Monopolies are often derided by economists and non-economists alike, and often for good reason: monopolist firms are less efficient than their perfectly-competitive counterparts (to use more technical language, they charge a price higher than their marginal costs), which means consumers pay more for fewer goods. Partly based off this theory (but also because of political pressures from reformers) the US in 1890 passed the Sherman Antitrust Act, which has become the main tool for the government to break up monopolies into more firms. This act is hailed even by some free-market advocates for its efforts to create competitiveness. Are monopolies undesirable and do they run counter to free market principles? I argue “no” to both questions below the fold.
Sometimes Monopolies Are Desirable
Monopolies may be desirable in certain circumstances. There are currently some legal forms of monopolies (think patents, utility companies, government, etc), but they are a topic for another time. Rather, I want to focus primarily on monopolies that naturally develop.
Monopolies can develop naturally in a number of ways. Usually, there are non-economic barriers to entry preventing new firms: geographic barriers, social barriers, things like that. There are economic barriers, too: high start up costs, technological costs, high fixed costs, etc. These barriers are often insurmountable and only one firm can operate in the market.* The implication of these barriers is that one firm is desirable in the market; that if efforts were made to break up the monopoly, the resulting firms would likely go under thus depriving the service area of the quantity of goods it once enjoyed (a monopoly seller is preferable to no seller at all). The technical name for this situation is a “natural monopoly.” This leads us into our next discussion…
Monopolies Can Be The Result of a Free Market
As discussed in the section above, monopolies can be the result of free market forces. Natural monopolies (or other forms of non-perfect competition such as duopolies, monopolistic competition, etc) can arise from a natural free-market situation. Nothing about the free market demands perfect competition. What is demanded is no artificial barriers to entry (regulations, zoning, licenses, etc). Artificial barriers are often much harder to overcome than natural barriers to entry: given enough time, a firm can overcome high fixed costs, or geographical boundaries, and the like with innovation and imagination. With artificial barriers, it requires some form of lobbying or political jockeying to overcome (and even then the firm is likely to be neutered).
In the short run, a monopoly may be a desired outcome of the free market. In the long run (and by that I mean the deliberately vague phrase “long enough for things to change”), other firms may enter the market due to the same free market processes. In short, we should not fear an initial lack of competition should there be free market processes available.
Keeping Monopolies in Check
An interesting result of a free-market monopoly is that they don’t necessarily behave like textbook monopolies. As Don Boudreaux (and others) have written, monopolies often behave as though they’re facing competition. It is when monopolies are protected by artificial barriers that we see monopolies behaving more like textbook monopolies. This has interesting implications for economic theory and our understanding of free markets: it is the threat of competition that makes firms behave efficiently, not just the actual existence of competition. When there are no artificial barriers protecting a firm, then the firm must act as though it will face competition even if they have monopoly privileges.
In their 1962 article Competition, Monopoly, and the Pursuit of Pecuniary Gain, Armen Alchian and Ruben Kessel argue “[The monopolist’s] cardinal sin is to be too profitable.” While Alchian and Kessel were talking specifically of government-regulated monopolies, their argument can easily be applied to naturally-arising monopolies. Their cardinal sin, the one that faces them with the punishment of competition if not government regulation, is to be too profitable. Entrepreneurs see excess profits made by other firms, and they begin to devise ways to break down the natural barriers to entry (the “innovation and imagination” I discussed above). This threat of competition is enough for firms to behave competitively and not fully exploit their market positions.**
An interesting implication of the above discussion is it would indicate much antitrust regulation is unnecessary and potentially even harmful. What are seen as harmful monopolies and actions taken against them by the government could in fact be beneficial. There are cases where antitrust legislation appears to have been beneficial (some international cartels have been broken up by concerted intra-governmental efforts). Given that these cartels have formed mostly in highly regulated and controlled industries, I am unwilling to rule out the free market case I’ve made above as a solution to this problem.
*This is not to say that, given enough time, these barriers wouldn’t be broken down and new firms can enter. But, given enough time anything can happen. We will focus our analysis on the period of the monopoly.
**This is another case of a point I made a few days ago, namely that we should be careful to toss out theory in light of seemingly contradictory evidence. The story of the behavior of monopolies appears to contradict our textbook models. Does that mean the models are wrong? Apparently not, according to the insights of Alchian, Boudreaux, et al.