MonopolyMonopoly

The definition of monopolyThe definition of monopoly– From the Latin: From the Latin: ““single sellersingle seller””

A structural viewA structural view– Unique product/service Unique product/service – Large relative to market Large relative to market

A theoretical viewA theoretical view– Must lower price to sell more unitsMust lower price to sell more units– Must find best price for output, so better Must find best price for output, so better

name is name is ““price searcherprice searcher”” or or ““price makerprice maker””

Sources of monopolySources of monopoly

Unique talentUnique talent– LeBron JamesLeBron James

Patent or copyrightPatent or copyright– Intel chipIntel chip

LocationLocation– McDonaldMcDonald’’s in airports in airport

RegulationRegulation– ProfessionsProfessions

CollusionCollusion– OPECOPEC

Consider this Price Maker Consider this Price Maker MarketMarket

You think so hard in econ class you have a You think so hard in econ class you have a headache!headache!

You go to buy a bottle of 100You go to buy a bottle of 100generic aspirin. Consider thesegeneric aspirin. Consider theseoptions: Wal-Martoptions: Wal-Mart

Grocery StoreGrocery Store Convenience storeConvenience store

Which is highest price and lowest price? Which is highest price and lowest price? Is the market competitive?Is the market competitive?What does monopoly mean in practice?What does monopoly mean in practice?

Marginal Revenue scheduleMarginal Revenue schedule

Marginal revenue (MR) is the change in Marginal revenue (MR) is the change in total revenue (TR) when there is a change total revenue (TR) when there is a change in quantity (Q) sold. To sell more, you must in quantity (Q) sold. To sell more, you must cut price (P) – move down the demand cut price (P) – move down the demand curve – so MR is always less than P. Price curve – so MR is always less than P. Price to the seller is the revenue received.to the seller is the revenue received.

Because a price cut to sell more units Because a price cut to sell more units reduces revenue on reduces revenue on ““earlierearlier”” units, extra units, extra revenue (the marginal revenue) is less revenue (the marginal revenue) is less than price. Assuming all sales at the same than price. Assuming all sales at the same price — P is Average Revenue — measured price — P is Average Revenue — measured by the Demand Curve.by the Demand Curve.

Anatomy of a Demand Anatomy of a Demand CurveCurve

Demand reflects what consumers pay for a Demand reflects what consumers pay for a good.good.

They pay a price, PThey pay a price, P’’, which, whichis Average Revenue to theis Average Revenue to theseller (AR). Total revenue inseller (AR). Total revenue ina given time period isa given time period isPP’’ x Q x Q’’ = TR. Marginal = TR. MarginalRevenue (MR) is the Revenue (MR) is the change in TR given achange in TR given achange in Q sold, whichchange in Q sold, whichrequires P to change. requires P to change.

Q

$

MR

D = AR

P ’

Q ’

MadonnaMadonna’’s problem:s problem:

How many songs?How many songs? TC Q Price TR MCTC Q Price TR MC

3.5 1 $10m/song 10 3.53.5 1 $10m/song 10 3.5 7 2 9 18 3.57 2 9 18 3.5 10.5 3 8 24 3.510.5 3 8 24 3.5 14 4 7 28 3.514 4 7 28 3.5 17.5 5 6 30 3.517.5 5 6 30 3.5 21 6 5 30 3.521 6 5 30 3.5 24.5 7 4 28 3.524.5 7 4 28 3.5 28 8 3 24 3.528 8 3 24 3.5

At each price, recording company demands (will buy) At each price, recording company demands (will buy) the number of songs shown, Qthe number of songs shown, Q-- Price-quantity combinations shown are points on -- Price-quantity combinations shown are points on demand curvedemand curve

What is the best price; or how many songs?What is the best price; or how many songs?Is maximum total revenue the best solution?Is maximum total revenue the best solution?

Marginal revenue is less than Marginal revenue is less than priceprice

TC MR Q Price TR MCTC MR Q Price TR MC 3.5 10 1 $10m/song 10 3.53.5 10 1 $10m/song 10 3.5

7 8 2 9 18 3.57 8 2 9 18 3.5 10.5 6 3 8 24 3.510.5 6 3 8 24 3.5 14 4 4 7 28 3.514 4 4 7 28 3.5 17.5 2 5 6 30 3.517.5 2 5 6 30 3.5 21 0 6 5 30 3.521 0 6 5 30 3.5 24.5 -2 7 4 28 3.524.5 -2 7 4 28 3.5 28 -4 8 3 24 3.528 -4 8 3 24 3.5

What is the most profitable P and Q?What is the most profitable P and Q?

New

The solution: marginal revenue = The solution: marginal revenue = marginal costmarginal cost

TC TC Profit MR Q Price/song TR Profit MR Q Price/song TR MCMC

3.5 6.5 10 1 $10m 10 3.53.5 6.5 10 1 $10m 10 3.5 7 11 8 2 9 18 3.57 11 8 2 9 18 3.5 10.5 13.5 6 3 8 24 3.510.5 13.5 6 3 8 24 3.5 14 14 4 4 7 28 3.514 14 4 4 7 28 3.5 17.5 12.5 2 5 6 30 3.517.5 12.5 2 5 6 30 3.5 21 9 0 6 5 30 3.521 9 0 6 5 30 3.5 24.5 3.5 -2 7 4 28 3.524.5 3.5 -2 7 4 28 3.5

28 -4 -4 8 3 24 3.528 -4 -4 8 3 24 3.5

Find the price that maximizes profits for Madonna (the Find the price that maximizes profits for Madonna (the seller)seller)

The solution: Choose Q such that MR = MCThe solution: Choose Q such that MR = MC

Note that P > MC at best QNote that P > MC at best Q

New

The solution graphicallyThe solution graphically

The profit-maximizing price is the one that induces The profit-maximizing price is the one that induces demanders to choose Q such that MR = MCdemanders to choose Q such that MR = MC

At any higher price,At any higher price,

MR > MCMR > MC

lost profitslost profits

At any lower price, At any lower price,

MR < MCMR < MC

lost profitslost profits

Only at P* is MR = MCOnly at P* is MR = MC

maximum profitsmaximum profits

MC = S

DMR

MC=3.5

P*=7

Quantity

$

1 2 3 4 5 6 7 8

The Price Maker: Common The Price Maker: Common in Highly Competitive in Highly Competitive MarketsMarketsSetting price at movie theaterSetting price at movie theater that has 1,000 seats in it.that has 1,000 seats in it.

Assume fixed costs of $2,000 for Assume fixed costs of $2,000 for movie rental, $250 for labor, & movie rental, $250 for labor, & $250 for building per night.$250 for building per night.

You know your customers from You know your customers from experience—what price do you experience—what price do you charge if only one price can be set?charge if only one price can be set?

Highly competitive market for Highly competitive market for entertainment dollars.entertainment dollars.

$

D

Q

MR

$6

$5

$4

400 500 600

Setting PricesSetting Prices

What is Marginal Cost in this situation?What is Marginal Cost in this situation?All costs are fixed, so MC = $0All costs are fixed, so MC = $0

At what quantity does MC = MR?At what quantity does MC = MR?500 seats500 seats

What price can be charged?What price can be charged?$5 (price is Average Revenue—Demand Curve)$5 (price is Average Revenue—Demand Curve)

What is Total Revenue?What is Total Revenue?TR = P * Q = $5 x 500 = $2500TR = P * Q = $5 x 500 = $2500

Can we do better?Can we do better?

There are unsold seats — and it costs $0 to serve There are unsold seats — and it costs $0 to serve another customer (MC=$0) — so should we cut another customer (MC=$0) — so should we cut the price to $4 to fill more seats? Cut price to $4, the price to $4 to fill more seats? Cut price to $4, add 100 customers, but TR falls $100, so MR per add 100 customers, but TR falls $100, so MR per extra customer is -$1.extra customer is -$1.

Some customers value the movie at more than $5. Some customers value the movie at more than $5. Should we charge a higher price, say $6? We go Should we charge a higher price, say $6? We go from TR = $2500 to TR = $2400, so TR falls $100, from TR = $2500 to TR = $2400, so TR falls $100, or -$1 as customer base falls from 500 to 400.or -$1 as customer base falls from 500 to 400.

Nothing beats the golden rule of MC = MRNothing beats the golden rule of MC = MR

Same example with positive Same example with positive MCMC

Now presume movie distributorNow presume movie distributor

charges a rental fee of $2 percharges a rental fee of $2 per

customer let into the theater,customer let into the theater,

so MC=$2 per customer let in.so MC=$2 per customer let in.

Building cost of $250 and labor costBuilding cost of $250 and labor cost

Of $250 per night are still Of $250 per night are still fixedfixed..

$6x400=$2400 is where MC=MR$6x400=$2400 is where MC=MR

Compare to $5 price (TR=$2500),Compare to $5 price (TR=$2500),

for 100 more customers, $100 morefor 100 more customers, $100 more

TR or MR = $1 per customer. MC = $2 for eachTR or MR = $1 per customer. MC = $2 for each

customer (TC=$1500), so net loss of $100.customer (TC=$1500), so net loss of $100.

D

Q

$

$6

$2

MR

MC

400

A A ““monopolistmonopolist”” has has competitioncompetition

This is called the monopoly pricing This is called the monopoly pricing model or price maker model.model or price maker model.

The market for movie theaters is The market for movie theaters is competitive —between theaters as competitive —between theaters as well as with substitutes such as well as with substitutes such as DVDs.DVDs.

The market is competitive, but firms The market is competitive, but firms act act as ifas if they are a monopoly. they are a monopoly.

Trying to apply model in real world—where do you have ability to set price?Parker Hannifin: Industrial parts maker:Parker Hannifin: Industrial parts maker:$9.4 billion revenue 2006; 800,000 parts $9.4 billion revenue 2006; 800,000 parts

sold. Traditional policy: sold. Traditional policy: ““costcost”” plus 35% plus 35% (the (the ““strategystrategy”” used by ~ 60% US used by ~ 60% US manufacturers)manufacturers)

Net income in 2002: $130 millionNet income in 2002: $130 millionNet income in 2006: $673 millionNet income in 2006: $673 millionReturn on invested capital up from 7% to Return on invested capital up from 7% to

21% in same time.21% in same time.How: Be a How: Be a ““monopolistmonopolist”” when possible when possible

Some things are “monopolistic,” some are not, from same seller

New Strategy: 4 Basic Categories of productsNew Strategy: 4 Basic Categories of productsA.A. Ones in highly competitive markets—Ones in highly competitive markets—

charge the market price; no price charge the market price; no price changeschanges

B.B. Partially differentiated products—Partially differentiated products—common products changed a bit for a common products changed a bit for a customer; prices up 0-9%customer; prices up 0-9%

C.C. Differentiated products—engineered for a Differentiated products—engineered for a customer; up 0-25%customer; up 0-25%

D.D. Specials—custom designed; no close Specials—custom designed; no close substitutes; prices up over 25%substitutes; prices up over 25%