5. Market Systems and Market Failure

The idea that the invisible hand results in the most efficient economic outcome breaks down in certain cases.

One such case is a monopoly. In economics, a monopoly is a market system where there is only one seller of a product that cannot be easily substituted by another product. Such a seller is commonly called a “monopolist”. An example of a monopoly in many countries is tap water. Tap water is typically supplied to all the households and businesses in a given area by a single seller and – for most uses, like bathing, cooking and cleaning – it is inconvenient to substitute tap water with another product like bottled water.

A monopoly can arise for one of three reasons:

Control of a key resource, product, or brand. For example, a firm that controls all the diamond mines will have a monopoly in the diamond market. Control of a market can also arise from advanced technology or good management practices that help a company develop a unique product. For instance, a technology company that creates the best computer operating system, with features that many people desire, can achieve a near-monopoly position in its market.

Natural monopoly. This is a situation where the entire demand for a product can be satisfied at the lowest cost by only one firm, rather than two or more. The supply of tap water is one such situation: it would be too expensive for two or more firms to build their own water pipe network reaching all households and businesses, so only one firm will usually exist.

Government licensing. Governments may choose to grant a license (or official permission) to carry out a specific business to only one firm. For example, many countries have only one licensed provider of a postal service.

In a monopoly, the selling firm wields market power that lets it set a higher price for its goods or services than the competitive price set in a market where there are many buyers and sellers of an identical good (which we call a perfectly competitive market). The firm will generate high profits, but consumers will suffer by paying a price above the competitive level. This can happen in Hegemony when there is only one producer of a certain good or service, like food or healthcare, that workers need to boost their standard of living. The player who owns all the production of such a good or service will likely set a very high price, simply because buyers have no other provider to go to. This is inefficient and can be described as a market failure. Governments often attempt to regulate monopolies to protect consumers.

However, a firm does not need to have a monopoly to wield market power and raise prices above the competitive level. This can also occur in an oligopoly, a much more common market system studied by 20th-century economists Joan Robinson and Edward Chamberlin. In an oligopoly, only a handful of sellers sell the same product or a family of products with broadly similar features. Computer operating systems and telecommunication services in many countries are oligopolies. If new firms entered the market, then competition would rise, and prices would fall. But barriers similar to those that create monopolies can prevent the entry of new competitors.

When only a few sellers dominate the market, they are well aware of each other’s pricing and product features. They do not need to be as worried about being undercut by someone else as they would be in a market where lots of sellers sold identical or almost-identical products (as might be the case with oil, pencils, or bottled water, for example). As a result, oligopolists can still set the price for their products higher than the competitive price, despite being somewhat less safe from competition than a monopolist.