The term monopoly is commonly understood to mean a single seller of a valuable item (good or service). While this view does capture the basic intuition of the nature of monopoly it can be very misleading. Being a single seller is neither a sufficient nor a necessary condition for the possession of monopoly power. The discussion is confused by the tendency to use the categories that have been developed in neoclassical economics to define monopoly and to fashion legislation and regulation to deal with it.
In order to understand both the question of monopoly and the anti-monopoly (anti-trust) regulatory environment, therefore, we need to understand the categories that have been development in neoclassical economics and how this has become embodied in the law and in the regulatory environment. Once we understand this we can analyze its limitations and move beyond it.
Neoclassical economics was born in 1871 with the discovery of the notion of marginal utility and the realization that the tools of marginal analysis could be applied to all aspects of economic life. It reached its definitive level of completion in the 1930’s when the theory of perfect competition and monopoly was worked out and it is this theory that has been the basis for the current regulatory environment. At the one extreme we have markets with very many buyers and sellers, each one of whom is a price taker. If this is a market for a standardized good or service, each competitor selling exactly the same item (no product differentiation), and if this market is one in which buyers and sellers are very well informed about all costs and prices, and if the technology of production and the characteristics of the good or service is not changing, and if there are well defined and enforced property rights – so that there are not hidden “social costs” - (all big ifs), then we will tend to have a situation that the neoclassicals refer to as perfect competition. In perfect competition, once a long run equilibrium has been established, the price will equal the marginal cost and both will be equal to the average cost at the lowest possible average cost. Thus perfect competition is seen as a situation of maximal efficiency. A competitive output is being produced at the lowest possible cost. This is frequently seen as a competitive ideal for economic policy in the sense that where it does not apply policy should take steps to promote it or simulate it (for example, by forcing the regulated company to produce at a price that is equal to marginal cost).
So our first problem with prevailing regulation is to note that perfect competition may be an inappropriate standard. It is not really a competitive situation. It is a situation in which all competition has ceased. No profits are earned, no innovation is taking place and there is no ignorance or bargaining in the market. It has very little relevance to the benefits that consumers may expect to gain from real world competition.
At the other extreme, neoclassical theory identifies the monopolist as a single seller. The single seller will maximize profits (like everyone else) by producing a quantity for which the marginal revenue equals the marginal cost and this, obviously, implies a lower quantity and a higher price than that which would prevail under hypothetical perfect competition. This approach leads one to infer the degree of monopoly by the number of firms (sellers) there are in an industry, by market share – the fewer the greater the degree of alleged monopoly power – or by the extent to which the seller can control the price - the elasticity of demand (but remember a seller will always raise the price as long as the elasticity is less than one (unity – 1), so even observing elasticity in this framework may be misleading).
This is our second problem with the prevailing regulation. This view of monopoly is, like the view of perfect competition just mentioned, completely static – it makes no mention of the passage of time and its effects. At any point of time one or a few sellers may dominate the market only to be replaced over time by a more efficient competitor. Even one or a very small number of sellers can face vigorous competition over time, or the threat of competition, which may greatly reduce their control over price.
Thinking about monopoly in the real world forces us to consider the process of competition over time. All of the conditions of the model of perfect competition are violated in important ways that make the perfect competition standard inappropriate. In the real world competition proceeds by companies experimenting with new products, new methods of production, new resources and competing with one another vigorously for the consumers’ business by lowering prices and/or improving quality. There is no way to predict who will win the competitive struggle and today’s winner may be eclipsed tomorrow.
Understanding this leads us to a different view of monopoly and of anti-trust policy. This view sees monopoly as the power that a seller has over the price he/she can charge by virtue of special protection against competition over time. So it is all about the ability to compete and freedom of entry by actual or potential competitors. We may ask, what constitutes a real or credible barrier to entry that would protect a seller? A number have been discussed in the literature and are discussed in Armentano. In the final analysis only one remains – governmental protection.
From this perspective, monopoly power has nothing to do with the number of sellers or the size of the elasticity of demand. The only relevant consideration would be whether the seller in question has the power to prevent competitors from entering the industry and the relevant consideration for policy is whether the policy-makers can be assured of making things better for consumers. Finally, note that the ability to price discriminate has nothing to do with monopoly per se and is a practice that is widely practiced throughout the economy with various effects.