Chapter 8: Monopoly

Chapter 8
Monopoly
LEARNING OBJECTIVES
 Appreciate how to gain market power.
 For a seller with market power, identify the scale of production/sales that
maximizes profit.
 Appreciate how to adjust sales to changes in demand and costs.
 For a seller with market power, identify the levels of advertising and R&D
expenditure that maximize profit.
 Appreciate that sellers with market power restrict sales to raise margins and
profit.
 Apply the incremental margin percentage to measure market power.
 For a buyer with market power, identify the scale of purchases that maximize
profit.

KEY TAKEAWAYS
 Gain market power by limiting competition and making demand less price-elastic.
 To maximize profit, produce if total revenue covers total cost, and, then, produce
at the scale where marginal revenue equals marginal cost.
 When demand or costs change, adjust production to the scale where marginal
revenue equals marginal cost.
 To maximize profit, spend on advertising to the level where the advertising-sales
ratio equals the incremental margin percentage multiplied by the advertising
elasticity of demand.
 To maximize profit, spend on R&D to the level where the R&D-sales ratio equals
the incremental margin percentage multiplied by the R&D elasticity of demand.
 Sellers with market power restrict sales to raise margins and profit.
 Measure market power by the incremental margin percentage.
 To maximize profit, purchase at the scale where marginal benefit equals
marginal expenditure.

PROGRESS CHECKS AND ANSWERS:

8A. What are the two ingredients of market power?

Answer
Barriers to competition and the elasticity of demand or supply.

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 Chapter 8: Monopoly

8B. If demand is extremely elastic, what will be the difference between the price and
the marginal revenue?

Answer
If the demand is very elastic, then the marginal revenue will be close to the price.

8C. Suppose that, at the current scale of production, Venus's marginal revenue is less
than its marginal cost. How should management adjust its price?

Answer
It should raise price, so reducing sales up to the quantity where its marginal cost equals
its marginal revenue.

8D. In figure 8.3, show how Venus should adjust sales if marginal cost increases by $20
at all scales of production.

Answer
If marginal cost increases by $20 at all scales of production, Venus should raise price to
e and decrease the production to c.

Price ($
per demand (marginal benefit)
unit)
e
e135

b
91 Increase in
a marginal cost
71

marginal
revenue

0 c 1.3 1.4

Quantity (million units a year)

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 Chapter 8: Monopoly

8E. Suppose that the profit-maximizing scale of production for Gamma-1 is 1.3 million
units. At that scale, the price is $135 per unit, the marginal cost is $71, and the
advertising elasticity of demand is 0.14. How much should Venus spend on advertising?

Answer
Advertising expenditure = (135 – 71) x 0.14 x 1.3 = $11.65 million.

8F. If price is higher while marginal cost is lower, how should R&D expenditure be
adjusted?

Answer
If price is higher while marginal cost is lower, then the incremental margin will be
higher, and so R&D expenditure should be higher.

8G. In figure 8.5, shade the area that represents Venus's total expenditure on the herb.

Answer
Venus’s total expenditure is represented by either the area u0vx under the marginal
expenditure curve from a quantity of 0 to 6,000 tons, or the rectangle t0vz.

REVIEW QUESTIONS AND ANSWERS:

1. By way of an example, explain how product differentiation contributes to market

power.

Answer
Coca-Cola. To differentiate its product, Coca-Cola has made intensive investments in its
brand that support a price premium over generic colas.

2. What are the major forms of intellectual property?

Answer
Patents, copyrights, trademarks, and trade secrets.

3. Explain how economies of scale can contribute to market power.

Answer

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 Chapter 8: Monopoly

With economies of scale, a producer that produces on a larger scale will have a cost
advantage over other producers. So, it can price lower and dominate its market.

4. For a seller with market power, why is marginal revenue less than or equal to price?

Answer
To sell additional units, a seller must reduce its price. So, when increasing sales by one
unit, the seller will gain the price of the marginal unit but lose revenue on the infra-
marginal units. Hence, the marginal revenue is less than or equal to the price.

5. True or false? A seller with market power can either set the price and let the market
decide how much to buy, or set the quantity to sell and let the market decide the price,
but not set both price and quantity.

Answer
True.

6. A software publisher has priced a new database program such that its marginal
revenue is more than its marginal cost. Advise the company how to raise its profit.

Answer
The publisher should reduce its price and sell additional units. For these units, the
marginal revenue is greater than marginal cost, thereby increasing total profit. It
should reduce price until the marginal revenue equals the marginal cost.

7. Why should a seller take account of both the marginal revenue and the marginal cost
when considering how to adjust price following a change in costs?

Answer
The profit-maximizing quantity is such that the marginal revenue equals the marginal
cost. Hence, after a change in costs, the seller should look for the quantity where the
marginal revenue equals the marginal cost. So, it must consider both the marginal
revenue and the marginal cost.

8. Why should a seller take account of both the marginal revenue and the marginal cost
when considering how to adjust price following a change in demand?

Answer

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 Chapter 8: Monopoly

The profit-maximizing quantity is such that the marginal revenue equals the marginal
cost. Hence, after a change in demand, the seller should look for the quantity where
the marginal revenue equals the marginal cost. So, it must consider both the marginal
revenue and the marginal cost.

9. The profit-maximizing price for a new electronic device is $100. At that price, the
advertising elasticity of the demand is 0.1 and sales are 500,000 units a year. The
marginal cost of production is $40 per unit. How much should the publisher spend on
advertising?

Answer
Advertising expenditure = (100 – 40) x 0.01 x 500,000 = $0.3 million.

10. For a medical device, the advertising to sales ratio exceeds the incremental margin
percentage multiplied by the advertising elasticity of demand. How can the
manufacturer increase profit?

Answer
Reduce advertising expenditure until the advertising-sales ratio equals the incremental
margin multiplied by the advertising elasticity of demand.

11. What factors affect the R&D elasticity of demand?

Answer
The R&D elasticity of demand depends on two factors: one is the effectiveness of R&D
in generating new products and enhancing existing products, and the other is the effect
of new and enhanced products on demand.

12. Explain the profit-maximizing rule for R&D expenditure relative to sales revenue.

Answer
Raise R&D expenditure until the R&D-sales ratio equals the incremental margin
multiplied by the R&D elasticity of demand. Intuitively, the higher is the incremental
margin and the more sensitive is demand to R&D expenditure, the more the business
should spend on R&D.

13. For a monopoly, the incremental margin percentage would be infinite. True or
false?

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 Chapter 8: Monopoly

Answer
False.

14. A buyer with market power restrains its purchases to reduce the market price. True
or false?

Answer
True.

15. Compare purchases and price with a monopsony vis-a-vis perfectly competitive
buyers.

Answer
In a perfectly competitive market, every buyer purchases at a scale where its marginal
expenditure equals the market price; hence, its incremental margin percentage is zero.
By contrast, a monopsony restricts purchases to get a lower price and increase its net
benefit above the competitive level. The more inelastic is the market expenditure, the
more the buyer can reduce price below its marginal expenditure.

DISCUSSION QUESTIONS AND ANSWERS:

1. Eli Lilly owns the patent to Xigris which is the only approved drug for the treatment
of sepsis. Sepsis is a severe illness caused by a bacterial infection which possibly leads
to the failure of multiple organs. Bayer manufactures aspirin, which is not covered by
patent, and is one of several drugs that relieve the symptoms of the common cold.
(a) Who has relatively more market power: Eli Lilly over treatments for sepsis or
Bayer over drugs for relieving the common cold? Please explain your answer.
(b) How is the difference between price and marginal revenue related to the price
elasticity of demand?
(c) Compare the incremental margin percentage at profit maximum for Lilly's Xigris
and Bayer's aspirin.

Answer
(a) Patients suffering from sepsis do not have an alternative to Xigris. People
suffering from the common cold can choose from many drugs including Bayer’s
aspirin. Accordingly, Eli Lilly has relatively more market power.

(b) If the demand is very elastic, then the marginal revenue will be close to the
price, and hence the difference between price and marginal revenue will be
small. If, however, the demand is very inelastic, then the marginal revenue will

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 Chapter 8: Monopoly

be much lower than the price, and hence the difference between price and
marginal revenue will be large.

(c) The demand for Xigris is relatively inelastic by comparison with the demand for
aspirin. Hence, the difference between price and marginal revenue will be
greater for Xigris.

2. Table 8.1 describes the demand and costs for Venus Pharmaceutical's Gamma-1
drug. Suppose that the costs are a fixed cost of $60 million and a constant marginal
cost of $50 per unit. The demand remains the same.
(a) Prepare a new table of revenues and costs according to the new data.
(b) What is the profit-maximizing scale of production and price?
(c) At that production scale, what are the marginal revenue, marginal cost, and
incremental margin percentage?

Answer
(a) Modified version of Table 8.1.
Price Sales Total Marginal Total Marginal Profit
($) Revenue revenue cost cost ($)
($) ($) ($) ($)

200 0.0 0 60 -60

190 0.2 38 190 70 50 -12
180 0.4 72 170 80 50 -8
170 0.6 102 150 90 50 12
160 0.8 128 130 100 50 28
150 1.0 150 110 110 50 40
140 1.2 168 90 120 50 48
130 1.4 182 70 130 50 52
120 1.6 192 50 140 50 52
110 1.8 198 30 150 50 48
100 2.0 200 10 160 50 40
90 2.2 198 -10 170 50 28
Note: Sales, total revenue, total cost, and profit in millions

(b) Two prices yield the same maximum profit of $52 million a year. One of the
profit-maximizing prices is $120 per unit, and the corresponding scale is 1.6
million units per year.
(c) At that scale, the marginal revenue = marginal cost = $50 per unit.

3. Apple outsources production of iPhones, iPads, and other electronic devices to

Taiwanese contract manufacturer, Foxconn, with 800,000 workers at factories in

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 Chapter 8: Monopoly

Shenzhen, Chengdu, and other locations in China. Faced with increased competition for
labor, Foxconn has raised wages and increased benefits for its workers. In April 2012,
Samsung sued Apple for violating various Samsung patents to produce mobile phones.
(Sources: “Foxconn to raise salaries 20% after suicides", Financial Times, May 28,
2010; “Samsung Sues Apple on Patent-Infringement Claims as Legal Dispute Deepens”,
Bloomberg, April 22, 2011.)
(a) Using a suitable figure, explain how Apple should set the production and price
of the iPhone to maximize profit. (Hint: You are free to assume any data
necessary to draw the figure.)
(b) Using your figure in (a), explain how Apple should adjust its production and
price if Foxconn raises its prices for contract manufacturing.
(c) Suppose that Apple must pay Samsung a royalty on each mobile device
produced. How should Apple adjust its production and price in response to the
royalty?
(d) How would you change the answer to (b) if Apple must pay Samsung a lump
sum in damages rather than a royalty per unit produced?

Answer
(a) See figure below.

Price
demand (marginal benefit)

marginal
Increase revenue
in price

Increase in
marginal cost
b

0 Reduction in
production Production

(b) Apple should raise its price, but by less than the increase in marginal cost, and
reduce production (and sales) accordingly.

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 Chapter 8: Monopoly

(c) If Apple must pay Samsung a royalty on each mobile device produced, then the
marginal cost of each product would be higher. The effect would be the same as
with the increase in Foxconn’s pricing.

(d) If Apple must pay Samsung a lump sum in damages, Apple should not adjust its
production and price (the profit-maximizing sales and price do not depend on the
level of fixed costs).

4. Atos Origin, Coca-Cola, Eastman Kodak, General Electric, John Hancock Financial
Services, Lenovo Group, McDonalds, Panasonic, Samsung, and Visa paid a total of $866
million to the International Olympic Committee to be global sponsors for the years
2004-08. The sponsorship period includes the 2006 Winter Olympics in Turin and the
2008 Summer Olympics in Beijing. By contrast, total sponsorship for the years 2000-04,
including the Salt Lake City winter games and the Athens summer games, amounted to
$666 million. (Source: “For Olympic sponsors, it's on to Beijing”, International Herald
Tribune, August 31, 2004.)
(a) Compare the benefit from Olympics sponsorship for global brands such as Kodak
and Samsung relative to regional and local brands.
(b) Considering the relative sizes of the Greek and Chinese consumer markets,
explain why sponsors paid more for the 2004-08 Olympics than the 2000-04
Olympics.
(c) Atos Origin's customers are primarily other businesses, while Lenovo's market is
mainly within China. Compare the benefit from Olympic sponsorship to these two
companies with the benefit to other sponsors.

Answer
(a) The Olympic audience is global – therefore, the advertising effectiveness will be
greater for global brands than for local or regional brands. The costs are similar,
so the greater benefits for global brands will result in their greater willingness to
pay for sponsorship.
(b) Although the Olympics will be watched globally, there are likely to be relatively
larger audiences within the nation in which the Olympics are held. Since the
Chinese market is so much larger than the Greek market, the benefits of
advertising will be greater in China than in Greece.
(c) Atos Origin’s market is global, but smaller than other global businesses (since it
is aimed at businesses rather than consumers). Similarly, Lenovo’s domestic
market is smaller than other advertisers’ global markets. So, both of these
advertisers would realize smaller benefits from advertising, relative to the other
sponsors.

5. At Google's 2013 third quarter earnings call, analyst Carlos Kirjner remarked, “the
perception by people outside the company is that Google spends a material amount in

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 Chapter 8: Monopoly

long-term R&D that will not generate revenue in the next two years or so”. CEO Larry
Page countered that, with respect to large innovations, “I think you overestimate short-
term and underestimate long-term”. He then pointed to how Google had transformed
the concept of self-driving cars from being far-fetched to inevitable.
(a) Explain the formula for the profit-maximizing level of R&D relative to sales
revenue in terms of the R&D elasticity of demand and incremental margin
percentage.
(b) Interpret the discussion between analyst Carlos Kirjner and CEO Larry Page in
terms of the R&D elasticity of demand
(c) Referring to Table 8.3, calculate the ratio of R&D to sales in the years 2010-13.
(d) Approximate the incremental margin percentage by the ratio of gross profit to
revenue. Suppose that the R&D elasticity of demand in the years 2010-13 is 0.2.
Calculate the R&D expenditure that would have maximized Google's profit in
each of the years 2010-13.
(e) Compare your calculations in (d) with Google's actual R&D expenditure.

$ millions 2013 2012 2011 2010

Revenue 59,825 50,175 37,905 29,321

Cost of goods sold 25,858 20,634 13,188 10,417
Gross profit 33,967 29,541 24,717 18,904
R&D 7,952 6,793 5,162 3,762
SG&A 12,049 9,988 7,813 4,761
Operating income 13,966 12,760 11,742 10,381
Ratio of R&D to sales 13.3% 13.5% 13.6% 12.8%
Incremental margin percentage 56.8% 58.9% 65.2% 64.5%
Profit-maximizing R&D-sales ratio 11.4% 11.8% 13.0% 12.9%

Answer

(a) The profit-maximizing ratio of R&D expenditure to sales = incremental margin

percentage x R&D elasticity of demand.
(b) Mr Kirjner estimated the R&D elasticity of Google’s demand to be lower than Mr
Page.
(c) See above table.
(d) See above table.
(e) The actual R&D-sales ratio was a little higher than the profit-maximizing. This
suggests that Google’s management perceived that the R&D elasticity of demand
was higher than 0.2.

6. In 1992, the state of Victoria, Australia, issued master licenses, valid until 2012, to
Tattersall's and Tabcorp for each to operate 13,750 slot machines at clubs and hotels.
Eventually, they set up 26,682 machines at 514 locations. In April 2008, the

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 Chapter 8: Monopoly

government decided to replace the master licenses with individual transferable licenses,
valid for 10 years from 2012. The market value of Tattersall's and Tabcorp fell by A$2.8
billion in one day. Subsequently, the government issued 27,290 new licenses for fees
totalling A$980 million. (Source: Victorian Auditor-General, “Allocation of Electronic
Gaming Machine Entitlements", Victorian Government Printer, June 2011.)
(a) Consider a club that has acquired one of new 10-year licenses. Using a suitable
figure, explain how the club should set the price of gambling to maximize profit.
(Hint: You are free to assume any data necessary to draw the figure.)
(b) How should it take account of the once-only license fee in its decisions: (i)
whether to continue in business, and (ii) its scale of operations? How does it
matter that the license is transferable?
(c) Comparing the master vis-a-vis individual licensing systems, what effect do you
expect on the quantity and price of gambling?

Answer

(a) See figure below.

(b) If the license is transferable, the re-sale price of the license is a fixed cost of
continuing in business. The profit-maximizing sales and price do not depend on
the fixed cost. If, however, the fixed cost is so large that the total cost exceeds
total revenue, then the business should shut down. If the license is not
transferable, then the cost of the license is sunk. The sunk cost should be
ignored in both the decision whether to continue in business and the scale of
operations.

(c) Under the master system, the master licensees can exercise market power and
limit competition among the sub-licensees. However, under the individual
licensing system, there would be more competition. So, the market price for
electronic gambling would be lower and the quantity of gambling would be
higher.

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 Chapter 8: Monopoly

7. The National Collegiate Athletic Association (NCAA) aims to “govern competition in a

fair, safe, equitable and sportsmanlike manner, and to integrate intercollegiate athletics
into higher education so that the educational experience of the student-athlete is
paramount". The NCAA restricts the amounts that member colleges and universities
may pay their student athletes (generally limited to the full cost of their education) and
requires student athletes to attend full-time programs of study.
(a) What market power does the NCAA have, and what are its source(s)?
(b) In April 2014, football players at Northwestern University voted in a secret ballot
on whether to form a union. Explain why the NCAA vigorously opposed the vote.
(c) If the U.S. government were to forbid the NCAA from such restrictive practices,
what would happen to: (i) each athlete's earnings, and (ii) the number of
athletes?

Answer
(a) The NCAA governs official tournaments and contracts for televised viewing of
NCAA games. This gives the NCAA considerable market power over universities,
both in selling television rights and in controlling access to prestigious
tournaments. It also gives the NCAA monopsony power over the “purchase” of
student-athlete services. There is a barrier to entry in that competing
organizations must overcome the large “installed base” of NCAA members.

(b) A union of football players would exercise monopoly power against the
university, and ultimately, against the NCAA. The union would bargain for higher
earnings.

(c) As a result of the monopsony power, student-athletes receive lower earnings

than they would in a competitive market. It achieves this reduction through
restricting the number of student-athletes. Hence, forbidding the NCAA practices
would increase both athlete earnings and the number of athletes.

8. Cricket is India's top spectator sport. Under Indian law, private broadcasters must
share any coverage of Indian cricket matches with the national television and radio
broadcasters, Doordarshan and All India Radio. However, the law does not require
national broadcasters to share their cricket telecasts with private channels. (Source:
“DD May Get a Blank Cheque," Times of India, August 13, 2004.)
(a) How would the Indian law affect the ability of a private television channel to
differentiate itself from Doordarshan?
(b) How would the law affect the amount that a private television channel would bid
for rights to broadcast Indian cricket matches?
(c) How would the law affect Doordarshan's degree of market power relative to (i)
television viewers, and (ii) the organizers of Indian cricket matches?

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 Chapter 8: Monopoly

(d) Some predicted that, owing to the law, only national broadcasters would bid for
rights to broadcast Indian cricket matches, and private broadcasters would not
bid. Do you agree?

Answer
(a) Private channels could not differentiate themselves through cricket coverage
since they would be forced to share this with the national broadcaster.

(b) The law makes cricket less effective as a way of differentiation and influencing
the demand for TV, thereby lowering the amount that private broadcasters
would bid for such broadcast rights.

(c) It would enhance Doordarshan’s market power over both viewers and match
organizers. Viewers could be sure that valuable matches would be available over
Doordarshan. Match organizers would have less competition in networks bidding
for the broadcast rights (since private channels would be forced to share their
telecasts with Doordarshan). The first is increased market power over
consumers, while the second is increased market power over sellers of broadcast
rights.

(d) The law gives little incentive for national broadcasters to bid. It also undermines
the private channels’ incentives to bid. Thus, in the extreme, the law would make
it unlikely that anybody would bid for these rights. In reality, the number of
broadcasters is limited, so both private channels and national broadcasters may
have some market power and be willing to bid. What the law does is reduce the
willingness of both private and national broadcasters to bid.

9. Some automobile parts, such as batteries and tires, wear out with use and must be
replaced frequently. Suppliers of these parts sell their products both as original
equipment to auto manufacturers and as replacement parts to car owners. By contrast,
supplies of air bags and ignition systems sell mainly to auto manufacturers.
(a) Assess the power of automobile manufacturers over suppliers of (i) batteries and
tires as compared with (ii) air bags and ignition systems.
(b) For products like batteries and tires, do you expect prices to be higher in the
original equipment market or the replacement market?
(c) Suppose that the supply of batteries is perfectly competitive. Using an
appropriate figure, explain how an automobile manufacturer would determine
the quantity of batteries to buy.

Answer

(a) Automobile manufacturers are the only buyers of air bags and ignition systems.
By contrast, they compete with car owners to buy batteries and tires. Hence,

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 Chapter 8: Monopoly

auto manufacturers have relatively more market power over sellers of air bags
and ignition systems.

(b) Auto manufacturers buy in the original equipment market, whereas car owners
buy in the replacement market. Where auto manufacturers have monopsony
power, the prices will be lower in the original equipment market.

(c) Consider an auto manufacturer with monopsony power in the original equipment
market. It would determine the quantity of batteries to buy at g and price at e
(marginal benefit = marginal expenditure).

Price marginal expenditure

f Supply (average
d
expenditure=m
arginal cost)
a

marginal benefit
b

0 g c
Quantity

© 1998-2015, Ivan Png