Public and private monopolies what are the positive and negative effects on the consumer
An economy comprises of a large collection of firms and consumers that operate on the basis of market mechanisms known as supply and demand. These are used by firms to determine the level of production, the output required to meet consumption, the price as well as the consumption level. From a microeconomic point of view, markets that exist within the economy are governed by these mechanisms but in actuality this is not the case. Inconsistencies do occur in markets due to competition and firms within the market’s tendency to earn more profits.
Power to over produce and earn more profits comes from successful firms that attain equilibrium in the market or through mergers and acquisitions. As a result of horizontal integration (in which two or more firms join hands to produce in one industry) and vertical integration (firm develops market dominance by integrating indifferent stages of production) a market tends to develop monopolies(Tutor2u.com 2004).
In such a market firms aim to generate higher profitability by increasing market share and by exploiting economies of scale. Competition in the market therefore is reduced as the result of firms growing through internal expansion. This kind of tactics according to economists harms the interests of the industry as well as the consumers which eventually lead to economic instability. To curb this, the government often adopt regulations to prevent monopolies from having an advantage over the existing or new firms and exploiting the consumers’ interests.
Why monopolies are discouraged is because their tendencies to earn higher profits at the cost of allocate efficiency (Tutor2u.com2004). A monopolist would set the price of the product or service high to exploit the consumers’ needs and wants without satisfying incompletely. Consumer sovereignty thus is replaced by producer sovereignty (Tutor2u.com 2004).
This turnaround from consumer sovereignty to producer sovereignty stems from the basic economic principles of economic welfare. Welfare refers to the best use of scarce resources in an economy. This means that welfare is about maximization of resources with optimum outcome(referred to as economic efficiency). Maximization means the firm needs to achieve:
a. “allocate” efficiency – resources being allocated to the activities where they are most valued; and
b. “productive” efficiency – resources being used in the most effective way possible (Coopers & Lybrand 1996).
Welfare economy is based on the free market concept with the assumptions that certain conditions are fulfilled. These conditions include large number of producers and consumers; it does not take into account of income distribution or equity considerations; there is perfect competition; and economic efficiency is achieved. Monopolies are also based on the economic models of competitive market and principles which include demand curves (D), supply curves (S), average cost curves (AC), marginal cost curves (MC) and marginal revenue curves(MR) (Coopers & Lybrand 1996).
Demand curve refers to the demand by the consumers and the price they are willing or able to pay for the products. This is in turn governed by the budget constraints, relative prices, preferences and income. What the consumer is willing to pay and what is the actual price are different and the difference between the two is called consumer surplus.
Supply curve illustrates the volume the producers are willing to supply at a given price. There is a difference between the actual price and the price at which the producer is willing to supply the products. Thesis known as producer surplus.
Marginal cost refers to the cost for producing each additional unit of output.
Marginal revenue curve show the total revenue earned by producers through a change in price and output demanded (Coopers & Lybrand1996).
Given the above constraints and principles, the researcher illustrates the condition of competitive market through the following model and leads the readers to the condition for monopolies.
In a perfectly competitive market it is assumed that there are a large number of informed buyers and sellers. The producers are the price takers while the market price is governed by the supply and demand mechanisms. It is further assumed that should any seller tries to raise the price the consumer would switch to another supplier and hence the condition of the profit maximizing firm is such that it would attempt to increase output to attain equilibrium through marginal cost and market price. This would allow the producer to earn maximum profit, incur constant average cost and no fixed cost. This condition is denoted by AC=MC (as shown in the figure).
In the above diagram one observes that the consumer surplus is the consumer’s ability to pay more indicated by the shaded area while there is no producer surplus. This means welfare maximization has been achieved. Even when the price is increased from P to P1 the output level would fall from O to O1, the consumer may not be willing to buy the product even if he/she has the money to do so. Alternatively, if the price is decreased from P to P2, below the MC then the level output would rise because the consumer is willing to buy more of the product at a lesser price. Hence, under perfect competition:
– “the price is equal to the marginal costs
– Producers earn a normal profit (zero producer surplus); and
– economic welfare is maximised, so the outcome is economically efficient” (Coopers & Lybrand 1996).
However, in the real world market condition and competition is far from perfect and this model of perfect competition is often marred by other kinds of unfair competition including monopolies.
In the classic case of the monopoly there is only one producer who is the price setter and the consumer is the price taker. The producer would maximize profit by setting the level of MR = MC and a price that the consumer will bear. In the following figure one observes that when the producer produce low level of output the MC is below the MR. What this tactic does is that it lets the producer to control the profit by increasing output while the price is set by the demand curve.
Hence in a monopoly there is:
“- a lower level of output (O compared with O1);
– A higher price (P compared with P1);
– Profits in excess of those required to earn a reasonable return (ABDE is “monopoly” profit or producer surplus); and
– a reduction in economic welfare; the loss of consumer surplus -resulting from higher prices is ABCE, which is more than the benefit tithe producers in terms of higher profits (ABDE); this net loss, represented by the triangle BCD, is called dead-weight loss” (Coopers& Lybrand 1996).
With this background monopoly can be defined as:
“A monopoly is a large, single supplier that dominates an industry”(Cleaver 2002). A single producer dominates the market by setting the price and gains high profits through producer surplus at the cost of consumer surplus. A monopoly therefore compromises the economic welfare. A monopoly can further be categorized as private or public monopolies. “Private monopolies can make huge profits by charging higher prices than a competitive firm could demand – for this reason they tend to be either outlawed in market societies or taken over byte state. Public monopolies are common, intending to provide public services (e.g. postal services transport, etc.) at low cost. The lack of competition for such giants, however, whether privately or publicly owned, tends to breed inefficiency: there is no incentive to serve the public well, since consumers have no other choice of producer to buy from.” (Cleaver 2002).
Given the above brief explanation of monopolies and the consumer’s position in the competitive market, one understands that economic theory form the basis for comprehending the structure of real markets, it does not actually present a realistic picture. A framework such as the above would guide the policy-makers in regulating the monopolists and establishing pricing policies but would it maximize consumer economic welfare? What are the effects on other firms? What impact do they have on the policies and the business environment? More importantly, how the differences between public and private monopolies affect these consumers? These are some of the aspects that the researcher aims to investigate in the following sections using the above framework as a guide.
To illustrate the above problem statement the researcher adopts the qualitative method to carry out the research. This entails the use of secondary resources as well as primary resources. In the next section the researcher reviews secondary literature including magazines, newspapers, websites and educational institution material. To enforce the concept of public and private monopolies the researcher also takes into account of primary resources such as journal articles, books and official publications. The purpose of combining primary and secondary resources is to ensure that the researcher has based the analysis on both the theoretical and real life situation.
To illustrate true life situation the researcher has also adopted the case study method. Case studies of Royal Mail and Microsoft have been included to represent public and private monopolies respectively. The cases would help the researcher and readers to understand why monopolies behave the way they do, and how they affect consumers as well as industry to which the firms belong.
By combining both the qualitative and case studies the researcher aims to analyse and come to conclusive views of how monopolies operate, its negative and positive effects on consumers and what impact do they have on the business environment.
In an economy there are public as well as private firms. The public and private nature of firms keeps a balance of private and public consumption. The rationale is that some goods and services are required by the public but they are not willing to pay for its welfare maximization. These goods and services are demanded by the people but nobody is willing to pay the price for its supplies. For this reason the government takes upon itself to create firms, either through deregulation or setting up independently, with the purpose to provide these public goods and services to the public.
With the high demand in today’s global market for higher efficiency and effective allocation of resources, many economies are opting for privatization of firms. Many consider privatization as more efficient even for public sector organizations. In the majority of countries, public utilities like electricity, gas, water and postal services remain in the control of the government. However, it must be noted that most of these utilities providing companies are running at a loss and cost of the government as there are only few people who are willing to pay for the goods and services provided.
According to Edwin West (1982)”Once in operation it is very difficult to stop individuals tuning into obtain its benefits free of charge. This creates the now familiar “free rider” dilemma, in which nobody will produce the good because nobody is willing to pay sufficiently to cover the costs.” Since there is no value or profit involved, the government becomes the undisputed provider and therefore attains the role of the monopolist.
In a public monopoly from an economic point of view there is only one seller in the market. Whatever profit, if any, acquired through the operation of the public monopoly belongs to the seller, in which case it is the government or the state. Public organization is owned by the government and often requires a lot of resources for its operations. Investments from taxes and the government budget provide for the required funding to operate these public entities.
It may or may not operate for profit and hence a fixed profit is not expected from government owned firm. The public sector organization becomes the undisputed seller in the industry because it runs through state subsidy and can afford to operate at a lesser or zero price. For private enterprise to compete with this structure is highly difficult especially at an operating loss. This is illustrated as follows:
In a state owned scenario the competitive market price is set at MC of dissemination and ED becomes the supply curve (S). Since this price is so low there is high demand for it. In some cases such as the Royal Mail there is a constant demand or outcome which does not get affected whether the price is low or high as postal services are required by the public regardless.
However, as the producer is operating at a low price that means the cost of dissemination is high and the producer is operating at a loss. The overall result is welfare loss due to the fact that the producer surplus is less than the consumer surplus which equates to producer low surplus. In the following diagram one observe that the area ABDE is the consumer surplus which is basically a loss while the area ACDE is the producer surplus which is negated by the consumer loss. The net welfare BCD is less than the loss incurred on the consumer.
Even when the government subsides and allocates more resources it would generate sub-optimal resource efficiency and thereby low social welfare. Government owned organizations such as the Royal Mail often require injection of investments by increasing the subsidies with the hope to increase the social benefit and welfare of the consumer. However, the external benefits may increase for a certain period only and relapse in the long run (see figure 6.3) (Coopers & Lybrand1996). This has been the case of Royal Mail in the United Kingdom.
The history of Royal Mail can be traced to the period of provocation in1979 in the UK. Most of the UK enterprises had been public enterprises and the government had taken extensive steps to privatize these enterprises with the view to reduce states’ expenditure and to shift the burden cost to the private sector. As a result 7.2 present of the public owned enterprise reduced to 2 present (Cook 2005). Despite the size of the program some of the government organizations remain within the domain of public sector.
During the 1980s under the Labour Government this process reversed and as a result most of the industries became nationalized including the steel, automotive, shipbuilding, aircraft and postal industries. Most of the policy makers favoured the public owned enterprise due to several reasons.
Firstly, it accounted for a larger share of the national total output and employment share. Most of these organizations are large and required a large number of workers to support its infrastructure. Since the Labour Government favoured labour intensive organizations, through public ownership it ensured job security for the majority of the population (Cook 2005).
Secondly public monopolies such as the mail, airline or the steel industry have been essential services for the country that only the government can subsidize and finance.
The massive infrastructure required for their operations made them unattractive to investors. For example the education system, legal framework as well as defence system. These were essential to the public but no single investor would be interested in investing huge funds with bleak future of running at aloes. Only the government with its access to huge funding was willing to invest in such public enterprises.
Thirdly, organizations belonging to the public sector may enjoy the monopolist status yet not become regulated due to the government’s backing. As a result the resources allocated for its operations secured public welfare.
Fourthly, public sector organizations worked in the interests of the consumer regardless of its inefficient status or costly structure. They were accountable to the electorate and not to a group of shareholders alone making them exclusive for a large group of consumers (Cook 2005).As a result of the deregulation, the UK government had been able to secure quite a few public monopolies.
It has been observed that most public monopolies are redundant and donor serve the purpose of the consumer as efficiently as the government perceive. Compared with the benefits they provide to the consumers, public monopolies are not as efficient in delivering what they promise to the consumers.
Due to the slow innovation and dynamic nature of these enterprises, the result is that they do not change with the consumer need. Poor quality is inherent in the kind of service they provide due to mismanagement and lack of training in the organizations. Other factors that lead to poor quality include incompetence, irresponsibility and the lack of accountability to specific authority (Saves 2000).
Since there is no competition in the industry to give public monopolies “wake up” call and motivating them to innovate to serve the consumer welfare the public enterprises continue to provide services that may not serve the welfare of the consumer fully. For example the need for postal service in this day and age of technological development has decreased significantly (even though parcel services are still required).
Public sector enterprises tend to lead to inefficiency due to the vast management and personnel structure. According to E. S. Saves (2000)government performance are reflected in these public enterprises in terms of inefficiency, overstaffing and low productivity. These organizations tend to employ twice as many employees per customer so that the resources become a waste which could easily be allocated to another entity where they are required. Although the government regularly inject investments for appropriating incentives through pay and rewards yet the distributed amount is so less to the individual worker that they remain unsatisfied working at the public organization leading to low productivity and inefficiency.
Secondly, one of the biggest complains is that the publicly owned organizations do not have a choice in the products and services they get due to the lack of variety and choice. Due to the monopolistic behaviour, public enterprises tend to lack innovation to diversify resources or products to attract the consumers. As a result the consumers are forced to purchase products that they may not prefer, thereby stifling consumer preference.
Thirdly, it has been observed that most public monopolies require huge investment funds at the cost of the taxpayers and the government. Indirectly, the consumer is forced to pay a price for services or products that they may or may not want to utilize.
Fourthly, the public monopolists are not accountable to any one in particular but to a body of electorate that may be influenced by political entities. Hence, if there is a Labour government then the public enterprise would get more subsidies to increase its performance and thereby serve the public welfare more. However, on the other hand if there is a Conservative government then the enterprises would get fewer subsidies, decreasing its resources and efficiency. As a result there are fewer benefits to the public despite the high price they pay through taxation and allocated cost.
Public policy in the past has been concentrating on the privatization of enterprise due to several reasons. Saves (2000) notes “Some state enterprises are not expected to break even or make money, but many are. Nevertheless, loss-making and debt-ridden government enterprises tend to be the rule rather than the exception even among the for-profit group, and this is the principal impetus behind the worldwide movement to privatize such entities. The underlying reason for this state of affairs is the lack of true financial accountability. That is, government agencies and GOEs are rarely subject to binding budget constraints; they can usually muster enough political pressure to extract more subsidies.”
Furthermore, public enterprises have less inclination towards improvements despite the high level of investments. According to Akira Nishimori and Hikaru Ogawa (2002) “First, suppression of the monopoly rents and improvements in allocate efficiency: admitting private firms into a market brings about increased output and lower prices. Second, a higher level of productive efficiency in the public sector; cost reducing incentives will emerge in the public sector’s service production when it faces private competitors.” They describe the public monopoly situation as follows.
A two-stage optimization situation for a public firm is taken as an example. The cost reduction choice of investment is the first stage and the quantity supplied to the consumer is the second stage. When the monopoly equilibrium is achieved, maximization diminishes with the increase in investment in the short term. In the long run therefore the public welfare is decreased as the price continues to increase yet welfare maximization is decreased with high costs. (Nishimori and Ogawa 2002).
Not only this but the authors also are of the opinion that in a public monopoly private firms that attempt to enter the industry would remain unsuccessful because public firms undertake cost reduction investment in the face of emerging private competition. When a private firm enters the market, there is a decrease in the consumer welfare. For this reason they propose that “in order to prevent decrease in the cost reducing incentive of public firm, subsidization policies such arid subsidies may be effective.” (Nishimori and Ogawa 2002).
Neoclassical economists are of the view that efficiency is inherent in competitive environment. Unlike public monopolies which do not breed competition, privatization thrives in competitive markets as it attracts more investments. Nigel M. Healey (1993) writes “The allocate and X-efficiency gains from increasing competition are illustrated … by a movement from north to south; that is, from monopoly towards more competitive markets.
By combining the capital market and competition arguments, and accepting the notion that private capital markets are beneficial for economic performance, it appears that the largest efficiency gains can be expected where there is an ownership change which leads to both more competition and more reliance on private capital markets.” Public monopolies therefore are not open to competition which is the reason why they tend to decrease inefficiency as competition rises. In the UK firms like National Freight Corporation, British Telecom and Royal Mail all tend to have decreasing market share when they are faced with private competition.
Royal Mail is the classic case of monopoly which has been dominating the postal industry in the UK for decades. According to a market report by Postcomm (2003) the postal industry is dominated by business mail. Twenty eight present of Royal Mail’s financial income is derived from its top 50 customers while 59 present of its mail volume comprise of commercial mail including utility bills, financial statements, invoices and government mail. The rest 29 present is made up of marketing material. On the other hand private postal services comprise of only 11percent of the market.
With 15 years licence Royal Mail has been the dominant postal service provider within the UK for all types of postage and parcel services. The Postal Services 2000 however revised this public monopoly and introduced competition in the market by allowing other companies to compete with Royal Mail. Despite this fact Royal Mail still remains the undisputed king in the postal industry creating barriers to competition. It has an advantage over its competitors because of its universal access to geographical location as well as collects and delivers mail on each working day (Postcomm Report 2003).
But more importantly Royal Mail has exemption from VAT, customs privileges and parking and traffic privileges which delineate it from competitors. The company serves in uneconomic and diverse areas which tend to increase its preference among consumers. Though this cost the government but nevertheless it has set a pattern and process of delivery to diversified destination which increases its competitive edge over other potential mail companies (Postcomm Report 2003).
As studied theoretically above, Royal Mail proves to be financially inefficient due to its failure to meet financial target.
Despite its increase in revenue due to increase in volume sales and price Royal Mail nevertheless does not earn as much as it is required to reach equilibrium. Instead it concentrates on making profits on business accounts; prepared items etc. and lose out on stamped items. As a result the Postcomm authority has increased restrictions on Royal Mail(Postcomm Report 2003).
In such a case of public monopoly, one observes that Royal Mail would continue to incur costs of investments and injections for the upkeep of the enterprise. The organization despite restrictions and strict policies has not been able to meet its performance target. But more importantly Royal Mail behaves in the same manner as in the cost dissemination model that the researcher discussed earlier. Despite high prices Royal Mail is operating at a loss due to a variety of reasons including inefficiency, lack of innovation, loss and compromising consumer welfare with its limited services.
As opposed to public there are private monopolies which are adopted by private enterprises. Private monopolies deal with the supply side of economics. According to Charles Geist (2000) private monopolies tend to dominate the market as effectively as public monopolies due to the incentives in the form of tax cuts, economic stimulation and increase in the demand of goods and services. As a result, a private monopolist raises the prices of goods and services higher than the market price with the intention to earn higher profits.
In the following illustration of private monopoly there is only one producer who influences the price. The producer sets MC=AC and setting the production low where MR=MC. This way there is low level of production which in turn creates high demand. The price set would that that the market will bear and hence the consumer becomes the price taker. In the following figure one see that low output at O would enable the producer to increase the price of the goods to meet the demand B.
Since MC is below MR the producer enjoys a high level of profit with low level of output. If he increases his output to O’ then he/she would lose out on the price set by the market mechanisms supply-demand. As a result the monopolist profits ABDE despite the high demand ABCE. The area BCD is the dead-weight loss which the market will bear as a result of the monopoly (Coopers and Lybrand 1996). Thus, in private monopolies do not actually serve the purpose of satisfying the consumer welfare because it involves:
“- a lower level of output (O compared with O1);
– A higher price (P compared with P1);
– Profits in excess of those required to earn a reasonable return (ABDE is “monopoly” profit or producer surplus); and
– a reduction in economic welfare; the loss of consumer surplus -resulting from higher prices is ABCE, which is more than the benefit tithe producers in terms of higher profits (ABDE); this net loss, represented by the triangle BCD, is called dead-weight loss.”(Coopers and Lybrand 1996)
Sometimes the government such as those under the Reagan’s administration induce private monopolies through privatization policies to get the country out of economic recession. However, according to Bauer et al (1995) “The impact of a regulatory system depends upon its influence on managerial behaviour. In the United States, where private monopoly suppliers of electricity, gas and water have existed for many years, the regulatory system has led to confusion, litigation and commercial disaster.
The regulations control, inter alia, the level of service, environmental considerations, and pricing, much as in Britain. “As a result private monopolies tend to affect the consumers and do not really satisfy their needs.
Not only has this but it been observed that private monopolies run on the basis of rate of returns on private capital. According to Healey(1993) “where a ceiling on the rate of return on capital exists, the incentive for management to control costs is reduced, and an incentive exists to extend the capital base through more investment—the so-called Avert-Johnson effect.”
This effect compromises the consumer welfare and undermines the enterprise objectives of serving the public. Privatization and the promotion of private monopolies therefore are costly as they need regulatory bodies to monitor them. Yet despite this fact policy makers are of the opinion that to increase firms ‘efficiency, privatization is the most feasible process. As a result private monopoly develops. Horton and Ridge (1972) writes about private monopoly as follows:
“Private monopoly is also more subject to erosion than governmental monopoly. Competition will make itself felt in one way or another whenever the monopoly price is far above the competitive price. There cent stock-market hearings offer a dramatic example. The commission charged on large purchases and sales is clearly exorbitant. As a result, firms executing such orders have been able to get the business only by agreeing to “give up” part, often a large part, of their commissions to other firms designated by the customers – clearly an indirect form of price-cutting.
In addition, a third market has developed in which large traders deal directly, bypassing the organized exchanges. A less dramatic but more pervasive example is competition among firms to provide “free” services to customers in the form of investment information and advice, attractive lounges with tickers, and so on.”
Erosion of this sort tends to undermine the management of private organizations and eventually lead to inefficiency which has been the objective of the government for inducing it in the first place. According to Hay and Morris (1991) whenever business activities are monopolistic in nature it involves engineering factors. Engineering here refers to the engineering of management processes and operation of social and economic factors within the enterprise. When the monopolist serve the market at a lower unit cost than other competing firms are unable to match the price or the resources upon which the monopolist is operating.
As a result the monopolist creates barriers to entries and drive out competition in the industry. Incentives to efficiency under monopoly prove to be weak as it is cheaper for the market to have two suppliers who are also competitors rather than a single producer. Button the other hand for a monopolist, instead of increasing goods quantity and decrease the price, it would be more profitable to use the same resources to produce related products. One example is the case of Microsoft which has used its technology base to create products that are interconnected and at a high price. As a result the consumer is forced to purchase these products because it is convenient for them to use Microsoft products without having technology clashes (Hay and Morris 1991).
Not only this but private monopolies largely lie within the domain of the private sector in which the authority and the accountability lies with the shareholders they serve. The government and policy makers only have authority to the extent of governing it through regulations. The monopolists tend to exist for their own profitability and efficiency as long as its resources are allocated for maximization. Ultimately, it is the market and the consumer which is affected.
Private monopolies for example tend to drive competition out of the market due to large consumer ba