2 Introduction Managerial Problem Drug firms have patents that expire after 20 years and one expects drug prices to fall once generic drugs enter the market. However, as evidence shows, often prices go up after the expiration. Why can a firm with a patent-based monopoly charge a high price? Why might a brand-name pharmaceutical's price rise after its patent expires? Solution Approach We need to understand the decision-making process for a monopoly: the sole supplier of a good for which there is no close substitute.
3 Marginal Revenue and Demand Marginal Revenue: MR = ΔR/Δq A firm s marginal revenue, MR, is the change in its revenue from selling one more unit. Marginal Revenue and Price A competitive firm that faces a horizontal demand and Δq=1, can sell more without reducing price. So, MR = ΔR = B = p 1
4 Marginal Revenue and Demand Marginal Revenue: MR = ΔR/Δq A firm s marginal revenue, MR, is the change in its revenue from selling one more unit. Marginal Revenue and Downward Demand A monopoly that faces a downwardsloping market demand and Δq=1, R 1 = B-C = p 2 - C
5 MR Curve for a Linear Demand With a linear demand curve, the MR curve is a straight line that starts at the same point on the vertical (price) axis as the demand curve but has twice the slope MR Function: MR = p + (Δp/ΔQ) Q The monopolist MR function is lower than p because the last term is negative. When inverse demand p = 24 Q, MR = 24 2Q MR Function with Calculus: MR(Q)=dR(Q)/dQ When inverse demand p = 24 Q, R(Q) = (24 Q)Q = 24Q Q 2, MR(Q)=24 2Q
6 MR & Price Elasticity of Demand The MR at any given quantity depends on the demand curve s height (the price) and shape. The shape of the demand curve at a particular quantity is described by the price elasticity of demand, ε = ( Q/Q)/( p/p) < 0 (percentage change in quantity demanded after a percentage change in price).
7 MR & Elasticity MR & Elasticity Relationship: MR = p (1 + 1/ε) This key relationship says MR is closer to price as demand becomes more elastic. Where the demand elasticity is unitary, ε = 1, MR is zero. Where the demand curve is inelastic, 1 < ε 0, MR is negative. Where the demand cure is perfectly elastic, ε = -, MR is p.
8 Monopoly Profit Maximization Choosing Price or Quantity Any firm maximizes profit where its marginal revenue and marginal cost are equal. Rule for monopoly maximization: MR(Q)=MC(Q) A monopoly can adjust its price or its quantity to maximize profit. Monopolist Sets One, Market Decides the Other Whether the monopoly sets its price or its quantity, the other variable is determined by the downward sloping market demand curve. The monopoly faces a trade-off between a higher price and a lower quantity or a lower price and a higher quantity. Either Maximize Profit Setting price or quantity are equivalent for a monopoly. We will assume it sets quantity.
9 Monopoly Profit Maximization Two Steps to Maximize Profit: 1 st, Output Decision Profit is maximized where marginal profit equals zero, MR(Q)=MC(Q)
10 Monopoly Profit Maximization Two Steps to Maximize Profit: 1 st, Output Decision Profit maximizing output is at point e, Q=6, p=18, π=60. This is the maximum profit in panel b. At quantities smaller than 6 unit, the monopoly s MR > MC, so its marginal profit is positive. By increasing its output, it raises its profit. At quantities greater than 6 units, the monopoly s MC > MR, so its marginal profit is negative. By reducing its output, it raises its profit. A monopoly s profit is maximized in the elastic portion of the demand curve.
11 Monopoly Profit Maximization Two Steps to Maximize Profit: 2 nd, Shutdown Decision A monopoly shuts down to avoid making a loss in the short run if its price is below its AVC at its profit-maximizing (or loss minimizing) quantity. The Figure illustrates a short run case. At the profit-maximizing output, p > AC (Q=6, AVC = 6, p = 18). So, the monopoly chooses to produce and it makes a positive profit. In the long run, the monopoly shuts down if the price is less than its average cost.
12 Monopoly Profit Maximization Using Calculus, Output Decision: dπ(q) / dq = 0 By setting the derivative of the profit function with respect to Q equal to zero, we have an equation that determines the profitmaximizing output dπ(q)/dq = dr(q)/dq dc(q)/dq = MR MC = 0 In the Figure, MR = 24 2Q = 2Q = MC Q=6. Substituting Q = 6 into the inverse demand function, p = 24 Q = 24 6 = 18. Using Calculus, Shutdown Decision At Q = 6, AVC = Q 2 /Q = 6, which is less than the price. So, the monopoly does not shut down.
13 Market Power Market Power & the Shape of the Demand Curve If the monopoly faces a very inelastic demand curve (steep) at the profitmaximizing quantity, it would lose few sales if it raises its price. However, if the demand curve is very elastic (flat) at that quantity, the monopoly would lose substantial sales from raising its price by the same amount. Profit-Maximizing Price: p = [1/(1+1/ε)] MC The monopoly s profit-maximizing price is a ratio times the marginal cost and the ratio depends on the elasticity. If ε = -1.01, only slightly elastic, the ratio is 101 and p = 101 MC If ε = -3, more elastic, the ratio is only 1.5 and p = 1.5 MC If ε = -, perfectly elastic, the ratio shrinks to 1 and p = MC
14 Market Power The Lerner Index or Price Markup: (p - MC)/p The Lerner Index measures a firm s market power: the larger the difference between price and marginal cost, the larger the Lerner Index. This index can be calculated for any firm, whether or not the firm is a monopoly. Lerner Index and Elasticity: (p MC)/p = - 1/ε The Lerner Index or price markup for a monopoly ranges between 0 and 1. If ε = -1.01, only slightly elastic, the monopoly markup is 0.99 (99%) If ε = -3, more elastic, the monopoly markup is 0.33 (33%) If ε = -, perfectly elastic, the monopoly markup is zero
15 Market Power Sources of Market Power Availability of substitutes, number of firms and proximity of competitors determine market power. Less Power with Less power with better substitutes: When better substitutes are introduced into the market, the demand becomes more elastic (Xerox pioneered plain-paper copy machines until ) Less power with more firms: When more firms enter the market, people have more choices, the demand becomes more elastic. Less power with closer competitors: When firms that provide the same service locate closer to this firm, the demand becomes more elastic (Burger King and McDonald s close to each other).
16 Take home assignments Chapter 9 Exercise 1.6 Exercise 1.7 Exercise 1.11 Exercise 2.4 Exercise 2.6
17 Monopoly (part 2)
18 Deadweight Loss of Monopoly Market Failure: non-optimal allocation of goods & services with economic inefficiencies (price is not marginal cost) A monopoly sets p > MC causing consumers to buy less than the competitive level of the good. So society suffers a deadweight loss. In the Figure, the monopolist s maximizing q and p are 6 and $18. The competitive values would be 8 and $16. The deadweight loss of monopoly is C E. Potential surplus that is wasted because less than the competitive output is produced.
19 Causes of Monopoly 1. Cost Based Monopolies Two cost structures facilitate the creation of a monopoly: A firm may have substantially lower costs than potential rivals: cost advantage. A firm may produce any given output at a lower cost than two or more firms: natural monopoly. Cost Advantage A low-cost firm is a monopoly if it sells at a price so low that other potential competitors with higher costs would lose money. No other firm enters the market. The sources of cost advantage over potential rivals are diverse: superior technology or better way of organizing production, control of an essential facility, control of a scarce resource
20 Natural Monopoly One firm can produce the total output of the market at lower cost than two or more firms could: C(Q) < C(q 1 ) + + C(q n ), where Q = q 1 + q q n is the sum of the output of any n firms where n 2 firms. Economies of scale explain this outcome: a natural monopoly has the same strictly declining average cost curve When just one firm is the cheapest way to produce any given output level, governments often grant monopoly rights to public utilities of water, gas, electric power, or mail delivery.
21 Causes of Monopoly 2. Government Creation of Monopoly Governments grant a license, monopoly rights, or patents Barriers to Entry Governments create monopolies either by making it difficult for new firms to obtain a license to operate or by explicitly granting a monopoly right to one firm, thereby excluding other firms. By auctioning a monopoly to a private firm, a government can capture the future value of monopoly earnings. However, for political or other reasons, governments frequently do not capture all future profits. Patents A patent is an exclusive right granted to the inventor of a new and useful product, process, substance, or design for a specified length of time. The length of a patent varies across countries, although it is now 20 years in the United States.
22 Networks & Behavioral Economics Network Externalities A good has a network externality if one person s demand depends on the consumption of a good by others. If a good has a positive network externality, its value to a consumer grows as the number of units sold increases. A telephone and fax are classical examples. For a network to succeed, it has to achieve a critical mass of users enough adopters that others want to join. A customer can get a direct benefit from a larger network, or an indirect benefit from complementary goods that are offered when a product has a critical mass of users (apps for a smart phone). Network Externalities & Behavioral Economics Bandwagon effect: A person places greater value on a good as more and more other people possess it Snob effect: A person places greater value on a good as fewer and fewer other people possess it
23 Networks & Behavioral Economics Network Externalities & Monopoly Because of the need for a critical mass of customers in a market with a positive network externality, we sometimes see only one large firm surviving. The Windows operating system largely dominates the market not because it is technically superior to Apple s operating system or Linux but because it has a critical mass of users. But having obtained a monopoly, a firm does not necessarily keep it. Managerial Implication: Introductory Pricing Managers should consider initially selling a new product at a low introductory price to obtain a critical mass. By doing so, the manager maximizes long-run but not short-run profit.
24 Advertising Advertising and Net Profit A successful advertising campaign shifts the monopolist market demand curve outward and makes it less elastic. In the Figure, D 2 is to the right and less elastic than D 1.
25 Advertising Deciding Whether to Advertise Do it only if firm expects net profit (gross profit minus the cost of advertising) to increase. In the Figure, gross profit is B. How Much to Advertise Do it until its marginal benefit (gross profit or marginal revenue) equals its marginal cost
26 Advertising and calculus Using Calculus: π (Q,A) = R (Q,A) C (Q) - A Profit is revenue minus cost. Advertising, A, is a fixed cost and affects revenue, R(Q, A) = p(q, A)Q. The monopoly maximizes its profit by choosing Q and A. First Order Condition: π (Q,A) / Q = 0 R(Q,A) / Q C (Q) / Q = 0 The monopoly should set its output so that MR = MC First Order Condition: π (Q,A) / A = 0 R(Q,A) / A 1 = 0 The monopoly should advertise to the point where its marginal revenue or marginal benefit from the last unit of advertising, R/ A, equals the marginal cost of the last unit of advertising, $1.
27 Managerial Solution Managerial Problem Drug firms have patents that expire after 20 years and Congress expects drug prices to fall once generic drugs enter the market. However, evidence shows, prices went up after the expiration. Why can a firm with a patent-based monopoly charge a high price? Why might a brand-name pharmaceutical's price rise after its patent expires? Solution When generic drugs enter the market after the patent expires, the demand curve facing the brand-name firm shifts to the left, and rotates to become less elastic at the original price. Price sensitive consumers switch to the generic, but loyal customers prefer the brand-name drug (familiar and secure product for them). Elderly and patients with generous insurance plans fit this group.
28 More on monopoly pricing: Introduction Managerial Problem Heinz dominates the ketchup market in the U.S., Canada, and U.K. When Heinz goes on sale, switchers purchase Heinz rather than the low-price generic ketchup. How can Heinz s managers design a pattern of sales that maximizes Heinz s profit? Under what conditions does it pay for Heinz to have a policy of periodic sales? Solution Approach We need to examine how monopolies and other noncompetitive firms set prices. These firms can earn a higher profit setting different prices for the same good or service depending on consumer s willingness to pay (non-uniform pricing).
29 What is Price Discrimination Price Discrimination and Equal Costs Price discrimination is based on charging different prices even for units of a good that cost the same to produce. Different Prices and Different Costs Newsstand prices and subscription prices for magazines differ in large part because of the higher cost of selling at a newsstand rather than mailing magazines directly to consumers. This is not price discrimination. Price Discrimination If a magazine standard subscription rate is higher than a college student subscription rate, it is price discrimination because the two subscriptions are identical in every respect except the price.
30 Price Discrimination Why Price Discrimination Pays For almost any good or service, some consumers are willing to pay more than others. Price discrimination increases profit above the uniform pricing level through two channels. Channel 1: Higher Prices for Some Price discrimination can extract additional consumer surplus from consumers who place a high value on the good. Channel 2: Attract New Customers Price discrimination can simultaneously sell to new customers who would not be willing to pay the profit-maximizing uniform price.
31 Conditions for Price Discrimination 1 st Condition, A Firm Must Have Market Power A monopoly, an oligopoly, or a monopolistically competitive firm might be able to price discriminate. A perfectly competitive firm cannot. 2 nd Condition, A Firm Must Identify Groups with Different Price Sensitivity If consumers have different demands, a firm must identify how they differ. Disneyland knows tourists and local residents differ in their willingness to pay and use driver licenses to identify them. 3 rd Condition, A Firm Must Prevent Resale If resale is easy, price discrimination doesn t work because of only lowprice sales. The biggest obstacle to price discrimination is a firm s inability to prevent resale.
32 Types of Price Discrimination Type 1, Perfect Price Discrimination The firm sells each unit at the maximum amount any customer is willing to pay. Price differs across consumers, and may differ too for a given consumer. Type 2, Group Price Discrimination The firm charges each group of customers a different price, but it does not charge different prices within the group. Type 3, Nonlinear Price Discrimination The firm charges a different price for large purchases than for small quantities so that the price paid varies according to the quantity purchased.
33 Perfect Price Discrimination How a Firm Perfectly Price Discriminates A firm with market power that can prevent resale and has full information about its customers willingness to pay price discriminates by selling each unit at its reservation price the maximum amount any consumer would pay for it. The maximum price for any unit of output is given by the height of the demand curve at that output level. Perfectly Price Discrimination: Price = MR A perfectly price-discriminating firm s marginal revenue is the same as its price. So, the firm s marginal revenue curve is the same as its demand curve
34 Efficiency of Perfect Price Discrimination Perfect price discrimination is efficient: It maximizes the sum of consumer surplus and producer surplus. All the surplus goes to the firm, consumer surplus is zero. In the Figure, at the competitive market equilibrium, e c, consumer surplus is A + B + C and producer surplus is D + E. At the perfect price discrimination eqm, Qd=Qc, no deadweight loss occurs, all surplus goes to the monopoly.
35 Difficulties with Perfect Price Discrimination Individual Price Discrimination Perfect price discrimination is rarely fully achieved in practice. Firms can still increase profits with imperfect individual price discrimination: charge individual-specific prices to different consumers, which may or may not be the consumers reservation prices. Transaction Costs and Price Discrimination It is often too difficult or costly to gather information about each customer s reservation price for each unit of the product (high transaction costs). However, recent advances in computer technologies have lowered these transaction costs. Hotels, car and truck rental companies, cruise lines, airlines, and other firms are increasingly using individual price discrimination.
36 Group Price Discrimination Conditions for Group Price Discrimination Group price discrimination: potential customers are divided into two or more groups with different prices for each group (single price within a group). Consumer groups may differ by age, location, or in other ways. A firm must have market power be able to identify groups with different reservation prices prevent resale.
37 Group Price Discrimination: A Graphic Approach If a firm can prevent resale between countries and has a common MC, then it can maximize profit by acting like a traditional monopoly in each country separately. Firm acts as a traditional monopoly in each country. U.S. market: MR A =1, Q A =5.8, p A =$29. U.K. market: MR B =1, Q B =2, p B =$39.
38 Group Price Discrimination: A Formal Approach Profit: (Q A, Q B ) = π A (Q A ) + π B (Q B ) = [R A (Q A ) mq A ] + [R B (Q B ) mq B ] Total profit is the sum of the profits in each market. In each country, profit is revenue minus cost (both depend on the Q sold in each country). To maximize profit: differentiate the monopoly s profit function with respect to each quantity, holding the other quantity fixed, and set derivatives equal to zero. Market 1: (Q A, Q B ) / Q A = 0 (Q A, Q B ) / Q A = dr A (Q A )/dq A m = 0 The monopoly sets MR = MC in this market, so MR A = dr A (Q A )/dq A = m Market 2: (Q A, Q B ) / Q B = 0 (Q A, Q B ) / Q B = dr B (Q B )/dq B m = 0 The monopoly sets MR = MC in this market, so MR B = dr B (Q B )/dq B = m
39 Group Price Discrimination: A Formal Approach Group Price Discrimination and Elasticities We know MR A = m = MR B We also know from Chapter 9 that MR = p (1 + 1/ε) So, MR A = p A (1 + 1/ε A ) = m = p B (1 + 1/ε B ) = MR B Implication: p B / p A = (1 + 1/ε A ) / (1 + 1/ε B ) The ratio of prices depend on the elasticity values in these two markets.
40 Group Price Discrimination Identifying Groups: Divide Buyers Based on Observable Characteristics The firm believes observable characteristics are associated with unusually high or low reservation prices or demand elasticities. Movie theaters price discriminate using the age of customers. Higher prices for adults than for children. Identifying Groups: Divide Buyers Based on Their Actions Allow consumers to self-select the group to which they belong depending on their opportunity cost of time. Customers may be identified by their willingness to spend time to buy a good at a lower price (buy at the store; low opportunity cost) or to order goods and services in advance of delivery (phone or online shopping; high opportunity cost).
41 Group Price Discrimination Effects on Total Surplus: Group Price Discrimination vs. Perfect Competition Consumer surplus is greater and more output is produced with perfect competition than with group price discrimination. Group price discrimination transfers some of the competitive consumer surplus to the firm as additional profit and causes deadweight loss due to reduced output. Effects on Total Surplus: Group Price Discrimination vs. Single-Price Monopoly From theory alone, we cannot tell whether total surplus is higher if the monopoly uses group price discrimination or if it sets a single price. The closer the firm comes to perfect price discrimination using group price discrimination (many groups rather than just two), the more output it produces, and the less production inefficiency the greater the total surplus.
42 Nonlinear Price Discrimination Characteristics and Conditions Many firms, with market power and no resale, are unable to determine high reservation prices. However, such firms know a typical customer s demand curve is downward sloping. Such a firm can price discriminate by letting the price each customer pays vary with the number of units the customer buys (nonlinear price discrimination).
43 Nonlinear Price Discrimination: Block Pricing A firm charges one price per unit for the first block purchased and a different price per unit for subsequent blocks. Used by gas, electric, water, and other utilities. In panel a of the Figure, the firm charges a price of $70 on any quantity between 1 and 20 1 st block and $50 for the 2 nd block. In panel b, the firm can set only a single price of $60. With block pricing, consumer surplus is lower, total surplus is higher and deadweight loss is lower. The firm and society are better off but consumers lose. The more block prices that a firm can set, the closer the firm gets to perfect price discrimination.
44 Take home assignments Chapter 9 Exercise 3.2 Exercise 3.4 Exercise 4.2 Exercise 5.3 Chapter 10 Exercise 2.5 Exercise 3.4