Chapter 10. Monopoly And Competition

Chapter Summary

Consumer preferences ultimately drive a market economy; many have termed this outcome as “consumers’ sovereignty.” Yet this is an inappropriate political metaphor; on a free market, individuals have complete control over their bodies and other property.

Cartels allegedly restrict output below the socially optimum level. But consider the “worst case” where a cartel destroys some of its product. Even here, the true “waste” is not the destroyed product, but rather the scarce resources that went into the production of the excess units; once the cartel produces the profit-maximizing amount in the future, these resources will be channeled elsewhere. Moreover, the formation of a cartel in the first place is quite similar to the founding of a corporation or a merger, yet many view only the cartel as inefficient.

In a free market, firms will tend to be the optimum size. Lower unit costs of large-scale production will tend to increase firm size, but the overhead costs of bureaucracy eventually check this trend. The ultimate limit is the chaos that would ensue if a firm eliminated the market prices for its inputs and products. Voluntary cartels formed for the purpose of restricting output and raising prices are inherently unstable. There will always be an incentive to cheat on the cartel agreement and produce more than the assigned quota. Even if the members of the cartel can reach an agreement and obey it, if they are truly earning “above normal” returns, outsiders will enter the industry.

A monopoly may be defined as (1) a single seller of a good or service, (2) the recipient of a government privilege, or (3) a business unit that can achieve monopoly prices. The first definition is vacuous; everyone is a monopolist in this sense. The second definition is legitimate, and focuses on government intervention that hampers welfare. The third definition is empty once we realize there is no such thing as “monopoly price.” Simply put, there is no such thing as a “monopoly price” to which we can contrast a “competitive price”; there is no way we can even in principle define these concepts. All we can discuss is the unhampered price that would emerge on a free market.

Although a union presents a coherent example of restriction of output and the achievement of higher prices, this is not an example of monopoly; the privileged workers gain at the expense of nonunion members. A typical argument for unions is that the marginal productivity determination of wage rates, in practice, leads not to a unique value but rather a zone of possible wage rates. The problem with such a justification is that such zones of indeterminacy shrink as more and more people enter the market. Moreover, in practice unions often rely on the actual use (or at least threat) of violence to achieve such “bargains” with management.

The crucial characteristic of a “perfectly competitive” industry is that each firm perceives the demand for its product as a horizontal line. Yet this is clearly absurd; even in theory, all demand curves must be downward sloping. The claims of “excess capacity” in monopolistically competitive industries defy rationality and ultimately rely on geometrical tricks: Once we drop the assumption of smooth cost curves, the argument falls apart.

Chapter Outline

1. The Concept of Consumers’ Sovereignty

A. Consumers’ Sovereignty versus Individual Sovereignty

Consumer preferences ultimately drive a market economy; many have termed this outcome as “consumers’ sovereignty.” Yet this is an inappropriate political metaphor; on a free market, individuals have complete control over their bodies and other property. Consumers can’t force producers to make certain goos; they can merely try to influence producers (to the extent that they seek monetary returns) by their spending decisions.

B. Professor Hutt and Consumers’ Sovereignty

Hutt’s treatment is the most comprehensive and yet is riddled with problems. Consumers truly exercise “sovereignty” over production only if we treat certain decisions by producers (when they pass up higher revenues in order to achieve psychic satisfaction) as implicit acts of consumption. In this formal sense, then, “consumption” always rules production decisions—but this isn’t a useful way to approach the exchange relations on a market. In any event, Hutt inconsistently drops the tautologous approach and then holds up consumers’ sovereignty, not as a necessary condition, but rather as an ideal benchmark against which to compare the actual economy.

2. Cartels and Their Consequences

A. Cartels and “Monopoly Price”

The alleged evil of a cartel is that it restricts output and thus hampers the achievement of consumers’ sovereignty. But consider the “worst case” scenario of a cartel that actually destroys product in order to increase its profit. Clearly the excess production was a mistake that will tend not to be repeated; even a cartel would rather produce the amount it intended to sell, rather than overproduce and then destroy the excess. The true “waste” then is not the destroyed product, but rather the scarce resources that went into the production of the excess units; once the cartel produces the profit-maximizing amount in the future, these resources will be channeled elsewhere.

B. Cartels, Mergers, and Corporations

Those who criticize cartels generally do not view mergers, let alone the formation of a corporation, as sinister or inefficient; but what is the essential difference between these events and the formation of a (voluntary) cartel?

C. Economics, Technology, and the Size of the Firm

In a free market, firms will tend to be the optimum (from the consumers’ point of view) size. On the one hand, lower unit costs of large-scale production will tend to increase firm size, but on the other, the overhead costs of bureaucracy eventually check this trend. The ultimate limit is the chaos that would ensue if a firm eliminated the market prices for its inputs and products.

D. The Instability of the Cartel

Voluntary cartels (i.e., those not supported by government restriction) formed for the purpose of restricting output and raising prices are inherently unstable. First, there will always be an incentive to cheat on the cartel agreement and produce more than the assigned quota. Second, the more efficient members will demand larger and larger quotas over time; why should they restrict their own output in order to benefit inefficient competitors? Third, even if the members of the cartel can reach an agreement and obey it, if they are truly earning “above normal” returns, outsiders will enter the industry.

E. Free Competition and Cartels

Some critics allege that cartels restrict the “freedom” of the consumer by eliminating choices. But this argument confuses freedom with power (of choice). Another argument is that certain industries have such high startup costs that this “entry barrier” allows for long-run profits. But no individual needs to come up with $20 million to enter the automobile industry; a large number of individuals can pool their assets by forming a corporation.

F. The Problem of One Big Cartel

The fear of a giant cartel overlooks the calculation problem. Moreover, why hasn’t a giant cartel emerged on the (relatively) free market already?

3. The Illusion of Monopoly Price

A. Definitions of Monopoly

A monopoly may be defined as (1) a single seller of a good or service, (2) the recipient of a government privilege, or (3) a business unit that can achieve monopoly prices. The first definition is vacuous; everyone is a monopolist in this sense. The second definition is legitimate, and focuses on government intervention that hampers welfare. The third definition is empty once we realize there is no such thing as “monopoly price.”

B. The Neoclassical Theory of Monopoly Price

The neoclassical theory of monopoly assumes that there is some identifiable “competitive” price and level of output with which to contrast the “monopolistic” price and output.

C. Consequences of Monopoly-Price Theory

Even if neoclassical monopoly theory were valid, the standard, sinister conclusions would not necessarily follow. Such monopolists would still be subject to the consumers’ voluntary spending decisions, and there would be no lasting monopoly “profits,” but rather monopoly gains imputed to certain factors of production.

D. The Illusion of Monopoly Price on the Unhampered Market

Simply put, there is no such thing as a “monopoly price” to which we can contrast a “competitive price”; there is no way we can even in principle define these concepts. All we can discuss is the unhampered price that would emerge on a free market.

E. Some Problems in the Theory of the Illusion of Monopoly Price

Certain “obvious” cases—such as so-called location and natural monopolies—may make the preceding section’s arguments appear incredible. Yet even in these cases, a careful analysis shows that either there are monopolies everywhere (in which case the concept is vacuous), or there are no monopolies (in which case it is irrelevant). Only when the government grants a privilege backed up by force is the concept of monopoly significant.

4. Labor Unions

A. Restrictionist Pricing of Labor

Although a union presents a coherent example of restriction of output and the achievement of higher prices, this is not an example of monopoly; the privileged workers gain at the expense of nonunion members.

B. Some Arguments for Unions: A Critique

A typical argument for unions is that the marginal productivity determination of wage rates, in practice, leads not to a unique value but rather a zone of possible wage rates. In this view, the union’s function is to use its collective bargaining power to achieve a wage rate on the high end of the zone of mutually advantageous wages. The problem with such a justification is that such zones of indeterminacy shrink as more and more people enter the market. Moreover, in practice unions often rely on the actual use (or at least threat) of violence to achieve such “bargains” with management.

5. The Theory of Monopolistic or Imperfect Competition

A. Monopolistic Competitive Price

The crucial characteristic of a “perfectly competitive” industry is that each firm perceives the demand for its product as a horizontal (i.e., perfectly elastic) line. Yet this is clearly absurd; even in theory, all demand curves must be downward sloping (though they may possess vertical drops). Another alleged difference is that perfectly competitive firms may disregard the response of their competitors to their own pricing and output decisions, whereas an oligopolist cannot. But this too is spurious: The demand curve, by definition, relates hypothetical prices to the quantities consumers will purchase. If lowering the price causes rivals to react in a certain way, the demand curve already contains this information.

B. The Paradox of Excess Capacity

Because of low entry barriers, in the long run there is zero economic profit in a monopolistically competitive industry; at the equilibrium output level, each firm’s price is just equal to average total cost. But because demand curves are downward sloping, by simple geometry this implies that each firm will set output at a level below that which minimizes ATC. Apparently, then, monopolistic competition leads to aggregate inefficiencies in production.

Yet this theory makes no sense. Why would firms deliberately construct factories that operate at lowest cost above the long-run planned level of output? The basic trick of the neoclassical argument relies on geometry, not economics. If we drop the assumption of smooth cost curves, it is no problem reconciling a downward sloping demand curve with operation at minimum ATC.

C. Chamberlin and Selling Cost

There is no important distinction between production and selling costs. Advertising does not “create” consumer demands for products that people don’t really “need.” On a free market, consumers are free to spend their money however they wish.

6. Multiform Prices and Monopoly

Once we take into account transactions costs, it is possible for multiple prices to exist even for “the same” good. However, this is not an infringement on consumers’ sovereignty; some consumers would rather risk paying higher prices in exchange for not spending time researching all relevant sellers.

7. Patents and Copyrights

On a free market, there would be no analogue to the patent; someone who independently discovers a technological recipe would be free to begin using it immediately. However, there would be copyrights, in the sense that it would be illegal to fraudulently impersonate another individual when selling a good or service.

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Notable Contributions

• Rothbard’s critique of the concept of consumers’ sovereignty is quite pioneering. Even Mises adopted the term (though Rothbard would view his treatment as more satisfactory than Hutt’s).

• His defense of cartels and his critique of the theory of monopoly price are some of Rothbard’s finest contributions to economics.

• Rothbard’s distinction between patents and copyrights was also quite revolutionary, although recent work (e.g., Stephan Kinsella’s) has questioned even the defense of copyright.

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Technical Matters

1. In his critique of the fear of monopoly, Rothbard says that consumers “benefit from the resulting voluntary exchanges” (p. 634), and that “if the resulting exchanges really hurt them, consumers would boycott the ‘monopolistic’ firm” (p. 635). He also points out that the motives of alleged monopolists are no different from the motives of any other producer. Although true, these particular responses would not satisfy a mainstream economist. The claim is not that consumers would be better off with no producer at all (rather than a monopolist), but rather that monopoly is bad compared to the case of a perfectly competitive market. Moreover, the standard mainstream economist does not attribute sinister motives to the monopolist; he concedes that the perfectly competitive firm seeks to maximize profits just as the monopolist does. The alleged difference, however, is that the market structure in the case of competition leads the selfish producers to set output at the “optimal” level, i.e., where P=MC, whereas the monopolist (because of a falling demand curve) sets output where P>MC. (Of course Rothbard later deals with these arguments.)
2. Almost all of mainstream industrial organization theory relies on the assumption of a single price for all units. But as Rothbard points out (p. 641), the alleged “deadweight loss” of producing where P>MC could always be avoided if the firms with market power were able to cut side deals with consumers and sell additional units at lower prices. Organizations such as Sam’s Club, which charges a flat membership fee and then charges very low unit prices, show that this type of arrangement is not a mere theoretical curiosity.
3. On page 660 and pp. 689–90, Rothbard argues that demand is always elastic above the free market price. However, a mainstream economist would respond that Rothbard is conflating the market demand curve with the individual firm’s “perceived” demand curve; the market demand for wheat may be inelastic at the “competitive” price, even though individual wheat farmers perceive perfectly elastic demand curves. (Of course Rothbard criticizes such a view elsewhere in the chapter.)

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Study Questions

1. How are anticartelists proposing a caste system? (pp. 640–41)
2. In what sense could Tiger Woods be considered a monopolist?
3. In New York City, cab drivers must obtain a medallion from the government in order to legally operate. Does such a restriction allow cabbies to earn long-run profits? (p. 679)
4. Why might a large firm be at a disadvantage in a “cutthroat” price war with a small competitor? (p. 684)
5. If a firm is caught selling “below costs,” isn’t this proof of strategic behavior designed to hurt its competitors rather than simply pleasing customers? (p. 687)
6. Rothbard rejects the coherence of a “competitive” price because it cannot be distinguished from the free market price. But what about, say, the pure rate of interest? In practice, the Austrian can’t tell what portion of the actual market rate of interest is due to time preference, risk, inflation, etc. (pp. 696–97)
7. Could there be a voluntary union that achieves a restriction in output and higher wages for union members? (p. 711)
8. On page 717, Rothbard argues that even if a zone of indeterminacy in wages exists, competition among employers will tend to push wages up to the maximum value in this range. But is this just another way of saying that there will be no zone at all?
9. On pages 739–40, Rothbard characterizes a seller’s behavior as an implicit act of consumption. Is this consistent with his earlier critique (footnote 2, page 630) of Hutt’s attempt to use a similar tactic in discussing consumer sovereignty?
10. In Rothbard’s view, how might it be a crime to take a video camera into a theater in order to produce a “bootleg” copy of a blockbuster? What contracts are being violated here?

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