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Bilateral Monopoly

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DOI: 10.1057/978-1-349-94848-2_532-1

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bilateral monopoly
DOI: 10.1057/9781137294678.0047
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bilateral monopoly
Definition
A bilateral monopoly exists when there is a single buyer
and seller of a given product in a market. Bilateral
monopolies present specific challenges to managers and
policymakers alike, as the final price and quantity are
determined through negotiation.
Abstract
Bilateral monopolies present challenges to private and
public managers. In a market characterized by bilateral
monopoly, the monopolist has an incentive to curtail
production to maximize profit while the monopsonist
should use its market power to expand production and
lower unit cost. The final price and quantity are determined
through a negotiating process that may, in part, depend on
the risk preference of the negotiator. Public policy may
restrict the ability of a government to take advantage of its
monopolist position. A government may, for reasons of
political or public interest, subsidize the monopsonist to
lower prices, increase supply, or both. A government may
also shift the risk of procurement from the monopsonist to
the government, decreasing the ability of the government
to negotiate on cost and schedule. Finally, laws, rules and
regulations may explicitly prohibit the government from
exercising monopolist power, even if such an exercise
would be of benefit to the taxpayer.
A bilateral monopoly exists when there is a single
buyer (monopsonist) and seller (monopolist) of a
given product in a market. For managers in the
public sector, especially those in security establish-
ments, markets characterized by bilateral monopoly
dominate the procurement of large systems and
projects. If the United States Department of Defence,
for example, desires to procure a new main weapon
system (aircraft, armoured vehicle, missile system)
built in the United States, it will recognize that the
number of potential suppliers has declined signifi-
cantly over the last four decades (Hensel, 2010). Once
a decision is made as to which manufacturer will
produce the weapon system, the market shifts from
oligopolists interacting with a monopsonist to a
monopolist interacting with a monopsonist. The
monopolist has an incentive to curtail production to
maximize profit while the monopsonist should (but
often does not) use its market power to expand
production and lower unit cost.
Monopolies and monopsonies
A monopolist exists where there is one, and only one,
seller of a good or service and significant barriers to
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10.1057/9781137294678.0047 - bilateral monopoly, Robert McNab
entry prohibit potential competitors from entering
the market. A monopolist thus has significant, but not
unlimited, market power and faces a downward
sloping demand curve. The downward sloping
demand curve is important in that it implies the
monopolist can set price or quantity but not both, that
is, if the monopolist sets a market price, quantity is
determined by the demand curve and vice versa. In the
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presence of monopoly power in the product market,
the value of the marginal physical product of labour is
always lower than the wage rate (Varian, 1992).
A monopsonist exists where there is one, and only
one, buyer of a good or service and significant bar-
riers to entry prohibit other potential buyers from
entering the market. The classic approach to mono-
psony involves a single buyer and multiple sellers.
The monopsonist establishes a market price and the
multiple, price-taking sellers select an output quantity
at which price is equal to the marginal cost of pro-
duction. As with a market with a single producer, the
market with a single buyer is inefficient relative to the
perfectly competitive market.
National governments, for example, are mono-
psonists for specific goods and services due to the legal
constraints imposed by the government. While private
militaries can (and do) exist, for example, governments
often retain the sole right for the legitimate use of
lethal force (Stafford, 2000), although this line has
become blurred since the 1980s. One could argue that
the use of private military contractors has led to a
more competitive labour market for those who provide
military force (Leander, 2005), as evidenced by the
flight of higher quality personnel to private military
contractors.
Bilateral monopoly
Markets characterized by bilateral monopolies appear
to be on the rise over the past four decades, especially
when one considers the expanding role of the public
sector in economic activity. Yet bilateral monopolies
may occur in private markets also. A geographical
location with a single maritime port and a single
maritime transport company would be considered
a market characterized by a bilateral monopoly.
Economic theory originally classified the bilateral
monopoly market price as ‘indeterminate’ since the
final price resulted from a bargaining process
(Pigou, 1908; Bowley, 1928; Pen, 1952). The relative
bargaining strength of the monopsonist and
1
bilateral monopoly
monopolist reduced this indeterminacy to a solution,
or at least a solution with bounds (Fellner, 1947;
Agapos and Dunlap, 1970). One bound is set where
the seller fixes his price, that is, when the mono-
psonist has no bargaining power. The lower bound is
likewise set where the buyer fixes his price. As long as
the price is within this contract zone, the market is
characterized by bilateral monopoly (Fellner, 1947;
Pen, 1952).
Economic theory suggests that markets character-
ized by bilateral monopolies consisting of two private
firms are likely to be relatively inefficient compared
with markets where there are either numerous buyers
or sellers (Baker, Farrell and Shapiro, 2008). With
private information, markets with one or more sellers
are relatively more efficient and have a relatively
higher quantity of goods produced than markets
characterized by one seller. Suppose, for example,
that marginal cost is $1 and that the buyer’s value is
either $2 or $4 with equal likelihood. Competition
between the sellers will likely yield a price below $2
and an efficient level of trade. On the other hand, if
only one seller exists, the seller wishes to maximize
profits by selling at $4. Half the time, the buyer’s
actual value will be $2 and no trade will occur, thus
illustrating the inefficiency of a single supplier rela-
tive to multiple suppliers (Vickers, 1996; Baker, Far-
rell and Shapiro, 2008).
If, however, the purchaser of the goods and ser-
vices is the government, the prevailing price is
dependent upon the contractual mechanism. The
government may desire to seek the lowest possible
price but may face legal and regulatory impediments
to doing so. Attempts, for example, to consolidate
purchases into fewer contracts of larger size may have
the unintended consequence of consolidation among
suppliers, moving the market further away from a
competitive equilibrium (Agapos, 1971).
Strategic management
From a strategic management perspective, bilateral
monopolies offer significant challenges to policy-
makers and managers alike. For policymakers, the
desire to intervene into these markets to move them
towards a competitive equilibrium may, in fact, have
the unintended consequence of exacerbating the
market power of the monopolist or monopsonist. For
managers, these markets often lack clear signals as to
price and quantity, and negotiation is relatively more
important than in a competitive market.
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With regard to economic policy, the relative bar-
gaining power of the monopsonist can be altered by
subtle changes in laws, regulations or procedures.
Imposing a minimum domestic content requirement,
for example, alters the resultant rent distribution
even if the content requirement is set to the free trade
input proportion (Beghin and Sumner, 1992). The
imposition of the requirement increases the relative
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bargaining power of the supplier of the content,
skewing the resulting rents. In defence procurement,
for example, the government may ‘give away’ bar-
gaining power by transferring research and develop-
ment risk from the supplier to the government. The
government may also reduce its bargaining power by
guaranteeing the monopsonist receives ‘cost+profit’.
As cost overruns plague major weapons systems,
from the F-22 Raptor (an advanced single-seat air-
superiority fighter aircraft) to new destroyers, one
may be drawn to the conclusion that the government
is to blame, in part, for the creation of contracting
mechanisms that reward underperformance and cost
overruns.
In the case of a market of an exhaustible resource,
a bilateral monopoly may create greater uncertainty.
The most important issue in these markets may be
one of commitment, that is, the ability of strategic
players to commit themselves to a course of action to
favourably influence their rivals (Lewis, Lindsey and
Ware, 1986). If we assume that a perfect substitute,
for example, is available for the exhaustible resource,
then a lack of commitment induces the monopolist to
extract the resource more quickly, which creates an
incentive for consumers to remain with the exhaus-
tible resource. Why would the monopolist not com-
mit? Commitment places the monopolist at a
strategic disadvantage and lowers their profits over
time. In essence, the monopolist has every incentive
to maximize profit, even if it means exhausting the
resource more quickly than would occur under
market conditions.
Mergers may not produce the results that standard
theory would predict. Mergers are often discussed in
terms of reaping the benefits of economies of scale.
The terms of the resulting transactions, however, are
determined through bargaining rather than by being
determined by one of the parties. The incentives for
mergers are sometimes significantly different than
they would be if prices were not determined by
bargaining (Horn and Wolinsky, 1988). The implicit
assumption that the merged firm would thus attempt

to lower its per-unit costs may be incorrect if such an
action resulted in lower profits over time.
Yet to think that bilateral monopolies are only
characterized by interactions between two firms or a
government and a firm would be incorrect. Bureau-
cracy is a classic issue in public choice and can be
modelled as a bureau selling its services to govern-
ment which, in turn, only buys services from the
bureau (Niskanen, 1996, 2007). If we assume that
the bureaucrats attempt to maximize their budget,
the level of output may be inefficient. Monitoring
may thus be necessary to discern what are the true
costs of the bureaucracy; and monitoring generates
additional costs. This argument, however, may be
sensitive to the assumption that the bureaucrats are a
discriminating monopoly. If this assumption is
relaxed, the bureaucrats’ preferred level of output is
equal to the sponsor’s preferred level (Casas-Pardo
and Puchades-Navarro, 2001). In other words, policy,
not bureaucratic attempts to maximize profits,
determines the level of output.
From a management perspective, price and quan-
tity are determined through a negotiating process.
Managers can thus directly attempt to maximize
profitability (for monopsonists) or minimize cost (for
monopolists). The personal characteristics of the
manager are an important (and oft ignored) input to
the negotiating process. The archetype is a successful
manager who is an extrovert, a risk-taker, and con-
fident in his or her ability to maximize the payout
from a negotiating process. The evidence, however,
suggests the archetype is more myth than reality.
Relatively risk-adverse managers appear to be more
able to obtain a higher payoff than risk-taking
counterparts (Harnett, Cummings and Hamner,
1973). Risk-adverse managers appear to pursue more
a more demanding negotiating strategy with a sig-
nificantly higher starting price than extroverted,
risk-loving managers. Thus, while economic theory
suggests that the relative power of a monopolist will
determine the final market price and quantity, the
human factor may result in a different outcome.
These elements combine to suggest that govern-
ments are ill-equipped to operate in markets char-
acterized by bilateral monopoly, yet the government
is often one side of these markets. The F-35 provides
an excellent example of how the government, even
though it is a monopolist, has been unable to employ
its market power to rein in costs and under-
performance. The per-unit acquisition price of the
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10.1057/9781137294678.0047 - bilateral monopoly, Robert McNab
bilateral monopoly
F-35 has increased by 75 per cent since 2001 and
shows no signs of abetting (GAO, 2012). Yet the
government has contracted to acquire hundreds of F-
35 before testing is complete, thereby decreasing its
relative bargaining power. In essence, the government
apparently (and willingly) moved the price away
from cost minimization to profit maximization.
From a strategic perspective, this is sheer folly (and
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regrettably avoidable) given the looming reductions
in discretionary expenditures in the United States.
ROBERT MCNAB
See also
ACQUISITION STRATEGY; AGENCY PROBLEMS; INDUSTRY CONCENTRATION;
MARKET STRUCTURE; PRINCIPAL-AGENT
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