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its through further activity. If such opportunities exist, the s)stem caiuiot be in equilibrium. Conversely if the system is in equilibrium, gains from further activity are presumabh exhausted.


A function of profits in a capitalist economy is to attract entry. entry does not occur in the face of long run profits barriers to entry are said to exist. We turn now to the sources of such barriers. Frequendy, the government itself imposes direct barriers to entry and compeddon. For example, prior to the wave of de-reguladon of industry supported by the Reagan administradon, the Interstate Commerce Communism (ICC) adopted rules which made new entry into trucking effectively impossible. The ICC published minimum rates which were enforced at public expense by inspectors employed to prevent price cutting. Essendally, the ICC was protecdng the transportation industry from price compeddon rather than protecting the public from the predations of monopohsts.

Government protecdon rather than comped-" don for the favor of consumers has also emerged in a number of other industries. For example, the Jones act shields American shippers from low cost foreign competidon on cargo hauls between American ports. Environmenul and healdi regulations are also often used to thwart competition and entry. As just one recent example. Eastern coal producers combining with environmentalists succeeded in passing a 1977 law requiring sulfur scrubbers on all new coal fired utility plants, including those burning low sulfur western coal. The effect - and we dare say intent - is to injure competition from western coal producers. Regulations that impede the flow of new drugs through protracted and costly testing can similarly shield existing, but inferior old drugs from new competition. ile this is not the place for a catalogue, competition for government protection has replaced competition for consumer satisfaction in numerous other industries. The basic point, however, is this: although regulation can be an extremely burdensome and costly nuisance for an industry, it can also confer benefits by hobbling competition. For this reason the strongest advocates for regulation are often die regulated industries themselves - trucks, railroads, drug companies, savings and loan associations, insurance companies, cable televasion networks, and a long list of others. VVTiile regulation only rarely creates true monopoly unaccompanied by price regulation (certain drugs are examples), it often does create the

downward sloping firm demand curve associated with monopoly. To the extent that any firms demand curve slopes down, regardless of whether it is a monopoly is said to possess monopoly power, also termed market power. Consequendy all price-searching firms have a degree of monopoly power by definition.

Occasionally the government creates insuperable barriers to entry thereby directly causing monopoly. For example, only die U.S. Post Office has the legal right to deliver mail, and in many states liquor and gambling are supplied solely by the government itself. More commonly, the government issues patents lasting eighteen years to inventors. While the patent is in force, nobody but the inventor, or more typically, the company to whom the inventor assigns the patent rights, will have the legal right to sell the invention. For example, Xerox once had a patent monopoly on photocopying and IBM has enjoyed a patent monopoly on certain computer Components. Patent monopoly is, of course, a short run phenomenon which prob ably serves consumer welfare. After all, would Xerox have been wilhng to invest in photocopying if iu discoveries could be insuntly stolen by a competitor?

Resource Barriers to Entry

Monopoly can also arise because a firm simply controls the worlds only mineral supply. For example, de Beers Consolidated Mines once controlled nearly all sources of natural diamonds in the world, though it had no control over synthetics. This type of monopoly is, however, exceedingly rare; the distribution and ownership of the worlds mineral resources is enormously diffiise.


If one firm can supply the good at a lesser cost than two or more firms, we would have an example of a cost barrier to entry. Consider the cost of delivering electric power to a cit) block. If there is only one customer on the block, he will have to co\er the entire cost of constructing power poles down his alley. As such, average total cost will be enormously high. But if we add a second customer, i.e., we double the quantity, average total cost will fall dramatically because the cost of the poles can now be spreiad out over tivo cu.v-tomers instead of just one. Adding still more customers continues to decrease average total cost; after all, the only new expense is the small cost of stringing more wire along the existing poles. Consequendy, in Figure Xlll, average total cost falls continuously over most of the range of the market demand cun-e. \

Fig. Xlli

Fig. XIV

Market too Small to Share

Natural Monopoly Equilibrium

this phenomenon occurs, a natural monopoly, sometimes called a technical monopoly, is said to exist.

Under natural monopoly only one firm can survive in the market because losses would be sustained under any alternative market structure. Starting with the inidal monopoly, imagine that a second firm enters and equally shares the market demand curve of Figure XIll. Then the demand curve faced by each individual firm would be half that of the market demand curve and would be given by d*. Under such circumstances, neither firm could cover its average total cost at any output along its demand d*. For instance, if each firm produces at arbitrary-output such as q, average total cost would be *. Since * exceeds the price P* at which these q unit could be sold, a loss such as the shaded area would occur.

Therefore, one of the firms would exit, leaving a natural monopoly behind.

The equihbrium of the remaining firm in Figure XrV is just the usual monopoly equilibrium. Note, however, that the average total cost curve is sdll "U" shaped; natural monopoly does not require continuously declining average total cost. Low market demand reladve to "normal" scale economies is sufficient to genera.te natural monopoly Nonetheless, if average total cost does fall continijoiisly,"wfiiclf is to say that economies of scale are unlimited, a natural monopoly will assuredly result.


Consider the natural monopoly of Figure XV.

Thi CiiinjHlilivr In II,

Our previous discussion implies diat ttie efficient output is Q, where the demand price or marginal benefit (MB) just equals marginal cost. However, even if the government orders the monopolist to produce Q, the output cannot be sustained. Q units sell for the price of P but the average total cost is , so that the natural monopolist would experience a loss equal to the shaded area. Under such condidons, the monopolist would ultimately be driven out of business.

Some economists have proposed that the government subsidize such natural monopolists. Under this scheme, known as marginal cost reguladon, the monopolist would produce the efficient output of Q, where the MC curve strikes the demand curve. It would then collect a total revenue of PQ, and receive a subsidy equal to ( - P)Q, die loss m Figure XV. That way the monopolist will eam a normal (zero) profit, and the efficient output Q will be produced.

While this proposal is technically correct, given its assrunpdons about costs, it rests upon an Achilles heel. Ifthe government guarantees a normal profit by making up the difference between averse total cost and price, the monopolist has litde incendve to keep his costs under control. After all, unlike compeddve firms, the monopohst in this situadon receives a guaranteed rate of return even if he incurs costs recklessly. As such, the subsidized natural monopolist can order fancy cars, ca ets, facilides, and experts, while using human and capital resources profligately. The effect of all this is to shift the subsidized monopoUsts average total cost curve up to * in Figure XVI. To avoid clutter, weve not bothered to depict the resuldng equilibrium. Nonetheless, no matter where the monofralist operates along this inflated cost curve, we would end up

with inefficiency. The total cost of producing the nionop olists chosen output would be higher than necessary

A second type of monopoly reguladon known as average cost reguladon allows the monopolist to charge a price high enough to cover his average total cost. Figure XVII displays how this type of regulation is supposed to work. The equilibrium price is given by P*, where the demand curve just strikes the firms average total cost curve. Equilibrium quandt) is Q*. Although the firm does not produce the opdmal quandty Q output is greater and price lower than in the unregulated monopoly equilibrium of P and Q.

Like marginal cost regulation, average cost regulation works better in principle than it does in practice. As with marginal cost reguladon, the monopolist under average cost reguladon lacks incentives to control costs. Thus, in Figure XVIII his average and marginal cost rise so much that the regulated price Pr is higher than the unregulated monopoly price . In addidon, the regulated output of Q- is even smaller than the unregulated output of Qu- The monopolist will be content with these massively inefficient results. Not only does he make a guaranteed normal profit, he can also enjoy all the wastefiil amerudes and indulgences available under marginal cost regulation.

While marginal cost reguladon is virtually unknown in the real world, average cost reguladon is almost universal. For example, in Califomia the Public Udlides Commission allows public udlides such as g2is, electric, and telephone companies a "fair" rate of return on their investment through average cost, reguladon; at the same dme it bars entry into these businesses by new compeddon.

Although in Figure XVIII weve sketched die

Fig. XVII Average Cost Regulation In Theory

Fig. XVIII Average Cost Regulation In Practice

P --

\ MC

r-0\ zATC

MC* -

Q, Q,

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