A new model explains the feedback loop between monopolies and politicians and the unexpected developments in the relationships between the two, as well as the importance for antitrust and competition.

The operation of markets and of politics are in practice deeply intertwined. Political decisions set the rules of the game for market competition and, conversely, market competitors participate in and influence political decisions. Since at least the time of George Stigler (1971), the connection between the two domains has been formalized in economics, and the flourishing literature that emerged has deepened our understanding of how special interests can distort political outcomes and how political decisions shape market outcomes.

At its best, the intervention of politics into markets provides the guardrails that allow competition and innovation to flourish. Of course, reality rarely works out as well as we hope. The ever-present fear is that a symbiotic relationship develops between policymakers and dominant firms, and that together they work to strangle competition to the detriment of us all. 

In our recent research, we show that those fears, if anything, are understated. Reality can be much worse, and a symbiotic relationship between dominant firms and policymakers can in fact have far-reaching negative consequences. In our paper, “Market Competition and Political Influence: An Integrated Approach,” we study a typical market with competing firms and a government policymaker who has the power to intervene into the market and favor one of the firms over the others. This type of market intervention is ubiquitous, such as state health care regulators who condition market entry on gaining approval of current market participants, or the ongoing baby formula shortage that arose because the US government had created de facto monopolies in production by signing exclusive procurement contracts with a single firm in each state.

The classic logic of capture is straightforward. In a competitive market, prices are low, as are profits, and consumers capture much of the value that is created. To instead capture some of the value themselves, the policymaker will partner with one of the firms, favoring it with regulations so that the other firms are excluded from the market, and this connected firm can operate as a monopolist. This drives prices–and profits–up, and the firm and the policymaker can share the spoils between themselves.

At a single point in time, this logic is airtight. But what happens over time? If the relationship between the policymaker and the firm holds, outcomes may not necessarily be very bad, or at least, they don’t need to get any worse. Although monopoly is bad for consumers, this does not imply that the industry cannot still be innovative. The desire of the monopolist to make as much profit as possible still drives investments in innovation. Products can still improve and processes can become more efficient. Perhaps gains may not be as high as in a competitive market, but improvements can still be significant.

Our insight is that even this won’t come about. To see how the market outcome can be much worse, the symbiotic relationship between the policymaker and the firm must hold over time. We point out that this is unlikely to be true. From a dynamic perspective, the relationship between the policymaker and the monopolist looks very different. 

“It is a cozy settlement for the firm and the policymaker but disastrous for the rest of us. The outcome is not only monopoly, but market stagnation.”

The change in the relationship comes from who has the leverage to capture the monopoly profits derived from their relationship. When potential competitor firms have the technological capability to challenge the connected firm, the threat of competition looms large, and the policymaker’s power to exclude competition is immensely valuable. From this power, the policymaker dominates the relationship with the connected firm and bargains her way to some of the value created. 

But if the connected firm invests and improves its capability and products over time, the excluded firms will fall behind. They have no reason or even opportunity to invest. Without being able to participate in the market, these other firms stagnate. But then their threat as potential competitors dwindles. At some point, the connected firm will ask itself: Why do I need protection? Why am I sharing my profits with the policymaker? If I can beat the competitors in the market, how valuable is political protection?

The answers to these questions might favor the firm, but they are disastrous for the policymaker. She has intervened so much in the market that she has rendered herself obsolete.

The policymaker’s loss of power may not seem like a cost to be too concerned about. Yet, as our research shows, the true cost lies elsewhere. To remain relevant, the policymaker responds to this possibility by removing protection should the connected firm gets too far ahead technologically compared to any potential competitors. The policymaker lets competition flourish, if only temporarily, so that the other firms can catch up technologically. With the firms once again evenly matched, the value of the policymaker’s protection is restored and she is able to remain relevant to the market leader.

This reaction may seem pro-competitive, but the outcome is not. The connected firm anticipates the policymaker’s response, and curtails its investment and innovation before the policymaker is tempted to open the market to competition. If the firm stops investing it remains protected, and if the firm stops investing the policymaker is able to collect its share of the spoils and continues to protect. It is a cozy settlement for the firm and the policymaker but disastrous for the rest of us. The outcome is not only monopoly, but market stagnation. The firm imposes the dead-weight loss of monopoly and invests and innovates at such a low level that the quality of the products produced and the efficiency of the market are stunted. It is the worst of both worlds.

Our insight represents a perversion of a classic insight from one of the 20th century’s greatest economists. In 1962, Kenneth Arrow described what has become known as the Arrow Replacement Effect. Arrow theorized that the more competitive a market, the more incentive there is for investment and innovation. That there is a positive relationship between competition and innovation.  Our result turns this result around. In our Reverse Arrow Effect, more investment and innovation lead to more competition as the policymaker removes protection. This is the exact opposite of what we hope for in a well-regulated market. It is no surprise, then, that investment and innovation stagnate at low levels.

So, what can be done about this problem? The answer, counter-intuitively, may be to make market entry more difficult. Working through the logic we have identified, if the threat of entry is what gives the policymaker her power, and if this power distorts the incentives of the connected firm to invest and innovate, then outcomes can be improved by weakening the threat of entry. We use our model to formalize this intuition and show that, indeed, the relationship between the ease of market entry and market outcomes is negative.

To be sure, this result should not be taken too far. Making market entry too onerous may neuter the policymaker’s power, but it condemns us all to monopoly power. We should expect better than that. 

What our research tells us is that the interaction of politics and markets is more subtle and non-linear than simple intuitions might have us believe. The benchmark of a perfectly competitive market is then not the best reference point that helps us understand how our economy works.  As the famous midcentury economist, Abba Lerner, observed in 1972, “An economic transaction is a solved political problem.” When politics is itself a live variable—a yet unsolved problem—the market transaction must be viewed through a broader lens.

What does this mean for antitrust? 

In recent years, a debate has raged about the appropriate role for antitrust. In the academy and the public domain, and even in the offices of government, the long-standing north star of consumer surplus has come under attack as the standard by which mergers and acquisitions should be evaluated. But if the standard is not consumer surplus, what should it be? A prominent group of activists, self-styled as New Brandeisians, argue that the level of competition in a market should be a key input into government decisions. Their argument harkens back to the time of Louis Brandeis, in which the role of business in government (and society more broadly) occupied a central place in public debate.

Our research provides a framework for better understanding the debate around the consumer surplus standard versus the level of market competition as inputs for antitrust policy. As our model shows, how the competitive landscape will change affects the relationship between dominant firms and regulators. Including this into the evaluation of a merger is important in understanding how the merger will impact consumer welfare. This calls for a closer economic analysis of the interdependence between the market and politics. It is our hope that our model provides the foundation for better understanding how the circularity between markets and politics can be harnessed productively for the benefit of us all.

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