Unit 7 The firm and its customers

7.11 Firms and markets with decreasing long-run average costs

Producers of differentiated products enjoy market power, which enables them to set a price higher than marginal cost—increasing their own profits, but causing deadweight loss. The source of market power is the characteristics of the product and the preferences of consumers, which leads to less direct competition and a low elasticity of demand.

Product differentiation is not the only reason for a price above marginal cost. A second potential source of market power is the firm’s cost structure.

If firms have decreasing average costs (perhaps due to economies of scale in production, or high fixed costs, or input prices declining as the firm purchases larger quantities), the last unit of output is produced at lower cost than the average for the previous units. In other words, the average cost of production is greater than the marginal cost at all levels of output. In this case, the firm’s price must be above marginal cost: the price has to be at least equal to average cost—otherwise it makes a loss.

Decreasing average costs therefore limit competition by limiting the number of producers that can participate profitably in the market. Consumer demand is served by a small number of firms operating at a large scale, lowering their costs per unit and leaving no opportunities for potential competitors.

natural monopoly
A production process in which the average cost curve is sufficiently downward-sloping, even in the long run, that a single firm can supply the whole market at lower average cost than two firms, making it impossible to sustain competition.

In domestic utilities with high fixed costs of providing the supply network, the average cost of producing a unit of water, electricity, or gas will be very high unless the firm operates at a large scale. If a single firm can supply the whole market at lower average cost than two firms, the industry is said to be a natural monopoly.

A different kind of example is a film production company. The company spends heavily on hiring actors, camera technicians, and a director; purchasing rights to the script; and advertising the film. These are fixed costs (sometimes called first copy costs). The cost of making available additional copies of the film (the marginal cost) is typically low: the first copy is cheap to reproduce. The firm’s marginal costs will be below its average costs (including the normal rate of profit). With a price equal to marginal cost, it would go out of business. The film industry is highly competitive, but price must be above marginal cost for firms to survive.

When firms have strongly decreasing average costs, competition tends to be winner-takes-all. The first to exploit the cost advantages of large size prevents other firms from succeeding and, as a result, limits competition. For example, in the market for internet search engines, Google established the technological infrastructure and expertise to meet the needs of a large number of users, and the more searches it carried out, the more data it gathered, lowering its costs of serving other users.

Figure 7.26 shows some examples of US markets dominated by small numbers of firms. Strongly decreasing average costs are an important factor in several cases, such as internet searches, dominated by Google; similarly, wireless carriers (mobile phone networks) have large fixed infrastructure costs, and just four providers dominate the US market. Another factor, particularly in the case of social media platforms like Facebook and YouTube, is the benefit from network economies of scale.

A variety of measures are used for market share in Figure 7.26. For digital companies, the most common measures of both market power and costs may not present an accurate picture. For example, some products are free to end customers, meaning that revenue from end users is not a useful measure. Similarly, employment may not be a strong indicator of costs. Focusing on usage—for example, the number of searches on a browser—or the number of users, or visits to a social media platform can provide a better comparison of scale.

This bar chart shows the US market share (percent) of different firms by market. The market share in the search engines market is as follws: (Google, 62%), (Microsoft, 22%), (AOL/Yahoo, 14%), (Ask, 2%). The market share in the wireless carriers market is as follows: (Verizon, 38%), (AT&T, 32%), (T-Mobile, 15%), (Sprint, 13%), (Other, 2%). The market share in the delivery services market is as follows: (FedEx, 42%), (UPS, 30%), (DHL, 20%), (TNT, 1%), (Other, 7%). The market share in the Pay TV market is as follows: (Comcast, 25%), (DirecTV, 23%), (Charter Spectrum, 18%), (Dish Network, 16%), (Other,  18%). The market share in the smartphones market is as follows: (Apple, 43%), (Samsung, 31%), (HTC, 1%), (Motorola, 5%), (Other, 20%). The market share in the social media market is as follows: (Facebook, 41%), (YouTube, 26%), (Twitter, 6%), (Reddit, 6%), (Other, 21%). The market share in the airlines market is as follows: (American, 18%),  (Southwest, 18%), (Delta, 17%), (United, 11%), (Other, 36%).

Figure 7.26 Economics of scale and market share.

J. Shambaugh, R. Nunn, A. Breitwieser, and P. Liu. 2018. The state of competition and dynamism: Facts about concentration, start-ups, and related policies. Hamilton Project. Washington, DC: Brookings Institution.

Exercise 7.5 Natural monopolies

Find an example of a natural monopoly in the country where you live. You can choose a firm or industry mentioned in this section, or come up with your own example. Use the concepts in this section, along with some internet research, to explain how and why this natural monopoly has arisen.