As the name suggests, a monopoly is a single firm that dominates a particular market. For example, there is likely only one water utility where you live.
One of the most difficult problems in identifying a Monopoly is determining the boundaries of the relevant market. My city of Saint Louis has only one major league baseball team. But it does have other teams representing other professional sports. And it has a large number of alternative entertainment options. And so, should we consider the Saint Louis Cardinals to be a “Monopoly”?
Probably the best solution is to think of “Monopoly Power” as existing along a continuum. Consider two public utilities, Natural Gas and Water. Water is clearly a Monopoly. There are no good substitutes for water. And water is a necessity. There likely is also only one supplier of natural gas where you live. But in most uses, electricity is a reasonably good substitute for natural gas. And so, natural gas, while technically a Monopoly, has less Monopoly power than water.
So, what exactly is Monopoly power and how does it affect market outcomes? First of all, the absence of direct competition gives the Monopolist pricing power. Unlike a Perfectly Competitive firm that must simply accept the prevailing market price, the Monopolist determines the price they sell their product or service for. But this doesn’t imply that a Monopolist has unlimited pricing power. Perhaps in your community there’s only one internet provider. While in a sense they are a monopolist, they still can’t charge an outrageous price. Should the price be too great, many potential customers may simply choose to do without. And so, every firm regardless of how much Monopoly power they possess is constrained by the market demand line.
In competitive markets, price often is competed down to cost and so the firms in that market earn only a modest level of profit – or near-zero “Economic Profit”. But the lack of competition means that a monopolist has the ability to price above cost, allowing it to potentially earn extraordinary profits – or positive Economic Profit. And if the Monopoly market is protected by some significant barriers to entry, such as regulatory hurdles, brand loyalty, command of some key resource, etc., these extraordinary profits may persist indefinitely. And so, one important difference between a competitive market and a Monopolistic market is the potential for extraordinary profits, or positive Economic Profits.
Another important implication of Monopoly power is the impact on the efficient allocation of resources. Because a Monopolist charges a higher price than would be charged in a competitive market, the amount sold decreases – with how much so depending on the responsiveness fo demand.
This is problematic. Think about the costs of operating a venue for wedding receptions. First there are all the explicit costs of operation: staff, supplies, rent, etc. And then there are implicit costs: value of the owner’s time, opportunity cost of any invested capital, etc. As long as the value to the clients exceeds the sum of all these, providing this service creates “value” for all involved.
First consider what happens when there quite a few possible venues in a community. How much more than the total of these costs can they charge? Not much. In most places, it’s a pretty competitive market and the margins aren’t so great. For sake of example, let’s say the cost of hosting a reception on a Saturday evening is $1,500. Perhaps we can charge $1,800. Any more than that and our competitors will get the booking.
Now what if there were only one venue? They may charge $3,000. The extra $1,200 is the extraordinary profit described above. But what about the couple who can pay only $2,000? In our competitive case, they would be able to make the booking, all costs would be covered, and the owner would earn a small amount of extra profit. But in the Monopoly case, the reception simply doesn’t take place. That value that could have been created is simply lost. Economists refer to this as Dead Weight Loss.
One of the greatest concerns about Monopoly power is that it creates inefficiency in the economy. The Monopolist earns extraordinary profit by creating artificial scarcity in the market. While this is appropriate from the perspective of the Monopolist, it distorts the allocation of resources. Too little of some more valuable things are produced and too much of less valued things are produced.
Traditionally we looked for Monopoly in cases where there were substantial capital costs (e.g. railroads) or where regulatory hurdles existed (e.g. Patent protection) or perhaps both (e.g. pharmaceuticals). But in the new economy, “network economies” have become much more important. Consider Facebook and other social media platforms. But no matter the underlying reason, the social costs of Monopoly remain the same.