Chapter 15 Professor Yuna Chen Economic Regulation and Antitrust Policy

1. Types of Government Regulation Three types of government regulation 1.1 Social regulations Aimed at improving health and safety Control over Unsafe working conditions, dangerous products Health care reform

1. Types of Government Regulation 1.2 Economic regulations Control: price, output, entry of new firms, quality of service Control over natural monopolies Local electricity transmission, local phone service

1. Types of Government Regulation 1.3 Antitrust policy Preventing monopoly Fostering competition Outlaws monopolies and cartels

2. Regulating a Natural Monopoly Case study: Subway system: a natural monopoly Average production cost is lowest when a single firm supplies the market

Exhibit 1 Regulating a Natural Monopoly $40 25 15 12.50 5 Dollars per trip a Demand MR c b LRAC Profit h g Long-run MC f Loss e 105 90 50 Trips per month (millions)

Regulating a Natural Monopoly (1) Unregulated monopoly Qm = 50 Pm = $40 TR = $200 TC = $ Profit = Consumer surplus = Result: inefficient in terms of social welfare

Regulating a Natural Monopoly (2) Setting P (marginal benefit)=MC Q* = P* = TR = TC = Profit = Consumer surplus = Result: a. social welfare is maximized. b. monopolist: economic loss c. In long-run: monopolist exits the market

Regulating a Natural Monopoly (3) Possible solutions a) Government-owned monopolies; use tax revenue to cover the loss

Regulating a Natural Monopoly b) Subsidizing the natural monopolist Monopolist: produce where P=MC Government covers the loss Firm: earn normal profit Drawback: government either raise taxes, or forgo public spending

Regulating a Natural Monopoly c) Setting P = average cost Breaking even normal profit Stay in business without a subsidy Higher social welfare than unregulated

Regulating a Natural Monopoly (4) 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 Not a socially optimal allocation

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

Alternative Theories Producers’ special interest Well-organized producer groups Expect to gain from economic regulation Persuade public officials to impose restrictions Reduce competition Increase prices

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

Antitrust Law and Enforcement Antitrust policy Reduce anticompetitive behavior Promote competition Attempts to promote socially desirable market performance

Origins of Antitrust Policy 1873-1883 sharp economic decline Competing firms formed a trust Sugar, tobacco, oil industries Widespread criticism

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

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

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

Origins of Antitrust Policy Federal Trade Commission Act of 1914 Federal trade commission (FTC) Enforce antitrust laws Cellar-Kefauver Anti-Merger Act Prevents one firm from buying physical assets of another firm If the effect is to reduce competition

Origins of Antitrust Policy Horizontal merger One firm combines with another firm That produces the same type of product Vertical merger From which it had purchased inputs or to which it had sold output

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 decides

Antitrust Enforcement Consent decree Accused party Without admitting guilt Agrees not to do whatever it was charged with If the government drops the charges

Per Se Illegality Per se illegal Business practices deemed illegal Regardless of their economic rationale or their consequences

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

Mergers and Public Policy Antitrust Division and FTC Approve/deny mergers and acquisitions Herfindahl-Hirschman Index, HHI Sales concentration Square the sales of each firm, then sum them Perfect competition: HHI closes to 0 Monopoly: HHI = 10,000

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

Exhibit 2 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.

Exhibit 3 U.S. Merger Waves in the Past Century

Exhibit 4 Competitive Trends in the U.S. Economy: 1939 to 2000