All Commentary
Thursday, June 1, 1995

Capitalism Is Merciless to Capitalists

Capitalism Is a Great Force for Efficiency

Mr. Levite is a freelance writer residing in San Francisco, California.

Attending college in the late 1960s left me with many unique memories. Among these was the economics class in which the instructor told the students that such firms as IBM and Xerox were so huge and powerful that they dominated their markets. Smaller competitors were helpless against them. They exercised such tremendous control over patents and technology, and spent so much on research and development, that other firms in their industries could never hope to compete effectively, much less overtake them. For these reasons, government intervention was necessary to protect both consumers and competitors.

Of course, this sort of thinking was neither confined to the 1960s nor the exclusive product of economics professors. Many decades ago, socialist author George Orwell, in an effort to demonstrate the superiority of socialism over capitalism, made much the same point when he mentioned a phonograph company that had bought a patent for a superior phonograph needle. The company did not produce the needle and never intended to. It simply wanted to kill the invention, so that it would not compete with its existing product line. (Orwell seems to have forgotten that patents are government-created and government-enforced monopolies.) He used this example to illustrate his point that capitalism suppresses more technology than it creates. Under capitalism, he wrote, money is risked only on projects that promise quick profits. Remove the profit principle, he claimed, and inventors would have a free hand.[1]

But time has completely disproven his theory. The phonograph companies were completely unable to use this tactic or any other to stop the spread of cassette tape and CD-ROM technology. This is an ample illustration that no matter how much they might try, capitalists cannot repeal the laws of markets. (Governments have also tried to do so, with the same lack of success.) For brief periods, capitalists can dominate markets or industries, but the achievement of such domination is always temporary. It sets in motion forces that no capitalist or group of capitalists could ever control. Lucrative profits, for example, attract competitors; and soon, the level of profit evens out. This does not prove Marx’s thesis about the falling rate of profit, for a decline of profitability in one industry will be offset by gains in another. But it does help to disprove the notion that “the big boys” run things. If they did, they would surely be able to prevent the loss of their own markets!

Both IBM and Xerox had ample power over technology by means of their tremendous research expenditures and control of patents, but it did not help them keep their markets. As for projects presumably being squelched because they do not offer quick profits, one need only compare the number of new ventures that appeared in socialist countries with the number that appear in capitalist countries. Whether or not a project promises profits is largely a matter of guesswork–that is, opinion. And opinions are never lacking. The mere fact that so many profit-oriented ventures fail is sufficient proof that a venture hardly needs to be demonstrably lucrative to be attempted.

On occasion, a product will enjoy such success among consumers that its leadership over competitive brands will appear to be unassailable. Backed by the profits thus generated, the firm will spend large sums on advertising to maintain the product’s leadership. Competitors will be unable to supplant it. Because of this market domination, the lucky corporation is protected from price competition and can unfairly maintain monopoly prices and profits–or so we are told. This certainly seemed to be the case with Marlboro cigarettes, which has been the leading brand for a long time. I’ve never smoked myself, so I’ve always wondered if Marlboro’s market leadership was solely the product of its hugely successful advertising efforts. But most of the smokers I’ve asked believe that Marlboros taste better than other brands. Despite this presumably better taste, however, and even though Philip Morris spends enormous sums on advertising this brand, it has lost some of its market share to low-priced “generic” cigarettes, which are hardly even advertised. Philip Morris was forced to respond by lowering Marlboro’s price by 40 cents per pack, which increased its market share by about 5 percent, but contributed to a fall in the company’s operating profit from $5.2 billion to $2.8 billion.[2] There have been very few instances in business history of brands as successful and powerful as Marlboro. Yet it could still not resist these competitive pressures.

Price Competition in the Computer Industry

The necessity of competing in terms of price is nothing new, nor is it confined to cigarettes. The company I work for sells hard disks for personal computers. The extent to which prices of PCs have dropped in the last ten years is already well known, but let me provide a typical example from our price lists. Our Fall 1991 price list showed a price of $5,099 for a 1-gigabyte (1,000-megabyte) SCSI hard disk. The current price for a drive of that capacity is $1,099—a drop of $4,000. Not only that, but our newer model also takes up less desk space and transfers data at a 42 percent faster rate.

Such examples did not need to wait for the development of the PC. Penicillin sold at first for $20 per dose. As more and more companies began to manufacture it, the price eventually dropped to 2 cents.[3] In 1908, Henry Ford’s Model-T Touring Car sold for $850. Eight years later, a new Ford Touring Car sold for only $360.[4] A labor union would consider it a great victory to have won for its members as much money as these capitalists allowed consumers to save. If a government bureau had disbursed the same amounts to the public, high school history textbooks from that era to this one would have been praising the foresight and benevolence of the bureau’s policies.

If capitalists had as much control over markets and prices as we have been led to believe, it seems highly unlikely that they would permit such price drops to occur. If costs decline, why not just maintain the retail price at its previous level and reap huge profits? The answer is that this cannot be done. Even the less astute capitalists are quick to see that if they drop prices just a little, additional sales can be gathered. Naturally, as Adam Smith pointed out over two centuries ago, they would also be quick to see that it would be advantageous to conspire together and agree to fix prices at certain levels, preventing a price war. But such agreements never last long. The same economic forces that inspire capitalists to make such pacts also break the pacts apart. Even if outsiders who are not parties to the agreement can somehow be kept under control and prevented from undercutting prices, the parties to the agreement will not hold to it for long. There is always more to be gained from breaking the covenant than from sticking to it. More importantly, consumers will find substitutes for the price-fixed product if they perceive that its price is being held above the true market price, which reflects the value they put on it.

The most noteworthy point about the conspiratorial argument is that anyone who accepts it would have to assume that all capitalists would operate in this manner. To be sure, all capitalists are driven by the prospect of financial gain, so they would all have a strong incentive to keep profits high by fixing prices and avoiding price competition. Geographic distance would no longer minimize this effect. It is true that foreign trade has played an increasingly important role in the world economy, and that capitalists in one country now compete against capitalists in other countries. But if capitalists in different countries wish to conspire together to fix prices, modern means of communication make this no more difficult than placing a phone call.

The capitalists in the computer industry would be characterized by all this no less than any others. But as we have seen, price wars have been the rule nevertheless, and not only in any one country, but on a worldwide basis. This gives us an excellent opportunity to look back in retrospect on the Justice Department’s antitrust suit against IBM, which was riddled with inaccuracies and contradictions, and which had to keep changing its premises to keep pace with changes in the market. In 1982, the Solicitor General finally decided that the case was without merit and dropped it–after both sides had wasted hundreds of millions of dollars fighting it.[5] (Part of this was money that IBM might have spent on research and development.) But if the government had wanted to break up IBM, it could have done so without spending a penny of taxpayers’ money. It could simply have waited for the market to do the job. In 1993, IBM lost eight billion dollars.

The Pitfalls of Bureaucratic Management

This illustrates that the market is not the only force that tends to cut giant firms down to size. Technology and bureaucracy can do that all by themselves. IBM has been the victim of both. Computer technology has made mainframe computers-’IBM’s mainstay–increasingly obsolete. IBM could have shifted entirely to smaller machines, but its bureaucracy resisted change for too long. Bureaucracy not only displaces the entrepreneurial spirit that turns small firms into big ones, it also makes the entrepreneurial spirit unwelcome. Big firms become bureaucratic, and bureaucratic firms become cumbersome and slow to respond to customers’ needs. Decisions take too long to make, and smaller firms that are not encumbered by such problems find ways to serve customers’ needs better. Government bureaucracies can endure because governments do not need to make a profit or to respond to competitive pressures. But in industry, the bureaucracy that is typical in large firms can undermine the most powerful corporations and gradually decrease their market power, while increasing that of the smaller firms.

This is not to say that IBM was inefficient or that it produced bad products. In fact, it has always been known for making good products, which is why it got to be as big as it was. But even good products cannot create and hold monopolies, because substitutes exist and because even firms that make good products might not be making the right products for the market. Despite IBM’s size and strength, other firms began to make other products that many of IBM’s customers started using as substitutes for IBM’s mainframes. The market “grew up” and no longer wished to be as dependent on IBM and its machines as it had been. The advent of PCs made it possible for customers to write or buy software that could perform the tasks they needed done, without depending on IBM.

Socialism and Innovation

But couldn’t socialism accomplish the same thing, by simply breaking up large corporations or nationalizing them? Let’s analyze how this would work—specifically, how it would treat innovations, since economic growth depends on innovations. Suppose that the government had taken over all industry by 1970. In 1975, a government planning bureau would have been visited by Steve Jobs and Steve Wozniak, the founders of Apple Computer. These young hobbyists would have had to ask the bureau to allocate funds for their project. But the government bureau would have had little reason to redirect money that had been destined to fill immediate needs, and devote it instead to an untried, unproven, and highly doubtful project–one that had nothing to do with necessities such as food, shelter, and health care. To top it all off, Jobs and Wozniak were neither recognized authorities nor successful managers. Worse still, in order for their machine to be useful, someone would have had to write software programs for it, which had’nt been done at that time. But in a country where the profit motive existed, the “two Steves” had little difficulty finding venture capitalists willing to fund their project. The fact that IBM dominated the computer industry at the time did not retard their progress in the least.

Many unanticipated uses were found for the machine they created. Socialist planning does not take unanticipated uses into account, and couldn’t even if it wanted to. The trial-and-error system of profit and loss determines what works much more adequately than central planning ever could. And if the project of the “two Steves” had failed (under capitalism), only the venture capitalists would have suffered a financial loss. Under socialism, the taxpayers as a whole would have borne the loss. This is why Orwell’s fears that capitalism would suppress innovation are groundless, although they would be true with respect to socialism.

What lessons can we draw from all this? First of all, capitalism is a great force for efficiency. It rewards firms that serve their customers’ needs and punishes firms that are inefficient. It allows firms to grow to huge size and to amass great wealth–if they earn it. If they cease to do so, or if competitors do it better, they will decline, no matter how big and powerful they were.

These are lessons we should all ponder the next time we are told that the powers of the government must be enlisted to redirect industrial activity toward various “public” goals.

1.   George Orwell, The Road to Wigan Pier (New York: Harcourt Brace Jovanovich, 1958), pp. 206-07.

2.   Andrew E. Server, “How to Escape a Price War,” Fortune, June 13,1994, p. 83.

3.   Stanley Siegelman, “Pharmaceuticals,” Chemical Week, August 2, 1989, p. 32.

4.   Richard S. Tedlow, New and Improved: The Story of Mass Marketing in America (New York: Basic Books, 1990), p. 125.

5.   Charles H. Ferguson and Charles R. Morris, Computer Wars (New York: Times Books, 1994), pp. 10-11.