The Welfare Losses Of A Monopoly

Introduction

‘The main effects of monopoly are to misallocate resources, to reduce aggregate welfare, and to redistribute income in favour of monopolists.’ (Harberger, 1954: 2) It is for this reason that monopoly power is generally condemned by neoclassical economists. Super-normal profits generated in both short and long run are a function of supra competitive prices being charged. And although vast amounts of wealth accrue to monopolists in an economy, such market failures remain unsolved. The objective of this paper is to review and critique the various attempts at measuring the ‘Deadweight Loss’ and examine alternative views on monopolistic behaviour.

Monopoly

The Monopolist sets its price and allows the market to determine the quantity it will demand: ‘Law of One Price.’ Where a firm in perfect competition produces output at a price equal to its marginal cost [1] , the Monopolist produces where the marginal cost of each unit equals its marginal revenue. This results in a constrained level of output below that which would be supplied under competitive conditions, thus representing the inefficiency of the operation. Perfectly competitive markets are in this way viewed as being productively efficient since in the long run no firm could survive without producing at the lowest point on its average cost curve. In contrast, monopolists restrict output below the technically most productive level in order to raise price. (O’Toole, 2008) Clarke and Davies (1982) show that the extent to which price exceeds marginal cost can be related to the level of market concentration, as measured by the Lerner index. Since the demand curve is downward sloping,

< 0, the monopolist must reduce its price in order to increase output (sales). Marginal revenue is the price at which the monopolist can sell the marginal unit, reduced by a loss of revenue on output that could have been sold at a higher price.

being the elasticity of demand, which is in tandem with the fact that is negative.

Lerner’s (1934) index of market power: gives us the output decision of the monopolist:

The ‘Deadweight Loss’ welfare triangle shows the lost (Marshallian) consumer and producer surplus, while rectangle L represents a transfer of income from the consumer to the Monopolist. Such a reallocation is said to be Pareto inefficient [2] , and it is this welfare loss associated with Monopolistic behaviour that exposes it to such flak on the economic and political front. Deadweight Loss, however, places producers and consumers on the same plane, whereas the income transfer from consumers to producers is not considered a social welfare loss because it is offset by monopoly profits which accrue to owners of the monopoly firm. (Martin, 1994)

Estimating the Welfare Triangle

‘If this estimate is correct, economists might serve a more useful purpose of they fought fires or termites instead of monopoly.’ (Stigler: 1956: 34)

The premier estimate of Deadweight Loss is attributed to the pioneering work of Arnold Harberger (1954) at the University of Chicago. The American manufacturing industry was examined over the period 1924-1928, using a sample of 2,046 corporations which account for 45% of the manufacturing industry. The time frame was selected mainly for its stable prices and resemblance to long run equilibrium.

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It is assumed that long run average costs exhibit constant returns to scale (which aids determination of marginal costs) and in equilibrium, all firms are operating on their long run cost curves, these cost curves yield the firm an equal return on its invested capital, and all markets are cleared. While a plausible image of ideal resource allocation, it may be less observable in the real world – but does allow for detecting any misallocation by simply observing the rates of return on capital. The dataset used consisted of rates of total profit to total capital for seventy-three manufacturing industries, with total capital defined as ‘book capital plus bonded indebtedness’ and total profit defined as ‘book profit plus interest on the indebtedness.’ (Harberger: 1954: 79) The excess profits are expressed as the difference between what would have been attained if that firm had achieved the average rate of profit for that industry. To eliminate these excesses, the reallocation of resources (defined as labour, capital and materials supplied by other industries) is largely dependent on the elasticity of demand facing each industry in question, which is assumed to be quite low or close to unity at the highest. This allows the amount of excess profit to measure the quantity of resources required to bring a firm’s profit rate toward the average. The effect of an industry expanding output (to the competitive ‘average profit’ level) may cause another industry supplying the former industry to expand its output. However, where some industries under-produce and others overproduce before the reallocation, a counter effect is assumed to occur.

The result is that misallocation of resources across the manufacturing industry could have been eliminated by a transfer of 4% of resources of the manufacturing industry or 1.5% of the economy’s total resources. Further, the total improvement in consumer welfare is estimated at $26.5 million; this translates into $59 million for the whole economy – ‘less than one tenth of one percent of national income [3] .’ (Harberger: 1954: 82) This estimate was confirmed in a later study by Schwartzman (1960). In 1954 dollars, this welfare gain amounted to $1.50 for every man, woman and child in the United States.

Algebraically, Harberger’s method was a modification of the basic triangle formula:

Where since, that is, in perfect competition price equals cost (AC/MC assumed constant).

return on sales.

Harberger assumed that , believing that elasticities would be fairly low for manufacturing industries.

Harberger’s estimation of Deadweight Loss is not without its flaws; the assumption of constant costs is improbable over time when we factor in the effects of inflation on costs of production. The estimated consumer welfare would hence be even less than 1% of GDP. When patents and goodwill are factored out of capitalised profit, the resource transfer would rise to 1.75%, and the welfare loss due to resource misallocation would work out at $81 million. (Harberger, 1954) Further, the sample included high profit firms resulting in an average profit rate of 10.4% over 8% in the manufacturing industry as a whole. A further issue with industry data is that the profits of firms exercising market power are offset by the losses of firms making losses because of inefficiencies. These firms are in short run disequilibrium due to inefficiently high costs; their losses are a cost to society but not because they have market power.

The assumption of price elasticity equalling 1 generated much debate; where elasticity is relatively high, incremental price increases cause quantities demanded to fall substantially, hence deadweight loss will be relatively high. In contrast, low elasticity (inelastic demand) means very light sensitivity to price increases – deadweight loss will therefore be quite small. In addition, unit elasticity of demand implies marginal revenue equal to zero, and since marginal costs are unlikely to be zero, this is at odds with fundamental profit maximization. (Ferguson et al, 1994)

As a final note, one could suggest that being associated with the Chicago School, Harberger’s work may have been slightly biased in its attempt to calculate monopoly welfare losses.

Rent Seeking: Beyond Harberger’s Triangle

‘The Gods help those who help themselves.’ AESOP

It is argued that the Monopolist’s supernormal profits do not just represent a transfer of income from consumer to producer, as rent seeking activities dissipate these profits over time. (O’Toole, 2008) The premise of rent seeking is generally associated with Tullock (1967) who argues that the very opportunity of monopoly profits will attract huge resources into efforts to obtain that monopoly position, which in turn represents an opportunity cost of such resources and a social cost to society. Tullock uses the analogy of theft to illustrate squandering of resources: the exchange of wealth from victim to thief bears no social cost upon society; it merely alters the distribution of wealth. However, the thief will invest resources to obtain this wealth: the very act of rent seeking. At the same time, potential victims invest resources in locks and paraphernalia to avert the possibility of crime, and it is this expenditure of resources by both parties which represents the social loss.

In this vein, Posner (1975) advocates that the deadweight loss triangle underestimates the true losses associated with monopoly. His model incorporates the deadweight loss as well as losses inherent in trying to obtain a monopoly position [4] . Assumptions include:

Cost of obtaining a monopoly is exactly equal to the expected profit of being a monopolist.

Long run supply of all inputs is elastic: no rent included in their supply price

Costs incurred in obtaining a monopoly have no socially valuable by products (for example, advertising expenditures)

Total social costs of Monopoly are D + L; since and

This can also be expressed in terms of price elasticity of demand:

The issue from here on is assuming the correct values in applying the formulae. Continuing with Harberger’s estimate of D = 0.1% of GNP, Posner found L = 3.3%, generating a total social cost of monopoly at 3.4% of GNP. (1975)

Cowling and Mueller Study

Just as Harberger adhered to the neoclassical judgement of monopoly, the Cowling and Mueller (1978) study is more theoretically robust. Data on price-cost margins collected at the firm level was used in estimating price elasticity of demand, and thereby the competitive rates of return and the level of monopoly profit. The deadweight loss was then estimated at half of monopoly profit (area L in diagram).

Cowling and Mueller then extend this formula to account for rent seeking – expenditures unrelated to production costs, for example advertising. Advertising then, leads to further increases in price and shrinkage of quantity:

This is can be extended further if advertising is considered a social cost:

Furthermore, to account for wasteful expenditure to maintain a monopoly position,which Cowling and Mueller denote as after tax supernormal profits [5] 

Using the final expression above, the authors estimated total welfare loss as a result of monopoly at 13.14% of gross corporate product for the USA (734 firms over 1963-66) and 7.2% for the UK (103 firms over 1968-9). When reverting back to Harberger’s approach, Cowling and Mueller estimate total welfare loss at 3.96% and 3.86% for the USA and UK over the respective sample periods. According to Reid (1989), this study provides a suitable vehicle for illustrating the practical consequences of taking a structure-conduct-performance approach to monopoly, as distinct from an Austrian approach.

At the very core of the Cowling and Mueller approach is the conformity with neoclassical analysis which advocates that monopoly possesses no socially beneficial attributes. However, costs outside those incurred in production cannot be sidelined as wasteful; advertising transmits information to all market participants, and the assumption of perfect information is crucial to the operation of a perfectly competitive market.

The conclusion to be drawn much of this empirical analysis is that the existence of monopoly exhibits an insubstantial deadweight loss on society. Such welfare losses are likely to increase in the presence of rent seeking activities and wasteful expenditures in maintaining a monopoly. On the aggregate, total welfare loss is just the sum of welfare losses in each market, but this gives rise to the tentative issue of market definition and whether to aggregate by industry. Siegfried and Tiemann (1974), whose estimate of welfare loss in 1963 amounted to just 0.07%, estimated large losses in plastics, petroleum and automobiles industries; but industries rarely contain the same group of firms as markets. And as Harberger (1954) is criticised for, focusing analysis on large firms (assumed monopolists) poses the problem of these companies competing in several markets due to multi product chains. (Ferguson et al, 1994).

On the other side of the coin rests the income redistribution effects of monopolistic competition. Whether area L in the diagram, being the transfer of income from consumers to producers, is socially acceptable varies across countries. In Europe, it is argued that the EU Competition Authority try to maximise consumer surplus rather than both consumer and producer surplus (George and Jacquemin, 1990). This is visible by looking at a stream of cases; the Ryanair v. the Commission (2006), Mastercard’s interchange fees case (2006), Wanadoo Interactive v. the Commission (2002) and Volkswagen v. the Commission (1998). US Antitrust Policy, on the other hand, strives to prevent trade restraints and monopolistic behaviour, in particular price discrimination and mergers which heavily alter market share.

It is interesting to look at the distributional impact of market power; in a study by Comanaor and Smiley (1975) over the period 1890-1962 estimated that 0.27% of households in the US in 1962 controlled some 18.5% of all household wealth. The authors suggest that in the absence of this market power, these households may only control between 3-10% of household wealth (1975). Furthermore, the poorest households (28.25%) held a negative net worth (i.e. debts exceeded assets) and in the absence of income transfers owing to monopolistic behaviour, their net worth would be at least 1.39%. (Comanor and Smiley, 1975). This puts a more harsh face on monopoly; being unable to purchase the infra-marginal unit of a good at the competitive price aggregates to widen the inequality gap between rich and poor.

Alternative: no orange juice at all?

Monopoly excess profits often act as a short term reward necessary for sustaining the competitive process in the long term. Firms that enter the process of creative destruction that underlies the competitive process are often motivated by the possibility of being a monopolist, albeit only temporarily. The monopolistic market structure is more conducive to the pursuit of research and development innovation which requires significant levels of up front and risky investments, which competitive firms do not have the available retained earnings for. (O’Toole, 2008)

Littlechild (1981) asserts that it is irrelevant to compare monopoly with perfect competition on the grounds that in the absence of monopoly, the product is often not provided, which represents a greater social loss.

With this idea of a competitive process in mind, we can reinterpret Fig. 1 (diagram above) to analyse the behaviour of an entrepreneur who discovers a new product before the rest of the market realises its potential. Assume he charges a monopoly price P, since for the moment he is the sole seller. It is true that he is restricting output compared to what he could produce, or compared to what would be produced if all his rivals shared his own insight. But they do not share his insight; this is not the relevant alternative. For the time being the relevant alternative to his action is no product at all. It would therefore be inappropriate to characterise his action as generating a social loss given by the welfare triangle A. On the contrary, his action generates a social gain given by his own entrepreneurial profit plus the consumer surplus.

(Littlechild: 1981: 358)

Do Microsoft and Apple products have substitutable counterparts? And as other entrepreneurs enter this market, society will gain further as profit is eroded and transferred to consumer surplus by way of falling prices and expanding output. In this respect, we could view monopoly as a mechanism which fulfils a yet unfulfilled demand, restricting output in the early days of evolution and eventually transforming into a competitive market.

Littlechild criticises Cowling and Mueller (1978) in their emphasis on long run equilibrium, deeming it inappropriate as it ignores profit arising from uncertainty and innovation. (1981) In addition, Littlechild asserts that the Harberger framework has its nature misinterpreted in relation to its extent, duration, costs and origins. (1981) It is a rarity that any monopolist is in long run equilibrium when there is an ongoing threat of new entrants and potential competition. Geroski (1991) found that in the UK over the period 1974-79 an average of 50 new firms per year entered each of the 87 three digit manufacturing industries in the study. It is hence implausible to assume output and prices remain constant in the long run. Finally, Littlechild (1981) believes that the Cowling-Mueller study over states welfare losses by not accounting for price discrimination, discounts and multi part tariffs and that post tax profits overstate the socially wasteful costs of obtaining a monopoly, as the initial resource owners will receive some monopoly rents. It can thus be argued that Littlechild takes the Austrian emphasis on competition as a process, by rejecting the neoclassical long run equilibrium framework for analysing welfare losses due to monopoly, pointing to variation in rates of return within industries as evidence of disequilibrium. (Reid, 1989) Public policy in the Littlechild (1981) tradition would seek to erode barriers to entry, which in itself would dissipate welfare losses.

Cases against monopoly are often woolly; Ferguson et al (1994) illustrates a situation where the monopolist’s cost structure is lower than that of the perfectly competitive firm and abnormal profits are a function of these lower costs of production [6] , which only the monopolist can attain through barriers to entry. Examples would include access to restricted technologies which could spur innovative production processes, often achieved through the Monopolists own research and development. These resource savings in the monopoly sector permit increased output elsewhere, and if this productive gain outweighs the DWL, there will be an overall improvement in society’s welfare. Needham (1978) showed empirically that these cost savings need not be that substantial for productive efficiency to offset the allocative loss: a price 20% above the competitive level requires only a cost saving of 4% when.

On the contrary, the monopolist’s costs may be higher than the equivalent competitive firm’s costs, simply because the monopolist can afford to be at least somewhat inefficient. Liebenstein (1966) is credited with the idea of ‘X-inefficiency’: the monopolist is not minimising costs due to unquantifiable factors such as lack of internal motivation or lower productivity of employees due to the absent competitive pressure. Likewise, market power may be associated with inflated costs rather than inflated profits: suppliers may squeeze the monopolist for higher prices in accordance with his means. Deadweight loss may be underestimated if costs are not kept to a minimum and we have no guarantee that every firm with market power is producing at the most efficient point on their production possibilities frontier.

Chicago School economist Harold Demetz suggests that high profits may not be a signal of market power, since the firm with lowest costs will tend to expand in size and market share over time, ensuring an efficient form of market leadership. (1973) Despite vast horizontal and vertical integration, the success of Wal-Mart can largely be attributed to its efficiency and resulting lower prices, paving the way to a near monopoly position in supermarket chains. Recognition of these beneficial effects questions the traditional neoclassical argument against monopoly. Areas such as proposed efficiencies and cost savings unravel great difficulties for policymakers and regulators alike. In its analysis of the proposed takeover of Aer Lingus by Ryanair (2006), the EU Commission found efficiencies from the merger to be insufficient to offset the potential price increases [7] .

Solution to Monopoly

Loeb and Magat (1979) outline a regulatory mechanism whereby the Government subsidises the consumer surplus on every unit sold conditional on the Monopolist charging the competitive price (that is, equal to marginal cost). The proposal is quite simple: allow the Monopolist (‘utility’) to choose its price and the regulator will subsidise the utility on a per unit basis equal to consumer surplus at the selected price. If reductions in cost are achieved, then additional profits accrue to the utility. This acts as an incentive to innovate if cost reductions are achieved via technological advancement.

This mechanism would maintain competitive prices in the short run; it can be assumed that competitors would enter in the long run. In addition, it is possible that if competitors enter the market, the Government could slowly withdraw its subsidy, as the monopolist would now have to behave competitively if he is to survive. However, the distributional effects must be considered: the subsidy means forgone expenditure in other areas of the economy, it may have to be raised via taxation and it represents a transparent form of income redistribution. Criticisms of this model by Cox et al (2008) argue that the regulator would need to know the entire demand function to implement the mechanism and that the income redistribution serves as a political barrier to acceptance. Harrison and McKee (1985) found that that when applied, the Loeb and Magat mechanism worked effectively 4/5 times.

Conclusion

The painstaking task of estimating the deadweight loss associated with monopoly has been given great attention over the last century, but has failed to reach a consensual agreement on the exact welfare losses which monopolies impose on society. We can take from empirical estimates of deadweight loss that monopoly behaviour may not be as welfare minimising as previously implied and that the truly inequitable effect of this market structure must lie in its income redistribution. Efficiency gains on the other hand, often combat the supposed welfare losses through greater output and economical use of resources. And as Littlechild (1981) advocates, monopolies are often beneficial to society. The onus of the policymaker seeking to regulate the monopolist should be to consider income redistribution as a predominant aspect of welfare losses. The Citigroup Plutonomy sums up the issue of income redistribution best:

We hear so often about “the consumer”. But when we examine the data, there is no such thing as “the consumer” in the U.S. or UK, or other plutonomy countries. There are rich consumers, and there are the rest. (2005: 30)

Reliable empirical evidence on estimates of deadweight loss would greatly aid economists and regulators alike. Unfortunately, as the tenor of this paper has indicated, neither of these millennia has yet arrived.