On Monopolies

Earlier today, my friend Vanessa texted me the following question (small edits made for grammatical purposes):

So almost dr of economics- Am I correct in thinking monopolies are bad for consumers, thus must be bad for the economy?

Vanessa’s intuition on this question is good.  As Bastiat said, we must evaluate economics through the lens of the consumer.  Below is my response to her (sorry for the weird spacing.  I don’t know how to fix it):

“Are monopolies bad for consumers?”  This depends on what the meaning of the word “bad” means.  Monopolies are output restrictiors (that is, they get a higher price by reducing the output they make), and they produce not where price equals the marginal cost of output (ie the “zero profit” level), but the highest price they can get.  So, compared to “perfect competition,” the monopoly produces less at a higher price; they are inefficient compared to the perfect competition model.  Since “bad” is a judgment call. I’ll leave that up to you.

However, there are some situations where monopolies, as inefficient as they are compared to perfect competition, are the preferable option:
1) In economics, the only way a monopoly can naturally arise is if there are natural barriers preventing entry into the market (eg. high start-up costs, geographical barriers, that sort of thing).  We call these, shockingly enough, natural monopolies.  The implication of these conditions is that multiple forms of similar firms could not exist at the same time (ie, competition).  So, breaking up of this monopoly would not lead to lower prices and more output, but no output at all!
2) Imagine we have a firm who is a major polluter of the water.  For every item they produce, they dump a gallon of waste into the local river.  Further, assume (unlike the example in item 1 above), that this firm is not a natural monopoly.  If an effort to break up this company were undertaken, and output was to increase, then one would see an increase in the pollution dumped into the river!  From an environmental POV, this the monopoly is more efficient since it pollutes less!
Just like all economic questions, the answer is ‘as compared to what?”  It’s possible, as I explain here, that monopolies may be the preferable option.  A blanket statement like “monopolies are bad” or “monopolies are good,” depends on the context in which we’re speaking (and also what “good” and “bad” mean).

Coase, Transaction Costs, and Environmental Entreprenureship

Today’s Quote of the Day comes from pages 7-8 of Ronald Coase’s 1988 book The Firm, the Market, and the Law [emphasis added]:

Markets are institutions that exist to facilitate exchange, that is, they exist in order to reduce the cost of carrying out exchange transactions.  In an economic theory that assumes transaction costs are nonexistant, markets have no function to perform and it seems perfectly reasonable to develop the theory of exchange by an elaborate analysis of individuals exchanging nuts for apples on the edge of a forest or some similar fanciful example.

Many readers of Coase (including economists!) misunderstand him.  This is evident in the improperly named Coase Theorem (it’s improper in that it’s not a theorem).  In fact, Coase is so often misunderstood, he felt compelled to write the book this quote is from to clarify his point!  Coase is often understood to say that, absent transaction costs (or sufficiently low transaction costs), externality issues (eg pollution, noise, etc) can be solved by an allocation of property rights and, regardless of their initial allocation, will result in a Pareto-efficient outcome.  This is correct, but only a partial understanding of Coase.

Much of Coase’s work (and work that spun off from him, such as with Armin Alchian, Harold Demsetz, Gordon Tullock, and many others including my own) focus on the role of the market in addressing externality issues.  Detractors from Coase argue that his insights, that markets for externalities can exist only if there are no/low transaction costs, are not applicable to the “real world,” since transaction costs abound and, therefore, government intervention is necessary.  But this argument represents a misreading of Coase.  In a purely ideal world, there would be no transaction costs, but then no market would be necessary.  As Coase says in the above quote, it is in the world of transaction costs that the market is most useful!  The existence of transaction costs gives rise to firms and other means of human collaboration, which in turn reduce transaction costs, and increase the market exchange of individuals (see The Nature of the Firm (1937) for a more in-depth conversation on this point).

Expanding the idea of markets, firms, and transaction costs to environmental issues, we see the rise of “enviropreneurs” (to use the phrasing of PERC), that is people who seek out and find ways to mitigate these transaction costs in order to achieve desired environmental ends; in short, a market process of environmental concerns (for a detailed look at many different kinds of enviropreneurs, see Free Market Environmentalism for the Next Generation, especially Chapter 9).  The fact transaction costs exist is not a detriment to free market environmentalism, like the detractors of Coase argue, but rather what allows it to come about!

Like Coase (and Buchanan and many others) before me, I realize the market is not a panacea.  There may be conditions for government to get involved (namely where involvement by the firm or an individual are too costly).  But the work of Coase (and Alchian and Demsetz and Buchanan and Tullock and Anderson and many others) show us that the mere existence of an externality and transaction costs is not enough to justify intervention.

Economics as a Positive Science

Following a natural disaster, one can count on two things in the opinion pages and blogosphere: economists of all stripes decrying price-gouging legislation in a disaster and proponents calling economists immoral for questioning such legislation.

The conversation/disagreement between these two is a microcosm of a much larger discussion: the difference between the normative (subjective) and the positive (objective).

Economics is a positive science.  It deals with what is, not what ought to be.  When economists argue that price ceilings (like price-gouging legislation) cause shortages, that is a positive claim: it is a claim of what is.  This claim can be empirically tested, but it does not reflect the moral positions or suppositions of the economist.  In fact, the claim carries with it no moral implications whatsoever.  The claim price-gouging legislation causes shortages carries with it no more or less moral weight than the claim the sky is blue.

Conversely, morality is a normative science.  It deals with what ought to be, not what is.  When moralists argue that raising prices during a disaster is immoral, that is a normative claim: it is a claim of what ought (not) to be.  This claim cannot be empirically tested (although it can be tested to see if it falls into various moral criteria).  It reflects the belief structure of the person making the claim.  The claim raising prices during a disaster is bad carries with it no more or less empirical weight than the claim the sky is blue is good.

Allow me to elaborate, lest I give the mistaken impression that normative and positive sciences are opposed.  Normative and positive are not opposed; in fact, they compliment each other quite well.  Normative can prevent positive from becoming abusive (think, for example, our modern sensibilities against eugenic human breeding [normative] despite knowing certain traits are genetic [positive]).  But positive can also keep normative from being “pie in the sky,” by explaining how the world is.  For example, normative claims like “one should not kill his neighbor,” are all well and good, but the positive claim that “murder happens,” is important to know, too.  Knowing the two together brings us to the conclusion that police are needed for the few who do break the law.

To apply this reasoning to disasters, knowing price-gouging legislation makes the logistical system worse is important to know, as it can help inform better forms of aid and legislation.

In short, answering a positive claim with a normative claim will get us nowhere, but the two must be given, and understood, concurrently.

Price Gouging Legislation Means Fewer Resources for Search & Rescue

Police, like any resource, is scarce: there simply is not enough to satisfy every want and need.

Because of this simple fact, anti-price-gouging legislation has two perverse effects on a disaster.  The first, and the one economists tend to focus on, is what I discussed the other day, namely that price controls create shortages.  The other, as the title of this post would suggest, is even more of an immediate threat to life and limb.

If police resources are diverted toward price-gouging enforcement, then that means there are fewer police resources for search and rescue operations!  A cop who has to spend his time making sure merchants don’t charge too much is not spending his time looking for people, or preventing looting, or distributing goods.

Just your daily reminder: scarcity is a thing

A Smithian Look at Price-Gouging

As Hurricane Harvey hits Houston, Texas has invoked its price-gouging legislation, preventing prices from rising to meet the new levels of supply and demand.  As usual, lots of ink has been spilled by economists denouncing this legislation (for example, see here, here, and here).  On a recent post, Mark Perry asks: “It’s really not that complicated is it, to understand the adverse consequences of anti-price-gouging laws?”

Part of the issue is the price theory arguments against price-gouging are not complicated, but they are subtle.

I think the other issue is people take the positive analysis of economics and try to impute normative analysis onto it. That prices rise when demand rises/supply falls is neither good nor bad. It just is. Just like the sun rising in the East and setting in the West is neither good nor bad. It just is.

However, people will take this positive and try to make it normative. It is “bad” prices rise and people profit off of the suffering of others. Or it is “good” prices rise and lure in profit-seeking individuals and that increases supply.

These normative imputations get problematic because it is trying to answer a different question than the one originally posted. The question is not “how should people act when disaster strikes” (the normative) but rather “how to allocate needed resources to disaster areas” (the positive). Giving a normative answer to a positive question is neither helpful or insightful.

This is not to say that there is no room for the normative. I think that is an important aspect. Should people raise prices during disasters? Should there be discounts for those in absolute need? I think the answers to these two question is “yes.” I think Adam Smith’s “impartial spectator”  would be pleased to see prices rise in order to attract more goods/services to where they are needed, but also to see prices not rise (a discount) to those in absolute need. Indeed, the impartial spectator may frown if prices are “gouged” for those in the most need.

But does the disapproval of the impartial spectator, (“The heart of every impartial spectator rejects all fellow-feeling with the selfishness of his [the price-gouger’s, in this case] motives,” to use Smith’s words [The Theory of Moral Sentiments, page 78.3]), necessarily imply the need to anti-gouging laws? I’d argue “no.” Punitive legislation, Smith (and I) argue exists to serve justice:

“Resentment seems to have been given us by nature for defense, and for defense only.  It is the safeguard of justice and the security of innocence.  It prompts us to beat off the mischief which is attempted to be done to us, and to retaliate that which is already done; that the offender may be made to repent of his injustice, and that others, through fear of the like punishment, may be terrified from being guilty of the like offense.  It must be reserved therefore for these purposes, nor can the spectator ever go along with it when it is exerted for any other.  But the mere want of the beneficent virtues, though it may disappoint us of the good which might reasonably be expected, neither does, nor attempts to do, any mischief from which we may have occasion to defend ourselves (page 79.4).”

And the violation of justice is injury, that is: “it does real and positive hurt to some particular persons, from motives which are naturally disapproved of (page 79.5).” Since the price-gouger’s actions do no real and positive harm or a person, he cannot be punished: “To oblige him by force [ie, by legislation] to perform what in gratitude he ought to perform, and what every impartial spectator would approve of him performing, would, if possible, be still more improper than his neglecting him to perform it (page 78.3-79.3).”*

In short, the anti-gouging legislation both cause economic problems by creating shortages of much-needed supplies when they are already extremely scarce, but also invoke an injustice upon the society by punishing people, by inflicting harm on people, when no real and positive harm has been done.

*Nota bene: This conversation here revolves around price-gouging in general.  We could carve out all kinds of exceptions here that would allow for punitive legislation, but we are discussing the general case, not specifics.

Models, Monopsony, and Minimum Wage

At Cafe Hayek, Don Boudreaux has an excellent post on models and their usefulness in economics.  Don’s gist is as follows:

Anyone can devise a model to show almost anything.  And economics is filled with widely referenced models that are useless (or worse than useless).  The Keynesian Cross comes to mind.  So, too, the textbook model of so-called “perfect competition” (which, in addition to being a model in which almost everything resembling real-world competition is either squeezed out or appears as a monopolizing (!) tactic, isn’t even logically coherent – for in the model no room exists for any agent actually to change prices).

The value of an economic model is found in its ability to make the world more understandable.  Devising a model is no evidence that the named concepts in the model have anything in reality to correspond to them, or that the model is a useful analytical tool.

I have made similar points in the past, noting that the results from models are, well, model-dependent.

In short, the mere fact that a model can show that some preferred policy will increase/decrease economic efficiency doesn’t mean said model is of any analytical use.  Sure, the minimum wage in a monopsony may improve the situation, but that information does us no good if the market is not a monopsony.

But let’s build upon this idea.  Let’s assume, for the sake of argument, that a given market where a minimum wage is considered is indeed a monopsony.  As such, it is theoretically possible that minimum wage would be beneficial, that we would not see, over a given price range, a decline in employment.  The poor economist stops here.  He might even advocate for minimum wage at this point.  But, as Bastiat reminds us, the economist looks for not just the seen effects (ie, what the model says), but the unseen effects, too.  The good economist is prompted now to ask “is minimum wage the most cost-effective solution to the problem we are trying to address (in this case, low wages for workers)?”  Minimum wage may be an option here, but it may not be the most beneficial option!  There may be other options, other institutional arrangements, other agreements that can be reached that will create a better outcome!

Gordon Tullock and James Buchanan drive this point home in their 1962 book The Calculus of Consent.  The following is from page 61 of the Liberty Fund Edition of the book (original emphasis):

The most important implication that emerges from the [analytical] approach taken here [in this chapter] is the following: The existance of external effects of private behavior is neither a necessary nor a sufficient condition for an activity to be placed in the realm of collective choice.

While Tullock and Buchanan are discussing externalities here, we can easily generalize their comment to any form of collective action including minimum wage or other methods used to “improve” monopsonies:  The existence of a monopsony market resulting from private behavior is neither a necessary nor sufficient condition for a minimum wage to be imposed.  The burden of proof requires the good economist to demonstrate that any proposed solution is the best of all available options.  Otherwise, the result of the market process, even if less-than-ideal, may be the best choice.

It is easy to play around with models, and any given model may have any number of policy implications.  But the mere fact the model suggests Policy A would work doesn’t necessarily mean that Policy A is the best choice.  If the costs of imposing A are high, then it may likely end up being a net loss!