And this is why Hayek called competition "a discovery procedure" in which the number of firms are irrelevant. George Stigler had been a strong supporter of the view that Samuel up holds with respect to markets and mergers. However, Stigler's mind was changed by observations which led him to ruefully remark:

I now marvel at my confidence at that in discussing the proper way to run a steel company. I certainly would not presume today to have that knowledge about any industry, even higher education. What is still more embarrassing is that I no longer believe the economics I was preaching… Memoirs of an Unregulated Economist, Basic Books Inc., 1988, P. 99).

Unfortunately Fels and Samuel apparently lack the late George Stigler's willingness to change his mind when theory cannot explain the facts, which is certainly the case with respect to the concept of perfect competition. We must now take the argument further. Under conditions of perfect competition there are multitude of suppliers all of whom face a horizontal demand curve, entry is costless, adjustments are instantaneous and all participants have perfect knowledge and prices equal costs.

No wonder the theory led to the erroneous belief that a market served by a few firms means that price and output will diverge from their competitive levels; the fewer firms in the market, the greater will be the divergence. Now there is no theoretical basis for this belief. Nevertheless, it has led to the peculiar position where a theoretical model that has absolutely nothing to say about competition is being used to define it! Yet economists like Fels and Samuel assume that deviations, i.e., real competitive actions, from this model are violations of competition. This results in policies that actually damage the competitive process.

What matters is not the number of firms but free entry, what is sometimes called "contestability". So long as others are not prevented by arbitrary obstacles from entering a market, that market is competitive, even if there is only one producer. Of course, the common view is that where a single producer owes his position to economies of scale a natural monopoly has emerged.

By this it is meant that the technological superiority of the firm acts as a barrier to potential competitors because they cannot produce at a sufficiently low cost to justify the risk of entering the market. From this it is concluded that a monopoly situation has been created and hence requires action to prevent monopolistic behaviour from emerging. This belief results in government agencies actually acting to prevent mergers that would create superior capital combinations that would expand output and lower prices.

What we have here is a clear case of economic schizophrenia. A quick look at the inconsistencies of this belief will swiftly reveal the basis for my charge. Now this view makes no attempt to explain how a company moves from economies of scale to monopoly pricing. This is important because it is assumed that monopoly pricing is accompanied by excess capacity. But as Sir Roy Harrod pointed out:

If the entrepreneur foresees the trend of events, which will in due course limit his profitable output to x – y units, why not plan to have a plant that will produce x – y units most cheaply, rather than encumber himself with excess capacity? To plan a plant for producing x units, while knowing that it will only be possible to maintain an output of x – y units, is surely to suffer from schizophrenia. What then should he plan to do? . . .Apparently it is impossible to be an entrepreneur and not suffer schizophrenia. (Roy Harrod, Economic Essays, Harcourt, Brace and Company, 1952, p. 149)

If the entrepreneur does in fact possess and exercises this foresight and invests accordingly in an attempt to obtain a monopoly price, then obviously no excess capacity will emerge. On the other hand, this also means that output is lower and costs and prices higher then would otherwise be the case. The result is that a potential competitor now has an incentive to enter the market with a plant employing full economies of scale that would produce greater quantities at lower prices.

The first company, however, could now complain to a regulatory agency that the interloper is using predatory pricing to drive him out of business so that it can then charge a monopoly price. Note: in these circumstances the 'theory' could be used to define the interloper's competitive price as anti-competitive and the existing monopoly price as competitive.

There is no disputing that economies of scale do lead to a better utilisation of resources, higher output, lower costs and prices. But this is where schizophrenia takes hold. The economies of scale company can then be accused of using greater output and lower prices to keep out competition. Lower prices are predatory while 'excess' capacity is monopolistic. This line of reasoning results in competitive activity, as we have seen, being condemned as anti-competitive!

Defenders of monopoly 'theory' raise the possibility of a firm with economies of scale producing at a price high enough to generate economic profits yet low enough to keep out potential competitors because of the cost of capital. (This argument rests on the fact that economies of scale require large capital outlays because of the indivisibilities involved).

Now this is really sloppy thinking. The hallmark of a monopoly is that it can raise prices by restricting output because it does not have to fear competition (I am ignoring the shape of the demand curve for reasons of simplicity). But if the fear of competition forces a company to lower its prices it obviously cannot be in a monopoly position, even though it is a sole producer.

If our imaginary firm is making economic profits then there must be a maladjustment between supply and demand. (That is to say, that the factors of production are under priced in relation to the value of their products). These profits will induce others to enter the market and compete away the profits by expanding output. But, claim our monopoly theorists, the large amounts of capital needed to compete will act as an effective barrier to entry. The error here should be obvious and rests on the confusion between scarcity and abundance. The real obstacle is not scarcity of capital, which is what this objection is really based on, but the expected rate of return.

If entrepreneurs believe the rate of return is high enough to justify the risk of entering the market the investment will be made. That is why Optus, rightly or wrongly, spent billions rolling out cable. Therefore the Optus cable investment decision is a graphic refutation of the argument that capital is a barrier to entry. But there are plenty of other examples upon which we can draw. Burton N. Behling described in detail the fierce competition between utilities in American cities in the late nineteenth and early 20th century:

There is scarcely a city in the country that has not experienced competition in one or more of the utility industries. Six electric light companies were organised in the one year of 1887 in New York City. Forty-five electric light companies had the legal right to operate in Chicago in 1907. Prior to 1895, Duluth, Minnesota, was served by five electric lighting companies, and Scranton, Pennsylvania, had four in 1906....

During the latter part of the nineteenth century competition was the usual situation in the gas industry in this country. Before 1884, six competing companies were operating in New York City....

Competition was common and especially persistent in the telephone industry. According to a special report of the Census in 1902, out of 1051 incorporated cities in the United States with a population of more than 4,000 persons, a 1002 were provided with telephone facilities....Baltimore, Chicago, Cleveland, Columbus, Detroit, Kansas City, Minneapolis, Philadelphia, Pittsburgh, and St. Louis, among larger cities, had at least two telephone services in 1905. (Burton N. Behling, Competition and Monopoly in Public Utility Industries, The University of Illinois Press, 1938, pp. 19-20).

Clearly the capital-as-a-barrier argument has no factual or theoretical support. What has been shown is that even with one producer the market can still be highly competitive provided that artificial barriers to entry have not been erected. These monopoly theorists overlook the fact that firms employing economies of scale are obviously being rewarded by consumers for their superior efficiency. If this were not so then consumers could demonstrate their dissatisfaction by buying from low-volume high-cost producers. That they do not clearly reveals they prefer the more efficient allocation of resources that economies of scale produce.

Thus we can draw the conclusion that it is consumers' preferences for economies of scale that really limits the number of producers. Therefore, so long as entry is free, monopoly will not emerge. It needs to be made very clear that free entry does not for a moment mean costless entry. What it really means is that the necessary factors of production are freely available to anyone who is prepared to pay for them. (To claim, as many do, that having to pay for factors is a barrier to entry makes as much sense as complaining about the existence of scarcity).

This line of reasoning reveals the invaluable insight that for a monopoly to emerge the aspiring monopolist must have sole ownership of an input that is essential for the production of the product and for which there are no substitutes.

In dealing with monopoly prices we must always search for the monopolized factor. If no such factor is in the case, no monopoly prices can emerge. The first requirement for monopoly prices is the existence of a monopolized good. If no quantity of such a good m is withheld, there is no opportunity for an entrepreneur to substitute monopoly prices for competitive prices. (Ludwig von Mises, Human Action, Henry Regenery Company, 1963, p. 360).

In response to the view that a free market can lead to the emergence of monopoly Dominick T. Armentano responded with the observation:

To establish a monopoly in a free market would require perfect entrepreneurial foresight [shades of Harrod], both in the short run and the long run, with respect to consumer demand, technology, location, material supplies and prices, and thousands of other uncertain variables; it would also require an unambiguous definition of the relevant market. (Dominick T. Armentano, Antitrust and monopoly: Anatomy of a Policy Failure, The Independent Institute, 1999, p. 41).

It follows from the above that sound economic theory does not support Graeme Samuel's economic opinions on competition, monopoly, cartels or price-fixing.

A note on so-called predatory pricing: It is sometimes argued that a very large company can drive competitors out of business by under-pricing its product. This reveals a very poor grasp of how markets operate. Such a tactic would be particularly foolish because being the large firm it would have more to lose. If it decided to embark on such an action the demand for its product would rise in response to the lower price. The firm would then have to increase production and hence raise its production costs. This means it might be necessary to purchase more capital goods to meet the increased demand. A very unlikely situation.

This means it would have to operate at a suboptimal level of production, a very costly action indeed. As Coase might put it: the firm would have to expand output — and possibly investment — beyond the point where production costs exceed transaction costs. In addition, the firm cannot know how long the battle will last. Obviously, the longer the battle the greater will be its costs.

Those who warn against predatory pricing assume that potential competitors have not taken into account the possibility of price cutting to drive them out of the market. Therefore their expectations will have been built into their demand curve. Not only that, they would be in a situation where they can close down until their competitor raises prices again.

Critics of "big business" frequently refer to Standard Oil as the premium example of predatory pricing. But this is a complete myth that was exposed by John S. McGee, Predatory Price-Cutting: The Standard Oil (New Jersey) Case, The Journal of Law and Economics, October, 1958.

*Anti-merger laws are bad for the Australian economy, Mr Barnaby Joyce disposes of the case against Richard Pratt.

Gerard Jackson is Brookes' economics editor

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