Industrial notes

What's so bad about monopoly

power?
BY MARK THOMA
SEPTEMBER 18, 2014 / 5:30 AM / MONEYWATCH
Google (GOOG) has been negotiating with European regulatory authorities since 2010 in an
attempt to settle an antitrust case concerning its search engine, and its third attempt to settle the
case has been rejected.

Google may also face new antitrust problems over its Android mobile operating system, and it's
not alone in facing tough antitrust scrutiny in Europe. Microsoft (MSFT) has also been the
subject of a long-running battle in Europe over market dominance issues.

But what's motivating this scrutiny from European regulators? What's so bad about a company
amassing monopoly power?

When firms have such power, they charge prices that are higher than can be justified based upon
the costs of production, prices that are higher than they would be if the market was more
competitive. With higher prices, consumers will demand less quantity, and hence the quantity
produced and consumed will be lower than it would be under a more competitive market
structure.

The bottom line is that when companies have a monopoly, prices are too high and production is
too low. There's an inefficient allocation of resources.

In addition, the tactics used to establish monopoly power, such as driving competitors out of
business or thwarting potential entrants, can also cause considerable harm to households who
own the businesses that are forced to close their doors.

For instance, a firm with deep pockets can set prices below costs and absorb losses until
competitors can no longer survive. Then, once the competition is eliminated, the surviving firm
can raise prices high enough to more than cover the losses it took while establishing its now-
dominant market position (under antitrust regulation, such tactics are prohibited).

The problems with monopolies go beyond the economic effects. Many large, economically
powerful companies also have considerable political influence and the ability to "capture" the
political and regulatory process. This allows a powerful firm to tilt the legal and regulatory
processes against any potential threat to its market power, and to bring about changes that further
enhance the profits it earns.

It can get health and safety regulations removed, have licensing requirements imposed that make
it harder for new firms to enter a market, avoid state sales taxes for online retailers, or get invited
to speak at congressional hearings on matters such as immigration and corporate taxation.

When an industry has just a few dominant firms, or a single dominant firm, market power can be
significant. But when the number of companies is sufficiently large, the power of any one is
considerably muted.

However, a small degree of monopoly power may even be desirable.

Whenever there is variety, and hence some amount of brand loyalty, firms will have some
market power, i.e. some ability to raise prices without driving customers away (when products
are identical, as required for textbook pure competition, an increase in the price above a nearby
competitor's price would result in the loss of all customers -- why pay more for the exact same
product?). So, the cost of variety is that firms will have some degree of pricing power.

But the benefit is a wide variety of goods to choose from. Consumers certainly seem to have a
taste for variety, so this benefit must be weighed against the market power that companies get
from differentiated products. As long as the number of firms in an industry is relatively large,
making a market "monopolistically competitive," it's likely that the benefits of variety will
outweigh the cost.

However, when the number of firms is smaller so that oligopolies (a few dominant firms) or
monopolies (a single dominant firm) appear, the likelihood that the benefits outweigh the costs is
substantially diminished and scrutiny from regulators is needed.

One case where scrutiny is certainly needed is one economists call a "natural monopolies." In
these cases, companies do not have to act strategically to eliminate the competition. It happens
naturally, often because of economies of scale that are still in effect even after the entirety of
market demand has been satisfied.

Because the monopoly power cannot be prevented by regulating the firm's strategic behavior,
and because breaking it up would often result in higher costs and hence higher prices for
consumers, the best course of action is to regulate the prices and quantities such a company can
charge.

A firm's size and market share do not necessarily indicate that it is exploiting its market power or
that substantial market share even exists. A dominant firm in an industry could, for example, face
substantial new entrants and competition if it attempts to raise its prices and exploit its dominant
position in the marketplace.

But firms that exploit their market power or undertake strategic behaviors that make it more
difficult for other companies to compete should come under the careful watch and, when
appropriate, receive penalties from regulators charged with promoting the public interest.

Benefits of Monopoly Power

29 January 2020 by Tejvan Pettinger

Monopoly power occurs when a firm has a dominant position in the market.
A pure monopoly is when one firm has 100% of the market share. A firm
might be considered to have monopoly power with more than 25% market
share.
The main benefits of monopolies include

1. Economies of scale – lower average costs and therefore lower

prices for consumers.
2. More profit for research and development – enabling better
products in the long-run
3. Firms who become monopolies need to be successful and
efficient.
4. Domestic monopolies provide international competition.
5. Monopolies reduce duplication of infrastructure and services.
6. Government regulation can enable best of both worlds
(economies of scale, low prices)
More detail on the benefits of monopolies

1. Economies of Scale
If the firms produce in an industry with very high fixed costs (e.g. steel
production), consumers can benefit from having a large firm which can
exploit economies of scale. Economies of scale lead to lower long-run average
costs and therefore give the potential of lower prices. Example:
Would you want several firms providing tap water? Would it make sense to
have 2-3 companies laying a network of water pipes and sewage systems
across the country? No. It is better to have one firm. This is an example of an
industry which is a natural monopoly because of the extensive fixed costs.
Industries like car production and airline production also have significant
economies of scale so it makes sense for firms to have some degree of
market power. There are only two main aeroplane manufacturers in the
world (Boeing and Airbus) but this is because of the huge fixed costs and
economies of scale in manufacturing planes.

2. Research and Development

Firms with monopoly profit can use their profit to invest in new products and
technologies that benefit consumers in the long run. e.g. oil companies who
find new sources of oil. Finding new oil supplies is expensive and risky; it
requires a degree of profit to undertake. Pharmaceutical companies also
have to invest significant sums in developing drugs which can treat disease.
To undertake this long-term investment (with no guarantee of success)
requires high profit.

3. Monopoly firms are efficient/innovative

An argument popular with economists of the Austrian School of economics is

that firms who gain monopoly power are invariably successful, innovative
and efficient. e.g. Google has monopoly power but who can do it any better?
Google gained monopoly power because it has developed an efficient and
innovative search engine. Apple has gained monopoly power through being a
product leader. Products like iPod, iPhone and Macbook – all broke new
technological ground giving them a loyal customer base. The market is still
competitive, but Apple has gained a high share of the market because many
customers think they are the best.

4. International Competition
A domestic monopoly may face international competition, therefore it still
faces incentives to cut costs and be efficient. However, it can also benefit
from economies of scale.

5. Monopolies reduce duplication of infrastructure and services

A town may have two or three bus companies providing a competitive
market. But, this can lead to congestion of buses as there is significant
duplication. A monopoly provider can limit the number of duplicate buses –
especially at off-peak times. This is an example, where the optimal number of
buses on the roads is important.

6. Government regulation enables the best of both worlds

If a monopoly is regulated by the government, then, in theory, we can have
the best of both worlds. We get a firm with significant economies of scale and
avoid duplication, but the regulator can prevent excessive prices.

7. Less output is good for the environment.

A profit maximising monopolist sets higher price and restricts output.
Ironically, this may lead to less production of negative externalities. For
example, a chemical firm with monopoly power will charge above a
competitive price. This monopoly price may actually be closer to the true
marginal social cost and so (without intending to) the firm is closer to social
efficiency.

If
Competitive price is £24, and monopoly price is £30. Then a monopoly is
more socially efficient.
Evaluation of the benefits
These are potential benefits of monopoly. But, it doesn’t mean that the
benefits will necessarily outweigh the costs. Also, the benefits of monopoly
depend on the particular firm and industry. Some industries have more fixed
costs (and therefore more potential economies of scale)
Monopoly power
A pure monopoly is defined as a single supplier. While there only a few cases of pure
monopoly, monopoly ‘power’ is much more widespread, and can exist even when there
is more than one supplier – such in markets with only two firms, called a duopoly, and a
few firms, an oligopoly.

According to the 1998 Competition Act, abuse of dominant power means that a firm can
‘behave independently of competitive pressures’. See Competition Act.

For the purpose of controlling mergers, the UK regulators consider that if two firms
combine to create a market share of 25% or more of a specific market, the merger may
be ‘referred’ to the Competition Commission, and may be prohibited.

Formation of monopolies
Monopolies are formed under certain conditions, including:

1. When a firm has exclusive ownership or use of a scarce resource, such as British
Telecom who owns the telephone cabling running into the majority of UK homes and
businesses.
2. When governments grant a firm monopoly status, such as the Post Office.
3. When firms have patents or copyright giving them exclusive rights to sell a product or
protect their intellectual property, such as Microsoft’s ‘Windows’ brand name and
software contents are protected from unauthorised use.
4. When firms merge to given them a dominant position in a market.

Maintaining monopoly power – barriers

to entry
Monopoly power can be maintained by barriers to entry, including:

Economies of large scale production

If the costs of production fall as the scale of the business increases and output is
produced in greater volume, existing firms will be larger and have a cost advantage over
potential entrants – this deters new entrants.
Predatory pricing
This involves dropping price very low in a ‘demonstration’ of power and to put pressure
on existing or potential rivals.

Limit pricing
Limit pricing is a specific type of predatory pricing which involves a firm setting a price
just below the average cost of new entrants – if new entrants match this price they will
make a loss!

Perpetual ownership of a scarce resource

Firms which are early entrants into a market may ‘tie-up’ the existing scarce resources
making it difficult for new entrants to exploit these resources. This is often the case
with natural monopolies, which own the infrastructure. For example, British
Telecom owns the network of cables, which makes it difficult for new firms to enter the
market.

High set-up costs

If the set-up costs are very high then it is harder for new entrants.

High ‘sunk’ costs

Sunk costs are those which cannot be recovered if the firm goes out of business, such
as advertising costs – the greater the sunk costs the greater the barrier.

Advertising
Heavy expenditure on advertising by existing firms can deter entry as in order to
compete effectively firms will have to try to match the spending of the incumbent firm.

Loyalty schemes and brand loyalty

If consumers are loyal to a brand, such as Sony, new entrants will find it difficult to win
market share.
Exclusive contracts
For example, contracts between specific suppliers and retailers can exclude other
retailers from entering the market.

Vertical integration
For example, if a brewer owns a chain of pubs then it is more difficult for new brewers
to enter the market as there are fewer pubs to sell their beer to.

Evaluation of monopoly
Following Adam Smith, the general view of monopolies is that they tend to seek out
ways to increase their profits at the expense of consumers, and, in so doing, generate
more costs to society than benefits.

The costs of monopoly

Less choice
Clearly, consumers have less choice if supply is controlled by a monopolist – for
example, the Post Office used to be monopoly supplier of letter collection and delivery
services across the UK and consumers had no alternative letter collection and
delivery service.

High prices
Monopolies can exploit their position and charge high prices, because consumers have
no alternative. This is especially problematic if the product is a basic necessity, like
water.

Restricted output
Monopolists can also restrict output onto the market to exploit its dominant position
over a period of time, or to drive up price.

Less consumer surplus

A rise in price or lower output would lead to a loss of consumer surplus. Consumer
surplus is the extra net private benefit derived by consumers when the price they pay is
less than what they would be prepared to pay. Over time monopolist can gain power
over the consumer, which results in an erosion of consumer sovereignty.

Asymmetric information
There is asymmetric information – the monopolist may know more than the consumer
and can exploit this knowledge to its own advantage.

Productive inefficiency
Monopolies may be productively inefficient because there are no direct competitors a
monopolist has no incentive to reduce average costs to a minimum, with the result that
they are likely to be productively inefficient.

Allocative inefficiency
Monopolies may also be allocatively inefficient – it is not necessary for the monopolist
to set price equal to the marginal cost of supply. In competitive markets firms are
forced to ‘take’ their price from the industry itself, but a monopolist can set (make) their
own price. Consumers cannot compare prices for a monopolist as there are no other
close suppliers. This means that price can be set well above marginal cost.

Net welfare loss

Even accounting for the extra profits derived by a monopolist, which can be put back
into the economy when profits are distributed to shareholders, there is a net loss of
welfare to the community. Welfare loss is the loss of community benefit, in terms of
consumer and producer surplus, that occurs when a market is supplied by a monopolist
rather than a large number of competitive firms.
A ‘net welfare loss’ refers any welfare gains less any welfare loses as a result of an
economic transaction or a government intervention. Using ‘welfare analysis’ allows the
economist to evaluate the impact of a monopoly.

Less employment
Monopolists may employ fewer people than in more competitive markets. Employment
is largely determined by output – the more output a firm produces the more labour it
will require. As output is lower for a monopolist it can also be assumed that
employment will also be lower.

The benefits of monopoly

Monopolies can provide certain benefits, including:

Exploit economies of scale

If the firm exploits its monopoly power and grow large it can also exploit economies of
large scale. This means that it can produce at low cost and pass these savings on to
the consumer. However, there would be little incentive to do this and the savings made
might be used to increase profits or raise barriers to entry for future rivals.
Dynamic efficiency
Monopolists can also be dynamically efficient – once protected from competition
monopolies may undertake product or process innovation to derive higher profits, and
in so doing become dynamically efficient. It can be argued that only firms with
monopoly power will be in the position to be able to innovate effectively. Because of
barriers to entry, a monopolist can protect its inventions and innovations from theft or
copying.

Avoidance of duplication of infrastructure

The avoidance of wasteful duplication of scarce resources – if the monopolist is a
‘natural monopoly’ it can be argued that competitive supply would be wasteful. Natural
monopolies include gas, rail and electricity supply. A natural monopoly occurs when all
or most of the available economies of scale have been derived by one firm – this
prevents other firms from entering the market. But having more than one firm will mean
a wasteful duplication of scarce resources.

Revenue
Monopolists can also generate export revenue for a national economy. A single firm
may gain from economies of scale in its own domestic economy and develop a cost
advantage which it can exploit and sell relatively cheaply abroad.

Remedies for monopoly

If a monopolist can gain a foothold in a market it becomes very difficult for new firms to
enter, with the result that the price mechanism is restricted from doing its job.
Resources cannot be allocated to where they are most needed because the monopolist
can erect barriers to other firms. These barriers will not ‘naturally’ come down.

The failure of markets to ‘self regulate’ is at the heart of monopoly as a ‘market failure.
There are a number of ways in which the negative effects of monopoly power can be
reduced:

Regulation of firms who abuse their monopoly power. This could be achieved in a
number of ways, including:

Price controls
Setting price controls. For example, the current UK competition regulator, the Office of
Fair Trading (OFT), has developed a system of price ‘capping’ for the previously state
owned natural monopolies like gas and water. This price capping involves tying prices
to just below the current general inflation rate. The formula, RPI – X, is used, where the
RPI (the Retail Price Index) is the chosen index of inflation and ‘X’ is a level of price
reduction agreed between the regulator and the firm, based on expected efficiency
gains.

Prohibiting mergers
Prohibiting mergers – in the UK the Competition Commission can prohibit mergers
between firms that create a combined market share of 25% or more if it believes that
the merger would be against the ‘public interest’. In making their judgment, the ‘public
interest’ takes into account the effect of the merger on jobs, prices and the level of
competition.

Breaking up the monopoly

Breaking up the monopoly into several smaller firms. For example regulators in the EU
are currently investigating potential abuse of market dominance by Microsoft, which is
under threat of being broken up into two companies – one for its operating systems and
the other for software.

Nationalisation
Bringing the monopoly under public control – which is referred to as
‘nationalisation’. The ultimate remedy for an abusive monopoly is for the State to take a
controlling interest in the firm by acquiring over 50% of its shares, or to take it over
completely. The monopolist can still be run along commercial lines, but be made to
operate as though the market were competitive.

De-regulation
In those cases where a monopolist is already State controlled, such as the Post Office, it
may be necessary to engage in deregulation to enable it to become more efficient.
Deregulation could be used to bring down barriers to entry and open up a previously
state controlled industry to competition, as has happened with the British Telecom and
British Rail monopolies. This may help encourage new entrants into a market.