The Monopoly Bogeyman

As this late 2010 article predicted, 2011 was indeed a year for mergers. The most noteworthy was AT&T’s attempt to buy T-Mobile. The attempted move by AT&T would have given them an estimated 43% of the market share for cellular phone providers. This number drew the ire of United States regulators which eventually landed AT&T in court where they are still negotiating. So much for efficiency. With all the hullabaloo over the potential merger, it’s worthwhile to examine the issue of monopoly as we head into 2012.

The Justice Department uses a metric called the Herfindahl-Hirschman Index to determine market shares for individual firms. When the concentration reaches a certain (arbitrarily determined) level, the offending firm is reminded of who is really in charge. Despite the fears of government officials and even many ignorant consumers, there are many reasons why it is difficult to identify monopolies, and why they are not to be feared.

  1. Antitrust legislation is based on a Neoclassical model of economics called “perfect competition.” This is a highly stylized model that makes several unrealistic assumptions about the real world. These include perfect knowledge of market conditions by all market participants, inability of any firm to affect the price, and the homogeneity of all goods (no substitutes). It is impossible to find a market with exactly these characteristics, but antitrust law is designed to “push” the market towards this “ideal.”
  2. There is no good way to define “monopoly.” If we define it as a single seller of a good, then every individual becomes a “monopolist” of his labor services.
  3. These two foundational problems lead to a host of others. For one, we cannot compare the “monopoly price” to the “perfectly competitive” because the latter is a fiction that exists only in economic models, not the real world of ever-changing markets.
  4. Every firm restricts output (with a resultant increase in price). To not restrict output would imply that all factors of production are producing as much as they can 24/7. This is obviously unrealistic, but it’s impossible to distinguish a firm that is restricting output under normal market operations, and one that is doing so with the “malicious” intent to increase price.
  5. Monopolists cannot earn profits in the long-run. If a firm finds itself a single seller of a good, it will bid up the prices of the factors of production used to produce that product so that its monopoly profits are dissipated.
  6. The restriction of output frees up resources for other firms to use.  Just as one firm is increasing prices by restricting its output, factors of production can now be employed by other firms who are expanding output and decreasing price.
  7. Antitrust laws constrain actual competition in the name of perfect competition. How do entrepreneurs make a profit? They do so by satisfying the preferences of consumers more effectively than any other rival entrepreneurs. Thus, antitrust laws effectually punish the most efficient entrepreneurs all in the name of a fictitious ideal (perfect competition).
  8. The monopolist is still constrained by demand. No matter how inelastic the demand for a good, there is still a price that will actually decrease revenues to the firm. If nothing else, this is simply a function of finite incomes. The firm must price its product below this price to maximize its profit.
  9. Antitrust is usually imposed to help less efficient firms instead of consumers. Cases against Standard Oil, Paramount, and Microsoft were all brought by less efficient, rival competitors. Antitrust legislation is an effective way for inefficient firms who can’t make it on the market to compete.
  10. Economist Dominick Armentano examined the 55 most noteworthy antitrust cases in United States history.  In each case, the firms accused of monopolistic behavior were lowering price, expanding output, and innovating. For a more detailed analysis, see Dominick Armentano’s book Antitrust and Monopoly: Anatomy of a Policy Failure.   
  11. With government barriers to entry, high profit margins will attract additional firms into the industry. Even the threat of additional entrants is usually sufficient impetus for monopolistic firms to reduce the price of their products.

Given these (and other) reasons, mergers should not be feared. A merger is simply an instance of entrepreneurs discovering more efficient ways to configure productive processes. The goal is to maximize profit, but this can only be done by satisfying the preferences of consumers.

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15 Responses to The Monopoly Bogeyman

  1. Steven Douglas January 2, 2012 at 7:56 am #

    “Monopolists cannot earn profits in the long-run. If a firm finds itself a single seller of a good, it will bid up the prices of the factors of production used to produce that product so that its monopoly profits are dissipated.”

    Strangest thing I ever heard. Why would a firm ever, EVER “bid up” the prices of “the factors of production”? What if the monopoly has no cost of production (intellectual property), or you own all the factors of production? A virtual monopoly on oil (OPEC), currency issuance (the Fed), land rents, etc., – you really can pretty much set your price…especially when you feign or contrive a fictitious form of artificial scarcity. How about union monopolies, like the AMA – manipulating value through artificial scarcity of degrees?

    And of the 55 most noteworthy antitrust cases, with firms accused of monopolistic behavior by lowering price, many of them were operating at deliberate losses in wars of attrition — for the sole purpose of putting their competition out of business. They were not monopolies – they were trying to become monopolies through predatory behavior.

  2. adeckert January 2, 2012 at 6:07 pm #

    Very good comment Caleb, the only thing I would like to add is the idea that mainstream analysis of monopolies greatly misses the mark when it comes to “monopolistic privileges.” The main point they make is that monopolies have “power” over individuals to make them pay the “monopoly price.” This completely contradicts the manner in which the economy operates on a voluntary transaction basis in attempt to satisfy preferences ex post. It further rules out consumer sovereignty in the market as the sole concept that determines who stays in business and who does not. This suggests that the monopolist can infinitely raise its prices to take advantage of a perfectly inelastic demand curve. This would further suggest the inability to produce substitute goods. This could not be further from reality because individuals have an incentive to innovate and find substitutes. Once substitutes are developed, profits are taken away from the “monopolist,” and he is then forced to charge a lower price if he wishes to stay in business (consumer sovereignty). The sole concept to understand in relation to monopolies in the free market is that the market will always adjust accordingly, and it is never a market failure if a monopoly does arise. The monopolistic behavior will only be temporary as the market adjusts accordingly.

    Therefore, the analysis of monopoly in the mainstream sense could only be applied to one form of monopolies–government privileged. When an industry has government privileges, it is impossible for the market to adjust accordingly. Take national defense for example. Because we do not have competing industries, prices become artificially high as there is no real incentive to keep costs low because there is no choice but to “purchase” services from the sole provider. We would never think that the government has a monopoly over defense services, but we see all the traces of a monopoly acting inefficiently.

    • csfuller January 2, 2012 at 7:37 pm #

      Great points all. One key difference is that Austrians emphasize the “market process” while the Neoclassical analysis seems much more static.
      You’ve read some Kirzner haven’t you? I know he wrote a lot on entrepreneurship. Did he address issues of monopoly?

      • adeckert January 2, 2012 at 8:07 pm #

        I actually have not read into Kirzner’s analysis beyond the point that I made about them not having the said market power over consumers. Interesting enough though, from his chapter on monopolies in “Market Theory and the Price System,” is essentially what your initial article was about. To summarize the chapter he writes (sorry for the length),

        This chapter has examined the modifications in the general market
        process that are introduced as a result of the concentration of the supply
        of particular resources (or the production of particular products) in the
        hands of single market participants.

        When the entire natural endowment of a particular resource is concentrated
        in the hands of one owner, it may or may not be profitable for
        him to force up the price by restricting supply (depending on the elasticity
        of demand for the resource). Where the monopolist finds it worthwhile
        to hold some of the resource off the market, corresponding changes are
        brought about in the methods and volume of production affecting the
        availability of goods to consumers. Where a resource is exclusively owned
        by a group of owners able to act in concert, they too may conspire to force
        up the resource price by restricting supply. (Several variants of resource
        cartel possibilities can be analyzed.) However, such cartels may face serious
        problems of enforcing the respective cartel agreements. Where all the
        buyers of a resource combine, they may be able to exert short-run effects
        on prices and production.

        Where the sole owner of a resource chooses not to sell any of it to
        other producers, but establishes himself as the sole producer of a product
        for whose production the resource is essential, he can employ his monopoly
        power in the product market. Detailed analysis shows the conditions under
        which he will be able to profit by using his monopoly power to raise the
        product price through output restrictions. Further analysis explains how
        his favored position may also have an impact upon the markets for the
        other resources required for the production of the exclusively produced
        product.

        In a market where there are numerous, slightly differentiated competing
        products, it may not always be immediately apparent whether or not
        some of the resources are monopolized.

        The analysis also clarifies the existence and impact of the sole producer
        in situations where he does not have monopoly power, as defined in this
        chapter. In such cases market activity is carried on under the influence
        of potential competition. A special case typical of this kind of situation
        is where the economies of large-scale production result in only one producer
        or a very small number of producers.

        The absence of monopoly power, as defined in this chapter, does
        not imply that each buyer of any good or service faces a perfectly elastic
        supply curve, nor that each seller face a perfectly elastic demand curve.
        These latter conditions are usually required for much discussed models
        of “perfect competition.” The idea should be avoided that such models
        are in any sense “normal.”

        One particular possible result of monopoly control is that more than
        one price may emerge for a particular good, even in equilibrium. Such
        possibilities are investigated by the techniques of the theory of monopolistic
        price discrimination.

  3. libertas January 2, 2012 at 3:06 pm #

    Thanks for the comment. In this post I was only referring to the specific case of a supposed monopoly on final goods (consumer goods). I did not address other complications (such as the one you mention about being the single owner of a factor). In the scenario I mention, the monopolist will indeed bid up the prices of factors so that they ensure that they become the owner of them and not some other firm (producing, of course, a different product that employs the same factors of production). This will reduce the spread between revenues and cost until the monopolist profit is dissipated. Does that make sense?

    You mention OPEC and the Fed. These are an entirely different set of monopolies–political monopolies that would not exist in an unhampered market (many people are unaware, but OPEC receives significant support from the governments of those countries). These are the kinds of monopolies that we should, indeed, be fearing. Again, unions are an example of monopoly that operates with government privilege–another kind of monopoly that does actual harm, and exerts destructive influences on the economy. Strictly speaking, unions are not monopolies, but they do achieve what economists might call “restrictionist wage rates.”

    Lastly, you bring up predatory pricing. There are a host of reasons why I believe this to not be a concern. I will mention a few of them.

    1. It is impossible to determine whether pricing is actually “predatory.” You cannot know the firm’s cost structure, maybe he is trying to liquidate etc…Again, there is no objective way to distinguish a monopoly or predatory price from a “competitive” one. Why? Because we only have the “market price.” It is impossible to distinguish a firm employing predatory pricing from one who is simply a better competitor–and is more skilled at satisfying consumer preferences.
    2. One firm cannot impose losses on another firm. Losses are a result of forecasting future demand less skillfully than one’s competitors.
    3. In order to recover its previous losses, a firm must raise prices to such a degree that it will attract competitors into the business (due to the high profit margins). These firms will most likely be able to operate more efficiently (lower prices) because they have no loss to recoup.
    4. A start-up firm might lower its prices temporarily to gain market share it would otherwise be unable to obtain.

    These are but a few reasons why predatory pricing is an illusion. Under our current antitrust laws, firms can be prosecuted for prices which are too high (monopolies), prices which are roughly equivalent to others’ (collusion), or for prices which are below the rest (predatory pricing). The bottom line is that these laws violate the private property ethic by constraining the decisions that firms make concerning their own property/assets.

    • Steven Douglas January 3, 2012 at 5:07 am #

      Thank you for the thoughtful reply. I only have few things to add, because I agreed largely with everything you wrote — especially the impossibility of determining whether pricing is actually “predatory”. I do note, however, that you did not conclude that pricing could not be predatory – only that it could not be determined (proved).

      On why bidding up the other factors may not be necessary when establishing a monopoly, I think it’s important to note the difference between production utility and end consumer utility, and an end consumer good can be monopolized based on a monopoly of a single crucial production factor utility required to create that good.

      If you’ll excuse an implausible example (for lack of a better one and only for the sake of illustration): if I held a monopoly on uranium, I could also hold a monopoly on all systems which required uranium. I could refuse to sell my uranium separately, but only sell it as one production utility factor contained within my particular brand of reactor, the end consumer good. As the only reactor that actually comes with the uranium needed to fuel it, the bidding up of all the other factors would not be required, as I could charge a premium for everything.

      As for predatory pricing, I actually watched a friend do this years ago, both deliberately and effectively, with a market war chest of his own – as he effectively destroyed all of his smaller competition (about seven other competitors in a niche market in the semiconductor industry), even to the point of buying up their liquidated stock at pennies on the dollar as each of them went under. He did this without government privilege or assistance of any kind, and for one reason only, and that was to weed out all the little mom and pops that were undercutting him. They weren’t even aware he was doing it deliberately, but all assumed that he simply had more efficient means of service and production which enabled him to keep is prices so low. He deliberately undercut all of them at a loss to himself – practically giving away goods and service in the niche he wanted to corner, effectively drowning them all out, save on larger competitor which did not rely on that niche for profit, and had no choice but to ride it all out.

      Now that the competitors are all gone, he and the one remaining competitor which survived have since raised their prices to comparable levels which far exceed what either were forced to charge when multiple competitors existed. Without any kind of formal agreement between the remaining two, they don’t ever engage in pricing wars, or deliberately undercut each other. They are content to split the market, effectively being the Coke and Pepsi of their niche, which in turn gives the illusion of competition. Since then, technology has advanced to the point where it is not even possible for smaller competitors to even form, as the capital requirements are too great. And the niche is too small and too specialized to attract threats from larger would-be predators.

      I know just from my one “inside” view of one anecdotal example, but it confirms (to me at least) the hypothesis that monopolies which can be artificially created, with markets that can be cornered, and are, without resorting to government privilege.

      Your comments were greatly appreciated, because it has forced me to think much, much deeper about the subject, since without an objective rule, the possibility of abuse will always exist, such that it would be better in my opinion to err against the side that simply cries “monopoly”.

      • adeckert January 3, 2012 at 11:03 am #

        I guess I have one question then: What exactly is wrong with the “predatory pricing” you are describing? It serves as a method to root out less efficient producers that cannot produce at the lower price. Is it not an entrepreneurial decision to lower your price in an attempt to steal the market share from others in an attempt to become more profitable. Is this not the same thing that happens in a cartel that breaks apart? Furthermore, the claim of antitrust in regards to predatory pricing, is to prevent the firm to raising their prices back up again to take advantage of being the only firm. If this is the case though, why would other firms not be able to enter in once again? I see “predatory pricing” that you explain, to be a result of good entrepreneurial foresight. You write in regards to your friend,

        “As for predatory pricing, I actually watched a friend do this years ago, both deliberately and effectively, with a market war chest of his own – as he effectively destroyed all of his smaller competition (about seven other competitors in a niche market in the semiconductor industry), even to the point of buying up their liquidated stock at pennies on the dollar as each of them went under. He did this without government privilege or assistance of any kind, and for one reason only, and that was to weed out all the little mom and pops that were undercutting him.”

        Did he not have good entrepreneurial foresight? If he did not, then he would be the one who went out of business, as the firms that were undercutting him would just reduce their price again to undercut him, proving their superior cost structures.

      • Steven Douglas January 3, 2012 at 4:44 pm #

        It wasn’t to “root out less efficient producers that cannot produce at the lower price.”

        He did not do that as a “more efficient producer”. His competitors had less overhead. They were the more efficient producers who are already producing at lower prices. He undercut them, incurring sustained losses, for the sole purpose of putting them out of business, so that once they were gone he could later RAISE his prices without fear of losing his customers.

        And I explained why other firms would not be able to enter in once again. Technology and equipment requirements had advanced to the point where the capital expenditures required to even enter the market would be too large to justify it. Remember also that I mentioned that he was buying up all the stock his small competitors were liquidating at pennies on the dollar. All of their inventory was highly specialized, actually had great value, so that much of what he acquired from them amounted to a corner on the market.

      • libertas January 3, 2012 at 5:14 pm #

        Actually, he was more efficient than his competitors if they were unable to respond in-kind by cutting prices also. The fact that he was able to sustain losses for a period of time, but they (as demonstrated by refusing to cut prices) evidently were not, demonstrates that he was indeed more efficient.

        Additionally, one strategy that small firms can employ against big ones is this. The small firm can short the stock of the large firm every time it re-enters the market where the large firm is operating, thus making money to support its losses.

        The market is a competitive process, and no economic model can determine the “right” number of firms that should be in the market–only the rivalrous competition of the marketplace can do this. You mention there being high capital requirements that keep other firms out. This is simply an example of what I’m saying (that only the market can determine the proper number of firms). What is popularly seen as a barrier to entry is really just a signal that in order to be profitable, producers must operate with low costs. There are many industries that require large scale, which in turn requires a large investment. But even firms successfully entrenched are still constrained by the level of demand.

        Lastly, you mention the case of someone who is the single owner of a factor of production (and make the point that this would *not* result in factor prices being bid up). However, it is *still* doubtful that this owner will reap a monopolist profit (in the economic sense of profit). Say ALCOA owns all the bauxite mines in the world, and so can charge a higher price for the final good–aluminum. After all, no one else has the means to produce aluminum since ALCOA controls all the bauxite. However, Austrian theory teaches us that final prices are imputed backwards to the factors of production. In this case, the higher price of the aluminum is imputed backwards to the land, so that it’s values rise. Outside investors are then willing to pay more for bauxite mines than they are for any ordinary plot of land. This represents a cost to ALCOA, and so we see that revenues have increased (through higher prices) but so have costs (the opportunity cost of not selling the land). This is not an obvious conclusion to most because it may not appear this way on the “books” of the firm, but it is an economic reality nonetheless.

      • Steven Douglas January 4, 2012 at 1:08 am #

        I feel kind of silly even arguing, because I pretty much agree with most of what the Austrian school teaches as axiomatic, and which I believe reveals much of the rampant insanity of mainstream Keynesian spawned theories. So while I would much rather argue from your premises, let me continue anyway, as devil’s advocate.

        I will note that shorting stocks of large firms, as you mentioned, implies that a firm is even publicly traded, which is not always the case, and definitely not the case here. Thus, no ability to capitalize on losses. Such an assumption also overemphasizes the importance of a stock market and derivatives, which Austrian theory can account for, but does not recognize or require for a free market to exist.

        I think we agree that government imposed monopolies of any kind are destructive to a free market. The only thing I wanted to explore was whether government is even required, without accepting, a priori, the presumption that a “free market” is, by mere definition, “a market free of government intrusion”, since doing so would establish a circular argument that cannot be examined or falsified on the basis of any principles, or principle violations, but rather a meaningless circular assumption. Thus, if a Warren Buffet type, with the help of some free market collective, was able, for example, to buy all available land in a small state, it would effectively have a land monopoly, and could artificially dictate prices. The fact that such a collective is a non-governmental “free market participant” would not be cause for a free pass, and for me that is an example where antitrust laws would apply, with a good old fashioned legislated split-up and forced liquidation. Likewise, had the Hunt Brothers been successful in cornering the market on silver back in the day, would I have called that a “free market move” for which no intervention is acceptable? I don’t know. I honestly don’t. The fact that it brings up the value of silver mines is meaningless to me, because I am not recognizing the notion of “economy-wide” corrections and responses as “solutions” – I don’t care that the market can react and respond, regardless if the meddling was of public or private origin.

        I would also like to point to an example where a lack of government intrusion results in a de facto industry monopoly that both distorts and is very destructive to the market on the whole. Fractional reserve lending is a case where a crime was never labeled a crime, and a banking network (an aggregate monopoly) was permitted to create conflicting, contradictory counter-party claims on the same wealth – without government interference or support, and without the existence of any central bank.

        Busts that result from the bursting of credit expansion bubbles created by fractional reserve banks test and reveal a network of inherent (and inherently fraudulent) bank insolvency. Every time this happens, bank depositors are treated by the state and bankers as “bad investors”, rather than the accurate case, had the banks themselves been identified and prosecuted as embezzlers. That has happened throughout history, and gave rise to the Fed, as the practice continues to this day, with the most recent example of a bust being MF Global, where glass is broken, and customer deposits, including even allocated holdings (strictly bailments), are claimed/stolen as if they were subject to the same counter-party claims as any other deposit or holding.

        I bring up this example only to establish a case where a lack of government intervention is tantamount to establishing an acceptable private “free market monopoly” in one industry that is damaging to everyone save those enriched thereby – through outright theft, no less. If I owned a corporation and sold 400% of its stock in a Ponzi scheme, and it was uncovered, I would not just “go bankrupt”, as we figured out how to settle fights between investors. I would face prison time.

        And yet, so long as there is no “owner” identified of a currency that is used by the public, selling 400% of “shares” of this currency in the form of worthless derivatives is completely acceptable. The only thing that banks face is “insolvency”, so that when contradictory claims arise, are finally forced by an implosion, as with a “run” on the Ponzi scheme, nobody looks to the perpetrator. It’s only a game of “let’s you and the other ‘investors’ fight”

        A toleration of fractional reserve lending, a monopolistic behavior unique to one industry, was already in effect, long before the establishment of the Fed which officially facilitates and enlarges this process with a stamp of approval on this practice by government (which didn’t come until much later). In other words, it was a “free market” public monopoly before it became a government granted (privatized but collectivized) monopoly on the currency creation process.

      • libertas January 4, 2012 at 12:23 pm #

        I have two final, major thoughts. First, in conclusion, I simply think it unwise to base policy on a model that is so arbitrary. It’s impossible to objectively determine “competitive prices,” and we essentially violate property rights with antitrust laws. Which brings me to my second point.

        You argue that there should be antitrust laws regarding monopolies such as our current banking system. There should, indeed, be laws against fractional reserve–but these would not be antitrust laws. Fractional reserve is essentially contract fraud and theft (because multiple claims are issued to a single piece of property). Thus, laws against fractional reserve would protect private property. Antitrust laws essentially dictate what one must do with his property. The two are fundamentally opposed.

    • Steven Douglas January 4, 2012 at 2:38 pm #

      Well stated. Back to the drawing board, as that’s pretty much the answer I would give myself. lol

      Thank you (both) for taking the time to entertain it.

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