In an economic context, a monopoly is a firm that has market power. That means, unlike firms in a competitive market, a monopolist has the ability to influence the market price of the good or service it sells. By definition, a firm is considered a monopoly if it is the sole seller of its good or service and its product does not have any close substitutes.
There are a number of different factors that can cause a monopoly to arise. However, all of these factors essentially have to do with barriers to entry. Thus, in the following paragraphs, we will look at the three most relevant causes of monopoly markets: (1) Ownership of a key resource, (2) government regulation, and (3) economies of scale.
1) Ownership of a Key Resource
A firm that has exclusive control or ownership of a key resource can restrict access to that resource and establish a monopoly. The limited availability of the key resource will make it impossible for new sellers to enter the market. Although this factor is important in economic theory, monopolies rarely ever arise for this reason in reality anymore. Mainly because most resources are available in various regions across the globe.
One famous example of a monopoly that arose because of ownership of a key resource is the diamond market in the twentieth century. During this period, the company De Beers effectively controlled most of the world’s diamond mines, either through direct ownership or exclusive agreements. As a result, De Beers could dominate the market and influence the market price at will.
2) Government Regulation
The government can restrict market entry by law (e.g. through patents or copyright laws), which may result in a monopoly. Governments usually do this to serve the public interest, because these regulations promote innovation as well as research and development (R&D). The idea behind this is that firms can be rewarded for their R&D efforts by getting exclusive rights to sell their product. Without this kind of protection, it would be more reasonable for many firms to let others do the research and just copy their products once they are on the market. However, this would eventually eradicate all innovation and research.
Arguably the most prominent (and controversial) examples of government regulated monopolies can be found in the pharmaceuticals industry. It often takes more than a decade for companies to develop new drugs. However, if they succeed, the firms can apply for a patent and become the sole seller of the new drug for a set period of time. This monopoly position allows them to make enough profits to make up for high R&D expenditures.
3) Economies of Scale (i.e. Natural Monopoly)
In some industries, a single firm can supply a good or service at a lower cost than two or more firms could. We call this a natural monopoly (because it arises without government intervention). A natural monopoly can arise in industries where firms face high fixed costs but are able to realize significant economies of scale over the relevant range of output. Those circumstances result in decreasing average total costs as output increases, which makes it more difficult for new firms to enter the market.
A common example of a natural monopoly is the market for electricity. Building the infrastructure to supply a city with electricity is extremely expensive. Thus, the market has high barriers to entry. However, connecting an additional house to the power grid is relatively cheap once the infrastructure is in place. As a result, a single firm can supply a whole city at a lower cost than two or more competing companies could.
In a Nutshell
A monopoly is a firm that has the ability to influence the market price of the good or service it sells. There are three main factors that can cause a monopoly to arise, all of which have to do with barriers to entry: (1) Ownership of a key resource: When a firm has exclusive ownership of a key resource it can restrict access to this resource and establish a monopoly. (2) Government regulation: The government can restrict market entry by law (e.g. through patents, copyright laws), which may result in a monopoly. (3) Economies of scale: In some industries, a single firm can supply a good or service at a lower cost than two or more firms could, which results in a natural monopoly.