Difficulty of exit can make for difficulty of entry. If a substantial fraction of a firm’s initial outlays will be lost upon exit from the industry, exit will be costly. An expenditure that has already been made and that cannot be recovered is called a sunk cost. Should the effort fail, there is no way to recover the expenditures for such advertising. Suppose, for example, that entry into a particular industry requires extensive advertising to make consumers aware of the new brand. That cost will, in turn, be greater if the outlays required to start a business are unlikely to be recovered if the business should fail. The greater the cost of establishing a new business in an industry, the more difficult it is to enter that industry. If another firm attempted to enter the industry, the natural monopolist would always be able to undersell it. In this situation, the industry demand is not large enough to support more than one firm.

By cutting its price below the minimum average total cost of the smaller plants, the larger firm could drive the smaller ones out of business. A firm that expanded its scale of operation to achieve an average total cost curve such as ATC 2 could produce 240 units of output at a lower cost than could the smaller firms producing 20 units each.

Suppose there are 12 firms, each operating at the scale shown by ATC 1 (average total cost) in Figure 10.1 “Economies of Scale Lead to Natural Monopoly”. Because this firm will have lower unit costs than its rivals, it can drive them out of the market and gain monopoly control over the industry. If this is the case, one firm in the industry will expand to exploit the economies of scale available to it. In a natural monopoly, the LRAC of any one firm intersects the market demand curve where long-run average costs are falling or are at a minimum. Utilities that distribute electricity, water, and natural gas to some markets are examples. If long-run average cost declines as the level of production increases, a firm is said to experience economies of scale.Ī firm that confronts economies of scale over the entire range of outputs demanded in its industry is a natural monopoly. Scale economies and diseconomies define the shape of a firm’s long-run average cost ( LRAC) curve as it increases its output. The result is a model that gives us important insights into the nature of the choices of firms and their impact on the economy. As always with models, we make the assumptions that define monopoly in order to simplify our analysis, not to describe the real world. Such conditions are rare in the real world. In assuming blocked entry, we assume, for reasons we will discuss below, that no other firm can enter that market. In assuming there is one firm in a market, we assume there are no other firms producing goods or services that could be considered part of the same market as that of the monopoly firm. We shall see in the next chapter that monopolies are not the only firms that have this power however, the absence of rivals in monopoly gives it much more price-setting power.Īs was the case when we discussed perfect competition in the previous chapter, the assumptions of the monopoly model are rather strong. A firm that acts as a price setter possesses monopoly power. The entry of new firms, which eliminates profit in the long run in a competitive market, cannot occur in the monopoly model.Ī firm that sets or picks price based on its output decision is called a price setter. It selects from its demand curve the price that corresponds to the quantity the firm has chosen to produce in order to earn the maximum profit possible. In the case of monopoly, entry by potential rivals is prohibitively difficult.Ī monopoly does not take the market price as given it determines its own price. Not only does a monopoly firm have the market to itself, but it also need not worry about other firms entering. There are no close substitutes for the good or service a monopoly produces. Monopoly is at the opposite end of the spectrum of market models from perfect competition. Define what is meant by a natural monopoly.

List and explain the sources of monopoly power and how they can change over time.

Define monopoly and the relationship between price setting and monopoly power.

Monopoly examples in real life