LECTURE EIGHT:
MARKET POWER
IPEM Tohoku University
Managerial Economics
Lecturer: Jack Wu
Period 1 and 2/ February 17
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
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 buyers
SOURCES OF MARKET POWER

unique resources
human
 natural


intellectual property
patent
 Copyright

economies of scale / scope
 product differentiation
 government regulation

MONOPOLY: MARGINAL REVENUE
AND PRICE
250
infra-marginal
units
150
130
demand (marginal benefit)
70
marginal revenue
50
0.4
-50
0.8
1.2
1.4
1.6
Quantity (Million units a year)
2
REVENUE, COST, AND PROFIT
Price
($)
200
190
180
170
160
150
140
130
120
110
100
90
Sales
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
2.2
Total
Revenue
($)
0
38
72
102
128
150
168
182
192
198
200
198
Marginal
Revenue
($)
190
170
150
130
110
90
70
50
30
10
-10
Total
Cost ($)
50
52
56
62
70
80
92
106
122
140
160
182
Marginal
Cost
($)
10
20
30
40
50
60
70
80
90
100
110
Profit
($)
-50
-40
16
40
58
70
76
76
70
58
40
16
MONOPOLY: PROFIT MAXIMUM, 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.
OPERATING SCALE:
PROFIT MAXIMUM
MONOPOLY: PROFIT MAXIMUM, III
contribution margin = total revenue less variable
cost
 profit-maximizing scale: selling additional unit
does not change the contribution margin

DEMAND CHANGE
Find new scale where marginal revenue = marginal
cost
 should change price
 new scale and price depend on both new demand
and costs
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
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?
ADVERTISING
benefit of advertising -- increment in contribution
margin
 advertising elasticity = % increase in demand
from 1% increase in advertising

ADVERTISING: PROFIT MAXIMUM
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
COKE VS PEPSI, NOV. 1999

Coke
raised prices by 7%
 increased advertising and other marketing


Pepsi
raised price by 6.9%
 what about advertising?

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 brandswitchers, 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
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

MARKET STRUCTURE
Relative to competitive market, monopoly
 sets higher price
 produces less
 earns higher profit
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

MONOPSONY
buyer with market power restricts purchases to
depress price
 trades off

marginal expenditure
 marginal benefit

MONOPSONY SCALE
marginal expenditure
400
supply
350
273
0
marginal benefit
6
8
Quantity (Thousand tons a year)