MONOPOLY IMBA NCCU Managerial Economics Jack Wu 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 ADVERTISING Industry/Company Curr. Sales Advertg Ratio IBM USD 89,131 1,406 1.6% Anheuser Busch USD 15,036 850 5.7% Fosters AUD 3,972 380 9.6% Microsoft USD 32,187 1,060 3.3% General Mills USD 11,244 477.0 4.2% Kellogg USD 10,177 858.0 8.4% SAP EUR 7,025 162 2.3% Unilever EUR 39,672 4,999 12.6% Units: millions 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 R&D SALES RATIOS (2005) Company Units Sales Rev R&D exp R&D/sales (million) USD 11,244 168 1.5% USD 10,177 181 1.8% Unilever EUR 39,672 953 2.4% IBM USD 91,134 5,842 6.4% Microsoft USD 39,788 6,184 15.5% SAP EUR 8,512 1,089 12.8% General Mills Kellogg MARKET STRUCTURE, I (a) Perfect Competition (b) Monopoly demand 30 Price (Cents per unit) Price (Cents per unit) demand supply 0 300 Quantity (Million units a year) 60 marginal cost 30 marginal revenue 0 150 Quantity (Million units a year) MARKET STRUCTURE, II 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)