Lecture 3July 12th 2010Saksarun (Jay) Mativachranon

Regulation and Antitrust Policy in Globalized Economy

Key learning objectives

•Distinguish between economic regulation and social regulation

•Recognize practical difficulties that arise when regulating the prices charged by natural monopolies

•Identify potential benefits and possible negative side effects of social regulation

•Understand the foundations of antitrust laws and regulations

Forms of Industry Regulation

•Two basic types of Government Regulations▫Economic Regulation of natural monopolies

and nonmonopolistic industries▫Social Regulation of all industries

•The US government began regulating both types early in the nation’s history

•The amount of government regulation began increasing in the 20th century

Regulation on the Rise

Regulation of Natural Monopolies

•Initially, most economic regulation in the US was aimed at controlling prices in industries considered natural monopolies

•Overtime, federal and state government have sought to influence products and processed of firms in a variety of industries

•Definition of Natural Monopoly:▫A natural monopoly exists in an industry

where a single firm can produce output such as to supply the market at a lower per unit-cost than can two or more firms.

•Ex.▫Electricity and Water supply industries are

often natural monopolies

Why Regulate Natural Monopoly?•The need to avoid duplication of facilities•The need to prevent industries from

earning monopoly profits

Profit Maximization and Regulation Through Marginal Cost Pricing

Quantity per Time period

Un

it

Pri

ce

LMC

LAC

Demand

MRQm

PmF

Point F• Profit maximizing point for natural monopolist• Price (Pm) where consumers willing to pay for the quantity (Qm)

Profit Maximization and Regulation Through Marginal Cost Pricing

Quantity per Time period

Un

it

Pri

ce

LMC

LAC

Demand

MR Q1

AC1

Point B• Regulated price = Long-term Marginal Cost, Quantity (Q1) = Demand• Average Cost (AC1) > Price (P1), natural monopolist is losing money = Area (Losses)• Regulatory commission will have to subsidize the cost

LossesP1

B

Average Cost Pricing

Quantity per Time period

Un

it

Pri

ce

LMC

LAC

Demand

MR Q1

AC1

Point C• Regulators cannot always force marginal cost pricing• Enforcing Cost-of-service regulation or Rate-of-return regulation

LossesP1 B

Q2

CP2

Regulating Nonmonopolistic Industries•To provide a coordinated system of

safeguarding the interests of citizens•Two common rationales for government

involvement▫Market Failure▫Asymmetric information

Regulating Nonmonopolistic Industries (cont.)•Lemons Problem

▫Potential asymmetric information problem bring about a general decline in product quality Example: Used car market, pharmaceuticals,

etc.•Implementing consumer protection

regulation▫Liability laws and government licensing▫Direct economic and social regulation

Social Regulation

•Social Regulations apply to all firms in the economy

•Designed to improve the functioning of the markets

•Almost all cases, increased regulation results in higher production cost, and those increment cost are ultimately absorbed by the consumer

•Strict regulation prevent smaller firms to enter the market

Social Regulation (cont.)

•Usually benefit the society in the long run▫Safer products▫Safer workplaces▫Clean environment▫Etc.

Incentives and costs of Regulation

Incentives and Costs of Regulation

•Capture Hypothesis▫Predicts that the regulators will eventually

be captured by the special interests of the industry being regulated

Incentives and Costs of Regulation•Share-the-Gains, Share-the-Pains Theory

▫The regulators must take account of the demands of three groups; Legislators Regulated industries Consumers

Incentives and Costs of Regulation•Benefits of regulation

▫Regulation offers many potential benefits▫Actual benefits are more difficult to

measure•Costs of regulation

▫Government uses taxes to pay for the cost of regulation

▫US has over 190,000 employees in regulatory agencies

Incentives and Costs of Regulation•Total cost of regulation (US)

▫Cost of compliance estimated to be around $500 billion - $600 billion per year

▫Opportunity cost of complying with regulations is as high as $270 billion

Antitrust Policy

Antitrust Policy

•To promote business competitions•US congress enacted 4 key antitrust laws

▫The most important is the Sherman Act.

Antitrust Policy

•Sherman Antitrust Act of 1890▫Section 1

Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several states, or with foreign nations, is hereby declared to be illegal

Antitrust Policy

•Sherman Antitrust Act of 1890▫Section 2

Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons to monopolize any part of the trade or commerce …. shall be guilty of a misdemeanor

Antitrust Policy

•Clayton Act of 1914▫Passed to remove the vagueness of the

Sherman Act•Robinson-Patman Act of 1936

▫Amended Section 2 of the Clayton Act▫Designed to protect independent retailers

and wholesalers from “unfair discrimination” by chain stores

Antitrust Policy

•Microsoft’s 2001 antitrust lawsuit

Antitrust Policy

•Exemptions from antitrust laws (US)▫All labor unions▫Public utilities▫Professional baseball▫Cooperative activities among US exporters▫Hospitals▫Public transit and water systems▫Supplier of military equipment▫Joint publishing arrangement in a single

city by two or more newspaper

International Antitrust Policy

•More firms across the borders are merging

•The European Union put restrictions against merging of any business that would enhance the market dominance of one firm

Antitrust Enforcement

Antitrust Enforcement

•Monopolization▫The possession of monopoly power in

relevant market▫The willful acquisition or maintenance of

that power, as distinguished from growth or development as a consequence of a superior product, business acumen, or historical accident

Monopoly power and the Relevant market•Monopoly is not just company size•Usually look at percentage of share in the

relevant market▫A firm is usually considered to have

monopoly power if share > 70%•Ex:

▫Being the “only” liquor store on a popular resort town (loosely)

Monopoly power and the Relevant market•Relevant market consists of 2 elements

▫Product market All items produced by different firms in the

market have identical attributes, this includes substitutable products

▫Geographic market Geographic boundaries include all area that

items are sold

Antitrust Enforcement

•Product Versioning▫Selling a product with altered forms or

functionalities to different groups of consumers

•Product Bundling▫Offering two or more products for sale as a

set

Product Versioning

•Software version▫Professional and Standard edition?

Product Bundling

•Microsoft Windows and Internet Browser software

Issues in Enforcing antitrust

•Enforcement is through Supreme Court interpretations

•Authorities use market share test and determine “relevant market”

International Trade

Basics of trade – what you should know•The principle of comparative advantage•The effect of tariffs•The effect of quotas•How restrictions on trade decrease the

wealth of a country•Know who gains and who loses from trade

restrictions

Comparative advantage

•Comparative advantage refers to the lowest opportunity cost to produce a product

•The ability to produce a good or service at a lower opportunity cost compared with producers

Comparative advantageItaly USA

Computer 8 1

Wine 2 2

Table indicates the unit cost of product.

Italy – a unit of Wine costs 2 hours of work and a unit of computer costs 8 hours of work

USA – a unit of Wine costs 2 hours of work and a unit of computer costs 1 hour of work

The USA has Absolute Advantage in producing both Wine and Computer. Should the US trade with Italy?

Comparative advantageItaly USA

Computer 8 1

Wine 2 2

Why not produce both computer and Wine in the US??

Comparative advantageItaly USA

Computer 8 1

Wine 2 2

Let’s look at computer perspective:• To make 1 wine, the US sacrifices 2 computers. While Italy sacrifices 0.25 computer to make 1 wine.

Comparative advantageItaly USA

Computer 8 1

Wine 2 2

Let’s look at wine perspective:• To make 1 computer, the US sacrifices 0.5 wine. While Italy sacrifices 4 wines to make 1 computer.

Comparative Advantage

•To make 1 wine, the US sacrifices 2 computers. While Italy sacrifices 0.25 computer to make 1 wine.

•To make 1 computer, the US sacrifices 0.5 wine. While Italy sacrifices 4 wines to make 1 computer.

Comparative advantageComputer Wine Hours

USA 1 2 5

Italy 2 4 24

Total consumption 3 6

Computer Wine Hours

USA 3 0 3

Italy 0 6 12

Total consumption 3 6