Ch. 13 and DeBeers

Market power
DWL
R & D
Rent-seeking behavior
HHI
cartel
blood diamonds

We have already discussed in general terms the reasons why economists are concerned about market power (monopoly or imperfect competition).  What can/should the government do when a firm gains market power?

The government must ask 2 questions:

1. When is market power an issue of concern?

2. What is the appropriate action to take when market power becomes a concern.

In the case of the monopoly the problem is both one of equity and efficiency – monopolies create dead weight loss (please note that we are defining DWL somewhat differently than the book does – please refer to my notes for the DWL area created by the monopolist!) and they take advantage of consumers, which is seen to be unfair. Of particular concern is the case where a good is a necessity.

As the book points out, not only do monopolies reduce their output, which creates dead weight loss, but they also tend to be wasteful (managerial slack), not to devote money to R & D and to become rent seekers.  Competition forces firms to be vigilant about costs, monopolists can be wasteful and still succeed. Because of a lack of competition, there is less incentive to do R & D. Finally the monopolist has to spend resources to maintain its monopoly power.  If a firm spends time lobbying government officials to maintain protection, these resources are seen as wasteful from a societal perspective, although they make sense from a firm’s perspective.

One job of government is to monitor markets to determine whether an industry is competitive.  In order to do this, the government must first:

Define market boundaries

            a. geography

            b. goods (differentiated products.)

Ex:  What is the electricity market. As we discovered, it is helpful to break it down into the transmission and production sectors. It is also important to think about what the geographical boundaries of the electricity market are.

Decide what changes in the market are likely to signal a decrease in competitiveness.

            a. price

            b. market concentration

Once the government has determined whether an industry is in danger of (or already) concentrated to the point where firms have market power, then they can decide what actions to take.

In the case of a natural monopoly it makes sense to have 1 producer so the solution chosen may involve:

1. regulation – eg. impose a price ceiling.  (Note that in this case a price ceiling increases rather than reducing efficiency!)

2. public ownership

Although these eliminate price gouging, they do not necessarily create incentives for cost savings and innovations.

Also there may be room for corruption (not to say this couldn’t happen in the absence of government regulation as well…)

 And certainly during a transition from regulated to an unregulated industry, there is lots of room for corruption to occur.)

Other options may include:

1. Forcing a firm to break up (this was being threatened in the case of Microsoft, but did not materialize, but it has been done historically in the US.)

Passage of the Sherman Anti-Trust Law resulted in the breaking up of various companies.

2. Deny a firm the right to merge with another firm, where competition will be reduced as a result.

Passage of the Clayton Act was supposed to assure this, but this has been very controversial. One example is the media (what Amy Goodman talked about).  When is the media too concentrated.  The US government used to impose much more stringent criteria than it does now, and some are concerned about this.

3. Do nothing. Some economists argue that the threat of competition is enough to keep monopoly power down.  (This has also been argued in the case of Microsoft.)  Other economists are more skeptical about this option.  A case can also be made to ‘do nothing’ if the good in question is not a necessity.

In order determine whether the concentration in an industry has become too high, the government calculates an index, called the Herfindahl-Hirschman index (HHI). The index is calculated by taking the square of the market shares.  The highest value is 10,000.

Case study: DeBeers

An example of a firm which is not a monopoly but has significant market power - DeBeers - the diamond cartel which basically launched a huge ad campaign to convince people that it was a tradition.

a cartel - a group of firms that get together to determine Q (below the perfectly competitive Q), in order to raise the price and ultimately the profits.

Not only was DeBeers able to reduce the S of diamonds (through both a cartel and stockpiling), they were also able to manipulate demand.

What do you think of when you think of marriage? Adiamond engagement ring.

Where did the tradition of the diamond engagement ring come from? Invented by DeBeers, through an advertising campaign less than 100 years ago. They didn't stop with the notion of the engagement ring. Now they have created other 'traditions' as well - eternity ring, etc. Hollywood cooperated, by showing glamerous actresses flashing diamonds.

So where does DeBeers get its monopoly power from?

1. control of a natural resource
2. inelastic demand
3. few substitutes
(2 and 3 are mostly a function of advertising.)

By advertising and convincing consumers that diamonds are a necessity (sign of love), DeBeers was able both to increase the demand for diamonds and make the demand more inelastic. Diamonds are a sign of status and of wealth.

Marketing is thus about psychological manipulation for economic gains.

When faced with the issue of 'blood diamonds' - eg diamonds coming from areas where there is violent conflict in Africa, and where slave labor is being used, DeBeers now gives purchasers a certificate, claiming diamond is not from one of these areas. Unfortunately it is very difficult to prove this, since diamonds can cross borders and after having been cut one cannot tell where the diamond originally came from.

The US government anti-trust division has been after DeBeers for years, not because of the blood diamonds nor because of their ability to manipulate the demand for diamonds, but because they have manipulated supply! They have not had much success though, since DeBeers is not within their jurisdiction.

The continued success of the diamond cartel is threatened not by US anti-trust laws, but by the fact that:

a. DeBeers is tired of 'carrying' the rest of the industry by stockpiling diamonds;
b. new players have entered the market and are increasing the supply of diamonds, refusing to play by DeBeers' rules (Australia and Russia)
(This also happened in the case of OPEC.)
c. it is almost impossible to tell real from fake diamonds now.