Answers to questions on monopolies and cartels

I explained how monopolies and cartels maximise their incomes a couple of days ago. Only Deniro had a stab at answering them, so for the benefit of everybody else...

Question 1: In the absence of government imposed price caps, a monopoly such as a water company would set its price so as to maximise its profits, which in the instant case is £3.75 per m3, giving it a gross profit of £585 per household.

Question 2: If the water company's input costs increase from 50p to 75p per m3, the profit maximising price is still £3.75 per m3. The water company's gross profits would fall to £540 per household, but any attempt to 'pass on' the increased costs in higher prices would lead to a fall in quantity consumed and hence a marginal loss of revenue and profits.

Question 3: Members of a cartel maximise their profits by restricting their own output, which has the effect of pushing up prices. Thus at the reduced level of output, they charge the highest price which the market will bear. An increase in their input costs has no impact on the price that they charge, for similar reasons to those outlined in the answer to Question 2.

Bonus Question 1: Owners of land and buildings are a mixture of monopolists and a cartel.

At a local level, and especially in town centres, they are monopolists - if you happen to own such land and buildings then they offer a unique combination of access to hundreds of thousands of potential customers or employees (for commercial premises) and a unique combination of job and shopping opportunities, museums, pubs, theatres, parks etc (for residential). And like all monopolies, they are massively subsidised by the government, which ensures that parks are kept green, that roads and railways are built and maintained etc.

On the outskirts of towns, and in smaller towns or villages, they are a cartel. Their main concern is preventing any increase in the supply of buildings. The members of any trade or professional body insist that the government allow them to impose strict conditions on membership, in order to ensure that their members 'meet the highest standards and provide the best service to consumers'. In the same way, the NIMBYs insist that they oppose new development for loftier aims, such as 'protecting our heritage and way of life for future generations'.

Then there are owners of land without planning permission (e.g. regular commentator Sobers) who want these barriers to new development so that they can share in the spoils enjoyed by the current members of the cartel.

And paying for all this are the potential consumers of land and buildings, who have to pay vastly over the odds to break into the hallowed ranks of landowners; not only are they forced to pay extra for the scarcity value, it is their taxpayer's money which pays for the parks and the roads; they are the ones paying for the railway tickets and working in and visiting the pubs, theatres etc.

Bonus Question 2: The supply of buildings is restricted either for limitations of space (in town centres, although they could always build upwards) or because of politically motivated restrictions (everywhere else), so owners of land and buildings collect quasi-monopoly profits when they rent out or sell their buildings. With competing businesses, such profits are competed away by new entrants, so we observe that the prices for cars, TVs or clothes are such that the customer pays for cost + a profit margin (of 10% or 20% - if demand for something falls to a level where the industry cannot make these margins, the industry disappears), the quasi-monopoly profit element of rents and prices in the land market is between 50% and 90% of the rent or selling price.

Therefore, any increase in costs faced by owners of land and buildings would be borne entirely by those owners; all that would happen is that the profit element would fall to a range of (say) 40% to 80% of the rents and prices charged. The only way to pass on the burden of the higher costs would be to sell the land and buildings to somebody else (but accepting a correspondingly lower price - so the new owner gets a discount up front to compensate him). This is a very similar answer to Question 2 or Question 3.

Bonus Question 3: We can measure the super-profits accruing to the water company by looking at its costs (50p per m3) and assuming a reasonable mark-up of 20% for normal profit and overheads. The balance of £3.15 in this example would be 'super-profits' or 'economic rents'.

The same arithmetic applies to members of the land-and-building-owning-cartel. Any rental income which exceeds the cost of maintaining and insuring the bricks and mortar is 'super-profits' or 'monopoly profits' or 'economic rent'.

As to selling prices, let's assume that the government scrapped the cap on water prices: the company's profits would more than double, so it's fair to assume that the companies' share prices would also more than double. So the difference between the company's value as a monopoly and its current value (when their prices are restricted to those they would be able to charge in a truly free market) is a measure of the value of that monopoly.

Remember: even though the water company is a monopoly in itself, there would still be a free market in shares in that monopoly.

The same applies to land (i.e. the price of land and building minus the cost/value of the buildings). As the production cost of land (to the owner) is precisely £nil (unless he has to pay for flood defences on his own land etc), the entire selling price of that land can be seen as the value of the monopoly. This is at its most extreme at the margins of towns and cities, where farmland without planning permission is worth £5,000 per acre, but once it has planning permission, it is worth at least £500,000 per acre.

The argument that "land is not a monopoly because anybody can buy it" simply does not hold. Land is by definition a monopoly as no new land can be created (land reclamation aside - and even reclaimed land needs a sea bed and access from existing land), so profits cannot be competed away. The fact that anybody can buy land is much like the fact that anybody can buy shares in a water company: you are buying into membership of a cartel or monopoly and not diluting it - you can only buy in if somebody else sells out.