Chapter 15

Chapter 15

Economic Regulations and Antitrust

Types of Government RegulationTypes of Government Regulation

• Market power: the ability of a firm to raise its price without losing all its customers to rival firms– Firms with downward sloping demand curves– The assumption is that a monopoly or firms acting

like a monopoly will restrict output to charge a higher price.

• Less social welfare is provided

Types of Government RegulationTypes of Government Regulation

• Three kinds of government policies are designed to alter or control firm behaviors– Social regulation– Economic regulation– Antitrust regulations

Social regulationSocial regulation

• Social regulation tries to improve health and safety– It has economic consequences– Improvements in safety of workers

Economic regulationEconomic regulation

• It aims to control the price, output, the entry of new firms, and the quality of service in industries in which monopoly appears inevitable or even desirable.– Government controls over natural monopolies

• Phone• Electricity• Subway Stations

Antitrust regulationAntitrust regulation

• Antitrust policy outlaws attempts to monoplize, or cartelize, markets in which competition is desirable.– It is pursued in the courts

Regulating a Natural MonopolyRegulating a Natural Monopoly

• Unregulated Profit Maximization– The price-output combination is inefficient in

terms of social welfare. – Consumers pay a price that is much higher than

the marginal cost of providing the service.

LO2

Regulating a Natural Monopoly

10590500 Trips per month (millions)

$4.00

2.50

1.501.250.50

Dol

lars

per

trip

Demand

MR Long-run MC

LRAC

a

bc

h g

ef

Profit

Loss

Natural monopoly maximizes profit: MR=MC, q=50, p=$4. Inefficient: p>MC.

Efficient output rate: set p=$0.50, then q=105 efficient outcome. But the firm: economic loss; requires subsidy.

Alternative: set p=$1.50; then q=90, the firm breaks even (p=average cost); earns normal profit.

Social welfare could still be increased by expanding output as long as the price >MC; but that would result in an economic loss, requiring a subsidy.

Exhibit 1

What can the government do?What can the government do?

• They can either operate the monopoly itself, or government can regulate a privately owned monopoly.

• Government-owned or government-regulation monopolies are called public utilities.

What are some of these regulations?What are some of these regulations?

• Setting Price Equal to Marginal Cost– The monopolist is operating at a loss– In the L-R, the monopolist will go out of business

rather than endure such a loss

• Subsidizing the Natural Monopolist– The Government can cover the loss by subsidizing

the firm to earn a normal profit• Amtrak’s $30 billion over the last three decades

What are some of these regulations?What are some of these regulations?

• Setting Price Equal to Average Cost– A “fair return” – The monopoly can stay in business without a

subsidy

Why do governments regulate certain industries?

Why do governments regulate certain industries?

• Why not let market forces allocate resources?• Two views of government regulation:

– Public interest– Special interest of producers

• Restricting entry into the market• Capture theory of regulation: producers’ political

power and strong stake in the regulatory outcome lead them, in effect, to “capture” the regulating agency and prevail on it to serve producer interests.

LO3C

ase

Stu

dy

Airline Regulation and Deregulation1938 Civil Aeronautics Board

Regulated interstate airlines 40 years: No new interstate airline Fixed prices among the 10 major airlines Blocked new entry Labor unions

Higher wages Pilots worked 2

weeks/month High price

LO3C

ase

Stu

dy

Airline Regulation and Deregulation1978 Deregulation

Price competition New entry Price: one quarter below regulated price More efficient airlines FAA regulates quality

and safety Accident rates declines by

10-45% More people fly (passenger

miles tripled)

LO3C

ase

Stu

dy

Airline Regulation and DeregulationFierce competition

Mergers Disappeared Bankrupt

Lower wagesLower faresMore flightsSaving lives

Origins of Antitrust PolicyOrigins of Antitrust Policy

• Antitrust is the government’s attempt to reduce anticompetitive behavior and promote a market structure that leads to greater competition.– They attempt to promote socially desirable

market performance

Origins of Antitrust PolicyOrigins of Antitrust Policy

• Two important developments were:– Technological breakthrough that lead to a larger

optimal plant size in manufacturing and– The rise of the railroad from 9,000 miles of track

in 1850 to 167,000 miles by 1890• Economies of scale and cheaper transport costs

extended the geographical size of markets, so firms grew larger to serve this bigger market.

AntitrustAntitrust

• Before the Civil War, industries were made up of small firms and monopoly power was not very prevalent at the time.

• After the Civil War, things began to change– 1870s and 1880s with many new inventions, such

as the railroads and the telegraph the country was becoming more linked.

– These technology changes allowed firms to expand into national markets

– They began to form “trust.”

TrustTrust

• A trust is a combination or cartel consisting of firms that place their assets in the custody of a board of trustees.– This allows firms that have not merged to form a

cartel that will control an industry in order to charge monopoly prices and earn higher profits.

• Today, these guys are no longer legal• Examples: Iron Trust, Sugar Trust, Cooper Trust, and

Steel Trust

Predatory PricingPredatory Pricing

• One practice that the trust use to run smaller competitors out of the market was known as “predatory pricing.”– Def: Predatory pricing is the practice of one or

more firms temporarily reducing prices in order to eliminate competition and then raising prices.

The Sherman Act

• So, how should we stop this behavior.• In the late 1890s, the government and the

country in general grew tired of this behavior, as a result the next 50 years or so would lead to several antitrust laws. The most famous and the first of these actions is “The Sherman Act."

The Sherman ActThe Sherman Act

• The Sherman Act of 1890 is the federal antitrust law that prohibits monopolization and conspiracies to restrain trade.– This is still used today as the cornerstone of

antitrust legislation.– Section 1- made trust illegal (i.e. no cartels)– Section 2- no monopolization of an industry

http://www.stolaf.edu/people/becker/antitrust/

The Clayton ActThe Clayton Act

• The Clayton Act of 1914 is an amendment that strengthened the Sherman Act by making it illegal for firms to engaged in certain anticompetitive business practices.– Made these things illegal when they “substantially

lessen competition or tend to create a monopoly.”• Price discrimination• Exclusive dealing• Tying Contracts• Stock Acquisition of Competing Companies• Interlocking Directories.

The Federal Trade CommissionThe Federal Trade Commission

• The Act established the Federal Trade Commission (FTC) to investigate unfair competitive practices of firms.

• Today’s concerns:– Enforcing consumer protection legislation– Prohibiting deceptive advertising– Preventing collusion

• How does it work?

The Federal Trade CommissionThe Federal Trade Commission

• This law can block horizontal and vertical mergers.– Horizontal merger: the merging of firms that

produce the same product• Wells Fargo and Wachovia

– Vertical merger: the merging of firms where one supplies inputs to the other or demands output from the other.

• Coke and a sugar farm

How to enforce them?How to enforce them?

• Three ways:– Antitrust Division of the Department of Justice– FTC

• Enforces through voluntary understanding or formal commission order

– Private proceedings• Lawsuits for damage

Per Se Illegality and the Rule of ReasonPer Se Illegality and the Rule of Reason

• Per Se Illegality: In antitrust law, business practices deemed illegal regardless of their economic rational or their consequences.– The courts examine the firm’s behavior

• Rule of Reason: Before ruling on the legality of certain business practices, a court examines why they were undertaken and what effect they have on competition.

Key Antitrust CasesKey Antitrust Cases

• The Standard Oil Case (1911)– Established the rule of reason

• The Alcoa Case (1945)– Established per s e rule

• The IBM Case (1982)• The AT& T Case (1982)• The MIT Case (1992)• The Microsoft Case (2001)

Mergers and Public PolicyMergers 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.

• A few firms account for a relatively large share of sales, the industry is said to be “concentrated.”

Mergers and Public PolicyMergers and Public Policy

• As a measure of sales concentration, the Justice Department uses the “Herfindahl-Hirschman Index” (HHI)– A measure of market concentration that squares

each firms percentage share of the market then sums these squares

– Pure Monopoly= 10,000= 100 squared

LO5

Herfindahl-Hirschman Index (HHI) Based on Market Share in Three Industries

Each of the three industries has 44 firms. The HHI is found by squaring each firm’s market share then summing the squares. Only the market share of the top four firms differ across industries; the remaining 40 firms have 1% market share each.

The HHI for Industry III is nearly triple that for each of the other two industries.

Exhibit 2

Mergers and Public PolicyMergers and Public Policy

• The Justice Department generally challenges any merger in an industry that meets two conditions:– The post merger HHI exceeds 1,800– The merger increases the index by more than 100

points

Merger WavesMerger Waves

• 1887-1904- Horizontal Mergers• 1916-1929- Vertical Mergers• 1948-1969- Conglomerate Mergers

– A merger of firms in different industries

• 1982-present- Horizontal and Vertical Mergers

Competitive Trends in the US Economy

LO6

1. Pure monopoly– One firm controls the market– Block entry

2. Dominant firm– One firm: more than half market share– No close rival

Competitive Trends in the U.S. Economy

LO6

3. Tight oligopoly– Top 4 firms: more than 60% of market

output– Evidence of cooperation

4. Effective competition– Low concentration– Low barriers to entry– Little or no collusion

Competition over TimeCompetition over Time

• The Growth in competition from 1958 to 2000:– Competition from imports– Deregulation– Antitrust policy

LO6 Competitive Trends in the U.S. Economy: 1939 to 2000

Exhibit 4

Problems with Antitrust Policy

LO6

Competition may not require that many firms

Abuse of antitrust Growth of international

markets Bailing Out Trouble

Industries