In Defense of Monopoly In Defense of Monopoly how market power fosters creative production Richard B. McKenzie and Dwight R. Lee The University of Michigan Press Ann Arbor Copyright © by the University of Michigan 2008 All rights reserved Published in the United States of America by The University of Michigan Press Manufactured in the United States of America c Printed on acid-free paper 2011 2010 2009 2008 4321 No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, or otherwise, without the written permission of the publisher. A CIP catalog record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data McKenzie, Richard B. In defense of monopoly : how market power fosters creative production / Richard B. McKenzie and Dwight R. Lee. p. cm. Includes bibliographical references and index. isbn-13: 978-0-472-11615-7 (cloth : alk. paper) isbn-10: 0-472-11615-0 (cloth : alk. paper) 1. Monopolies. 2. Production (Economic theory) I. Lee, Dwight R. II. Title. hd2757.2.m34 2007 338.8'2—dc22 2007035404 for charlie A system—any system, economic or other—that at every given point of time fully utilizes its possibilities to the best advantage may yet in the long run be inferior to a system that does so at no given point of time, because the latter’s failure to do so may be a condition for the level or speed of long-run performance. joseph a. schumpeter Capitalism, Socialism, and Democracy (1942, 83; emphasis in the original) Contents Preface xiii chapter 1 “the wretched spirit of monopoly” 1 Smith, Bentham, and Ricardo on the “Evils” of Monopoly 4 Bastiat and Marx on Monopoly as “Plunder” 9 Marshall on the “Net Revenues” of Monopoly 13 Schumpeter on the Vital Role of the “Monopoloid Specie” 15 The Schumpeter Hypothesis 19 Concluding Comments 22 chapter 2 deadweight-loss monopoly 25 The Ef‹ciency of Perfect Competition 26 The Inef‹ciency of Monopoly 30 The Locus of Market Failure: Firms? 34 The Locus of Market Failure: Consumers? 36 The Added Waste of Rent Seeking 37 The Imperfection of Perfection 39 Zero Economic Pro‹ts 42 Transitionary Economic Pro‹ts 47 Economic Pro‹t as a Source of Capital 48 Market Ef‹ciency and the Count of Competitors 50 Concluding Comments 52 chapter 3 monopoly as a coordination problem 54 The Conventional View of Monopoly 56 An Unconventional View of Monopoly 57 Changes in Agency Costs 62 Innovation 63 Concluding Comments 63 Appendix: Agency Costs and Cartels 64 chapter 4 welfare-enhancing monopolies 67 The Paradox in the Microsoft Antitrust Case 68 Unraveling the Paradox 72 Digital Markets 75 The Relevance and Potential Welfare Value of Entry Barriers 81 The Problem of Digital Piracy 87 Once Again, Why Monopolies? 90 The Microsoft Problem for Microsoft’s Competitors 91 Concluding Comments 94 chapter 5 locked-in consumers 96 Consumer Lock-In 96 A Product with Network Effects: A Model 100 Ef‹ciency Considerations 104 Creating Networks 106 Concluding Comments 109 chapter 6 monopoly prices and the client and bonding effects 110 The Client Effect 110 The Bonding Effect 122 Concluding Comments 123 chapter 7 the monopsony problem 126 The Conventional Monopsony Model 127 The Mysterious Existence of Monopsony 130 The Monopsonistic “Company Town” 135 Firm and Worker Mobility and Monopsony Market Power 139 Concluding Comments 140 chapter 8 the ncaa: a case study of the misuse of the monopsony and monopoly models 143 The Conventional Cartel Argument against the NCAA 146 Science as Ideology 153 The Mistaken Presumption of “Underpaid” Athletes 155 The Mistaken Interpretation of Cheating 157 The Mistaken Presumption of Monopsony Power 159 Sports Demand and NCAA Membership 162 College and University Sports as Games 164 College Athletics as an Open Market: A Review of the Legal Literature 166 Concluding Comments 171 chapter 9 monopoly as entrepreneurship 173 The Entrepreneurial Role in Firms and Markets 174 Monopoly Rents as Entrepreneurial Entitlement 177 The Justice of Entry Barriers Reconsidered 183 Monopolies, Public Goods, and the Gains from Price Discrimination 186 The Ef‹ciency of Monopoly Failures 191 Concluding Comments 196 chapter 10 property and monopoly 198 Property Rent as Monopoly Theft 199 The Property-Monopoly Equivalence 203 Copyrights as Monopoly Abuse 205 Property in Proper Context 211 “Good” and “Bad” Monopolies 214 Monopoly Pro‹ts versus Economic Pro‹ts 215 Concluding Comments 216 chapter 11 summing up 218 Notes 227 Bibliography 273 Index 289 Preface Most adults in the United States and much of the industrial- ized world today can vividly remember as children playing their way through marathon Monopoly games. Few have come close, however, to challenging the length of the longest Monopoly game in history (which dragged on for 1,680 hours, or seventy straight days).1 Although the board game involves key market institutions—money, a bank and banker, deeds, trades, and wealth accumulation—only a modicum of busi- ness savvy is required to win. Accordingly, ten-year-old kids can beat their par- ents, who may be astute, seasoned business people, mainly because the compe- tition among the players is highly constrained by detailed rules, the layout of the board, and elements of luck that are introduced through required tosses of the dice and draws of the “cards of chance.” The game’s popularity is probably attributable in no small way to the fact that it taps into twin passions: to win and to acquire wealth (even play wealth). Each player’s best strategy for winning is often to buy up all properties of given colors—for example, all the green properties of Pennsylvania, North Carolina, and Paci‹c Avenues—and then add (plastic) houses or hotels to them. We can only surmise that the game is called Monopoly because the rent that property owners can charge when another player lands on any particular property escalates both with the number of properties of a given color owned and with the number of houses and hotels that owners buy for each property. Market dominance translates into a form of “monopoly rents,” loosely de‹ned. The player who is able to buy both Boardwalk and Park Place (the only two blue properties) and put the maximum of four hotels on each has a good chance of winning, given that the rents on those properties are then the highest on the board. Of course, the owner of those two properties can be assured of their monopoly in the game because the players are trapped: They each in turn must throw the die and must follow in lockstep the route, square by square, around the board, which means that players must run the risk of landing on the monopolized properties. However, winning by developing monopolies on properties of given colors is never assured, mainly because of the properties’ costs and the several elements of chance. Economists play another monopoly “game” in their textbooks (and class- xiv preface room lectures) that is not totally unlike the board game. Like the board game, the economists’ textbook monopoly game is also highly constrained—not, of course, by the printed surface of a piece of cardboard, but by an underlying, explicitly stated set of assumptions. Economists start by loosely attributing the status of monopoly to any ‹rm that has “market power,” that is, the ‹rm is suf‹ciently dominant in its market and suf‹ciently protected by barriers to the entry of potential rivals that the monopoly can raise its prices and capture “economic rents” or “monopoly pro‹ts” by restricting output below the ideal- ized competitive output level.2 The assumption underlying the economists’ monopoly game that lines up best with the Monopoly board game is that the more control a ‹rm has over a carefully de‹ned, given market (or the greater the ‹rm’s “market dominance,” often de‹ned as percentage of all market sales) and the more the ‹rm is protected from market entry of rivals, the more eco- nomic rents the monopolist can earn. But there is another way the two games align: The prospects for creativity and improvement in both games are nil. In the case of the board game, the board and the properties on the board are given. That is to say, they are not created by the players in the course of the play. Their market values are also predetermined and ‹xed. The rent to be made on each property is also given and ‹xed, which is to say that the rent is merely extracted by the property own- ers, as opposed to being created by them. No new properties can be added, and neither can the existing properties be subdivided and recon‹gured to enhance the value of all properties. It follows that a player’s rent from becoming a “monopolist” over Boardwalk and Park Place will never affect the creation of new properties by others, which, of course, means that players have every rea- son to charge what the game (and market) will bear at the time of play. Because nothing is created or destroyed by the play of the Monopoly, the game can always be used again, with everything (rules, property values, and rents) remaining exactly the same. In the case of the economists’ monopoly game, the monopolized good is also given to the textbook (and blackboard) analytics. That is, by assumption, the monopolist has nothing to do with its own emergence as a monopoly or the creation of its good and its market. The monopoly and its good and market are simply assumed into existence. With the shapes and locations of the monopo- list’s demand and cost functions also given, again by assumption, there is not much more for economists to do in playing their model-building games other than move around their “boards” and deduce the monopoly’s output and price levels that maximize economic pro‹ts (or rents).