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.