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Monopoly and Regulation: Excerpt from Two Lessons book

December 17th, 2016

Here’s another excerpt from my book-in-progress, Economics in Two Lessons. Rather than work sequentially, I’m jumping between:

Lesson 1: Market prices reflect and determine opportunity costs faced by consumers and producers.
and
Lesson 2: Market prices don’t reflect all the opportunity costs we face as a society.

In the section over the fold, I’m looking at monopoly and regulation. Next up, public ownership.

As usual, praise is welcome, useful criticism even more so. You can find a draft of the opening sections here.

A crucial requirement of Lesson 1 is that prices are determined in competitive markets. But free markets are not necessarily competitive. If the technology of production involves economies of scale, as is the case for most kinds of manufacturing and many services, large firms will have lower average costs than small ones.

Over time, therefore, the number of firms will shrink through exits or mergers, until economies of scale are exhausted. In the limiting, but not unrealistic, case of natural monopoly, unrestrained competition will lead to the emergence of a single dominant firm.

Once a firm attains a dominant position, it can hold that position for a long time, even after any initial advantages have disappeared. Suppliers and dealers can be locked into long term contracts. If vital parts are produced to a standard design, patents over those parts can be used to exclude competitors. As an example, the AT&T Bell monopoly in the United States required that only phones made by its subsidiary, Western Electric, could be connected to its network. This and other restrictions excluded all competition for decades.

In a natural monopoly industry, production by a single firm is technically efficient. But the price that maximises profits will be higher than the opportunity cost of production. Some of the potential benefits of technical efficiency will be lost, while the bulk of what remains will go to the monopolist rather than to consumers [in a very simple model of monopoly pricing, the monopolist gets half of the potential benefits from the supply of the good, consumers get a quarter and the remaining quarter is lost because of the divergence between price and opportunity cost]

The situation is even worse where monopoly is maintained through costly devices used to exclude competitors. Not only will prices be higher than opportunity costs, they will exceed the competitive market price. Even the monopolist will dissipate much of its profit in its efforts to exclude competitors (Tullock).

These problems first emerged on a large scale in the late 19th century, as the growth of rail networks made it possible, and profitable, for firms to operate on a national scale. The railways themselves were one of the most important industries in which the benefits of scale economies, along with the appeal of potential monopoly profits, led to an rash of mergers.

These mergers were often undertaken using a legal device known as a ‘trust’, and the term came to be applied to monopolies and cartels in general. The most famous trust was John D Rockefeller’s Standard Oil company, which secured a near-monopoly (88 per cent in 1890 https://en.wikipedia.org/wiki/Standard_Oil) over the refined oil market. One of Standard Oil’s main advantages was the capacity to secure lower prices from railway companies in return for higher volumes.

The initial response, commonly referred to as ‘trustbusting’ involved breaking up large corporations into separate firms that were expected to compete against one another. Standard Oil was broken into 34 firms, the most successful of which were the Standard Oil Company of New York (later Mobil) and Standard Oil of New Jersey (later Exxon). Under the influence of the Chicago school of economics, trustbusting policies were gradually abandoned in the late 20th century. The last big corporate breakup was that of the former AT&T telephone monopoly in the 1970s. The shifting in thinking was symbolised by the 1999 merger of Exxon and Mobil to produce one of the largest corporations in the world, comparable in many ways to Standard Oil.

The logic of opportunity cost applies here, as usual. Breaking up monopolies reduces the extent of monopoly power, at the cost of forgoing opportunities for improved scale economies arising from mergers.

For much of the 20th century, the loss of scale economies was seen as an acceptable price to pay to keep monopoly in check. However, with the resurgence of free market ideas from the 1970s onwards, support for antitrust policies waned. The last big example of trustbusting was the breakup of the AT&T telephone monopoly, which took place in 1982 after nearly a decade of litigation.

As trustbusting has declined, attention has turned to various forms of regulation. The core idea of regulation is to fix the prices charged by monopolies at levels that reflect the opportunity cost of resources used in production, but not to allow the extraction of monopoly profits. In practice this balance has proved hard to achieve. The common result has been that regulated monopolies have been highly profitable.

One illustration of this is the fact that the ‘asset base’ of a regulated monopoly is typically valued at around 40 per cent more than the cost of its provision, as estimated by the regulator. This asset base premium reflects the fact that the regulated price is more than the opportunity cost of the resources used in production.

Regulation constrains the exploitation of monopoly power but it entails compliance and enforcement costs and may prevent firms and consumers from reaching bargains that are mutually beneficial. Where a natural monopoly business involves large scale investment, it may prove difficult to set a price that accurately reflects opportunity costs, while providing incentives for efficient investment.

The crucial trade-offs involve the distribution of income and property rights. To encourage appropriate levels of investment, it is desirable to offer high rates of return. However, this implies that monopoly profits will be enhanced at the expense of the community as a whole. One solution, discussed in the next section, is public ownership.

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  1. john
    December 17th, 2016 at 14:32 | #1

    I worked in the fertilizer and petroleum industry for a few years.
    Now you mention monopoly situations and in fact in those years there was only one base supplier of the product.
    I witnessed one stack of base product that progressively got dearer each year to the end buyer.
    It had been purchased but they managed to raise the retail price every year why?
    Because no one knew the situation, there was no transparency rather like petroleum all coming from the same place and in most areas there is about 1 to 2 months supply however as soon as the price of a barrel of crude goes up the retail price raises immediately even though in fact the fuel being pumped is in fact 3 months old from the purchase of that barrel of oil.
    What you pay is not transparent to the real cost inputs to the supplier.
    Actually Petroleum is the greatest joke of all products the mug buyer has been and is being ripped off every day with this laughable excuse of the price cycle, in fact it cycles with peak demand has zero to do with competition.

  2. john
    December 17th, 2016 at 15:55 | #2

    John has my previous post been posted?
    I would really like to talk to you over the coming weeks will be down your way then, will check with a person who did and still is at Griffith.

  3. hc
    December 17th, 2016 at 16:05 | #3

    “One illustration of this is the fact that the ‘asset base’ of a regulated monopoly is typically valued at around 40 per cent more than the cost of its provision, as estimated by the regulator. This asset base premium reflects the fact that the regulated price is more than the opportunity cost of the resources used in production.”

    Cryptic and undocumented.

  4. John Quiggin
    December 17th, 2016 at 16:09 | #4

    @hc

    “Cryptic and undocumented.”

    I’ll work on explaining it a bit better. As for “undocumented” I haven’t included a hyperlink, because this is a book draft, but I will have a reference in the paper. Here’s an example

    http://www.echo.net.au/2016/10/ausgrid-sale-great-everyone-except-consumers/

  5. hc
    December 17th, 2016 at 18:15 | #5

    Thanks. What happens if the regulator forces the utility to price at average cost? The price will still be too high. But you need to make the form of regulation something that is chosen. The cost estimated by the regulator is irrelevant – what matters are the actual costs.

  6. James Wimberley
    December 18th, 2016 at 05:09 | #6

    The dichotomy between monopoly (from economies of scale) and competition (from diseconomies of scale) is unrealistic. The typical case we observe is a fairly stable coexistence of a few large firms with a large number of smaller ones, distributed on some sort of power law (software, retail). In a few cases like telecoms, steel, airlines and cement, the minimum economic size of operation means that only large firms have a chance, and you get textbook oligopoly or monopoly; in others (plumbers) there are no economies of scale and some diseconomies, so it stays competitive. Two plumbers have to hire a secretary to coordinate.

    I suggest that the reason for this is that the boundary case of constant returns to scale is actually very common. It’s the standard case in light manufacturing (textiles, pv panels, etc. etc.) These are made on standard machines, like looms from Sulzer. A factory can have 1 or 1000, the basic cost of production will be very similar. The same holds for lawyers. Under strict constant returns to scale, the degree of concentration is indeterminate. In real life, other factors come into play, creating rather weak economies of scale or networking: marketing, product design, bargaining power with workers and suppliers, political influence, and so on. Because there are diseconomies too – loss of human relations with customers, overhead coordination costs, higher risks of internal freeloaders and looters – we get the both-sorts result. Does this modify John’s conclusions? Not much. But (a)realism makes the case stronger, (b) the costs of a pro-competition policy may not be large.

    The German Mittelstand is a good example here. It is made up of middle-sized patriarchal manufacturers, often based in small and cosy South German towns. The boss is still the boss, but you can find him at the Stammtisch in the pub on Friday night. German government policy supports the Mittelstand through its funding for innovation in the €2.1 bn-a-year Fraunhofer network, the NIH of technology. A large slice is funded by contracts with industry associations. The work is IIRC made freely or cheaply available to German manufacturers. This allows small German firms to compete in innovation with larger foreign ones. They may well be other policies favouring the Mittelstand, I don’t know.

    I may have said this before, but microprocessors are an example of benevolent monopoly: Intel’s in larger ones, ARM’s in smaller. Overall it’s a partial duopoly. The case is stronger for ARM, a pure design shop that licenses processor designs. The fees are low, pennies per chip – to discourage rivals from entering. The licensing policy is non-discriminatory. The same fear of entry, plus rivalry with Intel, keeps ARM relentlessly innovating. The network gains to the electronics industry from standardisation and innovation are large, and outweigh ARM’s monopoly profits. So most of Africa now has cheap mobile telephones, and your dishwasher may already have the computing power of ENIAC. It would not be good idea to rock this particular boat. (I don’t have any stake in the company.)

  7. Greg McKenzie
    December 19th, 2016 at 06:21 | #7

    You need to carefully define opportunity cost! The standard definition is “the loss of other alternatives when one alternative is chosen”. This is then a non-money cost. But does that mean it also includes social costs?

  8. Smith
    December 19th, 2016 at 11:29 | #8

    Essentially no technological progress in haircuts (p35). Not literally true. Electric trimmers, blow dryers and other technologies have sped up haircuts and improved quality. This is especially true for complex haircuts that (mostly) women get.

  9. Smith
    December 19th, 2016 at 11:47 | #9

    Law school graduates, p49.

    “The entering class of 2010-11 … is now joining the depressed job market”.

    This might have been true when you first wrote it, but that class finished law school in June 2013.

  10. derrida derider
    December 20th, 2016 at 11:45 | #10

    @Smith
    You could just rephrase it as “very slow progress” rather than “essentially no progress” – the point is that you can talk to someone on the other side of the world at trivial cost compared with previous centuries, but it is still non-trivial to cut their hair for them. Failing that, there are a myriad of other examples to make the point – eg a school teacher can still only teach 30 or 40 kids at a time, playing a Mozart string quartet costs the same in human effort as when Mozart wrote it (the example Baumol actually used IIRC).

  11. Smith
    December 20th, 2016 at 14:18 | #11

    @derrida derider

    Actually Baumol and Bowen actually used the example of a string quartet playing Beethoven. 🙂
    More substantively, while there is no measured productivity improvement in playing classic music, there is in quality-adjusted terms, because instruments are arguably better and acoustics are certainly better. And classical music can now be reproduced at streamed at zero cost, which is a recent and welcome development, entirely due to digital technology.

  12. Ikonoclast
    December 21st, 2016 at 05:53 | #12

    I have just been scanning the “Australian Infrastructure Audit Executive Summary”. This document has some really absurd howlers in it. Try these for size.

    “Market reforms have significantly improved the efficiency and competitiveness of the energy sector and more recently the telecommunications sector.” – Audit.

    Are they serious? “Nationally, prices are up 120 per cent over 10 years.” – Sydney Tele.

    Australia’s internet position globally has slipped from 30th to 60th in the last year or so.

    “The claim: “[The Coalition] have had almost three years on this… Over that time we have gone from 30th in the world for internet speeds to 60th in the world for internet speeds,” Opposition communications spokesman Jason Clare told ABC’s RN Breakfast on June 13, 2016.

    Has Australia’s global rank for internet speeds fallen from 30th to 60th under the Coalition? ABC Fact Check investigates. The verdict: Mr Clare is correct.” – ABC

    “The National Electricity Market is working well, providing a competitive market which provides
    for the long-term needs of consumers in an efficient and properly regulated manner.” – Audit.

    Again, are they serious? This is the most absurd howler I have read for a long time.

    With this ideological drivel continuing to promote privatisation and competition in natural monopoly, public interest, arenas we have no hope.

    My internet has been down or degraded for 2 weeks now. No service for days and then some service at about 25% down to 2.5% of normal speeds. Despite repeated calls, my retail provider blames the data wholesaler and the data wholesaler claims “no problems at our end”. I am on the edge of Brisbane, not out in the boondocks.

    Brisbane’s train service… how bad is that at the moment? Brisbane’s power? Suburbs knocked out by every storm, every time.

    Bottom line, our infrastructure is decaying. We are heading for a lot of trouble as we grow rapidly (immigration mainly) yet our infrastructure goes backward.

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