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14

REGULATION AND ANTITRUST LAW

C h a p t e r K e y I d e a sSocial Interest or Special Interests?

A. Natural monopoly is regulated by the U.S. Government.1. A city water supply, telephone service and cable TV service are

often supplied by regulated natural monopolies.2. Does regulation work in the interest of all—the social interest—

or in the interest of the regulated—special interests?B. Antitrust law restricts the actions of monopolies and blocks some

large firms from merging into one firm. 1. PepsiCo and 7-Up wanted to merge, as did Coca-Cola and Dr.

Pepper. The government blocked these mergers.2. Do these laws serve the social interest or merely satisfy certain

special interests?

2O u t l i n e

I. The Economic Theory of GovernmentA. The economic theory of government explains the economic roles of

governments, the economic choices that they make, and the consequences of those choices.1. Governments exist for two reasons:

a) First, they establish and maintain property rights, the foundation of which all market activity takes place.

b) Second, they provide mechanisms for allocating scarce resources when the market economy results in inefficiency—a situation called market failure.

2. In the case of market failure, choices made by consumers or producers are made in self-interest, but these choices fail to align with the social interest. a) Market failure presents the government with an opportunity

to correct the inefficient allocation of resources.b) Economic analysis can reveal whether these social choices

are efficient or inefficient.B. There are many examples of market failure that create the potential

for government regulation to increase efficiency:1. Decisions made by firms operating in a monopoly or oligopoly

prevent resources from being allocated efficiently.2. The market for public goods creates a free-rider problem

because once the good is provided, everyone can enjoy consuming it without having to pay for it.a) Producers are unable to make consumers pay for their level

of consumption and so they under-produce the good.b) The market process does not motivate these producers to

provide sufficient quantities of the good for an efficient allocation.

3. A lack of defined property rights makes people’s consumption of common resources inefficient. a) Common resources are resources that are not owned by

anyone and yet are used by everyone. b) The market fails to make consumers reflect the opportunity

cost of consumption in their choices.c) People consume too much of the common resource and the

market allocation is not efficient.4. A lack of protection of property rights creates external costs and

external benefits. a) Externalities are created when production or consumption

costs are borne by people not involved with the production or consumption of the good.

b) The market fails to motivate producers and consumers of goods that generate externalities to take into account the opportunity cost of their choices on society.

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W H A T I S E C O N O M I C S ? 3c) The producers create too much of the good and the

allocation of resources in this market is inefficient.C. Besides regulating economic behavior of producers and consumers,

the government can also reallocate resources to address concerns about equity.1. The government can tax some people and distribute the

revenues to others.2. This form of income redistribution can only legitimately be

performed by the government, which must make choices.

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D. A government operating within a democratic society can be described and analyzed as a complex organization making resource allocation decisions in a political marketplace.1. Economists have developed a public choice theory of the political

market place.2. Figure 14.1 shows how the

political marketplace can be described with four decision making groups interacting with each other to produce outcomes.a) Voters are the

consumers in the political marketplace who express their preferences through voting, campaign contributions and lobbying activities, supporting those policies that they perceive will make them better off and opposing those policies that they perceive will make them worse off.

b) Firms are also consumers in the political marketplace that express the preferences of their owners through campaign contributions and lobbying activities, supporting those policies that they perceive will make them better off and opposing those policies that they perceive will make them worse off.

c) Politicians are the entrepreneurs of the political marketplace, seeking votes for re-election by creating policies that garner a majority of voters and campaign contributions.

d) Bureaucrats are the hired officials that produce goods for the political marketplace, seeking job security and advancement by maximizing the scope and budget of their own programs.

3. Political equilibrium in the market place is the outcome that results from the choices of the voters, politicians and bureaucrats when all their choices are compatible and no one group can improve its position by making a different choice.

II. Monopoly and Oligopoly RegulationA. Government intervenes in monopoly and oligopoly markets in two

ways:1. 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.

2. Antitrust law is law that regulates or prohibits certain kinds of market behavior, such as monopoly and monopolistic practices.

B. The economic theory of regulation is a part of the broader theory of public choice. There are two components to regulation:1. Citizens and firms demand regulation that makes them better off.

a) Voters and firms express their demand through the political activity of voting, lobbying, or making campaign contributions.

b) The larger the consumer or producer surplus per voter or firm, or the greater the number of voters and firms, then the greater will be the demand for regulation by voters and firms.

2. Politicians supply regulations that increase campaign contributions and votes.a) Regulations that are noticed by and benefit more voters and

firms are favored and supplied by politicians. b) Regulations which are not noticed by or do not benefit many

voters or firms are not favored or supplied by politicians.c) The larger the consumer or producer surplus per voter or firm,

or the greater the number of voters or firms, the greater the supply of regulations produced by politicians.

C. In a political equilibrium, the regulation produced might be in the social interest or in the self-interest of the regulation producers.1. The social interest theory of regulation maintains that politicians

supply the regulation that achieves an efficient allocation of resources.a) Government relentlessly seeks out and identifies deadweight

loss.b) Politicians introduce regulation to eliminate it.

2. The capture theory of regulation maintains that regulation is in the self-interest of the producers.a) Political organization is a costly activity.b) Only those groups that stand to gain highly concentrated

benefits will organize politically and try to influence proposed regulations.

c) The politicians propose regulation with benefits to organized groups and costs that are dispersed thinly across all citizens.

d) This makes it very unlikely that the voters outside the politically organized group will be motivated to organize and oppose the regulation.

III. Regulation and DeregulationA. The Scope of Regulation

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1. Some of the main U.S. government agencies involved in regulation includes:a) Interstate Commerce Commission.b) Federal Trade Commission.c) Federal Power Commissiond) Federal Communications Commissione) Securities and Exchange Commissionf) Federal Maritime Commissiong) Federal Deposit Insurance Corporationh) Civil Aeronautical Boardi) Copyright Royalty Tribunalj) Federal Energy Regulatory Commission.

2. Activities regulated have included interstate railroads, trucking, buses, water, oil, and gas pipelines, airlines, electricity, natural gas, broadcasting, telecommunications, banking and finance.

3. Regulation reached its peak in the 1970s when about one quarter of the economy was subject to some type of regulation. Since then, deregulation of many industries (including broadcasting, telecommunications, banking and finance, and all forms of transportation) has occurred.

B. The Regulatory ProcessRegulatory agencies differ in many detailed ways, but all have the following features in common:1. 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.

2. 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.

3. Firms are generally free to their technology and quantities of inputs. But they are not free to set their own prices and sometimes, they are regulated in the quantities they can sell, and the markets they can serve.

C. Natural Monopoly A natural monopoly occurs when one firm can supply the entire market at a lower price than two or more firms can. The government often regulates natural monopolies.1. Figure 14.2 shows the demand

curve, MC curve, and ATC curve of a natural monopoly. a) A natural monopoly’s ATC

curve falls throughout the relevant range of production.

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b) The falling ATC curve means that the firm’s MC curve is below its ATC curve when the MC curve crosses the firm’s demand curve.

2. Figure 14.2 illustrates how regulating in the social interest can be achieved using the marginal cost pricing rule, which forces the monopoly firm to set its price equal to its marginal cost, P = MC. There are some complicating factors to this pricing rule:a) Using this regulatory policy will maximize the sum of consumer

and producer surplus, but the firm incurs an economic loss.b) The firm might be able to cover its economic loss by employing

price discrimination (see Chapter 12). Another example is for the firm to use a two-part price, such as the hook-up fee cable TV companies charge their subscribers.

c) 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.

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3. Figure 14.3 illustrates how the deadweight loss from the marginal cost pricing rule might be minimized by allowing the firm to use the average cost pricing rule, which sets price equal to average total cost, P = ATC.

B. Implementing pricing rules is difficult because the regulator doesn’t know the firm’s cost curves. Regulators often use two practical pricing rules:1. Rate of return regulation

requires a firm to justify its price by showing that the price enables it to earn a specified target percent return on its capital.a) The target rate of return is determined with reference to what is

normal in competitive industries. This type of regulation is equivalent to average cost pricing.

b) However, firm managers have an incentive to use more capital than the efficient quantity so that total returns increase. They also have an incentive to inflate depreciation charges and incur other costs for beneficial amenities that do not promote efficiency but deflate reported profits.

c) Figure 14.4 shows the maximum economic profit that a firm can earn when its managers inflate capital costs under rate of return regulation.

2. A price-cap regulation is a price ceiling—a rule that specifies the highest price the firm is permitted to set.a) Price cap regulation gives

managers an incentive to minimize costs because there is no limit on the rate of return they are


permitted to earn. Figure 14.5 shows the effects of price cap regulation.

b) The market price equals the cap price and output is the quantity demanded at the price cap, allowing the firm to earn a normal profit.

c) This outcome contrasts with that in a competitive market, where a price ceiling decreases the quantity. A monopoly regulated using a price cap will increase its output because the price cap replicates the conditions of a competitive market.

d) Price cap regulation is often combined with earnings sharing regulation, so if the firm’s profits rise above a target level, they must be shared with the firm’s customers.

C. Whether social interest or capture theory best describes how most natural monopoly markets are regulated is unclear.1. 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.a) Table 14.1 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.

b) While there has been some variation in rates of return over time, there is no overall trend to show a difference in rates of return exist between regulated and unregulated industries.

2. Another test is to study changes in the levels of producer and consumer surplus following deregulation. a) Table 14.2 shows the

gains (losses) in producer and consumer surplus when the railroad, telecommunications and cable TV industries were deregulated.

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b) These results show that railroad regulation hurt both producers and consumers, and that regulation in the other two industries mainly hurt the consumer.


D. 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.1. A cartel that acts like a

monopoly earns maximum economic profit.

2. However, there is a strong incentive for each member of a cartel to cheat on the cartel arrangement. Figure 14.6 shows two possible outcomes of cartel regulation.a) If the regulation is in the social interest, price and quantity will

equal their competitive levels and the outcome will be efficient. b) If the cartel captures the regulator, the cartel uses regulation to

prevent cheating to ensure that price and output equal monopoly levels and the outcome is inefficient.

E. Does Cartel Regulation Reflect the Social Interest Theory or Capture Theory?1. If the regulation is in the social interest, the rate of return for the

industry would not decline after the industry is deregulated. If the regulated firms capture the regulators, then the rate of return for the industry would decline after the industry is deregulated. a) Table 14.3 shows the

regulated and unregulated rates of return on investment for the airlines and trucking industry as compared to the economy as a whole.

b) The returns after deregulation of these industries decreased considerably and returned to the economy average.

2. If the regulation is in the social interest, consumer surplus for the industry would not increase after the industry is deregulated. If the regulated firms capture the regulators, then consumer surplus for the industry would increase after the industry is deregulated. a) Table 14.4 shows the

change in consumer

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and producer surplus after the airlines and trucking industries were deregulated.

b) While consumer surplus increased in both the trucking and airlines industries, producer surplus decreased in the trucking industry.

3. The empirical evidence on which theory of regulation prevails is mixed, but some industries show evidence that the capture theory of regulation prevails.

F. Deregulation of many industries occurred in the late 1970s and arose from three main influences:1. Economists have more vocally predicted gains from deregulation.2. The significant hike in energy prices of the early 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.

IV. Antitrust LawA. Antitrust law provides an alternative way in which the government may

influence resource allocation in the marketplace.B. The significant antitrust laws include:

1. The Sherman Act was the first federal antitrust law and was passed in 1890.a) It outlawed any “combination, trust, or conspiracy in restraint of

trade.”b) It also prohibited the “attempt to monopolize.”

2. A wave of merger activities occurred at the start of the 20th century, motivating Congress to create a stronger antitrust law in 1914 called the Clayton Act.a) It made illegal specific business practices such as price

discrimination, being a director of competing firms, exclusive dealing, tying contracts, and acquisition of a competitor’s shares if the practices “substantially lessen competition or create monopoly.”

b) The Clayton Act has had two major amendments:i. the Robinson-Patman Act, passed in 1936 ii. the Cellar-Kefauver Act passed in 1950

3. The Federal Trade Commission was also formed in 1914 to look for cases of “unfair methods of competition and unfair or deceptive business practices.”

C. While price fixing between firms is always illegal under antitrust laws, there are other practices that generate three antitrust policy debates:1. Resale price maintenance occurs when a manufacturer agrees

with a retail distributor on the price at which the product will be resold. Is this an efficient agreement?


a) It is inefficient if it allows retailers of the goods to operate a cartel and charge the monopoly price.

b) It is relatively more efficient if it allows the manufacturer to induce dealers to provide the efficient standard of service in selling the product.

2. A tying arrangement is an agreement to sell one product only if the buyer agrees to buy another, different product. Is this an efficient arrangement?a) It is inefficient if it allows manufacturers to sell one type of

goods that would not otherwise be profitable.b) It is relatively more efficient if it allows manufacturers to price

discriminate.3. Predatory pricing is setting a low price to drive competitors out of

business with the intention of setting a monopoly price when the competition is gone. Is this an efficient practice?a) It is inefficient in theory if the manufacturer can successfully

charge a monopoly price once the competition is eliminated.b) However, it is likely to be efficient in practice because unless

there is some barrier to entry, the remaining firm would be unable to charge a monopoly price after the competition is eliminated.

D. A Recent Showcase: The United States Versus Microsoft1. The most recent famous antitrust case was against Microsoft. In

1998, a trial began considering the following charges:a) Microsoft possesses monopoly power in the market for PC

operating systems and attained that position by exercising monopoly practices.

b) Microsoft used predatory pricing in the market for web browsers by offering its web browser for free.

c) Microsoft used tying arrangements to achieve monopoly in the web browser market.

d) Microsoft used other anti-competitive practices to strengthen its monopoly in these two markets. (Some charge that Microsoft enjoys economies of scale and network economies that create an effective barrier to entry by competing firms.)

2. But Microsoft counters that it has not violated antitrust law.a) Although Microsoft enjoys monopoly today, it did not use

monopolistic practices to attain that position. It merely survived a highly competitive market for operating software.

b) Microsoft is still vulnerable to competition from any newly developed operating systems (there are no real barriers to entry).

c) Microsoft claims that incorporating its web browser software with its operating system software is an attempt to increase customer value of the operating system software (innovation),

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rather than using a tying arrangement to monopolize the browser software market.

3. The final court decision found Microsoft not in violation of the anti-trust laws, but it was ordered to disclose details of its operating systems software to other software developers so they could more effectively compete against Microsoft.

D. Merger RulesThe Federal Trade Commission uses guidelines to determine which mergers to examine and possibly block.1. The Herfindahl-Hirschman Index (HHI) is one of those guidelines

(first introduced in Chapter 9). a) If the original HHI is less than 1,000, a merger is not challenged.b) If the original HHI is between 1,000 and 1,800, any merger that

raises the HHI by 100 or more is challenged.c) If the original HHI is greater than 1,800, any merger that raises

the HHI by more than 50 is challenged.E. Social or Special Interest?

1. 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.

2. On balance, the overall thrust seems to have been toward efficiency.

R e a d i n g B e t w e e n t h e L i n e sA news article discusses one aspect of re-importation of drugs: Is it legal for drug companies to restrict their exports to Canada in order to limit the amount of drugs re-imported back to the United States? The analysis looks at the market for drugs in Canada and the United States.

N e w i n t h e S e v e n t h E d i t i o nThe sequence of chapters in the seventh edition has changed such that Chapter 14 replaces Chapter 17 in the sixth edition. The Reading Between the Lines examines the market power of pharmaceutical firms in the United States.

Te a c h i n g S u g g e s t i o n s1. Market Intervention: The amazing Federal Register. Get your

students to go to Federal Register Web site at http://www.nara.gov/fedreg/ and click on “Today’s Table of Contents.” They (and you) will be amazed at the volume and detail of regulatory activity, almost all of which has an economic dimension and impact.


2. There is no “free lunch” in regulating firms and industries that embody market power. Make the issue of industry regulation intriguing for the students by emphasizing the following countervailing opportunity costs that arise in regulating the firms in those industries that are creating a market failure:Emphasize the tension between the potential for efficiency in production inherent with a natural monopoly and the inefficiency potential from the firm exercising its inherent market power. Be sure the students understand that economies of scale (or scope) enable the unregulated natural monopoly to provide products and services at the lowest possible cost. Yet the lack of competition also enables the firm to increase producer surplus at the expense of consumer surplus and creates a significant deadweight loss to society. Regulating this firm is the only way to ensure that the firm exploits economies of scale or scope without exploiting consumer surplus.Emphasize the tension between a manufacturer who wishes to insure that the consumer is properly informed of all the characteristics and potential benefits of the product and the retailer who wishes to minimize the cost of selling the product. Be sure the students understand that competition can take place within more dimensions than just between firms operating on the same level of production. Most manufacturers must sell to retailers who can enhance or minimize the information that consumers find useful when buying a newly available or complex product. Disallowing tying arrangements can raise consumer surplus by keeping prices lower but it can lower consumer surplus by keeping consumers ignorant of product characteristics for which they would voluntarily pay a higher price.Emphasize the tension between real and imagined concerns over predatory pricing practices. Be sure that the students understand the limitations of the claim that big businesses routinely price smaller firms out of the market and then monopolize the market after they have left. To get the smaller firms to exit, the price that the bigger store charges must be lower than what the smaller store can maintain with a normal profit. If the larger store is still able to earn a normal profit, it is charging a

price higher than ATC. Barring any barriers to entry, prevent the larger store from offering a lower price decreases consumer surplus, because the more efficient big store cannot then raise price once the small stores have left the market.

If the larger store is unable to earn a normal profit, then it is charging a price lower than ATC. In theory, it might be able to do so due to its “deep pockets,” which allow it to borrow money more cheaply to fund such a losing venture. However, its size advantage in the financial markets is the very same characteristic that hurts its ability to predatory price the smaller firms out of business. It must lose money on a far greater quantity of goods than the smaller stores, meaning it will bleed losses at a far higher rate than the smaller stores. If the larger store were successful in driving out its competitors, and if barriers to entry existed allowing the large store to raise prices to monopoly levels, it would take a substantial amount of time to make

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up for the huge losses incurred. This means that over a long time period, the firm would earn only normal profit, making predatory pricing a much less attractive practice that it appears to be in theory.

Emphasize the tension between combining formerly separate goods into a product as a monopolizing action (tying agreements) and combining goods as a form of technological advancement to enhance consumer surplus (product innovation). Microsoft’s defense to antitrust charges alludes to the inevitable combining of web browsers into computer operating system software to assure consumer satisfaction. If Microsoft is truly enhancing its product by incorporating its web

browser with its ubiquitous operating software, breaking up the company would decrease consumer surplus by slowing product innovation.

However, if Microsoft is using its market power in one market to leverage market power in another, more competitive market, allowing Microsoft to continue tying its web browser to its operating systems software could decrease consumer surplus in the web browser software market.

2. Economic Theory of Regulation: Emphasize the tension between social interest theory and capture theory of regulation.

Point 1: Point out how the political equilibrium is swayed by the consumers or producers with the most motivation to organize and spend resources influencing the politicians and bureaucrats supplying the regulation. Because the producers are fewer in number and have a high concentration of potential benefits, they are easy to organize into a special interest lobby. The consumers, on the other hand, are much greater in number and can expect only thinly spread benefits. They are less likely to be well organized and more likely to suffer from rational ignorance.Point 2: For regulation to achieve efficiency, both price and rate of return regulation require accurate knowledge of using industry-specific technology and firm-specific production costs. The only way the government can adequately assess these issues is to hire former senior managers from the regulated industries who still have a strong network of connections to current managers of firms in that industry. This is the classic case of hiring one fox to provide accurate production data on the other foxes that may or may not be raiding the chicken coop. How will the social interest theory answer the question, “Who is watching the watchman?”

3. Regulation and Deregulation: The California power debacle. The special Web feature on this topic is a ready to go case study with which you can have fun and review the entire section on pricing rules and their effects.


T h e B i g P i c t u r eWhere we have been

Chapter 14 builds on the student’s understanding of efficiency introduced in Chapter 2 and elaborated in Chapter 5. It also builds on natural monopoly introduced in Chapter 12 and oligopoly and cartels introduced in Chapter 13. This chapter uses the tension between social interest and capture theories to explore the implications of antitrust law, which are elements of the social choice theory introduced in Chapter 16.

Where we are goingChapter 14 is the first of three chapters dealing with government intervention in the economy as a result of market failure. Chapter 15 examines externalities and chapter 16 examines social choice economic analysis.

O v e r h e a d Tr a n s p a r e n c i e sTransparency Text figure Transparency title

92 Figure 14.1 The Political Marketplace93 Figure 14.2 Natural Monopoly: Marginal Cost Pricing94 Figure 14.3 Natural Monopoly: Average Cost Pricing95 Figure 14.4 Natural Monopoly: Inflating Cost96 Figure 14.5 Price Cap Regulation of Natural Monopoly97 Figure 14.6 Collusive Oligopoly98 Table 14.5 The Sherman Act of 1890

E l e c t r o n i c S u p p l e m e n t sMyEconLabMyEconLab provides pre- and post-tests for each chapter so that students can assess their own progress. Results on these tests feed an individualized study plan that helps students focus their attention in the areas where they most need help. Instructors can create and assign tests, quizzes, or graded homework assignments that incorporate graphing questions. Questions are automatically graded and results are tracked using an online grade book.

PowerPoint Lecture NotesPowerPoint Electronic Lecture Notes with speaking notes are available and offer a full summary of the chapter.

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PowerPoint Electronic Lecture Notes for students are available in MyEconLab.

Instructor CD-ROM with Computerized Test BanksThis CD-ROM contains Computerized Test Bank Files, Test Bank, and Instructor’s Manual files in Microsoft Word, and PowerPoint files. All test banks are available in Test Generator Software.

A d d i t i o n a l D i s c u s s i o n Q u e s t i o n s1. Are you an informed consumer-voter? Get the students to appreciate

the significant challenge of becoming an informed voter and successfully influencing the government’s regulatory process to become more oriented toward the social interest. Point out the level of effort and amount of resources needed by using the following example: Example: Would you become well informed on a regulatory issue if it saved you (maybe) about $1 per textbook? Tell the students that a proposed regulation in the textbook industry could impact their lives through an increase in the price of textbooks. Assume the following points: College textbook firms are seeking to ban the resale of textbooks by

secondary textbook firms in order to increase the profitability of selling new textbooks.

Some book market experts estimate that textbook prices will not be affected because nearly all professors adopt the latest edition of the text for their classes anyway (making the last edition near worthless) and the market trend has been to significantly decrease the time elapsing between text editions.

But some experts disagree, stating that the trend of shrinking time periods between editions will reverse itself once the secondary book market is made illegal. These experts estimate that the average textbook will increase in price by $1.00.

Ask the following questions: How would you determine which group of experts to trust? Point out

that a rational student wouldn’t want to expend his or her valuable time and money becoming an informed consumer voter if there really was nothing to be concerned about in the first place.

If you found that there was a legitimate concern, how would you find out what to do next? Point out that it is difficult to even know where to start becoming informed. Search the internet, newspapers and magazines, watching TV news programs, etc.?

How would you become organized as an effective group of textbook consumers? How would you organize your efforts effectively? Perhaps the biggest challenge is to get a disparate group of students together to act with one voice.


Who is your federal government representative and how would you reach him or her? Which government body should you approach with your concerns? It will become obvious to the class that the average student doesn’t even know the names of their own federal Congressional representatives, let alone how to go about finding their addresses and actually contacting them.

Will your voice be heard? Is it worth the effort and cost for one dollar per textbook? The students should ultimately see the futility in this effort when they realize that it is easier to just pay a small increase in textbook fees. Point out that this regulatory issue is only one of thousands addressed by the federal government each year, meaning that in reality, they are likely bearing much more in total regulatory costs than just one more dollar per textbook.

2. How would you define market behavior that is an attempt to monopolize the market? Get the students to appreciate the difficulty in differentiating competitive activities from monopolization activities. Ask the students to define the market for computer software games.

Point out that Microsoft includes the card game Solitaire on their Windows computer operating system. Ask if Microsoft is attempting to monopolize the software game industry by exerting their market power in the computer operating system software market? Ask them to explain why the inclusion of Microsoft Explorer with Windows should be thought of as monopolizing the web browser market.

Ask the students to define the market for car audio components. Imagine if General Motors, Ford, and Chrysler-Mercedes were to all install “free,” high-end car stereo equipment in their automobiles. Would we want to claim that the “Big Three” are using the barrier to entry in domestic car manufacturing that arises from their huge economies of scale as a means of exerting market power in the car audio market?

Ask the students to explain why selling output “below cost” could be thought of as hurting consumer interests, even in the long run. Point out that the only way a larger firm can drive out smaller firms from the industry through below-cost-pricing practices is if the large firm is willing to suffer far more economic losses than the smaller firms (because the larger firm must sell a much higher level of output per period). The only reason that the small firms would not be able to withstand extended periods of losses longer than the large firm (which is bleeding cash more heavily than the smaller firms) is if the financial capital market was sufficiently biased in favor of larger firms (who are assumed to have deep pockets) to overcome the larger volume of economic losses the larger firm is suffering.

3. How does one define the market in order to assess market concentration before and after a proposed merger? This issue was first addressed in Chapter 12 but is worth reiterating here. Does the market for personal transportation include just automobiles? Or should it include pick-up trucks and SUVs? How about motorcycles? What about imports? Point out that the defining line between within-market products

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and outside-the-market products is a vast gray area. The broader the definition, the lower the concentration ratio, and the greater the sense of competition to tame inefficient monopoly practices.

4. Is similarity in prices across firms evidence of price fixing or of extremely competitive market pressures? Ask the students to consider the case of four gasoline stations, one on each corner, with each charging an identical price per gallon. Ask them how they would distinguish between the claim that they are acting collusively to raise prices from the claim that they are merely responding to high competitive pressures that force them all to charge a price equal to average total cost. Consider the following points: If direct comparisons to other gasoline station prices in the city reveal a

price premium, this premium may not be legitimate evidence in support of regulating the gasoline station cartel, as the price of property on that busy street corner may be higher than property used by other gas stations, increasing their production costs and the price necessary to maintain normal profits.

Observing consistent, simultaneous changes in price among all four gas stations is also insufficient evidence of collusive actions requiring regulation. It may simply reflect high competitive pressure on each firm to: i) quickly drop prices in the face of decreasing costs and pass the cost savings to the consumer to avoid losing market share, and ii) reflect the absence of economic profits, which implies firms cannot steal away market share by delaying a necessary price increase in the face of rising costs.

Comparing the rates of return on capital for the four firms with that of other gas stations may be legitimate, although there may be differences in rates of return across gas stations that are attributable to characteristics unrelated to the business of selling gasoline.


A n s w e r s t o t h e R e v i e w Q u i z z e sPage 324

1. 1. Governments exist for two reasons: a) they establish and maintain property rights, the foundation of which all market activity takes place, and b) they provide mechanisms for allocating scarce resources when the market economy results in inefficiency—a situation called market failure.

2. Market failure occurs when the market economy allocates scarce resources inefficiently. Examples on school campuses include insufficient parking spaces (a common resource problem), poor quality food services in the dorms (natural monopoly provider), and noise pollution in the dorms (poorly defined property rights).

3. The political marketplace where resources are allocated through a democratic system where voters and firms (who demand policies that provide benefits) interact with politicians (who supply policies) and bureaucrats (who try to increase the size and scope of their programs). Demanders pay their suppliers with votes (just voters), campaign donations and lobbying activity (both voters and firms).

Page 3251. Consumers and producers express their demand for regulation in the

political market. Each of these groups desires the kind of regulation of an industry that furthers their own special interests. These two groups organize into special interest groups and spend resources getting out the vote, lobbying, and campaigning for regulations that best further their own interests.

2. Politicians that supply regulation are trying to appeal to the largest number of voters so as to achieve or maintain their elected office. Bureaucrats that supply regulation are trying to maximize their budgets. These objectives may be in conflict with each other, because the regulation that may maximize a the budget of a bureaucratic department may not be supported by the special interest group willing to bring the most votes or make the most campaign finance contributions.

3. Political equilibrium is when a regulation arises for which no interest group finds it worthwhile to use additional resources to press for changes and no group of politicians finds it worthwhile to offer different regulations. According to the social interest theory of regulation, political equilibrium achieves efficiency—regulations are supplied to satisfy the demand of consumers and producers to maximize total surplus. The capture theory of regulation predicts that most regulation is aimed at protecting producers’ interests to the neglect of consumers’ interests. Industries with large producer surplus per firm and well-organized firms lobby politicians with campaign finance support. The regulations they seek increase producer surplus and economic profit at the expense of consumer surplus. Because consumers are numerous and widespread,

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they find it too costly to effectively organize a group to defend their interests by lobbying the politicians on their own behalf.

Page 3321. The Interstate Commerce Commission (ICC) was authorized in 1887 to

control prices, routes and the quality of service of interstate railroads. Additional federal regulatory agencies were established during the Great Depression in the 1930s, and again in the 1970s. Regulation reached its peak in the 1970s when about one quarter of the economy was subject to some type of regulation.

2. A natural monopoly that is not regulated produces the quantity that maximizes profit, where marginal cost equals marginal revenue. It creates a deadweight because price (marginal benefit) exceeds marginal cost.

3. The marginal cost pricing rule eliminates inefficiency and forces the monopoly to price at marginal cost. This rule is difficult to implement because the monopoly incurs a loss. The firm must receive some subsidy equal to its fixed costs in order to stay in business in the long run.

4. Rate of return regulation requires the natural monopoly firm to justify its price by showing that the price enables it to earn only a specified target percent rate of return on its capital. This rate usually set as the rate of return the firm could expect on its capital under the pressures of a competitive market. However, managers of the firm have an incentive to use too much capital needed to boost total returns and to inflate depreciation charges and hide economic profits.

5. A price-cap regulation imposes a price ceiling on the firm. This regulation gives the managers an incentive to keep costs under control, because they cannot inflate the price to increase returns on capital investment. The price cap can be set to generate a normal rate of return on capital. But the regulators do not know the actual cost curves of the firm and may set the price high enough to allow the firm to earn an economic profit.

6. Social interest theory implies that cartel regulation can be used to ensure a competitive outcome that would increase output and decrease price as compared to the cartel’s profit-maximizing prices and production levels. However, there is evidence that deregulating cartels has increased consumer surplus. This evidence supports the capture theory of regulation of cartels.

Page 3351. The four acts of Congress that make up our antitrust law and the years of

their enactment are:a. The Sherman Act of 1890b. The Clayton Act of 1914c. The Robinson-Patman Act of 1936d. The Cellar-Kefauver Act of 1950


2. Price fixing always is a violation of antitrust law, whether or not the act was found to be harmful to consumers. If the Justice Department can prove the existence of price fixing, a defendant can offer no acceptable excuse.

3. Attempts to monopolize an industry are more difficult to define and are a matter of interpretation by the courts. The “rule of reason” seemed to say that size alone doesn’t constitute an attempt to monopolize as in the 1920 U.S. Steel case. But the “rule of reason” was overturned when size did matter as in the 1945 Alcoa case. Even in more recent cases, it is difficult to predict what the court will define as an attempt to monopolize. Decisions continue to be divided in this area of the law.

4. Resale price maintenance occurs when a manufacturer agrees with a distributor on the price at which the product will be resold. Resale price maintenance agreements are illegal but reseal price maintenance guidance is not illegal. Resale price maintenance can create inefficiency if it allows the manufacturer to set the monopoly price for its product. However it can create efficiency when it enables manufacturers to induce resellers to give the efficient level of sales service for the product.Tying arrangements occur when the seller agrees to sell one product to a buyer only if the buyer also buys another product. Tying can sometimes allow the producer to price discriminate and increase its profit. Tying arrangements can be illegal under the Clayton Act.Predatory pricing is setting a low price to drive competitors out of business in order to then set a high, monopoly price. If predatory pricing occurs, it can lead to monopoly but economists are skeptical that it occurs often because the firm trades off a sure loss for an uncertain future profit.

5. A merger is likely to be approved by the Justice Department as long as the merger does not raise the HHI index above 1,000 points. If it raises the HHI to a level between 1,000 and 1,800, the merger would generate a “moderately concentrated industry” by FTC definitions, and the merger would be approved only if it raises the HHI index by a small number of points (50 to 100 points).

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A n s w e r s t o t h e P r o b l e m s1. a. The price is 30 cents a bottle.

Elixir Springs is a natural monopoly. It produces the quantity that makes marginal revenue equal to marginal cost, and it charges the highest price it can for the quantity produced. The marginal revenue curve is twice as steep as the demand curve, so it runs from 50 on the y-axis to 1.25 on the x-axis. Marginal revenue equals marginal cost at 1 million bottles a year. The highest price at which Elixir can sell 1 million bottles a year is 30 cents a bottle, read from the demand curve.

b. Elixir Springs sells 1 million bottles a year. c. Elixir maximizes producer surplus.

If Elixir maximizes total surplus, it would produce the quantity that makes price equal to marginal cost. That is, it would produce 2 million bottles a year and sell them for 10 cents a bottles. Elixir is a natural monopoly, and it maximizes its producer surplus.

2. a. The price is 60 cents a bottle.Cascade Springs is a natural monopoly. It produces the quantity that makes marginal revenue equal to marginal cost, and it charges the highest price it can for the quantity produced. The marginal revenue curve is twice as steep as the demand curve, so it runs from 100 on the y-axis to 500 on the x-axis. Marginal revenue equals marginal cost at 400,000 bottles a year. The highest price at which Cascade can sell 400,000 bottles a year is 60 cents a bottle, read from the demand curve.

b. Cascade Springs sells 400,000 bottles a year. c. Cascade maximizes producer surplus.

If Cascade maximizes total surplus, it would produce the quantity that makes price equal to marginal cost. That is, it would produce 800,000 bottles a year and sell them for 20 cents a bottles. Cascade is a natural monopoly, and it maximizes its producer surplus.

3. a. The price is 10 cents a bottle.Marginal cost pricing regulation sets the price equal to marginal cost, 10 cents a bottle.

b. Elixir sells 2 million bottles.With the price set at 10 cents, Elixir maximizes profit by producing 2 million bottles—at the intersection of the demand curve (which shows price) and the marginal cost curve.

c. Elixir incurs an economic loss of $150,000 a year.Economic profit equals total revenue minus total cost. Total revenue is $200,000 (2 million bottles at 10 cents a bottle). Total cost is $350,000 (total variable cost of $200,000 plus total fixed cost of $150,000). So Elixir incurs an economic loss of $150,000 (a revenue of $200,000 minus $350,000).

d. Consumer surplus is $400,000 a year.Consumer surplus is the area under the demand curve above the price. Consumer surplus equals 40 cents a bottle (50 cents minus 10 cents) multiplied by 2 million bottles divided by 2, which is $400,000.


e. The regulation is in the social interest because total surplus is maximized. The outcome is efficient.The outcome is efficient because marginal benefit (or price) equals marginal cost. When the outcome is efficient, total surplus is maximized.

4. a. The price is 20 cents a bottle.Marginal cost pricing regulation sets the price equal to marginal cost, 20 cents a bottle.

b. Cascade sells 800,000 bottles.With the price set at 20 cents, Cascade maximizes profit by producing 800,000 bottles—at the intersection of the demand curve (which shows price) and the marginal cost curve.

c. Cascade incurs an economic loss of $120,000 a year.Economic profit equals total revenue minus total cost. Total revenue is $160,000 (800,000 bottles at 20 cents a bottle). Total cost is $280,000 (total variable cost of $160,000 plus total fixed cost of $120,000). So Cascade incurs an economic loss of $120,000 (a revenue of $160,000 minus $280,000).

d. Consumer surplus is $320,000 a year.Consumer surplus is the area under the demand curve above the price. Consumer surplus equals 80 cents a bottle (100 cents minus 20 cents) multiplied by 800,000 bottles divided by 2, which is $320,000.

e. The regulation is in the social interest because total surplus is maximized. The outcome is efficient.The outcome is efficient because marginal benefit (or price) equals marginal cost. When the outcome is efficient, total surplus is maximized.

5. a. The price is 20 cents a bottle.Average cost pricing regulation sets the price equal to average total cost. Average total cost equals average fixed cost plus average variable cost. Because marginal cost is constant at 10 cents, average variable cost equals marginal cost. Average fixed cost is total fixed cost ($150,000) divided by the quantity produced. For example, when Elixir produces 1.5 million bottles, average fixed cost is 10 cents, so average total cost is 20 cents. The price at which Elixir can sell 1.5 million bottles a year is 20 cents a bottle.

b. Elixir sells 1.5 million bottles.c. Elixir makes zero economic profit.

Economic profit equals total revenue minus total cost. Total revenue is $300,000 (1.5 million bottles at 20 cents a bottle). Total cost is $300,000 (1.5 million bottles at an average total cost of 20 cents). So Elixir makes zero economic profit.

d. Consumer surplus is $225,000 a year.Consumer surplus is the area under the demand curve above the price. Consumer surplus equals 30 cents a bottle (50 cents minus 20 cents) multiplied by 1.5 million bottles divided by 2, which is $225,000.

e. The regulation creates a deadweight loss, so the outcome is inefficient. The regulation is not in the social interest.

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6. a. The price is 40 cents a bottle.Average cost pricing regulation sets the price equal to average total cost. Average total cost equals average fixed cost plus average variable cost. Because marginal cost is constant at 20 cents, average variable cost equals marginal cost. Average fixed cost is total fixed cost ($120,000) divided by the quantity produced. For example, when Cascade produces 600,000 bottles, average fixed cost is 20 cents, so average total cost is 40 cents. The price at which Cascade can sell 600,000 bottles a year is 40 cents a bottle.

b. Cascade sells 600,000 bottles.c. Cascade makes zero economic profit.

Economic profit equals total revenue minus total cost. Total revenue is $240,000 (600,000 bottles at 40 cents a bottle). Total cost is $240,000 (600,000 bottles at an average total cost of 40 cents). So Cascade makes zero economic profit.

d. Consumer surplus is $180,000 a year.Consumer surplus is the area under the demand curve above the price. Consumer surplus equals 60 cents a bottle (100 cents minus 40 cents) multiplied by 600,000 bottles divided by 2, which is $180,000.

e. The regulation creates a deadweight loss, so the outcome is inefficient. The regulation is not in the social interest.

7. a. The price is $500 a trip, and the quantity is 2 trips a day.Regulation in the social interest is marginal cost pricing. Each airline charges $500 a trip and produces the quantity at which price equals marginal cost. Each airline makes 1 trip a day.

b. The price is $750 a trip, and the number of trips is 1 trip a day (one by each airline on alternate days).If the airlines capture the regulator, the price will be the same as the price that an unregulated monopoly would charge. An unregulated monopoly produces the quantity and charges the price that maximizes profit—that is, the quantity that makes marginal revenue equal to marginal cost. This quantity is 1 trip a day, and the highest price that the airlines can charge for that trip (read from the demand curve) is $750.

c. Deadweight loss is $125 a day.Deadweight loss arises because the number of trips is cut from 2 to 1 a day and the price is increased from $500 to $750. Deadweight loss equals (2 minus 1) trip multiplied by ($750 minus $500) divided by 2. Deadweight loss is $125 a day.

d. If there are only a few large producers and many consumers, public choice theory predicts that regulation will protect the producer’s interest and politicians will be rewarded with campaign contributions. But if there is a significant number of small producers with large costs or if the cost of organizing consumers is low, regulation will be in the social interest.

8. a. The price is 5 cents a call, and the number is 500 calls a day.Regulation in the social interest is marginal cost pricing. Each telephone company charges 5 cents a call and produces the quantity at


which price equals marginal cost. Each phone company produces 250 calls a day.

b. The price is 17.5 cents a call, and the number of calls is 250 a day. Each phone company produces 125 calls a day. If the telephone companies capture the regulator, the price will be the same as the price that an unregulated monopoly would charge. An unregulated monopoly produces the quantity that maximizes profit—that is, the quantity that makes marginal revenue equal to marginal cost—and charges the highest price (read from the demand curve). The quantity that maximizes profit is 250 calls a day, and the highest price that the telephone companies can charge for 250 calls (read from the demand curve) is 17.5 cents a call.

c. Deadweight loss is $15.625 a day.Deadweight loss arises because the number of calls is cut from 500 to 250 a day and the price is increased from 5 cents to 17.5 cents. Deadweight loss equals (500 minus 250) calls multiplied by (17.5 cents minus 5 cents) divided by 2. Deadweight loss is $15.625 a day.

d. Whether the regulation will be in the social interest or the producer interest will depend on which regulation will generate the more votes or campaign contributions for the politicians. If the producer demand for regulation offers the politicians the greater return, the regulation will be in the producer interest. But if consumers’ votes will give the politicians the greater return, the regulation will be in the social interest.

9. 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 regulates or prohibits price fixing and the attempt to monopolize. Regulation applies mainly to natural monopoly and antitrust law to oligopoly. Regulation of electric utilities is an example of regulation. The ruling against Microsoft is an example of the application of the antitrust law.

10. The first part of the Sherman Act, which outlaws all forms of price-fixing, has been applied consistently and firmly. The second part of the Sherman Act, which outlaws attempts to monopolize, has been applied with varying degrees of firmness. Price fixing is clear, easy to define, and once discovered, clearly violates the Act. Attempts to monopolize are vague and varied, hard to define, and ambiguous even when detected. This difference in the clarity of the violation probably accounts for the difference in the way the law has treated the two parts of the Act.

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