On monopolies – how to think about this concept and use it in a less naive way

Note: I see a lot of threads here that discuss monopolies (in particular “natural monopolies”) and the impression is that most (but not all) of you have a idealized, rigid and naive concept of the term – one that is not really very used in practice, either in economic analysis or in business. The notion of monopoly is very useful if you understand it correctly (i.e. not naively). The definition I will offer below is one that is consistent with microeconomics in general (i.e. its not exclusively Austrian, Marxian or Neoclassical, it is agnostic to the differences between these schools) and is the one that is typically implied when the term is used in real world business situations.

The naive way (and unfortunately the most common way) to understand the concept of monopoly is to assume it is a label that is only useful to describe a very unique and exclusive situation in markets. For example, a monopoly is a situation where a large group of customers demand some good or service that is only being supplied by a single entity. And that lead to infinite philosophical debates about whether the electric grid or railway operator is a “natural” monopoly, or if monopolies are always granted by the government as charters or things of that nature.

While that definition does help you start to understand the problem of monopoly, in terms of a certain structural scarcity of capital in the supply side, it is an artificially contrived definition, which can always or never applied, depending on the parameters you use for defining “large group of customers”, “some good or service”, and “single entity”.

Consider for example a small neighborhood convenience store. Is it a a monopoly or not?

The immediate answer would be no, because monopolies are big companies that serve millions of customers and have no competitors. Sure – that is how most people today probably think when they hear the word monopoly – but it is a contrived and arbitrary definition because you just made an arbitrary parameter decision (i.e. millions of customers) that has no intrinsic economic reason to be important in itself for the concept. If the world had only 999000 people then no monopoly could exist?

The more intelligent way to think about it is to consider that every shop that doesn’t have a very similar shop operating next door to it, offering the same products, is a “neighborhood monopoly”, provided you assume customers are very lazy, and you define the neighborhood as the small area around the shop in which that particular shop is the closest shop around. And if customers are indeed very lazy the shopowner will be incentivized to increase its own margin above the average risk adjusted margin of his segment, and thus reduce his volume output below the what his cost of capital would lead him to go in a perfect competition world, because he can get higher profits like that.

That allows us to come up with a more intelligent definition for a monopoly, one that doesn’t depend on arbitrary parameters like “sector, industry, large group of people”, but applies to the general phenomenon we want to describe.

A market is more monopolistic when the supply side is able to increase profits by decreasing their output below the point where the marginal risk adjusted cost of capital equals the marginal risk adjusted revenue. A market is more competitive when the supply side is (forced by competitors) to operate close to the optimal point where marginal cost equal marginal revenue. So monopoly and competition here are not exclusive categories, but rather a spectrum of market circumstances that affect the supply side output decision, in terms of how it deviates from point where marginal cost and marginal revenue offset each other (assuming those are absolute known attributes of the inherent supply and demand dynamics)

A firm can be the single supplier of their particular good or service – say a restaurant with their own unique menu items – but they aren’t a monopoly unless they can realize margins by reducing the amount of tables and meals they serve, even when their unit margin per incremental meal served is still positive. That means they control the supply and can extract a rent by creating a structural shortage of that unique meal they serve.

So fine dining restaurants are typically running some monopoly on the particularly fashionable dishes their chefs invent. People will often think they should expand because they have long lines and it is hard to make a reservation, and their margins are high enough per meal, but that is not necessarily the case – expanding could mean a reduction in total profit if the increased supply caused the net monopoly profit margin to decrease too much.

And in general any successful business operation that is not a standard commodity producer or broker-dealer will have some idiosyncratic feature in their products or geographic situation that should give them some kind of monopolistic edge, at least for a while, at least in terms of the risk adjusted expectations of their investors for the demand curve for that business. Otherwise the investors would just lend their money or buy stock in some other business, instead of operating their own venture.

So that is the way smart people think about monopolies. That is why Peter Thiel says he only “invests in monopolies”. That is the underlying meaning of the word – i.e. a condition of structural shortage in the supply side that enables deployed capital to generate higher than ordinary returns on risk adjusted basis.