What Is a Monopoly?

Monopolies Explained

Illustration showing the negative impacts of monopolies

The Balance / Bailey Mariner

A monopoly is a business that is effectively the only provider of a good or service, giving it a tremendous competitive advantage over any other company that tries to provide a similar product or service.

Keep reading to learn more about how monopolies can negatively affect the economy and the rare instances in which the government actually creates them on purpose.

Definition and Examples of a Monopoly

A monopoly is a company that has "monopoly power" in the market for a particular good or service. This means that it has so much power in the market that it's effectively impossible for any competing businesses to enter the market.

The existence of a monopoly relies on the nature of its business. It is often one that displays one or several of the following qualities:

  • Needs to operate under large economies of scale
  • Requires huge capital
  • Offers a product with no substitute
  • Prompts government mandate ensuring its sole existence
  • May possess—but does not always possess—technological superiority and control resources

Examples in the U.S.

The most famous monopoly was Standard Oil Company. John D. Rockefeller owned nearly all the oil refineries, which were in Ohio, in the 1890s. His monopoly allowed him to control the price of oil. He bullied the railroad companies to charge him a lower price for transportation. When Ohio threatened legal action to put him out of business, he moved to New Jersey.

In 1998, the U.S. District Court ruled that Microsoft was an illegal monopoly. It had a controlling position as the operating system for personal computers and used this to intimidate a supplier, chipmaker Intel. It also forced computer makers to withhold superior technology. The government ordered Microsoft to share information about its operating system, allowing competitors to develop innovative products using the Windows platform.

But disruptive technologies have done more to erode Microsoft's monopoly than government action. People are switching to mobile devices, such as tablets and smartphones, and Microsoft's operating system for those devices has not been popular in the market.

Some would argue that Google has a monopoly on the internet search engine market; people use it for more than 90% of all searches.

How Monopolies Work

Some companies become monopolies through vertical integration; they control the entire supply chain, from production to retail. Others use horizontal integration; they buy up competitors until they are the only ones left.

Once competitors are neutralized and a monopoly has been established, the monopoly can raise prices as much as it wants. If a new competitor tries to enter the market, the monopoly can reduce prices as much as it needs to squeeze out the competitors. Any losses can be recouped with higher prices once competitors have been squeezed out.

U.S. Laws on Monopolies

The Sherman Anti-Trust Act was the first U.S. law designed to prevent monopolies from using their power to gain unfair advantages. Congress enacted it in 1890 when monopolies were known as "trusts," or groups of companies that would work together to fix prices. The Supreme Court later ruled that companies could work together to restrict trade without violating the Sherman Act, but they couldn't do so to an "unreasonable" extent.

Some 24 years after the Sherman Act, the U.S. passed two more laws concerning monopolies, the Federal Trade Commission Act, and the Clayton Act. The Federal Trade Commission (FTC) was established by the former, while the latter specifically outlawed some practices that weren't addressed by the Sherman Act.

When Monopolies Are Needed

Sometimes a monopoly is necessary. Some, like utilities, enjoy government regulations that award them a market. Governments do this to protect the consumer. A monopoly ensures consistent electricity production and delivery because there aren't the usual disruptions from free-market forces like competitors.

There may also be high up-front costs that make it difficult for new businesses to compete. It's very expensive to build new electric plants or dams, so it makes economic sense to allow monopolies to control prices to pay for these costs.

Federal and local governments regulate these industries to protect the consumer. Companies are allowed to set prices to recoup their costs and a reasonable profit.

PayPal co-founder Peter Thiel advocates the benefits of a creative monopoly. That's a company that is "so good at what it does that no other firm can offer a close substitute." He argues that they give customers more choices "by adding entirely new categories of abundance to the world."

Criticism of Monopolies

Monopolies restrict free trade and prevent the free market from setting prices. That creates the following four adverse effects.

Price Fixing

Since monopolies are lone providers, they can set any price they choose. That's called price-fixing. They can do this regardless of demand because they know consumers have no choice. It's especially true when there is inelastic demand for goods and services. That's when people don't have a lot of flexibility about the price at which they will purchase the product. Gasoline is an example—if you need to drive a car, you probably can't wait until you like the price of gas to fill up your tank.

Declining Product Quality

Not only can monopolies raise prices, but they also can supply inferior products. If a grocery store knows that poor residents in the neighborhood have few alternatives, the store may be less concerned with quality.

Loss of Innovation

Monopolies lose any incentive to innovate or provide "new and improved" products. A 2017 study by the National Bureau of Economic Research found that U.S. businesses have invested less than expected since 2000 in part due to a decline in competition. That was true of cable companies until satellite dishes and online streaming services disrupted their hold on the market.

Inflation

Monopolies create inflation. Since they can set any prices they want, they will raise costs for consumers to increase profit. This is called cost-push inflation. A good example of how this works is the Organization of Petroleum Exporting Countries (OPEC). The 13 oil-exporting countries in OPEC are home to nearly 80% of the world's proven oil reserves, and they have considerable power to raise or reduce oil prices.

Key Takeaways

  • When a company effectively has sole rights to a product's pricing, distribution, and market, it is a monopoly for that product.
  • The advantage of monopolies is the assurance of a consistent supply of a commodity that is too expensive to provide in a competitive market.
  • The disadvantages of monopolies include price-fixing, low-quality products, lack of incentive for innovation, and cost-push inflation.