Transcript The Art and Science of Economics

Economic Regulation and
Antitrust Activity
CHAPTER
15
© 2003 South-Western/Thomson Learning
1
Market Power
The ability of a firm to raise its price
without losing all its sales to rivals is
called market power
Any firm facing a downward sloping
demand curve has some control over
price  some market power  they can
restrict output  marginal benefit of
the final unit produced exceeds its
marginal cost  social welfare could be
increased
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Market Power
Others argue that monopolies are
insulated from competition and will not
be as innovative as competitive firms
Finally, because of their size and
economic importance, monopolies may
exert disproportionate influence on the
political system, which they use to
protect and enhance their monopoly
power
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Government Regulation
Three are three kinds of government
policies designed to alter or control firm
behavior
Social regulation
• Consists of measures designed to improve health
and safety
Economic regulation
• Controls the price, the output, the entry of new
firms, and the quality of service in industries in
which monopoly appears inevitable  natural
monopolies
Antitrust activity
• Attempts to prohibit firm behavior that tries to
monopolize markets
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Regulating Natural Monopolies
Because of economies of scale, natural
monopolies have a downward-sloping
long-run average-cost curve over the
entire range of market demand
This means that the lowest average cost
is achieved when one firm serves the
entire market
Natural monopolies usually face huge
capital costs
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Unregulated Profit Maximization
The problem with letting the monopolist
maximize profit is that the resulting
price-output combination is inefficient
in terms of social welfare
Consumers pay a price that far exceeds
the marginal cost of providing the
service
Government could increase government
welfare by forcing the monopolist to
expand output and lower the price
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Unregulated Profit Maximization
To do this, government can either
operate the monopoly itself, as with
most urban transit systems, or can
regulate a privately owned monopoly
Government-owned and governmentregulated monopolies are called public
utilities
We will focus on government
regulation, though the issues are similar
if the government operates the
monopoly
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Price Equal to Marginal Cost
In regulating natural monopolies, the
price-output combination captures the
most attention
Suppose government regulators require
the monopolist to produce the level of
output that is allocatively efficient 
where, price, which is the marginal
benefit to consumers, equals marginal
cost
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Price Equal to Marginal Cost
Thus, in the long run, the monopolist
would go out of business rather than
continue suffering such a loss if forced
to charge a price equal to marginal cost
How can government encourage the
monopolist to stay in business yet
produce where price equals marginal
cost?
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Price Equal to Marginal Cost
The government can subsidize the firm
so it earns a normal profit
However, the drawback with this
approach is that to provide the subsidy
is that the government must raise taxes
or forgo public spending in some other
area  there is an opportunity cost to
the subsidy approach
As a result most public utilities are not
subsidized
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Price Equal to Average Cost
Rather than using marginal cost pricing,
regulators try to set a price that will
provide the monopolist with a “fair
return”
Recall that the average cost curve
includes a normal profit
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Regulatory Dilemma
Setting price equal to marginal cost
yields the socially optimal allocation of
resources because the consumers’
marginal benefit from the last unit sold
equals the marginal cost of producing
that last unit
However, this solution leads to losses
unless a subsidy is provided
These losses disappear if price is set
equal to average cost
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Regulatory Dilemma
The higher price associated with
average cost pricing ensures a normal
profit, but the output falls short of the
socially optimal level
Thus, the dilemma facing the regulator
is whether to set price equal to marginal
cost – the socially optimal solution, but
which requires a subsidy – or to set a
break-even price even though output
falls short of the socially optimal level
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Regulatory Dilemma
Although Exhibit 1 lays out the options
neatly, regulators usually face a fuzzier
picture of things
Demand and cost curves can only be
estimated and the regulated firm may
not always be completely forthcoming
with this information
For example, a utility may overstate its
costs so it can charge a higher price and
earn more than a normal profit
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Alternative Theories
There are two views of government regulation
The first view that has been explicit in our
discussion thus far is referred to as
economic regulation in the public interest
• This approach promotes social welfare by
controlling the price and output when one or a
few firms serve a market
A second view is that economic regulation is
not in the public interest, but rather in the
special interest of producers
• Well organized producer groups expect to profit
from economic regulation and are able to
persuade public officials to impose restrictions
that existing producers find attractive
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Special Interest of Producers
Producers have a strong interest in
matters that affect their livelihood 
they play a disproportionately large role
in trying to influence such legislation
Conversely, consumers have no special
interest in the majority of this
legislation
This asymmetry between the interests
of producers and consumers leads to
regulations that favor producer
interests
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Special Interest of Producers
Legislation favoring producer groups is
usually introduced under the guise of
advancing consumer interests
Producer groups frequently argue that
unbridled competition in their industry
would hurt consumers
Alternatively, regulation appears under
the guise of quality control
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Special Interest of Producers
The special-interest theory may be valid
even when the initial intent of the
legislation was in the consumer interest
Over time, the regulatory machinery
may begin acting more in accord with
the special interests of producers
Producers’ political power and strong
stake in the regulatory outcome lead
them, in effect, to capture the
regulatory agency  serve producers
18
Capture Theory
This capture theory of regulation was
first explained by George Stigler
Stigler argued that “as a general rule,
regulation is acquired by the industry
and is designed and operated for its
benefit”
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Antitrust Law and Enforcement
Antitrust policy is an attempt to curb
the normal anticompetitive tendencies
by
Promoting the sort of market structure that
will lead to greater competition
Reducing anticompetitive behavior
Promoting socially desirable market
performance
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Origins of Antitrust Policy
Economic developments in the last half
of the 19th century created a political
climate supportive of antitrust
legislation
Technological breakthroughs that led to
more extensive use of capital and a larger
optimal plant size in manufacturing
Lower transportation costs as railroad
coverage increased dramatically
Economies of scale and cheaper
transportation costs extended the
geographical size of markets  firms grew
larger and reached broader markets
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Origins of Antitrust Policy
Declines in the national economy in the
late 1880s, created problems and large
manufacturers reacted by lower prices
in an attempt to stimulate sales  price
wars erupted
Firms responded by forming trusts by
transferring their voting stock to a
single board of trustees, which would
vote in the interest of the entire
industry group and allegedly pursued
anticompetitive practices to develop
and maintain monopoly advantages
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Sherman Antitrust Act of 1890
Sherman Antitrust Act of 1890 was the
first national legislation in the world
against monopoly
The law prohibited the creation of trusts
and monopolization
However, its vague language in that it
failed to define what constituted such
activities hampered its enforcement
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Clayton Act of 1914
Was passed to outlaw certain practices
not prohibited by the Sherman Act and
to help government stop a monopoly
before it developed
Prohibits
Price discrimination when this practice
tends to create a monopoly
Tying contracts require the buyer of one
good to purchase another good as well
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Clayton Act of 1914
Exclusive dealing occurs when a producer
will sell a product only if the buyer agrees
not to buy from another manufacturer
Interlocking directorates whereby the same
individual serves on the boards of directors
of competing firms
Mergers through the acquisition of the stock
of a competing company if the merger
would substantially lessen competition
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Other Acts
Federal Trade Commission Act of 1914
and established a federal body to help
enforce antitrust laws
Celler-Kefauver Anti-Merger Act passed
in 1950 prevents one firm from buying
the assets of another firm if the effect is
to reduce competition and applies to
Horizontal mergers  the merging of firms
that produce the same product
Vertical mergers  the merging of firms
where one supplies inputs to the other or
demand output from the other
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Antitrust Enforcement
Either the Antitrust Division of the U.S.
Justice Department or the Federal Trade
Commission charges a firm or group of
firms with breaking the law
Those charged with the wrongdoing
may be able, without admitting guilt, to
sign a consent decree whereby they
agree not to continue doing what they
have been charged with
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Per Se Illegal
The courts have interpreted antitrust
laws in essentially two ways
One set of practices has been declared per
se illegal
Another set of practices falls under the rule
of reason
Per se illegal  illegal regardless of the
economic rationale or consequences
Government need only show that the
offending practice took place  need only
examine the firm’s behavior
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Rule of Reason
Here the courts engage in a broader
inquiry into the facts surrounding the
particular offense  the reasons why
the offending practice was adopted and
its effect on competition
First set forth in 1911, when the
Supreme Court held that Standard Oil
had illegally monopolized the petroleum
refining industry and by engaging in
predatory pricing
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Rule of Reason
Predatory pricing is the practice of
temporarily selling below marginal cost
or dropping the price only in certain
markets in the hopes of driving rivals
out of business
Here the court focused on both the
company’s behavior and the market
structure that resulted from that
behavior  Standard Oil had behaved
unreasonably
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Rule of Reason
In 1920 the rule of reason led the
Supreme Court to find U.S. Steel not
guilty of monopolization
Here the court said that mere size was
not an offense because U.S. Steel had
not unreasonably used its power
The court focused on market structure
rather than firm behavior as the test of
legality
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Mergers and Public Policy
In determining possible harmful effects
that a merger might have on
competition, one important
consideration is its impact on the share
of sales accounted for by the largest
firms in the industry
If a few firms account for a relatively
large share of sales, the industry is said
to be concentrated
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Mergers and Public Policy
The measure of sales concentration
used is the Herfindahl index
This index is found by squaring the
percent market share of each firm in the
market and then summing those
squares
For example, if the industry consists of
100 firms of equal size, the index is 100
 [(100 x (1)2]
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Mergers and Public Policy
Alternatively, if the industry is a pure
monopoly, its index is 10,000 =(1002)
The more firms there are in the industry
and the more equal their size, the
smaller the Herfindahl index
The index gives greater weight to firms
with larger market shares
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Mergers and Public Policy
The Justice Department sorts all
mergers into two categories
Horizontal mergers which involve firms in
the same market
Nonhorizontal mergers which include all
others
Any merger in an industry where two
conditions are met is challenged
The post-merger Herfindahl index would
exceed 1800
The merger would increase the index by
more than 100 points
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Merger Movements
There have been four merger waves in
this country over the last century
First wave occurred between 1887 and 1904
when some of today’s largest firms,
including U.S. Steel and Standard Oil, were
formed
• Most of the mergers during this wave were
horizontal mergers
Second wave occurred between 1916 and
1929 and was dominated by vertical
mergers
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Merger Movements
The third wave culminated in the peak
activity of 1964 to 1969 when conglomerate
mergers dominated
• Conglomerate mergers join firms in different
industries
• Merging firms were looking to diversify their
product mix and perhaps achieve some economies
of scope
Fourth wave, which is still underway, began
in 1982 with the onset of the deal decade
where there were numerous hostile
takeovers
• One firm would buy control of another against the
wishes of the target firm’s management
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Competitive Trends
Among the most comprehensive studies
of the level of competition in the U.S.
was done by William G. Shepherd
Shepherd sorted industries into four
groups
Pure monopoly, in which a single firm
controlled the entire market and was able to
block entry
Dominant firm, in which a single firm had
over half the market share and had no close
real rival
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Competitive Trends
Tight oligopoly, in which the top four firms
supplied more than 60 percent of market
output, with stable market shares and
evidence of cooperation
Effective competition, in which firms in the
industry exhibited low concentration, low
entry barriers, and little or no collusion
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Competitive Trends
According to Shepherd’s study
Growth in imports accounted for one-sixth
of the overall increase in competition
Deregulation accounted for one-fifth of the
increase in competition
Antitrust activity accounted for two-fifths of
the growth in competition
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Recent Competitive Trends
Shepherd’s analysis extended only to
1988  what has been the trend since
then?
Growing world trade has increased
competition in the U.S. economy
Other major markets are also growing
more competitive in part as a result of
technological change and in part
because of deregulation
41
Problems with Antitrust Legislation
Growing doubt about the economic
value of the lengthy antitrust cases
Microsoft case
Case against Exxon was in the court for 17
years before Exxon was cleared
A case against IBM began in 1969 and was
finally dropped in 1982
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Problems with Antitrust Legislation
Too much emphasis on the competitive
model
Joseph Schumpeter argued half a century
ago that competition should be viewed as a
dynamic process, one of creative
destruction
Firms are continually in flux trying to
compete for the consumer’s dollar in a
variety of ways  antitrust policy should
not necessarily be aimed at increasing the
number of firms in each industry
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Problems with Antitrust Legislation
In some cases, firms will grow large
because they are more efficient than rivals
at offering what the consumers want
Accordingly, firm size should not be the
primary concern
Moreover, market experiments have shown
that most of the desirable properties of
perfect competition can be achieved with a
relatively small number of firms
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Problems with Antitrust Legislation
Abuse of antitrust
Parties that can show injury from firms that
have violated the antitrust laws can sue the
offending company and recover treble
damages  more than 1,000 of these suits
are filed each year
Courts have been relatively generous to
those claiming to have been wronged
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Problems with Antitrust Legislation
Growing importance of international
markets
A standard approach to measuring the
market power of a firm is its share of the
market
However, with the growth of international
trade, the local or even national market
share becomes less relevant
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