Economies of scale and network externalities are two types of barrier to entry. They discourage potential competitors from entering a market, and thus contribute to the monopolistic power of some firms.
Economies of scale are cost advantages that large firms obtain due to their size.They occur because the cost per unit of output decreases with increasing scale, as fixed costs are spread over more units of output . Economies of scale are also gained through bulk-buying of materials with long-term contracts, the increased specialization of managers, ability to obtain lower interest rates when borrowing from banks, access to a greater range of financial instruments, and spreading the cost of marketing over a greater range of output. Each of these factors contributes to reductions in the long-run average cost of production.
Economies of Scale
Large firms obtain economies of scale in part because fixed costs are spread over more units of output.
A natural monopoly arises as a result of economies of scale. For natural monopolies, the average total cost declines continually as output increases, giving the monopolist an overwhelming cost advantage over potential competitors. It becomes most efficient for production to be concentrated in a single firm.
Network externalities (also called network effects) occur when the value of a good or service increases as a result of many people using it. Because of network effects, certain goods or services that are adopted widely will appear to be much more attractive to new customers than competing goods or services. This is evident in online social networks. Social networks with the largest memberships are more attractive to new users, because new users know that their friends or colleagues are more likely to be on these networks. It is also evident with certain software programs. For example, most people use Microsoft word processing software. While other word processing programs may be available, an individual would risk running into compatibility problems when sending files to people or machines using the mainstream software. This makes it difficult for new companies to enter the market and to gain market share.