A giant’s strength is valuable – if not used like a giant

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Natural monopolies – industries in which it is difficult for more than one firm to survive – seem the easiest, most rewarding of business opportunities. It’s not as easy as you think.

Natural monopolies – industries in which it is difficult for more than one company to survive – seem the easiest, most rewarding of business opportunities. It is not as easy as you think.

Natural monopoly has two main sources. Economies of scale may be large relative to the size of the market. However, lower production costs are often outweighed by the inflexibility of corporate bureaucracy. History is littered with fallen titans, from United Steel to IBM, whose leadership once seemed impregnable.

The manufacture of large commercial aircraft has greater scale economies than any other industrial process. However, with two companies competing for the natural monopoly, life is always tough for either Boeing or Airbus. Natural monopoly may be the result of the modest size of a market niche. But that is a problem as well as an opportunity.

Natural monopolies are also found when all customers benefit from using the same supplier. Like everyone who taught introductory economics, I used to point to local telephone services – people wanted to be connected to the network that had most subscribers – and competition in telephone services became possible only when regulators insisted that new competitors were given access to the incumbent’s customers. If I were teaching that course today, I would talk to my students about Ebay. Markets for homogeneous commodities are natural monopolies, because people flock to where the active trading is.

For decades, securities exchanges operated as natural monopolies. However, that stable industry structure has been disturbed both by consolidation and fragmentation. First, Nasdaq won new listings from the New York Stock Exchange with lower costs and better technology. Then dominant exchanges were slow to see the potential of derivatives and Chicago and Liffe grabbed market share. Competition developed between established exchanges in the same securities. New technology allowed entirely new trading platforms. Next year, the Markets in Financial Instruments Directive reduces the regulatory advantages of incumbent European exchanges and a group of leading investment banks has just announced a new pan-European exchange.

The basic economics of natural monopoly emphasise two main phrases: “sunk costs” and “contestability”. Sunk costs are the costs of entering a market that you cannot recover if you leave it: the costs you must incur to be able to deliver the good or service even if nobody buys it. Existing suppliers have already invested in sunk costs but new suppliers will have to invest in them to get into the game. So these costs are the measure of existing suppliers’ advantage. The higher the sunk costs, the lower is contestability. A perfectly contestable natural monopoly is still a natural monopoly, but such a business might be forced to behave like a competitive industry because behaviour is constrained by the prospect of “hit and run competition”.

This is the history of securities exchanges. Incumbents survived as natural monopolies because they did not exercise their market power. But when they used or abused it, they began to lose it. The New York Stock Exchange took advantage of the maxim that the best of all monopoly profits is a quiet life, resisting new technology and preserving outmoded trading arrangements. Then a wave of demutualisation set shareholders seeking higher profits and executives in pursuit of self-aggrandisement. New competition was the inevitable consequence. The paradox of contestability is that you can have a natural monopoly only so long as you behave as if you do not.

So will the new European platform, succeed? Only because it will help demonstrate that no exchange can, in the long run, be a very profitable business. The success of the project will be judged, not by its own profitability, but by its effect on the sponsor’s costs. Exchanges are destined to be low margin monopolies and such a market structure will inevitably emerge – in one set of hands or another. “O, it is excellent to have a giant’s strength: but it is tyrannous to use it as a giant.” And, Shakespeare might have added, often inimical to shareholder value.

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