Today’s social media giants might meet the popular definition of monopoly, namely having a very large market share. Economists, however, use a much stricter definition, and public utility regulation is applied only to the specific type known as a “natural” monopoly. Natural monopoly refers to industries where the cost per unit produced or customer served falls due to a very high first unit cost and a very low cost of serving extra customers.
Consider the electric grid. Establishing the grid requires generation plants, transmission lines, substations, and finally the power wires in our communities. Once built, the cost of connecting one more home or business to the grid is very low. The same dynamic applies to water and sewer systems, landline telephones, and roads and streets.
One large firm will likely dominate such industries. Why? Competition drives price down to the cost of production. Here the largest firm has a cost advantage and can profitably charge lower prices than its rivals. Smaller firms can either match the leader’s price and lose money or maintain a profitable price and likely lose customers. After the smaller guys go bankrupt, the large firm can raise its price and earn big profits.
We frequently use anti-trust laws to prevent the establishment of or to break up existing monopolies. But breaking up a natural monopoly is unlikely to produce competition for long. The largest firm’s cost advantage doesn’t go away.
What are the alternatives? One is government ownership of the utility, which we rely on for water, sewers, roads, and electricity in communities like Troy. Cooperative ownership by customers – electric and natural gas co-ops – prevents managers from trying to profit at customers’ expense.
Public utilities regulation gives a private, for-profit company an exclusive service territory, albeit with restrictions. Government regulators, in Alabama the Public Service Commission, set prices and other terms of service. And the utility is a common carrier who must provide service to all customers willing to pay the regulated price. Economists and lawyers developed the public utilities doctrine around 1900.
Another way to think about a public utility is that competition between profit-seeking businesses normally best serves customers. But the enormous cost of power grids renders multiple systems and competition unattractive. Perhaps having one grid and economists deliver the benefits of competition through rules makes more sense.
Whether the public utilities doctrine served America well during the 20th Century is a question for another day. How about applying this model to social media today?
Facebook and Google meet the popular definition of monopoly – they dominate their markets. Twitter dominates its unique product, but alternatives exist to push out messages. None of the three has a massive, critical physical infrastructure creating declining cost per customer.
The social media giants do possess an advantage resembling natural monopoly. They have coordination value: the value of being on Facebook increases with the number of other users. Economists call this a network effect. Although many economists fear that network effects might lock us into inferior technology, in practice entrepreneurs can get consumers to switch: we do not still watch VHS movies and listen to cassettes.
The social media companies serve their customers very well. For instance, YouTube’s advertising allows performers to earn money, with some stars earning millions per year. Facebook has offered users innovative features and an easy interface. Market domination due to better service benefits consumers.
Alternatives to Facebook currently exist, like LinkedIn and even MySpace. More significantly, a new rival would not have to duplicate a massively costly physical infrastructure. The economic case for regulating the fast-changing digital world with a model designed for the physical world is weak. Today’s social media giants will likely have a much shorter time on our economic stage than phone and electric utilities unless we cement their positions via regulation.
Daniel Sutter is the Charles G. Koch Professor of Economics with the Manuel H. Johnson Center for Political Economy at Troy University and host of Econversations on TrojanVision. The opinions expressed in this column are the author’s and do not necessarily reflect the views of Troy University.