Types of Government Regulation

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Economic Regulationand AntitrustPolicy

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Types of Government Regulation• Firms with market power

– Raise the price without losing all its customers to rival firms

– Downward-sloping demand curve– Produce less of the good than would be

socially optimal– Monopoly – insulated from competition

• Not too innovative• May influence public choice

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Types of Government Regulation• Government policies - firm behavior

– Social regulation– Economic regulation– Antitrust policy

• Social regulations– Aimed at improving health and safety

• Control over– Unsafe working conditions, dangerous products

• Health care reform

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Types of Government Regulation• Economic regulations

– Control: price, output, entry of new firms, quality of service• In industries in which monopoly appears

inevitable or even desirable– Control over natural monopolies

• Local electricity transmission, local phone service, and a subway system

• Land and air transportation

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Types of Government Regulation• Antitrust policy

– Preventing monopoly– Fostering competition in markets where

competition is desirable– Outlaws monopolies and cartels

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Regulating a Natural Monopoly• Natural monopoly

– Downward-sloping LRAC curve– Economies of scale– Average production cost is lowest when

a single firm supplies the market

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Regulating a Natural Monopoly• Unregulated profit maximization

– Produce where MR=MC– Economic profit– Some consumer surplus– Inefficient in terms of social welfare

• Price far exceeds marginal cost• Higher social welfare if output expanded

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Regulating a Natural Monopoly• Government

– Can increase social welfare– Force the monopolist to lower the price

and expand output• Public utilities

– Government-owned monopolies– Government regulated monopolies

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Regulating a Natural Monopoly• Setting P (marginal benefit)=MC

– Where D intersects MC– Higher consumer surplus– Monopolist: economic loss– In long-run: monopolist exits the market

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Regulating a Natural Monopoly• Subsidizing the natural monopolist

– Monopolist: produce where P=MC– Government covers the loss– Firm: earn normal profit– Drawback: government must raise taxes,

forgo public spending

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Regulating a Natural Monopoly• Setting P=average cost

– ‘Fair return’: normal profit– Stay in business without a subsidy– Higher social welfare (than unregulated)– Marginal benefit exceeds marginal cost

• Expanding output would increase social welfare

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Regulating a Natural Monopoly• The regulatory dilemma

– If P=MC• Socially optimal allocation of resources

– Marginal benefit=MC• Monopolists: loss• Requires government subsidy

– If P=average cost• Monopolist: normal profit• No socially optimal allocation

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© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit 1

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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

With a natural monopoly, the long-run average cost curve slopes downward where it intersects the market demand curve. The unregulated firm maximizes profit by producing where marginal revenue equals marginal cost, in this case, 50 million trips per month at a price of $4.00 per trip. This outcome is inefficient because price, or marginal benefit, exceeds marginal cost. To achieve the efficient output rate, regulators could set the price at $0.50 per trip. The subway would sell 105 million trips per month, which would be an efficient outcome. But at that price, the subway would lose money and would require a subsidy to keep going. As an alternative, regulators could set the price at $1.50 per trip.

The subway would sell 90 million trips per month and would just break even (because price equals average cost). Social welfare could still be increased by expanding output as long as the price, or marginal benefit, exceeds marginal cost, but that would result in an economic loss


Alternative Theories• Views of government regulation

– Economic regulation is in the public interest• Promotes social welfare by keeping prices

down– Economic regulation is in the special

interest of producers

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Alternative Theories• Producers’ special interest

– Well-organized producer groups• Expect to gain from economic regulation• Persuade public officials to impose

restrictions– Consumers have no special interest– Reduce competition– Increase prices

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Alternative Theories• Capture theory of regulation

– Producers have• Political power• Strong stake in the regulatory outcome

– Leads them to “capture” the regulating agency• Prevail on it to serve producer interests

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Antitrust Law and Enforcement• Antitrust policy

– Reduce anticompetitive behavior– Promote competition– Attempts to promote socially desirable

market performance

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Origins of Antitrust Policy• Economic developments

– Bigger forms serving wider markets– Technology: economies of scale– Railroad: reduced transport costs

• 1873-1883 sharp economic decline– Competing firms formed a trust

• Sugar, tobacco, oil industries• Widespread criticism

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Origins of Antitrust Policy• Sherman Antitrust Act of 1890

– First national legislation in the world against monopoly

– Prohibited trusts, restraint of trade, monopolization

– Vague and ineffective• Allowed room for much anticompetitive

activity

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Origins of Antitrust Policy• Clayton Act of 1914

– Improved the Sherman Act– Outlawed certain anticompetitive

practices not prohibited by the Sherman Act• Price discrimination, tying contracts• Exclusive dealing, interlocking directorates• Buying the corporate stock of a competitor

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Origins of Antitrust Policy• Tying contract

– A seller of one good requires a buyer to purchase other goods as part of the deal

• Exclusive dealing– A supplier prohibits its customers from

buying from other suppliers • Interlocking directorate

– A person serves on the boards of directors of two or more competing firms

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Origins of Antitrust Policy• Federal Trade Commission Act of 1914

– Federal trade commission (FTC)– Enforce antitrust laws– Commissioners, economists and lawyers

• Cellar-Kefauver Anti-Merger Act – Prevents one firm from buying physical

assets of another firm• If the effect is to reduce competition

– Horizontal and vertical mergers22


Origins of Antitrust Policy• Horizontal merger

– One firm combines with another firm• That produces the same type of product

• Vertical merger– One firm combines with another firm

• From which it had purchased inputs or to which it had sold output

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Antitrust Enforcement • Antitrust Division of the US Justice

Department or the FTC– Charges a firm/group of firms with

breaking the law– Acting on a complaint by a customer or a

competitor– Accused

• Sign a consent decree• Contest the charges: Court trial

– Judge decides24


Antitrust Enforcement • Consent decree

– Accused party• Without admitting guilt• Agrees not to do whatever it was charged

with • If the government drops the charges

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Per Se Illegality• Per se illegal

– Business practices deemed illegal – Regardless of their economic rationale or

their consequences– Government – examine firm’s behavior

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Rule of Reason• Rule of reason

– Reasons of the offending practice and its effect on competition

– Focus on• Firm’s behavior• Market structure resulting from that behavior

• Predatory pricing– Pricing tactics employed by a dominant

firm to drive competitors out of business

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Mergers and Public Policy• Antitrust Division and FTC

– Approve/deny mergers and acquisitions• Herfindahl-Hirschman Index, HHI

– Sales concentration– Horizontal mergers

• Firms in the same market– Nonhorizontal mergers

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Mergers and Public Policy• Antitrust Division and FTC

– Challenges any merger in an industry that meets two conditions• (1) the HHI exceeds 2,500• (2) the merger increases the index by more

than 200 points

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Exhibit 2

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

Each of the three industries shown has 44 firms. The HHI is found by squaring each firm’s market share then summing the squares. Under each industry, each firm’s market share is shown in the left column and the square of the market share is shown in the right column. For ease of exposition, only the market share of the top four firms differs across industries. The remaining 40 firms have 1 percent market share each. The HHI for Industry III is nearly triple that for each of the other two industries.


Merger Waves• First wave

– Technological progress in transportation, communication, and manufacturing

• Second wave– Stock market boom of 1920s

• Third wave– After WWII

• Fourth wave– One-third: hostile takeovers

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Exhibit 3

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U.S. Merger Waves in the Past Century


Competition Over Time• U.S. industries:

1. Pure monopoly• One firm controls the market• Blocks entry

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

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Competition Over Time• U.S. industries:

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

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Exhibit 4

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


Competition Over Time• Growth in competition (1958-2000)

– Competition from imports• One-sixth of the overall increase in

competition – Deregulation

• One-fifth of the overall increase in competition

– Antitrust policy• Two-fifths of the overall increase in

competition 36


Recent Competitive Trends• Growing world trade and competition

– Three major automakers• 80% of US market in 1970• Only 45% by 2010

• Deregulation of international phone service– $0.88 a minute in 1997– Under $0.10 by 2010

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Recent Competitive Trends• Technological change

– Prime-time audience share of three major TV networks• 90% in 1980• Under 30% today

– FOX became a fourth major network– Cable and satellite technology delivered

hundreds of networks and channels

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Problems with Antitrust Policy• Competition may not require that many

firms– Antitrust policy should not necessarily

aim at increasing the number of firms in each industry

– Firm size should not be the primary concern

– Most of the desirable properties of perfect competition can be achieved with relatively few firms

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Problems with Antitrust Policy• Antitrust abuses

– Treble damage suits• Parties -show injury from firms that violate

antitrust laws– Can sue the offending company– Recover three times the damages sustained

• Abused– Used to intimidate an aggressive competitor– Used to convert a contract dispute into treble

damage payoffs

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Problems with Antitrust Policy• Growth of international markets

– Market power of a firm• Its share of the market

– With greater international trade• Local and national market share becomes

less relevant– Antitrust enforcement that focuses on

domestic producers makes less economic sense

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Problems with Antitrust Policy• Bailing out troubled industries

– Financial institutions and two of the big three automakers

– Intent: to promote financial stability and keep the economy from sinking further

– Long-term effect• Remains to be seen

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Types of Government Regulation

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local phone service

monopolyfostering competition

safetycontrol overunsafe

subway systemland