ECON 338
Lecture Six: Competition and Monopoly
Sources used: F. A. Hayek, “The Meaning of Competition,” in Individualism and Economic Order and “Competition as a Discovery Procedure;” D. Armentano, Antitrust and Monopoly: Anatomy of a Policy Failure; Murray Rothbard, Man, Economy and State; Ludwig von Mises, Human Action; Pretty much any Intermediate Micro Text – for example, Frank, Microeconomics and Behavior.
The Importance of Market Structure in Mainstream Theory
Market Structure:
Perfect Competition:
Monopoly:
Monopolistic Competition:
Oligopoly (monopolistic competition):
So as we will see with monopoly -- it is the opposite of "perfect" -- structure basically determines everything in the model:
Structure - Conduct - Performance Theory:
The Model of Perfect Competition
This model was first introduced in the 1930s -- and although has been heavily criticized, remains in the mainstream textbooks. There are parts of the model that simply carry the theory forward to derive the short run supply curve for a firm - which we will do. But the theory in general came to be known as "the theory of competition" (and also monopoly) that supported and lead to the creation of government policy. We will discuss and understand the model -- and then critique it from an Austrian perspective.
The Model
The model first assumes that firms are seeking monetary profit (and nothing else).
The Four Conditions for Perfect Competition
1. Firms sell a standardized (or homogeneous) product:
2. Firms are "price takers" - the market price is given to every individual firm. Therefore, the idea is that there are many small firms, none of which have any influence on price because they are all so small. Any firm that changes its price and has an effect on the market is considered to have "monopoly power" and we are no longer in the situation of "perfect competition":
3. Factors of production are perfectly mobile in the long run (free or costless exit and entry in all industries):
4. Firms and consumers have perfect information:
As you can see -- none of the conditions of perfect competition are ever met in the real world. But – a model is a simplification of reality – should it be judged on its basis of “predictability” – not on the assumptions of the model (as per Milton Friedman)? So what does this model predict? Or as Austrian economists would ask, “what does it explain?” More on this later.
The Short Run Condition for Profit Maximization
Short Run:
Long Run:
Profit = Total Revenue - Total Costs (where costs include opportunity costs)
Therefore, a firm wants to maximize the difference between total revenue and total costs (when total revenue is higher) -- or if it is losing money, to minimize these losses.
So how do we find that point? The short run profit maximization (or loss minimization) rule (providing price is greater than AVC - more on this later) is that we will produce at the output level where Marginal Revenue = Marginal Cost when marginal cost is rising. This will give us the point relating to the one above (TR - TC is max).
Marginal Revenue: Change in total revenue due to a change in output sold.
Remember -- if every good is sold for the same price, then the marginal revenue = P and it is also = Average Revenue
Example: If Q = 100, P = $10
Total Revenue = P x Q = $1,000
Average Revenue = TR/Q = $1,000/100 = $10
Marginal Revenue = Change in TR/Change in Q = $10/1 = $10
So let's graph the marginal revenue and marginal cost curves and find our profit maximizing (or loss minimizing) level of output:
GRAPH
Note that the profit is maximized only if the price (MR) equals MC on the rising portion of the marginal cost curve. Why?
Short Run Competitive Equilibrium
So we have seen that in this model the firm chooses the most profitable output level given a certain market price. So where does the price come from exactly? The market -- the intersection of the market supply and demand curves.
So the firm takes that price as given and then chooses where to operate. Let's first assume that the firm is making a zero economic profit:
ZERO ECONOMIC PROFIT at a price of $10 and output level = 100:
GRAPHS (both the market and firm)
Note that the ATC curve is tangent at the level of output where MR = MC.
Now let's assume that the price goes up to $12 -- because of changes in market supply and/or demand:
POSITIVE ECONOMIC PROFIT at a price of $12:
GRAPHS (both the market and firm)
Where is the positive economic profit (above normal rate of return) on the graph? How much is it? Can you put this in total revenue - total cost terms?
Now let's assume that the price drops to $8 -- again because of changes in market supply and/or demand:
ECONOMIC LOSS at a price of $8:
GRAPH (both the market and the firm)
Where is the economic loss on the graph? How much is it? Can you put this in total revenue - total cost terms?
Adjustments in the Long Run
By definition, an equilibrium is a place where if we are there, there is no reason to move from there, if we are not there, we will try to get there.
Hence -- once there, there is no reason for action (it is a place of perfect information and no action). As Hayek explains -- everyone knows everyone else's plans.
So as the market moves from one equilibrium to the next (as market prices change for whatever reason – say there’s a freeze in Florida) -- individual firms either lose or gain. When this happens -- due to our assumptions of perfect information and costless exit and entry of resources -- firms will move in and out of markets in response to changes in market prices and the profits and losses that come from those price changes. Everything else, of course, is held constant.
NOTE: The model does not explain why some firms move out faster than others. If they are all homogeneous - wouldn't they all move out at the same time - basically leaving no market at all?
CASE ONE - ECONOMIC PROFIT - Assume the firms in the industry are making an economic profit. What will happen in this market? Remember the assumption in the model -- free exit and entry of resources and perfect information.
ENTRY - GRAPH (both the market and the firm)
So firms will enter the industry until firms in this industry (all the same remember) are making a normal rate of return (zero economic profit).
CASE TWO - ECONOMIC LOSS - Assume the firms in the industry are making an economic loss. What will happen in this market? Remember the assumption in the model -- free exit and entry of resources and perfect information.
EXIT - GRAPH (both the market and the firm)
So firms will exit the industry until firms in this industry (all the same remember) are making a normal rate of return (zero economic profit).
Efficiency in the Model of Perfect Competition
Why is this considered "perfect" competition? Why is this an "ideal" situation theoretically? Because the long run equilibrium situation is considered to be "efficient" in this model. Why - and how is efficiency defined?
Allocative efficiency:
No reason for the resources to move from long run equilibrium. Remember - zero economic profit - just making the firm's opportunity cost (can't do better). ALL POTENTIAL OPPORTUNITIES ARE KNOWN. OPPORTUNITY COST IS KNOWN. THERE IS NO REASON FOR AN ENTREPRENEUR. In fact, the firm itself is just a responder to what "the market" provides it. Yet, firms are part of the market.
Productive efficiency:
Producing at the minimum point on the ATC curve. ALL COSTS ARE KNOWN.
So the model basically produces an end state as the definition of competition. It is a “situation.” Any deviation from this situation is considered not ideal – not competitive.
OK – now let’s look at the mainstream theory regarding monopoly – which is seen as the opposite of “perfect competition.”
Monopoly - The Mainstream Model
Monopoly:
Remember the importance of market structure in the model – and the
Structure - Conduct - Performance Theory.
So under this view -- how the "industry" is defined (or how close substitutes are defined) is very important.
So in this model - the important distinction between monopoly and competition is that the demand curve facing the individual competitive firm is horizontal (irrespective of the price elasticity of the corresponding market demand curve), while the monopolist's demand curve is simply the downward-sloping demand curve for the entire market.
So how is this "monopoly power" measured?
One popular measure is the cross-price elasticity of demand with close substitutes. The higher the cross-price elasticity -- the more consumers see the goods as competitors.
Example: Famous antitrust case - DuPont Corporation. Had 80% of the market in cellophane traded. But it showed that the cross-price elasticities between cellophane and waxed paper and aluminum foil were pretty high. Broadening the market to include these products meant that DuPont only had about 20% of the market share. It won the case.
But of course there can be so many substitutes for a good -- or for how a consumer spends their money -- defining a monopoly really is very subjective (more on this later).
Another popular measure is the concentration ratio. How "concentrated" is the industry - do the top largest firms hold 80% of the market. Concentration ratio for 5 firms = 80%.
The Profit-Maximizing Monopolist
Assume again: The business wants to maximize monetary profit. In the model of perfect competition, price does not change as more or less units are sold. Under monopoly, with a negatively sloped demand curve, additional units can be sold only by lowering price, and price must be reduced on previous units sold.
The different firms are no longer homogeneous – in fact, each is very different. This gives the firm “market power” of choosing price. Does not have to take whatever price is offered in the market.
So again, in the short run, this means the firm will choose an output level where the difference between TR and TC is maximized.
So where does the MR curve lie with respect to the demand curve?
Remember with a perfectly competitive firm the Demand Curve was horizontal where = P = MR = AR. But this is not true with a downward sloping demand curve.
The demand curve is still the Average Revenue curve. Why? Whenever the monopolist sells a certain quantity of units, it sells all of them at that particular price on the demand curve. Example: Sell 100 units when the price is $5. What is the average revenue? Total revenue = 100 x 5 = 500. Average revenue = 500/100 = $5. So each price along the demand curve tells us average revenue at that price.
But the average is falling along the curve -- and if average is falling, where is marginal? Below it!!
Due to the downward sloping demand curve, marginal revenue is less than price for any change in output.
Where will the firm operate? At what level of Q?
Guess what -- just like the competitive firm, the monopolist will operate where MR = MC (for the same reasons).
GRAPH
So now we can graph the Short Run Profit Maximization Condition for the Monopolist:
A monopolist making economic profit:
Step one: Find output level where MR = MC.
Step two: Find the price at that output level along the demand curve (this is the price that the firm is able to get)
Step three: Where is ATC compared to AR? Remember, the demand curve = AR (Price) at any given level of Q. If ATC is below AR (price), economic profit, if they are equal, zero economic profit and if ATC is above AR (price) - economic loss. Monopolies can make an economic loss!
What if the ATC curve is below the price -- the monopolist is making an economic profit.
GRAPH:
What if the ATC curve is above the price -- the monopolist is making an economic loss.
GRAPH
Long Run Maximizing Monopolist
If the monopolist is covering costs (making at least a zero economic profit), it will continue to operate in the long run.
In fact, it will also continue to make an economic profit if that is the case. Why?
Because there is no long run entry in this model. There is exit – the monopoly can close in the long run, but others can NOT enter.
Barriers to entry – unlike perfect competition, all of the sources of monopoly are considered barriers to entry.
Furthermore, there is no reason to believe that the monopolist will operate at the minimum point of the long run average total cost curve (as in the model of perfect competition) – where firms will enter and exit and change size until that is the case in the long run. Therefore:
Efficiency? Is the monopolist efficient? When defined the same way (allocative and productive) – the answer is no.
The monopolist does not operate at the minimum of its long run average total cost curve and can earn a positive economic profit in the long run.
So “competition” is considered ideal, while a monopolist is considered “inefficient” by definition – as per the model.
Policy Recommendations:
Therefore, as an industry starts looking “monopolistic” it is watched carefully. Larger firms, few firms in an industry, etc. All considered less than efficient – and should be “forced” to look more like the model of perfect competition. All firms should be “small” regardless of what they are producing – a fast food restaurant should look like an airplane manufacturer (if taking the model to its conclusion).
Anti-trust laws are (generally speaking) based upon this model.
DO ICE SIX
The Critics of the Mainstream Theory of Competition and Monopoly
The Non-Economists (sociologists, anthropologists ,etc.) :
Markets are not as perfect as the model predicts. The perfect knowledge assumption regarding economic actors is bogus.
However, the solution is often: Government planning must be better than markets. But this assumes that planners have the knowledge of what is "best" for society.
We can also find this same knowledge issue within economics. Keynesian economists talk about the knowledge that economic actors don't have but basically assume that government planners (intellectuals) have the knowledge to plan an economy.
Efficiency standard also criticized:
The claim - economists always think that economic efficiency (allocative and productive) is the end-all result that should be strived for -- at the expense of justice, for example ("efficiency vs. equity") or at the expense of environmental issues.
However, certainly the mainstream model is claiming that a monopolist, for example, isn't "just" since there is an “ideal” that is not realized -- so there is a standard of justice in the model. There is a value judgment.
Not just because he makes "too much money" - he is making an above normal rate of return.
So maybe the two aren't so different after all?
But usually the claim is: "all you care about is making money (monetary profit) -- and the most efficient way possible no matter who gets hurt." The assumption being that making a monetary profit in markets hurts some people so others can gain.
Marxists: The major disagreement here is in the "nature of man." Mainstream economists do assume that man acts rationally, he chooses (under assumed constraints) in a free choice situation. His "nature" is to be self interested.
Marx, on the other hand, said that the economic system in which a person lives to a great extent determines the choices people make. There are a lot of "power" structures within a market economy that take choices away from people. Labor, for example, cannot choose the wage he or she works for -- they are at the whim of the power that the employer has.
Therefore the main critique here is the mainstream theory assumes that people act in their self interest and that profit maximizing (moving resources to their highest valued use) is a good thing. It benefits everyone. But if people really aren't making "free choices" regarding resource allocation -- but instead are "forced" to buy a blue car because of advertising, for example, then the allocation of resources within markets is not a good thing.
Of course, this always begs the question: then where should resources be allocated? Who knows? How have the Marxists escaped the wrath of the power structure within markets - able to rise above and know when people are making bad choices about resources?
There's a lot more to Marxism than this critique, but I think this is the big one.
Austrian or Process Economists
Main problem - Method: Having to conform a theory to a method (math model for example - in this case and others) leads one to completely miss the problem at hand!
So what is the problem then? Hayek says it is, "The economic problem is a problem of making the best use of what resources we have, and not one of what we should do if the situation were different from what it actually is."
So from "Competition as a Discovery Procedure, " ...'perfect competition' ... leaves no room whatever for the activity called competition, which is presumed to have already done its task." In other words, we are at an equilibrium, with no real discussion of how we got there.
There is no entrepreneur (no need for one).
Note under the model of perfect competition "perfect" is defined: allocative and productive efficiency.
Why do you think that situation is defined as "perfect?"
Least cost.
Best allocation of resources.
Aren't those what economist's study? The best way to discover these things.
Let's come back to this later.....
First let's look at the difference between the mainstream model and the Austrian or process theory with respect to different topics:
Definition of competition:
Competition becomes a behavior (purposeful human action). It is “rivalry” in the sense that one is trying to do better than what has happened in the past.
Therefore, it can also be defined as:
Hayek in "Competition as a Discovery Procedure" says this, " . . whenever the use of competition can be rationally justified, it is on the ground that we do not know in advance the facts that determine the actions of competitors. In sports or in examinations, no less than in the award of government contracts or of prizes for poetry, it would clearly be pointless to arrange for competition, if we were certain beforehand who would do best. As indicated in the title of this lecture, I propose to consider competition as a procedure for the discovery of such facts as, without resort to it, would not be known to anyone, or at least would not be utilized."
So in defining competition as a discovery procedure, interesting consequences can be observed that are not really obvious otherwise:
1. "... competition is valuable only because, and so far as, its results are unpredictable and on the whole different from those which anyone has, or could have, deliberately aimed at."
2. "... the generally beneficial effects of competition must include disappointing or defeating some particular expectations or intentions."
3. "If we do not know the facts we hope to discover by means of competition, we can never ascertain how effective it has been in discovering those facts that might be discovered." Or, "The necessary consequence of the reason why we use competition is that, in those cases in which it is interesting, the validity of the theory can never be tested empirically."
But - we can perhaps compare a world without competition to a world with it....
4. "... the benefits of particular facts, whose usefulness competition in the market discovers, are in a great measure transitory...... [the theory] does not predict particular results the market will achieve."
Therefore -- things change, what works changes, we can't say that in every case such and such will work.
5. "This, in the nature of the case, the theory of competition cannot do in any situation in which it is sensible to employ it. . . ., its capacity to predict is necessarily limited to predicting the kind of pattern, or the abstract character of the order that will form itself, but does not extend to the prediction of particular facts."
For example -- does not predict the structure of an industry, or exact market prices and costs. It does predict, however, that generally, with competition, there will be more innovation, more choice, etc. than would exist without competition. Any particular kind of innovation cannot be predicted.
So what about the Structure - Conduct - Performance theory?
Note that the structure of the industry is only important if it in some way impedes the discovery process (which most likely will not happen without legal barriers to entry).
Basically - the structure comes out of competition (conduct) and the performance (NOT defined as allocative and productive efficiency) is a feedback mechanism to those who are acting in the market: And this is a continuous process of change.
Efficiency here - defined as what the individual thinks (subjective) is his/her opportunity cost -- am I making enough to stay in this business (monetary and/or non-monetary profit or benefits - this could include a moral component to what you are doing). Much broader (subjective) definition of "efficiency."
We will discuss “efficiency” in more detail in another lecture.
The Concept of Monopoly:
Austrian economists have not agreed upon this – so let’s look at some of the theories.
Menger:
Monopoly was a natural stage in the progression of the market process.
Basically he said that both parties benefit from exchange and this is true even with a so-called monopoly situation.
All markets move from monopoly to competition – it is part of the process (first on the market is a monopolist in a sense).
Hayek basically agrees with Menger as we will see.
Ludwig von Mises:
Monopoly exists when “the whole supply of the monopolized commodity is controlled by a single seller or a group of sellers acting in concert.”
He did not like monopolies – “The monopoly prices are an infringement of the supremacy of the consumers and the democracy of the market.”
Monopoly price can exist – where the monopolist restricts output and sells at a higher price.
As a rule – this is brought about by legal barriers to entry (but not in every case)
F. A. Hayek:
Hayek's references to monopoly in The Meaning of Competition, "A person who possesses the exclusive knowledge or skill which enables him to reduce the cost of production of a commodity by 50 per cent still renders an enormous service to society if he enters its production and reduces its price by only 25 per cent - not only through that price reduction but also through his additional savings of cost. But it is only through competition that we can assume that these possible savings of cost will be achieved. Even if in each instance prices were only just low enough to keep out producers which do not enjoy these or other equivalent advantages, so that each commodity were produced as cheaply as possible, though many may be sold at prices considerably above cost, this would probably be a result which could not be achieved by any other method than that of letting competition operate." (my bold)
What the model of perfect competition considers "monopoly power" (downward sloping demand curve, pricing above MC), Hayek considers beneficial -- because the viable or realistic alternative is not P = MC, it is not having the lower price and new (better, different) product at all without competition. A downward sloping demand curve is the norm -- it is NOT monopolistic in any sense.
Can’t compare a “monopoly” situation with a perfect world – must compare with a viable alternative. Alternative is not having the good at all because it would not have been “discovered” without the process of competition.
We do not "beforehand" know what works and does not work -- that's the key.
Very Mengerian.
Also from The Meaning of Competition, "This is, however, only one of the many points on which the neglect of the time element makes the theoretical picture of perfect competition so entirely remote from all that is relevant to an understanding of the process of competition."
Notice the mention of the "time element" - what does Hayek mean by this?
This relates to his discussion on how quickly (or slowly) "adaptation" takes place in a market. Look at the grain market vs. the oil (or energy) market.
Hayek –“ It is only in a market where adaptation is slow compared with the rate of change that the process of competition is in continuous operation. And though the reason why adaptation is slow may be that competition is weak, e.g., because there are special obstacles to entry into the trade, or because of some other factors of the character of natural monopoly, slow adaptation does by no means necessarily mean weak competition."
He basically describes the oil (energy) market. Conclusion: competition will eventually discover alternatives if that's what people want -- this knowledge is complex and not easy to discover (not only technical) -- but what it is that people really want.
That's why, when an issue becomes so politicized and propaganda is everywhere -- it makes it more difficult for good knowledge to be discovered and utilized (good = real, the truth).
Looking at a market structure, for example, in one period of time misses the point. How will that structure change over time? As the entrepreneur generates knowledge – it all changes. But this does take time!
Murray Rothbard and D. Armentano:
They take a property rights view…. Or “subjectivist” view.
There is no such thing as a competitive price or monopoly price – there are only market prices.
Should not argue that monopoly is the control over the entire supply of some commodity or resource – since from a subjectivist point of view every seller would be a monopolist if his product were the least bit different.
How do we know that a price is competitive? Does not make sense from a process, subjectivist point of view.
So in conclusion regarding monopoly:
A "monopoly price" does not exist -- there are only market prices agreed upon in a trade.
Exception to Austrians: legal barriers - Hayek mentions this in The Meaning of Competition , "In such a situation how would conditions differ, if competition were "free" in the traditional sense, from those which would exist if, for example, only people licensed by authority, or both? Clearly there would be not only no likelihood that the different things would be produced by those who knew best how to do it and therefore could do it at lowest cost but also no likelihood that all those things would be produced at all which, if the consumers had the choice, they would like best."
So the standard for judgment under this model: is there knowledge generation (knowledge about what people want and know regarding their situation, skills, etc.) and utilization such that people are getting what they value?
Real rivalry – competition generates knowledge through trial and error. Those who undertake the uncertainty of this trial and error do so with their own pocketbooks at stake. This gives them a great incentive to generate new knowledge – to try to be successful. Not jump in with both feet without investigating the water first!
Note that the outcome is not specified in any particular way (what it is that people want in particular) -- only that whatever the truth (knowledge) is must be utilized if the outcome that people want is to be gained. The process of competition does this.
The end state situation in the model of perfect competition states the specific end of the process that never took place. Allocative and productive efficiency seem to appear out of thin air. And we KNOW the least cost method (how did we obtain that knowledge and how do we know it is “least”) and we know the highest valued use of all resources. How – how did we discover that knowledge? And how do we know it is “highest” valued?
So what about this profit motive -- is it necessary for knowledge generation and utilization?
This process of knowledge generation is valuable in achieving what it is people want -- the motive for achieving it has to be there (people will act in their own self interest) but it does not have to be "monetary profit." It can be "I want to feel good about myself and in order to do that I have to achieve something beyond myself -- I have to promote an ideal (religious, personal value, etc.) or I have to help others live better lives in a specific way" (for example). Can you think of other motivations?
Problem: one person being motivated by their ideal may not be enough to make it happen -- and there needs to be some kind of feedback as to whether or not a person's goals are being met. This is why the profit motive is such a constructive motive -- the feedback comes in the form of monetary profit or loss -- that tells the entrepreneur if what they are doing matches the "objective facts" as Hayek puts it -- meaning matches what consumers want or not? Without some kind of signaling device as to how you are doing in achieving your goal -- it becomes difficult, if not impossible, to achieve it.
However -- who knows what people will come up with in doing this if they have the freedom to try?
Each individual entrepreneur – with their own goals – can come up with their own benchmarks.
Must be careful, though. It might be nice to want to “save the world” using your business – but in the process (unless you have a very deep pocket) – you might just go out of business if you don’t keep an eye on the “bottom line.” And how will you gain the kind of knowledge that market prices (and profits and losses) provide us?
Be careful!!
So why is all of this important to an Austrian economist?
Remember – by assuming knowledge problems away, we assume away the very heart of what we want to understand – because if we want to coordinate resources with wants – then we must understand the process by which this might happen.
What helps it? What hinders it?
Bottom Line: Policy decisions made on the basis of the model of perfect competition hinders this knowledge generating processes. We do not get what we want!! We get what politicians or special interest groups want.
This all brings us to the concept of “efficiency” – our next topic!
DO ICE SIX (a)