The De Beers monopoly of South Africa was created in the 1880s by Cecil Rhodes, a British businessman. By 1880 mines in South Africa already dominated the world’s supply of diamonds. There were, however, many mining companies, all competing with each other. Rhodes bought the great majority of those mines and consolidated them into a single company. By 1889 De Beers controlled almost all of the world’s diamond production.

De Beers, in other words, became a monopolist. A producer is a monopolist if it is the sole supplier of a good that has no close substitutes. When a firm is a monopolist, the industry is a monopoly.

As we saw in Chapter 7, the supply and demand model of a market is not universally valid. Instead, it’s a model of perfect competition, which is only one of several different types of market structure.

A market will be perfectly competitive only if there are many producers, all of whom produce the same good. Monopoly is the most extreme departure from perfect competition.

In practice, true monopolies are hard to find in the modern American economy, partly because of legal obstacles. A contemporary entrepreneur who tried to consolidate all the firms in an industry the way that Rhodes did would soon land in court, accused of breaking antitrust laws, which are intended to prevent monopolies from emerging. Oligopoly, a market structure in which there is a small number of large producers, is much more common. In fact, most of the goods you buy, from autos to airline tickets, are supplied by oligopolies.

Why did Rhodes want to consolidate South African diamond producers into a single company? What difference did it make to the world diamond market?

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Figure 8-2 offers a preliminary view of the effects of monopoly. It shows an industry in which the supply curve under perfect competition intersects the demand curve at C, leading to the price P_C and the output Q_C.

Suppose that this industry is consolidated into a monopoly. The monopolist moves up the demand curve by reducing quantity supplied to a point like M, at which the quantity produced, Q_M, is lower, and the price, P_M, is higher than under perfect competition.

The ability of a monopolist to raise its price above the competitive level by reducing output is known as market power. And market power is what monopoly is all about. A wheat farmer who is one of 100,000 wheat farmers has no market power: he or she must sell wheat at the going market price. Your local water utility company, though, does have market power: it can raise prices and still keep many (though not all) of its customers, because they have nowhere else to go. In short, it’s a monopolist.

The reason a monopolist reduces output and raises price compared to the perfectly competitive industry levels is to increase profit. Cecil Rhodes consolidated the diamond producers into De Beers because he realized that the whole would be worth more than the sum of its parts—the monopoly would generate more profit than the sum of the profits of the individual competitive firms. As we’ve learned, under perfect competition economic profits normally vanish in the long run as competitors enter the market. Under monopoly the profits don’t go away—a monopolist is able to continue earning economic profits in the long run.

In fact, monopolists are not the only types of firms that possess market power. Oligopolists, firms that can have market power, do as well. Under certain conditions, oligopolists can earn positive economic profits in the long run by restricting output like monopolists do.

But why don’t profits get competed away? What allows monopolists to be monopolists?

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A monopolist making profits will not go unnoticed by others. (Recall that this is economic profit, revenue over and above the opportunity costs of the firm’s resources.) But won’t other firms crash the party, grab a piece of the action, and drive down prices and profits in the long run? For a profitable monopoly to persist, something must keep others from going into the same business; that “something” is known as a barrier to entry. There are five principal types of barriers to entry: control of a scarce resource or input, increasing returns to scale, technological superiority, a network externality, and a government-created barrier to entry.

1. Control of a Scarce Resource or Input A monopolist that controls a resource or input crucial to an industry can prevent other firms from entering its market. Cecil Rhodes created the De Beers monopoly by establishing control over the mines that produced the great bulk of the world’s diamonds.

2. Increasing Returns to Scale Many Americans have natural gas piped into their homes, for cooking and heating. Invariably, the local gas company is a monopolist. But why don’t rival companies compete to provide gas?

In the early nineteenth century, when the gas industry was just starting up, companies did compete for local customers. But this competition didn’t last long; soon local gas supply became a monopoly in almost every town because of the large fixed costs involved in providing a town with gas lines. The cost of laying gas lines didn’t depend on how much gas a company sold, so a firm with a larger volume of sales had a cost advantage: because it was able to spread the fixed costs over a larger volume, it had lower average total costs than smaller firms.

Local gas supply is an industry in which average total cost falls as output increases. As we learned in Chapter 6, this phenomenon is called increasing returns to scale. When average total cost falls as output increases, firms tend to grow larger. In an industry characterized by increasing returns to scale, larger companies are more profitable and drive out smaller ones. For the same reason, established companies have a cost advantage over any potential entrant—a potent barrier to entry. So increasing returns to scale can both give rise to and sustain monopoly.

A monopoly created and sustained by increasing returns to scale is called a natural monopoly. The defining characteristic of a natural monopoly is that it possesses increasing returns to scale over the range of output that is relevant for the industry. This is illustrated in Figure 8-3, showing the firm’s average total cost curve and the market demand curve, D. Here we can see that the natural monopolist’s ATC curve declines over the output levels at which price is greater than or equal to average total cost.

So the natural monopolist has increasing returns to scale over the entire range of output for which any firm would want to remain in the industry—the range of output at which the firm would at least break even in the long run. The source of this condition is large fixed costs: when large fixed costs are required to operate, a given quantity of output is produced at lower average total cost by one large firm than by two or more smaller firms.

The most visible natural monopolies in the modern economy are local utilities—water, gas, and sometimes electricity. As we’ll see, natural monopolies pose a special challenge to public policy.

3. Technological Superiority A firm that maintains a consistent technological advantage over potential competitors can establish itself as a monopolist. For example, from the 1970s through the 1990s the chip manufacturer Intel was able to maintain a consistent advantage over potential competitors in both the design and production of microprocessors, the chips that run computers. But technological superiority is typically not a barrier to entry over the longer term: over time competitors will invest in upgrading their technology to match that of the technology leader. In fact, Intel has found its technological superiority eroded by a competitor, Advanced Micro Devices (also known as AMD), which produces chips approximately as fast and as powerful as Intel chips.

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We should note, however, that in certain high-tech industries, technological superiority is not a guarantee of success against competitors because of network externalities.

4. Network Externality If you were the only person in the world with an internet connection, what would that connection be worth to you? The answer, of course, is nothing. Your internet connection is valuable only because other people are also connected. And, in general, the more people who are connected, the more valuable your connection is. This phenomenon, whereby the value of a good or service to an individual is greater when many others use the same good or service, is called a network externality—its value derives from enabling its users to participate in a network of other users.

The earliest form of network externalities arose in transportation, where the value of a road or airport increased as the number of people who had access to it rose. But network externalities are especially prevalent in the technology and communications sectors of the economy.

The classic case is computer operating systems. Worldwide, most personal computers run on Microsoft Windows. Although many believe that Apple has a superior operating system, the wider use of Windows in the early days of personal computers attracted more software development and technical support, giving it a lasting dominance.

When a network externality exists, the firm with the largest network of customers using its product has an advantage in attracting new customers, one that may allow it to become a monopolist. At a minimum, the dominant firm can charge a higher price and so earn higher profits than competitors. Moreover, a network externality gives an advantage to the firm with the “deepest pockets.” Companies with the most money on hand can sell the most goods at a loss with the expectation that doing so will give them the largest customer base.

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5. Government-Created Barrier The pharmaceutical company Merck introduced Propecia, a drug effective against baldness in 1998. Although Propecia was very profitable and other drug companies had the know-how to produce it, no other firms challenged Merck’s monopoly because the U.S. government had given Merck the sole legal right to produce the drug in the United States. Propecia is an example of a monopoly protected by government-created barriers.

The most important legally created monopolies today arise from patents and copyrights. A patent gives an inventor the sole right to make, use, or sell that invention for a period that in most countries lasts between 16 and 20 years. Patents are given to the creators of new products, such as drugs or devices. Similarly, a copyright gives the creator of a literary or artistic work the sole rights to profit from that work, usually for a period equal to the creator’s lifetime plus 70 years.

The justification for patents and copyrights is a matter of incentives. If inventors were not protected by patents, they would gain little reward from their efforts: as soon as a valuable invention was made public, others would copy it and sell products based on it. And if inventors could not expect to profit from their inventions, then there would be no incentive to incur the costs of invention in the first place. Likewise for the creators of literary or artistic works. So the law gives a temporary monopoly that encourages invention and creation by imposing temporary property rights.

Patents and copyrights are temporary because the law strikes a compromise. The higher price for the good that holds while the legal protection is in effect compensates inventors for the cost of invention; conversely, the lower price that results once the legal protection lapses and competition emerges benefits consumers and increases economic efficiency.

Because the duration of the temporary monopoly cannot be tailored to specific cases, this system is imperfect and leads to some missed opportunities. In some cases there can be significant welfare issues. For example, the violation of American drug patents by pharmaceutical companies in poor countries has been a major source of controversy, pitting the needs of poor patients who cannot afford retail drug prices against the interests of drug manufacturers that have incurred high research costs to discover these drugs.

To solve this problem, some American drug companies and poor countries have negotiated deals in which the patents are honored but the American companies sell their drugs at deeply discounted prices. (This is an example of price discrimination, which we’ll learn about shortly.)