Transcript ch14

CHAPTER
Regulation and Antitrust Law
14
After studying this chapter you will be able to
Explain the economic theory of government and how
government activity arises from market failure and
redistribution
Define regulation and antitrust law and distinguish
between the social interest and capture theories of
regulation
Explain how regulation and deregulation affect prices,
outputs, profits, and the distribution of the gains from
trade
Describe the antitrust laws and review three of today’s
antitrust policy debates
Social Interest or Special Interests?
Natural monopoly is regulated.
But does regulation work in the interest of all—the social
interest—or in the interest of the regulated—special
interests?
Antitrust law restricts the actions of monopolies and blocks
mergers.
Do these laws serve the social interest or special interests?
The Economic Theory of Government
The economic theory of government explains the purpose
of governments, the economic choices that governments
make, and the consequences of those choices.
Governments exist for two main economic reasons:
1. To establish property rights and set the rules for the
redistribution of income and wealth.
2. To provide a nonmarket mechanism for allocating
scarce resources when the market economy results in
inefficiency—a situation called a market failure.
The Economic Theory of Government
Governments and public choices deal with five economic
problems:
 Monopoly and oligopoly regulation
 Externalities regulation
 The provision of public goods
 The use of common resources
 Income redistribution
The Economic Theory of Government
Monopoly and Oligopoly Regulation
Monopoly and oligopoly, and the rent seeking to which
they give rise, prevent the allocation of resources from
being efficient and redistribute the consumer surplus to
producers.
Governments regulate monopoly and oligopoly and enact
antitrust laws that prevent cartels and other restriction on
competition.
The Economic Theory of Government
Externalities Regulation
External costs and external benefits are consequences of
an economic transaction between two parties that are
borne or enjoyed by a third party.
A chemical factory that dumps waste into a river that kills
the fish downstream imposes an external cost.
A bank that builds a beautiful office building creates an
external benefit.
External costs and external benefits prevent the market
allocation of resources from being efficient.
The Economic Theory of Government
Provision of Public Goods
A public good is a good that is consumed by everyone and
from which no one can be excluded
Examples are national defense, law and order, and
sewage and waste disposal services.
The market economy underproduces these goods
because it is impossible to exclude those who choose not
to pay from enjoying them—called the free-rider problem.
The Economic Theory of Government
The Use of Common Resources
Some resources are owned by no one and used by
everyone.
Examples are fish in the ocean and the lakes and rivers.
The market economy overuses these resources because
no one has an incentive to conserve them—called the
tragedy of the commons.
The Economic Theory of Government
Income Redistribution
The market economy delivers an unequal distribution of
income and wealth.
Progressive income taxes pay for public goods and
redistribute income.
The Economic Theory of Government
Public Choice and the Political Marketplace
Public choice theory applies the economic way of thinking
to the choices that people and governments make in a
political marketplace.
The actors in the political marketplace are
 Voters
 Firms
 Politicians
 Bureaucrats
The Economic Theory of Government
Figure 14.1 illustrates the
political market place.
Voters and firms are the
“consumers” in the
political marketplace.
Politicians are the
“entrepreneurs” of the
political marketplace.
Bureaucrats are the
producers, or firms, of the
political marketplace.
The Economic Theory of Government
Voters and firms express
their preferences for
publicly provided goods
and services by allocating
their votes, making
campaign contributions,
and lobbying government
decision makers.
They also pay the taxes
that provide the funds that
pay for public goods and
services.
The Economic Theory of Government
The objective of politicians is
to get elected to office and
remain in office.
Votes to a politician are like
profits to a firm, so they
propose policies that they
expect to attract enough
votes to get elected.
Bureaucrats produce the
public goods and services.
The Economic Theory of Government
Political Equilibrium
A political equilibrium is the outcome of the choices of
voters, firms, politicians, and bureaucrats.
It is a situation in which the choices of the three groups are
compatible and no group can improve its own situation by
making a different choice.
Monopoly and Oligopoly Regulation
Government intervenes in monopoly and oligopoly
markets to influence prices, quantities produced, and the
distribution of the gains from economic activity.
It intervenes in two main ways:
 Regulation
 Antitrust laws
Monopoly and Oligopoly Regulation
Regulation consists of rules administered by government
agency to influence economic activity by determining
prices, product standards and types, and the conditions
under which new firms may enter an industry.
Antitrust law is law that regulates or prohibits certain
kinds of market behavior, such as monopoly and
monopolistic practices.
Monopoly and Oligopoly Regulation
The Economic Theory of Regulation
The economic theory of regulation of monopoly and
oligopoly is an application of the general theory of public
choice that we’ve just reviewed.
There is a demand for regulation, a supply of regulation,
and an equilibrium amount of regulation.
Monopoly and Oligopoly Regulation
The Demand for Regulation
People and firms demand the regulation that makes them
better off and they express their demand through political
activity and making campaign contributions.
The greater the potential benefit (consumer surplus per
voter and producer surplus per firm) from regulation, the
greater is the demand for the regulation.
But numbers alone don’t translate to demand. Small wellorganized groups can be more effective than large
unorganized groups.
Monopoly and Oligopoly Regulation
The Supply of Regulation
Politicians supply the regulations that increase their
campaign funds and that gets enough votes to achieve
and maintain office.
Politicians choose policies that appeal to a majority of
voters.
Bureaucrats support the policies that maximize their
budgets.
Monopoly and Oligopoly Regulation
If a regulation benefits a large number of people by
enough for it to be noticed, the regulation will appeal to
politicians and it will be supplied.
If a regulation benefits a small number of people by a
large amount per person, the regulation will appeal to
politicians because it will help them to get campaign funds
from those who gain.
Monopoly and Oligopoly Regulation
Equilibrium Regulation
In a political equilibrium, no interest group finds it
worthwhile to use additional resources to press for
changes.
And no group of politicians or bureaucrats wants to offer
different regulations.
The political equilibrium might be in the public interest or
private interest.
Monopoly and Oligopoly Regulation
The social interest theory is that regulations are supplied
to satisfy the demand of consumers and producers to
maximize the sum of consumer and producer surplus—to
attain efficiency.
The capture theory is that the regulations are supplied to
satisfy the demand of producers to maximize producer
surplus—to maximize economic profit. In this case,
regulation seeks to maximize profits.
Monopoly and Oligopoly Regulation
Because the social interest and the self-interest of the
producer are in conflict, the political process cannot satisfy
both groups in any particular industry.
The highest bidder gets the regulation it wants.
Regulation and Deregulation
The Scope of Regulation
Some of the main agencies are
 Interstate Commerce Commission
 Federal Trade Commission
 Federal Power Commission
 Federal Communications Commission
 Securities and Exchange Commission
 Federal Maritime Commission
 Federal Deposit Insurance Corporation
 Civil Aeronautical Board
 Copyright Royalty Tribunal
 Federal Energy Regulatory Commission
Regulation and Deregulation
Activities regulated have included:
Interstate railroads, trucking, buses, water, oil, and gas
pipelines, airlines, electricity, natural gas, broadcasting,
telecommunications, and banking and finance.
Regulation reached its peak in the mid-1970s when almost
one quarter of the economy was subject to some type of
regulation.
During the 1980s and 1990s, a deregulation process
stimulated competition in:
Broadcasting, telecommunications, banking and finance,
and all forms of transportation (both passengers and
freight via air, rail, and road).
Regulation and Deregulation
The Regulatory Process
Regulatory agencies differ in many detailed ways, but all
have features in common:
First, each agency is run by bureaucrats who are experts
in the industry it regulates (often recruited from the
industry) and who appointed by the president or by
Congress and funded by Congress.
Second, each agency adopts a set of rules and practices
designed to control the prices and other aspects of
economic behavior in the industry it regulates.
Regulation and Deregulation
In a regulated industry, firms are generally free to
determine the technology to use and quantities of inputs.
But firms are not free to set their own prices and
sometimes, they are regulated in the quantities they can
produce and sell or the markets they can serve.
Regulation and Deregulation
Natural Monopoly
Natural monopoly is a firm
with economies of scale
that enable it to supply the
entire market at the lowest
possible price.
Figure 14.2 illustrates the
demand for the good
produced, the natural
monopoly’s marginal cost
and average cost.
Regulation and Deregulation
Regulation in the Social
Interest
Regulation in the social
interest is achieved by using
the marginal cost pricing
rule, which sets price equal
to marginal cost: P = MC.
Total surplus (the sum of
consumer surplus and
producer surplus) is
maximized.
Regulation and Deregulation
With marginal cost pricing,
the firm incurs an
economic loss.
Regulation and Deregulation
The firm might be able to cover its economic loss:
 By price discrimination. An example is the hook-up fee
that cable TV companies charge their subscribers.
 The government might pay the firm a subsidy.
But the taxes that generate the revenue for the subsidy
create a deadweight loss in other markets.
 The government might adopt a regulation that allows the
firm to break even.
That is, allow the firm to use the average cost pricing
rule, which sets price equal to average total cost.
Regulation and Deregulation
Figure 14.3 illustrates the
average cost pricing rule.
Price is set equal to
average cost.
The firm breaks even, but
total surplus is reduced.
A deadweight loss arises,
but it is minimized.
Regulation and Deregulation
Implementing the marginal cost and average cost pricing
rules is difficult because the regulator doesn’t know the
firm’s cost curves.
Two practical rules that regulators use are
 Rate of return regulation
 Price cap regulation
Regulation and Deregulation
Rate of Return Regulation
Under rate of return regulation, a regulated firm must
justify its price by showing that the price enables it to earn
a specified target percent rate of return on its capital.
The target rate of return is set at that of a competitive
market and with accurate cost observation is this type of
regulation is equivalent to average cost pricing.
Managers have an incentive to use more capital than the
efficient quantity so that total returns increase.
Managers also have an incentive to inflate depreciation
charges and other costs and deflate reported profits.
Regulation and Deregulation
Figure 14.4 shows the firm’s
economic profit under rate
of return regulation when
managers inflate capital
costs.
The firm persuades the
regulator that the inflated
costs are genuine costs.
The “breakeven” price rises
but the firm makes an
economic profit.
Regulation and Deregulation
Price Cap Regulation
A price-cap regulation is a price ceiling—a rule that
specifies the highest price the firm is permitted to set.
Price cap regulation gives managers an incentive to
minimize cost because there is no limit on the rate of
return they are permitted to earn.
The regulator might set the price cap too high, so pricecap regulation is often combined with earnings sharing
regulation, under which profits that exceed a target level
must be shared with the firm’s customers.
Regulation and Deregulation
Figure 14.5 shows the
effects of price cap
regulation.
Unregulated, the monopoly
maximizes profit by
producing the quantity at
which MR = MC.
A price cap is imposed that
enables the firm to make
only zero economic profit.
Regulation and Deregulation
The price cap lowers the
price and increases output.
In unregulated monopoly,
the profit-maximizing
quantity is less than the
efficient quantity.
The price cap provides an
incentive to keep costs as
low as possible and it
delivers average cost
pricing.
Regulation and Deregulation
Social Interest or Capture in Natural Monopoly
Regulation?
Whether the social interest theory or the capture theory
best describes how most natural monopoly markets are
regulated is unclear.
A test to determine whether the regulated firm has
“captured” the regulator and influenced regulation to favor
the firm is to compare the rates of return to capital for
regulated industries against that of the rest of the
economy.
Regulation and Deregulation
Higher rates of return are evidence in support of capture
theory of regulation.
Table 14.1 (p. 332) shows the rates of return for regulated
monopolies in the electricity, gas, and railroad industries
and compares these rates to the average rate of return for
the overall economy.
While there has been some variation over time, the rates
of return achieved by regulated natural monopolies were
not very different from those in the rest of the economy.
Regulation and Deregulation
Another test is to study changes in the levels of producer
and consumer surplus following deregulation.
Table 14.2 (p. 332) shows the gains (losses) in producer
and consumer surplus when the railroad,
telecommunications, and cable TV industries were
deregulated.
These results show that railroad regulation hurt both
producers and consumers and that regulation in the other
two industries hurt only the consumer.
Regulation and Deregulation
Cartel Regulation
A cartel is a collusive agreement among a number of firms
that is designed to restrict output and achieve a higher
profit for cartel members.
Cartels are illegal in the United States and in most other
countries.
A cartel that acts like a monopoly earns maximum
economic profit, but there is a strong incentive for each
member of a cartel to cheat on the cartel arrangement.
Regulation and Deregulation
Figure 14.6 shows two
possible outcomes of
cartel regulation.
If the regulation is in the
social interest, price and
quantity will equal their
competitive levels and the
outcome will be efficient.
Regulation and Deregulation
If the cartel captures the
regulator,
it uses regulation to
prevent cheating and to
produce the monopoly
profit-maximizing quantity
and price.
The outcome is inefficient
and in the producer
interest.
Regulation and Deregulation
Social Interest or Capture in Cartel Regulation?
Table 14.3 (p. 333) shows the rates of return on
investment for the airlines and trucking industry as
compared to the economy as a whole.
The returns after deregulation of these industries
decreased considerably and returned to the economy
average.
This evidence supports the capture theory of regulation.
Regulation and Deregulation
Table 14.4 (p. 334) shows the change in consumer
surplus, producer surplus, and total surplus after the
airlines and trucking industries were deregulated.
While consumer surplus increased in both the trucking and
airlines industries, producer surplus decreased in the
trucking industry. Total surplus increased in both
industries.
This evidence implies that regulation on the trucking
industry benefited producers by restricting competition.
Regulation and Deregulation
Making Predictions
Deregulation of many industries began in the late 1970s
and arose from three main influences:
1. Economists have become more confident and vocal in
predicting the gains from deregulation.
2. The significant hike in energy prices of the 1970s
increased the cost of regulation borne by consumers.
3. Technological progress has ended many natural
monopolies through increased competition, especially in
the telecommunications industry.
Antitrust Law
Antitrust law provides an alternative way in which the
government may influence the marketplace.
The Antitrust Laws
The first antitrust law, the Sherman Act, was passed in
1890. It outlawed any “combination, trust, or conspiracy
that restricts interstate trade,” and prohibited the “attempt
to monopolize.”
A wave of merger activities at the beginning of the
twentieth century produced a stronger antitrust law, the
Clayton Act, and created the Federal Trade Commission.
Antitrust Law
The Clayton Act was passed in 1914.
The Clayton Act made illegal specific business practices
such as price discrimination, interlocking directorships,
and acquisition of a competitor’s shares if the practices
“substantially lessen competition or create monopoly.”
Table 14.6 (p. 335) summarizes the Clayton Act and its
amendments, the Robinson-Patman Act passed in 1936
and the Cellar-Kefauver Act passed in 1950.
The Federal Trade Commission, formed in 1914, looks for
cases of “unfair methods of competition and unfair or
deceptive business practices.”
Antitrust Law
Three Antitrust Policy Debates
Price fixing is always a violation of the antitrust law.
If the Justice Department can prove the existence of price
fixing, there is no defense.
But some practices are more controversial and generate
debate. Three of them are
 Resale price maintenance
 Tying arrangements
 Predatory pricing
Antitrust Law
Resale Price Maintenance
Most manufacturers sell their product to the final consumer
through a wholesale and retail distribution chain.
Resale price maintenance occurs when a manufacturer
agrees with a distributor on the price at which the product
will be resold.
Resale price maintenance is inefficient if it promotes
monopoly pricing.
But resale price maintenance can be efficient if it provides
retailers with an incentive to provide an efficient level of
retail service in selling a product.
Antitrust Law
Tying Arrangements
A tying arrangement is an agreement to sell one product
only if the buyer agrees to buy another different product as
well.
Some people argue that by tying, a firm can make a larger
profit.
Where buyers have a differing willingness to pay for the
separate items, a firm can price discriminate and take a
larger amount of the consumer surplus by tying.
Antitrust Law
Predatory Pricing
Predatory pricing is setting a low price to drive
competitors out of business with the intention of then
setting the monopoly price.
Economists are skeptical that predatory pricing actually
occurs.
A high, certain, and immediate loss is a poor exchange for
a temporary, uncertain, and future gain.
No case of predatory pricing has been definitively found.
Antitrust Law
A Recent Antitrust Showcase: The United States
Versus Microsoft
The most recent antitrust case is against Microsoft.
In 1998, a trial began considering the following charges:
Microsoft possesses monopoly power in the market for PC
operating systems and attained that position by exercising
monopoly practices.
Antitrust Law
The Case Against Microsoft
Microsoft
 Possessed monopoly power—it had 80 percent of the
PC market
 Used predatory pricing and tying arrangements—offering
its browser with Windows for a zero price was viewed as
illegal predatory pricing and an tying arrangement
 Used other anticompetitive practices—network
economies and economies of scale created barriers to
entry.
Antitrust Law
Microsoft’s Response
Microsoft countered that although the firm enjoys
monopoly today, it is vulnerable to competition from other
operating systems such as Linux and Apple’s Mac OS and
there is a permanent threat of competition from new
entrants.
Microsoft claimed that integrating Internet Explorer with
Windows provided a single, unified product of greater
consumer value.
Antitrust Law
The Outcome
The courts agreed that Microsoft was in violation of the
Sherman Act and ordered that it be broken into two firms:
an operating systems producer and an applications
producer.
Microsoft successfully appealed this order.
But in the final judgment, Microsoft was ordered to
disclose details about how its operating system works to
other software developers so that they can compete
effectively with Microsoft.
Antitrust Law
Merger Rules
The Federal Trade Commission (FTC) uses guidelines to
determine which mergers to examine and possibly block.
The Herfindahl-Hirschman index (HHI) is one of those
guidelines (explained in Chapter 9).
 If the original HHI is between 1,000 and 1,800, any
merger that raises the HHI by 100 or more is challenged.
 If the original HHI is greater than 1,800, any merger that
raises the HHI by more than 50 is challenged.
Antitrust Law
Social or Special Interest?
The intent of antitrust law has been to protect consumers
and pursue efficiency, but at times the court interpretation
of these laws has favored the interests of producers.
On balance, the overall thrust seems to have been toward
achieving efficiency and therefor to serving the social
interest.
THE END