Why Do Monopolies Exist?

To earn economic profits, a monopolist must be protected by a barrier to entry—something that prevents other firms from entering the industry.

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 11, this phenomenon is called increasing returns to scale. There we learned that 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 natural monopoly exists when increasing returns to scale provide a large cost advantage to a single firm that produces all of an industry’s output.

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 13-3, 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.

Increasing Returns to Scale Create Natural Monopoly A natural monopoly can arise when fixed costs required to operate are very high. When this occurs, the firm’s ATC curve declines over the range of output at which price is greater than or equal to average total cost. This gives the firm increasing returns to scale over the entire range of output at which the firm would at least break even in the long run. As a result, a given quantity of output is produced more cheaply by one large firm than by two or more smaller firms.

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 now produces chips approximately as fast and as powerful as Intel chips.

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

A network externality exists when the value of a good or service to an individual is greater when many other people use the good or service as well.

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.

5. Government-Created Barrier In 1998 the pharmaceutical company Merck introduced Propecia, a drug effective against baldness. Despite the fact that Propecia was very profitable and other drug companies had the know-how to produce it, no other firms challenged Merck’s monopoly. That’s 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.

A patent gives an inventor a temporary monopoly in the use or sale of an invention.

A copyright gives the creator of a literary or artistic work sole rights to profit from that work.

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 are 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.

The Price We Pay

Although providing cheap patent-protected drugs to patients in poor countries is a new phenomenon, charging different prices to consumers in different countries is not: it’s an example of price discrimination.

A monopolist will maximize profits by charging a higher price in the country with a lower price elasticity (the rich country) and a lower price in the country with a higher price elasticity (the poor country). Interestingly, however, drug prices can differ substantially even among countries with comparable income levels. How do we explain this?

The answer is differences in regulation.

This graph compares the prices paid by residents of different countries for Nasonex, a drug commonly prescribed for nasal allergies. It shows that Americans pay much more than residents of other countries, even wealthy countries like Switzerland. As you can see, Swiss residents pay approximately one-third of what Americans pay, and the British pay about one-tenth.

And this is not an exceptional comparison. For Nexium, a drug commonly prescribed for indigestion, the Swiss price is again approximately one-third the American price, while the British price is about one-seventh. And for Lipitor, commonly prescribed for high cholesterol, the American price is three times as high as the British price.

The reason? Governments in these other countries regulate drug prices more actively than the U.S. government does, helping to keep drug prices affordable for their citizens.

To save money, it’s not surprising that Americans travel to Canada and Mexico to purchase their drugs, or buy them from abroad over the internet.

Yet, American drug-makers contend that higher drug prices are necessary to cover the the high cost of research and development, which can run into the tens of millions of dollars over several years for successful drugs. Critics of the drug companies counter that American drug prices are in excess of what is needed for a socially desirable level of drug innovation. Instead, they say that drug companies are too often focused on developing drugs that generate high profits rather than those that improve health or save lives.

What’s indisputable is that some level of profit is necessary to fund innovation.

Source: International Federation of Health Plans, 2012 Comparative Price Report.

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 more about shortly.)

!worldview! ECONOMICS in Action: Newly Emerging Markets: A Diamond Monopolist’s Best Friend

Newly Emerging Markets: A Diamond Monopolist’s Best Friend

An increase in demand for diamonds in emerging markets has led to increased depletion of the world’s diamond mines and higher prices.
© Abenaa/Getty Images

When Cecil Rhodes created the De Beers monopoly, it was a particularly opportune moment. The new diamond mines in South Africa dwarfed all previous sources, so almost all of the world’s diamond production was concentrated in a few square miles.

Until recently, De Beers was able to extend its control of resources even as new mines opened. De Beers either bought out new producers or entered into agreements with local governments that controlled some of the new mines, effectively making them part of the De Beers monopoly.

The most remarkable of these was an agreement with the former Soviet Union, which ensured that Russian diamonds would be marketed through De Beers, preserving its ability to control retail prices. De Beers also went so far as to stockpile a year’s supply of diamonds in its London vaults so that when demand dropped, newly mined stones would be stored rather than sold, restricting retail supply until demand and prices recovered.

De Beers’s peak market share reached almost 90% in the late 1980s but has been declining ever since. In 2013, decades-long litigation between De Beers and the U.S. government was finally settled with De Beers agreeing to stop attempting to monopolize the market for diamonds and to stop fixing the price of polished diamonds. De Beers has also lost control of supply as several independent companies have begun mining for diamonds in other African countries, as well as in Russia and Canada. In addition, high-quality, inexpensive synthetic diamonds have become an alternative to real gems, eating into De Beers’s profit. So does this mean an end to high diamond prices and De Beers’s high profits?

Not really. Although De Beers’ is no longer the largest producer of rough diamonds, it still earns the highest revenue of any producer. Although supply and demand determine the outcome of today’s diamond market much more than De Beers’s actions, it and other diamond producers are highly profitable. There is still severely limited supply, as old mines have become depleted and new sources of diamonds have been difficult to find. At the same time consumers from rapidly growing economies like China and India have significantly boosted diamond demand. As a result, prices for polished diamonds have risen over 6% every year since 2008, when the global financial crisis precipitated a sharp fall in diamond prices.

In the end, although a diamond monopoly may not be forever, a greatly restricted supply along with rising demand from rapidly growing economies may be almost as profitable.

Quick Review

  • In a monopoly, a single firm uses its market power to charge higher prices and produce less output than a competitive industry, generating profits in the short and long run.

  • Profits will not persist in the long run unless there is a barrier to entry such as control of natural resources, increasing returns to scale, technological superiority, network externalities, or legal restrictions imposed by governments.

  • A natural monopoly arises when average total cost is declining over the output range relevant for the industry. This creates a barrier to entry because an established monopolist has lower average total cost than an entrant.

  • In certain technology and communications sectors of the economy, a network externality enables a firm with the largest number of customers to become a monopolist.

  • Patents and copyrights, government-created barriers, are a source of temporary monopoly that attempt to balance the need for higher prices as compensation to an inventor for the cost of invention against the increase in consumer surplus from lower prices and greater efficiency.

13-1

  1. Question 13.1

    Currently, Texas Tea Oil Co. is the only local supplier of home heating oil in Frigid, Alaska. This winter residents were shocked that the price of a gallon of heating oil had doubled and believed that they were the victims of market power. Explain which of the following pieces of evidence support or contradict that conclusion.

    1. There is a national shortage of heating oil, and Texas Tea could procure only a limited amount.

    2. Last year, Texas Tea and several other competing local oil-supply firms merged into a single firm.

    3. The cost to Texas Tea of purchasing heating oil from refineries has gone up significantly.

    4. Recently, some nonlocal firms have begun to offer heating oil to Texas Tea’s regular customers at a price much lower than Texas Tea’s.

    5. Texas Tea has acquired an exclusive government license to draw oil from the only heating oil pipeline in the state.

  2. Question 13.2

    Suppose the government is considering extending the length of a patent from 20 years to 30 years. How would this change each of the following?

    1. The incentive to invent new products

    2. The length of time during which consumers have to pay higher prices

  3. Question 13.3

    Explain the nature of the network externality in each of the following cases.

    1. A new type of credit card, called Passport

    2. A new type of car engine, which runs on solar cells

    3. A website for trading locally provided goods and services

Solutions appear at back of book.