On the Importance of the Concept of Monopoly in Introductory Economics

In everyday life economics presents itself to us first and foremost as a problem of distribution, not of output, not of what economists would call “allocative efficiency.” This pizza place is ripping you off. That employer is lowballing you. In our intuitive economics, higher prices mean someone is taking money out of our pockets and putting it in theirs. And low prices mean we are taking money from someone else’s pockets and putting it in ours.

Only once we’ve considered these distributive consequences do we go on to consider the effect of pricing on output, and even then we usually do so only in the context of bargaining over distributive outcomes. Thus we might say: “If he doesn’t lower the price of a slice, I’m going elsewhere.” Now, that’s an effect on output: the high prices cause you to buy less. But even when we make threats like that, we think of them as a bargaining position: we threaten to go elsewhere, so that the price will go down, and we can therefore be richer.

Yes, maybe we go elsewhere because we can’t afford it, but then we rue the fact that we are not richer — that more wealth has not been distributed to us — so that we would be able to buy. We don’t think to ourselves: “this price tells me that I don’t care as much about this product as the person who produced it, and therefore it is right and proper that I not buy this product and buy something less expensive instead.” That would be a view focused on allocative efficiency. We think instead that we should be given more money, or should find a way to get it ourselves.

Our way of thinking about prices and markets is through and through about the distribution of wealth. But introductory economics takes almost no account of this. Instead, economists introduce their subject primary by reference to competition, not monopoly. (The wildly popular Varian Intermediate Microeconomics textbook, for example, teaches competition before monopoly.)

But theories of competition are not about distribution at all.

In competitive markets, there is no give whatsoever in price. Price is uniquely determined by supply and demand to be just high enough to cover the cost of production and just low enough so that everyone who is willing to pay the cost of production, but not a penny less, is able to buy. As a result, there is no distributive question in competitive markets. Sellers never make any profit, because they sell at cost. And buyers never get away with good deals, because they always pay the maximum that they would be willing to pay for the good.

Indeed, in a world of competitive markets, you cannot, must not, ever think of prices as being too high or too low. If the pizzeria raises prices, it must be because the costs of production have gone up. If your employer reduces your wages, it must be because the value of your labor to the employer has gone down. The pizzeria is not trying to redistribute wealth to itself, but only responding to changes in the value that society places on the ingredients of pizza — cheese, tomatoes, and labor. Society values some of these more than before, which is why their costs have gone up, and that in turn is why the price of your pizza must go up. If you can’t afford the new prices, then you must not care as much about pizza as society cares for the cheese, labor, and tomatoes, and so it is right and proper that you not buy. To complain about the higher prices is not just foolhardy — nothing you say or do can bring those prices down, unless you are able somehow to change the value that society places on those ingredients — complaining is also evil, because it amounts to demanding that you be given something that you don’t deserve. If the pizzeria were to listen to your blandishments and give you a discount, then someone who values the ingredients of pizza more than you, someone who is willing to pay more for them than you, will not be able to buy them, and society as a whole will be worse off, because it will have taken things from someone who values them more and given them to someone who values them less. To hold out for a better deal is to try to pervert a mechanism that, if left to its own devices, ensures the greatest good for the greatest number.

It is my sense that the main reason for which economics seems to turn off the students with the greatest interest in the field is that these students can find in theories of competitive markets no shred of the distributive intuition with which they are familiar. Moreover, the theory of competitive markets destroys the motivation to study economics of anyone who actually cares about economic outcomes. Because the theory of competition suggests that the economy is a machine, and not a social endeavor at all, which in turn suggests that non-interference is the proper way to interact with the economy. Do not complain about prices. Do not hold out. Do not bargain. Just accept the prices and wages that you are given, and make sure that everyone else does too, and you can be confident that the prices are just and the wages are just. But we do not become interested in, and study, things that we do not wish to interfere with. No. We become interested in, and study, things that we want to tweak, to improve, and so on.

So those who are most interested in economics come to economics (1) with a thirst to understand how economics drives distributive outcomes and (2) with a thirst to understand what can be done to improve those outcomes. Introductory economics courses tell these students: (1) economics poses no distributive questions at all and (2) to the extent that there are any problems with the economy, they can be solved only by doing nothing. No wonder that few economists seem really passionate about their subject. The way introductory economics is taught alienates all those students who are really passionate about the subject.

That is a shame, because the economic concept of monopoly speaks to all the frustrations of those who really care about economics. It’s a crime that the concept gets so little coverage in introductory economics courses, a crime all the more serious because not only do economists of all stripes agree — at least when pushed — that the monopoly concept is far more widely applicable to economic life than the competition concept (think product differentiation and monopolistic competition), but the monopoly concept is also the far older and more established of the two concepts in economics, stretching right back to Ricardo and beyond (Adam Smith talked about both competition and monopoly, but he didn’t have models for either). If there is one piece of good that might be done for the world in matters economic, it might well be to henceforth start all economics textbooks with monopoly, and leave competition for the last chapters, the way monopoly is left to the end today.

(This extends, as well, to the teaching of introductory game theory. The game theoretic counterpart of the monopoly concept is bargaining, also called cooperative game theory, because bargaining is all about the distribution of surplus, and not about immutable equilibrium results. Why, then, is it that Dixit only gets to bargaining in the final chapter of his seventeen-chapter introduction to the field, Games of Strategy? Do not tell me that it is because the mathematics of bargaining is harder. It’s only harder because distributive questions are underdetermined — any distribution is possible — which means mathematics isn’t all that useful for distributive questions to begin with. Distributive questions are political, not mathematical, questions. The responsibility of economics is to study the economy, and to emphasize the most important aspects of the economy, not to emphasize the aspects that are mathematically tractable. Economists ought to lose named chairs if they do otherwise.)

Why does the concept of monopoly speak to our basic distributive intuition about economics? Because the monopoly concepts admits that people can and do choose their prices, that the supernatural forces of the market do not choose prices for them, and therefore that the distribution of wealth matters. The pizzeria can choose higher prices, and in so doing can extract more wealth from us. And our employers can pay us lower wages, and deny more wealth to us. And when the pizzeria or the employer acts this way, the monopoly concept tells us that the prices the pizzeria charges and the wages the employer pays are not necessarily an accurate reflection of the cost of making pizza or the value of our labor. If the pizzeria raises prices, it might be because costs have gone up, but it might also be — indeed, it is most likely to be, if we accept that in a world of differentiated products every firm has some amount of power over price — because the pizzeria has decided to try to extract more wealth from us in exchange for providing a good that hasn’t changed in value at all. And now, knowing that prices can rise even when value does not, it makes sense that our instinct is immediately to bargain, to walk away, to hold out, in order to drive that price down. Indeed, knowing that prices can rise even when value does not, it makes sense now that we intuitively view all of our economic interactions first and foremost in distributive terms, because economic interactions are first and foremost about distribution. Any creature foolish enough to just intuitively accept prices as dictated was long ago flushed from the gene pool, having failed to reproduce, because the creature spent all its money on pizza, or failed to bargain for a higher wage.

The monopoly concept tells us that to complain about prices is not to threaten to upset a well-oiled machine, not to try to take from others what they value more, but to insist on a share of the productive pie. The pizzeria creates value — surplus — over the cost of production when the pizzeria makes pies. Why? Because the pies are worth more to us than cheese, tomatoes, and labor separately. That surplus is expressed in the maximum prices that we are willing to pay for pizza, maximum prices that exceed the cost of cheese, tomatoes, and labor. What to do with this surplus of pleasure (our pleasure) over cost, of this surplus of our pleasure over the pleasures foregone by those who would otherwise use the cheese and tomatoes, or spend their labor time on other pursuits? If the pizzeria charges a high price — a price equal to our maximum willingness to pay — then we give that surplus to the pizzeria. If the pizzeria chooses to pay a higher wage than the minimum that its workers are willing to accept, then the pizzeria passes some of that surplus along to its workers. Otherwise, the surplus goes to the owners. And if the pizzeria charges a low price, a price equal just to its cost of cheese, labor, and tomatoes, then we, pizza eaters, get all of the surplus. This is real economics, the economics of the everyday. It’s also a fundamental part of virtually all economic research today, but you wouldn’t know it from taking an introductory economics class. Persevere.

In the world of the monopoly concept, economics is inexorably political, there is always something to be done to improve the system, and doing nothing means catastrophe. Distribution is politics. Should the workers take more of the surplus? Should consumers? Are prices too high? Too low? Something must be done. The monopoly concept takes you straightaway to action.

There is much that can be done. You can lower prices by promoting competition in markets. Is it hard to find another pizza place charging a lower price, which is why your local pizzeria feels comfortable raising prices? Why, then, is it hard to find competitors? Are they all owned by the same firm, despite different branding? Do they use WhatsApp to fix prices? Are there just too few of them? To solve these problems, you need to advocate for greater antitrust enforcement.

But you can also lower prices through “rate regulation” — government setting of prices. This is a lot more common than you might think. States regulate the prices charged by power, gas, and water companies, among others. And have regulated prices in many more industries over the past century or so. Indeed, regulatory economics and auction theory are devoted to little else than finding low-cost ways for government to set prices (albeit with less attention to distributive concerns than there should be).

There are yet other ways to deal with prices. Thee is the political harangue. Studies show that when presidents complain about high drug prices, prices fall. There is also the reallocation of property rights. Indeed, the problem of pricing strikes deeper than antitrust, with its focus on anticompetitive conduct, deeper even than rate regulation, with its focus on dictating prices, and instead goes to the heart of our legal system, and in particular the part of it dedicated to property. The home you own monopolizes a bit of space in the world, and that is why, when that space is in great demand, homeowners can become enormously wealthy, because they exploit that monopoly to charge the highest possible prices to buyers. Maybe that’s a good thing if the homeowner started out with modest means. But the point is that property is monopoly (a thing that was said long before Eric Posner and Glen Weyl called attention to it in a recent book). One way to drive prices down, or more generally to redistribute wealth, is to divide up or redistribute property. And that bring us to tax policy, which strives to deprive you of the fruit of your property-based monopolies, albeit without tying to deny you title to them. Property tax makes you pay some of that higher price you can claim back to the state. Income tax makes you pay some of the higher wages you can charge due to your monopoly over your talents back to the state. Sales tax does almost the same thing as rate regulation, making the pizzeria pay some of the monopoly profits it earns from you back to the state (don’t be fooled by the way stores fight the tax politically by adding the tax onto your bill — the bill would be higher without the tax). Trust getting busted, price being set, Presidents complaining, property being expropriated, and everything being taxed. You don’t get any more political and interventionist than that.

Moreover, unlike in competition theory, in monopoly theory the alternative of doing nothing about prices is just not any option, unless you believe that owners should always enjoy all of the surplus generated by production. Why? Because all markets tend naturally toward monopoly. Firms acquire firms, and run others out of business. Over time the result is monopoly everywhere, and owners that charge consumers the highest possible prices, and redistribute nothing to their workers. Unless government does something, whether to promote competition through the antitrust laws or property reform, or to regulate prices directly as part of a rate regulatory regime, markets will tend naturally to allocate all wealth to business owners. We are very far now from the competitive world view in which any sort of intervention in the economy misallocates resources.Of course, the two models — competition and monopoly — do work together. If you drive prices too low, or wages too high, then the allocative effects that competition theory worries about start to kick in. The pizzeria does have costs, and if you drive price below costs, then you really will start taking cheese, tomatoes, and labor from those who value these things more highly than you do. But it’s a good rule of thumb to assume that the initial change in prices is a distributive change, not a competitive — or what economists would call an “efficiency”-driven change. Distribution comes first, which is why most of us intuitively think about it first when we consider economic issues, and why it ought to be taught first, too.

Indeed, I have come to believe that most of the differences I have with economists are attributable to the difference between the competitive and monopoly world views. Whether they admit it or not, all economists walk the earth with a default economic model in their heads, parsing and interpreting economic facts in the first instance through that model. And very often, precisely because they went through introductory economics courses that emphasized competition, economists’ default model is the competitive model, not the monopoly model. It’s fine to have a default model — all science has to start from priors — but for the reasons that I gave above, that economic reality is characterized in the first instance by pervasive monopoly, even if only of the differentiated product monopolistic competition variety, the default model that economists out to be carrying around with them is the monopoly model. But in fact economists don’t usually have the monopoly model in mind in the first instance, and sometimes they seem to have forgotten about it entirely when pressed on public policy matters, even though in their own advanced technical work they may use nothing but monopoly models themselves.

For example, I gave a paper last year in which I argued that antitrust law should be read to require that firms give all of their surpluses to consumers, by charging the lowest possible prices, consistent with covering costs, to their customers. A learned scholar in attendance chose not to put any questions to me during my talk, but, seemingly because he thought he would be saving me from embarrassment, approached me afterward to try to explain to me what he thought were basic economics concepts that my paper had ignored. Using, if I recall correctly, a fruit analogy (apples and oranges), he tried to explain that if the firm charges lower prices, then it will attract less investment, and that would ultimately harm the very consumers I was hoping to help. He seemed entirely immune to my insistence that I was talking about reducing prices down to costs, but not below them, so the prices would simply redistribute surplus.

I struggled and struggled with his comments, trying to understand what I might be missing, until I realized that he was thinking in purely competitive terms. In his world, there simply was no surplus! Reduce the price of a pizza, and either someone gets something they don’t deserve, or — his point — the pizzeria will just produce less pizza, because any reduction in price must drive price below cost, making some production unprofitable. The notion that a price drop might have no effect on output was entirely alien to him. And yet at that very conference he had himself given a paper about monopoly in the finance sector! It wasn’t that he was somehow unaware of the monopoly concept, but that it wasn’t the default model that he useds when talking about policy issues.

Such are the wages of failing to emphasize the monopoly concept in economics education.