Economic monopoly is a major issue in economic and political discussions and I want to make a small contribution on the subject. Even though I have postgraduate studies in economics I am not a specialist, and this document is a common sense rather than an academic approach on the subject, and it is written for the general reader with no economic knowledge. English is not my first language and you will have to excuse my syntax.
The essay is mainly a critique to both the traditional Marxist approach on monopolies, and to the more modern academic approach, the so called “neoclassical theory of competition and monopoly”. According to the traditional Marxist approach, capitalism leads to economic monopolies. Poor people become poorer, and capital is concentrated in fewer and fewer hands, and at the end of this process capital ends up in the hands of a small group of capitalists. The modern academic approach does not claim that. It examines whether government has to ensure that companies do not acquire excessive market power and use this power to charge consumers with “unfair” prices.
The two approaches are not irrelevant of course, but rather one is the continuation of the other. You cannot afford to ignore either of them, since they are both used to this very day. The Marxist approach is mainly used in the form of propaganda to convince the public that capitalism is bad and socialism is the solution, while the neoclassical approach examines whether government intervention is required in order to protect consumers from large companies.
My impression is that non economists tend to believe the Marxist propaganda which postulates that capitalism i.e. the free market, does indeed lead to monopoly. I think they believe so because they have been exposed to a lot of Marxist propaganda. The size of the huge corporate champions of the business world tends to enforce such beliefs. Socialists have convinced them that the large corporate size is equivalent to economic monopoly, which is actually something very wrong. Think of a small island where the government has issued only one taxi license. Is this taxi a monopoly? Of course it is, since it is the only provider of a particular service. Therefore the relationship between company size and monopoly is not as simple as it seems.
Since large corporations have been the victims of such intensive socialist propaganda, there is no point in examining the issue of monopoly, if we don’t first examine large corporations irrespective of ownership. That is without examining if they privately or publicly run. After all under both forms of ownership the aim is to produce as much wealth as possible. After I examine company size, I turn my attention to the issue of ownership and monopoly. So what is it that determines the size of corporations? Which is the right size? Is it better for a company to be small, medium or large? After all a bakery wants to produce as much bread as possible whether it is publicly or privately run. Therefore the most important issue is how more bread can be produced. Is it better for the consumer if one or many small companies exist? How many bakeries should exist in a market? What should the optimal market structure be? By market structure I mean the number and size of companies in a specific market.
Factors that lead to large corporate sizes
It is better to think about the factors that lead to large corporate sizes in a communist economy, in order not to confuse company size with capitalism.
Economies of scale
Economies of scale refer to a decrease in the average production cost with increasing levels of production. For instance a production unit costs 100 euros when 1.000 units are produced, 98 euros when 2.000 units are produced, 40 euros when 20.000 units are produced and so forth. There are many reasons why increasing levels of production lead to a decrease in average cost. Specialization is a good example. Imagine a company in a communist country that is producing 1.000 units of a product. This production level might allow for only one administrative employee. This employee must be both and accountant and a secretary. A production level of 2.000 units though, could possibly allow the company to operate with two administrative employees, one secretary and one accountant. These specialized employees could be far more productive. There are many other reasons why increasing levels of production lead to lower costs. Economies of scale are a very common and a generally accepted concept in economics.
Many non economists though, tend to think that economies of scale are present during all levels of production i.e. the more a company is producing the lower the average cost is. But this is of course nonsense. At some level of production economies of scale turn to diseconomies of scale, and this is accepted by all economists.
Diseconomies of scale
Diseconomies of scale refer to rising average costs for higher levels of production. This can occur for many reasons, for instance due to bureaucracy. The larger a company becomes the more people are required to monitor its operations, and the harder it is for decisions to be taken, since it is impossible to have managers who know everything about the company. There are many other reasons why diseconomies of scale appear at some production levels. Moreover it is very difficult for very big companies to adjust to changes in consumers’ tastes. Imagine a company in a communist country that produces 100 thousands units and another that produces 10 million units. It is much harder and costlier for the larger company to change its product.
If economies of scale persisted for all levels of production, Marx’s prediction about capitalism and monopoly would have been realized, at least for standardized products i.e. salt. But as we observe this is not the case. It would actually be very nice if average costs continued to fall for all levels of production. At the limit unlimited amounts could be produced with almost zero average cost. Unfortunately this is not what happens. But non economists tend to focus on the advantages of being large and forget the disadvantages of being large. Economists are of course fully aware of diseconomies of scale.
Transaction Costs Economics TCE
“Transaction cost” economics is a totally different approach to explain the size of companies. Economies of scale refer to production costs. Transaction costs refer to a very different category of costs. It is easier to understand “transaction cost” theory, when production costs are assumed to be known and given for everybody i.e. anybody can manufacture an iPhone given he has the required capital. This is very unrealistic but it enhances illustration of what transaction costs are.
Let me give an example of a transaction cost. I have a business and I need someone providing cleaning services for 8 hours a day. Let’s say that the market daily wage for such a service is 25 euros. This is not a transaction cost but a production cost (I use the term production costs to also refer to administrative, financial costs etc for greater simplicity). I will pay this production cost (25 euro) whether I hire this person as an employee or whether I use his services as a separate business entity. The price of 25 euros for this service is something determined by the market i.e. how many people are offering cleaning services and how many people are looking for such services.
The question is whether it is better for me to hire such a person or him in the form of an external cleaning service provider. In both cases there is a production cost of 25 euros. What is best for my company? To answer this question one needs to take into account transaction costs. If I use that person as an external associate, a contract must be written. And the contract must clearly specify what he will do and how he will do it, and many other details. And if the person providing the cleaning service does not honor the contract’s terms I would have to go to the court.
If I hire him on the other hand, we would only need to agree that he will clean for 8 hours a day in the way he will be instructed to, which is much simpler. On the other hand an external cleaner might be more motivated because he knows that I can try somebody else at any time, while an internal employee might not possess this kind of motivation and need supervision. But then again I can train my employee to do things in exactly the way I want things to be done. So what is better for my company? Well there is not a clear cut answer. It depends on transaction costs. There are both benefits and costs when a company integrates more operations.
And this is not only true in a capitalist economy. Transaction costs have nothing to do with capitalism. Imagine that I am the manager of a company producing ice cream in a communist economy. People in communist economies eat ice cream too you know. And companies in communist economies have managers too. I am therefore the manager. Let’s assume that there is no money. We count costs in terms of working hours. There are other public companies producing ice cream in the country. The communist leadership evaluates my efficiency in terms of how many working hours it takes for my ice cream to be produced and how good this ice cream is. I therefore need to be at least in the same position in terms of cost and quality i.e. 5th costlier and 5th in quality. If I am 5th costlier and 6th in quality I am inefficient and if I am 5th costlier and 4th in quality I am efficient.
I must therefore improve the company’s performance to impress the communist elite, otherwise they will demote me. Let’s further assume for simplicity that I only use milk to produce ice cream, and I take this milk from any public milk company I want. Assume that milk costs 1 working hour per liter, and that the production of 1 kilo of ice cream only requires 1 liter of milk. Therefore if it takes me 1.5 working hours to convert 1 liter of milk to 1 kilo of ice cream, my ice cream costs 2.5 working hours per kilo. But I want to do better than that in order to impress the communist elite. Would it be better for me to run a milk company too? Remember I assumed that production costs are given and known, which means that I can also produce 1 liter of milk per working hour if the communist elite allows me to run a milk company. What would be better for my final product i.e. my ice cream? Well, it depends again on transaction costs.
If I have my own milk company I will always have my milk on time, and there will be no more delays. Moreover I will make sure that the milk is always very fresh, while the current manager might give me milk that is not very fresh to squeeze his costs and impress the communist elite. I will also save the time I spent on checking the quality of the milk. On the other hand if I run a milk company too, I have to run a bigger company and it will be harder to control everything and I will have to rely on other people which might affect the quality of my decisions etc.
I hope the above provides in a simple way the “transaction cost” economics approach in explaining company size.
Imagine two factories in the same town both producing nails, and assume that consumers need 2.000 nails per month. Both factories have equipment that produces 1.000 nails per month at full capacity. But due to technological progress a new machine comes out which can produce 2.000 nails per month. For the technological progress to lead to lower prices one of the two companies must go. If both companies buy the new machine, and continue to produce 1.000 nails each, prices cannot go down since costs will have increased (new equipment) while sales have stayed at the same level. Actually prices have to increase if both companies buy the new equipment.
But if only one company is left, prices can fall. There are various ways for one of the companies to go. There might be a consolidation, one of the companies might go bankrupt etc. But no matter how this comes about, it is obvious that there is only space for one company. The example could involve 100 companies and technological progress could have wiped out 60 of them. The question is do we want cheaper nails or not? If we are not sellers and we are consumers we should prefer cheaper to expensive nails. If we sell nails we might prefer expensive nails of course.
The Development of Capital Markets
Large corporations involve investments that are far beyond the limits of even the biggest capitalists. The gradual development of capital markets made possible the pool of resources and allowed large projects to be realized. The more sophisticated the capital markets become the larger the companies can become.
Taxation and company size
It might sound strange, but the socialist way of taxation led to larger company sizes. One of the principles of socialist taxation was to tax companies in two levels. That is to first tax the company’s profits at a certain tax rate, and then impose an additional tax for the profits distributed to shareholders in the form of dividends. The purpose of this form of taxation is to offer incentives to companies to reinvest and not distribute profits.
Assume that a company makes 100 euros of profit. Let’s say the tax rate is 30%. The company pays 30 euros in taxes and there is another 70 euros left. If these 70 euros are not distributed to shareholders, socialists do not impose further taxes. If on the other hand they are distributed as dividends, there is an additional tax of 20% on the 70 euros that are distributed (random numbers). Thus the owners have an incentive not to take their profits, hoping that these profits will be reinvested and generate further profits, which will be reflected in a higher share price. And they can then sell their shares receiving their profits in the form of capital gains which are usually taxed with very low rates. At least they were taxed with very low rates in the past to enforce this socialist incentive scheme for reinvestement. Such policies are of course wrong. Company size should only reflect economic factors and not tax incentives.
Moreover profitable companies have an incentive to buy other companies that have accumulated large losses in the past, in order to use them for tax purposes. The highest the tax rates are, the higher the incentive to do so.
The Ideal Company Size
All the above factors i.e. economies of scale, transaction costs, technological progress and taxation affect company size. They are by no means the only factors affecting size. They are only some obvious considerations. After examining the above factors one has to wonder what is the optimal company size. According to Murray Rothbard there is no optimal company size. Each entrepreneur has to decide what the optimal size of his company is. On a theoretical basis one can only makes some basic assumptions about the optimal company size. For example economies and diseconomies of scale dictate some boundaries within which optimal size should be.
If for instance market conditions (technology, prices of raw materials, human capital, consumer tastes) in the automobile industry, lead to decreasing average costs until the production of 200.000 units, then the minimum company size involves production of 200.000 units. In the same way the other factors I examined dictate boundaries for company size. But the actual size can only be determined by the specific entrepreneur. The optimal size for Apple is different if it can sell 100.000, 200.000 or 100 million iphones. But we could say that economies of scale and transaction costs play a more important role in determining company size in markets for homogeneous products (i.e. salt), and a bit less important role in markets for products with great differentiation where the role of entrepreneur is more significant.
We could say that the optimal company size is determined by consumer preferences (quantities and quality required), from the ability of the economy (technology, availability of resources, human capital etc) to satisfy these needs, and from the ability of the specific entrepreneurs to detect and satisfy consumer needs by using scarce resources (highest possible quality at the lowest possible cost). The entrepreneur is a bridge between consumer preferences and scarce economic resources. And of course a charismatic entrepreneur will better satisfy consumers, will attract more clients, and employ more resources, and will end up with a larger company than a less charismatic entrepreneur facing the same conditions. In the place of the capitalist entrepreneur could be a manager in a communist economy without changing my discussion until now. I am not yet talking about capitalism or socialism, but instead for production units stripped from ideologies.
Therefore there is no optimal company size, but only boundaries within which a company’s size must be. What is unambiguous is that if the minimum possible price of salt is 50 cents per kilogram, and each production unit needs to produce at least 100 thousands tons to achieve this price, then the smallest company should produce at least 100 thousand tons of salt, both in capitalism and socialism. A useful concept for the discussion is that of “minimum efficient scale” of production (MES). Minimum efficient scale refers to a level of production at which it is not possible to increase production and achieve further economies of scale. Whether constant economies or diseconomies of scale appear after economies of scale depends on whether we consider the average cost curves to be L or U shaped, but this is beyond the scope of my document which is not a microeconomics document but a common sense approach to the issue of monopolies.
Company Size and Socialism
To show that the large company size has nothing to do with capitalism, I would like to use the example of the Soviet Union and Sweden. The first was a communist economy and the second is very often used by socialists as a proof of the superiority of socialism over capitalism. In both these countries the market was dominated by a small number of large companies.
Sweden & the Soviet Union
Sweden is considered as the country of multinationals. The following link
http://www.forbes.com/lists/2006/18/Sweden_Rank_1.html mentions 26 Swedish multinationals that are in Forbe’s list with the 2.000 biggest companies in the world. Total revenues of these 26 largest companies amount to 230 billion dollars. In other words the revenue of the 26 largest companies of “socialist” Sweden’s is almost equal to the GDP of Greece (they both have approximately 11 million inhabitants). Socialists use Sweden as a proof of socialism’s superiority, and at the same time socialists blame everything on “greedy multinationals”. And the funny thing is that the success of the “socialist” Sweden has always been based on her very successful multinational. This is a very inconsistent socialist rhetoric. In the following link
Sweden’s minister of commerce (2010) proudly explains how Sweden managed to become “the small country with the big companies”.
M. Henrekson and S. Davis of the universities of Stockholm and Chicago respectively, in their article “Explaining National Differences in the Size and Industry Distribution of Employment”, examined the reasons that led to large enterprise sizes in Sweden compared to the rest of the world. In page 6 of their article, they mention research conducted by the Swedish government in 1992, according to which Swedish companies with at least 500 employees employed 60% of the Swedish workforce, while the European average was 30.4%. On the other hand companies with less than 10 employees, employed less than 10% of the workforce in Sweden while the European average was more than double that figure.
The Soviet Union was another example of a market dominated by few and very large companies. In page 3 of their article “The Myth of Monopoly: A New View of Industrial Structure in Russia”, three academics from the university of Pennsylvania, explain that it was generally accepted in the Soviet Union that very large production units would lead to decreasing costs, and they provide further evidence. But I do not actually think that anybody claims this was not the case in the Soviet Union.
Since both in capitalist and socialist economies there is a tendency for companies to grow larger, one must conclude that large company size is not an attribute of capitalism or socialism, but rather a result of economic factors. And since both capitalism and socialism want as much wealth as possible to be produced, they must use large production units if the latter lead to more wealth creation.
I hope the discussion up to this point has persuaded the reader that large company size is not necessarily something negative, and that it is not an attribute of capitalism. And it is finally time to turn to the issue of “monopoly.”
The two theories of monopoly
There are as expected two theories of monopoly, the socialist one and the libertarian. The socialist theory believes in “economic monopolies”, and the libertarian theory believes in “political monopolies”. When I say socialist theory I mean both the traditional Marxist approach to monopolies, and the more modern theory of monopolistic competition. And I discuss them separately. According to the libertarian theory, monopolies are always created by governmental laws. They are therefore political monopolies. This can take the form of a public company which is by law the only company in the market, or it can take the form of very few private companies that enjoy government protection and support. They are private in the sense that they are not owned by the state, but they are still protected by the political system and in return they offer political and financial support to politicians either legally or in the forms of bribes.
According to the libertarian theory, as long as there is no barrier to entry in the form of regulation, there is no monopoly irrespective of the number and size of companies in a particular market i.e. the market structure. The only condition of this theory is that anybody having the capital and will to enter into a market must be allowed to do so. Therefore this view of monopoly does not relate the concept of monopoly to the size and number of companies, but rather to an absence of pressure for decreasing costs and improving quality.
On the other hand, the socialist theory of monopoly, which is by far the more widely spread and accepted, claims that monopolies are created by the free market, and therefore they are economic monopolies. According to this theory the state has to intervene to protect its citizens from the free market. What is crucial for this school of thought is the number and size of companies in a market.
The libertarian theory claims that monopolies are the result of government laws, which is quite straight forward, and therefore I will not discuss this theory any further. I will focus instead on the issue of economic monopolies and I will examine both the Marxist and the neoclassical theory of monopoly.
Marxism and Monopoly
Marxists in a way believe in the capitalist equivalent of “Chuck Norris”. They believe that capitalism leads to a capitalist that will beat all other capitalists, and employ and exploit all of us. And they therefore argue that capitalism leads to monopoly, and the only difference with socialism is that in capitalism the monopoly is run by a private tyrant that exploits everyone, while in socialism monopoly is run by righteous state employees that use their monopoly power for the benefit of their people.
In essence Marxists cannot distinguish between Microsoft and a state company. They do not see much difference between Microsoft, which derives its power from its ability to satisfy consumers, and a state monopoly which derives its power from the parliament. Actually Microsoft is a very good example, because it keeps improving its products and prices, without facing significant competition all these years. And the reason is that if Microsoft does not improve its products and lower its prices, one can keep using Microsoft XP and not upgrade to Windows 7. And if that happens profits will fall and the people that run the company will be fired. In other words Microsoft faces so much pressure without significant competition, simply by the threat of falling profits or the appearance of a potential competitor. Imagine if all these years there were another 5-6 companies seriously competing with Microsoft.
And the funny thing is that Google appeared out of the blue, and introduced the android operating system. And if tablets end up dominating the electronics industry as many people predict, the android system might threatens Microsoft’s windows. And this is not Linux or Mac, but Android which until very recently did not even exist. But that’s how capitalism works. And the truth is that Android did not appear out of the blue, but they were brought forward by another giant, namely Google. And this is where most people get it wrong. Because they think that since the small computer shop in their neighborhood cannot compete with Microsoft, no one can. But they forget that there are other giants in other sectors of the economy, that if they see profit opportunities in a market they can easily enter. They have the capital. The issue is whether there is enough profit to cover their investment. People tend to think that it is difficult to find the capital to compete with Microsoft. But they are wrong the issue is whether there is enough profit the costs. All free market companies are at the mercy of competition and consumers. And all consumers are at the mercy of political monopolies, which are immune from competition.
Private companies can indeed acquire monopoly power at some point of their economic life. But what is this monopoly power? If Samsung creates a new smart phone which we all want to buy, she will sure obtain some monopoly power. But what is this monopoly power? Isn’t this monopoly power exactly the same with consumers’ preference? For a private company monopoly power is nothing else than consumers’ loyalty. And government regulation is the monopoly power of political monopolies. But consumer loyalty and government regulation are very different forms of monopoly power. Samsung, or any corporate giant, cannot permanently enjoy the same consumer loyalty, since it is impossible to be always the first to understand what consumers want, and always be the best in finding the most cost efficient way to provide them with what they want. It is impossible for a management team to constantly come up with the best solutions, in the same way that it is impossible for a football team to always win the championship. And we should not forget that management teams have an expiry date. People die or they go to work for other companies. They leave Samsung for Apple and vice versa.
But even if a private company is always first in satisfying consumers, why should there be any problem? It means that this company is constantly improving quality and prices. On the other hand, if the government provides only one taxi license in a small island, the taxi driver has no motive to improve services and prices, because he has monopoly power. His taxi is a monopoly but not in the sense of large profits, but in the sense of no pressure for increasing quality i.e. buying a new car or reducing prices. Only political monopolies have the privilege to ignore the pressure for better services and lower prices. And therefore in the libertarian way of thinking the taxi is a monopoly and Microsoft is not.
And Marxists should answer a crucial question. Why capitalism did not lead to economic monopolies? Marx predicted so when he published “Capital” in 1867. Marx predicted in 1867 that the poor would become poorer and the rich richer, and that capitalism would end up with a small group of capitalists owning all the means of production and would exploit everybody else. The average worker is much richer today than the average worker of 1867, and there are still plenty of companies producing salt in each country. How many centuries does it take for the markets of homogeneous products like salt, to become monopolized? Why there are still so many companies producing salt, chocolate, alcohol etc?