Monopoly

Before and during the period of the classical economics (roughly 1776–1850), most people believed that this process of monopolies being eroded by new competitors was pervasive. The only monopolies that could persist, they thought, were those that got the government to exclude rivals. This belief was well expressed in an excellent article on monopoly in the Penny Cyclopedia (1839, vol. 15, p. 741):

It seems then that the word monopoly was never used in English law, except when there was a royal grant authorizing some one or more persons only to deal in or sell a certain commodity or article. If a number of individuals were to unite for the purpose of producing any particular article or commodity, and if they should succeed in selling such article very extensively, and almost solely, such individuals in popular language would be said to have a monopoly. Now, as these individuals have no advantage given them by the law over other persons, it is clear they can only sell more of their commodity than other persons by producing the commodity cheaper and better.

Even today, most important enduring monopolies or near monopolies in the United States rest on government policies. The government’s support is responsible for fixing agricultural prices above competitive levels, for the exclusive ownership of cable television operating systems in most markets, for the exclusive franchises of public utilities and radio and TV channels, for the single postal service—the list goes on and on. Monopolies that exist independent of government support are likely to be due to smallness of markets (the only druggist in town) or to rest on temporary leadership in innovation (the Aluminum Company of America until World War II).

Why do economists object to monopoly? The purely “economic” argument against monopoly is very different from what noneconomists might expect. Successful monopolists charge prices above what they would be with competition so that customers pay more and the monopolists (and perhaps their employees) gain. It may seem strange, but economists see no reason to criticize monopolies simply because they transfer wealth from customers to monopoly producers. That is because economists have no way of knowing who is the more worthy of the two parties—the producer or the customer. Of course, people (including economists) may object to the wealth transfer on other grounds, including moral ones. But the transfer itself does not present an “economic” problem.

Rather, the purely “economic” case against monopoly is that it reduces aggregate economic welfare (as opposed to simply making some people worse off and others better off by an equal amount). When the monopolist raises prices above the competitive level in order to reap his monopoly profits, customers buy less of the product, less is produced, and society as a whole is worse off. In short, monopoly reduces society’s income. The following is a simplified example.

Consider the case of a monopolist who produces his product at a fixed cost (where “cost” includes a competitive rate of return on his investment) of $5 per unit. The cost is $5 no matter how many units the monopolist makes. The number of units he sells, however, depends on the price he charges. The number of units he sells at a given price depends on the “demand” schedule shown in Table 1.

The monopolist is best off when he limits production to 200 units, which he sells for $7 each. He then earns monopoly profits (what economists call “economic rent”) of $2 per unit ($7 minus his $5 cost, which, again, includes a competitive rate of return on investment) times 200, or $400 a year. If he makes and sells 300 units at $6 each, he earns a monopoly profit of only $300 ($1 per unit times 300 units). If he makes and sells 420 units at $5 each, he earns no monopoly profit—just a fair return on the capital invested in the business. Thus, the monopolist is $400 richer because of his monopoly position at the $7 price.

Society, however, is worse off.

Customers would be delighted to buy 220 more units if the price were $5: the demand schedule tells us they value the extra 220 units at prices that do not fall to $5 until they have 420 units. Let us assume these additional 220 units have an average value of $6 for consumers. These additional 220 units would cost only $5 each, so the consumer would gain 220 × $1 of satisfaction if the competitive price of $5 were set. Because the monopolist would cover his costs of producing the extra 220 units, he would lose nothing. Producing the extra 220 units, therefore, would benefit society to the tune of $220. But the monopolist chooses not to produce the extra 220 units because to sell them at $5 apiece he would have to cut the price on the other 200 units from $7 to $5. The monopolist would lose $400 (200 units times the $2 per unit reduction in price), but consumers would gain the same $400. In other words, selling at a competitive price would transfer $400 from the monopolist to consumers and create an added $220 of value for society.

The desire of economists to have the state combat or control monopolies has undergone a long cycle. As late as 1890, when the Sherman antitrust law was passed, most economists believed that the only antimonopoly policy needed was to restrain government’s impulse to grant exclusive privileges, such as that given to the British East India Company to trade with India. They thought that other sources of market dominance, such as superior efficiency, should be allowed to operate freely, to the benefit of consumers, since consumers would ultimately be protected from excessive prices by potential or actual rivals.

Traditionally, monopoly was identified with a single seller, and competition with the existence of even a few rivals. But economists became much more favorable toward antitrust policies as their view of monopoly and competition changed. With the development of the concept of perfect competition, which requires a vast number of rivals making the identical commodity, many industries became classified as oligopolies (i.e., ones with just a few sellers). And oligopolies, economists believed, surely often had market power—the power to control prices, alone or in collusion.

More recently, and at the risk of being called fickle, many economists (I am among them) have lost both our enthusiasm for antitrust policy and much of our fear of oligopolies. The declining support for antitrust policy has been due to the often objectionable uses to which that policy has been put. The Robinson-Patman Act, ostensibly designed to prevent price discrimination (i.e., companies charging different prices to different buyers for the same good) has often been used to limit rivalry instead of increase it. Antitrust laws have prevented many useful mergers, especially vertical ones. (A vertical merger is one in which company A buys another company that supplies A’s inputs or sells A’s output.) A favorite tool of legal buccaneers is the private antitrust suit in which successful plaintiffs are awarded triple damages.

How dangerous are monopolies and oligopolies? How much can they reap in excessive profits? Several kinds of evidence suggest that monopolies and small-number oligopolies have limited power to earn much more than competitive rates of return on capital. A large number of studies have compared the rate of return on investment with the degree to which industries are concentrated (measured by share of the industry sales made by, say, the four largest firms). The relationship between profitability and concentration is almost invariably loose: less than 25 percent of the variation in profit rates across industries can be attributed to concentration.

A more specific illustration of the effect the number of rivals has on price can be found in Reuben Kessel’s study of the underwriting of state and local government bonds. Syndicates of investment bankers bid for the right to sell an issue of bonds by, say, the state of California. The successful bidder might bid 98.5 (or $985 for a $1,000 bond) and, in turn, seek to sell the issue to investors at 100 ($1,000 for a $1,000 bond). In this case the underwriter “spread” would be 1.5 (or $15 per $1,000 bond).

In a study of thousands of bond issues, after correcting for size and safety and other characteristics of each issue, Kessel found the pattern of underwriter spreads to be as shown in Table 2.

For twenty or more bidders—which is, effectively, perfect competition—the spread was ten dollars. Merely increasing the number of bidders from one to two was sufficient to halve the excess spread over what it would be at the ten-dollar competitive level. Thus, even a small number of rivals may bring prices down close to the competitive level. Kessel’s results, more than any other single study, convinced me that competition is a tough weed, not a delicate flower.

If a society wishes to control monopoly—at least those monopolies that were not created by its own government—it has three broad options. The first is an antitrust policy of the American variety; the second is public regulation; and the third is public ownership and operation. Like monopoly, none of these is ideal.

Antitrust policy is expensive to enforce: the Antitrust Division of the Department of Justice had a budget of $133 million in 2004, and the Federal Trade Commission’s budget was $183 million. The defendants (who also face hundreds of private antitrust cases each year) probably spend ten or twenty times as much. Moreover, antitrust is slow moving. It takes years before a monopoly practice is identified, and more years to reach a decision; the antitrust case that led to the breakup of the American Telephone and Telegraph Company began in 1974 and was under judicial administration until 1996.

Public regulation has been the preferred choice in America, beginning with the creation of the Interstate Commerce Commission in 1887 and extending down to municipal regulation of taxicabs and ice companies. Yet most public regulation has the effect of reducing or eliminating competition rather than eliminating monopoly. The limited competition—and resulting higher profits for owners of taxis—is the reason New York City taxi medallions sold for more than $150,000 in 1991 (at one point in the 1970s, a taxi medallion was worth more than a seat on the New York Stock Exchange). Moreover, regulation of “natural monopolies” (industries, usually utilities, in which the market can support only one firm at the most efficient size of operation) has mitigated some monopoly power but usually introduces serious inefficiencies in the design and operation of such utilities.

A famous theorem in economics states that a competitive enterprise economy will produce the largest possible income from a given stock of resources. No real economy meets the exact conditions of the theorem, and all real economies will fall short of the ideal economy—a difference called “market failure.” In my view, however, the degree of “market failure” for the American economy is much smaller than the “political failure” arising from the imperfections of economic policies found in real political systems. The merits of laissez-faire rest less on its famous theoretical foundations than on its advantages over the actual performance of rival forms of economic organization.