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Wednesday, March 8, 2023

How the Free Market Handles Monopoly

Ask an Economist #9

Image Credit Flickr: William Warby|CC BY 2.0

In the president’s recent State of the Union address he called for “bipartisan legislation to strengthen antitrust enforcement.” For those who aren’t policy wonks, antitrust law is the law that attempts to prevent the creation of monopolies and cartels.

On this same topic, for Ask an Economist, I received a question from AJ. He asks,

“without anti-trust laws how would the free market keep monopolies from forming? If other companies could just buy smaller companies without creating innovation, how would progress happen?”

In order to answer how a free market would address monopolies, we first need to understand what a monopoly is and what a monopoly is not.

Ambigopoly

What is a monopoly? Well, I think it’s important to consider the literal textbook definition. In the Microeconomics textbook I use for my courses (Gwartney, Stroup, Sobel, and Macpherson) the definition of monopoly is, “a market structure characterized by (1) a single seller of a well-defined product for which there are no good substitutes and (2) high barriers to the entry of any other firms into the market for that product.”

This is a pretty standard definition of monopoly, especially the first part about having a product with “no good substitutes.” Other textbooks will say a product with no “close” substitutes.

It’s important to recognize immediately that this definition is, at best, ambiguous. Is a smartphone a “good” or “close” substitute for a computer? Is college football a close substitute to the NFL? What about the NBA? Is a grocery store a substitute for a restaurant? Is Twitter a substitute for Facebook? Is Zoom a substitute for transportation? The point of these questions is that it isn’t clear. If you define a good narrowly enough you could argue all firms are monopolies.

That doesn’t mean the concept of monopoly is totally drained of importance. It only means that we’ll have a tendency to overestimate the number of monopolies if we ignore that many goods can be substitutes for other goods. It also means coming to an objective answer as to whether a firm is a monopoly is impossible by this definition.

Market Power

Even though we can’t use this definition to identify monopolies in practice, this doesn’t mean we can’t imagine this sort of firm. Likewise, this definition of monopoly isn’t the only way to conceptualize the problems created by a lack of competition. Another way we can categorize firms is their ability to affect the price of goods. In fact, this sort of categorization is used explicitly by anti-trust experts.

The thinking goes like this. Imagine the opposite of the definition of monopoly above. Instead of a company that sells a product with no close substitutes, imagine an industry where there are a large number of sellers who market an identical product. Think of, for example, corn.

When you go to the grocery store, you likely don’t think much about the brand of corn you buy (ignoring somewhat recent concerns about things like GMOs). Why? Because corn is corn. It doesn’t much matter which farm it comes from.

There are also thousands of sellers of corn. In such an industry, one seller will be unable to affect the price. If a farmer tries to raise the price, consumers will just substitute into the identical corn sold by the thousands of competitors.

Economists call this situation, where a seller’s actions have no effect on the market price, a price-taker industry.

In contrast, imagine there is a single seller of a product with “no close substitutes.” Let’s go with the example of an iPhone. What happens if Apple raises the price? Well, some consumers will likely not be willing to consume the product anymore—they’ll switch to Samsung, maybe. It has become too expensive. But because there is no smart phone that is exactly the same as the iPhone, not everyone will stop buying the product like they did in our corn example.

So what happens? Well the quantity of iPhones that Apple sells decreases, but the price it receives per phone increases. The former (selling fewer phones) means lower revenue, but the latter (a higher price per phone) means higher revenue. So what’s the final effect of the price increase? It depends on the magnitude of the change in quantity and price. In other words, it depends on the situation.

In contrast to price-takers, Apple in this example is what economists call a price-searcher. The owners have to “search” for the price that brings the highest profit.

What does this have to do with monopoly? Well, in a price-searcher industry, selling more units means lowering the price and, at some point, lowering the price will mean lower profit. In contrast, a price-taker can sell as many units as they want without lowering the price. So selling a larger quantity past some point has a negative impact on the total revenue for price searchers but not price takers.

This means that when there are relatively fewer sellers (such as is the case with price searchers), we would expect sellers to produce a lower quantity and charge a higher price compared to a situation with more sellers.

We could reframe this to say when a company has more power to effect the price, it will charge higher prices and sell fewer products. In the extreme version of this (monopoly) one seller can make more profit by cutting the number of units it sells by a relatively large amount and charging a relatively large price. Consumers don’t like the sound of this.

Market Process

So how do free markets deal with the problem of monopoly? Well, the thing about markets is they are a process. The price taker and price searcher models we discussed above are static models. In other words, they are a snapshot of a single moment in time. There is no innovation, entrepreneurship, or discovery.

In fact, a great irony of the price taker model is that it’s often called “perfect competition” by economists. But, as Nobel Prize-winner FA Hayek pointed out in his essay The Meaning of Competition, there is no real competition in the perfect competition model!

Think about it. What is competitive about a bunch of sellers offering an identical, unchanging product at an identical price? Do we really want our smartphone market to just be thousands of the exact same phone selling for the exact same price? I don’t. This insight caused Hayek to redub “perfect competition” as “perfect stagnation”.

What does real competition look like? Well, entrepreneurs attempt to discover new ways to better cater to consumer needs and budgets. Rather than making another MP3 player, Apple decided to scrap their wildly successful iPod and pursue the very risky smartphone idea. As a reward for taking this successful risk, they have many customers willing to pay higher prices for their product.

But what does this have to do with monopoly? Well, if there is a single firm selling a unique product, they can’t just passively ignore the possibility of future competition. In fact, if an industry is easy to enter, even a single monopolist will have to charge the same, lower price they would charge if there was competition. Why? Because if it is easy to enter, a competitor can come in, undercut them, and take all the customers for themselves. In other words, the mere threat of competition is enough to prevent a literal monopoly from acting like a monopoly.

This is a stunning conclusion. Even if we could identify an industry dominated by a single seller of a product with no close substitutes (a task that ambiguity renders impossible), it would still be inappropriate to treat this firm like a monopoly because the threat of competition can make companies act as if they are in fierce competition.

But what if, for whatever reason, it’s too expensive to enter an industry? This is the hardest case for the free market to answer. I submit, it still addresses this issue with relative ease.

Again, the market is a process. It occurs over time. Just because it is difficult or costly to enter an industry today doesn’t mean it will continue to be that way in the future. In fact, an industry that is difficult to enter and presided over by a stagnant monopoly offers huge returns relative to other more competitive industries.

At one point, Sears was considered to be an unstoppable titan of industry. Walmart exploded in profitability by usurping its spot. After Walmart succeeded, many began to say no one would ever be able to challenge their dominance. After all, the cost of competing with thousands of stores across the country is so high. How could anyone do it? But now Amazon, with its innovative shipping model, threatens to topple Walmart without the physical locations. Nowadays people worry Amazon is a monopoly. Is our memory really so short?

Innovation overcomes barriers to entry. And the higher the barriers to entry, the more companies have to gain by tearing them down. The profit motive that leads companies to seek monopoly power is the same profit motive that causes companies to tear each other down.

Skeptical? Consider the top 10 companies in terms of profitability over the last few decades. Visual Capitalist provides a valuable graphic to compare. From 1999 to 2019, only one company (Microsoft) remained in the top 10. Some of this depends on the metric used to measure, but there is clearly enormous movement in 20 years. For even more extreme results, compare the Fortune 500 companies in 1970 to today. You’ll recognize some companies—such as Exxon and Ford—on the list, but there will be some that younger Americans have never heard of—such as RCA, McDonnell Douglas, and Bethlehem Steel.

The point is that market competition is dynamic, and dominance in an industry today by no means guarantees dominance in the future.

Buy Competition

At this point, you may remember AJ’s second question. What if firms just buy out their competitors? In this case, even innovation may be unable to topple a monopoly. If monopolists just buy competitors, can’t they stay on top forever?

No. There are a few problems with this reasoning. Let’s say a monopolist is earning $1,000,000 worth of profit. A competitor comes along and thinks they can beat the stagnant monopolist and capture the $1,000,000 worth in profit for themselves. How much would the monopolist be willing to pay for the firm?

Well, if they are protecting $1,000,000, they certainly wouldn’t spend more than $1,000,000 to buy the competition. On the other hand, if the challenger is certain their business will succeed, they would never accept less than $1,000,000. No deal can be made.

Granted, this is a very simplified example, but you don’t have to go back far in history to find tech startups who wisely rejected buyout offers.

The second reason firm’s can’t just buy up all their competition is that there are internal costs to company growth. The more a company produces internally, the more it must rely on internal bureaucracies to make decisions. As the company grows, these bureaucracies grow, and so do the costs associated with bureaucracy.

As the economist Murray Rothbard argued, a firm that grows too big will lose its ability to successfully calculate the profit and loss associated with different operations. A firm of this size will be unable to figure out the source of successes and failures and will quickly become unprofitable. It collapses under its own weight.

Notably, this is the same problem which makes it impossible for centrally managed socialist economies to bring about material well-being. The more we centralize production, the less we have competition. The less we have competition, the less we have access to market prices. The less we have access to market prices, the more difficult it becomes to engage in economic calculation.

Fighting Fire with Fire?

Despite the historic success of the free market overthrowing seemingly unstoppable monopolies, many people are uncomfortable that the free market does not promise that every powerful company will be immediately destroyed. This discomfort causes them to turn to alternative means.

Anti-trust law is the state’s attempt to use government enforcement to end monopolies. I’m personally skeptical that anti-trust law is ever a good solution to the problems that come with monopoly.

To understand why, consider some issues we’ve already discussed. What is a monopoly? What does it mean that a product has no “close” substitutes? There is no clear answer to this question. Government will not be able to identify monopolies with this criteria.

Okay, but what about the price-search/price-taker framework? Perhaps the government can check to see whether a business is charging a competitive price? This doesn’t work either. Competitive prices are, by definition, the result of competition. If there is no competition, government cannot know the result of competition. Competitive prices are created in the process of competition. They cannot be estimated on an Excel spreadsheet in any meaningful way.

And even if the government could identify a monopolist, bureaucrats would also have to be certain that the threat of competition wasn’t causing them to already price competitively. If you add regulatory costs to a firm pricing competitively, you run the risk of making the business (or any business that steps into its place) unprofitable.

Anti-trust regulations also cannot anticipate future innovations which may solve monopoly problems. If these regulations discourage said innovations, it may make monopoly problems worse.

Lastly, there is no reason to assume political actors and bureaucrats will implement anti-trust laws in a way beneficial to consumers. Opponents of monopoly assume monopolists will set their prices to earn more profit even if it is a detriment to some consumers. Why would they turn around and assume politicians will set prices in a way that’s best for consumers?

In reality, politicians are subject to incentive problems which may, for example, cause them to wield anti-trust laws as a club to use against their enemies. If we assume businessmen are not angels, we should not assume politicians are angels.

Fighting monopoly with anti-trust is like fighting fire with fire. The political mechanism is as close to a monopoly as we can imagine. You cannot buy alternative law enforcement based on your preferences, and the government uses force as a powerful barrier to entry which prevents even the most creative entrepreneurs from developing alternatives to their services. Should we use monopoly to fix monopoly? It sounds silly when you say it out loud, doesn’t it?

Defending Monopolies!

My last problem with anti-trust stems from a somewhat controversial statement. Insofar as monopoly exists, it might be a good thing.

Monopoly as a concept is generally considered to be a bad thing, but, like many economic arrangements, there are costs and benefits to monopolies. We’ve been through the downsides: monopolies will produce fewer products and charge higher prices.

But what about upsides? Consider the company that was on both of the top 10 lists mentioned above, Microsoft. One of the biggest products Microsoft sells is its operating system (OS), Windows. Is Windows a pure monopoly? Well, no. Apple has a competing OS, and smartphones (which increasingly displace PCs) have their own OSs.

But Windows is much closer to a monopoly product than a lot of products we encounter. Is that a bad thing?

Let me answer with a question: if you are a Windows user, do you enjoy it when you have to use a Mac? If you’re a Mac user, do you like using Windows? Probably not. It’s probably annoying to have to use an OS you are unfamiliar with. Sometimes, we like aspects of single company domination.

I avoid using Apple computers like the plague. I don’t understand how to right-click. I don’t like trying to find software compatible with the OS. Apple annoys me.

Imagine now there were 100 different operating systems competing. Every time you used a school computer, a library computer, a work computer, or a home computer, you would have to learn an entirely new OS. Would this be the end of the world? No. Is it a downside of having a large number of competitors? Sure.

I’m not saying every monopoly is good. I’m just highlighting that there’s probably at least a few products where only a few competitors would be superior to many competitors.

Consider another example. Imagine an industry which is engaged in some form of unregulated pollution. With every unit of production, the air you and I breathe is polluted. In this situation, monopoly would actually be good. Remember, monopolies tend to produce less than competitive firms. So a monopoly in this industry means less pollution!

Trust the (Market) Process

In conclusion, I find it shocking that people are willing to defer the question of monopoly to government. Governments are:

  • Unable to identify monopolies due to ambiguity in the definition
  • Unable to identify monopolistic prices due to an inability to know counterfactual competitive prices
  • Unable to determine if monopolies are engaged in monopolist pricing or if they are pricing competitively due to the threat of competition
  • Unable to ensure their regulations will not stifle innovations which would help bring down current monopolies
  • Unable to fight monopoly without engaging in monopolistic practices themselves
  • Unlikely to have the best interest of the consumer in mind rather than the self-interest of the politician or bureaucrat
  • Seemingly uninterested in the possibility that there are benefits associated with other monopolies and unable to compare those benefits to costs

So while some may find it hard to stomach that we should trust the free market to deal with monopolies, I find the idea of trusting the government to successfully solve all of the above problems and implement the solution to be a far stranger proposition.

In free markets, the consumer is king. Entrepreneurs and innovators able to cater to consumers better than stagnant industry leaders will always earn the loyalty of those consumers. Under capitalism and the invisible hand of the market, no business is safe.

…Unless it is protected by the very visible hand of government laws.


  • Peter Jacobsen is a Writing Fellow at the Foundation for Economic Education.