Monopoly

What Is Monopoly and Why Does It Arise

Monopoly is a market structure in which a single firm is the sole producer of a good or service without close substitutes. Unlike perfect competition, where a firm is a grain of sand in an ocean, the monopolist is the entire market. The firm's demand curve coincides with the market demand curve, and the firm possesses significant market power—the ability to set the price.

It is important to understand: even a monopolist cannot set any price at will. They are constrained by consumer demand. If the monopolist sets too high a price, sales volume will fall so much that profits will decrease. The monopolist chooses the optimal “price–quantity” combination on the demand curve, but cannot simultaneously control both price and quantity sold.

Characteristics of Monopoly

Monopoly is defined by several key features, each with important implications:

Sole seller. One firm controls the entire supply in the market. A classic historical example is De Beers, which throughout most of the 20th century controlled up to 80–85% of the global diamond market. Founded by Cecil Rhodes in 1888 in South Africa, De Beers bought diamond mines around the world and controlled not only extraction but also distribution channels through its Central Selling Organisation trading entity. The famous advertising slogan “A Diamond is Forever” (1947) was part of a strategy to maintain high demand and prices. Although by the 2020s De Beers' share declined to about 30% due to competition from Russia's ALROSA and other producers, the company's history remains a textbook example of monopoly power.

No close substitutes. Consumers cannot switch to an alternative product. If you live in a city where water supply is provided by one company, there is no way to “switch to the competition”—the water network is singular. This fundamentally distinguishes monopoly from monopolistic competition, where every product has many close, though not identical, alternatives.

High barriers to entry. This is the most important feature, because barriers support monopoly in the long run. Without barriers, the monopolist’s supernormal profits would attract competitors, and monopoly would cease to exist.

Firm is a price maker. The monopolist chooses the price (or output volume), rather than taking it as given.

Barriers to Entry: Detailed Analysis

Barriers to entry are factors that prevent or make it unprofitable for new firms to enter the market. Without understanding barriers, one cannot understand why monopolies exist and persist.

Legal Barriers

Patents grant the inventor exclusive rights to use the invention for a defined period (usually 20 years). The pharmaceutical industry is a vivid example. When Pfizer developed Viagra (sildenafil), the patent protected it from competitors until 2012–2013. During this period, Pfizer earned billions of dollars annually—income that funded the development of new drugs. When the patent expired, generics flooded the market, and the price fell sharply. A similar situation occurred with the drug Lipitor (atorvastatin)—after its patent expired in 2011, Pfizer lost over $5 billion in annual revenue.

Licenses and permits. Governments can restrict the number of market participants via licensing. For example, in most countries broadcasting requires a license to use radio frequencies, which are physically limited. Likewise, in some cities the number of taxi licenses is tightly restricted—New York’s famous taxi “medallions” were worth up to $1.3 million in 2013 (although after Uber’s emergence, their price fell to $100–200 thousand).

Economic Barriers

Economies of scale. If the minimum efficient scale of production (MES—minimum efficient scale) is very large relative to the market size, only one firm can sustainably exist in the market. This phenomenon is called a natural monopoly (see more below). For example, laying a second system of water mains in a city would be economically impractical—average cost per unit of water would be significantly higher than in the existing network.

High initial investments (sunk costs). Some industries require enormous irreversible investments at the outset. Building a nuclear power plant costs $10–25 billion and takes 10–15 years. A potential competitor must be prepared to invest these funds, knowing that they would be lost in case of failure. This creates a powerful psychological and financial barrier.

Strategic Barriers

Predatory pricing. The incumbent firm may temporarily lower prices below cost to drive out a new entrant. After the competitor leaves, the monopolist restores prices to their former level. Although such practice is often illegal (it is considered abuse of dominant position), proving it is very difficult.

Control of key resources. If a firm controls access to a critically important resource, competitors cannot enter the market. A historical example is Alcoa (Aluminum Company of America), which in the first half of the 20th century controlled nearly all bauxite deposits in the US.

Network effects. The value of a product increases as the number of users grows. Google controls more than 90% of the global search engine market not only thanks to the quality of its algorithms, but also because the more people use Google, the more data the company gets to improve search—attracting even more users. A new search engine is very difficult to break this vicious cycle.

Demand, Revenue and Monopolist Pricing

Since the monopolist is the sole seller, its demand curve coincides with the market demand curve and has a negative slope. This creates a fundamental difference from perfect competition.

To sell an additional unit, the monopolist must lower the price not just on that unit but on all previous ones. That is why a monopolist's marginal revenue (MR) is always less than price (AR): MR < AR = P.

Suppose the monopolist sells 10 units at £100 each: TR = £1000. To sell the 11th unit, it must lower the price to £98 for all buyers: TR = 11 × £98 = £1078. Marginal revenue from the 11th unit is £1078 - £1000 = £78, noticeably below the price £98. The difference (£20) is the loss of revenue on the 10 units now sold for £2 less each.

Detailed Numerical Example: Monopolist Pricing

Consider a pharmaceutical company producing a patented drug. Inverse demand function: P = 200 - 5Q (where P is price in dollars, Q is quantity in thousands of packages per month).

Marginal costs are constant: MC = 50.

Step 1: Find total revenue. TR = P × Q = (200 - 5Q) × Q = 200Q - 5Q²

Step 2: Find marginal revenue. MR = dTR/dQ = 200 - 10Q

Note: the slope of MR (-10) is twice as steep as the slope of the demand curve (-5). This is a mathematical property of the linear demand function—MR always has the same price intercept, but twice the slope.

Step 3: Determine the optimal output (MR = MC). 200 - 10Q = 50 10Q = 150 Q = 15* (thousand packages)

Step 4: Determine the monopoly price. P = 200 - 5(15) = 200 - 75 = £125

Step 5: Calculate profit. TR = 125 × 15 = £1875 thousand TC = AC × Q. With constant MC = 50, AC also = 50 (if there are no fixed costs). TC = 50 × 15 = £750 thousand Supernormal profit = £1875 - £750 = £1125 thousand per month.

Step 6: Determine socially efficient output (P = MC). 200 - 5Q = 50 5Q = 150 Q_eff = 30, P_eff = 200 - 5(30) = £50

The monopolist produces 15 thousand packages instead of the socially efficient 30 thousand, and sells at £125 instead of £50. This vividly demonstrates monopoly inefficiency.

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Consumer and Producer Surplus. Deadweight Losses

Consumer Surplus

Consumer surplus is the difference between the maximum price a consumer is willing to pay and the actual market price. Graphically, it is the area of the triangle between the demand curve and the horizontal price line.

In our example under perfect competition (P = £50, Q = 30): CS_comp = ½ × (200 - 50) × 30 = ½ × 150 × 30 = £2250 thousand

Under monopoly (P = £125, Q = 15): CS_mon = ½ × (200 - 125) × 15 = ½ × 75 × 15 = £562.5 thousand

Consumer surplus shrank from £2250 to £562.5 thousand—by more than fourfold!

Producer Surplus

Under perfect competition (P = MC = £50): PS_comp = 0 (price equals marginal cost, no supernormal profit)

Under monopoly: PS_mon = (125 - 50) × 15 = 75 × 15 = £1125 thousand

Deadweight Loss

Deadweight loss is a net loss of societal welfare that belongs to no one: neither consumers nor the producer. These are mutually beneficial transactions that would occur but do not as a result of monopoly pricing.

DWL = ½ × (Q_eff - Q_mon) × (P_mon - MC) DWL = ½ × (30 - 15) × (125 - 50) DWL = ½ × 15 × 75 = £562.5 thousand

Check: Total surplus under competition = £2250 + 0 = £2250. Total surplus under monopoly = £562.5 + £1125 = £1687.5. Losses = £2250 - £1687.5 = £562.5. It matches!

This £562.5 thousand is the value of 15 thousand packages of medicine which could have been produced and sold with net benefits to society, but were not produced due to monopoly output restriction.

Monopoly vs Perfect Competition: Comparative Analysis

Natural Monopoly

A natural monopoly arises when one firm can serve the entire market at lower average costs than two or more firms. This happens when fixed costs are very high and marginal costs relatively low, so average costs continue to fall across the entire range of market demand.

Classic examples:

• Water supply and sewerage. Laying a second network of pipes in the same city would double infrastructure costs, with each network serving only part of the consumers.
• Electricity networks. Building a parallel grid of transmission lines is economically impractical.
• Railroads. Laying a second rail line between two cities (assuming the existing one covers demand) would duplicate enormous fixed costs.

In the case of a natural monopoly, breaking the monopoly would lead to increased, not decreased, average costs. Therefore, governments usually do not break up natural monopolies, but instead regulate them—set allowable prices, demand certain levels of service quality, and ensure service accessibility.

Should the Government Destroy Monopolies? Discussion

This is one of the central questions of economic policy, and the answer is not as obvious as it might seem.

Arguments For Fighting Monopoly

Monopolies reduce consumer surplus, create deadweight losses, and hinder efficient resource allocation. Antitrust policy can bring the market closer to the competitive outcome.

Historical example: in 1911, the US Supreme Court split John D. Rockefeller’s Standard Oil into 34 independent companies (from which ExxonMobil, Chevron, and others later grew). This decision became a symbol of antitrust policy and led to strengthened competition in the oil market.

The European Commission actively uses antitrust law: Google’s €4.34 billion fine in 2018 for abuse of Android’s dominant position in the mobile OS market is one of the largest ever.

Arguments Against Breaking Up Monopolies

Economies of scale. If monopoly achieves significant economies of scale, breaking it up may raise average costs and possibly prices for consumers. This is especially relevant for natural monopolies.

Innovation. Joseph Schumpeter argued that it is large firms with monopoly power that are the main drivers of innovation. Supernormal profit finances risky R&D that small firms in perfect competition cannot afford. Example: Apple’s investments in R&D exceed $25 billion annually—impossible without high product margin, provided by market power.

International competitiveness. Large national firms can compete more effectively on the global market. The government of South Korea deliberately supported large conglomerates (chaebols—Samsung, Hyundai, LG), helping the country become a major industrial power.

Government failures. Regulators may be inefficient, corrupt, or “captured” by the regulated industry (regulatory capture). Attempted regulation can cause more harm than good.

Alternatives to Destroying Monopolies

• Price regulation: setting maximum prices (price cap) or rate of return regulation.
• Taxation of supernormal profit: taking part of monopoly profit through taxes.
• Lowering barriers to entry: simplifying licensing, anti-dumping measures.
• State ownership: nationalization with management in the interests of society.

Practical Tasks

Task: Monopoly—Price, Output, and Welfare

Question: A monopolist faces the demand curve: P = 120 - 2Q. Marginal cost is constant: MC = 20. (a) Derive the marginal revenue (MR) curve. (b) Calculate the profit-maximizing output. (c) Calculate the monopoly price. (d) Compare the result to the socially efficient output. (e) Explain why monopoly creates deadweight loss. (f) Calculate deadweight loss numerically.

Solution: (a) For a linear demand curve P = a - bQ, the MR curve has the same price intercept but double slope: MR = 120 - 4Q.

(b) Maximizing profit: MR = MC → 120 - 4Q = 20 → 4Q = 100 → Q = 25 units.

(c) Substitute Q = 25 into the demand curve: P = 120 - 2(25) = 120 - 50 = £70.

(d) Socially efficient output: P = MC → 120 - 2Q = 20 → 2Q = 100 → Q = 50 units at P = £20. The monopolist produces half as much (25 vs 50) and sets a price 3.5 times higher (£70 vs £20).

(e) Monopoly creates deadweight loss because by reducing output from 50 to 25 units, there are consumers willing to pay more than marginal cost (MC = 20) but not receiving the good. Each unit from Q = 25 to Q = 50 is a foregone mutually beneficial transaction. Consumers value these units above their production cost, but the monopolist does not produce them to maintain a high price.

(f) Deadweight loss = area of triangle between demand curve and MC, from Q_m to Q_c.

• Base = Q_c - Q_m = 50 - 25 = 25
• Height = P_m - MC = 70 - 20 = 50
• DWL = 1/2 × 25 × 50 = £625