Mba1014 monopoly 220513


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Monopoly, Price discrimination

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Mba1014 monopoly 220513

  1. 1. Go Global !Managerial Economics :MonopolyByStephen OngVisiting Fellow, Birmingham City UniversityVisiting Professor, College of Management,Shenzhen UniversityMay 2013
  2. 2. Agenda1. Market Power2. Antitrust3. Price Discrimination
  3. 3. Learning ObjectivesTo understand market power,monopoly and monopsonyTo explain how the MR=MC rulehelps a monopoly to determine itsoptimumTo discuss government regulationand antitrust lawsTo understand price discriminationin monopoly markets
  4. 4. OverviewMarket powerCharacteristics of monopolyand monopsony marketsPricing and output decisionsin monopoly marketsImplications for managerialdecisions
  5. 5. 1Market Power
  6. 6. Firms With Market PowerThe ability of a firm toinfluence the prices of itsproducts and developother competitivestrategies that enable itto earn large profits overlonger periods of time.
  7. 7. The Monopoly ModelA market structurecharacterized by a singlefirm producing a productwith no close substitutes.
  9. 9. Comparing Monopoly and PerfectCompetition The PerfectlyCompetitive Firm At QPC : MR = MC P = ATC P = MC Minimum Point ofATC Curve Price-Taker Firm Has SupplyCurve The Monopoly Firm At QM : MR = MC P > ATC P > MC Not at MinimumPoint of ATC Price-Searcher Firm Has No SupplyCurve
  10. 10. Comparing Monopoly and PerfectCompetition - GraphicalPQPMQMDMRMCATCD = P = MRPCQCATCMC
  11. 11. Another Look at Monopolyvs. Perfect CompetitionPMPCQCQMAC=MCDMR$Q
  12. 12. Sources of Market PowerEconomies of scaleBarriers created bygovernmentInput barriersBrand loyaltiesConsumer lock-in andswitching costsNetwork externalities
  13. 13. Economies of ScaleEconomies of scale canact as a barrier to entryin different industriesbecause only large-scalefirms can achieve thecost-reduction benefitsof these economies.
  14. 14. Barriers Created byGovernmentLicensesPatents and Copyrights
  15. 15. Input BarriersOther barriers to entryinclude control over rawmaterials or other keyinputs in a productionprocess and barriers infinancial capital markets.
  16. 16. Brand LoyaltiesThe creation of brandloyalties throughadvertising and othermarketing efforts is astrategy that manymanagers use to createand maintain marketpower.
  17. 17. Consumer Lock-In andSwitching CostsBarriers to entry can alsoresult if consumersbecome locked intocertain types or brandsof products and wouldincur substantialswitching costs if theychanged.
  18. 18. Network ExternalitiesNetwork externalities actas a barrier to entrybecause the value of aproduct to consumersdepends on the numberof customers using theproduct.
  19. 19. Examples of ShiftingMarket PowerShifting Demandfor KleenexHome Depot andCustomerServiceBordersBookstores’Online Strategy
  20. 20. MonopolyMarket with only one seller.MonopsonyMarket with only one buyer.Market powerAbility of a seller or buyer to affectthe price of a good.
  21. 21. MonopolyAverage Revenue and Marginal RevenueMarginal revenue : Change in revenue resulting from a one-unitincrease in output.TABLE 1 TOTAL, MARGINAL, AND AVERAGE REVENUEPRICE(P)QUANTITY(Q)TOTALREVENUE(R)MARGINALREVENUE(MR)AVERAGEREVENUE(AR)$6 0 $0 — —5 1 5 $5 $54 2 8 3 43 3 9 1 32 4 8 1 21 5 5 3 1Consider a firm facing the following demand curve: P = 6  Q
  22. 22. Average andmarginalrevenue areshown forthe demandcurveP = 6 − Q.AVERAGE AND MARGINAL REVENUE
  23. 23. PROFIT IS MAXIMIZED WHENMARGINAL REVENUEEQUALS MARGINAL COSTThe Monopolist’s Output DecisionQ* is the output level at whichMR = MC.If the firm produces a smalleroutput—say, Q1—it sacrificessome profit because the extrarevenue that could be earnedfrom producing and sellingthe units between Q1 and Q*exceeds the cost of producingthem.Similarly, expanding outputfrom Q* to Q2 would reduceprofit because the additionalcost would exceed theadditional revenue.
  24. 24. We can also see algebraically that Q* maximizesprofit. Profit π is the difference between revenueand cost, both of which depend on Q:As Q is increased from zero, profit will increase until itreaches a maximum and then begin to decrease. Thusthe profit-maximizing Q is such that the incrementalprofit resulting from a small increase in Q is just zero(i.e., Δπ /ΔQ = 0). ThenBut ΔR/ΔQ is marginal revenue and ΔC/ΔQ ismarginal cost. Thus the profit-maximizingcondition is that
  25. 25. EXAMPLE OF PROFITMAXIMIZATIONPart (a) shows total revenue R, total cost C,and profit, the difference between the two.Part (b) shows average and marginalrevenue and average and marginal cost.Marginal revenue is the slope of the totalrevenue curve, and marginal cost is theslope of the total cost curve.The profit-maximizing output is Q* = 10, thepoint where marginal revenue equalsmarginal cost.At this output level, the slope of the profitcurve is zero, and the slopes of the totalrevenue and total cost curves are equal.The profit per unit is $15, the differencebetween average revenue and averagecost. Because 10 units are produced, totalprofit is $150.
  26. 26. A Rule of Thumb for PricingNote that the extra revenue from an incremental unit of quantity,Δ(PQ)/ΔQ, has two components:1. Producing one extra unit and selling it at price P brings in revenue(1)(P) = P.2. But because the firm faces a downward-sloping demand curve,producing and selling this extra unit also results in a small drop inprice ΔP/ΔQ, which reduces the revenue from all units sold (i.e., achange in revenue Q[ΔP/ΔQ]).Thus,With limited knowledge of average and marginal revenue, we canderive a rule of thump that can be more easily applied in practice.First, write the expression for marginal revenue:
  27. 27. (Q/P)(ΔP/ΔQ) is the reciprocal of the elasticity ofdemand, 1/Ed, measured at the profit-maximizingoutput, andNow, because the firm’s objective is to maximize profit,we can set marginal revenue equal to marginal cost:which can be rearranged to give usEquivalently, we can rearrange this equation to expressprice directly as a markup over marginal cost:
  28. 28. ASTRA-MERCK PRICES PRILOSECIn 1995, Prilosec, represented a new generation of anti-ulcer medication. Prilosec was based on a very differentbiochemical mechanism and was much more effectivethan earlier drugs.By 1996, it had become the best-selling drug in the worldand faced no major competitor.Astra-Merck was pricing Prilosec at about $3.50 per dailydose. The marginal cost of producing and packagingPrilosec is only about 30 to 40 cents per daily dose. Theprice elasticity of demand, ED, should be in the range ofroughly −1.0 to −1.2.Setting the price at a markup exceeding 400 percentover marginal cost is consistent with our rule of thumb forpricing.
  29. 29. Shifts in DemandA monopolistic market has no supply curve. In otherwords, there is no one-to-one relationship between priceand the quantity produced.The reason is that the monopolist’s output decision dependsnot only on marginal cost but also on the shape of thedemand curve.As a result, shifts in demand do not trace out the series ofprices and quantities that correspond to a competitivesupply curve. Instead, shifts in demand can lead to changesin price with no change in output, changes in output with nochange in price, or changes in both price and output.Shifts in demand usually cause changes in both price andquantity. A competitive industry supplies a specific quantityat every price. No such relationship exists for a monopolist,which, depending on how demand shifts, might supplyseveral different quantities at the same price, orthe same quantity at different prices.
  30. 30. SHIFTS IN DEMANDShifting the demand curveshows that a monopolisticmarket has no supply curve—i.e., there is no one-to-onerelationship between price andquantity produced. In (a), thedemand curve D1 shifts to newdemand curve D2. But the newmarginal revenue curve MR2intersects marginal cost at thesame point as the old marginalrevenue curve MR1. The profit-maximizing output thereforeremains the same, althoughprice falls from P1 to P2. In (b),the new marginal revenuecurve MR2 intersects marginalcost at a higher output levelQ2. But because demand isnow more elastic, priceremains the same.
  31. 31. THE DEMAND FOR TOOTHBRUSHESMonopoly PowerPart (a) shows the marketdemand for toothbrushes.Part (b) shows the demandfor toothbrushes as seen byFirm A.At a market price of $1.50,elasticity of market demandis −1.5.Firm A, however, sees amuch more elastic demandcurve DA because ofcompetition from otherfirms. At a price of $1.50,Firm A’s demand elasticity is−6. Still, Firm A has somemonopoly power: Its profit-maximizing price is $1.50,which exceeds marginalcost.
  32. 32. ELASTICITIES OF DEMAND FOR SOFT DRINKSSoft drinks provide a good example of the difference between amarket elasticity of demand and a firm’s elasticity of demand.In addition, soft drinks are important because their consumptionhas been linked to childhood obesity; there could be healthbenefits from taxing them.A recent review of several statistical studies found that themarket elasticity of demand for soft drinks is between −0.8 and−1.0.6 That means that if all soft drink producers increased theprices of all of their brands by 1 percent, the quantity of softdrinks demanded would fall by 0.8 to 1.0 percent.The demand for any individual soft drink, however, will be muchmore elastic, because consumers can readily substitute onedrink for another. Although elasticities will differ across differentbrands, studies have shown that the elasticity of demand for,say, Coca Cola is around −5.7 In other words, if the price of Cokewere increased by 1 percent but the prices of all other softdrinks remained unchanged, the quantity of Coke demandedwould fall by about 5 percent. Students—and business people—sometimes confuse the market elasticity of demand with the firm(or brand) elasticity of demand.
  33. 33. ELASTICITY OF DEMAND AND PRICE MARKUPThe Rule of Thumb for PricingThe markup (P − MC)/P is equal to minus the inverse of the elasticity ofdemand. If the firm’s demand is elastic, as in (a), the markup is small and thefirm has little monopoly power.The opposite is true if demand is relatively inelastic, as in (b).
  34. 34. MARKUP PRICING: SUPERMARKETS TODESIGNER JEANSAlthough the elasticity of market demand for food is small(about −1), no single supermarket can raise its prices verymuch without losing customers to other stores.The elasticity of demand for any one supermarket is often as large as−10. We find P = MC/(1 − 0.1) =MC/(0.9) = (1.11)MC.The manager of a typical supermarket should set prices about 11percent above marginal cost.Small convenience stores typically charge higher pricesbecause its customers are generally less price sensitive.Because the elasticity of demand for a convenience store is about −5,the markup equation implies that its prices should be about 25 percentabove marginal cost.With designer jeans, demand elasticities in the range of −2to −3 are typical. This means that price should be 50 to100 percent higher than marginal cost.
  35. 35. THE PRICING OF VIDEOSWhen the market for videos was young, producers had no goodestimates of the elasticity of demand. As the market matured,however, sales data and market research studies put pricingdecisions on firmer ground. By the 1990s, most producers hadlowered prices across the board.TABLE 2 RETAIL PRICES OF VIDEOS IN 1985 AND 20111985 2011TITLERETAIL PRICE($) TITLERETAIL PRICE($)VHS DVDPurple Rain $29.98 Tangled $20.60Raiders of the Lost Ark $24.95Harry Potter and theDeathly Hallows, Part 1 $20.58Jane Fonda Workout $59.95 Megamind $18.74The Empire Strikes Back $79.98 Despicable Me $14.99An Officer and aGentleman $24.95 Red $27.14Star Trek: The MotionPicture $24.95 The King’s Speech $14.99Star Wars $39.98 Secretariat $20.60
  36. 36. VIDEO SALESBetween 1990 and 1998, lower prices induced consumers to buymany more videos. By 2001, sales of DVDs overtook sales of VHSvideocassettes. High-definition DVDs were introduced in 2006,and are expected to displace sales of conventional DVDs. AllDVDs, however, are now being displaced by streaming video.THE PRICING OF VIDEOS
  37. 37. Sources of Monopoly PowerThe less elastic its demand curve, the moremonopoly power a firm has. The ultimatedeterminant of monopoly power is thereforethe firm’s elasticity of demand.Three factors determine a firm’s elasticity of demand.1. The elasticity of market demand. Because thefirm’s own demand will be at least as elastic as marketdemand, the elasticity of market demand limits thepotential for monopoly power.2. The number of firms in the market. If there are manyfirms, it is unlikely that any one firm will be able toaffect price significantly.3. The interaction among firms. Even if only two or threefirms are in the market, each firm will be unable toprofitably raise price very much if the rivalry amongthem is aggressive, with each firm trying to capture asmuch of the market as it can.
  38. 38. If there is only one firm—a pure monopolist—its demand curveis the market demand curve. In this case, the firm’s degree ofmonopoly power depends completely on the elasticity of marketdemand.When several firms compete with one another, the elasticity ofmarket demand sets a lower limit on the magnitude of theelasticity of demand for each firm.A particular firm’s elasticity depends on how the firms competewith one another, and the elasticity of market demand limits thepotential monopoly power of individual producers.Because the demand for oil is fairly inelastic (at leastin the short run), OPEC could raise oil prices far above marginalproduction cost during the 1970s and early 1980s. Because thedemands for such commodities as coffee, cocoa, tin, and copperare much more elastic, attempts by producers to cartelize thesemarkets and raise prices have largely failed. In each case, theelasticity of market demand limits the potential monopoly powerof individual producers.1. The Elasticity of Market Demand
  39. 39. 2.The Number of FirmsOther things being equal, the monopoly power ofeach firm will fall as the number of firmsincreases. When only a few firms account formost of the sales in a market, we say that themarket is highly concentrated.Barrier to entryCondition that impedes entry by new competitors.1. Sometimes there are natural barriers to entry.2. Patents, copyrights, and licenses3. Economies of scale may make it too costly formore than a few firms to supply the entiremarket. In some cases, economies of scale maybe so large that it is most efficient for a singlefirm—a natural monopoly—to supply the entiremarket.
  40. 40. 3.The Interaction Among FirmsFirms might compete aggressively, undercutting oneanother’s prices to capture more market share, or theymight not compete much. They might even collude (inviolation of the antitrust laws), agreeing to limitoutput and raise prices.Other things being equal, monopoly power is smaller whenfirms compete aggressively and is larger when theycooperate. Because raising prices in concert rather thanindividually is more likely to be profitable, collusion cangenerate substantial monopoly power.Remember that a firm’s monopoly power often changesover time, as its operating conditions (market demand andcost), its behaviour, and the behaviour of its competitorschange. Monopoly power must therefore be thought of in adynamic context. Furthermore, real or potential monopolypower in the short run can make an industry morecompetitive in the long run: Large short-run profits caninduce new firms to enter an industry, thereby reducingmonopoly power over the longer term.
  41. 41. The Social Costs of Monopoly PowerDEADWEIGHT LOSS FROMMONOPOLY POWERThe shaded rectangle andtriangles show changes inconsumer and producer surpluswhen moving from competitiveprice and quantity, Pc and Qc,to a monopolist’s price andquantity, Pm and Qm.Because of the higher price,consumers lose A + Band producer gains A − C. Thedeadweight loss is B + C.Rent SeekingSpending money in socially unproductive efforts to acquire, maintain, orexercise monopoly.We would expect the economic incentive to incur rent-seeking costs to bear a direct relation to the gains frommonopoly power (i.e., rectangle A minus triangle C.)
  42. 42. REGULATING THE PRICE OFA NATURAL MONOPOLYA firm is a natural monopolybecause it has economies ofscale (declining average andmarginal costs) over its entireoutput range.If price were regulated to be Pc thefirm would lose money and go outof business.Setting the price at Pr yields thelargest possible output consistentwith the firm’s remaining inbusiness; excess profit is zero.Natural MonopolyFirm that can produce the entire output of the market at acost lower than what it would be if there were severalfirms.
  43. 43. MonopsonyOligopsony Market with only a few buyers.Monopsony powerBuyer’s ability to affect the price of a good.Marginal valueAdditional benefit derived from purchasing one moreunit of a good.Marginal expenditureAdditional cost of buying one more unit of a good.Average expenditurePrice paid per unit of a good.
  44. 44. COMPETITIVE BUYER COMPARED TO COMPETITIVE SELLERIn (a), the competitive buyer takes market price P* as given. Therefore,marginal expenditure and average expenditure are constant and equal;quantity purchased is found by equating price to marginal value(demand). In (b), the competitive seller also takes price as given.Marginal revenue and average revenue are constant and equal;quantity sold is found by equating price to marginal cost.
  45. 45. MONOPSONIST BUYERThe market supply curve ismonopsonist’s averageexpenditure curve AE.Because average expenditure isrising, marginal expenditure liesabove it.The monopsonist purchasesquantity Q*m, where marginalexpenditure and marginal value(demand) intersect.The price paid per unit P*m is thenfound from the averageexpenditure (supply) curve.In a competitive market, price andquantity, Pc and Qc, are bothhigher.They are found at the point whereaverage expenditure (supply) andmarginal value (demand) intersect.
  46. 46. These diagrams show the close analogy between monopoly and monopsony.(a) The monopolist produces where marginal revenue intersects marginal cost.Average revenue exceeds marginal revenue, so that price exceeds marginalcost.(b) The monopsonist purchases up to the point where marginal expenditureintersects marginal value.Marginal expenditure exceeds average expenditure, so that marginal valueexceeds price.Monopsony and Monopoly Compared
  47. 47. MONOPSONY POWER: ELASTIC VERSUS INELASTIC SUPPLYMonopsony power depends on the elasticity of supply.When supply is elastic, as in (a), marginal expenditure and average expendituredo not differ by much, so price is close to what it would be in a competitivemarket.The opposite is true when supply is inelastic, as in (b).Monopsony Power
  48. 48. Sources of Monopsony PowerELASTICITY OF MARKET SUPPLYIf only one buyer is in the market—a pure monopsonist—itsmonopsony power is completely determined by the elasticity ofmarket supply. If supply is highly elastic, monopsony power issmall and there is little gain in being the only buyer.NUMBER OF BUYERSWhen the number of buyers is very large, no single buyer canhave much influence over price. Thus each buyer faces anextremely elastic supply curve, so that the market is almostcompletely competitive.INTERACTION AMONG BUYERSIf four buyers in a market compete aggressively, they will bid up theprice close to their marginal value of the product, and will thus havelittle monopsony power. On the other hand, if those buyers competeless aggressively, or even collude, prices will not be bid up verymuch, and the buyers’ degree of monopsony power might be nearlyas high as if there were only one buyer.
  49. 49. DEADWEIGHT LOSS FROMMONOPSONY POWERThe Social Costs of Monopsony PowerThe shaded rectangle andtriangles show changes inbuyer and seller surpluswhen moving fromcompetitive price andquantity, Pc and Qc, to themonopsonist’s price andquantity, Pm and Qm.Because both price andquantity are lower, there isan increase in buyer(consumer) surplus givenby A − B.Producer surplus falls byA + C, so there is adeadweight loss given bytriangles B and C.
  50. 50. Bilateral MonopolyMarket with only one seller and one buyer.It is difficult to predict the price and quantity in a bilateralmonopoly. Both the buyer and the seller are in a bargainingsituation.Bilateral monopoly is rare. Although bargaining may still beinvolved, we can apply a rough principle here: Monopsonypower and monopoly power will tend to counteract eachother. In other words, the monopsony power of buyers willreduce the effective monopoly power of sellers, and viceversa.This tendency does not mean that the market will end uplooking perfectly competitive, but in general,monopsony power will push price closer tomarginal cost, and monopoly power willpush price closer to marginal value.
  51. 51. MONOPSONY POWER IN U.S. MANUFACTURINGThe role of monopsony power was investigated to determine theextent to which variations in price-cost margins could be attributedto variations in monopsony power. The study found that buyers’monopsony power had an important effect on the price-cost marginsof sellers.In industries where only four or five buyers account for all or nearlyall sales, the price-cost margins of sellers would onaverage be as much as 10 percentage points lower than incomparable industries with hundreds of buyers accounting for sales.Each major car producer in the United States typically buys an individualpart from at least three, and often as many as a dozen, suppliers.For a specialized part, a single auto company may be theonly buyer.As a result, the automobile companies have considerablemonopsony power. Not surprisingly, producers of partsand components usually have little or no monopolypower.
  52. 52. 2Antitrust
  53. 53. Measures of Market PowerLerner IndexCross Price Elasticity ofDemandConcentration RatiosThe Herfindahl-HirschmanIndex
  54. 54. Measuring Monopoly Power :Lerner IndexRemember the important distinction between aperfectly competitive firm and a firm withmonopoly power: For the competitive firm,price equals marginal cost; for the firm withmonopoly power, price exceeds marginal cost.Lerner Index of Monopoly PowerMeasure of monopoly power calculated as excess of price overmarginal cost as a fraction of price.Mathematically:This index of monopoly power can also be expressed in terms ofthe elasticity of demand facing the firm.
  55. 55. The regulation of a monopoly is sometimes based on the rate of returnthat it earns on its capital. The regulatory agency determines an allowedprice, so that this rate of return is in some sense “competitive” or “fair.”Although it is a key element in determining the firm’s rate of return, afirm’s capital stock is difficult to value. While a “fair” rate of return mustbe based on the firm’s actual cost of capital, that cost depends in turnon the behaviour of the regulatory agency. Regulatory lag is a termassociated with delays in changing regulated prices.Another approach to regulation is setting price caps based on thefirm’s variable costs. A price cap can allow for more flexibility than rate-of-return regulation. Under price cap regulation, for example, a firmwould typically be allowed to raise its prices each year (without havingto get approval from the regulatory agency) by an amount equal to theactual rate of inflation, minus expected productivity growth.Regulation in PracticeRate-of-return regulationMaximum price allowed by a regulatory agency is based on the(expected) rate of return that a firm will earn.
  56. 56. The Effect of a TaxEFFECT OF EXCISE TAXON MONOPOLISTWith a tax t per unit, thefirm’s effectivemarginal cost isincreased by theamount t to MC + t.In this example, theincrease in price ΔP islarger than the tax t.Suppose a specific tax of t dollars per unit is levied, so that themonopolist must remit t dollars to the government for every unit itsells. If MC was the firm’s original marginal cost, its optimalproduction decision is now given by
  57. 57. PRICEREGULATIONIf left alone, a monopolistproduces Qm and chargesPm.When the governmentimposes a price ceiling ofP1 the firm’s average andmarginal revenue areconstant and equal to P1for output levels up to Q1.For larger output levels,the original average andmarginal revenue curvesapply.The new marginalrevenue curve is,therefore, the dark purpleline, which intersects themarginal cost curve at Q1.Price Regulation
  58. 58. PRICE REGULATIONWhen price islowered to Pc, at thepoint where marginalcost intersectsaverage revenue,output increases toits maximum Qc. Thisis the output thatwould be producedby a competitiveindustry.Lowering pricefurther, to P3, reducesoutput to Q3 andcauses a shortage,Q’3 − Q3.
  59. 59. Limiting Market Power:The Antitrust LawsAntitrust lawsRules and regulations prohibiting actions that restrain, or are likely torestrain, competition.Excessive market power harms potential purchasers and raisesproblems of equity and fairness. In addition, market power reducesoutput, which leads to a deadweight loss.In theory, a firm’s excess profits could be taxed away, but redistributionof the firm’s profits is often impractical.To limit the market power of a natural monopoly, such as an electricutility company, direct price regulation is the answer.It is important to stress that, while there are limitations(such as colluding with other firms), in general, it is notillegal to be a monopolist or to have market power. On thecontrary, we have seen that patent and copyrightlaws protect the monopoly positions of firms thatdeveloped unique innovations.
  60. 60. Restricting what Firms can doParallel conductForm of implicit collusion in which onefirm consistently follows actions ofanother.Predatory pricingPractice of pricing to drive currentcompetitors out of business and todiscourage new entrants in a market sothat a firm can enjoy higher futureprofits.
  61. 61. Antitrust IssuesThe Sherman Act of 1890The Clayton Act of 1914The Federal TradeCommission Act of 1914
  62. 62. The antitrust laws are enforced in threeways in USA :1. Through the Antitrust Division of theDepartment of Justice.2. Through the administrativeprocedures of the Federal TradeCommission.3. Through private proceedings.Enforcement of the Antitrust Laws
  63. 63. Antitrust in Europe At first glance, the antitrust laws of the European Unionare quite similar to those of the United States. Article101 of the Treaty of the European Community concernsrestraints of trade, much like Section 1 of the ShermanAct. Article 102, which focuses on abuses of market powerby dominant firms, is similar in many ways to Section 2of the Sherman Act. Finally, with respect to mergers, the European MergerControl Act is similar in spirit to Section 7 of the ClaytonAct. Nevertheless, there remain a number of procedural andsubstantive differences between antitrust laws inEurope and the United States. Merger evaluationstypically are conducted more quickly in Europe. Antitrust enforcement has grown rapidly through theworld in the past decade.
  64. 64. A PHONE CALL ABOUT PRICESRobert Crandall, president and CEO of American, made a phone callto Howard Putnam, president and chief executive of Braniff. It wentlike this:Crandall: I think it’s dumb as hell for Christ’s sake, all right, to sit hereand pound the @!#$%&! out of each other and neither one of usmaking a @!#$%&! dime.Putnam: Well . . .Crandall: I mean, you know, @!#$%&!, what the hell is the point of it?Putnam: But if you’re going to overlay every route of American’s ontop of every route that Braniff has—I just can’t sit here and allow youto bury us without giving our best effort.Crandall: Oh sure, but Eastern and Delta do the same thing in Atlantaand have for years.Putnam: Do you have a suggestion for me?
  65. 65. A PHONE CALL ABOUT PRICESCrandall: Yes, I have a suggestion for you. Raise your @!#$%&! fares20 percent. I’ll raise mine the next morning.Putnam: Robert, we. . .Crandall: You’ll make more money and I will, too.Putnam: We can’t talk about pricing!Crandall: Oh @!#$%&!, Howard. We can talk about any @!#$%&! thingwe want to talk about.Crandall was wrong. Talking about prices and agreeing to fixthem is a clear violation of Section 1 of the Sherman Act.However, proposing to fix prices is not enough to violate Section 1 ofthe Sherman Act: For the law to be violated, the two parties must agreeto collude.Therefore, because Putnam had rejected Crandall’s proposal, Section1 was not violated.
  66. 66. GO DIRECTLY TO JAIL. DON’T PASS GOIf you become a successful business executive, thinktwice before picking up the phone. And if yourcompany happens to be located in Europe or Asia,don’t think that will keep you out of a U.S. jail.For example:In 1996 Archer Daniels Midland (ADM) and two otherproducers of lysine (an animal feed additive) pled guilty tocharges of price fixing. In 1999 three ADM executives weresentenced to prison terms of two to three years.In 1999 four of the world’s largest drug and chemicalcompanies—Hoffman-La Roche of Switzerland,BASF of Germany, Rhone Poulenc of France, andTakeda of Japan—pled guilty to fixing the prices ofvitamins sold in the U.S. and Europe. The companies paidabout $1.5 billion in penalties to the U.S. Department ofJustice (DOJ), $1 billion to the European Commission, andover $4 billion to settle civil suits. Executives from each ofthe companies did prison time in the U.S.
  67. 67. GO DIRECTLY TO JAIL. DON’T PASS GODuring 2002 to 2009, Horizon Lines engaged inprice fixing with Sea Star Lines (Puerto Rico-basedshipping companies). Five executives got prisonterms ranging from one to four years.Eight companies, mostly in Korea and Japan, fixedDRAM (memory chip) prices from 1998 to 2002. In2007, 18 executives from these companies weresentenced to prison terms in the United States.In 2009, five companies pled guilty to fixing pricesof LCD displays during 2001-2006. 22 executivesreceived prison sentences in the United States (ontop of $1 billion in fines).In 2011, two companies were convicted of fixingprices and rigging bids for ready-mix concrete inIowa. One executive was sentenced to one year inprison, another to four years.
  68. 68. THE UNITED STATES AND THE EUROPEANUNION VERSUS MICROSOFTOver the past two decades Microsoft has grown to become thelargest computer software company in the world, and hasdominated the office productivity market. Under the antitrust lawsof the United States and the European Union, efforts by firms torestrain trade or to engage in activities that inappropriatelymaintain monopolies are illegal. Did Microsoft engage inanticompetitive, illegal practices?In 1998, the U.S. government said yes; Microsoft disagreed.The Antitrust Division of the U.S. DOJ filed suit, claiming thatMicrosoft had illegally bundled its Internet browser, InternetExplorer, with its operating system for the purpose of maintainingits dominant operating system monopoly. Following an eight-month trial that was hard-fought on a range of economic issues,the District Court found that Microsoft did have monopoly power inthe market for PC operating systems, which it had maintainedillegally in violation of Section 2 of the Sherman Act.The U.S. case was ultimately settled in 2004, with (among otherthings) Microsoft agreeing to give computer manufacturers(1) the ability to offer an operating system without InternetExplorer and (2) the option of loading competing browserPrograms on the PCs that they sell.
  69. 69. THE UNITED STATES AND THE EUROPEANUNION VERSUS MICROSOFTMicrosoft’s problems did not end with the U.S. settlement,however. In 2004, the European Commission orderedMicrosoft to pay $794 million in fines for its anti-competitive practices, to produce a version of Windowswithout the Windows Media Player to be sold alongside itsstandard editions.In 2008, the European Commission levied an additionalfine of $1.44 billion, claiming that Microsoft had notcomplied with the earlier decision. Even more recently, inresponse to a concern relating to the bundling of browsers,Microsoft agreed to offer customers a choice of browserswhen first booting up their new operating system.As of 2011, the European case against Microsoft remainson appeal. There is strong evidence that the European-imposed remedies have had little impact on the market formedia players or browsers. However, Microsoft is facing aneven stronger threat than U.S. or E.U. enforcement, suchas competition from the powerful Google search engineand social media sites such as Facebook.
  70. 70. 3Price Discrimination
  71. 71. Pricing and output decisionsin monopoly markets A monopoly market consists of one firm(the firm is the market)• firm has the power to set any price it wants• however, the firm’s ability to set price islimited by the demand curve for its product,and in particular, the price elasticity ofdemand
  72. 72. Pricing and output decisions inmonopoly marketsAssume demandis linear: it isdownward slopingbecause the firm isa price setterAssume MC isconstant choose outputwhere MR=MC,set price at P*
  73. 73. Pricing and output decisions inmonopoly marketsDemand is thesame as before, asis MRMC is upwardsloping, whichshows diminishingreturns set output whereMR=MC
  74. 74. Implications of monopolyfor decision making Monopoly market most important lesson is not to bearrogant and assume their ability toearn economic profit can never bediminished changes in economics of a businesseventually break down a dominatingcompany’s monopolistic power
  75. 75. Capturing Consumer SurplusCAPTURING CONSUMER SURPLUSPrice discriminationPractice of charging different prices todifferent consumers for similar goods.If a firm can charge only one pricefor all its customers, that price willbe P* and the quantity produced willbe Q*.Ideally, the firm would like to chargea higher price to consumers willingto pay more than P*, therebycapturing some of the consumersurplus under region A of thedemand curve.The firm would also like to sell toconsumers willing to pay priceslower than P*, but only if doing sodoes not entail lowering the price toother consumers.In that way, the firm could alsocapture some of the surplus underregion B of the demand curve.
  76. 76. First degree price discriminationPractice of charging each customer her reservation price.First-Degree Price DiscriminationVariable profitSum of profits on each incremental unit produced by afirm; i.e., profit ignoring fixed costs.Reservation priceMaximum price that a customer is willing to pay for agood.Price Discrimination
  77. 77. ADDITIONAL PROFIT FROM PERFECT FIRST-DEGREE PRICE DISCRIMINATIONBecause the firm chargeseach consumer herreservation price, it isprofitable to expand outputto Q**.When only a single price,P*, is charged, the firm’svariable profit is the areabetween the marginalrevenue and marginal costcurves.With perfect pricediscrimination, this profitexpands to the areabetween the demand curveand the marginal costcurve.
  78. 78. FIRST-DEGREE PRICEDISCRIMINATION IN PRACTICEPERFECT PRICE DISCRIMINATIONThe additional profit from producing and sellingan incremental unit is the difference betweendemand and marginal cost.IMPERFECT PRICE DISCRIMINATIONFirms usually don’t know thereservation price of every consumer,but sometimes reservation prices canbe roughly identified.Here, six different prices are charged.The firm earns higher profits, but someconsumers may also benefit.With a single price P4, there are fewerconsumers.The consumers who now pay P5 or P6enjoy a surplus.
  79. 79. SECOND-DEGREE PRICEDISCRIMINATIONSecond-Degree Price DiscriminationPractice of charging different prices per unit for differentquantities of the same good or service.Block pricing : Practice of charging different prices fordifferent quantities or “blocks” of a good.Different prices are charged fordifferent quantities, or “blocks,” ofthe same good. Here, there arethree blocks, with correspondingprices P1, P2, and P3.There are also economies of scale,and average and marginal costsare declining. Second-degreeprice discrimination can then makeconsumers better off by expandingoutput and lowering cost.
  80. 80. Third-Degree Price DiscriminationPractice of dividing consumers into two or moregroups with separate demand curves and chargingdifferent prices to each group.CREATING CONSUMER GROUPSIf third-degree price discrimination is feasible, howshould the firm decide what price to charge each groupof consumers?1. We know that however much is produced, totaloutput should be divided between the groups ofcustomers so that marginal revenues for eachgroup are equal.2. We know that total output must be such that themarginal revenue for each group of consumers isequal to the marginal cost of production.
  81. 81. DETERMINING RELATIVE PRICESLet P1 be the price charged to the first group of consumers,P2 the price charged to the second group, and C(QT) thetotal cost of producing output QT = Q1 + Q2. Total profit isthen
  82. 82. THIRD-DEGREE PRICE DISCRIMINATIONConsumers are divided into twogroups, with separate demandcurves for each group. Theoptimal prices and quantitiesare such that the marginalrevenue from each group is thesame and equal to marginalcost.Here group 1, with demandcurve D1, is charged P1,and group 2, with the moreelastic demand curve D2, ischarged the lower price P2.Marginal cost depends on thetotal quantity produced QT.Note that Q1 and Q2 are chosenso that MR1 = MR2 = MC.
  83. 83. NO SALES TO SMALLER MARKETSEven if third-degree pricediscrimination is feasible,it may not pay to sell toboth groups of consumersif marginal cost is rising.Here the first group ofconsumers, with demandD1, are not willing to paymuch for the product.It is unprofitable to sell tothem because the pricewould have to be too lowto compensate for theresulting increase inmarginal cost.
  84. 84. THE ECONOMICS OF COUPONS ANDREBATESCoupons provide a means of price discrimination.TABLE 1 PRICE ELASTICITIES OF DEMAND FORUSERS VERSUS NONUSERS OF COUPONSPRICE ELASTICITYPRODUCT NONUSERS USERSToilet tissue – 0.60 –0.66Stuffing/dressing –0.71 –0.96Shampoo –0.84 –1.04Cooking/salad oil –1.22 –1.32Dry mix dinners –0.88 –1.09Cake mix –0.21 –0.43Cat food –0.49 –1.13Frozen entrees –0.60 –0.95Gelatin –0.97 –1.25Spaghetti sauce –1.65 –1.81Crèmerinse/conditioner–0.82 –1.12Soups –1.05 –1.22Hot dogs –0.59 –0.77
  85. 85. AIRLINE FARESTABLE 2 ELASTICITIES OF DEMAND FOR AIR TRAVELFARE CATEGORYELASTICITYFIRSTCLASSUNRESTRICTEDCOACH DISCOUNTEDPrice –0.3 –0.4 –0.9Income 1.2 1.2 1.8Travelers are often amazed at the variety of fares available for round-trip flights from New York to Los Angeles.Recently, for example, the first-class fare was above $2000; the regular(unrestricted) economy fare was about $1000, and special discountfares (often requiring the purchase of a ticket two weeks in advanceand/or a Saturday night stayover) could be bought for as little as $200.These fares provide a profitable form of price discrimination.The gains from discriminating are large because different types ofcustomers, with very different elasticities of demand, purchase thesedifferent types of tickets.Airline price discrimination has become increasingly sophisticated. Awide variety of fares is available.
  86. 86. Intertemporal Price Discriminationand Peak-Load PricingINTERTEMPORAL PRICEDISCRIMINATIONIntertemporal pricediscriminationSpending money in sociallyunproductive efforts to acquire,maintain, or exercise monopoly.Peak-load pricingSpending money in sociallyunproductive efforts toacquire, maintain, orexercise monopoly.Consumers are divided intogroups by changing the priceover time.Initially, the price is high. Thefirm captures surplus fromconsumers who have a highdemand for the good and whoare unwilling to wait to buy it.Later the price is reduced toappeal to the mass market.
  87. 87. PEAK-LOADPRICINGPeak-Load PricingDemands for some goodsand services increasesharply during particulartimes of the day or year.Charging a higher price P1during the peak periods ismore profitable for the firmthan charging a single priceat all times.It is also more efficientbecause marginal cost ishigher during peak periods.
  88. 88. HOW TO PRICE A BEST-SELLING NOVELPublishing both hardbound and paperback editions of abook allows publishers to price discriminate.Some consumers want to buy a new bestseller as soon asit is released, even if the price is $25. Other consumers,however, will wait a year until the book is available inpaperback for $10.The key is to divide consumers into two groups, so thatthose who are willing to pay a high price do so and onlythose unwilling to pay a high price wait and buy thepaperback.It is clear, however, that those consumers willing to wait forthe paperback edition have demands that are far moreelastic than those of bibliophiles.It is not surprising, then, that paperback editionssell for so much less than hardbacks.
  89. 89. The Two-Part TariffTWO-PART TARIFF WITHA SINGLE CONSUMERForm of pricing in which consumers are charged bothan entry and a usage fee.SINGLE CONSUMERThe consumer hasdemand curve D.The firm maximizes profitby setting usage fee Pequal to marginal costand entry fee T* equal tothe entire surplus of theconsumer.
  90. 90. TWO-PART TARIFF WITHTWO CONSUMERSTWO CONSUMERSThe profit-maximizingusage fee P* will exceedmarginal cost.The entry fee T* is equalto the surplus of theconsumer with thesmaller demand.The resulting profit is2T* + (P* − MC)(Q1 + Q2).Note that this profit islarger than twice thearea of triangle ABC.
  91. 91. TWO-PART TARIFF WITH MANYDIFFERENT CONSUMERSMANY CONSUMERSTotal profit π is the sum of the profitfrom the entry fee πa and the profitfrom sales πs. Both πa and πs depend onT, the entry fee.Thereforeπ = πa + πs = n(T)T + (P − MC)Q(n)where n is the number of entrants,which depends on the entry fee T, andQ is the rate of sales, which is greaterthe larger is n.Here T* is the profit-maximizing entryfee, given P. To calculate optimumvalues for P and T, we can start with anumber for P, find the optimum T, andthen estimate the resulting profit. P isthen changed and the corresponding Trecalculated, along with the new profitlevel.
  92. 92. PRICING CELLULAR PHONE SERVICEMost telephone service is priced using a two-part tariff: amonthly access fee, which may include some free minutes,plus a per-minute charge for additional minutes. This is alsotrue for cellular phone service, which has grown explosively,both in the United States and around the world. In the caseof cellular service, providers have taken the two-part tariffand turned it into an art form. In most parts of the UnitedStates, consumers can choose among four national networkproviders—Verizon, T-Mobile, AT&T, and Sprint. Theseproviders compete among themselves for customers, buteach has some market power. Market power arises in partfrom oligopolistic pricing and output Decisions, but alsobecause consumers face switching costs: Most serviceproviders impose a penalty upwards of $200 for earlytermination. Because providers have market power, theymust think carefully about profit-maximizing pricingstrategies. The two-part tariff provides an ideal means bywhich cellular providers can capture consumer surplus andturn it into profit. The two-part tariff works best whenconsumers have identical or very similar demands.
  93. 93. PRICING CELLULAR PHONE SERVICETABLE 3 CELLULAR RATE PLANS (2011)ANYTIMEMINUNTESMONTHLYACCESSCHARGESNIGHT &WEEKENDMINUTESPER-MINUTERATE AFTERALLOWANCEA. VERIZON: AMERICA’S CHOICE BASIC450 $39.99 Unlimited $0.45900 $59.99 Unlimited $0.40Unlimited $69.99 Unlimited IncludedB. SPRINT: BASIC TALK PLANS200 $29.99 Unlimited $0.45450 $39.99 Unlimited $0.45900 $59.99 Unlimited $0.40C. AT&T INDIVIDUAL PLANS450 $39.99 5000 $0.45900 $59.99 Unlimited $0.40Unlimited $69.99 Unlimited Included
  94. 94. PRICING CELLULAR PHONE SERVICETABLE 3 CELLULAR RATE PLANS (2011) (continued)ANYTIMEMINUNTESMONTHLY ACCESSCHARGESNIGHT & WEEKENDMINUTESPER-MINUTE RATEAFTER ALLOWANCED. ORANGE (UK)100 £10.00 None 2.5 pence200 £15.00 None 2.5 pence300 £20.00 None 2.5 penceE. ORANGE (ISRAEL)None 28.00 NIS None 0.59 NIS100 38.00 NIS None 0.59 NIS400 61.90 NIS None 0.59 NISF. CHINA MOBILE150 58 RMB None 0.40 RMB450 158 RMB None 0.35 RMB800 258 RMB None 0.32 RMB1200 358 RMB None 0.30 RMB1800 458 RMB None 0.25 RMBTo convert the international prices to U.S. dollars (as of August 2011),use the following conversion factors: 1£ = $1.60, 1 NIS = $0.30, and 1RMB = $0.13.
  95. 95. Conclusion“Monopoly : The earnings of many inthe hands of one.”Eugene Debs
  96. 96. Core Reading• Keat, Paul G. and Young, Philip KY (2009)Managerial Economics, 6th edition, Pearson• Samuelson, William F. and Marks, StephenG.(2010) Managerial Economics, 6th edition, JohnWiley• Pindyck, Robert S. and Rubinfeld, Daniel L.(2013)Microeconomics, 8th edition, Pearson• Samuelson, P.A. and Nordhaus, W. D.(2010)“Economics” Irwin/McGraw-Hill, 19thEdition• Porter, Michael E. (2004)“Competitive Strategy –Techniques for Analyzing Industries and Competitors”Free Press
  97. 97. Questions?