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When Economists Didn't Buy the Free

Market An Interview with Michael
When Economists Didn't Buy the Free Market An Interview with Michael

October 29, 2006 By Michael Perelman

Michael Perlman is a longtime professor of economics at California State University, Chico. A prolific
author, his newest book is titled Railroading Economics: The Creation of the Free Market Mythology
(Monthly Review Press, 2006). He has also written The Invention of Capitalism: The Secret History
of Primitive Accumulation (Duke University Press, 2000) and Manufacturing Discontent: The Trap
of Individualism in a Corporate Society (Pluto, 2005). Perelman also finds time to moderate the
Progressive Economists Network List. This interview was conducted via e-mail.

Seth Sandronsky: What did the top economists of the late 19th century grasp as the U.S. railroad industry

Michael Perelman: Economists who studied the railroad industry, which was by far the dominant industry
in the country, realized that competition would necessarily drive prices so low that the railroads would
become bankrupt.

What they saw was similar to the airline industry today. The extra costs to fly me from San Francisco to
New York might cost $20 at the most on a flight that was scheduled but had empty seats. Unbridled
competition would drive prices down toward $20, which was not enough to cover the fixed costs.

The economists at the time recognized that the industry's viability would require restricting market forces.
They argued that the only hope for the industry was to restrict competition by allowing railroads to
combine and at least collude to keep prices high.

SS: For non-economists, can you please explain what fixed costs are for industry, and the connections with
prices in the marketplace?

MP: Fixed costs are expenses that do not depend on the quantity of goods or services provided. For
example, in the airline industry corporations must pay interest on the debt incurred or payment on the
leases for the planes that they use. Once a plane is scheduled to run, payments for the pilots and flight
attendants as well as the landing fees are set, regardless of how many seats on the plane are empty.
According to economic theory, the relation between fixed costs and prices is nonexistent under strong
competition. Prices depend on marginal costs -- the cost of supplying one more unit. In the case of the
airlines, the marginal cost of filling an empty seat is merely the extra fuel required to carry the extra weight,
maybe a lunch, and the cost of handling baggage. Processing of tickets used to cost about $20 but now
through computerization is practically nothing.

Fixed costs are also related to but not the same thing as long-lived capital. Economists rarely pay much
attention to long-lived capital, except to applaud the concept of capital accumulation. The reason for their
inattention is that capital goods require considerations of time, which complicates the simple economic
models with which they are enamored. Once a company has invested in such capital goods, it is stuck with
them because it will not get much for its investment on secondhand markets. Companies become desperate
to utilize these capital goods as efficiently as possible.

A large passenger airplane carrying only a couple people would be a disaster for the airline. They would
have to do something to fill up their seats.

If all the airlines were in a similar situation, they would have no choice but to engage in the price war. This
sort of competition occurred in the 19th century railroads. Bankruptcy became commonplace until J.P.
Morgan began to organize them into large cartels to prevent competition.

Modern economics assumes away this tendency even though common sense shows that no really
competitive industry today is very profitable. Profits are highest in industries protected by intellectual
property or by the influence necessary to garner government contracts.

SS: What effects did the "Morganizing" of U.S. industries have on the economics profession?

MP: At first, many of the most important economists of the time applauded Morganization. They argued
that a consolidated firm could be more efficient and even offer lower prices to consumers -- much like the
contemporary justification of Wal-Mart. They also added that excessive competition was destructive.

Within a short period of time, the concern about excessive competition fell away, although the efficiency
argument remained in vogue. After all, large corporations were coming to be common and conventional
economists were not about to challenge them. After all, business forces already wielded tremendous
influence in academia.

The Morgan-friendly economists introduced another argument, which fell out of fashion until it was re-
adopted in the 1970s. This thesis proposed that elimination of competition was not necessarily bad because
of potential competition. The idea was that if a company became too greedy and its profits soared, other
companies would rush in to claim some of the profit.

As a result, corporations would moderate their lust after profits, allowing the public to benefit from the
lowered prices due to the efficiency of large business.

A few decades later, Joseph Schumpeter offered another wrinkle to the debate. Even if a corporation
monopolized an entire sector, say, steel for example, other corporations that depended on steel could turn to
other materials such as aluminum as a substitute. Using this argument, monopolistic power magically
disappeared because of what economists call cross-product competition. I might mention that the
era adopted Schumpeter as its patron saint because of his advocacy of the essential role of the entrepreneur.

But now, such debates have subsided. Instead, economists exude confidence that the market operates as a
giant computer or even a super-brain, which allows it to ensure that business performs in the most efficient
manner possible. So great is the divorce from reality that such theories persist even in the post-Enron era.

SS: In your fifth chapter you cover welfare capitalism and war socialism.

Please explain the terms and their connections in terms of free market myths.

MP: During World War I, the United States adopted many features of socialism

-- not the bottom-up socialism that we would applaud, but more of a state planning economy. At the time,
just like World War II, the United States'
war effort required a considerable portion of the Gross Domestic Product.

The government could not have claimed so much of production and still have left a viable civilian economy
without state planning.

In fact, whenever serious crises hit, governments realize the folly of relying on markets. After all, who
would applaud someone charging an arm and a leg for drinking water in the wake of Hurricane Katrina?

Much of the planning of the World War I economy helped to create a framework for much of the
progressive vision for the New Deal. Unfortunately, business regarded the prosperity created by this
planning system business as its own creation. As a result, during the 1920s, business became so confident
of the market that the economy reverted back to a laissez-faire arrangement for a few years until the Great

Market forces were unable to handle one problem. Business relied heavily on immigrant workers, who
tended to be sympathetic to radical appeals.

Business addressed that problem in two ways. First, the government drastically restricted immigration.
Second, some of the most powerful corporations adopted practices now called welfare capitalism. The idea
was to create alternatives to the immigrant communities and radical political movements by smoothing
over some of the rough edges of capitalism, offering workers conditions that might be attractive -- housing,
pensions, or even more stable employment.

Many of these businesses attempted to maintain welfare capitalism even after the depression started, but
after 1931 competitive pressures became too great and business took the gloves off.

SS: To what extent do competitive forces in the economy pave the way for the growth of financial markets?

MP: Competition affects finance in two different ways. As in the rest of the economy, competitive forces
drive financial institutions to increase efficiency (in the narrow sense of improving things like the cost of
handling transactions). As in the nonfinancial sector, the outcome tends to be consolidation which
strengthens finance.

At the same time, competition in the nonfinancial sector tends to lower the rate of profit. Investors, seeking
substantial profits, lose interest in the nonfinancial sector and turn to purely financial operations. This
particular consequence of competition helps to explain the rise of hedge funds and the relative absence of
investment in productive sectors of the economy.

SS: You finish by backing "the end of economics and the beginning of something better." What examples of
such change can you name?

MP: Of course, I would like to see a peaceful, socialist world. If someone as far-seeing as Marx refused to
prepare cookbooks for the future, I would certainly not take up such a project. To build such a future
requires collective action, not the musings of an obscure academic.

SS: Thank you very much for your time.

Seth Sandronsky is a member of Sacramento Area Peace Action and a co-editor of Because People Matter,
Sacramento's progressive paper: