What is a Monopoly?

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Definition:

A monopoly is a business that dominates a market with little or no challenge from competitors, and thus can do as it pleases in setting prices and producing its goods.

🤔 Understanding a monopoly

A monopoly is a business that controls a market - in an industry, or for a particular product, or for services in a given area - and thus has the power to behave as it pleases. It can raise its prices, or skimp on the quality of its goods, without fear that a competitor will lure away its disgruntled customers. (In the board game Monopoly, for instance, the aim is to gain control over properties, extract rents, and force other players into bankruptcy.) There are laws aimed at preventing companies from gaining monopoly power, but sometimes there are good reasons for monopolies - utilities are monopolies because it doesn’t make sense to have more than one company providing electricity or water to a city, for instance. Monopolies in those cases are typically regulated.

Example

When a drug company invents a new drug, governments often grant patents that prevent other companies from producing the same drug. The company now has a technological monopoly that will allow it to recoup its research and development costs.

However, patients must often pay high prices for these drugs. Once patents expire, ending a drugmaker’s monopoly, other drugmakers typically flood the market with generic versions of the drug, driving prices down.

Takeaway

A monopoly is like the lone grocery store in a small desert town...

The store has complete control over the local market. In a town with many grocery stores, the stores continually offer sales in an effort to entice customers, but this small-town grocery store has little incentive to cut its prices because it has no competition. Instead, the store continually raises prices, forcing residents to pay more for goods because they have nowhere else to go. The store has achieved a geographical monopoly.

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What is a monopoly?

A business or other organization secures a monopoly when it has complete control of a market or is dominant enough that it doesn’t face competition. As a result, the company doesn’t have to worry about other companies that might offer better products or lower prices, and that can distort the market. Some monopolies are known as “trusts” - hence the term “antitrust,” which refers to laws aimed at preventing monopolies.

Free markets, those in which businesses can easily enter a market and compete with each other, generally force companies to innovate, cut prices, and take other steps that benefit consumers. In a monopoly, however, a company has little incentive to take these steps: It doesn’t have to worry about being undercut by competitors, and it has little incentive to innovate since no one is offering better products. Even if a company lowers production costs, there’s no incentive to pass on the savings to consumers.

In some circumstances, there are good reasons for monopolies. Public utilities are one example - it would be impractical for a town to have its electricity or water provided by multiple companies, each with its own infrastructure. So governments can authorize and establish monopolies in situations where it’s difficult for competitive markets to function.

There are prominent situations today in which monopoly power may be a concern. Some allege Amazon is gaining monopoly power over e-commerce since it already controls about 39 percent of the e-commerce market in the United States, according to eMarketer, a research company that focuses on digital technology. Google controls nearly 90 percent of the American search engine market, according to Statcounter GlobalStats, which tracks Internet usage.

What are the characteristics of monopolies?

Monopolies can vary by industry and type. However, they usually have some common characteristics.

High Barriers of Entry Protect Monopolies

Potential competitors sometimes can’t enter a market easily because of high startup costs, low profit margins, significant infrastructure requirements, and other factors that make it difficult or expensive for new companies.

Monopolies Have Power Over Pricing

In a free market, if a company raises its prices, it could be undercut by competitors. But since monopolies don’t have to worry about competition, they’re free to set higher prices for their goods without worrying about what competitors will do. The company also has little incentive to cut its costs and increase its efficiency.

Economies of Scale

Bigness can help a company. They’re able to buy raw materials and other items in massive quantities, which allows them to secure volume discounts. A company with monopoly power can use this advantage against any potential competitors. Economies of scale means the monopoly company can sell its products at an extremely low price that a competitor can’t match, forcing the competitor out of the market or even out of business.

Single Seller

If a company establishes a total monopoly, it becomes the single seller in the market. In this case, the company is essentially the same as the industry itself.

What are the four types of monopolies?

There are four primary types of monopolies, each with unique characteristics, though some companies may fall into multiple categories.

Natural Monopoly

A natural monopoly occurs when there are obstacles like high startup costs that make it difficult for competitors to enter the market. Many local public utility companies are natural monopolies. It’s cost-prohibitive to build power lines, water mains, and other public infrastructure. Even if a potential competitor wants to build power lines, there may not be room for more.

Technological Monopoly

A company has a technological monopoly when it controls specific manufacturing processes or has exclusive rights over key technologies that are crucial to making a product. Competitors can’t duplicate that. Drug companies are a good example. They spend hundreds of millions or even billions of dollars on research and development to create new drugs. But once that’s done, the drugs are often cheap to produce, so competitors would be able to piggyback on their R&D work and produce and sell the drugs themselves at a low cost.

So to encourage R&D and allow a company to recoup its R&D costs, the government grants patents that give the developer the exclusive right to make and sell a drug. That’s a technological monopoly. Most governments limit patents to a certain number of years. Once the patents expire, the company loses its technological monopoly and competitors can make and sell their versions of the drug.

Geographic Monopoly

Remember the example of the grocery store in the small desert town? As the sole grocery store in town, the store enjoys a geographic monopoly. Geographical monopolies often occur because there is no incentive for competitors to enter the market. A small desert town isn’t a very attractive market for other grocery stores because there aren’t many customers. With the potential for profit limited, there’s no incentive for other grocery stores to set up shop.

Government Monopolies

Governments sometimes establish monopolies through laws and regulations. Public utilities are one example. Governments may also establish monopolies for other public services, such as firefighting and policing. In some cases, government monopolies are natural monopolies. In other cases, the government may use various legal tools to protect the monopoly. A national oil company, for example, can have complete control over the country’s oil production, if the country deems that to be necessary or most efficient.

What are the pros and cons of monopolies?

While governments often regulate or aim to prevent monopolies, in some situations a monopoly is desirable or even necessary.

Pros of monopolies

Monopolies can deliver economies of scale, creating one large company that can be more efficient and eliminate unnecessary expense. Public utilities are one example of a beneficial monopoly. It’s impractical for multiple electricity companies to operate in one geographical area. By establishing a monopoly, the government can ensure a steady supply of electricity, and by regulating it the government can discourage the company from exercising its monopoly power in ways that might hurt consumers.

Cons of monopolies

Monopolies stifle competition and innovation. If left unregulated, monopolies may result in higher prices and market inefficiencies. Product quality may decline even as prices rise.

Are monopolies illegal?

Monopolies in general are not illegal. Governments sometimes establish monopolies for certain parts of the economy. Some public utilities enjoy monopolies over their respective markets, and some other companies may have monopoly power for valid reasons.

An electricity company may have a monopoly over a town’s electrical grid, for example. It’s often impractical for multiple companies to each build their own power lines running through a single city.

Still, many governments have anti-monopoly laws in place to prevent monopolies from forming in certain markets or industries. Since monopolies raise prices and have little incentive to innovate, they can be detrimental to consumers. In fact, many competition laws are aimed at protecting consumers, not competitors.

Monopoly laws are often referred to as antitrust laws or competition laws and help ensure fair and open competition.

Antitrust laws cover the following activities:

  • Mergers and Acquisitions: Companies that want to build a monopoly often buy up competitors. Using anti-monopoly laws, authorities can block mergers and acquisitions if they feel a transaction would give a company too much market power.
  • Market Allocation: Some companies try to work with competitors to allocate market share and reduce competition. Competition laws outlaw this behavior.
  • Bid Rigging: Companies can collude to ensure that one company wins a bid, often at an inflated price. Competition laws often forbid this.
  • Price Fixing: Companies in a market can work together to set prices, often making them artificially high for consumers. Agreements that restrict price competition are illegal.

Major Antitrust Laws in the United States

There are three major federal antitrust laws in the US:

  • Sherman Act: Enacted in 1890, the Sherman Act uses Congressional authority to regulate interstate commerce and outlaw “trusts” that form monopolies and cartels. The Sherman Act reduced concentrations of corporate power and ensured fairer competition. The government used the Sherman Act to break up companies like AT&T, which at one time controlled all US phone lines, and Standard Oil, which had controlled the American oil industry.
  • Clayton Antitrust Act: Enacted in 1914, the Clayton Antitrust Act built upon the Sherman Act and outlawed several specific practices, like price fixing, price discrimination, exclusive dealings, and other unfair business practices.
  • Federal Trade Commission Act: The Act grants the Federal Trade Commission authority to enact consumer protection laws to regulate and combat unfair and deceptive business practices.

State authorities may also implement their own competition laws and other regulations. Many other countries and authorities also have regulatory frameworks for regulating monopolies and protecting their societies from unfair business practices. Anti-monopoly laws can vary from jurisdiction to jurisdiction.

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This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

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© 2022 Robinhood. All rights reserved.