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The Economics Glossary defines monopoly as: "If a certain firm is the only one that can produce a certain good, it has a monopoly in the market for that good."
To understand what a monopoly is and how a monopoly operates, we'll have to delve deeper than this. What features do monopolies have, and how do they differ from those in oligopolies, markets with monopolistic competition and perfectly competitive markets?
Features of a Monopoly
When we discuss a monopoly, or oligopoly, etc. we're discussing the market for a particular type of product, such as toasters or DVD players. In the textbook case of a monopoly, there is only one firm producing the good. In a real-world monopoly, such as the operating system monopoly, there is one firm that provides the overwhelming majority of sales (Microsoft), and a handful of small companies that have little or no impact on the dominant firm.
Because there is only one firm (or essentially only one firm) in a monopoly, the monopoly's firm demand curve is identical to the market demand curve, and the monopoly firm need not consider what it's competitors are pricing at. Thus a monopolist will keep selling units so long as the extra amount he receives by selling an extra unit (the marginal revenue) is greater than the additional costs he faces in producing and selling an additional unit (the marginal cost). Thus the monopoly firm will always set their quantity at the level where marginal cost is equal to marginal revenue.
Because of this lack of competition, monopoly firms will make an economic profit. This would normally cause other firms to enter the market. For this market to remain a monopolistic one, there must be some barrier to entry. A few common ones are:
- Legal Barriers to Entry - This is a situation where a law prevents other firms from entering the market to sell a product. In the United States, only the USPS can deliver first class mail, so this would be a legal barrier to entry. In many jurisdictions alcohol can only be sold by the government-run corporation, creating a legal barrier to entry in this market.
- Patents - Patents are a subclass of legal barriers to entry, but they're important enough to be given their own section. A patent gives the inventor of a product a monopoly in producing and selling that product for a limited amount of time. Pfizer, inventors of the drug Viagra, have a patent on the drug, thus Pfizer is the only company that can produce and sell Viagra until the patent runs out. Patents are tools that governments use to promote innovation, as companies should be more willing to create new products if they know they'll have monopoly power over those products.
- Natural Barriers to Entry - In these type of monopolies, other firms cannot enter the market because either the startup costs are too high, or the cost structure of the market gives an advantage to the largest firm. Most public utilities would fall into this category. Economists generally refer to these monopolies as natural monopolies.
There's the need-to-know information on monopolies. Monopolies are unique relative to other market structures, as it only contains one firm, and thus a monopoly firm has far more power to set prices than firms in other market structures.