Critiques of Natural Monopoly Theory

Many see the monopoly as a hallmark of market failure. Still, historic proof suggests otherwise. In theory, we are told that growing economies of scale, associated with lower costs but at the same time burdening the costs in market entry for other and new firms, will ensure that the already established firms can continue to grow without fear about new competitors entering the market. This leads to a never-ending growing price level and lower service quality due to lack of competition, especially more so in services where there is lack of elasticity in demand (i.e., the prices going up or down don’t lower or increase private consumption). And as the already-established firms become larger and larger, the possibility to enter the market is further damaged.

In the The Myth of Natural Monopoly DiLorenzo (1996) tells us that the (western) economists in the 19th century see the monopoly as caused by government intervention and understand that the market is a dynamic, ongoing process, that market dominance was always temporary. Perhaps the best illustration of the market as an ongoing process is provided by the electric light companies. Indirect competition can deal with monopolistic situations. It serves the same purpose to the public but it provides just a different product.

Six electric light companies were organized in the one year of 1887 in New York City. Forty-five electric light enterprises had the legal right to operate in Chicago in 1907. Prior to 1895, Duluth, Minnesota, was served by five electric lighting companies, and Scranton, Pennsylvania, had four in 1906. … During the latter part of the 19th century, competition was the usual situation in the gas industry in this country. Before 1884, six competing companies were operating in New York City … competition was common and especially persistent in the telephone industry …

In 1880 there were three competing gas companies in Baltimore who fiercely competed with one another. They tried to merge and operate as a monopolist in 1888, but a new competitor foiled their plans: “Thomas Alva Edison introduced the electric light which threatened the existence of all gas companies.” [21] From that point on there was competition between both gas and electric companies, all of which incurred heavy fixed costs which led to economies of scale. Nevertheless, no free-market or “natural” monopoly ever materialized.

In one of the first statistical studies of the effects of rate regulation in the electric utilities industry, published in 1962, George Stigler and Claire Friedland found no significant differences in prices and profits of utilities with and without regulatory commissions from 1917 to 1932. [30] Early rate regulators did not benefit the consumer, but were rather “captured” by the industry, as happened in so many other industries, from trucking to airlines to cable television.

One would think that novelty (e.g., electric light replacing gas) is not a sufficient argument supporting free marketist views. Perhaps, one would say, it may come too late, and that the actual, existent monopolist had already generated a lot of damages. Because of this uncertainty, the critics argue, we should not rely solely on the plausibility of an “electric light which threatened the existence of all gas companies” at any time.

There is generally a problem of bargaining power with regard to what we usually call public utilities, since the owners of these big firms have an advantage against the customers. This deserves an explanation. To this matter, DiLorenzo talks about the problem of “excessive duplication”. This paragraph is very important, as we see that individuals lack the possibility to deal, to bargain with the firms willing to build a network of, say, water supply.

More precisely, the problem is really caused by the fact that governments own the streets under which utility lines are placed, and that the impossibility of rational economic calculation within socialistic institutions precludes them from pricing these resources appropriately, as they would under a private-property competitive-market regime.

Under private ownership of streets and sidewalks, individual owners are offered a tradeoff of lower utility prices for the temporary inconvenience of having a utility company run a trench through their property. If “duplication” occurs under such a system, it is because freely choosing individuals value the extra service or lower prices or both more highly than the cost imposed on them by the inconvenience of a temporary construction project on their property.

In the case of electric utilities, we learn the following :

Economist Walter J. Primeaux has studied electric utility competition for more than 20 years. In his 1986 book, Direct Utility Competition: The Natural Monopoly Myth, he concludes that in those cities where there is direct competition in the electric utility industries:

Direct rivalry between two competing firms has existed for very long periods of time — for over 80 years in some cities;

The rival electric utilities compete vigorously through prices and services;

Customers have gained substantial benefits from the competition, compared to cities were there are electric utility monopolies;

Contrary to natural-monopoly theory, costs are actually lower where there are two firms operating;

Contrary to natural-monopoly theory, there is no more excess capacity under competition than under monopoly in the electric utility industry;

The theory of natural monopoly fails on every count: competition exists, price wars are not “serious,” there is better consumer service and lower prices with competition, competition persists for very long periods of time, and consumers themselves prefer competition to regulated monopoly; and

Any consumer satisfaction problems caused by dual power lines are considered by consumers to be less significant than the benefits from competition.

Sometimes, complaints about “wasting” or so-called “duplication” regarded the market as rather inefficient. That criticism has been applied to cable TV as well, but we are told that “while over-building an existing cable system can lower the profitability of the incumbent operator, it unambiguously improves the position of consumers who face prices determined not by historical costs, but by the interplay of supply and demand”. And in this sector, again, monopoly problems were not related with economies of scale or costs at entry but generally due to collusion between the big private firms and politicians, i.e., the hallmark of crony capitalism. The very fact that government-granted (i.e., franchised) monopolists share the gains with politicians is one definitive proof.

In 1987 the Pacific West Cable Company sued the city of Sacramento, California on First Amendment grounds for blocking its entry into the cable market. A jury found that “the Sacramento cable market was not a natural monopoly and that the claim of natural monopoly was a sham used by defendants as a pretext for granting a single cable television franchise … to promote the making of cash payments and provision of ‘in-kind’ services … and to obtain increased campaign contribution.” [52] The city was forced to adopt a competitive cable policy, the result of which was that the incumbent cable operator, Scripps Howard, dropped its monthly price from $14.50 to $10 to meet a competitor’s price. The company also offered free installation and three months free service in every area where it had competition.

Still, the big majority of cable systems in the U.S. are franchise monopolies for precisely the reasons stated by the Sacramento jury: they are mercantilistic schemes whereby a monopoly is created to the benefit of cable companies, who share the loot with the politicians through campaign contributions, free air time on “community service programming,” contributions to local foundations favored by the politicians, stock equity and consulting contracts to the politically well connected, and various gifts to the franchise authorities.

In some cities, politicians collect these indirect bribes for five to ten years or longer from multiple companies before finally granting a franchise. They then benefit from part of the monopoly rents earned by the monopoly franchisee.

On the topic of telephone services, DiLorenzo cites mainly the works of Thierer (1994) for whom the AT&T, during 1876-1894, reached the monopoly status only due to its numerous patents, as Thierer (1994, pp. 268-271) writes :

As Robert Crandall (1991: 41) noted, “Despite the popular belief that the telephone network is a natural monopoly, the AT&T monopoly survived until the 1980s not because of its naturalness but because of overt government policy.”

During the period of competition (1894-1913) the expiration of patents allowed a rapid ascendancy of competition accompanied with better services and lower prices. The number of phones jumped from 270 000 to 6 millions. Why the competition didn’t endure is due to counter-measures undertaken to displace competitors. Thierer informs us that :

Wisely realizing the government was considering action to break up the growing firm, Vail decided to enter an agreement that would appease governmental concerns while providing AT&T a firm grasp on the industry. On December 19, 1913, the “Kingsbury Commitment” was reached. Named after AT&T Vice President Nathan C. Kingsbury, who helped negotiate the terms, the agreement outlined a plan whereby AT&T would sell offits $30 million in Western Union stock, agree not to acquire any other independent companies, and allow other competitors to interconnect with the Bell System.

The Kingsbury Commitment was thought to be pro-competitive. Yet, this was hardly an altruistic action on AT&T’s part. The agreement was not interpreted by regulators so as to restrict AT&T from acquiring any new telephone systems, but only to require that an equal number be sold to an independent buyer for each system AT&T purchased. Hence, the Kingsbury Commitment contained a built-in incentive for monopoly-swapping rather than continued competition. Brock (1981: 156) noted, “This provision allowed Bell and the independents to exchange telephones in order to give each other geographical monopolies. So long as only one company served a given geographical area there was little reason to expect price competition to take place.”

This system, apparently didn’t help Bell to drive out the independent companies but at the same time it also eliminated competitive long-distance systems. Some sort of cartelization had been promoted.

Steve H. Hanke & Stephen J.K. Walters (2011) discussed the matter of water supply. According to them, there is still the possibility to monitor the managers’ decisions. This avoids inefficient actions and wasted resources. Several issues related to franchise bidding have been addressed too.

Monitoring by owners can be quite costly. The necessity for owners to monitor managers, however, can be mitigated by providing the managers with compensation packages that include profit sharing or stock options. These packages are designed to make the managers’ interests coincide with those of the owners.

The combination of monitoring and incentive compensation packages tends to make managers operate private firms in an efficient manner. If managers do not maximize owners’ residual claims, however, the market for shares acts as a court of last resort. If the actions of incumbent managers are inappropriate, profits and share prices will be lower than they should be. This attracts corporate takeover specialists, because share prices that are relatively low enhance the returns from a takeover aimed at replacing current management. The threat of corporate takeovers thus helps discipline incumbent managements and generates an efficient provision of goods and services.

W. Mark Crain and Asghar Zardkoohi have compared the performance of public and private utilities in the United States. [8] They found that operating costs are significantly higher in the publicly owned utilities. Using 1970 data from a sample of twenty-four private and eighty-eight public water-supply companies, Crain and Zardkoohi established that public firms’ low labor productivity and underutilization of capital equipment led to operating costs about 25 percent higher than in the private companies. Using a different data set, W. Douglas Morgan reached similar conclusions; Hanke found that customer cross-subsidization (that is, overcharging some consumers so that other consumers can be sold water at prices below cost) is more common in public water companies than in private ones. [9]

The “Natural Monopoly Problem” and Franchise Bidding

Since most rate regulation involves enforcing some sort of “cost-plus” pricing rule, regulated firms tend to allow their costs to drift upward — since, in most cases, they can be reasonably confident that rates will be set high enough to cover these costs and provide a “normal” return on capital. Harvey A. Averch and Leland L. Johnson have documented this tendency. [13] Obviously, it will be difficult for even a well-intentioned regulatory authority to determine which costs are legitimate; there is also a strong possibility that the authority will be “captured,” come to serve the interests of the utility instead of the broader interests of consumers.

One approach has been a revival of interest — begun by Harold Demsetz [15] — in Chadwick’s concept of competition for the field. Chadwick recognized that those markets most cheaply served by a monopoly need not be afflicted with monopolistic conduct so long as there is meaningful competition for the rights to the monopoly franchise. ... Chadwick proposed that an auction be held in which the franchise is awarded to whichever bidder promises the best combination of price and quality to consumers. Competition would then drive bid prices down to competitive levels for each possible level of service quality.

Selecting a winner, that is, determining an optimal price structure and a mix of products, may be exceedingly complex, requiring the kind of expertise in the franchise-granting authority that one normally associates with a regulatory commission. In addition, there is no guarantee that bidding will be truly competitive; significant numbers of new firms may be reluctant to bid on a franchise that has expired when the previous franchisee is also in the bidding, since the previous supplier is almost certain to be better informed about actual cost and demand conditions than are the rivals.

Selecting a winning bidder may be difficult if technology has created a myriad of potential service options. But if it is possible to specify a limited number of service standards — as, for example, with water supply — awarding the franchise may not be troublesome at all. And where the pace of technological change is not too rapid — as, again, with water supply — it may be quite easy to agree on a formula for rate increases, and the possibility of midcontract renegotiation may never arise. Enforcing the contract will also be facilitated in industries with a relatively limited number of service standards to be specified.

Bids of current franchisees will incorporate a return to the knowledge asset that has been created, while bids of prospective franchisees will incorporate the capital cost of acquiring the asset.

Private Water Utilities in Practice

Privatization of the water supply in France has generally taken one of two franchise forms, though at least two variants of these bear mentioning as well. The first form is the concession. In this system, a private company is entrusted with the construction (or, possibly, overhaul or modernization) of the facility as well as its operation. Such a system is especially advantageous when the municipality lacks funds for a major capital expenditure. The concessionaire advances all capital for construction and operation, assumes full responsibility (and risk) for monitoring, management, and maintenance of facilities, and collects payment directly from users. The contract is usually signed for a long-term period — generally thirty years — to enable amortization of the original capital outlay. The contract sets the price of the water with a formula including a fixed and variable component. For example, a user may pay a set monthly fee for access to a supply pipe of a certain diameter along with a variable charge based on the number of cubic meters consumed.

In the second system, affermage, the expenses for the installation of major civil works are borne by the local community; the private firm then manages the completed facilities and provides working capital. Such systems are popular when municipal financing can be provided at preferential interest rates. The contract contains detailed specifications for maintaining or upgrading facilities. All electromechanical, hydraulic, and metering equipment is the operator’s responsibility, while civil works, water collection, and facility expansion are the responsibility of the municipality; pipe renewal may be the responsibility of either party. As in the concession system, a formula fixes the price of water; often, this formula contains a surcharge that the operator remits to the municipality for debt service.

Gerance, a variant of the affermage, involves roughly the same relationship between municipality and operator but more limited responsibilities for the private firm. The firm’s pay is based on a tariff list agreed upon by the local authority. Yet another variant, regie interressee, involves management of a public authority by a private firm that shares in the revenues or profits. In theory, the municipality retains overall management; the firm is an agent of the municipality and is paid a percentage of revenues (to which may be added productivity bonuses or a share of net profits). This system leaves greater authority with the municipality but retains access to the technical services of a company with specialized knowledge and abilities. Franchise contracts usually include clauses specifying the quality of services, the minimum quantity to be supplied to each individual consumer, the mains pressure, and procedures for renewal of the contract, in addition to the clauses relating to maintenance responsibilities and a pricing formula.

Additional evidence of the superiority of the private French system of franchising is provided by the observation that “water professionals” are increasingly traveling to Paris to learn the most recent developments in waterworks management and technology.

Chong & Huet (2009) studied the french water supply system. And give some more details about how public vs private firms may proceed their strategies. They hypothesize the following :

1) When the service is operated, managed by the municipalities, the officials (paid at fixed wage rate) have less incentive to collect all the relevant information about the network. But they would not hesitate to share, communicate this information. However, the information may be unreliable. For these reasons, they bear an “informational cost”.

2) When the service is managed by the private operators (services delegated to them by local communities) with franchise bidding contracts, the operators have more incentive to collect information about underground infrastructures because the costs deployed are compensated by more efficient pipe maintenance and renewals. However, because privately owned firms seek profits, they won’t probably communicate the information and will hide it, so that they benefit from their informational rents. For these reasons, they bear a “control cost”.

Chong & Huet (2009) discovered that information quality and prices of service are correlated only for the municipality-owned firms. That means higher informational quality is compensated by higher charged prices for the service from public-owned firms. Consequently, when information quality increases, the price difference among the privately- and publicly-owned firms tends to decrease when information quality increases, although the prices remain higher in privately-owned firms. They noted “when less than 20% of the network maps were actualised in 2004, the average price difference between delegated services and municipalized services approximately attained 42 euros. This difference is just 30 euros when information quality is excellent (i.e. when the values for INFO exceed 80%)”.

In their conclusion, they speculate that the control cost regarding the delegated (i.e., private) services would diminish in higher populated municipalities, for two reasons :

First, these municipalities generally dispose of more important internal skills than low populated ones, which enables them to exert a relatively more efficient (and then less costly) control of their private operator. Second, high populated municipalities represent an attractive market for private operators, which means that if shirking is detected, firms will have more to lose if their contract is not renewed. As a consequence, assuming that the probability for the municipality to detect shirking is constant, moral hazard issues may be less acute in high populated municipalities, which may result in less monitoring costs on average.

They show, graph 8, that there is a positive and high correlation between information quality and population (i.e., size of the municipality). They then conclude :

Consequently, when more explicit information is acquired (typically in high populated municipalities), the comparative disadvantage of delegated services with regards to control costs may be reduced whereas their comparative advantage in terms of both production costs and short-run benefits may not be affected. Indeed, concerning production costs, we have no reason to think that the public employee’s incentives to invest in the production of network information can be affected by the size of the municipality. Concerning short-run benefits, the improvement of network’s explicit information provide the municipality with a better idea of the operator’s operating costs, which may reduce its informational advantage. But the municipality may benefit from these gains before she acquires network information. If the firm anticipates that the municipality will seek to acquire new network information in the near future, he may report truthfully about its operating costs in the first place.

More generally, Rothbard (1962, ch. 10) in Man, Economy and State, provided perhaps what I believe to be the most cogent criticism of the natural monopoly on a theoretical ground. On the historic level, complaints made by small firms against monopolist abuses were the norm, as if the anti-trust laws were legitimate. To this effect, DiLorenzo (1985) talked about the origins of anti-trust laws. Because they were afraid about their own business, some businessmen asked price regulation laws against some large-scale firms, “In lobbying for antitrust legislation the farmers’ organizations claimed that trusts and combinations were monopolies so that the things they bought (from the trusts) were becoming increasingly expensive relative to the prices of farm products. Thus the trusts were allegedly ‘exploiting’ the farm population.” (p. 76), “If the trusts were restricting output (or slowing its expansion) and raising prices, small businesses would not have objected, for they would have benefited from the (higher) price umbrella. This point is of considerable importance. It is widely acknowledged that small businesses have always initiated antitrust cases against their larger (and often more efficient) competitors.” (p. 81). The facts told another story however. There had been increases in output. And decreases in prices even during the declining general price levels. Adding to this distortion of viewpoint, DiLorenzo cites some congressmen and senators who agreed that the corporate trusts, or the so-called monopolies with large businesses have reduced the prices, but that they have also committed a wrongdoing, specifically, driving out of business the smaller firms. For the customers, it’s probably not a wrongdoing. And yet, politicians wanted to ban the trusts. Congressmen generally seem to be afraid about the growing concentration of wealth of the capitalists making more and more profits. In sum, the historical opinion about monopolies didn’t match the hard facts.

References.

1. Chong & Huet (2009). Network information and performances in franchise bidding agreements: evidence from the French water industry.

2. DiLorenzo Thomas J. (1985). The Origins of Antitrust: An Interest-Group Perspective.

3. DiLorenzo Thomas J. (1996). The Myth of Natural Monopoly.

4. Hanke Steve H. & Walters Stephen J.K. (2011). Privatizing Waterworks: Learning from the French Experience.

5. Rothbard Murray N. (1962). Man, Economy, and State, 2nd edition, Chapter 9, Production: Particular Factor Prices and Productive Incomes.

6. Rothbard Murray N. (1962). Man, Economy, and State, 2nd edition, Chapter 10, Monopoly and Competition.

7. Thierer Adam D. (1994). Unnatural Monopoly: Critical Moments in the Development of the Bell System Monopoly.