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It’s also worth mentioning that the provision of public goods isn’t the only area in which private markets can operate less than perfectly. Market failure, as economists call it, can in fact happen for all kinds of reasons – monopolization, information asymmetry, cartelization, cost externalization, adverse selection, moral hazard, prohibitively high barriers to market entry… the list goes on. In all these cases, there are entirely valid economic reasons why it might be justifiable for government to get involved – if not to directly provide the goods and services itself, then to at least just set corrective rules and regulations where necessary to prevent the market failures from being too egregious.

So to take the issue of monopolization, for instance: We’ve already discussed why government is necessary to provide the basic physical and civil infrastructure for large-scale markets to exist in the first place – but in addition to this, it’s also vital for ensuring that once these markets do exist, they’ll remain competitive (and therefore efficient) instead of just being dominated by monopolies all the time. You can just imagine what it would be like if, say, there were only one place to get groceries, which controlled the entire market. Customers would have nowhere else to go to buy their basic necessities, so the grocery store would be able to charge practically whatever it wanted (and skimp on product quality as much as it wanted), and the customers would still have no choice but to pay. The entire rationale for having the goods and services supplied by the free market – keeping product quality high and prices low – would no longer apply, because there would no longer be a genuine competitive market; the grocery store would just be dictating terms for everyone unilaterally like a one-party state. For that reason, then, government intervention would be justifiable in order to avert such an outcome and ensure that free choice and competition were preserved.

But why would government have to be involved at all? Why couldn’t the problem instead just be solved by having other grocery stores enter the market and compete on their own? Well, normally this is the go-to solution; under ordinary market conditions, where barriers to entry are low and things like economies of scale aren’t so overwhelming as to make competition impossible, the standard way of keeping would-be monopolies in check is to just let them all keep each other in check, competing with each other for customers and thereby forcing each other to keep their product quality high and their prices low. In some cases, though, companies will figure out ways to avoid this kind of competition. Maybe they’ll collude with each other to fix their prices at artificially high levels, or maybe they’ll come together to form a cartel and coordinate their actions in other ways (bid rigging, reducing output, etc.). Or alternatively, maybe one company will take measures to prevent any competitors from being able to emerge and challenge their market dominance in the first place, so the question of whether to collude or compete with rival firms never even comes up. This was something that happened in the case of Kodak, for instance, in the early 20th century:

In the early 1900’s Kodak monopolized the American film industry, controlling 96% of the market. They were required by the American federal government to stop coercing retail stores to sign exclusivity deals with them as they had a hold on a large portion of the market. This prevented entry into the market by other corporations, therefore Kodak was using their market power to minimise competition in the market.

Even though Kodak was operating as a private market actor, its actions were decidedly anti-market. It wasn’t just trying to prevail in a fair competition – it was trying to rig the situation so there was no competition at all.

This kind of thing isn’t just limited to companies dictating blatantly one-sided terms for the products they sell, either. The examples we’ve been discussing so far typify the classic types of monopolies we’re all familiar with, in which a single seller dominates the market and is thereby able to dictate prices to buyers. But this dynamic can run in the other direction, too; under certain circumstances, it might be the case that there’s only one buyer dictating prices to its suppliers – a situation that economists refer to as a monopsony. So for instance, if we go back to our hypothetical grocery monopoly, we might imagine the grocery store requiring its suppliers (i.e. the farmers who produce the food) to sign contracts agreeing to only sell their food to it and no one else – thereby choking off any potential competitors before they can even enter the market, and simultaneously making itself so indispensable to its suppliers that they have no choice but to accept its every demand or else go out of business themselves. Similarly, if we consider a company’s employees to also be “suppliers” of a sort – specifically, suppliers of labor – we can see how the same kind of thing might play out in the context of hiring. If our hypothetical grocery monopoly were the only major employer in a remote town, for instance, we can imagine how it might be able to exploit its position to exercise monopsony power over the local labor market, grossly underpaying its employees because it knows there’s nowhere else for them to go for work. The workers might strongly prefer to take their services elsewhere, in theory – but because there simply isn’t any such alternative available to them (absent some outside party like government coming to the rescue), they have no choice but to accept terms that are much worse than what they’d get in a free and competitive market. It’s the same story for every kind of monopolization, whether it involves a company’s relationship with its customers, its suppliers, its employees, or anyone else.

Of course, not all cases of monopoly are especially overt or deliberate. In some cases, a company might attain monopoly status in their particular market niche not because of anything they’re actively doing to prevent competitors from entering the market, but just due to things like so-called network effects, in which customers are effectively locked into only using a particular product by mere virtue of the fact that everyone else is using that same product as well. So if you consider social media or e-commerce sites, for instance, these can be prime examples of this phenomenon in action, as Alexander describes:

Individual sites like blogs and little storefronts are in decline and conversation and commerce have moved to a couple of giant corporations: Facebook, Twitter, Reddit, Amazon, Paypal.

These companies aren’t exactly monopolies. To some degree, if you’re unsatisfied with Facebook you can move to Twitter. But they’re not exactly competitors either – there are a lot of things Facebook is good for that Twitter fails completely, and vice versa. It’s like Coca-Cola vs. milk: in theory you’ve always got the choice to drink either in place of the other; in practice you usually know which one you need at any given time. In that sense, there’s no real Facebook competitor except eg Orkut or Diaspora, which no one uses.

Which suggests one reason why these sites are so dominant: their main selling point is their size. Facebook is the best because all of your friends are on it; if I made a much better Facebook clone tomorrow no one would go unless everyone else was already there (Google found this out the hard way). Amazon is the best because you can buy pretty much everything you want there; Paypal is the best because most sites take PayPal. So not only do they have no competitors, but it’s really hard to imagine one ever arising. In order to compete with Facebook, you not only need a better product, you need a product that’s so much better that everybody decides to switch en masse at the same time. The only example I can think of where this ever worked was the Great Digg Exodus, where Digg screwed up their product so thoroughly that everyone simultaneously said “@#!$ this” and moved to Reddit.

So instead of “let a thousand nations bloom”, it ended up more like “let five or six big nations bloom that we can never get rid of”.

This is yet another example of a classic coordination problem; even if everyone preferred in theory to leave Facebook for a superior competitor, in practical terms (barring extreme circumstances) no such competitor would ever be able to get enough of a foothold in the market to start pulling users away from Facebook in the first place, because no individual user would have any incentive to make the switch unless everyone else had already done so. It’s an all-or-nothing type of situation; so whichever company holds the dominant market position is essentially assured of keeping it.

Similarly, even in situations that don’t involve network effects, if a particularly large company is dominating its market, it may be able to maintain that dominance for no other reason than simply because it’s so large. As I mentioned in my last post, the larger a company grows, the more it’s able to take advantage of efficiency enhancers like economies of scale and more specialized divisions of labor. As Taylor explains:

“Economies of scale” is the jargon for saying that, in certain cases, a larger firm can produce at a lower average cost than a smaller firm. A tiny factory that produces only one hundred cars a year will have much larger production costs per car than a factory making ten thousand cars, which can take advantage of specialization and assembly line production.

This can be a good thing for customers in the most immediate sense, since it means larger companies can sell their products more cheaply than they otherwise could. The downside, though, is that it can make it impossible for smaller firms without those economies of scale to compete on price in the immediate term – so even if they’re more efficient than the larger firms in every other regard, and would therefore be able to sell their products more cheaply if they actually did have the opportunity to grow to a comparable size, they never get the chance to do so, since the larger companies use their scale advantage to drive them out of business long before then. The effect of this dynamic on customers, of course, is that despite whatever savings they might enjoy from the big corporations’ economies of scale in the short term, they may still be made worse off in the long run. In order to offset this effect, then, some kind of government intervention to either tax the larger companies, subsidize the smaller companies, or otherwise level the playing field can help keep the market more competitive, and therefore more efficient. As Alexander puts it:

A tax on large corporations proportional to their size [can be used] to approximately balance economies of scale and give small mom-and-pop stores and start-ups ability to compete on an equal footing.

This kind of thing might not make the big companies too happy, naturally, but that shouldn’t necessarily be a reason not to do it – because after all, a good government’s job isn’t to just cater to individual businesses; it’s to protect the functioning of the market as a whole. As Harford puts it:

Economists believe there’s an important difference between being in favor of markets and being in favor of business, especially particular businesses. A politician who is in favor of markets believes in the importance of competition and wants to prevent businesses from getting too much scarcity power. A politician who’s too influenced by corporate lobbyists will do exactly the reverse.

In short, then, when monopolies threaten to undermine the health and competitiveness of the market, the government may be justified in taking measures to rein them in – either by imposing regulations to keep them from unduly wielding too much power, or ideally, to keep them from forming in the first place.

Of course, in some cases, monopolization might be unavoidable. There are some goods and services – particularly ones like physical infrastructure networks – that can only really be provided by some kind of monopoly. In such cases, though, it’s even more clear that simply leaving matters to the market is fundamentally unworkable as a one-size-fits-all approach. Friedman points to roads as just one illustration of this:

In [the] case [of highways], it is technically possible to identify and hence charge individuals for their use of the roads and so to have private operation. However, for general access roads, involving many points of entry and exit, the costs of collection would be extremely high if a charge were to be made for the specific services received by each individual, because of the necessity of establishing toll booths or the equivalent at all entrances. The gasoline tax is a much cheaper method of charging individuals roughly in proportion to their use of the roads. This method, however, is one in which the particular payment cannot be identified closely with the particular use. Hence, it is hardly feasible to have private enterprise provide the service and collect the charge without establishing extensive private monopoly.

In cases like this, then, the government may be warranted in taking a direct role – either by imposing strict regulations on private companies to keep them from abusing their monopoly power and overcharging their customers, or by cutting out the middleman and just directly providing the services in question itself. As Jeffrey Sachs writes:

There are many kinds of infrastructure, especially networks like power grids, roads, and other transport facilities—airports and seaports—which are characterized by increasing returns to scale. If left to private markets, these sectors would tend to be monopolized, so they are called natural monopolies. If such capital investments are left to the private sector, the privately owned monopolies would overcharge for their use, and the result would be too little utilization of this kind of capital. Potential users would be rationed out of the market. It is more efficient, therefore, for a public monopoly to provide network infrastructure and set an efficient price below the one that would be set by a private monopolist.

And Taylor explains further:

In some industries, market competition isn’t likely to work well. Instead, it leads to a situation in which all firms can suffer enormous and unsustainable losses. Back in the late nineteenth century, the U.S. railroad industry seemed to be booming. The biggest outlay that firms had was the cost of laying track; once that was done, the cost of moving goods along those tracks was low. If a company had the only tracks in a given area, it could charge high prices for shipping goods and use the profits to pay high dividends, which attracted more investors, which gave that company the money to lay more track, and so on. By 1882 almost 90,000 miles of track had been laid by competing railroads. But then competition drove shipping prices way down, and firms were unable to pay the bills incurred from building those tracks. By 1900, half the railroad tracks built by private firms were being operated by the bankruptcy courts. As a result, for most of the twentieth century, the U.S. government regulated the railroads—and, later, for similar reasons, the airlines.

Competition doesn’t work very well among public utilities, either. Why not? Try to imagine a city with four separate water companies; that’s four sets of pipes, one for each company, under every building in the city. It’s not viable. Imagine four times the number of electrical lines running down your street, or four times the number of railroad lines crisscrossing a city. Many water and electrical companies are technically privately owned, but they are closely regulated by the government.

These regulated industries share a common underlying characteristic: they rely upon networks of some kind. The cost of building the overall network tends to be high, whereas the cost of running it tends to be low. If you leave these big companies alone, you’ll tend to end up with a monopoly. Alternatively, two or more such firms in competition, once their infrastructure is in place, may compete each other into ruin—or to a merger, in which case there’s a monopoly again. This situation is referred to as “natural monopoly,” because the way in which the good is produced, with high fixed costs of building the network and low costs of delivering services afterward, can so easily lead to a monopoly outcome.

Again, it’s important to stress that just because a natural monopoly exists doesn’t necessarily mean that the government should always opt for the maximum possible response and completely take over the entire industry every time. It will often be the case that private firms can still play a central role – so inasmuch as it’s possible to maintain competitive private markets for a particular product, the dynamism of the market mechanism should be embraced. The point is not to insist on a 100% government-only approach, any more than we should want to insist on a 100% market-only approach; our goal should just be to follow what the economics tells us is the best approach in any given situation. As Taylor concludes:

Even in cases where some regulation is needed, regulated industries might have one or more parts that could be carved off and left to competitive market forces. Maybe the best example of this process is the breakup of the former telephone monopolist AT&T. AT&T’s long-distance, equipment, and research arms certainly became more innovative in the aftermath of competition. The local phone companies left in the wake of the breakup proved a bit slower to compete, but with the spread of smarter cell phones and Web-based technology, competition is rising. Other settings in which some level of competition might help include garbage collection, in which independent firms could bid for neighborhood contracts; and the service industries that support city and county governments, such as cleaning services, maintenance and repair services, cafeteria services, and building management.

Electricity has long been thought of as a natural monopoly and has been regulated as a public utility, thanks to the physical network of the grid. But arguments about the grid don’t focus on how the electrical power is generated. The grid might be publicly owned and regulated, but firms could compete to supply energy—including energy from alternative sources such as solar and wind farms. The United Kingdom has been experimenting with energy markets since 1989, and a number of U.S. states tried electricity deregulation in the 1990s, with some successes (Pennsylvania) and some disasters (California). There are as many lessons to be learned from what didn’t work as from what did.

Broadband Internet access has some of the traits of a natural monopoly. Again, it can be provided by setting up a network that has high fixed costs—running cable to everybody’s home. Therefore, some jurisdictions have argued that it should be provided by a regulated monopoly. But the broadband Internet industry also has potential for competition through the various delivery methods that have become viable over the past decade: cable, fiber optics, even wireless. With a rapidly evolving technology, it’s often better to encourage a multiplicity of technologies than for government to anoint one technology and then regulate it.

The forces of competition can encourage innovation and efficiency and benefit consumers. But in certain well-defined circumstances, when competition can’t or won’t work well, government has a useful role as a referee of economic competition. Government is also a logical arbiter of safety standards, financial honesty, and information disclosure. The real challenge when the outcomes of market forces seem undesirable is to identify the specific underlying problem and design the policy response accordingly. Is the problem a monopoly, a cartel, a restrictive business practice, a natural monopoly, a regulated industry that doesn’t need regulation anymore, or low-income people needing access to a certain service? Rather than locking yourself into a mental box—either vehemently for or against regulation—it’s often wise to take a case-by-case approach. Regulation works poorly when it assumes that government can simply dictate the outcome; regulation is more likely to work well when it respects the power of incentives and market forces.

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