Economics of public policy

Monopolies and Trusts:

Appropriate Areas for Government Intervention?

Capitalism is the economic system that has dominated the United States virtually since the day of its independence. A social and economic system based on the recognition of individual rights; capitalism demands that owners' rights to control, enjoy, and dispose of their own property must be respected. In a capitalist system, the purpose of government is to protect individual economic rights, and to make sure that no one individual, or group may employ physical or coercive force upon any other group or individual. The success of capitalism is well evident. The surpluses that this system produces have enabled individuals to experiment; to create new products, and market new ideas. These private surpluses are traded in a free market in direct competition with other buyers and sellers. Such competition is best represented by the efforts of two or more parties acting independently to secure the business of a third party by offering the most favorable terms. Where competition exists in a market place, there exists a rivalry between the different sellers for the business of potential consumers. This brand of competition has improved our economy as a whole, and has created in capitalist nations, a higher standard of living than is to be found elsewhere. It has permitted the efficient and free allocation of resources; a considerable amount of innovation and technological advancement, as well as a timely and effective response to consumer needs and preferences. With so many benefits we would fear to risk the destruction of competition that any dismantling or inhibiting of the Capitalist system would entail.

Yet a monopoly is a threat to this competition, and to the natural structures of the marketplace. A single seller of a product controls the entire market for that product by ensuring that there are no substitutes for that product. In a monopoly, there is no competition; trade is as completely constrained as if it that trade were subject to the most stringent government laws and regulations. Monopolies are illegal in the United States. They are illegal because it is believed that they deprive consumers of the benefits of technological innovation, and set prices above the natural level of market equilibrium. Down through the years, monopolies have in fact been controlled in many different ways, the most common approach being through government antitrust laws. Antitrust laws such as the Sherman Act, the Clayton Act, and the Federal Trade Commission Act, are all designed to prevent the formation of monopolies. In case after case, these antitrust provisions have been used against monopolists: the railroads, Standard Oil, and Alcoa. Many believe that it was only through the strict application of these antitrust measures that free market competition was preserved. According to this view, government must continue to intervene in the interests of all.

Nevertheless, others oppose just this sort of government invention, believing its the worst poison that could befall any free market economy. Government, so they say, is the only true source of monopolic power. It is their conviction that antitrust laws support, create, and protect the very monopolies they were meant to prevent and dismantle. This paper will review these classic arguments, endeavoring to discover whether the antitrust laws were properly applied and enforced. We shall consider both sides of the issue, and in so doing, determine if indeed antitrust laws represent the nest possible official policy, or if they in fact create the very situations they were designed to prevent.

B. Philosophical/Constitutional Issues

Prior to the Civil War, Americans feared to allow their government too much arbitrary power. As government was the only entity possessed of the power to compel absolute obedience, it was not considered possible that private business might exercise anything like this kind of total authority. These views, however, changed immediately after the Civil War with the coming of age of the railroad industry. While in reality, the railroads did not possess any legal powers of coercion, to ordinary individuals, they often appeared as powerful and intractable as the government itself. Indeed, the farmers of the West saw railroads as intrusive forces possessed of almost limitless power; the kind of power they believed was proper and appropriate only to the federal government. To these farmers, the railroads seemed to be interfering with the laws of competition. They seemed to be able to charge just enough to keep farmers in seed grain, but not otherwise permit these same farmers to enjoy a profit. Yet it is our belief that the Western railroads were monopolies not because of the unrestrained activities of the marketplace, but rather because of governmental subsidies, restrictions, and other interference. Believing nonetheless, that they were victims of a marketplace run amok, the farmers protested, their protests eventually taking the form of the National Grange movement. Their persistence was to pay off in the form of new federal legislation, the Interstate Commerce Act of 1887. This was followed by the Sherman Act in 1890. The rational for these two major acts remains today -- that, if left unregulated, the marketplace will become a tyranny worse than that of government intervention.

These antitrust laws were passed to halt the spread of monopolies and to restore competition to the market economy. Many supported these antitrust laws, while many opposed them. As to the source of their power to regulate in matters of the marketplace, Legislators point to Article One Section Eight of the United States Constitution: "The Congress shall have the power to . . . regulate commerce with foreign nations and among the several states ...." (Constitution) We had already seen legislative exercise of this right in such cases as Munn vs. Illinois in 1877. Munn, and also Scott, were business partners who owned a private grain-storage facility. These two men argued before the Supreme Court that nothing could compel them to make their rates public, or to obtain a license from the state, or to abide by government-fixed price limits. The majority on the Supreme Court disagreed, declaring that private property, if used for the benefit of the public, is subject to public -- and thus governmental -- control. In the words of Chief Justice Waite, "[Such properties] must submit to be controlled by the public for the common good." (Armentano) The supporters of antitrust laws believed that if left alone monopolies would occur naturally in any free market, thereby slowing the process of innovation. They believed that monopolies would charge high prices, misallocate resources, take away jobs from the people, and pay them lower wages. Hilaire Belloc once said, "The control of the production of wealth is the control of human life itself."(Armentano) The Sherman Act of 1890 was the first of the antitrust laws. Its sole philosophical purpose was to prevent monopolies and free up competition.

But from a Natural Rights perspective antitrust laws are seen as more conservative than progressive. Believers in Natural Rights hold that antitrust laws are an outrage, and that they strip away private property rights. It is their firm belief that individuals possess as inalienable rights, the rights to life, liberty, and property, and that any individual can enter into any non-coercive trading agreement on any terms, to produce and to trade any good or service that he or she owns. Anyone has the right to use his or her property in any way he or she sees fit, so long as such usages do not infringe on the rights of any other individuals to the full enjoyment of their own property. Our Founding Fathers were followers of Adam Smith, whose monumental work, the Wealth of Nations appeared at the time of the American Revolution. Adam Smith opposed government restrictions on production and trade because he believed that to hold down capital gains, retarded the growth of a nation's wealth and was damaging to the general welfare. As well, Jeremy Bentham and the Philosophic Radicals believed "that interests reflected in the private, selfish economic activities of individuals were harmonious, and created a stable economic system ...." They supported free market capitalism because it provided the greatest good to the greatest number." The Philosophic Radicals rejected government intervention because they believed experience had shown that the benefits of this intervention rarely exceeded its costs.

C. Sources of Monopoly

According to Robert H. Frank, in his text book Microeconomics and Behavior, 5th Edition, there are five different sources of monopoly. The first source consists of the exclusive control over important inputs, or the condition wherein a seller has complete control over the supply of a product, as for example DeBeers' control over the supply of mined diamonds. Economies of Scale are another source of monopoly. Economies of Scale exist when, given fixed input prices, the long-run average cost curve is downward sloping. In this case it is always cheaper to serve the market by having one firm producing the product. Patents are issued by governments for the purpose of protecting intellectual property rights. By protecting these intellectual property rights, they encourage invention as the holder of the patent -- in this case the inventor -- is permitted, for a fixed period of time, the sole enjoyment of any profits arising from his invention. Yet in the case of patents, there are both costs and benefits. On one side the cost creates a monopoly and usually leads to higher prices for the consumer, however, without patents we would doubtless not have seen many of the great inventions of history. Patents increase prices above marginal cost and speed up the pace of innovation. The protection from competition that is created by the patent allows firms to recover the costs of research and development; the costs of innovation. Network Economies are also established. In a Network Economy, a product becomes more valuable over time as it is used by greater numbers of consumers. One great example of a Network Economy is Microsoft's Windows operating system. This sytem enjoys a dominant position in the market. Lastly, a source of monopoly power is to be found licenses governments issue to franchises, thus preventing by law, any but a government-licensed firm from engaging in this particular business. Strict regulations and high fees for obtaining a license are common features of this arrangement. These fees and strict regulations are extremely costly, and are usually transferred to the consumer by way of premium prices.

In a monopoly, there is no supply curve because monopolies are the price maker and not the price takers they would be in a competitive market. Demand is downward sloping and the monopoly price is set above the equilibrium price. High prices discourage consumers from buying more products. For the monopolist to continue to sell larger and larger amounts of his product, prices must be cut back. The monopolist who continues to sell above the natural price equilibrium will experience a dead weight loss, as well as a loss in potential profit. In the long run if monopolies maintain sales at the same monopoly price they will forfeit consumer surplus, and lose potential revenues. Instead, what monopolies usually do is to use price discrimination. Price discrimination occurs when the monopolists charges different prices to different buyers in order to maximize his own profits. By employing a program of price discrimination, the monopolist would be able to withstand a fall in demand, and still make a profit. However, it is very difficult to practice perfect price discrimination because sellers generally lack the necessary information to determine how individuals understand the demand curve. Thus, no matter what a monopoly does over the long-term, it will see a loss in consumer surplus. Prices will eventually go back down to the level of market equilibrium. The only difference is that there will exist a deadweight loss not found in the competitive market:

PP

Profit

Profit

Pm Loss

Pe Dead Weight Loss

Q Q

Monopoly Staying at monopoly prices Price Discrimination

D. Specific Cases

The modern petroleum industry began in 1846 with the discovery by Dr. Abraham Gener that kerosene drawn off during the petroleum distillation process could be sold and used as an illuminant. Lamps that burned kerosene could replace those that burned expensive and unpleasant smelling whale oil, and other natural illuminants. Many tried to take advantage of this new market. Yet, from out of this welter of entrepreneurs came John D. Rockefeller, a successful twenty-three-year-old. By 1868 Rockefeller had already turned his attention to his soon-to-be-famous 'penny-pinching' techniques. Instead of buying oil from jobbers, he hired these same jobbers to get oil for him and his company. Rockefeller began to build storage facilities, and coaxed more kerosene from barrels of crude than others had been able to obtain. He made money even out of the residues of the petroleum distillation process. Once discarded, these substances were now marketed as lubricating oils, the most famous of which was Vaseline. His men also invented gasoline, and manufactured tar, and paint. Becoming more innovative, he began to build his own oil tankers. These oil tankers hooked up directly with the train lines, thus saving the expense of putting the oil into barrels, and first loading them onto the trains prior to shipping. After a while, he decided to dig his own pipeline in order to further speed up transportation, and reduce the costs involved in shipping oil such large distances by train. By 1870 the company he had founded had become the biggest refiner in the city of Cleveland. Still, Rockefeller's share of total refined output was no more than four percent. The existence of as many as two hundred fifty other independent refiners ensured an average price of twenty-two cents a gallon. As 1890 approached, the market price of oil dropped to about eight cents per gallon. The number of independent refiners had fallen to one hundred four, and Rockefeller's market share had risen to an astonishing eighty-eight percent!

It was during the period of 1880-1895 that john D. Rockefeller's Standard Oil resurrected an old common law arrangement known as a "trust." A trust consists of individuals who pool their property, while at the same time agreeing to appoint a trustee, or trustee group to manage that property in the interest of all the owners. While very successful for Standard Oil, Rockefeller's trust inflamed the hatred of competitors and of the public. They blamed him for being unfair, and for driving other firms out of business. Ida Tarbell, sister of William Tarbell, Treasurer of the Pure Oil Company, theorized that Rockefeller made use of predatory pricing. Predatory pricing is a technique wherein a firm deliberately undersells its competitors with the intention of driving them out of business, after which it then restores prices to their former levels -- this is a classic monopolistic technique. In 1909, Standard Oil was convicted of violations of the Sherman Act. The presiding judge in the case, Judge Hook, explained that "A holding company owning the stocks of other concerns whose commercial activities, if free and independent of common control, would naturally bring them into competition with each other is a form of trust or combination prohibited by section one of the Sherman Act. The Standard Oil Company of New Jersey is such a holding company." (Armentano) The Standard Oil Company appealed to the Supreme Court. To their disappointment, Judge White reaffirmed the lower courts decision. According to Judge White, "the creation of the Standard Oil Company of Ohio," constituted a violation of the law. "The organization of the Standard Oil Trust in 1882," and "the increase of the capital of the Standard Oil Company of New Jersey and the acquisition by that company of the shares of the stock of the other corporations in exchange for its certificates," further violated the government's anti-trust provisions. (Armentano)

Yet oil was not the only industry liable to forming combinations of questionable legality. Like petroleum, aluminum had been little used prior to the Nineteenth Century. In fact, Humphrey Davy had only first discovered the element in 1807. And it was Charles Hall discovered and patented the first commercially successful process for producing aluminum. Hall's process separated out the aluminum form the ore by applying electrolysis to a solution of molten alumina that had been dissolved in cyolite. Armed with his momentous discovery, Charles Hall joined forces with Captain Alfred E. Hunt and Arthur V. Davis to found am aluminum manufacturing company called Alcoa. At first, Alcoa only was able to make about two thousand pounds a year of aluminum ingots. These sold for between five and eight dollars per pound in 1887. Hall and his associates knew that in order for Alcoa to become commercially successful, it must find a cheaper way to obtain the raw material -- the aluminum ore -- if their product were to effectively compete with other possible substitute materials. Over time, Alcoa expanded, its expansion based on the kind of continuing innovation that created new technologies, new technologies that were beginning to drive down the prices of aluminum. In 1889, Alcoa produced fifteen thousand pounds of aluminum; by 1897 this had reached the astonishing figure of three million pounds. And still continuing to expand, by 1937 Alcoa was producing about five hundred million pounds of aluminum a year, and selling it for only twenty-two cents per pound. Through its perfection of the electrolysis process, the company had discovered how to turn low-grade ore into aluminum that was 99.9% pure. Furthermore, it found ways to strengthen the element and the increase the anti-corrosive properties of the metal, and also began production of numerous alloys with many different commercial uses.

But soon it seemed that Alcoa might possibly have grown too big. And In 1929 the Federal Trade Commission finally brought Alcoa to court. However, on eight different counts, the courts found that Alcoa was not a monopoly. The aluminum giant was innocent of monopolizing the scrap market in bauxite and other aluminum ores, and innocent too of attempting to monopolize aluminum sand casting, and the production of ingots of virgin aluminum. They were found not to exercise policy control over the Aluminum Goods Manufacturing Co., and foreign aluminum markets. They were found not to possess any arbitrary powers in regard to the setting or fixing of prices, rather these were controlled naturally according to the economic laws of supply and demand. Stated District Court Judge Caffey, "In consequence, I concluded that the government has failed to establish the charge of conspiracy between Alcoa and European producers of aluminum." (Armentano) The losing party, however, managed to win on appeal. In this case, Judge Hand argued instead that Alcoa's fabrication "pro tanto reduces the demand for ingot itself" and affects the primary ingot market and ingot price." Judge Hand reduced the relevant markets under consideration to a sole market: the market in virgin ingot aluminum. In this market, Alcoa's share had jumped from ten percent to ninety percent, thus giving the company a clear monopoly.

Still another example of the battle over the issue of monopolies is to be found in the production of cigarettes. Back in the 1850's when cigarettes were not yet common, especially in the United States, all firms were hand-rolling cigarettes from Turkish tobaccos; making only about two thousand cigarettes a day. It was not until a major change in public taste, in the 1880's, that there was a rapid shift from Turkish tobaccos to Virginia tobacco blends. Larger firms became increasingly innovative. They adopted new technologies such as cigarette-rolling machines that enabled them to produce one hundred thousand cigarettes a day. In this new, large-scale industry, James B. Duke quickly stood out above the rest. His company ran large newspaper ads, and rented billboards. Duke started placing coupons on cigarette boxes and gave incentives to retailers to sell his products. By January 1890 the five leading cigarette firms had merged together to form the American Tobacco Company with J.B. Duke as president. By 1910 there was no doubt that this was now the largest firm of its kind in the country. But there were still at least three hundred other independent cigarette firms, and twenty thousand independent cigar firms. At length, the American Tobacco Company took another and bigger step: deciding to cut out the middleman, it opened its own store as a cost-cutting measure. It was as a direct result of this action that the American Tobacco Company was finally charged for violating the Sherman Act. Justice White presided at the hearing. Based on the sum total of its business practices -- its activities, contracts, agreements, and combinations -- the American Tobacco Company was found guilty of violating the anti-trust regulations. Said the Judge of these practices, "[these were of such an] unusual and wrongful character as to bring them within the prohibitions of the law." (Armentano)

Notwithstanding, in all of these cases there were many things that were overlooked. For instance, the courts did not take note of the good that was being accomplished by Rockefeller and his company. Standard Oil had the highest paid employees in the industry, and most of the time, when Standard Oil bought other firms it would buy those firms above their market value. Rockefeller employed thousands of people, all of whom praised him. He donated thousands of dollars to charity, building among other things, many public libraries. The price drop in refined oil did not come primarily from Rockefeller's "penny-pinching" innovations, but rather owed its origin to the United States Treasury's deflationary policies and the general decline in demand for all goods -- and the resultant price drops -- that hit all American businesses in the aftermath of the Civil War. Most petroleum refining firms entered the industry only during that war, thus guaranteeing that, once the conflict had ended, many of these same firms would just as quickly disappear from the field -- another natural consequence of the actions of the law of supply and demand. The predatory pricing theory excoriated by Tarbell would have been economically foolish according to other experts, such as John S. McGee. McGee argued that predatory pricing would be very costly to large firms and that these same firms would not want to initiate a price war with each other. McGee explained that it would have been much more sensible for firms to just simply close down, and wait for prices to return to profitable levels. Or concomitantly, new owners could simply purchase bankrupt companies and make them competitive once again. Finally McGee stated that firms could not initiate predatory pricing practices unless they were already in possession of monopoly power. Nor could any firm achieve a monopoly through the agency of predatory pricing. It was also obvious that, by 1911, other firms had started to catch on to Rockefeller's innovations. Prices continued to drop until they hit about five cents per gallon. The number of refiners had increased, rising to one hundred forty-seven, with the effect that Rockefeller's once-dominant market share had dropped to sixty-four percent. Between 1896 and 1911 the petroleum industry changed dramatically, and the market for petroleum and petroleum products became increasingly less secure. New alternatives appeared in addition to simple, refined oil itself. Lighter fuel oils, lubricating oils, gasoline and other products began to compete with Rockefeller's kerosene. In fact, the kerosene age was coming to an end. Even before the government intervened in Standard Oil, its market the share was already beginning to drop. New firms were already arising, and if government had just left Standard Oil alone, natural economic forces would have ensured that its market share would have continued to drop as these new firms grew and expanded. Standard Oil was not a monopoly. It was just passing through a natural stage of growth and expansion that was the direct result of its own innovative approach. Furthermore, the Sherman Act was passed in 1890 while the Standard Oil Trust was formed in 1882. Judge White had rendered an ex-post facto judgment against Standard Oil -- a clear violation of the United States Constitution.