Market Failure 3: Imperfect Competition (This game of Monopoly plays you!)

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.

Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations

To understand what makes monopolies inefficient, we should begin by looking at Perfect Competition, the competitive structure assumed by the First Welfare Theorem.

Perfect Competition is a situation where there are a very large number of buyers and sellers, and no barriers to sellers (or for that matter buyers) entering and exiting the market freely. This has several important implications:

1. There is a minimum price at which a good will be produced. If the price for a good is below the cost of producing it, then no one will produce it. If the price is below what all but a small number of producers can produce it for, quantity supplied is small. Bear in mind that cost refers not just to accounting costs, like wages, interest, and input costs, but to all the resource costs of producing the good, including costs of capital. The owners of the company must make enough money to justify their investment (considering risks and the alternative options for using the money). Economists call this minimum acceptable profit “normal profit” (because we’re nothing if not optimistic). If businesses are not making enough money to satisfy their investors (subnormal profit), capital will siphon out of the industry, lowering supply and thereby raising prices until profitability is restored (or every producer exits the market causing it to collapse). Conversely if prices are above the minimum (supernormal profit), new firms will enter the market, pushing prices back down until profits return to normal.
2. Since the price is as low as feasible, the maximum sustainable number of consumers will be able to buy the product. This maximises the number of mutually-beneficial transactions, thereby maximising the total benefit generated from the resources used in the market.
3. The market contains no scope for bargaining. Everyone is offering things for the minimum price they can to justify the effort. That means firms can’t raise or lower prices, and neither can workers. The only choice everyone has is what quantity they offer into the market. Note that this doesn’t mean that everyone gets paid subsistence wages, merely that workers get paid what it takes to convince someone to work one more hour at that job. The pressures of supply and demand will bring the wage rate to the amount of value the employer can gain from hiring a worker for one more hour (the Marginal Product of Labour).

So now we know how this is supposed to work, how does the real world differ from the ideal?

The best-known example of Imperfect Competition is a monopoly, a situation where only one producer exists. The textbook monopoly exists because of barriers to entry – an advantage the incumbent firm has that would-be competitors do not. This could be anything from legal protections against competition (such as import quotas or a state-granted monopoly) to subtle strategic moves by the producer (such as setting up their production processes so they can ramp up production quickly to respond to new entrants). Not all monopolies are formed from barriers to entry, but barriers to entry are essential to understanding how monopolies differ from perfect competition.

A monopolist need not worry about new firms entering the market to increase supply (or existing firms expanding), so they have far more control over prices than a perfectly competing firm does. A monopolist’s control is not absolute – they can’t control how much consumers will buy at a given price point, but they can push the market to whichever combination of price and quantity demanded maximises their profit. Barring some weird exceptions, this will be at a higher price, and lower quantity, than a perfectly competitive market would produce. This has three separate effects on the market, relative to the perfect competition scenario:

1. Consumers pay higher prices
2. The monopolist gets higher profits
3. Some consumers chose not to buy the product, or to buy less of it.

The effects most people notice with monopolies are 1 and 2, but it’s effect 3 that causes the inefficiency. Effects 1 and 2 are of equal size, so its just a transfer from consumers to the monopolist. This may or may not be desirable for distributional reasons, but it’s not inefficient because the losses equal the gains. However, effect 3 is a loss to consumers and to the monopolist. Since it’s a loss with no offsetting gain, society as a whole is worse off under a monopoly.

Before we get to solutions, there are a couple of other kinds of Imperfect Competition it’s worth running over quickly:

1. Oligopolies are markets with more than one seller, but few enough that each has non-trivial control over the total quantity the market supplies. The outcomes for an oligopoly vary depending on the details of the market and how it operates. At one extreme the producers can form a cartel, effectively turning into a monopoly. At the other extreme, oligopolies can end up functioning in a very similar way to perfect competition. Often the outcome will be somewhere in between.
2. Monopsonies are markets with a single buyer and many sellers. These work a little like monopolies in reverse. By cutting how much product they will buy, they can force producers to sell to them at lower prices.

So, if monopolies are a problem, what do we do about them? The sphere of regulations for dealing with imperfect competition in the US is called “Antitrust” (it’s just called “Competition Law” in New Zealand). Here’s a survey of the standard approaches, and the advantages, limitations and complexities of each.

1. Impede the coordination of oligopolists. The most common variant of this is making cartels (or similar price or quantity-fixing agreements) illegal, or even criminal. Without the power of the government enforcing their agreements, it becomes much harder to stop the cartel members from defecting from the agreement. The risk of criminal sanctions only makes it harder to preserve the agreements.
2. Impede the consolidation of firms. By requiring firms in the same industry to justify any mergers (usually by requiring there be sufficient competition after the merger), you reduce the chances of an oligopoly growing less competitive. You can even take this further by requiring that firms split up. There’s a solid logic behind this: it won’t restore perfect competition, but oligopolies are generally better than monopolies, especially if they can be prodded into competing rather than colluding. One thing to watch out for, though, is that the determination as to whether competition is sufficient or not will depend heavily on how narrowly or widely the industry is defined (both in terms of product scope and of physical space). Expect there to be a lot of litigation by interested parties over how to define the industry structure.
3. Prevent Predatory Pricing. Predatory pricing (or “dumping” as it tends to be called when it happens across international borders) is when an incumbent temporarily lowers their prices to block an entrant, only to raise them later. I’m not fond of this solution for several reasons. For one thing, while one could use a strategy like that to block competitors, it’s difficult to tell it apart from the change in prices that would naturally come from an increase in supply. Furthermore, banning predatory pricing can actually reduce competition – it gives firms an excuse to accuse their competitors of charging too little.
4. Avoid making the problem worse. There are any number of things that governments can do to create or reinforce monopolies. Granting a firm legal protection from competition is an obvious example, but there are subtler ways governments can undermine competition. One thing is to use “needs assessments” (like an alcohol license that requires the applicant to demonstrate that an area needs another bar before the license will be granted – bonus points if the incumbent bars get a say in whether the applicant was sufficiently convincing). Other quantity-based regulations (like taxi medallions) have a pro-incumbent bias, undermining competition. Complex compliance requirements can also create a barrier to entry by making it harder for a new firm to understand what they have to do to enter a market. Also, international trade forces domestic producers to compete with foreign ones, so trade barriers can damage competition.

One final point before I wrap up is the special case of a Natural Monopoly. As I noted above, the size of a market and the cost structure of firms in the market define the optimum number of producers, and how large they are. If a market is sufficiently small, or fixed costs are sufficiently high, the optimal number of firms may be one. In this case, the perfectly-competitive price of a good would be too low to sustain the market – the lack of competition is necessary for the market to function. In the case you have three options, none of them particularly appetizing:

1. Leave the market alone, which may result in the monopolist exploiting its customers.
2. Have the government take over the industry, which may result in the government running a business it doesn’t have the expertise to run properly.
3. Regulate the prices the monopolist can charge. Expect to spend the rest of eternity arguing with the monopolist as to whether they are making too much profit or too little.

Which of these options is the least unfortunate depends too much on circumstances and your own values for me to offer any good advice, but I would suggest making sure you leave the option open for competitors to enter in the future. Just because a market is a natural monopoly now, doesn’t mean it will stay that way forever.

Next week we’ll go from too much coordination to too little – what happens when people can’t cooperate for mutual benefit.