Basic Economics

by Thomas Sowell

  Those bringing anti-trust lawsuits generally seek to define the relevant market narrowly, so as to produce high percentages of the market “controlled” by the enterprise being prosecuted. In the famous anti-trust case against Microsoft at the turn of the century, for example, the market was defined as that for computer operating systems for stand-alone personal computers using microchips of the kind manufactured by Intel. This left out not only the operating systems running Apple computers but also other operating systems such as those produced by Sun Microsystems for multiple computers or the Linux system for stand-alone computers.

  In its narrowly defined market, Microsoft clearly had a “dominant” share. The anti-trust lawsuit, however, did not accuse Microsoft of jacking up prices unconscionably, in the classic manner of monopoly theory. Rather, Microsoft had added an Internet browser to its Windows operating system free of charge, undermining rival browser producer Netscape.

  The existence of all the various sources of potential competition from outside the narrowly defined market may well have had something to do with the fact that Microsoft did not raise prices, as it could have gotten away with in the short run— but at the cost of jeopardizing its long-run sales and profits, since other operating systems could have been substituted for Microsoft’s system, if the prices of these other operating systems were right. In 2003, the city government of Munich in fact switched from using Microsoft Windows in its 14,000 computers to using Linux{264}— one of the systems excluded from the definition of the market that Microsoft “controlled,” but which was nevertheless obviously a substitute.

  In 2013, the Department of Justice filed an anti-trust lawsuit to prevent the brewers of Budweiser and other beers from buying full ownership of the brewer of Corona beer. Ownership of all the different brands of beer involved would have given the brewers of Budweiser “control” of 46 percent of all beer sales in the United States, as “control” is defined in anti-trust rhetoric. In reality, the merger would still leave a majority of the beer sold in the country in the hands of other brewers, of which more than 400 new brewers were added the previous year, raising the total number of brewers to an all-time high of 2,751. More fundamentally, defining the relevant market as the beer market ignored the fact that beer was just one alcoholic beverage— and “beer has been losing market share on this wider playing field for a decade or more” to other alcoholic drinks, according to the Wall Street Journal.{265}

  The spread of international free trade means that even a genuine monopoly of a particular product in a particular country may mean little if that same product can be imported from other countries. If there is only one producer of widgets in Brazil, that producer is not a monopoly in any economically meaningful sense if there are a dozen widget manufacturers in neighboring Argentina and hundreds of widget makers in countries around the world. Only if the Brazilian government prevents widgets from being imported does the lone manufacturer in the country become a monopoly in a sense that would allow higher prices to be charged than would be charged in a competitive market.

  If it seems silly to arbitrarily define a market and “control” of that market by a given firm’s current sales of domestically produced products, it was not too silly to form the basis of a landmark U.S. Supreme Court decision in 1962, which defined the market for shoes in terms of “domestic production of nonrubber shoes.” By eliminating sneakers, deck shoes, and imported shoes of all kinds, this definition increased the defined market share of the firms being charged with violating the anti-trust laws— who in this case were convicted.

  Thus far, whether discussing widgets, shoes, or computer operating systems, we have been considering markets defined by a given product performing a given function. But often the same function can be performed by technologically different products. Corn and petroleum may not seem to be similar products belonging in the same industry but producers of plastics can use the oil from either one to manufacture goods made of plastic.

  When petroleum prices soared in 2004, Cargill Dow’s sales of a resin made from corn oil rose 60 percent over the previous year, as plastics manufacturers switched from the more expensive petroleum oil.{266} Whether or not two things are substitutes economically does not depend on whether they look alike or are conventionally defined as being in the same industry. No one considers corn as being in the petroleum industry or considers either of these products when calculating what percentage of the market is “controlled” by a given producer of the other product. But that simply highlights the inadequacy of “control” statistics.

  Even products that have no functional similarity may nevertheless be substitutes in economic terms. If golf courses were to double their fees, many casual golfers might play the game less often or give it up entirely, and in either case seek recreation by taking more trips or cruises or by pursuing a hobby like photography or skiing, using money that might otherwise have been used for playing golf. The fact that these other activities are functionally very different from golf does not matter. In economic terms, when higher prices for A cause people to buy more of B, then A and B are substitutes, whether or not they look alike or operate alike. But laws and government policies seldom look at things this way, especially when defining how much of a given market a given firm “controls.”

  Domestically, as well as internationally, as the area that can be served by given producers expands, the degree of statistical dominance or “control” by local producers in any given area means less and less. For example, as the number of newspapers published in given American communities declined substantially after the middle of the twentieth century, with the rise of television, much concern was expressed over the growing share of local markets “controlled” by the surviving papers. In many communities, only one local newspaper survived, making it a monopoly as defined by the share of the market it “controlled.” Yet the fact that newspapers published elsewhere became available over wider and wider areas made such statistical “control” less and less meaningful economically.

  For example, someone living in the small community of Palo Alto, California, 30 miles south of San Francisco, need not buy a Palo Alto newspaper to find out what movies are playing in town, since that information is readily available from the San Francisco Chronicle, which is widely sold in Palo Alto, with home delivery being easy to arrange. Still less does a Palo Alto resident have to rely on a local paper for national or international news.

  Technological advances have enabled the New York Times and the Wall Street Journal to be printed in California as readily as in New York, and at the same time, so that these became national newspapers, available in communities large and small across America. USA Today achieved the largest circulation in the country with no local origin at all, being printed in numerous communities across the country.

  The net result of such widespread availability of newspapers beyond the location of their headquarters has been that many local “monopoly” newspapers had difficulties even surviving financially, in competition with larger regional and national newspapers, much less making any extra profits associated with monopoly. Yet anti-trust policies based on market share statistics among locally headquartered newspapers continued to impose restrictions on mergers of local papers, lest such mergers leave the surviving newspapers with too much “control” of their local market. But the market as defined by the location of a newspaper’s headquarters had become largely irrelevant economically.

  An extreme example of how misleading market share statistics can be was the case of a local movie chain that showed 100 percent of all the first-run movies in Las Vegas. It was prosecuted as a monopoly but, by the time the case reached the 9th Circuit Court of Appeals, another movie chain was showing more first-run movies in Las Vegas than the “monopolist” that was being prosecuted. Fortunately, sanity prevailed in this instance. Judge Alex Kozinski of the 9th Circuit Court of Appeals pointed out that the key to monopoly is not market share— even when it is 100 percent— but the ability to keep others out.
A company which cannot keep competitors out is not a monopoly, no matter what percentage of the market it may have at a given moment. That is why the Palo Alto Daily News is not a monopoly in any economically meaningful sense, even though it is the only local daily newspaper published in town.

  Focusing on market shares at a given moment has also led to a pattern in which the U. S. government has often prosecuted leading firms in an industry just when they were about to lose that leadership. In a world where it is common for particular companies to rise and fall over time, anti-trust lawyers can take years to build a case against a company that is at its peak— and about to head over the hill. A major anti-trust case can take a decade or more to be brought to a final conclusion. Markets often react much more quickly than that against monopolies and cartels, as early twentieth century trusts found when giant retailers like Sears, Montgomery Ward and A & P outflanked them long before the government could make a legal case against them.

  “Predatory” Pricing

  One of the remarkable theories which has become part of the tradition of anti-trust law is “predatory pricing.” According to this theory, a big company that is out to eliminate its smaller competitors and take over their share of the market will lower its prices to a level that dooms the competitor to unsustainable losses, forcing it out of business when the smaller company’s resources run out. Then, having acquired a monopolistic position, the larger company will raise its prices— not just to the previous level, but to new and higher levels in keeping with its new monopolistic position. Thus, it recoups its losses and enjoys above-normal profits thereafter, at the expense of the consumers, according to the theory of predatory pricing.

  One of the most remarkable things about this theory is that those who advocate it seldom even attempt to provide any concrete examples of when this ever actually happened. Perhaps even more remarkable, they have not had to do so, even in courts of law, in anti-trust cases. Nobel Prizewinning economist Gary Becker has said: “I do not know of any documented predatory-pricing case.”{267}

  Yet both the A & P grocery chain in the 1940s and the Microsoft Corporation in the 1990s were accused of pursuing such a practice in anti-trust cases, but without a single example of this process having gone to completion. Instead, their current low prices (in the case of A & P) and the inclusion of a free Internet browser in Windows software (in the case of Microsoft) have been interpreted as directed toward that end— though not with having actually achieved it.

  Since it is impossible to prove a negative, the accused company cannot disprove that it was pursuing such a goal, and the issue simply becomes a question of whether those who hear the charge choose to believe it.

  Predatory pricing is more than just a theory without evidence. It is something that makes little or no economic sense. A company that sustains losses by selling below cost to drive out a competitor is following a very risky strategy. The only thing it can be sure of is losing money initially. Whether it will ever recover enough extra profits to make the gamble pay off in the long run is problematical. Whether it can do so and escape the anti-trust laws as well is even more problematical— and anti-trust laws can lead to millions of dollars in fines and/or the dismemberment of the company. But, even if the would-be predator manages somehow to overcome these formidable problems, it is by no means clear that eliminating all existing competitors will mean eliminating competition.

  Even when a rival firm has been forced into bankruptcy, its physical equipment and the skills of the people who once made it viable do not vanish into thin air. A new entrepreneur can come along and acquire both, perhaps at low distress sale prices for both the physical equipment and the unemployed workers, enabling the new competitor to have lower costs than the old— and hence to be a more dangerous competitor, able to afford to charge lower prices or to provide higher quality at the same price.

  As an illustration of what can happen, back in 1933 the Washington Post went bankrupt, though not because of predatory pricing. In any event, this bankruptcy did not cause the printing presses, the building, or the reporters to disappear. All were acquired by publisher Eugene Meyer, at a price that was less than one-fifth of what he had bid unsuccessfully for the same newspaper just four years earlier. In the decades that followed, under new ownership and management, the Washington Post grew to become the largest newspaper in the nation’s capital. By the early twenty-first century, the Washington Post had one of the five largest circulations in the country.

  Had some competitor driven the paper into bankruptcy by predatory pricing back in 1933, that predatory competitor would have accomplished nothing except to enable the Post to rise again, with Eugene Meyer now having lower production costs than the previous owner— and therefore being a more formidable competitor.

  Bankruptcy can eliminate particular owners and managers, but it does not eliminate competition in the form of new people, who can either take over an existing bankrupt enterprise or start their own new business from scratch in the same industry. Destroying a particular competitor— or even all existing competitors— does not mean destroying competition, which can take the form of new firms being formed. In short “predatory pricing” can be an expensive venture, with little prospect of recouping the losses by subsequent monopoly profits. It can hardly be surprising that predatory pricing remains a theory without concrete examples. What is surprising is how seriously that unsubstantiated theory is taken in anti-trust cases.

  Benefits and Costs of Anti-Trust Laws

  Perhaps the most clearly positive benefit of American anti-trust laws has been a blanket prohibition against collusion to fix prices. This is an automatic violation, subject to heavy penalties, regardless of any justification that might be attempted. Whether this outweighs the various negative effects of other anti-trust laws on competition in the marketplace is another question.

  The more stringent anti-monopoly laws in India produced many clearly counterproductive results before these laws were eventually repealed in 1991. Some of India’s leading industrialists were prevented from expanding their highly successful enterprises, lest they exceed an arbitrary financial limit used to define a “monopoly”— regardless of how many competitors that “monopolist” might have. As a result, Indian entrepreneurs often applied their efforts and capital outside of India, providing goods, employment, and taxes in other countries where they were not so restricted. One such Indian entrepreneur, for example, produced fiber in Thailand from pulp bought in Canada and sent this fiber to his factory in Indonesia for converting to yarn. He then exported the yarn to Belgium, where it would be made into carpets.{268}

  It is impossible to know how many other Indian businesses invested outside of India because of the restrictions against “monopoly.” What is known is that the repeal of the Monopolies and Restrictive Trade Practices Act in 1991 was followed by an expansion of large-scale enterprises in India, both by Indian entrepreneurs and by foreign entrepreneurs who now found India a better place to establish or expand businesses. What also increased dramatically was the country’s economic growth rate, reducing the number of people in poverty and increasing the Indian government’s ability to help them, because tax revenues rose with the rising economic activity in the country.

  Although India’s Monopolies and Restrictive Trade Practices Act was intended to rein in big business, its actual effect was to cushion businesses from the pressures of competition, domestic and international— and the effect of that was to reduce incentives toward efficiency. Looking back on that era, India’s leading industrialist, Ratan Tata of Tata Industries, said of his own huge conglomerate:

  The group operated in a protected environment. The less-sensitive companies didn’t worry about their competition, didn’t worry about their costs and had not looked at newer technology. Many of them didn’t even look at market shares.{269}

  In short, cushioned capitalism produced results similar to those under socialism. When India’s economy was later opened up to competition, at home and
abroad, it was a shock. Some of the directors of Tata Steel “held their heads in their hands” when they learned that the company now faced an annual loss of $26 million because freight rates had gone up. In the past, they could simply have raised the price of steel accordingly but now, with other steel producers free to compete, local freight charges could not simply be passed on in higher prices to the consumers, without risking bigger losses through a loss of customers to global competitors. Tata Steel had no choice but to either go out of business or change the way they did business. According to Forbes magazine:

  Tata Steel has spent $2.3 billion closing decrepit factories and modernizing mines, collieries and steelworks as well as building a new blast furnace. . .From 1993 to 2004 productivity skyrocketed from 78 tons of steel per worker per year to 264 tons, thanks to plant upgrades and fewer defects.{270}

  By 2007, the Wall Street Journal was reporting that Tata Steel’s claim to be the world’s lowest-cost producer of steel had been confirmed by analysts.{271} But none of these adjustments would have been necessary if this and other companies in India had continued to be sheltered from competition under the guise of preventing “monopoly.” India’s steel industry, like its automobile industry and its watch industry, among others, were revolutionized by competition.

  Chapter 9

  MARKET AND

  NON-MARKET ECONOMIES

  In general, “the market” is smarter than the smartest of its individual participants.

  Robert L. Bartley{272}