In Defense of Monopoly

Front matter

HOW MARKET POWER FOSTERS CREATIVE PRODUCTION

Richard B. McKenzie and Dwight R. Lee

Copyright © by the University of Michigan 2008 All rights reserved

CHAPTER I “THE WRETCHED SPIRIT OF MONOPOLY” 1 Smith, Bentham, and Ricardo on the “Evils”

of Monopoly 4 Bastiat and Marx on Monopoly as “Plunder” 9 Marshall on the “Net Revenues” of Monopoly 13 Schumpeter on the Vital Role of the

“Monopoloid Specie” 15 The Schumpeter Hypothesis 19

CHAPTER 2 DEADWEIGHT-LOSS MONOPOLY 25 The Efficiency of Perfect Competition 26 The Inefficiency of Monopoly 30 The Locus of Market Failure: Firms? 34 The Locus of Market Failure: Consumers? 36 ‘The Added Waste of Rent Seeking 37 The Imperfection of Perfection 39 Zero Economic Profits 42 ‘Transitionary Economic Profits 47 Economic Profit as a Source of Capital 48 Market Efficiency and the Count of Competitors 50 Concluding Comments 52

CHAPTER 3 MONOPOLY AS A COORDINATION PROBLEM 54 The Conventional View of Monopoly 56 An Unconventional View of Monopoly 57 Changes in Agency Costs 62 Innovation 63 Concluding Comments 63 Appendix: Agency Costs and Cartels 64

CHAPTER 4 WELFARE-ENHANCING MONOPOLIES 67 The Paradox in the Microsoft Antitrust Case 68 Unraveling the Paradox 72 Digital Markets 75 The Relevance and Potential Welfare Value of Entry Barriers 81 The Problem of Digital Piracy 87 Once Again, Why Monopolies? go The Microsoft Problem for Microsoft’s Competitors 91 Concluding Comments 94

CHAPTER 5 LOCKED-IN CONSUMERS 96 Consumer Lock-In 96 A Product with Network Effects: A Model 100 Efficiency Considerations 104 Creating Networks 106 Concluding Comments 109

CHAPTER 6 MONOPOLY PRICES AND THE CLIENT AND BONDING EFFECTS IIO The Client Effect 110 The Bonding Effect 122 Concluding Comments 123

CHAPTER 7 THE MONOPSONY PROBLEM 126 The Conventional Monopsony Model 127 The Mysterious Existence of Monopsony 130 The Monopsonistic “Company Town” 135 Firm and Worker Mobility and Monopsony Market Power 139 Concluding Comments 140

CHAPTER 8 THE NCAA: A CASE STUDY OF THE MISUSE OF THE MONOPSONY AND MONOPOLY MODELS 143 The Conventional Cartel Argument against the NCAA 146 Science as Ideology 153 The Mistaken Presumption of “Underpaid” Athletes 155 The Mistaken Interpretation of Cheating 157 The Mistaken Presumption of Monopsony Power 159

Sports Demand and NCAA Membership 162

College and University Sports as Games 164

College Athletics as an Open Market: A Review of the Legal Literature 166

CHAPTER Q MONOPOLY AS ENTREPRENEURSHIP 173 The Entrepreneurial Role in Firms and Markets 174 Monopoly Rents as Entrepreneurial Entitlement 177 The Justice of Entry Barriers Reconsidered 183 Monopolies, Public Goods, and the Gains from

Price Discrimination 186

The Efficiency of Monopoly Failures 191 Concluding Comments 196

CHAPTER IO PROPERTY AND MONOPOLY 198 Property Rent as Monopoly Theft 199 The Property-Monopoly Equivalence 203 Copyrights as Monopoly Abuse 205 Property in Proper Context 211 “Good” and “Bad” Monopolies 214 Monopoly Profits versus Economic Profits 215 Concluding Comments 216

Preface

Most adults in the United States and much of the industrialized world today can vividly remember as children playing their way through marathon Monopoly games. Few have come close, however, to challenging the length of the longest Monopoly game in history (which dragged on for 1,680 hours, or seventy straight days).

Although the board game involves key market institutions—money, a bank and banker, deeds, trades, and wealth accumulation—only a modicum of business savvy is required to win. Accordingly, ten-year-old kids can beat their parents, who may be astute, seasoned business people, mainly because the competition among the players is highly constrained by detailed rules, the layout of the board, and elements of luck that are introduced through required tosses of the dice and draws of the “cards of chance.” The game’s popularity is probably attributable in no small way to the fact that it taps into twin passions: to win and to acquire wealth (even play wealth).

Each player’s best strategy for winning is often to buy up all properties of given colors—for example, all the green properties of Pennsylvania, North Carolina, and Pacific Avenues—and then add (plastic) houses or hotels to them. We can only surmise that the game is called Monopoly because the rent that property owners can charge when another player lands on any particular property escalates both with the number of properties of a given color owned and with the number of houses and hotels that owners buy for each property. Market dominance translates into a form of “monopoly rents,” loosely defined.

The player who is able to buy both Boardwalk and Park Place (the only two blue properties) and put the maximum of four hotels on each has a good chance of winning, given that the rents on those properties are then the highest on the board. Of course, the owner of those two properties can be assured of their monopoly in the game because the players are trapped: They each in turn must throw the die and must follow in lockstep the route, square by square, around the board, which means that players must run the risk of landing on the monopolized properties. However, winning by developing monopolies on properties of given colors is never assured, mainly because of the properties’ costs and the several elements of chance.

Economists play another monopoly “game” in their textbooks (and classxiv PREFACE room lectures) that is not totally unlike the board game. Like the board game, the economists’ textbook monopoly game is also highly constrained—not, of course, by the printed surface of a piece of cardboard, but by an underlying, explicitly stated set of assumptions. Economists start by loosely attributing the status of monopoly to any firm that has “market power,” that is, the firm is sufficiently dominant in its market and sufficiently protected by barriers to the entry of potential rivals that the monopoly can raise its prices and capture “economic rents” or “monopoly profits” by restricting output below the idealized competitive output level.? The assumption underlying the economists’ monopoly game that lines up best with the Monopoly board game is that the more control a firm has over a carefully defined, given market (or the greater the firm’s “market dominance,” often defined as percentage of all market sales) and the more the firm is protected from market entry of rivals, the more economic rents the monopolist can earn.

But there is another way the two games align: The prospects for creativity and improvement in both games are nil. In the case of the board game, the board and the properties on the board are given. That is to say, they are not created by the players in the course of the play. Their market values are also predetermined and fixed. The rent to be made on each property is also given and fixed, which is to say that the rent is merely extracted by the property owners, as opposed to being created by them. No new properties can be added, and neither can the existing properties be subdivided and reconfigured to enhance the value of all properties. It follows that a player’s rent from becoming a “monopolist” over Boardwalk and Park Place will never affect the creation of new properties by others, which, of course, means that players have every reason to charge what the game (and market) will bear at the time of play. Because nothing is created or destroyed by the play of the Monopoly, the game can always be used again, with everything (rules, property values, and rents) remaining exactly the same.

In the case of the economists’ monopoly game, the monopolized good is also given to the textbook (and blackboard) analytics. That is, by assumption, the monopolist has nothing to do with its own emergence as a monopoly or the creation of its good and its market. The monopoly and its good and market are simply assumed into existence. With the shapes and locations of the monopolist’s demand and cost functions also given, again by assumption, there is not much more for economists to do in playing their model-building games other than move around their “boards” and deduce the monopoly’s output and price levels that maximize economic profits (or rents).

In the narrow context of the model, because the monopolist necessarily restricts output below the (idealized) competitive level, a self-evident ineffi-

Preface xv ciency exists in the allocation of resources mandated by the underlying assumptions and the rules of the monopoly model. The monopoly rent is merely extracted from the consumer surplus that is presumed to exist independent of whatever the monopolist may have done in the past or proposes to do in the future. Under such conditions, the fairness of the rent extraction is, at best, suspect. Again, this is because the monopolist, by assumption, had absolutely nothing to do with the creation of the monopolized good, the good’s market, the protective entry barriers (which, under the model, serve only a negative economic function, that of permitting a curb in output), and the resulting consumer surplus and (hence) the monopoly rent that is extracted. Prices above marginal cost of production, of course, serve no valuecreating function.

The welfare consequences of the play of Monopoly are harmless. Everything about the game (all the properties, money, and pieces) remains fixed, no matter how many monopolies the players are able to create. If anything, the development of monopolies adds to the players’ received value from play. Obviously, public policies are not subject to change because of the Monopoly game’s rules or the manner in which the game is played. Monopoly is a game that simply would not sell if consumer gains from play (and the development of monopolies among the various properties) were absent.

That is hardly the case with the monopoly game economists play out in their models. This is because the economists’ monopoly game carries a direct and powerful lesson: Monopolies everywhere are “bad.” They are bad in terms of what they fai to do in the production of goods and, consequently, in terms of what they do to the allocation of countries’ scarce and therefore valuable resources. They are also bad because of what they do to countries’ income distributions. Monopoly rents can only be construed as an unnecessary grab on consumers’ (not the monopolist’s) surplus by firms that have absolutely no prior or justifiable claim on the surplus value. Monopolies everywhere, in other words, have no redeeming virtue (a central lesson all too frequently exposited with only minor and easily dismissed qualifications).

Because judges, journalists, politicians, policymakers, bureaucrats, and researchers (and economists) thoroughly absorbed the monopoly model in their college classes, it should surprise no one that welfare-destroying monopolies are seen everywhere.

e Microsoft is a monopolist because its Windows operating system and Office suite of productivity applications for personal computers are used on nearly all of the world’s personal computers (i.e., those that use Intel-compatible microprocessors).3 xvi PREFACE

¢ Clear Channel has monopoly power because it has more than 1,200 radio stations (of the 10,000-plus stations in the country) in its network.

e Intel has market power because its Pentium chips dominate the microprocessor market.

e The Irvine Company, a major property owner in Southern California, has monopoly power simply because of its large size and the strategic locations of its properties in a high-growth area of the country.

è Even J. K. Rowling, author of the Harry Potter series, has been accused of having a monopoly presence in the book market because she has sold so many books (hundreds of millions), which obviously gives her publisher the option of selling fewer than could have been sold to charge higher than competitive prices (Blais 2005).

Indeed, the economists’ model has been learned so well by many commentators that they are able to nimbly reverse the model’s logic: Any firm that makes a lot of money—or more than is required to keep the firm doing what it is doing—must have monopoly market power. Otherwise, the excess earnings would have been eroded by competition. Hence, people’s riches (Bill Gates’s billions) are prima facie evidence of an unseen inefficiency in the allocation of resources—a welfare loss that need not have been. Never mind that Gates’s fortune may amount to a small fraction of the societal welfare gains that have been, and will continue to be, realized because of key decisions he made with regard to the development of Microsoft years ago.

The public policy implication from the “play” of the economists’ monopoly game is equally clear: When the cost of antitrust action is lower than the monopoly’s deadweight loss imposed on its market, monopolies should be abolished wherever and whenever sighted. When the cost of such antitrust action is higher than the expected efficiency improvement, monopolies must be endured, but only as a “necessary evil.” Monopolies should never be welcomed for what they contribute to the development of human welfare. This is because, to restate our point, monopolies cannot be seen as beneficial, on balance, to human welfare—at least not from the perspective of the standard static monopoly model.

As economists over the past two hundred years have lamented the almost complete absence of any real-world market matching their competitive ideal market structure, “perfect competition,” and as economists have bemoaned the prevalence of monopolies, oligopolies, monopolistic competitors, and monopsonies in the economy, something very curious has occurred: The American economy has prospered as no other economy has prospered before in human

Preface xvii history. This is because the past two hundred years have stood witness to a record of discovery, invention, and innovativeness not matched in earlier epochs. Moreover, three-quarters or more of the welfare gains from all the innovativeness have been garnered not by the innovators (and all the firms built around the innovations) but by the consuming public.4 It is no exaggeration to suggest that economists’ myopic focus on monopolies’ wrongs is comparable to observers of the play of the Monopoly board game stressing how unreasonable the rent on Boardwalk is without ever recognizing that the players are having a lot of fun and that the prospects of each player acquiring the rights to the rent on Boardwalk is very likely one of the forces that inspires their continued play.

In this book, we develop at length two arguments that represent a frontal assault on conventional economic wisdom as related to monopolies: First, economists conventional, widely accepted, and parroted static model of monopoly greatly exaggerates the economic harm done by real-world monopolies in real-world markets, which are necessarily evolutionary, dynamic, creative processes that do not square well with the static, noncreative nature of economists monopoly model.

Second, contrary to conventional wisdom among economists (for reasons that are explored at length in this book), some degree of monopoly presence in an economy is “good” because without some monopoly presence no economy can ever hope to maximize human welfare improvement over time. In this regard, we argue that a perfectly fluid, perfectly competitive economy, idealized and idolized by economists, must be decidedly inferior to an economy that is beset with some degree of market entry and exit restrictions (or costs). In making these points, we repeatedly defer to the wisdom of the late Harvard economist Joseph Schumpeter, who observed succinctly and prophetically in his classic work Capitalism, Socialism, and Democracy more than six decades ago that market imperfections can be a source of an economy’s long-term progress (see the epigraph to this volume). Readers who appreciate the wisdom in that passage need not read on. However, we have written this book on the presumption that many economists and professionals in related fields (e.g., law and public policy) will view the passage with some skepticism. As documented throughout this book, much conventional criticism directed at monopoly ignores this Schumpeterian insight.

Our purpose in this book is to expound and then to extend Schumpeter’s key insight in ways that he failed to develop as fully as he could have. We seek to explain why we believe Schumpeter was actually too timid in making his xviii PREFACE point. Our essential position is stronger: An economic system’s failure to efficiently allocate its resources at all points in time ż¿s a necessary precondition for the maximization of the system’s long-term performance.

Our reasoning is at times complex, but more often it is elementary. In the main, much of what we write in this book reduces to the proposition that an economy is unlike a board game in which players compete for a limited number of given properties. It is unlike the blackboard games in which economists develop their monopoly models. In real-world economies, goods and services are not given, as is the case in both the board game Monopoly and in economists’ treatment of monopoly in their blackboard games. Goods and services are created, and the process by which goods and services are created and enhanced requires competition, but any process involving truly creative production also requires the prospects of gains beyond a “normal competitive rate of return.” In no small way creative production drives, in unheralded forms and to an unheralded extent, Schumpeter’s much-heralded “creative destruction.”

Monopolies (and their built-in monopoly rents, as well as their entry and exit barriers that inspire the rents) are an underappreciated inspiration for the development of new goods and services that enhance human value and, at the same time, undermine their (the monopolies’) own existence. This is to say that, unlike the board game Monopoly, monopolies in real-world economies can inspire new and more valuable properties and can give rise to players moving off the beaten path around the board and into uncharted territories. Even when given monopolies are said to be bad in their markets (as Standard Oil and Microsoft have been found to be by antitrust authorities and the courts), they can contribute much to the advancement of human welfare, primarily because they inspire others in close-by and far-removed markets to try to become like them, monopolies with above-competitive returns. The long-run improvements in human welfare from a greater variety of and higher quality products, inspired by the “bad” monopolies’ profits, can easily exceed any short-term loss in welfare due to “bad” monopolies’ restrictions on output.

Moreover, monopolies and their profits are absolutely essential and expected in real-world markets beset with risk and uncertainty, which make business failures not only a possibility but also a persistent fact of market life. In order for individuals and firms to venture forth in such real-world markets, they must have a realistic prospect of temporary monopoly profits just so that in an array—or a portfolio—of ventures, at least a competitive rate of return can, on balance, be expected.

Besides, in a world beset with risk and uncertainty, good luck is bound to happen, with the luck revealing itself in monopoly profits, enabled by natural

Preface xix and unexpected barriers to entry that emerge with the development of products. No doubt, J. K. Rowling never expected to sell hundreds of millions of books, and to have the degree of reader royalty that her Harry Potter series inspired among young and adult readers. Similarly, Apple could not have known that its iPod would become the standard for digital music players and would, for so long, dominate its market segment. In an imperfect world, the prospects of monopoly profits, from anticipated or unanticipated sources, surely inspires more risk taking than would otherwise occur, which should be expected to pay off in an economy that, over the long run, is more innovative than it could otherwise be.

So what if firms’ allocative efficiency in every product line is not achieved with perfection, when the resource base is expanded at the same time that consumer value is enhanced because of the incentive effects built into the prospects of monopolized markets? Clearly, as we shall argue repeatedly in this book, if antitrust enforcement were “perfect” in all regards, wiping out all monopolies and returning all markets to perfectly competitive market conditions, innovation and long-term prosperity would surely be undermined since we would replace an economy that is more productive over time with one that is as productive as possible at every point in time.

Before they take up monopoly in their classes, economists often review with their students Adam Smith’s clever metaphor, the “invisible hand,” which he used to explain how people’s drive to serve their own private ends results in the advancement of society’s ends. Our arguments represent an extension of Smith’s profound point, for we see monopoly as a crucial activating force behind the invisible hand. Take out the prospect of monopoly (and the attendant monopoly profits) from a market economy, and the invisible hand will likely go limp, a position that appears to be ironic only because of how monopoly has been caricatured for so long in economic models.

Our analysis leads to another transparent conclusion: The world of perfectly fluid, perfectly competitive markets (or any close approximation) is first of all unachievable (because of the unattainability of perfection) and furthermore undesirable even if it were achievable. The kind of competition in real-world markets is far superior to the competition in perfectly competitive markets precisely because the competition is not restricted solely to price competition. Rather, competition in real-world markets is multidimensional, with the avenues of competition constantly being created and redefined with the advent of new products and production processes, a point fully appreciated by Schumpeter, who asserted the far greater importance of nonprice competition over price competition in determining the allocative efficiency of resources over time.°®

XX PREFACE

Clearly, if the good that is subject to monopolization is given—that is, not actually created by the monopoly—nothing much can be said about the morality of any distribution of the surplus value from the good’s production and sale. This is true even when, assuming constant cost of production, the surplus value would go entirely to consumers, under conditions of perfect competition. So what if consumers get all of the gains from trade? There is no necessary justification for the monopoly getting any of the net gains, because the monopoly had no role in creating the good and bringing the net value into existence.

However, if the good is actually created by the monopoly, then surely the monopoly’s claim, on fairness or justice grounds, for a portion of the net gains is strengthened, while the consumers’ claim to all of the gains is undermined. Because successful real-world economies are advancing evolutionary processes marked by innovations developed by individuals and firms, we argue in the following pages that monopoly profits have far more moral merit than they are commonly accorded when viewed from the perspective of static models. And, we should never forget, above-competitive profits are the incentive that innovators need to innovate, and they are the cause of far more intense and meaningful forms of competition than price competition isolated from all other forms of competition.

Economists make much to-do about how competitive market prices are important signals to firms as they try to decide what to produce and what resources to employ (and pull away from other uses). Prices supposedly lead entrepreneurs as if by Adam Smith’s invisible hand into an efficient allocation of resources and maximization of human well-being. We ask in this book, following the lead of Paul Romer (1994), how can that be, given that, as economists themselves stress, the prices set in perfectly competitive markets only reflect goods’ marginal values, which means that prices in such markets do not and cannot reflect the full consumer value of the goods that are produced?

That question is irrelevant when the goods are given, that is, do not need to be created. However, if the goods need to be created and produced, perfectly competitive prices can lead to impaired incentives to create new and superior goods and improve old products and, hence, to an underallocation of resources toward economic progress that benefits us all. The failure to develop new and improved products that cost less than they are worth is a market inefficiency that easily goes unrecognized (it is difficult to recognize the lack of something that has never been available) and surely one that is as important as the short-run deadweight loss economists focus on in their static models of markets. To paraphrase Romer, a new good not produced is as easy (perhaps easier) to overlook as the dog that did not bark—and apparently for economists, far more difficult to conceptualize than the units of given goods that are not produced in

Preface xxi monopolized markets.” True competitive prices are particularly problematic when the marginal cost of production is close to zero, if not zero, as is the case for the burgeoning array of digital (or electronic) goods and services today.

Our arguments, in other words, lead to the observation that monopolies might create one form of short-run inefficiency, deadweight loss, but they also lead to a more-than-offsetting improvement in the efficiency with which goods are created and improved over time. Again, this is the point Schumpeter had in mind when he suggested that short-run inefficiencies could establish the conditions for improving “the level and speed of [an economy’s] long-run performance.”

From our reexamination of monopoly theory, we can only deduce that human welfare is today superior to what it would have been had policymakers followed, over the past couple hundred years, more assiduously the monopoly teachings of economists. At the same time, the world today would likely have been superior to what we see around us had more policymakers over the past six decades read carefully Professor Schumpeter’s seminal tract on the required market foundation for progress in free-market economies.

To avoid any misunderstanding and to be clear, we hasten to add that our arguments do not lead recklessly to the conclusion that all monopolies are good or that the more monopolies an economy encourages, the better. We can easily imagine that some level of monopolization of markets can be, on balance, welfare destroying. Our point is that not all monopolies and not all levels of monopolization are welfare destroying, a perspective that suggests economists should pay more attention to the institutional conditions for what might be called optimum monopoly. We acknowledge that optimum monopoly (discussed later) lacks the level of analytical precision that economists’ market models have. Nevertheless, we are proposing that the issue of monopolies of all kinds in a market economy should be addressed analytically, in the way that the terms for copyrights and patents have historically been addressed: Those forms of market protection are needed to inspire greater creativity than would otherwise exist, but the extent and term of the protection need not be unlimited. We suggest that optimum monopoly is no less relevant to public policy than optimum pollution or optimum crime rate.

In completing this book, we are deeply indebted to Tyler Cowen, Kenneth Elzinga, and Thomas Sullivan for their incisive and very helpful reviews of early drafts of the book.

Chapter 1

“The Wretched Spirit of Monopoly”

Historically, monopoly has, with limited exceptions, been seen by economists as a bane of markets, one of the more prominent forms of so-called market failure. Across time, economists have equated the “evils” of monopoly with theft and taxation, given that monopoly can impair an economy’s vigor just as theft and taxation can. Unfortunately, countries have, either all too willingly, with malice or political intention, created and nurtured monopolies, or else inadvertently, from ignorance of monopolies’ economic consequences, allowed them to arise and persist.!

In contemporary economics, monopoly is treated as a source of “inefficiency,” or “deadweight loss.” That is, monopoly forces a misallocation of resources, with too few resources being used in the monopolized industries and too many resources used to lesser advantage in other competitive markets.’ The chief modern standard of comparison for assessing the welfare loss of monopoly is “perfect competition,” a hypothetical market structure, developed mainly for analytical purposes, in which all potential gains from trade are realized—all resources are allocated among alternative uses with “perfection” (by assumptions of the model).

At the same time, many economists as far back as Adam Smith have doubted that the economic damage done by monopolies could long endure without the protective arm of government heeding the monopolies’ political demands for market protections. The main change in economists’ overall appraisal of monopoly through history has been the growing formalization of the monopoly model that shows ever more clearly the economic harm monopolies cause, a point that can be seen with a review of the treatment of monopoly by classical economists (covered in this chapter) and their more contemporary neoclassical counterparts (covered in the following chapters).

In this book, our central goal is to undertake a critical and extensive (but not exhaustive) reexamination of contemporary monopoly theory, though not with an eye toward dispensing with the theory altogether. We would be the first to argue that the monopoly model that economists widely employ has many good uses. However, we suggest that the model has been overused and abused, given that it has almost everywhere been employed to show that monopoly power— or the capacity of firms to affect market price and firm profits (or “monopoly rents”)—is prima facie evidence of a “market failure,” or a sign of “inefficiency” and consumer “welfare loss,” which amounts to the same thing. On the contrary, we suggest that there is much wisdom in a widely unappreciated position taken by Joseph Schumpeter (1883-1950) in his classic 1942 work Capitalism, Socialism, and Democracy, in which he observed, partly in an effort to explain why capitalism would not survive, that an economic system is necessarily an imperfect evolutionary process of “creative destruction,” which makes it ill-suited for ultimate appraisal by the static analysis of conventional economic theory.

Since we are dealing with a process whose every element takes considerable time in revealing its true features and ultimate effects, there is no point in appraising its performance of that process ex visu of a given point of time; we must judge its performance over time, as it unfolds through decades or centuries. A system—any system, economic or other—that at every point of time fully utilizes its possibilities to the best advantage may yet in the long run be inferior to a system that does so at no given point in time, because the latter’s failure to do so may be a condition for the level or speed of long-run performance. (1942, 83; emphasis in the original)