The Corrosive Effects of Market Power

15 Nov 2014 4:36 PM | Deleted user

In An Inquiry into the Wealth of Nations, Adam Smith puts forth the ideal of the "invisible hand" as the mechanism through which individual selfishness will be regulated for the larger public interest. Through competition, whereby sellers, whether they are selling consumer goods, inputs for the production process, or even labor services, will not overcharge and exploit for fear that the competitive market will otherwise punish them and put them out of business.

In a competitive market, then, there is no need for government to regulate because the invisible hand of the market will do it.

Editor's Note: For more, read the original article in the He is a regular contributor.

Although free marketeers hail Smith as the father of unfettered markets, nothing could be further from the truth. Smith, above all else, was a moral philosopher who was concerned with creating a just society. This becomes especially evident when his Wealth of Nations is read alongside his Theory of Moral Sentiments. He merely assumes that in a pre-commercial society where there would be true competition, people’s natural selfishness would be tamed and ultimately harnessed for the public good.

At the same time, Smith recognizes that markets fail and that when they do government needs to step in regulate in order to preserve the competitive nature of the market place. For Smith, the biggest market failure would be monopolies in restraint of free trade or competition. Smith certainly wasn’t blind to the reality that in competitive markets larger firms would ultimately be able to undersell smaller ones, thereby driving them out of business, or that they would be able to purchase the smaller ones, thereby creating monopolies. Nor was Smith blind to the reality that employers, especially large ones, would be able to collude with one another to drive down wage rates.

Smith’s remedy is that government should break up monopolies because they destroy competition. After all, when firms have monopolies they are able to exploit both consumers and workers alike. As the only place to purchase certain goods, consumers find themselves at the mercy of the high prices that they would charge. And as the largest employer, workers find themselves at the mercy of the low wages they would pay. One only wonders what Smith would say about what has been referred to as the "Walmart Effect."

The Walmart effect is the ability of big box stores and box store chains like Walmart and others to exploit their market power to drive up profits, often at the expense of their employees. But here it is with an interesting twist. Because it is done in the name of providing consumers with lower priced goods, we as a society only look the other way. Typically Walmart will dictate that its suppliers reduce its prices by say 5 percent. Failure to do so means that their suppliers won’t have a contract to sell their goods. For suppliers these contracts can represent a sizeable portion of their business that without them they may well go under. It isn’t, however, just 5 percent. The next year Walmart tells its suppliers to reduce it prices by another 5 percent, and so on.

A recent article in The New Republic revealed that Amazon, which practically sells everything these days, has also adopted the same practice. Walmart, however, takes it a step further by dictating to its suppliers what they may pay in wages and offer in benefits. Now if Walmart demands that supplier wage rates be reduced by 20 percent, they will be reduced by 20 percent. In other words, the Walmart effect is to drive down wages, not only in Walmart stores, but throughout the economy. And yet, this behavior doesn’t fit the traditional definition of monopoly power that would warrant the Justice Department stepping in to regulate on the grounds that it is activity in restraint of free trade.

Of course, Walmart will counter that it is simply using its market power to achieve lower prices for consumers. Still, we need to recognize that this type of market power is contributing to a low wage economy and the disappearance of the middle class. Even if we dismiss Walmart as primarily an employer of low-wage workers, its corrosive effects on the economy is to ultimately contribute to those forces that drive higher paying manufacturing firms out of the country in order that they can continue to reduce their costs so that they will continue to have contracts supplying Walmart and stores like them.

Arguably, the pure competitive market model would argue that in the face of lower wages rates, all sellers will be forced to lower their prices so that workers now earning less will be able to demand goods and services. That, after all, is supply and demand. But if people cannot afford things they will not buy, and because producers have fixed costs there are limits to how low prices can go. In other words, deflationary wages don’t mean that the equilibrium price on the standard demand curve moves down the curve, rather it means that the demand curve shifts downward to the left, thereby reflecting a much reduced level of overall demand.

It goes without saying that if the economy is harmed by the absence of real competition because of monopolies, it is equally harmed by the absence of real competition because of unchecked market power. A serious reading of Smith would lead most to conclude that he would be just as appalled by the Walmart effect as he was by monopolies. Although Smith did not favor unions, he certainly understood why workers would organize. In the face of employer collusion to drive down wages, workers would need a measure of market power to drive up wages, which could only come about through unionization. Moreover, Smith maintained that the wages a society pays its workers reflects its character, and that a low-wage society is ultimately an unhealthy one.

There is no doubt that we all benefit from inexpensive consumer goods, but it isn’t true that we aren’t paying for those low-priced consumer goods in other ways. By driving wages down so that we as consumers can purchase cheaper items, we are only imposing social costs on society in the form of subsidies that have to be provided, which we are paying through our tax dollars. We aren’t merely subsidizing workers who have now fallen out of the middle class, we are subsidizing the profits of these low-paying companies who at the dawn of the Twentieth Century during minimum wage debates were often referred to as parasitic industries.

Of course, as Smith rightly noted, the wages we pay our workers says a lot about our character as a nation. The real question that policymakers should be grappling with is not simply the desirability of generating growth at all cost, but whether we can generate growth while also paying higher wages. The question then becomes what steps need to be taken in order to do that, with the understanding that an economy is built from the bottom up; not the top down.

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