What is a monopoly? Market power, explained

A monopoly is a market with only one seller of a good or service that has no close substitutes. Because buyers have nowhere else to go, the seller has market power: it can choose its price, rather than taking the price competition would set. A monopolist typically charges more and sells less than a competitive market would, which is why most countries have laws against creating or abusing one.

In short

• A monopolist faces the whole market's demand curve, so it picks the price and quantity that earn it the most, not the ones competition would force.
• It sells less at a higher price, and some trades that would have benefited both sides never happen: the economists' deadweight loss.
• Some monopolies arise naturally, some are granted by law, such as patents, and some are built by shutting out rivals, which is where antitrust law steps in.

What makes a market a monopoly?

Two conditions: one seller, and no close substitute for what it sells. A town's only water utility is a monopoly, because nobody drinks anything else from the tap. The only coffee shop on a street is not, because people can walk a block or make coffee at home. Every market has to ration scarce goods; what differs is who sets the terms. In practice markets fall along a range, and economists sort them into four structures, as OpenStax's Principles of Economics does across its chapters on competition:

Structure	Number of sellers	Product	Control over price	Example
Perfect competition	Very many	Identical	None: each seller takes the market price	Wheat, sold by thousands of farms
Monopolistic competition	Many	Similar but differentiated	A little	Restaurants, hair salons
Oligopoly	A few	Identical or differentiated	Considerable, and each watches the others	Airlines on a route, mobile networks
Monopoly	One	No close substitutes	The most	A local water or power grid

What keeps a monopoly a monopoly is a barrier to entry: something that stops rivals from coming in when they see high profits. Without barriers, a monopoly's profits attract competitors and the monopoly doesn't last.

Why does a monopolist charge more and sell less? A worked example

A competitive seller can sell as much as it likes at the market price. A monopolist can't: to sell more, it has to cut its price, and it has to cut it on every unit, not just the extra one. So the extra revenue from one more sale, its marginal revenue, is less than the price. The monopolist keeps producing as long as marginal revenue is above the cost of making one more unit, its marginal cost, the logic set out in thinking at the margin and in OpenStax's section on how a monopoly chooses output.

Take a drug that only one firm can make, costing $20 per unit to produce, sold in units of 1,000 doses. Here is the demand:

Price per unit	Units sold	Total revenue	Marginal revenue of the last unit
$90	1	$90	$90
$80	2	$160	$70
$70	3	$210	$50
$60	4	$240	$30
$50	5	$250	$10
$40	6	$240	−$10
$30	7	$210	−$30
$20	8	$160	−$50

Step by step:

1. The fourth unit adds $30 of revenue and costs $20, so the firm makes it. The fifth adds only $10 and costs $20, so it doesn't.
2. The monopolist sells 4 units at $60. Revenue is $240, cost is 4 × $20 = $80, and profit is $160.
3. In a competitive market, where the price is set by supply and demand, sellers would keep undercutting each other until the price fell to the $20 cost. Then 8 units would sell at $20 each.
4. Compare. Under monopoly, buyers who value the 5th, 6th and 7th units at $50, $40 and $30, all above the $20 they cost to make, go without. Those lost gains, $30 + $20 + $10 = $60, belong to nobody. Economists call this the deadweight loss.

	Competition	Monopoly
Price	$20	$60
Units sold	8	4
Buyers' gain (value minus price paid)	$280	$60
Seller's profit	$0	$160
Total gain to society	$280	$220

The monopoly's harm is not only that it moves $160 from buyers to itself; it is also that $60 of trades worth making never happen. The example also shows why a monopolist always prices where demand is elastic: past 5 units, cutting the price loses revenue. The note on elasticity explains why.

How do monopolies form?

Barriers to entry come in a few kinds:

• Natural monopoly. When one network can serve a whole market more cheaply than two, as with water pipes, power lines or rail track, a second firm would duplicate enormous fixed costs. Governments usually regulate these firms' prices or own them outright, as OpenStax describes.
• Legal monopoly. Patents and copyrights grant temporary exclusive rights to reward invention and creative work. A US patent normally lasts 20 years from the date the application was filed, under 35 U.S.C. 154. Society accepts a monopoly price for a while in exchange for the invention existing at all.
• Control of a key resource, such as the only mine for a material.
• Network effects, where a product is worth more the more people use it, so customers gather on one network.
• Conduct, such as buying up rivals, exclusive contracts or pricing below cost to drive competitors out. This is the kind antitrust law targets.

Two related ideas complete the picture. A cartel is a group of sellers that agree to act like one monopolist, setting prices or output together; OPEC is the best-known example among countries, and cartels between companies are illegal in most countries. A monopsony is the mirror image of a monopoly: a single buyer, such as the only large employer in a town, which can push down the wages it pays. Whether firms in a market with only a few sellers compete or quietly cooperate is the subject of game theory.

How has antitrust law dealt with monopolies?

In the United States, Congress passed the Sherman Act in 1890, which outlawed contracts and conspiracies that restrain trade and made it illegal to monopolize a market. In 1914 it added the Clayton Act and the Federal Trade Commission Act, which created the FTC; the FTC calls these three the core federal antitrust laws still in effect. Being a monopoly is not itself illegal under US law; getting or keeping one by improper conduct is.

The landmark early case was Standard Oil. John D. Rockefeller's company controlled about 90% of American refining capacity in 1880. On 15 May 1911 the Supreme Court upheld an order dissolving it, and it was split into dozens of separate companies, several of which grew into major oil firms. By then, Wikipedia's account notes, its share of refining had already fallen to between 60% and 65% as competitors expanded. Later cases, such as the breakup of the telephone company AT&T, which took effect in 1984, applied the same laws to firms once treated as natural monopolies.

Still argued

How hard governments should act against large firms is argued. One school, influential in the US since the 1970s and associated with Robert Bork and the Chicago school, holds that antitrust should focus on consumer welfare, mainly prices, and warns that breaking up firms that grew by being efficient punishes success. Another, revived since the 2010s and sometimes called neo-Brandeisian, argues that market power also harms workers, suppliers, innovation and politics, and that the price test misses those harms, especially where services are free to users. Both sides accept that monopolies can raise prices; they differ on how to measure harm and when to step in. This note describes the debate, not any current case.

The board game Monopoly began as Elizabeth Magie's Landlord's Game of 1904, designed to show the harms of concentrated land ownership.

Check yourself

• Why is a monopolist's marginal revenue lower than its price?
• In the drug example, why does the firm stop at 4 units when buyers would pay more than the $20 cost for the 5th, 6th and 7th?
• What is a natural monopoly, and why do governments usually regulate one rather than break it up?

Sources

• 9.1 How Monopolies Form: Barriers to Entry — OpenStax, Principles of Economics 3e, 2022
• 9.2 How a Profit-Maximizing Monopoly Chooses Output and Price — OpenStax, Principles of Economics 3e, 2022
• 11.3 Regulating Natural Monopolies — OpenStax, Principles of Economics 3e, 2022
• The Antitrust Laws — U.S. Federal Trade Commission
• 2701 Patent Term — U.S. Patent and Trademark Office, Manual of Patent Examining Procedure
• Standard Oil — Wikipedia