Microsoft PowerPoint - 7.Market Power by sdfwerte

VIEWS: 17 PAGES: 10

									                                                              Introductory Story: Eli Lilly’s Prozac


               Market Power

                        Dr. Yi LU
                      February, 2008




                          @2008 Yi LU                                                   @2008 Yi LU




Introductory Story: Eli Lilly’s Prozac                        Introductory Story: Eli Lilly’s Prozac

• Depression is caused by the imbalance of                    • In 1996, generic manufacturer Barr laboratories
  neurotransmitters.                                            began legal action to challenge Lilly’s patent
• Leading drugs (SSRI) include                                  over Prozac.
  – Eli Lilly’s Prozac, Pfizer’s Zoloft and                   • U.s. Court of Appeals limited the patent to
    GlaxoSmithKline’s Paxil                                     August 2001.
• In December 1987, Eli Lilly’s Prozac became the             • Lilly priced Prozac at $2.63 for a day’s supply
  first SSRI to treat depression.                                 – profit-margin: 90%
  – By 1999, worldwide revenues were $2.6 billion a year          – Generic drug sold at half price
  – But losing market to Zoloft and Paxil.

                          @2008 Yi LU                                                   @2008 Yi LU




Introductory Story: Eli Lilly’s Prozac                        Outline

• After the court decision                                    •   sources of market power
  – Lilly’s price fell from $108.55 to $76.69, reducing the   •   operating scale
    market capitalization by $36 billion.
  – Barr’s stock price increased from $45.75 to $77,          •   advertising
    raising company value by $1.1 billion.                    •   limiting competition
• How should Lilly react                                      •   buyer market power
  – Pricing?
  – Advertising?



                          @2008 Yi LU                                                   @2008 Yi LU




                                                                                                                  1
Market Power                                                        Sources of Market Power

• Definition                                                        • Some barriers must exist to deter the entries
   – Can influence market conditions, i.e., supply, price,          • Unique Sources
     etc.                                                             – Natural Resources
• monopoly – single supplier of good or a service                          • e.g., Platinum is a relatively inert corrosion-resistant metal
  with no close substitute                                                   with relatively few substitutes.
                                                                           • Anglo-American Owns over 75% of the world’s reserves of
• oligopoly – few suppliers                                                  platinum.
• monopsony – single buyer                                            – Human Resources
                                                                           • e.g., Football terms have one quarterback and one
• oligopsony – few buyers                                                    goalkeeper
                                                                           • Those with better players enjoy market power

                               @2008 Yi LU                                                         @2008 Yi LU




Sources of Market Power                                             Sources of Market Power

• Intellectual Property                                             • Economies of Scale and Scope
   – Property over inventions or expressions                          – Economies of scale: e.g., Electricity distribution
   – Patent                                                                • Requires an extensive network of cables leading from
                                                                             generating stations to the various users
      • e.g., Eli Lilly’s Prozac
                                                                           • Two competing distributors would mean duplication of the
   – Copyright                                                               cable network
      • e.g., Microsoft has the copyright over Office XP.                  • Thus one provider is more efficient
                                                                      – Economies of scope: e.g., Cable TV/Telephone
                                                                           • Both depend on a network connecting the providers and the
                                                                             users
                                                                           • A combined provider would have lower costs


                               @2008 Yi LU                                                         @2008 Yi LU




Sources of Market Power                                             Sources of market power

• Product differentiation                                           • government regulation
   – To be different from your competitors and less the               –   electricity
     degree of competition                                            –   telecommunications
   – Through advertising, promotion, product design and               –   air services
     location.                                                        –   broadcasting
   – e.g., location                                                   –   gambling
      • Fast-good restaurants try to locate n streets with heavy
        pedestrian traffic                                            –   cigarettes and alcohol
      • Gasoline stations prefer to locate at busy intersections.




                               @2008 Yi LU                                                         @2008 Yi LU




                                                                                                                                              2
Sources of Market Power: U.S. Federal                                    Sources of Market Power: U.S. Federal
Reserve, 2003                                                            Reserve, 2003
• At time of US independence, many banks
  competed to issue currency                                              Currency in                           $689.0
• In 1913, Congress established the Federal                               circulation
  Reserve System with 12 Federal Reserve
                                                                          Revenue                                $ 23.8
  Banks, which have the exclusive right to
  issued currency notes.
   – Huge profits
                                                                          Expenses                               $ 2.5
   – Attract competition: counterfeit currency
        • In 2003, $63 million was seized.                                Units: USD billion


                                  @2008 Yi LU                                                                        @2008 Yi LU




Sources of Market Power: U.S. consumer                                   Sources of Market Power: U.S. consumer
products:market/brand-level elasticities                                 products:market/brand-level elasticities
• Generally, products of an entire market have                                                                    Price elasticity of demand
  fewer close substitutes than the product of an
  individual product                                                     Product                                      Market            Brand-level
• One extreme: completely competitive                                    Coffee                                        -1.42                  -3.06
   – The individual seller’s demand will be extremely
     elastic                                                             Ice cream                                     -0.74                  -2.58
• One extreme: monopoly                                                  Margarine                                     -0.12                  -2.34
   – Individual seller’s demand will be the same as the
     market demand                                                       Paper towels                                  -0.74                  -4.74
                                                                         Liquid detergent                              -1.70                  -5.66

                                  @2008 Yi LU                                                                        @2008 Yi LU




Operating scale: Revenue, cost, and profit                               Operating scale: Marginal revenue and price
Price   Sales      Total       Marginal    Total   Marginal Profit ($)
 ($)            Revenue ($)   Revenue ($) Cost ($) Cost ($)
 200     0.0        0                           50              -50
                                                                                                  250
 190     0.2        38           190            52     10       -40                                            infra-marginal units
                                                                             Price ($ per unit)




 180     0.4        72           170            56     20       16
                                                                                                  150
 170     0.6       102           150            62     30       40
 160     0.8       128           130            70     40       58                                130                                  demand (marginal benefit)
 150     1.0       150           110            80     50       70
 140     1.2       168            90            92     60       76                                70
 130     1.4       182            70         106       70       76
                                                                                                                                   marginal revenue
                                                                                                  50
 120     1.6       192            50         122       80       70
 110     1.8       198            30         140       90       58
                                                                                                        0.4    0.8       1.2 1.4 1.6      2
 100     2.0       200            10         160      100       40
                                                                                                  -50         Quantity (Million units a year)
 90      2.2       198            -10        182      110       16
                                  @2008 Yi LU                                                                        @2008 Yi LU




                                                                                                                                                                   3
Operating scale: Marginal revenue and price                                    Operating scale: Profit maximum

• Marginal revenue                                                             • To maximize profit, operate at scale where
  – The change in total revenue arising from selling an                          marginal revenue = marginal cost
    additional unit.
• example                                                                      • Justification:
  – Price from $190 to $180, sales increase from 0.2                             – If marginal revenue > marginal cost, sell more
    million to 0.4 million.                                                        and increase profit
  – Extra revenue: 180*0.2million=$36 million
  – Lose: inframarginal unit: 10*0.2million=$2 million                           – If marginal revenue < marginal cost, sell less
  – Total gains: $36-$2=$34 million                                                and increase profit
  – Marginal revenue: $34/0.2=$170


                                              @2008 Yi LU                                            @2008 Yi LU




                                                                               Operating Scale: Glaxo, Life-and-death
Operating scale: Profit maximum
                                                                               monopoly

                          250                                                  “Once its products were approved, a big drug firm
                                                                               such as Glaxo could sell them at almost whatever
     Price ($ per unit)




                          150
                                              demand (marginal benefit)        price it wanted” (Economist, Jan. 28, 1995)
                          130

                          70
                                                                               True or false?
                                                            marginal revenue
                          50    marginal cost

                                 0.4    0.8       1.2 1.4 1.6      2
                          -50          Quantity (Million units a year)
                                              @2008 Yi LU                                            @2008 Yi LU




Operating scale: Profit maximum – Another
                                                                               Operating scale: Demand change
view
• contribution margin = total revenue less variable                            Find new scale where marginal revenue =
  cost                                                                         marginal cost
• profit-maximizing scale: selling additional unit                               – should change price
  does not change the contribution margin                                        – new scale and price depend on both new demand
                                                                                   and costs




                                              @2008 Yi LU                                            @2008 Yi LU




                                                                                                                                    4
Operating scale: Prozac – Demand
                                                                                                               Operating scale: Cost change
reduction
                                                                                                               Find new scale where marginal revenue =
                                  250                                                                          marginal cost
   Price ($ per unit)




                                                                                                                 – change in MC     should change price (but less than
                                  200
                                                                                                                   change in MC)
                                  150                                                                            – change in fixed cost  should not change price or
                                                                                       marginal cost               scale
                                  100
                                                                                      original demand
                                   50
                                                                                      new demand
                                    0       0.4      0.8       1.2       21.6
                                                                        new marginal
                                        Quantity (Million units a year)
                                                                        revenue
                                                            @2008 Yi LU                                                                @2008 Yi LU




Operating scale: Marginal cost reduction                                                                       Operating scale: 3G Licensing

                                                                                                                “There’s good and bad in auctioning off
                                  200                                                                           spectrum … it may raise costs for telecoms
             Price ($ per unit)




                                                        demand                                                  providers” Anthony Wong, Director-General,
                                  150                                                                           OFTA, Hong Kong
                                        marginal revenue
                                                                                      original marginal cost       – How does one-time license fee affect price
                                  100
                                                                                                                     and scale of operations?
                                                                                       new marginal cost
                                  50                                                                               – What about annual fee based on
                                                                                                                     percentage of revenue?
                                           0.4        0.8        1.2        1.6   2
                                  -50
                                                  Quantity (Million units a year)
                                                            @2008 Yi LU                                                                @2008 Yi LU




Operating scale: 3G Licensing                                                                                  Advertising

• German, UK and Us use multiple-round sealed                                                                  • Benefit of advertising – increment in
  bid auctions.                                                                                                  contribution margin
• Singapore charges telecoms operators annual                                                                  • advertising elasticity = % increase in
  fee equal to 1% of gross revenue                                                                               demand from 1% increase in advertising




                                                            @2008 Yi LU                                                                @2008 Yi LU




                                                                                                                                                                         5
Advertising: Profit maximum                                           Advertising: Advertising-sales ratios

• Profit-maximizing advertising/sales =
  incremental margin x advertising elasticity                         Company            Curr.         Sales Advertg Ratio
   – incremental margin = (price - MC)                                Anheuser Busch USD           14,146.7     806.7 5.7%
                                                                      Fosters            AUD         4,731.5    313.5 6.6%
                                                                      Asia Pac.          SGD         1,261.1    210.9 16.7%
• Raise advertising/sales if                                          Breweries
   – higher incremental margin                                        IBM                USD       89,131.0    1,406.0 1.6%
   – higher advertising elasticity                                    Microsoft          USD       32,187.0    1,060.0 3.3%
                                                                      SAP                EUR        7,024.6      161.5 2.3%
                                                                      Units: millions
                               @2008 Yi LU                                                     @2008 Yi LU




                                                                      Advertising: Intel, Pentium-III launch, Feb.
Advertising: Prozac
                                                                      1999
• Competition from generics would                                     • Priced Pentium-III to yield higher incremental
   – reduce incremental margin                                          margin than previous version
   – raise advertising elasticity
                                                                      • Faced severe competition from AMD’s new K6-III
• Lilly’s 1999 advertising spending on Prozac:
   –   $60.2 million on “detailing”
                                                                        chip
   –   $8.2 million in medical journals                               • Doubled advertising to $300 million
   –   $0.15 million to consumers
• Conclusions:
   –  Lilly should increase/reduce advertising according to balance
     of effects
   – within advertising budget, should probably reallocate more to
     consumer advertising and less to advertising to doctors
                               @2008 Yi LU                                                     @2008 Yi LU




Advertising: Coke vs Pepsi, Nov. 1999                                 Advertising: Dollar General, 1998

• Coke                                                                • Operates over 4,000 stores in 24 states
   – Raised prices by 7%                                              • 2/3 of customers have household incomes
   – Increased                                                          below $30,000, with an average of $8.06 a trip.
     advertising and other                                            • In 1998, they had a significant change about is
     marketing                                                          advertising
• Pepsi                                                                  – cut advertising from 3.8% to 0.2% of revenue
   – Raised price by                                                     – sales dropped but profit rose
     6.9%                                                             • “Our customer lives within three to five miles of
   – What about                                                         the store, knows we’re there”
     advertising?
                               @2008 Yi LU                                                     @2008 Yi LU




                                                                                                                              6
Limiting competition: Market structure                                                                                 Limiting competition

                                   (a) Perfect                                              (b) Monopoly               • Relative to competitive market, monopoly
                                   Competition
                                                                                                                          – sets higher price
 Price (Cents per unit)




                                                            Price (Cents per unit)
                                                                                           demand                         – produces less
                                                                                                                          – earns higher profit
                                         demand                                      60
                                                                                                                       • Example
                                                                                                            marginal      – Singapore Telecom had exclusive license for domestic and
                          30        supply                                           30                     cost            international telecoms until March 31, 2007.
                                                                                                                          – In May 1996, Government decided to advance the introduction of
                                                                                                 marginal revenue           competition to April 1, 2000.
                                                                                                                          – For 7-year loss of monopoly, Government paid SingTel S$1.5
                               0             300                                      0      150                            billion
                          Quantity (Million units a year)                            Quantity (Million units a year)

                                                     @2008 Yi LU                                                                                    @2008 Yi LU




Limiting competition: Prozac vs generics                                                                               Limiting competition: Diamond
                                                                                                                        • why is diamond more expensive than water?
• Prozac
                                                                                                                           – treasured because of rarity
                    – In 1999, revenue $2.6 billion
                    – Open competition will cause a loss on the profit-margin, say 90%, then                            • History
                      the loss is 0.9*2.6=$2.34 billion                                                                    – accidental discovery of diamonds in South Africa in 1866,
                    – The court decision shortened the patent by 26 months (from August                                      and diamond fever by 1869
                      2001 to December 2003)
                                                                                                                           – 1874: Cecil Rhodes sold steam-powered pump, and
                    – The total loss was $2.34*26/12=$5.07 billion                                                           captured the market in Cape Province within one year
                    – But the market capitalization shrunk by $36 billion
                                                                                                                           – bought claims in diamond mines in the area, and completed
• Barr                                                                                                                       consolidation by 1887
                    – Market capitalization increased by $1.1 billion                                                      – If all South African gems were to sweep into Europe, the
• Why was Barr’s gain less than Lilly’s loss                                                                                 market would be flooded and prices would plummet.
                    – production expands beyond monopoly level
                    – lower price
                                                     @2008 Yi LU                                                                                    @2008 Yi LU




Limiting competition: Diamond                                                                                          Limiting competition: Visa and MasterCard
 • How to maintain monopoly
                          – 1890 Diamond Syndicate: All its members pledged to buy                                     • Visa and Mastercard are associations that are owned by
                            diamonds from Rhodes’s mines and sell them in specific                                       the banks -- joint ownership
                            quantities and at set prices.
                                                                                                                          • Restrictions on issuance of other cards – entry barrier
                          – 10 times per year
                                                                                                                          • “automatically terminate .. [if] .. issues .. Discover Cards or
                          – Preference indicated by 150 sight-holders 5 weeks before                                        American Express Cards” (Visa By-Law 2.10(e))
                            the sale
                                                                                                                          • “With the exception of ... Visa, members of MasterCard may not
                          – Take it or leave it (no more invitation in the future)
                                                                                                                             participate …”
 • Results
                                                                                                                       • Market shares: Visa (50%) , MasterCard (25%), Amex
                          – De Beers restricts production, restricts competition, fixes
                            prices, and denies competitors access to markets                                             (18%), Discover (6%)
                          – 13% margin, rare in a commodity-based industry


                                                     @2008 Yi LU                                                                                    @2008 Yi LU




                                                                                                                                                                                              7
Limiting competition                                 Limiting competition: Cartel

• implicit agreement                                 • Cartel is an agreement between competitors,
• cartel                                             normally to restrict the production (thus the
• horizontal integration                             competition) so as to increase the price and
                                                     profits.
                                                     • Typically cartel set a maximum sales quota for
                                                     each member, implicitly divide the monopoly
                                                     profits.




                      @2008 Yi LU                                             @2008 Yi LU




Limiting competition: Brisbane concrete              Limiting competition: Brisbane concrete
cartel                                               cartel
• Concrete is a homogenous product, but requires     • The big five held regular meetings to discuss
  the plant to locate near the clients                 upcoming concrete sales.
• In 1995, five major suppliers accounted fro        • The meetings allocated each sale to a particular
  about 95% of the concrete market in Brisbane,        supplier and fixed the price fro the sale.
  Australia                                          • To discourage cheating, each needed to report
• A price war broken among these incumbents let        the sales volume, prices and raw materials
  them suffer great from the fierce competition        costs.
• Thus they reached an agreement to maintain the     • From time to time the meetings arranged to raise
  total production and thus the sales                  the price

                      @2008 Yi LU                                             @2008 Yi LU




Limiting competition: OPEC                           Limiting competition: Cartel

• OPEC, the organization of petroleum exporting      • Effectiveness depends on
  countries, is the cartel organization including      –   number of sellers in the market
  major oil producers, Saudi Arabia, Iran, Kuwait,     –   industry capacity vis-a-vis market demand
  and Venezuela.                                       –   extent of sunk costs
• But it suffers from the problem that individual      –   extent of entry and exit barriers
  members prefer to exceed their quotas.               –   nature (homogeneity) of product
• In November 1994, OPEC members met to
  decide production quotas for the following year.
• 12 months later, Venezuela was believed to
  exceed its quota.
                      @2008 Yi LU                                             @2008 Yi LU




                                                                                                          8
Limiting competition: Vitamins, Inc., 1990-99            Limiting competition: Horizontal integration

• World’s top three manufacturers -- Roche (40%),        • Horizontal integration: combination of two or
  BASF (20%), Rhone-Poulenc (15%)                          more entities in the same or similar businesses.
   – allocated market shares                             • Vertical integration: combination of the assets for
   – fixed prices                                          two or more successive stages of production
   – rigged bids




                        @2008 Yi LU                                             @2008 Yi LU




Limiting competition: Horizontal integration             Limiting competition: China, Beer market


Acquirer           Target              Market

Anheuser-          Harbin Brewery China beer
Busch
Bank of            FleetBoston         U.S. banking
America Corp.      Financial
Granada            Carlton             U.K. television
                                       broadcasting
                                                          • How competitive?
                        @2008 Yi LU                                             @2008 Yi LU




Limiting competition: UAL                                Limiting competition: UAL

• At the same time United Airlines (UA) entered          • Business jets became more and more popular
  the bankruptcy, its parent UAL Corporation was           as congestion and hub airports made it difficult
  buying 30 luxury business jets, which caused             and time-consuming to visit secondary cities.
  $600 million totally.                                  • Private jets were increasingly used by middle
• UAL was entering a new business: providing               managers.
  services to corporations, celebrities and other        • 911 attack increased the concern over security.
  wealthy individuals, or tailored private service,      • It finally succeeded.
  instead of the mass public service.
• Politicians and workers unions got angrily
   – Asking for bankruptcy while “wasting money”
                        @2008 Yi LU                                             @2008 Yi LU




                                                                                                                 9
Limiting competition: Japan shifts gears in                Limiting competition: Japan shifts gears in
production                                                 production
• Japanese companies now faced competition                 • Japanese firms were leaving the production of
  from low-cost Chinese firms similar to what they           less-sophisticated products to Asian neighbors
  had done on the U.S. manufacturers in 1960-                while concentrated on high-value-added goods.
  1970s                                                    • “If the Chinese can make it, we can’t really afford
• How to react?                                              to be in the business” said Takao Iwasaki,
• An illustration                                            Kureha’s research director.
  – Kureha Corp., chemicals maker, turned down a
    factory that produced an inexpensive plastic but
    expanded a plat that made a pricey substance, called
    polyphenylene sulfide.

                       @2008 Yi LU                                                       @2008 Yi LU




Buyer market power                                         Buyer market power: Operating scale

• Buyer with market power restricts purchases to
  depress price                                                                                   marginal expenditure
• Trades off                                                                       400
                                                               Price ($ per ton)




                                                                                                               supply = average
  – marginal expenditure                                                                                       expenditure
  – marginal benefit
                                                                                   350

                                                                                   273                    marginal benefit



                                                                                    0    6, 000        8,000
                                                                                         Quantity
                       @2008 Yi LU                                                       @2008 Yi LU




                                                           Buyer market power: Robert Bosch,
Buyer market power: Restricting competition
                                                           Cheating on buyer cartel
• implicit agreement                                       • National collective bargaining
• cartel                                                      – employers’ federation, Gesamtmetall
                                                              – workers’ union, IG Metall
• horizontal integration
                                                              – March, 1995, agreed to 3.5% wage rise and cut
                                                                working hours to 35/week
                                                           • Robert Bosch negotiated better deal




                       @2008 Yi LU                                                       @2008 Yi LU




                                                                                                                                  10

								
To top