Antitrust Policy and Regulation In this chapter we will examine the laws that reflect the foundation of antitrust policy in the U.S., along with the application of the antitrust laws by the U.S. courts. We will then look at industrial regulation of natural monopolies, examining the case for and against industrial regulation as well as the results of deregulation. Lastly, we will look at social regulation and how it differs from industrial regulation. Chapter 19 Antitrust Policy and Regulation Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Antitrust Laws The purpose: Prevent monopolization Promote competition Achieve allocative efficiency Historical background Regulatory agencies Antitrust laws During the Industrial Revolution, businesses that were once small and localized started to grow and expand as transportation methods improved, production became mechanized and the corporate structure was developed. This led to the creation of dominant firms who sometimes used questionable tactics in consolidating their position in the market and once control was gained, charged higher prices to customers and demanded price concessions from resource suppliers. In response to this behavior, the government began regulating these businesses through regulatory agencies and antitrust legislation. LO1 LO1

Antitrust Laws Sherman Act 1890 Clayton Act 1914 Outlaws price discrimination Prohibits tying contracts Prohibits stock acquisition No interlocking directorates Federal Trade Commission Act 1914 Wheeler-Lea Act 1938 Celler-Kefauver Act 1950 The Sherman Act of 1890 was the first piece of antitrust legislation. It contains two main provisions: (1) any contract that tends to restrain trade is illegal, and (2) trying to monopolize any part of trade is a felony offense. This act provided a basic foundation for antitrust legislation but was not specific enough. In 1914, the Clayton Act was passed to elaborate and clarify the provisions of the Sherman Act. It outlawed price discrimination, prohibited tying contracts, prohibited the acquisition of stocks when the outcome would be less competition, and prohibited the formation of interlocking directorates. Also in 1914, the Federal Trade Commission Act was passed which created the Federal Trade Commission. The FTC has joint responsibility with the Justice Department for enforcing the antitrust laws. The Wheeler-Lea Act of 1938 gave the FTC additional authority over the area of deceptive advertising. The final piece of legislation is the Celler-Kefauver Act which amended the Clayton Act by closing the loophole in mergers. Prior to the Celler-Kefauver Act, firms could merely buy all of the physical assets of their competitors instead of buying the stock. LO1

Antitrust Policy: Issues and Impacts Issues of interpretation Monopoly behavior vs. Monopoly structure 1911 Standard Oil Case 1920 U.S. Steel Case 1945 Alcoa Case Relevant market 1956 DuPont Cellophane Case Issues of enforcement Obviously the interpretation of these laws has led to varied applications. Exactly how do you define a monopoly? Even the Supreme Court cannot always agree as we see in the three cases listed. In the 1911 case, the Court found that Standard Oil was guilty of monopolizing the petroleum industry and ordered them to be broken up into smaller firms. In the 1920 case, the Court used a “rule of reason” standard and stated that just because there was only one firm in an industry, it is not necessarily illegal. Only if the monopoly acted to “unreasonably” restrain trade should it be punished. The 1945 case reversed that decision and said that mere possession of monopoly power violated the law. More recent rulings have tended to follow the “rule of reason” standard. The other key issue is exactly how the market is defined. In the 1956 case, the Court looked at the overall market of “flexible wrapping materials” rather than the narrower market of just cellophane. Using this standard, DuPont was not found to be a monopoly and thus not in violation of the law. When it comes to interpretation, the administration of the laws will also reflect the views of the president who is in office at the time. Someone with a laissez-faire perspective would take a more hands-off approach than would someone with an active antitrust perspective. LO2

Effectiveness of Antitrust Laws Monopoly AT&T Microsoft Case Mergers Horizontal merger Vertical merger Conglomerate merger We can look at a couple of examples to evaluate the effectiveness of these laws. The first deals with AT&T. After being charged with violating the Sherman Act, AT&T was forced to divest itself of its regional phone companies. (Remember Ma Bell and the Baby Bells?) Microsoft has more recently been found to be guilty of violating the Sherman Act and, although was not required to break-up, was prohibited from engaging in specific anticompetitive business practices. The European Union is currently very pro-active in enforcing antitrust laws, perhaps due to the fact that their markets are younger and less developed than the U.S. markets and therefore need greater protection. LO2

Mergers Merger guidelines The Herfindahl Index Price fixing Price discrimination Tying contracts The Herfindahl Index is used by the government to decide whether or not to allow a merger. If it determines that the merger will give the combined firm too much power or control, the government can prevent the merger from occurring. Horizontal or vertical mergers are the most likely ones to be blocked. Price fixing, price discrimination and tying contracts are all prohibited behaviors under the Clayton Act. Price discrimination charges are rare since it tends not to reduce competition. Tying contracts are strictly prohibited and the government aggressively pursues the violators. LO2

Industrial Regulation Natural monopoly Economies of scale Public utilities Electricity, water, gas, phone Solutions for better outcomes Public ownership Public regulation Public interest theory of regulation There are some situations where everyone benefits from the monopoly. Natural monopolies exist when economies of scale are so large that a single firm can supply the entire market at a lower cost than could a number of competing firms. Public utilities are the most common examples of natural monopolies. In these cases, control of the monopoly may be achieved through public ownership or public regulation. The next slide lists examples of several agencies involved in the regulatory process. The economic objective of industrial regulation is embodied in the public interest theory of regulation. This theory supposes that industrial regulation is necessary to keep a natural monopoly from charging monopoly prices and therefore harming consumers and society. LO3

Problems with Industrial Regulation Regulators establish rates to give natural monopoly “fair return” No incentive to reduce cost X-inefficiency Perpetuating Monopoly Conditions of natural monopoly can end Legal Cartel Theory of Regulation There are a couple of problems with the effectiveness of industrial regulation. One is that an unregulated firm has a strong incentive to reduce costs in order to increase profits. Regulated firms have less of an incentive since they are guaranteed a fair return regardless of costs. The other problem is that regulation can actually end up perpetuating the monopoly, even when conditions have changed, so that competition would not be possible. For example, technological advances eliminated the need for monopolies in the telephone industry and today that industry is a competitive marketplace. Some firms may seek to be regulated if they believe that the regulation will reduce competition and raise prices the same way a private cartel would. In this system, the government would serve as the invisible hand guiding the industry to competitiveness through such means as blocked entry or dividing up the market. LO3

Deregulation Began in the 1970s Has produced large net benefits for consumers and society Industries deregulated include: Airlines Railroads Telecommunications Electricity In the 1970s it became apparent that technological advances had reached a point where, in many industries, there was now the potential for competitive industries. A wave of deregulation started as the government began to take a step back from protecting various industries. Most economists agree that deregulation has produced significant benefits to both consumers and society. For example, airfares have decreased by as much as one-third, while airline safety has continued to improve despite deregulation. More recently, there has been an attempt to deregulate electricity which would give consumers choices as to where they obtain their service. Unfortunately, problems with the process in California and the failure of Enron have tended to bring the idea to a temporary halt. LO3

Social Regulation Concerned with the conditions under which goods and services are produced Impact of production on society Physical qualities of goods Applied “across the board” to all industries Social regulation applies to many more firms than industrial regulation. It tends to intrude into the everyday processes of a business, affecting everything from hiring practices to production practices. Between 1970 and 1980, just a ten year period, the U.S. government created 20 new social regulatory agencies and Congress continues to establish new social regulations to be enforced. (Think of the Health Care Reform Act recently passed.) LO4

Social Regulation Optimal level of social regulation In support of social regulation Criticisms of social regulation Two reminders There is no free lunch Less government is not always better than more Obviously there is much disagreement on how much regulation is needed. Supporters of social regulation point out the many successes the country has achieved due to regulation. These include such items as fewer job-related accidents, less discrimination in the work place, reduced highway fatalities, and the list could go on and on. Critics of the system would argue that the costs related to achieving these gains are too high. They feel regulators will over-reach their authority and end up creating needless regulations. As a society, we will continue to struggle to find a balance. It is just very difficult to put a price on the value of one person’s life! LO4

United States vs. Microsoft Charged in May 1998 under the Sherman Act Accused of having a “Windows” monopoly District court findings: Used anticompetitive means District court remedy Appeals court ruling Final settlement The recent antitrust case involving Microsoft was probably the biggest monopoly case since the break-up of AT&T. In it, the government charged Microsoft with having a monopoly with its Windows operating system. The main concern dealt with its internet browser program, Explorer. There was another web browser called Netscape Navigator that was very popular. Microsoft designed their Windows operating system in such a way that if a consumer tried to use another company’s internet browser software, such as Netscape’s Navigator, the system would crash. Netscape claimed this was an unfair tying arrangement and the courts agreed. Originally, the court ordered Microsoft to split itself into two companies, one which would handle the operating systems and another which would handle other software, but Microsoft and the government reached a settlement in 2002 which allowed Microsoft to avoid a breakup but prevented them from repeating the behaviors which got them in trouble in the first place. Microsoft did have to pay billions of dollars in fines and penalties, much of which went to the other companies that suffered because of their monopolistic behavior.