IMPERFECT COMPETITION
Introduction to monopolies
If perfect competition is a market where firms have no market power and they simply respond to the
market price, monopoly is a market with no competition at all, and firms have complete market power. In
the case of monopoly, one firm produces all of the output in a market. Since a monopoly faces no
significant competition, it can charge any price it wishes. While a monopoly, by definition, refers to a single
firm, in practice the term is often used to describe a market in which one firm merely has a very high
market share. This tends to be the definition that the U.S. Department of Justice uses.
Even though there are very few true monopolies in existence, we do deal with some of those few every
day, often without realizing it: The U.S. Postal Service, your electric and garbage collection companies are a
few examples. Some new drugs are produced by only one pharmaceutical firm—and no close substitutes
for that drug may exist.
From the mid-1990s until 2004, the U.S. Department of Justice prosecuted the Microsoft Corporation for
including Internet Explorer as the default web browser with its operating system. The Justice Department’s
argument was that, since Microsoft possessed an extremely high market share in the industry for operating
systems, the inclusion of a free web browser constituted unfair competition to other browsers, such as
Netscape Navigator. Since nearly everyone was using Windows, including Internet Explorer eliminated the
incentive for consumers to explore other browsers and made it impossible for competitors to gain a
foothold in the market. In 2013, the Windows system ran on more than 90% of the most commonly sold
personal computers.
Barriers to entry
Because of the lack of competition, monopolies tend to earn significant economic profits. These profits
should attract vigorous competition as described in Perfect Competition, and yet, because of one particular
characteristic of monopoly, they do not. Barriers to entry are the legal, technological, or market forces that
discourage or prevent potential competitors from entering a market. Barriers to entry can range from the
simple and easily surmountable, such as the cost of renting retail space, to the extremely restrictive. For
example, there are a finite number of radio frequencies available for broadcasting. Once the rights to all of
them have been purchased, no new competitors can enter the market.
In some cases, barriers to entry may lead to monopoly. In other cases, they may limit competition to a few
firms. Barriers may block entry even if the firm or firms currently in the market are earning profits. Thus, in
markets with significant barriers to entry, it is not true that abnormally high profits will attract new firms,
and that this entry of new firms will eventually cause the price to decline so that surviving firms earn only a
normal level of profit in the long run.
There are two types of monopoly, based on the types of barriers to entry they exploit. One is natural
monopoly, where the barriers to entry are something other than legal prohibition. The other is legal
monopoly, where laws prohibit (or severely limit) competition.
NATURAL MONOPOLY
Economies of scale can combine with the size of the market to limit competition. Figure 9.2 presents a
long-run average cost curve for the airplane manufacturing industry. It shows economies of scale up to an
output of 8,000 planes per year and a price of P0, then constant returns to scale from 8,000 to 20,000
planes per year, and diseconomies of scale at a quantity of production greater than 20,000 planes per year.
, Now consider the market demand curve in the diagram, which intersects the long-run average cost (LRAC)
curve at an output level of 6,000 planes per year and at a price P1, which is higher than P0. In this situation,
the market has room for only one producer. If a second firm attempts to enter the market at a smaller size,
say by producing a quantity of 4,000 planes, then its average costs will be higher than the existing firm, and
it will be unable to compete. If the second firm attempts to enter the market at a larger size, like 8,000
planes per year, then it could produce at a lower average cost—but it could not sell all 8,000 planes that it
produced because of insufficient demand in the market.
The graph represents a natural monopoly as evidenced by the demand curve intersecting with the
downward-sloping part of the LRAC curve.
This situation, when economies of scale are large relative to
the quantity demanded in the market, is called a natural
monopoly. Natural monopolies often arise in industries
where the marginal cost of adding an additional customer is
very low, once the fixed costs of the overall system are in
place. Once the main water pipes are laid through a
neighborhood, the marginal cost of providing water service
to another home is fairly low. Once electricity lines are
installed through a neighborhood, the marginal cost of
providing additional electrical service to one more home is
very low. It would be costly and duplicative for a second water company to enter the market and invest in
a whole second set of main water pipes, or for a second electricity company to enter the market and invest
in a whole new set of electrical wires. These industries offer an example where, because of economies of
scale, one producer can serve the entire market more efficiently than a number of smaller producers that
would need to make duplicate physical capital investments.
A natural monopoly can also arise in smaller local markets for products that are difficult to transport. For
example, cement production exhibits economies of scale, and the quantity of cement demanded in a local
area may not be much larger than what a single plant can produce. Moreover, the costs of transporting
cement over land are high, and so a cement plant in an area without access to water transportation may
be a natural monopoly.
CONTROL OF A PHYSICAL RESOURCE
Another type of natural monopoly occurs when a company has control of a scarce physical resource. In the
U.S. economy, one historical example of this pattern occurred when ALCOA—the Aluminum Company of
America—controlled most of the supply of bauxite, a key mineral used in making aluminum. Back in the
1930s, when ALCOA controlled most of the bauxite, other firms were simply unable to produce enough
aluminum to compete.
As another example, the majority of global diamond production is controlled by DeBeers, a multi-national
company that has mining and production operations in South Africa, Botswana, Namibia, and Canada. It
also has exploration activities on four continents, while directing a worldwide distribution network of
rough diamonds. Though in recent years they have experienced growing competition, their impact on the
rough diamond market is still considerable.
LEGAL MONOPOLY
For some products, the government erects barriers to entry by prohibiting or limiting competition. Under
U.S. law, no organization but the U.S. Postal Service is legally allowed to deliver first-class mail. Many states
or cities have laws or regulations that allow households a choice of only one electric company, one water
Introduction to monopolies
If perfect competition is a market where firms have no market power and they simply respond to the
market price, monopoly is a market with no competition at all, and firms have complete market power. In
the case of monopoly, one firm produces all of the output in a market. Since a monopoly faces no
significant competition, it can charge any price it wishes. While a monopoly, by definition, refers to a single
firm, in practice the term is often used to describe a market in which one firm merely has a very high
market share. This tends to be the definition that the U.S. Department of Justice uses.
Even though there are very few true monopolies in existence, we do deal with some of those few every
day, often without realizing it: The U.S. Postal Service, your electric and garbage collection companies are a
few examples. Some new drugs are produced by only one pharmaceutical firm—and no close substitutes
for that drug may exist.
From the mid-1990s until 2004, the U.S. Department of Justice prosecuted the Microsoft Corporation for
including Internet Explorer as the default web browser with its operating system. The Justice Department’s
argument was that, since Microsoft possessed an extremely high market share in the industry for operating
systems, the inclusion of a free web browser constituted unfair competition to other browsers, such as
Netscape Navigator. Since nearly everyone was using Windows, including Internet Explorer eliminated the
incentive for consumers to explore other browsers and made it impossible for competitors to gain a
foothold in the market. In 2013, the Windows system ran on more than 90% of the most commonly sold
personal computers.
Barriers to entry
Because of the lack of competition, monopolies tend to earn significant economic profits. These profits
should attract vigorous competition as described in Perfect Competition, and yet, because of one particular
characteristic of monopoly, they do not. Barriers to entry are the legal, technological, or market forces that
discourage or prevent potential competitors from entering a market. Barriers to entry can range from the
simple and easily surmountable, such as the cost of renting retail space, to the extremely restrictive. For
example, there are a finite number of radio frequencies available for broadcasting. Once the rights to all of
them have been purchased, no new competitors can enter the market.
In some cases, barriers to entry may lead to monopoly. In other cases, they may limit competition to a few
firms. Barriers may block entry even if the firm or firms currently in the market are earning profits. Thus, in
markets with significant barriers to entry, it is not true that abnormally high profits will attract new firms,
and that this entry of new firms will eventually cause the price to decline so that surviving firms earn only a
normal level of profit in the long run.
There are two types of monopoly, based on the types of barriers to entry they exploit. One is natural
monopoly, where the barriers to entry are something other than legal prohibition. The other is legal
monopoly, where laws prohibit (or severely limit) competition.
NATURAL MONOPOLY
Economies of scale can combine with the size of the market to limit competition. Figure 9.2 presents a
long-run average cost curve for the airplane manufacturing industry. It shows economies of scale up to an
output of 8,000 planes per year and a price of P0, then constant returns to scale from 8,000 to 20,000
planes per year, and diseconomies of scale at a quantity of production greater than 20,000 planes per year.
, Now consider the market demand curve in the diagram, which intersects the long-run average cost (LRAC)
curve at an output level of 6,000 planes per year and at a price P1, which is higher than P0. In this situation,
the market has room for only one producer. If a second firm attempts to enter the market at a smaller size,
say by producing a quantity of 4,000 planes, then its average costs will be higher than the existing firm, and
it will be unable to compete. If the second firm attempts to enter the market at a larger size, like 8,000
planes per year, then it could produce at a lower average cost—but it could not sell all 8,000 planes that it
produced because of insufficient demand in the market.
The graph represents a natural monopoly as evidenced by the demand curve intersecting with the
downward-sloping part of the LRAC curve.
This situation, when economies of scale are large relative to
the quantity demanded in the market, is called a natural
monopoly. Natural monopolies often arise in industries
where the marginal cost of adding an additional customer is
very low, once the fixed costs of the overall system are in
place. Once the main water pipes are laid through a
neighborhood, the marginal cost of providing water service
to another home is fairly low. Once electricity lines are
installed through a neighborhood, the marginal cost of
providing additional electrical service to one more home is
very low. It would be costly and duplicative for a second water company to enter the market and invest in
a whole second set of main water pipes, or for a second electricity company to enter the market and invest
in a whole new set of electrical wires. These industries offer an example where, because of economies of
scale, one producer can serve the entire market more efficiently than a number of smaller producers that
would need to make duplicate physical capital investments.
A natural monopoly can also arise in smaller local markets for products that are difficult to transport. For
example, cement production exhibits economies of scale, and the quantity of cement demanded in a local
area may not be much larger than what a single plant can produce. Moreover, the costs of transporting
cement over land are high, and so a cement plant in an area without access to water transportation may
be a natural monopoly.
CONTROL OF A PHYSICAL RESOURCE
Another type of natural monopoly occurs when a company has control of a scarce physical resource. In the
U.S. economy, one historical example of this pattern occurred when ALCOA—the Aluminum Company of
America—controlled most of the supply of bauxite, a key mineral used in making aluminum. Back in the
1930s, when ALCOA controlled most of the bauxite, other firms were simply unable to produce enough
aluminum to compete.
As another example, the majority of global diamond production is controlled by DeBeers, a multi-national
company that has mining and production operations in South Africa, Botswana, Namibia, and Canada. It
also has exploration activities on four continents, while directing a worldwide distribution network of
rough diamonds. Though in recent years they have experienced growing competition, their impact on the
rough diamond market is still considerable.
LEGAL MONOPOLY
For some products, the government erects barriers to entry by prohibiting or limiting competition. Under
U.S. law, no organization but the U.S. Postal Service is legally allowed to deliver first-class mail. Many states
or cities have laws or regulations that allow households a choice of only one electric company, one water
