Monopoly and Market Power

A pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes. Unlike competitive firms that are price takers, a monopolist is a price maker. This power stems from barriers to entry—obstacles that prevent competitors from entering the market. These include legal barriers (like patents or licenses), control of essential resources (owning the only diamond mine), and economies of scale (being so big that new firms can't match your low costs).

In perfect competition, a firm can sell as much as it wants at the market price, so $P = MR$. However, a monopolist faces the entire downward-sloping market demand curve. To sell one more unit, the monopolist must lower the price for all units sold. Consequently, the Marginal Revenue (MR) is always less than the Price (P) for every unit after the first. The firm still maximizes profit where $MR = MC$, but because $P > MR$, the price charged to consumers is significantly higher than the marginal cost of production.

Monopolies create market failure because they do not achieve allocative efficiency. In a competitive market, $P = MC$, meaning the value consumers place on the last unit equals the cost to produce it. A monopolist restricts output to the point where $MR = MC$, but since they charge $P > MC$, they produce less than the socially optimal amount. This 'under-production' creates Deadweight Loss (DWL)—a loss of economic welfare that benefits neither the producer nor the consumer.

Sometimes, a monopoly is actually more efficient than competition. A natural monopoly occurs when economies of scale are so extensive that a single firm can provide a good or service to an entire market at a lower cost than two or more smaller firms could. This usually happens in industries with massive fixed costs, like water pipes or electricity grids. If two companies tried to compete, they would both have to build expensive infrastructure, doubling the average cost for everyone.