McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. ANTITRUST POLICY AND REGULATION ANTITRUST POLICY AND REGULATION Chapter 15

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Today’s lecture will: Explain the difference between the structure and the performance methods of judging competition. Outline a brief history of U.S. antitrust policy. Discuss the resolution of the IBM, AT&T, and Microsoft antitrust cases. Differentiate among horizontal, vertical, and conglomerate mergers.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Today’s lecture will: Discuss the five reasons why unrelated firms would want to merge. Compare U.S. antitrust policy with antitrust policy of other countries. Explain three alternatives to antitrust policy that government can use to affect the competitive process.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Antitrust Policy Antitrust policy is the government’s policy toward the competitive process. There are two views of competition:  Judgment by performance – the competitiveness of markets should be judged by the behavior of the firms in the market.  Judgment by structure – the competitiveness of markets should be judged by the structure of the industry.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved History of U.S. Antitrust Laws Americans generally favor a laissez-faire, but populist sentiment fears bigness and monopoly. A trust or cartel is a combination of firms which have not actually merged, but act as a single entity to set common price and govern the output of individual member firms. Cartels and trusts, which developed during the late 1800s, led to the passage of the Sherman Act, the Clayton Act, and the Federal Trade Commission Act.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Sherman Antitrust Act The Sherman Antitrust Act of 1890 is a law designed to regulate the competitive process. Its two main provisions are:  “Every contract, combination, or conspiracy in restraint of trade is illegal.”  “Every person who shall monopolize…shall be guilty of a misdemeanor.”

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Sherman Antitrust Act In the 1890s, economists debated if mergers:  Reflected increased economies of scale.  Were attempts to restrict output and generate monopoly profits. The performance viewpoint argued that competition would ultimately limit monopolies. The structure viewpoint argued that trusts should be broken up by government.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The U.S. Steel Case A firm is considered a monopoly only is it commits monopolistic abuses. In the 1920 U.S. Steel case, the Court ruled that while the company was a structural monopoly, it was not a monopoly in performance. U.S. Steel was not required to break up into smaller companies.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Clayton Act The Clayton Act of 1914 made four monopolistic practices illegal when their effect was to lessen competition:  Price discrimination  Tie-in contracts  Interlocking directorships  Buying stock in a competitor’s company

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Federal Trade Commission Act The Federal Trade Commission Act made it illegal:  To use “unfair methods of competition.”  To engage in “unfair or deceptive acts or practices,” whether or not those actions had any effect on competition. In 1938 the Federal Trade Commission was given the job of preventing false and deceptive advertising.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The ALCOA Case Judgment by performance governed antitrust policy until the ALCOA case of The court did not rule that ALCOA had engaged in unfair practices, but that it dominated the market. It expanded capacity and kept prices low. The court changed its viewpoint to judging markets by structure.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Judging Markets by Structure and Performance Judging by structure is practical though seemingly unfair.  The alleged wrongdoer is doing what it is supposed to be doing, producing the product at the lowest possible price. With judgment by performance, each action of a firm must be analyzed on a case-by-case basis.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Determining the Relevant Market and Industry Choosing the relevant market when evaluating competitiveness is difficult to do. The relevant market in the ALCOA case was the aluminum market, not the metals market at large. The relevant market in the Du Pont case (1956) was flexible wrap, not cellophane. Du Pont was not considered a monopolist even though it sold 100% of cellophane.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Recent Antitrust Enforcement Since the 1980s, the government has been more lenient in antitrust cases because:  Political pressure for antitrust action waned.  Globalization of the U.S. economy.  The increasing complexity of technology. There have been three recent important computer and telecommunications cases:  IBM  AT&T  Microsoft

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The IBM Case In 1967, the Justice Department sued IBM for violation of antitrust laws:  IBM unfairly bundled hardware, software, and maintenance service.  IBM constantly redesigned its hardware, so that competitors couldn’t keep up. In its defense, IBM argued:  The market was larger that the government claimed.  Changing technology and customer demand forced it to constantly upgrade its equipment.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The IBM Case The government dropped its suit in  Mainframe computers were replaced by PCs.  Globalization of the computer industry made IBM’s dominance in the U.S. far less important. The prosecution likely led to IBM’s problems in the 1990s.  IBM didn’t buy the DOS operating system from Microsoft because of the litigation.  PCs replaced mainframes.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The AT&T Case Up until 1982, AT&T was a regulated natural monopoly.  It controlled most long distance and local telephone services.  It produced telephones and other communications equipment. Satellite transmissions and fiber-optic cable began to compete for long-distance service. Competitors sued because they felt AT&T was charging too much to access their local lines.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Resolution of the AT&T Case In 1982, AT&T agreed to divest its 22 local operating companies which merged into the seven Baby Bells. It kept its long-distance telephone service, manufacturing arm, and Bell Laboratories. Other firms emerged as long-distance competitors and rates fell. Local rates doubled and tripled.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Developments Since the AT&T Case In 1996 Congress passed the Telecommunications Act, which allowed long- distance carriers, local phone companies, and cable companies to enter one another’s markets. Competition in telecommunications has also come from wireless providers, international companies, and the Internet. Voice over Internet Protocol translates phone calls into Internet messages, sends them over the Internet, and then translates them back to voice messages.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Microsoft Case Microsoft controls about 50% of the market for software and over 90% of the operating systems market. In 1998, the Justice Department charged Microsoft with:  Possessing monopoly power in the PC operating systems market.  Tying other of its products to Windows.  Preventing PC manufacturers that install Windows from offering competing software.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Is Microsoft a Monopolist? The software industry is characterized by:  Network externalities – as the number of applications supported by a single platform increase, the value of the platform also increases.  Economies of scale – the cost of developing new platforms and software is significant while the cost of producing it is minimal.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Is Microsoft a Monopoly? In a static framework, with its 90% market share, Microsoft is a monopoly. From a dynamic perspective, there is potential competition from:  Other operating systems, such as Jaguar and Linux  The merging of software and hardware In a dynamic view of the market, Microsoft’s monopoly is at best temporary.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Is Microsoft a Predatory Monopolist? Is Microsoft a Predatory Monopolist? By directing the development of software to favor Windows, Microsoft strengthened the barrier to entry created by network externalities. Microsoft penalized PC manufacturers that installed Windows if they also installed competing software. Microsoft damaged Netscape Navigator by packaging Internet Explorer for free as part of Windows 95. Microsoft altered Sun Microsystems' Java, a software language designed to run on other operating systems as well as Windows.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Resolution of the Microsoft Case In 2000 the court ruled that Microsoft violated the Sherman Act by using anti-competitive means to maintain its monopoly power. In the settlement Microsoft agreed that:  It would not prohibit PC makers from using competing products.  It would release technical information on Windows improvements to software makers.  It could continue to bundle and media players with Windows.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Assessment of Antitrust Policy Almost all economists agree that antitrust enforcement has not reduced the size of firms so that economies of scale have been eliminated. Performance advocates generally believe enforcement was not needed. Structural advocates generally believe that enforcement was necessary.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Mergers, Acquisitions, and Takeovers During the 1990s and early 2000s, firms have been breaking up and merging to achieve economies of scope and economies of scale. Merger is a general term meaning the act of combining two firms. Two types of mergers are takeover and acquisition.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Acquisitions and Takeovers A takeover is the purchase of one firm by a shell firm that takes control of the purchased firm’s operations.  Takeovers change the control of the firm, but not market concentration. An acquisition is a merger in which a company buys another company.  The purchaser has the right of direct control, but does not always exercise that right.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Mergers There are three types of mergers:  Horizontal merger – the merging of two companies in the same industry  Vertical merger – a combination of two companies that are involved in different phases of producing a product  Conglomerate merger – the merging of two companies in relatively unrelated industries

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Horizontal Mergers Since the Celler-Kefauver Act in 1950, almost all mergers of firms with substantial market shares in the same industry have been prohibited. Mergers having the following market share combinations are challenged: Acquiring firmAcquired firm 4%4% or more 10%2% or more 15%1% or more

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Vertical Mergers If the merged firms are able to limit access of other buyers or sellers to the market, the merger would be in violation of the Clayton Act. In the 1980s, the government challenged any vertical merger in which:  The supplying firm had a 10% or more market share.  The buyer company bought 6% or more of the market.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Conglomerate Mergers Conglomerate mergers are usually approved because they don’t restrict competition. There are five reasons why unrelated firms would wish to merge:  To achieve economies of scope  To get a good buy  To diversify  To ward off a takeover bid  To strength their political-economic influence

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Mergers in the U.S. Since 1892

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Antitrust Policy in Other Countries Antitrust legislation in other countries, with the exception of the European Union, is usually much weaker than in the U.S. In the early 2000s the European Commission, the EU’s antitrust agency, began to block mergers of U.S. companies, such as GE and Honeywell.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Regulation, Government Ownership, and Industrial Policies Governments can affect the competitive process by:  Regulating the activities of firms with:  Price regulations  Social regulations that affect aspects such as working conditions and product quality  Owning and taking direct control of the firms.  Industrial policy that influences firms with laws and taxes.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Summary Antitrust policy is the government’s policy toward the competitive process. The competitiveness of markets can be judged by:  Performance – behavior of firms in the market  Structure – number of firms in the industry and their market share

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Summary Important antitrust laws include:  The Sherman Antitrust Act  The Clayton Act  The Federal Trade Commission Act Important antitrust cases involved:  AT&T  IBM  Microsoft

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Summary Three types of mergers are:  Horizontal – two firms in the same industry  Vertical – two companies in different industries, one of which is a supplier for the other.  Conglomerate – combination of two companies in relatively unrelated industries Reasons unrelated firms would want to merge are:  Economies of scope  A good buy  Diversification  Warding off a takeover bid  Strengthening political-economic influence

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Summary The increasing internationalization of the U.S. market has changed U.S. antitrust policy from looking at just domestic competition to considering international competition. Antitrust issues are by nature global, but a country’s antitrust laws are not. Other than antitrust policy, government affects the competitive process through regulation, government ownership, and industrial policy.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Review Question 15-1 What are the two methods of judging the competitiveness of a market? The performance approach assesses competitiveness based on the behavior of firms in the market, whether they engage in unfair business practices. The structure approach judges the competitiveness of the market based on the number of firms and their market shares. Review Question 15-2 In what way is Microsoft a monopolist? In what way is it not a monopolist? In a static sense, Microsoft is a monopoly because it controls 90% of the market for operating systems with Windows. However, in a dynamic sense, Microsoft faces increasing competition from other operating systems, Linux and Jaguar, and from the merging of software and hardware. PDAs and smart phones run software without Windows.