No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Eight: Market Structure: From competition to monopoly 188 such that one firm can produce the total output at a cheaper cost than multiple firms. For the production quantities that matter, this industry will face increasing returns. To maintain competition would require deliberately spending more total resources for the same level of output. In the absence of government action, one firm will be able to dominate and capture the entire market. A standard example of natural monopoly is that of a public utility such as water or electric companies. These utilities have significant infrastructure costs (adding additional water pipes or electric lines) that make additional competitors uneconomic. PROTECTION FROM MONOPOLY Many critics of the market process will point to natural monopoly as a clear-cut reason why government must regulate an industry. Without regulation, the firm will raise prices and consumers will be exploited. Without straying too far down the argument of what government should do, are there market mechanisms that will restrain monopolist misbehavior? We have already covered the idea of substitutes and that there are substitutes for almost everything. Many people do not pay for a monopoly water provider; they may have a private well, or their development may have a community well. If the power company raised prices too high, many might ultimately find it beneficial to run their houses on diesel generators. These are less desirable actions, but they are available without government action. Further, changes in technology and the size of the market may also overcome natural monopoly. Phone lines used to be a natural monopoly for AT&T. The advent of wireless communication (cell phones) would have eliminated AT&T’s monopoly even without government action. Regulation may be the best answer, but it is not the only answer in dealing with monopoly. As you might imagine, there are both costs and benefits to regulation; a detailed “eyes wide open” review of regulation is prudent before concluding that regulation is the best option. We’ll explore some of those regulatory costs below as well as in chapter 14. The theory of contestable markets suggests that even with a market that has only one provider, firms may restrain monopolistic behavior if the barriers to entry are low . Imagine that there were only one automobile company, Government Auto (GA), but there were no legal restrictions on competitors entering the automobile manufacturing industry. While GA might be able to charge higher than competitive prices by restricting production in the short run, if they obtained higher than average profits that were expected to be sustained in the future, other potential competitors would notice. Could General Electric make cars if they thought the profits were high enough? How about Boeing? I suspect that they could, and that GA would try to keep prices just high enough to maximize their profits without enticing competitors to enter the fray. Further, most businesses understand they want a long-term relationship with their customer; maximizing short-run profits by exploiting their customers will not only alienate the customer but spur competitors into the market. Customers who would Contestable markets: When a market has low barriers to entry, even monopolists may behave according to competitive pressures to avoid inviting other entrants to the market.