Monopolies derive their market power from barriers to entry – circumstances that prevent or greatly impede a potential competitor’s entry into the market or ability to compete in the market.
There are three major types of barriers to entry; economic, legal and deliberate.
1. Economic barriers: Economic barriers include economies of scale, capital requirements, cost advantages and technological superiority.
Economies of scale: Monopolies are characterised by declining costs over a relatively large range of production. Declining costs coupled with large start up costs give monopolies an advantage over would be competitors. Monopolies are often in a position to cut prices below a new entrant’s operating costs and drive them out of the industry. Further the size of the industry relative to the minimum efficient scale may limit the number of firms that can effectively compete within the industry. If for example the industry is large enough to support one firm of minimum efficient scale then other firms entering the industry will operate at a size that is less than MES meaning that these firms cannot produce at an average cost that is competitive with the dominant firm. Finally, if long run average cost is constantly falling the least cost way to provide a good or service is through a single firm.
Capital requirements: Production processes that require large investments of capital, or large research and development costs or substantial sunk costs limit the number of firms in an industry. Large fixed costs also make it difficult for a small firm to enter an industry and expand
Technological superiority: A monopoly may be better able to acquire, integrate and use the best possible technology in producing its goods while entrants do not have the size or fiscal muscle to use the best available technology. In plain English one large firm can sometimes produce goods cheaper than several small firms.
No substitute goods: A monopoly sells a good for which there is no close substitutes. The absence of substitutes makes the demand for the good relatively inelastic enabling monopolies to extract positive profits.
Control of Natural Resources: A prime source of monopoly power is the control of resources that are critical to the production of a final good.
Network Externalities: The use of a product by a person can affect the value of that product to other people. This is the network effect. There is a direct relationship between the proportion of people using a product and the demand for that product. In other words the more people who are using a product the higher the probability of any individual starting to use the product. This effect accounts for fads and fashion trends. It also can play a crucial role in the development or acquisition of market power. The most famous current example is the market dominance of the Microsoft operating system in personal computers.
2.Legal barriers: Legal rights can provide opportunity to monopolise the market in a good. Intellectual property rights, including patents and copyrights, give a monopolist exclusive control over the production and selling of certain goods. Property rights may give a firm the exclusive control over the materials necessary to produce a good.
3.Deliberate Actions: A firm wanting to monopolise a market may engage in various types of deliberate action to exclude competitors or eliminate competition. Such actions include collusion, lobbying governmental authorities, and force.
In addition to barriers to entry and competition, barriers to exit may be a source of market power. Barriers to exit are market conditions that make it difficult or expensive for a firm to leave the market. High liquidation costs are a primary barrier to exit. Market exit and shutdown are separate events. The decision whether to shut down or operate is not affected by exit barriers. A firm will shut down if price falls below minimum average variable costs.