Does a free market create monopolies?

A question from Yahoo! Answers:

Does a truly free market inevitably create monopolies or not?

It depends on the cost structure. In a decreasing-cost industry, where marginal costs decline with increasing volumes, free market creates monopolies, because the competitor who produces the largest volume can sell the cheapest and price the competition out of the market. In an increasing-cost industry, where marginal costs rise with increasing volumes, free market results in a perfect competition.

But quite a few of today’s markets are not free. When Alfred Marshall coined the term “free market,” he assumed that limitations on market entry can only be artificial. In 1890, when Marshall’s work was published, this view had some validity to it. Since then, we have come to realize that there are natural barriers to entry, such as capital requirements. So when that happens, the market usually ends up being an oligopoly.

Finally, all of the above assumes that the good is homogeneous (i.e., cannot be differentiated). It it can, we get into a whole new game called monopolistic competition…

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