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Monopoly

bepp 250

Monopoly
Definition: The only producer of a good with no close
substitutes.
Examples: Carnegie Steel, Microsoft, Google.
Examples come in shades of gray: Google has about
80% of the US search market. But ~30B in revenue
is more like 15% of the US 200B advertising
market.

To last, monopolies need a moat.

Apple is a great example:
Brand, FoxConn scale, network effects, complex
technology integrating software and hardware,
patents.

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Monopoly Math

Only difference is prices depend on y: p(y)

The steps before are part of Bottom Floor,
Engineering.
These steps are Top Floor CEO decisions

Knows costs,
Makes Production
prices, competitive
Decision:
environment:
y
c(y), p(y)

Monopoly faces
downward sloping
demand curve!

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Defining Marginal Revenue

Revenue

r(y) = p(y)y
Profits
= r(y) c(y)
Denote r(y) = MR(y), marginal revenue.

Defining Marginal Revenue

One condition, marginal revenue equals marginal cost:

MR = MC
Could rewrite marginal revenue as

p(y) + y p'(y) = MC(y)

Revenue from Loss from reducing price

marginal Apple from all previous apples sold

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Graphically
p
MR curve starts at the same D
place as demand, but is lower
than demand.
MC

Optimal quantity at the

intersection of MR and MC.

MR

y*

Graphically
p
MR curve starts at the same D
place as demand, but is lower
than demand.
MC
p*
Optimal quantity at the
intersection of MR and MC.

Optimal price given by the

demand curve!
MR

y*

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Market Breakdown: iPads in 2012

The WSJ calculates that the iPad costs about $300 to make.

If demand (y is millions of iPads) is

p(y) = 700 5y
then what is the optimal quantity and price?

Solution
Step 1: MR = p(y) + y p'(y)
We know demand, and can
calculate MR=p(y)+p(y)y MR = 700 5y 5y
With linear demand MR always has same constant
and twice the slope of demand MR = 700 10y

Step 2: MC = MR
Setting MR=MC we get 300 = 700 10y
Step 3:
y = 40 million iPads.
Price is given by demand curve p(40)=700-5*40= $500

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p
D=700-5Q
$700 MR=700-10Q
D
$500

MC
$300

MR
Q
40 million

Graphically

Market Power

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Market Power
Market power is the ability of a firm to set prices above marginal cost.

Market power can be measured either from cost data or from the
demand elasticity: If the monopolist is optimizing, the answer has to
be the same.

Lets show this by manipulating the maximization condition:

MR = MC
p + p' y = MC
p MC = p' y
p MC 1
=
p | |

The Lerner Index

Definition: The Lerner index equals

p MC 1
=
Markup (given by price
p | |
Inverse Elasticity
and cost structure) (given by demand curve)

The Lerner index can be calculated either from costs or from the
elasticity, and measures how much monopoly power the firm has.
For Apple, (p-MC)/p=200/500=0.4. Not bad, but not as amazing as it
was when the iPad ruled the tab market alone. Elasticity about
1/.4=2.5.

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Observations
The Lerner index = 0 in a perfectly competitive market. We
can see this in two ways:

Firms price at marginal cost.

Or, the Elasticity is infinite because firm demand is
infinitely elastic.

Lerner index always below 1 for the monopolist: if elasticity

were below 1, monopolist would always raise the price!

In equilibrium, monopolist always prices so high that he

faces elasticity above 1, even if there are few good
substitutes!

Observations
Closest accounting concept to markup is the gross
margin/revenue, or (revenue-COGS)/revenue.
In an income statement this is gross income /
revenue.
Accounting definitions are averages not marginal,
but it is a start. Also sometimes they differ from
economic costs.
But looking at gross margin gives you an idea of
market power. Just check Google Finance.
Careful not to confuse econ vs. accounting
markups, the definitions are different.

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Observations
From a management perspective, can use the
gross margin to check if prices are set correctly.

The Lerner index formula subsumes several

pricing strategies from marketing:
Cost based pricing, demand based pricing,
competitor benchmarking.

Welfare Effects
of Monopoly
p
Monopoly sets price DWL
above marginal cost $700
(and above the D
competitive price). $500

Causes consumers to MC
buy less than the $300
competitive level of
output. MR
Q
For the iPad, the
40
deadweight loss is the
million
gray area in the figure.

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Moats
What features keep other firms from competing with a
monopolist? This is what Warren Buffett calls a moat, and
Michael Porter sources of competitive advantage.

Better Technology / Cost Advantage: (Carnegie Steel, Apple,

Geico)
Patents (Apple, Samsung)
Legal barriers to entry (US post office)
Economies of scale (PECO, a natural monopoly, and to some
extent Apple, Google)
Network Effects (Facebook, Google, Twitter)
Control of Unique Resource (a quarry)

Note that some companies are briefly successful, monetize well,

but do not have very good moats: e.g., Zynga, Groupon.

Example: Eyewear
Company: Luxottica. The world's largest eyewear company.
60 Minutes Video
Controls nearly 80% of luxury eyeglass production and retailing.
Merger and acquisitions eliminated competitors: Rayban, Oakley,
and acquired distribution channels Lenscrafters, Sunglass Hut,
Pearl Vision.
Moat:
Scale is now a cost advantage.
Ownership of distribution channels creates a barrier to entry.
Consequences:
High prices: high markups to client companies (e.g. Channel, Polo,
etc), and consumers.
But also create value through incentives to innovate: production
technology, introduction of a variety of designs.

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Example: Gene Therapy

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Generic Drugs

Key Points to Remember

Relationship between marginal revenue and the elasticity of demand
Monopoly profit maximization: MR=MC
Measuring market power: The Lerner Index

Sources of market power

Welfare cost of monopolies: DWL
Cost advantages of monopolies:
Economies of scale
Technology advantage and innovation

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Readings
Varian 25.
60 Minutes Luxottica video.
Bonus Readings: Gene therapy pricing, Martin
Shkrellis life, and Peter Thiels Essay.

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