IMBA Managerial Economics
Jack Wu
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
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
Monopoly: Profit Maximum, II
250
demand (marginal benefit)
150
130
70
50
0.4
-50
marginal revenue
marginal cost
0.8
1.2
1.4
1.6
Quantity (Million units a year)
2
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
Prozac: Demand Reduction
Price ($ per unit)
250
200
150
marginal cost
100
original demand
50
new demand
0
0.4
0.8
1.2
1.6
2
new marginal
Quantity (Million units a year) revenue
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
Reduction in Marginal Cost
200
demand
150
marginal revenue
original marginal cost
10
0
50
0.4
-50
new marginal cost
k
0.8
1.2
1.6
Quantity (Million units a year)
2
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 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
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 powerrestricts 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)
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.
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.
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.)
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?
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).
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.
