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Thursday, April 26, 2012

Mergers Harm Competition?

The New York Yankees have appeared in over one-third of all World Series since 1903. Does the presence of such a dominant player mean that professional baseball is not competitive? Many pundits would have to say yes, if they applied to sports the same logic they apply to business. For instance, the Washington Post’s Steven Pearlstein complained recently about the state of competition in the prescription drug industry (“End of the ‘Anything Goes’ Era of Antitrust?”). Pearlstein laments the “$29 billion merger between Express Scripts and Medco, two of the biggest pharmacy benefit managers—the companies that handle the prescription drug portion of your health insurance.” Pearlstein wants the Federal Trade Commission to block this merger to maintain competition and protect consumers in this market.

Pearlstein paints an eerie picture of insurance industry consolidation, but he doesn’t provide much evidence of the troubles he suspects this merger will bring. He alludes to “inferior and less-convenient service for customers” as a looming consequence of mergers but never bothers to explain exactly why we should expect such results. One gets the impression that Pearlstein is merely opposed to bigness in business, regardless of its causes or consequences.

If folks like Pearlstein are so concerned about anticompetitive behavior, they should steady their gaze on the halls of Congress. Significant barriers to market-based competition routinely arise from political shenanigans, not the market process itself. Since Adam Smith, savvy economists have recognized that businessmen tend to seek shelter from the stresses and insecurity of vigorous competition in the market by turning to the political process. In acts of what we might call political competition, entrepreneurs who aren’t willing to risk the uncertainty of a wide-open market will frequently use the law to ensure themselves a favorable outcome. Recent experience is rife with examples: subsidies, bailouts, tariffs, and labyrinthine new regulations, the true purpose of which, despite the populist labeling, is to prop up well-connected enterprises that could not stand on their own in the harsh arena of market competition. Blocking mergers is a poor substitute for abolishing those interventions.

Even though Pearlstein has every right to be offended by mergers, he has no warrant to label them as anticompetitive. Pearlstein’s presumptions about the proper size and number of companies in this industry reveal a deeply flawed and incomplete understanding of competition. Competition in a free market is a process, not a result, and the occurrence of mergers within an industry indicates that competition is alive and well. In other words, mergers are competitive, as is every business decision of every entrepreneur in the world, whether Pearlstein approves or not. Competitive entrepreneurial activity, in all its forms, is the driving force of the market economy. Entrepreneurs can only be “anticompetitive” by stepping outside of the market economy and entering the coercive realm of politics—as they often do.

Pundits like Pearlstein apparently rely on an outmoded and unrealistic “perfect competition” model, in which a competitive market is defined strictly in terms of a large number of sellers, each with relatively small market share. In this view, a small number of dominant companies in any industry is ipso facto evidence of inefficient, noncompetitive conditions.

In genuinely free markets, however, competition is not a numbers game. As the Austrian school economist Israel Kirzner explains in his book Competition and Entrepreneurship, competition is a rivalrous process in which any number of current enterprises (under pressure from potential competitors) attempt to outdo each other in providing the greatest value of goods and services at the lowest cost. In the Austrian view the actions of entrepreneurs, in the absence of legal barriers to entry, make markets competitive as they constantly seek to create or discover new and better products and methods of production. An effective competitor—one who is good at generating valuable innovations—will naturally gain market share.

Such a competitor might dominate the market, in the sense that other competitors can’t match the value it offers customers. In some cases a dominant enterprise might gain a substantial market share by buying up its competitors or simply outpacing them. Such results might outwardly look like monopoly—one dominant producer—but this doesn’t change the fact that this dominance is the result of competition, not evidence that it is lacking. Pearlsteinian logic focuses on the outward appearance, all the while ignoring the crucial process of action and reaction where true competition takes place.

This brings us to the claim that Pearlstein can’t prove: the assertion that “thuggish and unfair” competition, in the form of the Express Scripts-Medco merger, is somehow bad for customers. Pearlstein admits that the merger will “generate operating efficiencies,” but he remains convinced that none of the cost savings will be passed on to consumers. But it’s not consumers who are up in arms about the merger; as Pearlstein admits, the loudest complaints are coming from the small pharmacies, who can’t match the scale-economy efficiencies or negotiating clout the larger company will possess.

Economic history is full of examples like this, where supremely competitive dominant enterprises draw harsh critiques of “unfair competition” from smaller rivals. An apt case study is that of Standard Oil. As Burton Folsom documents in The Myth of the Robber Barons, John D. Rockefeller’s company rose to dominance in the kerosene market in the late 1800s, for a time controlling 90 percent of U.S. refining capacity and two-thirds of world sales. And while Rockefeller was famous for buying up his competitors, the results were nothing but positive for consumers. His awesome efficiencies relentlessly drove prices down while maintaining impeccable quality and customer service. Many other firms fit a similar mold.

It is easy to focus on numbers and become alarmed when a market share threshold is crossed. But it is foolish. We should rather focus on the competitive conditions in a market: Can entrepreneurs who have the capital, the knowledge, and the vision to offer a better product at a better price freely step into markets where they see opportunities? This is the defining criterion of competition in a free economy, and it is only violated when some entrepreneurs can use political tools to prevent or protect themselves from the competitive actions of their rivals.

Competition is a crucial and desirable element of a free-market economy, but we must bear in mind that competition is a continuing process and its results are unpredictable. Therefore when assessing competition we must focus on whether a system allows for competitive actions. This means, primarily, an environment that is open to the entry of any potential entrepreneur and in which the law gives no special favors nor special hindrances to specific groups of people. With competition the devil is in these institutional details.

  • Tyler Watts is an assistant professor of economics at East Texas Baptist University.