C H A P T E R C H E C K L I S T When you have completed your study of this chapter, you will be able to Explain the effects of regulation of natural monopoly and oligopoly. 1 Describe U.S. antitrust law and explain three antitrust policy debates. 2

17.1 REGULATION Regulation Rules administered by a government agency to influence economic activity by determining prices, product standards and types, and the conditions under which new firms can enter an industry.

The Changing Scope of Regulation 1877—Interstate Commerce Commission (ICC) 1930s—agencies established to regulate power, communications, securities, banking, and more 1970s—agencies to regulate copyrights and energy 1980s and 1990s—deregulation Deregulation is the process of removing restrictions on prices, product standards, and entry conditions.

17.1 REGULATION The Regulatory Process Governments appoint regulators and provide them with an operating budget. Agencies develop rules and practices based on accounting procedures. Rules are typically complex and hard to administer.

17.1 REGULATION Economic Theory of Regulation Two broad economic theories of regulation are: Public interest theory Capture theory

17.1 REGULATION Public Interest Theory The public interest theory is that regulation seeks an efficient use of resources. Capture Theory Capture theory is that regulation helps producers to maximize economic profit.

Natural Monopoly 17.1 REGULATION A natural monopoly is an industry in which one firm can supply the entire market at a lower price than can two or more firms.

Public Interest or Private Interest Regulation According to public interest theory, regulation achieves an efficient use of resources, which occurs if marginal cost equals marginal benefit (and price). Marginal cost pricing rule A rule that sets price equal to marginal cost to achieve an efficient output in a regulated industry. Figure 17.1 on the next slide illustrates this rule.

17.1 REGULATION 1. Price is set equal to marginal cost of $10 a month. 2. At this price, the efficient quantity (8 million households) is served. 3. Consumer surplus, shown by the green triangle, is maximized. 4. The firm incurs a loss on each household served, shown by the red arrow.

Average cost pricing rule 17.1 REGULATION Average cost pricing rule A rule that sets price equal to average total cost to enable a regulated firm to cover its costs. Figure 17.2 on the next slide shows a natural monopoly that is regulated by an average cost pricing rule.

17.1 REGULATION 1. Price is set equal to average total cost of $15 a month. 2. At this price, less than the efficient quantity (6 million households) is served. 3. Consumer surplus shrinks to the smaller green triangle.

17.1 REGULATION 4. A producer surplus enables the firm to pay its fixed cost and break even. 5. A dead-weight loss, shown by the gray triangle, arises.

17.1 REGULATION Rate of Return Regulation Under rate of return regulation, a regulated firm must set its price at a level that enables it to earn a specified target percent return on its capital. If the regulator could observe the firm’s true costs and be sure that the firm was minimizing cost, this type of regulation would be like average cost pricing. But a firm might mislead the regulator and get close to maximum monopoly profit under this regulation.

17.1 REGULATION Price Cap Regulation A price cap regulation is a price ceiling—a rule that specifies the highest price the firm is permitted to charge. A price cap regulation can be combined with earnings sharing regulation—a regulation that requires a firm to make refunds to customers if its profit rises above a target rate.

17.1 REGULATION Figure 17.3 shows how price cap regulation works. With no regulation, the firm maximizes profit by producing the quantity at which MC = MR. With a price cap, the firm increases output and lowers the price.

Oligopoly Regulation 17.1 REGULATION Firms have an incentive to form a cartel. Cartels are illegal in the United States. Oligopoly might be regulated to achieve a competitive outcome (public interest) or maximum profit (capture). Figure 17.4 on the next slide shows these possible outcomes.

17.1 REGULATION 1. Public interest regulation will achieve the efficient competitive outcome: a price of $20 a trip and 300 trips a week. 2. Regulation in the producers’ interest will limit output to 200 trips a week (where industry marginal revenue, MR, is equal to industry marginal cost, MC), and the price will be $30 a trip.

Antitrust Laws 17.2 ANTITRUST LAW The body of law that regulates and prohibits certain kinds of market behavior, such as monopoly and monopolistic practices. Antitrust Laws The first antitrust law, the Sherman Act, passed in 1890. The Clayton Act of 1914 supplemented the Sherman Act.

17.2 ANTITRUST LAW

17.2 ANTITRUST LAW

Three Antitrust Policy Debates 17.2 ANTITRUST LAW Three Antitrust Policy Debates Price fixing is illegal and uncontroversial. Some other practices generate debate. Three of them are Resale price maintenance Tying arrangements Predatory pricing

17.2 ANTITRUST LAW Resale Price Maintenance Resale price maintenance occurs when a manufacturer agrees with a distributor on the price at which a product will be resold. Resale price maintenance agreements (called vertical price fixing) are illegal under the Sherman Act. But it is not illegal for a firm to refuse to supply a retailer who won’t accept the manufacturer’s guidance on what the price should be.

17.2 ANTITRUST LAW Resale price maintenance is inefficient if it enables a manufacturer and dealers to operate a cartel and charge the monopoly price. Resale price maintenance can be efficient if it permits retailers to provide an efficient level of service in selling a product.

17.2 ANTITRUST LAW Tying arrangements A tying arrangement is an agreement to sell one product only if the buyer agrees to also buy another different product. Example: textbook plus Web site bundle It is sometimes possible to use tying as a way of price discriminating.

17.2 ANTITRUST LAW Predatory pricing Predatory pricing is setting a low price to drive competitors out of business with the intention of setting a monopoly price when the competition has gone. If a firm engaged in this practice, it would incur a loss while its price were low. The firm would gain only if the high monopoly price didn’t induce entry. Most economists say that predatory pricing is unprofitable and doesn’t occur.

A Recent Antitrust Showcase: The United States Versus Microsoft 17.2 ANTITRUST LAW A Recent Antitrust Showcase: The United States Versus Microsoft The Case Against Microsoft The Department of Justice claimed that Microsoft: Possesses monopoly power in the market for PC operating systems. Uses below-cost pricing and tying agreements to achieve monopoly in the market for Web browsers. Uses other anticompetitive practices to strengthen its monopoly in these two markets.

17.2 ANTITRUST LAW Microsoft’s Response Microsoft challenged all claims. It said that Windows competes with Macintosh. Windows dominates because it is the best product. Internet Explorer with Windows 98 provides a product of greater consumer value. The browser and operating system is one product.

17.2 ANTITRUST LAW The Outcome The court rules that Microsoft was in violation of the Sherman Act and ordered that the company be broken into two firms: One that produces operating systems One that produces applications Microsoft successfully appealed this order. In its final judgment, the court ordered Microsoft to reveal details of its code to other software developers.

Merger Rules 17.2 ANTITRUST LAW The Department of Justice uses guidelines to determine which mergers it will examine and possibly block in the bases of the Herfindahl-Hirschman index (HHI). An index between 1,000 and 1,800 indicates a moderately concentrated market, and a merger that would increase the index by 100 points is challenged by the Department of Justice.

17.2 ANTITRUST LAW An index above 1,800 indicates a concentrated market and a merger that would increase the index by 50 points is challenged. Figure 17.5 on the next slide summarizes these guidelines and shows how its was applied to block some mergers of well known brand names during the 1980s.

17.2 ANTITRUST LAW