Where Does Monopoly Power Come From?

Speak of the devil: I just googled the ADM scandal and apparently the new Matt Damon movie is based on the book about the scandal.

http://en.wikipedia.org/wiki/The_Informant!

Bryan, what about natural monopoly? When the extent of the market makes marginal case systematically lower than average cost. Sure, many times this is due to artificial limitations on markets like tariffs, and others like utilities seem more like a govt caused problem. But consider music, movies, software and maybe even some hardware: not that govt should or is competent to meddle in that market, but it seems there are monopoly profits going on. (Consider the ratio of success versus failures.) Or the little grocery store in the middle of nowhere: not sure if inventory alone accounts for the high prices.

I would be curious to here your views on the actions to break up Alcoa 60 years ago. Or breaking up Standard Oil.

There are cases in which, by first mover advantage, a firm takes over an entire market. Once it dominates the market,it charges a monopoly price. A firm can be so dominant that no effective competition is possible. Breaking the firm up could create competition, to the benefit of all except the monopoly itself.

Was there a case for breaking up Microsoft, which nearly happened? I bet we would have better software now if the break up had happened.

Dr. Caplan,
Would the complete nonexistence of government or laws – a totally free environment for any kind of competition and entrepreneurship – be a kind of freedom paradise? If it was possible to restart the society as that freedom paradise, what would it result after some centuries?
I know my question is pure speculation (maybe, a waste of time), but given the actual knowledge (history, technology, science, etc.) and a “new beginning”, would the society converge to an arrangement like the existent one?

I’ve outgrown arguing with textbooks [. . .]

Why did customers sign these contracts in the first place?

This is not entirely unusual. Consumers believe that they’re getting a better deal by not having to shop around, but they don’t understand that they’re getting screwed because one of the ‘producers’ has finagled their way to an advantage and used it to threaten the other ‘producers’ with a scorched earth price war unless they toe the line. In essence, one ‘producer’ has reduced future increases in consumer surplus by painting their competitors into a corner. How does that deliver better pencils, paper, office furniture and software to consumers? The only way in which we can justify this is in terms of the return to Staples’ shareholders who profited handsomely. But so what? What about the shareholders of the other firms who profited less? Is there a greater net surplus in the market? The profits of Staples’ shareholders don’t prove this is a better way to do business for the whole economy, and this tactic certainly doesn’t embrace the sort of competition that free markets are supposed to produce, the kind where the consumer wins in the end. This is a wholly different animal and one we’d be wise to keep an eye on.

The focus on how a monopoly came to be is misplaced. Perhaps they got where they did by being the best. It’s what they do once they become the monopoly that matters.

bd writes:

Initially, I would agree with Bryan that we should appreciate an innovator that provides a valuable new service, and in the course of doing so wins a monopoly. But, in many instances that monopoly may be able to be maintained without necessarily continuing that superior performance, for example when significant barriers to entry exist, or when the monopolist enjoys substantial economies of scale.

You’re repeating yourself. In the rare cases of natural monopoly — when it is more cost effective to have a single world-wide organization than several smaller ones — then breaking them apart is not a stable equilibrium (one of them will re-emerge as the natural monopoly if marginal cost is always lower than average cost for the market) and the competitive price may not even be lower than the monopoly price anyway.

B.B. writes:

There are cases in which, by first mover advantage, a firm takes over an entire market. Once it dominates the market,it charges a monopoly price. A firm can be so dominant that no effective competition is possible. Breaking the firm up could create competition, to the benefit of all except the monopoly itself.

If a firm has a breakthrough, you don’t necessarily want to avoid monopoly pricing. It signals others to enter the market, and mitigates any positive externalities from creating that market. Pretty rapidly, if you don’t curtail profits, capital will flow into that market.

If you’re talking about natural monopoly — the case where it is not cost-effective to have more than one single organization producing something — then “first mover advantage” or not, you’re going to have a monopoly. That’s the only equilibrium situation. Even if the firm was producing shoddy products to start with, they may still keep the monopoly, though it will depress their monopoly price.
You can’t break such a firm: every but one will go bankrupt. The only alternative is regulation if you trust politicians to be selfless, competent and omniscient.

Was there a case for breaking up Microsoft, which nearly happened? I bet we would have better software now if the break up had happened.

Microsoft is a natural monopoly. The cost of producing one more copy of Windows is virtually zero, even if the investment was very large. What’d happen in such a scenario is that those small Microsofties would undercut each other on price until they are charging you for the physical CD only, since every price cut takes the market. Investment in the product would halt, and eventually, out of the ashes, a monopoly would emerge.

Fazal Majid writes:

Certainly, Microsoft would have far more competition if the government did not enforce sundry things like copyright law… People would get into business openly selling pirated copies, in fact that is what happens in China pre-WTO. Or is there such a thing as too free competition?

Sure, copyright law allows monopoly. But the alternative isn’t much better: underproduction. Consider Windows vs Linux for the desktop. Sure, Linux is surprisingly good, and no single provider as a monopoly on it. But clearly consumers prefer to live with a monopoly than an inferior product. Maybe in the future, with the help of the law of diminishing returns, the underinvestment in Linux may not prove be such a handicap. Not sure if getting rid of copyright law would be such an improvement though.

Consider a very small monopoly.

I’m Bill Gates’s grandson. I have $2B in cash and the local pizza guy pisses me off. The block has enough pizza consumers to support 3 shops. Orson Wells style, I open a 4th shop and operate it at a deep loss for 10 years. I drive all three out of business and secure a monopoly. {Ignore national pizza chains and shops outside this little local block}

Now I die of a heart attack and my son takes over. He doesn’t have my strange vendetta against local pizza merchants. He simply wants to maximize his profits at all points.

Question: Is it possible for him to maintain a monopoly in the following manner?

1. When no competition is present bank his monopoly profits.

2. When competition presents itself revert to operating at a loss or breakeven drawing down his retained earnings until the competition is driven out.

3. When competition is gone return to monopoly price levels and rebuild the retained earnings.

Is there a proof that demonstrates that this would be an impossible solution to the question of how to optimize long run profits? If not it would seem like its possible for the market to produce a monopoly either by design or by accident that would not be subject to competition over the long run (long run meaning a ‘before we are all dead’ time frame).

To those commenters who are using natural monopoly as a counter-example, I am pretty sure Bryan had that in mind when he stated criterion number two:

“If the monopoly came from superior efficiency, broadly defined”

In the case of a natural monopoly, a single firm is the efficient solution.

Boonton, I think the answer to your question has to do with the idea of “contestable markets”

If there is always the threat that a new entrant would come in if prices are too high. The pizza shop owner is never able to charge very high monopoly prices. He acts like a competitive firm even though he is the only one because if he were to do differently a new competitor would enter.

Of course this only applies if barriers to entry are relatively low. Interestingly one of the things that creates barriers to entry are all types of government regulations.

If the new pizza shop owner has to get multiple permits, rent a building in a properly zoned area, get a sanitation grade, provide health insurance to his employees, etc etc. It makes entry harder. He can’t just sell Pizza out of his house when the other guy charges too much. Some of those regulations may be good, but they definitely help the monopolist.

To Patrick:
I cannot name an example of first mover advantage but doesn’t the phenomenon of increasing returns to scale provide theoretical plausibility?

I think you could analyze the economic consequences of a monopoly without knowing how the monopoly arose (this is a broad general analysis). You could not analyze policy solutions without knowing how it arose. Maybe this what you mean

It seems to me that you can have a path dependency here. Suppose that, 40 years ago, some weak or corrupt government made legislation which effectively created a monopoly. Now you’ve got a new administration in place, which would like to see competition. Can it not be the case that merely repealing the original legislation is insufficient? By this time, the monopolist might be sufficiently powerful to maintain barriers to entry by quite legitimate, non-governmental means, without thereby being more efficient than its competitors – it’s just able to take a loss for longer. In this case, I think you need government to break up what government created.

With that said, I do not necessarily claim that any such situation has actually existed in real history; I propose it as a theoretical exercise.

Boonton,

Is there a proof that demonstrates that this would be an impossible solution to the question of how to optimize long run profits? If not it would seem like its possible for the market to produce a monopoly either by design or by accident that would not be subject to competition over the long run (long run meaning a ‘before we are all dead’ time frame).

Agreed.

BTW one interesting thing about a natural monopoly that is a public company is that their customers can buy stock and participate in those monopoly profits.

I cannot name an example of first mover advantage but doesn’t the phenomenon of increasing returns to scale provide theoretical plausibility?

I think it more plausible that if the theory had merit we’d find some evidence of it occurring. And, we have plenty of evidence of e-commerce entrepreneurs in the 90s who believed in it and are no longer around.

El Presidente, Windows wasn’t the ‘industry standard’ when it was introduced, how did Microsoft induce hardware manufacturers to produce for it?

BTW one other monopoly that I would like to see discussed is the Federal Reserve’s monopoly on the creation of base money. Is it at the bottom of our current banking problems.

El Presidente, Windows wasn’t the ‘industry standard’ when it was introduced, how did Microsoft induce hardware manufacturers to produce for it?

DOS became the standard when Compaq cloned the IBM PC in hardware and licensed the OS, figuring that the OS was a commodity. Microsoft had a constant advantage not only from the hardware developers’ side but also from the application developers’ side that built up until they were the dominant player. And at some times in the past it played real hard ball with its monopoly advantage, like charging a bulk license for the total number of computers a manufacturer sold.

I’m nowhere near as anti-Microsoft as I was in college, and I use their products daily. But it’s simply bonkers to think that if the market share were to suddenly snap to 80% MacOS and 10% Windows that Windows would claw back “because it’s better.”

Thank you, Dan. You beat me to it.

The focus on how a monopoly came to be is misplaced. Perhaps they got where they did by being the best. It’s what they do once they become the monopoly that matters.

But what they do when they become the monopoly follows from how they got there. If they got there by government protection, they can gouge people and not suffer retaliation from consumers — it wasn’t they who voted the monopoly into power, so they can’t vote it out.

But if they got there by winning consumers’ votes, they wouldn’t dream of gouging people — in that case, consumers would vote them out and one of their many competitors would be there to dethrone them.

To keep things empirical, look at Nintendo. They utterly dominated Sega and Atari in the 8-bit era of video games by offering superior games. They had Sega nipping at their heels during the 16-bit era but still offered better games and came out ahead; they stomped all over the other 16-bit systems.

However, once the quality of their games started to slacken during the 64-bit or 3-D era, they lost bad to Sony’s PlayStation, which had better games. This continued through the next generation, with Nintendo’s GameCube getting crushed and buried by Sony’s PlayStation 2. Now, though, Nintendo’s games (for the Wii) have been voted superior to those of Microsoft’s Xbox 360 and Sony’s PlayStation 3, and Nintendo is once again back on top.

This shows that just because Nintendo was a near monopolist during the mid-late ’80s didn’t ensure that they’d be able to sit on their laurels, gouge consumers, etc. It was a very competitive industry, and once they faltered in the quality of their games, they got body-slammed by Sony and languished for the next 10 years. Only by making better games once again and re-gaining consumers’ votes have they managed to attain peak status once more.

If you’ve actually been in business, monopoly and cartel power isn’t a myth, it’s a goal. For example, the company I worked for negotiated a merger with its strongest competitor in a 3 company industry in 1987. But the Reagan Administration vetoed it as anti-competitive, which led to a 10-year-long price war, which cost me a lot of money.

Here’s a 1987 NYT article on it:

The Dun & Bradstreet Corporation yesterday withdrew its offer for Information Resources Inc., a market research company, after the Federal Trade Commission said it opposed a merger.

Information Resources stock plunged $8 in over-the-counter trading, to $13, yesterday. Shares of Dun & Bradstreet, parent of the market researcher A. C. Nielsen Company, slipped 62.5 cents, to $52.625, on the New York Stock Exchange.

The all-stock deal was worth nearly $600 million when it was first proposed in August, but it lost about a quarter of its value when the stock market collapsed last month. It foundered when several large packaged-goods companies protested the merger to Federal antitrust officials.

”The clients of Information Resources and A. C. Nielsen made a serious mistake fighting this transaction,” said Joseph E. Laird, Jr. an analyst with Hambrecht & Quist, the investment banker for Information Resources. He said neither company would be able to make the same breakthroughs on its own in developing new products.

Antitrust experts said the Government had little choice but to reject the deal. ”I can’t think of any proposed merger in the last 10 years that would be as restrictive of competition as this merger,” said Gordon Spivack, an lawyer with Coudert Brothers who represented the Coca Cola Company, which had been foiled by antitrust concerns in its attempt to buy the Dr Pepper Company. ”The effect would be a restraint of trade, if not a monopolization of a market.”

Mr. Spivack said that only one other company, SAMI-Burke Inc., sells research data similar to that sold by Information Resources and Dun & Bradstreet’s Nielsen unit.

The two former merger partners have already resumed their competitive battles.

”The biggest vote of confidence we could have been given is to have D.& B. vote to put $600 million into our technology and services,” said John Malec, chairman of Information Resources, ”Basically, our biggest competitor is saying that our technology is frightening enough to them that they think it would be beneficial to have them on our side.”

But John C. Holt, executive vice president of Dun & Bradstreet, responded: ”Our clients are very sophisticated and wouldn’t be fooled by statements like that. In this case, We thought we’d save time and buy some capabilities they had that we don’t, but instead we’ll just spend some money to develop them instead.”

Nobody would argue that Microsoft products were the best, yet they have achieved market power very close to monopoly. Everyone uses their products because everyone knows how to use their products. I would much rather use a free office suit but then I would not know how to use Microsoft office when I show up to a new job.

The qwerty keyboard has a monopoly over keyboards for the same reason. People use them because everyone else is. The qwerty keyboard was specifically designed to be inefficient. It was made to slow people down so the typewriter wouldn’t jam. It’s only been about 100 or so years sense this jamming problem was solved so people could type fast but people still use qwerty. Qwerty causes pain/injury and reduces worker productivity. Switching would be fast and easy for society. The monopoly prevents the switch.

About 10 years ago, I went into my keyboard settings and switched my keyboard to Dvorak. I used a picture of a Dvorak keyboard to learn the keys and was typing great in about a week. Then when I went to work, my fingers were confused. I could not make the switch alone.

DOS became the standard when Compaq cloned the IBM PC in hardware and licensed the OS, figuring that the OS was a commodity. Microsoft had a constant advantage not only from the hardware developers’ side but also from the application developers’ side that built up until they were the dominant player.

Somewhat lacking in logical rigor. Not to mention, misleading in the actual history.

‘Microsoft had a constant advantage’, yeah his name was Bill Gates.

‘Foresight’ permits natural monopolies established by the first mover.

Again, please name one.

Somewhat lacking in logical rigor. Not to mention, misleading in the actual history.

You need to say what is incorrect or misleading, not just fling poo.

Seriously, are you claiming that if we were to magically cause the established base of microcomputer OS’s to go 80% OSX and 10% Windows, that OSX would not then enjoy a supreme advantage merely by being the large established base?

There were many competing OS’s for the PC market in the 80’s. But IBM had chosen DOS, and people cloning IBM machines, like Compaq, also had chosen DOS, so that they could say “100%-IBM PC Compatible.”

Merely being the largest OS base caused hardware vendors to make sure that their hardware first worked with DOS. And merely being the largest OS base caused application developers to write their products first for DOS and worry about porting to other systems later.

It also means trying to break up the OS market would be a failure, because as other people have already said, we would just get another monopoly to rise from the ashes.

This isn’t anything amazing or controversial about this. You could go into deny-deny-deny mode, I guess, instead of trying to deal with the facts.

eccdogg

If there is always the threat that a new entrant would come in if prices are too high. The pizza shop owner is never able to charge very high monopoly prices. He acts like a competitive firm even though he is the only one because if he were to do differently a new competitor would enter.

Let’s think about this from the POV of a person entering the market. Say the start up costs of the pizza shop are $100K. Before I enter the market and spend these fixed costs I’d want to be sure I could be around long enough to at least recoup them. The high prices due to the monopoly might tempt me to enter, but the fear that the monopoly will turn my investment into a loss will serve to deter me. Yes the gov’t can lower some of these costs by streamling permits and fees but a pizza shop still costs a lot to get off the ground and selling pizzas out of the trunk of your car is not a pizza shop.

So it would seem like the fear of a new competitor will act like ‘virtual competition’ to the monopoly it, like virtual sex it is not quite as good as the real thing. You wouldn’t get the results of a competitive market unless the entrance costs were remarkably low.

I’m taking Bryan’s post to be more about theory than real life. I think its theoretically possible to have a monopoly arise not because of greater efficiency or because of gov’t policy. Whether its easy is quite anotehr question.

So Dan, why doesn’t Apple license it’s OSX to other PC manufacturers? Software licensing is a far better business than selling iMacs? And if it’s the case that OSX is so much better, than aren’t claims of a MSFT monopoly even more hollow? Basically, your argument is that MSFT has a monopoly because the owner of a competing and superior product refuses to make it broadly available. Is that somehow MSFT’s fault?

So Dan, why doesn’t Apple license it’s OSX to other PC manufacturers? Software licensing is a far better business than selling iMacs? And if it’s the case that OSX is so much better, than aren’t claims of a MSFT monopoly even more hollow? Basically, your argument is that MSFT has a monopoly because the owner of a competing and superior product refuses to make it broadly available. Is that somehow MSFT’s fault?

What in the world are you talking about?

Windows dominates because OSs tend to have one big winner, as has been explained many times by the commenters here. Getting an early plurality of the market, like Microsoft did, is a huge advantage.

Kind of key in this is that it doesn’t matter how or if OSX is better.

Windows dominates because OSs tend to have one big winner….

You’ve returned to square one. MSDOS had network effects, but Windows’ superiority enable it to overcome them. Why didn’t Apple license its superior OS and beat Gates to the punch?

Why didn’t Apple license its superior OS and beat Gates to the punch?

I suspect because Apple sought to secure a small niche where they could dominate rather than risk bleeding to death in combat on the open plains.

This discussion brings to mind the game Monopoly. Rarely have I ever played that game fairly (as a kid we kept changing the rules because no one would allow themselves to go bankrupt) or to its fair end but the typical pattern is that random events at the beginning of the game often cascade into a single player dominating the market at the end.

Sometimes skill is involved but if equal level players are competing it really does seem more of a function of random events.

Which reminds me of my micro class on the theory of oligopoly. Monopoly seems like it can be a special case of oligopoly (which no economist, I think, believes is a theoretical impossibility barring gov’t intervention) where one company gets the better of two or three of its main competitors (either out of luck, skill or stupidity on their part).

One last thought, I’d like to remind everyone that US antitrust law does not ban monopolies. It bans ‘unfair competition’. Basically you are free to have a giant monopoly but the laws kick in if you are using certain practices to either obtain or maintain that monopoly.

Ak Mike wrote:

In a merge to monopoly situation, the resulting company’s monopoly can only be sustained if prices are low enough to discourage new entrants. In that case, who cares whether it’s one firm or three firms? If high barriers to entry allow the price to be fairly high, that high price was there even before the merger – it was the barrier and not the competition among two or three firms that controlled the price.

I don’t believe that is correct. Even if there are high barriers to entry, as long as there is vigorous competition, prices will still approximate some measure of marginal cost. Take away the competition and prices will rise to the level just below where entry becomes attractive. Hence, in a market with high barriers to entry, a merger to monopoly will lead to permanently higher prices and the associated dead weight loss.

In the price-fixing situation, the same. Assuming none of the conspirators cheated by cutting prices to increase market share (always a danger), new entrants would come in if the fixed price is high enough to make for attractive profit levels. If the barriers to entry are high, the fixed price level could also be high, but then it would have been high even without the price-fixing conspiracy.

Same response, but let me add one point: Price-fixing conspiracies become a lot easier and more effective without antitrust laws. They wouldn’t have to take place as secret back room deals, but could take the form of legally enforceable contracts. Participants could even openly post bounties for any customer who reports a price cut below the fixed level.