Monopoly

1. Monopoly 1

2. Introduction • A monopoly (from the Greek word “mono” meaning single and “polo” meaning to sell) is that form of market in which a single seller sells a product (good or service) which has no substitute. • Monopoly exists when there is no close substitute to the product and also when there is a single producer and seller of the product • E.g. Indian Railway is a monopoly, since there is no other agency in the country that provides railway service. • Pure monopoly is that market situation in which there is absolutely no substitute of the product, and the entire market is under control of a single firm. 2

3. Close Substitute – Similar to a Particular Product in respect of Utility, Price, Availability.

4. Features • Single seller • The entire market is under control of a single firm. • Single product • A monopoly exists when a single seller sells a product which has no substitute or, at least, no close substitute in the market. • No difference between firm and industry • There is a single firm in the industry • Independent decision making • Firm is regarded as a price maker • Restricted entry • Existence of barriers leads to the emergence and/or survival of a monopoly 4

5. Reasons of Monopoly • Control over Key Raw material (Nuclear Weapons, Control over Uranium mines,). (De-Beer Diamond) • Specialized Know how (Special Technique of Production, Restriction through Patents, Licenses) (example IBM Mainframe.) • Economies of Scale. (IBM, Walmart Stores, Intel corporation, • Small Market Size.

6. Examples of Monopoly in India • Indian Railways has monopoly in Railroad transportation • State Electricity board have monopoly over generation and distribution of electricity in many of the states. • Hindustan Aeronautics Limited has monopoly over production of aircraft. • There is Government monopoly over production of nuclear power. • Land line telephone service in most of the country is provided only by the government run BSNL. • Oil marketing companies - IOCL, BPCL, HPCL all of them government companies.  •  BMTC in Bangalore. (Bangalore Metropolitan transport corporation)

7. Types of Monopoly • Legal Monopoly • Created by the laws of a country in the greater public interest. • To prevent disparity in distribution of wealth, or imbalanced growth of the economy(State electricity Boards) • Economic Monopoly • Created due to superior efficiency of a particular player. • Attainment of economies of scale leads to monopoly, often referred to as an “innocent” or a structural barrier. • Technical know-how restrained in the hold of single • Regional Monopoly • Geographical or territorial aspects also help in creation of monopolies. 7

8. Revenue, Cost AR MR O Quantity Demand and MR Curves • The demand curve of the monopolist is highly price inelastic because there is no close substitute and consumers have no or very little choice. • It is not perfectly inelastic because pure monopoly does not exist in real life. • Hence it faces a normal downward sloping demand (AR) curve. • MR curve corresponds. 8

9. Price and Output Decisions in Short Run AR>AC • The monopolist cannot set both price and quantity at its own will. • In order to maximize profit a monopoly firm follows the rule of MR=MC when MC is rising. • A monopoly firm may earn supernormal profit or normal profit or even subnormal profit in the short run. • The negative slope of the demand curve is instrumental for chances of monopoly profits in the short run. • In the short run, the firm would reap the benefits of supplying a product which not only is unique, but also has negligible cross elasticity. • Firm maximizes profit where • MR=MC (ii) MC cuts MR from below, at point E. • Equilibrium price=OPE, Output= OQE • Total revenue =OPEBQE • Total cost = OAEQE • Supernormal profit= AEBPE, • since price (AR) > AC 9

10. Price, Revenue, Cost Price, Revenue, Cost MC AC MC AC B A B PE PE C E AR E MR AR MR O Quantity O QE Quantity QE Price and Output Decisions in Short Run AR=AC AR<AC Total revenue= OPEBQE Total cost = OPEBQE Profit = Nil Firm makes normal profit. Total revenue= OPECQE Total cost = OABQE Loss = ABCPE Firm makes loss. 10

11. Price and Output Decisions in Long Run • A monopolist is in full control of the market price • It would not continue to incur loss in the long run. • Monopolist would try to earn at least normal profit in the long run and may earn supernormal profit due to entry restrictions in the market. • To retain its monopoly power, the firm may have to resort to a low price and earn only normal profit even in the long run to create an economic barrier to new entrants. 11

12. Supply Curve of Monopoly Firm • A monopolist is a price maker • The firm itself sets the price of the product it sells, instead of taking the price as given. • It equates MC with MR for profit maximization, but unlike perfect competition, it does not equate its price to MR. • Supply of the good by the monopolist at a given price would be determined by both the market demand and the MC curve. • As such, there is no defined supply curve for a monopolist. 12

13. Price Discrimination • Discrimination among buyers on the basis of the price charged for the same good (or service). • Objective is to maximise sales Preconditions ofPrice Discrimination • Market control • Market imperfection and control are necessary • Monopoly is the most suitable market condition, because it is a price maker. • Division of market • when the whole market can be divided into various segments, and transfer of goods between the markets is not possible. • Absence of arbitrage. • Different price elasticities of demand in different markets • Separation of market is a necessary condition for price discrimination, but the sufficient condition is that price elasticities of demand should be different in these market segments 13

14. Bases of Price Discrimination • Personal • On basis of the paying capacity and/or the intensity of needs. • Since this discrimination is being done on a personal basis, the good (or service) is non transferable. • Geographical • People living in different areas are required to pay different prices for the same product. • E.g. edible oils and many packaged food items are sold at different prices in different States of India. • Time • The same person may be required to pay different prices for the same product. • E.g. off season discounts. • Higher rates of movie tickets for first few days of release. • Purpose of use • Customers are segregated on basis of their purpose of use. • E.g. electricity rates are lower for domestic purpose and higher for industrial purpose. • Different rates for different loans (Home loan, Car loan, education loan) 14

15. Degrees of Price Discrimination Pigou has identified three degrees of price discrimination. • First Degree • The firm is able to charge the maximum possible price for each unit which enables the firm to capture all available consumer surplus for itself. • Example – Bidding, car dealers. • Joan Robinson referred to it as perfect discrimination. • Second Degree • Second-degree price discrimination means charging a different price for different quantities, such as quantity discounts for bulk purchases. • Takes away the major (but not entire) portion of consumer surplus. • Example buy in bulk at less price 15

16. Third Degree • Third-degree price discrimination means charging a different price to different consumer groups.  • Segregates consumers such that each group of consumers is a separate market, and charges the price on basis of price elasticity of different groups. • Takes away only a small portion of consumer surplus. • Example - Cinema goers can be subdivide into adults and children.

17. Price and Output Decisions of Discriminating Monopolist • Assume that the firm can segregate the market on basis of price elasticity of demand: M1 with high price elasticity and M2 with low price elasticity. • The rule is: • Lower price and more supply in the market with high price elasticity • Higher price and less supply in the market with low price elasticity. • The firm will charge lower price in the market M1 and higher price in the market M2 and it would supply more to the market M1 and less to the market M2. • Firm would determine the profit maximizing output at MC=MR while MC is increasing. • The upper portion of the AR curve refers to the less elastic demand and the lower portion to highly elastic demand. • The MR curve corresponds to the AR curve.

18. Price and Output Decisions of Discriminating Monopolist In the market M1 the optimum output is OQ1 and price is OP1 In the market M2 the optimum output is OQ2 and price is OP2 OQ1> OQ2 and OP1< OP2 Price discrimination leads to greater profits. OPEQ is less than the area given by total area of OP1E1Q1+OP2E2Q2. Price, Revenue, Cost MC P2 E2 E1 P1 E P MC=MR1=MR2 AR1 MR1 AR2 MR2 MR AR O O O Q1 Q2 Q Quantity Market 2 Firm Market 1

20. International Price Discrimination and Dumping When a country exports a product in bulk to a foreign country at a price which is either below the domestic market price, or below the marginal cost of production. Aimed at gaining monopoly in a foreign country or at disposing off excess inventory in order to avoid reduction in home price. WTO has a provision of imposing special import duties to counteract such a policy. In India there have been several instances where the government has initiated an antidumping investigation against imports of a consumer good item, including imports of dry cell batteries, sports shoes and toys from China.

21. Persistent Dumping • This type of dumping is concerned with the motive of maximization of profits of the monopolists who knows that national and international markets are segregated because of transport costs, tariff and other restrictions on trade. • The monopolist faces more substitutes at world level. Therefore, the demand for monopolist product becomes more elastic. While in domestic market the demand is less elastic, because of non-availability of substitutes. • Accordingly, the monopolist charges higher price in local market and lower price in world markets.

22. Sporadic Dumping • Such type of dumping is concerned with occasional price discrimination. • If the excess stock of a product develops with a firm either due to excess capacity or improper planning of the firm to sell it the firm has no choice to lower its world price. So this dumping may be treated like ‘International Sale’. • This is commonly observed in case of agricultural exports. If any time the cotton crop is bumper in Pakistan and we are in need of foreign exchange the cotton is sold in the world markets even at the price which is lower than domestic price.

23. Predatory Dumping • This is an unfair method of competition through international price discrimination. Such type of dumping occurs when a producer in order to get hold over the world markets throws away its rivals. • For this purpose it deliberately sells its product cheaper, though for a shorter period. While doing so it assumes that when the competitions run away it will earn abnormal profits by raising prices. • Accordingly, it is a temporary price discrimination. The logic behind discrimination is this that the monopolist will be able to maximise its profits in long run, even if it is facing losses in short run.

24. Economic Inefficiency of Monopoly • A monopoly firm operates at less than optimum output and charges a higher price. • Monopoly does not allow optimum use of all the factors of production, thereby allowing loss of output and creating excess capacity in the economy • Considered as a loss of social welfare, hence authorities make regulations to check and prevent monopoly practices. • Also termed as deadweight loss to the economy, since this increase in output is actually possible under perfect competition. • Compare two firms, one under perfect competition, and the other under monopoly to explain the condition; assuming that both the firms earn normal profits. • The firm under perfect competition faces a horizontal demand curve (DC), whereas the monopoly firm faces a downward sloping curve DM, which is less elastic. 24

25. Price, Revenue, Cost LAC D EM A PM PM EC E B PC PC MC=AC=MRP=ARP DC ARM DM MRM O O QM Quantity QC QM Quantity QC Economic Inefficiency of Monopoly • The monopolist produces an output QM(<QC), and sells at price PM(>PC) (Fig 1) • OQC-OQM (i.e. QMQC), is regarded as excess capacity. • Perfectly competitive firm allows maximum consumer surplus (PCDB) (Fig 2). • Monopoly takes away PCPMAE from consumers to the firm. • AEB is neither part of firm’s income nor of consumer surplus; hence is the deadweight loss or economic inefficiency due to monopoly. Fig 2: Deadweight Loss Fig 1: Excess Capacity

26. Summary • A monopoly is that form of market in which a single seller sells a product (or service) which has no substitute. • Pure monopoly is where there is absolutely no substitute of the product, and the entire market is under control of a single firm. • A monopoly has a single seller, sells a single product (pure monopoly) and decides on its own price and output, based on individual demand and cost conditions and is hence regarded as a price maker. • In monopoly the firm and the industry are one and the same. • Barriers to entry are the major sources (or reasons) of monopoly power and may include restriction by law, control over key raw materials, specialized know how restricted through patents or licences, small market and economies of scale. • A monopoly firm has a normal demand curve with a negative slope. The demand curve is highly price inelastic because there is no close substitute. • A monopolist firm may earn supernormal profit, or normal profit, or may even incur loss in the short run, but would not incur loss in the long run. 26

27. Summary • The monopolist being a price maker does not have any supply curve. • A multi plant monopolist decides on how much to produce and what price to sell at so as to maximize its profit on the basis of the principle of marginalism. • When a seller discriminates among buyers on basis of the price charged for the same good (or service), such a practice is called price discrimination. • Price discrimination can be done on personal basis (demographical, paying capacity or need), on the basis of geography, on the basis of time or purpose of use. • The discriminating firm will charge a higher price and supply less to the market having higher price elasticity and a lower price and supply more in the market having lower price elasticity. • Monopoly runs at less than optimum level of output and generates excess capacity in the economic system, which in turn results in deadweight loss that adds neither to consumer surplus, nor to seller’s profit. 27