Why Classical Economic Theories Are Inapplicable To Our High-Tech Global Economy
Products with long supply chains in markets dominated by a few sellers are far less subject to price competition
Free Market Competition Can No Longer Be Counted On To Deliver Low Prices
One of the simplistic and incorrect claims of 18th-century economics is that, in the absence of a cartel and in the absence of a supply shortage, market forces will always cause multiple companies selling similar products in the same market to compete on price and that, absent a cartel, a free market will always generate price competition that will result in low prices.
That’s not true. Here’s why.
The Perpetual Conflict Between The Incentive To (1) Lower Prices To Increase Sales & (2) Raise Prices To Increase Revenue
Sellers always want more money.
In a highly competitive market, more money is acquired by gaining more sales and more sales are acquired by lowering prices, that is, by Price Competition.
As the additional supply capacity of a product declines in relation to demand buyers become more and more the prisoners of their suppliers. This dependence means that fewer sales are at risk when the seller increases its prices.
At some level of market share and excess supply availability a seller can make more money by raising prices than it will lose from the lower sales that result from the increased price.
In any market, Price Competition — the seller’s incentive to gain more sales by competing on price (a downward pressure on prices) and the Profit Motive — the seller’s desire to acquire more money by raising prices, are constantly in conflict.
The real question is under what conditions do prices become more elastic and the seller will make more total revenue by raising prices?
When Markets Lower Prices
In a market where
- There are several sellers;
- Excess supply capacity is equal to or greater than the largest seller’s market share;
- No one seller has a material product marketing advantage, and
- Customers have equal access to multiple sellers.
Price Competition outweighs the Profit Motive and sellers will feel the pressure to price compete by lowering prices.
When Markets Raise Prices
In a market where:
- One or more firms have a large market share, and
- The market’s supply capacity is materially less than the largest seller’s market share, or
- Demand is greater than the available supply
the Profit Motive will
- Prevail over the incentive to price compete
- Motivate a the seller to materially raise prices,
- Cause the other sellers in that market to similarly increase their prices.
You can see examples of this in the markets for insulin, generic drugs, baby formula, meat, gasoline, etc.
For details on how this works and the formulas showing the relationship between market share and excess production capacity see my column:
How One Large Seller Can Drive The Market Price Up To A Monopoly Price
The key factor is if the large seller’s market-share is materially greater than the industry’s excess production…
→In decentralized markets with substantial additional supply capacity of similar or equivalent goods equal to or larger than the market share of the largest seller, price competition drives prices down, but
→In concentrated markets with additional supply capacity that is materially less than the market share of the largest seller, a majority of the buyers are prisoners of their seller and the profit motive drives prices up.
The more limited the supply of equivalent products that are available to fill consumer demand or satisfy the needs of consumers seeking to flee a higher-priced producer, the more the profit motive will drive prices up for all sellers.
Why Today’s Economy Is Fundamentally Different From Adam Smith’s
When the pressure inside a container reaches a certain point, Boyle’s Law no longer works. When the velocity of an object reaches a certain level, Newtonian mathematics no longer work.
The simplistic rules about price competition that classical economists derived from observations of the operation of large numbers of small, independent, owner-operated businesses like the butcher and the baker have little relevance to today’s commercial (not retail) economy.
Today’s economy is fundamentally different from any economic system in the history of humankind because of:
- The huge increase in the level of product technology and the complexity of most of today’s products and the
- Large geographic distance between some of the product’s components in its supply chains means that
- Transportation services become an additional component in the supply chain, all creating an
- Exponential increase in the length of supply chains, resulting in a
- Massive increase in the interdependence of supply chains making them not so much supply chains as supply webs for products
- Manufactured in factories that take years and hundreds of millions of dollars to build and
- Have little excess manufacturing capacity or substantial inventory of finished goods, parts or materials.
- Every additional link in a supply chain gives the supplier of that link the potential leverage to charge a higher price to its customers.
- The huge concentration of market shares of vital products in a small number of producers of
- Products manufactured by worldwide corporate sellers that are
- Managed by executives who have no material stake in their companies and which
- Executives’ principal compensation is dependent on the company’s short-term performance.
Vulnerabilities In Today’s Economy
The above factors have given today’s economy a greatly increased susceptibility to
- (1) Supply shortages caused by a supply-chain failures
- (2) Cascading supply shortages that propagate across several industries
- (3) much longer time and greater capital costs required to increase production capacity
- (4) much greater market concentration in the hands of fewer producers
- (5) choke-point leverage by one or more supply-chain suppliers to increase their prices
- (6) continuously increasing prices driven by a Price-Increase Feedback Effect.
There Is An Exponential Increase In The Length Of The Supply Chain In Today’s Economy
Why Today’s More Complex Products Have A Much Greater Risk Of A Supply-Chain Shortage
The more complex the product:
- The longer is its supply chain
- The more interconnected is its supply chain with those of other products
- The more transportation services become a crucial part of its supply chain
- The more fragile the supply chain
- The more likely there will be product shortages
- The larger is the number of suppliers with the economic leverage to be able to raise prices to those farther down the chain
- The more difficult, expensive and time consuming is the creation of additional production facilities
- The less likely manufacturers will spend the time and money to build facilities that
- — — have a material excess production capacity
- — — maintain a large quantity of finished products in inventory
- — — maintain a large quantity of parts & materials in inventory sufficient to increase production
Every chain is only as strong as its weakest link and because today’s products’ supply chains have hundreds of interconnected links, shortages caused by supply chain failures become exponentially more common. Shortages in supply will cause an increase in price.
Not A Supply Chain — A Supply Web
All this means that as products become both more complex, more globally sourced, and contain more technology, the more fragile their supply chain becomes.
Cascading Supply Shortages
Moreover, because many products have cross-linked supply chains, one shortage can lead to two which can lead to four which can lead to eight, and so on.
Not just a supply chain failure, but a supply-chain meltdown.
We are seeing not simply an arithmetic increase in supply chain shortages but an exponential increase in supply chain shortages and those shortages in the supply of products will result in corresponding price increases not only for those products but also for the other products down the line in their supply web.
More Complicated Products Mean More Shortages Lasting Longer
Eighteenth-century economics theory operated under the assumption that there would quickly be new potential sellers and enough additional product in any market to be able to quickly resolve any shortages or additional demand.
That may be true for simple products like corn, coal, buttons, etc. but it is not true for the products that are common in today’s economies.
You can’t materially increase the production of a complex product — refrigerators, integrated circuits, electric generators, etc. — in a few months for a few million dollars.
It may take years and billions of dollars to satisfy demand that today materially exceeds current market capacity.
That excess demand may not be caused by consumers suddenly desiring to purchase additional quantities of a product. It may well come from a reduction in supply stemming from one or more supply-chain failures.
Comic-book economics promotes the myth that capitalists will sense an opportunity presented by a supply shortage and will immediately spring into action and quickly bring new manufacturing facilities on line, but that usually does not happen.
No smart capitalist will spend half a billion dollars and two or three years of time constructing a new factory to fill the gap in production capacity arising from a supply chain failure that will be fixed before the factory can be in production.
Additionally, any new factory would also likely face the same supply chain problems as the existing producers so there’s point in building it.
And why spend hundreds of millions of dollars to enter a market against established competitors when the only way you can compete with them will be to sell your products at a lower price?
So, no, a supply-chain shortage won’t be automatically, quickly remedied by new manufacturers entering the market.
Why Products In Today’s Economy Are Likely To Have Higher Prices
Today’s economy has less price competition and therefor higher prices because today’s economy
- 1) Is Exponentially More Susceptible To Product Demand Exceeding Product Supply Because Of Supply-Chain Shortages
- 2) Has A Greater Concentration Of Market Shares In A Smaller Number Of Producers In Relation To Available Additional Supply Capacity
- 3) Has A Larger Number Of Suppliers’ Links In The Supply Chain, Each Of Which Sellers Potentially Has The Economic Leverage To Raise Their Prices To Those Farther Down The Chain
- 4) Is Susceptible To A Price-Increase Feedback Effect
For these reasons, in today’s economy
- Price competition is a declining factor, and
- Price competition cannot be counted on to reduce prices for an increasing number of products
We need to recognize and understand that these are fundamentally new and different economic conditions and realize that 18th Century simplistic economic notions are inapplicable to today’s commercial economy.
The Price-Increase Feedback Effect
We’re all familiar with feedback, that squeal we hear when we put a microphone too close to a speaker and the sounds from the speaker are picked up and amplified by the microphone and then broadcast even louder by the speaker, and so on.
Price feedback happens in an economy when a product’s price increase is passed on to another product and that price increase then circles around and feeds back into the cost of producing the first product which then raises its price a second time and so on.
- The mines pay a higher energy cost and raise the cost of coal and iron ore.
- This results in the machine shop paying more for steel and it then charges more for its gears and tooling.
- To cover the increased cost of gears and tooling, the manufacturer of mining equipment raises the price for the equipment and spare parts it sells to mine owners.
- The mine owners pay a higher price for mining equipment and spare parts and they raise the price they charge for iron ore and coal.
- The machine shop then pays an even higher cost for the steel it buys and again raises the price for its gears and tooling.
- And so on and so on.
You can run this exercise with workers paying more for food and demanding higher wages and grocery manufacturers and retailers paying higher labor costs and raising the price for food, causing workers . . . you get the picture.
This cycle would normally be interrupted by sellers in price-competitive markets grudgingly absorbing some or all of their extra costs thus tamping down the cycle of price increases like a series of waves slowing losing energy and flattening out.
But if the market is not highly price competitive sellers are able to simply tack every cost increase on to the price of their product and pass it on in full. So, the more the economy is dominated by products that are not price competitive, the worse the price increase feedback-effect is and the longer it lasts.
Because our economy is so subject to
- (1) the lack of additional product capacity and
- (2) to market concentration in a few sellers,
the products are less and less subject to price competition and thus are more subject to the price-increase feedback effect.
It’s a very difficult problem to solve. Somehow you’ve got to get the microphone away from the speaker; you’ve got to stop the cost increases on one end resulting in price increases on the other.
The only answer I can think of to ameliorate this situation is to create more price competition which will result from reducing sellers’ market shares below some level, e.g. 10%.
One possible way to do that might be to levy a corporate income-tax surcharge proportional to the company’s market share, thus encouraging a large seller to split into a number of smaller sellers who would be more likely to price compete and thus pass on either some or none of an increased cost.
Today’s economy is a linked web of complex products with little excess inventory or manufacturing capacity. That makes it fragile and subject to cascading, system-wide shortages.
Shortages plus low excess supply capacity in markets dominated by a few big players allow sellers to make more money by increasing prices, for example, oil refineries.
Because of these factors, price competition is less and less a factor in today’s economy and the market cannot be counted on to keep prices low through price competition.
Price increases in today’s economy often have a risk of a feedback effect where ever greater price increases feed on themselves.
18th Century simplistic economic theories are unable to model, predict, or deal with these changed conditions where today’s economy has fundamentally more complicated products and larger sellers’ market shares and they provide no effective tools that can neutralize cascading shortages and cascading price increases.