A pure monopoly exists when a single firm dominates a market for a particular product, such as the dominance that Microsoft has for operating systems or that the government has for particular public services. Although monopolies are rarely pure, their primary characteristic is that they are price makers — they can set the price of their product without worrying about any competition. This increases the producer surplus for the monopolist at the expense of a lower consumer surplus for the buyers of the product.
To achieve this so-called market power, a monopoly must have several characteristics.
- It must be a single seller in the market.
- There must be no close substitutes for the product or there must be some other economic barrier that prevents users from using substitutes. For instance, there are several computer operating systems available that consumers can use, but because many people have already made significant investments in hardware and software that require specific operating systems, they cannot easily switch — they are locked into their choices.
- There must be significant barriers to entry so that no competitors can enter the market.
These 3 characteristics must all be present for a monopoly to exist; otherwise, a monopoly would be reduced to an oligopoly, a monopolistic competition, or even pure competition.
Another characteristic of monopolies is that they do not need to advertise their product to increase market share. They generally use public relations and advertising to increase awareness of their products and to maintain a good relationship with their buyers.
Barriers to Entry
Barriers to entry are obstacles that prevent firms from entering a market. A monopoly is created when the barriers are steep. When barriers are not so steep, then an oligopoly results. When there are few or no barriers to entry, then either monopolistic competition results, if the product can be differentiated to some degree from close substitutes, or pure competition results when there is no significant difference among the products sold by many suppliers, which is the case for most commodities.
Barriers to entry can be either natural or artificial.
Natural Barriers to Entry
Natural barriers to entry arise from the nature of the enterprise, the quality of its workforce, or its position in the industry, rather than from legal barriers.
Some natural barriers to entry include:
- large startup costs,
- a wide technological superiority over competitors, or
- control of an essential resource required to produce the product. However, the most common natural barrier to entry is when the production of a product exhibits large economies of scale.
The primary natural barrier to entry is economies of scale.
Economies of Scale
Economies of scale result when the average total cost (ATC) of a product declines with increasing quantity produced. Because almost every firm has fixed costs, the cost to supply most products will generally decline with increasing quantity because these fixed costs can be apportioned to a greater supply of the product, which reduces the average total cost of each product. Eventually, average total cost of most products increases as the limits of the fixed resources is approached. However, if ATC declines over the quantity demanded by the market, then a single firm can dominate that market, since other firms would not be able to achieve the same economies of scale when the market is already dominated by a seller.
When average total cost declines over the entire market, then a natural monopoly exists. The best examples of natural monopolies are software and digital editions of media, such as movies, TV shows, music, magazines, and books, because the cost of producing additional items decreases continually.
Artificial Barriers to Entry
Most artificial barriers to entry are legal barriers, barriers that arrive from the government rather than from the nature of the enterprise. The government has several types of laws that limit competition, such as licenses that are required to operate a TV or radio station or to operate a taxicab. Licenses usually result in an oligopoly rather than a monopoly, since several firms can usually obtain licensing. However, the main rights given by governments that give the holder of the right an exclusive property right are copyrights and patents.
A copyright is a time-limited right, granted by the government, to creators of written works, music, software, or art, giving them the exclusive right to sell or license their copyrighted material. In the United States, the time period extends from the time the work is created until 70 years after the death of the author, if the author is a natural person; the copyright for corporations or materials created by work-for-hire lasts the shorter of 95 years from the first date of publication or 120 years after the creation of the work. Afterwards, the work enters the public domain, when it can be used by anyone without permission from the copyright holder.
A patent is a time-limited right, granted by the government, for the patent holder to use the patented item exclusively or to sell that right to someone else. Most nations have set the time limit of patents to 20 years after the patent application is filed. As with copyrighted materials, the patented item enters the public domain after the patent expires.
Many patented items are inventions that resulted from research and development. For instance, drugs are constantly being developed and patented by drug companies. Many of these drugs are extremely expensive, some costing $100,000 or more for a treatment using the drug. Obviously, drug companies would not be able to charge such high prices if they cannot prevent competitors from entering the market and providing the drug at a lower cost. Hence, the express purpose of patents is to motivate innovators to develop new ideas and products that will benefit society by giving them an exclusive monopoly over their invention.
Strategic Barriers to Entry
Because monopolies are very profitable, companies will frequently try to prevent competition by creating artificial barriers to entry, such as lowering prices to prevent startup firms from earning a profit in their early years, or by making deals with companies that influence the marketing of the product. For instance, Microsoft tried to corner the browser market in the 1990s by offering its Internet Explorer as part of its Windows operating system and by reducing prices on its operating systems to manufacturers of computer systems if they would include Internet Explorer on their desktop.
When a company lowers the prices of its products below its ATC to prevent competition, it is using a tactic that is sometimes referred to as predatory pricing. Predatory pricing is particularly effective when the marginal cost of additional product is virtually zero, as it is for software, for instance. Indeed, monopolies are so profitable that the company will sometimes give the product away in the hope of recouping large profits later. Microsoft successfully used this tactic to promote Microsoft Office, which is why it is the dominant office suite today. During the 1990s, computer manufacturers included Microsoft Office on the systems that they sold, usually at no additional cost to the consumer. Nowadays, Microsoft charges hundreds of dollars for Microsoft Office. Indeed, starting with Microsoft Office 2010, Microsoft has even eliminated upgrade pricing that allowed previous owners of Microsoft Office to upgrade at a reduced cost. In 2013, Microsoft started offering subscriptions, where the customers have to pay for the product monthly or annually. That monopolies are very profitable is also demonstrated by the fact that Microsoft is one the most profitable corporations in the world, even as it spends a lot of money in unprofitable areas, and its former CEO, Bill Gates, has been at or near the top of the Forbes 400 list of the richest people in the world for more than 2 decades.