Economic Theory

The popular misunderstanding of the word “monopoly” (Part 1)

Numerous misunderstandings and mythologies surround the meaning of capitalism and competition, but few match the confusions over the meaning and relevance of “monopoly” in the workings of the market economy. When looked at dispassionately, factually, and historically, monopoly has almost always represented a problem in society only when created or protected by government intervention.

Critics of capitalism have proposed to nationalise “monopolistic” industries, to break them up into smaller “competitive” firms, or to regulate their pricing policies and influence the output they produce. A noticeable amount of the criticism of the existence of, or supposed “threats” from, monopoly is connected with the particular way economists have come to think about “competition” and “monopoly,” especially as found in a textbook.

The Fantasy World of “Perfect Competition”

The student is told that the benchmark of market analysis is the theory of “perfect competition,” a conception in which there are so many competitors on the supply-side of the market that each is too small to influence the prevailing market price for the good they are offering to buyers. Each seller, therefore, takes the market price as “given,” and they respond in terms of the optimal output to produce and offer on the market given their (marginal) costs of manufacturing.

In addition, in the world of “perfect competition,” there is no competitive product differentiation in the sense of the individual seller trying to devise new and improved versions of his product to get an edge on his rivals in the market in which he operates.

It is assumed that entry and exit from any market are effortless and costless, so any discovered profits to be earned or losses to be avoided due to, say, a change in market demand, is appropriately adjusted to virtually instantaneously, so those profits or losses are eliminated in seemingly non-existent time.

And what assures all of the above is the additional assumption that all buyers and all sellers in each and every market have a “perfect” or “sufficient” knowledge of all relevant circumstances and conditions that no errors or mistakes will be made by buyers paying too much or sellers accepting too little for what they are, respectively, demanding and supplying.

The Logical Absurdity of Perfect Knowledge in Perfect Competition

University of Chicago economist Frank H. Knight formalized this now-textbook conception of “perfection competition” in Risk, Uncertainty, and Profit (1921). But five years earlier, in 1916, Knight emphasized the fictitious and logical absurdities in:

“. . . the impossible conditions of ideally perfect competition, where time and space were annihilated and universal omniscience prevailed […]

It is the fact of omniscience [perfect knowledge], however, which is the prerequisite to perfect competition, and if this were realized in any other manner, no amount or kind of change would disturb the operation of ideal economic law [the optimal equilibrium of the ‘perfect competition’ market].”

Once it is postulated that individuals in the marketplace possess “perfect knowledge,” then it is assured that the market will always be in a state of perfect long-run equilibrium because no other state of affairs can exist.

Nothing can ever be in the wrong place at the wrong time, and no good or service can ever be priced at the wrong price. Total “costs” always and everywhere equal total revenue. Profits can never be earned, and losses can never be suffered.

Since each individual wishes to “maximize” their subjective satisfaction (“utility”) or their profit, then having a perfect knowledge of all current and future circumstances, each can act in no other way than the “objectively” most “optimal” because to act otherwise would be contrary to the purpose of maximizing utility or profit.

The absurdity of the perfect knowledge assumption in the theory of perfect competition was especially highlighted by the Austrian economist Oskar Morgenstern in his 1935 article, “Perfect Foresight and Economic Equilibrium:”

“Full foresight […] must mean a foresight up to the end of the world […]

In consequence of the interdependence of all economic processes and given conditions on one another, and this with all other facts, no instance could be given of a sector, however small, of the event, the foresight of which would not mean, at the same time, the foresight of all the rest […]

The individual exercising foresight must thus not only know exactly the influence of his own transactions on prices but the influence of every other individual, and of his own future behavior on that of others, especially of those relevant for him personally […]

The individuals would have to have a complete insight into theoretical economics, for how else would they be able to foresee action at a distance?”

And as Austrian economist Friedrich A. Hayek explained in his famous articles “The Use of Knowledge in Society” (1945) and “The Meaning of Competition” (1946), such a theory assumes away all the reality of what we normally think of as competition: an active rivalry among sellers, each of whom has limited and imperfect knowledge and is attempting to discover ways and means to make new, better, and less expensive goods to offer to the consuming public. It is this active and dynamic real competitive market process operating with prices not already in equilibrium that tends to move markets into a coordinated balance between supply and demand, and in which, over time, profits may be competed away and losses eliminated.

The notion of “perfect competition” assumes the existence of the hypothetical “perfect” market equilibrium that it is the task of real-world dynamic competition to bring about. Actual market conditions are then judged by a standard, Hayek said, that almost by necessity condemns any real competitive situation at most moments in time as being “anti-competitive” and therefore potentially “monopolistic.”

The Textbook Portrayal of Monopoly

But what makes a market supplier’s actions “monopolistic” in the theoretical world of “perfect competition?” In essence, that he is able to influence the market price at which he sells his product and make his product different from that offered by any other seller. In the textbook expositions, the “monopoly seller” is able to select that higher price and lower quantity combination that maximises his profit but which does not reflect the lower price and total larger quantity that would be offered on the market if there were a multitude of sellers.

The textbooks portray the monopolist’s situation and his ability to pick and choose the price-quantity combination in a supply and demand diagram. However, this monopoly situation as shown in the textbook diagram has neither a past nor a future. It is the “frozen picture” of a market situation that is “out of time.”  The diagram, by itself, does not answer the following questions:

What market or other forces in the “past” brought about this current situation? Given this situation, are there any market forces at work looking to “tomorrow” that would change the circumstances from its present “monopolistic” state? Are there any non-market — that is, any government — barriers that would prevent such a change over time?

In other words, the monopoly situation pictured in the diagram is presented without a context to reasonably analyze what conclusions might be made in terms of whether the “social” significance of this monopoly situation suggests the need for an economic policy to “correct” some “problem” with it.

Or whether, instead, when analyzed from a perspective of a market process in time and through time, there may be no “monopoly problem” at all but just one of the “transition” stages through which markets are passing all the time.


To be continued…

This article was first published by the Foundation for Economic Education (FEE).

3 thoughts on “The popular misunderstanding of the word “monopoly” (Part 1)”

  1. Posted 11/12/2017 at 07:13 | Permalink

    In general, most economists describe a monopoly in the same way and it is often negatively associated. A monopoly is a market structure characterized by a single seller, selling a unique product in the market. In a monopoly market, the seller faces no competition, as he is the single seller of goods with no close substitute.

    Characteristics associated with a monopoly market make the monopolist the market controller as well as the price maker. The monopoly enjoys the power to prevent competitors from entering the market which leads to absence of competition. So natural monopolies occur when a company takes advantage of an industry’s high barriers to entry to create a protective wall around its operations. The utilities industry is a good example of a natural monopoly.

    The consequences for consumers are higher prices and limited choice. Therefore, Antitrust laws and regulations are put in place to discourage monopolistic operations – protecting consumers, prohibiting practices that restrain trade and ensuring a marketplace remains open and competitive.

  2. Posted 13/12/2017 at 03:40 | Permalink

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