The Region

The Costs of Monopoly: A New View

Contrary to conventional wisdom, monopolies inflict substantial economic harm, particularly on the poor

James A. Schmitz, Jr. | Senior Research Economist

Published July 12, 2016

Jim Schmitz
James A. Schmitz, Jr.Photo by Stan Waldhauser

Note1

Economists overwhelmingly agree that the actual costs of monopoly are small, even trivial. This consensus is based on a theory that assumes monopolies are well-run businesses that limit their output in order to drive up prices and maximize profit. And because empirical studies have found that monopolists do not restrict output or raise prices by very much, most economists have concluded that monopolies inflict relatively little harm on the economy.

In this essay, I review recent research that upends both the theoretical and empirical elements of this consensus view.2 This research shows that monopolies are not well-run businesses, but instead are deeply inefficient. Monopolies do drive up prices, as conventional theory suggests, but because they also reduce productivity, they often ultimately destroy most of an industry’s profits. These productivity losses are a dead weight loss for the economy, and far from trivial.

The new research also shows that monopolists typically increase prices by using political machinery to limit the output of competing products—usually by blocking low-cost substitutes. By limiting supply of these competing products, the monopolist drives up demand for its own. Thus, in contrast to conventional theory, the monopolist actually produces more of its own product than it would in a competitive market, not less. But because production of the substitutes is restricted, total output falls.

The reduction in productivity exacts a toll on all of society. But the blocking of low-cost substitutes particularly harms the poor, who might not be able to afford the monopolist’s product. Thus, monopolies drive the poor out of many markets.

Outline

In this essay, I first review the standard theory of monopoly that contends it inflicts little harm, and then I introduce a new theory that refutes that view. In this new theory, groups within monopolies act as both adversaries that reduce productivity and allies that eliminate substitutes. The new theory thus demonstrates that monopolies in fact cause substantial economic harm, and that harm falls disproportionately on people with fewer financial resources.

I then provide several historical examples of monopolies from my own research and that of others. I’ll discuss monopoly subgroups in their role as adversaries in the sugar, cement and construction industries. I’ll discuss monopoly subgroups acting as allies in the dental and legal industries. But I want to emphasize that in all monopolies, subgroups engage in both roles. I’ll also take a fresh look at a familiar example of a monopoly, U.S. Steel, showing how subgroups acted as both adversaries and allies. These few examples are illustrative only and provide a narrow glimpse of a far broader economic phenomenon: Monopolies are prevalent in the U.S. (and international) economy.

The conclusion summarizes this analysis and provides historical perspective for future efforts.

Monopoly theory, old and new

The standard view

In the standard theory of monopoly found in textbooks, the monopolist is a single seller of a good who increases his or her price above competitive levels, leading to reduced output. The key cost of monopoly is the restriction of industry production. Two basic assumptions, or tenets, underlie this theory.

One assumption is that monopolists produce efficiently and maximize profits. This tenet is based on logic, not evidence. Nobel Laureate George Stigler3 provides one rendition of this logic: “The goal of efficiency is pervasive in economic life, where efficiency means producing and selling goods at the lowest possible cost (and therefore the largest possible profit). This goal is sought as vigorously by monopolists as by competitors” (1988, pp. 162-63).

Another assumption is that monopolists have close substitutes. This tenet is primarily based on logic, not evidence. Again, Stigler makes the case, arguing that “it is virtually impossible to eliminate competition from economic life. If a firm buys up all of its rivals, new rivals will appear. … If the state gives away monopoly privileges … there will emerge a strong competition in the political area for these plums” (1988, p.164).

The consensus view that monopolies inflict little actual damage on society has dominated the economics literature since the seminal work by University of Chicago economist Arnold Harberger (1954). Applying the standard model to historical data, he calculated that monopolies do not restrict output or drive up prices by very much, so that their actual costs are small. This quickly became the accepted view. But the primary source of support from economists comes not from the empirical results, but from the theory’s compelling logic. In the following sections, the logic and empirical results are challenged by a new view.

A new view of monopoly

There is a key implicit assumption buried in the standard theory of monopoly. Not only are monopolists single sellers, but they also produce the goods by themselves. That is, the monopolist (and perhaps clones or mindless automatons) staffs all of the machines, all of the phones, all of the processes involved in producing the good. Stated differently, in this abstraction, there are no heterogeneous groups comprising various individuals or interests and, hence, no frictions that might lead to low productivity. Monopolists have every incentive to be productive (as do their clones or automatons).

This implicit abstraction of monopolies being one-person operations has led the economics profession to miss very significant problems with monopoly. Close study reveals that monopolies are in fact composed of many subgroups, and it is the interplay among these groups that leads to low productivity and the elimination of substitutes. Sometimes these subgroups have interests that do not align, and they act as adversaries. Sometimes their interests align well, and they act as allies.

Jim Schmitz
Photo by Stan Waldhauser

When a monopoly forms, it stops competition from the outside. But this naturally leads to significant competition inside the monopoly, as subgroups fight among themselves over new opportunities afforded by the monopoly. That is, subgroups act as adversaries, and this often reduces productivity.

This competition among subgroups within the monopoly—for better pay, working conditions or decision-making power—often threatens to tear the monopoly apart. To survive, the subgroups agree to find ways to limit internal competition. Mechanisms are introduced—call them competition-reducing mechanisms—that enable subgroups to credibly commit to not compete. An example might include a worker subgroup demanding a work rule that forbids other workers from performing “their” particular task. But these mechanisms come at a high cost: reduced productivity. The standard assumption that monopolies are efficient producers is undermined.

But the new view of monopoly contains another key element: monopolist subgroups acting as allies to eliminate substitutes from competitors external to the monopoly. Consider the logic of close substitutes. Politically adept monopolies (as they are de facto since the large majority of monopolies result from special privileges granted by the government) often use their political influence to weaken or destroy existing substitutes for their product. Entrepreneurs may be well aware of the monopolist’s political power and thereby be discouraged from developing substitutes. Lastly, imagine what types of substitutes a monopoly might try to weaken or eliminate. It would not go after those with broad political support. Rather, it would target those with little support, those purchased by politically disadvantaged low-income segments of the population.

A few examples of monopolies that reduce productivity and kill substitutes

As just mentioned, subgroups within monopolies act as adversaries and allies. Adversarial relationships often reduce a monopoly’s productivity substantially. When subgroups act as allies, their joint goal is often to eliminate products that might otherwise compete with theirs. While subgroups in any monopoly engage in both adversarial and cooperative actions, I’ll discuss separate examples of each in this section.

Adversaries: Reducing productivity

I’ll start by looking at some adversarial relationships. In the United States, the sugar cartel, cement industry and construction business provide excellent examples of subgroups within monopolies acting as adversaries and reducing productivity.

The New Deal U.S. sugar cartel

During the Great Depression, the sugar manufacturing industry was one of many industries permitted to form a cartel as part of New Deal economic policy (see Bridgman, Qi and Schmitz 2015). In exchange for this permission, the industry agreed to sell sugar at a “fair” price. In addition, members of the industry, including factory owners and incumbent farmers, drafted a joint plan (subject to government approval) for how the cartel would meet price targets and share cartel profits. The cartel allocated sales quotas to factories each year so as to hit the agreed-upon price target, a price in line with the agreement with the federal government. This cartel operated from 1934 to 1974.

There were many adversarial relationships within the sugar industry that led to cartel rules beyond the factory sales quotas. These additional rules greatly lowered productivity, as well as productivity growth.

One such example: conflict between farmers and factory owners. Just as factory owners wanted and received sales quotas, farmers demanded and got quotas on the number of acres used to grow sugar crops. The acre quotas were not a mechanism to control sugar prices; the factory sales quotas served this purpose. Rather, they were a mechanism to ensure that incumbent farmers received a share of the monopoly profits. Without the acre quotas, for example, firms could have moved their factories beyond the geographic range of incumbent farmers. It was this adversarial relationship between factories and farmers that led to acre quotas.

Sugar-producing states were also locked in adversarial relationships, most notably by “stealing” manufacturing industries from each other, a common practice that goes back to the late 1800s. So some cartel subgroups, in particular, local and state authorities, had the incentive to push for limits on the renting of quotas, whereby acre quotas could be traded only within counties. Ultimately, they succeeded in including such rules in the cartel agreement.

These cartel rules led to large productivity losses. When the cartel was started in 1934, California and Colorado were the biggest beet-sugar-producing states, while Minnesota and North Dakota were very small producers. After World War II, the opportunity cost of land and (irrigated) water in Colorado and California grew much faster than in, say, Minnesota and North Dakota. Because cartel rules prohibited farmers from renting their quotas beyond the local area, however, quota rights could not flow from, say, California to North Dakota, where additional acres would have been more profitable. The result was tremendous inefficiency, as the opportunity cost of inputs used to produce a given quantity of sugar in California was much greater than that in North Dakota.

The same thing happened where sugar cane was grown. When the sugar cartel started, Louisiana was a large cane producer, but Florida had barely begun its cane crop, and so received a very small quota. After WWII, the profit of the marginal farmer in Florida began growing much faster than that of his or her counterpart in Louisiana but, again, quotas could not move to Florida, where production would have been more profitable.

Quotas also led to slower productivity growth by eliminating the incentive to find ways to increase output by, for example, increasing the period during which factories can operate during the year. Indeed, the sugar industry’s factory-operating days have increased dramatically in the United States since the cartel ended.

The cement industry

The U.S. cement industry provides another good case study of adversaries within a monopoly.4

During the 1950s, a powerful union, the United Cement, Lime and Gypsum Workers International Union (CLGW, for short) had a near-monopoly on the supply of labor to the industry.

Again, there were many adversarial relationships among subgroups. One was between different groups of workers. Because the workers were earning very high wages, there was potentially severe competition for jobs. Hence, groups of workers fought for rules that would secure their jobs from competition from other workers. For example, union contracts had rules such as: “When the Finish Grind Department is completely down for repairs, the Company will not use Repairmen assigned to the Clinker Handling Department on repairs in the Finish Grind Department.”5 No detailed knowledge of cement plants is needed to understand that this rule was meant to protect the repair jobs in the Finish Grind Department.

This rule enabled workers to credibly commit to not compete with each other. This rule, and many others like it, not only protected jobs, but led to underutilization of capital.6 Such rules led to a waste of resources, like energy.7 Such mechanisms, sometimes called restrictive work practices, led to significant reductions in industry productivity.

Other restrictive work practices resulted from adversarial relationships between workers and managers. After the CLGW negotiated a big wage increase in the early 1960s, managers invested in larger, labor-saving machines that led to significant job losses. Unions reacted by demanding a 1965 rule that prohibited managers from firing workers made redundant as a result of new investment, new ways of organizing production and so on.

Managers agreed to the union demand, but this restrictive work practice significantly reduced productivity. One would expect this rule to have dulled investment incentives and, indeed, there is evidence of a dip in investment in the late 1960s. But the energy crisis of the 1970s hit the cement industry hard, and the industry responded by making big investments in new, energy-efficient machinery. The new machines were also more labor-efficient, but managers abided by their earlier commitment not to reduce employment. Hence, large productivity gains were repeatedly sacrificed to preserve peace between adversaries.

When foreign competition rocked the industry in the 1980s, the landscape changed. Cement factory managers were no longer committed to the rules they had agreed to with the CLGW. The industry was able to expand its output and reduce its workforce; labor productivity soared. The gains that were missed in the 1970s were enjoyed in the 1980s.

Construction: Size is not the issue

Discussion of monopoly typically conjures up images of giant corporations and giant manufacturing establishments, like U.S. Steel and its massive factories. But, in fact, the size of the monopolist’s operation does not correlate with its destructive impact. Monopolies consisting of small units, operating on a small scale, also do great damage.8

Judge Kenesaw Mountain Landis found this to be true 90 years ago in dealing with the Chicago construction industry. He described an industry in turmoil:

“It is the violation of no confidence to say that building construction has gotten into bad repute in this community. There was a general disposition to keep away from it as a thing diseased. Capital avoided it. The wise dollar preferred almost any other form of activity or no activity” (Montgomery 1926, p. 273).

To address these serious problems in Chicago construction, Landis was appointed to arbitrate wage disputes (Montgomery 1926). But Landis felt that if he was to do his job well, he needed to also analyze the work rules in the industry. This surprised and scared most of the parties involved. Landis also knew that the work rules contained in the contracts were the tip of the iceberg, so he spent a considerable amount of time going out to jobs, talking with the workers and investigating the situation firsthand (p. 270). He concluded that while high wages were an issue,

“The real malady lurked in a maze of conditions artificially created to give parties a monopoly, and in rules designed to produce waste for the mere sake of waste; all combined to bring about an insufferable situation, not the least burdensome element of which was the jurisdictional dispute between trade-union members of the same parent organization” (p. 273).

The waste he reported is with us still (Schmitz 2016).

Allies: Eliminating substitutes

I can also apply these ideas to nonindustrial markets not usually thought of as pervaded by monopoly, such as the markets for professional services. Although these markets are made up of thousands of independent professionals, these professionals band together to act as a cartel, a monopoly composed of many separate business entities. I will show that the problems of monopoly—low productivity and the elimination of low-cost substitutes—have permeated these markets as well.

Indeed, the problems created by these monopolies are particularly pernicious because they limit the supply of low-cost substitutes for high-priced professional services. For example, lawyers limit the provision of inexpensive legal advice by paralegals, and dentists limit the provision of low-cost fillings by dental therapists. These limitations are not too harmful to the rich. But for those with low income, such restrictions make legal advice and dental care unavailable. They are priced out of the market. Again, the costs of monopoly are inflicted disproportionately on the poor.

Jim Schmitz

Subgroups in a monopoly are not necessarily adversaries. Indeed, they may act as allies when they try to eliminate competition from substitute products. Consider, for example, the dental industry. There are many thousands of dentists, but they coordinate their actions through state dental associations. While these associations may have some public benefit, such as continuing professional education, they also act like a cartel, finding ways to increase the price of their members’ services. They do so in a way that also increases the demand for their services.

One service dentists provide is filling cavities. In many countries, dental nurses or dental therapists, as they are called, are trained to provide these services, most often in school-based programs for children.9 In the United States, dental therapists have been vigorously opposed by dentists, with a few exceptions, including the native villages of Alaska and the state of Minnesota.

The impact of these cartel restrictions is profound. Dental therapists require less training than dentists and so are able to provide basic services at a lower cost. Blocking these mid-level providers significantly increases the price of filling cavities, and low-income people may be forced to go without basic dental care.

The debate over dental therapists in the United States is not over. Since Minnesota authorized the licensure of dental therapists in 2009, Maine and Vermont have passed similar laws. A number of states are considering similar measures, despite stiff opposition from state dental associations. The laws often require that dental therapists work under the direct supervision of dentists, ostensibly for the protection of patients, but the arrangement also protects dentists from competing directly with dental therapists operating independently.

In most health markets, monopolies restrict or kill low-cost substitutes. For example, in the hearing aid industry, audiologists, who have Ph.D.s, often put tremendous entry restrictions on hearing aid fitters. The fitters are less skilled, but are perfectly capable of most work. Again, the poor are hurt by this.

This same analysis applies to many other types of services. Lawyers introduce statutes to prevent the “unlawful practice of law.” Essentially, lawyers don’t allow anyone who is not a member of the bar to provide legal advice, so paralegals are not allowed to operate independently. Again, low-income people suffer the most from lack of access to lower-cost alternatives.

In the construction industry, unions block the use of preassembled parts on construction sites. This eliminates a close substitute: factory assembly. Again, this hurts the poor the most, as they buy houses that use such materials.

Schmitz (2016) provides many more industries and much more analysis.

Adversaries and allies: Low productivity, few substitutes

U.S. Steel is often cited as a classic example of a monopoly. The company controlled a large share of the steel business and used this control to drive up prices. But it is also a good example of the new theory, illustrating the bigger picture of the costs its monopoly imposes on the economy. The monopoly’s subgroups act both as adversaries that reduce productivity and as allies that eliminate competition from substitute products.

The U.S. Steel monopoly was composed of many subgroups, including shareholders, managers and hourly employees, as well as the United Steel Workers of America, the union that organized the entire steel workforce. I’ll sometimes refer to the monopoly as the USS-USW monopoly.

In some settings, these groups were fierce adversaries. In others, they were strong allies. Consider their adversarial roles. Given that the monopoly was generating significant profits, at least at first, subgroups had an incentive to increase their share of the pie and certainly to protect their share from other subgroups. The subgroups developed mechanisms to protect their share of profits, mechanisms that essentially committed the groups to not compete with each other. Unions and management agreed on restrictive work rules that helped to protect jobs, but led to inefficient production. Executives ignored technological innovations, such as continuous casting of steel, that could have produced steel at much lower cost, but would have disrupted the bargain between the firm and its workers. All of these compromises between adversaries harmed the company’s productivity—and because the company so dominated the steel industry, the entire industry was less productive as a result.

Next consider the subgroups in their roles as allies. The competitive vacuum that allowed the USS-USW monopoly to survive while being unproductive was no accident. Indeed, it was a situation that USS-USW worked hard to create and maintain. The issue is not merely that U.S. Steel bought up and maintained control of competing steel companies within the United States, as monopolists always do, or that the USW successfully organized the entire steel workforce. If subgroups USS and USW had done only those two things, they still would have faced significant competition from foreign firms—competition that would have forced them to raise productivity and take on new, better technology. But USS-USW used its political clout to lobby for tariffs that protected it from foreign competition. That is, U.S. Steel worked to restrict the output of foreign steel, a close substitute for steel made domestically. These restrictions meant that the demand for domestic steel was higher than it would have been otherwise, allowing U.S. Steel to increase its output, even as it increased prices. These artificially inflated prices injured any U.S. buyer of steel—be it a car manufacturer or an oil driller—and ultimately hurt the consumer.

Summary and conclusion

For decades, the theoretical understanding and empirical analysis of monopoly have themselves been monopolized by a dominant paradigm—that the costs of monopoly are trivial. This blindness to new theory and analysis has impeded economists’ understanding of the actual harm caused by monopoly. Rather than inflicting little actual damage, adversarial relationships within monopolies have significantly reduced productivity and economic welfare. And in many industries, subgroups within monopolies collaborate to eliminate competition from low-cost substitutes. This lack of competition in the marketplace has a disproportionate impact on poor citizens who might otherwise find low-cost services that would meet their needs.

I’ve described this as a “new” theory, but in truth its roots go back decades, to the ideas of Thurman Arnold. Arnold ran the Antitrust Division at the Department of Justice from 1938 to 1943, taking aim at a broad range of targets, from automakers to Hollywood movie producers to the American Medical Association.10 He argued that lack of competition reduced productivity and that monopolies crushed low-cost substitutes, hurting the poor. Arnold supported his arguments through intensive real-world research. He and his staff undertook detailed investigations of monopolies, examining the on-site operations of many industries and documenting the productivity losses and destruction of substitutes caused by monopoly.

Arnold began his work at a pivotal time—in the midst of the Great Depression, just after the United States had experimented with the cartelization of its economy. Faith in competitive markets had reached such a low that cartels and monopolies were thought to be, perhaps, better alternatives. His work and ideas played a big role in reinvigorating confidence in competitive markets. He mounted an aggressive campaign to protect society from monopoly. The campaign had two parts: forceful prosecution of monopoly through the courts, accompanied by an array of speeches and articles to educate the general public about its costs.

Economists gradually forgot Arnold and his ideas, convinced by Harberger’s empirical work and the introspection of economists, leading to, for example, the logic provided by Stigler and others. Scholars and regulators who studied monopolies focused on prices alone and found little to worry about.

But as shown by the research reviewed in this essay—and an expanding body of empirical work—the problems caused by monopoly are significant, and still pervasive. My hope is that this paper will open a new era of discussion about monopoly and its costs, and ultimately lead policymakers to encourage greater competition for the benefit of all.


Endnotes

1 The author thanks Ann Harrington for her valuable suggestions on the content and organization of this essay. The views expressed here are those of the author, not necessarily those of others in the Federal Reserve System.

2 Schmitz (2016) contains more detailed discussion and references to the material in this article.

3 Stigler (1988) presents the familiar logic behind this assumption.

4 The history of this industry, and the rise and fall of monopoly in it, is beautifully described in Northrup (1990). A quantitative analysis, on which the following discussion is based, can be found in Dunne, Klimek and Schmitz (2016)

5 Quoted from the Voice (Oct. 1978, p. 86), a monthly publication of the CLGW union.

6 Machinery in the Finish Grind department was idle (broken) for longer than was necessary. Machines in other departments also may have had to be slowed.

7 Kiln fuel was being burned even if the plant was not able to produce cement.

8 For Thurman Arnold, who directed the Antitrust operations of the Justice Department from 1938 to 1943, size was not the decisive factor in determining a monopoly, but whether the monopoly reduced efficiency.

9 See W.K. Kellogg Foundation (2012).

10 See Kolasky (2013).


References

Bridgman, Ben, Shi Qi, James A. Schmitz Jr. 2015. “Cartels Destroy Productivity: Evidence from the New Deal Sugar Manufacturing Cartel, 1934-74.” Federal Reserve Bank of Minneapolis Staff Report 519.

Dunne, Tim, Shawn Klimek, James A. Schmitz Jr. 2016. “Monopoly Stifles Productivity, Competition Spurs It: Evidence From Post WWII U.S. Cement Manufacturing.” Federal Reserve Bank of Minneapolis Staff Report, forthcoming.

Harberger, Arnold C. 1954. “Monopoly and Resource Allocation.” American Economic Review 44 (2): 77-87.

Kolasky, William. 2013. “Thurman Arnold: An American Original.” Antitrust 27 (3): 91-92.

Montgomery, Royal E. 1926. “The Landis Arbitration and Award.” University Journal of Business (University of Chicago Press) 4 (3): 260-93.

Northrup, Herbert R. 1990. “From Union Hegemony to Union Disintegration: Collective Bargaining in Cement and Related Industries.” Journal of Labor Research 11 (3): 360.

Schmitz, James A. Jr. 2016. “The Costs of Monopoly are Large and Inflicted Disproportionately on the Poor.” Federal Reserve Bank of Minneapolis Staff Report, forthcoming.

Stigler, George J. 1988. Memoirs of an Unregulated Economist. University of Chicago Press.

W.K. Kellogg Foundation. 2012. “A Review of the Global Literature on Dental Therapists.” Available online at https://www.wkkf.org/resource-directory/resource/2012/04/nash-dental-therapist-literature-review.

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