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Amazon Ain’t Grandma’s Monopoly

Jay Goltz warns us in the New York Times that Amazon is keeping prices artificially low today  to gain market share:

Why would a company choose to operate without a profit? Because it wants to provide great value? Check. Because it wants everyone to love the brand? Check. Because it wants to gain market share? Check. Because it wants to put everyone else out of business, so that it can one day flick a switch to raise prices and make a fortune? CHECK!

Don’t believe me? Well, here is Jeff Bezos of Amazon, explaining why making a profit isn’t important. Of course, he doesn’t say he’s planning to raise prices after he puts a lot of people out of business, but let me translate something for you: Gaining market share by not taking a profit makes the most sense if you are planning to raise prices later when you have less competition.

That’s probably one of the most natural explanations of NASDAQ:AMZN, but I think Matt Yglesias is right:

And maybe it is. But it’s hard to see how that plan would work. Part of the genius of the Internet is that it makes it much easier for brands to directly market their wares to people. It’s easy to see how Amazon might put K-Mart out of business, but the only way for them to put Samsung out of business would be to actually manufacture mobile phones and televisions. And if Amazon ever starts trying to charge outrageous markups on Samsung’s products, people would just buy directly from Samsung. Amazon would probably be more efficient at delivering things quickly, but then any price premium Amazon charges would be in effect an upcharge for fast delivery not a monopoly rent. And most of the time delivery speed just isn’t that big a deal. 

There’s a word for this. Normally, when economist and journalist types talk about market health, they’ll use “perfect competition” and, by extension, number of firms, as a good baseline. In fact, the idea of “many firms” is so inculcated in the economic psyche that we’re loth to consider welfare efficiency by any other measure. Indeed Google returns 252,000,000 hits for “perfect competition” against a measly 555,000 for the much more appropriate “contestable market” – defined by The Economist as:

A market in which an inefficient firm, or one earning excess profits, is likely to be driven out by a more efficient or less profitable rival. A market can be contestable even if it is dominated by a single firm, which appears to enjoy a MONOPOLY with MARKET POWER, and the new entrant exists only as potential COMPETITION (see ANTITRUST).

In other words monopolistic rents are moderated by the threat of potential competition. As the Google hit numbers will tell you, this idea just hasn’t gained that much traction. But digital economics are very different. Internet monopolies are usually determined more by network effects (a la Facebook) more than real, physical barriers to entry. The obvious exceptions might be massively-scaled cloud storage etc. Even Paul Krugman missed this distinction regarding Google Reader. That’s why this little bit from Goltz really misses the mark:

If this competition with giant Internet companies seems like some kind of Brave New World, it’s really not. It’s pretty much the same strategy the robber barons employed in the 19th century. Today’s combination of tax avoidance and profit delay enjoyed by the Web retailers has made it very difficult for some local retailers. But is the end near?

In fact, it’s actually nothing like robber barons in the 19th century. For one, while Amazon is clearly the king of online retail, direct sales, as Yglesias notes, play an important role. But more importantly, Amazon’s appeal comes from rich, and reliable, system of product review it provides. Yeah Amazon Prime is great; the web infrastructure too. But do we really think consumers will let Bezos charge any real markups when Yelp is right next… click?

Furthermore, any markups can be so easily exploited by instant arbitrageurs that rents cannot exist for long. Price information spreads so rapidly that consumers will flock to other sites, or direct retail itself, the second they find any noticeable increase in price levels. iTunes reviewers have, on more than one occasion, saved me of $9.99 by pointing readers to legal ways of watching a movie free. Anecdotal, but powerful.

Goltz ends with what sounds like a guilt trip:

And if you are a customer, please think twice before you use the services of a local retailer without any intention of buying. We all may pay a hefty price for your “savings.” Empty storefronts don’t help a neighborhood.

Then again, the Times signs him off as:

Jay Goltz owns five small businesses in Chicago.

Okay, cheap shot! But I couldn’t resist… This is like a cry against efficiency and consumer surplus. For one, by selling in a public space using institutions funded by the American taxpayer, we have a right to cordially browse goods. And it’s not as if “local” stores don’t benefit from the likes of Amazon. Local shops need inputs, too, and I’m quite confident the long-run supply side effects of online retailing has brought that price down, allowing said shop to earn a greater margin on each product.

And think about the reviews! When a retailer is thinking about long-term inventories, it would be absurd if he or she didn’t use the rich information available on Amazon to better serve the local client base.

And if local businesses price their goods so fairly after all, implying a high level of competition, standard micro tells us that if Amazon were to raise prices too high, they’d just pop back into existence. Because if barriers to entry and exit aren’t low, then they’ve been earning rents this whole time, and are just upset that big, bad Amazon is making things fair. And if they are, well, Amazon can’t do much to keep them out.

Of course it’s a mix of both. Which is why we gotta think in terms of contestability. Yglesias is very correct: an evil Amazon will not stay in power for long. Network effects are rapidly eroded (see this), which forces digital “monopolies” to operate under the constant threat of competition.

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10 comments
  1. This is a tired, old, long discredited argument; First Mover Advantage; give away your product, profits don’t matter! Nicely demolished by Stan Liebowitz in Re-Thinking the Network Economy;

    http://www.amazon.com/Re-Thinking-Network-Economy-Digital-Marketplace/dp/0814406491/ref=sr_1_1?s=books&ie=UTF8&qid=1368825372&sr=1-1&keywords=re-thinking+the+network+economy

    Now, question; What famous Santa Fe Institute scholar believed–and probably still does–in First Mover Advantage

      • So, you finally disagree with something Brian Arthur believes?

  2. This is a really good post.

    I remember thinking how poor the examples given were when I studied perfect competition. But of course Amazon is the *perfect* example.

    The second to last paragraph is particularly brilliant.

    • Why, thank you!

      Yep, contestable markets were hardly mentioned in my textbook. In no small part, I think, because network effects seem to be a key distinguishing factor, something relatively new. (In an economic, if not sociological, sense). Perfect competition just serves as a better mold.

      Then again, I haven’t taken any college econ (only IB) so I can’t really judge how it’s taught.

  3. The entire opposition to predatory pricing revolves around a model premised on rational behavior where potential entrants always move into, or stay out of, a market depending on what side of the 0 NPV sits. Moreover, it’s not just a matter of a potential entrant to enter a market, but also that they are successful in attaining market share. As Dunne, Roberts,and Samuelsson wrote, “industries maybe more consistently characterized by turnover rates than by net entry rates.” In other words, even though entry occurs, exit rates occur at a commensurate rate and therefore would not diminish the overall market power of dominant firms.

    Likewise, in 1982 George Yip released his study of the behavior of nearly 800 markets in the U.S. and Canada. His study revealed that not only are new entrants undeterred by high entry barriers, but that new entrants are not substantial challengers to incumbent firms. In a sub-sample of 31 markets, Yip selected the 45 most successful firms and found that after 6 years nearly two-thirds “failed to capture a share level that the incumbents estimated as the minimum required for a major competitor in a particular market.” Further, the success of these new firms caused the profit margins of incumbents to fall only 7%.

    Moreover, the type of firm that is either first mover or one whom follows is highly relevant to the issue of whether entry and attaining market share is likely to happen (de novo new vs diversifying new vs incumbent). Capital and business accumen vis-a-vis that industry are highly relevant to whether a firm undertaking a predatory pricing move will be successful, or whether potential (and eventual entrants) are successful and thwarting a predatory pricing move.

    Sarah Julia Lane in her study of the ATM manufacturing industry to be a prime example of this. The ATM manufacturing industry began around 1969, with most de novo new firms entering around 1970, followed by diversifying firms in 1975, and lastly foreign firms in 1979. Lane found that de novo new firms dominated the market in the early stages of the industry due to their early entry. However, by the mid-1970s de novo new firms lost their market power, and were replaced by the diversifying firms. Although the average life of all de novo new and diversifying firms was approximately 2.5 years, the three largest market share holders by the mid-1980s were all diversifying firms.

    However, I am not as familiar with the network industry as far as entry barriers (structural and otherwise) to know whether the above applies to the network retail industry, but the assumptions of potential entrants a) entering the industry, and b0 grabbing market share to thwart a predatory pricing scheme are faulty.

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