1 Economic Regulation and Antitrust Policy Chapter 15 © 2006 Thomson/South-Western

2 Government Regulation Three kinds of government policies designed to alter or control firm behavior  Social regulation  Consists of measures designed to improve health and safety  Economic regulation  Controls the price, the output, the entry of new firms, and the quality of service in industries in which monopoly appears inevitable  natural monopolies  Antitrust activity  Attempts to prohibit firm behavior that tries to monopolize markets

3 Price Equal to Marginal Cost  The government can subsidize the firm so it earns a normal profit  Drawback is that to provide the subsidy the government must raise taxes or forgo public spending in some other area – there is an opportunity cost to the subsidy approach

4 Regulating a Natural Monopoly  Setting price equal to average cost provides a normal profit for a monopolist. This occurs at point h  Monopolist can stay in business without a subsidy

5 Regulatory Dilemma  Regulators usually face a fuzzier picture of things  Demand and cost curves can only be estimated and the regulated firm may not always be completely forthcoming with this information  For example, a utility may overstate its costs so it can charge a higher price and earn more than a normal profit

6 Alternative Theories  One view is that economic regulation is in the public interest  Competing view is that economic regulation is not in the public interest, but rather in the special interest of producers

7 Antitrust Law and Enforcement  Attempts to curb the normal anticompetitive tendencies by:  Promoting the sort of market structure that will lead to greater competition  Reducing anticompetitive behavior  Promoting socially desirable market performance

8 Sherman Antitrust Act of 1890  Prohibited the creation of trusts and monopolization  Its vague language failed to define what constituted such activities and hampered its enforcement

9 Clayton Act of 1914  Prohibits  Price discrimination  Tying contracts  Exclusive dealing  Interlocking directorates  Mergers

10 Other Acts  Federal Trade Commission Act of 1914  a federal body was established to help enforce antitrust laws  Celler-Kefauver Anti-Merger Act passed in 1950  prevents one firm from buying the assets of another firm if the effect is to reduce competition  Horizontal mergers  the merging of firms that produce the same product  Vertical mergers  the merging of firms where one supplies inputs to the other or demand output from the other

11 Per Se Illegal  The courts have interpreted antitrust laws in essentially two ways  One set of practices has been declared per se illegal  Another set of practices falls under the rule of reason  Per se illegal: illegal regardless of the economic rationale or consequences  Government need only show that the offending practice took place  need only examine the firm’s behavior

12 Rule of Reason  Set forth in 1911 when the Supreme Court held that Standard Oil had illegally monopolized the petroleum refining industry and engaged in predatory pricing  Predatory pricing is the practice of temporarily selling below marginal cost or dropping the price only in certain markets in the hope of driving rivals out of business  Court focused on both the company’s behavior and the market structure that resulted from that behavior

13 Mergers and Public Policy  The measure of sales concentration used is the Herfindahl index  found by squaring the percent market share of each firm in the market and then summing those squares  For example, if the industry consists of 100 firms of equal size, the index is 100 [(100 x (1) 2 ]

14 HHI Based on Market Share in Three Industries

15 Mergers and Public Policy  The Justice Department sorts all mergers into two categories:  Horizontal mergers  Nonhorizontal mergers  Any merger in an industry where two conditions are met is challenged:  The post-merger Herfindahl index would exceed 1800  The merger would increase the index by more than 100 points

16 Merger Waves

17 Competitive Trends  Shepherd sorted industries into four groups:  Pure monopoly: a single firm controlled the entire market and was able to block entry  Dominant firm: a single firm had over half the market share and had no close real rival  Tight oligopoly: the top four firms supplied more than 60 percent of market output, with stable market shares and evidence of cooperation  Effective competition: firms in the industry exhibited low concentration, low entry barriers, and little or no collusion

18 Competitive Trends  Increase in competitiveness of economy stems from:  Growth in imports accounted for one-sixth of the overall increase in competition  Deregulation accounted for one-fifth of the increase in competition  Antitrust activity accounted for two-fifths of the growth in competition

19 Exhibit 4: Competitive Trends in the U.S. Economy

20 Problems with Antitrust Legislation  Too much emphasis on the competitive model  Joseph Schumpeter argued half a century ago that competition should be viewed as a dynamic process, one of creative destruction  Firms may grow large because they are more efficient than rivals at offering what the consumers want  firm size should not be the primary concern  Market experiments have shown that most of the desirable properties of perfect competition can be achieved with a relatively small number of firms

21 Problems with Antitrust Legislation  Abuse of antitrust  Parties that can show injury from firms violating antitrust laws can sue the offending company and recover treble damages  Growing importance of international markets  A standard approach to measuring the market power of a firm is its share of the market  With growth of international trade, local – or even national – market share becomes less relevant