The Market Cops

Transaction costs are only one reason that real prices typically remain above the marginal cost of production. The rarity of perfect competition also plays a role. In many industries, a small number of sellers exhibit a fair degree of power in setting prices.

Oligopolies are markets dominated by a small number of large sellers. Oligopolists generally know a great deal about their competitors’ iden­tities and behavior. Because they can observe each other’s production, prices, marketing, etc., they also can send each other subtle (or at times, not so subtle) signals. An oligopolist, for example, might try to raise his prices. His competitors can either match the increase so that everyone earns a higher profit on each item sold, or keep their prices low and steal his customers. But they know that if they take the second route, he’ll cut his price and win back his customers. So they decide—quite rationally— to match the price increase. If the market had many vendors, someone would eventually bid the price back down toward marginal costs, but in an oligopoly market, prices can stabilize above costs; oligopolists can thus extract “rents” above competitive profit levels from their many small customers.

Contemporary IO models the interactions among oligopolists as games. Game theorists recognize that when the same players repeatedly show up to play the same games, they learn something about each other and about the game. The players learn how to signal each other—and how to interpret the signals that they receive. Such signals often convince oligopolists to “meet” a price increase “suggested” by a competitor. Two different names describe this behavior: conscious parallelism (a neutral­sounding term) and tacit collusion (which definitely sounds negative).

But oligopolists are hardly in the best possible position to exploit their customers fully, because truly disgusted customers always have other choices. Maximum exploitative power requires the elimination of all pos­sible alternatives. Monopolies are markets with only a single seller. All that a monopolist has to do to extract rents is raise prices. No signal, no response, no delay, no risk. After all, the customers rave nowhere else to go. Their only other choice is to “do without” and exit the market. From the monopolist’s perspective, the downside of high prices is that every price increase chases away some consumers and reduces sales volumes. At some point, the volume reductions will be great enough to make the price increase unprofitable; the monopolist is then better off making a smaller per-sale profit on a larger sales volume.

Monopolists also worry about the threat just over the horizon. Markets populated by disgruntled consumers paying exorbitant prices for shoddy products in order to generate consistent obscene profits for an unpopular incumbent monopolist must look attractive to someone. Eventually someone would see this market as an opportunity. This threat is often enough to convince the incumbent monopolist to temper its behavior—if for no reason other than to avoid “inviting entry” of a new competitor.

Most people other than devout antitrust priests find it hard to swallow that this crass exploitation of the consuming public by an incumbent monopolist is perfectly legal.³ Monopolists who defeat their competitors using nothing more than a legal combination of product quality, savvy marketing, and dumb luck can then turn around and extract whatever rents consumers are willing to pay.

Fortunately, most markets aren’t prone to monopolization. IO studies the relationship between a market’s basic characteristics and the struc­ture that emerges as it matures.

New entrants also may have to sink costs to attract customers. In many settings, consumers have sunk their own costs buying their existing equipment and learning how to use it. An entrant who expects to induce consumers to switch to his new product will have to compensate them somehow. Such “switching costs” also form a barrier to entry that can help maintain a durable monopoly. Once again, it’s perfectly legal for a monopolist who finds herself protected by such barriers to exploit consumers—as long as the barriers are “natural” artifacts of the market, and not artificial constructs that the monopolist devised to protect her own profits. And therein lies the fourth key: monopoly rents can only be as high as the barriers to entry.

This spectrum of market structures, from perfect competition through concentrated oligopoly to unitary monopoly, frames the IO view of the world. Players in these different types of markets interact in different ways. All of the interactions discussed so far are legal—even if some are unpalatable. But oligopolists have opportunities that competitive firms lack, and monopolists possess even broader opportunities than that.

Sometimes their behavior crosses the line from smart-and-legal into illicit cheating—say, by creating artificial barriers to entry to inflate their rents. Such behavior disrupts the natural flow of the market. Only legal inter­vention can correct it.

Such necessary intervention is squarely in the realm of antitrust law. Modern antitrust adheres to the consumer welfare standard captured by a somewhat idealized market dynamic: Because monopolists earn the largest possible profits, every seller in every market would like to become a monopolist. The profit motive tells us that. But a competitor only can become a monopolist by winning customers away from its competitors— and the only way to do that is to offer the best, least expensive, most desirable products on the market. Thus, the greater the competition, the greater the race to improve the product. Such races serve the best inter­ests of consumers and reward the most efficient producers.

These races also highlight the futility of trying to cheat in a competi­tive market. A seller who offers an unattractive combination of price and quality will lose potential customers to a competitor striving to become dominant. Markets of this sort are essentially self-policing. Market forces push producers toward both greater efficiency (i.e., cost reductions), and appropriate pricing. As a result, antitrust law isn’t much concerned with behavior in competitive markets. Attempts to cheat tend to be suicidal. The winners in a competitive market are the producers whose products best reflect a fair combination of price and quality.

As these efficient producers grow, inefficient competitors shrink and eventually disappear; in some industries, the market may dwindle to few enough players to qualify as an oligopoly. Prices in an oligopoly market, as noted above, tend to be higher than they would be in a competitive market, thanks to signaling. But some oligopolists might notice that sig­naling is awkward and inexact. They may come up with a better way to raise prices. Why not just collude? Why not, to put the matter bluntly, work together as a CARTEL!

The truth is, there’s no internal reason not to take this approach. At least, the basic rules of capitalism suggest that this approach is highly rational; it allows sellers to reduce product quality, increase price, and follow the dictates of their internalized profit motives. Cartelization is great for cartel members. Only consumers lose. Left to the brutal nature of the marketplace, consumers would have no protection from cartels— other than to rely on human nature and to wait for the cartel members to begin cheating on each other. This sort of internal dissent happens all the time in cartels. OPEC and the world oil market provide a high-profile case in point. OPEC members periodically get their act together and drive up oil prices. Eventually they all start to cheat, and prices fall. Cartel theorists recognize that this sort of behavior is endemic, and that rela­tively few oligopolies really lend themselves to stable cartels. But cartels need not be long-lived to be destructive; OPEC’s 1973 embargo sent the global economy into a tailspin in less than a year.

So consumers need more than the basic rules of economics to protect them from rational oligopolists. At times, they also need the market cops, who have two big guns—the Sherman Act and the Clayton Act—and a couple of smaller, less important ones. The market cops watch for four types of particularly suspicious behavior: oligopolists behaving as if they were a cartel, oligopolists trying to merge to become something closer to a monopoly, monopolists trying to leverage their monopolies into competitive parts of the market, and monopolists constructing artificial barriers to protect their monopoly positions.

Our market cops thus restrict most of their antitrust inquiries to oli­gopoly and monopoly markets, and they generally scrutinize the behav­ior of monopolists more closely than that of oligopolists. After all, whatever incentive an oligopolist might have to collude with competi­tors, form a cartel, and exploit consumers, the monopolist has in spades. And because the monopolist doesn’t need to coordinate her behavior with her competitors, monopolies are much more stable. In fact, without the market cops looking over the monopolist’s shoulder, she has few limits on her power—particularly if she monopolizes a product that con­sumers consider to be essential and that’s protected by high barriers to entry.

In its few short years of existence, the information sector has demanded a fairly active police presence—largely, though not exclusively, concerning the behavior of an unruly young monopolist accused both of leveraging its platform software monopoly into previously competitive markets and of constructing barriers to prevent the introduction of competing platforms. But before examining Microsoft, we should think about monopolies in general. Antitrust law recognizes that even a legal metamorphosis from competitor to monopolist changes incentives and behavior. A monopolist has two basic goals—neither of which is to provide top-flight product value. First, a monopolist must make sure that consumers continue to want its products. Second, a monopolist must make sure that no new competition emerges to challenge its monopoly. One approach might be to continue to release better, cheaper versions of the monopolized product. But that approach is both difficult and risky; it requires investing in research and development that might fail. A variety of other approaches are also possible—few of which actually benefit consumers. Monopolists could attempt to sign large numbers of exclusive contracts, threaten distributors who carry a new entrant’s competing products, introduce secret product features that make their monopoly products incompatible with competitors’ products, bundle monopoly products with new innovations that had previously been sold in competitive markets, etc. In other words, monopolists have an incen­tive to create artificial barriers to entry that protect their profit streams.

These barrier-creating techniques raise some of the toughest issues in antitrust analysis. After all, there’s nothing inherently wrong with exclu­sive contracts (the only thing that makes franchising possible) and integrated products (an important way to design and deliver product improvements). As a result, market cops must be trained to differentiate between good and bad uses of select business practices.

Antitrust is thus a highly context-specific body of law. A few activities are always prohibited, known as the “per se offenses.” Everything else is evaluated on a case-by-case basis, or “subject to the rule of reason.” Most antitrust analyses begin by identifying market structure. If the market is competitive, self-policing market forces provide all the discipline that we need. In oligopoly markets, the matter is less clear. Oligopolists receive greater scrutiny than do out-and-out competitors because it’s possible though difficult for them to cheat. Monopolized markets are rarely self-correcting; cheating is often not only possible, but also easy, which is why market cops spend so much time scrutinizing monopolists’ behavior. While the status of being a monopolist is hardly illegal—and may prove a history of superior product development— monopolists have both the ability and the incentive to cheat the market and to exploit consumers. The only way to balance these incentives is through the law. And therein lies the fifth key: the more concentrated the market, the more important it is to maintain an active police presence.

We’ve now collected five keys to information economics: digital prod­ucts should all be free; the information sector reduces transaction costs; middlemen will fight against information technology to reimpose trans­action costs; monopoly rents can only be as high as the barriers to entry; and the more concentrated the market, the more important it is to main­tain an active police presence. These keys, while general and applicable to all of the economy’s sectors, are particularly important when unlock­ing the mysteries of network economics.