Behaviour of Monopolistic Firms

The development of neo-classical economics in the late 19th century

coincided with the maturing of the "Industrial Revolution" in Britain and the rapid expansion of industrialization in continental western Europe and North America. Competitive industrial capitalism had become a world-wide force, but, as industrial production and organisation expanded, free competitive markets appeared to be giving way to monopolistic forms of business organisation. Many of the most rapidly expanding modern industries, such as iron and steel, ship-building, railroads, chemicals and machine-making, were already showing signs of increasing concentration of ownership and, in many instances, outright monopoly. Large corporate entities were replacing traditional family-owned and operated business, single proprietorships and partnerships of the kind Adam Smith and his followers seem to have assumed would be the normal forms of business enterprise. During the 19th century, business amalgamations, mergers and buy-outs became commonplace and have continued ever since. Even in Britain, where the resistance to monopoly was more strongly entrenched in law and popular opinion than in other European countries, by the time of World War I a number of large monopoly organisations had developed. An often cited example in the business history literature would be the J.& P. Coates cotton sewing thread organisation which controlled not only the British domestic market, but most of the world market as well. In other industries a few large firms (oligopolies) exercised effective control over prices and output levels. These developments were particularly conspicuous in continental European countries, in part because there a different legal tradition permitted them to be more overt than in Britain. In Germany, quickly emerging as the dominant industrial power on the continent, there was no resistance, either in law or opinion, to monopoly practices. The formation of "cartels", producer organisations set up to control the market for particular products, was actually regarded as desirable. Why? Because such organisations it could be (and was) argued, eliminated wasteful competition and duplication of production facilities, made it easier for firms to plan their activities, and ultimately might yield benefits to consumers in the forms of secure supplies and lower prices. In the other great industrial economy emerging at the turn of the century, the United States, the growing concentrations of economic power also taking place there presented something of a paradox. Then, as now, most Americans professed a commitment to the ideals of competition, freedom and individual opportunity. Powerful constitutional and legislative enactments were in place to protect these ideals. Yet the legal apparatus which was supposed to ensure such freedom also served to shelter large corporate enterprises from any serious intervention by government in their activities. For example, Americans could point with pride to the Fourteenth Amendment to their Constitution (ratified by the States in 1868) which, most learned at school, was intended to confer equal rights on the black population. But, in practice, the so-called "due process" provision (which prohibited any state legislature

from depriving any person of life, liberty, or property without due process of law) was instead most often used by corporations to prevent state legislatures from interfering with their business arrangements corporations having the legal status of persons and their purchases and sales of assets clearly involving "private" property. When World War I began in Europe in 1914, the United States was already in a position to become the worlds leading industrial country and most of its major industries were dominated by one or a few very large firms. World War I, if anything, reinforced these trends. On both sides of the conflict the niceties of competition were subordinated to the critical task of maximising production, particularly in the heavy industries upon which military output depended. During the 1920s there were further rounds of mergers and acquisitions. In the United States a highly influential book, published in 1932, The Modern Corporation and Private Property, by Adolf A. Berle and Gardner C. Means, focused attention on the issue of what was happening to the business sector. Berle and Means undertook to show (a) how the corporate form of business enterprise had become dominant in modern society and (b) how its distinguishing feature was the separation of ownership (in the hands of widely-dispersed shareholders) and control (in the hands of professional managers who had little if any ownership interest in the enterprise). The evidence they presented suggested that business decisions were designed to promote the interests of managers and not the shareholders or, necessarily, the customers. Berle and Means had a great impact on scholarly and public opinion relating to business, especially in the US, and their influence remains significant even today. But for our purposes such ideas were particularly important for bringing into question the relevance of the neo-classical assumption of "perfect competition" in basic economic theory. Not surprisingly, a number of economists began trying to develop theory capable of explaining a world in which perfect competition was the exception rather than the rule. The extreme case at the opposite end of the scale from perfect competition is monopoly. A pure monopoly would be an industry comprising a single firm, instead of the "large number" of firms which is characteristic of perfect competition. Such a situation could be imagined if a firm were producing a good which was virtually unique, having no good substitutes and if some kind of barriers existed, such as patent rights, which prevented other firms from participating in its production A firm with a monopoly is in a position to influence the market price by deciding how much of the good to produce. Unlike a perfect competitor, a monopolist does not have to take the market price as a "given" and adjust output accordingly. A monopolist is said to be a "price seeker" rather than a "price taker" because maximising monopoly profits (or minimising monopoly losses monopolies are not necessarily profitable) entails finding the optimum price to charge for the product. While it is common to think of monopolies as possessing power over the market it is still the case that buyers retain the capacity to refuse to buy at a price they consider too high for

the value they receive. In fact, the monopolist faces the same demand curve as the industry in perfect competition. (The monopolist is the industry.) And the common characteristic of such a market demand curve, as we have seen, is that it slopes downward to the right. If the monopolist wants to increase sales, price will have to be lower than if a lower level of sales is preferred by the firm. The monopolists production decision, then, entails finding a level of output that maximises profits or minimises losses, just as was the case for the perfectly competitive firm already discussed.The decision rule for the monopolist is also the same: to choose a level of output that maximises the difference between costs and revenues or, in terms of marginal analysis, to expand output until marginal cost equals marginal revenues. The reasoning behind this is the same as for the competitive firm. So far as the costs of a monopoly firm are concerned, again they are conceptually the same as those of a competitive firm. However, applying the standard decision rule has quite different consequences in the two cases. When the monopolist sets output to equate marginal cost and marginal revenue, average revenue, or price, is greater than marginal revenue, whereas under perfect competition marginal revenue and average revenue are the same. At the monopolists most profitable level of output marginal cost equals marginal revenue but not, as in the case of the perfectly competitive firm, average revenue (price). To equate marginal cost with average revenue would entail producing a larger output at a lower price. This is the key to the criticism of monopoly which is inherent in conventional market theory. Monopolists restrict output and may charge higher prices than firms would in a competitive setting. This means that monopolists may earn profits. In the case of competitive firms, such profits would attract increased competition. In the long run profits would attract new firms to the industry. This would result in a further increase in total output and a fall in price ultimately to the point where all greater than normal returns were eliminated. But a monopoly situation precludes such a corrective development, even in the long run, because of the "blocked entry" which makes monopoly possible in the first place. (If there were no obstacles to prevent firms from entering this industry, the monopoly situation would not, of course, exist.) Therefore the social losses caused by the reduced output and higher prices which exist under monopoly compared to perfect competition may be even greater than the short run analysis would predict. When monopoly exists, too few resources are allocated to the production of the goods affected and the total satisfaction of consumers could, consequently, be increased by altering the allocation of resources among alternative uses. How serious a problem this allocative inefficiency may be is, however, difficult to determine with any certainty.