Wednesday, December 12, 2012

Are monopolies back? Part 2

Part 2: How likely are monopolies? 
In my last post I showed that Standard Oil and Alcoa were not quite the terrifying monopolies that they have been made out to be. But how can this be? Standard Oil controlled 88% of the refined oil market by 1890 and Alcoa controlled 91% of the primary aluminum market by the 1930's. Those sure sound like market dominating numbers.

The real problem with trying to define a monopoly is coming up with the definition of the potential monopoly's market. How a market is defined will directly impact the number of available substitutes. The number and quality of substitute goods are both very important when determining how much competition a firm faces.

Let's think about Standard Oil. Was Standard Oil really only competing with other oil refining companies? One of Standard Oil's most important products was kerosene for lamps. If you think of Standard Oil as being in the light producing business instead of the oil refining business, you can begin to see that Standard Oil had a large number of competitors. In addition to other oil refining companies, Standard Oil had to compete with candle makers, trees, and the sun to name a few. All 3 of those goods are substitutes, but they are hardly the only ones. Whale oil can light lamps. People can alter their behavior by sleeping more and working less when it is dark. While none of these may be perfect substitutes for kerosene, if the price of kerosene increases people on the margin will switch to some combination of these goods or something else that I have failed to mention.

But perhaps most importantly, new goods that are even better substitutes can be invented. In 1879 Thomas Edison patented an incandescent light bulb that used a carbon filament. By 1914 88.5 million lamps were being used in the U.S. Three years earlier, in 1911, Standard Oil's market share had fallen to 60%.

If Standard Oil had kept the price of their refined oil and thus kerosene artificially high, they would not only have had to worry about other oil refining companies undercutting them. They also would have had to worry about people switching to wood, candles, whale oil, or even forgoing artificial light altogether. To make matters worse, they constantly had to worry about someone inventing something even better than what they were selling! This unseen competition always exists for every company in every industry. The higher Standard Oil's prices, the stronger the incentive for entrepreneurs to come up with something new, better, and of greater value.

This same analysis just as easily applies to Alcoa. Only government sanctioned monopolies are truly shielded from the threat of competition. The thought of natural monopolies arising on their own with no state assistance, either direct or indirect, is very hard to believe.

The next time you hear about a company monopolizing a market, think hard about what their market really is. Chances are it is much larger than you first thought. When the company is correctly viewed as a competitor in this larger market I bet that they are not as dominant as they first seemed.

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