All Commentary
Wednesday, December 6, 2017

Most People Have a Basic Misunderstanding of the Word “Monopoly”

A monopoly situation happens a few ways and can mean a few things, but it's pretty much never a problem unless the state is involved.

Numerous misunderstandings and mythologies surround the meaning of capitalism and competition, but few match the confusions over the meaning and relevance of “monopoly” in the workings of the market economy. When looked at dispassionately, factually, and historically, monopoly has almost always represented a problem in society only when created or protected by government intervention.

Critics of capitalism have proposed to nationalize “monopolistic” industries, to break them up into smaller “competitive” firms, or to regulate their pricing policies and influence the output they produce. A noticeable amount of the criticism of the existence of, or supposed “threats” from, monopoly is connected with the particular way economists have come to think about “competition” and “monopoly,” especially as found in a textbook.

The Fantasy World of “Perfect Competition”

The student is told that the benchmark of market analysis is the theory of “perfect competition,” a conception in which there are so many competitors on the supply-side of the market that each is too small to influence the prevailing market price for the good they are offering to buyers. Each seller, therefore, takes the market price as “given,” and they respond in terms of the optimal output to produce and offer on the market given their (marginal) costs of manufacturing.

All buyers and all sellers in each and every market have a “perfect” or “sufficient” knowledge of all relevant circumstances. In addition, in the world of “perfect competition,” there is no competitive product differentiation in the sense of the individual seller trying to devise new and improved versions of his product to get an edge on his rivals in the market in which he operates.

It is assumed that entry and exit from any market are effortless and costless, so any discovered profits to be earned or losses to be avoided due to, say, a change in market demand, is appropriately adjusted to virtually instantaneously, so those profits or losses are eliminated in seemingly non-existent time.

And what assures all of the above is the additional assumption that all buyers and all sellers in each and every market have a “perfect” or “sufficient” knowledge of all relevant circumstances and conditions that no errors or mistakes will be made by buyers paying too much or sellers accepting too little for what they are, respectively, demanding and supplying.

The Logical Absurdity of Perfect Knowledge in Perfect Competition

University of Chicago economist Frank H. Knight formalized this now-textbook conception of “perfection competition” in Risk, Uncertainty, and Profit (1921). But five years earlier, in 1916, Knight emphasized the fictitious and logical absurdities in:

. . . the impossible conditions of ideally perfect competition, where time and space were annihilated and universal omniscience prevailed . . .

It is the fact of omniscience [perfect knowledge], however, which is the prerequisite to perfect competition, and if this were realized in any other manner, no amount or kind of change would disturb the operation of ideal economic law [the optimal equilibrium of the ‘perfect competition’ market].

Once it is postulated that individuals in the marketplace possess “perfect knowledge,” then it is assured that the market will always be in a state of perfect long-run equilibrium because no other state of affairs can exist.

Nothing can ever be in the wrong place at the wrong time, and no good or service can ever be priced at the wrong price. Total “costs” always and everywhere equal total revenue. Profits can never be earned, and losses can never be suffered.

Since each individual wishes to “maximize” their subjective satisfaction (“utility”) or their profit, then having a perfect knowledge of all current and future circumstances, each can act in no other way than the “objectively” most “optimal” because to act otherwise would be contrary to the purpose of maximizing utility or profit.

The absurdity of the perfect knowledge assumption in the theory of perfect competition was especially highlighted by the Austrian economist Oskar Morgenstern in his 1935 article, “Perfect Foresight and Economic Equilibrium:”

Full foresight . . . must mean a foresight up to the end of the world . . .

In consequence of the interdependence of all economic processes and given conditions on one another, and this with all other facts, no instance could be given of a sector, however small, of the event, the foresight of which would not mean, at the same time, the foresight of all the rest . . .

The individual exercising foresight must thus not only know exactly the influence of his own transactions on prices but the influence of every other individual, and of his own future behavior on that of others, especially of those relevant for him personally . . .

The individuals would have to have a complete insight into theoretical economics, for how else would they be able to foresee action at a distance?

And as Austrian economist Friedrich A. Hayek explained in his famous articles “The Use of Knowledge in Society” (1945) and “The Meaning of Competition” (1946), such a theory assumes away all the reality of what we normally think of as competition: an active rivalry among sellers, each of whom has limited and imperfect knowledge and is attempting to discover ways and means to make new, better, and less expensive goods to offer to the consuming public. It is this active and dynamic real competitive market process operating with prices not already in equilibrium that tends to move markets into a coordinated balance between supply and demand, and in which, over time, profits may be competed away and losses eliminated.

The notion of “perfect competition” assumes the existence of the hypothetical “perfect” market equilibrium that it is the task of real-world dynamic competition to bring about. Actual market conditions are then judged by a standard, Hayek said, that almost by necessity condemns any real competitive situation at most moments in time as being “anti-competitive” and therefore potentially “monopolistic.”

The Textbook Portrayal of Monopoly

But what makes a market supplier’s actions “monopolistic” in the theoretical world of “perfect competition?” In essence, that he is able to influence the market price at which he sells his product and make his product different from that offered by any other seller. In the textbook expositions, the “monopoly seller” is able to select that higher price and lower quantity combination that maximizes his profit but which does not reflect the lower price and total larger quantity that would be offered on the market if there were a multitude of sellers.

The monopoly situation pictured in the diagram is presented without a context. The textbooks portray the monopolist’s situation and his ability to pick and choose the price-quantity combination in a supply and demand diagram. However, this monopoly situation as shown in the textbook diagram has neither a past nor a future. It is the “frozen picture” of a market situation that is “out of time.”  The diagram, by itself, does not answer the following questions:

What market or other forces in the “past” brought about this current situation? Given this situation, are there any market forces at work looking to “tomorrow” that would change the circumstances from its present “monopolistic” state? Are there any non-market — that is, any government — barriers that would prevent such a change over time?

In other words, the monopoly situation pictured in the diagram is presented without a context to reasonably analyze what conclusions might be made in terms of whether the “social” significance of this monopoly situation suggests the need for an economic policy to “correct” some “problem” with it.

Or whether, instead, when analyzed from a perspective of a market process in time and through time, there may be no “monopoly problem” at all but just one of the “transition” stages through which markets are passing all the time.

Reasons There May be a “Single Seller” in a Market

The word “monopoly” originates from the ancient Greek: “mono,” meaning single, and “poly,” meaning seller.  But there are a variety of reasons why there may be only one seller in a market at or over a given period of time. First of all, it may be because an entrepreneur has creatively developed a new or significantly different product, and as a result, he is the first and only supplier of this good on the market. After all, every new idea must begin in some individual’s mind and that person’s willingness to undertake the task of bringing it to market.

There may be a single seller because the consumer demand is too limited to make it profitable for more than one seller to operate in that market. To the extent that he has correctly anticipated future consumer demand for this new or different product, the very profits that he may earn will attract the competitors who will enter his market and, over time, compete away the profits he has been earning by their devising ways to make similar versions of his new idea with more attractive features and offered at lower prices than the “monopolist” initially was charging.

If, on the other hand, this single seller has misjudged future market demand for his product and suffers losses, it would not be socially desirable for rivals to enter his market and waste more time and resources producing a loss-making product – unless, of course, if they see a way to make profitable that which the initial “monopolist” could not.

Second, there may be a single seller because the consumer demand is too limited to make it profitable for more than one seller to operate in that market. Imagine the small, rural town with one general store. The owner may be making a profitable go of it, but if a rival entered the area and opened a competing general store, the sales and revenues now divided between the two of them may not be enough to cover their respective costs of operations. The market is too limited to sustain more than one seller.

Third, there may be a single seller in a market due to their ownership or control of a vital resource or raw material without which a product cannot be successfully produced. This was a hypothetical possibility pointed out by Austrian economists Ludwig von Mises and Israel M. Kirzner.

The Dynamic Workings of Free Market Competition

However, if we look beyond the situation at a moment in time, we can see countervailing market forces that likely will be set in motion if there are potential profits to be made from selling this resource-specific product.

First, this situation would create incentives to prospect for and extract any possible alternative supplies of this resource outside the control of the “monopolist,” so competitors could enter this market at some point in the future.

Second, if this is a profitable product, there would be incentives for competitors to market substitutes to his product out of alternative types of resources and offer their substitute products at lower prices than the monopolist’s. Thus, over time, competitive market forces would either eliminate or weaken even a “monopoly” position of this type.

The Austrian-born economist Joseph A. Schumpeter argued that the essence of the dynamic market economy is the innovative entrepreneurs who introduce the new, better products as well as new methods of production. To understand what Schumpeter called the competitive process of “creative destruction,” it is necessary to look beyond any seemingly “monopoly” situation at a moment in time and take the longer historical perspective of the market.

Textbook conceptions of “perfect competition” and “monopoly” are of little relevance or help, therefore, for understanding how markets actually work. As Schumpeter explained it in Capitalism, Socialism and Democracy (1942):

In dealing with capitalism we are dealing with an evolutionary process . . . that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism.

The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.

In capitalist reality as distinguished from its textbook picture . . . The kind of competition which counts . . . [is] the competition from the new commodity, the new technology, the new source of supply, the new type of organization . . . The competition that commands a decisive cost or quality advantage . . .

It is hardly necessary to point out that competition of the kind we now have in mind acts not only when in being but also when it is merely an ever-present threat. It disciplines before it attacks. The businessman feels himself to be in a competitive situation even if he is alone in his field.

Market Competition Is Best Understood as a Process Through Time

The market economy, to the extent that it has a noticeable degree of competitive freedom, is an arena of change, transformation, and creativity. But looking at the textbook diagram of a supposed monopoly situation easily misses all this by ignoring what preceded it or what may follow it.

Suppose you are shown a single frame of a motion picture, one that contains the image of a person hanging in midair just off the edge of a cliff. What conclusions are we to draw from this image? It all depends upon what preceded that frame and what follows it. Suppose that the person was cornered by an attacker who has thrown this unfortunate fellow off the cliff with the intention of killing him on the rocks below. But what if he saw his attacker coming, and this person chose to jump off the cliff to escape this aggressor, hoping to survive the fall by successfully landing in a river below and swimming to safety?

Only 59 enterprises were on the list in both these years — less than 15 percent. We do not know how to evaluate the situation captured in that single frame taken out of the motion picture. It all depends. And in the same way, we do not know how to evaluate a market situation of a single seller in the market unless we know the market processes before and after that diagram-depicted moment in time.

To show the relevance of taking this longer view of competitive and monopoly situations, we may draw upon an interesting article published on October 20, 2017, by economist Mark Perry on the website of the American Enterprise Institute. He compares the lists of Fortune 500 firms in 1955 with those six decades later in 2017.

Only 59 enterprises were on the list in both these years — less than 15 percent. Many of the companies on the 1955 Fortune 500 list were not only not on the 2017 list, but they no longer existed at all. Many of the companies on the list both of those years held different relative positions, with some higher and others lower in 2017 than in 1955. And a good number of companies on the 2017 list had not even existed sixty years earlier and therefore could not have been on the 1955 list.

Government Intervention as the Cause of Monopoly Problems

What, then, may be the cause behind a “monopoly” that may be considered as “anti-competitive” and “socially harmful?” This requires us to appreciate the role of the state in creating and perpetuating such a situation.

There may be a single seller in a market (or a small number of sellers) because of a legal privilege given by the government to be the only producer and/or seller of a good or service within a part or the whole of the geographical area over which the government has political authority. This is one of the oldest meanings of monopoly frequently used by economists since Adam Smith published The Wealth of Nations (1776).

In modern American history, it was the government that legally provided a monopoly position to AT&T. In this case, the privileged monopolist may be in the position to limit supply and raise his price because he is protected from any direct market competition since the government has made it illegal for all others to compete in this market. This is the one case in which the “frozen picture” of the textbook monopoly diagram is most appropriate because market competition cannot change the “picture.” The government prevents any market process working over time from generating the competition that would likely emerge in a more open market.

However, it would be expected that potential competitors might still try to develop and offer various substitutes for the government-protected monopoly product to the extent they could do so without breaking the law. Also, it might still occur that illegal “black markets” might emerge if profits were sufficiently high to make it attractive to run the risk of being caught and imprisoned by the government.

In modern American history, it was the government that legally provided a monopoly position to AT&T in the provision of telephone services around the United States through most of the Twentieth Century. It was government regulation that limited market entry and controlled pricing and routes to a handful of passenger airline carriers from the mid-1930s to the end of the 1970s. It was government control of the airwaves that restricted radio and television broadcasting to a limited number of companies, again, until the late 1970s.

But once these government-created-and-protected monopoly or near-monopoly situations were abolished through legislative repeal, the markets for communication, travel, and information and entertainment exploded into the vibrant and diverse array of far more competitive providers and suppliers and offerings that we now happily take for granted.

Taking the market process long-view, the appearance of single sellers and seemingly “monopoly” or near-monopoly situations is easily shown to be limited moments in the wider horizon of dynamic and creative competition over time. As long as government secures and protects private property rights, enforces all contracts entered into voluntarily and through mutual agreement, and assures law and order under an impartial rule of law, “monopoly” as an economic or social problem is virtually non-existent. But introduce government intervention into the market system, and monopoly invariably becomes a social harm and an economic problem.  

  • Richard M. Ebeling is BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel in Charleston, South Carolina. He was president of the Foundation for Economic Education (FEE) from 2003 to 2008.