1 economic regulation and antitrust activity chapter 15 © 2003 south-western/thomson learning

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Economic Regulation and Antitrust Activity

CHAPTER

15

© 2003 South-Western/Thomson Learning

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Market PowerThe 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 RegulationThree 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 MonopoliesBecause of economies of scale, natural monopolies have a downward-sloping long-run average-cost curve over the entire range of market demandThis means that the lowest average cost is achieved when one firm serves the entire marketNatural monopolies usually face huge capital costsExhibit 1 shows the demand and cost conditions for a natural monopoly

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Exhibit 1: Regulating the Natural Monopoly

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Trips per month (millions)

a

b

Profit

Demand

Long-run average cost

Marginal cost

MR

Do

llars

per

un

it

50

c

The unregulated monopolist will choose the price-quantity that maximizes profit marginal revenue equals marginal cost 50 million riders per month paying $4 per trip monopolist will reap the blue-shaded rectangle abc triangle measures the consumer surplus.

Consumer surplus

$4

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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 monopolyGovernment-owned and government-regulated monopolies are called public utilitiesWe will focus on government regulation, though the issues are similar if the government operates the monopoly

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Price Equal to Marginal CostIn regulating natural monopolies, the price-output combination captures the most attentionSuppose 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 costExhibit 1 shows this solution

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0


$4.00

a

b

Demand


Marginal cost

MR

Do

llars

per

un

it

50

0.50

105

g

e

1.25

90

c

f

The allocatively efficient combination is shown as point e, where the demand curve – the marginal benefit curve – intersects the marginal cost curve price of $0.50 per trip and a quantity of 105 million trips per month. Consumers will clearly prefer this price to the profit maximizing one consumer surplus, a measure of consumers’ net gain from riding the subway, increases from triangle abc with profit maximization to aef with regulated efficiency.

The problem with this solution is that the average cost of supply 105 million trips per month is $1.25 point g on the average cost curve the monopolist suffers a loss of $0.75 per rider, or about $80 million per month shown by the pink-shaded loss rectangle.

Loss

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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 CostRather 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

Again, Exhibit 1 can be used to illustrate this approach to pricing

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0


Demand


Marginal cost

MR

Do

llars

per

un

it

1.50

90

h

Setting price equal to average cost provides a normal, or fair, profit for the monopolist. This occurs at point h a price of $1.50 and a quantity of 90 million trips per month the monopolist can stay in business without a subsidy.

This enhances economic welfare compared to the unregulated situation, but the monopolist would prefer to earn an economic profit. However, note that the marginal benefit to consumers of the 90 millionth trip exceeds the marginal cost lowering the price to expand output would increase social welfare.

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Regulatory DilemmaSetting 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 DilemmaThe 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 DilemmaAlthough 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 TheoriesThere 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 ProducersProducers have a strong interest in matters that affect their livelihood they play a disproportionately large role in trying to influence such legislationConversely, consumers have no special interest in the majority of this legislationThis 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 ProducersThe 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

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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 PolicyEconomic 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 manufacturingLower transportation costs as railroad coverage increased dramaticallyEconomies 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 PolicyDeclines 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 eruptedFirms 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 1890Sherman 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 1914Was passed to outlaw certain practices not prohibited by the Sherman Act and to help government stop a monopoly before it developed

ProhibitsPrice discrimination when this practice tends to create a monopolyTying contracts require the buyer of one good to purchase another good as well

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Clayton Act of 1914Exclusive 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 ActsFederal Trade Commission Act of 1914 and established a federal body to help enforce antitrust lawsCeller-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 productVertical 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 IllegalThe courts have interpreted antitrust laws in essentially two ways

One set of practices has been declared per se illegalAnother 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 ReasonHere 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 ReasonPredatory 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 ReasonIn 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 PolicyThe 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 PolicyAlternatively, 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 as can be seen in Exhibit 2

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Exhibit 2: Herfindahl Index

Industry I Industry II Industry III Market Market Market Market Market Market Share Share Share Share Share ShareFirm (percent) squared (percent) squared (percent) squared

A 23 529 15 225 57 3249 B 18 324 15 225 1 1 C 13 169 15 225 1 1 D 63 6 15 225 1 1Other* 1 40 1 40 1 40

Herfindahl Index 1098 940 3292

* Remaining 40 firms at 1% each

Computation of the Herfindahl Index Based on Market share in

Three Industries

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Mergers and Public PolicyThe Justice Department sorts all mergers into two categories

Horizontal mergers which involve firms in the same marketNonhorizontal mergers which include all others

Any merger in an industry where two conditions are met is challenged

The post-merger Herfindahl index would exceed 1800The 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 MovementsThe 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 TrendsAmong 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 entryDominant firm, in which a single firm had over half the market share and had no close real rival

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Competitive TrendsTight 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

Exhibit 4 presents Shepherd’s breakdown of U.S. industries for the years 1939, 1958, and 1988

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Exhibit 4: Competitive Trends in the U.S. Economy

Sources: W. G. Shepherd, “Causes of Increased Competition in the U.S. Economy, 1939–1980,” Review of Economics and Statistics 64, (November 1982); and W. G. Shepherd, The Economics of Industrial Organization, 3rd ed. (Englewood Cliffs, N.j.: Prentice Hall, 1990) 15.

Modest trend toward increased competition between 1939 and 1958.

Between 1958 and 1988, there was a sharp rise in competitiveness with the share of effectively competitive industries jumping from 56 to 77 percent.

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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 TrendsShepherd’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

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Problems with Antitrust Legislation

Growing doubt about the economic value of the lengthy antitrust cases

Microsoft caseCase against Exxon was in the court for 17 years before Exxon was clearedA case against IBM began in 1969 and was finally dropped in 1982

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Problems with Antitrust LegislationToo 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 destructionFirms 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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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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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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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

1 economic regulation and antitrust activity chapter 15 © 2003 south-western/thomson learning

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