1. 17
Regulation and Antitrust Law
CHAPTER

2. 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

3. 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.
Get your students to go to Federal Register Web site, located at They (and you) will be amazed at the volume and detail of regulatory activity, almost all of which has an economic dimension and impact. There is no free lunch in regulating firms and industries that embody market power. Make the issue of industry regulation intriguing for the students by emphasizing the following countervailing opportunity costs that arise in regulating the firms in those industries that are creating a market failure.

4. The Changing Scope of Regulation (U.S.)
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.

5. 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.

6. 17.1 REGULATION Economic Theory of Regulation
Two broad economic theories of regulation are:
Public interest theory
Capture theory

7. 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 regulated firm captures the regulator and makes a monopoly profit.

8. 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.
BUT: is this efficient for society?
- lack of competition enables the firm to increase producer surplus and reduce consumer surplus which creates significant deadweight loss to society
Emphasize the tension between the potential for efficiency in production inherent with a natural monopoly and the inefficiency potential from the firm exercising its inherent market power. Be sure the students understand that economies of scale or scope enable the unregulated natural monopoly to provide products and services at the lowest possible cost, but the lack of competition also enables the firm to increase producer surplus at the expense of consumer surplus and creates a significant deadweight loss to society.

9. 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.

10. 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.

12. 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.

13. 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.
To help present the differences between marginal cost pricing and average cost pricing, draw matching graphs side-by-side. Show students the prices that will be allowed by regulators. Ask students which regulation is “better.” Be sure to show your students that marginal cost pricing generates an economic loss even though output is at the competitive level.
3. Consumer surplus shrinks to the smaller green triangle.

14. 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.

16. 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 (management might inflate costs or corporate perks).

17. 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.
Figure 17.3 shows how price cap regulation works.

18. 17.1 REGULATION
1. With no regulation, the firm maximizes profit by producing the quantity at which MC = MR.
2. With a price cap,
3. The price cap outcome is at the intersection of the demand curve and the price cap.
4. The price falls and output increases.

20. 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.

21. 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.

23. 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.
A large percentage of students read the Clayton Act as always prohibiting the activities listed, such as price discrimination or exclusive deals. Ask your students why airlines and movie theaters can price discriminate even though it is outlawed by the Clayton Act. Ask them why Coke and McDonald’s are allowed to have an exclusive deal so that only Coke products can be purchased at McDonald’s while Pepsi and KFC have similar exclusive deal. The objective is to force the students to understand that the business practices mentioned in the Clayton Act are illegal only if they substantially lessen competition or create monopoly. You can state this qualifying phrase as often as you like but real-life, specific examples are necessary to hammer the point home!

24. 17.2 ANTITRUST LAW

25. 17.2 ANTITRUST LAW

26. 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

27. 17.2 ANTITRUST LAW Resale Price Maintenance
Resale price maintenance is an agreement between a manufacturer and 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.

28. 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.

29. 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.

30. 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.

31. 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 predatory 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.
Some students are familiar with the government’s case against Microsoft or, if not with the details, with the fact that the government had filed suit. When you discuss this case, be sure to point out that many expert witnesses were called at Microsoft’s trial. And, of course, each side brought its own economists…some of whom were paid over $1,000 an hour! More seriously, you can emphasize the tension between combining formerly separate goods into a product as a monopolizing action (tying agreements) and combining goods as a form of technological advancement to enhance consumer surplus (product innovation). The Microsoft defense to antitrust charges alluded to the inevitable combining of web browsers into computer operating system software. Microsoft could be truly enhancing its product but it also could be using its market power in one market to capture market power in another, more competitive market. If students are not sympathetic to Microsoft’s argument, ask them if when they buy a car, they also expect to get tires installed by the manufacturer.
Challenge them about this point—aren’t there independent tire companies? Why is the tire tied to purchase of the automobile? If students object that “you need a tire for the car to run,” quickly ask them if a radio should be tied to the purchase of the car? Why shouldn’t the purchase of a radio be an independent decision? You don’t need to take sides with this discussion. Just point out to your students that arguments aren’t always as clear cut as they might seem initially.

32. 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.

33. 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.

34. 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.

35. 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 s.

36. 17.2 ANTITRUST LAW

38. Regulation in YOUR Life
Regulation and deregulation touch your life at many points.
Pay attention as you go about your everyday affairs and think about the regulation that you encounter.
You wake up to an alarm clock that uses regulated electricity.
You turn on the regulated cable news channel.
You go to school on a regulated commuter train.
You use a lap top that runs Windows produced by a firm that has been pulled through the courts.
It’s hard to get away from regulation and antitrust laws.

39. Regulation in YOUR Life
Think hard about who benefits from regulation and who bears the cost of the regulation.
Do we really need all the regulation we’ve got?
Do we need more regulation in some areas?