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Competition and monopoly

April 1, 2022

Dr. Michael Makovi teaches economics at Northwood University.

Best way to support competition is often to get the government out of the way

It is generally acknowledged — at least by those with a basic familiarity with economic theory — that markets will usually function well when there is sufficient competition. If one firm tries to profit by charging a price that is far above the cost of production, competing firms will seek to undercut them by charging a price that is slightly lower, but still above the cost of production — and is therefore still profitable. These profits will continue to attract entry until the price is bid down near the cost of production, eliminating profits.

In a competitive market, profits tend to be temporary. A firm may earn profits when unexpected increases in consumer demand allow them to charge higher prices. Or a firm may earn profits when it successfully innovates with a new product that offers higher quality and/or a lower price than competing products. But these profits will be temporary. When increased consumer demand leads to higher prices and profits, these profits attract entry, increasing supply until the price falls, eliminating the profits.

Similarly, innovation encourages imitation. For example, Apple may have earned profits when it introduced the original iPhone, the first smartphone with a multi-touch touchscreen. But similar Android phones soon followed. Apple could continue to maintain profitability only by successively introducing improved iPhones with new features. In competitive markets, success requires repeated innovation, and those who attempt to rest on their laurels will soon be surpassed and threatened with bankruptcy.

Firms can earn profits due to unexpected reduction in supply

A firm may even earn profits due to an unexpected reduction in supply. Some commentators have expressed astonishment at record profits during COVID-related supply chain problems, but there is really nothing surprising about this. The goal of every monopolist is to increase profits by restricting output, as long as the percent reduction in output is smaller than the percent increase in price. For example, a monopoly will seek to reduce output by 1% as long as this increases the price by more than 1%. But in a competitive market, this strategy will usually fail. If one firm reduces its output by 1%, then all other firms collectively will increase their output, increasing their market share at the expense of the firm that reduced its output. In the end, the restrictionist firm will have reduced its own sales volume without successfully increasing the revenue per sale. However, when there are unexpected supply chain problems, all firms collectively are required to behave as if they were a cartel which had unanimously agreed to jointly restrict their output.

For example, the current chip shortage effectively forces all automobile manufacturers to behave as if they had created a restrictionist cartel. So it is not at all surprising to find excess profits during a negative supply shock. However, even these profits will be temporary. Each individual automobile manufacturer has an incentive to increase their output faster and sooner than their competitors. Although automobile manufacturers will all profit from the crisis which compels them to restrict output, those manufacturers who successfully circumvent the crisis by maintaining their output despite the crisis will profit the most. This is similar to the fact that even within a restrictionist cartel, it is in the interest of each cartel member to defect by violating the cartel agreement, maintaining maximum output and sales while all their competitors adhere to the cartel agreement by restricting output.

Excess profits create incentive to increase output

In the long run, the excess profits enabled by the negative supply shock will encourage every manufacturer to find new sources of supply until output, prices, and profits all return to normal. In fact, these excess profits can even be socially beneficial because they create an incentive to increase output. If excess profits were taxed during a negative supply shock, then firms might be indifferent between lower and higher levels of output, and they might have no incentive to alleviate the shock. Any firm which profited by maintaining output during the shock better than its competitors would find their excess profits taxed away, leaving them no better off than if they had done nothing. The excess profits created by the negative supply shock are themselves an incentive to alleviate the shock and benefit consumers.

Therefore, it is generally acknowledged — at least by mainstream economists — that free markets will usually create positive social benefits as long as there is competition. The major question is what to do when competition is lacking. In such a situation, critics often advocate regulatory intervention, especially antitrust law enforcement in order to promote competition. Non-competitive firms may be broken up into a smaller number of firms, and mergers may be prohibited whenever they would reduce the number of competing firms. Meanwhile, firms in non-competitive markets may be prohibited from charging monopolistic prices, thereby compelling them to behave as if they faced competition.

Antitrust laws, regulations have severe shortcomings

However, antitrust laws and similar regulations suffer from a number of severe shortcomings. In the first place, it is often difficult if not impossible for any firm to know whether they are violating the law. There is no guaranteed, objective way to determine precisely how a firm would behave if it were behaving competitively. In fact, if it were possible to determine in advance how a competitive firm ought to behave, then one of the chief challenges of central planning under socialism would have been solved. One of the reasons why socialism always fails is what is known as the problem of economic calculation: it is impossible for any central planner to scientifically determine the optimal prices of goods without free competition. Therefore, as Nina W. Cornell and Douglas W. Webbink have observed, “The requirements on an economic regulatory agency that tries to do its job properly according to traditional public utility regulatory concepts are not very different from the requirements on a central planning agency in a socialist or communist country.”

But if the antitrust authorities cannot unambiguously and objectively define competitive behavior, then it is impossible to lay down unambiguous, objective regulations. Therefore, no business firm can ever be entirely sure what will be considered legal or illegal by the antitrust authorities.

In his book, The Antitrust Religion, Edwin S. Rockefeller argues that antitrust law therefore violates the due process of law, under which all violations of the law must be recognizable as such in advance. A business faces the risk that it may unknowingly violate the law no matter what they do. This dilemma is reflected by a joke often told by economists: “Three businessmen met in prison. ‘What are you here for?’, they each asked one another. ‘I was charged with predatory pricing because I charged lower prices than my competitors,’ said the first. The second replied, ‘I was charged with price-gouging because I charged higher prices than my competitors.” Finally, the third exclaimed, ‘I was charged with collusion because I charged exactly the same prices as my competitors.’”

In fact, antitrust enforcement can often have perverse consequences which are the opposite of what is intended. In his book, Is Government the Source of Monopoly? and Other Essays, Yale Brozen observes incidents in which the Federal Trade Commission (FTC) sued companies who gained market share by cutting their costs and expanding output. The FTC viewed this increased market share as evidence of anti-competitive behavior, and instructed these firms to raise their prices and reduce their output. But raising prices and reducing output is precisely what monopolies do! In an effort to curtail monopoly, the FTC actually promoted monopolistic behavior.

Furthermore, the anti-competitive consequences of antitrust law are sometimes quite intentional. Business firms who are unable to successfully compete against their superior rivals will sometimes claim that their competitors are violating antitrust law. In effect, unsuccessful businesses may hire the Federal Trade Commission (FTC) and the Department of Justice (DOJ) to act as their mafia enforcers to bust the kneecaps of any companies who succeed in a competitive market. Antitrust law can become the source of the very anti-competitiveness that it is meant to prevent. Nor is this perverse use of antitrust law anything new. Ida Tarbell, author of The History of the Standard Oil Company in 1904, was the sister of the treasurer of the Pure Oil Company, which could not successfully compete with Standard Oil’s low prices. And why were Standard Oil’s prices so low? Because Standard Oil had innovated a variety of new production methods which allowed it to refine oil at lower cost, and even to transform what had previously been waste and refuse into valuable products. In effect, Standard Oil was accused of anti-competitive behavior by its inferior rivals who could not successfully match its innovative methods.

Government regulation a primary source of monopoly power

Indeed, government regulation is itself one of the primary — if not the primary — sources of monopoly power. In a process economists call “rent-seeking,” business firms will often lobby for regulations that impose costs on their rivals, especially by raising barriers to entry. Historian Gabriel Kolko documented this phenomenon in his book, The Triumph of Conservatism: A Reinterpretation of American History, 1900-1916 putting forth “[a] radically new interpretation of the Progressive Era which argues that business leaders, and not the reformers, inspired the era’s legislation regulating business.” Sometimes, in a dynamic known as “bootleggers and baptists,” businesses will “bootleg” by taking advantage of lobbying by so-called “baptists.” For example, Gabriel Kolko’s book Railroads and Regulation, 1877-1916 shows that railroad companies took advantage of the popular demand for progressive antitrust regulation by lobbying for laws that restricted railroads’ abilities to charge different prices and to open or close new routes. By empowering the Interstate Commerce Commission (ICC) to regulate routes and rates, the railroads encouraged the federal government to as a cartel with the power to prevent one railroad from competing with another by undercutting its rates or offering expanded routes.

Economics Nobel laureate George Stigler concluded that “Even today, most important enduring monopolies or near monopolies in the United States rest on government policies. The government’s support is responsible for fixing agricultural prices above competitive levels, for the exclusive ownership of cable television operating systems in most markets, for the exclusive franchises of public utilities and radio and TV channels, for the single postal service — the list goes on and on. Monopolies that exist independent of government support are likely to be due to smallness of markets (the only druggist in town) or to rest on temporary leadership in innovation (the Aluminum Company of America until World War II).”

And indeed, the list does go on and on. Until the advent of Uber and Lyft, many local governments restricted competition in the taxicab industry by requiring all taxicab drivers to possess a medallion, whose supply was restricted, artificially restricting competition and raising the price of a taxi ride. In 1935, facing new competition from the trucking industry, the railroad industry successfully lobbied to pass the Motor Carrier Act, which subjected the trucking industry to the same regulation by the Interstate Commerce Commission as the railroads were already subject to. If an individual or company intended to establish new trucking routes or compete with existing routes, they had to obtain a “certificate of public convenience and necessity,” which the ICC often denied. Moreover, any company could protest another company’s rates through the ICC. This anti-competitive regulation was not repealed until the Motor Carrier Act of 1980, signed by Jimmy Carter. Similarly, the Civil Aeronautics Board (CAB) — formed by the Civil Aeronautics Authority Act of 1938 — cartelized the airline industry by preventing airlines from cutting their rates or expanding their routes without permission. Airline flights used to be a luxury affair because economy flights were illegal. It was not until the signing of the Airline Deregulation Act of 1978 — again, by Jimmy Carter — that market competition in airline flights became permissible. Today, we see airlines often charging extra for legroom, baggage, and even overhead bins because deregulation has created an environment in which every airline competes vigorously to cut prices for any passenger who is extremely price-sensitive. Of course, those passengers who prefer luxury accommodations are still free to purchase first class tickets, but now, those who prefer to save money are given that option as well.

‘Certificate of need’ is blatant form of anti-competitive government regulation

One of the most blatant forms of anti-competitive government regulation today is the so-called “certificate of need,” aptly referred to by its acronym, “CON.” Originally promoted by the federal government via the National Health Planning and Resources Development Act of 1974, a certificate of need law is a state-level regulation that prohibits any entrepreneur from offering certain healthcare services unless a state or local government health board determines that those services are “needed.” But government health boards are usually staffed by industry insiders who are loathe to certify that their industry needs more competition. Thus, certificate of need laws exist to create government-enforced healthcare cartels which restrict the availability of healthcare and increase its cost.

Rules crafted by industry insiders who are meant to be regulated

The fact is, regulations will often be written and enforced by the very industry insiders who are meant to be regulated. After all, who else knows enough about that industry to write sensible regulations and enforce them? The theory of “regulatory capture” therefore predicts that regulations will be written and enforced with the purpose and intention of benefiting the very industries being regulated. We recently witnessed an unusually transparent case of this dynamic in the Facebook hearings in Congress. Sen. Lindsey Graham asked Mark Zuckerberg whether he supported regulation. Zuckerberg replied affirmatively, as long as the regulations were reasonable. Graham responded, “So would you work with us in terms of what regulations you think are necessary in your industry? . . . Would you submit to us some proposed regulations?” To which Zuckerberg replied, “Yes. And I’ll have my team follow up with you.” Jeffrey Tucker observes, “Do you see what has happened here? We have a transcript from the Senate that Facebook will be the consulting author of the regulations. How does that strike you? Conflict of interest? Welcome to regulatory politics. The large-scale stakeholders are always and everywhere involved in crafting regulations, and they do so in a way that benefits them, precisely as one might expect.”

Greatest guarantor of market competition is freedom of entry

The greatest guarantor of market competition is freedom of entry. As long as entrepreneurs are legally free to compete in any industry with above-normal profits, we will tend to obtain competitive outcomes in the long run. William J. Baumol observed that often, it is not even necessary for there to be more than one firm in any industry as long as the industry is “contestable.” As long as it is possible for competitors to enter the industry, incumbents will behave as if they face competition. Even if antitrust regulation weren’t harmful, it would frequently be superfluous. As Joseph Schumpeter observed, “[C]ompetition . . . 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 or if, though not alone, he holds a position such that investigating government experts fail to see any effective competition between him and any other firms . . . In many cases, though not in all, this will in the long run enforce behavior very similar to the perfectly competitive pattern.” In short, the best way to support competition is often to get the government out of the way.

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