LESSONS LEARNED #63: “There is no such thing as a monopoly in free market capitalism.” -Old Pithy

Posted by PITHOCRATES - April 28th, 2011

Even the mighty Coke-Pepsi Duopoly can’t stop People from Drinking Tap Water

Coke and Pepsi have a near monopoly in the cola market.  Or a duopoly.  They dominate.  And they’re bitter enemies.  Few brands are locked in such a bitter struggle that we call it war.  The Cola Wars.  They are archenemies.  Even though they may cooperate by alternating their discounting to limit their losses.  One month Coke may be on sale.  The following month, Pepsi.  They’re big and their powerful and when you ask for a Coke at a restaurant you’ll either get a Coke.  Or they’ll ask you if Pepsi is okay.  Or vice versa.  Because they own the market.

But do they?  There’s always another choice.  At a restaurant, we can order ice tea.  Hot tea.  Coffee.  Orange drink.  Beer.  Wine.  A cocktail.  Or even water.  Ditto at the grocery store.  Walk down an aisle and there’s more to choose than Coke or Pepsi.  RC Cola, for one.  And then there’s the un-cola (7-Up).  VernorsA&W Root BeerSquirtDr. PepperCrushSnapple.  And other name brands that aren’t owned by the Dr. Pepper Snapple Group.  Not to mention all the store brands.  And, of course, tap water.  Which I personally drink with most of my meals.  Even though there’s nothing finer than a Coke or Pepsi to wash down a greasy pizza.

Try as they might Coke and Pepsi can’t limit entry into the beverage market.  The barriers they can erect are minimal.  They can offer a special price to a store or restaurant in exchange for keeping out their hated rival, but they can’t prevent people from asking for tap water.  Or from people simply going elsewhere to get the Coke or Pepsi product they want.  Or the million other options out there.  And if they raise their prices in their ‘duopoly’, people will just seek out those other options.  Yes, they may be able to tell the difference between Coke and Pepsi in blind taste tests.  But if the price isn’t right, they’ll enjoy RC Cola just fine.  Or even the store brand cola.

Go ahead and Tax our Tea.  We’ll just drink Coffee Instead.

You see, to keep out the competition, you need the power of government.  Just ask the sugar importers.  Who would love to sell to the cola companies.  But don’t.  Because government has erected a barrier to that market.  Now, we don’t know what their highly guarded secret recipes are, but we do know that they each use the same sweetener.  High fructose corn syrup (HFCS).  They don’t use sugar.  Why?  Because Big Ag lobbied Congress to slap high tariffs on imported sugar.  Which they have.  Now the price of sugar is so high the cola companies use HFCS instead.  Though that may be changing as of late with a new round of health concerns about HFSC.  But that’s a whole other story.

To limit consumer choice, you need government to step in.  Because only government can write laws to erect market barriers.  For example, the last straw of British oppression before America’s Declaration of Independence was about a British law that erected a market barrier.  British Americans, being of British stock, liked their tea.  But they didn’t like paying the high price of East Indian Company tea.  In the Mercantile economics of the day, everything bought and sold in the British Empire shipped on British ships through British ports.  Indian opium shipped on British ships to China (via Calcutta).  The British than used the proceeds from those sales to purchase tea.  Which they shipped on British ships back to London.  Where they paid a duty on it.  And then on to America.  Where the colonists paid a tax on it.  All these markups made their tea pretty expensive.

Famine and recession caused financial problems for the East India Company.  To help alleviate their problems, British Parliament stepped in.  Said they could ship their tea directly to British North America (without going through London).  And sell it tax-free in the colonies.  Which made all other tea more expensive.  Which did not go over well with the American tea merchants.  Or the colonists in general.  This led to the Boston Tea Party.  American Independence.  And the switch from drinking tea to drinking coffee in America.  Because even when there is only one tea that is legal to drink, there is always another choice.

Rockefeller benefited Consumers.  The ICC did not.

People love Teddy Roosevelt for his trust busting.  Attacking the big robber barons.  To help the little guy.  And one of the big guys the little guys loved to hate was John D. Rockefeller.  Of Standard Oil fame.  Rockefeller was richer than most nations.  And some people just hated that.  He made his wealth by making refined oil products affordable to the consumer.  And he was a great environmentalist.  He saved the whales by replacing whale oil with kerosene.  And his relentless research and development made every bit of refined oil into a useful product.  While his competitors dumped most of their waste back into the environment.  Not Rockefeller.  He hated waste.  He even experimented in finding the least number of welds it would take to hold an oil barrel together.  He invented vertical integration (controlling industries up and down the product pipeline from the collection of raw resources to the sale of a finished product).  He not only made refined oil products cheap.  He made them plentiful.  Which made America the world’s leading economic power.  Successful corporations follow his example today.

Sure, he put a lot of his competitors out of business.  But it wasn’t because he was a monopoly.  It was because he was just that much better.  He produced refined products better and cheaper than his competition.  By the time the trust busters busted up Standard Oil, competition was coming into being on the Standard Oil model.  Which ultimately produced more refined products at lower costs.  He forced the competition to step up to his level which benefited consumers.  While the trust busters tried to bring Rockefeller down to his competitor’s level which benefited his competitors.  Not the consumers.  No, consumers did very well by John D. Rockefeller.  He created and produced at a relentless rate.  He didn’t ask for government help.  Unlike his competitors.  Who complained to the government.  (It is never a consumer that complains about predatory pricing).  Because when you can’t compete legitimately, you petition government for special favors.  Much like some of the railroads did.

Building a railroad is costly.  And takes a lot of friends in government.  At all levels.  Because you have to lay track through federal land, state land, county land as well as through cities.  Of course, everyone wanted that track to go through their land because the railroad was the way to ship goods.  And people.  So the system was ripe for corruption.  And it often was.  Once built some shippers complained about unfair shipping rates compare to what others got.  Rockefeller, for example, was highly criticized for getting better rates by far than any of his competitors.  Of course, he shipped by far more product than any of his competitors.  Which probably had a lot to do with his rates.  But the government saw that things were unfair in the railroad business.  So they stepped in.  And created the Interstate Commerce Commission (ICC).  Which was to right all the wrongs.  Which, of course, it didn’t.  It just made it easier for the big companies to fix things in their favor.  For they now had a single governing body to buy.  Which made it easier to buy political influence.

But none of this made a difference to save the railroads.  They started to die in the Fifties.  Of arrogance.  When people asked the big railroad executives what business they were in, they replied, “The railroad business.”  But they weren’t.  They were in the transportation business.  What’s the difference?  The ‘railroad’ business had only other railroads for competition.  The transportation business had cars, trucks and, eventually, planes, as competition.  So even though those who used the power of government to restrict other railroads from entering their markets, there was still competition.  The interstate highways and the automobile killed passenger rail.  And the trucking industry almost killed the freight railroads.  What saved them was realigning their operations into the transportation business.  Intermodal transportation combined container ships, railroads and trucks into a seamless and cost efficient transportation system.  Roadrailers took that concept to a higher level.  These are truck trailers that can be pulled by a locomotive without the need of a rail flatcar.  Trucks deliver these trailers to a rail yard.  They add a train bogey to the trailer.  Put it on the track.  Couple them together.  And attach them to a single locomotive.  Very little non-revenue weight.  Making it very efficient.  John D. Rockefeller would be impressed.

In a Free Market there is always a Choice

Wherever there is a market there is competition.  For any market where a profit can be made will attract others to that market.  Companies can try to restrict competitors.  But that’s all they can do.  Try.  Because if it’s a free market, it’s open to competition.  There are no barriers that a competitor can’t overcome.  Except one legislated by government.  And competitors can even crack that barrier.

And this is what it takes to make a monopoly.  Government.  Railroads had monopolies for awhile.  But creative business people found a way to crack their government-imposed monopoly.  Truckers came in and shipped at rates lower than the ICC said was fair.  Of course, fair is a relative term.  What’s fair to the railroad is not fair to the shipper.  Or the consumer.  But a trucker shipping at rate that he can cover his expenses and support his family is fair to everyone.  Except the railroad who depended on government instead of innovation for their business profits.

Coke and Pepsi can fight their cola wars but they can’t keep out competition.  There’s always root beer, ginger ale, orange drink, beer, wine, liquor, water, coffee or tea.  And even when government uses their full weight and power to create and maintain a tea monopoly, tea drinkers can simply become coffee drinkers.  For in a free market there is always a choice.  Always.

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LESSONS LEARNED #20: “It is never a consumer that complains about ‘predatory’ pricing.” -Old Pithy

Posted by PITHOCRATES - July 1st, 2010

ECONOMIES OF SCALE and vertical integration can do two things very well.  Make industrialists rich.  And make the things they sell cheap. 

The more you make, the less each thing you make costs.  Businesses have fixed costs.  Big one time investments in plant and equipment.  Businesses have to recover these costs.  Each thing they sell has a portion of these fixed costs added to its price.  The more they sell, the less they need to add to each unit sold.  This is economies of scale.  Think of bulk goods.  Warehouse clubs.  Places where you can buy large quantities of things at lower unit prices.  You may buy an ‘economy pack’ of 3 bottles of shampoo shrink-wrapped together.  The purchase price of a 3-pack will be greater than the price of a single bottle of shampoo at your convenient corner drug store.  But the unit cost of each of the bottles in the 3-pack will be less.  You save more over time by buying 3 bottles at a time.  Spending more, then, means spending less.  In time.

Few of us buy raw materials.  Few have a need for crude oil.  Iron ore.  Coal.  Limestone.  Manganese.  But they make the stuff we buy.  A lot of things have to happen before those raw materials make it to us in those things we buy.  It has to be mined or drilled/pumped.  Transported.  Processed.  Stored.  Transported again.  Processed again.  Stored again.  Transported again.  There are many different stages between extracting raw materials from the earth and incorporating them into a final product we consumers buy.  At every stage there are costs.  And inefficiencies.  Which add to costs.  By reducing these costs along the way, the component materials used at the final manufacturing stage cost less.  This reduces the selling price of the final product.  This is what vertical integration does.  It puts everything from the extraction of raw materials to the incorporation of those processed materials into the final product for sale under control of the final user.  It brings in a high level of quality, cost containment and reduction of inefficiencies into the entire process resulting in a high quality, mass produced, inexpensive product.

Not everyone can do these things.  You have to live and breathe the industry you’re in.  You have to understand it intimately.  An industrialist at the top of his game can do this.  A politician can’t.  States trying to take control of their economy have failed.  Every time they’ve tried.  Why?  Politicians are ‘intellectuals’.  They’ve never run a business.  They only thought about it.  And, somehow, that gives them the moral authority to tamper in something they are simply unqualified to do.  And when they meddle, they destroy.  Purposely.  Or through unintended consequences.  In the process, though, they enrich themselves.  And their cronies.

ANDREW CARNEGIE WAS a brilliant entrepreneur.  After working for a railroad, he saw the future.  Railroads.  And he would build its rails.  And its bridges.  With his Keystone Bridge Company.  Which used steel and iron.  So he built his Union Mills.  Which needed pig iron.  So he built his Lucy blast furnace.  Which consumed raw material (iron, coke, limestone).  So he secured his own sources of raw materials. 

His Lucy blast furnace set world records, nearly doubling the weekly output of his steel competitors.  No one made more steel than Carnegie.  For less.  In about 20 years, he brought the price down for steel rails from $160/ton to $17/ton.  And got rich in the process.

Economies of scale.  Vertical integration.  And innovation.  Carnegie hired the best people he could find and used the latest technology.  Always improving.  Always cutting costs.  Always making steel more plentiful.  And cheaper.  His steel built a nation.  Dominated the industry.  And destroyed the competition.  Of course, that drew the attention of the government.  And they tried to break up the steel giant because it was unfair to the competition.  Who couldn’t sell steel as cheap as he could.

JOHN D. ROCKEFELLER was a brilliant entrepreneur.  After trying the oil drilling business, he saw the future.  The refining business.  For America lit the night with kerosene.  And he would provide that kerosene.  At prices that a poor man could afford.  And he did.  And he saved the whales in the process (his cheap kerosene put the whale oil business out of business).

Like Carnegie, cutting costs and production efficiencies consumed him.  He built his own kilns and used his own timber for fuel.  He made his own barrels from his own timber.  He used his own horse-drawn carts, boats, rail cars and pipelines.  He bought up competitors.  He grew to dominate the industry.  By far the biggest shipper, he got better shipping rates than his competitors.  And he constantly innovated.  When others were dumping the gasoline byproduct from refining kerosene into the river (no internal combustion engine yet), he was using it for fuel.  He hired the best talent available to find a use for every byproduct from the refining process, giving us everything from industrial lubricants to petroleum jelly (i.e., Vaseline).

His company, Standard Oil, was close to being a monopoly.  When they controlled 90% of the market kerosene was never cheaper.  He brought the price down from $0.26/gallon to $0.08/gallon.  And that was an outrage.  We can’t allow any one company to control 90% of the market.  Sure, consumers were doing well, but the higher-cost competitors could not stay in business selling at those low prices.  So the government broke up Standard Oil via antitrust legislation (the Sherman Act).  To protect the country from monopolistic practices.  And cheap kerosene, apparently.

BILL GATES WAS a brilliant entrepreneur in building Microsoft.  The personal computer (PC) was new.  You couldn’t do much with it in the early days unless you were pretty computer savvy.  But programs were available that made them great business tools (word processing and spreadsheet programs). 

IBM created the PC.  And they licensed it so others could make IBM-like machines.  IBM clones.  The PC industry chewed each other up.  But Gates did well.  Because all of these machines used his operating system (Microsoft’s Disk Operating System – DOS).  Apple developed the Macintosh (with a mouse and Graphical User Interface – GUI) but it was expensive.  Anyone who used one in college wanted to buy one.  Until they saw the price.  So they bought an IBM clone instead.  And when Gates came out with Windows, they were just as easy to use as the Macs.

Because of the higher volume of the IBM platform sold, Microsoft flourished.  Software was bundled.  New machines came preloaded with Windows.  And Internet Explorer.  And Windows Media Player.  You got a lot of bang for the buck going with a Windows-based PC.  And Windows dominated the market.  Consumers weren’t complaining.  Much.  Sure, there were things they did bitch about (glitches, drivers, viruses, etc.), but it sure wasn’t price.

Of course, Microsoft’s competitors were hurting.  They couldn’t sell their products if Microsoft was giving away a similar product free.  Because they were hurting their competitors, the government tried to break up the company with the Sherman Act. 

THE NORTHERN SECURITIES SUIT of 1902 found a holding company guilty of not yet committing a crime.  Teddy Roosevelt’s administration filed a Sherman antitrust suit against Northern Securities.  This was a holding company for Northern Pacific, Great Northern, and Chicago, Burlington, and Quincy Railroads.  What’s a holding company?  It replaced a trust.   Which large corporations created in response to government’s attacks on large corporations.

Small competitors feared large corporations.  They could not compete against their economies of scale and vertical integration.  The little guys couldn’t sell things as cheap as the big corporations could.  So the government intervened to protect the little guy.  So they could sell at higher prices.

But businesses grow.  All big corporations started out as little guys.  And the growing process doesn’t stop.  So the big corporations had to find other ways to grow.  They formed trusts.  Then the trust-busters busted up the trusts.  The next form was the holding company. 

The trust-busters said that the big corporations, trusts and holding companies were all trying to become monopolies.  And once they eliminated all competitors, they would raise their prices and gouge the consumers.  Northern Securities never did.  But they could.  So they were guilty.  Because they might commit a crime.  One day.

ALL BUSINESS OWNERS aren’t morally ethical and honest.  But the market is, albeit cruel.  Economies of scales will always put the little guy out of business.  Sad, yes, for the little guy.  But for every little guy put out of business, millions of consumers save money.  They can buy things for less.  Which means they have more money to buy more things.  New things.  Different things.  From new little guys who now have a chance with this new surplus of purchasing power.

But when politicians get involved, consumers lose.  When they help a competitor, they help them by keeping prices high.  To keep competition ‘fair’.  For the politically connected.

Consumers never complain about low prices.  Only competitors do.  Or their employees.  Those working on whaling ships didn’t like to see the low price of Rockefeller’s kerosene.  But the new refining industry (and its auxiliaries) created far more jobs than were lost on the whaling ships.  We call it progress.  And with it comes a better life for the many.  Even if it is at the expense of the few.

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