What's so bad about monopoly power?

Google (GOOG) has been negotiating with European regulatory authorities since 2010 in an attempt to settle an antitrust case concerning its search engine, and its third attempt to settle the case has been rejected.

Google may also face new antitrust problems over its Android mobile operating system, and it's not alone in facing tough antitrust scrutiny in Europe. Microsoft (MSFT) has also been the subject of a long-running battle in Europe over market dominance issues.

But what's motivating this scrutiny from European regulators? What's so bad about a company amassing monopoly power?

When firms have such power, they charge prices that are higher than can be justified based upon the costs of production, prices that are higher than they would be if the market was more competitive. With higher prices, consumers will demand less quantity, and hence the quantity produced and consumed will be lower than it would be under a more competitive market structure.

The bottom line is that when companies have a monopoly, prices are too high and production is too low. There's an inefficient allocation of resources.

In addition, the tactics used to establish monopoly power, such as driving competitors out of business or thwarting potential entrants, can also cause considerable harm to households who own the businesses that are forced to close their doors.

For instance, a firm with deep pockets can set prices below costs and absorb losses until competitors can no longer survive. Then, once the competition is eliminated, the surviving firm can raise prices high enough to more than cover the losses it took while establishing its now-dominant market position (under antitrust regulation, such tactics are prohibited).

The problems with monopolies go beyond the economic effects. Many large, economically powerful companies also have considerable political influence and the ability to "capture" the political and regulatory process. This allows a powerful firm to tilt the legal and regulatory processes against any potential threat to its market power, and to bring about changes that further enhance the profits it earns.

It can get health and safety regulations removed, have licensing requirements imposed that make it harder for new firms to enter a market, avoid state sales taxes for online retailers, or get invited to speak at congressional hearings on matters such as immigration and corporate taxation.

When an industry has just a few dominant firms, or a single dominant firm, market power can be significant. But when the number of companies is sufficiently large, the power of any one is considerably muted.

However, a small degree of monopoly power may even be desirable.

Whenever there is variety, and hence some amount of brand loyalty, firms will have some market power, i.e. some ability to raise prices without driving customers away (when products are identical, as required for textbook pure competition, an increase in the price above a nearby competitor's price would result in the loss of all customers -- why pay more for the exact same product?). So, the cost of variety is that firms will have some degree of pricing power.

But the benefit is a wide variety of goods to choose from. Consumers certainly seem to have a taste for variety, so this benefit must be weighed against the market power that companies get from differentiated products. As long as the number of firms in an industry is relatively large, making a market "monopolistically competitive," it's likely that the benefits of variety will outweigh the cost.

However, when the number of firms is smaller so that oligopolies (a few dominant firms) or monopolies (a single dominant firm) appear, the likelihood that the benefits outweigh the costs is substantially diminished and scrutiny from regulators is needed.

One case where scrutiny is certainly needed is one economists call a "natural monopolies." In these cases, companies do not have to act strategically to eliminate the competition. It happens naturally, often because of economies of scale that are still in effect even after the entirety of market demand has been satisfied.

Because the monopoly power cannot be prevented by regulating the firm's strategic behavior, and because breaking it up would often result in higher costs and hence higher prices for consumers, the best course of action is to regulate the prices and quantities such a company can charge.

A firm's size and market share do not necessarily indicate that it is exploiting its market power or that substantial market share even exists. A dominant firm in an industry could, for example, face substantial new entrants and competition if it attempts to raise its prices and exploit its dominant position in the marketplace.

But firms that exploit their market power or undertake strategic behaviors that make it more difficult for other companies to compete should come under the careful watch and, when appropriate, receive penalties from regulators charged with promoting the public interest.