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.
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.