The Price of Inequality: How Today's Divided Society Endangers Our Future (10 page)

By looking at those at the top of the wealth distribution, we can get a feel for the nature of this aspect of America’s inequality. Few are inventors who have reshaped technology, or scientists who have reshaped our understandings of the laws of nature.
Think of Alan Turing, whose genius provided the mathematics underlying the modern computer. Or of Einstein. Or of the discoverers of the laser (in which Charles Townes played a central role)
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or John Bardeen, Walter Brattain, and William Shockley, the inventors of transistors.
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Or of Watson and Crick, who unraveled the mysteries of DNA, upon which rests so much of modern medicine. None of them, who made such large contributions to our well-being, are among those most rewarded by our economic system.

Instead, many of the individuals at the top of the wealth distribution are, in one way or another, geniuses at business. Some might claim, for instance, that Steve Jobs or the innovators of search engines or social media were, in their way, geniuses. Jobs was number 110 on the
Forbes
list of the world’s wealthiest billionaires before his death, and Mark Zuckerberg was 52. But many of these “geniuses” built their business empires on the shoulders of giants, such as Tim Berners-Lee, the inventor of the World Wide Web, who has never appeared on the
Forbes
list. Berners-Lee could have become a billionaire but chose not to—he made his idea available freely, which greatly speeded up the development of the Internet.
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A closer look at the successes of those at the top of the wealth distribution shows that more than a small part of their genius resides in devising better ways of exploiting market power and other market imperfections—and, in many cases, finding better ways of ensuring that politics works for them rather than for society more generally.

We’ve already commented on financiers, who make up a significant portion of the top 1 or 0.1 percent. While some gained their wealth by producing value, others did so in no small part by one of the myriad forms of rent seeking that we described earlier. At the top, in addition to the financiers, whom we have already discussed,
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are the monopolists and their descendants who, through one mechanism or another, have succeeded in achieving and sustaining market dominance. After the railroad barons of the nineteenth century came John D. Rockefeller and Standard Oil. The end of the twentieth century saw Bill Gates and Microsoft’s domination of the PC software industry.

Internationally, there is the case of Carlos Slim, a Mexican businessman who was ranked by
Forbes
as the wealthiest person in the world in 2011.
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Thanks to his dominance of the telephone industry in Mexico, Slim is able to charge prices that are a multiple of those in more competitive markets. He made his breakthrough when he was able to acquire a large share in Mexico’s telecommunications system after the country privatized it,
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a strategy that lies behind many of the world’s great fortunes. As we’ve seen, it’s easy to get rich by getting a state asset at a deep discount. Many of Russia’s current oligarchs, for example, obtained their initial wealth by buying state assets at below-market prices and then ensuring continuing profits through monopoly power. (In America most of our government giveaways tend to be more subtle. We design rules for, say, selling government assets that are in effect partial giveaways, but less transparently so than what Russia did.)
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In the preceding chapter, we identified another important group of the very wealthy—corporate CEOs, such as Stephen Hemsley from UnitedHealth Group, who received $102 million in 2010, and Edward Mueller from Qwest Communications (now CenturyLink, after a merger in 2011), who made $65.8 million.
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CEOs have successfully garnered a larger and larger fraction of corporate revenues.
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As we’ll explain later, it is not a sudden increase in their productivity that allowed these CEOs to amass such riches in the last couple of decades but rather an enhanced ability to take more from the corporation that they are supposed to be serving, and weaker qualms about, and enhanced public toleration of, doing so.

A final large group of rent seekers consists of the top-flight lawyers, including those who became wealthy by helping others engage in their rent seeking in ways that skirt the law but do not (usually) land them in prison. They help write the complex tax laws in which loopholes are put, so their clients can avoid taxes, and they then design the complex deals to take advantage of these loopholes. They helped design the complex and nontransparent derivatives market. They help design the contractual arrangements that generate monopoly power, seemingly within the law. And for all this assistance in making our markets work not the way markets should but as instruments for the benefit of those at the top, they get amply rewarded.
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Monopoly rents: creating sustainable monopolies

To economists large fortunes pose a problem. The laws of competition, as I have noted, say that profits (beyond the normal return to capital) are supposed to be driven to zero, and quickly. But if profits are zero, how can fortunes be built? Niches in which there isn’t competition, for one reason or another, offer one avenue.
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But that goes only a little way to explaining sustainable excessive profits (beyond the competitive level). Success will attract entry, and profits will quickly disappear. The real key to success is to make sure that there won’t ever be competition—or at least there won’t be competition for a long enough time that one can make a monopoly killing in the meanwhile. The simplest way to a sustainable monopoly is getting the government to give you one. From the seventeenth century to the nineteenth, the British granted the East India Company a monopoly on trade with India.

There are other ways to get government-sanctioned monopolies. Patents typically give an inventor a monopoly over that innovation for a temporary period, but the details of patent law can extend the length of the patent, reduce entry of new firms, and enhance monopoly power. America’s patent laws have been doing exactly that. They are designed not to maximize the pace of innovation but rather to maximize rents.
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Even without a government grant of monopoly, firms can create entry barriers. A variety of practices discourage entry, such as maintaining excess capacity, so that an entrant knows that, should he enter, the incumbent firm can increase production, lowering prices to the point that entry would be unprofitable.
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In the Middle Ages, guilds successfully restricted competition. Many professions have continued that tradition. Although they argue that they are simply trying to maintain standards, restrictions on entry (limiting the number of places at medical school or restricting migration of trained personnel from abroad) help keep incomes high.
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At the turn of the previous century, concern about the monopolies that formed the basis of many of the fortunes of that period, including Rockefeller’s, grew so great that under the trust-busting president Theodore Roosevelt, America passed a slew of laws to break up monopolies and prevent some of these practices. In the years that followed, numerous monopolies were broken up—in oil, cigarettes, and many other industries.
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And yet today, as we look around the American economy, we can see many sectors, including some that are central to its functioning, where one or a few firms dominate—such as Microsoft in PC operating systems, or AT&T, Verizon, T-Mobile, and Sprint in telecommunications.

Three factors contributed to this increased monopolization of markets. First, there was a battle over ideas about the role that government should take in ensuring competition. Chicago school economists (like Milton Friedman and George Stigler) who believe in free and unfettered markets
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argued that markets are naturally competitive
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and that seemingly anticompetitive practices really enhance efficiency. A massive program to “educate”
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people, and especially judges, regarding these new doctrines of law and economics, partly sponsored by right-wing foundations like the Olin Foundation, was successful. The timing was ironic: American courts were buying into notions that markets were “naturally” competitive and placing a high burden of proof on anyone claiming otherwise just as the economics discipline was exploring theories that explain why markets often were
not
competitive, even when there were seemingly many firms. For instance, a new and powerful branch of economics called game theory explained how collusive behavior could be maintained tacitly over extended periods of time. Meanwhile, new theories of imperfect and asymmetric information showed how information imperfections impaired competition, and new evidence substantiated the relevance and importance of these theories.

The influence of the Chicago school should not be underestimated. Even when there are blatant infractions—like predatory pricing, where a firm lowers its price to force out a competitor and then uses its monopoly power to raise prices—they’ve been hard to prosecute.
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Chicago school economics argues that markets are presumptively competitive and efficient. If entry were easy, the dominant firm would gain nothing from driving out a rival, because the firm that is forced out would be quickly replaced by another firm. But in reality entry is not so easy, and predatory behavior does occur.

A second factor giving rise to increased monopoly is related to changes in our economy. The creation of monopoly power was easier in some of the new growth industries. Many of these sectors were marked by what are called network externalities. An obvious example is the computer operating system: just as it’s very convenient for everyone to speak the same language, it’s very convenient for everyone to use the same operating system. Increasing interconnectivity across the world naturally leads to standardization. Those with a monopoly over the standard that is chosen benefit.

As we have noted, competition naturally works against the accumulation of market power. When there are large monopoly profits, competitors work to get a share. That’s where the third factor that has increased monopoly power in the United States comes in: businesses found new ways of resisting entry, of reducing competitive pressures. Microsoft provides the example par excellence. Because it enjoyed a near-monopoly on PC operating systems, it stood to lose a lot if alternative technologies undermined its monopoly. The development of the Internet and the web browser to access it represented just such a threat. Netscape brought the browser to the market, building on government-funded research.
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Microsoft decided to squelch this potential competitor. It offered its own product, Internet Explorer, but the product couldn’t compete in the open market. The company decided to use its monopoly power in PC operating systems to make sure that the playing field was not level. It deployed a strategy known as FUD (fear, uncertainty, and doubt), creating anxiety about compatibility among users by programming error messages that would randomly appear if Netscape was installed on a Windows computer. The company also did not provide the disclosures necessary for full compatibility as new versions of Windows were developed. And most cleverly, it offered Internet Explorer at a zero price—free, bundled in as part of its operating system. It’s hard to compete with a zero price. Netscape was doomed.
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It was obvious that selling something at a zero price was not a profit-maximizing strategy—in the short run. But Microsoft had a vision for the long run: the maintenance of its monopoly. For that, it was willing to make short-run sacrifices. It succeeded, but so blatant were its methods that courts and tribunals throughout the world charged it with engaging in anticompetitive practices. And yet, in the end, Microsoft won—for it realized that in a network economy, a monopoly position, once attained, is hard to break. Given Microsoft’s dominance of the operating system market, it had the incentives and capabilities to dominate in a host of other applications.
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No wonder, then, that Microsoft’s profits have been so enormous—an average of $7 billion per year over the last quarter century, $14 billion over the past ten years, increasing in 2011 to $23 billion
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—and reaping wealth for those who bought shares early enough. The conventional wisdom has it that in spite of its dominant position and huge resources, Microsoft has not been a real innovator. It did not develop the first widely used word processor, the first spreadsheet, the first browser, the first media player, or the first dominant search engine. Innovation lay elsewhere. This is consistent with theory and historical evidence: monopolists are not good innovators.
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Looking at the U.S. economy, we see in many sectors large numbers of firms, and therefore infer that there must be competition. But that’s not always the case. Take the example of banks. While there are hundreds of banks, the big four share between them almost half of the country’s banking assets,
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a marked increase from the degree of concentration fifteen years ago. In most smaller communities, there are at most one or two. When competition is so limited, prices are likely to be far in excess of competitive levels.
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That’s why the sector enjoys profits estimated to be more than $115 billion a year, much of which is passed along to its top officials and other bankers—helping create one of the major sources of inequality at the top.
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In some products, such as over-the-counter credit default swaps (CDSes), four or five very large banks totally dominate, and such market concentration always gives rise to the worry that they collude, albeit tacitly. (But sometimes the collusion is not even tacit—it is explicit. The banks set a critical rate, called the London Interbank Offered Rate, or Libor. Mortgages and many financial products are linked to Libor. It appears that the banks worked to rig the rate, enabling them to make still more money from others who were unaware of these shenanigans.)