Monopoly: a game economists love to play--badly!(2003 Presidential Address)

• Author: McKenzie, Richard B.

When I started in this profession as a southern economist, now nearly four decades ago, I never imagined that I would one day have this opportunity. And it is a distinct opportunity. Not only do I have a chance to talk to you this afternoon on a topic of my choosing, I also know that my talk will be published. Nevertheless, the opportunity I have this afternoon also carries with it a daunting duty: to develop an argument of some consequence on a topic that can be adequately developed in a talk, without resort to the usual graphs and equations. A presidential address is not intended to be a seminar, nor should it be one. I submit that such a talk should be venturesome, that is, should address fundamental issues at the heart of what we do and, at the same time, pose a challenge to conventional thinking.

In choosing my topic for this address, I take to heart the words of Lord Acton that James Buchanan quoted at the start of his presidential address back in the early 1960s (Buchanan 1964), which for me remains the quintessential model for all such addresses, "[I]t is not the popular movement, but the traveling of the minds of men who sit in the seat of Adam Smith that is really serious and worthy of all attention" (Acton 1904, p. 212). I have written much over the years for the popular movement, as many of you know. However, for this talk I want to focus on the traveling of our collective minds, as represented by conventional wisdom within the profession. In the end, for all of us who aspire to sit in the seat of Adam Smith, it is in the ongoing battle of fundamental ideas for space in what will eventually become conventional wisdom--that we will likely make our most lasting mark.

My topic for the talk is monopoly. Indeed, this is a topic very familiar to those who sit in Adam Smith's seat. Perhaps the theory of monopoly is so firmly established in microeconomic theory that you might wonder how I could possibly think there is anything novel to say about it. However, I submit that our theory of monopoly is in serious need of repair, especially since it is so widely studied and, because of embedded problems, is so misleading when it comes to understanding the dynamics of a market economy and to guiding antitrust and other government policies.

Admittedly, one of my essential points is not totally novel. It is one that the late and great Joseph Schumpeter made, albeit as an aside, in his classic Capitalism, Socialism and Democracy, first published back in 1942 (the year I was born):

A system--any system, economic or other--that at every given 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 point of time, because the latter's failure to do so may be a condition for the level and speed of long-run performance. (1942, p. 83; emphasis in the original) In this talk, I will seek to elaborate on Schumpeter's counterintuitive and little appreciated point, adding extensions along the way. My thesis will be threefold:

(i) My weak point is that economists' standard static model of monopoly exaggerates in various ways the harm done by the prevalence of monopolies in a market economy.

(ii) My stronger point is that some monopoly prevalence is absolutely necessary for a well-functioning, dynamic market economy.

(iii) My strongest point is that under some market conditions, monopoly pricing, as represented by the standard model, can be, on balance, beneficial to consumers.

That is to say, an economy made up of a perfectly fluid, perfectly efficient, perfectly competitive market system--the idealized standard of market analysis--will, as Schumpeter recognized, likely be inferior in the long run to a system that is less than perfectly efficient at every point in time. Perfect fluidity of resources is hardly the idealized market state that we, as economists, make it out to be.

You will be pleased to hear, I suspect, that my central points are sufficiently elementary that my address will be short. However, you should know that there are many details to my arguments that are intentionally left out because of the time (and journal space) limits. These details are covered in a book that I recently completed with Dwight Lee, called Monopoly: Market Bane or Boon? (2003).

1. The Conventional Monopoly Model

   Within the economics profession, monopoly has a well-entrenched definition. In its purest form it is almost everywhere defined as a market structure in which there is a single producer of a product that has no close substitutes and that is protected by consequential, if not prohibitive, barriers to entry. Accordingly, the (pure) monopolist faces the market demand for its good and is capable of choosing among the various price-quantity combinations on its demand curve with the single-minded goal of maximizing firm profits. A profit-maximizing monopolist will, of course, invariably price above marginal cost.

   Economists might quibble over when substitutes are sufficiently close to withdraw the monopoly designation of a market structure, but all seem to agree that monopolists of all stripes necessarily face downward-sloping demand curves, with the elasticity of demand affected by how close the substitutes are and how high the entry barriers are.

   Regardless of the fine distinctions that can be drawn, the monopolist's ability to affect, consequentially, total market supply of its product enables it to charge more than the competitive price and to extract monopoly rents. As a consequence, under this construction of monopoly, consumers are necessarily harmed by the monopolist's pricing decisions since consumers lose consumer surplus, not all of which is recaptured by the monopolist in the form of rents, an outcome fully appreciated by the venerable Dr. Smith and many philosophers before him. (1) That is to say, any self-respecting monopolist will give rise to some deadweight loss, the so-called Harberger triangle. In this regard and to this degree (the size of the Harberger triangle), the only good monopoly is one that has been made extinct by the forces of Schumpeter's creative destruction. Few seem to appreciate, as Schumpeter did, the good that can come from the actual prevalence, at all points in time, of monopolies and the deadweight losses (in static terms) they impose. After all, a deadweight loss should be exactly what is implied, a drag on the economy. The irony of monopolies is that the static deadweight losses are the sources of a market economy's dynamism.

   What is especially interesting about standard monopoly theory in which the deadweight loss of monopoly is precisely identified is the unstated presumption that the organization of a market has absolutely no impact on the cost of production. That is to say, the market supply curve under perfectly competitive market conditions is identical with the monopolist's marginal cost curve, a position that should give any economist familiar with the principal/agency literature reason to pause. If a (perfectly) competitive market is served by numerous small firms, then surely there is a greater correspondence of the interests of the principals with those of the agents (if the principals are not often the same as the agents) than can be the case if the entire market is served by one overarching megafirm--a monopolist--in which many, if not all, of the former principals will be transformed into agents, owning only a minor fraction of the firm's stock, if they are owners at all.

   Surely the internal coordinating costs in the two market structures cannot be the same. Just as surely, a market structured as perfect competition cannot tolerate any (but the minimal) agency costs simply because there exists zero opportunity for the firms to make an economic profit (or to cover anything more than minimal production costs). (2) Any perfectly competitive firm that suffers any (but the minimal) agency costs is a firm that is doomed to be replaced. Agency costs are not only possible but also likely in the same market structured as a monopoly.

   As Dwight Lee and I have argued (2000), on the one hand, the principal/agency problems embedded in the replacement of a formerly competitive market with a single firm ensure that production will be constrained, independent of any imposed restriction on production that the monopolist imposes to generate economic profits. On the other hand, unless internal coordination/agency costs are zero, the curb in production under monopoly cannot be as great as the standard model suggests. This is true simply because of the growing coordination/agency costs that are bound to emerge as output is restricted and economic profits emerge and become progressively larger with further restrictions. These escalating costs will, at some point, choke off the curb in output before the standard monopoly output level is reached. As a consequence, scholars pressing the rent-seeking perspective may have overstated the extent of rent-seeking because, if monopoly is seen as a principal/agency-coordination problem, there will be less rent to seek than the standard model presupposes. Some of the rents (which will be less than the standard model describes) will be soaked up by internal (rent-seeking) agents.

   Of course, this perspective suggests another point rarely noted: Not all reductions in agency costs are welfare enhancing in monopolized markets. This is because a reduction in agency costs can ease the monopolist's task of coordinating a greater curb in production.

   Furthermore, we must note that in virtually all discussion of monopoly, the deadweight loss--the monopoly problem or market failure--is attributed exclusively to the monopolist's control over supply, which emerges from the existence of barriers to entry. Few economists seem to realize that the monopoly problem could just as easily be laid squarely in the lap of consumers who, because of the very existence of the deadweight loss...