Natural monopoly Essay Example for Free

Natural monopoly Essay This report studies what are the various sources of monopoly and real life examples for each source. It analyses how each of these businesses grew into a monopoly and substantiates the analysis with actual facts figures (wherever available). Methodology of study: The subject has been divided into sub-topics based on the source out of which the monopoly arises. The report begins with the introductory analysis of the monopoly functioning. Each source has then been studied with reference to one real life example followed by the conclusion. What defines a Monopoly – Its Characteristics: Profit Maximizer, Price Maker, High Barriers to Entry, Single seller, Price Discrimination: Major sources of monopolies: 1. Ownership of strategic resources: A monopoly is likely to arise if a firm has complete control over a key input or resource used in production. Famous example is diamond trade monopoly firm De Beers. 2. Government regulations: A government-granted monopoly (also called a de jure monopoly) is a form of coercive monopoly by which a government grants exclusive privilege to a private individual or company to be the sole provider of a commodity. Potential competitors are excluded from the market by law, regulation, or other mechanisms of government enforcement. 3. Patents: Patents grant the inventor the exclusive right to produce a product for 20 years (new worldwide patent period established with a 1995 GATT agreement). By granting the right to produce a new product without fear of competition, patents provide incentive for companies or individuals to continue developing innovative new products or services. For example pharmaceutical companies spend large sums on research and development and patents are essential to earning a profit. 4. Natural monopoly: A natural monopoly is a company that experiences increasing returns to scale over the relevant range of output and relatively high fixed costs. A natural monopoly occurs where the average cost of production declines throughout the relevant range of product demand. When this situation occurs, it is always cheaper for one large company to supply the market than multiple smaller companies. An early market entrant that takes advantage of the cost structure and can expand rapidly can exclude smaller companies from entering and can drive or buy out other companies. Monopoly through ownership of key resource: De Beers Diamonds are one of the worlds, and specifically Africa’s, major natural resources. An estimated US$13 billion worth of rough diamonds are produced per year, of which approximately US$8. 5 billion are from Africa (approximately 65%). Global diamond jewellery sales continue to grow, increasing three-fold in the past 25 years, and are currently worth in excess of US$72 billion every year. Chronology over which DeBeers has become one of the world’s most powerful monopolies:1. Ownership of all South African diamond mines: Smaller groups needing common infrastructure form diggers committees and small claim holders wanting more land merge into large claimholders to form larger ones. In no time, it could establish De Beers consolidated mines. 2. Supply and Demand control: The Diamond Trading Company has been formed. The mantra is: Create a scarcity of diamonds and high prices will follow. And while other commodities have seen price fluctuations over the years, diamonds prices have climbed since the Great Depression mostly. Demand has also been consistently good over the years irrespective of economic scenario. [pic] [pic] 3. Business model: De Beers and its Central Selling Organization established exclusive contracts with suppliers and buyers, making it impossible to deal with diamonds outside of De Beers. The structure remained the same for much of the 20th century: A De Beers subsidiary would buy the diamonds. De Beers would determine the amount of diamonds they wanted to sell, and at what price, for the whole year. How the monopoly functions: Sends invitations to 250 chosen clients to attend the 10 annual â€Å"sights â€Å"client receives a small box: uncut diamonds price of the box ($1-$25 million) client can only buy the whole box and he cannot resell it in a rough form. Thus, De Beers decides: How many diamonds of each quality will be distributed in total. How this supply will be divided among the clients and the Price of diamonds. 5. The creation of Debswana: A joint venture between the company and the nation of Botswana meant a significant shareholding claim in De Beers by the African country. 6. Marketing campaigns: Coined world famous marketing campaign, A diamond is forever† 7. Antitrust laws of US and conflict with various governments: During its initial years, it controlled over 90% of world’s diamond production but over time, it has lost its monopoly to various controversies and oppositions from countries with great stockpiles. [pic] Source: CNN Money Report 8. Statistical graphs showing how De Beers fared over years in its sales, production and profitability: [pic] Source: De Beers Group Website [pic] [pic] Source: Rapaport Trade Report [pic]. Above graph indicates how competitors have dampened the monopoly of DeBeers over the years. Like ALROSA, De Beers needs to be assured of a sustainable level of demand for its goods. Monopoly through govt. owned strategic resources: Coal India limited CIL is the worlds largest coal mining company both in terms of proven coal reserves and coal production. It is entirely owned by the union government, under the administrative control of the Ministry of Coal. It is involved in coal mining and production and contributes around 81. 1 per cent of Indias coal production. It produced around 431. 32 million tons of raw coal in fiscal 2011. CIL currently operates eight subsidiaries, of which, seven are involved in coal production while the eighth is Central Mine Planning and Design Institute (CMPDI) which is involved in mine planning and other consultancy services related to mining. The seven coal-producing subsidiaries of CIL: Eastern Coalfields Ltd (ECL) ,Bharat Coking Coal Ltd (BCCL),Central Coalfields Ltd (CCL),Northern Coalfields Ltd (NCL),Western Coalfields Ltd (WCL),South Eastern Coalfields Ltd (SECL),Mahanadi Coalfields Ltd (MCL)[pic] Outlook on demand, supply, and imports of non-coking coal and cooking coal in India over the next five years: CRISIL Research expects the total demand for non-coking coal to grow at 10 per cent CAGR over the next 5 years (2012-13 to 2016-17). Production of non-coking coal is expected to rise only at a CAGR of 7 per cent from 2012-13 to 2016-17. Consequently, imports are set to increase to 196 million tonnes by 2016-17 from 83 million tonnes in 2011-12. Growth in steel production through the blast furnace route and pig iron production are expected to increase coking coal demand, to 68 million tonnes in 2016-17 from 38 million tonnes in 2011-12 rising at 12. 4 per cent CAGR over the next five years. On the other hand, coking coal production is expected to rise to 60 million tonnes in 2016-17 at a CAGR of only 6. 6 per cent. CIL hike domestic coal prices in February 2011 Coal India Limited (CIL) has increased the prices of different grades of coking and non-coking coal with effect from February 28, 2011. For the first time in its history, CIL adopted a differential pricing approach by increasing the prices of coal for industrial end-use sectors such as steel, cement, paper, and aluminum, while effecting only a marginal increase in the prices of coal for deemed essential services such as power utility, fertilisers, and defense sectors. This differential pricing is intended to bring the prices of coal consumed by non-priority sectors in line with the international coal prices. Cement and sponge iron players to be affected. The Economic Survey has said that Coal India Ltds (CIL) â€Å"near monopolistic† position has also led to â€Å"supply bottlenecks†. Calling for infusing competition in the domestic coal sector, due to the CIL’s dominance there have been delays in development of new coal fields and inadequate emphasis on cost reductions at operational levels. [pic] Federation of Indian Chambers of Commerce and Industry (FICCI) said the Government should take steps to end the monopoly of Coal India and allow private players in coal mining. As regards coal, today our imports are 15 per cent. By the end of the 12th plan, imports are going to be 28 per cent, he said, adding currently power plants with 22,000 MW capacities are suffering due to lack of availability of coal. What can be done to reduce monopoly of CIL India 1. The gap between demand for coal and domestic availability is widening at a faster pace. There is perhaps need to introduce competition in this sector India must bring in more private miners to develop coal reserves which majority state-owned Coal India Ltd has left untapped.. It will push up the cost of power generation and the resultant pressure on the regulated tariffs in the power sector. Therefore, both the factors should be considered. 2. Coal pricing is also a major issue. It has to be transparent, flexible and based on global norms. Monopoly through the ‘Patent’ way : In the highly competitive pharmaceuticals sector where development programmes last for years and have budgets ranging into six-figure sums, maintaining a monopoly position for an important drug is key to commercial success. Only by securing a monopoly can a company justify the very significant investment of time and funding into the pre-clinical and clinical development necessary to support the stringent requirements for grant of a marketing authorization. The mechanisms for achieving this include: †¢ Patent protection †¢ Supplementary protection certificate †¢ Data exclusivity †¢ Orphan drug status. The European framework for pharmaceutical regulation and authorization attempts to protect the investment of companies in their innovations by providing periods of so-called data exclusivity. The Food and Drug Administration can also protect the company’s exclusive access to the market, independent of the patents. Such exclusivity prevents FDA approval for a competing drug for up to seven years, depending on the type of drug. In addition to the market exclusivity and patents, drug companies already receive incentives to develop so-called orphan drugs used to treat rare diseases. These incentives include FDA research grants, tax credits for up to 50 percent of the cost of clinical research and a waiver of FDA fees. Fewer drug companies competing in a therapeutic class leads to fewer prescription drugs being developed within that class and allows the companies to use their patents and market exclusivity to further increase prices. Effect on price of the Drug before and after Patent expiry The following graph shows the effect on price of the drug when the patent gets expired and more and more generic manufacturers enter into the marketplace. Initially the price of the drug is very high but as patent gets expired and more manufacturers comes in the price of the drug falls[pic] Effect on revenues earned by company before and after patent expiry: The following graph depicts the effect of the revenues due to patent. Initially the revenues earned are in negative because of huge initial investment that is required for the launch. The next few years the revenues earned increases every year till the year when the patent gets expired and more players enter into the market and the revenue earned by the company goes down. [pic]. The case of Zyprexa : Zyprexa (olanzapine), an antipsychotic for the treatment of schizophrenia and bipolar disorder is an atypical antipsychotic medication by Eli Lilly. The patent of which got expired in October 2011, generated more than 20 percent of the company’s total revenue in the year-ago quarter. With new generics now competing in the market, revenue from the drug slid 44 percent to $749. 6 million from $1. 34 billion [pic] The case of Ambien (Zolpidem by Sanofi aventis): The first drug to compete with Ambien was Sonata (active ingredient Zaleplon) introduced to market in 1999, but did little to compete with Ambien. In fact, it did not even make the list of top 200 selling drugs from 2003-2007. By that time Ambien had already captured most of the United States insomnia market. Ambien and Sonata held the market until 2005 when Lunesta (active ingredient eszopiclone) was approved. Lunesta’s popularity steadily grew and sales remain around $900 million. All three drugs are structurally similar, and act on the same class of receptors. The sales of Ambien continued to stay strong until its patent expired in 2007. Shortly after, 13 generic drugs manufactures got approval to manufacture Zolpidem and the sales of Ambien fell from about 2 billion to less than 1 billion. [pic] Total yearly sales of Ambien and Lunesta. A case of Natural Monopoly: Indian Railways At the centre, there is a Union Minister of Railways, under whom there are two Minister of State for Railways. At the national level, the Railway Board is responsible for formulation of policies and effective operation of railways. Operating ratio was 91. 1 percent in 2010-11, improved to 95. 0 percent in 2011-12. How it became a monopoly: IR is a classic example of a public monopoly. Historically, this monopoly was a necessity since construction of railway infrastructure required large resources, investment involved long gestation periods and returns were uncertain. Capital Intensive venture, which can be understood from the fact that Indian railways has a separate budget each year 1. Economies of scale, as Indian railways operate all over India and thus have sufficient operating domain to achieve economies of scale which a new entrant cannot easily replicate 2. Government rules and regulations Factors that enabled railways to engage in price discrimination using up part of consumer surplus: 1. The products or services of Indian railways are not resalable and thereby restricts its discount customers to become resellers and benefit from arbitrage. 2. It has monopoly and hence is able to dictate the pricing terms and conditions to a greater extent, in spite of being owned and regulated by Indian government. Degrees of price discrimination, the tools that express monopolist’s power and capacity of price making: Second degree price discrimination: Usually monopolist sets the block prices, under which prices are highest for first block of quantity bought and it is reduced for each successive purchase. Indian railways charge for every kilometer which is reduced as one travels longer and longer. Thus a train ticket for the Rajdhani’s 1st AC between Bangalore to Delhi (Rs 4555) is lesser than the cost of two 1st AC tickets one from Bangalore to Nagpur (Rs 3245) and Nagpur to Delhi (Rs 2845). The cost differences are negligible if any for providing the same seat on the same train on same day. The price differences are much more than what can be explained by cost, hence this is a case of second degree price discrimination. | |Bangalore to Delhi |Bangalore to Nagpur |Nagpur to Delhi | |Rajdhani 1st AC fares |4555 |3245 |2845 |. * Source: www. irctc. co. in Third degree price discrimination: Here, price usually varies by attributes such as location of purchase, customer segment etc. Indian railways heavily employs third degree of price discrimination as below: |Train |Child (5-12 years) |Citizen (12 60 years) |Senior Citizen (M, F) | |Sampark Kranti |1873 |3560 |2548, 1873 | |Rajdhani |2330 |4555 |3220, 2330 | |Karnataka Express |1806 |3427 |2455, 1806 | |Discount Code |Description |Discount Percent | |SPORTN |Sports National Level |50% | |STDNT |Student Concession |50% | |TEACHR |Teacher |25% | |TLSMIU |Thalassemia Patient |50%. | |KIDNEU |Kidney Patients |50% | |YTH2SR |Unemployed Youth for Interview |100% | * Source: www. irctc. co. in Statistical data showing the indispensable monopoly of Indian railways: [pic] [pic][pic] Conclusion: Whilst we want to be in a perfect competition, sometimes it isn’t possible due to multiple constraints. Sometimes, it is also useful especially when it comes to cost efficiency in terms of natural monopolies. And then there are cases of strangle holding system to exert monopoly like De Beers. All these play different roles under different situations. Going by the examples we discussed, there may not be complete monopoly due to inherent monopoly’s inefficiencies and a constant push to improve market equilibrium for the social welfare of the society. References: 1. Unvieling the diamond industry – 2011 report – Bain and Company 2. www. diamondcouncil. org 3. http://www. businessinsider. com/history-of-de-beers-2011-12? op=1#ixzz25KFAEdXk 4. Crisil Research Report – Coal India Limited 5. Railway Budget Highlights 2011-2012, Govt. of India report. 6. www. irctc. co. in 7. Indian Pharmacy Society Report 8. Sanofi Aventis Annual Report.