Lecture 7
Pricing I: Market Power

1

15.0.11/0111 Economic Analysis for Business Decisions

Oz Shy

2

Some common terminology

Monopoly: A single seller that can raise price to restrict supply (could be protected against entry by patent rights, regulations, or by leveraging complementary markets)

Cartel: Firms joining together to restrict output and raise prices (example: OPEC)

Monopsony: Single buyer (example: a large firm hiring in a small town (restricts hiring to lower wages)

Oligopoly (oligopsony): Firms can exercise ‘some’ degree of market power

3

Monopoly in the news

The National Development and Reform Commission (NDRC), responsible for enforcing rules against anti-competitive pricing, today said that it had found Chrysler in Shanghai and Audi in Hubei to be engaging in monopolistic behavior.

BEIJING (Reuters) -- China said it will punish Audi and Chrysler as well as some 10 Japanese spare-parts makers for violating the country's anti-monopoly law.

4

Monopoly in the news

Specialists in infectious disease are protesting a gigantic overnight increase in the price of a 62-year-old drug that is the standard of care for treating a life-threatening parasitic infection.

The drug, called Daraprim, was acquired in August by Turing Pharmaceuticals, a start-up run by a former hedge fund manager. Turing immediately raised the price to $750 a tablet from $13.50, bringing the annual cost of treatment for some patients to hundreds of thousands of dollars.

5

The monopoly

  • is a price-setter, not a price taker, hence
  • a monopoly does not have a supply curve
  • Unlike a competitive firm (price taker), a monopoly must study the demand very carefully!
  • Chooses a price/quantity pair on the demand curve to maximize profit
  • Legal issues: Antitrust will be discussed later on in the course

Note: Setting high prices need not always be illegal. Preventing competition is illegal

6

The marginal-revenue (MR) function

Definition:

MR = the increase in total revenue resulting from a small (one unit) increase in output (quantity sold)

TR

MR > 0 if the demand is elastic

MR < 0 if the demand is inelastic

MR = 0 unit elasticity (revenue is maximized)

Commonly used formula:

7

The marginal-revenue (MR) function: An example

Formula to memorize (No need to memorize the proof):

If P(Q) = a - b Q, then

MR(Q) = a - 2 b Q

In the example on the left:

P

Q

TR = P x Q

MR

MR (formula)

6

0

0

n/a

6

5

1

5

5

4

4

2

8

3

2

3

3

9

1

0

2

4

8

-1

-2

1

5

5

-3

-4

0

6

0

-5

-6

The maximum revenue output is found from:

Remark: Here, MR(2)=3 is the revenue change from selling the 2nd unit, etc.

8

The monopoly’s profit-maximizing output (and price)

The monopoly’s profit maximizing output is found from MR(Q) = MC(Q), as long as the resulting price satisfies: P ≥ ATC (Q) in the long-run and P ≥ AVC(Q) in the short-run

MC

MR

Example: TC(Q) = 5 + 2 Q, hence MC(Q) = $2

MR(Q)=MC(Q) implies 6 - 2Q = 2, hence Qm = 2 units & Pm = $4

Short-run profit = shaded area = ∏SR= ($4 - $2) 2 = $4 >0

But, in the LR, taking fixed costs into account, the firm makes a loss because

LR= ($4 - $2) 2 - $5 < 0

9

What’s wrong with having a monopoly seller?

Consumer advocates “complain” about high prices (surplus transfer from consumers to the firm)

Economists “complain” about inefficiency associated with uncaptured surplus (deadweight loss) due to output reduction

10

Price markup: Definition

Largest markup in the grocery store

To express in % terms, simply multiply by 100

Example 1 from slide #6: Pm = $4 and MC = $2

Example 2: Competitive firm P=MC, so markup = 0

11

Price markup and price elasticity:

Important relationship

In a monopoly equilibrium:

Note: Yes, also MR = MC (one condition implies the other)

Example from Slide #7: Let’s verify that the formula is “working”

Slide #7 shows that the markup is 0.5 or 50%

Let’s compute the price elasticity at equilibrium: P=$4 and Q=2

Implications: (1) Higher elasticity implies lower markup

(2) Lower elasticity implies higher markup

Lecture-7-Pricing-I-Revised-151014 - Google Slides