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

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Rolf Casey
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1 A Rule of Thumb for Pricing: Example 10-1 Market for antiulcer drugs Previous drugs: Tagamet (1977); Zantac (1983); Pepcid (1986); Axid (1988) By 1996, Prilosec it had become the bestselling drug in the world. Recent introduction: Prilosec (1995) The producer of Prilosec, Astra-Merck, was pricing the drug at about $3.50 per daily dose. Chapter 10 1

2 A Rule of Thumb for Pricing: Example 10-1 Market for antiulcer drugs The marginal cost of producing & packaging Prilosec is only about cents. 3.5 =.3 1+ (1/ E d ) or = E d E d 1.09 Chapter 10 2

3 Prilosec Read the FT articles on your handouts on Losec. Note that 1 Chapter 10 3

4 Monopoly Power Pure monopoly is rare However, a market with several firms, each facing a downward sloping demand curve, will produce so that price exceeds marginal cost Firms often product similar goods that have some differences (product differentiation), thereby differentiating themselves from other firms (monopolistic competition (Ch. 12)) Chapter 10 4

5 Monopoly Power: Example Four firms share a market for 20,000 toothbrushes at a price of $1.50 Profits maximizing quantity for each firm is where MR = MC In our example that is 5000 units for Firm A, with a price of $1.50, which is greater than marginal cost Although Firm A is not a pure monopolist, they have monopoly power Chapter 10 5

6 The Demand for Toothbrushes $/Q 2.00 At a market price of $1.50, elasticity of demand is $/Q 2.00 Firm A has some monopoly power and charges a price which exceeds MC where MR=MC MC A Market Demand D A 1.00 MR A Quantity 10,000 Q A 20,000 30,000 3,000 5,000 7,000

7 Measuring Monopoly Power Our firm would have more monopoly power, of course, if it could get rid of the other 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 than others? Chapter 10 7

8 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 and 1) the greater the monopoly power L is expressed in terms of E d L = (P - MC)/P = -1/E d E d is elasticity of demand for a firm, not the market Chapter 10 8

9 Monopoly Power Monopoly power, however, does not guarantee profits Profit depends on average cost relative to price: π=q(p - AC) One firm may have more monopoly power but lower profits due to high average costs Chapter 10 9

10 Rule of Thumb for Pricing Pricing for any firm with monopoly power: If E d is large, markup is small If E d is small, markup is large P = 1+ MC ( 1 E ) d Chapter 10 10

11 Elasticity of Demand and Price Markup $/Q The more elastic is demand, the less the markup. MC $/Q P* MC P* P*-MC D P*-MC MR D MR Q* Quantity Q* Quantity

12 Questions Is it possible for a monopolist to keep its market for a long period? Can a firm with monopoly power continue to exercise the power for a long period? Chapter 10 12

13 Markup Pricing: Supermarkets & Convenience Stores (Ex. 10.2) Supermarkets 1. Several firms 2. Similar product 3. E d = 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 13

14 Markup Pricing: Supermarkets & Convenience Stores (Ex. 10.2) Convenience stores have more monopoly power Convenience stores do have higher profits than supermarkets, however Volume is far smaller and average fixed costs are larger Chapter 10 14

15 Markup Pricing: Supermarkets & Convenience Stores (Ex. 10.2) Convenience Stores 1.Severalstores 2Similar products 3E d 5 MC 4 P = 1+ ( 1/5) = MC.8 =1.25MC 5Pricesset about 25%aboveMC Chapter 10 15

16 Sources of Monopoly Power Why do some firms have considerable monopoly power, and others have little or none? Monopoly power is determined by ability to set price higher than marginal cost A firm s monopoly power, therefore, is determined by the firm s elasticity of demand Chapter 10 16

17 Sources of Monopoly Power The less elastic the demand curve, the more monopoly power a firm has The firm s elasticity of demand is determined by: 1) Elasticity of market demand 2) Number of firms in market 3) The interaction among firms Chapter 10 17

18 Elasticity of Market Demand With one firm, their demand curve is market demand curve Degree of monopoly power is determined completely by elasticity of market demand With more firms, individual demand may differ from market demand Demand for a firm s product is more elastic than the market elasticity Chapter 10 18

19 Number of Firms The monopoly power of a firm falls as the number 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 to entry to keep new firms out of market Patent, copyrights, licenses, economies of scale Chapter 10 19

20 The Social Costs of Monopoly Power Monopoly power results in higher prices and lower quantities However, does monopoly power make consumers and producers in the aggregate better or worse off? We can compare producer and consumer surplus when in a competitive market and in a monopolistic market Chapter 10 20

21 The Social Costs of Monopoly Perfectly competitive firm will produce where MC = D P C and Q C Monopoly produces where MR = MC, getting their price from the demand curve P M and Q M There is a loss in consumer surplus when going from perfect competition to monopoly A deadweight loss is also created with monopoly Chapter 10 21

22 Deadweight Loss from Monopoly Power $/Q P m Lost Consumer Surplus Deadweight Loss MC Because of the higher price, consumers lose A+B and producer gains A-C. A B P C C AR=D MR Q m Q C Quantity Chapter 10 22

23 Chapter 10 23

24 Chapter 10 24

Learning Objectives. Chapter 6. Market Structures. Market Structures (cont.) The Two Extremes: Perfect Competition and Pure Monopoly

Learning Objectives. Chapter 6. Market Structures. Market Structures (cont.) The Two Extremes: Perfect Competition and Pure Monopoly Chapter 6 The Two Extremes: Perfect Competition and Pure Monopoly Learning Objectives List the four characteristics of a perfectly competitive market. Describe how a perfect competitor makes the decision