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On the origins of the concept of natural monopoly

Manuela Mosca

Paris, 2 février 2011Université Panthéon Assas (Paris 2)

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Natural monopoly

The most efficient number of firms is one

The socially optimal market structure has only one seller

Efficiency is achived with only one firm producing

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The problem

• Dupuit (1852-53): transport network is a monopoly

• spontaneously generated for reasons linked to the technology of the industry

• recognition of non-legal restraints to competition

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HET Literature

• how monopoly power was explained in the history of economic thought?

• Bain (1956): the causes of firms’ market power are entry barriers

• economists’ ideas on “barriers to entry” before Bain (1956)

• there was a gap in the literature on the sources of monopoly power

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Scale economies

• one of the sources of monopoly power: economies of scale

• scale economies over the entire range of market demand are incompatible with competition

• this incompatibility is crucial in identifying natural monopoly

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Historical problems

• Who discovered this incompatibility?

• Who formalized it for the first time?

• Why some didn’t believe in it?

• Which were economists’ ideas on the policy treatment of natural monopoly?

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My aims

• To contribute to the history of the concept

• To reconstruct the origins of the concept

• To find out policy implications

• To providing a sound basis for further research

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Method (1)

• History of analysis

• What are we talking about?

• Definition of the concept

• History of the concept

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Method (2)

• Mainly “rational reconstruction”:absolutist approach; thin, Whig history

• reading the past from the perspective of a given theory

• Limits of this perspective:

– Focused on the theory– No contextualization– In retrospect– Continuity in the HET– Past as a progression from errors to truth

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Method (3)

• extract parts concerning natural monopoly

• no implication of a progression from errors to truth

• a progressive decline!

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Method (4)

• a first step: clarifying confusions

• found priorities and influences

• some contextualization

• providing a sound basis for a further “historical reconstruction”

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Method (5)

• Secondary literature

– Sharkey (1982: chapter 2), Hazlett (1985), DiLorenzo (1996): some synthetic reconstruction of the initial history of natural monopoly

– Ekelund and Hébert (1981), O’Driscoll (1982) and Stigler (1982): hints

– Crain and Ekelund (1976): the principle of ‘competition for the field’

– Ekelund and Hébert (2003): Dupuit– Béraud (2004): Walras– Tynan (2007): J.S. Mill and Senior on London’s water

supply

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Method (6)

• Complex concept → different elements:

1. the expression2. the concrete situations3. the inquiry into economies of scale 4. the consideration of their incompatibility with

competition5. the drawing of the diagram6. the need for government intervention

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Method (7)

• breaking down the concept into all its component parts

• analyzing their particular paths separately

• each component had a different speed

• let’s start with the proper definition of the concept of of natural monopoly

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Natural monopoly

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Cost structure

• The firm produces below its MES

• why are average costs lower at higher levels of output?

• high fixed costs (es. a single indivisible facility)

• low (zero) variable costs

• no long run

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Pricing policies

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Policy implications

• It is a market failure

• Government intervention is required– nationalization– regulation– antitrust

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History of the concept

• the origins

• a different origin for every feature

• a separate analysis of the 6 elements

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1. The expression (1)

• Smith (1776): – goods produced only in special situations – fixed-supply natural input– supply cannot satisfy the demand

• Malthus (1815):– called them “natural” monopolies vs “artificial”– “peculiar products of the earth”

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1. The expression (2)

• Bastiat (1850): created by nature and not by law (“unnatural”)

• J.S.Mill (1848): ‘those which are created by circumstances, and not by law’

– not only fixed-supply natural input– also technology (gas, water)

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1. The expression (3)

• Walras (1875): railways, roads, and canals ‘make up a natural monopoly’

• Ely (1886ff) consolidated the meaning referring to technology

• Marshall (1890) “indivisible industries”

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2. Concrete situations (1)

• Who identified industries in which natural monopoly is spontaneously generated?

• Reasons they gave

• Without a theory of costs

• Without calling them “natural monopolies”

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2. Concrete situations (2)

• Smith (1776): domains where large size firms work better than small ones:– banking– insurance– navigable canal– supply water

• They are successful if:– simple tasks– general utilily– large capital requirement

• They are not monopolies

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2. Concrete situations (3)

• J.S. Mill (1848) gives examples of monopolies– Postal service– Supply of water and gas

• Dupuit (1852-53): transport networks (a ‘de facto’ monopoly)– huge capital requirement– profit not enough for more than one– the first business uses the best conditions

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2. Concrete situations (4)

• Walras (1875):

transport networks, public utilities are monopolies– expropriation of the land (decided by the government)– laying pipes under public roads (authorization)– permission to very few firms → monopoly

• De Viti de Marco (1890): network effect– telephone industry

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3. Economies of scale (1)

• scale economies or increasing returns

(no expression, no situation, no monopoly)

• massive literature

• very old idea

• inquiry limited to scholars (no business men)

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3. Economies of scale (2)

• Serra (1613): in manufacturing it is possible to multiply inputs with proportionately less expense

• Turgot (1767): description of the increasing returns that occur initially when a given piece of land is tilled

• From Smith (1776) onwards: increasing returns in manufacturing vs decreasing returns in agriculture

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3. Economies of scale (3)

• Senior (1836): scale economies with fixed costs– the spinning of cotton in a mill: ‘As the quantity

produced is increased, the relative cost of production is diminished’

• Cournot (1838): total cost function and its derivative = marginal cost– diminishing for ‘manufactured articles’, because of ‘a

better organization of the work, . . . and . . . [the] reduction [of] general expenses’

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3. Economies of scale (4)

• J.S. Mill (1848): for a large scale of production (like the post office) ‘the expenses … do not increase by any means proportionally to the quantity of business’

• Dupuit (1852–53): numerical example of a canal in which the cost per unit transported decreases as the quantity increases

• Walras (1875): distribution of water and gas: average costs decrease, because ‘the expenses of the initial set-up, and up to a certain point in its utilization, can be spread over a varying number of products’

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3. Economies of scale (5)

• Nördling (1886): relationships between total, average and marginal costs

• Cheysson (1887): diagram of a decreasing average cost function: this function may have different shapes ‘for large industry, for small industry or for agriculture’

• H.C. Adams (1887) classified industries according to their returns to scale: constant returns, diminishing returns, and increasing returns

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3. Economies of scale (6)

• Pantaleoni (1889): – similar classification, but seen from the costs

side

• De Viti de Marco (1890): – industries with high fixed costs (some are sunk) and

low marginal costs (transport networks, telegraph and telephone industries), or zero marginal costs (the production of non-rival goods, like theaters)

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3. Economies of scale (7)

• Marshall (1890): – ‘supplementary costs are, as a rule, larger relatively to

prime costs for things that obey the law of increasing return than for other things’

– but he does not include them among the sources of internal economies

• Pareto (1906): – ‘for each type of production, there is a certain size of

enterprise which corresponds to the minimum cost of production’

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3. Economies of scale (8)

• Barone (1908): – precise, complete description of a U-shaped average cost

curve: – ‘if the [total cost] curve [. . .] were transformed into a

diagram with the unit costs of production on the y-axis, it would slope downward until a certain point, and then upward’

– where does that ‘certain point’ lies in relation to the market demand?

• Edgeworth (1911) – increasing returns of a firm in relation to marginal and

average costs– railway industry: scale economies due to input indivisibility

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4. Incompatibility (1)

• Scale economies over the entire range of market demand are incompatible with competition → monopoly

• What economists thought would happen to the market structure as the average cost decreased over the full range of market demand

• Decisive step in identifying natural monopoly

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4. Incompatibility (2)

• Smith (1776) increasing returns are not at the origin of monopolies

• Senior (1836) linked scale economies with monopoly, but he never stated that they could lead to monopoly by themselves

• Cournot (1838): if the marginal cost function is diminishing, ‘nothing would limit the production of the article’ and a monopoly would occur

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4. Incompatibility (3)

• J.S. Mill (1848): when competition brings about only a multiplication of costs, a single firm will survive

• Walras (1875) : ‘Laying a second system of water or gas pipes in a city where there is already one that could satisfy all the needs, building a second network of roads in a country where there is already one that is enough for all the communications, would be an absurd way of chasing after economies’

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4. Incompatibility (4)

• Ely (1886) ‘there is great economy and convenience in the conduct of the transportation . . . by those operating on a vast scale . . . and this gives to that industry its inherent and irresistible impulse toward monopoly’

• Hadley (1886): since the railroad ‘is not subject to the law of the diminishing return . . . there is . . . no direct limit to [the] cut-throat competition’ → monopoly

• De Viti de Marco (1890): telephone industry is a monopoly not only due to cost features, but also due to network effects

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4. Incompatibility (5)

• Marshall (1890) criticizes Cournot for having ‘misapplied mathematics here. He ignored the conditions which, in real life, prevent the speedy attainment of monopoly by a single manufacturing firm’

• Pareto (1906) also disapproves the theory that economies of scale necessarily lead to monopoly, and concludes that ‘the facts are not in accord with this theory’

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4. Incompatibility (6)

• Barone (1908): – ‘If the unit cost of the product were to diminish indefinitely, as the

quantity of output increases, it would be advantageous for the production of every good to be concentrated in a single firm … this can occur when . . . there is . . . a type of firm such that, while its costs decline toward a limit, its size is enough to satisfy the entire market demand’

• Edgeworth (1911-1913): a truly complete analysis of a typical situation of natural monopoly– as railways exhibit increasing returns, they will tend to become a

monopoly

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4. Incompatibility (7)

• We could stop here– contributions to the issue reappear only in the 1920s

• Sraffa (1925): critique of the Marshallian supply function – the only economies that could in principle be

compatible with perfect competition are the external ones

• Knight (1921ff): criticisms of Marshall’s solutions for the problem of incompatibility

• “Cost controversy”: no mention of natural monopoly

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5. The diagram

• Edgeworth (1913):– the theory of railway

rates– two cost curves

(average and marginal) and the demand function intersecting the decreasing portion of the average cost curve

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6. Government intervention (1)

• natural monopoly is a rationale for government intervention

• J. S. Mill (1848): ‘When . . . a business of real public importance can only be carried on advantageously upon so large a scale as to render . . . competition . . . illusory . . . it is much better to treat it at once as a public function’

• Dupuit (1852–53): ‘The government management of any industry is an exception which must always be justified by exceptional circumstances. Now, here [transport network, water distribution, lighting, heating] the circumstance is monopoly’

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6. Government intervention (2)

• Chadwick (1859): ‘competition for the field’– the government can regulate entry through a system

of competitive bidding; natural monopolies must be nationalized and privately managed

• Walras (1875) wanted the government to intervene in the railways either by directly controlling or by regulating them

• Ely (1886) Hadley (1886) H.C. Adams (1887): government intervention

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6. Government intervention (3)

• Marshall (1890): – ‘arguments are now used, especially in

America … , in support of the active participation of the State in industries which conform to the law of increasing return’

– private corporations whenever possible

• Edgeworth (1911) in favor of the intervention of the state for railway and public utilities in general

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An overview

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History of the concept (1)

• Smith (1776) gave nothing more than suggestions

• Malthus (1815) introduced the expression

• Cournot (1838) analysis of the decreasing marginal cost function, statement of its incompatibility with competition

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History of the concept (2)

• J.S. Mill (1848) had all the elements to identify natural monopoly, without any analytical tools

• Dupuit (1852-53) – identified the transport network as a situation in which

natural monopoly would have occurred– made a first step in the elaboration of the decreasing

average cost function (numerical example)

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History of the concept (3)

• Walras (1875): from J.S.Mill and Dupuit, but much more focused on the issue → his essay was on railways; he did not use mathematics

• Cheysson (1887) plotted a decreasing average cost curve

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History of the concept (4)

• American economists– Ely (1886) consolidated the use of the expression– Hadley (1886) focused on the adjustment process– H.C. Adams (1887) distinguished three classes of

returns to scale

• Italian marginalists– De Viti de Marco (1890): link between network effects

and monopoly – Barone (1908): consideration of market demand,

which is essential to qualify a natural monopoly, and the description of the diagram

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History of the concept (5)

Edgeworth (1911-1913)

All the elements that make up the concept of natural monopoly are present – except the expression

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Conclusions (1)

• The idea that monopoly implies the absence of competition is linked to a specific notion of competition, that of perfect competition– there is a remarkable overlapping between the

histories of the two concepts

• Smith, Senior, Pantaleoni, Marshall, and Pareto did not believe in the incompatibility of scale economies with competition– potential competition, or competition as free entry, or

competitiveness of large firms (oligopoly)

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Conclusions (2)

• Theory came first– the problem of compatibility of scale conomies with

competition was mainly a theoretical matter

• A typical case of economic thought shaped by reality– the spread of the expression ‘natural monopoly’ in its

current meaning, and the consolidation of the related theory, came about mainly with the spread of public utilities, networks, etc

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Criticisms (1)

• free market-oriented literature

• no interventions are required– public ownership or regulation for utilities – antitrust policies for networks

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Criticisms (2)

• Contestable markets theory (1977ff)

• radical change in the definition

• natural monopoly is described as characterized by – subadditivity of cost functions (production

costs less if it is done by one firm only) – sustainability (entry is not profitable)

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Cost

Output0

The cost function is subadditive up toQ*, meaning a single firm can produce any

output less than Q* more cheaplythan 2, 3, 4, or any number of firms

with each supply some fractionof Q*

LAC1 LAC2

Q’ Q”Q*

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Criticisms (3)

• Sustainability:

The price is sustainable if it prohibits the possibility of profitable entry for potential competitors

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Criticisms (4)

• The link of natural monopoly with economies of scale is broken

• The result of contestable markets is not monopoly pricing

• Market forces are enough – even in industries with scale economies

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Other criticisms (5)

• Neo-Austrians never contrast monopolistic markets with competitive markets: – markets are competitive by definition

• “It is a myth that natural monopoly theory was developed first by economists, … they used it as an ex post rationale for government intervention”.

• Ely, Clark, Fisher, Seligman, and all the others professional economists in the U.S. “agreed that large-scale production produced competitive benefits”.

• The economic profession came to embrace the theory of natural monopoly after the 1920s.

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Other criticisms (6)• I desagree. It’s true that competition was often seen as a market

process, but …

• The idea that a decreasing average cost curve could bring to monopoly was already in Cournot (1838)

• J.S. Mill (1848) Dupuit (1852) and Walras (1875) recognized natural monopoly and were in favor of public intervention

• Ely (1886 and 1889), Hadley (1886), H.C. Adams (1887) claimed for the extension of the duties of the State in case of natural monopoly

• De Viti de Marco (1890): the government can regulate entry in a natural monopoly through a system of competitive bidding

• These are all before 1920s!

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Other criticisms (7)

• Chicago school: market power is always temporary– market share does not imply market power – monopolies are dictated by efficiency

• monopolies created by strong network economies are very fragile because of the particularly innovative character of that industry

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Other criticisms (8)

• other studies deny the empirical relevance of the concept– as transaction costs are important, average cost

curves for any firm are likely to be U-shaped

• funeral bells have repeatedly been tolled

• Will natural monopoly be expelled from economic theory?

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No!

• the game theoretical approach to industrial organization, studying the strategic contexts in which the potential entrants and the incumbents operate,

• shows that monopoly power might persist under free entry, even in a contestable market– important sunk costs– network esternalities– anti-competitive practices

• market mechanisms alone might not prevent a monopolist from exercising market power