Monopoly and tariffs are costly

By Paul Walker 17/09/2012

If you didn’t already know.

James A. Schmitz, Jr. takes a look at the New and Larger Costs of Monopoly and Tariffs. The abstract of the paper reads:

Fifty-eight years ago, Harberger (1954) estimated that the costs of monopoly, which resulted from misallocation of resources across industries, were trivial. Others showed that the same was true for tariffs. This research soon led to the consensus that monopoly costs are of little significance—a consensus that persists to this day.

This paper reports on a new literature that takes a different approach to the costs of monopoly. It examines the costs of monopoly and tariffs within industries. In particular, it examines the histories of industries in which a monopoly is destroyed (or tariffs greatly reduced) and the industry transitions quickly from monopoly to competition. If there are costs of monopoly and high tariffs within industries, it should be possible to see those costs whittled away as the monopoly is destroyed.

In contrast to the prevailing consensus, this new research has identified significant costs of monopoly. Monopoly (and high tariffs) is shown to significantly lower productivity within establishments. It also leads to misallocation within industries: Resources are transferred from high- to low-productivity establishments.

From these histories, a common theme (or theory) emerges as to why monopoly is costly. When a monopoly is created, “rents” are created. Conflict emerges among shareholders, managers and employees of the monopoly as they negotiate how to divide these rents. Mechanisms are set up to split the rents. These mechanisms are often means to reduce competition among members of the monopoly. Although the mechanisms divide rents, they also destroy them (by leading to low productivity and misallocation).

Recently, a new literature has been developing that looks within industries to try and estimate the cost of monopolies and tariffs. This literature examines the histories of industries in which a monopoly is destroyed and the industry transitions quickly from monopoly to competition, as well as the histories of industries that rapidly moved the opposite way, from competition to monopoly. The notion being that if there are costs of monopoly, those costs should be destroyed when the monopoly is destroyed. Similarly, when an industry is monopolised, costs should be created. In both cases, costs should be apparent when comparing the industry before and after monopolisation.

Industries in the U.S., such as transportation and the manufacturing of sugar, iron ore and cement, have been studied utilising the new approach. The historical records of these industries show that there are costs of monopoly and tariffs within industries. The studies have shown that monopoly led to, among other costs, the following:

1. Low productivity at each factory. That is, for any given amount of inputs, monopoly meant that less output was produced than under competition.

2. Misallocation of resources between high- and low-productivity factories. That is, monopoly led to resources (capital, labor, etc.) being transferred from productive factories to unproductive factories. Again, this misallocation occurs within an industry and is different from the misallocation that Harberger considered.

These findings are interesting since in standard monopoly theory productive efficiency is maintained while the deadweight loss of monopoly comes from allocative inefficiency.

When measured it is found that

[i]n sharp contrast to Harberger’s finding, [ … ] the welfare costs associated with monopoly and tariffs are not small. The consequence of cases (1) and (2) above is that industry output could have been produced with fewer inputs. One way to measure the loss, then, is to calculate the value of the “wasted” inputs. The histories of these industries show that as monopoly was destroyed in each, productivity at each factory soared. Doubling of productivities in a few years was common. The value of the wasted inputs was as much as 20 percent to 30 percent of industry value added.