Monopolies have played a major role in American economic history. From Standard Oil in the early 1900s to Microsoft in the early 2000s, there has been a consistent concern about the roles of monopolies in the American economy. These concerns are well-founded considering the mountain of dedicated economic theory about the consequences of business with a lot of market power, known as monopolies. For the casual observer of economics, the tendency is to believe the dangers of monopoly are essentially that they can and do charge high prices.
Monopolies Drive Output
There are three important and underappreciated points about monopolies that economists would impart to those interested in the topic. First, that the real cost to an economy of a monopoly is the lost output, not the higher prices. Second, the monopolist cannot charge any price they want but instead are limited by their consumers. Third, that not only are monopolies not invincible, but often sew the seeds of their own demise.
The non-economist would tell you monopolies are unfortunate because they charge higher prices. This is not the real cost to the economy. Higher prices are distasteful to the observer because the observer tends to be a consumer. Prices merely transfer surplus benefit from one group, the consumer, to another, the producer. The real issue is that the consequence of charging higher prices is that consumers want less of the monopolist’s product. This leads to fewer units produced and sold.
A basic principle of economics is that economic activity is mutually beneficial. An economic exchange happens because the parties involved both believe they are set to be better off if the exchange occurs. When you go to purchase a sandwich for lunch you gladly exchange your hard-earned money for the sandwich, and the sandwich shop gladly takes your money in exchange for making the sandwich. Everyone involved benefits. So if the monopoly charges a higher price and causes some people who would have purchased the good at what the market price would have been, then some mutually beneficial exchanges are lost and the economy is worse off because of it.
A common misperception that stems from the first belief regarding monopoly behavior is that monopolies are unlimited in their selection of price. In teaching about monopolies in the classroom, the most difficult idea to convey to students is that monopolies are limited by their consumers. When setting their business strategy the monopolist must take into account that they can choose the price they offer to consumers but then consumers get to choose what quantity of the good they will consume.
For example, suppose I design and patent a new product which features no substitutes, but suppose also that this product is poorly received by the market. No one likes my design. I have a monopoly, no one can legally make my product in this example, and I can charge any price I choose, but setting a high price would lead to few or no sales based on the consumer demand. Thus, we see the monopolist still faces the powerful limitation of how consumers value their product.
Finally, the more successful the monopolist is in creating and preserving their monopoly, the more incentive there is for competitors to figure out how to undermine that monopoly situation. This is where the market mechanism of prices and profit send signals to producers that the product the monopolist is producing is highly valued by consumers. Historically we see example after example of monopolies that sewed the seeds of their own demise. Economist Tyler Cowen gives the following list of monopolists that succumbed to this “incipient competition”.
- Digital Equipment Corp
- General Motors
The textbook example of this is Southwestern Bell whose success launched the now massive telecommunications industry and eventually led to its downfall as mobile phones emerged to replace land lines.
Now some economists have observed that this notion of how a monopoly behaves misses an important observation that the monopoly motive is to become and remain a monopoly so they actually have an incentive to produce high quantity and charge low prices.
To get a more in-depth discussion of monopolies, including whether Google and Facebook are really monopolies, be sure to check out EconBuff Podcast #18 where I interview economist and West Texas A&M University College of Business faculty member, Dr. Anne Barthel about monopolies.
Assistant Professor of Economics