Choosing between economy of scale and ‘too big to fail’

Monopolies: Choosing between economies of scale and ‘too big to fail’

Representative image.

Following the recent US Congressional hearing, the need for breaking up giant internet firms like Microsoft, Google, Facebook and Amazon is being debated in the media. However, this debate on small versus large firms is not really new and we need to understand it in the larger context.  

The word ‘monopoly’ or a big firm exercising ‘monopoly power’ instinctively arouses a sense of popular resentment as it is considered an unmitigated evil. In the language of economics, a monopolist restricts output and charges a price higher than what it would have been under perfect competition, thereby fleecing customers. Consequently, in almost all countries in the world, there are anti-monopoly laws and Competition Commissions to ensure that business firms do not become too big (by mergers/acquisitions or by organic growth) and are not engaged in anti-competition practices.  

However, in economics textbooks, some redeeming features of a monopolist are also mentioned. For example, if there are significant technological economies of scale (where bigger firms will be able to produce at lower cost) like in public utility companies (electricity, gas, landline telephone), governments in most countries bestow exclusive monopoly right to one or two companies to serve the entire market. Usually, the firm selected by the government is chosen on the basis of open competitive tender and regulatory restrictions are put on the price that the selected firm(s) can charge. Also, firms (especially in IT and pharmaceuticals) are given the incentive to spend large sums on innovating new products as the temporary monopoly power, provided by patents and copyright, enables them to recoup the big costs of R&D.

This way, society gets the benefit of new technological breakthroughs and cost-saving through economies of scale. Further, a monopolist (single seller of a product or service to the entire market) or a few sellers selling similar products (called ‘oligopoly’, as in car manufacturing) earn more profits, compared to a large number of small firms under perfect competition. These ‘monopoly’ or ‘oligopoly’ profits can be used to spend on R&D activities which small firms are not able to do.

Apart from theory, historically, in consumer goods like textiles, clothing, footwear, toys, television sets, cars, mobile phones and heavy machinery, big-sized Japanese, Korean and Chinese firms, helped by State subsidies in various forms and initial ‘infant industry protection’, have fostered innovation, cut costs, made technological improvements and lowered prices in both domestic and foreign markets. Big firms have also diffused superior technology in different parts of the world by opening factories and licensing proprietary knowledge.

Irrespective of unfair trade practices, early mover IT and telecom firms derive advantages through what is called the ‘network effect.’ This refers to the fact that the value of the product or the service provided by a firm increases as more people join the network. Growth begets more growth. On the other hand, the late entrants have the advantage over the first movers (‘leapfrogging effect’) in that they can enter the market with more advanced, cost-efficient technologies from the beginning and do not suffer from the legacy costs of the early entrants (Ex: Tesla with electric cars, newer airlines with more fuel-efficient fleets of planes).

Giant firms, especially in banking, insurance and telecom sectors, create another problem called ‘too big to fail’. Even if inefficient and loss-making, such big firms cannot be allowed by the government to fail and go out of business as it would have large negative effects on the working of the entire economic system. Governments are then forced to bail them out with public funds. Such cases became particularly manifest in the global financial crisis of 2007-8. This provides another argument against firms becoming ‘too big.’ At the same time, we should remember that in the days of ‘industrial licensing’, even efficient firms were not allowed to grow. This resulted in assured market shares for all existing firms (efficient or inefficient), with no incentive to cut costs or improve quality. 

To sum up, small is not necessarily beautiful and large is not necessarily ugly. There are both positives and negatives of big firms. However, irrespective of the size of firms, we have a case for regulating unfair business practices like restricting entry of new firms, buying up existing and potential competitors to neutralise them, collusion in price-setting, unauthorised use of customer data, patenting trivial technological improvements, bundling of products, services and software to prevent customers from buying a cheaper component of the bundle from a competitor (a charge against Microsoft), and predatory pricing when a firm with deep pockets drives out competitors by keeping prices artificially low for some time and then overcharging the consumers (as being alleged against Jio by some telecom competitors), stopping servicing of old products/versions (of software) to force consumers to buy the new product/ version.

For well-functioning markets, we need knowledgeable and independent (of both government and business lobbies) regulators to quickly detect unfair practices and correct them by penalising the violators. However, it is easier said than done. In India, most of the market regulators are chosen from among retired bureaucrats. Their appointments and re-appointments are in the hands of the government and, in some cases, parliamentary committees. This makes it difficult for many regulators (of course, with notable exceptions) to function independently of the government, the political parties or the business lobbies (which influence politicians through large donations to political parties).

Here, the bigger firms, because of their deeper pockets, have a natural advantage over smaller ones in influencing regulators. But the mere existence of this potential does not make all big firms guilty.

(The writer is a former Professor of Economics, IIM-Calcutta and Cornell University, USA)

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