Business 33001: Microeconomics Owen Zidar University of Chicago Booth School of Business Week 7 Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 1 / 88
Today s Class 1 Introduction Context: how monopolies fit into microeconomics Overview of Monopolies 2 Revenues Marginal revenue Relation to elasticities Amazon example 3 Monopoly production: how much to sell and at what markup Example problem Markups 4 Social Costs of Monopoly Uber example 5 Advertising Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 2 / 88
Motivation: why should you care? 1 Understand why monopolies exist 2 Production decisions of firms with market power Framework for thinking about how much to sell Framework for thinking about how much to advertise 3 Pricing Strategy Framework for thinking about optimal pricing and how much to mark up prices over costs 4 Applications Amazon pricing strategy Benefits of uber Introduction to some key anti-trust tradeoffs (see Tirole Nobel lecture) Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 3 / 88
Context: Market Structure and Individual Firm Demand Competitive Industry that we have studied thus far: Individual firms are small Products have close substitutes Market demand is downward sloping Individual firm demand is perfectly elastic (flat) Individual demand for my product goes to 0 if I offer above market price Individual demand very large for below market price Can sell any amount at market price Industries like this: Sellers of commodities (natural gas, wheat) Close enough: small businesses, with many (potential) entrants Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 4 / 88
Context: Market Structure and Individual Firm Demand Monopoly : Only producer of a good Market demand is downward sloping Individual demand curve is Market demand curve Oligopoly : in between One of a few large producers Individual firm demand depends on behavior (pricing) of other firms Firm may or may not have pricing power Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 5 / 88
Overview of Monopolies Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 6 / 88
What is a Monopoly?: Definition A monopolist is a producer that faces no competition from other firms Two key aspects for being the sole producer of a good: 1 No Entry: competitors cannot enter the industry 2 No close substitutes for the product produced by the monopolist Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 7 / 88
Examples: producers that are the only seller in a market Examples: Coca-cola has a monopoly on Dasani water. Is this a real monopoly? No, because there are many close substitutes Comcast has a monopoly on cable in Chicago. Is this a real monopoly? Probably, but there are some close substitutes (e.g., DirectTV), but they really are not the same Question: does Microsoft have a monopoly on operating systems? This is very complicated and comes down to the definitions of a monopoly, of entry, and of the market These firms have some pricing power not perfectly competitive. Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 8 / 88
Reasons for Monopoly Where does pricing power come from? Neither close substitutes nor entry 1 Scarcity: Land, Property (beachfront, city blocks) Natural Resources Comparative advantages (experience, skill) China Consolidates Grip on Rare Earths NYT, Sept 2011 China produces nearly 95 percent of the world s rare earth materials, which are vital for green-energy products including giant wind turbines, hybrid gasoline-electric cars and compact fluorescent bulbs. China has been imposing tariffs and quotas on its rare earth exports for several years, curtailing global supplies and forcing prices to rise eightfold to fortyfold during that period for the various 17 rare earth elements... The average price for fluorescent bulbs has risen 37 percent this year. Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 9 / 88
Reasons for Monopoly Where does pricing power come from? Neither close substitutes nor entry 2 Legal entry restrictions: Patents, Copyrights Zoning restrictions Liquor licenses Taxi medallions Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 10 / 88
Reasons for Monopoly Where does pricing power come from? Neither close substitutes nor entry 2 Legal entry restrictions: Drug Firms Face Billions in Losses as Patents End NYT, March 2011 Because of patent expirations, this year the drug industry will lose control over more than 10 megamedicines whose combined annual sales have neared $50 billion. At the end of November, Pfizer stands to lose a $10-billion-a-year revenue stream when the patent on its blockbuster cholesterol drug Lipitor expires and cheaper generics begin to cut into the company s huge sales. Sales of Lipitor are Leveling Off NYT, Jan 2012 Two new generic versions came on the market at the beginning of December, and in the first full week of the month, they had siphoned off a combined 59 percent of sales. Pfizer is fighting hard to retain sales, with big discounts to patients and insurers. Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 11 / 88
Monopolies Where does pricing power come from? Neither close substitutes nor entry 3 Entry Costs: Branding / Marketing Trade Secrets Fixed investment costs (factories, train tracks, storefronts) Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 12 / 88
Monopolies Where does pricing power come from? Neither close substitutes nor entry 3 Entry Costs: Thomas : The Original Nooks and Crannies English Muffins Owen Zidar (Chicago Booth) Microeconomics Competitor: Left Thomas : Right Week 7: Monopoly 13 / 88
Monopolies For our purposes today, a monopoly is a firm with pricing power. Consider an individual firm facing some fixed demand curve Demand not perfectly elastic ie, some pricing power Legal monopoly? Other firms in its market? Not relevant Key assumption: other firms might exist, but don t react How much to sell, and at what prices? Future lecture: Interaction of firms with some market power (oligopoly) Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 14 / 88
Monopoly Pricing NYTimes, 2012: White House and the F.D.A. Often at Odds In February 2011, the F.D.A. approved an application from KV Pharmaceutical to sell 17P, a decades-old drug used to prevent premature births. Since KV s version, called Makena, was the only one officially approved, the F.D.A. would normally have banned the sale of cheaper unapproved ones. For years, pharmacists had been making unapproved versions of this injectable form of progesterone for $200 to $400 for a 20-week course. Though F.D.A. officials were then not aware of any safety complaints about the pharmacy-made 17P, they worried about repeated instances over the years when other pharmacy-made drugs had been found to lack potency or be contaminated with deadly bacteria. Once it had won F.D.A. approval, KV announced its price $30,000 for a 20-week course. Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 15 / 88
Maximizing Profit A firm seeks to maximize Profit: Profit = Revenue Costs Say firm produces a single output good Revenue is Price Quantity (linked by demand curve) Costs depend on Quantity produced Optimal quantity equates marginal revenue and marginal cost Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 16 / 88
Revenues and Marginal Revenues Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 17 / 88
Preliminaries: Inverse Demand Curves Demand Curve Q(P) : At a given price, what is the most units can I sell? Q declining in P Revenue as a function of price: P Q(P) Inverse Demand Curve P(Q) : For a given number of sales, what is the highest price I can charge? P declining in Q Revenue as a function of quantity: Q P(Q) Demand and Inverse Demand are equivalent Let Q(P) = 10 2P. What is P(Q)? P(Q) = 5 Q 2 Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 18 / 88
Perfect competition: perfectly elastic (flat) demand curve Revenue = P Q P Revenues at q P Revenues at q + 1 p p Rev Rev q Q q 1 Q Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 19 / 88
Monopoly: downward-sloping demand curve Revenue = P Q P Revenues at q P Revenues at q + 1 p Rev P Q p Rev P Q q Q q 1 Q Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 20 / 88
Monopolists face price-quantity tradeoff Monopolist: High Price: large profit per unit, sell few units Low Price: small profit per unit, sell many units Best choice: set price that maximizes total profits, given this tradeoff Perfectly competitive firms do not face this trade-off: Higher Price: no purchases Lower Price: lose money on every unit Your own output does not affect price Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 21 / 88
Monopolists face price-quantity tradeoff Revenue as a function of quantity: Rev(Q) = P(Q) Q P Rev p P Q Rev q Q High P, Low Q Low P, High Q Q Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 22 / 88
Example Suppose P(Q) = 5 Q 2 What is the expression for demand? What is revenue? Rev(Q) = P(Q) Q = ( 5 Q ) Q 2 Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 23 / 88
Example Revenue Table Revenues Graph Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 24 / 88
Marginal Revenue The slope of the revenue function is marginal revenue MR = drevenue dq Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 25 / 88
Marginal Revenue Since Revenue = P(Q) Q, we have 1 MR = dp dq Q + P This expression shows the quantitive price-quantity tradeoff. Since dp dq < 0 (i.e., demand is downward-sloping), marginal revenue is less than the price MR is decreasing in Q because producing more quantity lowers the price, so get less revenue per unit 1 by Product Rule for differentiation Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 26 / 88
Example MR = drevenue dq = d dq ) (5Q Q2 = 5 Q 2 MR Table MR Graph Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 27 / 88
Revenue and Marginal Revenue Marginal Revenue is the derivative of Revenue Rev measured in $, MR in $/unit Rev P P Q MR Q Positive MR Negative MR 0 q Q q Q If Rev is upside-down-u-shaped, then MR is decreasing Goes from positive to negative Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 28 / 88
Revenue and Marginal Revenue P MR Q P Q 0 q Q Notice that MR(0) = P(0): MR(Q) = P(Q) + QP (Q), so MR(0) = P(0) + 0P (0) = P(0) What is the interpretation of this? Normally, you gain P(Q) but lower the price of all previous units. On the first unit, there are no previous units you only gain P(Q) Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 29 / 88
Revenue and Marginal Revenue Linear (Inverse) Demand: P(Q) = A BQ Rev(Q) = AQ BQ 2 MR(Q)? MR(Q) = A 2BQ P A P Q AB Q A 2 MR Q A2 B Q A 2 B A B Q Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 30 / 88
Recall Elasticities from Week 1: Example We have demand Q(P) = 10 2P from the example before dq(p) dp = 2 So the demand elasticity ε D is: ε D = dq(p) dp P Q = 2 P Q Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 31 / 88
Revenues and Elasticities MR = dp dq Q + P ( ) dp Q MR = P dq P + 1 ( ) MR = P MR = P 1 dq dp P Q ( 1 ε D + 1 MR is positive if the price elasticity of demand is less than -1 (i.e., on the elastic portion of the demand curve) + 1 ) Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 32 / 88
Revenues and Elasticities: Example We can plug the demand elasticity ε D = 2 P Q into the MR formula: ( ) 1 MR = P ε D + 1 So MR is: ( 1 MR = P 2 P Q + 1 ) = Q 2 + P = Q 2 + (5 Q 2 ) = 5 Q Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 33 / 88
Revenues and Elasticities: Example Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 34 / 88
Revenues and Elasticities: Example Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 35 / 88
Revenues and Elasticities: Example Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 36 / 88
Revenues and Elasticities: Example Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 37 / 88
Revenues and Elasticities P Elastic Rev Unit Elasticity p Unit Elasticity Rev P Q Inelastic q Q Elastic Inelastic Q Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 38 / 88
Revenues and Elasticities Hachette wants to set own prices for ebooks, not charge flat $9.99 Spring 2014: Amazon delays shipping or stops selling Hachette books Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 39 / 88
Revenues and Elasticities Amazon releases statement, July 2014: Many e-books are being released at $14.99 and even $19.99. That is unjustifiably high for an e-book. With an e-book, there s no printing, no over-printing, no need to forecast, no returns, no lost sales due to out-of-stock, no warehousing costs, no transportation costs, and there is no secondary market e-books cannot be resold as used books. E-books can be and should be less expensive. It s also important to understand that e-books are highly price-elastic. This means that when the price goes up, customers buy much less. We ve quantified the price elasticity of e-books from repeated measurements across many titles. For every copy an e-book would sell at $14.99, it would sell 1.74 copies if priced at $9.99. So, for example, if customers would buy 100,000 copies of a particular e-book at $14.99, then customers would buy 174,000 copies of that same e-book at $9.99. Total revenue at $14.99 would be $1,499,000. Total revenue at $9.99 is $1,738,000. The important thing to note here is that at the lower price, total revenue increases 16%. This is good for all the parties involved: [Customer, Author, Publisher, Retailer]. Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 40 / 88
Profit-Maximization Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 41 / 88
The Monopolist s Problem The firm s goal is to maximize profit Π Convenient to write as choice over quantity Q: At optimum, Π (Q) = 0: Π (Q) = Profit Rev Cost {}}{{}}{{}}{ Π(Q) = P(Q) Q C(Q) Marginal Revenue {}}{ Marg Cost {}}{ P(Q) + QP (Q) C (Q) = 0 = Marginal Revenue {}}{ P(Q) + QP (Q) = Given a solution for Q, price P(Q) is chosen Marg Cost {}}{ C (Q) Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 42 / 88
The Solution: Marginal Revenue = Marginal Costs Marginal Revenue {}}{ P(Q) + QP (Q) = Marg Cost {}}{ C (Q) Benefit of selling one additional unit: Revenue increases by MR Cost of selling one additional unit: Costs increase by MC If MR > MC, sell more If MR < MC, sell less MC is positive, so we must have positive MR. Selling the last unit was costly, so it must have increased revenue to be worthwhile Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 43 / 88
Math Example Let Costs be C(Q) = 4Q Let Demand be Q = 48 2P Inverse Demand: P = 24 Q/2 Profit-Maximization 1 Set Marginal Revenue equal Marginal Cost MC = dc(q) = 4 dq Rev(Q) = Q P = 24Q Q 2 /2, so MR = drev(q) dq MR = MC at 24 Q = 4, so Q = 20. Plug into demand to get P = 24 20/2 = 14. = 24 Q NOTE: Write revenue in terms of Q, not P, before differentiating for MR! Rev(P) = P(48 2P), derivative 48 4P If we said MR = 48 4P and set equal to MC = 4, we would get P = 11 wrong answer Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 44 / 88
The Monopolist s Problem, in Graphs Math example continued Solution: Q = 20, P = 14, Profit $200 P 25 20 15 10 5 MC MR Demand P Q 0 10 20 30 40 50 Q Where are revenues, costs, and profits on this graph? What is the efficient level of production? Cost was C(Q) = 4Q. What happens to graph, output & profits if C(Q) = 4Q + 100? What about C(Q) = 4Q + 300? Now firm goes out of business Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 45 / 88
The Monopolist s Problem, in Graphs P p m MC MR D q m Q Monopolist chooses quantity q m, price p m Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 46 / 88
The Monopolist s Problem, in Graphs P p m PS MC MR D q m Producer Surplus, i.e., Profit Revenue = p m q m rectangle Cost = Area under MC curve (ignoring fixed costs) If MC is derivative of Cost, then Cost is integral of MC Fixed costs affect profit and entry decision, but not pricing Profit = Revenue Cost Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 47 / 88 Q
Markups Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 48 / 88
Monopoly Production Marginal Revenue = Marginal Cost Suppose Marginal Costs are 0 Digital Goods software, music downloads Prescription drugs under patent How do we choose price/quantity? Choose quantity to set MR = 0, i.e., maximize revenue Equivalent to choosing price to set price-elasticity ε D = 1 Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 49 / 88
Revenues and Elasticities P Elastic Rev Unit Elasticity p Unit Elasticity Rev P Q Inelastic q Q Elastic Inelastic Q Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 50 / 88
Revenues and Elasticities If MC = 0: set elasticity ε D = 1 to maximize revenue. If MC > 0: ε D < 1 (inelastic): Raising prices increases revenue Raising prices decreases quantity Costs go down Raise prices! ε D = 1 (unit elasticity): Raising prices doesn t change revenue Raising prices decreases quantity Costs go down Raise prices! ε D > 1 (elastic): Raising prices decreases revenue Raising prices lowers quantity and costs Trade off decrease in revenue vs. decrease in costs Always raise prices (reduce quantity) until demand is elastic! Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 51 / 88
Elasticities and Profit Maximization Set Marginal Revenue = Marginal Cost Maximize profit condition: MR = MC MR in terms of elasticity: MR = P ( 1 + 1 ) ε D Put these together: MR = MC ( ) 1 P ε D + 1 = MC = P = MC 1 + 1 ε D Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 52 / 88
Elasticities and Profit Maximization P = MC 1 + 1 ε D, or P = MC 1 1 ε D with ε D > 1 This relates the elasticity to the percentage mark-up over costs: Elasticity ε D 1 1 Markup ε D 1 1 1 ε D 1 1 0-100.99 1.01 1% -3.67 1.5 50% -2.5 2 100% -1.5.33 3 200% Under perfectly elastic demand (competitive markets) with ε D = : Choose P = MC P is constant for any choice of Q, so MR = P More elastic demand lower markup Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 53 / 88
Math Example Example from before: Elasticity: Costs C(Q) = 4Q, MC = 4 Demand Q = 48 2P, or P = 24 Q/2 Solution: P = 14, Q = 20 Mark-Up Equation: P 25 20 15 10 P Q dq dp = P Q 2 = 7 5 P = MC 1 + 1 ε D = 4 1 5 7 5 MC MR Demand P Q 0 10 20 30 40 50 Q at optimum = 14 Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 54 / 88
Application: Firm Information When setting prices, what do firms need to know? Scientist analyses brainwaves to work out how much we re willing to pay for a coffee - and claims Starbucks should INCREASE its prices Daily Mail, Oct 2013 A German neurobiologist Muller is convinced that... Starbucks is effectively throwing away millions of dollars in profit as it could be charging more for its coffees. He said that while Starbucks charges e 1.80 for a small white coffee in Stuttgart, people would be willing to pay up to e 2.40. The scientist showed people the same cup of coffee on a screen but with different prices while monitoring the brain s activity. People reacted strongly to prices that seem very low or too high - such as 10 cents or e 10 per cup. But the experiment showed that people were comfortable paying 60 cents more than Starbucks was charging. Should Starbucks hire him to run brain scans to determine their prices? Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 55 / 88
Application: Firm Information Firms set prices based on knowledge of Marginal Costs and Demand Curve. Do firms need to know their full individual demand curve? No, just the local elasticity (i.e., marginal revenue). P = MC 1 + 1 ε D If P is lower, raise price until equal; if P is higher, lower price Equivalently: Find marginal revenue, raise price if MR > MC Is it realistic to think that firms know the local elasticities? Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 56 / 88
Application: Firm Information Do firms know the local elasticity for a given product? Probably... 1 If they have any ability to experiment with prices... Supermarkets, online retailers, gas stations: yes. Postal service, CTA: probably not Amazon, after setting $9.99 flat price for ebooks: maybe not 2 If they don t need to know how it affects other goods they sell... Restaurant: Easy to measure number of meat loafs sold as a function of price Hard to measure what people buy instead when the price is higher Shift to higher priced entrees? Good Shift to lower priced entrees? Bad Stop coming to my restaurant? Really bad Amazon: Drop price of one ebook from $14.99 to $9.99 (1.74x sales), vs. cutting price of all ebooks at once (more or less than 1.74x?) 3 And if they only care about short-term elasticity. If I keep the price of meat loaf low for a year, will people slowly start coming to my restaurant more often? Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 57 / 88
Application: Firm Information Amazon is probably better at experimenting with prices, measuring sales, analyzing data than most other retailers With rare exceptions, the volume increase in the short term is never enough to pay for the price decrease. However, our quantitative understanding of elasticity is short-term. We can estimate what a price reduction will do this week and this quarter. But we cannot numerically estimate the effect that consistently lowering prices will have on our business over five years or ten years or more. Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com. We ve made similar judgments around Free Super Saver Shipping and Amazon Prime, both of which are expensive in the short term and we believe important and valuable in the long term. Jeff Bezos, Founder & CEO of Amazon.com, 2005 Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 58 / 88
Social Costs of Monopoly Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 59 / 88
The Monopolist s Problem, in Graphs P p m CS PS MC MR D q m Q Consumer Surplus is area between Demand Curve and Price To maximize total surplus PS + CS, set Q & P equal to intersection of MC and Demand Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 60 / 88
The Monopolist s Problem, in Graphs P p m p e MR MC D Monopolist: quantity q m, price p m Efficient: quantity q e, price p e q m q e Q Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 61 / 88
The Monopolist s Problem, in Graphs P p m CS PS DWL MC MR D q m Deadweight Loss: Decline in Consumer Surplus + Producer Surplus from efficient output Moving from efficient to monopoly output: Firm is better off Consumer is more worse off Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 62 / 88 Q
The Monopolist s Problem, in Graphs P p m CS PS DWL MC MR D q m Q Why are monopolies bad? Price > Marginal Cost implies Inefficiency (DWL) P > WTP > MC sale should go through, but it doesn t Doesn t just transfer $ from Consumer to Firm lowers total welfare In Supply-and-Demand free market, we get efficiency Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 63 / 88
How large is the social loss from monopoly? DWL triangle with P MC for height and length q e q m DWL = 1 2 (pm MC)(q e q m ) DWL = 1 (p m MC) (q e q m ) 2 p m q m (p m q m ) DWL 1 2 (% markup in price)(% reduction in output)(monopoly revenues) A monopolist with a markup of 40% who reduces output 40% below the competitive level would have a distortion of roughly 40% 40% = 8% of monopoly revenues 1 2 Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 64 / 88
Example: Taxi Medalions and Uber Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 65 / 88
Taxi Medalions and Uber Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 66 / 88
The Effect of a Restriction on the Number of Cabs Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 67 / 88
The Effect of a Restriction on the Number of Cabs When government doesn t restrict, we are at the first equilibrium n 1 cab firms in the market, making no profit as p 1 q 1 = AC 1 Suppose taxi industry gets government to restrict medallions to n 2 When government restricts medallions, we are at the second equilibrium n 2 < n 1 cab firms in the market, making profit as p 2 q 2 > AC 1 Can think of impact of uber as going from E2 to E1 Can also think of other occupational restrictions (e.g., doctors and the number of AMA residency slots) similarly One could argue that one of more effective ways to reduce inequality would be to lower the price of skill by increasing the supply of skill For example, we could increase residency slots or allow qualified doctors to obtain US citizenship and practice Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 68 / 88
Application: Monopoly Pass-Through What happens to prices and profits when costs or taxes go up? Monopoly: If costs go up, will prices go up? If costs go up, will profits go up? If costs go up by $1, how much do prices go up? Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 69 / 88
Application: Monopoly Pass-Through What happens to prices and profits when costs or taxes go up? Competitive Market: P D p' p p't D S' t S q' q Q Surplus loss shared by firms and consumers Price goes up, but not by full cost increase Depends on supply/demand elasticities Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 70 / 88
Application: Monopoly Pass-Through Consider a firm with constant marginal costs, linear demand: Demand P = A BQ Marginal Revenue: A 2BQ = 2P A Marginal cost MC per unit P MC MR D Solution: Set MR = MC, plug in MR = 2P A to get P = A 2 + MC 2 What happens if MC increases by? (eg, tax of per sale) Price goes up by /2 Q Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 71 / 88
Application: Monopoly Pass-Through Linear demand: Cost increases by, Price goes up by /2 Is it generally true that firms do not fully pass through cost increases? No for other demand functions, firms might increase costs by less than,, or more than Example: Let Q(P) = P 2 (with inverse demand P(Q) = Q 1 2 ) Special Case of Constant Elasticity Demand Q = AP εd for ε D < 0 Elasticity: ε D = 2 Mark-up equation: P = MC 1+ 1 ε D = MC 1 1 2 = 2MC Cost increases by, price goes up by 2 Even if we pass on >100% of cost increase, profits still lower! Could have set New Price with Old Costs would be worse off New Price with New Costs even worse Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 72 / 88
Advertising Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 73 / 88
Advertising can increase demand Simple model of advertising A is that it can impact demand Demand is Q = D(P, A) where Q is the quantity demanded, P is price of Q, and A is expenditures on advertising Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 74 / 88
Advertising can increase demand Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 75 / 88
Advertising can increase demand An increase in advertising shifts the firm s demand curve outward The firm can earn additional profits by increasing sales at the same price (as shirt in left-hand figure) or by increasing price at a given quantity (middle figure) or lead to some combination of an increase inp and Q Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 76 / 88
Advertising, Prices, and the Elasticity of Demand The firm will keep the price constant when demand increases due to advertising if the changes in advertising do not affect the elasticity of demand The firm will increase price with advertising if advertising reduces the elasticity of demand The firm will reduce price if advertising makes demand more elastic Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 77 / 88
How much should a firm advertise? Profits = Revs - Costs First consider the case in which advertising increases demand by increasing sales at the same price Then we will consider the case in which advertising increases demand by increasing willingness to pay at a given level of output Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 78 / 88
How much should a firm advertise? π= Revs - Costs Revs are P Q(P, A) Costs are the sum of constant marginal costs c times quantity plus advertising expenses, i.e., costs=c Q + A max PQ(P, A) cq A A Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 79 / 88
How much should a firm advertise? The optimal level of advertising solves P dq da c dq da 1 = 0 (P c) dq da = 1 A (P c)dq PQ da = A PQ 1 dq A = A da Q PQ P c P }{{} = 1/ε D }{{} =ε A This shows advertising as a share of revenues should equal εa ε D Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 80 / 88
How much should a firm advertise? Firms will spend more on advertising when the advertising elasticity ε A is larger and when the price elasticity of demand ε D is lower However, the incentive to advertise does not depend on how advertising affects the elasticity of demand In general, firms do not advertise in order to reduce the elasticity of demand for their product They advertise in order to increase demand for their product (whether it makes demand more elastic or not) Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 81 / 88
How much should a firm advertise? π= Revs - Costs Revs are P(Q, A) Q This formulation amounts to looking at how a consumers willingness to pay P depends on the quantity consumed Q and the level of advertising Costs are the sum of constant marginal costs c times quantity plus advertising expenses, i.e., costs=c Q + A max P(Q, A)Q cq A A Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 82 / 88
How much should a firm advertise? The optimal level of advertising solves dp da Q 1 = 0 dp da Q = 1 A PQ ε PA = dp da Q = A PQ A PQ 1 This shows advertising as a share of revenues should equal ε PA where ε PA is the elasticity of the willingness to pay with respect to advertising This is consistent with the first formulation since ε PA = εa ε D Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 83 / 88
How much should a firm advertise? Therefore another way to express the optimal advertising condition is that firms will spend more on advertising when advertising has a greater impact on consumer s willingness to pay Note that the elasticity of demand doesn t enter this expression The gain from advertising depends on how much advertising shifts the firm s demand curve upward independent of the elasticity of demand Hence, the elasticity of demand matters for the level of advertising only when we hold the effect of advertising on sales constant Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 84 / 88
How does advertising affect consumer welfare? The effects of advertising on consumer welfare depend on how advertising affects price Consider first the case where advertising affects the level of demand but does not affect its elasticity In this case prices are unchanged and the graph looks like the figure on the following slide Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 85 / 88
How does advertising affect consumer welfare? Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 86 / 88
How does advertising affect consumer welfare? In the figure, advertising shifts demand from D1 to D2 Since the elasticity of demand is unchanged and the marginal costs are constant, the optimal monopoly price is unaffected As a result, the quantity increases from X 1 to X 2 and the monopolist s revenues increase by the darker shaded region Clearly, as shown in the figure, WTP was increased by advertising Even with the increases in expenditures, consumer surplus grows by the lightly shaded region Unless the advertising lowers utility substantially at zero consumption, the great consumer surplus implies that the consumer has gained from the advertising. The advertising has increased the consumer s value of the good to the consumer and this generates increased surplus Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 87 / 88
How does advertising affect consumer welfare? If advertising increases prices significantly, the story can be different In this case, the demand increases consumer surplus (at a fixed price) but the increase in price reduces consumer surplus If the price increase is large enough, consumer surplus and hence consumer welfare can decline Advertising can also reduce price. Of course, this makes it even more likely that consumers will gain Owen Zidar (Chicago Booth) Microeconomics Week 7: Monopoly 88 / 88