Transcription

Monopoly

As much as the perfectly competitive market seems fair and just it is impossible for the market to exist in the real
world. In this segment, you will learn about the real-world markets. You will start this session by learning about the
monopoly market structure.

Suppose, you want to search for something online and you need to open a search engine, which search engine comes
to your mind? Well, almost everyone chooses google. So much so that when you tell someone to search for something
on the internet, we say google it. Why don't you say Yahoo it or Bing it?

This is because google has established itself as the most preferred search engine in the market. It accounts for more
than 90% of the world's search engine market share. In economics, we can call google a monopoly. Now, let's
understand the monopoly markets in further detail.

© Copyright 2019. UpGrad Education Pvt. Ltd. All rights reserved

What is monopoly? We use the step analysis as we have learned before.

1. First, we take a look at the number of sellers in the market. A firm is called a pure monopoly when it is the sole
seller of a particular good or service.
2. About the type of product in monopoly, no other firm sells the same good or service. The demand for the
firm's product is the market demand curve.
3. Third, there are high barriers to entry and exit in monopoly.
4. Fourth, the firm, who is the sole seller of the product has a control over the price, so it is a price maker in the
market.

Recall, the scenario from the introductory video of this session, in which you interacted with the monopoly market. It
was with regard to your train ticket. IRCTC is a government owned monopoly and barriers to entry and exit are quite
high due to requirements of huge investments. The ticket price is solely decided by IRCTC, as there is no substitute
available.

Now, let's try to understand what are the two main sources of power for a monopolist. The natural sources of
monopoly power can be of different types. First is control over scarce resources. This occurs when the firm has a
control over scarce physical resources. For example, in 1930s, the Aluminum Company of America or Alcoa controlled

© Copyright 2019. UpGrad Education Pvt. Ltd. All rights reserved

most of the supply of bauxite, which is a raw material used to produce aluminium. Other firms were simply unable to
produce more aluminium in order to compete with Alcoa.

De Beers, a multinational company, it controlled 80% of diamond mines in the late 1990s, which was possible due to
the agreements with owners of diamond mines in Africa. However, by the late 2000s, as newer mines were discovered
in Canada, Australia and Russia, De Beers began to lose its monopoly status and it is no longer a monopoly in world
diamond production.

Second is economies of scope or cost advantage. Economies of scope or cost advantages that bigger firms get due to
their size. New firms cannot enter the market because of the high investment requirements. For example, utilities
such as water pipelines or electricity lines.

Third, is network externalities. This occurs when the value of a product or service increases, as many people use it. For
example, most people use Microsoft, word processing softwares, irrespective of the availability of the other processing
softwares because they would risk running into compatibility issues while transferring files to others.

© Copyright 2019. UpGrad Education Pvt. Ltd. All rights reserved

Then, there can be created sources of monopoly power. First, government owned and government granted. This
happens when a government agency is the sole provider of a good or service, or a government gives the right to a
private firm to be the sole provider of a good or service in the market. For example, the IRCTC for Indian railways is
the example that we have discussed earlier.

Next is patent and other legal barriers. Governments grant exclusive rights to firms to produce a particular good or
service, enabling them to monopolize the market for that product. Apart from the government, there can be certain
rules and regulations that grant a single firm to sell a particular product. Pharmaceutical companies use patents to
create a monopoly all the time.

The famous case of Novartis cancer drug Gleevec is an example. Novartis wanted to patent its cancer drug to keep the
prices high. However, it fought the case for five years before the Supreme court of India rejected its plea in 2013. The
barriers to entry went down and Novartis lost its monopoly status. The price of Gleevec was reduced from 1,60,000
rupees for one-month treatment to 6000 rupees in the generic drugs market.

Tying contracts. This refers to selling a product to a buyer with an agreement of buying another product from the same
seller. For example, a HP printer and HP ink cartridge that you need for that printer.

© Copyright 2019. UpGrad Education Pvt. Ltd. All rights reserved

In this segment, we will learn the monopolist's profit maximizing conditions. Now, price in a monopoly is limited by
the quantity demanded by consumers. To sell more, the monopolist needs to reduce the price. Therefore, the
monopolist would have a downward sloping demand curve, which is also its average revenue curve.

Let's take a look at the table. We plot quantity against average revenue, total revenue and marginal revenue. As you
can see from this graph, marginal revenue lies below the average revenue. Now, MR or marginal revenue, it falls faster
than AR or average revenue, because if the monopolist lowers the price for the next unit, it has to charge the lower
price for all previous units as well. Therefore, the marginal revenue would be lower than the average revenue.

© Copyright 2019. UpGrad Education Pvt. Ltd. All rights reserved

What are the conditions for profit maximization? Now, let's take a look at the cost curves. We have here the family
are U-shaped average total cost curve that is intersected at its minimum by the marginal cost curve. Profit
maximization occurs when marginal cost is equal to marginal revenue and price to be charged is the point on the
average revenue curve at the output, where marginal cost is equal to marginal revenue.

So, what is the profit in this case? Take a look at the diagram. We have already seen that average revenue is given by
P and average cost is ATC, so profit is equal to AR minus AC, which is average revenue minus average cost multiplied
by total quantity or profit can be written as Q x P minus ATC. The shaded area of the rectangle depicts the profit of
monopoly.

Let's take a numerical example. Suppose, a pharmaceutical company Abbott determines the demand function as P
equals to 20 minus Q for its antibiotic drug, where Q is the demand for drugs at the given price P. The cost of producing
a single drug tablet is given by the function CQ is equal to 8 plus 4Q. What will be the profit maximizing output Q?

First, we find out the total revenue. We write this as RQ because total revenue is a function of Q, the output. Now, the
number of tablets sold multiplied by the price is the total revenue or we can write it as Q x P. We have already seen
that P is 20 minus Q, so the total revenue is 20 Q minus Q square.

© Copyright 2019. UpGrad Education Pvt. Ltd. All rights reserved

Then, we calculate the marginal revenue, which is the derivative of the revenue function. We differentiate the total
revenue with respect to Q, and we get R dash Q, that is the marginal revenue, is equal to 20 minus 2Q, and marginal
cost is the derivative of the cost function with respect to Q. Marginal cost can be written as C dash Q is equal to 4.
Now, for the monopoly, marginal cost is equal to marginal revenue in equilibrium, that is 20 minus 2Q is equal to 4.

Solving this, it gives us Q is equal to 8, that is the optimum equilibrium output. Now, what will be the optimum price.
We substitute Q is equal to 8 in the demand function and we get P is equal to 20 minus Q or 20 minus 8 that is 12. So,
the equilibrium price is 12 rupees.

Now, we have the equilibrium price and we have the equilibrium output. So, what will be the maximum profit? We
know that profit is equal to total revenue minus total cost or PQ minus C as a function of Q. We have found out that P
is equal to 12 and Q is equal to 8, so the PQ or total revenue is 12 multiplied by 8. We subtract from it the total cost.
In the cost function, we substitute Q is equal to 8, and we get the total cost equal to 48 plus 32, subtracting 40 from
96, we get the profit equals to 56 rupees, so 56 rupees is the monopolist's profit in equilibrium.

You understood the monopoly markets. In monopoly, a single firm has control over the market, and thus it enjoys
certain powers in the market. However, similar to every market monopoly has its own shortcomings and inefficiencies.
Let's take a look at them. If you want to travel by an auto rickshaw, then there are many auto drivers available to give
you a ride, but because the market is so competitive that all of them must follow the meter. This is a case of a perfectly
competitive market.

On the other hand, as we discussed earlier, IRCTC is a monopoly. Now, what are the key differences between these
two?

© Copyright 2019. UpGrad Education Pvt. Ltd. All rights reserved

Let's compare perfect competition and monopoly.

1. First, in perfect competition, there is no restriction on entry and exit of firms. However, in monopoly, there is
a strong restriction on entry and exit.
2. Second, the demand curve is perfectly elastic for a perfectly competitive firm, while in monopoly it slopes
downwards.
3. Third, in perfect competition, a large number of sellers are involved in supply. Hence, individual supply is
negligible, whereas in monopoly only one seller has total control over supply.
4. Fourth, in perfect competition, a firm does not have any control over price. However, in monopoly a firm can
control the price of the product because there is no substitute available.

This brings us to the discussion of efficiency loss for monopoly. Now, a monopoly sets a particular price of a product
that is available to all customers. The quantity of the good is less and the price is high compared to perfect competition.
This creates an inefficiency in the market, which further creates deadweight loss.

Deadweight loss is a potential gain that does not go to the producer or customer. Due to this deadweight loss, the
combined surplus of a monopoly farm and its consumers is less than the surplus obtained by consumers in a
competitive market. Thus, the monopoly market becomes inefficient.

© Copyright 2019. UpGrad Education Pvt. Ltd. All rights reserved

Let's learn the concept of deadweight loss using a diagram. We'll also see how to calculate the deadweight loss. Take
a look at this diagram. Since the monopoly producer is the only producer, the marginal cost curve represents the
supply curve for the market. Hence, if the price was determined by the market for maximum efficiency, then it would
be the point of intersection between marginal cost and demand.

However, the equilibrium price in monopoly is actually at a higher level and hence at a lower quantity. The consumer
surplus shrinks and producer surplus increases. However, some part of the surplus does not go to either the producer
or the consumer, this is the deadweight loss. The shaded area in the graph represents the deadweight loss in a
monopoly.

The deadweight loss here is the area of the shaded triangle, which is half multiplied by 50 minus 30 multiplied by 80
minus 40. This comes out to be 400.

An example of this would be Indian Railways, where the government is giving up the monopoly. The famous argument
that is given by the government for privatization is that during the year 2018-19 a total of 8.85 crore passengers were
in the waiting list and only 16% of these passengers were provided with reservations. So, consumers are experiencing
shortages, and the producer is not earning as desired, therefore, this is a deadweight loss situation.

© Copyright 2019. UpGrad Education Pvt. Ltd. All rights reserved

In this example, we will look at a real life or realistic example for a monopoly market structure. So, now look at the
example.

Consider an Indian currency note, right, and assume that this currency note is the commodity that is being produced.
So, if you assume that the Indian currency note say that 10-rupee note is the product that is being produced, you will
realize that the Reserve Bank of India, which is India's central bank, is the monopoly producer of this 10-rupee notes,
because there is no one in this country or in this world who is authorized to produce or print this 10-rupee note. So,
that makes the Reserve Bank of India, the monopolist in producing the commodity, which is the 10-rupee note.

So, now the question would arise is then, how does Reserve Bank generate a revenue or how does Reserve Bank
generate a profit from this kind of an exercise? So, that brings us to the concept of Seigniorage. So, the one-way
Reserve Bank can generate revenue or generate profit in this kind of a monopoly setup is through Seigneur, technically,
this is known as Seigniorage, which means the difference between the intrinsic value of the 10-rupee note and the
actual value of the 10-rupee note.

Now, intrinsic value of the 10-rupee note is the cost of producing the 10-rupee note. So, there is paper cost, there is
ink cost, there is printing cost and let's assume that it takes 6 rupees to produce one 10-rupee note. So, the average
cost of a 10-rupee note is 6 rupees, right, and the actual value of the rupee, which is 10-rupee, because this is a 10-

© Copyright 2019. UpGrad Education Pvt. Ltd. All rights reserved

rupee note. The value of the note is 10 rupees, in the market, it is valued at 10 rupees. So that is the total revenue
from that note. So, we have the cost, which is 6 rupees and we have the revenue which is 10 rupees, and if you deduct
cost from revenue, what do you get? You get the profits.

So, in this case, for the Seigniorage part of the profit, Reserve Bank is making 10 rupees minus 6 rupees that is 4 rupees
of profit every 10-rupee note that it is releasing in the market. Well, hang on! There is one more source of income
from this printing note business, so that this Seigniorage is one.

The second one is through interest rates. So, how do you think? What is that market where reserve bank sells these
notes? Reserve bank does not set up a shop or does not distribute more through e-commerce websites, do they? They
don't, right. So, what they do is they give these notes as loans or as lending to various Indian banks and in return the
Indian banks commit to the reserve bank a certain interest rate.

So, say, for example, Reserve Bank gives ten such 10-rupee notes to State Bank of India and State Bank of India says
that, okay, in return of these ten 10-rupee notes, which is 100 rupees. A State Bank of India will pay a 10% every year
interest rate to Reserve Bank. So, that means what? Every end of year, Reserve Bank makes a revenue of 10 rupees
on the 100 rupees that it had given to State Bank of India, right.

So, that's the other source of revenue. So, if you combine these two that will give the total revenue, then you have
total cost and then the market forces would tell you what the profit levels are, what is the best, what is the MC equal
to MR situation for Reserve Bank to continue producing notes so on and so forth.

© Copyright 2019. UpGrad Education Pvt. Ltd. All rights reserved