Is Monopoly Always Bad?

Natural monopoly presents something of a dilemma. On the one hand, economic efficiency could be enhanced by restricting the number of producers to a single firm. On the other hand, monopolies have an incentive to underproduce and can generate unwarranted economic profits.

Nevertheless, it is important to recognize that monopoly is not always as socially harmful as sometimes indicated. In the case of Microsoft Corp., for example, the genius of Bill Gates and a multitude of research associates has created a dynamic computer software juggernaut. The tremendous stockholder value created through their efforts, including billions of dollars in personal wealth for Gates and his associates, can be viewed only as a partial index of their contribution to society in general. Other similar examples include the DeKalb Corporation (hybrid seeds), Kellogg Company (ready-to-eat cereal), Lotus Corporation (spreadsheet software), and the Reserve Fund (money market mutual funds), among others. In instances such as these, monopoly profits are the just rewards flowing from truly important contributions of unique firms and individuals.

It is also important to recognize that monopoly profits are often fleeting. Early profits earned by each of the firms mentioned previously attracted a host of competitors. The tremendous social value of invention and innovation often remains long after early monopoly profits have dissipated.

Countervailing Power: The Monopoly/Monopsony ConfrontationCOUNTERVAILING POWER:Unregulated monopoly sellers typically limit production and offer their products at high prices. The private and social costs of this behavior are often measured by above-normal profits, inefficient production methods, and lagging rates of innovation. How is this inefficiency reduced, if not eliminated, in unregulated markets? Sometimes the answer lies in the development of countervailing forces within markets.

Seller Versus Buyer Power

Countervailing power is an economic influence that creates a closer balance between previously unequal sellers and buyers. The classic example is a single employer in a small town that might take advantage of the local labor force by offering less-than-competitive wages. As the single employer, the company has a monopsony in the local labor market. Workers might decide to band together and form a union, a monopoly seller in the local labor market, to offset the monopsony power of the employer.

To illustrate this classic confrontation, consider the following figure, which shows demand and supply relations in a local labor market. The downward-sloping demand for labor is simply the marginal revenue product of labor (MRPL) curve and shows the amount of net revenue generated through employment of an additional unit of labor (ΔTR/ΔL). It is the product of the marginal product of labor (MPL) and the marginal revenue of output (MRQ). Thus, MRPL = ΔTR/ΔL = MPL X MRQ. MRPL falls as employment expands because of the labor factor’s diminishing returns. An upward-sloping supply curve reflects that higher wages are typically necessary to

expand the amount of labor offered. Perfectly competitive demand and supply conditions create an exact balance between demand and supply, and the competitive equilibrium wage, WC, and employment level, EC, are observed.

A monopsony employer facing a perfectly competitive supply of labor sets its marginal cost of labor, MCL, equal to the marginal benefit derived from employment. Because the employer’s marginal benefit is measured in terms of the marginal revenue product of labor, an unchecked monopsonist sets MCL = MRPL. Notice that the MCL curve exceeds the labor supply curve at each point, based on the assumption that wages must be increased for all workers in order to hire additional employees. This is analogous to cutting prices for all customers in order to expand sales, causing the MR curve to lie below the demand curve. Because workers need to be paid only the wage rate indicated along the labor supply curve for a given level of employment, the monopsonist employer offers employees a wage of WM and a less than competitive level of employment opportunities, EM.

An unchecked union, or monopoly seller of labor, could command a wage of WU if demand for labor were competitive. This solution is found by setting the marginal revenue of labor (MRL) equal to the labor supply curve, which represents the marginal cost of labor to the union. Like any monopoly seller, the union can obtain higher wages (prices) only by restricting employment opportunities (output) for union members. A union is able to offer its members only the less than competitive employment opportunities, EU, if it attempts to maximize labor income

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Compromise Solution

What is likely to occur in the case of the monopoly union/monopsony employer confrontation? Typically, wage/employment bargaining produces a compromise wage/employment outcome. Compromise achieved through countervailing power has the beneficial effect of moving the labor market away from the inefficient unchecked monopoly or monopsony solutions toward a more efficient labor market equilibrium. However, only in the unlikely event of perfectly matched monopoly/monopsony protagonists will the perfectly competitive outcome occur. Depending on the relative power of the union and the employer, either an above-market or a below-market wage outcome typically results, and employment opportunities are often below competitive employment levels. Nevertheless, monopoly/monopsony confrontations can have the beneficial effect of improving economic efficiency from that experienced under either unchecked monopoly or monopsony.MEASUREMENT OF BUSINESS PROFIT RATESIn long-run equilibrium, profits in perfectly competitive industries are usually just sufficient to provide a normal risk-adjusted rate of return. In monopoly markets, barriers to entry or exit can allow above-normal profits, even over the long run. Nevertheless, high profits are sometimes observed in vigorously competitive markets, while some monopolies stumble from one year to the next without realizing superior rates of return. To appreciate the sources of profit differences, it is first necessary to understand conventional measures of business profits.

Rate of Return on Stockholders’ Equity

Business profit rates are best evaluated using the accounting rate of return on stockholders’ equity (ROE). ROE is net income divided by the book value of stockholders’ equity, where stockholders’ equity is total assets minus total liabilities. ROE can also be described as the product of three common accounting ratios. ROE equals the firm’s profit margin multiplied by the total asset turnover ratio, all times the firm’s leverage ratio:

Profit margin is accounting net income expressed as a percentage of sales revenue and shows the amount of profit earned per dollar of sales. When profit margins are high, robust demand or stringent cost controls, or both, allow the firm to earn a significant profit contribution. Holding capital requirements constant, profit margin is a useful indicator of managerial efficiency in responding to rapidly growing demand and/or effective measures of cost containment. Rich profit margins do not necessarily guarantee a high rate of return on stockholders’ equity. Despite high profit margins, firms in mining, construction, heavy equipment manufacturing, cable TV,

and motion picture production often earn only modest rates of return because significant capital expenditures are required before meaningful sales revenues can be generated. Thus, it is vitally important to consider the magnitude of capital requirements when interpreting the size of profit margins for a firm or an industry.

Total asset turnover is sales revenue divided by the book value of total assets. When total asset turnover is high, the firm makes its investments work hard in the sense of generating a large amount of sales volume. A broad range of business and consumer service business enjoys high rates of total asset turnover that allow efficient firms to earn attractive rates of return on stockholders’ equity despite modest profit margins.

Leverage is often defined as the ratio of total assets divided by stockholders’ equity. It reflects the extent to which debt and preferred stock are used in addition to common stock financing. Leverage is used to amplify firm profit rates over the business cycle. During economic booms, leverage can dramatically increase the firm’s profit rate; during recessions and other economic contractions, leverage can just as dramatically decrease realized rates of return, if not lead to losses. Despite ordinary profit margins and modest rates total asset turnover, ROE in the securities brokerage, hotel, and gaming industries can sometimes benefit through use of a risky financial strategy that employs significant leverage. However, it is worth remembering that a risky financial structure can lead to awe-inspiring profit rates during economic expansions, it can also lead to huge losses during economic downturns.