What it means
Most monopolies arise because a firm is hard to beat, but a legal monopoly arises because the government says so. The law may give a company the sole right to sell a product, such as a patented medicine, or to supply a service in a given area, such as a water network.
Competitors are legally prevented from entering the market while the protection lasts. Governments grant legal monopolies for different reasons.
Patents and copyrights reward innovation by giving inventors time to earn a return. Utilities such as water pipes and electricity grids are natural monopolies, meaning it would be wasteful to build several competing networks, so the state allows one provider but regulates it.
The danger is that a protected firm can charge higher prices and offer lower quality than it would face in a competitive market. To control that, regulators often set the prices or the allowed profit.
A common method is rate-of-return regulation, in which the regulator lets the firm recover its operating costs plus a fair return on the capital it has invested. For finance professionals, legal monopolies are interesting because their earnings can be very stable and predictable, which affects valuation, credit ratings and borrowing costs.
Utilities are often seen as lower-risk investments that pay steady dividends. The key risk is regulatory: a change in the permitted return or the end of a patent can reduce profits sharply.
A useful measure of market power is the Lerner index, which shows how far price is above marginal cost. The nuance is that protection is temporary or conditional.
Patents expire, licences are reviewed and legislation changes, so a business built on a legal monopoly must plan for the day competition arrives.
In practice
Real-world examples.
Example
A drug company patents a new treatment and is the only legal seller for 20 years, a typical length of patent protection in many countries. It prices the drug well above its production cost to recover research spending. Investors value the company on the expected profits before the patent ends.
Example
A city grants a single company the right to supply water to its residents. Because the company has no competitors, a regulator sets the prices it may charge and reviews them every few years. The finance team builds its forecasts around the allowed return.
Example
A national postal service has the sole legal right to deliver standard letters. It must offer a uniform price across the country even to remote areas. When the law changes to allow competitors, the service has to restructure its costs.
Formula
Calculation
Lerner index = (price - marginal cost) / price
A pharmaceutical company holds a patent on a drug that costs $30 to make for each additional pack, which is its marginal cost, and sells it for $50 a pack. The Lerner index is ($50 - $30) / $50 = $20 / $50 = 0.40. A value of 0 would mean price equals marginal cost, as in a highly competitive market, while 0.40 shows that 40% of the price is a margin above the cost of production. If competitors enter when the patent expires and the price falls to $35, the index becomes ($35 - $30) / $35 = 0.14, about 14%.Case study
Seen in the real world.
Clearwater Utilities is an illustrative, fictional company that holds an exclusive licence to supply water to a mid-sized city. Its regulator allows it to earn 7% on a regulated asset base of $400,000,000, which produces an allowed return of $28,000,000 a year plus recovery of operating costs.
When the regulator announced a review and proposed cutting the allowed return to 6%, the finance director calculated the impact: 6% of $400,000,000 is $24,000,000, a reduction of $4,000,000 a year. The share price fell as investors recalculated future dividends. The illustrative lesson is that the profits of a legal monopoly depend on the regulator's decisions as much as on the company's own efficiency.
Watch out
Common mistakes.
- Assuming a legal monopoly can charge any price it likes, when regulators often cap prices or returns.
- Treating the protection as permanent, when patents expire and licences can be changed or ended.
- Confusing a legal monopoly with one created by market dominance, which can be challenged under competition law.
Questions
People also ask.
What is the difference between a legal monopoly and a natural monopoly?
A natural monopoly arises from the cost structure of an industry, while a legal monopoly is created or protected by law, and some monopolies are both.
Why do governments allow legal monopolies?
They can reward innovation through patents or avoid wasteful duplication in networks such as water and electricity.
How do investors value a legal monopoly?
They usually forecast the regulated or protected earnings and then adjust for the risk of rule changes or competition arriving.
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