Lecture Notes: Oct. 30

Econ. 103, Fall 2002, Prof. Nancy Folbre

Today we finish off Chapter 9 and view a video on Coke-Pepsi competition.

The soda industry represents a good example of an oligopoly–a small number of firms competing for market share.

I'm going to review what we did on Monday, go over the concepts of price discrimination, discuss your homework for next week, go over a couple of multiple choice questions, and fill in a bit of Coke-Pepsi history before showing you the clip from Sixty Minutes.

Focus on Figure 9.9 in the text, the monopolist's profit-maximizing output level.

Note how this picture differs from previous pictures.

Why is the marginal revenue curve below the demand curve?

Because, when a monopolist (or any firm operating outside of the rules of perfect competition) lowers price, it lowers price for ALL the units it can sell.

But the monopolist still follows the same rule a perfect competitor does: profits are maximized where marginal revenue equals marginal cost. The reason for this is that it wants to keep selling products until its potential for profit is exhausted. As long as marginal revenue is greater than marginal cost, it is making a profit on the last unit sold. Given the shapes of the curves (marginal cost is positively sloped, marginal revenue is negatively sloped) it should expand production until it reaches the point where these two lines intersect.

Note that the price that it charges at this point is NOT the same as its marginal revenue. To determine the profit-maximizing price, you must find the point on the demand curve that is directly above the point at which MR=MC.

Ideally, a firm would like to charge each individual consumer as much as that consumer would be willing to pay. The problem for the firm is that this willingness to pay differs substantially across all consumers. But usually it must charge the same price for its product to everyone.

There is a way around this problem, however.

Price discrimination is the practice of charging different buyers different prices for essentially the same good or service.

Examples: discounts to senior citizens and children, super-saver discounts on air travel, rebate coupons on retail merchandise. It's only effective when the good or service cannot be resold.

Perfect price discrimination would involve charging each buyer exactly his or her reservation price. This may be possible sometime in the future. E.g. if everyone bought on-line, and businesses had information about everything you had bought in the past, and could also determine your economic and demographic characteristics.

The hurdle method of price discrimination is a more approximate method. Basically, it involves creating a hurdle, or small obstacle, which some buyers (those who have a lower reservation price) will be willing to jump over, but others will not. Examples of hurdles: waiting for the price to decline (e.g. if you're willing to wait until a book comes out in paperback, which costs less than hardback, or willing to wait for a sale); mailing in a rebate or collecting a coupon (both of these require a certain amount of time and effort; agreeing to less flexibility in scheduling (this is what you have to put up with if you buy a super-saver air ticket).

Controversy over MP3s and their effect on sale of CDs. The hurdle that faces MP3 buyers is the time and effort that's required to download and burn the files on CDs. Problem for music companies is that college students–a big part of their market–have the time (and the high speed connections) to do this.

Let's try a couple of multiple choice practice questions:

Suppose monopolist M charges a uniform price of $10 based on profit maximization and has constant marginal costs of $3. Beth is willing to pay $6 for the monopolist's output.

Therefore,

A. the monopolist should lower his price to $6 for all consumers

B. the monopolist should ignore Beth's want; he is already profit-maximizing

C. if resale of the output is impossible, the monopolist should lower his price to $6 just for Beth

D. if resale of the output is possible, he should lower his price to $6 just for Beth

E. the monopolist will not be better off if he lowers his price to $6 just for Beth.

The correct answer is C.

Which of the following is not an example of the hurdle method of price discrimination?

A. A rebate offer

B. Eliminating all sales specials and reducing all prices by 10%

C. After Christmas sales.

D) Blue light specials

E) End of year clearance sales.

Correct answer is B. There's no discrimination involved when all prices are reduced.

Homework:

Assignment 5: Due in discussion section the week of November 4. From Ch. 9, # 1, # 7, # 8. Short thought piece: Describe a company that you deal with that can be described as a monopoly. How does it maintain its market share? How are you affected by its behavior?

#1 Two car manufacturers, Saab and Volvo, have fixed costs of $1 billion and marginal costs of $10,000 /car. If Saab produces 50,000 cars/year and Volvo produces 200,000, calculate the average production cost for each company. On the basis of these costs, which company's market share do you think will grow in relative terms?

Step 1: calculate the AVERAGE FIXED COST for each company,

fixed costs divided by number of cars produced

Step 2: add the average fixed cost and the marginal cost (which is equivalent to the average variable costs) to arrive at the average production cost.

The company with the lower costs (which is almost certainly the bigger company, because of likely economies of scale) will be able to sell its product at a lower price and gain market share.

Some Coke-Pepsi history:

(based on Mark Pendergrast, For God, Country, and Coca-Cola)

Remember from the last film–Candler signed a bottling agreement–

bottlers agreed to use only syrup provided by the Coca-Cola company, and its price was fixed in perpetuity at $1 a gallon. Initially a big success–bottling plants proliferated...

But meanwhile... Asa Candler's sons were running the company...Asa Jr. was an alcoholic who kept a public swimming pool, laundry and zoo in his front yard. He owned four elephants named Coca, Cola, Refreshing, and Delicious; they sold out to the Woodruff family.

For many years, the price of sugar was about 5 cents per pound but during World War I it went up....

In 1919, Coca-Cola announced it would go public; common stock was priced at $40 a share, the company was valued at $1 million. A year later the price had fallen to $21 per share.

Why? Partly because the price of sugar skyrocketed during the war...and shortly thereafter... (due to a Cuban sugar cane cartel). But other sources of sugar became available (including beets and corn)...and they renegotiated contract with bottlers...

Share prices resumed an upward trajectory. If you had bought 100 shares in 1919 for an investment of $4000, it would be worth $600 million today.

In the late 1990s, Coke earned about 17 cents of (accounting) profit on every dollar of sales.

The Cola Wars: Coke spends over $100 million a year to convince consumers that its products are superior; Pepsei almost as much. Half of all soft-drink consumers profess loyalty to either Coke or Pepsi. Ironically, few people can identify their favorite cola in blind taste tests; 70% of people who swore loyalty to either Coke or Pepsi picked the wrong cola in a taste test.

Coke–more than 3% of the liquid intake of the entire population of planet earth

one of the greatest brand recognitions