Economic Regulation and Antitrust Activity

Market Power • The 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

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

Government Regulation • Three 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

Regulating Natural Monopolies • Because of economies of scale, natural monopolies have a downward-sloping long-run average-cost curve over the entire range of market demand • This means that the lowest average cost is achieved when one firm serves the entire market • Natural monopolies usually face huge capital costs

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

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 monopoly • Government-owned and government-regulated monopolies are called public utilities • We will focus on government regulation, though the issues are similar if the government operates the monopoly

Price Equal to Marginal Cost • In regulating natural monopolies, the price-output combination captures the most attention • Suppose 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 cost

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?

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

Price Equal to Average Cost • Rather 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

Regulatory Dilemma • Setting 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

Regulatory Dilemma • The 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

Regulatory Dilemma • Although 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

Alternative Theories • There 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

Special Interest of Producers • Producers have a strong interest in matters that affect their livelihood  they play a disproportionately large role in trying to influence such legislation • Conversely, consumers have no special interest in the majority of this legislation • This asymmetry between the interests of producers and consumers leads to regulations that favor producer interests

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

Special Interest of Producers • The 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

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”

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

Origins of Antitrust Policy • Economic 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 manufacturing • Lower transportation costs as railroad coverage increased dramatically • Economies of scale and cheaper transportation costs extended the geographical size of markets  firms grew larger and reached broader markets

Origins of Antitrust Policy • Declines 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 erupted • Firms 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

Sherman Antitrust Act of 1890 • Sherman 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

Clayton Act of 1914 • Was passed to outlaw certain practices not prohibited by the Sherman Act and to help government stop a monopoly before it developed • Prohibits • Price discrimination when this practice tends to create a monopoly • Tying contracts require the buyer of one good to purchase another good as well

Clayton Act of 1914 • Exclusive 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

Other Acts • Federal Trade Commission Act of 1914 and established a federal body to help enforce antitrust laws • Celler-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 product • Vertical mergers  the merging of firms where one supplies inputs to the other or demand output from the other

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

Per Se Illegal • The courts have interpreted antitrust laws in essentially two ways • One set of practices has been declared per se illegal • Another 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

Rule of Reason • Here 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

Rule of Reason • Predatory 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

Rule of Reason • In 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

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

Mergers and Public Policy • The 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]

Mergers and Public Policy • Alternatively, 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

Mergers and Public Policy • The Justice Department sorts all mergers into two categories • Horizontal mergers which involve firms in the same market • Nonhorizontal mergers which include all others • Any merger in an industry where two conditions are met is challenged • The post-merger Herfindahl index would exceed 1800 • The merger would increase the index by more than 100 points

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

Merger Movements • The 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

Competitive Trends • Among 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 entry • Dominant firm, in which a single firm had over half the market share and had no close real rival

Competitive Trends • Tight 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

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

Recent Competitive Trends • Shepherd’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

Problems with Antitrust Legislation • Growing doubt about the economic value of the lengthy antitrust cases • Microsoft case • Case against Exxon was in the court for 17 years before Exxon was cleared • A case against IBM began in 1969 and was finally dropped in 1982

Problems with Antitrust Legislation • Too 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 destruction • Firms 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

Problems with Antitrust Legislation • 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

Problems with Antitrust Legislation • 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

Problems with Antitrust Legislation • 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

Economic Regulation and Antitrust Activity