The wealth differential is increasing not just between rich and poor individuals, by in the corporate world as well. I have been thinking about the increasing trend towards monopolies and the problems with modern government structure and monopolies. Starting with some thoughts on the background, and then why monopolies may be on the increase.
The natural monopoly formulae:
Natural Monopoly strength = market advantage / perceived differentiation scope.
market advantage (is proportionate to) fixed costs / unit cost
‘Market Advantage’ is usually a cost/price advantage derived from the above formulae but can also be features, derived or as a result of cost advantage. Monopolies not based on advantages through scale (e.g. through legislation) are not ‘natural’ monopolies. With any product or service there are fixed costs independent of the size of the business and these costs must be recovered over all products or services. The higher the component of these fixed costs in each unit, the greater the potential market advantage to the business recovering fixed costs over more units.
‘Perceived differentiation scope’ is the scope for a competitor to offer an a product that the market perceives as different from the product or service produced by the monopoly, and still addresses the same market. If it is not possible to make a product seen as different, then it will be most difficult to battle against the monopoly. Conversely a product seen as different can gain market share even if otherwise at a significant disadvantage.
Actual monopolies can arise for a variety of reasons, but can expect to arise when a ‘natural monopoly’ situation is present.
The term ‘natural monopoly’ well known, but I will review it anyway 🙂
A ‘natural monopoly’ can be described as a product or service where market dominance for the largest supplier is a logical consequence of economies of scale, or other benefits of scale, to a significant aspect of the business arise as scale increases. As the largest supplier has the largest scale, the largest supplier is as a market advantage over all other suppliers.
‘Natural monopolies’ vary in breadth as well as strength. The key is that at least one aspect of the business gains advantage from significant economies of scale, which results in significant disadvantages to any potential competitor.
The strength of the natural monopoly is dependant on how significant the advantage resulting from scale. Is production cost reduced over a smaller competitor by a factor or 10% or a factor of 1,000%?
The impact of this strength is also dependant on the scope for a competitor to provide an acceptable a substitute product or service which is in some way different by can address the same need. For example: A monopoly car manufacturing business still has to consider bicycles and horses as potential competitors, but they are not a highly satisfactory substitute in many of the uses of a car in today’s world. The breadth of the monopoly is how wide the range or products which enjoy the monopoly. Is the car example, the monopoly could be simply one type of car or all types or also include bicycles. A company with a special red paint that does not fade could have a monopolies on cars that are the special red colour, but this may not be a very significant monopoly unless consumers value the red colour highly.
If consumers perceive alternative products as significantly different, then those alternative products can potentially succeed in some market share despite their disadvantage of scale. However if the product is perceived as exactly identical and has price or other disadvantage then success will be very different. Consider a battery manufacturer. If the lead manufacture of a standard size battery (e.g. AAA) markets batteries with 3000mAh (a certain amount of power) then it will be difficult for a competitor who also makes 3000mAh or less (equal lower power) batteries at twice the price to succeed in the market, as it is difficult to see the batteries as different in other ways. However if making clothing, even if twice the price and technically less advanced a competitor can enter the market by style or colour or fashion.
As stated, it need only be one aspect of a business that benefits from scale being sufficient to create an advantage that can create a natural monopoly. The importance of aspects of businesses changes over time as does the impact of scale as technologies change, so natural monopolies are not static.
Generally the more mature an industry, the more significant the impact of scale and therefore the greater the potential for natural monopoly. As an industry emerges absolute cost efficiency is often offset by innovation. In a mature industry the product often becomes more of a commodity and cost efficiencies become more important. This often means that the mature the industry, the more likely for the conditions for a natural monopoly.
It is generally accepted that in any manufacturing there are economies of scale. There are always ‘on off’ set up, design and tooling costs to be spread across the cost of all products. So is manufacturing itself a ‘natural monopoly’ and one day one single company will undertake all manufacturing of every product worldwide?
A review of the basics.
Monopolies and scope for perceived difference.
If two companies produce a product that consumers perceive as being absolutely identical, then if one producer has a significant advantage in, for example price, every consumer would choose the product with the advantage. However any perceived difference at all would enable some consumers to choose the product that is at the disadvantage. In reality simply pricing a product higher can create a perceived difference. The greater the perceived difference, the greater the disadvantage that can be overcome, provide at least some consumers can see the difference as a benefit.
Consider two cafes two blocks apart, The rent or ownership of the locations, the equipment and almost all staff must be duplicated at each location even if there was a common ownership so these are effectively unit costs. But purchasing staff, accounts and some marketing costs could be fixed costs shared across stores to produce a reduced total cost. Some aspects can benefit from scale, others do not. So the cafes could benefit from joint ownership, but not to the extent that it is not feasible for a competitor to open another café. A key reason here is that cafe’s can have a significant perceived difference. The advantage is small as the coffee cannot be significantly less expensive and the café experience can easily vary.
But alternatively consider the product/service as a familiar café wherever you go. This requires a significant ‘chain’ of cafe’s and is very expensive to reproduce. Having a café in every city is a very large fixed cost. This enables a dominant and effective monopoly of a ‘chain’ of cafe’s whereas a monopoly of the individual café market is not possible. Thus individual cafe’s still exist even when creating an alternative dominant ‘chain’ of cafe’s is difficult do to the fixed cost of establishing a large number of cafe’s.
New Growth of Monopolies.
The concept of the chain being the pathway to a new market definition that can give rise to a type of monopoly is one of the recent trends. ‘Chains’ of either franchise stores, or stores all under a common ownership, gives the scale that can drive economies of scale to sufficient aspects of the business to produce market advantage. In many cases, the monopoly is simply the monopoly of having a chain, while independent stores are still able to flourish. McDonald’s dominates as the ‘hamburger’ chain while independent hamburger stores are still able to exist and this is repeated over and over in the food industry. The movie “You’ve got mail” was set in the environment of the independent book-store, unable to compete with the large scale chain. There is a march towards creating chains for each business that possibly can derive advantage and become a monopoly. Individual businesses often are able to compete only when they can position their product or service as different from the largest industry wide player.
The effect of Computer Software.
Computer software for any given purpose is a strong natural monopoly since fixed costs for software are almost all costs and unit costs are almost zero. The impact of software on monopolies deserves its own post which will soon follow. But computer software is another driving force towards more monopolies.
This is a background post. But the impact of software, globalisation and ever increasing business sophistication and government privatisation means that the impact of monopolies is of increasing importance.