Kaldor (1935)

The Suntory and Toyota International Centres for Economics and Related Disciplines
Market Imperfection and Excess Capacity

Author(s): Nicholas Kaldor
Source: Economica, New Series, Vol. 2, No. 5 (Feb., 1935), pp. 33-50
Published by: Wiley on behalf of The London School of Economics and Political Science and The
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'935]
and Excess
MarketImperfection
Capacity
By,NICHOLAS KALDOR
OF all the doctrines emerging from recent work on the

economics of imperfect competition, none appears more
intellectuallystrikingor more significantfrom a practical
point of view than the doctrineof " excess capacity." It is
intellectuallystriking,because it admits possibilitieswhich
the traditional" laws of economics" seem to have excluded:
e.g. thatan increase in " supply " may be followedby a rise
in price.' And it is practicallysignificant,because if the main
contentionsof the theoryare found to be correct,it affords
some reasons for interferingwith the " free play of comn-
petitiveforces" on groundsupon which traditionaleconomic
theorywould have dismissed the case for interference.The
theoryenvisagesa situation,where,on theone hand the market
facinga group of competingfirmsis, forone reasonor another,
not absolutely" perfect,"while on the other hand the entry
of resourcesinto the " industry" is free,and it shows that
under such conditions" competition" (i.e. the free flow of
resources into uses where they expect to obtain the largest
net remuneration)will drive each producer to a situationin
which it is not using its resourcesto the best advantage; and
it will thus lead to a reductionof the physicalproductivityof
resourcesall round. In a sense, it thus reversesthe old argu-
mentabout " increasingreturns" and monopoly; it not only
says thatfallingcosts will lead to monopolybut thata mono-
polistic or rather a pseudo-monopolistic situation2 will auto-
maticallylead each firmto a positionwhere it is faced with
1 Since Marshall,we are awareof thefactthatgivencertaincost conditionsan increase
in demand may be followedby a fall in price. But neitherthe Marshallian,nor, so
faras the presentwriteris aware,any othertheoreticalsystemleftroom forthe possi-
bilitythat under certainmarketconditions,an increasein th,enumberof sources of
supply (an inflowof resourcesinto the " induistry
") could lead to a risein prices.
2 We shallseelaterwhatpreciselytheterm" monopolistic" impliesin thisconnection.
33

34 ECONOMICA [FEBRUARY
fallingaverage costs.' It is a highlyingeniousand one might

almostsay revolutionary doctrine: it shows up" freecompeti-
tion'" (i.e. the freedomof entryinto any trade or industry)
not in the traditionaland respectablerole as the eliminatorof
the unfitbut in the much more dubious role as the creatorof
excess capacity. It affordsan excellenttheoreticalbackground
for the age-old cry of business men about the " wastes of
competition"-so farcompletelyneglectedby the economists.
It is worth while thereforeto examine this theoryin some
detail.
The theoryis put forwardboth in ProfessorChamberlin's
recent work and also in Mrs. Robinson's book.2 Closer
inspection reveals, however, that Mrs. Robinson's version
possesses a merelyformalsimilaritywith ProfessorChamber-
lin's theory. For Mrs. Robinson includes in her " cost
curves" such profitswhich are not competed away by the
entryof new producers; and under the circumstances,her
statementthat " demand curves will be tangential to cost
curves" and that firmswill be of " less than theiroptimum
size " is merelya statementof a tautology.3It does not imply
" excess capacity" or anythingof thatsort. In the subsequent
analysiswe shall followthereforemainlyProfessorChamber-
lin's statementof the theory.
II
The main argumentcan be stated briefly. Although not
stated so explicitly,it is really based on four assumptions.
1 "Falling average costs," if they are to be regardedas the criterionof " excess
capacity" should be interpreted thatin therelevantoutput,costsarefallingin a stateof
long-period equilibrium(afterall adjustmentshave beenmade to thatoutput),whichalso
impliesthat variable costsare falling(since in the long run the supply of all factors-
even the resourcessupplied by the entrepreneur himself-can be assumedvariableand
consequentlythereare no " fixed" costs). Since in a stateof fullequilibrium" short-
run" cost curvesmust be tangentialto the long-runcost curve: fallinglong-period
costsalso implythatshort-runtotalcostsare falling.But theconverseis not necessarily
true; fallingshort-runtotalcosts(the " fixedcosts" being calculatedon a " historic"
basis) need not involvefallinglong-runcosts,for the same output,and consequently
theseare no safecriteriaforthe prevalenceof excesscapacity.
2 Chamberlin, The Theoryof Monopolistic Competition, Ch. V. Mrs. Robinson,
The Economicsof Imperfect Competition, Ch. 7. The theoryof course,is by no means
completelynew. Wicksellalreadystatedit (Lectures,p. 86)-and it is also to be found,
in essentials,in Cairnes' PoliticalEconomy, p. I I 5. It was outlinedin P. Sraffa'swell-
known article (;' The Laws of Returns under CompetitiveConditions," Economic
7fournal,1926). The firstsystematicexpositionis, however,Chamberlin's.
3 Cf. on this point G. F. Shove, " The Imperfection of the Market" (Economic
Journal,March, I933), an article,which in the presentwriter'sview, containsone of
the mostpenetrating analysesso farpublishedon thiswholesubject.

I 935] MARKET IMPERFECTION AND EXCESS CAPACITY 35
itis assumedthattherearea largenumberofindepen-

Firstly,
dent producers,each selling one productonly, which is
"slightlydifferent"fromthe productsof the rest of the
producers.The words" slightly " imply,thatwhile
different
thedemandfortheproductof anyof theproducersis highly
to thepriceschargedbytheothers,yetthissensitive-
sensitive
nessis neverso greatas to compelall producersto sell at the
sameprice. It impliesthata producer,by loweringhis price
to his competitors'
relatively prices,will attractaway some,
butnotall theircustomers;or alternatively, thathe willlose
some,but notall of his own customers, if he raiseshis price
relativelyto the rest.' It is assumed,secondly,that " con-
sumers'preferences are fairly evenlydistributed amongthe
,"2 and sincetherearea largenumber
varieties
different ofthem
"any adjustmentof priceor of ' product' by a singlepro-
ducerspreadsits influence over so manyof his competitors
thattheimpactfeltbyanyone is negligibleand does notlead
himto anyreadjustment ofhis ownsituation."3 Thus, given
thepricesof all theothers,a " demandcurve" can be drawn
up withrespectto theproductofeach.4 Thirdly,it is assumed
thatno producerpossessesan "' institutional monopoly" over
any of the varietiesproducedand thus the entryof new
producers" intothe fieldin generaland everyportionof it
in particularis freeand unimpeded."Fourthly, thelong-run
costcurvesof all producersare assumedto be fallingup to a
certainrateof output; in otherwords,it is assumedthatup
to a certainoutput,thereare " economicsof scale " (Professor
Chamberlin's cost curves are U-shaped, i.e. they begin to
1 In technicaltermsthis implies that the consumer's" elasticityof substitution"
betweenthe different producers'productsis large, but not infinite;which is the same
thing as saying that the " cross-elasticities
of demand " (the elasticityof demand for
one producer'sproductwith respectto anotherproducer'sprice) are considerablebut
not infinite. Looking at it in this way, " monopoly" and " perfectcompetition"
appear as the two limitingcases, where the " cross-elasticities " are zero or infinite,
respectively;and therecan be littledoubt thatthelargemajorityofindustrialproducers
in the real world are facedwith imperfectmarketsin thissense.
2 Which implies,in the above terminology, of the demand
that the cross-elasticity
forthe productof any produceris of the same orderof magnitudewithrespectto the
priceof anyof his competitors.Cf. myarticle," Mrs. Robinson'sEconomicsof Imper-
fectCompetition," EcoNoMIcA, August,1934, p. 339.
3 Chamberlin,p. 83. Mrs. Robinsondoes not statethisso definitely, but heranalysis
is implicitlybased on the same assumptions. ProfessorChamberlinstates(pp. 82-3)
that he only makestheseassumptionstemporarilyin orderto facilitatethe exposition,
and removesthemlateron (pp. IOO-iI). But, as I shall tryto show, the theory,in
its rigid format any rate,reallystandsor fallswiththeseassumptions.
4 In the absence of theseassumptionsone can speak of a demand curve only in the
senseof an " imagineddemand curve," cf. below.

riseaftera certainpoint. But whilethe legitimacyof the latter

assumptionin the case of long-runcurvesappears doubtful,l
it does not affecthis argument,which merelyrequires that
costs should be fallingover-a certainrange.) The elasticities
of the demand curve and the cost curvesof each producerare
also assumed to be the same, but this,as I shall tryto show,
is not essentialto the main argumentso long as " institutional
monopolies" are assumed to be absent. Now, given thesetwo
curves each producer will tryto produce that output which
will maximise his own profits,i.e. equate marginal revenue
with marginalcost. But since marginalrevenue is less than
price,price will be higherthan average cost (includingunder
the latterthe displacementcost of the resourcessupplied by
the entrepreneur himself)unless average cost is also, and to a
correspondingdegree,higherthanmarginalcost (which it can
only be if average costs are falling). Let us assume that this
is not the case initially. Entrepreneursin the industrywill
then make " monopoly profits,"i.e. remunerationfor their
own resourceswill be higherthanthatwhichsimilarresources
could earn elsewhere. This will attractsuch resourcesintothe
" industry"; new firmswill come in, producing new sub-
stitutes,wh-iich will reduce the demand for all existingpro-
ducers; and this process will continue, until profitsare
reduced to normal, i.e. the differencebetween the actual
earnings and the displacement costs of the entrepreneur's
own resourcesis eliminated. In the position of finalequili-
briumnotonlywillmarginalcost be equal to marginalrevenue,
but average cost will also be equal to price. The demand
curvewill thus be " tangential" to the cost curve. The effect
of the entryof new competitorswill not necessarilyreduce
the price of existingproducts; it may even raise them. The
profitswhich the entrepreneurno longer earns will thus not
be passed on to the consumer in the form of lower prices
but are mainlyabsorbed in lower productiveefficiency.The
producers, as a body,could of course prevent this from
occurringby reducingtheirprices in anticipation of the entry
of new competitors. But since the appearance of any single
new producerwill only affectthe demand of a-single existing
producervery slightly,while similarlythe reductionof price
of a singleexistingproducerwill only slightlyaffectthe profits
which a potential producer can expect, no producer could
' Cf.my article,"TShe Equilibriumof the Firm," Economic7ournal, March, 1934,
P. 70.

1935] MARKET IMPERFECTION AND EXCESS CAPACITY 37
on his own pricepolicyintocon-

taketheseindirecteffects
sideration.
Therecan be littledoubtthatgiventheseassumptions the
theoryis unassailable. Any criticismthereforemust be
directedagainstthe usefulnessand the consistencyof the
assumptionsselected.
ILL
of theseconcernstheassumptions
I. The first madeabout
of thedemandforthe productsof various
the interrelations
producers(whichare substantially the same as thoseunder-
lyingMrs. Robinson'sconceptionof an " imperfectly com-
petitiveindustry" 1). No doubt,in mostcases,the products
of variousproducerssellingthe same sortof goods are not
" perfectsubstitutes " to each otherin the sense that the
slightestpricedifferencewouldeliminateall demandforthe
productsof higher-price producers.The reasonsfor such
marketimperfectionmay be classedunderone of three
headings. There may eitherbe slight differences in the
productsthemselves(as in the case of motorcars, wireless
sets, etc., the absence of " standardisation"); or differences
in the geographicallocation of producersin cases where the
consumersthemselvesare distributedover an area; or finally,
there may exist a certain " inertia" on behalf of the buyers
themselveswho will require either some time, or a certain
magnitudein the price-difference, beforetheymake up their
minds to buy from another seller-even if-they are quite
indifferentas between the products of differentsellers.-
Whatever the cause, the effect,fromthe analyticalpoint of
view, will be the-same: the " cross elasticities" of demand
' Cf. The Economicsof ImperfectCompetition, Ch. I. Cf. on this point my review,
op. cit.,p. 339.
2 It might be objected that anythingwhich causes a lack of indifference between
buyers will make the products " imperfectsubstitutes" in relation to each other
(since the consumers'attitudeis the finalcriterionfor classifying" products") and
consequentlyno distinctioncan be madeout between" buyers'inertia" and " product-
differentiation"as causes of marketimperfection.There is, however,a very good
reason for keeping themseparate. Whereasin the ordinarycase of imperfectly sub-
stitutablecommodities the consumers' " elasticity of substitution" between two
productsis symmetrical (i.e. a givenchaiigein the price ratiowill cause a givenchange
in the relativequantitiesdemanded,whicheverof the two prices has moved relatively
to theother)thisis by no meansthecase whenthelack of indifference is merelydue to
the inertiaof buyers. In the lattercase, one cannot even speak of a given " marginal
according to the directionof the
rate of substitution,"since thisrate will be different
change.

will have a positivefinitevalue. But is thereanyjustification

forthe furtherassumptionthat theywill also be of the same
orderof magnitudewith respectto the pricesof anygroup of
rivalproducts? Can we say thatany adjustmentof priceor of
" product" by a single producer will spread its influence
evenlyover all his competitors? No doubt, cases are conceiv-
able when it would. When the" imperfection of the market"
is due to sheerbuyers'inertiaand nothing else,we could invoke
the law of large numbers arid say that the buyers who no
longer buy fromA, will pair themselvesmore or less evenly
withB, C, D. . . . But buyers'inertia,thoughan important
factorin practice,is rarelyfound in isolation as a cause of
market-imperfection. It is generallycoupled with either or
both of the othercauses.' And in these cases, it is clear that
the different producers'productswill never possess the same
degree of substitutabilityin relationto any particularproduct.
Any particularproducerwill always be faced with rivalswho
are nearerto him,and otherswho are "fartheroff." In fact,
he should be able to class his rivals,fromhis ownpointofview,
in a certainorder, according to the influenceof theirprices
upon his own demand (which will not be necessarilythe same
orderas thatapplyingto any particularrivalof his). This is
clear in the case where " marketimperfection " is merelydue
to differences in the geographicallocationof producers. It is
equally true in cases of " product-differentiation."Savile
Row tailors will be most influencedby Savile Row prices;
theywill be less concernedwith fluctuationsin the price of
East-end clothes.2
" Pseudo-monopolists"-distinguished from the old-
fashioned " real monopolists" merely by the fact that the
"cross-elasticitiesof demand" for their product is large-
thus cannot be grouped togetherin a lump but can at best
be placed into a series. Each " product" can be conceived
as occupyinga certainpositionon a " scale "; the scale being
so constructedthat those products are neighbouringeach
1 Moreover, the case wheremarket-imperfection is merelydue to buyers'inertia
is not a verygood one fromthe point of view of this theory:since it always implies
the presenceof " institutionalmonopoly" as well. Cf. p. 45.
2 It is conceivablethatthe" scale of preferences
" of different
consumersshoulddiffer
in just that degree as to eliminatethe differences of
in the degreeof substitutability
different products for the body of consumersas a whole. (If individualX regards
productB as a nearersubstituteto A thaneitherC or D, but Y regardsC as a nearer
substitutethan eitherB or D, while Z regardsD as the nearestsubstituteto A, then
the pricesB, C, D may have the same influenceon the demand forA.) But thisis a
ratherimprobablesupposition.

I935] MARKET IMPERFECTION AND EXCESS CAPACITY 39
other betweenwhich the consumers'elasticityof substitution

is thegreatest(a " product" itselfcan be definedas a collection
of objects between which the elasticityof substitutionof all
relevantconsumersis infinite). Each producer then is faced
on each side with his nearestrivals; the demand forhi-sown
product will be most sensitivewith respect to the prices of
these; less and less sensitive as one moves furtheraway
fromhim. "Product variation" by an individual producer
can then itselfbe representedas a movementalongthe scale;
and, given the positionof all other producers,each producer
willtendto settleat thatpointon thescale wherehis anticipated
profitsare the greatest. New entrantsmust also occupy a
positionon thatscale, and will thusnecessarilymake the chain
of substitutes " tighter."
The idea of such a " scale " can best be envisagedin the case
of the simplesttype of market-imperfection: the distribution
of consumersover an area. Let us assume that all consumers
are situatedalong a road (a kind of " ribbon development"),
they are of an even degree of density,and all of them have
an equal desire to buy. They are completelyindifferent as
between the productsof different sellers; or ratherthe only
difference consistsin respectto transportcosts (which can be
equally regarded to be borne either by the buyers or the
sellers). Under such conditions,sellers will tend to settle at
equidistant points fromeach otheralong the road,' and thus
they are all " pseudo-monopolists,"since no two producers
sell fromthe samnespot.2 Looked at fromthe pointof view of
any seller,a change of price by any otherparticularseller (the
prices of the rest being assumed as given) is less and less
importantfor him, the furtheraway that particularseller is
situated.
It followsfromthis, first,that even when the number of
producersis large (the chain of substitutestight)it cannot be
assumed that the effectof a single producer's action will
spreaditselfevenlyover a large numberof his rivalsand will be
negligibleforeach of themindividually.The otherproducers'
1 If only thereare more than two of them,cf. Chamberlinp. I96, whereProfessor
Hotelling'srelevanttheoremis corrected.
2 The assumptionthat " institutional monopolies" are absent,impliesin this case,
that any sellercould,if he wantedto, move to the same spot as that occupied by any
in transportcosts)and thusmake
otherseller(or so nearto it as to eliminatedifferences
his own product" indistinguishable " fromthatof the other. Neglect to distinguish
betweenthesetwo casesof " monopolies" has been thesourceof much confusionin the
past.

pricesand " products" thuscannotbe assumedas " given"

in drawingup the demandscheduleforthe first;and the
real demandcurvefora singleproducer'sproductis thus
indeterminate (dependingon any of the large numbersof
possiblereactionsin whichhis rivalsmightindulge).' The
problemsof " duopoly" are thusnotmerelyconcomitants of
a situationwherethereare a " smallnumberof producers"
but arise in all cases whereproducersare sellingsubstitute
products,since the fact of " imperfectsubstitutability"
necessarily involvesthe presenceof the " scale" and thus,of
the" smallnumber."" Duopoly" is thusseennotas a special
class by itselfbut ratheras " the leadingspeciesof a large
genus."
Secondly,it can just as little be assumed that " new
products"(theproductsof newor prospective will
entrants)
standin thesameor similarrelation withall existingproducts.
A new productmustnecessarily be placed in betweentwo
existingproducts; and will thusmake considerableinroads
intothemarkets of his nearestneighbours.Thus a producer,
if far-sighted, will take the effectof his own actionsnot
merelyon his existingcompetitors intoconsideration butalso
on his potential competitors.2 He will act on the basis of an
" imagineddemandcurve" whichshowstheamounthe can
sell at differentpricesin the longrun, underthe assumption
thathis competitors' products, prices,and thenumberof his
competitors are all adjustedto his price. If a producerknows
thatifhe chargesa highpriceto-daya competitor willappear
to-morrow whosemereexistence willputhimin a permanently
worseposition,he willchargea pricewhichwillafford
him
only a low profit,if only he hopes to secure this profit
1 Which does not imply that each producer ,will not base his policy upon certain
ideas concerningthe relationbetweenthe demand of his product and its price. But
this" imagineddemand curve" is based on certainexpectationsconcerninghis rivals'
behaviour as a result of changes in his own policy;-irrespectivelywhetherthese
expectationsare corrector not. Such an " imagineddemand curve" is always deter-
minate(since something- must always exist in the producer'sown mind). But it is a
different sortof thingfromthe " demand curves" of traditionalanalysiswhichalways
implied an objecti'verelationshipbetweenprice and the quantity demanded. For a
fullertreatmentof the distinctionbetweena real and an imagineddemand curve,cf.
my previousarticlequoted above (ECONOMICA,August, 1934, p. 340.).
2 If a producertakesinto account the consequencesof his own policy on his existing
competitors,this will probably induce him to charge a higher-price than otherwise
(will make his " imagined demand curve" less elastic). But-if he takes potential
competition into account, this will probably induce him to charge a price lower than
otherwise(make his imagineddemand curve moreelastic). " Potentialcompetition"
implies both (a) the appearance of a new rival, (b) the possibilityof " product-
adjustment" ratherthan price-adjustment by an existingrival.

I935] MARKET IMPERFECTION AND EXCESS CAPACITY 41
permanently; i.e. hewillactin a manneras ifhisowndemand

curve were very much more elastic than it is. And this
" foresight
" will,or at anyratemay,preventhimfrombeing
driventoa stateof" excesscapacity."1
2. Moreover,it can be shownthat even if none of the
producerstakes the indirecteffectsof his own policyinto
consideration2" potential competition" will never succeed
in makingtheindividualdemandand cost curvestangential,
if "economies of scale" exist; while the possibilityof
" product-differentiation"
will by itselfnever preventthe
establishment of " perfect competition " if " economies of
scale" arecompletely
absent.Demandcurvesand costcurves
thereforewill only become necessarily" tangential" to each
otherwhen" demandcurves" havealso becomehorizontal.
In orderto provethis,letus againtakethesimplestcase of
marketimperfection whichis at the same timetheone most
favourableto the " excesscapacity" theory:when it exists
solelyon accountof thespreadingof consumers overa large
area. Let us again assumethatconsumersare evenlydistri-
butedover the whole area; that theyhave no preferences
whateveras betweenthe different sellers; and thatthe cost
functions,of all producersare identical.The demandcurves
of individualsellerswill be " downwardsloping" solelyon
accountof theincreasein transport costsas moreis sold. Let
us assumethatproducersare situatedat equal distancesfrom
eac1:otherand thattheyall make " profits " (sell at prices
whichmorethancoveraveragedisplacement costs). Let us
assumethatnew producersenterthe field. Each producer's
marketwillbe smaller;theelasticity of-demand, at anyprice,
higherthan before. But if we assume that economiesof
scale are completelyabsent (i.e. long-runcost curves are
horizontal)profits willneverbe eliminated altogether so long
1 Whether it willdo so or not,willdependon therelative willingness and ability
ofbearinglosses-onbehalfofthe" existing producer " and the" newentrant." For
letus assumethata producer reduceshispricein anticipation of theentrance of new
competitors. If the" newproducer " comesin nevertheless,at theruling price,both
willbeinvolved in losses.Buttherewillbesomehigherpriceat whichbothwillmake
someprofits;and ifthenewentrant can inducetheold producer to raisehis'priceto
thatlevelhecan thereby securehisplaceon the" scale" permanently. If on theother
hand,theold producerpersists in chargingthelow price,one of themwill haveto
dropout. (In so faras " buyers' at all,there
inertia"is present is alwaysa presumption
thatsucha price-war willcostlessto theold producer thanthenewone.)
2 I.e. theyall acton thebasisofan " imagined demandcurve" whichcorresponds
to a " realdemandcurve" drawnon theassumption thatthepricesand " products"
of all otherproducers remainthesame,irrespectively of whatthefirstproduceris
doing(whichis theassumption underlying Professor Chamberlin's demandcurves).

as the elasticityof demand is less than infinite. For each

producercan always recoversome of his lost profitsby reduc-
ing output up to the point where marginal revenue equals
marginal cost (which in this case, also equals average cost).
The inflow of new producers will continue, leading to a
continuousreductionin the output of existingproducersand
a continuousincreasein the elasticitiesof theirdemand until
the latter becomes infiniteand prices will equal " average
costs." There the movementwill stop. But each " firm"
will have reduced his output to such an extent that he has
completelylost his hold over the market.
We see thereforethat the mathematicaleconomists in
making" perfectcompetition" as theirstartingpoint,weren't
such fools afterall. For theyassumed perfectdivisibilityof
everything;and where everythingis perfectlydivisible,and
consequentlyeconomiesof scale completelyabsent, " perfect
competition" must necessarily establish itself solely as a
resultof the " free play of economic forces." No degree of
" product-differentiation " and no possibilityof furtherand
"
further product-variation " will be sufficientto preventthis
result, so long as all kinds of " institutionalmonopolies"
and all kindsof indivisibilities
are completelyabsent.
Let us now introduce indivisibilitiesand economies of
scale. The movementof new " firms" into the fieldwill then
not continue until the elasticitiesof demand for individual
producersbecome infinite;it will be stopped long beforethat
by the increasein costs as the outputof producersis reduced.
But thereis no reasonto assumethatit will stoppreciselyat the
pointwherethe demandand costcurvesare tangential.For, on
accountof the veryreasonof " economiesof scale " the poten-
tial producercannothope to enterthe fieldprofitably withless
than a certain magnitude of output; and that additional
output may reduce demand, both to his nearest neighbours
and to him, to such an extentthat the demand curves will
lie belowthe cost curvesand all will be involvedin losses. The
interpolation of a thirdproducerin betweenany two producers
may thus transform" profits" into " losses." The same
reason thereforewhich prevents competition from becoming
" perfect"-i.e. indivisibles-will also prevent the complete
eliminationof " profits." It will secure a " monopolistic
advantage" to anybodywho is firstin the fieldand merelyby
virtueof priority.The ultimatereason for this bDeingthwat it
is not the originalresourcesthemselves,but the various uses

to whichtheyare put thatare indivisible-youcan divide

"freecapital" butyoucannotinvestlessthana certainamount
of it in a machine-and consequentlythe investmentof
resourcescannotbe so finelydistributedas to equalise the
levelof marginalproductivities.'
The above argumentdoes not hold, if we assume as
ProfessorChamberlinassumedat the start,thatconsumers'
preferencesare evenlydistributed over the whole field; and
consequentlythe entryof a new firmaffectsall existingfirms
to an equal degree. Then the demand foreach is onlyreduced
by an insignificantamount by a single new entrant; and
consequentlythe number of firmscould increase with im-
punityuntil profitsare completelywiped out and the demand
curves become " tangential."
That ProfessorChamberlinis aware of our firstobjection is
clear from his analysis of chain-relationships on pp. IO2-4
of his book. That he is also aware of the second is clear from
certain remarks in connection with spatial competition on
p. I 99. It would be most unfairthereforeto criticise
him on a
point of logic-since the logic of Professor Chamberlin's
analysis is indeed excellent. What he does not seem to be
aware of is the degree of unrealityinvolved in his initial
assumptions; and the extentto which his main conclusions
are dependenton those assumptions.
3. So far we have not mentionedthe most freqquent and
conspicuous objection against the " excess capacity" theory:
that it assumes " identicalcost and demand curves" for the
differentproducers. In our view, this is no valid criticism
on Professor Chamberlin's assumptions. The identity of
the demand curves merelyensures that the pricesof different
producerswill be identical. But since producersare free to
varythe qualityof theirproductas well as theirprice, differ-
ences in elasticitywill not save producersfrombeing driven
to a positionof " tangency"-although they may reach this
positionby sellingat different prices. The identityof the cost
curves-in therequiredsense-follows on the otherhand from
theassumptionof theabsenceofany" institutional monopoly."
It is assumed, that is to say, that everyproducer,could,if he
1 This brings out clearly also the objection against Mrs. Robinson's "normal
profits."We see how thelevelof profitsin each firm-the difference betweenits actual
remunerationand the displacementcost of its earnings-is determinedby the degree
of indivisibilitywhich acts as a " protectiveshield" against intruders. There is no
morereasonto assumetheseprofitsto tendto a ' normal" levelthan thereis to assu1lie
thattheextenitof indivisibilities
is thesame in all cases.

wantedto,producecommodities
completely identicalto those
ofanyotherproducer-ifhe does not,thisis merelybecause
he would not findit profitableto do so.1 2 Such " institutional
monopolies " mayconsistof patents,copyrights,trade-marks
or even a trade-name.They may be conferred by law, by
ownership, or merelyby thewillof thepublic. If thepublic
to buyfromMessrs.Smithand Robinsonand thusthe
prefers
nameofthesellerbecomespartofthe" qualityoftheproduct,"
then Messrs. Smithand Robinsonhave an " institutional
monopoly " oftheirproducts.Theypossesssomething which
otherscannotpossess. Similarly,if the enterpreneur owns
betterfittedfortheproduction
resourceswhichare relatively
of some varietiesthanthe resourcesoverwhichotherentre-
preneurshave command,he has exclusive controlover
resourceswhichtothatextentareunique: andthisalsoimplies
thepresenceofsome " institutional monopoly."3 Consequent-
ly,in the absence of these,since the relativecostsof producing
differentvarietiesmustbe thesame forthe different producers,
theircostcurves, foreachsinglevariety, mustalso be identical.
It mightbe objected,that" institutional monopoly " thus
defined,coversa muchlargernumberof cases thanwhatis
generallyunderstoodby thisterm. Indeed,one could make
outa nicedistinction betweenthepossessionofan " absolute"
monopoly (when no otherproduceris able to producea
completely identicalproductat anycost)or a comparative or
" partial" monopoly(when no other produceris able to
producethe same productat the same relativecost). But as
all " products" are more or less close substitutes for one
another, this distinction becomes analytically unimportant
since it comes to the same thingwhetherproducerB can
producemerelya " moreor less close substitute " to A-
or whether he can produce the same product but onlyat a
higher cost than A.4 Anything therefore which imposes
highercostson one producerthananother(whether it is due
I Professor doesnotstatethisexplicitly;butthisis theonlylogically
Chamberlin
consistent one can give to his assumption
interpretation that" the entryof new
producers intothefieldin generaland everyportionof it in particular is freeand
unimpeded."
2 This impliesin our terminology thateveryproduceris freeto movealongand
settleat anypointof the" scale,"he can gettherefore " as nearto " theproductsof
anyotherproducer as he wantswithoutincurring higherrelati'vecosts.
3 In orderto avoid misunderstanding it mustbe pointedout thattheabsenceof
institutional
monopoly " doesnotimplythattheabilities ofeachentrepreneur, and
consequently theabsolutele'veloftheircosts,areidentical.
4 In bothcasesproducer B willobtainsmaller totalreceiptsforthesametotaloutlay.

to the possessionof " unique" resourcesby one entrepreneur

or whetherit is merelydue to " buyers inertia imposinga
special " cost of entry" on new producers) implies, to that
extent,the presenceof" institutionalmonopoly."
Such " institutionalmonopolies" of course are never
completelyabsent. Their presence-though as we have seen
in the last section, is by no means essential-may even be
directlyresponsiblefora large part of marketimperfection-
as ProfessorChamberlinhimselfso convincinglyshows in his
appendix in favourof " unfairtrading." They cannot there-
foreusefullybe assumed absent when a situationis analysed
which is oftenlargelybound up with them. And what does
the sifuationlook like when theyare not absent ?
If the " scale of differentiation
" of the consumerscan be
regardedas given-(as e.g. in the previous example, when the
degree of substitutabilityof different " products" was rigidly
determined by the level of transport costs) institutional
monopoly,to the extent to which it is present, will prevent
the generationof excess capacity"-since
" to that extent,
" profits" earned by one producercannot be competed away
by another producer. Many types of " institutionalmono-
polies " however,by themselvesincreasethe degree of market
imperfection, and to thatextentare favourableto the genera-
tion of " excess capacity."2 The sudden appearance of
buyers'inertia,forexample,lhasthe double effectof reducing
the elasticityof demand for the individual products and of
imposinga cost of entryon potentialcompetitors; these two
opposing tendenciesmay cancel out, or the net effectmay go
in either direction.
1 What we designatedabove as " sheerbuyers' inertia" (i.e. that consumersrequire
eithera certainlapse of time, or a certainminimumof price-difference beforethey
changeoverfromone sellerto another,even iftheyare otherwisecompletelyindifferent
betweenthe different sellers'products)is merelya special case of " institutionalmono-
poly "; since it always imposes a differential advantage on the existing producer
relativelyto thenewentrant.The mereexistenceof specialiseddurable plant,however,
does not implysuch a differential advantagein the long run, althoughit may prevent
adjustmentsbeing undertakenin theshortrun.
2 The difference betweenthesetwo types of " institutionalmonopolies" (the one
whichaffects merelytherelativecostsof differentproducers,and theotherwhichaffects
the elasticitiesof the demand curvesfor productsas well) can best be elucidated by
examples. A legal patentfor a certaincheap processof producing ordinarywindow
glass will not lead the consumersto differentiate between glass produced by one
processor another. It will merelyhave the effectof imposinghighercosts upon any-
body who does not possessthe patent. A trade-markprotectinga certainsoap or
medicinemay lead, however,the consumersto differentiate betweendifferent soaps
or medicines; and thusreducethe elasticityof demand forthe productsof each pro-
ducer.
D)

To sum up the resultsof the above argument. The extent

to which " excess capacity" may be generated as a result
of " free competition" (under the assumption that the
existenceof " economiesof scale " willpreventthiscompetition
frombecoming " perfect") will depend: (i) On the degree
of " short-sightedness " or " far-sightedness"of producers
(how far they take potential competitioninto account 'in
deciding upon their price- and product-policy). This is a
question of business psychology rather than economics.
(ii) The extent to which " institutionalmonopolies" are
present. This, as we have seen, will tend to prevent the
generation of " excess capacity" if it leaves the scale of
differentiation unaffected; while it will have an uncertain
as well. (iii)
effectif it increases the scale of differentiation
The extentto which the market-situation resemblesa " chain
relationship" (in Professor Chamberlin's terminology),i.e.
the extentto whichthevarious" cross-elasticities " of demand
differin order of magnitude. Only in the special case when
they are all of the same order of magnitude will Professor
Chamberlin's conclusion (that demand curves will be tan-
gential to cost curves) necessarilyfollow. At the same time,
thereis a presumptionthatsome degreeof " excess capacity"
will be generatedeven if profitswill not be completelycom-
peted away: since " indivisibilities,"by themselves,will not
offera strong enough shield to prevent some rise in costs
as a consequence of the intrusionof new competitors.Many
of the objections thereforewhich can be broughtagainst the
theoryifput forwardin its rigid-form (thatdemand curveswill
tend to become " tangential" with the cost curves), do not
affectthe fundamentalproposition that the effectof the
competitionof " new entrants" and consequentreductionof
the level of profitsearned may take the formof a rise in costs
ratherthana reductionof prices.'
' ProfessorChamberlin'sanalysisis most valuable also in throwinglight upon the
probable consequencesof all monopolisticagreementswhich referto selling prices
ratherthan quantitiesproduced. It explains why, if a uniformtaxi-fareis imposed,
one will findtoo manyemptytaxisabout. Or if the code of " professional etiquette"
preventsdoctorsand lawyersfromundercuttingeach other,sooneror later theywill
all complain that theyare " under-employed."Or if manufacturers' cartelsor trade
associationsimpose a uniformprice or a uniform" profit-margin " on retailers,one
will find too many tobacco-shopsround the streets. It should also make us very
scepticalabout any remedyingof theevilsof " imperfect competition" by compulsory
or any type of interference
rationalisation,-cartellisation, with price-competition.
For measureswhich intendto preventthe alleged evils of " price-cutting " not infre-
quentlytendto aggravatethe realevilswhich theyare supposedto remedy.

4. So far we have not touched upon anotherabstract

assumptionwhichProfessorChamnberlin has made, i.e. that
each producerproducesonlya single" product." In reality
themajority ofproducers producea seriesofdifferent products,
if productsare to be definedby the same rigid market-
criteriaas wereappliedin theearlierpartsofthisarticle.And
at firstsightat anyrate,it does appearas if thespreadingof
production over a seriesof different productsis the way in
whichproducerscan overcomethe effectof those" indivisi-
bilities" whichformthe conditio sine qua nonof imperfect
competition.If thereis not a sufficiently greatdemandto
produceoneproducton an " optimalscale,"theproducermay
stillutilisehisplantfullybyproducingtwoor mnore products,
ratherthanbuildinga smaller,sub-optimalplantor leaving
his existingplantunder-employed. In this wav, " indivisi-
bilities" will be overcome; and consequently" excess
capacity"will notmakeits appearanceeither.TIheeffectof
" competition fromoutside" will be to induceproducersto
producea largerseriesof products,ratherthanto reducetile
scaleof outputas a whole.
In our view thislineof reasoningis not strictly accurate;
forevenifit is admittedthatvaryingthenumberof different
kindsof productsproducedprovidesone line of adjustment
forthe entrepreneur, this does not implythatthe essential
consequences of thistypeofsituation(thatincreasedcompeti-
tionwill lead to an increasein costs)can therebybe avoided.
Whethertheywill or not,will dependon the natureof the
cost-function of thejointlyproducedproducts.
Commodities, ofcourse,willonlybe producedjointlyifitis
cheaperto producethemjointlythanseparately.For certain
commodities (suchas wheatand straw)thisis alwaysthecase:
whatever is theamountproducedof each (or ratherwhatever
is the amountof resourcesengaged in producingthem);
irrespectively therefore whetherthe economiesdue to scale
are attainedor not. These are the cases of " by-products ";
wheremorethanone commodity emergesas a resultof single
productive process.Certainothercommodities, however,may
bejointlyproducedsimplybecausethedemandforanyofthem
is not largeenoughto be producedon a scale whichshould
enabletherealisation oftheeconomiesofscale; whilesomeof
theseeconomiescan be retainedbyutilisinga larger" plant"
forthe productionof severalcommodities.For such com-
modities" jointproduction " willonlybe profitableas certain

outputs,and will become unprofitableas soon as the demand

for each or any of them is sufficiently large to enable the
" economies of scale " to be secured in case of separate
production. This is the case simplybecause the " indivisible
factors" (buildings, machinery,etc.) which are responsible
for these economies, are never completelyspecialised; and
can be used, more or less effectively, for the productionof
several thingssimultaneously.
Since, however,in mostcases, " indivisiblefactors" are not
completelyunspecialised either,such a "spreading of pro-
duction" is always attendedwithsome cost; i.e. the physical
productivity of a givenquantityof resourcescalculatedin terms
of any of the products will always be less, the greater the
number of separate commoditiesthey are required simul-
taneouslyto produce. That thisis the case fora large propor-
tion of jointlv produced commoditiesis shown by the fact
thatthe developmentof an " industrv" is alwaysattendedby
specialisation " or " disintegration," i.e. the reduction of
the numberof commoditiesproducedby single firms.'
Assuming thatthe cost-functions of jointlyproduced com-
moditiesare of thisnature,how does the equilibratingprocess
work itselfout under our previous assumptions? For sim-
plicitv, we can postulate that there are a given number of
firms,and initiallyeach of themproduce onlyone productand
all are making profits(not necessarilyto the same degree).
Let us suppose thatone of themfindsit profitableto produce
anothercommodity,highlycompetitivewith the productsof
some other producers. These latterproducerswill now find
the demand fortheirproductsreduced; and thismay make it
profitablefor them to engage in the productionof a second,
or even a third,commodity-even if this was not profitable
before. This in turn will induce other producers (possibly
our " first" producer)to do the same, which in turnwill lead
to a further " spreading of production" by competing
producers. Assuming always that producersmerelytake the
directeffectsof theiractions into consideration(i.e. act upon
an " imagineddemandcurve" whichregardsthepricesand the
products" of all otherproducersas given2) thisprocesswill
continue,so long as producerscontinueto make someprofits;
1 Cf. Allyn Young, " Increasing Returns and Economic Progress," Economic
7Qurnal,9z29.
2 This impliesin thiscase thatproducersignorenot only any adjustment of priceor
of productby otherproducersas a resultof theirown policy,but also any effectupon
the demand forsome of the othercommoditiesproduced by themselves.

I 935] MARKET IMPERFECTION AND EXCESS CAPACITY 49
and so longas thelosscausedbya reduction in theamountof

resourcesengaged (if the reductionin the outputof one
commodity werenotcompensated byan increasein theoutput
ofanother) thanthelosscausedbya further
is greater " spread-
ing of output." A preciseformulation of thisprocesswould
requireeithersome verycumbrouslanguageor some rather
involvedmathematics;but withoutresorting to either,it is
easyto see whatconditions thefinalequilibrium willinvolve.
The demand curve for each single " product,"will have
becomeverymuch moreelastic' (since each producernow
producesa very much smallershare of each product,or
" typeofproduct"); profits willhavebeenwipedoutand the
generallevelofcostsforeachproduct, or typeofproduct,will
have become higher. There will not be much " excess
capacity" in the sense, that given the number of different
productsproducedsimultaneously by each firm,an increase
in theoutputof all of themwouldreducecostsperunit. Yet
therewill be a " technicalwastage,"sincethe physicalpro-
ductivity ofresourceswillbe lessthanwhatit-wouldbe ifeach
producerproduceda smallernumberof productsand a large
proportion ofthetotaloutputofeach; a policytheyundoubted-
ly wouldprefer,if all of themwouldforeseetheultimate, as
distinctfromtheimmediate, consequences oftheiractions.2
IV
We haveseentherefore thatin all caseswhereeconomiesof
scale are presentover certainrangesof outputand where
marketimperfection exists(in the sensethathighlyand yet
imperfectlysubstitutable commodities areon sale), " increased
competition " (i.e. an increasein the numberof firmsin a
particularindustrial field)mightlead to a reductionof tech-
nical efficiencyratherthan to a reductionin price or an
increasein aggregateoutput; whilein cases wherefirmscan
varythe numberof different productsproduced,thismight
comeaboutevenwithoutan inflowof " newfirms."In both
1 It cail becomeinfinitely elasticonly when the " spreadingof output " involvesno
additional cost at all. In this case the " economiesof scale " referto the amount of
resourcesused by single firmsratherthan thoseengaged in the productionof certain
products; and foreach single product,conditionsof perfectcompetitionmight be
broughtabout even if the totalnumberof firmsis small.
2 There may be anotherreason,apart fromthis type of " short-sightedness," why
producerswould prefera policyof many-productproduction: and thisis thereduction
of risk, especiallyimportantin cases of " fashionable" articles,where they cannot
calculatewith aiiy precisionhow the public will take any particular" variety."

cases this resultwas seen to depend on a certain" short-

sightedness " of producers whoact on thebasisof theimme-
diateindustrial situationconfronting themratherthanfollow
out the further consequencesof theirown policy. The pre-
valenceofsuchshort-sightedness accounted
can be sufficiently
for,however,partlyby the producers'ignoranceof those
further consequencesand partlyby theuncertainty as to the
extentoffar-sighltedness withwhichtheiractualand potential
competitions are endowed.
It is extremnely to deduceany generalconclusions
difficult
fromthe above analysisas to the effect of the generation of
" excess capacity " upon economic welfare in general-in
whatever arbitrary waythisconceptmaybe defined. If the
money-value of the NationalDividend is to be made its
criterion (calculatedon the basis of somegivenprice-level),
then no doubt,it could be increased,in some fieldsquite
considerably, by compulsory "standardisation," cartel-agree-
ments, the restriction ofentryor anysimilar measure enabling
producers to realise more fully the " economies of scale."
The recognitionof thisfact,however,as yetfarfromwarrants
the advocacy of such measures. Apart fromthe ill-effects on
distribution(and in a world of wage-rigidities, upon employ-
mnent)which such processes of monopolisationinevitably
involve,the public would be offeredfinallylargeramountsof
a smallernumberof commodities; and it is imnpossible to tell
how far people preferquantity to diversity or vice versa.
Neitheris it permissibleto argue,on the other hand, that
the generationof " excess capacity" is itself the result of
consumers'choice; since it only comes about by creatinga
greater diversity of commodities: and consequently its
emergenceis evidence that the public, to that extent,prefer
"varietv " to " cheapness." This line of reasoningwould only
be permissibleif consumerswere actuallyconfrontedwiththe
choice of havingeithera smallerrangeof commoditiesat lower
prices or a largerrange at higherprices. In fact,theynever
are in a position to choose between these alternatives: they
are offeredeitherthe one or the other,but never both. To
expect the consumersto be so " far-sighted"as to concen-
trateon the purchaseof a fewvarietiesmerelyin the hope of
therebyreducingprices in the fu'ture, is an assumptionwhich
even the hlighestlevel of abstraction should avoid.


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The Suntory and Toyota International Centres for Economics and Related Disciplines

Market Imperfection and Excess Capacity

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OF all the doctrines emerging from recent work on the

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fallingaverage costs.' It is a highlyingeniousand one might

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itis assumedthattherearea largenumberofindepen-

senseof an " imagineddemand curve," cf. below.

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riseaftera certainpoint. But whilethe legitimacyof the latter

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on his own pricepolicyintocon-

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will have a positivefinitevalue. But is thereanyjustification

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other betweenwhich the consumers'elasticityof substitution

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pricesand " products" thuscannotbe assumedas " given"

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permanently; i.e. hewillactin a manneras ifhisowndemand

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as the elasticityof demand is less than infinite. For each

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to whichtheyare put thatare indivisible-youcan divide

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to the possessionof " unique" resourcesby one entrepreneur

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To sum up the resultsof the above argument. The extent

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4. So far we have not touched upon anotherabstract

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outputs,and will become unprofitableas soon as the demand

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and so longas thelosscausedbya reduction in theamountof

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cases this resultwas seen to depend on a certain" short-

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