ANU Inaugural Trevor Swan Distinguished Lecture

New Lecture Theatre, John Curtin School of Medical Research, Bldg 54, Garran Rd, ANU 4.30pm-6.00pm

“How well has the Market Structure Irrelevance Principle for Durability, Product Quality and Innovation withstood the Test of Time?”

Peter L. Swan*

University of New South Wales

First Draft 19 May, 2006

This Version 23rd May, 2006

In my 1970 AER piece, Swan (1970), and related articles I annunciated the then highly controversial “irrelevance” principle. A monopolist will always wish to generate rents in the most efficient and least cost way possible. This means that, generally, a monopolist will produce goods of the same optimal durability as under competition without “planned obsolescence”, and that the monopolist’s product range and quality choices are the same, or at least not systematically inferior. Moreover, an incumbent monopoly is eager to innovate and not suppress superior technology, despite the apparent loss of the incumbent’s existing business. Have these views withstood nearly a 40 year test of time and the “Coase (1972) conjecture” critique? How universal are these ideas, what is the extent of empirical support, and what are their implications for competition and regulatory policy?

The “irrelevance principle” when it is boiled down to its essence should not have been at all controversial. It states that rent extraction by a single or multi-product monopolist should be as painless as possible. It is clear that monopoly can give rise to a contraction in output relative to the competitive or social welfare ideal so that one condition for social optimality is violated. Decisions on product choice such as durability and product quality should nonetheless not be biased away from the social ideal (Swan, 1970; 1971a; 1971b; 1972b; Sieper and Swan, 1973). In the case of durable goods, both monopoly profit maximisation and competition requires that the overall cost of providing the service flow from the durable be minimised. See Tirole (1988), Carlton and Perloff (1994), and Shy (1996) for modern treatments of these

* Contact details: Peter L. Swan, School of Banking and Finance, UNSW, tel. 02 9385 5871; email: [email protected]. I wish to thank Ari Melnik for useful comments. market structure irrelevance results. In order to bypass the problem of the second-best giving rise to an additional distortion, some form of separability is required. For example, between scale factors that reflect market structure and the choice of the product or durability.

This topic has attracted much interest and given rise to several important surveys. These include Schmalensee (1979) and Waldman (2003) with additional perspectives provided by Kamien and Schwartz (1975), Waterson (1989), Lancaster (1990), Saving (1982) and Orbach (2004). Waldman (2003) contends that three major advances in the microeconomic theory of durable goods over the last 30 or so years were made in the 1970s by Swan (1970, 1971a), together with Sieper and Swan (1973), Coase (1972) and Akerlof (1970).

The interest in this topic is understandable as it is critical to know if the social harm due to monopoly and hence the need for regulatory and trade practices legislation is simply due to output contraction. Does it extend to the product range, suppression of new products and innovations, planned obsolescence of durable goods, suppression of high quality goods and focus only on the lowest quality? In fact, a whole plethora of anti-social behaviour could be the norm, as is alleged in the popular literature such as Packard (1961). I conclude that nearly forty years of research supports the generality and continuing relevance of the “irrelevance” principle.

One of the first formal treatments of durability choice was provided by Wicksell (1934) who examined the optimal design life of an axe under competitive long-run equilibrium conditions. A feature of his result was that the optimal durability is independent of the demand for axes. This result Wicksell (1934, p. 278) found “rather peculiar”. This is because he did not understand that optimal durability is independent of demand conditions because the optimality condition simply requires that the costs of providing the services of axes be minimised. Dorfman and Steiner (1954) introduced a model of advertising and product quality but with little in the way of structure so that not much could be said.

An analysis of durability as a specific indicator of quality provided the necessary structure for Martin (1962), Kleiman and Ophir (1966), Levhari and Srinivasen (1969) and Schmalensee (1970) to show that a monopolist would always produce a good of lower durability than under competition. However, Wicksell’s result should

2 have already warned them that their answer must be wrong. Swan (1970, 1971a) initially pointed out the nature of these errors. The most general exposition of the error made by these authors is given by Sieper and Swan (1973) who place few restrictions on the nature of the asset. The service flow from a durable is assumed to depend only on the age of the product and the choice of durability at the time of production. This flow cannot increase as the durable ages but is otherwise unrestricted. These authors maximise the long-run equilibrium profit of the monopolist, which is in of itself unobjectionable. In fact, they extend Wicksell’s correct treatment for competition to the monopoly case. They do so by assuming that the monopolist’s previous durability choice, embodied in the stock of the durable and encapsulated in the initial conditions on the problem, can be varied today in the interests of future profitability. In effect, monopolies have “time machines” that enable them to undo past decisions by turning back time. Once this error is corrected both the monopoly that adopts a sales policy in long-run equilibrium and competition produce goods of the same cost-minimising durability. This is to minimise the total cost of providing the stock of the durable from which the service is derived.

In each of the sections I relax one of the critical assumptions that gave rise to market structure indifference result. I begin in Section 1 with the most critical assumption that has attracted the most attention, especially in recent years, namely the ability to commit to an optimal sales schedule. Section 2 relaxes the assumption of constant costs to examine rising marginal costs. Section 3 allows for secondhand and reproduction markets in which competitive repair and recycling markets may compete with the monopoly seller in the market for new goods. Section 4 extends the analysis to aspects of product quality other than durability, while heterogeneous consumers need to be discussed under several headings is mainly considered in Section 5 and technological innovation in Section 6. Further applications of the approach are considered in Section 7, empirical tests are analysed in Section 8 and the final section concludes.

1. Dynamic inconsistency problem

The original market irrelevance results focus on long-run equilibria in which output is constant and participants have perfect foresight. Perhaps the problem that has attracted more attention than any other concerns the behaviour of the monopolist and consumers in a dynamic situation in which participants may lack perfect foresight. An

3 important reason why participants may lack perfect foresight is what is known as “dynamic inconsistency”. An agent who has formulated a plan at a given point in time that is optimal at that point in time may no longer wish to obey that plan in future if he is free to reconsider (Strotz, 1955).

Actually, this problem of dynamic inconsistency was not only posed by the author of the first novel, Homer, about 3,000 years ago, but he also provided the answer: The hero, Ulysses, is being rowed past the island of the Sirens on his return from the Trojan War. Knowing that the song of these desirable women will lead to his death, he has himself bound to the mast and gagged by his men wearing earplugs with the command to his men to disobey any command he gives to follow the Siren song. He gets to be seduced but not destroyed by the song. By precommitting himself to a plan toward his goal of reaching home alive he is able to adopt a dynamically consistent path.

In the context of the monopoly seller of a durable product, it may be optimal today to sell another unit of the product. Once that unit has been sold and the firm once again formulates an optimal plan, more of the good is now in the hands of the consumer. Selling an additional unit now inflicts a greater capital loss on the consumer at no cost to the seller who gets to enjoy an additional sale that was not originally planned. This is the self-destructive Siren song. Hence the plan that was optimal prior to the sale is no longer optimal. The new plan this instant calls for greater sales the next period, only to be unexpectedly revised again and again until price falls to marginal cost. Anticipating these capital losses, the consumer may reduce his purchases until the price is lower. Even if the consumer is perfectly informed of the seller’s plans at each instant of time, he gets it wrong. In contrast, for a renter the costs of this over- production are internalised as the capital losses directly impact the monopolist. Clearly, if the monopolist rents the good, behaviour is time consistent. Time consistency, or the lack of it is, also a feature of important macroeconomic contributions such as Kydland and Prescott (1977).

Douglas and Goldman (1969) avoid this problem by endowing consumers with expectations of future prices known to the monopolist, e.g., stationary expectations that are formulated independently of both the monopolist’s plan and actions, and having the selling monopolist exploit this imperfect knowledge in an optimal fashion. Coase (1972) points to the time inconsistency problem of a selling monopolist to

4 conjecture that the unconstrained monopoly seller will simply sell the product at the competitive price equal to marginal cost and forgo all monopoly profit. This is because the smart buyer who can predict what the monopolist will do will refuse to pay more than the competitive price. The policy implications of such a finding are immense: durable good monopolies are simply competitive industries with no social costs or efficiency distortions. Much of competition law could be redundant.

We actually see few examples of durable goods monopolies giving away their products at marginal cost, as is predicted. What could explain this prediction failure? The monopolist could make the product less durable, constrain himself by renting, or enter into contractual arrangements to bind himself from flooding the market. Once again, the policy ramifications are immense: potentially a myriad of contractual and legal arrangements that appear innocent on the surface are really disguised anti- competitive devices. Traditional competition law could be redundant and any device that helps a monopolist achieve time-consistency is potentially anti-competitive.

Sieper and Swan (1973) examine the selling and renting/leasing durable goods monopolist under two mechanisms describing how consumers derive their expectations of future prices for the service provided by the durable. In the first case they examine, under the most general decay conditions for the product and constant costs with respect to scale, there is a general specification of “common foresight”. Prices are conditional on the prices implicit in the firm’s profit-maximising plan. Hence, all agents in the economy are equally informed for all possible maximising plans. Under these conditions within a discrete time framework the market structure irrelevance result for durability of Swan (1970, 1971a) is always shown to hold as it is always optimal to minimise the total cost of providing the service.

However, perfect knowledge by the firm of future demand and cost conditions and common foresight does not result in perfect foresight due to the time inconsistency problem that arises in the case of a sales policy. The monopolist must bind himself in some way. The Coasian (1972) solution of selling at marginal cost is shown to be always dominated by other strategies. If a rental or lease policy is adopted then common foresight implies perfect foresight on the part of consumers.

The second expectations mechanism they examine is a generalised form of “imperfect” foresight in which consumers form expectations of future service prices

5 on the basis of past and current service prices. All such expectations mechanisms including that of Douglas and Goldman (1969) are shown to yield the market structure irrelevance result that minimises the cost of service provision, except for the implausible case of universal zero foresight for all initial conditions.

Stuart (1980) examines the case of monopoly control of a perfectly durable extractive resource to show that a form of intertemporal price discrimination can arise with the price falling over time, as in Löfgren (1971). The intertemporal price-discriminating monopolist selling a single unit such as a ticket to a first-run movie, DVD release, cable television, free-to-air, etc., is also examined by Stokey (1979), but the focus here is not on durable goods per se.

Stokey (1981) examines a continuous time perfect rational expectations equilibrium for a monopoly durable good such that every participant (consumers and the producer alike) has correct beliefs about how every other participant would behave in any situation, even in situations that may never be observed. Under these conditions she obtains the stunning, if not unbelievable, Coase (1972, p.141) result that the entire monopoly stock is sold in “a twinkling of an eye” at the competitive price.

In the discrete-time variant of her model the monopolist has some ability to pre- commit. This has the result that the competitive solution is only reached in the limiting case as the period length goes towards zero. If the weaker requirement is adopted, such that expectations are rational for any observed stock of the asset, then a continuum of equilibria exist that could support almost any behaviour.

Bulow (1982 and 1986) considers a perfectly durable good sold by a monopolist within a simple discrete two period framework that is similar to the common foresight model of Sieper and Swan (1973) without commitment, except for the finite (and smaller) number of periods. The simple two-period discrete-time model structure permits solution via backward recursion and rules out the non-stationary equilibria and indeterminacy that can arise in infinite length horizon problems. In common with Sieper and Swan, he proposes a commitment strategy to raise profitability given the time inconsistency problem.

Costly ways to precommit proposed by Bulow include inefficient technology with low fixed costs and high marginal costs and inefficiently lower durability. Fishman, Gandal and Shy (1993) point out that this shortening can be socially beneficial in a

6 model in which technological progress is slowed if durability is set at the competitive level. Another method that may not be as inefficient includes the rental strategy examined by Sieper and Swan (1973). Bulow (1986) also considers the threat of entry to predict that the ratio of sales to rental will increase as the threat of competition looms. This is because the selling monopolist is more inclined to expand output and is thus more likely to discourage entry.

Surprisingly, we see few instances of durable goods monopolists wishing to rent or lease, although Bulow (1986) shows that both IBM and Xerox had higher rental/sales ratios in the early years. Does this mean that the time inconsistency problem is problematic in the real world or that there are severe moral hazard problems arising from lack of care in the consumer maintenance of rented goods that are sufficient to discourage this practice (Rust, 1985, Mann, 1992)? Dybvig and Lutz (1993) analyse the provision of product warranties with respect to consumer abuse and repair. An alternative explanation is provided by Bhatt (1988) in the presence of demand uncertainty and risk-averse firms.

Bond and Samuelson (1984) adopt an extension of Stokey’s (1981) perfect rational expectations equilibrium to argue like Bulow (1982) that, in order to precommit, a monopolist with a perfectly durable product may inefficiently reduce product durability. This will artificially create replacement sales. The prospect of more profitable replacement sales keeps the monopolist further away from the competitive solution. Gul, Sonnenschein and Wilson (1986) extend the Stokey (1981) proof of the Coase (1972) conjecture within a game theoretic framework with explicit modelling of the preferences and actions of consumers that her approach lacks. Clearly, under these conditions we can dispense with competition law for durable-good monopoly producers as their behaviour is perfectly competitive.

Gul (1987) reaches the even more surprising counter-intuitive conclusion that duopoly or oligopoly is more profitable than monopoly. This is because the threat of an anticipated price war which is good for consumers encourages consumers to delay purchase. Paradoxically, this delay enables the duopolists to better commit to not lowering price to the competitive level while the threat of the price war discourages entry. Bond and Samuelson (1986) derive other interesting consequences of monopoly durable goods sale resulting in the monopolist looking more like a competitive industry. The greater output encourages the monopolist to devote more

7 resources to cost-reducing innovations in a two-period Bulow (1982) framework. However, unlike in Bulow (1982), the monopolist has greater, not fewer, incentives than the social welfare maximising level to innovate.

Levinthal and Purohit (1989) also examine innovation within the two-period Bulow model. They focus on product innovation rather than cost reductions. Under certain conditions they show that buy-back of the obsolete product is more profitable than limiting sales of the initial product. Butz (1990) argues that “best-price” provisions that appear to have the normative purpose of equal treatment of all customers also provide commitment. This is the same as with “buy-backs” and similar schemes. Does this mean that all arrangements that appear to reduce “unfairness” and provide consumer guarantees and protection should be banned because they incidentally aid commitment? How would we ever know that it is “anti-competitive commitment” driving the use of a myriad apparently beneficial provisions in sale and lease agreements?

Kahn (1986) extends the Stokey (1981) continuous time rational expectations approach to show that with linear demand and increasing quadratic costs the monopoly seller will produce less than the perfectly competitive and socially efficient output of the durable in every period. The increasing marginal costs prevent the monopolist achieving the optimal socially efficient stock instantly. Likewise, if there is a finite supply of a resource converted at no cost into a durable that decays, the entire stock is not extracted instantaneously. Karp (1993) shows that it is the delayed sale of the entire stock that leads to the failure of the Coase conjecture.

Kahn’s (1986) results are extended further by Driskill (1997) who added in stock depreciation, along with rising marginal cost, to show that a monopolist’s steady state output is intermediate between the precommitment (rental) level and the efficient level. A further extension incorporating leaning by doing is provided by Olsen (1992). The Coasian (1972) insight concerning durable goods is extended to contract renegotiation by Hart and Tirole (1988) and to the assignment of property rights by Jehiel and Moldovanu (1999).

A problem with all the rational expectations equilibria discussed so far, satisfying the Coase (1972) conjecture of the monopolist immediately producing the competitive stock, is that they lack plausibility. They fail to correspond to any known real-world

8 monopoly behaviour. Ausubel and Deneckere (1989) adopt a reputational bargaining approach to a monopoly seller of a perfectly durable costless good. They show that a trigger strategy in the form of a threat of becoming a Coase-type seller is sufficient to support a continuum of subgame perfect equilibria between the static monopoly equilibrium and the zero-profit Coase extreme when consumers are not confined to stationary strategies.

Given a choice across these equilibria the monopolist would clearly prefer to stay on the highest-profit close to static monopoly equilibrium. Paradoxically, the shorter the length of the period, the greater the loss from Coasian behaviour and the easier it is for the monopolist to sustain a price path close to the static monopoly solution. Here the existence of multiple equilibria is similar to Stokey (1981), who found dynamic rational expectations equilibria other than the unique perfect equilibrium that were not robust to deviations from the actual path.

Ausubel and Deneckere (1992) reconsider the Coase conjecture when there is private information relating to the monopolist’s costs. One of several interesting results is the propensity of a low-cost monopolist to lower his price. This acts in a Coasian fashion leaving a high-cost monopolist to earn high profits. It thus pays the low-cost firm to imitate the high-cost firm if it has a high probability of trade. Consequently, incentive compatibility means that no firm has a high probability of trade. Another is the ability of the monopolist to replicate close to a rental outcome using a sales policy without the dire consequences of the Coase outcome.

The authors point out that an unfortunate outcome from a societal viewpoint of a focus on the Coasian outcomes is that what may be harmless and potentially beneficial contractual arrangements such as rental policies could become subject to bans, as in United States v. United Shoe Machinery Corp., when there was a requirement that all leased machines must also be offered for sale.

Sobel (1991) extends the infinite-horizon monopoly durable good sales problem by allowing entry of new consumers. So long as consumers do not have to use stationary strategies the outcomes are very similar to Ausubel and Deneckere (1989). Any equilibria with profits close to or less than the static monopoly solution supported. As with Stokey (1981) and Bond and Samuelson (1984), stationary equilibria exhibit the

9 Coase conjecture. Cyclic behaviour with occasional sales to low value customers can arise in this model as in Conlisk, Gerstner and Sobel (1984), and Pesendorfer (1995).

Bagnoli, Salant and Swierzbinski (1989) claim that the Coasian outcomes of Stokey (1981), Gul, Sonnenschein and Wilson (1986) and others are dependent on the assumption of a continuum of atomistic consumers. If this assumption is replaced by the assumption of an arbitrary but finite number of consumers then the conclusions of the earlier literature are reversed. A monopolist who is able to implement a dynamic strategy to extract most of the consumer surplus by “eating” his way down the consumer demand curve when all buyers with the highest reservation price have purchased the good has adopted what Bagnoli, Salant and Swierzbinski (1989) dub a Pacman strategy.

The intuition is that with a finite number of buyers, the buyer impacts on the seller. A buyer cannot credibly commit to wait for a given price such as the competitive price as he gains by bidding a higher price in order to consume earlier. The fact that an individual buyer makes a finite impact on the seller strengthens the monopolist’s bargaining power and weakens the buyer’s credibility. The seller is assumed to know the valuation of potential buyer with the highest valuation and to make a take-it-or- leave-it offer. In the case of a continuum of infinitesimally small buyers the situation is reversed. A particular buyer has no impact on the seller. The seller can no longer credibly hold out and refuse to sell until one or more such consumers has purchased. The seller is unable to extract most of the consumer surplus of eager buyers to do even better than a traditional single price monopolist. The buyer effectively has all the bargaining power and holds out for the competitive price.

The results obtained by Bagnoli, Salant and Swierzbinski (1989) are shown by Morch von der Fehr and Kühn (1995) to be particular to one aspect of their modelling assumptions. They are thus not merely the result of having discreet buyers. The buyers analysed by Bagnoli et al (1989) must have market power for the Pacman strategy to work. This is not likely to be plausible.

Dudley (1995) also reconsiders the Bagnoli et al (1989) model with discrete buyers in the context of the two-period rational expectations Bulow (1982) model. He shows that buyers who act strategically are made worse off and that the monopolist gains by being able to extract buyer surplus. Once again, the conditions for the Pacman

10 strategy to work are very special. An outcome close to the perfectly discriminating intertemporal monopolist can be expected for a first-release movie. Such a durable good has distinct additional types of release, DVD, Pay TV, free-to-air TV, etc., for less and less impatient customer classes.

The Coasian scenario is more plausible when there is a large amorphous group of largely indistinguishable consumers who are not impatient to be the first to consume. Clearly, the perfectly discriminating intertemporal monopolist has no incentive to throw away resources by artificially reducing product durability as say for Bulow (1982) in the Coasian case. Hence the market structure irrelevance result applies to such firms able to price discriminate.

Spicer and Bernhardt (1997) draw a distinction between durables that cannot be credibly stored by the monopolist, durable service providers such as a firm that provides a white water rafting experience, and more traditional durable goods providers that cannot promise to dispose of unsold stock in a credible fashion. In this framework the service provider is able to extract more than the static monopoly profit. He uses rationing to deny access to the lower-priced durable service to high-valued would-be customers. These potential customers are penalised if they decline to purchase before the price falls.

Kühn and Padilla (1996) further weaken the plausibility of the Coasian outcome. They show that a durable goods monopolist who also sells a non-durable substitute will never sell the durable product in the limit at marginal cost, as in the Coase conjecture. Most companies such as IBM and Xerox that sell durable goods also sell non- or less- durable substitutes. These ideas are extended in Kühn (1998) in which a firm with both a durable and a substitutable non-durable are able to intertemporally price discriminate. The non-durable serves as an “outside option” that prevents the monopolist from giving away its durable at marginal cost, as in the Coase conjecture. Further extensions are provided by Fethke and Jagannathan (2000).

Other authors have continued to explore the Coasian time-inconsistency issue in other forms. For example, Waldman (1993) and Choi (1994) argue that, in the absence of time-consistency issues, a monopolist has too much incentive to introduce a new version of a product incompatible with the old and that this is socially harmful. Waldman (1996b) allows the monopolist in the second period to be subject to time-

11 inconsistency that encourages him to lower his own profitability but is more socially beneficial.

Fethke and Jagannathan (2002) extend the two-period Bulow framework, in a multi- period horizon, to show that durable good efficiency result of market structure irrelevance of Swan (1970, 1971a, 1972b) and Sieper and Swan (1973) always applies when commitment to a production plan is possible. When commitment to production is not possible, the results have some resemblance to those of Bulow (1986). Interestingly, Fethke and Jagannathan (2002) obtain the opposite of planned obsolescence: optimal durability is increasing in both the initial degree of durability and in the level of the initial stock. When the monopolist who is unable to precommit to production can switch from one durability choice to another, so that both choices are endogenous, there is a cut-off degree of durability. Above this level the monopolist will switch from the durable to non-durable production. This is true even though non-durable production is more expensive. Otherwise the efficient degree of durability will always be produced. Karp and Perloff (1996) also address the switching issue from a different perspective. Güth, Kröger and Normann (2004) find experimental evidence consistent with Coasian behaviour when discount rates differ.

In summarising this vast literature, it is fair to say that there is a growing consensus that monopoly durable good producers do not act like perfect competitors in giving away their monopoly advantage at marginal cost. Nor is there evidence that such firms even use elementary strategies such as lease or rental to ensure time consistency. In fact very few firms adopt rental-only strategies. When they do, it is most likely driven by the desire to price discriminate. While some firms may benefit from reducing durability as a way of achieving time-consistency with a sales policy, nobody has produced evidence that firms actually do this.

2. Increasing cost

The original market structure irrelevance results were obtained under assumptions of constant returns to scale to better facilitate comparisons across market structures. How is this conclusion affected by recognising the possibility of capacity constraints and rising marginal costs? Recall that Kahn’s (1986) results incorporating rising marginal costs discussed in Section 1 are in themselves sufficient to affect the monopolist’s dynamic behaviour and prevent the extreme Coasian outcome.

12 This first attempt to deal with this issue required some stringent simplifying assumptions. Within the context of an almost entirely general product decay, i.e., durability, function. Sieper and Swan (1973) deal with this issue by the introduction of fixed costs of capacity. Durability choice must be made at the same time that plant capacity is chosen. Both average variable and average capacity costs dependent on durability choice. Two kinds of equilibria are identified: 1) the “characteristic” fixed cost case in which the fixed cost constraint is always binding and production is forever too low relative to the unconstrained case and 2) the unconstrained case in which some capacity becomes unused prior to the desired unconstrained stock level being reached. In this second case the cost minimising durability level is chosen despite the existence of planned for “excess capacity” in long run equilibrium. In the first case the cost minimising durability is also chosen in the myopic “zero foresight” case and in long-run equilibrium if plant is not infinitely long lived. In the remaining cases exactly the same pattern of product decay is chosen if the price function describing demand is homothetic. This includes the familiar linear and log-linear demand cases. Thus in the fixed cost case there are no systematic differences between the optimum choice of durability under monopoly and competition.

Despite this extension of the market structure irrelevance result to the case of rising marginal costs due to fixed capacity, Kamien and Schwartz (1974) contend that the monopolist will always produce goods of lower durability than under competition. Their model is of n plants with U-shaped average cost curves under competition and a single U-shaped average cost curve under monopoly. In effect, the competitive industry has constant long-run average and marginal costs while the monopoly has rising short- and long-run marginal costs. This looks like discriminatory bias here. In an “apples with apples” comparison the monopolist that produces some fraction of the competitive output would be able to choose the same fraction of the number, n, of competitive plants. That is, both the monopoly and competitive industries should be able to choose the optimum number of plants. Not only would the technology available then be the same as in the two market structures but the durability choice is also identical, as shown by Swan (1977) in a dynamic model with rising short-run marginal costs.

Auernheimer and Saving (1977) extend Swan’s market structure irrelevance results by showing that they hold with both short-run and long-run increasing costs in a

13 framework in which the firm adopts a rental policy. The costs of adjusting both the rate and durability of output are examined. As in Swan (1977) the monopolist is modelled as a collection of plants such that acts like cartel of competitive plants/firms. They also ask why Kamien and Schwartz (1974) failed to obtain the correct solution. Firstly, competitive firms optimally adjust durability over time but the monopolist must make a once and for all choice of durability. Secondly, there is no distinction between the short- and long-run in the sense that the firm is not allowed to choose an optimum point along its long-run average cost curve.

Abel (1983) generalises the Sieper and Swan (1973) model to investigate external economies and diseconomies of scale. With one form of external diseconomy the monopolist is shown to produce goods of higher durability than under competition. Levhari and Peles (1973) and Parks (1974) suggest that particular forms of non- separability in the firm’s cost function, such that marginal cost depends on output choice that in turn depends on market structure, will overthrow the market structure irrelevance result. Abel (1983) shows that any cost function satisfying the specification, f ()Xg() D , where X is output, D is durability, and both gD() and f () are arbitrary differentiable functions, generates the irrelevance result.

This literature is conclusive in establishing that rising marginal cost is not an explanation for any departures from the market structure irrelevance result.

3. Secondhand and reproduction markets

So far a durable good has been assumed to provide perfectly substitutable services over its life-time. Do the market structure irrelevance results still hold if this assumption is relaxed? No, according to White (1971) who argued that a cut in the durability of secondhand vehicles that are only partially substitutable for new ones would raise the price of secondhand vehicles, increase trade-in values and thus make sale of new cars more profitable. Swan (1972b) showed that this argument is false in the context of homothetic demand functions that include as special case, linear, log linear and constant elasticity of substitution forms. Thus all standard estimable forms are included.

The supply of new and used vehicle services is modelled as the vertical sum of the services from both types of vehicles. Allowing a durable as it ages to be substitutable, complementary, or intermediate with new units has no necessary distorting effect on

14 durability choice across market structures. This is essentially because the homothetic nature of demand combined with higher prices and reduced service flow under monopoly relative to competition preserves the same proportions of new and used goods irrespective of market power. The need to minimise production costs of the service under both market structures still preserves the same conditions for optimum durability choice irrespective of market structure.

An important application of durable goods models has been to the markets for new and used textbooks and to photocopying and reproduction. Miller (1961) discussed new and used durable markets and questions the claim supported by book publisher representatives and some economists that the reason new editions of textbooks are brought out is to “kill of the used textbook market” (Miller, 1974). However, he does claim incorrectly that there are cases in which it will pay the monopolist to suppress the secondhand market (Liebowitz, 1982).

The issue of whether or not competitive or monopoly producers of new vehicles would welcome a ban on used vehicles is examined by Benjamin and Kormendi (1974) using graphical analysis. They claim to have found cases in which suppression would be profitable but their claims are faulty (Liebowitz, 1982). Liebowitz (1982) also claims using graphical analysis that a monopolist wishes to suppress the market for a used good if and only if the new and used items are imperfect substitutes and the used demand is smaller than new demand. This is despite the fact that Swan’s (1972b) analytical model provides quite general conditions under which this cannot happen. I am always puzzled when graphical analysis is offered as proof relating to some complex issue.

Bremmer and Mazur (1993) argue that used textbooks constrain the monopolist issuer of new textbooks, but no account is paid to the benefits that the new textbook buyer receives from the sale in the secondhand market. Perhaps this is because the focus is on promotional expenses in the form of ‘give-away” desk copies.

Neither White (1971) nor Swan (1972b) allow the users of secondhand vehicles to influence product durability as the focus is on inbuilt durability that is unaffected by consumer maintenance efforts. If maintenance efforts are supplied competitively within an industry with monopoly supply of new goods, then we enter the classic world of vertical relationships in which the monopolist has an incentive to vertically

15 integrate to remove an input distortion. For example, a labour union representing coal miners has an incentive to integrate forward into coal mine ownership. This is because a competitive owner will substitute mechanisation for expensive workers in the mine (Warren-Boulton, 1974, 1977).

Schmalensee (1974), Parks (1974) and Su (1975) point out that if competitively supplied maintenance is over-supplied when the monopoly seller attempts to raise the price of the new item, the monopolist has an incentive to rent or lease the good so as to discourage substitution of competitive input for the restricted monopoly supply. Parks (1979) shows empirically that automobile lives are shorter the higher are repair costs. This suggests that a selling monopolist should load up the prices of replacement parts relative to the price of the new vehicle so as to discourage “excessive” vehicle owner input into car maintenance.

Rust (1985) provides a theoretical treatment of equilibrium in new and used durable markets where the items are partial substitutes. Rust (1986) examines the severity of the impact of a competitive maintenance market on the durability decision of the new good monopolist. Rust’s (1986) model is criticised by Waldman (1996a) on the grounds that because all consumers are alike, that there is no real purpose served by a secondhand market to begin with. Moreover, it purports to be a criticism of my market structure independence results and makes a number of claims about my assumptions whereas they have mostly been relaxed.

In summary, if a consumer durable is sold, the monopolist’s profit and efficiency may be threatened by “excessive” maintenance effort. If, on the other hand, the durable is rented or leased, then the opposite problem can occur with insufficient care being taken due to moral hazard. A partial solution to this dilemma is offered by Esteban and Llobet (2005) who propose a lease with an option to buy. Consumers who are careless or have a high cost of effort will rent new units each period while careful ones will exercise the option to buy.

In what has been called “one of the most celebrated judicial opinions of our time” (Adams, 1951, p.917) Judge Learned Hand concluded that Alcoa constituted an illegal monopoly because of its domination of virgin aluminium produced from bauxite. He rejected the earlier decision that, because of the 30% of the market was supplied by competitively recycled secondary aluminium, Alcoa’s monopoly was weakened.

16 According to Gaskins (1974) Friedman (1962, pp. 278-279) disagreed to argue that the existence of the secondary market was a major impediment to Alcoa but Friedman is actually silent on this (see Swan, 1980). Gaskins (1974) finds that that because of the secondary market the price of aluminium could have been driven to the competitive level in the long run. In his framework, this is really a form of optimal intertemporal price discrimination. He concludes that the major impact of the secondary market was to reduce the supply of virgin. Swan (1980) empirically tests Hand’s reasoning to show that indeed Alcoa reduced the supply of virgin in response to the greater competitive recycling.

Suslow (1986a) found that Alcoa had substantial market power by virtue of the imperfect substitutability of recycled aluminium for primary aluminium and long “recycling” lags. Clearly, this finding does not suggest that Alcoa converged to a competitive outcome as predicted by the Coase conjecture. She also establishes an empirically estimable equation that would in principle allow an econometrician to distinguish between the durable good monopolist able to commit modelled by Swan (1980) and the Coasian monopolist that converges to the competitive outcome (Suslow, 1986b). Pindyck (1985) points out the inapplicability of standard monopoly market power measures for the dynamic monopolist such as Alcoa.

Singer (1981) extends Swan’s (1980) treatment of Alcoa to secondhand trading of artistic works in the art market. Carlton and Gertner (1989) show that monopoly- inducing mergers for previously competitive producers of durable goods need not have severe anticompetitive effects. Inherited existing stocks can weaken the ability to generate monopoly profits. Sigman (1995) shows that successful control of recyclable pollutants such as lead in batteries requires taxes on the raw material and deposit/refunds on batteries. Recycling subsidies encourage too much consumption of the pollutant.

Liebowitz (1985) examines indirect appropriability of property rights in copyrighted material via unauthorised photocopying. This is akin to competitive recycling of a monopolist’s used goods. Indirect appropriability occurs when the subscription price of the publication reflects the demand for unauthorised photocopying. He finds empirical evidence that unauthorised photocopying has not has a detrimental impact on publishers of academic journals.

17 Besen and Kirby (1989) extend Swan’s (1980) Alcoa model to examine unauthorised photocopying as a competitive fringe to the monopoly producer (owner of the copyright). Unless the marginal costs of copying are increasing, they argue that publisher profits must decline in the absence of indirect appropriability. Varian (2000) examines technologies for sharing, copying, or reselling in markets for used goods, including circulating libraries, software sharing, video stores, resale markets and interlibrary loans. He concludes that there are many opportunities for profit to be enhanced by the monopolist encouraging such sharing.

It would seem, in principle, that competitive repairers and recyclers have the ability to add to the monopolist’s stock in an inefficient manner. Most likely, in reality this is not a serious problem. If it were sufficiently serious, I would expect more firms to avoid it by adopting rental or lease policies. Alcoa was either not troubled by competitive recycling, or could overcome the problem by further cutting back on virgin production.

3. Imperfect capital markets and taxes

Barro (1972) and Ramm (1974) consider consumers with a higher discount rate than the monopoly producer. Such circumstances provide an incentive for the monopolist to rent or lease rather than sell. The argument is that if forced to sell, then the monopolist would rationally reduce durability from his cost-minimising level to that of consumers with the higher discount rate preferring less durable goods. Raviv and Zemel (1977) consider the impact of depreciation allowances and investment tax credits on the monopoly seller within the framework of an income tax. They claim that the seller will reduce durability in response to the tax, allowances and tax credit.

Swan (1981) points out the ad hoc nature of the wedge that is assumed by Barro (1972) and Ramm (1974) to exist between consumer and producer discount rates. Infinite wealth can be created by producers borrowing at low rates and lending at high rates. Implicitly, the authors’ assume that producers are lenders and that consumers are borrows. Is it is really valid for the firm to ignore distortions in capital markets when making investment decisions?

Swan (1981) uses the income tax wedge between the borrowing and lending rate to model a logically valid distortion as if it were a capital market imperfection. It is shown that all the durability distortions claimed by Barro (1972), Ramm (1974), and

18 Raviv and Zemel (1977) disappear once the tax wedge is modelled as a tax on economic income and based on economic depreciation (Samuelson, 1964). The Swan (1970) and Swan (1971a) market structure irrelevance results are restored. The error of Raviv and Zemel (1977) arose because they failed to recognise that the monopolist’s after-tax cash flows must be discounted at the firm’s after-tax cost of capital given by ir=−()1 τ , where i is the after-tax rate, τ the tax rate and r the pre- tax cost of capital, rather than at the pre-tax rate, r. Parks (1974) introduces transaction costs such as the costs of shopping time into the analysis. Auerbach (1979) considers the impact of distortionary taxes on durability choice as a consequence of inflation. Arnott and Young (1979) recognise that the property tax is a distorting tax on durability, unlike a tax on economic income.

4. Monopoly choice of product quality in non-durability dimensions

Some of the earliest models of monopolistic quality choice belong to Chamberlain (1948) and Abbott (1955). Perhaps the first attempt to provide a theory of product quality based on a simple scalar specification of quality was Dorfman and Steiner (1954), but as Schmalensee (1979) points out, more structure is required. The durable good specification of quality provided such needed structure.

Swan (1971b, 1972b) offers what I believe to be the first attempt to address the quality issue across different market structures in a very general way. These articles provide the necessary and sufficient conditions for a single monopolist producing multi-products to precisely duplicate the product range of different substitutable qualities optimally produced by a competitive industry. More realistically, there are potentially n different competing competitive industries where n is the potential societal optimal number of related product varieties or “qualities”, not all of which need be produced. The setting is comparative-static rather than dynamic, but this is not restrictive.

For comparative purposes all firms are assumed to have access to the same constant returns technology for current or future products and both the monopolist and competitive firms face identical consumers and demand conditions in the form of n continuous, twice differentiable, price (i.e., inverse demand) functions for the

potential n interrelated product outputs, xi :

19 Fxxin()12, ,..., xy , , i= 1,..., nx ; i≥ 0, (1)

j where y is income and the jth partial derivative is ∂FxFiji(.0) ∂< , indicating downward sloping demand. Two conditions must be satisfied for monopoly product qualities, durabilities, product range, etc., to be identical across market structures: Identity of the cross partial derivatives of the price functions meaning that income effects are not substantially different given symmetric substitution effects:

ji FFijij ( ,= 1,..., nij ; ≠ ) , (2)

and

Faiii=+ fxx( 12, ,..., xyi n ,) , = 1,..., nx ; i ≥ 0, (3)

where ai ≥ 0 is a constant and fi ,in= 1,..., , is homogeneous of degree vi in outputs

x1,..., xn with vi > 0 when xi > 0 and − 1<

1 mcv xii=+⎣⎡11()vx⎦⎤ , (4)

m where xi is the monopolist’s output vector that is proportional to the competitive

1 c mc v output vector, xi , and 0111<=+−1.

Swan (1970b, 1972b) also shows that just about all the standard functional forms estimated by econometricians such as the class of linear and constant elasticity of substitution demand functions are special cases of equations (2) and (3) so that the market structure irrelevance results do not only apply to durability but are quite general. The reason the findings do not extend to all functional forms is that consumers are worse off under monopoly than under competition because of the output contraction so that consumer real incomes differ across market structures. Only when income effects are small do these differences in utility level not matter for the composition and qualities of the output vectors across market structures.

Under the homothetically-separable conditions implicit in equations (2) and (3), quality-adjusted units of both output and price can be constructed. The monopolist essentially produces less output of each product, or of a single product, but with

20 quality set at the same optimal level as under competition. The general requirements placed on consumer utility functions to ensure equality of quality choices or product choices across market structures are as follows: Relative monopoly marginal revenues must equal relative prices under monopoly which, in turn, equal relative competitive prices that must in turn equal relative marginal costs under both market structures (see Swan, 1972b):

MR MR=== p p p p Cij C (5) ()i jMMC( ij) ( ij) ( i j)M and C for all services ()ij,=≠ 1,..., ni ; j. The requirement for this is that the consumer utility function must take the form:

uugx= ⎣⎡ ( 1,..., xn ) , y⎦⎤ (6)

where x1,...,xn are the service levels for the group of goods or quality attributes, the sub-utility index gx()1,..., xn is homothetic of degree v, and y is a composite good with unitary price. In effect, gx( 1,..., xn ) is a perfect aggregate index of the service

MMM flows from the monopolist, ggxx= ( 1 ,..., n ) and group of n competitive

CCC industries, ggxx= ( 1 ,..., n ) . The price indexes that correspond to these perfect indexes of the vector of service flows under each market structure are easily constructed.

The results might also seem special in that, for comparability and expositional purposes, both the monopolist and competitive industries are assumed to have constant returns to scale. This assumption is simple to relax in quite a general way by replacing the assumption of constant costs by interrelated multi-product cost functions described across all n potential products that satisfy precisely the symmetry and homotheticity restrictions of the type represented by the price functional equations (2) and (3) above or sub-utility function, gx( 1,..., xn ) in equation (6).

White (1972) models the impact of price regulation on product quality. Oi (1973) models a quality aspect of a good that he calls “safety” in which the full price of a good consists of the price of the good itself plus the expected damage costs. Spence (1975) and Sheshinski (1976), like Dorfman and Steiner (1954), treat product “quality” as a simple scalar, with no structure to describe what it might actually mean as in the durability literature and Swan (1971b), on the assumption that the

21 monopolist produces only one product, not n endogenous products or qualities as in Swan (1971b). Not surprisingly, he finds that just about anything can happen. He asserts that when average and marginal valuations by consumers differ that the monopolist either under- or over-supplies quality relative to the social optimum.

This cannot happen with a single product in the durability literature or the general case of n qualities or products of Swan (1971b). Nor do I believe it can happen in any well-specified quality choice problem. This is because in a competitive or socially optimal regime, product or quality choices are determined at the margin with product price, or the price of quality, as the relevant factor. Under monopoly, marginal revenue for the product, or the quality, plays exactly the same role. The optimal contraction in monopoly output relative to competition ensures the equality of monopoly marginal revenue for output, or quality with the relevant marginal condition in a socially optimum framework.

Think of the number of potential products, n, under the fairly general restrictions of Swan (1971b, 1972b) as being close to infinite but cost conditions describing scale economies are such that only one of a very large number of potential products defining a particular “quality” is viable under either monopoly or competition. Then, as in the durability market structure irrelevance result, quality choice must be identical but output will be lower under monopoly than under competition.

Lancaster (1975) argues that a monopolist will offer the optimal range of variety, consistent with Swan (1970b). White (1977) claims that Lancaster’s result is false as the monopolist cannot perfectly price discriminate. Lancaster (1979, 1990) claims that his earlier results, of Lancaster (1975), were false in general. This seems surprising given the results of Swan (1971b, 1972b) showing that equality of outcomes across market structures, whilst not universal, is a good benchmark.

Mussa and Rosen (1978) add structure by considering the distribution of preferences over the population based on a simple utility function,

uy= +−θ qp, (7) where q denotes quality, y is a composite commodity, p denotes price of a unit, and θ indexes customer types. Each consumer buys only one unit of the product.

22 This formulation imposes a constant slope for the marginal rate of substitution between price and quality. A separating, as opposed to a pooling, equilibrium is assumed in which each consumer pays a separate price and receives a different quality of product. By contrast a pooling equilibrium involves a uniform quality and price. Mussa and Rosen conclude that the discriminating monopolist, who uses quality to discriminate between consumers with different valuations of quality, will sell the same highest quality under both monopoly and competition, to the highest valuation customer,θ , but will systematically reduce quality below the competitive level for all consumers for whom θ < θ .

Acharyya (1998) points out that not only within the Mussa and Rosen framework, but also those of Tirole (1988), Kim and Kim (1996) and Wauthy (1996), that the Mussa and Rosen solution is not guaranteed. In fact, the separating equilibrium assumed by Mussa and Rosen is only possible under exceptional conditions. The optimal outcome is either the pooling one with the maximum quality consumed by all participants, or one with only part of the distribution of consumers included in the pooling equilibrium. With the precise formulation used in these contributions with a constant marginal rate of substitution the highest quality is chosen and is the same across monopoly and competition. It is exceedingly difficult to escape the efficient market structure irrelevance solution, try as one might.

The Mussa and Rosen (1978) model is extended by Itoh (1983), Katz (1984), and by Donnenfeld and White (1988) who finds that the monopolist will restrict product variety. Unlike Mussa and Rosen, the distortion could occur at either the high or low quality end of the market. Kwoka (1992) finds strong empirical support for the Mussa-Rosen-Katz model from estimated price-quality schedules for motor vehicles. Leffler (1982) argues that changes in product quality are ambiguous and that little can be said in general. De Vany and Saving (1977) consider shorter waiting times or delays as an indicator of quality in a trucking industry subject to uncertainty. They show that more valuable loads pay a higher transport charges but benefit from shorter delays or waiting times. Schmalensee (1978) models the determination of product quality as a result of advertising and consumer experience. Saving and De Vany (1981) treat reliability in a peak-load pricing model as an aspect of quality. They identify conditions under which the discriminating monopolist is more likely to implement peak-load pricing than under competition. In an interesting paper, but one

23 that comes from a different tradition to most of the papers considered here, Shaked and Sutton (1982) show that quality competition leads in their framework to only two firms entering and the production of distinct products. De Vany and Saving (1983) have a model of quality based on waiting times. Gal-Or (1983) argues that the impact of the entry of firms is to reduce average quality and increase output with an ambiguous impact on consumer welfare.

In the spirit of Swan (1971b) and Swan (1972b), Saving (1982) solves for the form of the price and utility function necessary for a monopolist and competitive firms to produce goods of the same quality. He begins with an inverse demand function of the multiplicative separability form:

p = VqHWqX( ) ⎣⎡ ( ) ⎦⎤ , (8) where Vq(),0 V′ () q> , is the marginal value of quality, q, and Wq(),0 W′ () q> , adjusts quantity, X, into quality-adjusted units of consumption, WqX() . Utility in quality-adjusted units,

uvWqX= ⎣⎦⎡⎤( ) + y, (9) where y is a composite good with unitary price, is maximised subject to the budget constraint,

mpVqWqXy=+⎣⎦⎣⎦⎡⎤⎡⎤( ) ( ) . (10)

p Vq() is the price of quality-adjusted consumption. This optimisation yields the inverse demand function, equation (8).

Saving (1982) obtains the marginal relationship for the competitive industry with constant long-run costs with respect to scale:

∂∂=p qVVLq( ′ ) ( ) (11) where L()q is industry average cost with respect to quality, and for monopoly,

∂∂=MRq( VVLq′ ) ( ) , (12) where MR denotes marginal revenue. Both expressions are independent of long-run output and the choice of product quality, q, must be the same.

24 While these results might superficially appear different from Swan (1971b, 1972b), the requirements for the quality-adjusted output level, WqX( ) , and quality-adjusted price, p Vq(), are in fact very similar. The main difference is the discrete nature of the product qualities in the earlier literature and the continuous nature of the quality indicator here. Saving (1982) then proceeds to show that in the case of the production of a durable good with life q that this is a special case of the separable demand case, equation (8), with Wq()= q and is in fact Swan’s (1970) result. Now think of q as representing the reliability of a good such that it yields a service, X, with probability q and nothing with probability ()1− q . If consumers are risk neutral then p = qH() qX so that Vq()= q and Wq()= q. Finally, let the income of the consumer depend on the time, q, it takes him to acquire X units of an item, mq( ) =− m qX. In all three examples the choice of the quality attribute is the same under monopoly and competition. Thus Saving (1982) confirms the generality of the market structure irrelevance results in a very neat and effective manner.

5. Heterogeneous consumers

Salop (1977) models what he calls a “noisy monopolist” able to exploit dispersion in prices, durabilities, product qualities, etc., when consumers differ in the ability to gather information. Although such dispersion is costly to the monopolist, diverse consumers can be better pooled into different categories to facilitate price discrimination. Likewise but in an even simpler framework, Basu (1987) models consumers with diverse preferences purchasing one unit of good such as a toothbrush such that some wish to discard and replace frequently and others more slowly. By setting a higher rate of product decay or less “newness” that actually raises the cost to the monopolist of providing the service, he is better able to price discriminate across these consumers with varying willingness to pay for “durability”. An example is provided where the revenue gain from better price discrimination is able to offset the efficiency loss. A model that has something in common with Mussa and Rosen (1978) and Basu (1987) is Waldman (1996a) in which the production of socially optimal durability would reduce the scope for the monopolist to price discriminate across new and secondhand units. Of course, as with Acharyya (1998), a pooling equilibrium is quite plausible in which case efficiency is achieved. Huang, Yang and Anderson

25 (2001) provide a more general model of heterogeneous consumers in which both leasing and selling is used concurrently, largely to facilitate price discrimination. Bond and Lizuka (2004) model the textbook market with heterogeneous consumers. If some buyers place a value on the old edition of the textbook, the price of the book could increase over the life of the edition. Empirical support is found for this prediction. They also find that textbook prices increase as the share of the used textbook market increases. Blackstone (1975) details how a monopolist was able to price discriminate according to intensity of use with respect to photocopiers.

This surveyed literature on quality choice suggests that the market structure irrelevance results are likely to extend to most reasonable forms of quality specification. The cases in which they may not largely appear to be ones with heterogeneous consumers such that distorting quality choice enables better separation of buyer groups so as to facilitate price discrimination.

6. Technological innovation

Will a monopolist’s own plant, when faced with new technology reducing costs, differ in terms of the embodied technology from the competitive case? Salter (1960, pp. 90- 92) argues that innovation and scrapping of plant will occur at the same time irrespective of market power. This is because the monopolist’s marginal return on a new plant where marginal revenue cuts marginal cost is the competitive rate of return, not the higher average monopoly return. Similarly, Hirshleifer (1971) argues that a monopolist will never wish to suppress an invention such as a better light bulb that competes with his initial light bulb monopoly.

Swan (1971b, 1972a) applies the model set out in equations (1) to (4) above to show that not only will a monopolist not suppress cost-reducing process innovations, it will not suppress any related product or quality that meets the separability and homothesticity conditions. This is the case because when scale or size does not affect relative demands or costs, the monopolist is just a smaller scale version of the group of equivalent competitive industries producing identical related products and not producing (i.e., suppressing) exactly the same “would-be” or non-viable products.

The usual argument is that the monopolist’s product range should be smaller because he will take into account the harmful impact of a new product on existing products that are partial substitutes for the existing product range, whereas the competitive

26 innovator with no incumbent products or processes to cause concern will innovate earlier. The falsity of this argument stems from the fact that the monopolist has already cut back all his existing products to the point where marginal revenue is equal to marginal cost. Hence, he is quite happy to have a viable new product compete with his existing product range so long as it, too, is suitably cut back to the restrictive monopoly output level. Thus, there should be no “sleeping patents” in the sense of technology or product design that a competitive firm would wish to use in the complete absence of monopoly.

This proof that “sleeping patents”, i.e., patents on inventions that are not put to commercial use should not exist might seem strange given the extensive literature predicting sleeping patents in theory and finding them in practice, e.g., Gilbert and Newbery (1982) who report that SCM Corporation alleged that Xerox Corporation had maintained a “patent thicket” including unused inventions to discourage competition. Of course, the fact that both statements can be true arises from the incentive for the monopolist to invent and patent inferior technology and products or qualities that would never be used in either a pure monopoly regime or under perfect competition everywhere for a group of interrelated products. These “inferior” sleeping patents prevent potential entrants competing with the incumbent monopolist.

Bond and Samuelson (1987) recognise that because monopoly output is low relative to the social optimum, this might reduce the resources available for monopoly innovation. However, when they analyse a durable good innovator they find that incentives to innovate could either be too high or to low. Fishman and Robb (2000) argue that in the absence of “planned obsolescence” that the monopolist’s rate of innovation will be too slow relative to the social optimum. However, reducing product life can restore the socially optimal rate of innovation. Lee and Lee (1998) build a model in which innovation requires two forms of price discrimination: 1) between consumers with different valuations and consumers with different purchase histories. Filson (2002) models cost and quality innovations in the personal computing industry together with lifecycle effects.

When “sleeping patents” are properly considered there seem to be no strong grounds to believe that monopolies systematically fail to innovate or maintain sleeping patents that would otherwise be utilised in a completely competitive setting.

27 There is also a considerable literature on innovation that lies outside the focus of this review. For example, Aghion and Howitt (1992) and Aghion, Harris, Howitt and Vickers (2001) who explore endogenous growth within the Schumpeterian framework of creative destruction.

7. Other applications of the market irrelevance model

Holtsmann (1972) examines worker obsolescence and retraining in a model similar to a durable goods model. Shy and Stenbacka (2004) identify a large literature which asserts that increased competition between banks, perhaps due to financial deregulation, increases incentives for risk taking in such a way as to increase the risk of bank failures. They extend the irrelevance results of Swan (1970) and Sieper and Swan (1973) by their finding to the contrary that a bank’s incentives for risk taking are actually invariant with respect to market structure. Importantly, Courville and Hausman (1979) show the market structure irrelevance principle extends to the setting of product reliability and warranty terms. Rodriguez (1979) examines the impact of tariffs, quotas, and quality controls as protective devices when product quality is endogenous.

There is also a long tradition of investigation into how a monopolist can best set the inflation rate to exploit his control over real money balances. For example, Cagan (1956), Baily (1956), Friedman (1971), Auernheimer (1974), Kydland and Prescott (1977), Sargent (1977), Calvo (1978), Swan (1987) and others. Since the marginal cost of creating real money balances is essentially zero, the dynamically consistent pre-commitment strategy for a profit-maximising money issuer is to set the growth rate of money balances such that the absolute elasticity of demand for real money balances with respect to the opportunity cost, the nominal interest rate, is zero.

8. Empirical tests

The only attempt I am aware of to directly test the proposition that the durable good monopolist sets the durability of his product at the efficient cost-minimising level is my examination of the choice of product life for light bulbs by General Electric’s , GE, control over the U.S. lamp industry from 1913 to 1945 (Swan, 1982). Avinger (1981, p.353) describes this study as an “important new look at engineering cost functions. Estimates of the long-run production function for lighting services are used

28 to compare the design life of electric lamps with the optimal or ‘rational cost minimizing’ durability.”

As I state in Swan (1982) “in the popular mind the everlasting light bulb is in precisely the same category as the car fuelled entirely by water: ‘Technically both have been feasible for decades. In the first case, a conspiracy by the international light bulb cartel, in the second, oil producers in cahoots with vehicle manufacturers, has denied consumers' the fruits of man's ingenuity’. What conspiracy theories neglect, of course, is the crucial distinction between technical feasibility and economic viability. The optimum life of the conventional domestic light bulb depends upon the capital cost of the bulb, which is roughly independent of the life, and the operating cost (power usage represented by wattage) which rises with life for a given luminosity (light output). The higher is the filament's operating temperature, the greater is the proportion of electrical energy given off as light instead of heat. But the hotter the filament, the more rapidly does the tungsten evaporate and the shorter is bulb life. Hence a relatively cool-running bulb can be designed using a heavier filament, as thick, say, as fencing wire, which will (almost) never fail. The price of this miracle comes high. The additional electricity needed to maintain luminosity more than outweighs the savings in bulb replacement. Similarly, the water-fuelled car has extravagant electricity requirements to convert water into hydrogen fuel and oxygen by hydrolysis.”

“It is one thing to show that an everlasting light bulb is uneconomic. It is another to assert that the standard incandescent bulb has more or less the life characteristic desired by consumers. It is shown in Swan (1982) that the standard bulb in the U.S. and the U.K. today generally has a life which is less than the optimum, particularly for lower wattage varieties, though from 1913 to 1945, when General Electric's (GE) control over the U.S. lamp industry was at its greatest due to ownership of key patents, bulb life was, if anything, too long. Evidence pertaining to present-day bulbs supports the findings of Prais (1974a, 1974b, 1978) and appears, on the surface at least, consistent with the popular view that firms often suppress long-life consumer- durables in the interests of profitability, a central issue in the House of Commons committee's investigation into the durability of bulbs (U.K. Parliament, 1978).

At this inquiry Prais (1978) alleged that "manufacturers understand well enough 'which side their bread is buttered on,' and this has effectively inhibited any serious

29 competition amongst them to provide longer lengths of life which would, in the end, reduce their sales volume." Stocking and Watkins (1946, p. 362), in referring to the now defunct Phoebus international cartel, make the same point even more clearly: "A vigorously enforced standardization program has shortened the life of lamps partly at least to increase profits." These allegations, together with econometric estimates of the "long-run production function" for lighting services, provide a unique opportunity to test the modern theory of the determination of durability developed in Swan (1970).

Critics have also focused on the well-documented attempts by GE to reduce life of flashlight bulbs. GE tried to reduce bulb life from a three battery to a one-battery basis, but this was rejected by the battery manufacturers who in 1925 compromised on a bulb with two battery lives. In 1933 GE added a new line of bulbs to its range with a life of a single battery (Bright, 1949, p.334). These bulbs were 22 percent cheaper than two-battery bulbs. Bright concludes: "although flashlight users benefited somewhat by obtaining stronger beams, it appears that the primary motive behind the change was to increase lamp sales".

Since the optimum life of a flashlight bulb is the result of balancing off the frequency of bulb replacement as against battery replacement, it was perhaps presumptuous of Bright to conclude the way he did without objective evidence as to whether the existing life was too high or too low relative to the optimum. The tug-of-war between GE and battery manufacturers such as Union Carbide over the life of the flashlight battery poses a dilemma for the conspiracy theorists: are the battery manufacturers to blame for wanting a long-life bulb leading to a short battery life and thus greater battery sales; or is GE to blame for allegedly trying to accomplish the same (illogical) aim with respect to its own sales?” A modern account of recent changes in light bulb technology is provided by Menanteau and Lefebvre (2000). Avinger (1981) also examines phonographic needles, vacuum tubes and razor blades, as well as light bulbs. While he finds evidence consistent with the “traditional view” he is also sufficiently cautious to explore alternative explanations.

9. Conclusions

Having reviewed this vast literature it would seem that the market structure irrelevance results are valid under a much wider range of conditions and assumptions than at first appeared to be the case. Perhaps this is not surprising as it is very hard to

30 either imagine or find conditions under which the monopolist will deliberately create technological inefficiencies for durability, process, product, or quality choice as his own profitability is likely to be the first victim of such strategies. Perhaps the most promising line of inquiry in terms of generating exceptions to the irrelevance principle is in relation to heterogeneous buyers such that “pooling” strategies are not viable. “Inefficient” durability or product quality choice may facilitate price discrimination. However, so far any empirical evidence in support is very limited.

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