MONOPOLY I: HOW TO LOSE YOUR SHIRT

One of the most effective arguments against unregulated laissez faire has been that it invariably leads to monopoly. As George Orwell put it, “The trouble with competitions is that somebody wins them.” It is thus argued that government must intervene to prevent the formation of monopolies or, once formed, to control them. This is the usual justification for antitrust laws and such regulatory agencies as the Interstate Commerce Commission and the Civil Aeronautics Board.

The best historical refutation of this thesis is in two books by socialist historian Gabriel Kolko: The Triumph of Conservatism and Railroads and Regulation. He argues that at the end of the last century businessmen believed the future was with bigness, with conglomerates and cartels, but were wrong. The organizations they formed to control markets and reduce costs were almost invariably failures, returning lower profits than their smaller competitors, unable to fix prices, and controlling a steadily shrinking share of the market.

The regulatory commissions supposedly were formed to restrain monopolistic businessmen. Actually, Kolko argues, they were formed at the request of unsuccessful monopolists to prevent the competition which had frustrated their efforts.

Those interested in pursuing the historical question should read Kolko’s books, which deal with the Progressive period, as well as the articles by McGee and Stigler mentioned in Appendix II. McGee discusses the history of Standard Oil, Stigler examines the question of whether concentration has historically tended to increase. His conclusion is that the degree of concentration in the economy has been relatively stable. It always appears to be increasing, because highly concentrated industries are much more visible than more competitive ones. We are all aware that, sometime between 1920 and the present, General Motors acquired a commanding position in the automobile industry. Few of us realize that during the same period U.S. Steel lost its dominance in the steel industry. For the same reason, we tend to exaggerate the amount of concentration existing at any given time. The areas of the economy which we think of as important tend to be those in which we can identify a single large firm. We rarely consider such industries as the restaurant and bar business, domestic service, or the manufacture of textiles and apparel, each of which is highly competitive and eachof which employs more people than iron, steel, and automobile manufacturing combined.

Whatever the facts about monopoly may be, the belief that competition inevitably tends to produce monopoly is widespread. The remainder of this chapter is devoted to understanding the arguments that support this belief and why they are wrong.

There are three different sorts of monopoly: natural monopoly, artificial monopoly, and state monopoly. Only the first is of any importance in a laissez-faire society.

In most economic activities, the efficiency of a firm increases with size up to some optimum size and then decreases. One steel mill is far more efficient than a backyard blast furnace but making an existing mill still larger brings no added advantage — that is why steel mills are the size they are — and two steel mills are no more efficient than one. Increasing size also brings increased cost of administrative bureaucracy. The men at the top get further and further removed from what is actually going on at the bottom and are therefore more likely to make costly mistakes. So efficiency tends to decrease with increasing size once firms have passed the point where they can take full advantage of mass production. For this reason some very large firms, such as General Motors, break themselves down into semi-autonomous units in order to approximate as nearly as possible the more efficient administrative arrangements of smaller firms.

A natural monopoly exists when the optimum size for a firm in some area of production is so large that there is room for only one such firm on the market. A smaller competitor is less efficient than the monopoly firm and hence unable to compete with it. Except where the market is very small (a small town grocery store, for example), this is an uncommon situation. In the steel industry, which is generally regarded as highly concentrated, there are between two hundred and three hundred steel mills and between one hundred and two hundred firms. The largest four firms (which are by no means the most profitable) produce only half the total output, and the next four produce only 16 percent of total output.

Even a natural monopoly is limited in its ability to raise prices. If it raises them high enough, smaller, less efficient firms find that they can compete profitably. Here Orwell’s implicit analogy of economic competition to a contest breaks down. The natural monopoly wins in the sense of producing goods for less, thus making a larger profit on each item sold. It can make money selling goods at a price at which other firms lose money and thus retain the whole market. But it retains the market only so long as its price stays low enough that other firms cannot make a profit. This is what is called potential competition.

A famous example is Alcoa Aluminum. One of the charges brought against Alcoa during the anti-trust hearings that resulted in its breakup was that it had kept competitors out of the aluminum business by keeping its prices low and by taking advantage of every possible technological advance to lower them still further.

The power of a natural monopoly is also limited by indirect competition. Even if steel production were a natural monopoly and even if the monopoly firm were enormously more efficient than potential competitors, its prices would be limited by the existence of substitutes for steel. As it drove prices higher and higher, people would use more aluminum, plastic, and wood for construction. Similarly a railroad, even if it is a monopoly, faces competition from canal barges, trucks, and airplanes.

For all of these reasons natural monopolies, although they occasionally exist under institutions of laissez faire, do not seriously interfere with the workings of the market. The methods government uses to control such monopolies do far more damage than the monopolies themselves, as I show in the next chapter.

An artificial monopoly is a large firm formed for the purpose of controlling the market, raising prices, and thus reaping monopoly profits in an area where the conditions for natural monopoly do not exist. When the same effect is produced by an agreement among several firms, the group of firms is called a cartel. Since a cartel has most of the problems of a monopoly in addition to problems of its own, I shall discuss monopolies first.

Suppose a monopoly is formed, as was U.S. Steel, by financiers who succeed in buying up many of the existing firms. Assume further that there is no question of a natural monopoly; a firm much smaller than the new monster can produce as efficiently, perhaps even more efficiently. It is commonly argued that the large firm will nonetheless be able to achieve and maintain complete control of the industry. This argument, like many others, depends on the false analogy of market competition to a battle in which the strongest must win.

To see why this is wrong, suppose the monopoly starts with 99 percent of the market and that the remaining 1 percent is held by a single competitor. To make things more dramatic, let me play the role of the competitor. It is argued that the monopoly, being bigger and more powerful, can easily drive me out.

In order to do so, the monopoly must cut its price to a level at which I am losing money. But since the monopoly is no more efficient than I am, it is losing just as much money per unit sold. Its resources may be 99 times as great as mine, but it is also losing money ninety-nine times as fast as I am.

It is doing worse than that. The monopoly must be willing to sell to everyone who wants to buy, since otherwise unsupplied customers will buy from me at the old price. Since at the new low price customers will want to buy more than before the monopolist must expand production, losing even more money. If the good we produce can be easily stored, the anticipation of future price rises once our battle is over will increase present demand still further.

Meanwhile, I have more attractive options. I can, if I wish, continue to produce at full capacity and sell at a loss, losing one dollar for every hundred or more lost by the monopoly. Or I may save money by laying off some of my workers, closing down part of my plant, and decreasing production until the monopoly gets tired of wasting its money.

What about the situation where the monopoly engages in regional price cutting, taking a loss in the area where I am operating and making it up in other parts of the country? If I am seriously worried about that prospect, I can take the precaution of opening outlets in all his major markets. Even if I do not, the high prices he charges in other areas in order to make up for his losses against me will make those areas very attractive to other new firms. Once they are established, he no longer has a market in which to make up his losses.

Thus the artificial monopoly which tries to use its size to maintain its monopoly is in a sad position, as U.S. Steel, which was formed with 60 percent of total steel production but which now has about 25 percent, found out to its sorrow. It has often been claimed that Rockefeller used such tactics to build Standard Oil, but there seems to be little or no evidence for the charge. Standard Oil officials occasionally tried to use the threat of cutting prices and starting price wars in an attempt to persuade competitors to keep their production down and their prices up. But the competitors understood the logic of the situation better than later historians, as shown by the response, quoted by McGee, of the manager of the Cornplanter Refining Company to such a threat: “Well, I says, ‘Mr. Moffett, I am very glad you put it that way, because if it is up to you the only way you can get it [the business] is to cut the market [reduce prices], and if you cut the market I will cut you for 200 miles around, and I will make you sell the stuff,’ and I says, ‘I don’t want a bigger picnic than that; sell it if you want to,’ and I bid him good day and left.”

The threat never materialized. Indeed it appears from McGee’s evidence that price cutting more often was started by the small independent firms in an attempt to cut into Standard’s market and that many of them were successful. Cornplanter’s capital grew, in twenty years, from $10,000 to $450,000. As McGee says, commenting on the evidence presented against Standard in the 1911 antitrust case: “It is interesting that most of the ex-Standard employees who testified about Standard’s deadly predatory tactics entered the oil business when they left the Standard. They also prospered.”

Another strategy, which Rockefeller probably did employ, is to buy out competitors. This is usually cheaper than spending a fortune trying to drive them out—at least in the short run. The trouble is that people soon realize they can build a new refinery, threaten to drive down prices, and sell out to Rockefeller at a whopping profit. David P. Reighard apparently made a sizable fortune by selling three consecutive refineries to Rockefeller. There was a limit to how many refineries Rockefeller could use. Having built his monopoly by introducing efficient business organization into the petroleum industry, Rockefeller was unable to withstand the competition of able imitators in his later years and failed to maintain his monopoly.

So far I have been discussing the situation where there is a single monopoly firm. When the monopoly is shared by several firms who make up a cartel, the difficulties may be even greater.

A cartel is strongest in an industry where there is almost a natural monopoly. Suppose, for instance, that the optimum size of a firm is such that there is room for only four firms large enough to be efficient. They agree to raise prices for their mutual benefit. At the higher price the firms, which are now making a large profit on every item sold, would each like to produce and sell more. But, at the higher price, the total demand for their product is lower than before. They must in some way divide up the total amount of business.

A firm that sells more than its quota can greatly increase its profit. Each firm is tempted to chisel on the agreement, to go to customers and offer to sell them more at a slightly lower price without letting the other members of the cartel know about it. As such chiseling becomes widespread, the cartel agreement effectively breaks down; this seems to be what happened to many of the short-lived cartels formed at the beginning of this century. ‘Chiseling’, of course, is what the other cartel members call it; from the standpoint of the rest of us it is a highly desirable form of behavior.

If a cartel manages to prevent chiseling among its members, it, like a monopoly, still has the problem of keeping new firms from being attracted into the industry by the high prices and consequent high profits. Even where there is almost a natural monopoly, such that any new competitor must be very large, this is difficult.

The obvious strategy of the cartel members is to tell any potential competitor that, as soon as he has sunk his capital into constructing a new firm, they will break up the cartel and return to competition. The new firm will then find himself the fifth firm in an area with room for only four. Either one of the firms will go broke or all will do badly. Either way, entering the industry does not look like a very attractive gamble.

That strategy will work as long as the cartel does not raise prices much above their market level. When it does, a profitable counter-strategy becomes available. The potential competitor, before investing his capital in building a new firm, goes to the major customers of the cartel. He points out that if he does not start a new firm the cartel will continue to charge them high prices, but that he cannot risk investing money until he has a guaranteed market. He therefore offers to start the new firm on condition that the customer agrees to buy from him for some prearranged period of time at a price high enough to give him a good profit but well below the cartel’s price. Obviously, it is in the interest of the customers to agree. Once he has signed up a quarter of the total business, he builds his factories. Either the cartel restricts output still further, keeps its prices up, and accepts the loss of a quarter of the market, in which case the newcomer may eventually expand, or it competes for the customers the newcomer has not already tied up. Since there is only enough business to support three firms, one of the four goes broke.

Although an artificial monopoly or cartel may be able to influence prices somewhat, and although it may succeed for a while in gaining additional profits at the cost of attracting new competitors, any attempt to drive prices very far above their natural market level must lead to the monopoly’s own destruction.

Unfortunately, the same cannot be said of the third kind of monopoly, state monopoly. State monopoly occurs when competition is prevented in one way or another by the government. It is far and away the most important kind of monopoly, both historically and presently. Ironically, one of its most common causes — or at least excuses — has been the attempt to prevent or control monopolies of the first two kinds.

The Post Office is a state monopoly run directly by the government. Competition in the delivery of first-class mail is forbidden by law. Contrary to common opinion, there have been many private post offices in both American and English history; such post offices have been responsible for many, perhaps most, innovations in the business of carrying mail. At one point in the nineteenth century, illegal private post offices, operating on the black market with wide public support, carried about one-third of all U.S. mail. The United Parcel Service presently offers better service than parcel post and at a lower price, and the business of delivering third-class mail privately is growing rapidly.

The Post Office has often defended its monopoly on the grounds that it needs the money it makes on first-class mail to subsidize the other classes; it claims that private competitors would ‘skim the cream of the business’ and leave the Post Office to lose money or raise rates on the less profitable classes. And yet private firms are providing better service (guaranteeing delivery by a particular time, for example) than the Post Office, charging considerably less, and making money in precisely the area that the Post Office claims it needs its profits from first class to subsidize.

The history of private post offices and their present status is discussed at some length by William Wooldridge in Uncle Sam the Monopoly Man. My main concern is with a less obvious sort of state monopoly, but I cannot leave the subject of the Post Office without making two historical notes.

One of the largest of the private post offices was the American Letter Mail Company founded by Lysander Spooner, a nineteenth-century libertarian anarchist and author of an anarchist tract entitled ‘No Treason: The Constitution of No Authority’. In it, Spooner attacks the contract theory of government like a lawyer arguing a case. He asks precisely when he signed the social contract (specifically, the Constitution), whether, indeed, anyone signed it, and if so, whether the signers had his power of attorney and, if not, on what basis he can be held bound to it. After dealing with all of the standard arguments he concludes «that it is obvious that the only visible, tangible government we have is made up of these professed agents or representatives of a secret band of robbers and murderers who, to cover up, or gloss over, their robberies and murders, have taken to themselves the title of ‘the people of the United States.’» The ALMC was legislated out of existence, but the Post Office, Spooner claimed, imitated his low rates. My second historical note may be apocryphal; I have never had courage and enterprise enough to check back and verify the story. If it is not true, it should be. It seems that in the early nineteenth century, when railroads were beginning to become important, some enterprising gentleman conceived the novel idea of using them, instead of horses, to carry mail. Private post offices were at this time already illegal but the law was not rigorously enforced. The gentleman did very well for himself until the day that he tendered a bid to the U.S. government to carry the government’s mail—at one-fifth the price the U.S. Post Office was charging. The Post Office regarded this as going a bit too far and insisted on its rights. The gentleman was put out of business and the Post Office stole his idea.

When a mail truck gets stuck in the mud, third class is what they throw under the wheels.

Stewart Brand