Quotations from Mankiw (2018):
A firm is a monopoly if it is the sole seller of its product and if its product does not have any close substitutes. The fundamental cause of monopoly is barriers to entry: A monopoly remains the only seller in its market because other firms cannot enter the market and compete with it. Barriers to entry, in turn, have three main sources:
- Monopoly resources: A key resource required for production is owned by a single firm.
- Government regulation: The government gives a single firm the exclusive right to produce some good or service.
- The production process: A single firm can produce output at a lower cost than can a larger number of firms.
The simplest way for a monopoly to arise is for a single firm to own a key resource. For example, consider the market for water in a small town. If dozens of town residents have working wells, the model of competitive markets discussed in the preceding chapters describes the behavior of sellers. Competition among suppliers drives the price of a gallon of water to equal the marginal cost of pumping an extra gallon. But if there is only one well in town and it is impossible to get water from anywhere else, then the owner of the well has a monopoly on water. Not surprisingly, the monopolist has much greater market power than any single firm in a competitive market. In the case of a necessity like water, the monopolist can command quite a high price, even if the marginal cost of pumping an extra gallon is low.
Although exclusive ownership of a key resource is a potential cause of monopoly, in practice monopolies rarely arise for this reason. Economies are large, and resources are owned by many people. The natural scope of many markets is worldwide, because goods are often traded internationally. There are, therefore, few examples of firms that own a resource for which there are no close substitutes.
In many cases, monopolies arise because the government has given one person or firm the exclusive right to sell some good or service. Sometimes the monopoly arises from the sheer political clout of the would-be monopolist. Kings, for example, once granted exclusive business licenses to their friends and allies. At other times, the government grants a monopoly because doing so is viewed to be in the public interest.
The patent and copyright laws are two important examples. When a pharmaceutical company discovers a new drug, it can apply to the government for a patent. If the government deems the drug to be truly original, it approves the patent, which gives the company exclusive right to manufacture and sell the drug for 20 years. Similarly, when a novelist finishes a book, she can copyright it. The copyright is a government guarantee that no one can print and sell the work without the author’s permission. The copyright makes the novelist a monopolist in the sale of her novel.
The effects of patent and copyright laws are easy to see. Because these laws give one producer a monopoly, they lead to higher prices than would occur under competition. But by allowing these monopoly producers to charge higher prices and earn higher profits, the laws also encourage some desirable behavior. Drug companies are allowed to be monopolists in the drugs they discover to encourage research. Authors are allowed to be monopolists in the sale of their books to encourage them to write more and better books.
Thus, the laws governing patents and copyrights have both benefits and costs. The benefits of the patent and copyright laws are the increased incentives for creative activity. These benefits are offset, to some extent, by the costs of monopoly pricing, which we examine later in this chapter.
An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a lower cost than could two or more firms. A natural monopoly arises when there are economies of scale over the relevant range of output.
An example of a natural monopoly is the distribution of water. To provide water to residents of a town, a firm must build a network of pipes throughout the town. If two or more firms were to compete in the provision of this service, each firm would have to pay the fixed cost of building a network. Thus, the average total cost of water is lowest if a single firm serves the entire market.
The Welfare Cost of Monopolies
Is monopoly a good way to organize a market? We have seen that a monopoly, in contrast to a competitive firm, charges a price above marginal cost. From the standpoint of consumers, this high price makes monopoly undesirable. At the same time, however, the monopoly is earning profit from charging this high price. From the standpoint of the owners of the firm, the high price makes monopoly very desirable. Is it possible that the benefits to the firm’s owners exceed the costs imposed on consumers, making monopoly desirable from the standpoint of society as a whole?
We can answer this question using the tools of welfare economics. Recall from Chapter 7 that total surplus measures the economic well-being of buyers and sellers in a market. Total surplus is the sum of consumer surplus and producer surplus. Consumer surplus is consumers’ willingness to pay for a good minus the amount they actually pay for it. Producer surplus is the amount producers receive for a good minus their cost of producing it. In this case, there is a single producer—the monopolist.
You can probably guess the result of this analysis. In Chapter 7, we concluded that the equilibrium of supply and demand in a competitive market is not only a natural outcome but also a desirable one. The invisible hand of the market leads to an allocation of resources that makes total surplus as large as it can be. Because a monopoly leads to an allocation of resources different from that in a competitive market, the outcome must, in some way, fail to maximize total economic well-being.
Conclusion: The Prevalence of Monopolies
This chapter has discussed the behavior of firms that have control over the prices they charge. We have seen that these firms behave very differently from the competitive firms studied in the previous chapter.
From the standpoint of public policy, a crucial result is that a monopolist produces less than the socially efficient quantity and charges a price above marginal cost.
How prevalent are the problems of monopoly? There are two answers to this question.
In one sense, monopolies are common. Most firms have some control over the prices they change. They are not forced to charge the market price for their goods because their goods are not exactly the same as those offered by other firms. A Ford Taurus is not the same as a Toyota Camry. Ben and Jerry’s ice cream is not the same as Breyer’s.
Yet firms with substantial monopoly power are rare. Few goods are truly unique. Most have substitutes that, even if not exactly the same, are similar. Ben and Jerry can raise the price of their ice cream a little without losing all their sales, but if they raise it a lot, sales will fall substantially as their customers switch to other brands.
In the end, monopoly power is a matter of degree. It is true that many firms have some monopoly power. It is also true that their monopoly power is usually limited. In such a situation, we will not go far wrong assuming that firms operate in competitive markets, even if that is not precisely the case.
See week 3 Lecture Notes.