What happens when markets do not work perfectly?
Most markets are not perfectly competitive. Because these markets do not allocate goods and services in the most efficient way, they are examples of what economists call imperfect competition. Economists define imperfect competition as any market structure in which producers have some control over the price of their products. In other words, those producers have market power. The most extreme version of imperfect competition — and the opposite of perfect competition — is monopoly.
A monopoly is a market or an industry consisting of a single producer of a product that has no close substitutes. The term monopoly comes from a combination of the Greek words mono. meaning “alone,“ and polein, meaning “to sell.“ Literally, then, a monopoly is the only seller of something. Monopolies share four main characteristics.
One producer. There is no competition in a monopoly. A single producer or firm controls the industry or market. An economist might say that the monopolistic firm is the industry.
Unique product. A monopoly provides the only product of its kind. There are no good substitutes, and no other producers provide similar goods or services.
High barriers to entry. The main factor that allows monopolies to exist is high barriers to entry that limit or prevent other producers from entering the market.
Substantial control over prices. Monopolistic firms usually have great market power because they control the supply of a good or service. They can set a price for a product without fear of being undercut by competitors. Unlike competitive firms, monopolistic businesses are price setters rather than price takers.
Like perfect competition, pure monopoly is relatively rare in today’s economy. Monopolies may form and survive for a time, but they often break down in the face of competition or government regulation.
In the late 1800s, however, a number of monopolies arose in the United States. Some took the form of one firm that controlled the market for a unique product. Others took the form of trusts, or combinations of firms, that worked together to eliminate competition and control prices.
One of the most famous, and feared, monopolies was John D. Rockefeller’s Standard Oil Company. Rockefeller built his monopoly by buying out or bankrupting his competitors until he controlled about 90 percent of U.S. oil sales. Viewing monopolies as harmful to the public interest, Congress enacted antitrust laws to limit their formation. In 1911, the federal government took Standard Oil to court for antitrust violations and broke up its oil monopoly. Figure 7.3 shows the results of that famous trustbusting case.
The government still seeks to prevent the formation of most monopolies. However, it does allow certain kinds of monopolies to exist under particular circumstances. These legal monopolies fall into three broad categories: resource monopolies, government· created monopolies, and natural monopolies.
Resource Monopolies. Resource monopolies exist when a single producer owns or controls a key natural resource. Other firms cannot enter the market because they do not have access to the resource. For example, if a firm owns the only stone quarry in a town, it may be able to monopolize the local market for building stone. Resource monopolies are rare, however, because the economy is large and supplies of resources are not usually controlled by one owner.
Government-created monopolies. Government-created monopolies are formed when the government grants a single firm or individual the exclusive right to provide a good or service. The government does this when it considers such monopolies to be in the public interest. Government-created monopolies may be formed in three ways.
Patents and copyrights. These legal grants are designed to protect and promote intellectual capital. They give inventors or creators the right to control the production, sale, and distribution of their work, thus creating a temporary monopoly over that work. For example, a patent issued to a pharmaceutical company gives that company the sole right to produce and sell a particular drug for a period of 20 years. Such patents encourage investment in research and development. 1n the same way. a copyright grants exclusive rights to an artist, writer, or composer to control a creative work, such as a painting, a novel, or a song, for a period of time.
A public franchise is a contract issued by a government entity that gives a firm the sole right to provide a good or service in a certain area. For example, the National Park Service issues public franchises to companies to provide food, lodging, and other services in national parks. School districts may issue public franchises to snack food companies to place their vending machines in public schools. In each case, a single firm has a monopoly in that particular market.
A license is a legal permit to operate a business or enter a market. In some cases, licenses can create monopolies. For example, a state might grant a license to one company to conduct all vehicle emissions tests in a particular town. Or a city might license a parking lot company to provide all the public parking in the city. Licenses ensure that certain goods and services are provided in an efficient and regulated way.
Natural monopolies. The third type of monopoly is a natural monopoly. This kind of monopoly arises when a single firm can supply a good or service more efficiently and at a lower cost than two or more competing firms can. For example, most utility industries are natural monopolies. They provide gas, water, and electricity, as well as cable TV services, to businesses and households. Because natural monopolies are efficient, governments tend to view them as beneficial.
A natural monopoly occurs when a producer can take advantage of economies of scale to dominate the market. The term economies of scale refers to the greater efficiency and cost savings that result from increased production. A firm that achieves economies of scale lowers its average cost per unit of production by increasing its output and spreading fixed costs over a larger quantity of goods.
You can see how economies of scale work by looking at the cost of supplying water to a new subdivision of 50 homes. Suppose it costs a water company $100,000 to build a network of pipes that will bring water to the subdivision. In addition, installing a water meter at each home costs $1,000. The total cost of supplying water to the first home is $100,000, plus $1,000 for a meter, or $101,000 total.
Now look at the cost per home as the number of homes increases. A water meter for the second home costs $1,000, bringing the total cost for two homes to $102,000, or $51,000 per home. A water meter for the third home costs another $1,000, bringing the total cost for three homes to $103,000, or $34,333 per home. By the time the water company gets to the 50th home, its total cost is $I50,000 — $I00,000 for pipes and $50,000 for 50 meters. The cost per home has decreased to $3,000.
Consider, now, what would happen if two companies were to compete to bring water to the subdivision. Each company would have to build its own network of pipes. The fixed costs of bringing water to the subdivision would essentially double, but the number of homes served would stay the same. As a result, the economies of scale would be substantially reduced. For that reason, it makes sense for the government to allow water companies, like other utilities, to do business as natural monopolies.
Our government permits certain monopolies that are judged to be in the public interest to exist. In most other circumstances, monopoly is illegal. As in the Standard Oil Company case, the government may take action to break up a monopoly.
Consider the case of Microsoft, the giant computer software firm. In the 1980s, Microsoft received a copyright for its computer operating system known as Windows. Microsoft then made deals with computer makers to sell machines with Windows already installed on them. In this way, Microsoft gained control of about 90 percent of the market for operating systems. Microsoft’s monopoly power allowed it to charge more for Windows than it might have in a more competitive market.
Microsoft also used its market power to drive potential competitors out of the market. In 1994, a software company called Netscape began selling a new computer application known as a Web browser to computer users. A Web browser enables computer users to find and view Internet sites from around the world. Microsoft effectively drove Netscape out of business by bundling its own version of a browser, Internet Explorer, into its Windows operating system. As part of Windows. Internet Explorer came already installed on most new computers. severely reducing the market for browsers from Netscape or any other software company.
In late 1997, the U.S. Department of Justice accused Microsoft of trying to stifle competition by expanding its monopoly power into the Internet market. In 1998, Justice Department lawyers charged Microsoft with antitrust violations and took the company to court. In its defense, Microsoft argued that it had merely added new features to its operating system. It claimed that the integration of its Web browser was a natural and logical step in efforts to improve its products and satisfy its customers.
In November 1999, the trial judge found that Microsoft had violated antitrust laws. He ordered the company to be broken into two separate businesses: one that sold the Windows operating system and another that sold applications software. Microsoft appealed the decision to a higher court, which overturned the breakup order but upheld the antitrust verdict.
In 2002, Microsoft settled its case with the government by agreeing to change the way it dealt with other software firms. The company’s troubles did not end there, however. It was later hit by several private antitrust suits and was fined in Europe for anticompetitive actions.
The government’s case against Microsoft focused mainly on the company’s aggressive efforts to drive other firms out of the market. But the case also underscored the negative effects of monopoly for consumers. Because a monopolistic firm has considerable market power, it can set prices without fear of lower-priced competition from other firms. As a result, consumers may be forced to pay more for a good or service provided by a monopoly than they would in a competitive market.
Furthermore, because such firms face little or no competition, they have less incentive to innovate or to satisfy consumers. Viewing their customers as a “captive market,“ monopolies may offer consumers products of lesser quality or fewer product choices than they would if the market were more competitive.