What is a monopoly?

The other extreme, in contrast to the perfect market, is a monopoly.

A monopoly in economics means there is only one firm producing within a particular market (note that countries may in regulation adopt a different definition, but we deal with the concept in economic terms here).

The monopoly firm can exercise power over the market, and may be able to set prices much higher than its average cost of production due to the lack of competition. However, the ability to do this will depend on the inherent demand for the good (or service) the monopoly firm produces, and the closeness of substitutes for the good.

Pros

Monopolies can take advantage of economies of scale. As a firm produces more of a good, the average cost for producing extra goods may decrease, up until a certain point. This may happen where there is a large one-off cost to set up production, such a high machinery cost, but little or no additional costs when producing more goods. A monopoly may pass on this lower average cost of production to the consumer, however whether it does so will depend upon a number of factors - including regulation, whether there are any substitutes, and how easily competitors could enter the space if given the chance (have a look at the Introduction to Perfect Competition article and consider whether any other factors listed there could impact whether a monopoly passes on lower costs to consumers).

Further, monopolies may be conducive to research and development ("R&D"). Monopolies may charge prices for goods that are significantly above their cost of production and may generate supernormal profits compared to firms in a perfectly competitive market. This profit can then be used to fund further R&D.

In addition, innovation and product development may be encouraged within the industry, because the monopoly has no competition and can sell these new products to generate even more supernormal profits.

Cons

Because a monopoly firm has control of the market, it may be able to set prices much higher than its cost of production, resulting in reduced allocative efficiency (depending upon a number of factors discussed above).

Also, the lack of competition in the market may remove incentives for the monopoly firm to be productively efficient because they do not have to keep costs low to compete – the firm could spend on lavish items which are not necessary, employ too many staff etc.

Alternatively to the point above about monopolies being conducive to R&D, there could in fact be less incentive for a monopoly firm to engage in R&D because it already dominates the market.

Further, the supernormal profits that a monopoly firm makes could be seen as unfair by some groups.

Due to the potential cons of monopolies, countries often have competition laws to prevent monopolies from occurring. These rules may set limits on the percentage market share a single firm can have (usually well below 100% - often around the 25% mark), or impose certain restrictions on firms where going above that market share is unavoidable. Further, these laws often prevent certain anti-competitive practices, or consumer exploitation. To enforce these laws, there may be a competition regulator - for example, the Competition and Markets Authority in the UK.

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