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Monopoloy Regulation for Social Welfare

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Published: 8th Feb 2020 in Economics

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Competition is an essential attribute in the market, with varying degrees of competition leading to different market structures and outcomes. Monopolies mark one extreme of market structures, existing ‘when a specific individual or enterprise has significant control over a particular product to determine significantly the terms on which other individuals should have access to it’ (Friedman 1962, p. 120). Despite this generalised statement, there is no clear-cut definition of what comprises a monopoly, with various types and degrees, some more socially desirable than others. Depending on the extent of monopoly, the market structure can pose problems to markets through barriers to potential competitors. In theoretical economic terms, this allows monopolies to extract consumer surplus and social welfare through imposing inefficiencies, leading to social disadvantages for consumers. However, theory can be misleading and certain monopolies can provide advantages to markets by contributing to social welfare. To capture these advantages, it is argued that different types of monopoly should be complemented by appropriate government regulation to ensure they do not abuse their market power. However, this is dependent on the characteristics of the monopoly and type of regulation, as shown in the case of natural monopolies. Therefore, depending on the degree of monopoly, appropriate regulation can help realise monopolies potential to contribute to social welfare and minimise the problems they present.

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To determine whether monopolies pose a problem to the market, it is vital to understand the wide range of definitions and types underlying the market structure. According to Friedman (1962, p. 121), it is ‘difficult to cite a satisfactory measure of the extent of monopoly and competition, as these concepts as used in economy theory are ideal constructs to analyse particular problems rather than describe existing situations’, leading to various definitions of monopolistic markets. If there are no close substitutes for a product and only one seller in the market, then the market structure is that of a ‘pure monopoly’. In reality, it is difficult to find a market in which similar products do not exist, with The Fair Trading Act (1973, in OECD 2002, p. 20) stating a ‘scale’ monopolistic market is where a firm does not face any significant competitive forces and possesses at least 25 per cent of the market. The characteristics of a monopolistic market also depend on how it sourced market power. Friedman (1962, p. 129) believes that direct and indirect government assistance is the most important source of monopoly through its affect on the entry of potential competitors. To ensure consistent production and delivery, markets such as public utilities that are essential and cannot tolerate disruptions from free market forces are often directly granted government regulations, creating natural monopolies (Amadeo 2018). Private monopolies are also constantly, often through vertical integration to control the entire supply chain or buying up competitors to achieve horizontal integration (Amadeo 2018). A common factor behind these monopolies is the use of barriers to the market, creating problems by limiting competition.

A monopoly gains market power through barriers that prevent potential competitors, directly opposed to social welfare and competitive forces. Monopolies benefit from these practices as they enable pricing power, a practice traditionally incompatible with welfare gain and competitive forces (McKenzie 2012, p. 386). Through existence in various distinct forms, these barriers are fundamental for an existing monopolistic firm to maintain market power (Habtay & Holemen 2010, p. 10). Economies of scale exist when a firm experiences decreasing average costs of production for higher levels of output, meaning there is an incentive to produce at increased volumes (Stiglitz 2015, p. 193). If economies of scale and high initial fixed costs are present, larger firms are likely to have gained experience to reduce costs, preventing small inefficient firms from gaining market shares. Network externalities are present when a products value and utility increases due to an increasingly large network of consumers, reflecting relevant network effects and trends (Lambertini & Orsini 2003, p. 99). In a way, this is a source of economies of scale, as a firm is able to produce at a larger scale if it is able to ‘own the standard’ of a product (Stiglitz 2015, p. 182). For example, with the initial dominance of Microsoft Windows, a large percentage of software developers wrote in Windows format and gave Microsoft a near monopoly (Stiglitz 2015, p. 182).

Licenses represent a legal barrier to competitors, granted by government to allow limited firms the right of production under appropriate government supervisions. In certain circumstances, firms give money to politicians to maintain regulations that restrict competition to maintain high profits and market power, representing a waste of real resources to win favourable rules rather than contribute to production (Stiglitz 2015, p. 215). However, licenses can also be granted in the circumstance where industries cannot accommodate multiple firms, referred to as a natural monopoly and evident with public utilities industries (Stiglitz 2015, p. 183). According to Sherer (1980, p. 1), a natural monopoly exists because substantial economies of scale imply that entry is unprofitable, making it efficient for a single firm. Such a situation appears in an industry where long-term cost is subject to a wide range of production levels, in which case there may be a single supplier that can fully exploit all the internal economies of scale, as well as achieve productive efficiency (Stiglitz 2015,p. 193). Amadeo (2018) states that natural monopolies are often necessary, as they ensure consistent delivery of a product or service with a high-up front cost. Major utilities such as gas, water or electricity are examples of industries with strong natural monopoly tendencies, as there are huge costs required to build these networks, as well as their maintenance (Sherer 1980, p. 1). Although natural monopolies maintain a degree of pricing power to make feasible profits, they continue to be regulated by government authorities to protect consumer interests (Amadeo 2018). These barriers allow monopolies to use their market power to impose inefficiencies on markets, leading to economic and social disadvantages.

The Hilmer Report on National Competition Policy (1993, p. 3) states that ‘efficiency is a fundamental objective of competition policy because of the role it plays in enhancing community welfare’. Although economic efficiency is evident in competitive markets where firms need to be efficient to survive, monopolies are considered inefficient. Allocative efficiency, the situation where resources are allocated to their highest valued uses, increases under competition, as firms set prices equal to marginal cost in order to stay in the market (Hilmer, Rayner & Taprell 1993, p. 4). In contrast, it is unlikely a monopoly is allocatively efficient due to restricting production from the competitive level to collect unearned profits, or ‘rents’, extracted from consumer surplus to impose a deadweight loss (McKenzie 2012, p. 385). The Hilmer Report (1993, p. 4) states productive efficiency occurs where production factors are used at the lowest cost per unit, so costs are minimized. With a lack of competitive forces, monopolies have less incentive to use available technology and keep costs to a minimum, raising the long run average cost curve (LRAC) above what is technically possible. In addition, monopolies present problems through limiting dynamic efficiency and innovation, which are apparent under competitive forces.

According to the Hilmer Report (2017, p. 4), increased competition acts as an incentive for firms to ‘undertake research and development, effect innovation in product design, reform management structures and strategies and create new products and production processes’. Dynamic efficiency emphasizes the need to respond to changes in consumer preferences and market opportunities, existing in competitive markets as competitive forces encourage research and development, product innovation and improved production processes (Hilmer, Rayner & Taprell 1994, p. 4). However, in a monopoly, Freidman (1962, p. 120) raises the issue of ‘limitation on voluntary exchange through a reduction in the alternatives available to the individual’. In the absence of competition, monopolies produce inferior goods in terms of quality, quantity and pricing, as they know they will be able to sell them. Therefore, monopolies lose any incentive to develop ‘new and improved products’ (Amadeo 2018). This is illustrated by a study by the National Bureau of Economic Research (2017, in Amadeo 2018), concluding that United States businesses have invested less than predicted since the beginning of the 21st century due to decreased competitive forces. Not only do monopolistic markets have less innovation, but also certain monopolistic powers actively seek to suppress rival innovations that threaten their market dominance (Stiglitz 2015, p. 212). Therefore, the main effects of monopoly are to ‘misallocate resources, reduce aggregate welfare, and to redistribute income in favour of monopolists’ (Harberger 1954, p. 77). However, underlying monopoly theory can be misleading as certain monopolies can present advantages to the market.

Economically and theoretically, perfect competition is generally considered as more desirable than monopoly. However, underlying monopoly theory can be misleading considering certain monopolies may be competitive and efficient, bringing advantages to the market. Contradictory to theory, monopolies can prove to be more innovative, competitive and welfare contributing than the economic model of perfect competition. McKenzie (2012, p. 390) states that if the model of perfect competition existed it would experience static markets, but its existence is unlikely with no incentives to develop perfectly competitive markets initially. This innovation is a driving force behind monopolies ability to make supernormal profits, which can be used for costly capital investment and research for long-term development of improved products and lower prices (McKenzie 2012, source). Legal barriers, such as patents for intellectual copyright, are tolerable as they encourage monopolies to undertake research and product development, allowing firms to earn back their investment. Therefore, contradictory to the inefficiency of the pure monopoly model, in reality innovative monopolies can be considered to be dynamically efficient due to the benefits of research and development (McKenzie 2012, p. 387).

Peter Thiel, the co-founder of PayPal, promotes the benefits of a creative monopoly that is ‘so good at what it does that no other firm can offer a close substitute’, providing consumers with more choices ‘by adding entirely new categories of abundance to the world’ (Amadeo 2018). Schumpeter (in McKenzie 2012, p. 390) reiterates this point, stating that ‘the fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production or transportation, and the new markets, the new forms of industrial organization that capitalist enterprises create”. Under the threat of potential competitors, monopolies are forced to become internationally competitive, rather than just domestically competitive.

The opportunity for supernormal rents in free markets ultimately encourages potential competitive forces to enter the monopolistic market, forcing a monopoly to increase efficiency. As William Baumol (1982, p. 4) argues, the threat of competition means a monopoly may be forced to make similar production decisions as what would occur under a competitive market structure. Although economies of scale may act as a barrier to limit potential competition, the phenomenon may also result in a monopolistic market becoming more productively efficient than a competitive market structure. Decreased prices from increased production levels may be passed onto consumers through a lowering of prices, vital for industries with natural monopolies characterised by high initial fixed costs (Stiglitz 2015, p. 195). Domestic firms may hold significant monopoly market power domestically, but still face international competitive forces. With markets increasingly integrated and globalised, Kerr and Gaisford (2001) highlight the need for a firm to have a domestic monopoly in order to be competitive in the global economy. Therefore, despite criticism of certain dominant firms, Monopolies can provide benefits including, but not limited to, innovation, research and development, economic efficiency and international competiveness. If complimented by appropriate government policy, these advantages of monopolies can be realized.

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With a ‘social responsibility’ and appropriate government regulation, monopolies can contribute to social welfare rather than reduce it. Friedman (1962, p. 120) claimed that since a ‘monopolist is visible and has power; easy to argue that should use power to further own interests and socially desirable ends’. This responsibility does not affect competitive markets, as ‘the participant in a competitive market has no power to alter terms of exchange’ (Friedman 1962, p. 120). Therefore, monopolies have a ‘social responsibility’ to participate in charitable activities that go beyond serving stakeholder and member interests. Concerning government regulation, Friedman (1962, p. 132) argues that the most pressing issue is the ‘elimination of those measures which directly support monopolies’, which can be achieved through anti-trust laws and extensive tax reform. The main contribution of antitrust laws in inhibiting private collusion has been through indirect efforts rather than actual prosecutions, such as making collusive practices more costly by eliminating multiple collusive devices (Friedman 1962, p. 131). Another possibility for regulation of monopolies is a government regulator that prevents excessive use of market power and dominance. As mentioned earlier, natural monopolies can occur for public utilities such as water and gas (Stiglitz 2015, p. 183). The regulator can ensure the monopoly does not excessively raise prices and meets market standards. An example of monopoly regulation concerns Microsoft, which used market dominance in the operating systems market to intimidate the supplier Intel and forced computer suppliers to withhold advanced technology (Amadeo 2018). The US District Court ruled Microsoft as an illegal monopoly in 1998, ordering the company to share information and allow competitors to use Windows to develop innovative and technological products, encouraging innovation and development in markets (Amadeo 2018). Therefore, appropriate government regulation and social responsibilities can ensure monopolies do not abuse their market power, but this is dependent on the particular monopoly and regulation.

Although natural monopolies ensure consistent production of vital products, they can present a problem for government regulation. According to Sherer (1980, p. 2), allowing a natural monopoly to independently set the monopoly price results in Pareto inefficiency, but on the other hand forcing the monopoly to sell at the allocative efficient price, equal to marginal cost, results in negative profits for the monopolist. One solution to overcome this dilemma is for the government to subsidise losses to ensure the natural monopoly remains in operation, but taxes raised to finance this subsidy imposes other economic costs (Sherer 1980, p. 2). In addition, managers and workers of natural monopolies often have an incentive to manipulate wages and other production costs to obtain a larger government subsidy (Stiglitz 2015, p. 222). To overcome concerns of privately owned natural monopolies, the government can overtake operation, historically the case in Australia with monopolies such as Australia Post. However, governments are often inefficient producers with a lack of incentives to decrease production costs and influences from political business cycles (Stiglitz 2015, p. 223). Another option is to allow private natural monopolies to operate, but under regulation to keep prices low whilst maintaining adequate monopolist profits. However, criticisms to this approach claim that regulations cause cross-subsidies, decreased innovation and inefficiencies. In addition, a major criticism focuses on the theory of regulatory capture, with regulators often losing focus on the public interest due to corruption, bribery and personal relationships (Stiglitz 2015, p. 226).

Although there are complications with the regulation of natural monopolies, appropriate regulation is needed to overcome problems of market failure and dynamic inefficiency. Regulatory practices are often theoretically underpinned by the market failure argument, describing a situation ‘under which a market economy fails to allocate resources efficiently’ (Kim & Horn 1980, p. 3). According to Yarrow (1994, p. 39), the most critical market failure issues occur in industries with characteristics of natural monopolies including high capital intensity, high-entry barriers, and the need for significant investments in sunk capital. Regulation of natural monopolies is also beneficial for dynamic efficiency and ‘moral considerations’. Particularly for developing nations, dynamic efficiency objectives such as economic growth are of higher significance than static efficiency (Kim & Horn 1980, p. 2). According to Bradburd (1992, p. 28), the most significant consideration underlying dynamic efficiency is whether an unregulated private monopoly will make necessary investments for a sufficient service quality fitting for a particular nation’s changing needs. Natural monopolies and the essential services they provide are an important and vital part of a country’s infrastructure and development, and if they are sub-optimally provided, growth will be negatively affected. Therefore, although they present difficulties with appropriate regulation, natural monopolies are an essential component of the market and require appropriate regulation to contribute vital services.

There are various definitions of monopolies, leading to different types and degrees of monopolistic markets, some more welfare enhancing than others. Despite misunderstandings and no clear-cut definition of what comprises a monopoly, various monopolies pose a problem to the market. Barriers to entry, such as economies of scale, network externalities and licenses, allow a monopoly to gain and abuse market power to limit potential competitors. These allow a monopoly to create allocative, productive and dynamic inefficiencies in markets, extracting from consumer surpluses to create a loss of social welfare. Barriers also allow monopolies to limit innovation and produce inferior and limited goods in the absence of competition, creating disadvantages for the consumer. Due to these disadvantages, Friedman argues the highly visible and powerful monopoly has a ‘social responsibility’ that can allow monopolistic firms to contribute to society. This is complemented by appropriate government regulation ensuring monopolies do not abuse their market power. However, the success of government regulation is dependent on the characteristics of a monopoly, as well as whether the regulation is appropriate. As with the case of natural monopolies, appropriate government regulation is required to provide benefits of dynamic efficiency and overcome problems of market failure. With the support of appropriate government policy and ‘social responsibility’, the problems posed by monopolies can be overcome to ensure they contribute to social welfare.


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