The petroleum market is pinched at several points, like the longer pipelines and the refineries. Many producers, many end sellers, and just a few paths from one to the other. The rules of supply and demand often only reflect the supply and demand at the middle, not at either end.
Or various agricultural markets, like milk, where there are again many producers going to a few co-operatives or bottlers, with price and content control. In California we cannot buy milk from Nevada, because they have different rules about standard amounts of milk solids per category.
And for hundreds of grocery products, since one chain dominates my city, my demand doesn’t affect the local supply at all. Safeway will carry one brand of soup and not another, so I have to leave town to find it. They have removed part of the market. Perhaps the majority of their categories only have one brand represented with shelf space. If 1/3 of the city wanted the #2 brand it would still not get shelf space. And their data would show not 1/3 but zero demand.
The “free” in “free market” does not mean infinite choices of various brand names and competitive manufacturers to satisfy every desire.
The “free” means free to make a choice – it may not be the most desirable choice, but it’s a choice that’s not distorted by government price manipulations. If my favorite color shirt is purple, and the only colors I see at the clothing store are blue and red, it does not mean there’s isn’t a free market.
I think you need to distinguish between mismatches in supply and demand (i.e. ** Ruminator’s ** desire to buy a purple shirt when there is none) due to natural market forces, and distortions introduced artificially by the government - who is an arbitrary decision-maker that deprives you of options and in some cases, leaves you with zero choice.
P1. There is nothing stopping another entity from accumulating capital and building a refinery if they feel it will be economically advantageous to do so. Actually, there is…the governmental permitting system, which hasn’t allowed a new refinery to be built since the last one in Louisiana in the 1970s. Perrysville, if I remember correctly.
So right off the bat, you see how the cost of building new refining capacity has been distorted by the government. It has been artificially raised.
But even if it hadn’t, that doesn’t mean it still makes sense to do so, given the cost of capital involved, the time value of money, and the risk factors that go into a long-term project like building a refinery with intent of reaping the rewards. No actor has stepped forward (in the theoretical government-free case) with their own money and decided to do it. That isn’t necessarily ‘market failure’. If the capacity of refineries becomes so pinched, and the potential rewards so great, someone will build one if they are allowed to do so by the government.
P2. The rules in California were arbitrarily imposed by the government. I’m going to go out on a limb and say that people in Nevada are probably not dropping dead because of different milk-solid restrictions. How much do you want to bet the milk-solid restrictions had something to do with a California milk lobby petitioning the legislature, thereby driving up the price of milk in California via restricted competition? I know nothing about this case, and I’ll bet $20 that is what happened.
P3. Like Ruminator’s purple shirt case, above.
But I’ll add that there is nothing stopping Ruminator from purchasing some purple dye, some cloth, and trying to make a purple shirt for himself. It will have a certain cost and quality to it, no doubt, that may be different than from what could be obtained in the store.
So you see…there is a free market solution occurring automatically, even if you don’t realize it. It’s the trade-off that Ruminator is making between constructing a purple shirt himself (since he sees none in the stores) and going without, or perhaps making another choice.
It doesn’t really matter why the monopoly came about, all that matters is that they attempt to maximize their profits. For a monopoly, this means monopolistic pricing. For the economy, that means a deadweight loss.
Not to get too much into economic theory here, but in order for there to be deadweight loss there has to be another choice available, that is economically beneficial to the consumer, and that is being denied to them. If there is no other choice available in a free market, then there is no loss.
So for example, if Madonna was the only recording artist in the world, and Madonna albums were selling at $100 a pop, and everybody was cool with that, and other artists tried to fill the void with $10 or $20 albums and nobody wanted them, Madonna would have a monopoly. But there would be no deadweight loss, because there was no economic surplus lost by the consumer due to lack of choice.
Mathematically, equilibrium pricing in perfect competition obtains when marginal revenue equals marginal cost, which incidentally also maximizes profit (which is zero, interestingly, though free marketeers tend to miss this point). As a great many wonders of the market obtain in this condition (what people tout as the economic benefits of free markets), deviating from this condition is an indication that there’s some problem. In the case of monopolies, the problem is that they can maximize profit without having marginal cost equal marginal revenue. So profit maximizing firms (what we assume firms will do is maximize their profits) will move to this point. But this is inefficient, as there are people who would receive marginal benefit in excess of the marginal cost that are unable to do so; i.e., they forego consumption.
This is thematically equivalent to the deadweight loss caused by taxation, where individuals forego consumption because of the added cost of the tax when their marginal benefit would be greater than the marginal cost in absence of the tax.
In effect, monopolistic pricing behaves just like a tax. Please note that the deadweight loss caused by taxation makes absolutely no reference to who collects the tax. Seen in this light, the conclusion is hopefully clearer.
This is entirely incorrect. It is a fundamental misunderstanding of freshman economic theory.
Deadweight loss is a market distortion caused when the output level is not at its most efficient point, where the marginal cost of producing an additional unit of a good matches the price of that good, which is to say, when the cost of creating an additional good matches the price consumers are willing to pay for that additional unit. And all profit-maximizing monopolies, when unregulated, will have deadweight loss as they maximize profit by under-producing. “Government monopolies” have nothing to do with anything.
Your own definition is self-serving nonsense. It has nothing whatever to do with real economic theory.
Thanks for the post. I’ll go back and revisit my understanding of the definition of deadweight loss. I am perhaps confusing it with the economic surplus of the system as a whole.
But certainly, you can see how the deadweight loss and ‘excess surplus’ captured by the producer in the free-market monopoly will incent competition to compete away that surplus, whereas the government taxation case has no such alternative.
Also, even a free market monopoly provider can price-discriminate amongst certain segments to minimize the deadweight loss, can he not? Yours and Hellestal’s post above assume commodity pricing for all consumers, I believe.
I understand the allure of this type of thinking but it is backwards.
The better analysis is understanding the source of the “tax” as you call it. Monopolistic pricing comes about because of the aggregation of consumer preferences. On the other hand, government tax is a comes from the top down by decree and is very faintly and very indirectly affected by consumer choices (via the convoluted and often ineffective process of representative democracy.)
Yep, and single human workers are “unregulated” too. Perhaps it would be better for society Mr John Doe would work 55 hours instead of 40 hours. That Mr. Doe chooses to not work the extra 15 hours to maximize the efficiency of consumers benefit is also a type of “deadweight loss”. And this academic distinction means what exactly? Should govt impose a rule that every laborer work extra hours until a pareto optimum for all downstream consumers is maximized? The economic analysis that you apply to companies can also be applied to singular individuals and I think it’s a good litmus test of whether it is a useful theory in both a moral and practical sense.
It does not matter where the tax comes from, or who collects it. It creates a loss because it means people will forego consumption even though the marginal benefit exceeds the marginal cost (i.e., even though everyone would be better off without anyone being made worse off if they consumed).
It is not. Benefits are benefits. In the case of a monopoly, we could make everyone better off if we shifted to the competitive market equilibrium. One way to do this is to have actual competition, in which case the profit-maximizing firm will move on its own. In the example you give, we would not be making everyone better off, we’d be taking a benefit from one party and distributing it.
It absolutely matters because that’s the real heart of the issue. To punish companies (regulate them) for the monopolistic pricing situation created by the consumers themselves is bizarre and backwards. You want the consumers to benefit from fairer pricing but the “problem” is caused by the consumers.
Does the Microsoft have monopolistic pricing for Windows and MS Office? And who held a gun to consumers heads during the 1990s to collectively choose MS Windows over Linux, Unix, IBM OS2, NeXT? It does matter where the source of the tax comes from.
It looks like you’re too biased against companies to see the generalized abstraction. Let’s say Madonna thinks it maximizes her profit by performing 30 concerts on a North American tour of major cities (New York, Chicago, etc). Conceivably, hundreds of thousands of extra fans could benefit if Madonna would play 20 extra dates, maybe at some of the mid-tier cities like Cleveland and Phoenix. You’re saying it would be better for society if we could “regulate” Madonna so that she is forced to add stops to her concert tour (or add multiple nights to existing cities) until the pareto optimum is achieved for consumers benefit. The logic you’ve applied to companies should also apply to Madonna and every other laborer on the planet.
The desires of the consumers (the fans of Madonna) are worthy considerations but Madonna has her own desires as well. In her mind, the extra 20 concert performances are not worth the additional hassle and travel time away from home. Or she’d rather use the time that the 20 concerts would take to record a new album instead. Her calculation for “profit” in her mind should be respected just like my calculation and your calculation for profit should be as well. You have not given a good reason why this understanding should not be extended to companies.
Your emphasis on consumers efficiency taking precedence over profit is one-sided and seems hypocritical.
You are welcome to read into it that far if you like. But I made only one suggestion about how to remedy this, and it had nothing to do with compelling anyone to do anything.
Ok, let’s focus on one simple scenario. If Madonna, you, and I each decide to work less (output less, produce less, etc) than Pareto optimum for consumers, have we each created a “deadweight loss” or “tax” ? Yes or no?
There’s no pareto optimum “for” subsets of society. It’s an all or nothing point; either we can improve at least one person’s position without removing a benefit from anyone, or we are at a pareto optimum. If your position is, “The monopoly just wants to price this way, it wouldn’t find it worth their time to produce up to the point where marginal cost equals marginal revenue, and that’s their right,” you are welcome to hold this position, but it is hard to draw conclusions from it. Instead we might make an assumption like, “Firms aim to maximize profits.” This is what they like to do. And it so happens that in a monopolistic environment, the profit-maximizing position is not at a pareto optimum.
You are welcome to consider a model where firms act some other way, but I don’t know what that is, so I cannot comment on it one way or another.
If you exclude Madonna from your analysis because she’s a “subset” as you say, then why is she included if she partners with her brother and creates a company called “Madonna, Inc.”
Why does the “Inc.” (Incorporated) suddenly invites all this analysis about profit-maximizing and “deadweight loss” but Madonna the person does not? To me, they are virtually the same.
I have not excluded anyone. Why do you suppose I have excluded anyone? You used the term “pareto optimum” as if there were such a point for consumers that had nothing to do with producers; my reply is that there’s no such thing here. Producers and consumers count equally, be they individuals, firms, aliens, drug users, serial killers, or any other conceivable economic agent.
I have no idea why you think I think this, but I don’t. If Madonna the individual has monopoly power–and she does–then the analysis would be the same, if she aims to maximize profits. I see no obvious way to correct any deadweight loss that would be the result of this monopoly, due to the peculiarities of taste in music. But, if the assumptions hold, the loss is there.