Chapter 13 ANTITRUST AND REGULATION Gottheil — Principles of Economics, 7e © 2013 Cengage Learning 1

Economic Principles © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 2 Regulating a natural monopoly “Fair” price Marginal cost pricing Laissez-faire Nationalization

Economic Principles © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 3 The theory of contestable markets The theory of countervailing power The theory of creative destruction

Economic Principles © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 4 Patents Antitrust legislation

Paradise Lost © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 5 To many economists, perfect competition is the closest thing on earth to paradise.

Paradise Lost © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 6 Under perfect competition, market prices are at their lowest levels, all goods are produced at the minimum point on their average cost curves, and the quantities supplied are greater than would be forthcoming under any other market condition.

Paradise Lost © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 7 Unfortunately, perfect competition does not exist in the real world.

Paradise Lost © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 8 The real world is one of monopoly, monopolistic competition and oligopoly.

Learning to Cope Without Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 9 There are several competing views among economists regarding what we should do about monopolies and oligopolies.

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e 10 EXHIBIT 1WHAT TO DO ABOUT MONOPOLY

Learning to Cope without Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Regulating monopoly : Monopolies are inevitable and undesirable. Use government regulation to make monopoly price conform more closely to the price that would exist if the markets were competitive.

Learning to Cope without Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Nationalizing the industry : Monopolies are inevitable and undesirable. Government should take over the monopolies.

Learning to Cope without Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Laissez-faire : Monopolies are inevitable, but not necessarily undesirable. Government policy of nonintervention in market outcomes. Translated, it means “leave it be.”

Learning to Cope without Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Encouraging concentration : Monopolies are inevitable and desirable. Government should promote less-competitive markets because they are technically superior, generate low prices and benefit society.

Learning to Cope without Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Splitting up monopoly : Monopolies are neither inevitable nor desirable. Government should promote anti-monopoly legislation, break monopolies into fragments and prevent their restoration.

The Economics of Regulation © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 16 How does government regulation of monopoly work? It separates monopoly pricing from monopolies and the price-making function is taken over by a government-appointed regulatory commission or agency.

The Economics of Regulation © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 17 Regulation Although the ownership of the regulated firm remains in private hands, pricing and production decisions of the firm are monitored by a regulatory agency directly responsible to the government.

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e 18 EXHIBIT 2THE CITY BUS COMPANY

Exhibit 2: The City Bus Company © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 19 1.Using the MR = MC rule, what fare and passenger capacity maximizes profit in Exhibit 1? Profit is maximized at a fare of $5.00 and service to 80,000 passengers.

Exhibit 2: The City Bus Company © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 20 2.What is the profit of the bus company at a price of $5.00 and service to 80,000 passengers? Profit = (Price × Number of passengers) - (Average cost per passenger × Number of passengers) Profit = ($5.00 × 80,000) – ($3.00 × 80,000) = $160,000

Exhibit 2: The City Bus Company © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 21 3.What fare would lead to zero economic profit for the bus company? The company would achieve zero economic profit where price equals average total cost ( P = ATC ). P = ATC at $1.00

Exhibit 2: The City Bus Company © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 22 4.Why is zero economic profit considered a “fair” price? The price is considered “fair” because the company is entitled to cover its costs, as well as enjoy normal profit, and passengers enjoy a lower bus fare.

The Economics of Regulation © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 23 Benefits of government regulation of the bus service include: Lower bus fares Increased number of passengers

The Economics of Regulation © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 24 Concerns with bus company regulation include: The possibility that the ATC will begin to shift upward. Since price is set at ATC, when ATC goes up, bus fare also goes up. Under this scenario, there is little incentive to try to control ATC.

The Economics of Regulation © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 25 Government commissions regulating markets must be vigilant in monitoring cost drift and keeping costs under control.

The Economics of Regulation © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 26 Marginal cost pricing A regulatory agency’s policy of pricing a good or service produced by a regulated firm at the firm’s marginal cost, P = MC.

The Economics of Regulation © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 27 Marginal cost pricing P = MC indicates society’s optimal use of resources. The value that people place on a service is indicated by the price they are willing to pay.

The Economics of Regulation © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 28 Marginal cost pricing At P = ATC, or a $0.90 fare, the price people are willing to pay for the service is higher than the cost to produce the service ($0.40). In other words, P = ATC > MC.

Exhibit 2: The City Bus Company © 2013 Cengage Learning Gottheil — Principles of Economics, 7e What are price and quantity when P = MC in Exhibit 1? At P = MC, price is $0.30. Quantity is 180,000.

Exhibit 2: The City Bus Company © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 30 6.Why must the city subsidize bus transportation if price is regulated at P = MC ? At P = MC, revenue for the bus company = ($0.30 × 180,000) = $54,000. Average total cost is $0.70.

Exhibit 2: The City Bus Company © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 31 Total cost for the firm = ($0.70 × 180,000) = $126,000. At P = MC the bus company suffers a loss of $(126,000 – 54,000) = $72, Why must the city subsidize bus transportation if price is regulated at P = MC ?

The Economics of Regulation © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 32 Who makes up a regulatory commission, and what interests they represent, is a delicate matter. Sometimes regulatory commissions end up protecting the monopolies they are supposed to regulate.

The Economics of Regulation © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 33 Deregulation The process of converting a regulated firm into an unregulated firm.

The Economics of Nationalization © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 34 Nationalization Government ownership of a firm or industry. Price and production decisions are made by an administrative agency of the government.

The Economics of Nationalization © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 35 Governments can nationalize industries by either buying out the shares held by the shareholders or by simply confiscating the property.

The Economics of Nationalization © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 36 Governments typically buy firms by exchanging their own bonds for the nationalized firm’s shares. Assessing the firm’s net worth can be a problem, but governments have generally been generous when nationalizing a firm.

The Economics of Nationalization © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 37 What pricing options does the government have, once it has nationalized a firm? The options available to the government are exactly the same as those available to the regulatory commission under regulation.

The Economics of Nationalization © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 38 What pricing options does the government have, once it has nationalized a firm? The government can act as a profit-maximizing firm and follow the MR = MC rule, it can set price at ATC, or it can set price at MC.

The Economics of Nationalization © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 39 Some people believe that the government-run industries are inherently inefficient. One reason government may appear inefficient is that it often takes over industries that were struggling in the first place.

The Economics of Nationalization © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 40 Another reason for the fear of inefficiency is that governments cannot go bankrupt. While private firms cannot absorb large losses over the long term, governments can continue to subsidize failing industries indefinitely.

The Economics of Nationalization © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 41 It is virtually impossible to distinguish ownership on the basis of performance, however. There are many examples of government-run industries which perform well, including airlines, colleges, and football teams.

The Economics of Laissez-Faire © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 42 Some economists are not at all disturbed by monopolies. They believe that even with considerable industry concentration, there is still enough competition to generate acceptable price and output levels.

The Economics of Laissez-Faire © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 43 Three theories try to explain why monopolies are not undesirable: 1.Contestable markets 2.Countervailing power 3.Creative destruction

The Economics of Laissez-Faire © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 44 Contestable market A market in which prices in highly concentrated industries are moderated by the potential threat of firms entering the market.

The Economics of Laissez-Faire © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 45 According to this theory, does there actually need to be competitors in a market in order to moderate prices? No. There only needs to be a potential threat of competition in order to moderate prices.

The Economics of Laissez-Faire © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 46 Critics of the contestable market theory find the argument compelling, but the applicability limited. They argue that in reality, barriers to entry and the cost of shifting resources make the market uncontestable.

The Economics of Laissez-Faire © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 47 Countervailing power The exercise of market power by an economic bloc is ultimately counteracted by the market power of a competing bloc, so that no bloc exercises undue market power.

The Economics of Laissez-Faire © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 48 The countervailing power theory argues that while competition may not exist among firms within a highly concentrated industry, it may still exist among highly concentrated industries.

The Economics of Laissez-Faire © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 49 What are the four competing power blocs, according to the countervailing power theory? The four competing blocs power are industrial, labor, agricultural and retail.

The Economics of Laissez-Faire © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 50 For example, in the canned food industry, the oligopoly power of industrial producers of canned food is checked by the oligopoly power of the major retail grocery stores.

The Economics of Laissez-Faire © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 51 Creative destruction Effective competition that exists not among firms within highly concentrated industries but between the highly concentrated industries themselves. Such competition ensures competitive prices.

The Economics of Laissez-Faire © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 52 The theory argues that while it may be difficult for firms to break into a monopolized industry, it is much less difficult for them to break the monopolized industry’s hold on a market by developing new products. Monopolies are destroyed by the creative process.

The Economics of Laissez-Faire © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 53 Using the creative destruction theory, how was the coal oligopoly destroyed? The coal oligopoly was destroyed not by more competition, but by the development of petroleum.

The Economics of Encouraging Monopoly © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 54 Some economists prefer the monopoly structure to competition. They rely on Schumpeter’s argument that monopolies can take advantage of economies of scale.

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e 55 EXHIBIT 3FIRM SIZE AND ECONOMIES OF SCALE

Exhibit 3: Firm Size and Economies of Scale © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 56 What is the lowest ATC that can be achieved by the competitive firm and the monopoly in Exhibit 2? The lowest ATC that can be achieved by the competitive firm is $6. The monopoly can achieve an ATC of $2.

The Economics of Encouraging Monopoly © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 57 Government, in this scenario, can foster an environment favorable to innovating industries. It can award and protect patents and encourage research and development by providing tax incentives.

The Economics of Encouraging Monopoly © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 58 Patent Exclusive right granted by government to a market product or process for 20 years.

The Economics of Splitting Up Monopoly © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 59 Splitting up monopolies is the preferred option when: Competition among many small firms is preferable. Laissez-faire theory doesn’t hold up in reality. Government regulation and nationalization are inefficient.

The Economics of Splitting Up Monopoly © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 60 Proponents of splitting up monopolies argue that monopolies come into being and persist by unfair market practices. The role of the government is to stop crime.

The Economics of Splitting Up Monopoly © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 61 Antitrust policy Laws that foster market competition by prohibiting monopolies and oligopolies from exercising excessive market power.

The History of Antitrust Legislation © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 62 The core of elements of federal antitrust legislation are: Sherman Antitrust Act of 1890 Clayton Act of 1914 Federal Trade Commission Act of 1914

The History of Antitrust Legislation © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 63 The effectiveness of antitrust legislation is limited by the funding appropriated to the agencies delegated the responsibility of ensuring the laws are enforced.

Antitrust Goes to Court © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 64 The rule of reason A judicial standard or criterion by which a firm’s size within an industry is insufficient evidence for the court to rule against it in an antitrust suit. Evidence must show that the firm actually used its size to violate antitrust laws.

Antitrust Goes to Court © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 65 The issue, according to this criterion, is the firm’s behavior, not its size or its share of the market. The rule of reason

Antitrust Goes to Court © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 66 This criterion has been favored by the courts during the early twentieth century and since the 1970s. The rule of reason

Antitrust Goes to Court © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 67 Per se A judicial standard or criterion by which a firm’s size within an industry is considered sufficient evidence for the court to rule against it in an antitrust suit.

Antitrust Goes to Court © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 68 The issue, according to this criterion, is the size of the firm. The antitrust legislation does not differentiate between good and bad monopolies. Per se

Antitrust Goes to Court © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 69 This criterion was favored by the courts during the post-World War II period. Per se

Antitrust Goes to Court © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 70 The courts and Congress have been lenient since the 1980s in applying antitrust legislation to conglomerates.

Do We Have a Policy on Monopoly? © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 71 The U.S. does not have a clear and consistent policy on what to do about monopoly. For example, the utility industry is highly regulated, the post office is nationalized, and conglomerates are generally left alone.