Government 1B: Lesson 19 – Monopoly

Reading: “The Misplaced Fear of ‘Monopoly.’” The link to this article is temporarily not working, so you can find the text of the article by scrolling down on this page below the video.



Those of us who get drawn, often against our better judgment, into Internet debates soon discover that the case against the market economy in the popular mind boils down to a few major claims. Here I intend to dissect one of them: under the unhampered market we’d be at the mercy of vicious monopolists.

This fear can be attributed in part, no doubt, to the cartoon history of the 19th century virtually all of us were exposed to in school. There we learned that rapacious “robber barons” gained overwhelming market share in their industries by means of all sorts of underhanded tricks, and then, once secure in their position, turned around and fleeced the helpless consumer, who had no choice but to pay the high prices that the firms’ “monopoly” position made possible.

This version of events is so deeply embedded in Americans’ brains that it is next to impossible to dislodge it, no matter the avalanche of evidence and argument applied against it.

Historian Burton Folsom made an important distinction, in his book The Myth of the Robber Barons, between political entrepreneurs and market entrepreneurs. The political entrepreneur succeeds by using the implicit violence of government to cripple his competitors and harm consumers. The market entrepreneur, on the other hand, makes his fortune by providing consumers with products they need at prices they can afford, and maintains and expands his market share by remaining innovative and responsive to consumer demand.

It is only the political entrepreneur who deserves our censure, but both types are indiscriminately attacked in the popular caricature that has deformed American public opinion on the subject.

Andrew Carnegie, for instance, almost single-handedly reduced the price of steel rails from $160 per ton in 1875 to $17 per ton nearly a quarter century later. John D. Rockefeller pushed the price of refined petroleum down from more than 30¢ per gallon to 5.9¢ in 1897. Cornelius Vanderbilt, operating earlier in the century, reduced fares on steamboat transit by 90, 95, and even 100 percent. (On trips for which a fare was not charged, Vanderbilt earned his money by selling concessions on board.)

These are benefactors of mankind to be praised, not villains to be condemned.

To be sure, there are caveats, as there always are in history. For a time, Carnegie did support steel tariffs. Since he substantially reduced the price of steel rails, though, this political position of his did not harm the consumer. Other critics will point to the Carnegie and Rockefeller foundations and the dubious causes those institutions have supported. Their objection is irrelevant to the specific question of whether the men themselves, in their capacity as entrepreneurs, improved the American standard of living. That question is not even debatable.

Mainstream economics identifies monopolists by their behavior: they earn premium profits by restricting output and raising prices. Was that behavior evident in the industries where monopoly was most frequently alleged to have existed? Economist Thomas DiLorenzo, in an important article in the International Review of Law and Economics, actually bothered to look. During the 1880s, when real GDP rose 24 percent, output in the industries alleged to have been monopolized for which data were available rose 175 percent in real terms. Prices in those industries, meanwhile, were generally falling, and much faster than the 7 percent decline for the economy as a whole. We’ve already discussed steel rails, which fell from $68 to $32 per ton during the 1880s; we might also note the price of zinc, which fell from $5.51 to $4.40 per pound (a 20 percent decline) and refined sugar, which fell from 9¢ to 7¢ per pound (22 percent). In fact, this pattern held true for all 17 supposedly monopolized industries, with the trivial exceptions of castor oil and matches.

In other words, the story we thought we knew from our history class was a fake.

Beyond the appeal to specific examples from history, critics of the market propose plausible-sounding scenarios in which firms might be able to harm consumer welfare. Larger firms can afford to lower their prices, even below cost, as long as it takes to drive their smaller competitors out of business, the major argument runs. Once that task is accomplished, the larger firms can raise their prices and take advantage of consumers who no longer have any choice but to buy from them. That strategy on the part of larger firms is known as “predatory pricing.”

Dominick Armentano, professor emeritus of economics at the University of Hartford, surveyed scores of important antitrust cases and failed to uncover a single successful example of predatory pricing. Chicago economist George Stigler noted that the theory has fallen into disfavor in professional circles: “Today it would be embarrassing to encounter this argument in professional discourse.”

There is a reason for that disfavor. The strategy is suicidal.

For one thing, a large firm attempting predatory pricing must endure losses commensurate with its size. In other words, a firm holding, say, 90 percent of the market competing with a firm holding the remaining 10 percent of the market suffers losses on its 90 percent market share. Economist George Reisman correctly wonders what is supposed to be so brilliant and irresistible about a strategy that involves having a firm — albeit one with nine times the wealth and nine times the business — lose money at a rate nine times as great as the losses suffered by its competitors.

The dominant firm, should it somehow succeed in driving all competitors from the market, must now drive prices back up, to enjoy its windfall, without at the same time encouraging new entrants (who will be attracted by the prospect of charging those high prices themselves) into the field. Then the predatory-pricing strategy must begin all over again, further postponing the moment when the hoped-for premium profits kick in. New entrants into the field will be in a particularly strong position, since they can often acquire the assets of previous firms at fire-sale prices during bankruptcy proceedings.

During the period of the below-cost pricing, meanwhile, consumers tend to stock up on the unusually inexpensive goods. This factor means it will take still longer for the dominant firm to recoup the losses it incurred from the predatory pricing.

A chain-store variant of the predatory-pricing model runs like this: chain stores can draw on the profits they earn in other markets to sustain them while they suffer losses in a new market where they are trying to eliminate competitors by means of predatory pricing.

But imagine a nationwide chain of grocery stores, which we’ll call MegaMart. Let’s stipulate that MegaMart has a thousand locations across the country and $1 billion of capital invested. That comes out to $1 million per store. Those who warn of “monopoly” contend that MegaMart can bring to bear its entire fortune in order to drive all competitors from one particular market into which it wants to expand.

Now for the sake of argument, we’ll leave aside the empirical and theoretical problems with predatory pricing we’ve already established. Let’s assume MegaMart really could use its nationwide resources to drive all competitors from the field in a new market, and could even keep all potential competitors permanently out of the market out of sheer terror at being crushed by MegaMart.

Even if we grant all this, it still makes no sense from the point of view of business strategy and economic judgment for MegaMart to adopt the predatory-pricing strategy. Yes, for a time it would enjoy abnormally high profits, and indeed the prospect of those profits explains why MegaMart would even consider this approach. But would the premium profits be high enough for the whole venture to be a net benefit for the company?

George Reisman insists, correctly, that they would not. “Such a premium profit is surely quite limited — perhaps an additional $100,000 per year, perhaps even an additional $500,000 per year, but certainly nothing remotely approaching the profit that would be required to justify the commitment of [the firm’s] total financial resources.”

Let’s suppose that the premium profit that could be reaped by MegaMart after removing all its competitors amounted to $300,000, the average of those two figures. Assume also that the average rate of return in the economy is 10 percent. That means MegaMart can afford to lose $3 million — the capitalized value of $300,000 per year — in order to seize the market for itself. Spending an amount greater than that would be a poor investment, since the firm would earn a lower-than-average rate of return (lower, that is, than 10 percent). For that reason, MegaMart’s $1 billion in capital is simply irrelevant.

What follows from this, according to Reisman, is that “everyone contemplating an investment in the grocery business who has an additional $5 million or even just $1 million to put up is on as good a footing as [MegaMart] in attempting to achieve such [premium] profits. For it simply does not pay to invest additional capital beyond these sums. In other words, the predatory-pricing game, if it actually could be played in these circumstances, would be open to a fairly substantial number of players — not just the extremely large, very rich firms, but everyone who had an additional capital available equal to the limited capitalized value of the “monopoly gains” that might be derived from an individual location.”

Coming back to the more general “predatory pricing” claim, one final argument buries it forever. Economist Don Boudreaux invites us to imagine what would happen if Walmart adopted the predatory- pricing strategy and embarked on a price war over pharmaceutical products, with the aim of driving other drug retailers from the market. Who would be harmed by this? Consumers, to be sure, as well as rival drug suppliers.

But there’s a less obvious set of victims, and it’s they who hold the key to solving the alleged problem. Companies that distribute the drugs to Walmart also stand to lose. Why? Because if Walmart drives competitors from the field and then raises drug prices, which is the whole point of predatory pricing, then fewer drugs will be sold. It’s as simple as the law of demand: at a higher price of a good there is a lower quantity demanded. That means a company like Merck, which distributes a lot of drugs to Walmart, will sell less of its product.

Is Merck going to take that lying down? Of course not. Since a successful predatory-pricing strategy for Walmart would mean lower sales and profits for Merck, it has a strong incentive to block Walmart’s move. And it can do so by means of minimum- or maximum-resale- price-maintenance contracts. A minimum-resale-price-maintenance agreement establishes a minimum selling price at which a retailer must sell a company’s product. Such a minimum would make it impossible for Walmart to engage in predatory pricing in the first place; they would have to sell the product at the stipulated minimum price, at the very least, and could not go any lower. Maximum-resale-price-maintenance agreements would allow a company, once predatory pricing has succeeded — and again, for the sake of argument we set aside all the reasons we’ve given for why predatory pricing can’t work — to limit the extent of the damage. It would forbid a retailer to sell its product above a stipulated price. Walmart’s putative “monopoly profits” could not be realized to any great extent under such an arrangement.

In other words, profits all across the structure of production are threatened when one stage, whether retailing or anything else, attempts to reap so-called monopoly profits. You can bet that firms threatened with a reduction in their own profits will be particularly alert to the various ways in which they can prevent the creation of “monopolies.”

What about the DeBeers diamond cartel? Surely that is an example of free-market “monopoly,” defying the economists’ assurances that cartels on a free market tend to be unstable and short-lived. In fact, there has been no free market in diamonds. The South African government nationalized all diamond mines, even ones it hadn’t yet discovered. Thus, a property owner who discovers diamonds on his property finds ownership title instantly transferred to the government. Mine operators, in turn, who lease the mines, must get a license from the government. By an interesting happenstance, the licensees have all wound up being either DeBeers itself or operators willing to distribute their diamonds through the DeBeers Central Selling Organization. Miners trying to distribute diamonds in defiance of government restrictions have faced stiff penalties.

In short, opponents of laissez faire have spooked public opinion with a combination of bad history and worse theory. The average person, although in possession of few if any hard facts in support of his unease at the prospect of laissez faire, is nevertheless sure that such a dreadful state of affairs must be avoided, and that our selfless public servants must protect us against the anti-social behavior of the incorrigible predators in the private sector.