On the origins of the concept of natural monopoly

							On the origins of the concept
    of natural monopoly
              Manuela Mosca

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




                                             1
          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
                                            2
              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
                                             3
              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
                                                     4
           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
                                                   5
         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?
                                          6
                 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
                                                7
               Method (1)
• History of analysis

• What are we talking about?

• Definition of the concept

• History of the concept

                               8
                        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
                                                            9
               Method (3)
• extract parts concerning natural monopoly

• no implication of a progression from errors
  to truth

• a progressive decline!


                                            10
                Method (4)
• a first step: clarifying confusions

• found priorities and influences

• some contextualization

• providing a sound basis for a further
  “historical reconstruction”
                                          11
                  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
                                                       12
                  Method (6)
•    Complex concept → different elements:

    1. the expression
    2. the concrete situations
    3. the inquiry into economies of scale
    4. the consideration of their incompatibility with
       competition
    5. the drawing of the diagram
    6. the need for government intervention

                                                     13
                  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
                                                  14
Natural monopoly




                   15
                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

                                                         16
Pricing policies




                   17
          Policy implications
• It is a market failure

• Government intervention is required
  – nationalization
  – regulation
  – antitrust



                                        18
       History of the concept
• the origins

• a different origin for every feature

• a separate analysis of the 6 elements




                                          19
        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”
                                                  20
        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)
                                              21
        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”

                                             22
     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”
                                               23
        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

                                                      24
     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

                                                  25
      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

                                                         26
     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)

                                                  27
     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

                                                       28
      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‟

                                                              29
      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‟

                                                                30
     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                                           31
     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)

                                                        32
     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‟

                                                             33
      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

                                                                  34
         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

                                                  35
         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
                                                     36
          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‟
                                                       37
            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

                                                                 38
          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‟

                                                    39
             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



                                                                         40
           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

                                                                41
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


                               42
 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‟
                                                               43
 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
                                                          44
 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
                                                     45
An overview




              46
    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
                                             47
      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)


                                                            48
    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

                                         49
      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

                                                         50
  History of the concept (5)

Edgeworth (1911-1913)

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

                                51
              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)

                                                              52
              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

                                                          53
               Criticisms (1)

• free market-oriented literature

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



                                                   54
              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)
                                                  55
         The cost function is subadditive up to
       Q*, meaning a single firm can produce any
           output less than Q* more cheaply
Cost      than 2, 3, 4, or any number of firms
            with each supply some fraction
                           of Q*




                  LAC1             LAC2




0      Q’      Q*        Q”                Output
                                                    56
              Criticisms (3)
• Sustainability:

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




                                                  57
             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
                                             58
              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.



                                                                      59
              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!
                                                                      60
         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
                                               61
           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?

                                                       62
                              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

                                                          63