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Wednesday, July 13, 2016

The Costs of Monopoly: A New View

James Schmitz:

The Costs of Monopoly: A New View, The Region, FRB Minneapolis: Economists overwhelmingly agree that the actual costs of monopoly are small, even trivial. This consensus is based on a theory that assumes monopolies are well-run businesses that limit their output in order to drive up prices and maximize profit. And because empirical studies have found that monopolists do not restrict output or raise prices by very much, most economists have concluded that monopolies inflict relatively little harm on the economy.
In this essay, I review recent research that upends both the theoretical and empirical elements of this consensus view.2 This research shows that monopolies are not well-run businesses, but instead are deeply inefficient. Monopolies do drive up prices, as conventional theory suggests, but because they also reduce productivity, they often ultimately destroy most of an industry’s profits. These productivity losses are a dead-weight loss for the economy, and far from trivial.
The new research also shows that monopolists typically increase prices by using political machinery to limit the output of competing products—usually by blocking low-cost substitutes. By limiting supply of these competing products, the monopolist drives up demand for its own. Thus, in contrast to conventional theory, the monopolist actually produces more of its own product than it would in a competitive market, not less. But because production of the substitutes is restricted, total output falls.
The reduction in productivity exacts a toll on all of society. But the blocking of low-cost substitutes particularly harms the poor, who might not be able to afford the monopolist’s product. Thus, monopolies drive the poor out of many markets.
In this essay, I first review the standard theory of monopoly that contends it inflicts little harm, and then I introduce a new theory that refutes that view. In this new theory, groups within monopolies act as both adversaries that reduce productivity and allies that eliminate substitutes. The new theory thus demonstrates that monopolies in fact cause substantial economic harm, and that harm falls disproportionately on people with fewer financial resources.
I then provide several historical examples of monopolies from my own research and that of others. I’ll discuss monopoly subgroups in their role as adversaries in the sugar, cement and construction industries. I’ll discuss monopoly subgroups acting as allies in the dental and legal industries. But I want to emphasize that in all monopolies, subgroups engage in both roles. I’ll also take a fresh look at a familiar example of a monopoly, U.S. Steel, showing how subgroups acted as both adversaries and allies. These few examples are illustrative only and provide a narrow glimpse of a far broader economic phenomenon: Monopolies are prevalent in the U.S. (and international) economy. ...

Skipping forward to the summary and conclusion:

For decades, the theoretical understanding and empirical analysis of monopoly have themselves been monopolized by a dominant paradigm—that the costs of monopoly are trivial. This blindness to new theory and analysis has impeded economists’ understanding of the actual harm caused by monopoly. Rather than inflicting little actual damage, adversarial relationships within monopolies have significantly reduced productivity and economic welfare. And in many industries, subgroups within monopolies collaborate to eliminate competition from low-cost substitutes. This lack of competition in the marketplace has a disproportionate impact on poor citizens who might otherwise find low-cost services that would meet their needs.
I’ve described this as a “new” theory, but in truth its roots go back decades, to the ideas of Thurman Arnold. Arnold ran the Antitrust Division at the Department of Justice from 1938 to 1943, taking aim at a broad range of targets, from automakers to Hollywood movie producers to the American Medical Association.10 He argued that lack of competition reduced productivity and that monopolies crushed low-cost substitutes, hurting the poor. Arnold supported his arguments through intensive real-world research. He and his staff undertook detailed investigations of monopolies, examining the on-site operations of many industries and documenting the productivity losses and destruction of substitutes caused by monopoly.
Arnold began his work at a pivotal time—in the midst of the Great Depression, just after the United States had experimented with the cartelization of its economy. Faith in competitive markets had reached such a low that cartels and monopolies were thought to be, perhaps, better alternatives. His work and ideas played a big role in reinvigorating confidence in competitive markets. He mounted an aggressive campaign to protect society from monopoly. The campaign had two parts: forceful prosecution of monopoly through the courts, accompanied by an array of speeches and articles to educate the general public about its costs.
Economists gradually forgot Arnold and his ideas, convinced by Harberger’s empirical work and the introspection of economists, leading to, for example, the logic provided by Stigler and others. Scholars and regulators who studied monopolies focused on prices alone and found little to worry about.
But as shown by the research reviewed in this essay—and an expanding body of empirical work—the problems caused by monopoly are significant, and still pervasive. My hope is that this paper will open a new era of discussion about monopoly and its costs, and ultimately lead policymakers to encourage greater competition for the benefit of all.

    Posted by on Wednesday, July 13, 2016 at 12:24 AM in Economics, Market Failure | Permalink  Comments (44)


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