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The Austrian Theory of “Unnatural” Monopoly Manuela Mosca University of Lecce ESHET-JSHET MEETING 17-20 December 2006 Nice (France)

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1 The Austrian Theory of “Unnatural” Monopoly Manuela Mosca University of Lecce ESHET-JSHET MEETING December 2006 Nice (France)

2 2 Introduction This presentation is part of a wider research project concerning the sources of market power in the history of economic thought. In microeconomics, the existence of monopoly is often merely postulated, without being explained (profit maximization models). On the contrary, the Austrian scholars are interested in the sources of monopoly power. “One of the most controversial areas in Austrian economics, and one where even long-established Austrian theorists differ sharply, is monopoly theory” (Armentano 1978).

3 3 Introduction The well known Austrian view of competition as a market process (Kirzner 1992) leads to a different notion of monopoly. “Austrians do not contrast monopolistic market with competitive markets: markets are competitive by definition” (Kirzner 1991). Competitive rivalry includes cases of market power (product differentiation, advertising, innovation…).

4 4 This presentation will … 1. Discuss the different positions inside the Austrian school on monopoly theory. 2. Discuss their view on natural monopoly. Economies of scale. Network effects. 3. Compare the Austrian view on natural monopoly with the mainstream view. 4. Present the Austrian historical reconstruction of the theory of natural monopoly.

5 5 1. Mises (1944, 1949) and Kirzner (1973, 1991, 1999) There is only one instance in which monopoly arise in the free market: exclusive ownership of an essential input. –Input, not output (monopoly revenue is a rent). –Demand curve perfectly inelastic. The monopolist is able to withhold part of his resource in order to raise its price. However, the monopolist is not immune from competitive process (entry in similar activities is not blocked, as well as innovation). They do not consider this possibility to be of much practical importance.

6 6 1. Rothbard (1962), Black (1977) Armentano (1978), Costea (2003), Misesian theory is wrong: monopoly prices do not exist in a free market; there are only free market prices. –Any attempt to distinguish between monopoly and competitive prices in a free market is operationally meaningless. –There is no way to identifie a monopolist. All individual stock of resources are monopolized (resources are never homogeneous). All firms are able to set their prices (they all have some influence over price). All firms restrict their supplies in order to raise profits. –Consumers are perfectly free to change the “elasticity” of their own demand. Monopoly is only the grant by government of an exclusive privilege to produce or sell a product.

7 7 1. O’Driscoll (1982) Mises and Kirzner adopt a variant of neoclassical monopoly theory, while Rothbard adhers to a property-rights view. None has followed Menger’s approach: a distinctively Austrian theory of monopoly remains to be written. Monopoly and competition have to be treated dynamically. All markets begin with monopoly and move toward being more and more competitive. “The sensible Mengerian question would be to ask at what point a given market is in his natural evolutionary process”.

8 8 2. Natural monopoly due to economies of scale Microeconomics: it occurs when technology causes average total costs to decline as output increases for the entire range of market demand. The “strong economies of scale [are] due to the significant investment in infrastructure needed to start the operation, and a very small marginal cost for services produced over the existing infrastructure” (Shy 2001). For Mises and Kirzner the only source of monopoly is the ownership of an essential input. –As the existing infrastructure is an essential input, its owner is a monopolist. –Mises and Kirzner monopoly theory could be applied to natural monopolies due to economies of scale. O’ Driscoll claims that any monopoly becomes competitive. –Therefore there can be temporary non-legal (technological) barriers to entry. These two views are compatible with the concept of natural monopoly.

9 9 2. Natural monopoly due to economies of scale Rothbard and others deny the existence of any non-legal barrier to entry; –Therefore they also deny that technological barriers to entry can create a natural monopoly: for them natural monopolies are anything but “natural. Armentano: Economies of scale, like low-cost technology or innovation, do make market rivalry more difficult, but … it is efficiency that keeps competitors out, while inefficiency acts as an invitation to entry. Moreover, it is the consumer who ultimately decide to support efficient and penalize less efficient firms. Furthermore, economies of scale “are no iron-clad guarantee of long-run success; business history is filled with ‘first mover’ firms that experienced … losses in market share” (1999a).

10 10 2. Natural monopoly due to network effects Microeconomics: another source of natural monopoly can be the presence of network effects (they raise the value received by consumers as market get larger): “networks with larger market shares will have an advantage over smaller competitors” and this advantage can lead to natural monopoly (Liebowitz and Margolis 1996). *** It is true, network effects can lead to high market share, but the process of achieving that outcome is both competitive and efficient (Armentano 1999b). “The source of advantage is the … value that consumers receive from participating in the network. It’s that benefit which keeps consumers in the network, and it’s that benefit which can limit the entry of new suppliers”(Armentano 2000). Any monopoly is ultimately unstable: newer, more efficient innovations will break through, leading to some new monopoly (Armentano 1999a). There is always a profit opportunity for entrepreneurs to innovate, overcoming or adapting to the older networks (Foldary 2006).

11 11 3. Non-Austrians Similar conclusions to the Austrians: –Criticisms of the traditional barriers-to-entry doctrine comes from Bork (1978, chap. 16), Demsetz (1982). –“The telephone monopoly … has been anything but natural”; what we need is “a fundamental reassessment of the validity of natural monopoly theory …” (Thierer 1994). –“Monopolies … are efficient outcomes in network industries … the rivalry that they create, is sufficient to discipline to hold monopoly prices in check and to keep the rate of innovation very rapid” (Liebowitz and Margolis 1999). –“There is nothing ‘natural’ in the formation of monopolies. Therefore this term is likely to disappear” Shy (2001).

12 12 3. Austrian and Non Austrians Different policy implications: –Non Austrians: reform for a reduction in the power and scope of Antitrust. It has the mission of preventing the restriction of output, combating cartels, horizontal mergers and predatory practices (Bork 1978, Posner 1986). –Austrians: total repeal of Antitrust. “The most rational antitrust reform would be a thorough and complete business deregulation and the immediate repeal of the antitrust laws” (Armentano 1983, Block 1994).

13 13 4. Austrian History of the Theory of Natural Monopoly (DiLorenzo 1996) “It is a myth that natural monopoly theory was developed first by economists, … they used it as an ex post rationale for government intervention”. Ely, Clark, Fisher, Seligman, and all the others professional economists in the U.S. “agreed that large- scale production produced competitive benefits”. The economic profession came to embrace the theory of natural monopoly after the 1920s”. I desagree. It’s true that competition was often seen as a market process, but …

14 14 4. “On the concept of natural monopoly in the history of economic thought” forthcoming The idea that a decreasing average cost curve could bring to monopoly was already in Cournot (1838). Dupuit (1852): transport networks are a “de facto monopoly”. Walras (1875) even employed the expression “natural monopoly” for the transport networks. Marshall (1890) was perfectly aware of the problem, and tried various ways of solving the “Cournot dilemma”. Wicksell (1902): with increasing renturns “the whole industry … comes under the control of one … enterprise possesing an actual, if not legal, monopoly”. Barone (1908): “If the unit cost of the product were to diminish indefinitely, as output increases, it would be advantageous for the production … to be concentrated in a single firm”.

15 15 Conclusions We have seen that –Not all of the Austrians reject the concept of natural monopoly. The theory of Mises and Kirzner is compatible with it. O’ Driscoll does not deny the possibility of temporary non- legal barriers to entry. –It is not the same with the third view.

16 16 Conclusions To summarize the third view, let us consider this last quotation: “Long-run profits may imply that some organizations are relatively more efficient than others over long periods of time and that the competitive process has not yet reached any final equilibrium” (Armentano 1999a). Firms are able to set their prices and to earn positive profits “over long period of time”. It means that, due to some kind of non legal impediments, new firms do not enter the market – even in the long run. They actually admit the existence of some “natural” barrier to entry, but they do not think it is a problem that need any kind of Government regulation.

17 17 Bibliography (1) Armentano, D. T. (1978), A Critique of Neoclassical and Austrian Monopoly Theory, in New Direction in Austrian Economics, Kansas City: Sheed Andrews and McMeel: Armentano, D.T. (1983), Antitrust Policy: Reform or Repeal?, Cato Policy Analysis no.21. Armentano, D.T. (1989), Antitrust Reform: Predatory Practices and the Competitive Process, The Review of Austrian Economics, Vol.3: Armentano, D.T. (1999a), Antitrust, The Case for Repeal, Aubum, The Ludwig von Mises Institute. Armentano, D.T. (1999b), Review of Liebowitz and Margolis (1999), The Quarterly Journal of Austrian Economics, vol. 2, no.32 (Fall): Armentano, D.T. (2000), Barriers to entry, Mises Institute. Block, W. (1977), Austrian Monopoly Theory – A Critique, Journal of Libertarian Studies, vol. I, no. 4: Block, W. (1994), Total Repeal of Antitrust Legislation: A Critique of Bork, Brozen, and Posner, The Review of Austrian Economics, vol. 8, no.1: Block, W. and Llewellyn H.R. Jr (1988) (eds.), Man, Economy, and Liberty: Essays in Honor of Murray N. Rothbard, Alabama: The Ludwig von Mises Institute. Bork, R., The Antitrust paradox,New York, Basic Books.

18 18 Bibliography (2) Costea, D. (2003), A Critique of Mises’s Theory of Monopoly Prices, The Quarterly Journal of Austrian Economics, vol. 6, no.3 (Fall): DiLorenzo, T.J. (1996), The Mith of Natural Monopoly, The Review of Austrian Economics, Vol. 9: n. 2: Demsetz, H.(1982), Barriers to entry, American economic review, 72, n.1: Elzinga, K.G. (1999), Industrial Organization and Human Action, Cato Journal, vol.19, no.2 (Fall): Foldvary, F.E. (2006), Market Never Fail, Paper presented at APEE Conference, Las Vegas, April 4. Hoppe H.-H. (1990), Review of Block and Llewellyn (1988), The Review of Austrian Economics, Vol. 4: Kirzner, I.M. (1973), Competition and entrepreneurship. Chicago and London: University of Chicago Press. Kirzner, I.M. (1982a) (ed.), Method, Process, and Austrian Economics: Essays in Honor of Ludwig von Mises, Toronto, Lexington Books. Kirzner, I.M. (1982b), Competition, Regulation, and the Market Process: An Austrian Perspective”, Policy Analysis, Cato Institute, September. Kirzner, I.M. (1991), The Driving Force of the Market: The Idea of “Competition” in Contemporary Economic Theory and in the Austrian Theory of the Market Process, in R. M. Ebeling (ed.), Austrian Economics, Hillsdale, Hillsdale College Press:

19 19 Bibliography (3) Kirzner, I.M. (1992), The Meaning of Market Process, London and New York, Routledge. Kirzner, I.M. (1999), Mises and His Understanding of the Capitalist Stystem, Cato Journal, vol.19, no.2,, Fall: In The Driving Force of the Market, London and New York, Routledge, Liebowitz, S.J. and Margolis, S.E. (1996), Market process and the selection of standards, Harvard Journal of Law and Technology, 9: Liebowitz, S.J. and Margolis, S.E. (1999), Winner, losers, and Microsoft: Competition and antitrust in, High Technology, Oakland, The Independent Institute. Machovec, F.M. (1995), Perfect Competition and the transformation of Economics, London, Routledge. Machovec, F.M. (1999), Mises, Monopoly, and the Market Process, Cato Journal, vol. 19, no. 2 (Fall): McAfee, R.P., Mialon, H.M., Williams, M.A. (2004) When are sunk costs barriers to entry? Entry barriers in economic and antitrust analysis, AEA Papers and Proceedings, vol.94, no.2. Mises, L. von (1944), Monopoly prices. The Quarterly Journal of Austrian Economics, vol.1, no. 2 (Summer 1988): Mises, L. von (1949), Human Action, New Haven, Yale University Press.

20 20 Bibliography (4) O’Driscoll, G.P. Jr (1982), Monopoly in theory and practice, in Kirzner (1982a: ). Pasour, E.C., Jr (1982), Monopoly in theory and practice – Some subjectivist implications: Comment on O’ Driscoll, in Kirzner (1982a: ). Rothbard, M.N. (1974), Review of Kirzner (1973), Journal of economic literature, vol.12, no.3, (Sep.): Rothbard, M.N. (1962), Man, Economy and State, Princeton, Van Nostrand. Shy, O. (2001), The Economics of Network Industries, Cambridge, Cambridge University Press. Terrell, T. (1999), Review of Armentano (1999a), The Quarterly Journal of Austrian Economics, vol. 2, no. 3 (Fall): Thierer, A.D. (1994), Unnatural Monopoly: Critical Moments in the Development of the Bell System Monopoly, The Cato Journal, vol. 14, no.2.

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