Chapter 12: The Arthritic Hand of Oligopoly
| As organization acquires power, it uses that power, not surprisingly, to serve the ends of those involved. These ends - job security, pay, promotion, prestige, company plane and private washroom, the charm of collectively exercised power - are all strongly served by the growth of the enterprise. So growth both enhances power over prices, costs, consumers, suppliers, the community and the state and also rewards in a very personal way those who bring it about. Not surprisingly the growth of the firm is a dominant tendency of advanced economic development. - John Kenneth Galbraith |
The Invisible Hand identified by Adam Smith in 1776 channeled private interest into the efficient production of goods and services. But it would only work in markets where there was sufficient competition. Yet many modern markets are oligopolistic. A handful of large firms produce most of the output in these industries. The growth of oligopoly poses problems both for economic theory and for economic policy. Standard economic theory predicts that any significant diminishment of competition should lead to slower economic growth; yet the age of oligopoly has been accompanied by rapid - although uneven - rates of economic growth. The economic policy problem is to find an effective way to use public policy as a substitute for what competition accomplishes in the world of small business. This chapter explores how this situation came about, looks at the changes in the social structure of accumulation that it entails, examines some of the common practices of big business, and investigates some of the forces - including antitrust laws - that allow an economy dominated by gigantic firms to function.
The large firm is a prominent feature of the economic landscape. Many industries are dominated by a handful of gigantic firms. This concentration of economic power is most apparent in the manufacturing sector - about 50 firms now produce about 15 percent of the manufactured goods in the industrialized world. But such concentration is not limited to manufacturing. We are seeing increasing concentration in the service sector - airlines, fast-food chains and the entertainment industry are just a few examples. Galbraith noted over twenty years ago that the heads of the firms that together produce more than half of the economic output of the United States would not fill a university auditorium; he suggested that we view our economy as two significantly different economies - one composed of about 1,000 gigantic corporations and another composed of about twelve million small businesses. If anything, this concentration of economic power has increased since Galbraith wrote Economics and the Public Purpose (1973). Moreover, economic power takes many forms. Some sources of economic power are market share, absolute size, operating on a global scale, vertical integration, strategic alliances and a wide scope of operations.
One source of economic power is market share. In a perfectly competitive industry, no firm can significantly affect the price through its own actions. This is clearly not so when one firm's output is 15 or 20 percent of the total output. There are about 150 firms in the worldwide motor vehicle industry. But the two largest firms, General Motors and Ford, together produce almost one-third of all vehicles. The five largest firms produce half of all output and the ten largest firms produce three-quarters. Four appliance firms manufacture 98 percent of the washing machines made in the United States. In the U. S. meatpacking industry, four firms account for over 85 percent of the output of beef, while the other 1,245 firms have less than 15 percent of the market. [1] Power from a large market share within one industry is called horizontal power. Often, such power is attained by merger or acquisition. If Toyota were to buy Chrysler Corporation, that would be a horizontal acquisition.
While we normally think of national or global industries when we think of oligopolies, there are also local oligopolies. If a city only has two commercial bakeries or three radio stations these firms would enjoy economic power stemming from market share, although their small absolute size might not be much of a barrier to potential competitors.
Oligopolistic firms that operate on a national or global scale are also huge in another sense - they are just plain big. Many have several hundred thousand employees and multi-billions of dollars in assets. Size is itself a source of power. Size provides protection against potential competition - remember that ease of entry is one of the factors by which we measure competition. Very few of us could raise the $8 billion or so that it takes to start an automobile firm. And such size makes it easier avoid a forced exit. There were over 100 automobile firms in the U.S. in 1929. Of the eight firms that survived the Great Depression, seven had been the seven largest in 1929. The three surviving U.S. automobile firms today are the same firms that were the three largest in the 1920s. Creditors are less likely to force a large firm into bankruptcy. There is an old saying to this effect: 'If your owe your banker a million dollars you are a customer, but if you owe your banker a billion dollars you are a partner.'
Size also opens opportunities for further expansion by swallowing other firms. IBM paid $3.5 billion for Lotus in 1995. That is about equal to the entire annual output of Nepal, which has a population of 20 million.
Another source of economic power is the ability to operate on a global scale. The automobile and tire industries are examples of global oligopolies. Major firms in both of these industries have production facilities in North America, Western Europe, Latin America and Asia. The ability to shift production from one country to another gives these firms more bargaining power with governments and with their labor forces.
Firms can also gain economic power through vertical expansion. This means controlling more steps of the production process. General Motors owns many of its parts suppliers, including a large automotive electrical equipment manufacturer. After automobiles are assembled, they must be sold, and GM also owns GMAC, an auto financing firm. Recently, Intel -with near-monopoly power in the CPU-chip sector - began making computer motherboards. Motherboard design has been one of the methods by which many of Intel's customers have tried to carve out their own niches in the computer industry, yet these firms have usually suffered from low profits while Intel has enjoyed operating margins of 30 percent of sales. [2]
Large firms often have ownership or other working relationships with other large firms and many smaller firms in the same industry. Ford, for example, owns Jaguar, half of Aston Martin, 25% of Mazda, and 10% of Kia (Mazda owns another 8% of Kia); Ford also has technology-sharing agreements with Fiat and Nissan. General Motors and Toyota jointly own and operate an auto plant in California.
More recently, Motorola joined the strategic alliance formed earlier by IBM, Siemans and Toshiba to jointly develop the next generation of memory chips. Since Motorola lagged behind these firms in research, it paid several million dollars to the leading firms for access to their chip-design research. Toshiba and IBM have a separate agreement for computer-screen technology and will jointly operate a flat-screen factory in Virginia. [3] Kodak entered into a strategic alliance with Canon, Minolta, Nikon and even arch-rival Fuji to develop a new film format. This alliance developed the new film system even as Kodak was charging that Fuji conspired with film distributors to limit Kodak's market share in Japan. Kodak and Fuji are launching their marketing drive for the new film just as U.S. trade officials are considering pursuing Kodak's charges against Fuji through the World Trade Organization. [4] According to one of the Kodak executives working on the project, "It was a real challenge to get our people to view Fuji as an ally while simultaneously viewing them as a samurai on the street." [5] These agreements among supposedly competing firms certainly appear to restrict the range of competition.
Firms might increase their size and financial power by expanding into unrelated or only peripherally related areas. Such strategies can also reduce risk. This conglomerate fad was particularly popular in the 1960s. Corporate leaders and business school professors talked about achieving 'synergy' from the joining together of unrelated firms. Business schools in the United States also supported the conglomeration fad by promoting the idea that management is a profession unto itself and that there is no essential difference in managing a soft-drink company from managing a computer manufacturing firm.
The period from the 1860s to the 1890s saw a fundamental transformation of the economic landscape. At the beginning of this period most manufacturing was undertaken by small firms. Adam Smith's 1776 description of a ten-employee pin factory could still be used to describe a 'typical' firm. But by the 1890s many manufacturing and transportation sectors were dominated by large firms, often organized into trusts in the US and cartels in Europe, which employed thousands of workers and enjoyed significant political power. Shifts in the scale of technologies of production were behind this transformation. Yet these technological shifts by themselves cannot explain the size of modern corporations. Technology alone can explain the increase in size of the factory, but we will need to probe deeper below the surface to understand why the modern large firm comprises multiple factories; that is, the administrative unit - the firm - is much larger than the production unit - the factory or mill. The reasons for this gigantism lie in the way in which production technologies interacted with economic institutions.
Economies of Scale One root of this shift in the structure of capitalism was the relentless march of technology. Technological changes in manufacturing and transportation had two major effects on the structure of enterprise. First, while the cost of producing many goods fell, low-cost production could only be attained by firms that could increase their scale of production. In the 1860s an efficient steel mill produced up to 10 tons of pig iron per day. By 1900 pig iron could be produced much cheaper by mills large enough to make 500 tons per day. As the expanded output of these new large mills drove down the price of iron and steel, the small mills could not survive. The same process occurred in many other industries. Factories, mills, railroads and freighters all had to become much larger than before in order to achieve optimal economies of scale.
Second, the new technologies required very expensive specialized equipment and facilities. Even the term capital took on a new meaning. When Adam Smith wrote The Wealth of Nations, capital was thought of as a fund of money which the capitalist used to pay for labor and raw materials. By the 1890s, people used the term capital to describe the rope factory, steel mill, freighter or sugar refinery itself. The change in usage reflects changes in business conditions. An ever-increasing portion of the costs of production was taken up by payments on the plant and equipment. It is helpful to divide costs into two types: fixed costs are the costs you incur even if you don't produce anything, such as the payments on the loan for the factory; variable costs are the costs that vary with output and that can be eliminated by ceasing to produce, such as labor and raw materials costs. The costs of the pin-making operation that Smith described were almost all variable costs. A large proportion of the costs of a modern steel mill or automobile factory are fixed costs.
The consequences of this technological shift were profound. First, since the optimal scale of production was growing faster than the market in most manufacturing sectors, total demand was being met by a smaller and smaller number of firms. For example, if the output of an efficient steel mill increases 50-fold while the demand for steel increases 10-fold, total demand will now be met by only one-fifth as many steel mills. Business was straying ever further from the world of perfect competition described by the early classical economists. Second, the high capital costs limited entry into many branches of manufacturing, restricting competition even further: in 1860, a master steel-maker might reasonably aspire to owning his own steel mill - by 1900 this would be out of the question.
Effects of High Fixed Costs Most important, perhaps, was the effect of these large fixed costs on the price adjustment mechanism itself. It became harder to go out of business - remember that ease of exit is also one of the criteria for perfect competition - and more likely that firms would keep producing even as they lost money. Since you will have to continue making the payments on the factory and equipment even if you are temporarily not producing anything, you will generally continue to produce as long as the price is high enough to cover your labor and raw materials costs. Losses will add up, but losses would add up even faster if you produced nothing.
But if firms keep producing the price is likely to stay so low that all or most firms in that business will continue to lose money. This will continue until enough of the weaker ones are driven into bankruptcy to bring the prices back up. And even bankruptcy may not provide any price relief. The bankrupt firm may eliminate the major part of its fixed costs - the payments on the loans it took out to build production facilities - then go on producing the product. In this way, over-production will continue until either the equipment wears out or demand increases sufficiently that the price can rise to profitable levels. This can take a long time. And during this long adjustment process, there will be little or no new investment in these money-losing sectors of the economy. The larger the proportion of total costs that are fixed - rather than variable - the more severe this effect can be.
Note that it makes little difference if the firm's factories were funded by issuing stock rather than by borrowing money. The firm will usually continue to produce as long the price is sufficient to cover the variable costs. If the fixed investment was funded by issuing stock, the value of the stock will fall to the extent that the margin of price over variable cost is not sufficient to yield a return on the investment.
A numerical example may be helpful. If the production of a particular type of bolt requires a 1 million dollar factory plus an expenditure of 2 million dollars per year on labor, raw materials, etc. in order to produce 5 million bolts per year, most of the costs will be variable costs. The variable costs will come to $0.40 per bolt. If the bolts can be sold for $0.42 each, there will be an operating profit of $100,000. This is a 10% return on the 1 million dollars invested in the factory.
Now we can introduce some new technology. The new bolt factory costs 100 million dollars, uses 5 million dollars in labor and raw materials per year, and produces 100 million bolts per year. The variable costs per bolt have fallen to $0.05. But it will take a price of $0.15 per bolt in order for this firm to earn a 10% return on its 100 million dollar investment. [6]
Capitalists, of course, do not build factories unless they expect to earn a profit at least as high as they could earn elsewhere. If that rate is 10%, then, under the earlier technology, the factory will be built if the price of bolts is expected to normally be $0.42 each or higher. But at prices higher than $0.42, profits will be greater than 10%, and additional capital will enter the bolt business. This will increase bolt production and drive prices down. If the price falls below $0.42, the profit rate will fall below 10% and no new factories will be built. However, if the price falls below $0.40, production will cease, as the price does not even cover the labor and raw materials. As production drops, the price can once again rise to normal levels.
Our second example is quite different. Again, assume that there will be investment in this industry as long as the capitalists expect a 10% return. This requires a price of $0.15 per bolt. But overoptimism plus normal competition leads to occasional overinvestment. With too many bolt factories, the price falls by a third, to $0.10. The profit rate falls to 5%. Firms that borrowed money to build their factories will not even be able to pay their loans. Nonetheless, production will continue since the price is more than enough to cover all of the variable costs. As long as production continues at normal levels, the price of bolts will remain low. Since there is no incentive for any existing firm to cut bolt production, production will not drop. There will be bankruptcies, but bankruptcies wipe out the debt and allow the production to continue. Certainly no new factories will be built. Eventually either the equipment will wear out and not be replaced or some combination of population growth and economic growth will increase the demand for bolts until price and profitability are restored. But this can take a considerable time.
M-C-M' The nature of capital itself had changed. Our earlier characterization of the process of production under capitalism, M-C-M', is no longer sufficient. When capital was primarily an operating fund with which the capitalist purchased labor and materials, the capital (M) was returned to the capitalist at the end of the process (as M'). If M' turned out to be less than M, that was tough luck, but it assured that no more capital would be converted into that particular commodity until there was a reasonable expectation of profitability. The capitalists would take what was left of their capitals and invest elsewhere.
Once fixed capital becomes a large part of the picture, it gets much more complicated. We need to look at it as two capitals, MV (which covers variable costs), and MF (which pays for the factory). First, the capitalist invests MF to build F (the factory). Then the additional investment of MV covers the costs of producing the commodity, C, which is then sold for MV'. This is followed by reinvestment of MV and so on for the life of the factory. Each production cycle generates an operating profit equal to MV' minus MV:
Fixed Investment: MF-F
Production: MV-C- MV', MV-C-MV', MV-C-MV'...
Operating Profit: (MV' - MV )+(MV' - MV )+(MV' - MV)+....
Investment always involves uncertainty. However, where there is no or little fixed capital, the period of uncertainty is very short. If conditions change, a decision can be made to not reinvest in the same production process. When there is a lot of fixed capital, the uncertainty extends over the life-span of the factory. Will the sum of the (MV' - MV) s over the life of the factory, plus the scrap value of the factory itself, be sufficient return on the initial investment of MF F ? The period of uncertainty may be fifteen years or longer! Moreover - and this is really one of the central problems of fixed capital - firms will continue to produce during this period of uncertainty as long as MV' - MV is positive. But they will not continue to invest if MV' - MV is too small to bring a reasonable rate of return on MF.
Note that the problem stems from the interaction of production technology with the institutional arrangements of capitalism. New production technologies drastically reduce the cost of production by reducing the amount of direct labor needed. At the same time, these cost reductions can only be realized by investing in specialized, expensive and long-lived capital equipment. That is the technological side. On the institutional side, we need to recognize that capitalists only invest when there is an expectation of profits; and that the drive for profits combined with the competitive urge to expand often leads to overinvestment - so many factories are built at once that their output pushes prices down to unprofitable levels. And - the technological aspect once more - once built, these factories, refineries, ships, etc. last a long time. The original investor may go bankrupt, but the factory does not disappear. Which brings us back to the institutional side: as long as the price of the product exceeds the variable costs someone - a bankruptcy receiver, the original firm after bankruptcy, a firm that financed the factory through stock issue rather than borrowing - will find it in their interest to operate the factory. But no one will make a real profit. This is obviously a highly unstable situation.
In fact, just as numerous new technologies were revolutionizing production, the industrial economies were mired in depression. The United States went through depressions in the 1870s and 1890s. Europeans often refer to the entire period from the 1870s through the early 1890s as the "long depression." The time was ripe for a fundamental change in the operating rules of capitalism, the social structure of accumulation. Business needed to find a way to avoid ruinous price competition. Society needed assurance that investment could continue and that capitalists would continue to find more efficient ways to produce things.
Technology had raced ahead of the social structure of accumulation. The operating rules of capitalism were based on small scale business with little in the way of specialized equipment. These operating rules would not suffice for large-scale industry with fixed payments on specialized and durable capital equipment. Firms might enter into agreements to fix prices at profitable levels, but such agreements rarely lasted long. One firm would soon find it in its temporary interest to break the agreement and lower its prices in order to increase its market share. In the United States and Britain, such agreements were illegal and therefore not enforceable in court.
Trusts and Cartels There was much experimentation with forms of business structure until the pattern of oligopoly finally evolved. In the United States, during the last quarter of the 19th century, businesses avoided competition by forming trusts. The leading firm in one industry would hold voting stock in its former competitors. Output could be limited and prices kept high. In many parts of Europe, cartels were legal. Firms in the same line of business would enter into a formal - and enforceable - agreement to limit production and thus maintain high prices. But both arrangements - trusts and cartels - brought business stability (and profits) at the cost of high consumer prices, limited new investment (in order to limit production) and a diminution of the type of competition that drives firms to develop new products and new production processes.
Oligopolies As the formation of trusts was restricted in the United States and cartels came under greater regulation in Europe, the oligopoly became the predominant big-business structure. With four or five large firms responsible for most of the output of each industry, avoidance of price competition became almost automatic. If one firm were to lower its prices, it is likely that its competitors will do the same and all will suffer lower profits. On the other hand, it is dangerous for any single firm to increase its prices since the others might hold their prices in order to gain market share. The safest thing is to never lower prices and only raise prices when there is abundant evidence that the other firms will also raise prices. The largest or lowest-cost or most aggressive firm will often emerge as the price leader. When business conditions permit, the price leader will raise prices with the expectation that the others will follow. The practice of price leadership prevails in many industries: automobiles, breakfast cereals, beer, steel and bank loans are among the many goods and services that are usually priced in this manner.
On the surface, it looks as though the effect of price leadership is the same as the effect of the fixing of prices by a cartel or a trust. But there is a fundamental difference. The trust or cartel assigns production quotas to its members in order to keep production down. Competition does not exist in any form. Oligopolies that follow a price leader do not engage in price competition, but they still contest for market share with a variety of forms of non-price competition. Pepsi and Coke each spend billions on TV ads designed to entice the consumer to switch cola brands, but those expensive adds never mention price.
Oligopoly, then, is a compromise - a social adaptation to powerful technological trends. While the rules of perfect competition should both assure that prices reflect the true costs of production and that firms continue to improve their products and production processes, operating under these rules leads to the type of price competition that continually threatens the value of vast holdings of expensive and specialized production facilities. So we have accepted a set of economic rules that limit price competition but still seem to result in competition over product and production process development. Technology forced firms to become bigger, yet that very bigness put them at such risk that they had to become even bigger in order to control prices.
Managing the Big Firm It was not enough just to want to consolidate corporate power into a structure that helped avoid price competition. Firms also had to develop management practices that would allow them to undertake such consolidation. Before the growth of trusts, most firms consisted of only one producing unit - one textile mill, or one iron mill. The owner was usually also the manager. Other administrative tasks were performed by hired managers, but many of these were members of the owner's family. This structure was certainly not adaptable to a multiplant firm; it was particularly not adaptable to a multiplant firm spread over a large geographic area.
Of course there was some assistance from new technologies. The railroad, the telegraph and the steamship all helped in the development of a communication network that allowed multiplant management. Later, the telephone and the typewriter further increased the ability to manage a multiplant and multilocation firm. It had been the railroad, in fact, that first forced its own owners and managers to develop many of the management routines and techniques that were later applied in other industries.
From the trusts of the 1880s to the oligopolies of today, there have been a number of strategies and tactics use by these firms to either limit competition or expand their markets. Oligopolies enjoy periods of stability in which price competition is limited or absent even while these firms struggle over market share through various forms of non-price competition. But there are also periods of instability - for example, when a new firm is invading an established market - in which even the leading firms might also use price as a competitive weapon. Oligopolies have developed a number of practices which serve to limit entry into the industry, avoid price competition and manipulate demand.
Oligopolies can become unstable when new firms attempt to gain entry. Of course the high cost of acquiring plant and equipment acts as a barrier to entry. It is also costly to enter an industry dominated by a small number of known trade names. Small firms already in the industry present a special problem. Some might try to grow beyond their established niches. The large firm will often simply purchase the up-and-coming small firm. Or the large firm or firms may rely on its established relationships with customers or suppliers to limit the activities of smaller firms.
Market dominance by two or three megafirms may make it more difficult for smaller firms to introduce innovative products or production processes. Consider the implications of Phillip Morris' 1988 acquisition of Kraft (Phillip Morris also owns General Foods):
However much the acquisition might help Phillip Morris, many industry experts think it would be rough on rivals, a challenge to food retailers and do consumers little good. They fear Phillip Morris could grab a huge portion of the retail shelf and stifle innovation by muscling out smaller and regional concerns where new products are often born.
...Recently, the company used its clout at 7-Eleven to get the convenience stores to carry only Oscar Meyer hot dogs. [7]
Price Leadership Changing a price is always a dangerous practice for an oligopoly. If the firm lowers the price, its competitors are also likely to lower theirs, then all will suffer from lower profits. On the other hand, raising prices may lead to a loss of market share unless competitors also raise their prices. In many industries, one firm (usually the largest) is accepted by the others as the price leader. The price leader will be the first to adjust prices to new conditions (higher labor costs, lower raw materials costs, etc.) and the others will fall into line. Of course this arrangement is entirely informal and unwritten - since any actual agreement to follow such a practice would violate the antitrust laws.
Price Setting But on what basis does the price leader set prices? The interplay of supply and demand forces so beloved by neoclassical economists loses its cogency as a theory of prices when 1) there is too little competition to force prices to equal marginal costs and marginal benefits through a Darwinian struggle; 2) costs per unit fall with increased output as the firm is able to spread its fixed costs over a larger number of units; and 3) demand is itself subject to manipulation by the firm through advertising.
Institutionalists and Post-Keynesians claim that the structure of oligopoly leads to a form of administered pricing. The price leader will use its average cost as a basis for price setting. Prices will be set at a level which achieves a target level of operating profits. This target level will be sufficient to enable the firm to self-finance expansion without the need to issue new stock or to borrow amounts of money that might threaten the firm's independence. Rather than constantly move the price up and down in order to sell as many units as the firm is capable of producing at a profit, the firm will normally adjust its output in order to maintain its target price. When this form of administered pricing is combined with the normal tendency of firms to expand, one result is that firms will usually have more production capacity than they use. When demand increases, they will increase output rather than prices.
Enforcement of Price Leadership In the economic as in the political arena, leadership will occasionally be challenged. Sometimes the mere threat of lowering prices suffices. In 1989, Miller and Coors tried to expand their market shares by discounting their premium beers. Anheuser-Busch, with 41 percent of the U.S. beer market, simply issued a press release:
We cannot permit a further slowing in our volume trend... [the company will take] appropriate competitive pricing actions to support our long-term market share growth strategy. [8]
One analyst commented: "Anheuser is the biggest guy in the bar, and he just decided to join in the barroom brawl." But another analyst warned against expecting a replay of the cola wars, noting that discounting is "a loser's game for anyone without a dominant market share," - adding that the Anheuser statement is simply a warning to competitors that if they do not stop discounting they will face a costly battle which they will certainly lose.
But sometimes actual price reductions are necessary. In the late 1960s, Chrysler tired to break away from the pricing pattern then set by General Motors. But GM was a larger and more efficient producer and was not about to abandon its price-leader role. So GM lowered prices below the cost of production in those lines in which Chrysler was competitive. Thus Chrysler was left with a lower margin per vehicle sold but was still unable to expand its market share. When GM raised their prices again in 1971 Chrysler quickly followed. Chrysler also filed suit charging GM (and Ford) with predatory pricing, but Ford and GM were acquitted due to lack of evidence.
Predatory Pricing A large or diverse firm that can stand temporary losses can cut its prices below the cost of production until it runs competitors out of business or establishes its price leadership. Then it can raise prices again. This is illegal. But it is very hard to prove, since normal competitive pressures can lead to prices set temporarily below the cost of production.
Price Fixing Formal agreements to fix prices are also used, although they are unquestionably illegal. Collusion is probably as old as markets. Even Adam Smith, an early proponent of unregulated markets, noted that capitalists did not really want to compete with each other if they could avoid it:
People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.
And, if such a conspiracy results in monopoly power:
The monopolists, by keeping the market continually understocked, by never fully supplying the effectual demand, sell their commodities much above the natural price, and raise their emoluments, whether they consist in wages or profit, greatly above their natural rate.
The price of monopoly ...is upon every occasion the highest which can be squeezed out of the buyers... [9]
The fear of monopoly runs deep in British and U.S. customs and laws. Conspiracies to set prices were considered illegal well before our first antitrust acts. And, while the enforcement of antitrust laws waxes and wanes, collusion cases almost always lead to enforcement efforts.
Some collusion attempts achieve considerable notoriety. In 1982, Robert Crandall, CEO of American Airlines, phoned Howard Putnam, CEO of Braniff Airlines. Mr. Putnam was taping the call and gave the tape to The Wall Street Journal:
Putnam (Braniff CEO): Do you have a suggestion for me?
Crandall (American CEO): Yes, I have a suggestion for you. Raise your [expletive deleted] fares 20% and I'll raise mine the next morning.
Putnam: Robert, we...
Crandall: You'll make more money and I will too.
Putnam: We can't talk about pricing.
Crandall: Oh [expletive deleted], Howard. We can talk about any [expletive deleted] thing we want to talk about. [10]
The large firm is often in a position to create a demand for its own product through advertising. While this sometimes leads to actual product improvement, it can also lead to the production of images rather than truly different products.
A study of the tactics of brand names points out that good brand names are most important for the type of products that are "relatively undifferentiated in terms of product specifications or performance and where consumers are relatively satisfied with existing brands." One conclusion of the study is that "...on the whole, branding is important only where the character of the product is not." [11]
Sometimes advertisers are able to create an essentially new product. In the 1960s, the United Fruit Company was faced with declining banana consumption and a declining market share: from 66% in 1953 to 57% by 1960. With prices falling as well, profits fell from $44 million to $2 million over the same period.
A major advertising firm convinced United Fruit that:
The consumer does not know United Fruit bananas from any other kind of bananas and, therefore, doesn't care whose bananas she buys. Assuming that the quality of the bananas is comparable, the lowest price banana gets the sale. . . . in order to raise the price of its bananas, United Fruit must first build consumer preference for its own brand of bananas. . . . The objective of the brand program was to sell United Fruit bananas for a higher price than they would normally get. . . .
. . . our bananas would probably not look any better than the competition's at retail, . . . We could not use any product claims that were checkable at retail. [12]
The goal was to stop selling just bananas and start selling Chiquitas. With the slogan "Keeps days longer," by 1964 Chiquita had a wholesale price premium of over 80 cents per box. A survey after heavy advertising showed 49% of customers would look for the Chiquita label, 27% would ask for them by name, and 25% would go to another store in order to get them.
But advertising slogans also raise expectations ("keeps longer" was demonstrably false), so United Fruit switched to advertising based on better packaging. When this backfired because shoppers then expected less bruising, Chiquita settled on being "fussy about what we put our name on." By 1967 profits were back up to over $20 million.
Probing the Consumer By today's standards, the United Fruit program of polling shoppers to measure the effectiveness of the advertising campaign is far from state of the art. Advertising agencies are currently making increasing use of psychoanalytic techniques. They now assemble 'focus groups' with characteristics - age, sex, region and income - similar to their target markets and psychoanalyze these potential customers. A manufacturer of roach killer was distressed when customers continued to use sprays instead of their product, in which roaches would enter a plastic receptacle and die quietly. The entire receptacle could be discarded without any need to sweep up or even see the dead roaches. It was thought that this would appeal to women, who were presumably squeamish about using the sprays. So their advertising agency, McCann-Erickson, put together a focus group:
To try to understand this contradiction, the researchers asked the women to draw pictures of roaches and write stories about their sketches. What McCann-Erickson hoped to do was probe the women's subconscious feelings about roaches. Before advising a client on developing a new insecticide, the agency wanted to know how people really relate to roaches.
According to Paula Drillman, the agency's director of strategic planning, the roaches in the pictures were all male, symbolizing men who the women said had abandoned them and left them feeling poor and powerless. "Killing the roaches with a bug spray and watching them squirm and die allowed the women to express their hostility toward men and have greater control over the roaches," Ms. Drillman says. [13]
Price Discrimination Why sell everyone your good or service at the same price? A firm can increase profits if it can separate its markets. Airlines are the classic example. Sell business fliers seats at high prices, since their demand is highly inelastic. Sell seats to tourists, who will only fly if the price is right, at a lower price. The trick is to design restrictions which will keep business fliers from getting tickets at the tourist price.
Airlines call the art of setting air fares "yield management." Critics call it "the dark science." American Airlines, widely regarded as the most sophisticated practitioner of this art, has a staff of 90 "yield managers" linked to five mainframe computers. They program the "mix" of discount and full fare seats on flights as far ahead as 330 days and as soon as right up to two hours before boarding. They know, for example, that business flyers take a lot of Friday afternoon flights but do not book them until the last minute. So American does not offer very many discount seats on those flights. That is why the tourist may try to book a particular flight months in advance only to be told it is full - it isn't really full; the airline is holding the seats for its later expected bookings at full fare or smaller discounts.
American Airlines Vice President of Pricing put it this way: "You don't want to sell a seat to guy for $69 when he's willing to pay $400." [14]
Another example of price discrimination is Del Monte selling canned goods under its own name at one price and with supermarket labels at a lower price. Price discrimination is such a common practice that it has many names: dual pricing, class pricing and market segmentation are among them.
We have now had over a century of experience in crafting public policies that limit the power of oligopolies. Yet we still have not resolved the problem of size itself. One direction taken by antitrust law has been to outlaw anticompetitive practices. Another, less certain, direction has been to prevent the development of industrial structures that could potentially inhibit competition.
Had the United States waited until the 1930s to restrict the anti-competitive activities of business, we would probably have called our laws antimonopoly laws. But the first major piece of national legislation was passed at the height of the era of trusts, consequently we still use the term antitrust law.
The Sherman Antitrust Act (1890) made it illegal to "monopolize trade" and outlawed "combination or conspiracy in restraint of trade." Most of the trusts simply changed their legal structure. When a single company produces most of the output of an industry there is no need to conspire to set prices. Judges often used the Sherman Act against labor unions. [15]
Right up to the present the key question has been whether or not size itself is anticompetitive. Standard Oil and American Tobacco Company were broken up in 1911, but this was due more to the anticompetitive practices of these firms rather than to their near-monopoly structures. In these cases, the Supreme Court developed the rule of reason doctrine. The Sherman Act would henceforth be applied to unreasonable restraints on competition - that is - the actual and provable use of specific anticompetitive practices. Size and market share would not normally be sufficient cause to break up a firm when a firm grew on its own. But there have been exceptions. In 1945 Alcoa, which had a 90 percent share of the aluminum market, was broken up even though there was no evidence of anticompetitive practices and Alcoa had grown through its own expansion rather than through merger and acquisition.
On the other hand, the Sherman Act will often be invoked when a firm attempts to gain market share through acquisition rather than self-propelled growth. For example, there would be no antitrust problems if Microsoft's personal-finance software were to gain an overwhelming market share (unless Microsoft used predatory pricing or other anticompetitive practices to gain that market share). However, when Microsoft tried to acquire Intuit for $1.5 billion in order to get Quicken, the dominant personal-finance software, the Justice Department's antitrust division announced that it would review the proposed acquisition. Microsoft backed out.
The Clayton Antitrust Act (1914) outlawed specific anticompetitive practices. Among these were tie-in contracts and interlocking directorates. A tie-in contract is forcing a consumer to purchase something when the consumer buys another product. The - now prohibited - former practice of local phone companies requiring the customer to rent the phone itself in order to be able to buy phone service is a tie-in contract. An interlocking directorate occurs when the same individual sits on the boards of directors of competing corporations - the same person could not be on the boards of directors of both Ford and General Motors, for example. The Clayton Act also exempted labor unions from the antitrust laws.
The Federal Trade Commission was also established in 1914 and given a role in the enforcement of antitrust legislation. But there are still no clear lines separating its authority and responsibility from that of the antitrust division of the Justice Department.
Popularly known as the "Chain Store Act," the Robinson-Patman Act (1936) attempts to protect small retailers from large chains that might be able to force suppliers to sell to them at exceptionally low prices. Suppliers' discounts are prohibited except where they are based on cost differences or competitive pressures.
One recent case under Robinson-Patman was set into motion when a clerk at Avon Books accidentally sent B. Dalton's invoice to Cody's Books, an independent bookstore in Berkeley, California. The invoice revealed that Avon was granting a 4% discount to chain stores. The Northern California Booksellers Association filed a suit in 1982 against the Hearst Corporation, owner of Avon Books, claiming that Avon had been extending "secret and preferential discounts" to Waldenbooks, B. Dalton and Crown. Avon argued that the practice was justified by the lower costs of bulk selling and that they had to meet competition from other publishers -both of these reasons would be "escape clauses" under the Robinson-Patman Act.
While Avon claimed that it had to maintain an expensive sales force in order to sell to the independent booksellers the booksellers counterargued that the salespersons were a "non-necessary cost," and that they could do most of their ordering through catalogues.
The judge agreed with the independent booksellers, calling the sales representatives "only marginally useful." The judge also noted the secrecy of the policy and the fact that Avon did not put the policy into writing until three years after the suit was filed. He found that Avon "did not have any objective criteria for granting discounts but did so in response to pressure from the chain stores." [16]
The Reagan administration neglected the enforcement of antitrust legislation, except where there was evidence of price-fixing. Arguments for neglect include growing foreign competition that is eroding the power of traditional oligopolies (the auto industry, for example). Large U.S. firms also claim that they need to merge in order to compete with large Japanese and European competitors.
Conservative economist Gary Becker presents the case for limited use of antitrust laws:
Conspiracies in restraint of trade tend to break down eventually without an active antitrust policy. Companies that are part of a conspiracy cheat on their output quotas, and high prices attract new companies into their industry...
...Competition will weed out inefficient behavior without government intervention. Antitrust action should only challenge behavior that obviously encourages collusion, such as agreement among rival producers to divide a market into exclusive territories.
The stiffest challenge to a domestic conspiracy often comes from foreign producers. Competition in the U.S. market for cars and steel increased when Japanese and other foreign companies became important players. Since domestic producers try to use their political clout to reduce foreign competition through tariffs or import quotas, an open trade policy is as valuable as antitrust laws in the fight against collusion and anticompetitive behavior. [17]
The increasing globalization of the economy has revealed the weaknesses inherent in national governments attempting to enforce antitrust laws. Many antitrust issues cross national boundaries. The U.S. Justice Department recently lost a case in which they prosecuted General Electric for conspiring with De Beers to fix the prices of industrial diamonds. De Beers does not have offices in the United States and was out of reach. The larger problem, according to Assistant Attorney General - and chief U.S. antitrust enforcer - Anne Bingaman, was that critical documents and witnesses were also out of reach.
A U.S. case against British glass maker Pilkington P.L.C. was more successful. Pilkington was shutting U.S. firms out of numerous markets abroad. Still, prosecution of this case was dependent on the cooperation of foreign, particularly British, antitrust officials. [18]
In some industries, rapid structural and technological change makes antitrust regulation a moot point. Major antitrust cases can take years while some industries seem to reinvent themselves almost overnight. Overwhelming market shares in critically important industries would seem to make Microsoft and Intel antitrust enforcement targets. Recently, the Justice Department was widely criticized - particularly by Microsoft's competitors - for its settlement of complaints against Microsoft. But a consent decree is immediate and a court case that would certainly work its way to the Supreme Court would take years. Breaking up Microsoft would definitely be to the benefit of Microsoft's competitors. But would it benefit software customers?
The dangers are in the future. As long as Microsoft and Intel reinvent computer operating systems and microchips every few years, they are acting as if they face serious competition. But if either or both of them begin to rely on their dominant market shares and fail to improve the product - rather like the U.S. automobile industry in the 1960s - then consumers will feel the damaging effects of economic power.
The growth of oligopolies has also sent economists back to our drawing boards. Perhaps there are economic forces, in addition to the legal forces of antitrust laws, that limit the power of large firms. Potential, rather than actual, competition might play a role. This idea comes to the forefront in Joseph Schumpeter's theory of creative destruction. Or the oligopolists might face equally powerful suppliers and/or customers. This idea is the core of John Kenneth Galbraith's theory of countervailing power. Or, possibly, the professionalization and bureaucratization of management channels the power of large firms into product development and growth rather than simply exploiting their power through higher prices. This is embodied in the concept of a management technostructure, also from Galbraith.
Joseph Schumpeter took his fellow economists to task for defining competition far too narrowly. This led us to see only the least important forms of competition and to miss entirely the way the firms seize significant strategic advantages over their competitors:
The first thing to go is the traditional conception of the modus operandi of competition. Economists are at long last emerging from the stage in which price competition was all they saw. As soon as quality competition and sales effort are admitted into the sacred precincts of theory, the price variable is ousted from its dominant position. However, it is still competition within a rigid pattern of invariant conditions, methods of production and forms of industrial organization in particular, that practically monopolizes attention. But in capitalist reality, as distinguished from its textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization (the largest-scale unit of control for instance) -competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives. This kind of competition is as much more effective than the other as a bombardment is in comparison with forcing a door, and so much more important that it becomes a matter of comparative indifference whether competition in the ordinary sense functions more or less promptly; the powerful lever that in the long run expands output and brings down prices is in any case made of other stuff. [19]
You may dominate your present market, Schumpeter warns the oligopolist, but you will always face competition from unexpected sources. An oligopolist who overcharges or fails to innovate will eventually be out of business. Douglas had a near monopoly of propeller-driven commercial aircraft but it was upstart Boeing that created the commercial jet industry while destroying the older industry. Gustavus Swift invented the modern meatpacking industry, but his heirs missed the changing land cost patterns that gave Omaha meatpackers a strategic advantage over Chicago packers. The steam locomotive manufacturers failed to make the transition to diesel and the major radio tube manufacturers (GE, RCA) failed to anticipate transistors and microchips.
Big firms will either innovate or die. Some will build innovation potential into their structures - through large research and development programs, for example. Others will simply keep an eye open to new trends and jump on bandwagons that get established by smaller firms (for example, IBM following the leadership of Apple and Tandy and jumping into the desktop computer business). Those big firms that do neither will become industrial dinosaurs.
American economist John Kenneth Galbraith launched several penetrating criticisms of the standard view of oligopoly. If oligopoly really led to high prices and a lack of innovation, asked Galbraith, why has the industrial world enjoyed an increasingly rapidly-flowing stream of new products even while economic concentration is increasing?
When we look at gigantic firms from the perspective of the lone minuscule customer, we only get part of the picture. But even such a giant as General Motors is subject to countervailing power. Much of this is in the form of other large firms which GM encounters as suppliers and customers. General Motors purchases steel and tires from other oligopolies. It borrows money from megabanks. It sells many of its vehicles to powerful rental agencies, corporate fleets and government agencies. Most of the rest are sold to an increasingly well-organized and well-capitalized network of dealers. According to Galbraith, power breeds power. We can see this today in the ongoing organizational changes in the automobile sales business:
United Auto sells 22 brands, from Jeeps to BMWs. Business is booming at the fast-growing 41-franchise chain, and Spielvogel says he may take it public.
That possibility, more than anything else, may pose the biggest threat to the status quo. With his limited resources, the independent dealer has been locked in an uneasy standoff with Detroit. A national chain able to sell shares to the public could achieve the kind of clout that has allowed Wal-Mart to dictate terms to its suppliers and to obtain huge advantages over its smaller competitors. [20]
The actions of government have often served to create other centers of countervailing power. Ever since the National Labor Relations Act (1935) and the spectacular sit-down strikes of 1937, GM has negotiated the terms and conditions of employment of blue-collar workers with the United Auto Workers. Government agencies that were formed to protect the environment and assure workplace safety also help hold GM's power in check.
The major problem from oligopolies, Galbraith argues, comes where their immense market power intersects with the powerless small-business sector. They should really be viewed as two separate economic systems: a 'planning system' in which prices are set by negotiation and a market system in which prices are set by the familiar forces of supply and demand. In the beef industry, four meatpackers oligopolize 85% of the market. But they purchase their beef from 44,000 feedlot operators, who, in turn, purchase cattle from 911,000 ranchers. In 1994, the largest meatpacker, IBP, enjoyed a margin of $26.50 per steer even while the feedlot operators lost $38.00 per head. [21] A similar scenario is playing out in the clothing industry. Recent mergers of department stores have increased their power vis-à-vis the much smaller manufacturers of fashionable clothing. The department stores demand special packaging, delivery days and even particular ways of placing the clothes on hangers. They even fine their suppliers when these conditions are not met. The small clothing makers prefer to sell to boutiques, but these smaller stores are rapidly disappearing. [22]
The traditional method of coping with such inequities is to turn the antitrust investigators loose on the packers to see if they are manipulating cattle prices. In fact, the antitrust division of the Department of Agriculture is doing just that. But Galbraith's theory suggests a different approach. Fight power with power. Instead of trying to break up the powerful, a never-ending and usually fruitless endeavor, we could empower the powerless. Let the feedlot operators form a marketing board and negotiate the price of cattle with the packers. When senate hearings in the early 1930's publicized the abuse of workers by large firms we didn't break up the large firms - we passed the National Labor Relations Act which allowed workers to confront these firms with their own collective power.
Additionally - in The New Industrial State (1967) - Galbraith claims that innovation in the modern economy requires the resources of a large firm. The firm must in fact be large enough to be sort of a planned economy in itself. Before it can make an irreversible commitment to the specialized capital equipment that modern production demands, the firm must know that it will have both the workers and the customers that it will need far into the future.
Moreover, the bureaucracy of experts and specialists, which Galbraith calls the technostructure has a different set of interests than the stockholders. The technostructure enhances its own power through the growth that comes from successful innovation; thus growth, not short-run profits, becomes the real bottom line.
Note that even in a world of innovative big firms held in check by their equally oligopolistic customers and their powerful unions, we still have to keep our guard up - since corporate power to manipulate consumers and to impose corporate values on modern society is growing.
There is no question that taking a global - rather than national - view makes the industrial landscape look much more competitive. And there is no question that this global vision must affect our antitrust policies. But it is possible that we are merely enjoying a temporary respite from the curse of oligopoly.
If there are still advantages to bigness, it is likely that these advantages will not stop at national borders. A strictly national picture of the automobile industry shows us the 'Big Three' with dangerous levels of economic power. A global view shows us the big ten instead, and market power is much less worrisome.
Shall we than relax our antitrust enforcement? Should we let Toyota buy Chrysler? Or let Ford merge with Fiat? Perhaps by 2010 there will once again be a big three.
Yet there are also technological and social forces leading in the other direction. Some optimistic observers of modern technology - we might call them the techno-utopians - claim that the advent of the desktop computer has given a new impetus to small business. The instant availability of information and independent ability to examine and process information may be undermining the dominance of the technostructure. Mere manufactured products may become commodities. IBM launched a successful series of desktop computers, but was not able to hold its market share as small shops began to assemble them out of standardized components. Ideas are the only 'commodities' with lasting value, and our new technologies might allow ideas to proliferate outside of the large corporate management structures.
It is too early to tell if the techno-utopians are correct on the scale effect of computer technologies. Similar predictions were made over 100 years ago when the electric motor began to replace the steam engine in factories. [23]
Starting about 1870, capitalism underwent a sea change. New technologies of production began to increase productivity at an increasingly rapid rate. But these same technologies required a major shift in the scale and form of capital itself. The minimum size of operation required for efficiency increased more than 50-fold in many industries. Moreover, operating at this scale required massive investment in fixed capital. The positive side of this was vastly reduced costs of producing steel, transporting goods and even manufacturing such basic goods as rope and sugar. The negative side was that ruinous price competition could last for years. Once built, these factories would continue to be used as long as the price was high enough to cover operating costs.
The solution was for firms to become even larger than dictated by technology alone - large enough to avoid price competition. Oligopoly is a compromise between society's interests in assuring that firms continue to improve products and production processes and the capitalists' interest in making a profit. Antitrust laws have been used to keep oligopolies from becoming monopolies, and to put some limits on their market behavior. Actual agreements to fix prices, for example, are strictly outlawed. There are also other economic forces at work to constrain the power of oligopolies. Even the most powerful of firms are at risk of creative destruction as a new product or production process renders them obsolete. Powerful firms must also face the countervailing power of large suppliers, unions and customers.
At the present, the growing globalization of many markets has limited the power of national oligopolies. In the U.S., for example, we once spoke of the "Big Three" of the automobile industry. During much of the 1950s and 60s the big three behaved almost like caricatures of the "lazy oligopolist." Since then, however, competition from Japanese and European auto firms has revitalized that industry. Perhaps we should just enjoy the competition while it is here. The likelihood is that our current bout of global competition can only provide temporary relief. Within ten to fifteen years we may well see a well-evolved structure of global oligopoly, with three or four firms dominating most global markets.
Economic Theory - Economics Explained, Chapter 16, "A Look at Big Business."
Economic History of the United States - The Economic Transformation of America, Chapter 8, "The Age of the Businessman," Chapter 9, "The Technology of Industrialization," Chapter 10, "From Trust to Antitrust."
Economic History of the Western World - The Making of Economic Society, Chapter 6, "The Change in Market Structure" ; Economic Development of the North Atlantic Community, Chapters 20-23.
Vanderbilt University maintains a net site on antitrust policy. It contains news commentary on antitrust cases, economic and legal research, and status of many current cases. There are also links to other antitrust sites.
U.S. Supreme Court cases on antitrust issues can be found at a site maintained by Saint Olaf College.
The Antitrust Division of the Department of Justice and the Federal Trade Commission both have antitrust enforcement roles.
You can explore antitrust enforcement in Canada at the Industy Canada page.