Monopoly in its pure form is an extreme market form with complete lack of competition. A monopoly firm, or a monopolist, is the only seller, facing no competition in the marketplace for the good or service it is selling. The product in question is unique and has no close substitutes. An example is a single ferry service between two islands, or a pharmaceutical firm that is the sole manufacturer of a particular drug.
Pure monopolies, where there are no close substitutes for the product or service offered, are uncommon in the modern world due to the availability of substitute products and/or government mandates, but monopoly power is exercised by producers in various markets. Monopoly power is a broad term that refers to the ability of sellers to hike prices above costs. For instance, although the seller of a famous clothing label is not considered to be a pure monopolist, it has monopoly power to charge prices above those of less popular labels. Conversely, sellers facing many competitors (e.g., newspaper vendors) must price at or very close to costs, and have little monopoly power.
Less common variants of a monopoly include monopsony and a bilateral monopoly. A monopsonist is a single buyer facing many sellers: for example, the Department of Defense is the sole buyer of the wares of various defense equipment manufacturers. A bilateral monopoly is the special scenario where a single buyer faces a single seller. Exchange in a bilateral monopoly takes place depending upon the relative bargaining strengths of the buyer and seller. In the case of a natural monopoly structurally there is room for only one firm in a market.
In such cases, a single firm’s costs decline as it serves more customers. Hence, one firm can continue to lower costs by producing more, and competitors with small market shares are unable to survive due to higher costs. Public utility companies such as power and water companies are prime examples of natural monopolies.
The primary reason for the emergence and long-term viability of a monopoly is the presence of entry restrictions, or entry barriers, for new competitors (see Bain 1956). These entry restrictions include exclusive ownership of raw materials, patents, franchises (both public and private), and so on. Some entry restrictions may be natural or independent of the monopolist’s efforts, whereas others may be deliberately created by the monopolist (e.g., lobbying to make entry more difficult for firms that follow by having them satisfy stricter environmental restrictions). Governments sometimes create artificial monopolies for limited periods by mandating entry restrictions. Patents are a principal example of this. A patent confers a monopoly upon the patent holder until its expiry. In certain instances, governments enter into business by themselves to ensure service and reliability, or for national security considerations.
The longevity of a monopoly depends on the strength and the height of entry barriers. A monopolist can continue to earn supernormal profits over the long term if entry barriers are successful at preventing the entry of competitors. A monopolist ferry operator can continue to earn supernormal profits if the transit authority does not award another ferry license over the foreseeable future. On the other hand, a monopoly will be eroded as competitors are able to circumvent entry restrictions over time. For example, successful innovations are often copied as time passes.
The measurement of monopoly power is essential before any government action can be undertaken to dismantle monopolies to promote competition. A common (and easy to calculate) measure is the concentration ratio. The concentration ratio is the percentage of industry sales accounted for by the largest firm(s) in question. A pure monopoly has the concentration ratio of 100 percent. Thus, the farther away (less than) the concentration ratio is from 100 percent, the more competitive (or less like a monopoly) a market is. Although concentration ratios have the advantage of ease of computation, their primary drawback lies in their inability to reveal the actual behavior of firms (e.g., are firms aggressive or passive competitors?). There are other measures of monopoly power that overcome these shortcomings, but they are relatively difficult to compute.
There are some common misperceptions about monopolies. First, it is not true that a monopolist can charge whatever price it pleases, including the highest possible price, because at the highest price for most goods, consumers either buy poor substitutes or do not buy at all. Second, a monopolist does not always make profits. In reality, monopolists initially might have to take losses as consumers are educated about their new product(s). This explains the losses of some Internet startup companies.
Economists have shown that compared to a competitive firm, a monopolist’s price is higher and production is smaller (Intriligator, 1971). For example, a single airline serving a town will have higher fares and a less frequent schedule than if there were numerous airlines serving the same route. The monopolist’s behavior with regard to other strategic variables such as advertising and research and development (R&D) is less clear; that is, it is not clear whether a monopolist would advertise more (or conduct more R&D) than would a competitive counterpart. On the one hand, a monopolist might not have an incentive to advertise because it has no competitors to take customers from; on the other hand, a monopolist might advertise if advertising were to expand the total market by bringing in new buyers. With respect to R&D, a monopolist has the resources to innovate but might not have the desire to introduce new products (Goel 1999).
Public policy in most countries is driven by a pro-competitive, antimonopoly stance. Government regulators try to break up monopolies and make markets more competitive, though government tolerance of monopolies varies across nations. The recent antitrust proceedings against Microsoft Corporation and the earlier breakup of American Telegraph and Telephone (also known as AT&T or the "Bell System") are examples. The main criticism against monopoly is that it deliberately reduces production to raise prices. This quantity restriction shuts out some buyers who otherwise would have benefited from buying the product at the (lower) competitive price. Less significant criticisms of monopoly are that it promotes corruption (potential monopolists might be willing to bribe public officials to obtain exclusive contracts) and organizational waste (due to a lack of competition, a monopolist is likely to have a "fatter" organization than is essential to successfully conduct business). Taxation of a monopolist might also pose problems. Given a captive market, a monopolist might see a higher excise tax as an opportunity to raise the price of the product by more than the amount of the tax. This is in contrast to the behavior of a competitive firm, whose post-tax price increase is equal to or less than the amount of the tax.
Joseph Schumpeter (1942) provided the main redeeming grounds for a monopoly in arguing that monopolies were perhaps better at producing innovations because of their deep pockets (resources). Competitive firms with rather limited resources, in contrast, are less willing to undertake risky research projects. Empirical evidence on the advantage of monopoly firms over other (competitive) firms in producing innovations is inconclusive, however. The state-run patent programs in various countries are driven by the recognition that state-sanctioned monopolies granted by patents will spur innovation. Technology, therefore, has the potential to create as well as to dismantle monopolies. A successful new inventor receives a patent and establishes a monopoly. On the other hand, some technologies might create substitutes for existing monopoly products or services; an example of this is Internet companies creating online travel agents to compete with conventional travel agents.
Even for sellers, having a monopoly might not be such a desirable scenario when pricing decisions for a durable good are being considered (see Coase 1972). Durable goods are goods such as cars and washing machines that last a number of years. The dilemma facing monopolist sellers of durable goods is whether to lease them or sell them, and at what level of longevity (durability) to market the durable product. Relatively low initial prices for durable goods do not generate repeat business because the customers use durable goods for such long periods, and high selling prices encourage second-hand (used goods) markets that do not make any money for the monopolist. In contrast, there are no resale markets when a good is leased rather than sold, but complex lease clauses might scare some buyers away.
In sum, although monopolies are not very common in their pure form, monopoly power exists in many markets. Whereas government policy across the world continues to generally favor competitive markets, there are some redeeming features of monopolies. However, as new technologies emerge, we can expect more monopolies (at least in the short term) and destruction of existing ones.