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What’s Behind the Downward Slope of a Seller’s Demand Curve?

Warning: wonkish.

This post is inspired by thoughts that I’ve had for quite some time but that just came together (at least more fully than before) in my writing of this just-completed paper for a forthcoming volume edited by Pete Boettke and Todd Zywicki.

One of the worst offenses of neoclassical economics against common sense and sound policy is its identification of monopoly power with the ability of a seller to raise the price of its product without losing all demand for its product.  Put in econ-talk terms, when an individual seller faces a downward-sloping demand curve (rather than a horizontal demand curve) that seller is said to have some quantum of monopoly power.

On the buyers’ side, any buyer facing an upward-sloping supply curve is said to have some quantum of monopsony power.  (This theoretical interpretation of the fact that, in reality, nearly every employer has some ability to lower wages without driving away all current and potential employees is sometimes taken as evidence for the theoretical case that minimum-wage legislation can improve employees’ welfare.)  For the remainder of this post I’ll write only about demand curves facing sellers, but much of what I say has direct analogies to supply curves facing buyers.

So many flaws weaken this static way of looking at markets that no single blog post can deal with them all.  Fortunately, very good work on the differences between this static understanding of competition and the more realistic – and more theoretically compelling – “market process” (or Austrian) understanding of competition is ample.  See, for example, book 2 of Joseph Schumpeter’s Capitalism, Socialism, and Democracy; Israel Kirzner’s Competition and Entrepreneurship; F.A. Hayek’s “The Meaning of Competition” and “Competition as a Discovery Procedure“; Paul McNulty’s “Economic Theory and the Meaning of Competition“; and (please pardon my unpardonable vanity) my own “Schumpeter and Kirzner on Competition and Equilibrium.”

But I’ll use a few words here to explain what I believe to be a principal source of these flaws.  That source is the failure to ask why a seller’s demand curve slopes downward.  What’s behind the reality of any given downward-sloping demand curve?  What’s the reality behind a particular seller’s ability to raise the price of its output without losing all customers?

To the extent that the downward slope of a seller’s demand curve exists because of a grant of special privilege by government – say, protection from the competition of foreign rivals – the resulting higher prices and reduced output are legitimately described as the results of monopoly power.  And the corresponding deadweight welfare loss is indeed a loss; the world is poorer than it could have been and would have been without the grant of special privilege to the favored seller(s).

In contrast, if a seller gains more ability to raise its price – that is, if the demand curve facing the seller becomes less elastic – as a result of actions taken by that seller to make its product more attractive to consumers, then the higher price is no loss at all.  And, importantly, there is no artificial restriction of output, properly reckoned.  The seller might for a long length of time succeed in selling its output at prices well above marginal cost, but the proper point of reference is not the price and the rate of output that would prevail if this successfully innovating seller sold its product at a price equal to marginal cost.  Indeed, the proper point of reference isn’t simply some other price and rate of output.

In my abstract hypothetical here, the seller’s innovation entices consumers voluntarily to regard the seller’s output as being more desirable than was the seller’s output before the innovation.  The market itself has been changed; the product itself is new and not easily comparable through price and rates of output to the pre-innovation product.

Suppose, for a more concrete example, a garlic farmer invents a seed variety that (at no higher cost than before) enables the farmer to grow garlic that tastes just as good as regular garlic but leaves no odor on the breath of people who eat this new variety of garlic.  Presumably people would ‘value’ this garlic more highly than the standard variety.  The demand curve facing this innovative farmer would be less elastic than was the demand curve he or she faced before the innovation.  The price that this farmer fetches for his new’n’improved garlic will not only be higher than the price fetched for standard garlic, it will be higher – perhaps significantly so – than this innovative farmer’s marginal cost of growing this garlic.

The mainstream neoclassical economist describes this ‘power’ over price as monopoly power (because this farmer doesn’t yet face enough competition to oblige him to lower the price of his new’n’improved garlic to the marginal cost of supplying this garlic to consumers).  But note just how bizarre is this use of the term “monopoly power.”  The ‘power’ over price – the ‘power’ of this farmer to earn above-normal profits – is not in the least the consequence of any market restriction, market imperfection, or market failure.  This ‘power’ is exclusively the result of an innovation that consumers ratify as worthwhile by voluntarily buying less of the lower-priced regular garlic and more of the new’n’improved garlic.  This ‘power’ is the result of market success.

This innovative farmer’s more-inelastic demand curve, his higher price, his P>MC, and his above-normal profits – although all phenomena that would exist had this farmer gotten special protection from competition by government – in fact here are the result exclusively of actions taken by the farmer that unambiguously improve consumer welfare.  To call some consequences of this innovation “monopoly power” is to abuse language intolerably and, as a result, not only to confuse the general public who listen to economists’ analyses but also to confuse economists themselves who do this sort of theorizing.

In this garlic example the elasticity of the innovative-farmer’s demand curve, his higher price, his ability to charge P>MC, and his above-normal profits are the result of – and are evidence of – not any quantum of monopoly power but, rather, of what we might call “competitive power.”  Or, better yet, let’s call it “competitive ability.”

That neoclassical economists so poorly distinguish successful innovators who improve consumer well-being from genuine monopolists who diminish consumer well-being is (or should be) an embarrassment to those economists.  They fail with sufficient rigor to look behind the downward slope of demand curves.

Insofar as the inelasticity of a demand curve facing a seller is a result of actions taken by that seller to make its product more attractive to consumers – regardless of whether or not this enhanced attractiveness is ‘real’ (e.g., longer life expectancy of the product) or ‘not real’ (e.g., consumers respond positively to a soda because J-Lo is a paid pitch woman for that soda) – the seller’s ability to raise its price above marginal cost is a consequence of actions best described as competitive and not in the least as monopolistic.