[Note for bibliographic reference: Melberg, Hans O. (1997), Pushkin or Baumol -
Poets, Economists and Contestable Markets, http://www.oocities.org/hmelberg/papers/970505.htm]
Pushkin or Baumol
Poets, Economists and Contestable Markets
by Hans O. Melberg
Baumol is, among other things, famous for his theory of contestable markets. According
to this theory, low entry and exit costs may make a monopolist behave as if he were in a
competitive market. The argument is that if the monopolist does not keep his prices down,
a competitor would find it profitable to enter the market. The implication of this is that
competition/regulation policy should not be guided only by the number of firms in the
market. Even if there is only one firm, it might not charge too high prices (compared to
the efficient price i.e. when price is equal to marginal cost). Moreover, the theory shows
that competition can be encouraged by reducing entry/exit costs, for example by using laws
to regulate how much a big telephone company may charge small competitors for renting its
cables.
This is all well known. However, recently I came across a quotations which showed that
the famous Russian poet Pushkin knew about this mechanism long time ago. What is even more
surprising, the poet Pushkin draws different and maybe more correct conclusions than the
economist Baumol. Consider the following quotation:
"Booksellers may buy the whole printing for 1 rouble a copy and sell it for 5 to 6
roubles. In this case the author could produce the second, cheaper edition of this poetry,
but then the bookseller can also reduce his price and thus block the new printing. Trade
tricks of this sort are only too familiar to us, poor authors" (p. 101)
The point here is that the monopolist would charge too high prices as long as he could,
only threatening to lower his price if a competitor entered the market. This sounds
plausible. It also takes away some of the force of Baumol's argument. A monopolist will
not be forced by potential entrants to lower its price since it need only to threaten to
lower its prices to keep the entrant away.
There is, however, one counter-argument: The threat to lower your price if another
competitors enters the market may not be credible. That is, if a competitor really entered
the market, it would not really be profitable to lower the price as much as to make it
unprofitable for the new entrant. There is some force in this argument, but Kreps and
Wilson has showed in an article that as long as your competitors are slightly uncertain
about whether you really will fight a new entrant, it is profitable to fight (since it
increases reputation for toughness which, in turn, deters new entrants and allows you to
charge a higher price than in a perfectly competitive market). Moreover, there is the
option of making your threat credible (by building excess capacity or delegating powers to
your managers). Returning to the real world I also think people would agree that most
monopolists do not behave as if they were in a perfectly competitive market. In sum, I
would place my money on Pushkin, not Baumol.
It is, however, a bit unfair to compare the two. Baumol's theory is perfectly correct
in the sense that his conclusions follow from his assumptions. He did not really claim
that the theory was a good description of the real world. He is also right in pointing out
that entry and exit costs are important determinants of the competitiveness of a market.
Lastly, Pushkin - as most poets - is also a bit ambiguous. Is he really implying that the
threat of lowering the price is enough to deter a potential competitor, or does he mean
that the prospect of a new entrant actually affects the current price? Maybe the correct
answer is a bit of both!
References
The quote from Pushkin is from V. Kantor, (translated by N. Perova) (1996), Russian
Literature: Love and Fear of Capitalism, Social Sciences Quarterly Review, no. 3,
pp. 90-113. For more on Pushkin's implicit ideas on economics, see A. Anikin's book Muse
and Mamon. Social and Economic Motifs in Puskin.
[Note for bibliographic reference: Melberg, Hans O. (1997), Pushkin or Baumol -
Poets, Economists and Contestable Markets, http://www.oocities.org/hmelberg/papers/970505.htm]