Institutions Matter, Even for Monopolies

Noah Smith has a rather interesting new article at Bloomberg detailing new research and proposals on regulating monopolies. I have written on the dangers of knee-jerk regulation as a solution to various market failures and others have written on the dangers of the perfectly competitive model to measure market failure. However, there is a different flaw I want to discuss with Smith’s article:

The big question Smith needs to ask is this: what are the institutional arrangements that allow for the monopoly (granting that the effects discussed, lower wages and higher prices, are due to the monopoly) to arise and persist? Monopolies are not necessarily a permanent fixture in industries; they always face competition (think of once “dominant” firms that are now on the garbage bin of history: Sears, Blockbuster, Myspace, etc). Monopolies theoretically arise under only a handful of situations and are constantly feeling the pressure of competition. Why is it some of these firms can now effectively ignore competition and suppress wages?

Smith blames lax anti-trust regulation and implicitly blames low minimum wages and unions. (The irony, of course, of using these last two options to “solve” monopoly issues is that both minimum wage and unions are themselves means of building monopoly power). However, the issue may (and, I’d wager, likely is) not one of lax regulation but rather excessive regulation. Regulation, by its nature, restricts competition. Granted, some restrictions may be desirable (eg, prohibition on using violence to conduct business), but that does not change the fact that regulations are designed to restrict competition and this provides some level of monopoly power to firms. So, what are these institutional arrangements? What legislation is in place? Occupational licensing? Tariffs? Environmental Regulations? All these things raise the fixed costs of suppliers, and when fixed costs rise, and subsequently barriers of entry imposes, one should not be surprised when monopolies arise.

By not considering the institutional framework in which economic activity takes place, Smith is mistaking symptoms for causes. Regulation, even if we ignore the public choice, law & econ, and behavioral economics concerns laid out in my linked article, would at best be treating these symptoms rather than the causes of monopolies. Indeed, ignoring institutional arrangements may lead to regulatory action that worsens, rather than helps, the problem.

Whenever some “market failure” is supposed, the first question in any analysts mind should be “why did this outcome happen?” That is the line of inquiry for the economist, for the lawyer, for the scientist. We assume too much by ignoring that all important question.

Don’t Fear Monopoly: Competition is a Process

CNBC reports that a large deposit of rare earth metals, enough to supply current world demand for nearly 1,000 years, was discovered off the coast of Japan.

Presently, almost all of the world’s rare earth metal consumption is supplied by China. This effective monopoly on rare-earths have caused some to wring their hands in fear of Chinese dominance and calls for protectionists tariffs soon followed. While this seems like a classic national-defense argument for tariffs, and a textbook case for monopoly regulation, the result of Japan indicates why fears of monopolies are overblown.

From the article:

Japan started seeking its own rare-earth metals after China held back shipments in 2010 during a dispute over islands both countries claim, Reuters reported in 2014. As a major electronics manufacturer, Japan needs rare earths for components.

Separately, China held back exports of certain types of rare earths starting 2010, which caused prices to jump by as much as 10 times — further pushing Japan to seek other sources, according to the Journal.

The Chinese government attempted to flex their “market power” on Japanese consumers in order to get some policy change (again, a classic example of protectionist fears). However, simple price theory predicted why the strategy would fail: Demand curves slope downward and (subsequently) supply curves slope upward. When China raised the relative price of rare earth metals for Japan, Japan looked for other sources and indeed discovered this massive deposit.

Currently, the deposit is too expensive to mine profitably given current prices. But, if China were to try and flex their “market power” again, they would quickly find another competitor in Japan (indeed, when China attempted to raise prices on rare earth metals though their role of a monopoly in 2008, it failed miserably as mothballed mines in other countries came back online).

Monopolies are not perpetual things. Relatively high prices induce people to enter the market (note this is true even when there are high barriers to entry). Relatively high prices induce technological innovation (like fracking in oil). If a monopolist seeks to exploit “market power,” then we will find people who respond. The Law of Demand remains in effect.

In short, I do not fear monopolies, even one that dominates like China and rare earths, because competition is a process, not a static state of affairs.

Harold Demsetz 1930-2019

The great Harold Demsetz passed away on January 4th. He was 88. Demsetz was a professor of economics at UCLA and University of Chicago who, along with his frequent co-author Armen Alchian, dramatically shaped how economists think about property rights, transaction costs, and the theory of the firm. His work laid the foundations of law & economics, environmental economics, industrial organization, and institutional economics. He was an excellent thinker and writer those of us who were his students, either directly or indirectly (like me, who benefits greatly from studying with those who studied closely with him like Walter Williams and Larry White) will miss him.

For an excellent remembrance of him, here is Pete Boettke.

Revealed Preferences Matter

Below is an open letter to the Spectator USA:

Editor:

The Spectator USA report “Identity is Just as Important as Wealth. Why Don’t Economists Get That?” contains a number of errors and strawmen versions of economic theory. However, the largest error is the premise of the article stated here:

But apart from the needless fear [nationalism] generates, it is also slightly dubious to suggest that it is the gilets jaunes or the Five Star Movement or the supporters of Brexit or even Donald Trump who are acting intemperately. It is perfectly possible to argue that these movements are a sensible, overdue reaction against governments that have imposed economic globalization on the world at a pace that is entirely inconsistent with the human lifespan and the speed at which we can adapt to change. The free movement of people, the euro, large-scale immigration, the dissolution of the nation state — for that matter the admission of China to the WTO… all were imposed on the world by ideologically motivated elites with little public consultation. Regardless of whether you think they are good or bad, there is a perfectly sensible secondary question to be asked about whether they were too much too soon. Remember, such decisions are usually made by economists, who do not really understand either time or scale.

Globalization, by definition, cannot be imposed. What freedom of trade and freedom of movement means is people, not elites, not economists, not governments, choose how people choose to deploy their resources. Liberalization of trade no more imposes on people than freedom of religion imposes on people. You, your readers, and all other people are free to choose to buy local or choose not to. When China joined the WTO, it did not impose on anyone to conduct business with them, nor did the WTO impose anyone to deal with China.

The fact of the matter is, however, people were free to deal or not deal with foreigners and they chose to deal with foreigners. Given this was an action freely taken, we can conclude that no, nationalism isn’t preferred to globalization. People choosing freely chose more than identity, and for whatever reason. The revealed preferences of Americans and Britons was to trade with foreigners. Indeed, trade liberalization indicates that national identity is not as strong a force as nationalists believe, which is why nationalism, not globalization, needs to be imposed.

Despite your claims otherwise, economists are not “obsessed with the gains arising from scale.” Rather, we study the interactions of people and the gains from trade freely made. Scale is just one side benefit of that; the real benefit is people improving on their current position. Any intro textbook will explain that (indeed, I highly recommend William Allen and Armen Alchian’s newly-released “Universal Economics”).

Signed,

Jon Murphy

George Mason University

Fairfax, VA

Ruminations on the Law of Demand

Two events today caused me to start thinking on the Law of Demand and its power as an explanatory tool.

The Law of Demand in Medical Care

When I lecture on the Law of Demand, which simply states that all else held equal as price rises quantity demanded falls, I inevitably get the objection: “What about necessities like food, water, health care?”

Even for these supposed necessities, the Law of Demand applies. Relatively high prices cause people to search for alternatives. One such example of this is in the Bob’s Burgers episode “Sexy Dance Healing” (Season 6, Episode 8). The titular character, Bob Belcher, goes out on a walk to try and gain inspiration for his Burgers of the Day (a running gag in the show. Each of the Burgers of the Day are usually pun-named, such as the “Never Been Feta Burger” (comes with feta cheese)). While walking past a message parlor storefront, Bob slips on oil poured on the sidewalk and tears his labrum. Bob goes to the doctor who informs him he’ll need surgery and his deductible is super-high: “like, $6,000 high.”

As per the Law of Demand, Bob begins to consider different options to pay for the surgery he wants but cannot afford outright. He considers suing the store that poured the oil on the sidewalk. He even goes so far as to have his lawyer serve notice, but the masseuse offers Bob a deal: the masseuse insists he can heal Bob without surgery. If Bob is not healed after 10 sessions, he will pay for Bob’s surgery.

So, the lesson from this story: the relative price of Bob’s surgery was high. Even though Bob needed medical care, the high price caused him to search for alternatives (spoiler alert: the alternative Bob chose worked out well). The doctor’s price of surgery was too high. If he lowered the price, Bob would participate; in technical terms, if the price fell, Bob’s quantity demanded for labrum surgery would increase.

A high price of medical care causes people to seek alternatives. A diabetic may try to change their diet. A person suffering arthritis may seek holistic approaches. A person suffering from psoriasis may move to a more humid climate. Et cetera. That these people seek alternatives, thus implying that if the price was lower they’d consume more of the good in question, indicates that the Law of Demand holds even in the case of medical care.

The Law of Demand and Power over Consumers

The second example of the power of the Law of Demand comes from the realm of trade. Commenting on this Cafe Hayek post, Jorod Smith writes:

Voluntary exchanges are nice. Now what happens when one country becomes so dependent on imports from and exports to one other country? The other country actually controls the country that relies on it for imports and exports. This is exactly the problem we have with China.

Mr. Smith’s fears are unwarranted. Imports and exports do not equate to “dependence” on another individual, regardless of how much they might make up your trade. Currently, 100% of my food comes from sources external to me, namely Wies Supermarket. I grow none of my own food. However, despite this, Wies holds exactly no sway over me. They cannot dictate to me in any way, shape, or form my behavior. If Wies were to try to jack up prices or exert some other kind of pressure on me, I could easily go to another competitor. But what if there is no other competitor? Then I would seek other alternatives: I could grow my own food or seek some other substitute (consume less food, switch to things that get me more calories per dollar, etc). In other words, they’d have no influence on my behavior as I could seek alternatives.

To bring this back to China, if the Chinese government were to try to impose some preferred policy on the US by threatening trade disruptions, it’d be as ineffective as the US blockade was in forcing the Castros out of power in Cuba or the Kims out of power in North Korea. Economic sanctions tend to be very ineffective. Why? Because of the Law of Demand. As relative prices rise, people start to seek alternatives. In the case of the Castros, it caused them to look toward the Soviet Union. In the case of the Koreans, it caused them to look toward the Chinese. If the Chinese were to try to threaten something, US consumers could seek other competitors. If none are available, they could turn inward. Indeed, this is why the attempt by the Chinese to jack up rare earth metals prices failed.

Conclusion

In his classic book, The Theory of Price, George Stigler writes of the Law of Demand:

How can we convince a skeptic that this “law of demand” is really true of all consumers, all times, all commodities?… Perhaps as persuasive a proof as is readily summarized is this: if an economist were to demonstrate its failure in a particular market at a particular time, he would be assured of immortality, professionally speaking, and rapid promotion while still alive. Since most economists would not dislike either reward, we may assume that the total absence of exceptions is not from lack of trying to find them. And this of course hints at the real proof: innumerable examples, ranging from the wife who cuts down on strawberries because they are out of season ( =more expensive) to elaborate statistical investigations, display this result.

Pgs. 22-23

The Law of Demand remains an extremely powerful tool. Indeed, one can build all of price theory off of it. My above two examples show its utility. A thorough understanding of the Law of Demand can get one very far.