Element 3.2: Regulate Monopolies

“Monopoly, besides, is a great enemy to good management, which can never be universally established, but in consequence of that [unless there is] free and universal competition which forces everybody to have recourse to it for the sake of self-defense.” ⁽⁷⁸⁾

If a society is going to get the most out of its resources, these resources must be used efficiently. Competition is central to this efficient use. As previously discussed, competition provides businesses with strong incentives to cater to the views of consumers and produce goods and services economically. If businesses do not provide consumers with value for the price they pay, customers will spend their money elsewhere.

A monopoly exists when there is only a single producer of a good or service for which there are no good substitutes. When this is the case, the producer has an incentive to restrict output and raise the price. By producing a smaller quantity and charging a higher price, the firm may be able to earn more profit than it would if resources were being used more productively by producing a larger quantity at a lower price. Inefficiency will result because the monopolist is failing to produce some products that customers value more than their cost of production.

There are two major sources of monopoly: economies of scale and grants of political favoritism. Economies of scale occur when large firms have lower per-unit costs than their smaller rivals. If economies of scale persist as a firm obtains a larger and larger share of the market, a single firm will dominate and become a monopoly. The production of electricity provides an example. As power plants for electricity generation become larger, the per-unit cost of generating electricity generally declines. As a result, there is a tendency for a single, large firm to dominate the market. This is why the government usually regulates the prices charged by electric power companies and, in some cases, owns and operates the power plants.

Even where monopolies do not develop, some industries may have only a few dominant firms, usually because the market is costly to enter. A firm may need to produce a large share of the industry output—for example 20 or 25 percent—to achieve a low per-unit cost and compete effectively. When this is the case, there may be room for only four or five firms, all of which experience low per-unit costs. Such markets tend to be dominated by a small number of firms, which have an incentive to collude, raise prices, and act as a monopolist would. Manufacturing industries, such as those making automobiles, television sets, and computer operating systems, are examples of markets dominated by a relatively small number of firms. Such industries are known by the technical term oligopoly. Analysis of oligopolies is a fascinating, but complex, field of study because there is no unique outcome. The best action by one player depends on that of the other player(s). The field of mathematics known as game theory that studies such markets was invented by economists John Nash, Osker Morgenstern and John von Neuman in the 1950s and is widely used in many fields today.⁽⁷⁹⁾

But the government itself is sometimes the source of monopoly. Licensing, taxes that favor one group over another, tariffs, quotas, and other grants of privilege reduce the competitiveness of markets. While some of these policies may be well-intentioned, they protect existing firms at the expense of potential rivals, thereby encouraging monopolies and dominant firms. Government-created monopolies were prevalent in almost every sector in the Soviet Union. For example, the State Committee for Construction (Gosstroy) had exclusive control over the construction sector, effectively creating a monopoly on construction projects and materials. Private construction companies were prohibited, and all construction activities, including building new infrastructure and housing, were overseen and managed by Gosstroy. This monopoly stifled competition, innovation, and efficiency in the construction industry, leading to corruption and subpar quality in many projects.

What can the government do to ensure that markets are competitive? The first guideline might be borrowed from the medical profession, “Do no harm.” The government should refrain from intervening in markets and making things worse through licensing requirements, discriminatory taxes, and other forms of political favoritism. In the vast majority of competitive markets, sellers find it difficult or impossible to limit the entry of rival firms (including rival producers from other countries). This means that suppliers cannot limit competition unless government imposes policies to restrict entry or creates rules and regulations that favor some firms.

To promote competition, governments can also prohibit anticompetitive actions such as collusion, the merger of dominant firms in an industry, and interlocking ownership of firms. In this regard, the European Union competition law promotes competition within the European single market by making it illegal for firms to collude or attempt to monopolize a market. For example, in 2019, the European Commission blocked the merger of Siemens, a German multinational conglomerate, and Alstom, a French multinational company specializing in transport. The Commission argued that the merger would have created a dominant player in the European market for railway signaling systems and high-speed trains, leading to reduced competition and potentially higher prices for customers. Despite efforts by the companies to address competition concerns, such as offering to divest certain assets, the Commission ultimately concluded that the merger would harm competition and innovation in the rail sector, and therefore blocked the deal.⁽⁸⁰⁾

As always in economics, however, things are not quite so simple. US President Harry S. Truman asked his advisers to please find him a “one-handed economist,” so tired was he of economists always saying, “but on the other hand.” Sometimes governments create monopolies that are in the public interest. Patents are an obvious example. Imagine a new medicine that can cure a deadly disease. Such a drug might cost hundreds of millions of Euros to develop and test before it can be used but only pennies a pill to produce. Without protection of the intellectual property of the inventor, competitors who had not invested anything in the development cost would gladly sell the pill for only what it cost to produce. If this occurred, who would ever have the incentive to develop the drug in the first place?

Another complex question is what, exactly, is an industry or a product. As we have seen, goods may be more or less capable of being used as substitutes. The US Supreme Court was once asked to decide whether aluminum foil and plastic wrap were close enough substitutes that the maker of foil did not have a monopoly because consumers could always use plastic wrap instead. This may seem a rather trivial question, but it was actually an important policy issue.

The record of government has been mixed. On the one hand, government policies have made many innovations possible by reducing the incidence of collusion and various practices that limit competition. On the other hand, occupational licensing, regulatory burdens on small businesses, and other laws have had almost the opposite effect. They restrict entry into markets, protect existing producers from rivals, and limit price competition. Thus, while high entry barriers and the absence of competition provide the potential for government to improve market performance, some policies actually grant monopoly powers. As we proceed, the underlying reasons for this anticompetitive policy behavior by governments become more visible.