Free Lunch (10 page)

The fact is that matching marginal cost and marginal revenue is one of the building blocks of business, even if it is implicit in the decisions businesses make rather than explicitly stated. The clothes retailer in the example above knows fairly precisely the prices he or she needs to be able to achieve at various times during the selling season in order to maximize profit. The retailer also knows that things can occur in real life that complicate the task. A mild autumn, for example, when few people buy winter clothes, would make it very hard to maximize profit. These complications aside, in the end businesses that ignore the economic rules will not survive long.

Theory and practice come together in areas such as economies of scale, which provided the rationale for mass production, for Henry Ford’s assembly lines, and therefore for industrial development in the twentieth century. Perhaps the best example where theory and practice come together, however, is in the field of competition. It is a rather interesting area.

Playing the monopoly game

When Britain’s Labour government was elected in May 1997, it promised many things. In the economic sphere, however, under Gordon Brown it was able to deliver a three-pronged reform of the economic policy framework. The first was to give operational independence – control over interest rates – to the Bank of England. The second was to put in place rules for the conduct of fiscal policy, tax and spending, of which more later. The third, which took the Treasury into an area usually thought of as the preserve of the Department of Trade and Industry, was a significant beefing-up of competition, or anti-monopoly, policy. The powers and resources of the competition authorities, the Competition Commission (the old Monopolies and Mergers Commission) and the Office of Fair Trading, were strengthened. The OFT, in effect the country’s competition watchdog, was given the power not only to initiate investigations but also to fine companies it suspects of stitching-up the market – running cartels – up to 10 percent of their turnover, and to prosecute, with the threat of imprisonment, directors who obstruct its investigations. Some of this was influenced by America, where tough anti-trust laws have been in place for decades. There has also been a strengthening of EU-wide competition regime.

It remains to be seen how successful this approach, criticized by the business lobby as draconian, turns out to be. There were two reasons, however, why the government was keen to crack down on monopolies. The first was that it believed they acted to the detriment of consumers, charging them higher prices than would be the case if many companies were competing for custom. The second was that lack of competition was seen to be damaging in another way. Competition, ministers and officials said, was vital for economic efficiency. Monopolies, because they have the market to themselves, can become bloated and inefficient. This, in turn, affects the country’s ability to compete with others, the nation’s ‘competitiveness’. As an aside, you will have noticed by now that there is a tendency in economics for similar words to have quite different meanings. In this case, competition refers to the extent to which different firms are able to compete for business in a particular market. A contestable market, to introduce another term, is one in which it is easy for firms to enter (or leave). Competitiveness means the ability of one country’s economy (or the individuals and firms than make up that economy) to compete with others.

Why is lack of competition, monopoly, bad for consumers? After all, if economies of scale are involved to any degree, will it not be the case that bigger is cheaper? Ford, which would doubtless love to have a complete monopoly of the car market, could claim that adding to its already very long production runs would bring down the cost of each car produced. It would also save on the vast amounts of advertising it employs to try to convince customers its products are better than those of General Motors, Toyota or Fiat. A benign monopolist would surely give us the best of all worlds.

The problem, apart from the fact that the idea of a benign monopolist is probably a contradiction in terms, is that it would not be the best of all worlds, by a long way. For one thing it would deprive consumers of choice, and choice is in itself a significant benefit. More importantly, monopoly is likely to mean higher prices. Why is this? The best way of thinking about it is to compare two extremes. One is ‘perfect’ competition, a situation in which very many firms compete in an industry, each producing identical products, and none big enough to influence the price with its behaviour. Each firm produces to the point where its marginal cost equals marginal revenue, so this is also the situation for the industry as a whole. Each firm has to accept the price set by the market and that price, by the magic of competition, not only maximizes the profit of each individual firm but it is also lower than would be charged by any monopolist.

This is because the monopolist, in contrast, can influence prices. Let us suppose that Ford, which we assume for these purposes is the sole supplier to the UK car market, could sell one million cars a year at £10,000 each but two million at a price of £5,000. It cannot, by the way, sell the first million at £10,000 and the second at £5,000 because it would not be acceptable to the first million customers. The more the company supplies, the lower the price it gets. The monopolist’s demand curve (the lower the price the more customers will want to buy) is the same as that for the industry as a whole. He, in other words, is the industry. So what does the monopolist do? What he does is simply follow the standard rule, by also producing to where his marginal cost and revenue are equal. The monopolist, however, is unusual: the extra revenue he gets from selling, say, an additional car, has to take into account the fact that producing more in a given period will lower prices across the board. This is easy to demonstrate. Say Ford worked out that it could sell 1,000 cars at a price of £10,000, but to sell 1,001 the price has to drop to £9,999. The marginal revenue from the 1,001st is, in effect, £9,999 less £1,000, £8,999. Why? Because the £1 price cut on the 1,001st also has to apply to the first 1,000 off the production line but not yet sold.

Two things result from this. The first is that a monopolist will produce less than would be the case in a perfectly competitive market with lots of firms fighting for their share. The second is that prices will be higher. For the perfectly competitive firm, marginal revenue is equal to the price in the market. For the monopolist, price – in this case £9,999 – is higher than marginal revenue (£8,999), and he is able to make ‘supernormal’ or monopoly profits. This is why monopolies are bad for consumers.

Real-world competition

Textbook ideas of competition and the real world are rather different. There are very few cases of firms being so powerful and dominant that they can maintain a permanent monopoly position in which barriers to entry are so formidable that potential competitors are permanently deterred from trying to take them on. There are plenty of examples of temporary monopolies, such as when a company has developed an entirely new product, particularly when it is protected by patent. Typically though, such monopolies do not last, even with patents. The makers of the Rubik cube, an immensely popular puzzle, enjoyed a brief and hugely profitable monopoly in the 1980s before competitors and black-market copiers moved in. So did Laszlo Biró, who in 1938 invented and marketed the first ballpoint pen. We may still often call such pens ‘Biros’ but the market in them is no monopoly, in fact it is highly competitive. Some monopolies do, however, survive. So do plenty of examples of oligopolies – industries where there are just a small number of competitors, perhaps four or five.

In Britain it is common to talk of the Big Four high street banks – currently HSBC, Lloyds-TSB, Barclays and Royal Bank of Scotland (which acquired National Westminster, previously a big four bank). In food retailing, too, it is common to talk of the Big Four – Tesco, Sainsbury, ASDA and Safeway. Both sectors have been the subject of regular investigations by the competition authorities to try to detect whether they are engaged in collusive, or cartel-like, behaviour. A cartel is when a group of firms, big enough to dominate the market, plot together so that they collectively act as a monopoly, setting higher prices and achieving monopoly profits. On its website, the OFT offers immunity from prosecution to people who inform on companies they suspect of engaging in cartel activity. Anti-competitive behaviour does not necessarily involve cartel activity. In 2001, for example, the OFT successfully pushed through a change which significantly reduced the prices of over-the-counter medicines. In that case, while high prices were benefiting the pharmaceutical companies, they existed because, thirty years earlier small chemists had persuaded the government that resale price maintenance (the fixing of prices by the manufacturers) should be allowed to prevent them being driven out of business by the bigger pharmacy chains. The OFT’s view was that this was a restrictive practice that acted against the interests of consumers.

When it comes to cartels, the real-world example most people think of is the Organisation of Petroleum Exporting Countries, OPEC, which has in the past successfully restricted output in order to raise world oil prices, most dramatically in 1973–4 and 1979–80. There is, however, a question about whether OPEC, which controls about 40 percent of world oil supplies, has a sufficiently dominant position to act as a true cartel. In recent years it has relied on the co-operation of non-OPEC oil producers to achieve its aims. Experts predict, perhaps worryingly, that OPEC’s dominance of world oil supplies will increase significantly during the twenty-first century.

Monopolies and privatization

One of the problems economists have with monopolies is that there is often a trade-off between the efficiency that can arise from having one large supplier, most notably economies of scale, and the risk, indeed the likelihood, that monopolies will exploit their position. What happens, for example, if the optimum size of an industry, in terms of efficiency, is just one big firm? What happens if there is a ‘natural’ monopoly? In Britain the traditional response to this problem was to accept the argument that there were certain natural monopolies, or at least sectors where competition was wasteful and inefficient. What purpose could be served, it was argued, from having two companies competing to send gas along adjacent pipelines to supply homes, factories or offices? Or two or more sets of electricity cables? The solution, therefore, was to allow monopolies in these areas but bring them under public ownership in order to ensure they did not make excessive profits. Many of Britain’s nationalized industries, most brought into public ownership by the 1945–51 Labour government, were monopolies. But, being controlled, they did not make profits at the expense of the consumer. Many, in fact, did not make profits at all.

The existence of public sector monopolies, in gas, electricity, water, coal, rail, telecommunications and other areas, created a problem for the Conservative government when it wanted to privatize them in the 1980s. On the one hand, their monopoly status made them highly attractive to investors with an eye on the potential profits these industries could make once transferred to the private sector. On the other, there was a risk of creating Frankenstein’s monsters – great bloated but enormously profitable firms, dominating the supply of essential services. The approach to this problem evolved over time. British Telecom, in which the government in 1984 first sold shares, was transferred to the private sector as a monopoly. It was given its own regulator, Oftel, vital to oversee the conduct of such a huge monopoly, but the regulatory regime for the first few years was a loose one. Investors made a lot of money. Gradually, through the privatizations of gas, electricity and water, a more sophisticated approach evolved, allowing enough in terms of potential profit to achieve a successful sell-off but introducing stiffer competition at an earlier stage. By the time the government privatized British Rail in 1996, it believed the process had evolved enough to allow competition from day one. Thus, the nationalized British Rail was broken up into three broad segments, one company with responsibility for the track, signalling, stations and land, Railtrack; a whole series of train-operating companies running different services; and rolling-stock leasing companies, which took on BR’s locomotives, carriages and trucks and leased them to the operating companies. The result was not only the instant break-up of a monopoly but, many would say, a fragmentation that led to many of the subsequent problems of the railways, including the failure of Railtrack, culminating in the Labour government’s decision to put it into administration in October 2001. Monopoly can be bad, but you have to take care when dismantling it. Indeed, the debate over rail privatization raises questions of whether the nationalized industry was a natural monopoly and whether a better solution would have been to invest more money in it while maintaining public ownership.

Is the Internet perfect competition?

When the dot.com revolution happened in the second half of the 1990s industry analysts predicted an explosion in online retailing, or B2C (business-to-consumer) sales, as well as a big increase in B2B (business-to-business) and B2G (business-to-government) activity – there are probably many more of these acronyms but that is enough. Economists, meanwhile, asked a rather different question. Was the Internet a real-world example of the perfectly competitive market of the textbooks? Its claims to be so were rather good. For one thing, the barriers to entry in the vast majority of online markets appeared to be very low. Anybody could set themselves up as an e-tailer of, say, books or compact discs, as long as they could buy such products wholesale from the publishers or manufacturers and could take on a few people to pack them up and send them off to customers. Compared with the cost of establishing a nationwide network of shops to take on WHSmith, Our Price or Virgin, even a state-of-the-art website required only a small outlay. If one requirement of perfect competition is that there are many competitors, the Internet also fulfilled another. One source of monopoly pricing, for any product, is the lack of information available to customers. I can sell you a CD for £15 as long as you are unaware that a few miles away somebody is selling it for £12. To make you aware, my competitor would have to advertise, which would increase his costs. Even then, you might decide it is not worth the journey.