

Monopoly: Profit Maximum, II

Monopoly: Profit Maximum, IIIcontribution margin = total revenue less

variable costprofit-maximizing scale: selling additional

unit does not change the contribution margin

Demand ChangeFind new scale where marginal revenue = marginal cost should change price new scale and price depend on both new demand and costs

0

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100

150

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250

0.4 0.8 1.2 1.6 2

marginal cost

new demand

original demand

new marginal revenueQuantity (Million units a year)

Pri

ce (

$ p

er

unit

)

Prozac: Demand Reduction

Cost ChangeFind new scale where marginal revenue = marginal costchange in MC --> should change price (but

less than change in MC)change in fixed cost --> should not change

price or scale

-50

50

100

150

200

0.4 0.8 1.2 1.6 2

demand

Quantity (Million units a year)

Pri

ce (

$ p

er

unit

)

k

marginal revenue

original marginal cost

new marginal cost

Reduction in Marginal Cost

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?

Advertisingbenefit of advertising -- increment in

contribution marginadvertising elasticity = % increase in demand

from 1% increase in advertising

Advertising: Profit MaximumProfit-maximizing advertising/sales = incremental margin x advertising elasticity

• incremental margin = (price - MC)

Prozac: AdvertisingCompetition from generics wouldreduce incremental marginraise advertising elasticity

Coke vs Pepsi, Nov. 1999Coke

raised prices by 7% increased advertising and other marketing

Pepsi raised price by 6.9%what about advertising?

AnswerPepsi 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)

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

0

30

300

Quantity (Million units a year)

Pri

ce (

Cents

per

unit

)

0

30

Quantity (Million units a year)

Pri

ce (

Cents

per

unit

)

supply

demand

150

60

marginal revenue

marginalcost

demand

(a) Perfect Competition

(b) Monopoly

Market Structure, I

Market Structure, IIRelative to competitive market, monopoly sets higher price produces less earns higher profit

Competitivenessentry and exit barriersperfectly contestable market -- sellers can

enter and exit at no costLerner Index (incremental margin

percentage) -- measures the degree of actual and potential competition

Monopsonybuyer with market power restricts purchases

to depress pricetrades off

marginal expenditure marginal benefit

0

273

350

400

6 8

marginal expenditure

marginal benefit

supply

Quantity (Thousand tons a year)

Pri

ce (

$ p

er

ton)

Monopsony Scale

Discussion 1Pfizer 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.

Discussion 1: continuedWho 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.

Discussion 2Hong 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.)

Discussion 2: continuedTypically, 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?

Discussion 3Discount 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).

Discussion 3: continuedHow 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.