Free Market Monopolies

It is argued that in a free market monopolies either aren’t possible or possible but acceptable. The reasoning behind both is really the same: the mechanics of free markets only allow a monopoly if no one has any objections to it. In classical economics there is an idea called diminishing marginal returns. It’s held that as companies get bigger their unit costs increase. Actually, it’s a law. It seems to be derived from observations of agricultural economies in which the most fertile land is usually taken first. As the agricultural industry scales up every unit of land it takes is progressively less productive. This idea clearly doesn’t apply to most industries, and might not even apply to agriculture anymore, but it is held as a law. It, in of itself, if true, would prohibit monopolies.

In the real world there are ideas called economy of scale and profit maximization, which are some of the most fundamental and generalizable concepts in all business modeling, both of which form a powerful incentive to monopolize. I doubt any pro-market types could disagree with that and keep a straight face. So the pressures exist, so what stops bad monopolies from forming? The answer is competition.

Take the example of banking. There are lots of banks. You can use whichever you want. The banks all form a cartel, agreeing to charge the same super-normal prices. We don’t need to worry about that because in a free market there are no barriers to entry. Anyone can create a bank, charge market prices and everyone will sheeple over to the new, non-monopoly bank. Great, right? Almost magical. This argument is profoundly flawed for the following reasons.

Firstly, imagine the context. You have a series of large, established banks. Banks, by their nature, work better the bigger they are because they have to cover fewer inter-bank payments, which reduces their reserve requirements (or risk exposure). There probably aren’t that many of them because they managed to form a stable cartel. The new-comer would have to compete, from day zero, with all existing banks. This comes down to more than just saying “hi, I’m a bank and I’m cheaper than all the other ones.” You have to find someone willing to invest who agrees with you mission to bring down the cartel, or use your own money, in an extraordinarily risky venture. And you have to source your capital, including all of the technology needed to be a competitive, integrated bank, which hopefully doesn’t belong to someone that’s in the cartel. Or you could build it from scratch. This is risky and expensive, and the whole banking sector is against you, so you’ll probably find it hard to get a loan. The “no barriers to entry” idea seems a little naïve.

The next problem is getting people to use your bank. In real life there are all kinds of transition costs that are ignored in most pro-market positions, which tend to assume frictionless interactions. In this case there are costs, both financial and otherwise, associated with changing bank. Anyone who can’t afford the cost of changing bank, can’t change bank, regardless of how good a deal the new bank is. What are the transition costs? Who knows. They could be anything, free market theories don’t prohibit any of the financial ones and can’t prohibit any of the non-financial ones. The transition costs mean that even if the new-comer charged market prices, they would still be too high. They would have to expect the customers to take the hit, or cover those costs, making themselves uncompetitive. Hopefully that doesn’t push prices up to monopoly levels.

Another problem is scalability. As I mentioned banks, by their nature, become more efficient as they get bigger. The reverse is that small banks don’t make any practical sense. The pro-market anti-monopoly mechanism assumes a kind of perfect scalability, in which the new-comer’s business model is competitive from the first customer and remains so after every new customer joins, regardless of the passage of time. All new businesses generally make a loss at first and are vulnerable to cash-flow problems. A bank with 1 customer is not even a viable bank because any transaction that customer would like to do would incur use of a vast proportion of the bank’s reserves, they’d also have no lending power, so no profit. Banks are only banks because the aggregate transactions to almost to zero and can lend. Their profits are interest payments. For a new business the clock is ticking, it needs to get to a viable size in a relatively short time. If it’s cash-flow fails the business fails. There is a chasm between the new-comer and success that can’t be jumped one customer at a time, it has to be cleared in one go, quickly.

What’s more is that the above process, which seems to rely on a lot of ideal circumstances, must happen so frequently and reliably that investors believe it to be a reasonable investment.

Things get worse though. If the new-comer jumps the chasm and becomes a viable bank, in stable competition with the cartel… why wouldn’t it join the cartel? It seems like the most attractive reason to do all of the above is to do just that.

None of the above takes into account the possible action of the existing cartel, which, according to pro-market theory, just roles over. How can it intervene without breaching free-market rules? Easily. Obviously. Firstly by refusing to fund the venture. Secondly, savings account aren’t liquid, you can’t just close them, and the rules about changing bank accounts generally could be anything. Everyone might have signed a contract saying they have to give 6 months notice to change their accounts. Why would they? It’s a monopoly they have no choice.

There is also a pretty obvious step the cartel could take: give their customers discounts for staying until the new-comer’s cash-flow fails. They’ve been raking money in from years of monopolying, it would be trivial to put some of that money into a fund to bribe customers to stay put whenever a new-comer shows up, strangling them and making the idea of competing with the cartel even more un-fundable.

 

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2 comments
  1. Eric Schiedler said:

    I’ve discovered your blog today and will be reviewing your arguments in the next few days. Your range of topics is very interesting to me and I will also be looking into some of the well-researched sources. By the way, the article that let me find your blog is the one you made about Stefan Molyneux. I spotted it while I was doing some research see the extent of where people are making well-reasoned criticisms of his poor arguments.

    • Hi Eric, thanks for your time. Glad it’s of some interest to you.

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