🛒principles of microeconomics review
9.1 How Monopolies Form: Barriers to Entry
Last Updated on June 25, 2024
Monopolies dominate markets, wielding significant power. They arise through natural advantages, legal protections, or geographic isolation. Understanding their formation and strategies is crucial for grasping market dynamics and competition.
Monopolies use various tactics to maintain their dominance. These include predatory pricing, brand leverage, exclusive deals, and limit pricing. By examining these strategies, we can better understand how monopolies shape economic landscapes and influence consumer choices.
Monopoly Characteristics and Formation
Types of Monopolies
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- Natural monopoly
- Single firm supplies market at lower cost than multiple firms due to economies of scale (utilities, telecommunications, transportation)
- Legal monopoly
- Government-created through patents, copyrights, or exclusive licenses to incentivize innovation or protect intellectual property (pharmaceutical patents, copyright protection)
- Geographic monopoly
- Sole provider in specific geographic area due to high transportation costs or limited local demand (remote gas station, local cable TV provider)
Factors Enabling Monopoly Power
- Economies of scale
- Long-run average costs decrease as output increases, enabling large firm to produce at lower cost than smaller competitors, creating natural barrier to entry
- Control of essential resources
- Monopolies control critical inputs (raw materials, distribution channels), preventing potential competitors from entering market (De Beers' historical control of global diamond supply)
- Legal protections
- Government-granted patents, copyrights, or licenses provide exclusive rights to produce good or service, preventing competition during protection period (regulated utility companies)
Monopoly Strategies and Deterrence
Strategies to Deter Competition
- Predatory pricing
- Monopoly temporarily sets prices below cost to drive out competitors, accepting short-term losses to eliminate competition and maintain long-term market control, then raises prices to recoup losses and earn higher profits
- Leveraging brand recognition and loyalty
- Established monopolies have strong brand recognition and customer loyalty, creating psychological barrier to entry as new competitors struggle to attract customers (Microsoft's PC operating system dominance, Google's search engine market share)
- Exclusive dealing arrangements
- Monopolies enter exclusive contracts with suppliers, distributors, or customers, preventing competitors from accessing essential resources or markets (monopoly requiring retailers to sell only its products)
- Limit pricing
- Monopoly sets prices just low enough to deter potential entrants, below level that maximizes short-term profits but high enough to make entry unattractive, sacrificing some short-term profits to maintain long-term market control
Key Terms to Review (20)
Economies of Scale: Economies of scale refer to the cost advantages that businesses can exploit by expanding their scale of production. As a company increases its output, its average costs per unit typically decrease due to more efficient utilization of resources, specialized equipment, and division of labor.
Monopoly: A monopoly is a market structure in which a single seller (or a group of sellers acting as one) controls the entire supply of a particular good or service, with no close substitutes available. This allows the monopolist to exercise significant influence over the price and output of the product, often leading to higher prices and lower production compared to a competitive market.
Price Discrimination: Price discrimination is the practice of charging different prices for the same product or service to different customers or groups of customers based on their willingness or ability to pay. It allows a firm to maximize profits by segmenting the market and capturing consumer surplus.
Sunk Costs: Sunk costs refer to costs that have already been incurred and cannot be recovered, regardless of future actions taken. These costs are considered irrelevant for decision-making purposes as they do not affect the future outcome of a situation.
Fixed Costs: Fixed costs are expenses that do not change with the level of production or output. They are incurred regardless of how much a business produces and must be paid even if the business produces nothing. Fixed costs are a critical component of a firm's cost structure and play a key role in various economic concepts.
Licenses: Licenses are legal permits granted by government authorities that allow individuals or businesses to engage in specific activities or operations. They serve as a means of regulating and controlling various industries and markets, often acting as a barrier to entry for new competitors.
Switching Costs: Switching costs refer to the perceived or actual costs associated with changing from one product, service, or provider to another. These costs can create barriers to entry for new competitors and help established firms maintain their market position, contributing to the formation of monopolies.
Legal Monopoly: A legal monopoly is a situation where a single provider of a good or service is protected from competition by law or regulation. This allows the monopoly to maintain control over the market and pricing without the threat of new entrants.
Barriers to Entry: Barriers to entry are obstacles or factors that make it difficult for new firms to enter a particular market or industry. These barriers can give existing firms a competitive advantage and allow them to maintain higher prices and profits in the long run.
Patents: A patent is a government-granted exclusive right to an invention or innovation, which prevents others from making, using, or selling that invention without the patent holder's permission. Patents serve as a legal mechanism to protect intellectual property and encourage innovation by providing inventors with a temporary monopoly over their creations.
Vertical Integration: Vertical integration is a business strategy where a company acquires or controls its upstream suppliers or downstream distributors, effectively expanding its operations across different stages of the production and distribution process. This allows the company to have greater control over its supply chain and potentially reduce costs and increase efficiency.
Network Effects: Network effects refer to the phenomenon where the value of a product or service increases as more people use it. The more users a network has, the more valuable it becomes to each individual user, creating a self-reinforcing cycle of growth and adoption.
Natural Monopoly: A natural monopoly is a market structure where a single firm can most efficiently serve the entire market due to high fixed costs and economies of scale, making it uneconomical for competitors to enter the market. This leads to a single provider dominating the industry.
Copyrights: Copyrights are a form of intellectual property protection that grants the creator of an original work exclusive rights to its use and distribution. These rights are crucial in shaping how monopolies form and how governments can encourage innovation.
Intellectual Property: Intellectual property refers to creations of the mind, such as inventions, literary and artistic works, designs, and symbols, names, and images used in commerce. It is a legal concept that grants creators exclusive rights over their creative works for a limited period of time, allowing them to benefit from their intellectual efforts.
Natural Resources: Natural resources are the materials and resources that exist naturally within an environment, without any human intervention. They are essential for the functioning of ecosystems and the economic development of societies.
Predatory Pricing: Predatory pricing is a pricing strategy in which a company sets its prices at an extremely low level, often below its own cost of production, in order to drive competitors out of the market and establish a monopoly. This practice is considered anticompetitive and is often regulated by antitrust laws.
Trademarks: A trademark is a distinctive sign, design, or expression that identifies and distinguishes the source of a product or service. Trademarks serve as a barrier to entry for new competitors, as they help establish brand recognition and loyalty, which can be a significant advantage for monopolistic firms.
Market Power: Market power refers to the ability of a firm or group of firms to influence and control the market by setting prices, restricting output, and limiting competition. It is a measure of a firm's ability to charge prices above the competitive level and earn economic profits in the long run.
Market Concentration: Market concentration refers to the degree to which a small number of firms or companies dominate a particular industry or market. It measures the level of competition within a market and can have significant implications for consumer welfare, firm behavior, and regulatory policies.