Economic Regulation and Antitrust Policy

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

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

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

Types of Government Regulation Antitrust policy Preventing monopoly Fostering competition in markets where competition is desirable Outlaws monopolies and cartels

Regulating a Natural Monopoly Downward-sloping LRAC curve Economies of scale Average production cost is lowest when a single firm supplies the market

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

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

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

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

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

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

Exhibit 1 Regulating a Natural Monopoly $4.00 2.50 1.50 1.25 0.50 Dollars per trip a 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. Demand MR c b LRAC Profit h g Long-run MC f Loss e 105 90 50 Trips per month (millions) 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

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

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

Airline regulation and deregulation 1938 Civil Aeronautics Board Regulated interstate airlines 40 years: No new interstate airline Created a cartel Fixed prices among the 10 major airlines Blocked new entry Capture theory of regulation

Airline regulation and deregulation 1938 Civil Aeronautics Board Labor unions Higher wages Pilots worked 2 weeks/month High price No regulatory power over airlines that flew only intrastate routes Fares on intrastate airlines were only half those on identical routes flown by regulated airlines

Airline regulation and 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)

Airline regulation and deregulation Fierce competition Mergers Disappeared Bankrupt Lower wages Lower fares More flights Saving lives (less driving)

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

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

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 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 mergers

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 Government – examine firm’s behavior

Rule of Reason Rule of reason Predatory pricing 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 Horizontal mergers Firms in the same market Nonhorizontal mergers

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.

Merger Waves First wave Second wave Third wave Fourth 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

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

Competition Over Time U.S. industries: Pure monopoly Dominant firm One firm controls the market Blocks entry Dominant firm One firm: more than half market share No close rival

Competition Over Time U.S. industries: Tight oligopoly Top 4 firms: more than 60% of market output Evidence of cooperation Effective competition Low concentration Low barriers to entry Little or no collusion

Exhibit 4 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

Charges Protect Windows monopoly (90%) Microsoft on trial Charges Protect Windows monopoly (90%) Extend monopoly into Internet Explorer Internet Explorer’s integration into Windows 98 Microsoft: to make life easier for customers Government: boost IE’s market share Predatory practices Anticompetitive behavior

Ruling Microsoft maintained a monopoly in operating-system software Microsoft on trial Ruling Microsoft maintained a monopoly in operating-system software Anticompetitive means Microsoft attempted to monopolize the browser market Unlawful “tying” Internet Explorer with Windows

Out-of-court settlement Microsoft on trial Out-of-court settlement Personal-computer makers Greater freedom to install non-Microsoft software on new machines Banned retaliation against companies that take advantage of these freedoms Prohibited exclusive contracts Microsoft - disclose design information to hardware and software makers

Antitrust charges brought by the European Union Microsoft on trial Antitrust charges brought by the European Union Settled most charges by 2010 Windows software 90% of the world’s computers Microsoft Stock market value = $225 billion in May 2010

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

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

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

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

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

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