# The Ludwig von Mises Institute

## Advancing the scholarship of liberty in the tradition of the Austrian School

Chapter 10—Monopoly and Competition (continued)

B. The Paradox of Excess Capacity

Perhaps the most important conclusion of the theory of monopolistic or imperfect competition is that the real world of monopolistic competition (where the demand curve to each firm is necessarily falling) is inferior to the ideal world of pure com­petition (where no firm can affect its price). This conclusion was expressed simply and effectively by comparing two final equilib­rium states: under conditions of pure and monopolistic competi­tion (Figure 70).

AC is a firm’s average total-cost curve—its alternative dollar costs per unit—with output on the horizontal axis and prices (including costs) on the vertical axis. The only assumption we need in drawing the average-cost curve is that, for any plant in any branch of production, there will be some optimum point of production, i.e., some level of output at which average unit cost is at a minimum. All levels of production lower or higher than the optimum have a higher average cost. In pure competition, where the demand curve for any firm is perfectly elastic, Dp, each firm will eventually adjust so that its AC curve will be tangent to Dp, in equilibrium; in this case, at point E. For if average revenue (price) is greater than average cost, then competition will draw in other firms, until the curves are tangent; if the cost curve is irretrievably higher than demand, the firm will go out of business. Tangency is at point E, price at 0G, and output at 0K. As in any definition of final equilibrium, total costs equal total revenues for each firm, and profits are zero.

Now contrast this picture with that of monopolistic competi­tion. Since the demand curve (Dmf) is now sloping downward to the right, it must, given the same AC curve, be tangent at some point (F), where the price is higher (JF) and the production lower (0J) than under pure competition. In short, monopolistic competition yields higher prices and less production—i.e., a lower standard of living—than pure competition. Furthermore, output will not take place at the point of minimum average cost—clearly a social “optimum,” and each plant will produce at a lower than optimum level, i.e., it will have “excess capacity.” This was the “welfare” case of the monopolistic-competition theorists.

By a process of revision in recent years, some of it by the origi­nators of the doctrine themselves, this theory has been effectively riddled beyond repair. As we have seen, Chamberlin and others have shown that this analysis does not apply if we are to take consumer desire for diversity as a good to be satisfied.[75] Many other effective and sound attacks have been made from different directions. One basic argument is that the situations of pure and of monopolistic competition cannot be compared because the AC curves would not, in fact, be the same. Chamberlin has pur­sued his revisionism in this realm also, declaring that the com­parisons are wholly illegitimate, that to apply the concept of pure competition to existing firms would mean, for example, assuming a very large number of similar firms producing the identical product. If this were done, say, with General Motors, it would mean that either GM must conceptually be divided up into nu­merous fragments, or else that it be multiplied. If divided, then unit costs would undoubtedly be higher, and then the “com­petitive firm” would suffer higher costs and have to subsist on higher prices. This would clearly injure consumers and the stand­ard of living; thus, Chamberlin follows Schumpeter’s criticism that the “monopolistic” firm may well have and probably will have lower costs than its “purely competitive” counterpart. If, on the other hand, we conceive of the multiplication of a very large number of General Motors corporations at existing size, we cannot possibly relate it to the present world, and the whole comparison becomes absurd.[76]

In addition, Schumpeter has stressed the superiority of the “monopolistic” firm for innovation and progress, and Clark has shown the inapplicability, in various ways, of this static theory to the dynamic real world. He has recently shown its fallacious asymmetry of argument with respect to price and quality. Hayek and Lachmann have also pointed out the distortion of dynamic reality, as we have indicated above.[77]

A second major line of attack has shown that the comparisons are much less important than they seem from conventional dia­grams, because cost curves are empirically much flatter than they appear in the textbooks. Clark has emphasized that firms deal in long-run considerations, and that long-run cost and demand curves are both more elastic than short-run; hence the differences between E and F points will be negligible and may be nonexistent. Clark and others have stressed the vital importance of potential competition to any would-be reaper of monopoly price, from firms both within and without the industry, and also the competi­tion of substitutes between industries. A further argument has been that the cost curves, empirically, are flat within the relevant range, even aside from the long- vs. short-run problems.[78]

All these arguments, added to our own analysis given above, have effectively demolished the theory of monopolistic competi­tion, and yet more remains to be said. There is something very peculiar about the entire construction, even on its own terms, aside from the fallacious “cost-curve” approach, and practically no one has pointed out these other grave defects in the theory. In an economy that is almost altogether “monopolistically com­petitive,” how can every firm produce too little and charge too much? What happens to the surplus factors? What are they doing? The failure to raise this question stems from the modern neglect of Austrian general analysis and from undue concentration on an isolated firm or industry.[79] The excess factors must go somewhere, and in that case must they not go to other monopolistically com­petitive firms? In which case, the thesis breaks down as self-con­tradictory. But the proponents have prepared a way out. They take, first, the case of pure competition, with equilibrium at point E. Then, they assume a sudden shift to conditions of monopolistic competition, with the demand curve for the firm now sloping downward. The demand curve now shifts from Dp to Dmo. Then the firm restricts production and raises its price accordingly, reaps profits, attracts new firms entering the indus­try, the new competition reduces the output salable by each firm, and the demand curve shifts downward and to the left until it is tangent to the AC curve at point F. Hence, say the monopolistic-competition theorists, not only does monopolistic competition suffer from too little production in each firm and excessive costs and prices; it also suffers from too many firms in each industry. Here is what has happened to the excess factors: they are trapped in too many uneconomic firms.

This seems plausible, until we realize that the whole example has been constructed as a trick. If we isolate a firm or an industry, as does the example, we may just as well start from a position of monopolistic competition, at point F, and then suddenly shift to conditions of pure competition. This is certainly just as legitimate, or rather illegitimate, a base for comparison. What then? As we see in Figure 71, the demand curve for each firm is now shifted from Dmf to Dpo. It will now be profitable for each firm to expand its output, and it will then make profits. New firms will then be attracted into the industry, and the de­mand curve will fall vertically, until it again reaches tangency with the AC curve at point E. Are we now “proving” that there are more firms in an industry under pure than under monopolis­tic competition?[80] The fundamental error here is failure to see that, under the conditions established by the assumptions, any change opening up profits will bring new firms into an industry. Yet the theorists are supposed to be comparing two different static equilibria, of pure and of monopolistic competition, and not discussing paths from one to the other. Thus, the monopolis­tic-competition theorists have by no means solved their problem of surplus factors.

But, aside from this point, there are more difficulties in the theory, and Sir Roy Harrod, himself one of its originators, is the only one to have seized the essence of the remaining central difficulty. As Harrod says:

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.

And yet, asserts Harrod puzzledly, the “accepted doctrine” ap­parently deems it “impossible to be an entrepreneur and not suf­fer from schizophrenia!”[81] In short, the theory assumes that, in the long run, a firm having to produce at F will yet construct a plant with minimum costs at point E. Clearly, here is a patent contradiction with reality. What is wrong? Harrod’s own answer is an excellent and novel discussion of the difference between long-run and short-run demand curves, with the “long run” al­ways being a factor in entrepreneurial planning, but he does not precisely answer this question.

The paradox becomes “curiouser and curiouser” when we fully realize that it all hinges on a mathematical technicality. The reason why a firm can never produce at an optimum cost point is that (a) it must produce at a tangent of demand and average-cost curves in equilibrium, and (b) if the demand curve is falling, it follows that it can be tangent to a U-shaped cost curve only at some point higher than, and to the left of, the trough point. There are two considerations that we may now add. First, there is no reason why the cost “curve” should, in fact, be curved. In an older day, textbook demand curves used to be curves, and now they are often straight lines; there is even more reason for believing that cost curves are a series of angular lines. It is of course (a) more convenient for diagrams, and (b) essential to mathematical representation, for there to be continuous curves, but we must never let reality be falsified in order to fit the nice­ties of mathematics. In fact, production is a series of discrete al­ternatives, as all human action is discrete, and cannot be smoothly continuous, i.e., move in infinitely small steps from one produc­tion level to another. But once we recognize the discrete, angular nature of the cost curve, the “problem” of excess capacity imme­diately disappears (Figure 72). Thus the falling demand curve to the “monopolistic” firm, Dm, can now be “tangent” to the AC curve at E, the minimum-cost point, and will be so in final equilibrium.

There is another way for this pseudo problem to disappear, and that is to call into question the entire assumption of tangency. The tangency of average cost and demand at equilibrium has ap­peared to follow from the property of equilibrium: that total costs and total revenues of the firm will be equal, since profits as well as losses will be zero. But a key question has been either over­looked or wrongly handled. Why should the firm produce any­thing, after all, if it earns nothing from doing so? But it will earn something, in equilibrium, and that will be interest return. Mod­ern orthodoxy has fallen into this error, for one reason: because it does not realize that entrepreneurs are also capitalists and that even if, in an evenly rotating economy, the strictly entrepreneur­ial function were no longer to be required, the capital-advancing function would still be emphatically necessary.

Modern theory also tends to view interest return as a cost to the firm. Naturally, if this is done, then the presence of interest does not change matters. But (and here we refer the reader to foregoing chapters) interest is not a cost to the firm; it is an earn­ing by a firm. The contrary belief rests on a superficial concentra­tion on loan interest and on an unwarranted separation between entrepreneurs and capitalists. Actually, loans are unimportant and are only another legal form of entrepreneurial-capitalist in­vestment. In short, in the evenly rotating economy, the firm earns a “natural” interest return, dictated by social time preference. Hence, Figure 72 must be altered to look like the diagram in Figure 73 (setting aside the problem of curves vs. angles). The firm will produce 0K, its optimum production level, at minimum average cost, KE. Its demand curve and cost curve will not be tangent to each other, but will allow room for equilibrium interest return, represented by the area EFGH. (Neither, as some may object, will the price be higher in this corrected version of monopolistic competition; for this AC curve is lower all around than the previ­ous ones, which had included interest return in costs. If they did not include interest, and instead assumed that interest would be zero in the ERE, then they were wrong, as we have pointed out above.)[82] And so the paradox of the monopolistic-competi­tion theory is finally and fully interred.[83]

C. Chamberlin and Selling Cost

One of Professor Chamberlin’s most important contributions is alleged to have been his sharp distinction between “selling cost” and “production cost.”[84] “Production costs” are supposed to be the legitimate expenses needed to increase supply in order to meet given consumer demand schedules. “Selling costs,” on the other hand, are supposed to be directed toward influencing con­sumers and increasing their demand schedules for the firm’s prod­uct.

This distinction is completely spurious.[85] Why does a business­man invest money and incur any costs whatever? To supply a hoped-for demand for his product. Every time he improves his product he is hoping that consumers will respond by increasing their demands. In fact, all costs expended on raw materials are incurred in an attempt to increase consumer demand beyond what it would have been in the absence of these costs. Therefore, every production cost is also a “selling cost.”

Conversely, selling costs are not the sheer waste or even tyranny that monopolistic-competition theorists have usually assumed. The various expenses designated as “selling costs” perform defi­nite services for the public. Basically, they furnish information to the public about the goods of the seller. We live in a world where there can be no “perfect knowledge” of products by any­one—especially consumers, who are faced with a myriad of avail­able products. Selling costs are therefore important in providing information about the product as well as about the firm. In some cases, e.g., displays, the “selling cost” itself directly improves the quality of the product in the mind of the consumer. It must always be remembered that the consumer is not simply buying a physical product; he may also be buying “atmosphere,” prestige, service, etc., all of which have tangible reality to him and are valued accordingly.[86]

The view that a selling cost is somehow an artifact of “monop­olistic competition” stems only from the peculiar assumptions of “pure competition.” In the “ideal” world of pure competition, we remember, each firm’s demand is given to it as infinitely elas­tic, so that it can sell whatever it wants at the ruling price. Naturally, in such a situation, no selling costs are necessary, be­cause a market for a product is automatically assured. In the real world, however, there is no perfect knowledge, and the demand curves are neither given nor infinitely elastic.[87] Therefore, firms have to try to increase demands for their products and to carve out market areas for themselves.

Chamberlin falls into another error in implying that selling costs, such as advertising, “create” consumer demands. This is the determinist fallacy. Every man as a self-owner freely decides his own scale of valuations. On the free market no one can force another to choose his product. And no other individual can ever “create” someone’s values for him; he must adopt the value himself.[88]

6. Multiform Prices and Monopoly

Up to this point we have always concluded that the market tends, at any given time, to establish one uniform market price for any good, under competitive or monopoly conditions. One phenomenon that sometimes appears, however, is persistent multi­formity of prices. (We must consider, of course, a good that is really homogeneous; otherwise, there would merely be price dif­ferences for different goods.) How, then, can multiformity come about, and does it in some sense violate the workings or the ethics of a free-market society?

We must first separate goods into two kinds: those that are resalable and those that are not. Under the latter category come all intangible services, which are either consumed directly or used up in the process of production; in any case, they them­selves cannot be resold by the first buyer. Nonresalable services also include the rental use of a tangible good, for then the good itself is not being bought, but rather its unit services over a period of time. An example may be the “renting” of space in a freight car.

Let us first take resalable goods. When can there be persistent multiform pricing of such goods? One necessary condition is clearly ignorance on the part of some seller or buyer. The market price for a certain kind of steel, for example, may be one gold ounce per ton; but one seller, out of pure ignorance, may persist in selling it for half a gold ounce per ton. What will happen? In the first place, some enterprising person will buy the steel from this laggard and resell it at the market price, thus establish­ing effective uniformity. Secondly, other buyers will rush to out­bid the first buyer for the bargain, thus informing the seller of his underpricing. Finally, the persistently ignorant seller will not long remain in business. (Of course, it may happen that the seller may have a strong desire to sell steel for lower than market price, for “philanthropic” reasons. But if he persists in doing so, then he is simply purchasing the consumers’ good—to him—of philanthropy and paying the price for it in lower revenue. He is here acting as a consumer rather than as an entrepreneur, just as he would if he hired his ne’er-do-well nephew at the expense of a cut in profits. This, then, would not be a genuine case of multiform pricing, where the good must always be homogeneous.)

Nor is the buyer in a different condition. If a buyer were ig­norant and continued to buy steel at two gold ounces a ton when the market price was one gold ounce, then some other seller would soon apprise the buyer of his error by offering to sell him the steel for much less. If there is only one seller, then the cheaper buyer can still resell at a profit to the buyer charged a higher price. And a persistently ignorant buyer will also go out of business.

There is only one case where a multiform price could pos­sibly be established for a resalable good: where the good is being sold to consumers—the ultimate buyers. For while entrepreneurial buyers will be alert to price differentials, and a buyer of a good at a lower price can resell to another buyer charged a higher price, ultimate consumers do not usually consider reselling once they buy. A classic case is that of American tourists at a Middle Eastern bazaar.[89] The tourist has neither the time nor the inclina­tion to make a thorough study of the consumer markets, and therefore each tourist is ignorant of the going price of any good. Hence, the seller can isolate each buyer, charging highest prices to the most eager buyers, less high prices to the next most eager, and much lower prices to the marginal buyers, of the same good. In that way the seller achieves a generally unfulfilled objective of all sellers: the tapping of more of the “consumers’ surplus” of the buyers. Here the two conditions are fulfilled: the con­sumers are ignorant of the going price and are not in the market to resell.

Does multiform pricing, as has often been charged, distort the structure of production, and is it in some way immoral or ex­ploitative? How is it immoral? The seller aims, as always, to maximize his earnings in voluntary exchange, and he certainly cannot be held responsible for the ignorance of the buyer. If buyers do not take the trouble to inform themselves of the state of the market, they must stand prepared to have some of their psychic surplus tapped by the bargaining of the seller. Neither is this action irrational on the part of the buyer. For we must deduce from the buyer’s action that he prefers to remain in ig­norance rather than to make the effort or pay the money to in­form himself of market conditions. To acquire knowledge of any field takes time, effort, and often money, and it is perfectly rea­sonable for an individual on any given market to prefer to take his chances on the price and use his scarce resources in other directions. This choice is crystal clear in the case of a tourist on holiday, but it is also possible in any other given market. Both the impatient tourist, who prefers to pay a higher price and not spend time and money on learning about the market, and a companion who spends days on an intensive study of the bazaar market are exercising their preferences, and praxeology cannot call one or the other more rational. Furthermore, there is no way to measure the consumer surpluses lost or gained in the case of the two tourists. We must therefore conclude that multiform pricing, in the case of resalable goods, does not at all distort the allocation of productive factors, because, on the con­trary, it is consistent with, and in the case of the tourist, the only pricing consistent with, the satisfaction of consumer preferences.

It must be emphasized here that no matter how much the seller at the bazaar taps of his customers’ psychic surplus, he does not tap it all; otherwise the sale would not be made at all. Since the exchange is voluntary, both parties still benefit from making it.

What if the good is not resalable? In that case, there is far greater room for multiform pricing, since ignorance is not re­quired. A vendor can sell an intangible service at a higher price to A than to B without fear that B can undercut him by resell­ing to A. Hence, most actual cases of multiform pricing take place in the realm of intangible goods.

Suppose now that seller X has managed to establish multiform prices for his customers. He might be a lawyer, for example, who charges higher fees for the same service to a wealthy than to a poor client. Since there is still competition among sellers, why does another lawyer Y not enter the field and undercut X’s price to the wealthy clients? In fact, this is what will generally hap­pen, and any attempt to establish “separate markets” among cus­tomers will lead to an invasion of the more profitable, higher-price field by other competitors, finally driving the price down, reducing revenues, and re-establishing uniform pricing. If a seller’s service is unusual and it is universally recognized that he has no effective competitors, then he might be able to sustain a multiform structure.

Multiformity can be established only when total proceeds are greater than uniformity provides. This is by no means always the case, for the supramarginal buyers may restrict their purchases by more than the submarginal buyers can compensate.[91]

Multiform pricing has been accorded a curious reception by economists and laymen. In some cases it is deemed vicious ex­ploitation of the consumers; in others (e.g., medicine and edu­cation) it is considered praiseworthy and humanitarian. In re­ality, it is neither. It is certainly not the rule in pricing that the most eager should pay in proportion to their eagerness (in prac­tice, usually gauged by their wealth), for then everyone would pay in proportion to his wealth for everything, and the entire monetary and economic system would break down; money would no longer function. (See chapter 12 below.) If this is clear in general, it is difficult to see a priori why specific goods should be singled out for this treatment. On the other hand, the con­sumers are not being “exploited” if there is multiformity. It is clear that the marginal and submarginal buyers are not exploited: the latter obviously gain. What of the supramarginal buyers who are receiving less consumer surplus? In some cases, they gain, because without the greater revenues provided by “price discrimi­nation” the good would not be supplied at all. Consider, for ex­ample, a country doctor who would leave the area if he had to subsist on the lower revenues provided by uniformity. And even if the good were still supplied, the fact that the supramarginal buyers continue to patronize the seller at all shows that they are content with the seemingly discriminatory arrangement. Other­wise, they would quickly boycott the seller, either individually or in concert, and patronize competitors. They would simply re­fuse to pay more than the submarginal buyers, and this would quickly induce the seller to lower his prices. The fact that they do not do so shows that they prefer multiformity to uniformity in the particular case. An example is private school education, which able but poor youths may often attend on scholarships—a principle that the wealthy parents who pay full tuition demon­strably do not consider unjust. If, however, the sellers have re­ceived grants of monopolistic privilege by the government, en­abling them to restrict competition in the serving of the supra­marginal buyers, then they may establish multiformity without enjoying the demonstrable preference of these buyers: for here governmental coercion has entered to inhibit the free expression of preferences.[92]

So far we have discussed price discrimination by sellers in con­sumers’ markets, where consumer surpluses are tapped. Can there be such discrimination in producers’ markets? Only when the good is not resalable, total proceeds are greater under multi­formity, and the supramarginal buyers are willing to pay. The latter will happen when these buyers have a higher DMVP for the good in their firms than other buyers have in theirs. In this case, the seller of the good with multiform prices is absorbing a rent formerly earned by the supramarginal buying firm. The most notable case of such pricing has been railroad freight “dis­crimination against” the firms shipping a cargo more valuable per unit weight than that of other firms. The gains are not, of course, retained by the railroad in the long run, but absorbed by its own land and labor factors.

Can there be price discrimination by buyers when the good is not resalable (and ignorance among sellers is not assumed)? No, there cannot, for the minimum reserve price imposed by, say, a laborer, is determined by the opportunity cost he has fore­gone elsewhere. In short, if a man earns five gold ounces a week for his labor service in firm A, he will not accept two ounces a week (although he would take two rather than earn nothing at all) since he can earn nearly five ounces somewhere else. And the meaning of price discrimination against sellers is that a buyer would be able to pay less for the same good than the seller can earn elsewhere (cost of moving, etc., omitted). Hence, there can be no price discrimination against sellers. If sellers are ignorant, then, as in the case of the ignorant consumers at a bazaar, we must infer that they prefer the lower income to the cost and trouble of learning more about the market.

Turning now to patents and copyrights, we ask: Which of the two, if either, is consonant with the purely free market, and which is a grant of monopoly privilege by the State? In this part, we have been analyzing the economics of the purely free market, where the individual person and property are not subject to mo­lestation. It is therefore important to decide whether patents or copyrights will obtain in the purely free, noninvasive society, or whether they are a function of government interference.

Almost all writers have bracketed patents and copyrights to­gether. Most have considered both as grants of exclusive mo­nopoly privilege by the State; a few have considered both as part and parcel of property right on the free market. But almost everyone has considered patents and copyrights as equivalent: the one as conferring an exclusive property right in the field of me­chanical inventions, the other as conferring an exclusive right in the field of literary creations.[93] Yet this bracketing of patents and copyrights is wholly fallacious; the two are completely different in relation to the free market.

It is true that a patent and a copyright are both exclusive property rights and it is also true that they are both property rights in innovations. But there is a crucial difference in their legal enforcement. If an author or a composer believes his copy­right is being infringed, and he takes legal action, he must “prove that the defendant had ‘access’ to the work allegedly infringed. If the defendant produces something identical with the plaintiff’s work by mere chance, there is no infringement.”[94] Copyrights, in other words, have their basis in prosecution of implicit theft. The plaintiff must prove that the defendant stole the former’s crea­tion by reproducing it and selling it himself in violation of his or someone else’s contract with the original seller. But if the de­fendant independently arrives at the same creation, the plaintiff has no copyright privilege that could prevent the defendant from using and selling his product.

Patents, on the other hand, are completely different. Thus:

You have patented your invention and you read in the newspaper one clay that John Doe, who lives in a city 2,000 miles from your town, has invented an identical or similar device, that he has licensed the EZ company to manufacture it. . . . Neither Doe nor the EZ company . . . ever heard of your invention. All believe Doe to be the inventor of a new and original device. They may all be guilty of in­fringing your patent . . . the fact that their infringement was in ig­norance of the true facts and unintentional will not constitute a de­fense.[95]

Patent, then, has nothing to do with implicit theft. It confers an exclusive privilege on the first inventor, and if anyone else should, quite independently, invent the same or similar machine or product, the latter would be debarred by violence from using it in production.

We have seen in chapter 2 that the acid test by which we judge whether or not a certain practice or law is or is not consonant with the free market is this: Is the outlawed practice implicit or explicit theft? If it is, then the free market would outlaw it; if not, then its outlawry is itself government interference in the free market. Let us consider copyright. A man writes a book or composes music. When he publishes the book or sheet of music, he imprints on the first page the word “copyright.” This indicates that any man who agrees to purchase this product also agrees as part of the exchange not to recopy or reproduce this work for sale. In other words, the author does not sell his property out­right to the buyer; he sells it on condition that the buyer not reproduce it for sale. Since the buyer does not buy the property outright, but only on this condition, any infringement of the con­tract by him or a subsequent buyer is implicit theft and would be treated accordingly on the free market. The copyright is there­fore a logical device of property right on the free market.

Part of the patent protection now obtained by an inventor could be achieved on the free market by a type of “copyright” protection. Thus, inventors must now mark their machines as being patented. The mark puts the buyers on notice that the in­vention is patented and that they cannot sell that article. But the same could be done to extend the copyright system, and without patent. In the purely free market, the inventor could mark his machine copyright, and then anyone who buys the machine buys it on the condition that he will not reproduce and sell such a machine for profit. Any violation of this contract would consti­tute implicit theft and be prosecuted accordingly on the free market.

The patent is incompatible with the free market precisely to the extent that it goes beyond the copyright. The man who has not bought a machine and who arrives at the same invention in­dependently, will, on the free market, be perfectly able to use and sell his invention. Patents prevent a man from using his in­vention even though all the property is his and he has not stolen the invention, either explicitly or implicitly, from the first in­ventor. Patents, therefore, are grants of exclusive monopoly priv­ilege by the State and are invasive of property rights on the mar­ket.

The crucial distinction between patents and copyrights, then, is not that one is mechanical and the other literary. The fact that they have been applied that way is an historical accident and does not reveal the critical difference between them.[96]The cru­cial difference is that copyright is a logical attribute of property right on the free market, while patent is a monopoly invasion of that right.

The application of patents to mechanical inventions and copy­rights to literary works is peculiarly inappropriate. It would be more in keeping with the free market to be just the reverse. For literary creations are unique products of the individual; it is almost impossible for them to be independently duplicated by someone else. Therefore, a patent, instead of a copyright, for literary productions would make little difference in practice. On the other hand, mechanical inventions are discoveries of natural law rather than individual creations, and hence similar inde­pendent inventions occur all the time.[97] The simultaneity of in­ventions is a familiar historical fact. Hence, if it is desired to maintain a free market, it is particularly important to allow copy­rights, but not patents, for mechanical inventions.

The common law has often been a good guide to the law con­sonant with the free market. Hence, it is not surprising that com­mon-law copyright prevails for unpublished literary manuscripts, while there is no such thing as a common-law patent. At common law, the inventor also has the right to keep his invention unpublicized and safe from theft, i.e., he has the equivalent of the copy­right protection for unpublicized inventions.

On the free market, there would therefore be no such thing as patents. There would, however, be copyright for any inventor or creator who made use of it, and this copyright would be per­petual, not limited to a certain number of years. Obviously, to be fully the property of an individual, a good has to be perma­nently and perpetually the property of the man and his heirs and assigns. If the State decrees that a man’s property ceases at a cer­tain date, this means that the State is the real owner and that it simply grants the man use of the property for a certain period of time.[98]

Some defenders of patents assert that they are not monopoly privileges, but simply property rights in inventions or even in “ideas.” But, as we have seen, everyone’s property right is de­fended in libertarian law without a patent. If someone has an idea or plan and constructs an invention, and it is stolen from his house, the stealing is an act of theft illegal under general law. On the other hand, patents actually invade the property rights of those independent discoverers of an idea or invention who made the discovery after the patentee. Patents, therefore, in­vade rather than defend property rights. The speciousness of this argument that patents protect property rights in ideas is demon­strated by the fact that not all, but only certain types of original ideas, certain types of innovations, are considered patentable.

Another common argument for patents is that “society” is sim­ply making a contract with the inventor to purchase his secret, so that “society” will have use of it. In the first place, “society” could pay a straight subsidy, or price, to the inventor; it would not have to prevent all later inventors from marketing their in­ventions in this field. Secondly, there is nothing in the free econ­omy to prevent any individual or group of individuals from pur­chasing secret inventions from their creators. No monopolistic patent is necessary.

The most popular argument for patents among economists is the utilitarian one that a patent for a certain number of years is necessary to encourage a sufficient amount of research expen­diture for inventions and innovations in processes and products.

This is a curious argument, because the question immediately arises: By what standard do you judge that research expenditures are “too much,” “too little,” or just about enough? This is a problem faced by every governmental intervention in the mar­ket’s production. Resources—the better lands, laborers, capital goods, time—in society are limited, and they may be used for countless alternative ends. By what standard does someone assert that certain uses are “excessive,” that certain uses are “insuffi­cient,” etc.? Someone observes that there is little investment in Arizona, but a great deal in Pennsylvania; he indignantly asserts that Arizona deserves more investment. But what standards can he use to make this claim? The market does have a rational standard: the highest money incomes and highest profits, for these can be achieved only through maximum service of consumer de­sires. This principle of maximum service to consumers and pro­ducers alike—i.e., to everybody—governs the seemingly mysterious market allocation of resources: how much to devote to one firm or to another, to one area or another, to present or future, to one good or another, to research as compared with other forms of investment. But the observer who criticizes this allocation can have no rational standards for decision; he has only his arbitrary whim. This is especially true of criticism of production-relations. Someone who chides consumers for buying too much cosmetics may have, rightly or wrongly, some rational basis for his criti­cism. But someone who thinks that more or less of a certain re­source should be used in a certain manner or that business firms are “too large” or “too small” or that too much or too little is spent on research or is invested in a new machine, can have no rational basis for his criticism. Businesses, in short, are produc­ing for a market, guided by the ultimate valuations of consumers on that market. Outside observers may criticize ultimate valua­tions of consumers if they choose—although if they interfere with consumption based on these valuations they impose a loss of utility upon consumers—but they cannot legitimately criticize the means: the production relations, the allocations of factors, etc., by which these ends are served.

Capital funds are limited, and they must be allocated to vari­ous uses, one of which is research expenditures. On the market, rational decisions are made in setting research expenditures, in accordance with the best entrepreneurial expectations of an un­certain future. Coercively to encourage research expenditures would distort and hamper the satisfaction of consumers and pro­ducers on the market.

Many advocates of patents believe that the ordinary competi­tive conditions of the market do not sufficiently encourage the adoption of new processes and that therefore innovations must be coercively promoted by the government. But the market de­cides on the rate of introduction of new processes just as it decides on the rate of industrialization of a new geographic area. In fact, this argument for patents is very similar to the infant-industry argument for tariffs—that market processes are not suf­ficient to permit the introduction of worthwhile new processes. And the answer to both these arguments is the same: that peo­ple must balance the superior productivity of the new processes against the cost of installing them, i.e., against the advantage pos­sessed by the old process in being already built and in existence. Coercively privileging innovation would needlessly scrap valuable plants already in existence and impose an excessive burden upon consumers. For consumers’ desires would not be satisfied in the most economic manner.

It is by no means self-evident that patents encourage an in­creased absolute quantity of research expenditures. But certainly patents distort the type of research expenditure being conducted. For while it is true that the first discoverer benefits from the privilege, it is also true that his competitors are excluded from production in the area of the patent for many years. And since one patent can build upon a related one in the same field, com­petitors can often be indefinitely discouraged from further re­search expenditures in the general area covered by the patent. Moreover, the patentee is himself discouraged from engaging in further research in this field, for the privilege permits him to rest on his laurels for the entire period of the patent, with the assur­ance that no competitor can trespass on his domain. The com­petitive spur for further research is eliminated. Research expen­ditures are therefore overstimulated in the early stages before anyone has a patent, and they are unduly restricted in the period after the patent is received. In addition, some inventions are con­sidered patentable, while others are not. The patent system then has the further effect of artificially stimulating research expen­ditures in the patentable areas, while artificially restricting re­search in the nonpatentable areas.

Manufacturers have by no means unanimously favored patents. R.A. Macfie, leader of England’s flourishing patent-abolition movement during the nineteenth century, was president of the Liverpool Chamber of Commerce.[99] Manufacturer I.K. Brunel, before a committee of the House of Lords, deplored the effect of patents in stimulating wasteful expenditure of resources on searching for untried patentable inventions, resources that could have been better used in production. And Austin Robinson has pointed out that many industries get along without patents:

In practice the enforcement of patent monopolies is often so diffi­cult . . . that competing manufacturers have in some industries pre­ferred to pool patents; and to look for sufficient reward for technical invention in the . . . advantage of priority that earlier experimenta­tion usually gives and in the subsequent good-will that may arise from it.[100]

As Arnold Plant summed up the problem of competitive re­search expenditures and innovations:

Neither can it be assumed that inventors would cease to be employed if entrepreneurs lost the monopoly over the use of their inventions. Businesses employ them today for the production of nonpatentable inventions, and they do not do so merely for the profit which priority secures. In active competition . . . no business can afford to lag behind its competitors. The reputation of a firm depends upon its ability to keep ahead, to be first in the market with new improvements in its products and new reductions in their prices.[101]

Finally, of course, the market itself provides an easy and ef­fective course for those who feel that there are not enough ex­penditures being made in certain directions. They can make these expenditures themselves. Those who would like to see more in­ventions made and exploited, therefore, are at liberty to join to­gether and subsidize such effort in any way they think best. In that way, they would, as consumers, add resources to the research and invention business. And they would not then be forcing other consumers to lose utility by conferring monopoly grants and dis­torting the market’s allocations. Their voluntary expenditures would become part of the market and express ultimate consumer valuations. Furthermore, later inventors would not be restricted. The friends of invention could accomplish their aim without call­ing in the State and imposing losses on a large number of peo­ple.

[75]And the product differentiation associated with the falling demand curve may well lower costs of distribution and of inspection (as well as improve consumer knowledge) to more than offset the supposed rise in production costs. In short, the AC curve above is really a produc­tion-cost, rather than a total-cost, curve, neglecting distribution costs. Cf. Goldman, “Product Differentiation and Advertising.” Furthermore, a genuine total-cost curve would then not be independent of the firm’s demand curve, thus vitiating the usual “cost-curve” analysis. See Dewey, Monopoly in Economics and Law, p. 87. Also see section C below.

[76]See Chamberlin, “Measuring the Degree of Monopoly and Competi­tion” and “Monopolistic Competition Revisited” in Towards a More General Theory of Value, pp. 45–83.

[77]See J.M. Clark, “Competition and the Objectives of Government Pol­icy” in E.H. Chamberlin, ed., Monopoly and Competition and Their Regulation   (London: Macmillan & Co., 1954), pp. 317–27; Clark, “Toward a Concept of Workable Competition” in Readings in the Social Control of Industry (Philadelphia: Blakiston, 1942), pp. 452–76; Clark, “Dis­cussion”; Abbott, Quality and Competition, passim; Joseph A. Schumpeter, Capi­talism, Socialism and Democracy (New York: Harper & Bros., 1942); Hayek, “Meaning of Competition”; Lachmann, “Some Notes on Economic Thought, 1933–53.”

[78]See the above citations by Clark; and Richard B. Heflebower, “Toward a Theory of Industrial Markets and Prices” in R.B. Heflebower and G.W. Stocking, eds., Readings on Industrial Organization and Public Policy (Homewood, Ill.: Richard D. Irwin, 1958), pp. 297–315. A more dubious argument—the flatness of the firm’s demand curve in the relevant range—has been stressed by other economists, notably A.J. Nichol, “The Influence of Marginal Buyers on Monopolistic Competition,” Quarterly Journal of Economics, November, 1934, pp. 121–34; Alfred Nicols, “The Rehabilitation of Pure Competition,” Quarterly Journal of Economics, November, 1947, pp. 31–63; and Nutter, “Plateau Demand Curve and Utility Theory.”

[79]But cf. Abbott, Quality and Competition, pp. 180–81.

[80]The author first learned this particular piece of analysis from the class­room lectures of Professor Arthur F. Burns, and, to our knowledge, it has never seen print.

[81]Harrod, Economic Essays, p. 149.

[82]After arriving at this conclusion, the author came across a brilliant but neglected article pointing out that interest is a return and not a cost, and showing the devastating implications of this fact for cost-curve theory. The article does not, however, apply the theory satisfactorily to the problem of monopolistic competition. See Gabor and Pearce, “A New Approach to the Theory of the Firm,” and idem, “The Place of Money Capital.” While there are a few similarities, Pro­fessor Dewey’s critique of the “excess capacity” doctrine is essentially very different from ours and based on far more “orthodox” considera­tions. Dewey, Monopoly and Economics in Law, pp. 96ff.

[83]Since the erroneous but popular theory of “countervailing power,” propounded by J.K. Galbraith, falls with the monopolistic-competition theory, it is unnecessary to discuss it here. For a more detailed critique of its numerous fallacies, see Simon N. Whitney, “Errors in the Concept of Countervailing Power,” Journal of Business, October, 1953, pp. 238–53; George J. Stigler, “The Economist Plays with Blocs,” American Economic Review, Papers and Proceedings, May, 1954, pp. 8–14; and David McCord Wright, “Discussion,” ibid., pp. 26–30.

[84]Chamberlin, Theory of Monopolistic Competition, pp. 123ff. Cham­berlin includes in selling costs advertising, sales expenses, and store displays.

[85]See Mises, Human Action, p. 319. Also see Kermit Gordon, “Concepts of Competition and Monopoly—Discussion,” American Economic Re­view, Papers and Proceedings, May, 1955, pp. 486–87.

[86]It is surely highly artificial to call bright ribbons on a packaged good a “production cost,” while labeling bright ribbons decorating the store selling the good as a “selling cost.”

[87]Cf. Alfred Nicols, “The Development of Monopolistic Competition and the Monopoly Problem,” Review of Economics and Statistics, May, 1949, pp. 118–23.

[88]See Mises:

The consumer is, according to . . . legend, simply defenseless against “high-pressure” advertising. If this were true, success or failure in business would depend on the mode of advertising only. However, nobody believes that any kind of advertising would have succeeded in making the candlemakers hold the field against the electric bulb, the horse­drivers against the motorcars. . . . But this implies that the quality of the commodity advertised is instrumental in bringing about the success of an advertising campaign. . . . The tricks and artifices of advertising are available to the seller of the better product no less than to the seller of the poorer product. But only the former enjoys the advantages de­rived from the better quality of his product. (Mises, Human Action, pp. 317–18)

[89]See Wicksteed, Common Sense of Political Economy and Selected Papers, I, 253ff.

[90]It is difficult to conceive of a case, in reality, to which such a restriction imposed on buyers (called “perfect price-discrimination”) would apply. Mrs. Robinson cites as an example a ransom charged by a kidnapper, but this, of course does not obtain on the free, unhampered market, which precludes kidnapping. Robinson, Economics of Imperfect Competition, p. 187 n.

[91]See Mises, Human Action, pp. 385ff.

[92]An example is medicine, where the government helps to restrict the supply and thus to prevent price-cutting. See the illuminating article by Reuben A. Kessel, “Price Discrimination in Medicine,” The Journal of Law and Economics, October, 1958, pp. 20–53. Also see chapter 12 below on grants of monopoly privilege.

[93]Henry George was a notable exception. See his excellent discussion in Progress and Poverty (New York: Modern Library, 1929), p. 411 n.

[94]Richard Wincor, How to Secure Copyright (New York: Oceana Pub­lishers, 1950), p. 37.

[95]Irving Mandell, How to Protect and Patent Your Invention (New York: Oceana Publishers, 1951), p. 34.

[96]This can be seen in the field of designs, which can be either copyrighted or patented.

[97]For a legal hint on the proper distinction between copyright and monopoly, see F.E. Skone James, “Copyright” in Encyclopedia Britan­nica (14th ed.; London, 1929), VI, 415–16. For the views of nineteenth-­century economists on patents, see Fritz Machlup and Edith T. Penrose, “The Patent Controversy in the Nineteenth Century,” Journal of Eco­nomic History, May, 1950, pp. 1–29. Also see Fritz Machlup, An Eco­nomic Review of the Patent System (Washington, D.C.: United States Government Printing Office, 1958).

[98]Of course, there would be nothing to prevent the creator or his heirs from voluntarily abandoning this property right and throwing it into the “public domain” if they so desired.

[99]See the illuminating article by Machlup and Penrose, “Patent Controversy in the Nineteenth Century,” pp. 1–29.

[100] Cited in Edith Penrose, Economics of the International Patent System (Baltimore: Johns Hopkins Press, 1951), p. 36; see also ibid., pp. 19–41.

[101]Arnold Plant, “The Economic Theory concerning Patents for Inven­tions,” Economica, February, 1934, p. 44.