Friday, May 22, 2015

The Benefits of Free Market Monopoly

For most politically-minded people, the term "monopoly" typically brings to mind an image of greedy corporate executive laughing as he counts his wads of cash. They likely think of unjustifiably high prices and industries dominated by one or a few firms. Certainly most people view monopoly as a bad thing.

The primary reason economists consider monopoly to be a bad thing is deadweight loss. Deadweight loss refers to the loss in consumer and producer surplus due to lower optimal output relative to the outcome in perfect competition. This deadweight loss is problematic because it represents value that is never created. It's not such a concern who would have captured that value (i.e. whether it would have been consumer or producer surplus), but that the value is never created in the first place. Even if the appeal to perfect competition seems problematic, doesn't it still seem sensible to oppose monopoly on the grounds of the deadweight loss it creates?

I would argue that the answer is "no." While the deadweight loss might seem at first to be a negative, in this post I'll show that deadweight loss is actually just the cost of the differentiation and innovation that creates more wealth for everyone.

The market process approach and the resource-based view of firm behavior both describe a situation in which the lure of monopoly profits serves a productive function. That is, it drives entrepreneurs to innovate by creating differentiated products which increase the range of choices provided to consumers. If consumers decide that they like these new products, they are made better off. This is in stark contrast to the "monopoly >> deadweight loss >> inefficiency" story above.

VRIO analysis is a key component of the resource-based view of the firm that shows how entrepreneurs use the resources and capabilities of the firm to create a sustained competitive advantage. VRIO can be broken down into  four questions: Valuable (Is the resource or capability able to generate a competitive advantage over the firm's competitors?), Rare (Is the resource or capability relatively rare in the industry?), Inimitable (Is it difficult for another firm to imitate this resource or capability?), Organization (Is the firm organized to capture the value generated by this resource or capability?). If the firm can answer "Yes" to all four questions, it has created a sustained competitive advantage.

Barriers to entry are a necessary condition for sustained competitive advantage. Barriers to entry are simply costs associated with entry into an industry that keep profits for incumbent firms artificially high. The Rarity and Imitability of a resource or capability are dependent on the existence of costs of entry into the industry. Except in cases where these barriers to entry are created by government favors, they are merely features of the real world that economic actors can use to their (temporary) advantage.

At some point, the firm can no longer sustain their competitive advantage and other firms will compete away its monopoly profits. If the firm has created a differentiated product that consumers value, it has created wealth that would not have existed otherwise. The owners of the firm are rewarded with (short term) monopoly profits that drove them to innovate in the first place. It's true that some firms will attempt to innovate and create products that are not valued by consumers. These firms are punished by losses. These profits and losses are a key feature of the market economy as they constitute the feedback necessary to guide firms into investments that create value for consumers. Overall, the initial deadweight loss and the losses generated by poor entrepreneurs are offset to some degree or another by the increased wealth due to innovation.

Note that this feedback mechanism is crucial. In cases where the lure is simply a government favor or when the monopoly profits the firm earns are protected by the government, there is no feedback from consumers. Entrepreneurs within the firm can't know whether the resources and capabilities they have developed are useful to consumers. These firms don't have the same ability to generate value that firms which compete on the market openly do. Bureaucrats and politicians simply don't know what consumers want and thus can't generate the same wealth-creating outcomes that a free market would.

The standard economic analysis of monopoly is a story of waste and inefficiency. Viewed as a process by which the market generates innovation and wealth creation, we can see that, contrary to the standard view, monopoly profits generated on the market can be beneficial to consumers. Monopolies created during this innovative process are always on shaky ground because the threat of further innovation is always lurking in an economy free of government restrictions on entrepreneurial behavior.

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