Some of the earliest examples of government intervention concern the activities of monopolists. In the US the Interstate Commerce Commission (1887) was established to prevent price discrimination and other ‘abuses’ of the railroads, while the Federal Trade Commission (1914) was concerned to police the anti-trust legislation contained in the Sherman and Clayton Acts.
As was seen in Module 1, the development of economic theory in the first half of the twentieth century with its refinement of the notion of economic efficiency provided a powerful theoretical justification for regulation of market structure. Elementary analysis indicates that monopolists will restrict output and set a price in excess of marginal cost. If this price (P) is taken as representing the willingness of consumers to pay for an additional unit of output, and if marginal production costs (MC) represent the compensation required to induce the relevant factors of production to produce an extra unit of output, it is clear that P > MC implies that there are social gains available from expanding output. The availability of unexploited possibilities for exchange is, in terms of conventional welfare economics, ‘Pareto inefficient’. Regulation may therefore be regarded as an attempt to enforce a pricing structure which is efficient.
The argument is summarized in the familiar diagram shown in Figure 3.1. A profit maximizing monopolist with constant costs produces output q1 and sells at price p1. The shaded area bcd is an approximate representation of the efficiency losses associated with monopoly. If output increased from q1 to q2 total costs would rise by the area under the MC curve (q1bdq2). Total extra benefit to consumers, however, can be represented by the area under the demand curve (q1cdq2). Clearly benefits exceed costs by area bcd.
Figure 3.1 Efficiency losses and monopoly
Monopoly also has redistributional consequences. The higher price q1 implies that the monopolist receives a monopoly profit ap1cb. Had price been equal to MC, this profit would have been received by purchasers of the product in the form of ‘consumers' surplus’. Politically it seems likely that the transfer from consumer to producer associated with monopoly may be considered as at least as important as considerations of Pareto efficiency.
In addition to restricting output and charging higher prices, the absence of competing firms may enable monopolists to operate ‘wastefully’, to suppress the disruptive consequences of innovation, and generally to opt for a quiet life. If this is true, costs of production will be higher for a monopolist than for a competitive firm. Consumers lose out but managers and workers in the monopoly will benefit. Suppose, for example, that a competitive industry were able to produce at constant cost MC* in Figure 3.1, then assuming that the lower cost level does not simply reflect lower prices of inputs, there are extra efficiency gains associated with competition of the area adfe accruing to consumers.
Occasionally it is possible to use comparative evidence to indicate the importance of competition to productive efficiency.
Regulation of the trucking industry by the Interstate Commerce Commission in the United States began in 1935 and severely impeded new entry. A series of court decisions, however, exempted the transport of poultry and frozen food and vegetables from regulation in the mid-1950s. It was found that rates were up to 36 per cent lower for these classes of goods than for regulated classes. The fact that intrastate transport was unregulated or more lightly regulated in some states compared with others also enabled comparisons to be made and confirmed the existence of technical inefficiency. Costs in the UK, where freight rates were not regulated, could also be used as a point of comparison.
Source: Moore (1976)
In the case of airlines it was the US industry which in the 1980s was relatively free of economic regulation. Comparisons between European and American airlines have therefore been used to investigate the influence of competition on costs. Cost per seat mile for US airlines in 1983 was 8.7 cents compared with 14.2 cents for European airlines. Most of this difference is attributable to inefficiency permitted by the existence of monopoly restrictions.
Source: Sawers (1987)
If positions of monopoly power give rise to pure profits or ‘rents’, there will exist an incentive to invest resources in attempting to create monopoly. This is called ‘rent-seeking’. Thus, as we have observed already, interest groups will lobby politicians for protection from competition via tariff or other barriers to trade, legal restrictions on entry, unnecessary regulations enforcing quality or other ‘standards’, and so forth. It has even been argued that activities such as advertising are designed to create barriers to the entry of new competition and can be seen as a form of rent-seeking. The resources used for rent-seeking may equal or even exceed the profits derivable from the monopoly position created, and this has led to the idea that the pure profits identified in Figure 3.1 may not represent net benefits to producers but a return to resources invested in creating and policing the monopoly position.
Although the losses incurred by voters and consumers from positions of entrenched monopoly may be substantial, and suggest that a government strategy of encouraging competition and/or regulating monopoly might be popular, we must interpret the theoretical case with care. No government can simply declare its support for competitive markets and wait for the benefits to flow in. Figure 3.1 would mislead if the student were to receive the impression that the issue is a simple ‘policy choice’ between competition or monopoly. If business people attempt to make their lives more comfortable by attempting to suppress competition or by establishing monopoly positions, the government will require instruments to enforce and police its competition policy, and these will be subject to problems of incentives and control. Further, there may be circumstances in which a single producer can achieve cost economies which would not be available to an industry of many competing firms. This ‘natural monopoly’ problem is considered in the next section.
It is usual to think that natural monopoly exists where it would be ‘wasteful’ to employ more than one producer. Conventional examples include the public utilities such as gas, water, and electricity distribution, the services yielded by railway track, and certain aspects of telecommunications (for example the use of cable). In each of these cases large fixed costs must be incurred in establishing networks of pipes, cables, or permanent ways, and average costs to customers are expected to decline over a very large range. Duplication of these facilities by competing firms is unlikely to happen in the cases just cited, but if such an event did occur, the cost of the services would be greater than technically necessary. We have seen already that this view ignores the point that costs are not determined entirely by technological factors. It is at least conceivable that the gains in technical efficiency derived from the existence of competing producers would outweigh losses in economies of scale. However, the possibility that duplicated overhead capital would increase costs to consumers has provided a justification for governments in the past to prevent new entry into industries considered to be natural monopolies.
For many years in the UK there were restrictions on private concerns attempting to compete with public enterprises supplying coal, telecommunications services, certain transport services, electricity, and postal services. In most countries of the world postal services were until recently considered a natural monopoly. Many of these restrictions are now being removed.
A more precise definition of natural monopoly is provided by the concept of sub-additivity. If the costs incurred by a single producer at a given output are lower than the sum of the costs of a set of competing producers whose combined output is the same as that of the single producer, the industry's cost structure is said to be sub-additive. The significance of this rather formal idea is that an industry can be a natural monopoly even if economies of scale have been exhausted and average costs are rising. In Figure 3.2, for example, average costs are lowest at output level q’. If more than q’ is demanded (say q*) it would not follow that another firm should enter and produce the additional output. A new firm operating at low levels of capacity would face higher costs than would the existing firm if it supplied the extra output. Thus, up to a certain point, a single firm can remain a natural monopolist even if average costs are rising. Eventually, however, a point will be reached where it will be less costly for two firms to share the market than for a single firm to produce the entire output.
Figure 3.2 Natural monopoly with diminishing returns
