Theory of the Firm, Industry Structure, and Regulation, Part One
The follow-up question posed was thus: "[W]ould big business agree with him? Or, would they prefer the economy as it is now, with less regulation, and less oversight?" This edition of Pulp Economics is the first in a three-part series that begins by addressing the matter of what 'big business' seems to want in terms of a lax regulatory environment versus what is not only preferable for both workers and the economy, but also perhaps more desirable, at least in some cases, for businesses themselves in large-scale industries dominated by only a few companies. A widely applicable answer to what business wants versus what it needs must necessarily address different industry structures, even when discussing 'big business' since at least several broad and fundamentally different kinds of firms populate the large-scale enterprise landscape. To address the different types, they must be categorized and distinguished, which will be done in the second part of this series. The third part will then use the classification system so motivated to demonstrate a somewhat surprising result for a certain type of industry, a result which renders the very concept of a "free," private market moot in the instance.
For this first part of the series, however, the focus will be on introducing and demonstrating the use of a few key economics concepts in industries dominated by a relatively small number of very large firms. The emphasis will be on how they naturally tend operate in a relatively free, unregulated environmentone they might seem to desireand the consequences to them of that freedom from a government exercising control over the competitive conditions they face.
What big business wants and what it needs are two different things; and what big business thinks it wants and what it really wants are two different things, also. Right now, large-scale business enterprises are simply delighted with the regulatory environment, although parts of the old system are still functioning, much to the chagrin of those who are still under the thumbs of those regulatory bodies. That general sense of joy notwithstanding, the business environment always has always had a love-hate relationship with regulation because, while there was plenty to dislike about administrative agencies courts were reticent to control, establishing strongly enforced, consistent, well-thought-out ground rules that every business had to obey was a godsend to business as a whole because it created a less risky, less speculative environment in which day-to-day and year-to-year operations could be managed.
Even big companies are beginning to grasp that being on their ownleft to their own devices to deal with certain forces to a greater or lesser extent beyond their controlhas created a fairly brutal environment, especially in the wide swath of corporations that operate in what economists call "monopolistic competition," where short-term economic profits can be garnered through product differentiation, while long-term competitive entry absorbs those short-term gains. In this sector, a set of clear, consistent, well-enforced rules applied by overseeing regulators at the federal level might be glad news; for one thing, the federal government exercising the full extent of its authority under the so-called "commerce clause" of the U.S. Constitution keeps states from getting into the act and passing crazy-quilt patchworks of legislation enforced by sometimes less professional, sometimes more parochial state officials. That "commerce clause"the clause that gives the federal government broad power to regulate commerce within the U.S.when properly utilized by the government and applied by the federal courts, allows businesses across the country to understand that there is a uniformity of procedural and operational standards from one coast to the other and from one state to the next. No business need concern itself with the several states having too-lax or too-aggressive enforcement within their own borders, and no business need worry about some competitor using a loose-regulation state as a platform from which to project unlawfully uncompetitive practices upon interstate competitors.
On the other hand, if the discussion is about industries where market concentration reaches what economists describe as "oligopoly" or possibly even near-"monopoly," there is going to be little cheer in board rooms for any level of regulation since the industries can self-regulate by one or another mechanism broadly called "collusion" (perhaps less harshly described as "congenial competition" or maybe even "touch football"). Unfortunately, wide exemptions in anti-trust laws have always allowed for collusive behaviors under the general banner of "self-policing" or some other such term. This is the case in industries such as major league sports, city newspapers, HMOs, and others. In some cases, this kind of internal regulation might work, but only when there remains a federal regulatory framework that can and will come down as needed on the self-policing bodies and those they are supposed to regulate.
The problem becomes deeper with larger and larger scales of enterprise. One of the most fascinating places to look is in industries where economies of scale extend to such large scales of production that the industries become dominated by "natural monopoly" types of companies, which will be surveyed in Part Three of this series.
Just short of pure natural monopolies is what can be an ugly world of brutish competition that quite frequently has undesirable effects both upon the companies therein and upon the wider, national economy. Such industries were arguably far better off when a deeply committed, federal regulatory environment allocated market share and oversaw pricing while maintaining an iron fist of regulatory control over the corporate beneficiaries. The balance of the present article will survey the characterizing cost structure of firms that are "nearly," but not quite, natural monopolies and how this cost structure can lead to dire long-run consequences for typical firms within such industries left to their own rational incentives and the harsh realities of more-or-less "free market" action.
The term "nearly" qualifies the description of certain firms because of the extent to which long-run economies of scale are realized. A firm is said to be realizing economies of scale if, as the company produces more output, the average costthat is, per-unit costof the output declines. For example, if the per-unit cost for a firm's first 10,000 units was $8.25, but the per-unit cost for that firm's first 12,000 units was $7.95, then the company was realizing economies of scale between 10,000 and 12,000 units. Economies of scale are quite frequently the result of huge, up-front, costs, the kind that exist even before output begins: as more and more units of output are produced, those massive start-up costs get spread, on average, over more and more units. Economies of scale are best considered a long-run kind of concept; most companies for a while realize falling average costs, but it's what happens over a longer period of timethe forces that shape the long-run structure of an industrythat should be the focus of policy at the government level, even though no firm, by itself, can or should think about the "long run" so long as the short run, attended as it is by everything from marketing products to meeting payroll, is nipping at the heels of executive decision-making.
Although Part Two of this series will reinforce this point, average costs for a company are driven by what economist call marginal cost: the cost of the very lastor very next unit produced. If the cost of the last unit produced is less than the average cost of all units produced so far, then the cost of that last unit will pull down the average cost. On the other hand, if the cost of the last unit produced is greater than the average cost of all units produced, then the cost of making that last unit will drive average cost up.
If that explanation of the relationship between average cost and marginal cost doesn't mean much, think about it this way. Suppose a bunch of people take a test, and the average comes out to be, let's say, 78 percent. In other words, the overall, per-person test score was 78. Now, suppose one more person takes the test, and this person (being, for example, a neo-conservative Republican) gets a 62 percent. His score, which is the last (or "marginal") score, is going to pull down the overall average when it gets entered into the calculation. Thus, when the last is below the average, it causes the average to fall. On the other hand, if the overall average was 78 percent to start with, and someone then took the test and scored, say, a 90 percent, that score would pull the average up. Thus, when the last is above the average, it causes the average to rise. This is why economists draw average and marginal cost curves as depicted at left, below.
Notice how the graphs show a mathematically necessary relationship between marginal and average: when the marginal cost of the last unit produced is under the per-unit cost, average cost is being pulled downward; but when the marginal cost of the last unit produced is higher than per-unit cost, average cost is being pulled upward. This is not some economic phenomenon; the example above was with test scores, not costs. The relationship between marginals and averages is purely an arithmetic result; it's just that this mathematical phenomenon plays a powerful role in how costs shape not just the decision-making within individual firm, but also the overall structures of industries.
In the bestiary of industries prowling the planet, there are more than a few where extraordinarily steep fixed costs make per-unit costs very high at low output levels. For the most part, the cost of making the goods, themselves, isn't all that bad; it's just those up-front ("overhead") costs that are the killers, and it is these costs that create barriers to entry by young, start-up firms. That means the typical company in such an industry would, at low output levels, have its average cost curve way up and a marginal cost curve far below it. Recall from above that, in such a situationwhere marginal cost is below average costthe result would be a falling average cost curve. Not only that, the firm would experience falling average costs for a long while as it produced more and more and more, just because it would take a whole lot of output for per-unit cost to get down to the level of the cost of the last unit produced. That's the same thing as saying that the typical firm in such an industry would realize economies of scale (falling average cost per unit) over an enormous range of production levels, as depicted in the graph below, which shows a classical, "U"-shaped average cost curve.
The graph above exemplifies the usual situation, one where the marginal cost curve, hidden as it is in this picture, finally begins to close in from below on the average cost curve, slowly coming up to finally meet it, and then pulling above it, thereby ultimately drawing average cost per unit upward. The relatively flat part of the long-run average cost curve above might go on over quite a range of output levelsa range of output levels where constant returns to scale are being experiencedor the relatively stable per-unit cost might not exist over more than a quite narrow range; but it is depicted above to show all the possible long-run situations a firm might encounter. Sooner or later, though, the cost of the last unit, in many cases, will be greater than average cost per unit, and that is when a company is said to be experiencing diseconomies of scale. At what point this happens, if ever, is entirely dependent upon forces only partially within the control of the executive management of the company, itself.
If an industry is such that companies can configure themselves in a way so that their long-run average cost curves keep declining clear up to very large levels of output, the market will probably be dominated by these big behemoths since, the bigger they get, the cheaper the next unit is for them to produce. As long as such companies are realizing economies of scale, they will tend to keep expanding output, and this can go on in some cases to enormous output levels.
Nevertheless, unless the companies are what economists call the pure "natural monopolies" mentioned above, the economies of scale will eventually end: at some point, perhaps at a truly huge level of production, the cost of the last unit will be more the cost of the average unit, and the average cost curve will have bottomed out and begun the inexorable rise into the scale of output where diseconomies of scale are being experienced. The output level where long-run average cost bottoms out is called the minimum efficient scale of production, and it is a relatively logical long-term output level at which a firm would settle.
But what would happen in an industry where this long-term output level, even though huge, of the typical firm was well short of that necessary to satisfy the demand of the entire market? It is not difficult to imagine how such a situation would cause an industry to have awful cycles of entries and exits of giant competitor companies, with each downstroke attended by large-scale employee layoffs and substantial market disruptions.
Consider this example: an industry exists where the long-term minimum efficient scale of operation for the typical firm is at an output that would meet, say, 40% of the market demand at the prevailing price level. In other words, the cost structure of the industry is such that a single company would be at its long-term most efficient by providing the product to a very significant, but not overwhelming, part of the market. The graph below shows the scenario.
This is an industry where two very large companies could co-exist quite comfortably, pretending to compete against each other while enjoying a joint market share of 80%. It is possible in this industry for lots of small competitors to handle the other 20%, but that's not guaranteed since it could be the case that the reason economies of scale extend so far is because the fixed start-up costs are very high, which would create a more-or-less natural barrier to entry for small firms. Still, it is most definitely possible that, at least in some industries, we could see two-tiered competition; in others, however, those steep costs of entry would pretty much ensure that only big companies could even start, which means that their joint market share, 80 percent, would be insufficiently supplemented by smaller firms to satisfy the entire consumer universe of demand. That would mean the most logical route for the 20 percent deficit of output to be met would be through the entry of a third, very financially well-off company that could handle the high fixed start-up costs along with the attendant, low profits while ramping up to get unit costs down to minimum efficient scale. The big inducement to entry would most likely be prices in the industry. With only two competitors and 20 percent of a huge pool of demand not being met, the bait is almost too tempting to resist, especially for a firm that has known only success in its traditional arenas of activity.
But wait a minute. In this industry, minimum efficient scale for a typical company is at a production level satisfying about forty percent of the market, which means this new entrant is going to have to try to get big enough so that it and the other two companies are jointly producing one hundred twenty percent of what the consumer side of the market needs! That means the third entrant is going to kick the industry supply curve outward so hard that the three competing firms will all have to lower their prices and engage in the kind of competition that big companies have a really hard time handling because of the scales of their operations. First will come the price competition, which consumers will love and conservative pundits will declare as proof positive that a free market works; then, however, will come the company losses because of those massive fixed costs that made the long-run average cost curves so steeply downward-sloping in the first place. The lower prices they're being forced by competition to levy on consumers will force the companies to cut costs the only way possible: since, in the short run, the companies can't very well do anything about their huge fixed costs of operations, they'll have to go for the only type of costs they can affect: variable costs, the most vulnerable of which is labor. That's right: industry-wide, mass layoffs.
This won't fix the problem because, even though the three firms are, indeed, lowering total costs, they're also scaling back output, which means they're pulling back from that golden, minimum efficient scale of output. Long-term average costs are rising as the firms "downsize," and the competitive environment is still putting downward pressure on prices they can charge consumers, so sooner or later something is going to break; and it will probably be one of the three firms, which will finally go bankrupt, simply leave the industry, or, more likely, become so weakened that it will be receptive to a merger/acquisition arrangement with one of the other two companies. That, or it will become so debilitated that it will be vulnerable to a hostile acquisition by some other company, perhaps one that thinks it can make a buck in the industry that's already shown how it can wreck companies that step up to the plate without thinking deeply about long-run average cost curves, minimum efficient scales of operations, and market shares.
A market free of government interference will, of course, take care of the problems: over a long period of time, large firms will come and go, mass layoffs will happen, and industry consolidations will occur; then all will be well for a while, until the next time the incentive to enter a market with high profits and unmet demand draws in a large firm looking for a place to flex its competitive, well-financed muscles; and then the cycle will start all over again.
As an alternativethe one vigorously pursued in the Keynesian era of American economic policy-makingthe federal government could place a firm, steady hand of regulatory control over such industries. Policy could be to the end of ensuring that a sufficient number of companies was permitted to operate in an industry to satisfy most, if not all, potential demand, and the firms allowed to operate were guaranteed that, in exchange for abiding by tight regulation, they would be allowed to charge prices sufficiently high to earn a decent return on investment for their shareholders without breaking the wallets of consumers or making their industries so attractive that competitors would beat on the doors to get their shot at market penetration and eventual, almost inevitable, market disruption.
But that was the way things used to be done, for a while, anyway, during the era when the country was doing pretty darned well and even most of the conservatives bawling for free markets didn't believe their own drool. Fortunately for the United States of that era, neither did the politicians.
The Dark Wraith will continue this series in the weeks to come.