Market power is the ability to influence the market price of goods and services. The extreme case of market power is monopoly, where only one firm produces the entire supply of a particular product. A monopolist selects the quantity to be supplied to the market and sets the market price.
The distinguishing feature of any firm with market power is that the demand curve it faces is downward-sloping. In a monopoly, the demand curve facing the firm and the market demand curve are identical.
The downward-sloping demand curve facing a monopolist creates a divergence between marginal revenue and price. To sell larger quantities of output, the monopolist must lower product prices. Marginal revenue is the change in total revenue divided by the change in output.
A monopolist will produce at the rate of output at which marginal revenue equals marginal cost.
The monopolist will produce less output than will a competitive industry confronting the same market demand and cost opportunities. That reduced rate of output will be sold at higher prices, in accordance with the (downward-sloping) market demand curve.
A monopoly will attain a higher level of profit than a competitive industry because of its ability to equate industry (i.e., its own) marginal revenues and costs. By contrast, a competitive industry ends up equating marginal costs and price, because its individual firms have no control over the market supply curve.
Because the higher profits attained by a monopoly will attract envious entrepreneurs, barriers to entry are needed to prohibit other firms from expanding market supplies. Patents are one such barrier to entry. Other barriers are legal harassment, exclusive licensing, product bundling, and government franchises.
The defense of market power rests on (1) the ability of large firms to pursue long-term research and development, (2) the incentives implicit in the chance to attain market power, (3) the efficiency that larger firms may attain, and (4) the contestability of even monopolized markets. The first two arguments are weakened by the fact that competitive firms are under much greater pressure to innovate and can stay ahead of the profit game only if they do so. The contestability defense at best concedes some amount of monopoly exploitation.
A natural monopoly exists when one firm can produce the output of the entire industry more efficiently than can a number of smaller firms. This advantage is attained from economies of scale. Large firms are not necessarily more efficient, however.
