The long-running Selected Papers series features notable work by University of Chicago faculty and other business leaders. This essay is an edited excerpt; the original was presented in 1969 at the 18th Annual Business Economists Conference.
Economic theory and experience tell us that competition weeds out inefficiency. Competitive markets select those who employ the most-efficient technology to produce the most-efficacious products. As a consequence of the competitive process, industry uses resources in the ways that maximize consumer satisfaction.
If it happens that the most efficient producer operating at his most economic scale can supply the entire market, competition concentrates production in the hands of one firm. This the textbooks call “natural monopoly.” The courts may designate this as legal under the antitrust laws because the “monopoly” status was thrust upon the natural “monopolist.” Reading some of the language of decisions of recent years, however, beginning with Judge Learned Hand’s in the Alcoa case (United States v. Alcoa, 1945), I am dubious that a single seller could succeed in defending himself on these grounds unless he met certain tests.
If his product differed from that of his former competitors and was clearly superior enough in the eyes of all buyers that they willingly paid as high or higher a price than that charged by other sellers, this defense might be accepted if his behavior has been pure. If he ever committed a sin, however, such as producing a special model of his product for a large buyer with whom he signed a requirements contract calling for the buyer to assign at least, let us say, three-quarters of his purchases to him before he invested in special tooling for the special model, he will be regarded as having unclean hands and be ruled guilty despite the superiority of his product. If he anticipated an expansion of the market and built capacity in time to supply the needs of his customers as their demand expanded, then superiority of a product and higher price than his former competitors would not preserve him from being ruled a transgressor.
I am afraid that if a single seller succeeded in reaching this position with an inferior product for which he charged less, and enough less to offset its inferiority in the eyes of all buyers, our seller might be ruled as having engaged in predatory action despite this being the efficient way in which to use resources. Of course, if the other sellers he drives from the field by his greater efficiency and lower prices are larger companies engaged primarily in other markets, he would not be ruled in violation of the antitrust laws.
This is only one example of the conundrums that exist in our antitrust policy. These conundrums can be summarized in saying that the law as presently interpreted seems to say that firms should compete but should not win. Firms should be efficient enough to survive but, if more efficient, should not share the fruits of that greater efficiency with their customers. The relatively more efficient firms must not operate competitively. They must not press the rate of output to the point where marginal cost approaches price if that rate of output is sufficient to supply most of the market, particularly if their efficiencies spring from the large-scale provision of advertising. We have confused high concentration with monopoly and competitive activity by large firms with predatory behavior. We have taken descriptions of sufficient conditions for competition, such as a large number of firms, and confused them with necessary conditions.
If the US Department of Justice Antitrust Division and the Federal Trade Commission are to permit the competition that will press efficiency in the economy to its optimum level, they and the courts must learn what are the necessary conditions for competition. The leap beyond what is strictly necessary is repressing competition when applied in inappropriate cases. Unfortunately, although we economists are very sure of what constitute sufficient conditions for competition to prevail in some circumstances, we are not at all sure of what are the necessary conditions in all circumstances.
Open entry is, it seems to me, a necessary condition if a competitive result is to prevail in a market. I am confident, furthermore, that open entry is sufficient to enforce competitive behavior in most, if not all, circumstances.
If I am correct, the task of the Antitrust Division can be confined to the demolition of arbitrary barriers to entry and the prevention of the erection of such barriers. It need not confuse itself with such tasks as attempting to break up major firms in highly concentrated industries. It need not determine what is a market or an industry. The courts would not have to listen to endless arguments as to whether a line of commerce or a market includes only domestically produced virgin aluminum; all virgin aluminum pig used in the US, whether produced at home or abroad; all virgin aluminum pig sold in the US, whether produced at home or abroad; all virgin aluminum plus secondary aluminum; all metals used for the purposes for which aluminum is used; all materials used for the purposes for which aluminum is used; etc. The courts would not have to decide such arguments as whether the shoe market consists of a neighborhood, a city, a metropolitan area, a state, a region, or a nation. If the Antitrust Division concentrated on the task of eliminating contrived impediments to entry, it would efficiently accomplish the twin goals of ensuring competitive behavior and maximizing efficiency in the economy.
Barriers that are not barriers
The sophists in our profession have confused the meaning of barrier to entry. Because of this confusion, I am sure that the Antitrust Division would do ridiculous things in the name of removing impediments to entry. Even enlightened chiefs of antitrust have fallen for the notion that advertising is a barrier to entry. One of the widely used texts in industrial organization tells us that differentiation of product is a barrier to entry. A basic text in price theory informs us that, “Barriers to entry arise because of economies of scale.”
Limitations on advertising would erect a new block to entry rather than removing one. It would, in fact, create grandfather rights. It would become more expensive to inform prospective customers that a firm new to a given market is prepared to supply them. It would raise the cost of letting the world know that a better mouse trap has been built. It would force firms to invest more heavily in a dealer network or in a distribution system if they were limited in their advertising outlays, thus raising the long-term-cost curves of prospective entrants. It would become more expensive to build volume quickly to a level that would achieve the major part of the available economies of scale. Efficiency would fall because firms would be forced to resort to the inefficient substitutes for advertising they otherwise avoid.
Attacks on product differentiation by the Antitrust Division or the Federal Trade Commission also could result in blocking entry. A new entrant can usually insinuate itself more easily into the market if its product is not identical with those offered by established firms. Why should buyers switch to a new supplier unless its product serves their tastes more efficiently than those already available?
It may be argued that a market may be more competitive—more open to entry—with product differentiation than without it because of its effect on buyer behavior. Buyers dissatisfied with a product from a current supplier will more readily engage in a search for an alternative supplier if there are no legal barriers to the offering of alternative varieties. If only a standardized product is allowed, search is less likely to be fruitful and less likely to be undertaken.
Even with the Antitrust Division focusing on the task of removing artificial impediments, there will be thickets of sophistry to clear away if the division is to do a proper job of promoting competition. That sophistry can lead to ridiculous attacks by the Antitrust Division was certainly demonstrated in one case in which the division maintained that it needed certain accounting and budgetary data from the defendant in order to prove that he was the low-cost producer. The division’s theory was that being a low-cost producer conveyed monopoly power by making it possible for the defendant to sell at lower prices than its competitors and thereby drive them from the field. Being a low-cost producer and not using such efficiency to preempt the market seems to me to be more akin to undesirable monopolistic behavior. Efficiency is hardly an arbitrary or artificial barrier to entry.
Real barriers to entry
If free entry is the (or only a) necessary condition for the maintenance of competition, I would suggest that the Antitrust Division should be devoting itself to attacking controls on entry. It should enter those cases where, for example, the Interstate Commerce Commission denies certificates to those who would enter, let us say, the trucking industry. When someone seeks a charter from the Office of the Comptroller of the Currency or from state banking authorities to enter the banking business and is arbitrarily denied, the division should come to the assistance of the applicant. When the Massachusetts Pharmacy Board refuses permission to a pharmacist to open a drug store, presumably because an adequate number already operate in the area, the division should leap to attack this artificial barrier. When the Minnesota Pharmacy Board denies any nonpharmacist the right to start a drug store and hire a pharmacist, the division should train its legal artillery on the barricade. When New York, Chicago, San Francisco, and all major cities other than Washington, DC, refuse to issue taxicab licenses to those who willingly satisfy all requirements for the provision of trained, licensed chauffeurs and safe equipment, with appropriate amounts and types of insurance, the division could certainly ride to the rescue of the patrons of this fenced-in market. When the Postal Service harasses those who would compete with it and shuts them out of the postal market on the authority of a law that makes it illegal for anyone but the post office to use a householder’s mailbox or to carry written messages, the division should recommend the repeal of such arbitrary barriers. When the division attacks the New York Stock Exchange, it should concentrate on the practices and rules of the exchange that impede entry to the stock brokerage business, such as limitations on the business member firms are allowed to do with nonmember firms.
The division should also be devoting attention to the attempts to erect new barriers to entry. When bills are offered prohibiting banks from entering the computer service market, the division should be as eager to maintain this source of potential entrants to an industry as it is when it attacks joint ventures and acquisitions.
What is entry?
On the subject, those attacks raise some interesting questions as to the meaning of entry and of “arbitrary barriers to entry.” It would appear that the Antitrust Division itself has become an arbitrary barrier to entry.
The division defines entry as the appearance of a new name in the list of those competing for a given set of customers. If the new name is simply a replacement of an old name because an acquisition has occurred, the division regards this as no improvement in the competitive situation. In many cases, it has argued that this is a degradation of competition because a name has been removed from the list of potential entrants.
To an economist, expansion of capacity—either by de novo entrants or by established companies—is entry in the meaningful sense of moving resources (capital and manpower) into the use in question. Monopoly in an economically functional sense means a situation where an industry fails to add resources when justified and called for by the demand and cost situation. If customers are willing to pay more for the additional product than the cost of using resources to produce more, and if these resources are not moved into the industry in question, monopoly prevails and inefficiency is a consequence.
The Antitrust Division barrier
If a potential entrant into an industry chooses to enter by acquisition of an established firm, it will have to offer a price that is worth more to the sellers than retaining ownership of the firm. Presumably, it will offer such a price if it believes that it can manage the acquired assets more efficiently than they are being managed. Alternatively, it finds it cheaper to enter the industry in this way than by building new assets, and it believes the industry worth entering at this cost. If the former is the situation, and the division blocks the acquisition, it is blocking a probable improvement in efficiency. If the latter is the case, the blockage of the acquisition may block the entry of the firm since more-expensive methods of entry may mean that it will not be worth entering at the higher cost.
The main barriers to entry are those imposed by regulatory commissions, tariffs, quotas, licensing requirements, and some of the activities of the antitrust authorities.
Preventing acquisitions in new markets or new industries by major firms because they might be potential entrants de novo may reduce the number of de novo entrants rather than increase them. Barring minor firms from selling their assets to leading firms—whether already established in the field or looking to enter the field—will limit their marketability. De novo entrance into a field by new firms will be reduced by this lack of marketability. The incentive for entrepreneurs to establish firms will be reduced, and it will be more difficult to obtain financial resources.
For no apparent reason that can be justified by economic analysis, the Antitrust Division and the Federal Trade Commission take a dim view of vertical acquisitions. They do have a (non-) theory of foreclosure—a set of words without an analytic base. Vertical integration is not automatically anticompetitive and should not be treated as if it were. Even if the vertically integrating firm is a monopolist in its original field, integration does not extend monopoly power outside the field of the monopolist.
The current furor over conglomerates apparently may lead to legislation limiting the ability of multi-industry companies to move into new fields. If this occurs, it will block the openness of entry that I believe is the one condition necessary to enforce competition. It will reduce the list of potential entrants. The Antitrust Division should be alert to such a possibility and be prepared to recommend against inappropriate legislation.
To the extent that conglomerates improve efficiency in the use of resources, the antitrust authorities should approve. If they remove resources from fields where they are used less efficaciously than they can be used in alternative applications, and move them into these applications, conglomerates should be applauded. These activities make markets more competitive and move industries more rapidly toward a long-term competitive equilibrium.
To make our markets more competitive, the main thrust of antitrust activity should be in the direction of removing contrived barriers to entry. We must recognize that calling things such as advertising and product differentiation barriers does not make them such. The main barriers to entry are those imposed by regulatory commissions, tariffs, quotas, licensing requirements, and some of the activities of the antitrust authorities. The division can at least cease these activities. Further, it can act as a “friend of the court” before agencies that are rejecting would-be entrants in many fields, and it should be recommending against proposed legislation that would erect more barriers and pressing for repeal of present legislative barriers. The return, in terms of the restoration of meaningful competition, can be very large indeed, especially in the reinvigoration of the forces that guarantee efficiency and spur innovation.
Yale Brozen was professor of business economics from 1957 to 1987 at Chicago Booth. He died in 1998.