A market, or industry, in which individual firms have some control over the price of their output is imperfectly competitive. All firms in an imperfectly competitive market have one thing in common: They exercise market power, the ability to raise price without losing all of the quantity demanded for their product. Imperfect competition and market power are major sources of inefficiency.
Imperfect competition does not mean that no competition exists in the market. In some imperfectly competitive markets competition occurs in more arenas than in perfectly competitive markets. Firms can differentiate their products, advertise, improve quality, market aggressively, cut prices, and so forth.
For a firm to exercise control over the price of its product, it must be able to limit competition by erecting barriers to entry. If your firm produces t-shirts, and if other firms can enter freely into the industry and produce exactly the same t-shirts that you produce, the result will be the outcome that you would expect in a perfectly competitive industry: The supply will increase, the price of t-shirts will be driven down to their average cost, and economic profits will be eliminated.
However, note that t-shirts having the official National Basketball Association team logo are more expensive than generic t-shirts. If your firm can prevent other firms from producing exactly the same product, or if it can prevent other firms from entering the market, then it has a chance of preserving its economic profits. Only the NBA's licensees are allowed to use the official logo.
Defining Industry Boundaries
There are several different market structures. A monopoly is an industry with a single firm in which the entry of new firms is blocked. An oligopoly is an industry in which there is a small number of firms, each large enough to have an impact on the market price of its outputs. Firms that differentiate their products in industries with many producers and free entry are called monopolistic competitors, but where do we set the boundary of an industry? Although Procter & Gamble is the only firm that can produce Ivory, there are many other brands of soap.
In general, the ease with which consumers can substitute for a product limits the extent to which a monopolist can exercise market power. The more broadly a market is defined, the more difficult it becomes to find substitutes.
Consider hamburger. A firm that produces brand X hamburger faces stiff competition from other hamburger sellers, even though it is the only producer of brand X. The brand X firm has little market power because near perfect substitutes for its hamburger are available. If a firm were the only producer of hamburger (or, better yet, the only producer of beef), it would have more market power, because fewer (or no) alternatives would be available. When fewer substitutes exist, a monopolist has more power to raise price because demand for its product is less elastic, as Figure 1 shows. A monopolist that produces all the food in an economy would exercise enormous market power because there is no substitute at all for food as a category.
To be meaningful, therefore, our definition of monopolistic industry must be more precise. We define pure monopoly as an industry (1) with a single firm that produces a product for which there are no close substitutes and (2) in which significant barriers to entry prevent other firms from entering the industry to compete for profits.
Barriers to entry
Firms that already have market power can maintain that power either by preventing other firms from producing an exact duplicate of their product or by preventing firms from entering the industry. A number of barriers to entry can be erected.
Government Franchises Many firms are monopolies by virtue of government directive. Public Utility commissions in each state watch over electric companies and locally operating telephone companies. One of the government's responsibilities is to regulate the prices charged by these utilities to ensure that they do not abuse their monopoly power.
Fairness, or equity, is a frequently cited defense of government regulated monopolies. Technological progress in the telecommunications industry has reduced the advantages that come from size, for example, but some states are clearly not ready to open local exchange service to competition. The reason is that most state governments want to ensure that everyone has access to a telephone at affordable rates. In most states, private households are provided with telephone service at a price below the cost of producing it; local telephone companies earn the bulk of their profits from business users, who are charged a price above cost. Deregulating local service, it is argued, would mean higher telephone bills for households, a change that many would consider "unfair."
 Large economies of scale and equity are not the only justifications that governments give for granting monopoly licenses, however. Sometimes government wants to maintain control of an industry, and a monopoly is easier to control than a competitive industry.
Patents Another legal barrier that prevents entry into an industry is a patent, which grants exclusive use of the patented product or process to the inventor. Patents are issued in the United States under the authority of Article 1, Section 8, of The Constitution, which gives Congress the power to "promote the progress of science and the useful arts, by securing for limited times to authors and inventors the exclusive right to their respective writings and discoveries." Patent protection in the United States is currently granted for a period of 20 years.
Patents provide an incentive for invention and innovation. New products and new processes are developed through research undertaken by individual inventors and by firms. Research requires resources and time, which have opportunity costs. Without the protection that a patent provides, the results of research would become available to the general public very quickly. If research did not lead to expanded profits, very little research would be done. On the negative side, though, patents do serve as a barrier to competition, and they do slow down the benefits of research flowing through the market to consumers.
The expiration of patents after a given number of years represents an attempt to balance the benefits of firms and the benefits of households: On the one hand, it is important to stimulate invention and innovation; on the other hand, invention and innovation do society no good unless their benefits eventually flow to the public.
Public attention is often focused on the high costs of healthcare. One factor contributing to these costs is the very high price of many prescription drugs. Equipped with newly developed tools of bioengineering, the pharmaceutical industry has been granted thousands of patents for new drugs. When a new drug for treating a disease is developed, the patent holder can charge a very high price for it. The drug companies argue that these rewards are justified by high research and development costs; others say these profits are the result of a monopoly protected by the patent system.
Economies of Scale and Other Cost Advantages Some products can be produced efficiently only in big, expensive production facilities. For example, the Federal Trade Commission (FTC) has estimated that an oil refinery large enough to achieve maximum scale economies in the production of gasoline would cost more than $500 million to build (Case & Fair, p. 256). A small entrepreneur is not going to jump into the refining business in search of economic profit. The need to raise an initial investment of half a billion dollars is compounded by the riskiness of the business. Hence, large capital requirements are often a barrier to entry.
Sometimes large economies of scale are not production related. Breakfast cereal can be produced efficiently on a very small scale, for example; large-scale production does not reduce costs. However, to compete, a new firm would need an advertising campaign costing millions of dollars. The large front-end investment requirement in the presence of risk is likely to deter would-be entrance to the cereal market.
Ownership of a Scarce Factor of Production You cannot enter the diamond producing business unless you own a diamond mine. There are not many diamond mines in the world, and most are already owned by a single firm, the De Beers company of South Africa. Once the Aluminum Company of America (now Alcoa) owned or controlled virtually 100 percent of the bauxite deposits in the world and until the 1940s monopolized the input production and distribution of aluminum. Obviously, if production requires a particular input, and one firm owns the entire supply of that input, that firm will control the industry. Ownership alone is a barrier to entry.
Price: The Fourth Decision Variable
To review: a firm has market power when it has some control over the price of its product---raising the price of its product without losing all of the quantity demanded. The exercise of market power requires that the firm be able to limit competition in some way. It does this either by erecting barriers to the entry of new firms or by preventing other firms from producing the same product.
Regardless of the source of market power, output price is not taken as given by the firm. Instead, price is a decision variable for imperfectly competitive firms. Firms with market power must decide not only (1) how much to produce, (2) how to produce it, and (3) how much to demand in each input market, but also (4) what price to charge for their output.
This does not mean that "market power" allows a firm to charge any price it likes. The market demand curve constrains the behavior even of a pure monopolist. To sell its product successfully, a firm must produce something that people want and sell it at a price they are willing to pay.
*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 253-257*
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