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.
2.
3.
4.
the expression
the concrete situations
the inquiry into economies of scale
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 setup, 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
Cost
The cost function is subadditive up to
Q*, meaning a single firm can produce any
output less than Q* more cheaply
than 2, 3, 4, or any number of firms
with each supply some fraction
of Q*
LAC1
0
Q’
Q*
LAC2
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