 Today, we're going to talk more specifically about monopoly theory and offer some Austrian critiques of the theory as it's conventionally presented, and suggest some alternative ways to think about monopoly from an Austrian perspective. I suggested a couple of readings, a chapter by Dom Armentano surveying some Austrian approaches, and for a further and more advanced reading, an article by Joe Salerno that traces the history of Austrian monopoly theory from Karl Manger's day on through the 1930s. So just to recap what we talked about the last time, most neoclassical monopoly theory is really best understood in contrast with the neoclassical understanding of competition with the so-called model or theory of perfect competition, which sort of has its origins in Alfred Marshall's writings, but it was really perfected by Frank Knight and also by Kenneth Aro and Gerard De Bru as they developed the most sort of formal mathematical version of competition theory. And some version of this is what's in almost all of the mainstream economics textbooks. You remember in that understanding of competition, right, it's a very highly stylized abstract model in which you have a large number of firms each selling a perfectly identical product, such that each seller faces a perfectly elastic demand curve. And remember what that means is because each seller's product is identical to that of every other seller, and because there are so many sellers in the market, each seller is very small relative to the market as a whole. So no seller has any ability whatsoever to influence the market to drive the price up or drive the price down by withholding supply or by sending additional supply to the market. Every firm is a so-called price taker, meaning prices are exogenously determined and then the firm simply reacts to those prices in the perfect competition model simply by deciding what quantity to produce. Let's also assume that everyone in the market, every seller, every buyer has perfect information about all market conditions. And finally, and most importantly, that there is free entry and exit, meaning any seller who's not currently in the market can instantly and costlessly jump into the market and anybody who's in the market and wants to exit can immediately get out without having to worry about selling equipment or abandoning a lease in the middle of the term or something like that. Complete 100% resource mobility, anybody can get in, anybody can get out. So of course, you can see right away that this is not meant to be a description of any actual market. It's this sort of strange hypothetical construct which unfortunately ends up being used as a welfare benchmark and that's going to be really important in thinking about public policy towards monopoly and competition. So why does anybody care? Well under perfect competition, according to the standard theory, the neoclassical theory, we get the best possible outcomes that you could anticipate in terms of efficiency and consumer well-being and so forth, right? First, all prices are exactly equal to the marginal costs of production because it's assumed that each seller looks at the market price, looks at his or her own marginal cost curve, and sets quantity where the marginal cost curve and the market price intersect. So every firm is producing at the level of output where for that firm price is equal to marginal cost. Second, in the short run, firms can earn profits or losses depending on the relationship between these exogenously given prices and their average costs of production. So all firms are producing where price is equal to marginal cost but at that level, if the firm's average costs are lower than that market price, the firm will have a positive economic profit. If the firm's average costs are higher than that market price, the firm will earn an economic loss. Now you might wonder why firms would have different cost structures. That's sort of not really explained by the theory. It's just assumed that that could be the case in the short run. Now critical to understanding the supposed benefits of perfect competition are the long run outcomes, right? So in the long run, entry and exit drive prices to average costs so that all firms earn zero profits. What do we mean by that? That if firms are earning positive economic profits in the short run, then other firms will enter the market and that will help to drive down the market price. Again, no individual firm can do this, but if a lot of firms enter the market, then market prices will be driven down as supplies increase, as the quantities supplied increase, as supply curve shifts to the right, the market price will be driven down, and those positive profits will be squeezed down to zero. If firms are earning a loss, if their average costs are above the market price, then firms will exit, which remember is costless, as the supply curve shifts to the left that will tend to drive up the market price until those losses are sort of squeezed out. So in long run equilibrium, all firms, no firms earn a profit and no firms earn a loss. Every firm just exactly breaks even and earns zero economic profits. So this is supposed to be a good thing, right? Profits are bad, right? So no firms are earning profits. All goods and services are priced at prices equal to marginal cost. So we have perfect sort of allocative efficiency. Let's get the highest possible outputs, the highest possible market output at the lowest possible price, the price that just barely covers the average cost of production. Hooray! That sounds great from the consumer's point of view, although actually I was saying highest possible outputs, lowest possible prices sounds like Walmart maybe, but of course Walmart is an evil monopoly. If you look at this in a picture, which you can see on the next slide, this is a version of the picture we looked at the last time, right? You've got that perfectly elastic or horizontal demand curve, which also corresponds to the firm's marginal revenue for those of you who are interested in that little technical detail. All firms are producing where that horizontal demand curve, the market price, intersects the marginal cost curve. And in the long run, because prices will be driven up and down, they'll be driven to the point where that demand curve just hits the bottom of the U-shaped average cost curve. So there's all of the identical firms earning zero economic profits, producing where prices equal to marginal cost and where prices equal to average cost. Well, if that's competition, what about monopoly? What's the neoclassical theory of monopoly? Well, monopoly obtains when you have a market containing sellers which produce unique or differentiated products, right? Such that each firm faces a downward sloping demand curve for its product or to use the terminology that neoclassical economists use. Each firm has market power. So market power refers to the ability to raise the price above the marginal cost. And if the demand curve is downward sloping, then the firm might have the opportunity by selling less, by reducing output, to sort of ride up that upward sloping demand curve and be able to charge a higher price. So the assumption is that entry into this market is either completely blocked or partially blocked, right? And we'll talk a little bit more about why, but note that these barriers to entry could come from sort of formal legal barriers. It could be government-granted monopoly, but it could also be a market power could also come from advertising, right? The firm sort of falsely, I guess, convinces consumers that its product is unique or their economies of scale, meaning firms that are already producing at a large scale have a cost advantage over firms that are not yet in the market. So it's very difficult or impossible for newcomers to enter. In other words, it's not just government action that blocks entry in this theory. There could also be sort of naturally occurring market phenomena that also constitute entry barriers and hence give firms market power. Now who cares what's wrong with market power? Well according to Neoclassical Monopoly theory, there are a number of outcomes under monopoly that are not as desirable as those under perfect competition. So you get market quantities that are lower than the market quantities that obtain under perfect competition and you get prices that are higher, not only above marginal cost, but even above the average cost of production, right? Because the monopolist in this theory, unlike the perfectly competitive firm, is not constrained to charge whatever is the going market price because this firm sells a unique product or a differentiated product, the seller can charge whatever the market will bear. He can sort of, he or she can reduce quantity and ride up that downward sloping demand curve. The result of which, and we'll see this in a picture in just a moment, is so-called deadweight loss. There's a supposed inefficiency here in that consumers might have been willing to pay for extra units of the good at a price that is above the marginal cost, but the seller refuses to sell these units because that would reduce the seller's total profit. So the implication is that the government should step in and break up monopolies or force monopolies to charge prices and to produce quantities that are more like what you would get under perfect competition. So here's a picture of a firm with so-called market power, right? You see the downward sloping demand curve, the red line, and that downward sloping green line is the firm's marginal revenue curve. The upward sloping blue line is the firm's marginal cost curve. So the monopolist seeking to maximize profits chooses a quantity where marginal revenue is equal to marginal cost. That's the way you maximize profit. So where you see that QM, that's the monopoly quantity, it's determined by the intersection of the upward sloping blue line, marginal cost, and the downward sloping green line, marginal revenue. But notice the monopolist does not charge a price where the green curve and the blue curve intersect. Rather, the monopolist uses that to determine the optimal quantity, then goes all the way up to PM, right, the highest price you can charge and still sell that many units given the position of the demand curve, the red demand curve, right? So that leads to this kind of bluish-purplish area in this graphics-labeled producer surplus, but we would normally just call that profit, right? That's the area below the price that's being charged and above the marginal cost of production at the quantity chosen by the monopolist. The problem with this, according to the neoclassical theory, has to do with this little yellow triangle, right? The yellow triangle represents sort of an amount of production that could be sort of feasible, but would not be chosen by the monopolist, right? In other words, if the monopolist would increase quantity to QC, the competitive quantity where the downward-sloping red demand curve intersects the marginal cost curve, or sorry, to put it more clearly, where the marginal cost curve intersects not the marginal revenue curve, the green one, but the demand curve, the red one, right? At that quantity, it would still be possible to produce where price is above marginal cost. In other words, the firm wouldn't have to earn a loss, but the firm would earn zero economic profit at that level. So consumers would be better off, the firm would be worse off, but this little triangle represents an area, you know, a sort of potential value that nobody captures. In other words, at QC and PC, the so-called perfectly competitive outcomes, consumers would get the area equal to that larger triangle in so-called consumer surplus, the red triangle plus the top part of that blue rectangle and the top part of that yellow triangle. Producers could still potentially earn some profit, right? The area below PC, but above that blue marginal cost curve. The problem is, producers can earn even more profit by restricting output to QM, and they get that sort of trapezoid shape in bluish-purple. That leaves the consumers with less consumer surplus. They only get the little red triangle, and then you have this yellow area that's kind of lost to everyone just evaporates into the ether, and so that's an inefficiency, according to this theory, that the government needs to remedy. So what are some critiques of neoclassical monopoly theory? Or what I should say is some critiques of the idea that monopoly is bad and that the government needs to step in and remedy the problem by breaking up the monopolist into a small bunch of small firms, or by regulating the price and quantity. Well, within the neoclassical school itself, there are a number of critiques of the idea that monopoly is bad and should be dealt with, should be remedied, should be corrected. I mean, some economists, this view is famously associated with Joseph Schumpeter, but others have made the point as well, that maybe monopoly is inefficient, maybe monopoly reduces consumer well-being in the short run, but we kind of need it anyway for long-run economic growth because you need monopoly to generate innovation. This could mean Schumpeter's idea was that innovation comes from research and development, and only large firms will have enough profits to fund research and development and to discover new stuff and to bring new products to market. So yeah, even though monopoly has this undesirable effect on consumers, that's sort of a price we have to pay because you need those monopoly profits to generate innovation and other kinds of longer-run improvements. We'll talk a little bit about patents in the next lecture, but some people have also argued, yeah, I mean, if the government grants a firm a patent, that gives it a temporary monopoly, and that's bad from the point of view of the picture we just looked at. But you need to dangle those monopoly profits in front of entrepreneurs to give them an incentive to try to invent new stuff that they can patent, and we can sort of trade those things off and say, well, maybe the benefits of having new stuff outweigh the efficiency loss and welfare loss from granting a temporary monopoly to the patent holder. Another point that many Chicago school economists have made is that, look, the reason that firms are large, the reason that firms have a large market share, the reason the perfect model of perfect competition doesn't obtain is because some firms are just actually better. They have more managerial talent, they have a better workforce, they have superior technology, and so yeah, we wouldn't expect to see markets in which you have lots and lots of teeny, tiny, identical firms, because some firms are just better, and the firms that are better are going to attract more customers, they're going to be able to raise more capital, they're going to end up being large and dominating the market and maybe charging monopoly prices, but who cares, I mean, that's just sort of the outcome you get in a market in which some entrepreneurs, some managers, some workers and so forth are better than others. There's another kind of a strand of critique that emerged in the 1990s, arguing that, well, even if you have only one firm in the market, that firm may not be able to act as a monopolist, using the notion of monopolist that we've just discussed, because of the prospect of potential competition, right? So even if there's only one firm in the market, as long as there's some potential for other firms to enter, that one firm will be constrained in its behavior, because it doesn't want to encourage entry by an outsider, so even a market with just one firm in it, that firm may produce the larger quantity and charge the lower prices that would obtain in perfectly competitive markets, because otherwise firms would enter and the monopolist wants to prevent that from happening. We can talk about some examples in the Q&A, the airline industry has sometimes been used as an example of this situation. I'll just mention in passing one argument that hasn't been developed enough, I think, but would also apply here. Notice that the argument about deadweight loss assumes that there's some kind of transaction costs or bargaining costs that prevent the consumers who would like to have higher quantities and pay lower prices from sort of taking up a collection amongst themselves and agreeing to pay the monopolist to sort of bribe the monopolist to increase output. If it's true that monopoly means consumers lose, producers gain, but the consumers lose more than the producers gain, leading to this deadweight loss, then it ought to be possible for them to sort of bargain to reduce that inefficiency. In other words, the consumers can say, well, if we could convince the monopolist to produce a higher quantity and charge a lower price, we would gain $1 million worth of consumer surplus, but the monopolist would lose $800,000 of profit. Well, can't we just raise $900,000 amongst ourselves and we'll use it, we'll offer that as a bribe to the monopolist to act like a perfect competitor. We'll just give you a lot, we'll write you a check for $800,000, if you agree to take an action that reduces your profit by $700,000, sorry, by $800,000, but actually increases our well-being by a million. Now, there's some room to bargain in the middle there. The fact that that doesn't happen suggests that it's impossible to bargain in this fashion. I'm referring to the so-called cost theorem, which suggests that all of these inefficiencies can be bargained away if transaction costs are low. So if we think that doesn't happen, we're assuming that the transaction costs of bargaining among the consumers are prohibitively high, and they might be, but there's not necessarily so. If you have a small number of large influential buyers, if we're talking about, if the monopolist is a wholesaler selling to large and powerful retailers, those retailers might be able to persuade the wholesaler to lower its prices and increase its output with a contractual agreement to make some kind of a lump sum payment. But what we want to really focus on here is the Austrian critiques. And Armantano, I think, does a nice job summarizing the standard theory and explaining some things that are wrong with it. So for example, Armantano points out correctly, as I've already emphasized, that a perfect competition is not only impossible, but sort of irrelevant. I mean, why would we want to evaluate the properties of actual real world markets, according to how closely they approximate this weird, totally hypothetical, abstract model of perfection, which, I mean, just doesn't have any bearing on actual markets, on real behavior. It's just sort of irrelevant. So it doesn't make any sense to evaluate markets according to how close they are to perfect competition. We should just throw perfect competition out as totally useless and not, not worthy of any attention. He also points out that the standard approach to monopoly takes a kind of a snapshot view, right? It assumes that competition and monopoly are states of affairs, are end states, rather than taking the view emphasized by Kershner, and Armantano points this out, Israel Kershner, that we can think of competition as the sort of ongoing, dynamic, rivalrous process through time, in which case, even if at this moment there's only one firm in the market charging a high price, who cares? What's more important is how did that firm come to have that position? Is that position sustainable? How likely is it that innovation and entrepreneurship and entry and so forth will compete that position away? What we really want as desirable, according to this point of view, is a world in which, you know, people are free to try new things in which there's a fluid sort of ongoing process in which all firms are free to try to charge whatever prices they want, and to establish whatever market conditions they want, and others are free to try to compete against them. And it's the efficiency of this overall process, rather than how the market looks at any one particular snapshot moment that we ought to be concerned about. And finally, Armantano does a good job describing problems with the neoclassical notion of entry barriers. Here I mean not legal barriers to entry, but these sort of naturally occurring economic barriers like product differentiation or economies of scale. As he points out, you know, firms cannot force differentiated products onto the market. If a firm in fact produces a product that consumers view as distinct from those of other sellers of similar products, well, that's just another way of saying consumers prefer the characteristics of one product to another. In other words, product differentiation reflects the preferences of consumers. It doesn't impose something artificial or false on consumers. The second point is very similar. If we say that scale economies are present, meaning, you know, the incumbent firm can produce at a lower average cost than rivals because it's producing on a large scale. Well, that simply reflects the fact that in the past, consumers have preferred to buy these products, the incumbent firm's products, to some other products that could have been offered on the market, right? And if consumers don't like scale economies, they're free to purchase products and services from newer, smaller firms that don't have the advantages of scale economies. There's no reason why they can't do that. The fact that a firm with scale economies can do very well in the market is simply another way of saying consumers prefer low prices to high prices, other things equal. Consumers like the fact that scale economies allow some firms to produce products at a very low, sell products at a very low price. So what did the Austrians think about monopoly? Well, as Joe Salerno's article points out, Armantano suggests as well. Austrians did think about monopoly and monopoly pricing, starting with Karl Manger. Manger had a kind of a not totally developed, but a sort of skeletal notion of monopoly that was then developed by second and third generation Austrian scholars, and then later revived by Mises and by Rothbard. They did think about this issue. They didn't ignore it. But for the Austrians, the key issue was not sort of monopoly as a condition, but rather monopoly prices as distinct from other kinds of prices. So the issue is whether monopoly prices exist as something distinguished from other prices and Manger, and most of Manger's followers and Mises, but not Rothbard as we'll see, did believe there was a meaningful notion of monopoly price. They thought that there were such things as monopoly prices, and it was worth thinking about them, that monopoly prices were different from other kinds of prices, but that they emerged only under particular market conditions, and the key to these conditions are the preferences of buyers and sellers. Now, typically, for most of these thinkers, they thought that monopoly prices were not necessarily better or worse than so-called competitive prices, from the point of view of market performance or well-being, but rather this was sort of an interesting, potentially interesting and important characteristic of the market that we should study. If we want to understand why prices are higher in some markets than others, we want to look at these market conditions. We want to explain that difference in terms of the preferences of buyers and sellers, and we may want to classify some of those prices as monopoly prices as that aids our analysis. As we'll see, this may be much harder to do than even Manger and his followers were anticipating, but both Mises and Rothbard were building on this older tradition from Carl Manger and his successors on monopoly price. And as I said, Joe Salerno's article provides a lot of useful detail and insight about this. Well, what about Mises? Let's start with Mises. Mises' theory of monopoly, as summarized by Armantano, holds that there are such things as monopoly prices, but that monopoly prices emerge only under very special conditions. And for Mises, there were two conditions. First, that you have a single seller of a unique good or a cartel of sellers selling a unique good. So it must be the case that consumers do distinguish the good in question from the one seller or the seller's cartel from those of competing products. That's condition one. Condition two is that the demand curve for the product or the demand for the product must be any elastic above the so-called competitive price. So the competitive price for Mises is the price that would otherwise have obtained on the market. In other words, the price that would have obtained if there were not a single seller or a seller's cartel, if consumers considered other products to be equal substitutes or very close substitutes, then a different set of prices would emerge. So those are what Mises calls competitive prices. If you have a single seller or a seller's cartel and demand is any elastic above that competitive price, then what emerges is what Mises called monopoly price or monopoly prices. And Mises does say that the emergence of monopoly price is sort of a caveat to his more general notion of consumer sovereignty. Right. Mises argues that in general, consumers are sovereign in the market, consumers make the ultimate decisions about what is produced and how it's produced and how goods and services, what goods and services are available and what prices are charged and so forth. Consumers make the ultimate decisions about resource allocation in a market. That's Mises' notion of consumer sovereignty. Mises says that monopoly prices represent an exception to this principle. There is sort of a violation of consumer sovereignty in that consumers would prefer that the monopolist produce a higher quantity and charge a lower price, but the monopolist's ability to increase total revenue by raising the price when demand is inelastic sort of frustrates consumer sovereignty. Now, Mises did not think that in practice, this was a very big deal because he thought the conditions that give rise to monopoly prices are extremely rare. And so the whole notion of monopoly is just usually not very relevant for public policy. Rothbard offered a refinement of Mises monopoly theory. So Rothbard agreed that the key is not monopoly as a condition, but monopoly prices. And Rothbard started with Mises analysis and said Mises analysis is correct as far as it goes, but there's some problems. Namely, Rothbard said, look, all sellers face a downward sloping demand curve for their product, even if it's just a infinitesimally, infinitesimally downward sloping curve. In other words, no two products are truly identical. They may, even if they look very similar, I mean, they're offered under different circumstances, sold in different places at different times. Every product to a greater or lesser degree is different from other products that are on the market. I mean, even, you know, the textbooks talk about wheat and say, oh, well, the wheat market is perfectly competitive. Or that's our example of a perfectly competitive market because consumers don't distinguish between, you know, Farmer Smith's wheat and Farmer Jones's wheat. I mean, even that isn't really true. Right. I mean, the buyers are wholesalers, not consumers buying from the farm. And they do distinguish based on the location of the farm, the timeliness of the delivery. And of course, in our, in our world, there's no such thing as wheat. There's lots of different grades of wheat. There's organic wheat. There's GMO free wheat. You know, winter wheat. There's red wheat. And there's lots of different kinds of wheat. So for every product, there is some distinction among sellers among the products offered by different sellers. So Rothbard says, look, in practice, and even theoretically, there's no way to distinguish the monopoly price from the competitive price in the absence, as we'll see in just a moment, of formal legal restrictions on entry. In other words, Rothbard says, look, all firms try to maximize profit or net income, given their estimates of demand. Right. Whether they sell products that are very similar to those of other firms or are quite different from those of other firms, everybody's trying to maximize profit based on their estimates of demand. And furthermore, all firms charge prices. This is kind of a techie point. Some of you have studied this probably in classes, but all firms charge prices in the elastic range of the demand curve. Why do we say that? Remember, elasticity refers to the sensitivity of quantity demanded to price. So if demand is any elastic, that means when a firm increases its price by a certain percentage, the percentage reduction in quantity demanded is smaller than the percentage increase in price, such that total revenue goes up. But of course, if total revenue goes up when the price increases, then all firms would want to increase their price. I mean, that's kind of a no-brainer. Right. You get an increase in total revenue and if you're reducing the amount produced, you're going to get a reduction in total cost. So your profits are always going to go up when demand is any elastic if you reduce your price when demand is any elastic. Right. Firms will always keep increasing their prices until they reach the elastic part of the demand curve. So Rothbard says, I mean, for all firms, yeah, they're, you know, at prices lower than the prices currently being charged, demand is an elastic, but otherwise they would keep raising their price. So how do we know that some particular price below the price that's being charged on the market is the competitive price and the current price is not a competitive price. I mean, maybe Rothbard says the price that's being, maybe we should say the price that is currently being charged is the competitive price and some hypothetical lower prices like a sub-competitive price. Right. In other words, according to Rothbard, there's competition. Competitive prices are simply the prices that emerge on the free market when everybody is free to enter or exit to experiment with different technologies, to market their products in different ways. Those are competitive prices. And even theoretically, we can't distinguish profits that emerge under particular conditions with profits that might have emerged under other conditions and call one a monopoly price and the other a competitive price. All prices on the free market are competitive, according to Rothbard's position. So what then, according to Rothbard, does monopoly mean? Is there any meaningful notion of monopoly? Rothbard says, yes, he appeals back to the sort of common law notion of monopoly as a government grant as an exclusive privilege that's provided by the state. Right. So for example, the state gives me a patent. So for the life of that patent in the U.S., say it's 17 years, no one else can produce a product that is similar to mine or I can sue for monopoly infringement of my monopoly privilege. Or the government says, I, Peter, am the only one who can legally provide water or electricity service in a particular town. Then I have a legal monopoly on the provision of water or electricity or I have a license. I'm the only licensed broadcaster in my area. Or I mean, if there's a protective tariff, let's say, say there are no other domestic firms that produce a product similar to mine, but there are lots of foreign firms that do a tariff is also a way of restricting, if not completely eliminating competition with my product. So Rothbard says, yeah, I mean, we can talk about monopoly and monopoly prices that are inefficient and harmful to consumers and to the market, but only if we refer to monopoly prices that come from special government granted privilege. And notice that there may be less obvious sources of government granted monopoly privilege, like certain aspects of the tax code, right? Taxes on progressive taxation on consumers, corporate income taxes and so forth that make it harder for new firms to accumulate capital could be a way of protecting incumbent firms that already have large amounts of capital, you know, labor and environmental restrictions may impose differential costs on new firms compared to existing firms and thus provide a degree of monopoly privilege for those incumbent firms. So according to Rothbard's view, the only meaningful notion of monopoly is a special grant that is issued by the state. And we can argue that that's an inefficiency because that's different from what would have emerged, of course, on the free market. Now, there may be ways for the market to kind of compete around a legally granted monopoly. This is a problem we'll see next time of market definition, which is problem for antitrust policy. But even, for example, if I have an exclusive grant to supply water, you know, through pipes in my town, I may not legally be able to prevent a customer from disconnecting from the water system and just having bottled water trucked in and having their own private, you know, septic tank or sewage collection, which they then take away in a truck or something. So there may be ways for the market, especially with innovation and entrepreneurship to kind of get around some government granted monopoly privilege. But nonetheless, the privilege is harmful relative to what would have obtained on the market. So just to summarize, neoclassical monopoly theory is based on the contrast with an impossible and irrelevant benchmark model of perfect competition. Austrians, in contrast, understand competition as a rivalrous interaction among entrepreneurs, investors, resource owners and consumers. So absent government restrictions, especially in Rothbard's view, all market behavior is competitive and there isn't any way to distinguish perfect competition from monopoly or the other labels you find in neoclassical textbooks, oligopoly, monopolistic competition and so forth. Now in the next session after this, we'll talk about some applications to antitrust, regulation, the minimum wage and other issues building on the discussions that we've had so far. So look forward to seeing you then.