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.


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James is a government policy analyst, and lives in Wellington, New Zealand. His interests including wargaming, computer gaming (especially RPGs and strategy games), Dungeons & Dragons and scepticism. No part of any of his posts or comments should be construed as the position of any part of the New Zealand government, or indeed any agency he may be associated with.

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46 thoughts on “Market Failure 3: Imperfect Competition (This game of Monopoly plays you!)

    • natural monopolies tend to be things that involve networks. Electricity generation is not necessarily a natural monopoly, but electricity distribution most likely is. Similarly a competitive train transport industry is more likely than competitive train networks.

      I nee dot speak in tendencies here because market conditions can affect what is and isn’t a natural monopoly. A small country like New Zealand has more natural monopolies than the US would, especially the more densely-populated parts of the US.

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      • The US had competitive train networks in high density areas (and particularly, high cargo density areas – i.e. New York & Pennsylvania and their namesake railroads). They only failed when the demand for rail transport fell with the advent of cars and trucking. (and ironically, were kept separate for far too long because of anti-trust regulation, with an earlier combination possibly preventing the catastrophic business failure in the early 70s)

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        • The big Japanese metropolitan areas like Tokyo, Osaka-Kobe-Kyoto, and Nagoya also have competitive train networks with different public and private train services offering similar if not exactly the same service.

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        • Yes and no. If we are talking about transporting passengers and cargo between Philadelphia and New York City, sure. There was ample competition. But if we are talking about transporting coal (and incidentally other cargo as well as passengers) between the Pennsylvania coal country and anywhere else, then not so much. The small coal towns didn’t produce the volume to tempt competing railroads to come in. A lot of those coal mines were owned by small operations, and had little leverage with whatever railroad served them. The results were pretty much what you would expect: the railroads had them by the balls, and weren’t shy about squeezing. They controlled freight rates, or even whether there was any freight service, giving them the power to destroy. There were scandals where it came out that railroad managers, running up to very high levels within the corporations, were demanding kickbacks. The railroads objected to their employees freelancing, but they did the same thing on the corporate level. The eventual outcome was the creation of the Interstate Commerce Commission, which reined in the worst excesses.

          A modern comparison would be cable companies. In an area without cable people desperately want it, but once they have it they pretty much uniformly despise the cable company, and for excellent reason. Railroads, outside of the major hubs, were regarded similarly.

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    • Potentially Amazon in the future? Not yet of course but if they eventually corner the market the amount of cost necessary to create a comparable distribution network would be prohibitive.

      Cable providers I think are a more extant current example. Laying all that transmission wire is a significant barrier to entry.

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      • Their distribution itself relies on local sources. In the UK, I get amazon stuff by royal mail. And in Singapore, I would get it by singpost etc. You would have to get rid of dhl, fedex, the post office etc in order to rely on amazon’s own distribution network. But anyone can set up an online shop. And arguably if amazon gets uppity, you can always use ebay to hawk your stuff.

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        • Yes, agreed that it’s a reach. Amazon seems set to be a kind of “buy anything and have it delivered to you” behemoth but its competitors will likely be a host of “buy a number of specific things and have them shipped to you” companies rather than a second Amazon like behemoth.

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          • When you wrote “Amazon” I immediately thought of Amazon Web Services, where there is indeed great potential for monopoly. The barriers to entry for starting a cloud service provider are quite high and the market is currently dominated by 2 (maybe 3) players: Amazon, Microsoft and (maybe) Google.

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  1. This is something I know a bit about because of experience in antitrust law and studying it in law school.

    There are a few things which are illegal per se in the United States antitrust law. The big two are Horizontal Price Fixing and Territorial Division. Horizontal Price Fixing is one of the few parts of Antitrust Law that the US Government will enforce with criminal penalties. Interestingly, horizontal price fixing seems firmly culturally rooted in Asia. A lot of Asian companies and executives get in trouble for Horizontal Price Fixing in the United States.

    A lot of states ban vertical price fixing but the Federal Government seems to think this is okay. This is called the Colgate Doctrine. A manufacturer has the right to set the terms of sale.

    As to natural monopolies, I believe in price regulation, utilities commissions, and control boards. There are some things like Internet which are treated as natural monopolies in the U.S. but should not be.

    Antitrust/Competition Law seems to be another big divide among liberals and libertarians with Libertarians insisting (and often firmly) that antitrust is unnecessary and hinders competition. Libertarians seem doubtful of the idea of a monopoly and believe that antitrust law has a firm and necessary part of law and enforcing competition. Fair competition laws have existed in one form or another for hundreds of years.

    The big battles in economics seem to be between engineers and ecologists. I lean more towards engineering.

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    • Re: Libertarians & Antitrust – it isn’t that antitrust is not needed, it’s that absent government meddling in markets (specifically in raising barriers to entry), it would not be needed.

      In short, monopolies form because governments make it hard for competition to emerge.

      I don’t hew to that precisely, but it has a point in that not all of the monopolies the government has had to deal with have been natural monopolies. Many of them are the result of regulatory barriers to entry (note I am not judging the validity of the regulations in question, only stating that their existence had a hand in the formation of a monopoly).

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      • How does this explain the ur-monopoly Standard Oil and other 19th century trusts though? There wasn’t much in the way of federal or state regulation that would naturally lead to monopolies during the 19th century. Businessmen still found to their advantages to form monopolies and did so.

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        • Don’t know, I’m not well versed on the period with regard to the regulatory framework. It could be that in that case, it was less barriers & more cronyism. Or perhaps there were barriers that I’m not aware of.

          I’m just clarifying the libertarian position.

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        • If you will, look at the (imperfect) example of cigarettes vs. vaping.

          There are a handful of problems with vaping. Health issues are a concern somewhat compared to not vaping, there are appearance issues insofar as we don’t like thinking about how we’re constantly walking through clouds of each others’ exhaust, that sort of thing.

          But smoking has been “grandfathered in”. There are hurdles that vaping has to jump over that smoking never had to.

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        • What happened here was Standard Oil was able to buy its competitors out first in Cleveland, and then elsewhere (Rockefeller was not greedy and was willing to pay a fair price). Standard Oil may have bought properties out and not disclosed it for a while as well. But they went city by city and bought up the refiners in each city (Standard Oil was downstream only at this time). Standard was big enough to offer the railroads a large enough business that they were willing to pay rebates on the shipments (even for competitors shipments). Standard played the Pennyslvania RR off against the NYC and the Erie Since all 3 served Clevland and the oil country in NW pa.

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          • Standard Oil was, so far as I can tell, operating in a very free market, at least so far as the government was concerned, either with regard to regulation and cronyism. Railroads nearly always involved some sort of government involvement, if only for eminent domain to obtain rights of way (or outright land grants, for roads through virgin territory). Standard Oil wasn’t like this. I don’t doubt that Rockefeller bought political favor as needed, but who didn’t? It was (and is) part of the cost of doing business, and Rockefeller didn’t start with any particular advantage. The upshot is that Standard Oil is, even apart from being the ur-monopoly, a good counter-example to the claim that monopolies don’t occur without government assistance.

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            • Standard Oil wasn’t a monopoly. Its market share peaked around 90%, and had declined to around 60% by the time the breakup happened. It’s not clear that breakup solved any real problem.

              The claim isn’t that companies don’t ever acquire very high market share in the absence of government-imposed barriers to entry*. It’s that the threat of competition makes it difficult for firms to exploit monopoly pricing power to a significant degree while maintaining that market share.

              The rationale for antitrust law is that, having acquired a high market share, a company can exploit that position to charge monopoly prices without losing market share. It’s the latter part that’s questionable.

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              • Standard Oil had all the qualities of a monopoly and functioned as one for most regional markets. They were ruled a monopoly in Standard Oil Co. of New Jersey v. United States, 221 U.S. 1 (1911). I don’t see how claiming they weren’t a monopoly is in any way justifiable or defensible logically.

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    • I do think libertarians don’t take market failure seriously enough in general, though it is certainly the case that government action, even antitrust law itself, can impede competition.

      I also think there is something to the “engineers vs. ecologists” paradigm, I’ve heard it used by people who self-identify as ecologists. I lean more that way myself, but as this series indicates I’m not averse to a little engineering so long as you really know what you’re doing.

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        • Getting more game designers to write laws would be a good idea.
          I’m not happy with regulations that reward killing old people — particularly when asshole corporations are actually dumb enough to start writing their internal regulations to actually kill people.

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          • Getting more game designers to write laws would be a good idea.

            The problem is that play-testing is a bitch. It’s not that game designers are necessarily wonderful at anticipating undesirable consequences, as that they have the opportunity to see how the rules work in action before they go live with those rules.

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            • They’re better than the idiots we have in charge now (warning: I may be biased).

              And yes, we are playtesting with people’s fucking lives on the line.
              (And, thank god, the government does see something wrong with killing people to get more money, because the corporations DON’T. Regs will be changing, and soon).

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            • Playtesting is a hell of a lot easier when you crowdsource it online — and yes, you can totally do that for governmental laws. If it worked for Amazon Prime Pantry, it works for that too.
              Did you ever play the Star Wars pizza delivery game? (ahem. the game that was a pizza delivery game, until they redid it for Star Wars).

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      • My issue with ecology is that it is often used as an argument for doing nothing in the form of human suffering.

        People lose their jobs in recessions and depressions through no fault of their own. There might not be jobs for them to take up in those conditions. Yet there is a strong strain of arguing against the welfare state even knowing these facts.

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      • Consider the pencil market from ‘s first post. It has various stages in getting the raw materials from their starting points and states and turning them into a pencil in your hand (or classroom, as the case may be). Horizontal consolidation (and the horizontal price fixing that goes with it) is when a single firm controls all of a particular stage in that market. Maybe Bob’s Lumber Yard is the only outfit selling pencil-quality wood, and they’ve managed to prevent everyone else from doing so. They don’t have the entire pencil making process locked up, but they’ve got a huge part of it under their control.

        Vertical consolidation is when a firm controls the entirety of their supply chain – Charlie’s Pencils cuts its own trees, extracts its own rubber, and mines its own graphite and so on and so forth. It may have competitors at various stages of this process, but Charlie’s is able to avoid dealing with them and still make a profit. Effectively, all the manufacturers and distributors that make up the Charlie’s production chains refuse to deal with anyone who isn’t also a division of Charlie’s.

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        • Vertical consolidation lite is when a firm deliberately buys up all the available production time to prevent competing products from coming to market, forming a temporary monopoly because they have the monetary heft to pull it off. This happened a few years ago when Apple overbought production and then sat on a mass of un-used iPad screens to prevent Samsung and other competitors’ Android-based tablets from being available in time for the christmas shopping season.

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      • Horizontal Price Fixing means among competitors or people who should be competitors for market share. Say, Levi’s, 7 for All Mankind, Citizens of Humanity, etc. met and agreed that they would only sell jeans for 125 dollars or more. That’s price fixing.

        Vertical price fixing is trickier because it is often a manufacturer laying out terms and conditions for retailers such as “Retailers cannot sell my product for below X. Sales can only happen after X date.” Some of these are allowed and others are not. This is usually called the Colgate Doctrine.

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        • Thanks. Horizontal is what I tend to think of. Vertical seems okay provided all parties agree to the terms. A lot of that (I assume) is about brand control as much as anything. My understanding is that manufacturers aren’t really impacted by retail price since they make their money selling wholesale. But True Religion doesn’t want to be seem as cheap jeans.

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  2. Again, excellent work James. About the only thing I would add would be some points on quality. I’m not sure if that is something economists bring into analysis or if it was just omitted for clarity.

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  3. The alcohol market in a lot of American states is a de-facto monopoly, with less variety of what’s being sold than actual state supported monopolies (as profit motive would suggest).

    There are known inefficiencies with state supported monopolies, but I think it’s generally a mistake to simply assume that “competition” will take over if we get rid of the state monopoly.

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  4. You may be planning to discuss this, but the legality of vertical price fixing has been a question under US law for a long time. It was only relatively recently (2007) that the US Supreme Court declared that such fixing was not per se illegal (in an opinion that, to bring it back around, cited Coase’s writings on economics).

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