Reasons for a Monopoly

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Learn all about reasons for a monopoly in just a few minutes! Professor Jadrian Wooten of Penn State University explains reasons monopolies form, including economies of scale, barriers to entry and strategic pricing.

Barriers to entry prevent or obstruct the entry of new firms into a market and limit the amount of competition that existing firms must face.

Monopolies are formed through purposeful profit-rendering tactics or through a firm being the sole owner of a new technology, among other methods. Monopolies are desired by businesses and their shareholders because they lead to great profits. Other firms know that the monopolist makes above-normal profits. This makes entering the market attractive for them, because if they start producing they can also make above-normal profits, at least in the short run (the period of time where some factors in the firm are variable and some remain fixed). If firms did start operating in the market, the level of competition between firms would increase and the rate of profit for each company would fall. As long as each firm is making above-normal profits, it is still worthwhile for new firms to enter the market. For instance, say there is one ride-sharing app in a city. If another new app began in the same city, the firm would likely still profit more than the average. But if 30 new ride-sharing apps all started operating in the same city, they would not be as profitable because they would not be needed as much.

New firms in monopoly situations see opportunities to profit but do not often succeed. A monopoly is protected from competition because, unlike in perfect competition, the market has significant barriers to entry. In the case of a monopoly, these barriers are formidable enough to prevent new entrants from getting started in the market. There are five main types of barriers to entry: economies of scale, ownership or control of a key resource, strategic pricing, innovation, and legal barriers.

Economies of Scale

Economies of scale, wherein products made in larger quantities become cheaper and products made in smaller quantities are more expensive, create barriers to entry when average total costs are high.

In some markets, a single large firm is more efficient than many firms. This is because firms in these markets have economies of scale in production. Economies of scale is the observation that a firm's long run average total costs decrease as production levels increase, which lowers the break-even price (the lowest price that the firm needs to charge in order to cover its costs). This usually leads to the creation of natural monopoly, which is preserved because economies of scale make production by a single large firm the most cost-effective way of producing. In this case, the nature of the market itself gives one producer a big cost advantage. This can happen when the market has few consumers and there is not enough buyers for more than one firm to make a profit. A natural monopoly can also occur when an industry has high fixed costs. Utility industries such as electric companies have high fixed costs that make it difficult to profit unless they have a lot of customers. Energy is expensive and the infrastructure needed to provide it is expensive. It is unlikely many corporations would enter the market for utilities such as water, electricity, and cable television because the high fixed costs make it too difficult to ensure a profit.

Even if there were just two large firms, by splitting up the market, each firm would produce less and as a result could face higher average total costs (ATC). Their inability to make a larger quantity of products as well as resources they would be required to spend on competitive advertising would create inefficiency. Thus, the two large firms have a higher break-even price. On a graph, the demand curve (D₁₎ is the market demand curve—if the market is a monopoly, this is also the demand curve that the monopolist would face. The ATC curve is the firm's average total cost curve. The monopolist faces economies of scale in production along the downward-sloping portion of the long run ATC curve—in this range of production, the cost per unit produced is falling and the firm can at least break even by charging a price equal to its cost.

D₁ is the market demand curve. It is also the demand curve faced by a monopolist, as in that case the monopolist is the only supplier. The average total cost (ATC) curve shows decreasing total costs along the downward-sloping portion of the curve. In that range of production, the firm is facing economies of scale in production. Because in this case the nature of the market itself makes having one supplier the most efficient option, this is a natural monopoly. If instead there were two firms in the market, each firm would face demand curve D₂ because consumers will purchase from both firms. However, the price that these two firms could charge would be less than their total costs, and the firms would not be able to make profits.

Ownership or Control of a Key Resource

Monopolists can use control of key resources to create barriers to entry for potential competitors.

A monopolist can use its ownership or control of key resources to keep potential rivals out of the market. For example, De Beers was once the dominant supplier of diamonds in the world. It became so by purchasing diamond mines in the 1880s and, later, through establishing a one-channel distribution system in which it made exclusive contracts with both suppliers and wholesale buyers. This system made it virtually impossible for a consumer to buy a diamond without De Beers profiting. At its height, the firm controlled 90% of the world's diamond market. However, even with De Beers's considerable advantages, more recent changes in the market, especially lower consumer demand for diamonds and increased resistance to De Beers's monopoly from countries with large amounts of diamond production, reduced the firm's power in the 2010s.

Distribution Systems

Firms may use different methods of distributing their products. Monopolies may use any of these methods. In a one-channel or two-channel distribution system under a monopoly, the monopoly controls the product available to retailers and wholesalers.

More recently, Microsoft lost an anti-monopoly case in Europe in 2007 and an antitrust case in the United States in 2011. Microsoft's monopoly stems from the fact that its operating system was dominant at the time of these cases, it was the operating system for about 95% of the world's personal computers. In both the anti-monopoly case and the antitrust case, the court's position against Microsoft was that it abused its dominant position to keep competitors out, and as an effect of its actions, it also stifled innovation in the development of software and computer applications. In its defense, Microsoft argued that its monopoly was a result of its own technological innovation and that it had a natural monopoly that created a positive network effect—the effect when one good or service is used by the majority of consumers in the market—because of the dominant position of its operating system. Interestingly, in both cases, the court largely agreed that Microsoft was a natural monopoly but also found that Microsoft's actions had been a deliberate abuse of its market power.

In the United Kingdom, Wall's Ice Cream created a monopoly position in the ice cream market by supplying freezers to stores, free of charge—as long as the stores only stocked Wall's ice cream in them. In this case, the key resource was not an input or a process, it was prime space in the store itself. At its height, Wall's controlled just over 70% of the ice cream market, while its two biggest rivals combined had about 26% of the market. Even after the court ruled that Wall's could not make its freezers exclusive and had to allow stores to use half of the freezer space to stock rivals' products, Wall's maintained control of over 60% of the market.

Strategic Pricing

Economies of scale give monopolists lower break-even prices, allowing them to strategically set prices below those at which competitors can make a profit.

Strategic pricing (sometimes called predatory pricing) is the ability of the monopolist to reduce the market price in order to keep potential competitors from succeeding. Because the monopolist has some economies of scale, it also has a lower break-even point than a competitor producing a lower quantity. If a new competitor moves into the market, the monopolist can slash its price and still break even. Even if the rival tries to match the monopolist's price, it cannot do this for long. The price is below the rival's break-even point, so the rival is taking a loss for every sale at this price. The rival will eventually have to leave the market. The monopolist could even sell at a point below its break-even price in the short run, then raise its prices once its rivals are bankrupt.

The monopolist can also utilize price discrimination—the practice of charging different prices for the same product in different markets. Part of the case against Microsoft was that it was charging computer makers that featured Microsoft's web browser (Internet Explorer) a lower price for its operating system than it charged for manufacturers that featured a rival browser, such as Netscape Navigator. Selling at the firm's break-even point (or even at a loss) is not entirely illegal, and neither is price discrimination, but often it can hurt the company's image and dissuade customers. The United States and other countries do have anti-dumping laws in place that make it illegal for foreign firms to sell products in the country well below the price that firm would charge in their home country.

Innovation

Monopolies may stimulate or stifle innovation, and economists debate the extent to which they benefit or harm the economy as a result.

Innovation is the economic application of a new idea, which could be a new or modified product, production process, or method of organizing a business. Determining the exact relationship between monopoly and innovation is a difficult task. Monopolies may stimulate innovation as competitors discover new ways to enter the market, but they may also stifle innovation because of their dominant position.

If a company can establish an innovation, as with new technology, it can end up with an initial monopoly because it is the only firm with the technological advantage. If the firm can keep its advantage over time, this monopoly can persist. This occurred when Apple introduced the iPhone, the first smartphone on the market with a touch screen. Apple dominated the market until other corporations caught up with the innovation. Either way, this innovation creates a barrier to entry for competitors.

Regarding the benefits of innovation for the overall economy, there are two arguments within economics. One position says this chance at having a temporary monopoly is the reason for innovation, and this is a crucial dynamic for a successful market economy. This argument stems from the work of Joseph Schumpeter, the first economist to write at length about the role of entrepreneurs and innovators. He saw their behavior as "creative destruction"—that as inventors found new and better ways of doing things, it drove the whole economy forward—and argued that established companies would also have to continue to innovate in order to maintain their position. In Schumpeter's point of view, monopolies in the short run will be innovated away in the long run as competitors continually look for an advantage over established companies. The other position argues that a monopoly by its very nature will stifle innovation. The monopolist will use its dominant position to keep rivals out of the market, and as a result, new ideas will not make it into the marketplace.

These are important points to consider because this debate occurs not only in economics but also within governments regarding how strict anti-monopoly policies should be, as well as the appropriate extent of legal barriers such as patents (the exclusive right of an inventor to use or allow others to use their invention, which creates a temporary monopoly) and copyrights (the exclusive rights of an artist and their estate to profit from their work).

Legal Barriers

Legal barriers to entry, such as patents and copyrights, are intended to encourage innovation. These barriers create a temporary monopoly for inventors and patent holders.

A legal barrier is a government-created barrier to entry, such as a patent, copyright, trademark, or license, intended to encourage innovation. When developing prescription drugs, companies spend years funding research and development before they can sell an effective drug on the market. Patents allow them to recoup all of the money they invested developing the drug. A patent is the exclusive right of an inventor to use (or allow others to use) their invention. Once awarded, the patent usually lasts for 20 years from the time of submission for the patent. The patent does create a temporary monopoly for the inventor. A copyright is the legally provided right of an artist and their estate to profit from their work for the life of the artist plus 70 years, but in certain cases it can be as long as life plus 120 years. This is an incentive because artists know they will maintain exclusive monetary gain, which allows many artists to fund further creation and encourages them to enter the market.

A trademark is a symbol, word, or words legally registered or established by use as representing a company or product. It can be argued that trademarks are protected in order to provide information in the marketplace. When consumers see a trademark, they can be sure they are buying from the producer what they intend to buy, and the trademark is thus part of a company's brand. A company has a monopoly over its own brand, even if it is not a monopolist in the overall market. Trademarks can also create some interesting court cases, such as the one between Apple Corp., the record label for the Beatles, and Apple Computer, the technology giant. The case concerned the apple logo that Apple Computer used, which Apple Corp. said was too close to its own apple logo, as well as lingering effects between the two companies (and copyright concerns that the Beatles and band members' estates had) that made Beatles music unavailable on Apple's iTunes store for years. In 2006, a court in England ruled in favor of Apple Computer, and eventually relations warmed.

The government can also create a barrier to entry through restricting the issuing of licenses needed by suppliers. A license is official permission to conduct an activity. The government issues licenses to ensure some important services are profitable. Governments could potentially restrict a license to one supplier, as it does with the US Postal Service, which is the only entity with the license to deliver first-class letter mail. Another common example is the restricted number of taxi licenses. In New York City, a taxi has to have a medallion attached to it to be legal, and those medallions are tightly restricted. The limit in New York City is one taxi for every 600 people, giving the city around 13,500 taxi medallions. Even though the taxi industry has recently faced new competition in many places from ride-sharing companies such as Uber and Lyft, those companies also need licenses in order to legally operate in a city.

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