Reflections On The Nature And Characteristics Of Business Monopoly

What are Monopolistic Businesses?

By definition, a monopoly is the exclusive possession or control of the supply of or trade in a commodity or service. In reality, monopolistic businesses are rare and rarely exhibit full control of their market, but instead, represent dominant control. Most monopolistic businesses are characterized by the strongest players in a niche or market. As a result, monopiles typically have the ability to make it difficult for new competitors to achieve growth, have the ability to raise prices, and often enjoy superior profitability.

The etymology of the word monopoly is the Latin combination of ‘Mono’, single and ‘Poly’ seller.  

The prerequisite economic characteristics of a monopoly are typically found in businesses of economic franchises. Naturally, such companies will have many of the characteristics of the best businesses. In our post about the Reflections on the Nature and Character of Superior Businesses we detail many of these characteristics.

In broad terms. There are two major types of monopoly. Absolute and relative.

Absolute Monopoly – fit the textbook definition of a monopoly. They are the only seller of a good or service and there is no substitute for what they offer. Generally, absolute monopiles include a large number of buyers, act as price makers and a have downward-sloping demand curve for their good or service.

Of the characteristics previously touched on, absolute monopolies generally share a number of special characteristics in common including:

• Price making – they can decide the price of a service or product to be sold. They determine the quantity to be sold and set production price targets in producing those goods.
• Price discrimination – they have the ability to change the price or quantity of a product at will, selling more goods in a low price market and less goods in a high-price market.
• High barriers to entry – new sellers are effectively unable to enter the market.
• Single [limited] seller – as the single seller of the good producing all the output, the company is the industry.
• Profit maximization - companies always seek to maximize their profitability and long-term potential for ongoing profitability with an aim to preserve and enhance it in the future.

Relative  Monopoly – companies with a maintainable comparable advantage but no price-making capacity or single limited seller characteristics. Most businesses with any sort of monopolistic characteristics are relative monopolies.

Do monopolies exist today?

Monopolies are more common than you might think. They exist in various markets and in different forms. Perhaps the most common example of a monopoly is power generation companies in most states in the US.

Retail power providers are state-sanctioned monopolies. Because of the infrastructure and economics of scale required to produce electricity for the grid, it is more favorable for a society to have a single provider of electricity rather than many smaller inefficient players.  

Retail power monopolies are regulated. As such, they have a maximum amount of profit they can earn in any given year. The result is to otherwise curb the tendency towards profit maximization and the other ill effects of monopolistic power to harm consumers.

Do monopolies have competition?

The vast majority of firms with monopolistic characteristics are relative monopolies. This means they do not exhibit the characteristics of absolute monopoly. They face limited competition in a market.

Google for example has 80% of the US search market but they do not have all of the market. Competitors like Microsoft Bing and Duck Duck Go have market share and are growing with the size of the market but not appreciably into Google's share of the market.

Do monopolies always make a profit?

No, monopolies do not always make a profit. Consider the biggest institutions that do not have shareholders in the traditional sense. Many monopolies are public services such as schools, universities, libraries, a town’s sewer, and water system, and more.

In general, if a basic public good or service is demanded by all of society its value to a private owner or individual equity holders will trend towards zero over a very long period of time.

Telecommunications companies are an example of companies that spend nearly every dollar they take in on better equipment and coverage. Because demand for their goods and services is so high they are forced to. The net effect for shareholders in such a firm is often a near-zero-sum game.

Monopolies that need to spend all of the capital they earn to maintain their relative position in the market are examples of investments that would produce inadequate returns to investors. These companies can be risky to own or invest in. For more on this subject see our discussion on investment risk.

Do monopolies hurt the economy?

The simple answer is they can, but not always. Most absolute monopiles should probably be carefully evaluated by the public and regulators. The forms of monopoly which are likely to become illegal and should be avoided include:

• Any type of monopoly which actively prevents the formation of or entrance of new competition into the marketplace to compete with them.
• Monopolistic competition which is contrary to the best long term interest of a population.

As absolute monopolies are hard to come by, the examples become a little extreme. Could the only municipal water company in town shut off all the water to homes in a district that half of the town didn’t like? Could a country with a monopoly on the production of nuclear weapons harm the rest of the world disproportionately; just with mere threats? Unequivocally. But competition and regulation help prevent these extremes from occurring. Anticompetitive practices hurt an economy more than a monopoly as such.

Every Type Of Monopoly Defined

Monopolies can be categorized into specific types based on how the extremes of their market characteristics. Many of these definitions will overlap. It may be helpful to think of the different types in economic terms, as we do below. Almost all of the extreme examples are regulated.

Perfect Monopoly – is another term for absolute monopoly, previously defined. The company is not only the only producer of a good with no substitute, there are no substitutes even close to what they produce. As a result, outside competition is at a level of zero.

An example of perfect monopoly is the power transmission company in a city with regulated power. No one else is even able to transmit power over the grid.

Imperfect Monopoly – is another term for relative monopoly. Markets with relative monopolies still have no close substitute but a remote substitute exists.

An example of this is the water your city provides. While it might be potable, many consumers will prefer to buy bottled water.

Private Monopoly – simply when the production of the good or service is controlled by a private individual or organization.

Public Monopoly – are simply government monopolies that may or may not be coercive. Government is the sole provider of a particular good or service and competition is prohibited by law. They may be created or subsumed by the government.

Utilities, legal identification, roads, and transit systems often take the form of a public monopoly.

Simple Monopoly – often called single-priced monopolies are where every customer pays the same market price for all units purchased in a single market.

Discriminating Monopoly – charges different prices to different customers for the same product. It prevails in more than one market.

Cargo, freight or travel providers such as airlines or railroads may have exclusive access to a geography or mode of transport. They may sell tonnage or space at prices based on demand.

Legal Monopoly – Is a monopoly that is protected by law from competition. The firm may be government regulated.

Fannie Mae and Freddie Mac operated as government-sponsored and legal monopolies in the secondary mortgage market in the US.

Technological Monopoly – may result from superior technology, first mover advantage, economies of scale in production, new production methods, etc. Technology monopolies may have the tendency to become natural monopolies over time.

YouTube is the largest video search engine in the world. Because it was a pioneer in the field, hit the market at the right time, and had some of the best platform technology. Allowing it to retain and then solidify its position as the number one video platform.

Joint Monopoly  –  two or more monopolies working together to control a market.

Duopoly - where two firms have dominant or exclusive control over a market.

Examples include Visa and Masterard, Boeing and Airbus, CocaCola and Pepsi, Uber and Lyft, Fannie Mae and Freddie Mac.

Natural Monopoly – occur when it is more efficient to have a single dominant player in a market either because fixed or start-up costs are too high or the marginal costs of operating multiple businesses in a particular industry is too great to be practical. The technological or marginal advantage to the consumer can also be so great that it only makes sense for a single player to have dominant market share.

Examples include not just large-scale infrastructure projects but also some of the biggest businesses.

Google’s web and video search platform represent an example of a natural monopoly. It is more efficient for consumers to be able to search from a single location for everything rather than begin at disparate points.

Facebook, Twitter, and LinkedIn’s social platforms only continue to benefit from network effects. As an increased number of people or participants use the service it improves the value of those services.

Government often regulates certain natural monopolies to ensure that consumers get a fair deal.

How New Monopolies Are Created or Formed

Competition is for losers.

– Peter Theil

We have established the primary characteristics a monopoly must exhibit. For a new monopoly to form, however, certain opportunities in markets must first exist. All of the following conditions must be present:

1. Creation of a breakthrough technology or process that is an order of magnitude better than the process before. Not incremental improvements.
2. Timed appropriately to launch in the market, right time to start.
3. Begins with a large share of a small market.
4. Team capable of capturing the opportunity.
5. Ability to deliver and distribute the good or service at scale.
6. Market position will be defensible in 10-20 years.
7. Attacks an opportunity not yet discovered or exploited by others.

These are the characteristics described in Blue Ocean Strategy by W. Chan Kim and Renée Mauborgne and similarly considered by Peter Theil in his work Zero to One. A monopoly’s influence will generally last only as long as it retains the ability to compound at rates greater than the market it serves (A) in aggregate and (B) the broader market in aggregate.

New monopolies will almost certainly create value for their creators. However, if a good or service solves a fundamental human need, then sheer demand will draw in competitors or regulators to drive out profit-making tendencies. The net effect will be that the good’s equity value will tend towards zero over a very long period of time.

What are the sources of a monopoly’s power?

Monopolies get their power to limit competition from economic and legal sources. Importantly, many sources of this power are derived from incentives allowed for by government within markets. The objective is to create incentives for entrepreneurs to benefit from the creation of new services and better tools.

Legal Sources – generally sanctioned by governments and markets.

• Government-imposed monopolies, as in the case of utility providers.
• Intellectual property rights such as patents and copyrights grant the rights to the exclusive production of certain goods.
• Property rights give a corporation or individual exclusive control of the materials necessary to produce a good.
• Combative legal action against rivals which can force them to use their more needed reinvestment capital towards otherwise unproductive ends litigation.

Economic Sources - economies of scale and technology advantages over the competition.

• Production costs - Through sheer size, companies may become large enough to continually lower their cost of production as they grow. The result is that new competitors entering the market will need to match or exceed this efficiency by an order of magnitude as long as the long-term average unit cost of the largest company is continuing to go down.

• Purchase economics - Companies with large purchase volumes are often able to extract price reductions from suppliers with outsized purchase volumes.
• Physics - For example, as a cargo ship gets larger it can move disproportionately more volume with only incremental increases in the width of the hull.
• Capital requirements – certain projects may simply be too capital intensive in the form of research and development or sunk costs to allow new entrants after a certain point.
• Network effects – where certain networks become more valuable as more people use them, increasing the demand for other people to consume the services or goods of the monopoly. The biggest social networks are examples.
• Switching costs – come into play when the opportunity cost of switching away from a product or service is too high to easily switch even if the price is significantly higher to remain with the monopoly company. Time and effort also play a factor.  
• Managerial or Human resources – increased specialization of managers or labor with size. Or the ability to hire all of the best talent for a given market. The biggest firms in Silicon Valley frequently take this approach with hiring engineers. Wells Fargo famously did this in the 80s ahead of the commoditization of banking.
• Time scale – either through first mover advantage or having enough time to develop a market without any material competition for extended periods of time. Amazon was able to grow its AWS business because no one was competing in the space for extended periods of time and it was able to leverage infrastructure in a way where others had to pay to play catchup years later.
• Financial – lower interest rate charges when borrowing from lenders or better access to a wider array of financial products. The company may also have the ability to simply acquire the competition and new technologies.
• Marketing – simply being able to disproportionately outspend the competition.
• Fraud or coercion – a company with unprecedented scale may be able to undertake deliberate action to exclude competitors or eliminate competition. This can include lobbying, bribery, collusion, and other anti-competitive practices.

Technical superiority - Technological superiority can be developed as a result of economics of scale along with the following components:

• Expertise to leverage technology – If a company can develop or acquire the expertise to integrate technology into the production of its goods or services it may be able to gain advantages of efficiency in producing future goods.
• Lack of substitutes – the production of a new good or service is the production of a technology. If a company sells a good for which there is no close substitute, the demand for that good may become relatively inelastic.
• Control of natural resources – A company with control over natural resources may also control the intellectual capital and limited ability to extract and process those raw materials.

The internet has a tendency to create monopolies

The internet is the land of pure competition. Pure competition is a term for a market where there are many independent sellers offering identical products. While the internet will allow for numerous small competitors it is also an arena that will create a new share of monopolies.

Take the production of software for example. The economic cost of producing new software is decreasing as the tools to create software become ever more accessible. Frameworks, which work much like scaffolding, allow for the deployment of enterprise-grade applications in months instead of years.

The internet also offers new opportunities to market and sell products with unprecedented targeting of customers. The incremental cost of adding a user to a software product is minimal. Software companies in particular may be able to achieve the benefits of scale quickly and then play a winner take all game as the incremental costs for their competition rises to market their own wares.

Consider any number of technology-enabled companies and how a few lines of code have allowed for unprecedented monopolization of a market. A few examples of the biggest players in the category fit our earlier criteria for the formation of a new monopoly:

Amazon – all shopping in one place for nearly everything
Uber – ride-hailing application
Facebook & Linkedin & Twitter – The specialized social networking applications
Quora – the biggest public question-and-answer forum
Ebay –Biggest second-hand marketplace
Paypal – online payment processor with the most integrations
Google – the most comprehensive search engine with the most search volume and data to produce superior search results
Spotify –  music streaming app
Groupon – coupon website
Dropbox – online storage

Key takeaways from studying monopolies

All businesses should aim for some form of monopolistic competition within their market. The results may include superior levels of profitability.

Due to the structural nature of how monopolies function, investors in monopolistic companies may reap disproportionate rewards. Investors looking to earn outsized returns on their investments should look to make investments in firms exhibiting monopolistic characteristics, being careful to avoid investments that are harmful or likely to become illegal.

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