Debating with Uncle Milt, Part II

It all began in the fifties or so, with a Mr. Milton Friedman, herein `Uncle Milt', which is what U of Chicago professors really called him when I was a student there. Uncle Milt wrote this little book called `Free to Choose', and the name basically describes everything there is to know about the theory. If you have to choose among a few options, an unconstrained choice is always better than a constrained choice. It's almost a tautology. Therefore, government restrictions on the choices available to people, be they consumers or managers of business, are bad.

[This is often called the Neoclassical school, since it's a reinvention of Adam Smith's work. You know Adam Smith: he wrote A theory of moral sentiment, which explained how a market requires good will among its members in order to properly function. He also wrote something about an invisible hand moving the market to an optimal state.]

`Free to Choose' is basically the Republican position on all economic issues. It's appealing because it's so simple: restrictions bad. But economics since the dominance of Uncle Milt and the Chicago School has been all about the exceptional situations where the simple logic of constrained vs unconstrained choice is too oversimplified to do reality justice. Generally, regarding any issue where we in the modern day consider government to be potentially relevant, one of these exceptional cases will come up. Pointing out the appropriate exception is often enough to get a free marketeer to stop smirking.

Monopoly One of the main money-makers for the working economist are anti-trust proceedings, in which one set of well-paid economists proves that a merger allow a company to `unfairly' use its expanded market share, while another set of well-paid economist proves that this won't happen. Many a conservative I have met believes that this is all silly, and that if a monopolist can find a price at which people will buy their goods, then the monopolist is clearly still providing something valuable, so why is the government being all pissy about it? Leave the companies to merge to their hearts' content.

The first is that there aren't any theorems about the optimality and welfare-maximizing properties of monopolists (that I know of). So, Mr. Conservative, you can have a government that doesn't try to prevent monopolies, but then all of your other arguments about the virtues and automatic optimality of the market are thrown out of the debate.

Second, monopolies are often in things that we'd like people to have easy access to, like bread or information. [E.g., a professor of mine did an extensive investigation of a merger between two bakeries in Boston.] If the market is providing these things well, and suddenly one day it doesn't, then this creates problems. Media monopolies, by the way, are not directly a problem for consumer choice---it works indirectly through the providers of content: they have fewer and fewer companies to negotiate with about disseminating their works, which will make it difficult for independent content producers to survive (see price-taking, below). And thus, consumers will have fewer choices.

To digress briefly, the way that we figure out who has undue market power is to look for massive price changes. For example, when a large music distributor cuts its prices 30% and still expects to make a profit, this is a gigantic red flag that there was some sort of collusion in price-setting before the fact. We don't need to know anything about the cost of recording or promoting a CD, just that prices were out of equilibrium.

Lock-in Third, products often interoperate with other products, meaning that a company which is doing wonderful market-pleasing things in one field can exert its power to sell crappy goods in another market where it's not necessarily the best. I am thinking, of course, of Microsoft. The company, at this point, is built entirely on the concept of lock-in, and spends most of its marketing budget trying to convince consumers of two things: you should upgrade your existing MSFT product, and you shouldn't switch to something else. Not much in the way of innovation going on here.

MSFT's argument to the Justice department was that anti-monopoly laws hinder their ability to innovate, by dictating that certain things can not be integrated into MSFT Windows. The other side countered that MSFT uses its monopoly to prevent innovation---most notably, they killed Java. Java is a set-up designed to allow you to run applications from your web browser. You'd go to a web page, and instead of getting an article or pictures of naked people, you'd get a word processor. When you leave the office, you'd be able to go to the same web page and work at home using exactly the same software. When the word processor needs an update or a security fix, the guys who run the web page would take care of it.

A few years ago, many people were very optimistic about this paradigm, and MSFT was very threatened by it, since every computer would work the same, whether it was running Windows, MacOS, or even no operating system at all. I will spare you the technical details, but their solution to the threat was to include a web browser with every version of Windows that had a broken version of Java. People tried the new paradigm, it didn't work, and innovation was soundly prevented. Here in 2004, we use the same computing paradigm that we used in 1998 (windowing operating system running OS-specific applications we bought at the store); who knows what our machines would be like if MSFT hadn't taken explicit steps to kill Java.

So what can you tell your conservative pals? That incremental innovation isn't necessarily a problem when there are monopolists involved, but innovation on a larger scale---paradigm shifts---are blocked when there are monopolists who can use their influence to prevent that innovation. [More technically, monopoly rents are a strong incentive to keep the market underlying the monopoly as large as possible.]

Price-taking More generally, the idea of a monopoly gets to the concept of market power: the ability of a single player in the market to influence the market itself. Most of neoclassical economics assumes that every agent has zero market power, and is thus a price taker---they can't influence prices at all, just take them from the market.

Large companies are clearly not such price takers, and conservatives frequently need to be reminded of this. For example, Wal Mart negotiates the price it pays on most (maybe all) of the items it sells. There is one Wal Mart, and dozens of pretzel vendors, so Wal Mart can use this asymmetry to negotiate down the price it pays for pretzels. The most important price for Wal Mart it the price of labor, and the market is again clearly asymmetric: one Wal Mart, and millions of potential employees.

Setting a price is a negotiation over how surplus should be divided. If an hour of work is worth $6 to Wal-Mart, and a person is willing to work for $4, then any wage between the two would work, in the sense that the person would work the hour and Wal Mart would pay the person and both would walk away better off. Uncle Milt stops here, content in the belief that even if Wal Mart stands firm at $4.01, the employee is still better off.

The main problem with this is that the lowest wage a person will accept depends on the conditions. Notably, because of what I will call the `food constraint', any job is better than no job at all. Our conservative pals forget the food constraint all the time, since it's hard to work in to a simple model of agents [nondifferentiable kink and/or discontinuity in the utility function at zero], and it's easy to forget that `agents' means `people'.

Also, the wage Wal Mart sets is interdependent with any of a number of other things, such as the wage the company next door sets. In the theory, there's a menu of wages available, so if you don't like Wal Mart's wage, you go next door to Sam's Club and take the wage they offer. But if Wal Mart and Sam's Club set their wages in concert, and Sears and K-Mart follow Wal Mart's lead in price-setting, then the model falls apart again, because it is impossible for people to negotiate the price of their labor by threatening to go next door.

The solution to the asymmetry of the market is unionization. One Wal Mart and one worker's union is a symmetric market, which has some hope of working as it should. Conservatives often miss this, and only see that the union is a restriction on the behavior of its workers and the employer. That it is, but it is a restriction that allows negotiation of prices to work.