Amazon: a Natural Monopoly?
We have all heard of the increasing and immense power of the tech companies. By any measure — stock market valuation, profits, revenues, they are huge. There is much to be grateful for in this: who doesn’t love the ability to order overnight on Amazon? And there is no doubt that our experience of the coronavirus pandemic would have been far different without these companies: our ability to continue to learn, stay in touch, work and shop was largely due to their technology.
But there are many concerns surrounding the dominant position and seemingly unstoppable growth of these firms. In a nutshell, their dominant position allows them to raise prices and leave us nowhere else to go. It’s as simple as that.
In November 2020 the UK government announced a new digital watchdog which is going to regulate these companies. The question of monopoly and its benefits or abuse of power is not a new one but the application of this theory to new, global tech, most certainly is.
It’s a very tricky problem, particularly in the case of a natural monopoly — and it may be that Amazon is becoming one. Not only does it dominate e-commerce, it is also seeking to deliver on behalf of its rivals!
According to Amazon itself: “Amazon has spent years building one of the world’s most efficient and optimised supply chains. Our vision is ambitious — to fulfil orders for customers around the world, regardless of where the transaction occurs.”
Let’s look at this question of natural monopoly more closely:
A Natural Monopoly is a market structure where only one firm tends to dominate an industry due to the cost benefits of being large. As firms expand in the long run they can experience economies of scale. Economies of scale are a reduction in long run average costs due to an increase in the scale of operations. (LRAC) fall as output rises. The opposite is diseconomies of scale, when LRAC increases as output rises. Internal economies of scale include the following:
- Purchasing — e.g. it will cost roughly the same whether a firm is placing an order for 100 units or 1000. A firm can negotiate discounts when it places a big order.
- Selling — selling costs can be spread over more units — e.g. running a big distribution lorry doesn’t cost twice as much as a small lorry.
- Technical — bigger companies can use more sophisticated complex machinery
- Managerial — large firms can employ managerial specialists — e.g. accountants. Management costs can be spread over a bigger output.
- Financial — large firms can borrow at lower rates of interest. It can issue shares etc.
- Risk-bearing — a bigger firm can bear risks better — including differentiating products so if one product does badly another may be ok.
Due to such economies, the average cost per unit of production falls as the scale of the firm’s operation increases. We can see how all these can be applied to Amazon. And it explains why indeed Amazon can fulfil your order overnight.
The point at which all these cost reductions from expanded operations have been realised is called the Minimum Efficient Scale of operations. Often, as the firm expands beyond this point, average costs may start to rise due to Diseconomies of Scale, especially problems of coordinating the use of resources across a large company. But in some industries Economies of Scale are not only particularly large, they are continuous — the bigger and bigger the firm becomes the lower will be its Average Cost per unit. Put another way, the Minimum Efficient Scale will be large relative to total market demand. This is the case of Natural Monopoly.
A traditional example of this is a public utility like electricity or gas distribution. Constructing an electricity supply system is very expensive, involving cables, pylons, generators, and converters across the country and down every street, but once it is done the average cost per unit of electricity carried will be very low. The MES for a electricity supplier is high relative to the market. This is shown in the below diagram.
Economies of Scale are very significant here — the long run average cost curve ATC falls continuously and even at output of 30 billion KW the Minimum Efficient Scale is not reached. Hence one firm producing close to the MES at point A can supply ALL the market demand for electricity shown by the downward sloping market demand line and there will be no room for another firm in the market. At the output 30 billion the average cost per unit of electricity is $0.04, which is very low. Any smaller firm operating in the market and producing less will have higher average costs and hence is unlikely to survive. For example a firm producing 15 billion KW at point B will have cost of $0.06 and can be undercut by the larger firm producing at A. Such a market will tend towards Monopoly since if one firm expands relative to the others it will drive down costs below theirs and be able to undercut them by greater access to Economies of Scale. Put simply: when the MES is approximately equal to the total market demand, the industry will tend to be a Natural Monopoly.
We are used to this being a characteristic of electric, gas, and rail companies. But it seems it might well apply to Amazon which is on the way to becoming a Natural Monopoly as a distribution company. And it is doing this by fully exploiting economies of scale, fulfilling orders from its own website, and now seeking to fulfill orders for Shopify, eBay, Etsy etc.
According to the FT: “Sellers gain the convenience of keeping their stock within one system, while Amazon grabs a slice of its competitors’ business — leveraging the immense capabilities of its delivery network, the capacity of which has more than doubled in the past two years.”
In short, it’s going to be almost impossible not to use Amazon — just like it’s impossible not to use your local electricity or water supplier. No one else will be able to match the efficiency of the Amazon distribution network, so that even when you buy a product online from a rival retailer, that retailer will be increasingly likely to dispatch that order to you via the Amazon distribution network, rather than run their own rival system of distribution centres and delivery vans.
This all sounds good: Amazon has an efficient and cheap distribution network and why should you care who delivers it, if you get the item you selected quickly and cheaply? The problem is that once Amazon consolidates its market power as a distribution network it will become, in effect, a monopoly producer and a monopolist will probably wish to maximise its profits — not sell at the lowest possible price. This may well involve Amazon cutting output and raising the price of its distribution services and if it does this rival firms and their customers will be forced to pay more since there is no other distribution game in town.
This problem of Natural Monopolies using market power to raise prices at the expense of consumers is a familiar one and governments have intervened, for example, to regulate the prices charged by electricity and gas suppliers. Given our reliance on technology, will the government eventually have to intervene to regulate Amazon? Will this be the next forum in the stand-off between governments and big tech? Socialist governments in the past have nationalised public utilities like gas, rail and water and there are calls today for the railways to be re-nationalised. Will a future government want to nationalise Amazon in the public interest?
By Kirti Shah & Dr I St John
