10.05. The Theory of Monopolistic or Imperfect Competition

0:005. THE THEORY OF MONOPOLISTIC OR IMPERFECT COMPETITION a. MONOPOLISTIC COMPETITIVE PRICE The theory of monopoly price has been generally superseded in the literature by the theories of monopolistic or imperfect competition. As against the older theory, the latter have the advantage of setting up identifiable criteria for their categories, such as a perfectly elastic demand for pure competition. Unfortunately, these criteria turn out to be completely fallacious. Essentially, the chief characteristic of the imperfect competition theories is that they uphold as their pure competition, rather than competition or free competition.

0:56Pure competition is defined as that state in which the demand presented to each firm in the economy is perfectly elastic. In this supposedly pristine state of affairs, no one firm can, through its actions, possibly have any influence over the price of its product. Its price is then set for it by the market. Any amount it produces can and will be sold at this ruling price. In general, it is this state of affairs, or else this state without uncertainty, perfect Competition, that has received most of the elaborate analysis in recent years.

1:41This is true both for those who believe that pure competition fairly well represents the real economy and for their opponents who consider it only an ideal with which to contrast the actual monopolistic state of affairs. Both camps, however, join in upholding pure competition as the ideal system for the general Welfare, in contrast to various vague, monopoloid states that occur when there is departure from the purely competitive world. The pure competition theory, however, is an utterly fallacious one. It envisages an absurd state of affairs, never realisable in practice and far from idyllic if it were.

2:29In the first place, there can be no such thing as a firm without influence on its price. The monopolistic competition theorist contrasts this ideal firm with those firms that have some influence on the determination of price and are therefore in some degree monopolistic. Yet it is obvious that the demand presented to a firm cannot be perfectly elastic throughout. At some points, increase in supply will tend to lower market price. In aggregating market demand, we saw that for each hypothetical price, the consumers will decide to purchase a certain amount.

3:14If the producers attempt to sell a larger amount, they will have to conclude their sale at a lower price in order to attract an increased demand. Even a very small increase in supply will lead to a perhaps very small lowering of price. The individual firm, no matter how small, always has a perceptible influence on the total supply. In an industry of small wheat farms, the implicit model for pure competition, each small farm The term contributes a part of the total supply, and there can be no total without a contribution from each farm. Therefore, each farm has a perceptible, even if very small, influence.

4:04No perfectly elastic demand can then be postulated, even in such a case. The error in believing in perfect elasticity stems from the use of such mathematical concepts as second order of smalls, by which infinite negligibility of steps can be assumed. But economics analyzes real human action, and such real action must always be concerned with discrete, perceptible steps, and never with infinitely small steps. Of course, the demand for each small wheat farm is likely to be very highly, almost perfectly elastic.

4:51And yet, the fact that it is not perfect destroys the entire concept of pure competition, for how does this situation differ from, say, the Hershey Chocolate Company, if the demand for the latter firm's products is also elastic? According to the monopolistic competition theorists, the two influences sabotaging the possible existence of pure competition are differentiation of product and oligopoly, or fewness of firms, where one firm influences the actions of others. As to the former, the producers are accused of creating an artificial differentiation among products in the mind of the public, thus carving out for themselves a portion of monopoly.

5:44And E.H. Chamberlain originally attempted to distinguish groups of producers selling slightly differentiated products from old-fashioned industries of firms making identical products. Neither of these attempts has any validity. If a producer is making a product different from that of another producer, then he is a unique industry. There is no rational basis for any grouping of varied producers, particularly in aggregating their demand. Furthermore, the consuming public decides on the differentiation of products on its value scales. There is nothing artificial about the differentiation and, indeed, this differentiation serves to cater more closely to the multifarious wants of the consumers.

6:38Recently, Professor E. H. Chamberlain has conceded this point and has, in a series of remarkable articles, astounded his followers by repudiating the concept of pure competition as a welfare ideal. ideal, Chamberlain now declares, the welfare ideal itself is correctly described as one of monopolistic competition. This seems to follow very directly from the recognition that human beings are individual, diverse in their tastes and desires, and moreover, widely dispersed spatially. It is clear, of course, that Ford has a monopoly on the sale of Ford cars.

7:23But this is a full monopoly, rather than a monopolistic tendency. Also, it is difficult to see what difference can come from the number of firms that are producing the same product, particularly once we discard the myth of pure competition and perfect elasticity. Such a do indeed has been made about strategies, warfare, etc. between oligopolists, but there is little point to such discussions. Either the firms are independent and therefore competing, or they are acting jointly and therefore cartelizing. There is no third alternative. Once the perfect elasticity myth has been discarded, it becomes clear that all the tedious This discussion about the number and size of firms and groups and differentiation, etc., becomes irrelevant.

8:20It becomes relevant only for economic history, and not for economic analysis. It might be objected that there is a substantial problem of oligopoly, that under oligopoly each firm has to take into account the reactions of competing firms, whereas under pure competition, In competition, or differentiated products without oligopoly, each firm can operate in the blissful awareness that no competitor will take account of its actions, or change its actions accordingly. Hiram Jones, the small wheat farmer, can set his production policy without wondering what Ezra Smith will do when he discovers what Jones' policy is.

9:37These alleged difficulties are non-existent, however, there is no reason why the demand presented to a firm cannot include expected reactions by other firms. The demand presented to a firm is the set of a firm's expectations at any time of how many units of its product consumers will buy at an alternative series of prices. What interests the producer is the hypothetical set of consumer demands at each price.

10:27He is not interested in what consumer demand will be in various sets of non-existent situations. His expectations will be based on his judgment of what would actually happen should he charge various alternative prices. If his rivals will react in a certain way to his charging a higher or a lower price, then it is each firm's business to forecast and take account of this reaction, in so far as it will affect buyer's demand for its particular product. There would be little sense in ignoring such reactions if they were relevant to the demand for its product or in including them if they were not. A firm's estimated demand, therefore, already includes any expected reactions of rivals.

11:20The relevant consideration is not the fewness of the firms or the state of hostility or friendship existing among firms. Those writers who discuss oligopoly in terms applicable to games of poker or to military warfare are entirely in error. The fundamental business of production is service to the consumers for monetary gain and not some sort of game or warfare or any other sort of struggle between producers. In oligopoly, where several firms are producing an identical product, there cannot persist any situation in which one firm charges a higher price than another, since there is always a tendency toward the formation of a uniform price for each uniform product.

12:15Whenever Firm A attempts to sell its product higher or lower than the previously ruling market price, it is attempting to discover the market, to find out what the equilibrium market price is, in accordance with the present state of consumer demand. If, at a certain price for the product, consumer demand is in excess of supply, the firms will tend to raise the price, and vice versa if the produced stock is not being sold. In this familiar pathway to equilibrium, all the stock that the firms wish to sell clears the market at the highest price that can be obtained. The jockeying and raising and lowering of prices that takes place in oligopolistic industries is not some mysterious form of warfare, but the visible process of attempting to find market equilibrium, that price at which the quantity supplied and the quantity demanded will be equal.

13:21The same process indeed takes place in any market, such as the non-oligopolistic wheat or Strawberry Markets. In the latter markets, the process seems to the viewer more impersonal, because the actions of any one individual or firm are not as important or as strikingly visible as in the more oligopolistic industries. But the process is essentially the same, and we must not be led to think differently by by such often inapt metaphors as the automatic mechanisms of the market or the soulless impersonal forces on the market. All action on the market is necessarily personal.

14:08Machines may move, but they do not purposefully act. And in oligopoly situations, the rivalries, the feelings of one producer toward his competitors may be historically dramatic, but they are unimportant for economic analysis. To those who are still tempted to make the number of producers in any field the test of competitive merit, we might ask, setting aside the problem of proving homogeneity, how can the market create sufficient numbers? If Crusoe exchanges fish for Friday's lumber on their desert island, are they both benefiting? or are they bilateral monopolists exploiting each other and charging each other monopoly prices?

14:56But if the state is not justified in marching in to arrest Crusoe and or Friday, how can it be justified in coercing a market where there are obviously many more competitors? Economic analysis, in conclusion, fails to establish any criterion for separating any elements of the free market price for a product. Such questions as the number of firms in an industry, the sizes of the firms, the type of product each firm makes, the personalities or motives of the entrepreneurs, the location of plants, etc., are entirely determined by the concrete conditions and data of the particular case.

15:44Economic analysis can have nothing to say about them.

15:54Perhaps the most important conclusion of the theory of monopolistic or imperfect competition is that the real world of monopolistic competition is inferior to the ideal world of pure competition, where no firm can affect its price. The only assumption we need to understand this is that for any plant and any branch of production, Production, there will be some optimum point of production, that is, some level of output at which average unit cost is at a minimum. All levels of production lower or higher than the optimum have a higher average cost.

16:39In pure competition, where the demand presented to any firm is perfectly elastic, each firm will eventually adjust so that its total costs equal total revenues and profits are zero. Now contrast this picture with that of monopolistic competition. Monopolistic competition yields higher prices and less production, that is, a lower standard of living, than pure competition, for output will not take place at the point of minimum by a process of revision in recent years, some of it by the originators of the doctrine themselves, this theory has been effectively riddled beyond repair.

17:37As we have seen, Chamberlain and others have shown that this analysis does not apply if If we are to take consumer desire for diversity as a good to be satisfied, many other effective and sound attacks have been made from different directions. One basic argument is that the situations of pure and of monopolistic competition cannot be compared. Chamberlain has pursued his revisionism in this realm also, declaring that the comparisons are wholly illegitimate. That to apply the concept of pure competition to existing firms would mean, for example, assuming a very large number of similar firms producing the identical product. If this were done, say, with General Motors, it would mean that either GM must conceptually be divided up into numerous fragments, or else that it be multiplied.

18:36If divided, then unit costs would undoubtedly be higher, and then the competitive firm would suffer higher costs and have to subsist on higher prices. This would clearly injure consumers and the standard of living. Thus, Chamberlain follows Schumpeter's criticism that the monopolistic firm may well have, and probably will have, lower costs than its purely competitive counterpart. If, on the other hand, we conceive of the multiplication of a very large number of General Motors corporations at existing size, we cannot possibly relate it to the present world, and the whole comparison becomes absurd.

19:22In addition, Schumpeter has stressed the superiority of the monopolistic firm for innovation and progress, and J.M. Clark has shown the inapplicability in various ways of this static theory to the dynamic real world. He has recently shown its fallacious asymmetry of argument with respect to price and quality. Hayek and Lockman have also pointed out the distortion of dynamic reality as we have indicated. A second major line of attack has shown the vital importance of potential competition to any would-be reaper of monopoly price from firms both within and without the industry, and also the competition of substitutes between industries.

20:14All these arguments, added to our own analysis, have effectively demolished the theory of of Monopolistic Competition, and yet more remains to be said. There is something very peculiar about the entire construction, even on its own terms, and practically no one has pointed out these other grave defects in the theory. In an economy that is almost altogether monopolistically competitive, how can every firm produce too little and charge too much? What Happens to the Surplus Factors? What are they doing? The failure to raise this question stems from the modern neglect of Austrian general analysis, and from undue concentration on an isolated firm or industry.

21:05The excess factors must go somewhere, and in that case, must they not go to other monopolistically competitive firms? In which case, the thesis breaks down as self-contradictory. But the proponents have prepared a way out. They take first the case of pure competition. Then they assume a sudden shift to conditions of monopolistic competition. Then the firm restricts production and raises its price accordingly, reaps profits, attracts new firms entering the industry, and the new competition reduces the output saleable by each firm. Hence, say the monopolistic competition theorists, not only does monopolistic competition suffer from too little production in each firm, and excessive costs and prices, it also suffers from too many firms in each industry.

22:05Here is what has happened to the excess factors. They are trapped in too many uneconomic firms. This seems plausible, until we realize that the whole example has been constructed as a trick. If we isolate a firm or an industry as does the example, we may just as well start from a position of monopolistic competition, and then suddenly shift to conditions of pure competition. This is certainly just as legitimate, or rather illegitimate, a base for comparison. What then? It will now be profitable for each firm to expand its output, and it will then make profits. New firms will then be attracted into the industry.

22:51Are we now proving that there are more firms in an industry under pure than under monopolistic competition? The author first learned this particular piece of analysis from the classroom lectures of Professor Arthur F. Burns, and to our knowledge, it has never seen print. The fundamental error here is failure to see that under the conditions established by the assumptions, any change opening up profits will bring new firms into an industry. Yet the theorists are supposed to be comparing two different static equilibria of pure and of monopolistic competition and not discussing paths from one to the other.

23:37Thus, the monopolistic competition theorists have by no means solved their problem of surplus factors. But aside from this point, there are more difficulties in the theory, and Sir Roy Herod, himself one of its originators, is the only one to have seized the essence of the remaining central difficulty. As Herod says, if the entrepreneur foresees the trend of events, Which will, in due course, limit his profitable output to x-y units, why not plan to have a plant that will produce x-y units most cheaply, rather than encumber himself with excess capacity? To plan a plant for producing x units, while knowing that it will only be possible to maintain And yet, asserts Herod puzzledly, the accepted doctrine apparently deems it impossible to be an entrepreneur and not suffer from schizophrenia.

24:47Clearly here is a patent contradiction with reality. What is wrong? Herod's own answer is an excellent and novel discussion of the difference between long The paradox becomes curiouser and curiouser when we fully realize that it all hinges on a mathematical technicality. But we must never let reality be falsified in order to fit the niceties of mathematics. In fact, production is a series of discrete alternatives, as all human action is discrete, and cannot be smoothly continuous, that is, move in infinitely small steps from one production level to another.

25:43There is another way for this pseudo-problem to disappear, and that is to call into question and the entire assumption that total costs and total revenues of the firm will be equal since profits as well as losses will be zero. But a key question has been either overlooked or wrongly handled. Why should the firm produce anything, after all, if it earns nothing from doing so? But it will earn something in equilibrium, and that will be interest return. Modern orthodoxy has fallen into this error for one reason, because it does not realize that entrepreneurs are also capitalists, and that even if in an evenly rotating economy the strictly entrepreneurial function were no longer to be required, the capital advancing function would still be emphatically necessary.

26:45Modern theory also tends to view interest return as a cost to the firm. Naturally, if this is done, then the presence of interest does not change matters. But, and here we refer the reader to foregoing chapters, interest is not a cost to the firm. It is an earning by a firm. The contrary belief rests on a superficial concentration on loan interest and on an unwarranted separation between entrepreneurs and capitalists. Actually, loans are unimportant and are only another legal form of entrepreneurial capitalist investment. In short, in the evenly rotating economy, the firm earns a natural interest return dictated by Social Time Preference, and so the paradox of the monopolistic competition theory is finally and fully interred.

27:47C. Chamberlain and Selling Cost. One of Professor Chamberlain's most important contributions is alleged to have been his sharp distinction between selling cost and production cost. Selling costs are supposed to be the legitimate expenses needed to increase supply in order to meet given consumer demand schedules. Selling costs, on the other hand, are supposed to be directed toward influencing consumers and increasing their demand schedules for the firm's product. This distinction is completely spurious. Why does a businessman invest money and incur any costs whatever?

28:33to supply a hoped-for demand for his product. Every time he improves his product, he is hoping that consumers will respond by increasing their demands. In fact, all costs expended on raw materials are incurred in an attempt to increase consumer demand beyond what it would have been in the absence of these costs. Therefore, every production cost is also a selling cost. Conversely, selling costs are not the sheer waste or even tyranny that monopolistic competition theorists have usually assumed. The various expenses designated as selling costs perform definite services for the public.

29:21Basically, they furnish information to the public about the goods of the seller. We live in a world where there can be no perfect knowledge of products by anyone, especially consumers, who are faced with a myriad of available products. Selling costs are therefore important in providing information about the product as well as about the firm. In some cases, for example, displays, the selling cost itself directly improves the quality of the product in the mind of the consumer. It must always be remembered that the consumer is not simply buying a physical product, he may also be buying atmosphere, prestige, service, etc., all of which have tangible reality to him and are valued accordingly.

30:14It is surely highly artificial to call bright ribbons on a packaged good a production cost, while labeling bright ribbons decorating the store selling the good as a selling cost. The view that a selling cost is somehow an artifact of monopolistic competition stems only from the peculiar assumptions of pure competition. In the ideal world of pure competition, we remember, each firm's demand is given to it as infinitely elastic so that it can sell whatever it wants at the ruling price. Naturally, in such a situation, no selling costs are necessary because a market for a product is automatically assured.

31:03In the real world, however, there is no perfect knowledge, and demand is neither given nor are infinitely elastic. Therefore, firms have to try to increase demands for their products and to carve out market areas for themselves. Chamberlain falls into another error in implying that selling costs, such as advertising, create consumer demands. This is the determinist fallacy. Every man as a self-owner freely decides his own scale of valuations on the The free market, no one can force another to choose his product, and no other individual can ever create someone's values for him.

31:49He must adopt the value himself. As Mises puts it, the consumer is, according to legend, simply defenseless against high pressure advertising. If this were true, success or failure in business would depend on the mode of advertising only. However, nobody believes that any kind of advertising would have succeeded in making the candle-makers hold the field against the electric bulb, the horse drivers against the motor cars, but this implies that the quality of the commodity advertised is instrumental in bringing about the success of an advertising campaign. The tricks and artifices of advertising are available to the seller of the better product, No less than to the seller of the poorer product, but only the former enjoys the advantages derived from the better quality of his product.