Chapter 13: Monopoly.
Economists have classified markets into four categories: perfect competition, monopoly, oligopoly, and
monopolistic competition.
These market structures are based on two dimensions:
• The number of producers in the market.
• Whether the goods offered are identical or differentiated.
Differentiated goods that are different but considered somewhat substitutable by consumers. E.g. Coke
vs Pepsi.
(Figure 13-1)
A monopolist is a firm that is the only producer of a good that has no close substitutes. An industry
controlled by a monopolist is known as a monopoly.
In practical world, monopolies are found very rarely because of legal obstacles. A firm cannot
consolidate various producers into one firm and establish a monopoly. Oligopolies, however, are found
much more commonly.
Market power: Market power is the ability of a firm to raise prices.
(Figure 13-2)
A monopolist possesses market power to reduce the quantity supplied and therefore raise prices. A
wheat farmer, who is 1 of 100,000 producers has no market power to influence the quantity or price of
wheat, but a sole water supply company to a city does possess the ability to effect market prices and is
therefore a monopolist.
Under perfect competition, new firms enter the market in the long run and economic profits vanish. But
in a monopoly, the monopolist is able to earn economic profits in the long run as no firms enter the
market.
To earn economic profits, a monopolist must be protected by a barrier to entry-something that
prevents other firms from entering the industry. There are 5 principle types of barriers to entry:
• Control of a scarce resource or input:
A firm that controls a resource or input crucial to an industry can prevent other firms from entering its
market. An example could be De Beers which had exclusive control over the world’s diamonds.
• Increasing returns to scale:
A natural monopoly exists when increasing returns to scale provide a large cost advantage to a single
firm that produces all of an industry’s output.
An example could be gas companies which supply gas to entire cities. The number of gas companies is
not greater than 1 owing to increasing returns to scale. When the gas industry was just starting up,
many companies competed for local customers. But this competition didn’t last long as local gas supply
soon became a monopoly in almost every city. Firms with larger volumes of sales had an advantage:
they were able to spread the fixed costs over a larger volume and therefore had lower average total cost
than smaller firms. The phenomenon that average total cost falls as output increases is called increasing
returns to scale. This leads to firms growing larger and establishing a monopoly. In an industry
characterized by increasing returns to scale, larger companies are more profitable and drive out smaller
ones. This also prevents new companies from entering the competition. So, increasing returns to scale
can both give rise to and sustain a monopoly.
A natural monopolist’s Average total cost curve (ATC) declines over the output levels at which price is
greater than or equal to average total cost. The natural monopolist has increasing returns to scale over
the entire range of output for which any firms would want to remain in the industry- the range of output
at which the firm would at least break even in the long run. The source of this condition is large fixed
costs: when large fixed costs are required to operate, a given quantity of output is produced at lower
average total cost by one large firm than by two or more smaller firms.
Local utility companies are the most common example of natural monopolies.
(Figure 13-3)
• Technological superiority:
A firm that maintains a constant technological advantage over potential competitors can establish itself
as a monopolist. For example, Intel was able to sustain a technological advantage from the 1970s to
1990s in the manufacture of microprocessors. But technological superiority is typically not a barrier
because over the long term, competitors will invest in upgrading their technology to match that of the
technology leader.
Technological superiority, however, is not a guarantee of success because of network externalities.
• Network externality:
A network externality exists when the value of a good or service to an individual is greater when many
other people use the good or service as well. Network externalities are very prevalent in technology and
communications sectors of the economy. An example could be the Facebook. The value of Facebook
page increases if more people use it.
When a network externality exists, the firm with the largest network of customers using its product has
an advantage in attracting new customers, one that may allow it to become a monopolist. It can charge
a higher price and so earn higher profits.
• Government created barrier:
A patent gives an inventor a temporary monopoly in the use or sale of an invention. In most countries, it
typically lasts from 16 to 20 years. Patents are usually given to the producers of new products or
devices.
A copyright gives the creator of a literary or artistic work sole rights to profit from that work. It usually
lasts for a period equal to the creator’s lifetime plus 70 years.
Patents and copyrights are the most important legally created monopolies.
Patents and copyrights are types of incentives for invention. If an inventors are not protected by
patents, they would gain little rewards from their efforts. Others would copy their valuable invention
and sell it. And if there are no significant profits to be reaped from invention, inventors would have no
incentive to innovate and produce new products.
Patents and copyrights are temporary because the law strikes a compromise. The higher price for the
good that holds while the legal protection is in effect compensates investors for the cost of invention.
However, this system is imperfect and leads to missed opportunities. E.g. the patent given to
pharmaceutical companies results in poor patients being unable to afford some medications.
To solve this problem, some American drug companies have signed deals which honour patients by
