Productivity and market power in general equilibrium

Let’s assume away cyclical factors, so full employment always holds.

If every sector of an economy becomes monopolistic, output will contract in each sector, and it might appear that productivity will decline.  But for the most part this output reduction will not be achieved by burning crops in the fields.  Rather, less will be produced and factors of production will be freed up for elsewhere.  New sectors will arise, and offer goods and services too, perhaps with monopolies as well.  In any case, the consumer surplus gains from those new sectors might be especially high, because they will be selling to the highest points on demand curves that previously were unsatisfied altogether.

You can cite the deadweight loss of monopoly all you want, but we’re getting more outputs of other stuff.  Value-added could be either higher or lower, productivity too.

The Schumpeterian tradition, of course, suggested that market power would boost innovation.  There are at least two first-order effects pushing in this direction.  First, the monopoly has more “free cash” for R&D, and second there is a lower chance of the innovation benefiting competing firms too.  I don’t view the “monopoly boosts innovation” hypothesis as confirmed, but it probably has commanded slightly more sympathy from researchers than the opposite point of view.  Bell Labs did pretty well.  In any case, partial equilibrium output restrictions won’t get you to any kind of smooth conclusion about monopoly causing low productivity growth.

Let’s say instead that every sector is ruled by monopolistic competition, a’la Chamberlin.  In the model, that puts firm production at points on the AC curves above minimum AC for each firm or sector.  You might consider that to be a productivity problem, though of course you must compare it to the rise in product diversity that follows from monopolistic competition.

But under those same conditions, profits are zero and so the mark-up arguments from the DeLoeker and Eeckhout paper do not apply and indeed cannot hold.

I find most of what is written on monopoly and productivity these days to be under-theorized.


Is it MaiTais or Margaritas?

"the consumer surplus gains from those new sectors might be especially high, because they will be selling to the highest points on demand curves that previously were unsatisfied altogether."
the reason they were unsatisfied altogether was because they were marginal to begin with. the kind of markets that feature regularly in the 'markets everywhere' section of this site, which have a total joint value of zero. Plus, under monopoly the direction of innovation and the direction in which new markets open do not lead to maximise gains from trade but rather gains for the monopolist. Markets with very few buyers who are willing to pay a lot rather than markets with tons of very price-elastic buyers.

TC: " I don’t view the “monopoly boosts innovation” hypothesis as confirmed, but it probably has commanded slightly more sympathy from researchers than the opposite point of view" - but it is confirmed. The Founding Fathers of the US knew it: that's why they put patents in the Constitution of all places.

Bottom line: if there's no monopoly, legal or otherwise, there's less incentive to produce. Nobody wants to be a marginal farmer growing wheat or rice at market prices for MR = MC = price of the commodity (except in the Philippines, where they still use water buffalo and most of the crop is eaten by the farmer's family, or at least we eat most of what we grow there; compare to Thailand with the Thaksin's sister rice price fixing scandal). Everybody who is anybody wants a monopoly. That's why doctors have boards, lawyers have bars, and business-people lobby reps to establish licensing requirements. Even professors have their own caste system, with tenure disguised as academic freedom, for this very same reason. Monopoly = innovation = incentive to produce. I would argue most of the producer surplus goes to the owner of the capital rather than the innovator, under the present rules, and this is wrong, but it's a necessary fact of life. The US north got rich in the 19th century behind a bunch of protective tariffs, also a form of favoring monopoly. Same in Asia (see Joe Studwell's book).

Peter thiel wrote a whole book on this topic saying exactly what you just did Ray. The question is whether monopolies are as good for consumers as they are for producers.

What changed over the last 40 years and is it a good or bad thing? Same as the inequality debate, many libertarians just want to sweep this point under the rug.

@Ray: Standard Oil as technological innovator

Standard oil argued they became a monopoly because technological innovation allowed them to lower prices. Their major "innovation" was to refine high sulfur oil. However, the "innovation" was to buy the patent from an smaller oil company. The second important innovation in refining, thermal cracking, was developed after Standard was forced to divide. Between 1870 and 1910, when the company controlled the market, the development of oil refining technologies stagnated.

Standard Oil "benefited" the public by selling cheap kerosene illuminating oil, but slowed the development of thermal cracking required to yield more gasoline for cars.

@Axa - Good point (as you say, innovation often comes from smaller companies or people that are initially shunned, it echoes my complaint above in the OP where I say 'I would argue most of the producer surplus goes to the owner of the capital rather than the innovator, under the present rules, and this is wrong, but it’s a necessary fact of life') but keep in mind "slowed the development" could simply have been economics: Google "the tyranny of Silicon" which means semiconductor transistors are still made of doped silicon despite better technologies, since making them from silicon is so cheaper (however, I have noticed they are now using fiber optics for the data pathways within a semiconductor chip, which is surprising).

Bonus trivia: Bill Gates, a decent but not great programmer himself (same as me), bought MS-DOS from a hippie programmer, for a nice sum of money for the hippie but nowhere near where Bill made it through marketing. Similar in theme to the tech savvy Wozniak vs the business savvy Jobs.

I am an entrepreneur that often uses economics in his decision process, but also economists should use real world insights in their job. Competition is what brings innovation (especially process innovation) because the state of mind of somebody that competes is completely different by that of a monopolist. When I switch off the light and before falling asleep, I think on how I can shave a few tens of basis point in the cost of a process, and the same I do while I am having the first coffe in the morning in bed. And it is not only me, it is most of the high level of my organization, even a few salaried positions, because my main job is to build an organization that cares.There is simply no way you can have this type of focus if you do not have a continuos fire on your butt that is your competitors.

BTW, your example of Bell labs is weak, because there is not a counter-example. Actually, in my opinion, if there was today level of competition in the industry for all those years, it is very likely that the level of innovation would have been larger.

Did Bell Labs do cost effective research? Where they customer driven in solving problems that customers wanted?

How many wasteful projects did they pursue? What was there return on investment?

Could the monopoly profits have been invested elsewhere for even greater social outcomes?

Command economies always claim that they are redirecting resources into projects that are more beneficial to society then the bad choices that a free market makes. How does that work out?

Manhattan project, mass-produced penicillin, man-on-the-moon (and all telecommunications that came from that, Comsat comes to mind) and last but not least, Teflon, all 'government boffin' research. Maybe even Tang (TM). The private sector, unless you have strong patent rights (and we don't) only looks about four years ahead it's been estimated.

Isn't that a common misconception. I thought Teflon was invented at DuPont? Tang was invented by general foods corporation. I think I'd be hard to be convinced that the Manhattan project produced positive consumer surplus compared to the alternative for all that R&D.

I'm also super skeptical that putting a man on the moon produced much consumer surplus. Super cool, but efficient, seems like a low probability assertion.

Bell Labs may have done OK, but how long did it take for their innovations to make it to the market? Bell deliberately stifled innovation, managing network and hardware standards to their advantage through regulatory capture, to maximize return from their investment in existing infrastructure. Bell also controlled licenses for their innovations ruthlessly, ensuring that they didn't result in seemly non-telecom products that could displace their services or areas they hoped to expand into.

Whatever productivity might come from maximizing specific investments into obsolescence, would overall productivity have been higher if the markets were free to invest in them most productive innovations rather than being channeled away from the monopoly's interests? For example, what other innovations could have made up for the loss of the Internet as we know it and the information revolution it spawned? Surely a telecom monopoly would never have allowed such a disruptive technology out of their control. The messy Internet revolution could easily have turned out as a stately roll out of products and services directed and approved by Bell's notoriously conservative, centralized management. Try to imagine an Internet designed by the 55 year olds in Bell's middle management.

It's not an accident innovation took off after the break up. All the Bell Labs example proves is that investment in research can produce innovations, not that monopoly is a good or an especially productive model for funding it.

A key point is that Bell Labs was a subsidiary of AT&T. It was a research arm which did NOT produce products. Its discoveries went in the public domain, and were more likely to be used by other companies than AT&T, which was a monopoly limited to telecommunications, and slow to adopt new technologies. Bell Labs may have been a great research group, but it is a very poor example.

But the breakup itself was in reaction to innovations that were occurring in the communications space.

Yes and no. The innovations themselves weren't particularly innovative. (Microwave transmission, Non-Bell PBX Systems, etc.) The problem was that these innovations upset a regulator-imposed cross-subsidy structure in which long distance rates well above cost subsidized the fixed cost of access. This then allowed uneconomic bypass to be profitable. (MCI's microwave-based long distance was more expensive than Bell's.) The breakup was an attempt to make the efficient Baby Bells compete with each other, and with the long-distance remnant AT&T, whose prices eroded with the rise of MCI and Sprint. Manufacturing (Western Electric) had no particular scale advantages at all.

The eventual competition that arrived had little to do with any of this, as cellular eventually crippled the wireline business.

"Bell also controlled licenses for their innovations ruthlessly, ensuring that they didn’t result in seemly non-telecom products that could displace their services or areas they hoped to expand into."

In one specific instance, they restricted the connection of automated answering machines to any Bell phone line to drive customers to use their far more expensive Manned messaging service.

Tyler, your idea is essentially that you can rely on monopolies for innovation. That's silly because monopolies are by definition protected from market forces.
As for comparing 100% monopoly to 100% monopolistic competition, there's such a simple answer. Too much monopolistic power squelches productivity because no entrepreneur would come up with an innovation in an area where all the benefit will go to the monopoly. Also, too much monopolistic competition will disincentivize an entrepreneur from creating an innovation because they won't get paid. Therefore, you need a middle ground where the entrepreneur gets paid but doesn't have an absolute monopoly forever. Hence the logic of the patent system to grant monopolies for limited amount of time.

But that seems to miss the type of innovation suggested. Seem to me that the innovation is about make stuff that's not being made in industries/product spaces that may not even exists yet.

I think the real question on that is related to where those new innovation fit into the larger economic mix. Very few product seem to be purly isloated consumption/use. When I have dinner how many different industries are involved? If each of those is already a monopoly that is satisfying the maket (i.e. fitting in to it's network setting) the new poduct lacks that network participation so will likely have a lower valuation and so be more likely to be a failed innovation than a successful one.

When two economists can't agree whether rent is a fixed cost or a variable cost, the rest of their debate loses something. In any case, I get the feeling that the debate is being carried on in a 20th century context with 20th century markets and 20th century theories. But I digress. I will accept Thiel's advice that the path to prosperity is through monopoly. But here are a couple of real world cases I would like to consider. First, Amazon. Amazon certainly is innovative and has a large market share for online retailing, but it's far from a monopolist in retailing. Amazon has prospered and been able to afford all that innovation and growth because it doesn't generate much in the way of profits. Amazon has the luxury of not needing profits because investors are willing to buy its stock at prices that bear no relationship to its earnings, allowing Amazon (and Bezos) to sell stock to fund innovation and growth (and the purchase of the WP). Why would investors buy the stock at what appears to be grossly inflated prices? The explanation I hear most often is that, one day, Amazon will have a monopoly in retail and, hence, will generate enormous profits. Rational? Second, Google. Like Amazon, Google is innovative and has a near monopoly in search engines. Unlike Amazon, Google generates enormous profits, which it uses to fund innovation and growth. But the profits aren't generated by charging for its core service (i.e., search) but digital advertising. Indeed, together with Facebook, which uses the same model, Google and Facebook capture between 60% and 70% of total revenues from digital advertising. Who knew? While it's funny that two economists can't agree whether rent is a fixed cost or variable cost, it's absurd that few would agree what business Google and Facebook are in - in my book, they are in the advertising business, the boy wonders the Madmen of the 21st century. I could go on. And I will. Cell phones. Top of the line phones sell for over a thousand dollars (for a phone!), but nobody actually pays the retail price. Instead, service providers (Verizon, etc.) sell the phones for a fraction of that price if the customer will sign a long-term service contract at ridiculous rates (rates that generate enormous profits for the providers), and the customer always does. Unwitting customers no doubt believe they are getting a great deal. Cell phone producers and cell service providers have collaborated in the biggest heist since the Great Train Robbery. House prices. College tuition. What's with the boom and bust in prices of the former and the boom (and future bust?) in the prices of the latter? Rational? Nothing is as it seems, which seems to be the point, making a silly disagreement between two economists rather small.

Some of these issues--what is fixed and variable--are longstanding arguments that arise when economists, for example, try to analyze the effect of concentration on profitability, or the role in advertising in raising barriers to entry. Not surprisingly, sometimes you see people switching sides on whether advertising expenditures should be treated as an expense, or treated as a capital expenditure, based on which side of the argument they want to be on for questions such as the relationship between concentration and profitability, or the effect of advertising on market structure.

No. Monopolistic/oligopolistic industries are lazy, bureaucratic, and inefficient. Recently innovative companies like Google may spend extra money on R&D out of habit or idiosyncrasies of the majority shareholders. But most legacy companies spend very little on R&D, nearly all of it "D", and when revenues increase from competition being excluded, they (1) buy back shares, (2) add to their bureaucracy, (3) make more acquisitions to further exclude competition.

Your hypothetical scenario looks a lot like 1970s USSR. Yes they spent quite a bit on research - more than the US as % of GDP.

Toothbrushes priced at $5 because they have silicone handles and multicolored bristles of various lengths and orientations is technically "product diversity" but in fact is a giant marketing hoodwink. As is the 3M purple sandpaper that "lasts 10x longer" and costs 8x as sandpaper used to. The kicker is you can't even find regular sandpaper on the shelves at Home Depot, 3M owns the aisle. What is the cheapest toothbrush you can even buy at Walmart, supposedly a discount retailer? Now go to Dollar Tree, where China, not corporate America, owns the aisles, and get 20 toothbrushes for the same price. That is not research, that is broken windows.

"The kicker is you can’t even find regular sandpaper on the shelves at Home Depot, 3M owns the aisle."

You can try shopping at the competition. Lowe's certainly has more than one brand of sandpaper.

That was my impression of the literature as well - they are stating that X-inefficiency due to a lack of competition is the issue, it has nothing to do with deadweight loss. Cowen's point that we need to articulate the mechanism through theory more clearly is a good one, but I think the post missed the primary mechanism that people have been concerned about, namely incentive problems within firms that appear without the discipline of competition.

So, we are advocating for monopolies as long as they satisfy the consumer with lots of stuff. Check.
"That's why poker players like Derek spread their risks around a little. Instead of just making one giant bet on themselves, they make all these other little bets too. Of course, buying shares in other players can get expensive, so there's another thing poker players do. They trade shares of themselves with other players."

Just would like to say these are my favourite kinds of posts and the reason I keep coming back. This and your links to bloomberg articles and your 'list of links' posts are my favourite. Thanks!

So that is what America has become, a country where merciless monopolies dominate the economy and a dispossessed populace can do nothing to defeat them. How could that happen in the nation of Jefferson, Jackson and Long?

Stop impersomating me I said!

"You can cite the deadweight loss of monopoly all you want, but we’re getting more outputs of other stuff. Value-added could be either higher or lower, productivity too."

Does that work? If a monopolist restricting output and employment in Industry 1 would drive workers into activities with a higher surplus in Industry 2, then surely those same workers would have an incentive to move into those activities if Industry 1 were competitive? After all, if the increased surplus is greater from joining industry 2 than it would be for a marginal increase in production around the monopoly output in Industry 1, it must be higher than the near-zero increased surplus around competitive levels.

In other words - if your monopolists push workers to more productive activities elsewhere, why wouldn't we have just the same if not more effect without the monopolies?

OK, all just static micro. I can see that in a more dynamic framework you could argue some other industry would be started up out of desperation, that might become productive. But the same could be said of any business-harming policy. Bomb factories and there will be some gains as owners and workers respond...

Creative destruction implies that monopoly loses its power from innovation, and that innovation is the goal, not monopoly.

The dead hand of monopoly does not lift a finger, other than the middle one, for anyone.

"In the 1940s Schumpeter partially change its positions, going to argue that the monopoly created by innovation tends to be transitory, but permanent, as businesses are encouraged to strengthen its monopolistic position, controlling the innovative application with oligopolistic arrangements, and/or patent protection and other barriers to entry. In addition, through the internalization of the research activity, generate further innovation that excludes others from access to technology.(Malerba 2000)
In other words, the monopoly encourages innovation and provides the ability to implement dynamic efficiency: that this condition is more rewarding favors for economic development when compared to static efficiency of perfect competition. Ultimately, according to the approach of creative destruction, dynamic efficiency is highest with a competitive market ' dynamic ' where, at least in the short run, the entrepreneur has market power.(Basile 2001)"

It seems to me that monopolistic competition is the law of the land for most enterprises. And what's wrong with that? From the production side, no one wants to be commoditized. And preferences are fluid.

"It seems to me that monopolistic competition is the law of the land for most enterprises. "

Businesses build moats, but I think it's getting pretty squishy with the language to classify every attempted barrier to entry as "monopolistic competition".

Is Walmart's low price strategy truly "monopolistic"? In my mind, monopolistic has to be a type of barrier which a competitor can't economically get around. Generally, a legal barrier, or natural barrier (geographic ownership of valuable land, minerals, etc).

One area where you can question the Schumpeterian hypothesis today is his reliance on the belief that only monopolists with a cushion of cash could innovate. It would be the battle of the titans who had war chests who would innovate.

Look at the origins of small companies that became big and ask yourself: why didn't this product or service start from a monopolist. The economies of scale in innovation are much different than they were when Schumpeter wrote. The world of electrons and code is quite different than the age of steel and railroads.

Re growing margins and monopoly:

"So which is it — political rent seeking or cutting-edge investments? In a new research paper, I tease apart the factors associated with the growth in corporate valuations relative to assets (Tobin’s Q) and the growth in operating margins. I account for the roles of R&D, spending on advertising and marketing, and on administrative costs, including IT. I also consider investments in lobbying, political campaign spending, and regulation; and I look for links between rising profits and industry concentration and stock volatility.

I find that investments in conventional capital assets like machinery and spending on R&D together account for a substantial part of the rise in valuations and profits, especially during the 1990s. However, since 2000, political activity and regulation account for a surprisingly large share of the increase."

That's the first I've heard suggested that the AT&T monopoly was good for innovation. Evidence seems to point in the opposite direction. After the breakup we started seeing things like call waiting, blocked calls, caller id, cordless phones, voice mail.... Bell Labs may have done reasonable well in 'big thinking' innovation to some extent - but they were woefully inadequate on the steady beat of incremental improvements that make everyone's lives a little bit better day by day by day.

I think what the claim was is that Ma Bell would not employ all those engineers and the unemployeed would then would be available to help develop other goods that don't currrently exist hence innovative.

Those things (well, not email) existed well before divestiture. What held them back was pricing. AT&T was ordered by regulators to price them way over cost to subsidize access. AT&T was a monopoly, but a price-regulated monopoly. That makes a lot of the difference in this discussion.

"New sectors will arise, and offer goods and services too, perhaps with monopolies as well. In any case, the consumer surplus gains from those new sectors might be especially high, because they will be selling to the highest points on demand curves that previously were unsatisfied altogether"

That doesn't seem to follow at all. Producer surplus may actually be especially high, particularly given the potential for monoloy, even if we assum to standard monopoly graph of a single output price. But we also know that most monopolists will see to price discriminate so even more of the consumer surplus would be transferred to the producer side and away from the consumer side.

Here are some issues and questions.

Suppose we have increasing returns to scale in an industry. If the firms in that industry consolidate to a monopoly, society loses from monopoly power but gains from lower average costs in that industry. The net gains are ambiguous. It is not necessarily true that prices would be higher.

Some monopoly firms, like the old IBM, kept their monopolies by innovating. Keeping ahead of any competition. A firm in an innovative industry like high-tech is like a shark: you keep swimming or you die.

Bell Labs was part of ATT which was a monopoly. A lot of innovation at Bell Labs. But ATT was a regulated monopoly. It could innovate at the expense of its customers who were stuck with whatever price the regulators allowed. A competitive ATT spun off Bell Labs.

It matters a lot if the monopoly arises organically in the market, or if the monopoly is produced by government cronyism or the threat of violence.

Monopolies are a creation of government regulation. Absent government regulation all monopolies fall apart over time.

Yes patents are a form of regulation, that can encourage innovation and societal benefits at the cost of granting monopoly power. However if the monopoly becomes too powerful, i.e. profitable, competitors will find ways around the monopoly. The monopoly will spread the monopoly profits too workers and government actors, who in turn will work to defend the monopoly. The monopoly gives us higher prices, lower output and a misallocation of resources.

Whole new sectors don't arise just because there are free factors of production. Every once and awhile you do something kinda like this It's like you've never read anything on the history of technology. I'm sure you have so I'm just baffled. Maybe you are confusing firms with sectors? Sure new firms will be created.... and then we break down monopolies.

The question of how the monopoly is maintained may determine whether the “monopoly boosts innovation” hypothesis is valid or not.

In the case of a competency driven monopoly like Intel, Microsoft, etc. where the monopoly is created and maintained by out innovating competitors, the higher monopoly profit margins attract innovation trying to get a piece of the action like how video chips evolved.

The case of a politically created monopoly like AT&T or US sugar producer just produced anti-innovation cultures who may throw a PR token in the form of Bell Labs into the equation. However, AT&T sold the non-exclusive patent rights to the transistor for almost nothing while the phone system remained the last electronic institutional area to become transistorized. They were still using mechanical switched in the 90's in our area and they failed all the time.

The sugar producers and processors in the US are technologically way behind the rest of the world and the last to even adopt any modern technology.

I'm not convinced that monopolies can be modeled by traditional rational actor economics, because I'm not convinced that managers in monopolies are rational actors acting in the interests of the firm. I think the temptation is to establish a satisificing routine, defend the status quo to fix the situation in stone, and plan to hand this situation down to either sons and daughters of the current managers or favorites of the current managers, regardless of their ability.

Just to be boringly technical, but the deadweight loss already accounts for all the new stuff, allowed to happen because of the full employment assumption. The value of that new stuff is the rest of the column below the deadweight loss in the usual monopoly figure, the value of the alternative stuff that gets produced instead of the non-produced monopoly good. If all that other stuff is so valuable, the deadweight loss will be accordingly low, although in fact dating back to Harberger's estimates, we have long known that estimated deadweight losses in the US economy are well below 1% of GDP. What gets people upset about monopoly is more often the Tullock rectangle of rent redistribution, which is not a deadweight loss but that which the monopolist extracts from the consumers, something they can see and get annoyed about. Deadweight losses are invisible as they do not exist.

“If firms’ costs minimize and markups go up, it’s almost a direct implication that their expenditure for labor over sales will go down. If I’m a monopolist, I’m going to reduce quantity, so I need fewer workers, then my prices go up, and my profits go up. It’s almost a direct consequence of the optimal behavior of the firm. Essentially, nominal and real wages will go down, which is something that we see in the data, flows will go down across sectors, and you will see participation going down. Those are the logical implications for market power.”

>and factors of production will be freed up for elsewhere

this is a classic lump-of-labor fallacy. and moreover, it is in blatant contradiction with the empirical observation (that you yourself have made elsewhere!) that U.S. mobility is low. reallocating factors of production is not a trivial endeavor.

also, yes market power can spur innovation, but only up to a point--see Aghion et al.:

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