IO Chapter 5

Monopolies

What is a monopoly? Historically it has been defined based on market share, but a more helpful definition is related to elasticity of demand, which in turn is generally related to the number of substitutes.

In its purest form a monopoly supplies 100% of the market (ex: utilities) Generally these are also natural monopolies.

But more common is the example of a dominant firm, with considerable power, which is one with 50% or more of market share (or in the article "Small is Beautiful" what % of market share is controlled by top four firms.)

We can think then of monopoly power being on a spectrum, with those with 100% of the market generally having considerable monopoly power, while in the case of a market where one firm has less than 100% the situation is more complicated. In fact even with 100% of the market, some firms do not really have much monopoly power, since their power is related to the elasticity of demand. For example although there may only be one hot dog manufacturer in an area, that firm may not be able to raise its price because consumers consider lots of other foods (like bologna, hamburger, etc.) as substitutes). If a firm can raise its price far above their marginal cost, it has considerable market power. As such it is important to examine both market share and elasticity of demand.

Review of the algebra concerning monopolies:

In the case of a pure monopoly, the firm maximizes profits, and setting MR = MC. Generally economic suggests that monopolies reduce Q, which in turn causes P to rise, in their attempts to maximize profits. Where the monopoly sets the price will be a function of the elasticity. The monopoly's manipulation of the market leads to dead weight loss, which is seen as allocatively inefficient.

More common is the case of the dominant firm. Examples of dominant firms historically (dominance may or may not last): Kodak, AT&T. What other examples did we get in the reading we did the first day?

Generally in the case of a dominant firm, the dominant firm sets the price and the other smaller producers follow the price lead of the dominant firm. The smaller producers produce as much as they can and then the dominant firm produces the rest.

The book suggests that in the phone industry this is how AT&T operates.

Another example is OPEC with Saudi Arabia acting as the dominant country in this case.

Since economists consider monopolies allocatively inefficient, and the general public finds monopolies pernicious (or unfair) most countries have legislation which prohibits monopolies, or at least prohibits the exercise of monopoly power. But first the policy makers have to determine whether a firm has market power AND whether they are using that power in a detrimental manner. As we will see in some of the case studies, determining whether monopoly power exists and/or whether it is being exercised to the detriment of consumers is often difficult.

How does one define a monopoly? Basically one needs to look at it's demand elasticity.

But before doing that, also need to define a few more things.

First one has to define a good. How narrowly or widely should goods be defined?

Ex: Macintosh/computer/electronic product (what happens to the elasticity as one broadens the category?)

Second one has to define a market. Sometimes this can be done based on geography. In discussing a service (a haircut) a shop could have considerable monopoly power if it is the only one in a 50 mile radius. On the other hand, a mail order catalog company is unlikely to gain much monopoly power based on geographic distance.

To estimate the elasticity we need to establish what the product is and what the market is (ie who makes up the demand curve).

What possible policies can be used, once one determines that there is a monopoly.

1. control price

2. break up the monopoly thus creating competition

3. other forms of regulation

The choice will depend on the type of monopoly.

First let's look at the case of the natural monopoly.

A quick review: what is a natural monopoly? It is one where there are huge returns to scale. In other words, the fixed costs are very large and as such the average costs decline for a long time. In this case, it doesn't make sense to have two suppliers, because they will not be able to supply the market as cheaply as one producer. So the first thing the government has to do is determine whether a particular firm is a natural monopoly. This has turned out to be trickier than economists thought, and various firms which historically have been defined as natural monopolies (phone, electric) are now being pushed towards competition (although in the first case considerable monopoly power still exists, and in the second case, as we will find, the path to deregulation has been rocky.)

This brings us back to the earlier point, about defining the product. Now electricity is broken down into two components: production and distribution. While production is no longer seen as a monopoly (in part because of technological developments : for instance, historically electricity was produced by dams, nuclear power plants, etc. and these may have been sponsored by the government) the distribution is still seen as a monopoly. So by splitting the definition of the product into two parts, deregulation can occur at the production level (or can it?) and then the monopoly is forced to provide other producers access to the distribution grid (still requires some regulation!) The monopoly portion is known as a 'bottleneck' and the assets of the monopoly are considered an 'essential facility.' In other words, while there is a certain amount of competition possible in the area of electricity, there is still the issue that the industry being based on a monopoly! The problem of regulation then does not disappear, although certain segments of the process may be deregulated. A further problem is whether to let the monopoly compete in the deregulated parts of the product. (ALL of these issues came up in the case of deregulating electricity in California!) This is further complicated by the fact that a certain amount of monopoly power, especially in the form of vertical integration, may be beneficial to consumers, if it means lower prices.

Once the government does determine that it is dealing with a natural monopoly, it then has two choices:

1. set the price at which the firm can sell

2. nationalize the firm (government ownership)

In the US the former choice has generally been followed, although not always. For example in the LA Water and Power are distributed by a government entity. In other countries, particularly in the case of natural resource control, nationalized firms have been established.

Neither of these choices is easy and a couple of issues remain:

1. Where to set the price? (Whether it be the price to consumers or other producers in the case where a market which has a component which is a natural monopoly is deregulated.)

2. How to make sure the firm continues to innovate and try to reduce costs.

Concerning the first problem, although generally economists believe that MC=P this may not work for the natural monopoly. Because of its cost structure it might mean a loss. The book suggests that the government could subsidize the firm, but this causes more distortions.

Two other options are rate-off-return pricing and price cap regulation.

In the first case the price is as closely linked to average cost as possible, thus minimizing possibility of large profits. This though exacerbates the second problem, since any time the firm finds a way reduce costs the price they can charge also declines.

In the second case the price is set at one level, and the firm can thus keep any profits it gains by further reducing costs.

In both causes prices are renegotiated every so often.

Of course this again reduces the incentives to firms, if they know in a few years they will face a lower price if they are able to cut costs.

In the case of nationalization the government still faces the same questions, although it is easier to know exactly what the cost curve looks like and to price accordingly, while the latter problem is not easily resolved. In the US this has to some degree been addressed by making these government owned firms semi-private (Postal service, trains, etc.)

Another complication is that although now we may view electricity, mail, etc. as things the private sector can provide, these are also very important parts of our basic infrastructure. The ability to produce and thus to have a healthy economy is closely linked to the provision of some of these products, which may be another reason why historically these have often been supplied or subsidized by the government.