Chapter 11: Monopoly and Competition
Chapter 11: Monopoly and CompetitionWe’re entering the wild, wonderful world of monopoly and competition. To sum up from the last lecture, what’s happened is that the words “monopoly” and “competition” have been changed. In the seventeenth, eighteenth, and nineteenth centuries, and also in the mind of the ordinary person even today, what competition means is competing; in other words, rivalry, trying to offer a better product or a cheaper price than the other guy, the next guy in the industry. Competing means acts of competing and, as I say, it’s what the average person thinks of, what businessmen think of, when hearing the word “competition.”
Also, a very important point, competition can be potential as well as active. Even if you have one firm in an industry, it could still suffer or be subjected to the rigors of competition, because if it raises prices and cuts production, another firm might come in and outcompete it, and then it’s stuck with the other firm forever. And what business firms hate more than anything else is to bring in other competitors. And if they cut production and raise prices when they enjoy a monopoly price, then their higher profits will attract more competitors. Other capitalists will come in with new equipment and new plants, more modern equipment than this firm has. So potential competition is just as powerful as actual competition in the minds of the businessmen. We have competing, either actual or potential or both.
“Monopoly” meant, from the seventeenth century on, a grant of exclusive privilege by the government. It means exclusively either one person or one firm or several firms. So, for example, the king of England gave to John Smith the monopoly of production of all playing cards in the kingdom of England. Anybody else who produced cards was shot. Doing this put you in a state of illegality, in other words.
Why did the government do this? John Smith benefits and the consumers suffer and potential competitors suffer. Suppose a given price and quantity supplied for playing cards, decks of cards. You say that only John Smith can produce it. That means you’re shifting the supply curve to the left and you’re forcing consumers to pay more for a lower quantity supplied. You’re keeping out all other competitors, people who would want to produce cards if they were allowed to do it.
You should ask yourself this in all cases of government interference, who benefits and who pays. Who? Whom?1 In other words, who is screwing whom in any act of government whatsoever? The beneficiary is John Smith, the monopolist with playing cards. The losers are the consumers and the competitors, the people who would have competed; excluded competitors, in other words. Also benefiting is the king and his bureaucracy. In the old days, the king would simply sell the monopoly privilege to John Smith. John Smith gets a monopoly privilege producing playing cards for twenty years; the king gets paid for it. And also the king or the government builds up a bureaucracy and builds up political allies, in this case John Smith. This, of course, is happening all the time, not just with monopolies but also with cost-plus contracts, in fact with any government contract.
Take, for example, the New York City scandals right now, the famous parking violation scandal The City administration had a question, who should get the computer contract—it wanted to buy computerized machines that search for parking violators. Two companies competed for the contract, Motorola—it’s an old distinguished computer company—and an obscure little outfit called CompuSource, one nobody ever heard of. CompuSource gets the contract. CompuSource has no money and no computers yet. Why did they get the contract? Because Stanley Friedman, the distinguished head of the Bronx Democracy—the Bronx Democratic Party—was the lobbyist of the contract. Stanley Friedman received no money but, in return for getting the contract, received a majority shareholdership of the company. In other words, he got $1.5 million in shares as his legal fee. He became the majority shareholder to a previously non-existent company, which was formed only for the purpose of getting the contract.
Who benefits? The recipient of the monopoly privilege or contract, and the government official. So whether it’s the king who does it or some city official who does it, it really doesn’t make much difference. The government is in a position of selling monopoly privileges and people are then buying them.
If roulette wheels are outlawed, for example, but if a police captain allows a certain roulette wheel establishment to operate in his district and he’s on the take from the company that does it, then the police captain is selling monopoly privileges. The monopoly privilege is operating a roulette wheel in that district. This sort of thing is going on all the time. This is essentially known as the Government-Industrial Complex. In the defense area, it’s called the Military-Industrial Complex, but it’s wider than that. It’s the Government-Industrial Complex, the Government-Business-Complex, also known as Government-Business Partnership. We’ll see that examples of exclusive privilege are rife, for example in the taxi industry, the airlines before deregulation, etc., etc., etc.
Now, to continue with monopoly—the American Revolution was fought largely against monopoly. In other words, against the British government, which had given to the East India Company, a corporation which had a monopoly of all trade with the Far East, the exclusive privilege to import tea into America. And the Americans rose up against them and dumped the tea in Boston Harbor, in the so-called Boston Tea Party. This was an attack not only on the tax but also on the monopoly privilege. When the first American states were created, they put provisions in their constitutions outlawing monopoly. What they intended, of course, was not outlawing what is now meant by monopoly in the textbooks. They meant no grants of monopoly privilege by the government. Of course, this has become a dead letter basically; but at least it was there in the state constitutions to express the fact the American Revolution was an anti-monopoly revolution as well as an anti-tax one.
To simplify the situation, these were the definitions of “competition” and “monopoly” until the 1930s, basically. In the 1930s, a crazy new theory in microeconomics was coined slightly earlier than Keynesian macroeconomics. What we’ve had in the last thirty years is a process of roll-back by which Keynesianism is getting increasingly discredited in macroeconomics, and none too soon; and also increasingly discredited is this new monopolistic competition theory, which, however, is still in the textbooks. In other words, it’s been rolled back quite a bit. It’s not taken as seriously as it used to be, in the 1930s. But it’s still there, the alleged ideal of perfect competition.
During the 1930s, competition and monopoly were redefined. But the old terms were retained and they kept the old value connotation they had with their customary meanings. In other words, everybody was in favor of competition and against monopoly. The American public, economists, intellectuals, and everybody else agreed that competition was good and monopoly was bad. Or if they wanted to speak in so-called scientific terms, competition was efficient and monopoly was inefficient; but basically, this was another way of saying good and bad. And for obvious reasons they redefined the words “competition” and “monopoly,” and then applied the same old value judgments, the emotional baggage these terms had, to a new set of definitions.
Competition was defined as a state not of competing, but as a state of so-called perfection and purity. Monopoly was a state of imperfection— monopolistic meant imperfect and impure. Now, notice the terms here. They’re supposed to be value-free scientific terms. But perfect—who does not prefer perfection to imperfection? I mean, the very terminology gets you to be in favor of perfect. Who doesn’t prefer pure to impure? Who doesn’t prefer perfect competition to monopolistic competition? So the term “monopolistic competition” is used to suggest a negative value judgment.
And the redefinition was as follows. Competition meant a situation where each firm, not the industry but the firm, faces a horizontal demand curve, an infinitely elastic demand curve. And monopoly—or monopolistic competition, or impure, imperfect competition—it’s all the same, bad—is defined as a situation where each firm faces a falling demand curve. That’s it. Now, this is really the definition. You cut through all the jargon and all the junk in many chapters of the textbooks and this is the heart of the matter. Fortunately, Miller has less of such junk than you’ll find in most other textbooks.
In previous lectures, I’ve already proved—and it took me several weeks to demonstrate this—that all demand curves are falling. Where then do we get this horizontal demand curve from? We get it in this way: The model is the wheat industry. There are two million wheat farms in the world and you have Hiram Jones, who has 100 acres of wheat in Iowa. If Hiram Jones is a very, very tiny proportion of the total wheat industry, whatever he does on his wheat farm doesn’t make any difference to the price. In other words, if he increases his production like 20 percent, it’s not going to make a big dent in the total supply. We can therefore assume, according to the theory, that he’s facing a horizontal demand curve. In other words, he can increase his supply by cutting the fat. He can sell it at the same price because it makes a very tiny dent on the total. In this model of the ideal, every firm is so tiny that it can’t affect its price, relative to the total quantity supplied by the industry. Whether it goes out of business or triples its production will have no effect on price. This is supposed to be an ideal situation. Everything else is imperfect, impure, monopolistic.
And, of course, each one of us is a monopolist, by the way. Each one of us faces a falling demand curve, We’re all monopolists, every one of us, if we’re engineers or economists or whatever, If you go out in the engineering labor market and you insist on a higher wage rate, a very high wage rate, you’re going to see a falling off of demand for your services. For example, you insist that you won’t work for IBM for less than $500,000 a year, you’ll probably get disemployed very fast. What kind of a crazy system is it where everybody is a monopolist? Everybody except possibly Hiram Jones and the wheat industry. It makes very little sense.
The next point is trying to figure out why it is that competition is better than so-called monopoly. Why is it? What’s so great about a horizontal demand curve anyway? And by the way, the result of this was, all during the 1930s and 1940s, the Anti-Trust Division, which was influenced by the economists who have this view, was trying to break up big business into small parts so as to duplicate the small wheat-farm situation. In other words, it’s like taking General Motors and Ford and breaking them up into two million teeny little blacksmith shop-sized automobile plants. Automobiles used to be made in blacksmith shops and bicycle shops when the auto industry first got started in the 1900s. Bicycle shops used the wheel and axle technology, so they were able to shift to producing cars. But these shops were very small. You’re grinding out two cars a month. That’s the ideal of the perfect competition supporters.
I’ll now give you the whole shtick, the full argument about, why is this better, why a falling demand curve is supposed to be evil.2 I’m going to set forth for you now a series of insane assumptions, none of which are realistic, and all of which are flawed, deeply flawed. Using these assumptions, we wind up with the conclusion that competition in the sense of a horizontal demand curve is better than monopoly in the sense of a falling demand curve.
First of all, we need to consider the concept of final or long-run equilibrium. Now, long-run equilibrium is different from what I’ve been talking about, supply and demand on a day-to-day basis. Long-run equilibrium is this: In the real business world, there are lots of changes taking place in values and resources and technology. Suppose that the angel Gabriel came to the earth and froze everything, all value scales, resources, supply, labor, land, and technology, etc. Then, in a few years, you would wind up with every corporation making the same long-run interest rate say, 6 percent. In other words, there would be no pure profit and no pure losses, because everything would be the same all the time. If you can foresee everything, you’re not going to make any losses If a firm is now making heavy profits, for example one in a capital-poor industry, new firms will enter the industry, until you wind up with the usual 6 percent. If industries are making losses, firms will leave. You wind up after a kind of shuffling back and forth after a few years with everybody making 6 percent, no more, no less—or 4 percent, whatever the interest rate is.
But remember, final equilibrium does not exit; never can exist; never has existed and never will exist. You can’t freeze the data. The data are always changing. Value scales are changing, fashions are changing; technology changes, investment changes and labor changes. A lot is changing all the time. So you never get to long-run equilibrium.
The important thing about long-run equilibrium is to show you how to analyze profits and interest. Equilibrium shows you that profits and losses are a matter of forecasting, and interest is a matter of time preference. It’s really an analysis of where the economy is going. It should not be taken seriously as an existing situation because it never has existed and it never will.
But what has happened, unfortunately in microeconomics since the 1930s is that long-run equilibrium has been taken seriously as not only existing, but as something which should exist. But it shouldn’t. If it did, we’d all be in miserable shape. We’d be in a state of stasis; where nothing ever improved and nothing ever changed. It would be pretty miserable, like an ant heap or a beehive. Anyway, this is supposed to be the ideal situation.
In this situation where all firms earn the same return, you wind up geometrically with total cost tangent to total revenue at whatever the production point is. In the average-cost diagram, you have your U-shaped average-cost curve and you have an average-revenue curve—they would have to be tangent in final equilibrium.
And given a U-shaped average cost curve, we can compare what happens when a firm faces a horizontal demand curve and a falling demand curve. The points of tangency will be different. With a firm facing a falling demand curve, the output will be smaller and the price will be higher than a firm with a horizontal demand curve. That’s it. That’s the whole shtick. The supporters of perfect competition compare this to a monopoly privilege where the government excludes firms. Here you have a smaller product at a higher price. The conclusion they draw is that consumers are being screwed by a monopoly whenever a firm faces a falling demand curve. Therefore, the Anti-Trust Division should come in and break every firm up into teeny parts so as to get to the bottom of the average cost curve.
Now, to say there are many problems with this is putting it kindly. In the first place, mean, just one question: How big is this difference in price and quantity anyway? You’re going to the trouble of breaking up firms. Is this difference one half of 1 percent or is it really important? Nobody knows. Remember, all laws in economics are qualitative. You might be going through this entire headache for a very small fraction of return. As a matter of fact, some economists have tried to estimate what this percentage is. It’s something like 2 percent. But that’s the least of the problems here.
One problem is, who says we have a U-shaped cost curve? As we’ve already seen, it’s not really U-shaped. In most cases, the cost curve goes down and it’s flat. In a flat plateau, none of this works. This whole thing is out the window because, first of all, the intersection point is now a whole area, not just one point. You have a whole range at which marginal costs and average costs are equal. It’s possible that a falling demand curve could intersect with the cost curve at its lowest point.
Don’t forget, there’s nothing that says that the falling demand curve has to be linear. Remember, the linear part is truly for simplification purposes. Nobody knows that it’s a straight line. All we know is that it’s falling. There could be a little gap in the line. And so you could easily twist it around a little bit so that a falling demand curve, like a horizontal demand curve, could hit the cost curve at the bottom. With a flat bottom, the intersection point is pretty extensive.
Second of all, the model only works in equilibrium. In other words, the rest of the time, in the real world when there is no equilibrium, none of this applies. There’s no way you can say that output is smaller or priced higher in so-called monopolistic situations. You can only show that in long-run equilibrium. Since there never is long-run equilibrium, this whole thing is pointless. This situation, tangency at one point, never exists in real life. It never can exist. It never will exist. And we ’ d be in bad shape if it did exist. There’s nothing great about long-run equilibrium.
Also, and finally, and probably the most important point here is, who says that the cost curve would remain the same if large firms were broken up? Where is it written? In fact, it’s just the opposite. If we took General Motors or Ford and broke them up into 500,000 or whatever number of teeny plants, each the size of the blacksmith shop, you might hit the bottom of the cost curve, it’s true. But the cost curve would be extremely high because each plant would be very inefficient. You wouldn’t capture the advantage of large-scale production. So you might get a price of $5 million per car, which only a few millionaires could afford. This is, by the way, what happened in the early days of the automobile. It was a toy for the rich. Diamond Jim Brady and his like could ride around in them. And only when Henry Ford introduced mass production and interchangeable parts could the average person ride.
So in other words, we could have inefficient production in an industry, but the consumers would have the thrill of knowing that each firm would be at the bottom of the cost curve. You would have eliminated the so-called monopoly here. On the other hand, unfortunately, you would be paying $5 million a car because each cost curve would be enormously higher than the cost curve under large-scale production. So the fallacy of the perfect competition school is to assume the cost curves are equal after breaking up large firms. Cost curves are never equal. And the reason for large-scale production is precisely because the cost-curve is lower.
So all this, I think, is to demonstrate the egregious fallacy with this whole idea that somehow perfect or pure competition is better than so-called monopolistic competition, that there’s something evil about a falling demand curve.
So how did this whole idea arise? And the answer is interesting. It was partly in the anti-business climate of the 1930s that this kind of doctrine became popular. So what’s been happening over the years is that the economics profession has been slowly rolling backward from this commitment to this crazy perfect-competition doctrine. But it’s still there as an idea. It’s still listed as the ideal outcome. And it’ll take quite a while before that gets blasted loose, I’m afraid.
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What’s happening now is the economists have essentially stopped endorsing the idea of breaking up all businesses into tiny little blacksmith-shop size. But they’re still somehow intellectually committed to this alleged ideal, largely because you see the U tangency in equations in differential calculus. If everything is tangent and in equilibrium and the curves are smoothly arcing and so forth, you also have beautiful equations of tangency and the graphs are great. This produces the alleged hard science of economics. Of course, this hard science is only alleged; it’s really a fabrication of hard science. But as soon as you drop tangency and equilibrium and bring in the real world, the graphs and equations have to be either modified or eliminated. The “science” has to be abandoned.
Another feature of the perfect competition doctrine is that goods are “given.” This means that you can’t have any improvement. Any improvement is “monopolistic,” because only one firm will come out with a new product or invention.
So according to this doctrine, if Polaroid is the first firm that comes out with the Polaroid process, it becomes monopolistic right away. “Monopoly,” taken in the way perfect competition people use the term, is good because without it, you wouldn’t have any improvements at all. Under their ideal, every firm would be like a small wheat farm. No firm would be able to invent a new product or a new process. There wouldn’t be any computers. There wouldn’t be any Xerox. There wouldn’t be any Polaroid. There would be nothing, no calculators. Everybody would be stuck in the old wheat-farm kind of situation, where no one firm could do anything. No firm could even be active as a competing force, much less do anything else. So what I’m saying here is that the whole alleged ideal is a lot of hocus pocus; it’s mumbo jumbo based on a whole series of crazy assumptions.
In real life, again, the real problem of monopoly is not the falling demand curve. There’s nothing wrong with a falling demand curve. There’s nothing inefficient or unethical or anything of the sort. The problem of monopoly is once again the same problems we had in the seventeenth, eighteenth, and nineteenth centuries, namely government grants of exclusive privilege, either for one firm or for several firms. That’s really the situation when monopoly comes in. Cost-plus or exclusive contracts, or keeping out different parts of the industry and, thereby, shifting the supply curve to the left, raising prices, keeping out competitors, that sort of thing, This always has existed and always has been the problem with monopoly. It still is.
Let’s see how this works. For example, before the deregulation of airlines, from the 1930s to a couple of years ago, [before 1986] we had the Civil Aeronautics Board. It’s a lovely institution. It served as a cartelizing device, in other words, a monopolizing device. The CAB was lobbied for by the big airlines. It was essentially staffed by people from the big airlines. The idea was to exclude competing airlines and to assign monopoly routes and also to regulate the rates so the rate would keep going up. For example, I think only Eastern Airlines could do the New York to Boston route in those days. If anybody else tried to fly from New York to Boston, they were shot. In other words, they were considered illegal. They were excluded by the CAB. The CAB gave Certificates of Convenience and Necessity, I think they were called, to any airline on the route. If the CAB said, no, you can’t fly on that route, you couldn’t do it. There was no free market, no free enterprise in the airline industry. I think at one point Pan Am had the entire Pacific locked up. All routes to the Pacific had to be flown by Pan Am. I think Pan Am was the Republican Airline and TWA was the Democratic. The Democrats came in and they allowed TWA to fly that route.
And there still [i.e., in 1986] is, by the way, a very powerful international airline cartel, the IATA, International Airline Transport Association, that has a lock up on all European flights. Now those of you who have never flown to Europe will see, to your horror, that it’s more expensive to fly from London to Frankfurt than it is from New York to London, because the intra-European flights are locked up by a very powerful inter-governmental cartel.
In other words, you have a rationing situation. You assign routes. You exclude everybody except one or two airlines on each route. You lock up particularly the major routes, the most profitable routes, and jack up the price.
Now originally, I think until as late as the 1950s, there was no such thing as First Class and Coach. All classes were First Class. Everything was extremely expensive, at least relatively speaking. But one thing you have to realize, which we’ll emphasize in this course, is that a big company doesn’t necessarily outcompete a small one. Sometimes small competitors are more efficient. And so, in this case, the small airlines came in and started out competing the big ones by offering cheaper service and a no-frills service. What you had then were heroic little airlines. There had names like Transamerica and Continental and Transcontinental. They were named the poor-people express. And immediately, the CAB and the rest of the airlines came in and prohibited them from scheduling their flights.
There was no safety problem, by the way. Safety is handled by the FAA, the Federal Aviation Administration. The CAB was purely in charge of economic monopoly; it was part of the airline business. And these small airlines had very good safety records, much better than the big airlines per mile flown. But the CAB said, “You guys are unfair competitors; we won’t allow you to schedule your flights.” In other words, they couldn’t have any timetable. They had to sit there on the runway until they filled up. So they could only say, “We’re flying on Tuesday.” They couldn’t say, “We’re flying Tuesday at 11:00 a.m.” They were prohibited by the law and by the CAB from doing that. They were non-scheduled airlines, called the non-scheds.
Even as non-scheds, they were able to outcompete the big airlines. They were able to fly people from New York to LA, let’s say, for half the price of United or American or TWA. It’s true, there were no frills. Some of these outfits used to weigh you along with the luggage. It was the maximum weight of you plus the luggage. Those of us who are on the heavyset side thought of it as a kind of discrimination. Still, in all, it’s a trade-off, the ignominy of getting weighed against the fact that it costs you a lot less.
I remember my wife flew from Los Angeles to New York on a non-sched. I think it was Transamerica. It was very cheap. It was kind of scary. At one point, they announced, “Please, everybody, go to the back of the plane.” It didn’t give you a feeling of great confidence. Also, at one point, it was raining, and there was a leak in the ceiling of the plane. The stewardess, with great aplomb, went up there and took a Band-Aid and put it on the leak.
They didn’t give you great security. On the other hand, they had a very good safety record. They had no crashes that I remember. And the competition of Transamerica and Transcontinental forced the big five to create a Coach section in the rear of their planes, with a fare cut in half of the First Class price. That was in the 1950s.
Finally, the CAB, they simply forced them out of business, saying, from now on, you can’t fly anymore. That was the end of that, the end of Transamerica and the end of Transcontinental and the rest of them.
And there was another plane that went to Europe a friend of mine used to go on. It would fly to Iceland and Luxemburg, and on the return trip would land somewhere in a field in New Hampshire. You would then make your way to New York by train or bus, Again, it was very cheap, much cheaper than the official fares in that period.
What, happened when minimum fares were set by the CAB at a very high rate? There are all sorts of ways to compete. If you can’t compete on the basis of price, you can compete on the basis of quality of service, the frills. And so you start giving better food or swankier portions, prettier stewardesses and so on. These became the methods of competition rather than price.
At one point, IATA cracked down and said, from now on, no more hot meals on Trans-Atlantic flights. You can only have sandwiches. And so what the individual airlines started to do in order to break the cartel was to have open-faced sandwiches. They took the whole Beef Bourguignon dinner and put it on a piece of bread and called it a sandwich, in this way, getting around the crazy cartel regulations. You see this pattern frequently in economic history: the government puts on crazy regulations and the market tries to get around them.
What finally began to happen on the airlines is characteristic of government granted monopolies. If you’re a monopoly, you’ve got a very high profit; but in the long-run, the profit gets competed away and costs rise. In other words, you have a high demand curve, which generates high profits. That increases your demand for workers and raw materials and these prices start going up. You have very high salaries, for example, for pilots and stewardesses, much higher for these big airlines than for anybody else, such as the un-scheduled type. You have very high costs, plush offices and so forth; and an enormous amount of inefficiency. You wound up after about forty years of this with the airlines losing money, even though they’re monopolistic. This, by the way, is what happened with the railroads. Railroads were overbuilt. They were then regulated. Their fares were kept up by the Interstate Commerce Commission.
Finally, when the move for deregulation came in the late years of the Carter administration, 1978, the airlines were almost ready for it. They had to try something new. So they more or less went along with it, even though reluctantly, because the monopoly just wasn’t working. They were just losing money anyway. And they began to realize, maybe we would do better under deregulation. Their love for monopoly had more or less withered away after forty years.
And as a result of deregulation, you had tremendous changes in the airline industry. Some lines went bankrupt. Other lines have popped up as new and effective competitors, like People’s Express, which offers much cheaper fares. On the other hand, you’re not quite sure when they’re going to take off because they might sit there, loading up. And you realize that you pay for the difference.
So various outfits have been involved, and there has been a lot of reshuffling in the airline industry. Another development was the invention of the hub and spoke plan, which came about when the market began to realize this plan was more efficient. There are hub cities, like Denver, let’s say. Instead of having a lot of non-stop flights from New York to Los Angeles, you stop at Denver. You have a lot of airlines coming in from other cities into Denver and going out again. Nobody could have predicted it in advance, but this is what happened.
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To keep you up on the news since the term has started, the current Time magazine, on the front cover, it says “Oil Price, Cheap Oil, Good News.” And underneath, it has a headline, “Cheap Oil, Bad News.” And then it has a typical Time-type discussion, which is very middle of the road, having quotes from both sides, saying “Cheap oil, good; Cheap oil bad.” In the latest political flap, Vice President George H.W. Bush, who is, indeed, a Texas oil man came out in favor of raising the price of oil, “stabilizing it,” thereby violating the current principles of the Reagan administration.
The price of oil has magnificently fallen from $30—$35 a barrel several years ago to about $10 a barrel now (1986). In real terms, since prices in general have tripled in the last twenty years, it’s the equivalent of about $3 a barrel in 1967 or so. It’s just a little bit higher than before the OPEC Arab oil explosion in the early 1970s.
So what happens with any price change? Hysteria hits. Whether the price is going up or down, most of the establishment and most of the media are attacking it. A terrible thing; it’ll cause inflation or a depression, depending on the nature of the price change. The claims can’t both be right. It couldn’t have been a terrible thing to raise the price of oil from three bucks to $35 and also terrible to go down to $10. You can’t have it both ways, unless you think that any change whatsoever is bad, which is an idiotic position.
So what’s the real story here? If you’re a Texas oil man, you love the $35 barrel crude oil price. You don’t like it going down to $10. On the other hand, who cares about Texas oil men? Why should they set the standard for how we decide something?
You shouldn’t judge these price changes by taking Gallup polls or asking a Texas congressman and a New England congressman. What you should do is figure out where the consumers stand on this thing. The whole point of production of an economy in general is for consumption. The whole point of producing oil is that it will eventually get to the consumer in the form of kerosene, gasoline, heating oil, or whatever it’ll be used for. From the days of the caveman to the present, more and more consumer wants are being satisfied. The standard of living keeps going up. Everything gets cheaper and more abundant. The choices available to the consumer keep improving and increasing. New products come on the market and the old products get cheaper. That’s what an increased standard of living means, that the consumers can get more and more goods and services.
So we know how to judge any price change up or down, namely, cheaper is better, Hold it in your heart. This of course, is what the average person’s reaction is anyway. What you find in economics is that the average person’s immediate reaction is usually correct. Unfortunately, this reaction is often misdirected by phony economics and bad advice people get from the media. Of course, if you have maximum price controls, you screw everything up. I’m talking about cheaper on the free market. A cheaper market is an expression of increased supply. Cheaper prices often result from breaking up cartels, and cartels are our next topic.
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Notice some of the phony arguments you get about cheap prices. One is that the trouble with cheaper oil is that people use a lot of it and then it’ll get more expensive. In response, we worry about it if and when it does get more expensive. You don’t say that you have to jack up the price of oil now and re-establish the cartel, essentially what Bush wants to do, to avoid an increase in the price of oil ten years from now. The whole concept is nuts. That’s an argument so ridiculous, nobody can really hold it. These arguments are advanced for sinister economic interests. By “sinister,” I mean interests that want to re-establish the cartel, jack up the price of oil and lower the supply, against the public interest. Texas oil people want to do these things, of course.
The cartel is the situation where suppliers of any sort try to band together to restrict the supply and raise the price, taking advantage of an alleged inelastic demand curve. Let’s assume the demand curve for the industry is inelastic. We know, of course, the demand curve of every firm is elastic. It’s fairly flat. If, for example, Wonder Bread tried to raise the price to two bucks a loaf, nobody’s going to buy it, except a couple of the very wealthy Wonder Bread fanatics. Everybody will shift to Pepperidge Farm or Tasty Bread. But if all the bread firms get together and try to raise the price, they’re trying to go up their industry demand curve. This industry demand curve doesn’t have to be inelastic; but if it is, firms are tempted to try to restrict production and raise the price, thereby benefiting each firm and screwing the consumer.
Most people think it’s easy to have a cartel , but in this case, the average person has the wrong instincts. Let’s say General Electric and Westinghouse are essentially a two-firm electrical industry. The vice presidents of each company get together over at the Union League Club and one says to the other, “Hey, Jim, why don’t we increase our price by 20 percent? We’ll both do it, and because we’ll have an inelastic demand curve, we’ll have increased profits.” And Jim says, “That’s a great idea, Joe.” People think that’s the end of it, but it isn’t. It’s very difficult to establish a cartel, even disregarding the anti-trust laws.
The reason is this. In order to have a viable rise in price, they have to cut production. But every businessman hates to cut production. Every businessman wants to expand his operations. So to form a cartel is a very difficult process, requiring months of negotiations.
Let’s say that two or three firms in the industry each agree to cut production by 15 percent, using 1985 as the base year to determine the cuts. Well, they can do that. In a year or so, though, each one will say, “I’ve got new machines. I’ve got better equipment. I’ve got new products. Why should I be bound by the 1985 restrictions when I know that if I expand production, I can outcompete these other firms now? I can get a bigger share of the market.” Each firm has to believe that, because to be an entrepreneur, you have to be an optimist. You’re spending a lot of money, investing a lot of money. And pessimists don’t last long in business. And so the cartel quotas tend to be busted. Each businessman tries to renegotiate the cartel agreement. They say, “I’ve got a better product. I want to increase my production this year.” And the rival says, “No, you can’t do that; you’re violating the quota.” And often, the whole agreement breaks up in mutual recriminations of hatred. So it’s very difficult to maintain sustained quotas of this sort over time.
And, in addition to that, each firm has a tremendous temptation to cheat. They’re restricted in production by 15 percent. They have a higher price and each is making higher profits. Each one says, “If I can cut my price secretly, I could pick up an enormous increase in sales. I’ll go down the firm demand curve and make millions.” So he goes to his customer, and says, “Look, Jim, I’ll give you a secret discount, a rebate of 15 percent or 20 percent. Don’t tell Westinghouse about it, because we have a cartel agreement to keep prices up and cut production.” After about six months, everybody spies on everybody else. Each firm finds out that the others cheat and the whole cartel breaks up in mutual hatred.
When the railroads were the big business in the nineteenth century, a person who owned two railroads would form a pool or a cartel with another railroad. He couldn’t get his own managers not to cheat. Each vice-president in charge of sales was devoted to increasing sales and hated to make cuts. Even though the one tycoon owned both railroads, the mangers still cheated.
Another reason cartels break up stems from the fact that there’s a lot of loose capital around. Capitalists throughout the world, who have a lot of money they’d like to invest, are looking around for profitable investments. When they see a profitable cartel, they say, “Let’s go in and put in a new plant, new equipment, and undercut the cartel.” So a new capitalist comes in. They create a new railroad or a new plant. And the old firms are now confronted with this new plant with better equipment. Because it’s starting from scratch, it’s going to have new modern equipment. And then they’re faced with a question: Either they have to cut the new firm into the cartel, which means they might have to cut their own production by 30 percent. Otherwise, the whole cartel gets busted, and you’re back down again to square zero.
And when you have external pressure, when a new sugar refining plant comes in or a new shoe production plant or a new railroad, the new firm is there permanently. No industry likes the situation where a high-profit umbrella invites new, unwelcome competitors into the industry.
Every cartel in history, in the world, has broken up on the free market, very quickly broken up. It doesn’t take very long either, a year or two. The cartel has to break up. The only thing which can sustain a cartel is government intervention, compulsory cartels to keep the price up, keep production limited, and keep new firms from coming in. This is a compulsory cartel, when the government comes in and forces the establishment of a cartel. It’s the essence of what we’re living under right now, whether you want to call it the warfare state, or the warfare-welfare state. Essentially, we have a cartelizing state where government intervenes to try to cartelize different industries.
[Lecture presented at New York Polytechnic University in 1986.]