1. © 2005 Thomson C hapter 13 Antitrust and Regulation

2. © 2005 Thomson 2 Gottheil - Principles of Economics, 4e Economic Principles Regulating a natural monopoly “Fair” price Marginal cost pricing Laissez-faire Nationalization

3. © 2005 Thomson 3 Gottheil - Principles of Economics, 4e Economic Principles The theory of contestable markets The theory of countervailing power The theory of creative destruction

4. © 2005 Thomson 4 Gottheil - Principles of Economics, 4e Economic Principles Patents Antitrust legislation

5. © 2005 Thomson 5 Gottheil - Principles of Economics, 4e Paradise Lost To many economists, perfect competition is the closest thing on earth to paradise.

6. © 2005 Thomson 6 Gottheil - Principles of Economics, 4e Paradise Lost 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.

7. © 2005 Thomson 7 Gottheil - Principles of Economics, 4e Paradise Lost Unfortunately, perfect competition does not exist in the real world.

8. © 2005 Thomson 8 Gottheil - Principles of Economics, 4e Paradise Lost The real world is one of monopoly, monopolistic competition and oligopoly.

9. © 2005 Thomson 9 Gottheil - Principles of Economics, 4e Learning to Cope Without Perfect Competition There are several competing views among economists regarding what we should do about monopolies and oligopolies.

10. © 2005 Thomson 10 Gottheil - Principles of Economics, 4e EXHIBIT 1WHAT TO DO ABOUT MONOPOLY

11. © 2005 Thomson 11 Gottheil - Principles of Economics, 4e Learning to Cope Without Perfect Competition 1. 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.

12. © 2005 Thomson 12 Gottheil - Principles of Economics, 4e Learning to Cope Without Perfect Competition 2. Nationalizing the industry: Monopolies are inevitable and undesirable. Government should take over the monopolies.

13. © 2005 Thomson 13 Gottheil - Principles of Economics, 4e Learning to Cope Without Perfect Competition 3. Laissez-faire: Monopolies are inevitable, but not necessarily undesirable. Government policy of non-intervention in market outcomes. Translated, it means “leave it be.”

14. © 2005 Thomson 14 Gottheil - Principles of Economics, 4e Learning to Cope Without Perfect Competition 4. Encouraging concentration: Monopolies are inevitable and desirable. Government should promote less-competitive markets because they are technically superior, generate low prices and benefit society.

15. © 2005 Thomson 15 Gottheil - Principles of Economics, 4e Learning to Cope Without Perfect Competition 5. Splitting up monopoly: Monopolies are neither inevitable nor desirable. Government should promote anti-monopoly legislation, break monopolies into fragments and prevent their restoration.

16. © 2005 Thomson 16 Gottheil - Principles of Economics, 4e The Economics of Regulation 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.

17. © 2005 Thomson 17 Gottheil - Principles of Economics, 4e EXHIBIT 2THE CITY BUS COMPANY

18. © 2005 Thomson 18 Gottheil - Principles of Economics, 4e Exhibit 2: The City Bus Company 1. Using the MR = MC rule, what fare and passenger capacity maximizes profit in Exhibit 1? Profit is maximized at a fare of $1.80 and service to 80,000 passengers.

19. © 2005 Thomson 19 Gottheil - Principles of Economics, 4e Exhibit 2: The City Bus Company 2. What is the profit of the bus company at a price of $1.80 and service to 80,000 passengers? Profit = (Price × Number of passengers) - (Average cost per passenger × Number of passengers) Profit = ($1.80 × 80,000) - ($1.20 × 80,000) = $48,000.

20. © 2005 Thomson 20 Gottheil - Principles of Economics, 4e Exhibit 2: The City Bus Company 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 $0.90.

21. © 2005 Thomson 21 Gottheil - Principles of Economics, 4e Exhibit 2: The City Bus Company 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.

22. © 2005 Thomson 22 Gottheil - Principles of Economics, 4e The Economics of Regulation Benefits of government regulation of the bus service include: Lower bus fares Increased number of passengers

23. © 2005 Thomson 23 Gottheil - Principles of Economics, 4e The Economics of Regulation 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.

24. © 2005 Thomson 24 Gottheil - Principles of Economics, 4e The Economics of Regulation Government commissions regulating markets must be vigilant in monitoring cost drift and keeping costs under control.

25. © 2005 Thomson 25 Gottheil - Principles of Economics, 4e The Economics of Regulation 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.

26. © 2005 Thomson 26 Gottheil - Principles of Economics, 4e The Economics of Regulation 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.

27. © 2005 Thomson 27 Gottheil - Principles of Economics, 4e The Economics of Regulation 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.

28. © 2005 Thomson 28 Gottheil - Principles of Economics, 4e Exhibit 2: The City Bus Company 5. What are price and quantity when P = MC in Exhibit 1? At P = MC, price is $0.30. Quantity is 180,000.

29. © 2005 Thomson 29 Gottheil - Principles of Economics, 4e Exhibit 2: The City Bus Company 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.

30. © 2005 Thomson 30 Gottheil - Principles of Economics, 4e Exhibit 2: The City Bus Company 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) = $72,000. 6. Why must the city subsidize bus transportation if price is regulated at P = MC?

31. © 2005 Thomson 31 Gottheil - Principles of Economics, 4e The Economics of Regulation 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.

32. © 2005 Thomson 32 Gottheil - Principles of Economics, 4e The Economics of Regulation Deregulation The process of converting a regulated firm into an unregulated firm.

33. © 2005 Thomson 33 Gottheil - Principles of Economics, 4e The Economics of Nationalization Nationalization Government ownership of a firm or industry. Price and production decisions are made by an administrative agency of the government.

34. © 2005 Thomson 34 Gottheil - Principles of Economics, 4e The Economics of Nationalization Governments can nationalize industries by either buying out the shares held by the shareholders or by simply confiscating the property.

35. © 2005 Thomson 35 The Economics of Nationalization 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.

36. © 2005 Thomson 36 Gottheil - Principles of Economics, 4e The Economics of Nationalization 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.

37. © 2005 Thomson 37 Gottheil - Principles of Economics, 4e The Economics of Nationalization 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.

38. © 2005 Thomson 38 The Economics of Nationalization 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.

39. © 2005 Thomson 39 Gottheil - Principles of Economics, 4e The Economics of Nationalization 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.

40. © 2005 Thomson 40 Gottheil - Principles of Economics, 4e The Economics of Nationalization 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.

41. © 2005 Thomson 41 Gottheil - Principles of Economics, 4e The Economics of Laissez-Faire 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.

42. © 2005 Thomson 42 Gottheil - Principles of Economics, 4e The Economics of Laissez-Faire Three theories try to explain why monopolies are not undesirable: 1. Contestable markets 2. Countervailing power 3. Creative destruction

43. © 2005 Thomson 43 Gottheil - Principles of Economics, 4e The Economics of Laissez-Faire Contestable market A market in which prices in highly concentrated industries are moderated by the potential threat of firms entering the market.

44. © 2005 Thomson 44 Gottheil - Principles of Economics, 4e The Economics of Laissez-Faire 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.

45. © 2005 Thomson 45 Gottheil - Principles of Economics, 4e The Economics of Laissez-Faire 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.

46. © 2005 Thomson 46 Gottheil - Principles of Economics, 4e The Economics of Laissez-Faire 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.

47. © 2005 Thomson 47 Gottheil - Principles of Economics, 4e The Economics of Laissez-Faire 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.

48. © 2005 Thomson 48 Gottheil - Principles of Economics, 4e The Economics of Laissez-Faire What are the four competing power blocs, according to the countervailing power theory? The four competing blocs power are industrial, labor, agricultural and retail.

49. © 2005 Thomson 49 Gottheil - Principles of Economics, 4e The Economics of Laissez-Faire 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.

50. © 2005 Thomson 50 Gottheil - Principles of Economics, 4e The Economics of Laissez-Faire 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.

51. © 2005 Thomson 51 Gottheil - Principles of Economics, 4e The Economics of Laissez-Faire 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.

52. © 2005 Thomson 52 Gottheil - Principles of Economics, 4e The Economics of Laissez-Faire 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.

53. © 2005 Thomson 53 Gottheil - Principles of Economics, 4e The Economics of Encouraging Monopoly Some economists prefer the monopoly structure to competition. They rely on Schumpeter’s argument that monopolies can take advantage of economies of scale.

54. © 2005 Thomson 54 Gottheil - Principles of Economics, 4e EXHIBIT 3FIRM SIZE AND ECONOMIES OF SCALE

55. © 2005 Thomson 55 Gottheil - Principles of Economics, 4e Exhibit 3: Firm Size and Economies of Scale 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.

56. © 2005 Thomson 56 Gottheil - Principles of Economics, 4e The Economics of Encouraging Monopoly 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.

57. © 2005 Thomson 57 Gottheil - Principles of Economics, 4e The Economics of Encouraging Monopoly Patent Exclusive right granted by government to a market product or process for 20 years.

58. © 2005 Thomson 58 Gottheil - Principles of Economics, 4e The Economics of Splitting Up Monopoly 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.

59. © 2005 Thomson 59 Gottheil - Principles of Economics, 4e The Economics of Splitting Up Monopoly 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.

60. © 2005 Thomson 60 Gottheil - Principles of Economics, 4e The Economics of Splitting Up Monopoly Antitrust policy Laws that foster market competition by prohibiting monopolies and oligopolies from exercising excessive market power.

61. © 2005 Thomson 61 Gottheil - Principles of Economics, 4e The History of Antitrust Legislation The core of elements of federal antitrust legislation are: Sherman Antitrust Act of 1890 Clayton Act of 1914 Federal Trade Commission Act of 1914

62. © 2005 Thomson 62 Gottheil - Principles of Economics, 4e The History of Antitrust Legislation The effectiveness of antitrust legislation is limited by the funding appropriated to the agencies delegated the responsibility of ensuring the laws are enforced.

63. © 2005 Thomson 63 Gottheil - Principles of Economics, 4e Antitrust Goes to Court 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.

64. © 2005 Thomson 64 Gottheil - Principles of Economics, 4e Antitrust Goes to Court The issue, according to this criterion, is the firm’s behavior, not its size or its share of the market. The rule of reason

65. © 2005 Thomson 65 Gottheil - Principles of Economics, 4e Antitrust Goes to Court This criterion has been favored by the courts during the early twentieth century and since the 1970s. The rule of reason

66. © 2005 Thomson 66 Gottheil - Principles of Economics, 4e Antitrust Goes to Court 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.

67. © 2005 Thomson 67 Gottheil - Principles of Economics, 4e Antitrust Goes to Court 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

68. © 2005 Thomson 68 Gottheil - Principles of Economics, 4e Antitrust Goes to Court This criterion was favored by the courts during the post-World War II period. Per se

69. © 2005 Thomson 69 Gottheil - Principles of Economics, 4e Antitrust Goes to Court The courts and Congress have been lenient since the 1980s in applying antitrust legislation to conglomerates.

70. © 2005 Thomson 70 Gottheil - Principles of Economics, 4e Do We Have a Policy on Monopoly? 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.