Joseph Schumpeter on Competition and Alcoa

Take that, Learned Hand.

I wrote approximately 100 biographies of famous economists for my Concise Encyclopedia of Economics, which is online at Liberty Fund’s site here. One of my favorite bios to research and write was that of Joseph Schumpeter. You can find it here.

My favorite book by Schumpeter is Capitalism, Socialism, and Democracy. It’s in that book that he introduces the concept of creative destruction. That’s my second favorite part of his book. But my favorite part is his discussion about the kind of competition that matters.

Here’s what I wrote:

Schumpeter argued with the prevailing view that “perfect” competition was the way to maximize economic well-being. Under perfect competition all firms in an industry produce the same good, sell it for the same price, and have access to the same technology. Schumpeter saw this kind of competition as relatively unimportant. He wrote: “[What counts is] competition from the new commodity, the new technology, the new source of supply, the new type of organization … competition which … strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives.”

I then added:

Schumpeter argued on this basis that some degree of monopoly is preferable to perfect competition. Competition from innovations, he argued, is an “ever-present threat” that “disciplines before it attacks.” He cited the Aluminum Company of America as an example of a monopoly that continuously innovated in order to retain its monopoly. By 1929, he noted, the price of its product, adjusted for inflation, had fallen to only 8.8 percent of its level in 1890, and its output had risen from 30 metric tons to 103,400.

I also pointed out:

Schumpeter never made completely clear whether he believed innovation is sparked by monopoly per se or by the prospect of getting a monopoly as the reward for innovation. Most economists accept the latter argument and, on that basis, believe that companies should be able to keep their production processes secret, have their trademarks protected from infringement, and obtain patents.

Here’s the passage on Alcoa that I was referencing, which still blows me away. It’s on p. 101 of my copy of the book, footnote 20:

The Aluminum Company of America is not a monopoly in the technical sense as defined above, among other reasons because it had to build up its demand schedule, which fact suffices to exclude a behavior conforming to the Cournot-Marshall schema. But most economists call it so and in the dearth of genuine cases we will for the purposes of this note do the same. From 1890 to 1929 the price of the basic product of this single seller fell to about 12 per cent or, correcting for the change in price level (B.L.S. index of wholesale prices), to about 8.8 per cent. Output rose from 30 metric tons to 103,400. Protection by patent ceased in 1909. Argument from costs and profits in criticism of this monopoly must take it for granted that a multitude of competing firms would have been about equally successful in cost-reducing research, in the economical development of the productive apparatus, in teaching new uses for the product and in avoiding wasteful breakdowns. This is, in fact, being assumed by criticism of this kind; i.e., the propelling factor of modern capitalism is being assumed away.

When I read that, I was reminded of something I read my first time when I was 17 in “Antitrust,” an essay by Alan Greenspan in Ayn Rand’s book Capitalism: The Unknown Ideal. Greenspan discussed the antitrust case against the Aluminum Company of America (ALCOA) and quoted the famous (infamous?) statement of Judge Learned Hand. Judge Hand, I later learned, was regarded as one of the best judges who never made it to the Supreme Court. According to the Wikipedia entry on Hand:

As of 2004, Hand had been quoted more often by legal scholars and by the Supreme Court of the United States than any other lower-court judge.^[3]

Here’s what Hand said:

It was not inevitable that it [Alcoa] should always anticipate increases in the demand for ingot and be prepared to supply them. Nothing compelled it to keep doubling and redoubling its capacity before others entered the field. It insists that it never excluded competitors; but we can think of no more effective exclusion than progressively to embrace each new opportunity as it opened, and to face every newcomer with new capacity already geared into a great organization, having the advantage of experience, trade connections and the elite of personnel.

Yikes! If he was a great judge, he must have had a bad day. As the saying goes, “Even Homer nods.”

Between Schumpeter and Hand, I’ll take Schumpeter.

Postscript: Try to guess what left-wing economics professor stated, on the cover of my copy of Capitalism, Socialism, and Democracy:

Schumpeter may well be the most important economist of the twenty-first century… His economic understanding was brilliant…Capitalism, Socialism, and Democracy is superb.