Sources of Monopoly

Barriers to entry describe the disadvantages of potential entrants relative to established firms in an industry. They play important role in determining the structure of an industry, such as· the number of firms and the size of distribution. Joe Bain (1956) mentioned economies of scale, product differentiation, absolute cost advantage of established firms and capital requirements as the main sources of barriers to entry and, therefore monopoly power.

1.      Economies of scale: Operation of scale economies over sufficiently large range of outputs leaves only one firm supplying the entire market. Such a firm is called a 'natural monopoly'. The potential entrant would have to build a large plant in order to compete with such established firm.           

2.      Product differentiation: Product differentiation may confer advantages to established firms because entrants would have to compete in marketing the product in addition to producing it. Entrants may also need to overcome consumer loyalty to established brands and this would increase costs and risks of entry. The new firm may be forced to sell the product at a lower price that may not generate adequate profit or may be forced to sell at higher costs due to large advertisement budget. 

3.      Absolute cost advantage: Established firms in the industry can obtain resources at a lower cost than potential entrants. This advantage occurs when established firms have access to important inputs, or unique assets (such as prime location or manufacturing process) which allow them to produce at a lower cost than potential entrants. Under these conditions, established firms would be able to charge prices above their marginal costs and earn economic profits without attracting entry. 

4.      Capital requirements: In some industries (automobiles, defence, oil refining and deep sea drilling) the capital requirements of production are enormous. In others, (chemicals, pharmaceuticals and electronics) large investment in R&D is necessary. Entry becomes risky when large sunk costs of this kind are required. 

5.      Control over inputs: Control over the entire supply of raw material like mineral deposits, oil supplies and even scientific talent can also lead to monopoly power. Till World War II, Alcoa, the Aluminium Company of America controlled supply of bauxite and, therefore, had monopoly in production of aluminium. Other examples of monopoly based on resource control are French Champagne, De Beers (diamonds) and OPEC (crude oil). 

6.      Legal restrictions: Patents held by existing firms make it virtually impossible for other firms to produce a comparable product or use a particular production process. Xerox had monopoly on copying machines and Polaroid on instant cameras when they were produced first.

Exclusive franchises granted by the government are another form of legal restrictions. A firm is set up as the sole producer and distributor of a product or service but is subject to government regulations. For example, post offices set up by government.

7.      Strategic barriers: A monopoly firm may exercise limit pricing, that is, keep price below monopoly levels to discourage new entry. For the same reason, it may engage in extensive advertising and brand proliferation, not because this is profitable in itself, but to raise the cost of entry of new competitors. This is generally called as retaliation pricing. The firm may intentionally create excess capacity, as a warning that it can quickly expand capacity should a new firm attempt to enter. 

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