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11.2: Barriers to Entry: Reasons for Monopolies to Exist

  • Page ID
    3499
  • [ "article:topic", "Market power", "Barriers to entry", "economic rent", "economies of scale", "network externalities", "natural monopoly", "government monopoly", "government-granted monopoly", "copyright", "patent", "network effects", "authorname:boundless" ]

    Resource Control

    Control over a natural resource that is critical to the production of a final good is one source of monopoly power.

    Learning Objectives

    • Explain the relationship between resource control and monopolies

    Control over natural resources that are critical to the production of a good is one source of monopoly power. Single ownership over a resource gives the owner of the resource the power to raise the market price of a good over marginal cost without losing customers to competitors. In other words, resource control allows the controller to charge economic rent. This is a classic outcome of imperfectly competitive markets.

    A classic example of a monopoly based on resource control is De Beers. De Beers Consolidated Mines were founded in 1888 in South Africa as an amalgamation of a number of individual diamond mining operations. De Beers had a monopoly over the production of diamonds for most of the 20th century, and it used its dominant position to manipulate the international diamond market. It convinced independent producers to join its single channel monopoly. In instances when producers refused to join, De Beers flooded the market with diamonds similar to the ones they were producing. De Beers also purchased and stockpiled diamonds produced by other manufacturers in order to control prices through supply. The De Beers model changed at the turn of the 21st century, when diamond producers from Russia, Canada, and Australia started to distribute diamonds outside of the De Beers channel. The sale of diamonds also suffered from rising awareness about blood diamonds. De Beers’ market share fell from as high as 90 percent in the 1980s to less than 40 percent in 2012.

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    Diamonds: For most of the 20th century, De Beers had monopoly power over the world market for diamonds.

    In practice, monopolies rarely arise because of control over natural resources. Economies are large, usually with multiple people owning resources. International trade is an additional source of competition for owners of natural resources.

    Economies of Scale and Network Externalities

    Economies of scale and network externalities discourage potential competitors from entering a market.

    Learning Objectives

    • Define Economies of Scale., Explain why economies of scale are desirable for monopolies

    Economies of scale and network externalities are two types of barrier to entry. They discourage potential competitors from entering a market, and thus contribute to the monopolistic power of some firms.

    Economies of scale are cost advantages that large firms obtain due to their size.They occur because the cost per unit of output decreases with increasing scale, as fixed costs are spread over more units of output. Economies of scale are also gained through bulk-buying of materials with long-term contracts, the increased specialization of managers, ability to obtain lower interest rates when borrowing from banks, access to a greater range of financial instruments, and spreading the cost of marketing over a greater range of output. Each of these factors contributes to reductions in the long-run average cost of production.

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    Economies of Scale: Large firms obtain economies of scale in part because fixed costs are spread over more units of output.

    A natural monopoly arises as a result of economies of scale. For natural monopolies, the average total cost declines continually as output increases, giving the monopolist an overwhelming cost advantage over potential competitors. It becomes most efficient for production to be concentrated in a single firm.

    Network externalities (also called network effects) occur when the value of a good or service increases as a result of many people using it. Because of network effects, certain goods or services that are adopted widely will appear to be much more attractive to new customers than competing goods or services. This is evident in online social networks. Social networks with the largest memberships are more attractive to new users, because new users know that their friends or colleagues are more likely to be on these networks. It is also evident with certain software programs. For example, most people use Microsoft word processing software. While other word processing programs may be available, an individual would risk running into compatibility problems when sending files to people or machines using the mainstream software. This makes it difficult for new companies to enter the market and to gain market share.

     

    Government Action

    here are two types of government-initiated monopoly: a government monopoly and a government-granted monopoly.

    Learning objectives

    • Discuss different types of monopolies initiated by government

    Monopoly Creation

    There are instances in which the government initiates monopolies, creating a government-granted monopoly or a government monopoly. Government-granted monopolies often closely resemble government monopolies in many respects, but the two are distinguished by the decision-making structure of the monopolist. In a government monopoly, the holder of the monopoly is formally the government itself and the group of people who make business decisions is an agency under the government’s direct authority. In a government-granted monopoly, on the other hand, the monopoly is enforced through the law, but the holder of the monopoly is formally a private firm, which makes its own business decisions.

    Government-Granted Monopoly

    In a government-granted monopoly, the government gives a private individual or a firm the right to be a sole provider of a good or service. Potential competitors are excluded from the market by law, regulation, or other mechanisms of government enforcement. Intellectual property rights such as copyright and patents are government-granted monopolies. Additionally, the Dutch East India Company provides a historical example of a government-granted monopoly. It was granted exclusive trading privileges with colonial possessions under mercantilist economic policy.

    Government Monopoly

    In a government monopoly, an agency under the direct authority of the government itself holds the monopoly, and the monopoly is sustained by the enforcement of laws and regulations that ban competition or reserve exclusive control over factors of production to the government. The state-owned petroleum companies that are common in oil-rich developing countries (such as Aramco in Saudi Arabia or PDVSA in Venezuela) are examples of government monopolies created through nationalization of resources and existing firms. The United States Postal Service is another example of a government monopoly. It was created through laws that ban potential competitors from offering certain types of services, such as first-class and standard mail delivery. Around the world, government monopolies on public utilities, telecommunications systems, and railroads have historically been common.

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    Postal Service: The postal service operates as a government monopoly in many countries, including the United States.

    Legal Barriers

    The government creates legal barriers through patents, copyrights, and granting exclusive rights to companies.

    Learning objectives

    • Identify the legal conditions that lead to monopolistic power.

     In some cases, the government will grant a person or firm exclusive rights to produce a good or service, enabling them to monopolize the market for this good or service. Intellectual property rights, including copyright and patents, are an important example of legal barriers that give rise to monopolies.

     

    Copyright

    Copyright gives the creator of an original creative work (such as a book, song, or film) exclusive rights to it, usually for a limited time, with the intention of enabling the creator to be compensated for his or her work. The intent behind copyright is to promote the creation of new works by providing creators the opportunity to profit from their works. The copyright holder receives the right to be credited for the work, to determine who may adapt the work to other forms, who may perform the work, and who may financially benefit from it, along with other related rights. When the copyright on a work expires, the work is transferred to the public domain, enabling others to repurpose and build on the work.

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    Copyright: Copyright is an example of a temporary legal monopoly granted to creators of original creative works.

     

    Patent

    A patent is a limited property right the government gives inventors in exchange for their agreement to share the details of their invention with the public. During the term of the patent, the patent holder has the right to exclude others from making, using, or selling the patented invention. The patent provides incentives (1) to invent in the first place, (2) to disclose the invention once it is made, (3) to make the necessary investments in research and development, production, and bringing the invention to market, and (4) to innovate by designing around or improving upon earlier patents. When a patent expires and the invention enters the public domain, others can build on the invention.

    For example, when a pharmaceutical company first markets a drug, it is usually under a patent, and only the pharmaceutical company can sell it until the patent expires. This allows the company to recoup the cost of developing this particular drug. After the patent expires, any pharmaceutical company can manufacture and sell a generic version of the drug, bringing down the price of the original drug to compete with new versions.

     

    Government Granted Monopoly

    It is also possible that there is a monopoly because the government has granted a single company exclusive or special rights. The water utility company, for example, is a monopoly in your area because it is the only organization granted the right to provide water. Another example is that the Digital Millenium Copyright Act the proprietary Macrovision copy prevention technology is required for analog video recorders. Though other forms of copy prevention aren’t prohibited, requiring Macrovision effectively gives it a monopoly and prevents more effective copy prevention methods from being developed.

     

    Natural Monopolies

    Natural monopolies occur when a single firm can serve the entire market at a lower cost than a combination of two or more firms.

    Learning Obejectives

    • Demonstrate an understanding of how a natural monopoly is created

    Natural monopolies occur when a single firm is able to serve the entire market demand at a lower cost than any combination of two or more smaller firms. For example, imagine there are two firms in a natural monopoly’s market and each of them produces half of the quantity that the monopoly produces. The total cost of the natural monopoly is lower than the sum of the total costs of two firms producing the same quantity.

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    Natural Monopoly: The total cost of the natural monopoly’s production is lower than the sum of the total costs of two firms producing the same quantity.

     

    Cost Structure

    A natural monopoly’s cost structure is very different from that of most industries. In other industries, the marginal cost initially decreases due to economies of scale, then increases as the company experiences growing pains (as employees become overworked, the firm’s bureaucracy expands, etc.). Along with this, the average cost of production decreases and then increases. In contrast, a natural monopoly will have a marginal cost that is constant or declining, and an average total cost that drops as the quantity of output increases.

     

    Fixed Costs

    Natural monopolies tend to form in industries where there are high fixed costs. A firm with high fixed costs requires a large number of customers in order to have a meaningful return on investment. As it gains market share and increases its output, the fixed cost is divided among a larger number of customers. Therefore, in industries with large initial investment requirements, average total costs decline as output increases. Once a natural monopoly has been established, there will be high barriers to entry for other firms because of the large initial cost and because it would be difficult for the entrant to capture a large enough part of the market to achieve the same low costs as the monopolist.

    Examples of natural monopolies are water and electricity services. For both of these, fixed costs of building the necessary infrastructure are high. The cost of constructing a competing transmission network and delivering service will be so high that it effectively bars potential competitors from entering the monopolist’s market.

     

    Other Barriers to Entry

    Firms gain monopolistic power as a result of markets’ barriers to entry, which discourage potential competitors.

    Learning Obejectives

    • Identify the common conditions that lead to monopolistic power

     

    Monopolies derive their market power from barriers to entry: circumstances that prevent or greatly impede a potential competitor’s ability to compete in the market. There are several different types of barriers to entry.

    Control Over Natural Resources

    The supply of natural resources such as precious metals or oil deposits is limited, giving their owners monopoly powers. For example, De Beers controls the vast majority of the world’s diamond reserves, allowing only a certain number of diamonds to be mined each year and keeping the price of diamonds high.

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    Diamond: De Beers controls the majority of the world’s diamond reserves, preventing other players from entering the industry and setting a high price for diamonds.

    High Capital Requirements

    Some production processes require large investments in capital or large research and development costs that make it difficult for new companies to enter an industry. Examples include steel production, pharmaceuticals, and space transport.

    Economies of Scale

    Monopolies exhibit decreasing costs as output increases. Decreasing costs coupled with large initial costs give monopolies a cost advantage in production over would-be competitors. Market entrants have not yet achieved economies of scale, so their output simply costs so much more than the incumbent firms that market entry is difficult.

    Network Effects

    The use of a product by other people can increase its value to a person. One example is Microsoft spreadsheet and word processing software, which is still used widely. This is because when a person uses software that is used by so many others, he or she is less likely to run into compatibility problems in the course of work or other activities. This tendency to use what everyone else is using makes it difficult for new companies to develop and sell competing software.

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    Facebook: Network effects are one reason why it’s so difficult for new companies to compete against Facebook: they simply will have difficulty establishing a network of users to compete.

    Legal Barriers

    Legal rights can provide an opportunity to monopolize a market for a good. Intellectual property rights, such as patents and copyright, give the rights holder exclusive control over the production and sale of certain goods. Property rights may give a company exclusive control of the materials necessary to produce a good. The granting of permits or professional licenses can also favor certain firms, while setting standards that are difficult for new firms to meet.

    Government Backing

    There are cases in which a government agency is the sole provider of a particular good or service and competition is prohibited by law. For example, in many countries, the postal system is run by the government with competition forbidden by law in some or all services. Government monopolies in public utilities, telecommunications systems, and railroads have also historically been common. In other instances, the government may be an invested partner in a monopoly rather than a sole owner. This will still make it difficult for competitors to operate on equal footing.

     

    Key Points

    • Single ownership over a resource gives the owner the power to raise the market price of a good over marginal cost without losing customers to competitors.
    • De Beers is a classic example of a monopoly based on a natural resource. De Beers had a lot of market power in the world market for diamonds over the course of the 20th century, keeping the price of diamonds high.
    • In practice, monopolies rarely arise because of control over natural resources.
    • Economies of scale are cost advantages that large firms gain because of their size.
    • Natural monopolies arise as a result of economies of scale. Natural monopolies have overwhelming cost advantages over potential competitors.
    • Network effects occur when the value of a good or service increases because many other people are using it. This makes competing goods or services with lower levels of adoption unattractive to new customers.
    • Government-granted monopolies and government monopolies differ in the decision-making structure of the monopolist. In a government-granted monopoly, business decisions are made by a private firm. In a government monopoly, decisions are made by a government agency.
    • In a government-granted monopoly, the government gives a private individual or a firm the right to be a sole provider of a good or service.
    • In a government monopoly, an agency under the direct authority of the government itself holds the monopoly.
    • In both types of government-initiated monopoly competition is kept out of the market through laws, regulations, and other mechanisms of government enforcement.
    • Intellectual property rights are an example of legal barriers that give rise to monopolies.
    • A copyright gives the creator of an original creative work exclusive rights to it for a limited time. This provides an incentive for the continued creation of innovative goods.
    • A patent is a limited property right the government gives inventors in exchange for the details of their invention being made public.
    • The government can provide exclusive or special rights to companies that legally allow them to be monopolies.
    • A natural monopoly ‘s cost structure is very different from that of most industries. For a natural monopoly, the average total cost continues to shrink as output increases.
    • Natural monopolies tend to form in industries where there are high fixed costs. A firm with high fixed costs requires a large number of customers in order to have a meaningful return on investment.
    • Other firms are discouraged from entering the market because of the high initial costs and the difficulty of obtaining a large enough market share to achieve the same low costs as the monopolist.
    • There are several different types of barriers to entry, including a firm ‘s control over scarce natural resources, high capital requirements for an industry, economies of scale, network effects, legal barriers, and government backing.
    • Some industries require large investments in capital or research and development, making it difficult for new firms to enter.
    • Monopolies benefit from economies of scale, which give them a cost advantage over their competitors.
    • The legal system can grant firms monopoly rights over a resource or production of a good.

    Key Terms

    • market power: The ability of a firm to profitably raise the market price of a good or service over marginal cost. A firm with total market power can raise prices without losing any customers to competitors.
    • economic rent: The portion of income paid to a factor of production in excess of its opportunity cost.
    • economies of scale: The characteristics of a production process in which an increase in the scale of the firm causes a decrease in the long run average cost of each unit.
    • Network externalities: Are evident when the value of a product or service is dependent on the number of other people using it.
    • Natural monopoly: Occurs when a firm is able to serve the entire market demand at a lower cost than any combination of two or more smaller, more specialized firms.
    • Government monopoly: A form of monopoly in which a government agency is the sole provider of a particular good or service and competition is prohibited by law.
    • Government-granted monopoly: A form of monopoly in which a government grants exclusive rights to a private individual or firm to be the sole provider of a good or service.
    • Copyright: A legal concept that gives the creator of an original work exclusive rights to it, usually for a limited time, with the intention of enabling the creator to be compensated for his or her work.
    • patent: A declaration issued by a government agency declaring the inventor of a new product has the privilege of stopping others from making, using or selling the claimed invention for a limited time.
    • Barriers to entry: Circumstances that prevent or greatly impede a potential competitor’s ability to compete in the market.
    • Network effects: When the value of a product or service is dependent on the number of people using it.

     

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