The Trump Administration is following the playbook of Reaganomics. As part of its Reaganomics program, the Reagan Administration cut back sharply on the regulation of everything from monopoly and oligopoly to pollution and product safety, important elements that likewise effect the aggregate supply curve.
Adam Smith’s Perfect Competition Model
Using his famous “invisible hand” analogy, Adam Smith argued that the self-interested actions of individuals actually guide market outcomes to yield great economic benefits for the broader society.
It looks and sounds good on paper but in reality, few markets are perfectly competitive.
Few sectors of the economy fulfill Adam Smith’s vision of a perfectly competitive marketplace delivering goods and services at the lowest price and highest quality.
A Mixed Economy
The U.S. as well as most other modern industrialized nations, has what is called a mixed economy.
At one end of this mixed economy, we have industries like farming and mining. These industries are characterized by many buyers and sellers and come closest to approximating Adam Smith’s model of perfect competition.
At the opposite end of Perfect Competition, we have Pure Monopolies.
We have pure monopolies like the post office characterized by one seller and run by the government. In between the two opposite poles of perfect competition and a pure monopoly, we have oligopoly (examples are Internet Technology, Tobacco Industry, Automobiles, Oil).
Oligopolies are industries which typically have a small number of large firms.
Many of America’s largest industries are oligopolies much more likely to engage in collusive practices such as price fixing than the type of fierce competition envisioned by Adam Smith.
A cartel like OPEC is an oligopoly.
In contrast to Adam Smith’s free market economy, and America’s mixed economy, a Command Economy is one in which the government makes all the important decisions about production and distribution (most communist countries run a Command Economy like China).
In a command economy:
- Government makes all the important decisions about production and distribution.
- The government owns most of the means of production (land and capital).
- Government owns and directs the operations of enterprises in most industries.
- It is the employer of most workers and tells them how to do their jobs.
Perfectly Competitive Market
In a perfectly competitive market, where numerous buyers and sellers meet, consumers pay the lowest price for the most goods and all resources are allocated efficiently.
What one firm does has little influence on what other firms do. Perfectly Competitive firms are price takers rather than price makers. This figure illustrates the Price Taker concept.
The figure shows supply and demand equilibrium in a perfectly competitive market for widgets. Equilibrium occurs where supply and demand cross at P* and Q*.
Now because there are numerous buyers and sellers in this perfectly competitive industry, what do you suppose will happen if any one firm tries to raise its price above P*?
The correct answer is C. If one firm tries to raise its price above P*, customers will simply buy their widgets from any one of thousands of other firms thus quantity demanded falls to zero.
To understand what happens in a monopoly, let’s use the market for ice cream cones.
Here’s the market for ice cream cones in a perfectly competitive equilibrium at a price of Pe and the quantity of Qe. At this equilibrium, what is the consumer surplus and what is the producer surplus?
The correct answer is B. The consumer surplus is triangle C and the producer surplus is triangle E. If it helps picture triangle C as being on the D (demand) line that slopes downward (demand increases as you move along the D line to the right). Picture triangle E as being on the S (supply) line that slopes upward (supply increases as you move along the S line to the right). Consumer surplus measures the difference between what consumers would have been willing to pay and what they actually pay. The producer surplus is the difference between the price at which producers would have been willing to supply a good and the price they actually receive.
Now suppose a monopolist corners the market for ice cream cones and raises the price to Pm. In this case, quantity falls to Qm. What is the impact of this monopoly pricing on consumers?
The correct answer is A. Consumers have to pay more for less quantity, and the rectangle B is transferred to the monopolist. That means consumers are poorer and the monopolist is richer. What portions of consumer and producer surplus represent the loss of allocative efficiency (deadweight loss) from monopoly pricing? Here’s a hint. The efficiency loss on the consumer side comes from the consumption of ice cream that is forgone, under monopoly pricing. By the same token, the loss of efficiency on the producer’s side comes about by a reduction in output and an under supply of resources to the ice cream market.
The loss of consumer surplus is measured by triangle C while the loss of producer surplus is measured by triangle E.
Together, the triangles C and E measure the loss in allocative efficiency from the monopoly pricing. Economists call this lost the deadweight loss.
From this example, you can see why people don’t like monopolies and oligopolies as both transfer income from the many to the few, and it also creates an efficiency loss in the economy.
Google Oligopoly On Internet Advertising
When Google first began, it was a search engine competing with other popular search engines like Yahoo, Ask Jeeves, Excite, AltaVista, AOL Search, and All the Web. In that perfectly competitive market, Google had only a small portion of search engine traffic and hence a small portion of businesses advertising over its search engine.
In the competitive market during the early days of Google, if Google attempted to raise its CPC advertising, advertisers would leave Google and go to AltaVista, Yahoo, or Ask Jeeves.
Over time, Google became an internet monopoly controlling as much as 80% of all search traffic in the U.S.
Website owners like me were able to advertise over Google at very affordable prices but over time, as Google eventually cornered the internet search market and hence advertising market, the cost of advertising on Google soared. The bid price for CPC ads went from $0.05 per click to more than $5 per click in some industries. This squeezed many small business owners like me with limited cash flow out of the market.
What is the distributional impact of this monopoly pricing on small business owners wanting to advertise on Google? Business owners have to pay more for less quantity, and the rectangle B is transferred to Google, the monopolist. That means small business owners are poorer and Google is richer. It also means many small business owners like me are pushed out of the market and thus inefficient deadweight loss occurs in the economy. The efficiency loss on the consumer side comes from the purchase of advertising that is forgone, under monopoly pricing. By the same token, the loss of efficiency on the producer’s side comes about by a reduction in output (search engines, video services, and other internet properties put out of business by Google) and an under supply of competitive resources to the internet advertising market.
The point here is not to pick on Google. In fact, it’s just the opposite. This microeconomics lesson on monopolies and oligopolies explains why oligopolies like Google are a great long-term investment.
Facebook is another oligopoly and so is Microsoft and Amazon in their respective technology industries. While these oligopolies are bad for a free market economy and competitive pricing for consumers, they are great for investing in.
Most countries have laws against price fixing and collusion so investing in these companies does carry that risk.
Seek Out Oligopolies To Invest In
The goal of every business is to become a monopolist and gain complete price control over their respective market. As an investor, you want to identify the monopolies and oligopolies to invest in. If the government steps in to break up the monopoly, you’ll want to get out of the market quickly. For example, the pharmaceutical industry oligopoly, that set prices on some drugs, is now under fire by Congress which is why the companies involved had their stock prices plunge.
Oligopolies are often able to set prices, rather than take them. For this reason oligopolies are able to increase profit margins above what a truly free and competitive market would allow which is another reason they make great long-term investments. For further reading, I did another lesson on monopolies here.