How Monopoly Is Maintained: Barriers to Entry

Our discussion of long-run competitive equilibrium showed how profits serve as a signal to attract new suppliers in competitive markets. If free entry were possible in monopolistic markets, economic profits earned by monopoly firms would attract new sellers. Supply would increase, as would the number of sellers. The monopolist’s control over price would eventually disappear as the market became competitive. A barrier to entry is a constraint that prevents additional sellers from entering a monopoly firm's market.

There are three barriers to entry: (1) control over an essential resource, (2) economies of scale, and (3) legal barriers to entry.

1. Control over an Essential Resource. We tend to think of resources as natural resources — oil, coal, iron ore, arable land — but in economics, the basic resources are land, labor, and capital.

A monopoly can also be maintained as a result of owning the entire source of supply of a particular input.

Unique ability or knowledge can also create a monopoly. Talented singers, artists, athletes, and the "cream of the crop" of any profession have monopolies on the use of their services. Firms with secret processes or technologies have monopolies if other firms can't duplicate the techniques.

Examples:

1. The Metropolitan Opera has a near monopoly because it has most of the world's opera stars (labor) under contract.

2. DeBeers Diamond Company in South Africa owns four fifths of the world's diamond mines, and the International Nickel Company of Canada controls about 90 percent of the world's nickel reserves. The Standard Oil Company controlled the oil industry in the 1880s and later because it owned over 90 percent of the nation's oil fields and refineries. At that time, the American Tobacco Company happened to control 90 percent of U.S. tobacco production.²

2. Economies of Scale. Typically, heavy industry—iron and steel, copper, aluminum, and automobiles—has high setup costs. But once your plant and equipment are set up, by increasing your output you can take advantage of economies of scale.

Economies of scale are cost savings that result from large-scale production. These cost savings favor the establishment of monopolies because bigger firms in industries for which economies of scale prevail can produce at lower average cost than smaller competitors.

If firms can continually reduce average costs of production and profits by expanding in the long run, one firm will eventually emerge as the dominant supplier. Under such circumstances much higher average costs of production would result perfect competition which requires many small firms with small markets shares. If perfect competition existed initially, it would end as soon as existing firms merged or one firm purchased their assets and consolidated them to achieve lower average costs. Eventually one firm dominates. Once it does, new firms can't enter because they are too small initially to achieve the low average costs the dominant firm enjoys by virtue of producing the entire market supply in very large market.

The term natural monopoly is sometimes used to describe a situation in which a firm emerges as a single seller in a market because of cost or technological advantages contributing to lower average costs of production. Competition among firms in such industry results in one large firm supplying the entire market demand at lower cost than two or more smaller firms. A natural monopoly can produce the entire quantity demanded by buyers at any price at lower average cost than would be possible for each firm in the industry if more than one firm existed.

Examples:

1. General Motors, Ford, and Chrysler were able to realize these economies much more than could American Motors and Volkswagen of America, both of which are relatively small. So, we are really talking about two things: having the wherewithal to set up and having enough demand so that your product sells enough to realize economies of scale.

2. Imagine how difficult it would be to set up a rival phone network or even a rival electric company in a large city. What protects monopolies from potential rivals is that they're selling enough units to have a relatively low ATC. If you were to enter the industry, how could you hope to have the capital to set yourself up so that you could compete effectively?

Natural monopoly: A monopoly that occurs because of a particular relation between industry demand and the firm's average total costs that makes it possible for only one firm to survive in the industry.