Introduction
Economic monopoly is a major issue in
economic and political discussions and I want to make a small contribution on
the subject. Even though I have postgraduate studies in economics I am not a
specialist, and this document is a common sense rather than an academic
approach on the subject, and it is written for the general reader with no
economic knowledge. English is not my first language and you will have to
excuse my syntax.
The essay is mainly a critique to
both the traditional Marxist approach on monopolies, and to the more modern
academic approach, the so called “neoclassical theory of competition and
monopoly”. According to the traditional Marxist approach, capitalism leads to
economic monopolies. Poor people become poorer, and capital is concentrated in
fewer and fewer hands, and at the end of this process capital ends up in the
hands of a small group of capitalists. The modern academic approach does not
claim that. It examines whether government has to ensure that companies do not
acquire excessive market power and use this power to charge consumers with “unfair”
prices.
The two approaches are not irrelevant
of course, but rather one is the continuation of the other. You cannot afford
to ignore either of them, since they are both used to this very day. The
Marxist approach is mainly used in the form of propaganda to convince the
public that capitalism is bad and socialism is the solution, while the
neoclassical approach examines whether government intervention is required in
order to protect consumers from large companies.
My impression is that non economists
tend to believe the Marxist propaganda which postulates that capitalism i.e.
the free market, does indeed lead to monopoly. I think they believe so because they
have been exposed to a lot of Marxist propaganda. The size of the huge
corporate champions of the business world tends to enforce such beliefs.
Socialists have convinced them that the large corporate size is equivalent to
economic monopoly, which is actually something very wrong. Think of a small
island where the government has issued only one taxi license. Is this taxi a monopoly? Of course it is, since it is the only
provider of a particular service. Therefore the relationship between company
size and monopoly is not as simple as it seems.
Since large corporations have been
the victims of such intensive socialist propaganda, there is no point in
examining the issue of monopoly, if we don’t first examine large corporations
irrespective of ownership. That is without examining if they privately or
publicly run. After all under both forms of ownership the aim is to produce as
much wealth as possible. After I examine company size, I turn my attention to
the issue of ownership and monopoly. So what is it that determines the size of corporations?
Which is the right size? Is it better for a company to be small, medium or
large? After all a bakery wants to produce as much bread as possible whether it
is publicly or privately run. Therefore the most important issue is how more
bread can be produced. Is it better for the consumer if one or many small
companies exist? How many bakeries should exist in a market? What should the optimal
market structure be? By market structure I mean the number and size of
companies in a specific market.
Factors that lead to large corporate sizes
It is better to think about the
factors that lead to large corporate sizes in a communist economy, in order not
to confuse company size with capitalism.
Economies of scale
Economies of scale refer to a
decrease in the average production cost with increasing levels of production.
For instance a production unit costs 100 euros when 1.000 units are produced,
98 euros when 2.000 units are produced, 40 euros when 20.000 units are produced
and so forth. There are many reasons why increasing levels of production lead
to a decrease in average cost. Specialization is a good example. Imagine a
company in a communist country that is producing 1.000 units of a product. This
production level might allow for only one administrative employee. This
employee must be both and accountant and a secretary. A production level of
2.000 units though, could possibly allow the company to operate with two
administrative employees, one secretary and one accountant. These specialized
employees could be far more productive. There are many other reasons why
increasing levels of production lead to lower costs. Economies of scale are a
very common and a generally accepted concept in economics.
Many non economists though, tend to
think that economies of scale are present during all levels of production i.e.
the more a company is producing the lower the average cost is. But this is of
course nonsense. At some level of production economies of scale turn to
diseconomies of scale, and this is accepted by all economists.
Diseconomies of scale
Diseconomies of scale refer to rising
average costs for higher levels of production. This can occur for many reasons,
for instance due to bureaucracy. The larger a company becomes the more people
are required to monitor its operations, and the harder it is for decisions to
be taken, since it is impossible to have managers who know everything about the
company. There are many other reasons why diseconomies of scale appear at some
production levels. Moreover it is very difficult for very big companies to
adjust to changes in consumers’ tastes. Imagine a company in a communist
country that produces 100 thousands units and another that produces 10 million
units. It is much harder and costlier for the larger company to change its
product.
If economies of scale persisted for
all levels of production, Marx’s prediction about capitalism and monopoly would
have been realized, at least for standardized products i.e. salt. But as we
observe this is not the case. It would actually be very nice if average costs
continued to fall for all levels of production. At the limit unlimited amounts
could be produced with almost zero average cost. Unfortunately this is not what
happens. But non economists tend to focus on the advantages of being large and
forget the disadvantages of being large. Economists are of course fully aware
of diseconomies of scale.
Transaction Costs Economics TCE
“Transaction cost” economics is a
totally different approach to explain the size of companies. Economies of scale
refer to production costs. Transaction costs refer to a very different category
of costs. It is easier to understand “transaction cost” theory, when production
costs are assumed to be known and given for everybody i.e. anybody can
manufacture an iphone given he has the required capital. This is very
unrealistic but it enhances illustration of what transaction costs are.
Let me give an example of a
transaction cost. I have a business and I need someone providing cleaning
services for 8 hours a day. Let’s say that the market daily wage for such a
service is 25 euros. This is not a transaction cost but a production cost (I
use the term production costs to also refer to administrative, financial costs
etc for greater simplicity). I will pay this production cost (25 euro) whether
I hire this person as an employee or whether I use his services as a separate
business entity. The price of 25 euros for this service is something determined
by the market i.e. how many people are offering cleaning services and how many
people are looking for such services.
The question is whether it is better
for me to hire such a person or him in the form of an external cleaning service
provider. In both cases there is a production cost of 25 euros. What is best
for my company? To answer this question one needs to take into account transaction
costs. If I use that person as an external associate, a contract must be
written. And the contract must clearly specify what he will do and how he will
do it, and many other details. And if the person providing the cleaning service
does not honor the contract’s terms I would have to go to the court. If I hire him on the other hand, we would only
need to agree that he will clean for 8 hours a day in the way he will be
instructed to, which is much simpler. On the other hand an external cleaner
might be more motivated because he knows that I can try somebody else at any
time, while an internal employee might not possess this kind of motivation and
need supervision. But then again I can train my employee to do things in
exactly the way I want things to be done. So what is better for my company?
Well there is not a clear cut answer. It depends on transaction costs. There
are both benefits and costs when a company integrates more operations.
And this is not only true in a
capitalist economy. Transaction costs have nothing to do with capitalism.
Imagine that I am the manager of a company producing ice cream in a communist
economy. People in communist economies eat ice cream too you know. And
companies in communist economies have managers too. I am therefore the manager. Let’s assume that there is no money. We count costs in terms of working hours. There are other public companies producing ice cream in the country. The communist leadership evaluates my
efficiency in terms of how many working hours it takes for my ice cream to be
produced and how good this ice cream is. I therefore need to be at least in the
same position in terms of cost and quality i.e. 5th costlier and 5th
in quality. If I am 5th costlier and 6th in quality I am
inefficient and if I am 5th costlier and 4th in quality I
am efficient.
I must therefore improve the
company’s performance to impress the communist elite, otherwise they will
demote me. Let’s further assume for
simplicity that I only use milk to produce ice cream, and I take this milk from
any public milk company I want. Assume that milk costs 1 working hour per liter,
and that the production of 1 kilo of ice cream only requires 1 liter of milk.
Therefore if it takes me 1.5 working hours to convert 1 liter of milk to 1 kilo
of ice cream, my ice cream costs 2.5 working hours per kilo. But I want to do
better than that in order to impress the communist elite. Would it be better
for me to run a milk company too? Remember I assumed that production costs are
given and known, which means that I can also produce 1 liter of milk per working
hour if the communist elite allows me to run a milk company. What would be better
for my final product i.e. my ice cream? Well, it depends again on transaction
costs.
If I have my own milk company I will
always have my milk on time, and there will be no more delays. Moreover I will
make sure that the milk is always very fresh, while the current manager might
give me milk that is not very fresh to squeeze his costs and impress the
communist elite. I will also save the time I spent on checking the quality of
the milk. On the other hand if I run a milk company too, I have to run a bigger
company and it will be harder to control everything and I will have to rely on
other people which might affect the quality of my decisions etc.
I hope the above provides in a simple
way the “transaction cost” economics approach in explaining company size.
Technological Progress
Imagine two factories in the same
town both producing nails, and assume that consumers need 2.000 nails per
month. Both factories have equipment that produces 1.000 nails per month at
full capacity. But due to technological progress a new machine comes out which
can produce 2.000 nails per month. For the technological progress to lead to
lower prices one of the two companies must go. If both companies buy the new
machine, and continue to produce 1.000 nails each, prices cannot go down since
costs will have increased (new equipment) while sales have stayed at the same
level. Actually prices have to increase if both companies buy the new
equipment.
But if only one company is left,
prices can fall. There are various ways for one of the companies to go. There
might be a consolidation, one of the companies might go bankrupt etc. But no
matter how this comes about, it is obvious that there is only space for one
company. The example could involve 100 companies and technological progress
could have wiped out 60 of them. The question is do we want cheaper nails or
not? If we are not sellers and we are consumers we should prefer cheaper to
expensive nails. If we sell nails we might prefer expensive nails of course.
The Development of Capital Markets
Large corporations involve
investments that are far beyond the limits of even the biggest capitalists. The
gradual development of capital markets made possible the pool of resources and
allowed large projects to be realized. The more sophisticated the capital
markets become the larger the companies can become.
Taxation and company size
It might sound strange,
but the socialist way of taxation led to larger company sizes. One of the
principles of socialist taxation was to tax companies in two levels. That is to
first tax the company’s profits at a certain tax rate, and then impose an
additional tax for the profits distributed to shareholders in the form of
dividends. The purpose of this form of taxation is to offer incentives to
companies to reinvest and not distribute profits.
Assume that a company
makes 100 euros of profit. Let’s say the tax rate is 30%. The company pays 30
euros in taxes and there is another 70 euros left. If these 70 euros are not distributed
to shareholders, socialists do not impose further taxes. If on the other hand
they are distributed as dividends, there is an additional tax of 20% on the 70
euros that are distributed (random numbers). Thus the owners have an incentive
not to take their profits, hoping that these profits will be reinvested and
generate further profits, which will be reflected in a higher share price. And
they can then sell their shares receiving their profits in the form of capital
gains which are usually taxed with very low rates. At least they were taxed
with very low rates in the past to enforce this socialist incentive scheme for
reinvestement. Such policies are of course wrong. Company size should only
reflect economic factors and not tax incentives.
Moreover profitable
companies have an incentive to buy other companies that have accumulated large
losses in the past, in order to use them for tax purposes. The highest the tax
rates are, the higher the incentive to do so.
The Ideal Company Size
All the above factors
i.e. economies of scale, transaction costs, technological progress and taxation
affect company size. They are by no means the only factors affecting size. They
are only some obvious considerations. After examining the above factors one has
to wonder what is the optimal company size. According to Murray Rothbard there
is no optimal company size. Each entrepreneur has to decide what the optimal size of his company is. On a
theoretical basis one can only makes some basic assumptions about the optimal
company size. For example economies and diseconomies of scale dictate some
boundaries within which optimal size should be.
If for instance market
conditions (technology, prices of raw materials, human capital, consumer
tastes) in the automobile industry, lead to decreasing average costs until the production
of 200.000 units, then the minimum company size involves production of 200.000
units. In the same way the other factors I examined dictate boundaries for
company size. But the actual size can only be determined by the specific entrepreneur.
The optimal size for Apple is different if it can sell 100.000, 200.000 or 100
million iphones. But we could say that economies of scale and transaction costs
play a more important role in determining company size in markets for
homogeneous products (i.e. salt), and a bit less important role in markets for
products with great differentiation where the role of entrepreneur is more
significant.
We could say that the
optimal company size is determined by consumer preferences (quantities and
quality required), from the ability of the economy (technology, availability of
resources, human capital etc) to satisfy these needs, and from the ability of
the specific entrepreneurs to detect and satisfy consumer needs by using scarce
resources (highest possible quality at the lowest possible cost). The
entrepreneur is a bridge between consumer preferences and scarce economic
resources. And of course a charismatic entrepreneur will better satisfy
consumers, will attract more clients, and employ more resources, and will end up
with a larger company than a less charismatic entrepreneur facing the same
conditions. In the place of the capitalist entrepreneur could be a manager in a
communist economy without changing my discussion until now. I am not yet
talking about capitalism or socialism, but instead for production units
stripped from ideologies.
Therefore there is no
optimal company size, but only boundaries within which a company’s size must
be. What is unambiguous is that if the minimum possible price of salt is 50
cents per kilogram, and each production unit needs to produce at least 100
thousands tons to achieve this price, then the smallest company should produce
at least 100 thousand tons of salt, both in capitalism and socialism. A useful
concept for the discussion is that of “minimum efficient scale” of production
(MES). Minimum efficient scale refers to a level of production at which it is
not possible to increase production and achieve further economies of scale.
Whether constant economies or diseconomies of scale appear after economies of
scale depends on whether we consider the average cost curves to be L or U
shaped, but this is beyond the scope of my document which is not a
microeconomics document but a common sense approach to the issue of monopolies.
Company Size and Socialism
To show that the large company size
has nothing to do with capitalism, I would like to use the example of the
Soviet Union and Sweden Sweden ’s
success has anything to do with socialism, as I explain in my document “The
Swedish Economic Model: A socialist or a free market success”, but nonetheless
socialists very often use Sweden
mentions 26 Swedish multinationals that are in Forbe’s list
with the 2.000 biggest companies in the world. Total revenues of these 26
largest companies amount to 230 billion dollars. In other words the revenue of
the 26 largest companies of “socialist” Sweden Sweden Sweden
M. Henrekson and S. Davis of the
universities of Stockholm and Chicago
respectively, in their article “Explaining National Differences in the Size and Industry Distribution of Employment”, examined the reasons that led to large enterprise sizes in Sweden Sweden
The Soviet Union
was another example of a market dominated by few and very large companies. In
page 3 of their article “The Myth of Monopoly: A New View of Industrial
Structure in Russia”, three academics from the university of Pennsylvania, explain
that it was generally accepted in the Soviet Union that very large production
units would lead to decreasing costs, and they provide further evidence. But I
do not actually think that anybody claims this was not the case in the Soviet Union .
Since both in capitalist and
socialist economies there is a tendency for companies to grow larger, one must
conclude that large company size is not an attribute of capitalism or
socialism, but rather a result of economic factors. And since both capitalism
and socialism want as much wealth as possible to be produced, they must use
large production units if the latter lead to more wealth creation.
I hope the discussion up to this point has
persuaded the reader that large company size is not necessarily something
negative, and that it is not an attribute of capitalism. And it is finally time
to turn to the issue of “monopoly”.
The two theories of monopoly
There are as expected two theories of
monopoly, the socialist one and the libertarian. The socialist theory believes
in “economic monopolies”, and the
libertarian theory believes in “political
monopolies”. When I say socialist theory I mean both the traditional
Marxist approach to monopolies, and the more modern theory of monopolistic
competition. And I discuss them separately. According to the libertarian
theory, monopolies are always created by governmental
laws. They are therefore political monopolies. This can take the form of a
public company which is by law the only company in the market, or it can take
the form of very few private companies that enjoy government protection and
support. They are private in the sense that they are not owned by the state,
but they are still protected by the political system and in return they offer
political and financial support to politicians either legally or in the forms
of bribes.
According to the libertarian theory,
as long as there is no barrier to entry in the form of regulation, there is no
monopoly irrespective of the number and size of companies in a particular
market i.e. the market structure. The only condition of this theory is that
anybody having the capital and will to enter into a market must be allowed to
do so. Therefore this view of monopoly does not relate the concept of monopoly
to the size and number of companies, but rather to an absence of pressure for decreasing costs and improving quality.
On the other hand, the socialist
theory of monopoly, which is by far the more widely spread and accepted, claims
that monopolies are created by the free market, and therefore they are economic
monopolies. According to this theory the state has to intervene to protect its
citizens from the free market. What is crucial for this school of thought is
the number and size of companies in a market.
The libertarian theory claims that
monopolies are the result of government laws, which is quite straight forward,
and therefore I will not discuss this theory any further. I will focus instead
on the issue of economic monopolies and I will examine both the Marxist and the
neoclassical theory of monopoly.
Marxism and Monopoly
Marxists in a way believe in the
capitalist equivalent of “Chuck Norris”. They believe that capitalism leads to
a capitalist that will beat all other capitalists, and employ and exploit all
of us. And they therefore argue that capitalism leads to monopoly, and the only
difference with socialism is that in capitalism the monopoly is run by a
private tyrant that exploits everyone, while in socialism monopoly is run by
righteous state employees that use their monopoly power for the benefit of their
people.
In essence Marxists cannot
distinguish between Microsoft and a state company. They do not see much difference
between Microsoft, which derives its power from its ability to satisfy consumers,
and a state monopoly which derives its power from the parliament. Actually
Microsoft is a very good example, because it keeps improving its products and
prices, without facing significant competition all these years. And the reason
is that if Microsoft does not improve its products and lower its prices, one
can keep using Microsoft XP and not upgrade to Windows 7. And if that happens
profits will fall and the people that run the company will be fired. In other
words Microsoft faces so much pressure without significant competition, simply
by the threat of falling profits or the appearance of a potential competitor.
Imagine if all these years there were another 5-6 companies seriously competing
with Microsoft.
And the funny thing is that Google
appeared out of the blue, and introduced the android operating system. And if
tablets end up dominating the electronics industry as many people predict, the
android system might threatens Microsoft’s windows. And this is not Linux or
Mac, but Android which until very recently did not even exist. But that’s how
capitalism works. And the truth is that Android did not appear out of the blue,
but they were brought forward by another giant, namely Google. And this is
where most people get it wrong. Because they think that since the small
computer shop in their neighborhood cannot compete with Microsoft, no one can.
But they forget that there are other giants in other sectors of the economy,
that if they see profit opportunities in a market they can easily enter. They
have the capital. The issue is whether there is enough profit to cover their
investment. People tend to think that it is difficult to find the capital to
compete with Microsoft. But they are wrong the issue is whether there is enough
profit the costs. All free market companies are at the mercy of competition and
consumers. And all consumers are at the mercy of political monopolies, which
are immune from competition.
Private companies can indeed acquire
monopoly power at some point of their economic life. But what is this monopoly
power? If Samsung creates a new smart phone which we all want to buy, she will
sure obtain some monopoly power. But what is this monopoly power? Isn’t this
monopoly power exactly the same with consumers’ preference? For a private
company monopoly power is nothing else than consumers’ loyalty. And government
regulation is the monopoly power of political monopolies. But consumer loyalty
and government regulation are very different forms of monopoly power. Samsung,
or any corporate giant, cannot permanently enjoy the same consumer loyalty, since
it is impossible to be always the first to understand what consumers want, and
always be the best in finding the most cost efficient way to provide them with
what they want. It is impossible for a management team to constantly come up
with the best solutions, in the same way that it is impossible for a football
team to always win the championship. And we should not forget that management
teams have an expiry date. People die or they go to work for other companies.
They leave Samsung for Apple and vice versa.
But even if a private company is always first
in satisfying consumers, why should there be any problem? It means that this
company is constantly improving quality and prices. On the other hand, if the
government provides only one taxi license in a small island, the taxi driver
has no motive to improve services and prices, because he has monopoly power. His
taxi is a monopoly but not in the sense of large profits, but in the sense of
no pressure for increasing quality i.e. buying a new car or reducing prices. Only
political monopolies have the privilege to ignore the pressure for better
services and lower prices. And therefore in the libertarian way of thinking the
taxi is a monopoly and Microsoft is not.
And Marxists should answer a crucial
question. Why capitalism did not lead to economic monopolies? Marx predicted so
when he published “Capital” in 1867. Marx predicted in 1867 that the poor would
become poorer and the rich richer, and that capitalism would end up with a
small group of capitalists owning all the means of production and would exploit
everybody else (for a discussion on the socialist myth of the poor who are
getting poorer, see my document “Are the rich getting richer and the poor
getting poorer? Another socialist
myth”). The average worker is much richer today than the average worker of 1867,
and there are still plenty of companies producing salt in each country. How
many centuries does it take for the markets of homogeneous products like salt,
to become monopolized? Why there are still so many companies producing salt,
chocolate, alcohol etc?
Concentration of Capital and Markets
“Market concentration” usually refers
to the market share of the 4-5 biggest companies of a particular market. The
question however is whether companies become larger in the Marxist sense i.e.
that one capitalist eats the other and wealth is constantly concentrating in
fewer and fewer hands, with the poor becoming poorer an the rich richer, or
whether they became larger due to cost factors, in order for lower prices to be
achieved thus making more and more products available for everybody, including the
poor. Because it is not enough to say that there are fewer and bigger companies
in a sector than they were some years ago, to prove that the Marxist analysis is
correct. If socialists are right, the fewer and larger companies in a market
must have caused the production of lower quality and more expensive goods. If
on the other hand increasing concentration led to higher quality and lower
prices for goods, the Marxist analysis must be wrong, and there must be other
factors i.e. cost factors, that led to increasing concentration. So what do you
think? What has happened to the quality and pricing of products since 1867 when
Marx’s “Capital” was published? Do workers today have access to more and higher
quality or less and lower quality products than they had almost two centuries
ago?
Therefore if socialists want to prove
that Marx was right about capitalism, they have to prove that increasing market
concentration leads to products that are of lower quality and higher prices (actually
Marx was very wrong and most economists today agree on that, and I provide a
simple explanation of why this is so, in my document “Why Marx was wrong”). Steven
Lustgarten, in his article “Productivity and Prices: The Consequences of Industrial Concentration” showed that for the period 1947-1972, price
increases were lower in industries with the highest increase in concentration,
and in industries with the highest decrease in concentration, as compared to price
increases in industries with relatively stable levels of concentration over
time. He claims that changes in industry concentration were due to
technological development which caused changes in the market structure and
increased productivity, thus putting downward pressure on prices. While he
claims that in industries that did not experience significant technological
progress, concentration and prices tended to remain stable over time.
There is a lot of research on whether
higher industry concentration leads to higher or lower prices. You should know
that for every academic article that claims that higher market concentration
leads to price increases, there is another paper showing the opposite. You just
need to google expressions like “benefits of industrial concentration, benefits
of market concentration, cost reductions-industrial concentration, why market
concentration is good, which is the optimal market structure, benefits of
mergers and acquisitions, prices and industrial concentration, innovation and
industrial concentration” and you will find plenty of evidence.
People also tend to
forget that large corporations are the sums of a huge number of capitalists.
Millions of small, medium and large capitalists hold the shares of large
corporations. And this was actually the reason that the institution of the
stock market was invented i.e. to make huge projects feasible. Assume that
there are 1.000 businessmen producing a particular product. And they then form
a new company in which they all hold shares. Is there an increase in
concentration? Well there is but isn’t this a pool of resources in a common
effort to exploit economies of scale? In reality of course, not all of the
1.000 businessmen will hold shares in the new company, but some will go
bankrupt instead. But there is an inherent risk in the business world and
bankruptcy is a possibility for both a small grocery shop and a large corporation.
And to have an idea of
the dispersion of ownership in large corporations, I provide the following
links from yahoo finance. The following link states the largest shareholders of
Microsoft
And this link states the largest shareholders of
Apple
The largest
individual shareholder of Microsoft is Bill Gates with 357 million shares,
which represent less than 5% of ownership. And this man is the founder of
Microsoft. The next biggest individual shareholder is Kevin Brian Turner with
1.5 million shares, which represent a bit more than 0% of ownership. The
largest institutional shareholder of Microsoft is Vanguard Group with 366
million shares worth 12 billion dollars, representing less than 5% of
ownership. And then there are few other institutional investors with a bit more
than 1% ownership.
For Apple the
largest shareholder is Arthur Levinson, with 162 thousands shares, which
represent ownership of a bit more than 0%. The largest institutional investor
is again the Vanguard Group with less
than 5% of ownership. And it must be noted that Vanguard Group is a company
investing for millions of smaller investors. Consequently the ownership of
large corporations like Microsoft and Apple is widely spread. Note that the data are not
recent and my aim is not to provide up to date data, but rather to demonstrate
the dispersion of ownership in big corporations.
I also want
to give an example to show that market concentration is not necessarily
something negative. Imagine an island where only cars and nothing else is
produced. And there are let’s say 10 companies producing cars. After 10 years
there are only 4 companies manufacturing cars but there is also a computer
industry. Cars account for 40% of the island’s economy and computers for 60%.
Has market concentration in the automobile industry increased? Well it did, but
is this something negative? It is not because new companies appeared in other
sectors. Isn’t that what we want? To produce what we already produced with less
resources, in order to have resources for the production of new stuff?
Imagine 10
fishermen living in an island. In the beginning they are all fishing. Isn’t it
a good thing if after some years, due to technology improvements, only 2 people
are catching the same or even a larger amount of fish than before, and the
other 8 people are producing something else? Doesn’t that make the island as a
whole richer? If in 1950 there were 100 automobile industries employing 100.000
employees, and now there are only 40 companies employing only 50.000 employees,
but at the same time these 50.000 employees are producing a larger quantity of
higher quality automobiles than in 1950, it means that 50.000 people are freed
from the automobile industry and can spent their time producing computers. That
is what wealth creation is about.
The price mechanism
Non economists have a tendency to
confuse the workings of the price mechanism with monopoly. And before
explaining what I mean, I want to say a few words about the price mechanism.
One of the strongest arguments against the Marxist model is that it does not
allow the price mechanism i.e. the law of demand and supply, to allocate scarce
economic resources. Without the price mechanism, the state has to
decide how resources must be allocated. For instance the bureaucrats will
decide that 100 oranges and 100 lemons will be produced without considering
consumer preferences. Therefore if consumers prefer 150 oranges and 50 lemons
they will not be able to manifest their preferences through the price mechanism.
In
a capitalist economy on the other hand, excess demand for oranges and excess
supply of lemons, would push orange and lemon prices upwards and downwards
respectively, increasing and squeezing at the same time profitability for
oranges and lemons. This would create new jobs in the orange market and a loss
of jobs in the lemon market. The result would be a transfer of labour and
capital from the lemon to the orange market. This process would stop when the
market would reach a production level which would be in accordance with
consumer preferences i.e. 150 oranges and 50 lemons. It is therefore this
mechanism that signals that a transfer of resources must take place.
If
Nokia manufactures a very good smart phone that we all want to buy, she will
indeed be able for a while to charge high prices, since consumers will not
consider smart phones sold by other companies as close substitutes, and they
will have a strong preference towards the Nokia smart phone. Some companies might even go bankrupt, but you cannot blame Nokia for
coming up with a better product. It is the price mechanism that will drive
these companies out of business. The price mechanism will signal that the
market needs more Nokia style smart phones, and it will manifest that through
increased profits for Nokia and reduced profits for her competitors. Because
that is what the price mechanism does. It shows through profit fluctuation
where and how scarce economic resources should be allocated. And what is the
price mechanism or the law of demand and supply? It is the needs of consumers
on one side (demand), and the ability of the economy to satisfy these needs on
the other side (supply). There is therefore nothing wrong with increasing
profits in some sectors and decreasing profits in some others. That is of course if the market is left to
operate freely. If on the other hand the government intervenes excessively,
increasing and decreasing profits might also show the relative power of
interest groups that put pressure on government in order to gain privileges.
Moreover the libertarian competition
model is based on what is called “innovation and imitation”. Companies struggle
for a market share, and some of them manage to introduce new products and make
large profits. The other companies will try to imitate the innovative
companies, until they manage themselves to come up with something new. How easy
it is for other companies to imitate depends on how sophisticated the product
is. If for instance a company made large profits because it understood
consumers’ need for more tomatoes, very quickly the other companies will
increase production of tomatoes. If profits are due to a highly sophisticated
and technologically advanced product, it will take some time for other companies
to imitate or come up with something better. It might also be possible that the
new product is protected by a patent and therefore the other companies have to
wait some time before they are allowed to produce the product themselves.
Patents should not be confused with government intervention. Patents must be
protected in the same way that our home is protected otherwise businesses will
not have a motive to invest on research and development of new products.
There is also the issue of “excess
profits”. What do we mean by “excess profits”? There is no such thing as
“excess profits”. By penalizing profits we also penalize the price mechanism
which is the foundation of capitalism. And we should not confuse the cost of
entering into a market with the profit opportunities that the market offers. If
indeed a market offers profit opportunities new companies will enter. For
instance if Samsung needs 1 billion euros to enter the automobile industry, she
can find the capital to do so. Capital is not the issue for Samsung. The issue
is whether the automobile industry has enough profits for one more player, or
whether Samsung can come up with something better or cheaper than the products
already produced in this market.
The free market anti-monopoly self defense
There are many mechanisms that
protect the free market from monopoly policies. These mechanisms ensure that
there will be a continuous improvement in quality and a continuous reduction in
costs and prices.
a) Substitutes For
almost all products there are substitutes i.e. motorbikes, bicycles, public
transportation are all substitutes for cars.
b) Potential Competition Even if there is only one company in a market, there
is always the chance that new competition will appear. This company has a
motive to continually improve its products and prices to discourage potential
competitors. Microsoft’s windows and Google’s android is a good example. Only
by government regulations can a company become immune to competition.
c) Demand Elasticity Demand for goods is never perfectly inelastic. For instance a
dramatic increase in the price of cigarettes might lead consumers to quit
smoking (actually taxes account for most part of the price of cigarettes). Or
consumers can reduce the quantity they purchase or stop buying the new products
of the company. For instance if Microsoft charges very high prices, consumers
might decide to stay with windows XP and not buy windows 7.
d) Competition from all goods in the market People tend to think that a product
only competes with similar products, which is not true. For instance a Fujitsu
laptop does not only compete with an HP laptop. In reality all products compete
with all products, because consumers’ income is limited and given. Therefore
Fujitsu has to persuade a consumer to buy a new Fujitsu laptop and not a new
bicycle or a new dvd player or take a short holiday instead. All companies compete
with all companies in a free market.
e) Free International Trade As Milton Friedman said, the best
defense against monopoly practices is to open the country to international competition.
That is guaranteed to bring the lowest possible prices for consumers. And free
international trade cannot lead to unemployment as I explain in my document
“Free Trade or Protectionism? A Case for Free Trade”.
f) Division of labor and specialization. One of the main reasons capitalism
managed to create this tremendous wealth in only 3 centuries, is the division
of labor and specialization. Before capitalism that is before the market
economy, every small society was organized as a self sufficient economic unit.
Even families were organized as small self sufficient economic units. Each
family would produce almost everything it needed. The market economy introduced
the division of labor and specialization. Great businessmen became great
because they had a specific talent. Bill Gates managed to create Microsoft, but
that does not mean that he could be a successful businessman in the automobile
industry, or that he could have made Microsoft what it is, without the help of
millions of others i.e. employees, shareholders, scientists etc. I mean that
Bill Gates is nothing on his own. He was clever in something, he had luck, but
he is too insignificant on his own to control the world as Marx predicted, even
with the help of some other mean capitalist friends.
The neoclassical theory of monopolistic competition
The Marxist theory of monopoly has
long been discredited and it is rarely mentioned in academia. It is mainly used
as a means of propaganda, as a means of convincing people that they need more
government. In academia the neoclassical theory of monopolistic competition is
taught, and even though it is a wrong theory, it is much more serious than its
Marxist counterpart. Even though it is not probably correct to say that one
wrong theory is more serious than another wrong theory, but anyway. The
neoclassical theory of monopolistic competition can be found in most
microeconomic textbooks if not all, and is taught in the best universities of
the western world.
This theory is very strongly related
to the supposedly superiority of equality over freedom. In the same way that we
are taught that all people must be equal, we are taught that all companies must
be equal. People that have studied economics will recognize egalitarianism as
the basis of the neoclassical theory of perfect
competition and monopolistic
competition. Contrary to the Marxist approach this theory is in favor of a market
economy but it recognizes as the PERFECT (and therefore ideal) form of
competition, an economic environment where: a) There is a very large number of
small firms b) The products produced are almost identical c) All consumers and
producers have complete knowledge of the market d) There are no barriers to
enter and exit the market e) Companies cannot affect prices i.e. they are price
takers.
It is clear from the above that the
philosophical base of perfect competition is equality (egalitarianism). In the
same way that all people must be equal, all companies must be equal. After all,
companies are simply an extension of people. Therefore to accept the above form
of competition as perfect, is to indirectly also accept that the opposite i.e.
a market with a few large companies that sell differenciated products, which
have some control over their prices, and which have established some forms of
barriers of entry i.e. successful brand names, is an inferior and problematic
form of competition.
But they forget something very
important. From all 5 characteristics of perfect competition, the element of
competition is absent. The large number of small companies ignores the struggle
of companies to grow larger in order to exploit economies of scale and become
more efficient than their competitors. The assumption of identical products
forgets that companies have to differentiate their products in order to make
them more attractive to consumers, than their competitors’ products. The
absence of barriers of entry means that companies should not establish
successful brand names, or obtain high capitalization to exploit economies of
scale. The assumption of perfect information forgets that one factor that
separates successful from unsuccesful businessmen is the ability to communicate
with customers. Finally to consider companies as price takers, is to ignore that
companies must always struggle to find more cost efficient ways of production
to obtain an advantage over their competitors.
Therefore the whole idea of perfect
competition is totally incompatible with the notion of competition and
perfectly compatible with egalitarianism. The economic environment it refers to
is a business environment of zero competition and of equal business
opportunities. It is clearly a socialist idea. And it is the idea of perfect
competition that leads to the arbitrary assumption that a market with few large
companies is not competitive. But this is not true. Large companies are the
result of severe competition and of consumers’ pressure for better products and
prices and not the result of monopolistic or oligopolistic competition.
The basic argument of monopolistic competition
I will now present the basic argument
of monopolistic competition by giving an example. It might look silly to
someone that never took a microeconomic course, and yet it is on this silly
idea that monopolistic theory is based. And the idea that the government should
intervene to protect consumers from monopolies, is based on the theory of monopolistic
competition, and therefore this silly idea that I will present have very
important repercussions. It is actually a silly which is taught at all western
universities.
Assume that there is a manufacturer
of tables. He buys wood and produces tables. The more tables that he produces
the lower their selling price will be. The latter follows from the law of
demand and supply which says that a higher supply leads to lower prices
(ceteris paribus). This is a theoretical
model and therefore prices are supposed to be know for different level of
production i.e. the producer knows what the price of a table will be if he produces
100, 1.000 or 100.000 tables. He knows
prices before even producing a single table. This is not realistic but this is
only a theoretical model and not real life.
Let’s assume that he can sell each
table for 10 euros if he produces 1.000 tables and 9.95 euros if he produces
1.001 tables. We see that the increase in quantity supplied generates a small
fall in price from 10 to 9.95 euros or 0.05 cents. The thing is that the price
fall does not only involve the last piece but all production i.e. each one of
the 1.001 tables will be now sold for 9.95 and not 10 euros. And this is what
makes the difference. Assume that marginal cost i.e. the cost of producing one
more table, from 1.000 to 1.001, is 4 euros (fixed costs do not change with
production). What would the producer do? Well by producing the 1.001th unit, he
would incur a variable cost of 4 euros, would receive and additional 9.95
euros, and lose 0.05 for all the previous 1.000 units i.e. 1.000 times 0.05 =50
euros. Therefore the effect on his profits from the production of the 1.001th
unit would be -50-4+9.95= -55.55 euros, and therefore he would not produce the
1.001th unit.
If on the other hand the company was
operating in an environment such as the one described by perfect competition,
the producer would be a price taker, and therefore he would go ahead with the
production of the 1.001th unit. Because he would be a price taker, and
therefore his production would not affect costs or selling prices. Therefore
the situation would be the following. He would pay an additional cost of 4
euros, he would receive 10 euros for the 1.001th unit, since his increased
production would not affect prices, and he would therefore increase his profits
by 10-4=6 euros. He will then continue to produce until his marginal cost
equals price i.e. MC=P. For those that have taken a course in microeconomics,
what I am saying is that a monopoly produces until marginal cost equals
marginal revenue i.e. MC=MR, while a perfectly competitive company produces
until marginal cost equals price i.e. MC=P.
Therefore the dominant model of the
neoclassical competition theory claims that the government should intervene to
prevent companies obtaining significant market power, because significant
market power will lead to higher prices and lower number of units produced, and
therefore lower employment. Therefore the basic argument of monopolistic
competition, and therefore of government intervention is that the
“non-perfectly” competitive producer will take into account the effect that his
production will have on the prices of his product, while the “perfectly”
competitive producer will not take this into account.
And it is this model that determines
government policies and not the Marxist nonsense. The Marxist monopoly nonsense
is simply used to develop a corporate phobia to the public. Because it is much
easier to say to the public that the poor are getting poorer and the rich are
getting richer and that capital is increasingly concentrated in a few hands and
bla bla bla, and that capitalism leads to monopoly, than explaining the
neoclassical theory of competition. The Marxist approach is much more
convenient for propaganda purposes. But policy makers in the Western world do
not consider the Marxist nonsense at all. Policies are rather based on the
neoclassical theory of competition.
Criticism to the model of monopolistic competition
My criticism to the Marxist view of
monopoly applies to the model of monopolistic competition too, and therefore I
will not repeat it here. I will simply add a few things. As I already said, the
key argument of the monopolistic theory is that big companies have some control
over their prices, while small companies are price takers. But this is not a
realistic assumption, since in reality all companies have some control over
their prices, even the small ones. Moreover to penalize increased market
concentration, is to give wrong incentives. Imagine a market with 4 big
companies, where one of them has come up with a more efficient way of
production. And the company wants to pass the reduction in cost to prices i.e. sell
at lower prices. But if the company does so, it might increase its market share
and drive some companies out of the market, thus making the state’s competition
commission to take action against it. And therefore the company might decide to
keep prices at the current level.
The other problem is that the
government has to decide which price is low, reasonable or high. But how can a
government decide that? If one invents a new vehicle that can fly and can
substitute cars, how much should he charge for it? What should determine its
price until competition comes up with something similar or even better? Should
the price be determined by its cost, by the inventor’s intelligence, by its
utility to consumers, a combination of these factors or something else? Why not
let consumers decide what they are willing to pay for it? Is there really a
better way to determine the right price? For an excellent criticism to the
theory of monopolistic competition see chapter 2 of Dominick Armentano
“Antitrust and Monopoly: Anatomy of a policy failure”, Brian Simpson “Markets
don’t fail”, and Brian Simpson’s super article “Two theories of monopoly and
competition”, which you can find at the following link
The rhetoric of economic monopoly
Politicians very often attack large
corporations and multinationals because there is a huge dispersion of ownership
and nobody pays much attention. People that hold significant numbers of shares
are very few and they represent a very small number of votes. And politicians
care about votes. Only with large number of votes they can remain in their
office. And voters do not perceive attacking multinationals as an attack on
their own interests, even when they hold some shares. But they should care
because these companies are very important to them. And they are important not
because they might hold a few shares, but because of the great products that
these companies manufacture. But there is so much propaganda about big
companies that people tend to be very suspicious towards them.
The truth is that the rhetoric of
monopoly is always put forward by small less competitive units, in order to
protect themselves from competition from larger and much more efficient
producers. Small production units i.e. farmers, always represent more votes
than big companies, and they therefore can exert much more political pressure.
But people tend to think the opposite. That is they believe that the 50-100
largest companies of the country, actually run the country. But this is very
wrong. Sure the political system can have and almost always have linkages to
these companies, and might receive financial support or even bribes in
corrupted countries, but it is always the large number of voters that keep
politicians in place. And politicians care much more about gaining the support
of strong guilds than the support of multinationals. Multinationals cannot keep
politicians in office, but strong guilds and syndicates can. It is always and
everywhere true, that the rhetoric of monopoly is in reality used to protect
less efficient production units from competition and leads to higher and not to
lower prices for consumers as politicians claim all the time.
I mean that the rhetoric of
monopolies is used to cause corporate phobia to the public, and thus justify
the introduction of regulations which are supposed to protect consumers from
higher prices, but which are in reality meant to protect small inefficient
producers that represent significant voting power i.e. farmers, or to protect
large domestic producers from more efficient foreign competitors. In either
case the result is higher prices for consumers.
Conclusion
If after reading this document one
agrees that large companies and high market concentration is not necessarily
something negative, one has to also realize that it is not possible to have
very large numbers of very big corporations. Germany cannot have hundreds of
automobile companies, because such economic sizes require huge amounts of
capital to operate. And the economy does not only need automobiles, but it also
needs medicines, food, houses, computers etc, and therefore there must be some
champions in all economic sectors. The more the German economy grows the more
automobile companies she can have, if that is what German people want.
What I mean is that there are few large
corporations in the automobile industries because large economic size is
required to produce better and cheaper cars, and there are not hundreds of such
companies because an economy cannot afford to have many such companies, and not
because capitalism leads to monopoly. An economy can only afford to have a few
giants producing something. Some countries cannot afford to have any such companies
actually. Therefore if we want highly sophisticated products at good prices, we
have to see large companies as something positive, and at the same time we
should not expect to see hundreds of them. The question then is what do
socialists want? Do they want many small automobile, computer, airplanes
companies to be happy and stop saying that capitalism leads to monopoly? Do
they want each city to produce its own cars and airplanes in the same way it
produces its own bread?
The wise thing to do before calling a
market monopolistic is to observe whether there is pressure on the company or
companies in this market to improve quality and prices. In my opinion the
problem with these big companies is that they are under so much pressure to
satisfy their clients and generate profits that they might sometimes do things
they should not do. But I do not worry at all that they take consumers as
granted and charge unreasonable prices.
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