Chapter 10 1©2005 Pearson Education, Inc.

A Rule of Thumb for Pricing: Example 10-1 Market for antiulcer drugs

Previous drugs: Tagamet (1977); Zantac(1983); Pepcid (1986); Axid (1988) By1996, Prilosec it had become the best-selling drug in the world.

�Recent introduction: Prilosec (1995)

� The producer of Prilosec, Astra-Merck,was pricing the drug at about $3.50 perdaily dose.

Chapter 10 2©2005 Pearson Education, Inc.

A Rule of Thumb for Pricing: Example 10-1 Market for antiulcer drugs

� The marginal cost of producing &packaging Prilosec is only about 30 - 40cents.

3.5 =.3

1+ (1/Ed )

or3.5 − .3

3.5= −

1

Ed

Ed ≅ −1.09

Chapter 10 3©2005 Pearson Education, Inc.

Prilosec

�Read the FT articles on your handouts onLosec. Note that �������������� ����� ������������������������������������������������ �����������������������������������������������������������������������

Chapter 10 4©2005 Pearson Education, Inc.

Monopoly Power

� Pure monopoly is rare

� However, a market with several firms, eachfacing a downward sloping demand curve, willproduce so that price exceeds marginal cost

� Firms often product similar goods that havesome differences (product differentiation),thereby differentiating themselves from otherfirms (monopolistic competition (Ch. 12))

Chapter 10 5©2005 Pearson Education, Inc.

Monopoly Power: Example

� Four firms share a market for 20,000toothbrushes at a price of $1.50

�Profits maximizing quantity for each firmis where MR = MC

� In our example that is 5000 units for FirmA, with a price of $1.50, which is greaterthan marginal cost

�Although Firm A is not a pure monopolist,they have monopoly power

At a market priceof $1.50, elasticity of

demand is -1.5. 2.00

$/Q

1.50

1.00

Quantity10,000 QA20,000 30,000 3,000 5,000 7,000

$/Q

2.00

1.50

1.00

1.40

1.60

DA

MRA

Market Demand

Firm A has some monopolypower and charges a pricewhich exceeds MC where

MR=MC.

MCA

The Demand for Toothbrushes

Chapter 10 7©2005 Pearson Education, Inc.

Measuring Monopoly Power

� Our firm would have more monopolypower, of course, if it could get rid of theother firms�But the firm’s monopoly power might

still be substantial� How can we measure monopoly power to

compare firms?� What are the sources of monopoly power?

�Why do some firms have more thanothers?

Chapter 10 8©2005 Pearson Education, Inc.

Measuring Monopoly Power� Could measure monopoly power by the extent to which

price is greater than MC for each firm

� Lerner’s Index of Monopoly Power� L = (P - MC)/P

�The larger the value of L (between 0 and1) the greater the monopoly power

� L is expressed in terms of Ed

�L = (P - MC)/P = -1/Ed

�Ed is elasticity of demand for a firm, notthe market

Chapter 10 9©2005 Pearson Education, Inc.

Monopoly Power

�Monopoly power, however, does notguarantee profits

�Profit depends on average cost relativeto price: π=Q(P - AC)

�One firm may have more monopolypower but lower profits due to highaverage costs

Chapter 10 10©2005 Pearson Education, Inc.

Rule of Thumb for Pricing

�Pricing for any firm with monopoly power:�If Ed is large, markup is small

�If Ed is small, markup is large

( )dEMC

P11+

=

Elasticity of Demand and PriceMarkup

P*

MR

D

$/Q

Quantity

MC

Q*

P*-MC

The more elastic isdemand, the less the

markup.

D

MR

$/Q

Quantity

MC

Q*

P*P*-MC

Chapter 10 12©2005 Pearson Education, Inc.

� Is it possible for a monopolist to keep itsmarket for a long period?

�Can a firm with monopoly power continueto exercise the power for a long period?

Questions

Chapter 10 13©2005 Pearson Education, Inc.

Markup Pricing: Supermarkets &Convenience Stores (Ex. 10.2)

�Supermarkets

1. Several firms

2. Similar product

3. Ed = −10 for individual stores

4.P =MC

1+ 1 −10( )=MC

0.9=1.11(MC)

5. Prices set about 10 -11% above MC.

Chapter 10 14©2005 Pearson Education, Inc.

Markup Pricing: Supermarkets &Convenience Stores (Ex. 10.2)

�Convenience stores have moremonopoly power

�Convenience stores do have higherprofits than supermarkets, however�Volume is far smaller and average fixed

costs are larger

Chapter 10 15©2005 Pearson Education, Inc.

Markup Pricing: Supermarkets &Convenience Stores (Ex. 10.2)

�Convenience Stores

1.Several stores

2Similar products

3Ed ≅ −5

4P =MC

1+ (−1/5)=MC

.8=1.25MC

5 Pr icesset about25%aboveMC

Chapter 10 16©2005 Pearson Education, Inc.

Sources of Monopoly Power

�Why do some firms have considerablemonopoly power, and others have little ornone?

�Monopoly power is determined by abilityto set price higher than marginal cost

�A firm’s monopoly power, therefore, isdetermined by the firm’s elasticity ofdemand

Chapter 10 17©2005 Pearson Education, Inc.

Sources of Monopoly Power

� The less elastic the demand curve, themore monopoly power a firm has

� The firm’s elasticity of demand isdetermined by:

1) Elasticity of market demand

2) Number of firms in market

3) The interaction among firms

Chapter 10 18©2005 Pearson Education, Inc.

Elasticity of Market Demand

�With one firm, their demand curve ismarket demand curve�Degree of monopoly power is determined

completely by elasticity of market demand

�With more firms, individual demand maydiffer from market demand�Demand for a firm’s product is more elastic

than the market elasticity

Chapter 10 19©2005 Pearson Education, Inc.

Number of Firms

� The monopoly power of a firm falls as thenumber of firms increases; all else equal�More important are the number of firms with

significant market share�Market is highly concentrated if only a few

firms account for most of the sales

� Firms would like to create barriers toentry to keep new firms out of market�Patent, copyrights, licenses, economies of

scale

Chapter 10 20©2005 Pearson Education, Inc.

The Social Costs of MonopolyPower

�Monopoly power results in higher pricesand lower quantities

�However, does monopoly power makeconsumers and producers in theaggregate better or worse off?

�We can compare producer and consumersurplus when in a competitive market andin a monopolistic market

Chapter 10 21©2005 Pearson Education, Inc.

The Social Costs of Monopoly

� Perfectly competitive firm will produce where MC= D � PC and QC

� Monopoly produces where MR = MC, getting theirprice from the demand curve � PM and QM

� There is a loss in consumer surplus when goingfrom perfect competition to monopoly

� A deadweight loss is also created with monopoly

Chapter 10 22©2005 Pearson Education, Inc.

BA

Lost Consumer Surplus Because of thehigher price,

consumers loseA+B and

producer gainsA-C.

C

Deadweight Loss fromMonopoly Power

Quantity

AR=D

MR

MC

QC

PC

Pm

Qm

$/Q

Deadweight Loss

Chapter 10 23©2005 Pearson Education, Inc.

Chapter 10 24©2005 Pearson Education, Inc.