14 REGULATION AND ANTITRUST LAW CHAPTER.

14 REGULATION AND ANTITRUST LAW CHAPTER

Objectives After studying this chapter, you will able to
Explain how government arises from market failure and redistribution Define regulation and antitrust law Distinguish between the social interest and capture theories of regulation Explain how regulation affects prices, outputs, profits, and the distribution of the gains from trade between consumers and producers Describe the antitrust laws and review three of today’s antitrust policy debates

Social Interest or Special Interests?
Natural monopoly is regulated But does regulation work in the interest of all—the social interest—or in the interest of the regulated—special interests? Antitrust law restricts the actions of monopolies and blocks mergers. Do these laws serve the social interest or special interests?

The Economic Theory of Government
The economic theory of government explains the purpose of governments, the economic choices that governments make, and the consequences of those choices. Governments exist for two main economic reasons: To establish property rights and set the rules for the redistribution of income and wealth. To provide a non-market mechanism for allocating scarce resources when the market economy results in inefficiency—a situation called a market failure.

Public choices deal with five economic problems. Monopoly and oligopoly regulation The provision of public goods The use of common resources Externalities Income redistribution

Monopoly and Oligopoly Regulation Monopoly and oligopoly, and the rent seeking to which they give rise, prevent the allocation of resources from being efficient and redistribute the consumer surplus to producers.

Provision of Public Goods Public goods are goods that are consumed by everyone and from which no one can be excluded Examples are national defense, law and order, and sewage and waste disposal services. The market economy under produces these goods because it is impossible to exclude non-payers from enjoying them—called the free-rider problem.

The Use of Common Resources Some resources are owned by no one and used by everyone. Examples are fish in the ocean and the lakes and rivers. The market economy over uses these resources because no one has an incentive to conserve them—called the problem of the commons.

Externalities External costs and benefits are consequences of an economic transaction between two parties that are borne or enjoyed by a third party. A chemical factory that dumps waste into a river that kills the fish downstream imposes an external cost. A bank that builds a beautiful office building creates an external benefit. External costs and benefits prevent the market allocation of resources from being efficient.

Income Redistribution The market economy delivers an unequal distribution of income and wealth. Progressive income taxes pay for public goods and redistribute income.

Public Choice and the Political Marketplace Public choice theory applies the economic way of thinking to the choices that people and governments make in a political marketplace. The actors in the political marketplace are: Voters Firms Politicians Bureaucrats The political marketplace does not work as smoothly as the private marketplace. Throughout this text students have learned that competitive markets can deliver an efficient resource allocation because: Individual households and firms act in their own self-interest and (in the absence of externalities) receive the full benefits and bear the full costs of their decisions. Market prices and profits send signals to consumers and producers that coordinate their decisions. In the absence of price floors and ceilings, monopoly, and taxes, competitive pressures determine an equilibrium price (marginal benefit) equal to marginal cost—the efficient outcome.

Figure 14.1 illustrates the political market place. Voters and firms are the “consumers” in the political marketplace. Politicians are the “entrepreneurs” of the political marketplace. Bureaucrats are the producers, or firms, of the political marketplace. The political marketplace does not possess the same power as the competitive market to convert self-interest into an efficient outcome. In the political marketplace: Individuals still act in their self-interested. As James Buchanan, the Nobel Prize winning economist once noted, when we pull the curtain closed in the voting booth to indicate which representative we wish to elect, we do not suddenly sprout the wings of angels and vote in the public interest. We vote our own best interests, possibly to the detriment of the public interest. But one person, one vote does not ensure equal political influence over the resource allocation process. Some avenues to seek favor from politicians and bureaucrats require resources, which are unequally distributed. Individuals no longer receive the full benefits nor bear the full costs of their actions, and so are less motivated to act on the basis of complete information The absence of price and profit signals makes it difficult to coordinate the actions of self-interested individuals to generate socially beneficial outcomes. Many political marketplace decisions are inseparable, bundled together as a package, which decreases the competitive pressures that force individuals to respond to opportunity cost and marginal benefit.

Voters and firms express their preferences for publicly provided goods and services by allocating their votes, making campaign contributions, and lobbying government decision makers. They also pay the taxes that provide the funds that pay for public goods and services. Correct misconceptions about the political process. Democracy doesn’t guarantee efficiency. Many political science classes tout that democratic politics is the “art of compromise,” implying that the compromise solutions to conflicting objectives that are inherent in democratic decision processes necessarily generate efficient outcomes. It is easy to show that democracy can generate inefficient outcomes. (See the additional discussion questions below for a simple but revealing example of economically inefficient outcomes supported by democratic voting processes.) Out of the fry pan and into the fire? Stress that when market failure brings pleas for political processes for resource allocation to replace the market process, it should be shown that the inefficiencies created by the market failure are greater than the inefficiencies inherent in the proposed political allocation process. Point out that when politicians and bureaucrats propose public sector policies to replace market allocation processes, they rarely discuss whether their policy prescriptions would pass such an analysis. Emphasize that when it comes to moving resource allocation decisions out of the private market and into the realm of political markets, there is still an opportunity cost to be weighed against the perceived benefits: there is no such thing as a free lunch!

The objective of politicians is to get elected to office and remain in office. Votes to a politician are like profits to a firm, so they propose policies that they expect to attract enough votes to get elected. Bureaucrats produce the public goods and services.

Political Equilibrium A political equilibrium is the outcome of the choices of voters, politicians, and bureaucrats. It is a situation in which the choices of the three groups are compatible and no group can improve its own situation by making a different choice.

Monopoly and Oligopoly Regulation
Government intervenes in monopoly and oligopoly markets to influence prices, quantities produced, and the distribution of the gains from economic activity. It intervenes in two main ways: Regulation Antitrust laws The amazing Federal Register. Get your students to go to Federal Register Web site at and click on “Today’s Table of Contents.” 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: 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.

Regulation consists of rules administered by government agency to influence economic activity by determining prices, product standards and types, and the conditions under which new firms may enter an industry.

Antitrust law is law that regulates or prohibits certain kinds of market behavior, such as monopoly and monopolistic practices.

The Economic Theory of Regulation The economic theory of regulation of monopoly and oligopoly is an application of the general theory of public choice that we’ve just reviewed. Regulation is influenced by the demands of voters and firms, the supply by politicians and bureaucrats, and the equilibrium that balances the two sides of the political market place.

Four main factors influence the demand for regulation: Consumer surplus per buyer Number of buyers Producer surplus per firm Number of firms The greater the potential benefit from regulation, the greater is the demand for it. But numbers alone don’t translate to demand. Small well-organized groups can be more effective than large unorganized groups.

Politicians and bureaucrats supply regulation. Politicians choose policies that appeal to a majority of voters. Bureaucrats support policies that maximize their budgets.

Given these objectives, the supply of regulation depends on three main factors: Consumer surplus per buyer Producer surplus per firm Number of people affected

In a political equilibrium, no interest group finds it worthwhile to use additional resources to press for changes. And no group of politician or bureaucrat wants to offer different regulations. The political equilibrium might be in the public interest or private interest.

The social interest theory is that regulations are supplied to satisfy the demand of consumers and producers to maximize the sum of consumer and producer surplus—to attain efficiency. The capture theory is that the regulations are supplied to satisfy the demand of producers to maximize producer surplus—to maximize economic profit. In this case, regulation seeks to maximize profits.

Because the public interest and the special interest of the producer are in conflict, the political process cannot satisfy both groups in any particular industry. The highest bidder gets the regulation it wants.

Regulation and Deregulation
The Scope of Regulation Some of the main agencies are: Interstate Commerce Commission. Federal Trade Commission. Federal Power Commission Federal Communications Commission Securities and Exchange Commission Federal Maritime Commission Federal Deposit Insurance Corporation Civil Aeronautical Board Copyright Royalty Tribunal Federal Energy Regulatory Commission. Regulation began with the Interstate Commerce Commission (ICC) in 1887 and peaked in the 1970s. Since 1970 many industries have been deregulated.

Activities regulated have included interstate railroads, trucking, buses, water, oil, and gas pipelines, airlines, electricity, natural gas, broadcasting, telecommunications, banking and finance. Regulation reached its peak in the 1970s when about one quarter of the economy was subject to some type of regulation. Since then, deregulation of many industries (including broadcasting, telecommunications, banking and finance, and all forms of transportation) has occurred.

The Regulatory Process Regulatory agencies differ in many detailed ways, but all have features in common: Each agency is run by bureaucrats who are experts in the industry it regulates (often recruited from the industry) and who appointed by the president or by Congress and funded by Congress. Each agency adopts a set of rules and practices designed to control the prices and other aspects of economic behavior in the industry it regulates.

Firms are generally free to their technology and quantities of inputs. But they are not free to set their own prices and sometimes, they are regulated in the quantities they can sell, and the markets they can serve.

Natural Monopoly Natural monopoly occurs when one firm can supply the entire market at a lower price than two or more firms can. Figure 14.2 shows the demand curve, marginal cost, MC, curve and average total cost, ATC, curve of a natural monopoly.

A natural monopoly’s ATC curve falls throughout the relevant range of production so that the firm’s MC curve is below its ATC curve when the MC curve crosses the demand curve.

Regulating in the public interest—efficient regulation—is achieved using the marginal cost pricing rule, which sets price equal to marginal cost: P = MC. The sum of consumer surplus and producer surplus—total surplus in the figure—is maximized.

With marginal cost pricing, the firm incurs an economic loss.

The firm might be able to cover its economic loss by price discrimination. An example is the hook-up fee cable TV companies charge their subscribers. The government might pay the firm a subsidy. But the taxes that generate the revenue for the subsidy create a deadweight loss in other markets.

Deadweight loss might be minimized by allowing the firm to use the average cost pricing rule, which sets price equal to average total cost. Figure 14.3 illustrates the average cost pricing rule.

Implementing the marginal cost and average cost pricing rules is difficult because the regulator doesn’t know the firm’s cost curves. Two practical rules that regulators use are: Rate of return regulation Price cap regulation.

Under rate of return regulation, a regulated firm must justify its price by showing that the price enables it to earn a specified target percent rate of return on its capital. The target rate of return is set at that of a competitive market and with accurate cost observation is this type of regulation is equivalent to average cost pricing. Managers have an incentive to use more capital than the efficient quantity so that total returns increase. They also have an incentive to inflate depreciation charges and other costs and deflate reported profits.

Figure 14.4 shows the maximum economic profit that a firm can earn when its managers inflate capital costs under rate of return regulation.

A price-cap regulation is a price ceiling—a rule that specifies the highest price the firm is permitted to set. Price cap regulation gives managers an incentive to minimize cost because there is no limit on the rate of return they are permitted to earn. The regulator might set the price cap too high, so price-cap regulation is often combined with earnings sharing regulation, under which profits that exceed a target level must be shared with the firm’s customers. The California power debacle. The special Web feature on this topic is a ready to go case study with which you can have fun and review the entire section on pricing rules and their effects.

Figure 14.5 shows the effects of price cap regulation. Unregulated, the monopoly maximizes profit by producing the quantity at which MR = MC. A price cap is imposed that enables the firm to earn zero economic profit.

The price cap lowers the price and increases output. This outcome contrasts with that in a competitive market. In monopoly, the profit-maximizing quantity is less than the efficient quantity and the price cap provides an incentive to increase output to avoid economic loss.

Social Interest or Capture in Natural Monopoly Regulation? Whether the social interest theory or the capture theory best describes how most natural monopoly markets are regulated is unclear. A test to determine whether the regulated firm has “captured” the regulator and influenced regulation to favor the firm is to compare the rates of return to capital for regulated industries against that of the rest of the economy.

Higher rates of return are evidence in support of capture theory of regulation. Table 14.1 shows the rates of return for regulated monopolies in the electricity, gas and railroad industries and compares these rates to the average rate of return for the overall economy. While there has been some variation over time, there is no overall trend to show a difference in rates of return exist between regulated and unregulated industries.

Another test is to study changes in the levels of producer and consumer surplus following deregulation. Table 14.2 shows the gains (losses) in producer and consumer surplus when the railroad, telecommunications and cable TV industries were deregulated. These results show that railroad regulation hurt both producers and consumers, and that regulation in the other two industries mainly hurt the consumer.

Cartel Regulation A cartel is a collusive agreement among a number of firms that is designed to restrict output and achieve a higher profit for cartel members. Cartels are illegal in the United States and in most other countries. A cartel that acts like a monopoly earns maximum economic profit, but there is a strong incentive for each member of a cartel to cheat on the cartel arrangement.

Figure 14.6 shows two possible outcomes of cartel regulation. If the regulation is in the public interest, price and quantity will equal their competitive levels and the outcome will be efficient.

If the cartel captures the regulator, it uses regulation to prevent cheating and price and output equal their monopoly levels and the outcome is inefficient.

Public Interest or Capture in Cartel Regulation? Table 14.3 shows the rates of return on investment for the airlines and trucking industry as compared to the economy as a whole. The returns after deregulation of these industries decreased considerably and returned to the economy average. This evidence supports the capture theory of regulation.

Table 14.4 shows the change in consumer and producer surplus after the airlines and trucking industries were deregulated. While consumer surplus increased in both the trucking and airlines industries, producer surplus decreased in the trucking industry. This evidence supports the capture theory of regulation.

Making Predictions Deregulation of many industries occurred in the late 1970s and arose from three main influences: Economists have more vocally predicted gains from deregulation. The significant hike in energy prices of the early 1970s increased the cost of regulation borne by consumers. Technological progress has ended many natural monopolies through increased competition, especially in the telecommunications industry.

Antitrust Law Antitrust law provides and alternative way in which the government may influence the marketplace. The Antitrust Laws The first antitrust law, the Sherman Act, was passed in It outlawed any “combination, trust, or conspiracy that restricts interstate trade,” and prohibited the “attempt to monopolize.” A wave of merger activities at the beginning of the twentieth century produced a stronger antitrust law, the Clayton Act and created the Federal Trade Commission. 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 alludes 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.

Antitrust Law The Clayton Act was passed in 1914 and made illegal specific business practices such as price discrimination, interlocking directorships, and acquisition of a competitor’s shares if the practices “substantially lessen competition or create monopoly.” Table 14.6 summarizes the Clayton Act and its amendments, the Robinson-Patman Act passed in 1936 and the Cellar-Kefauver Act passed in 1950. The Federal Trade Commission, formed in 1914, looks for cases of “unfair methods of competition and unfair or deceptive business practices.”

Antitrust Law Landmark Antitrust Cases
The impact of antitrust laws depends on their interpretation by the courts. Price fixing has always been found to be illegal (Section 1 of the Sherman Act) but decisions on attempts to monopolize (Section 2 of the Sherman Act) have fluctuated over the decades. This material was in the sixth and earlier editions but has been removed from the seventh edition. If you want to cover it, unhide slides 53 through 58.

Antitrust Law Price fixing cases
The 1927 case against Trenton Potteries Company established the hard line against price fixing. Trenton Potteries agreed to fix prices with other firms and this action was found to be in violation of antitrust law even if the resulting prices were themselves reasonable. Price fixing per se (in and of itself) is a violation of the law.

Antitrust Law In 1961, General Electric, Westinghouse, and other electrical component manufactures were found guilty of price fixing. Executives were fined and jailed. In 1996, Archer Daniels Midland was found guilty of conspiring to fix prices of lysine and citric acid and was fined $100 million.

Antitrust Law Attempts to monopolize
In 1911, the American Tobacco Company and the Standard Oil Company were found guilty of conspiring to monopolize an industry and were ordered to divest themselves of large holdings in other companies. The court enunciated the “rule of reason,” which states that a monopoly arising from mergers and agreements among firms is not necessarily illegal. Only combinations are violations. U.S. Steel Company was acquitted under the rule of reason: “size alone is not an offense.”

Antitrust Law In 1945, the Court apparently renounced the “rule of reason” by finding that ALCOA was an illegal monopoly simply because its share of the aluminum market was too large. Aspen Skiing, owner of three of the four downhill ski facilities, was found guilty of trying to monopolize when it refused to offer an all-Aspen ticket and share revenues on a use basis with the owner of another facility.

Antitrust Law Spectrum Sports was found not guilty of trying to monopolize even though it had become the national distributor of sorbothane athletic products. There was no evidence to support the actual act of monopolization, despite the claims that the producer surplus of the other firms was negatively impacted by the business actions of Spectrum Sports.

Antitrust Law Three Antitrust Policy Debates
Price fixing is always a violation of the antitrust law. If the Justice Department can prove the existence of price fixing, there is no defense. But some practices are more controversial and generate debate. Three of them are: Resale price maintenance Tying arrangements Predatory pricing

Antitrust Law Resale price maintenance
Most manufacturers sell their product to the final consumer through a wholesale and retail distribution chain. Resale price maintenance occurs when a manufacturer agrees with a distributor on the price at which the product will be resold. Resale price maintenance is inefficient if it promotes monopoly pricing. But resale price maintenance can be efficient if it provides retailers with an incentive to provide an efficient level of retail service in selling a product.

Antitrust Law Tying arrangements
A tying arrangement is an agreement to sell one product only if the buyer agrees to buy another different product as well. Some people argue that by tying, a firm can make a larger profit. Where buyers have a differing willingness to pay for the separate items, a firm can price discriminate and take a larger amount of the consumer surplus by tying. You might want to talk about Windows and the Explorer Browser at this point as an example.

Antitrust Law Predatory pricing
Predatory pricing is setting a low price to drive competitors out of business with the intention of then setting the monopoly price. Economists are skeptical that predatory pricing actually occurs. A high, certain, and immediate loss is a poor exchange for a temporary, uncertain, and future gain. No case of predatory pricing has been definitively found. You might like to talk about John D. Rockefeller’s Standard Oil and the accusation that it engaged in this practice back in the 1890s. See for a useful source of material for a classroom discussion of this topic.

Antitrust Law A Recent Showcase: The United States Versus Microsoft
The most recent antitrust case is against Microsoft. In 1998, a trial began considering the following charges: Microsoft possesses monopoly power in the market for PC operating systems and attained that position by exercising monopoly practices.

Antitrust Law Microsoft used below-cost pricing (called predatory pricing) in the market for web browsers by offering its web browser for free. Microsoft used tying arrangements to achieve monopoly in the web browser market. Tying arrangements are when a seller requires products to be sold together rather than sold individually, extending its market power from one market into another market.

Antitrust Law Microsoft used other anti-competitive practices to strengthen its monopoly in these two markets. Some charge that Microsoft enjoys economies of scale and network economies that create an effective barrier to entry by competing firms. But Microsoft counters that although the firm enjoys monopoly today, it is vulnerable competition from new operating systems.

Antitrust Law Additionally, Microsoft claims that incorporating its web browser software with its operating system software is an attempt to increase customer value of the operating system software, rather than using a tying arrangement to monopolize the browser software market.

Antitrust Law Merger Rules
The Federal Trade Commission uses guidelines to determine which mergers to examine and possibly block. The Herfindahl-Hirschman index (HHI) is one of those guidelines (explained in Chapter 9).

Antitrust Law Figure 17.6(a) illustrates these HHI guidelines.
If the original HHI is less than 1,000, a merger is not challenged. If the original HHI is greater than 1,000 a merger might be challenged.

Antitrust Law If the original HHI is between 1,000 and 1,800, any merger that raises the HHI by 100 or more is challenged. If the original HHI is greater than 1,800, any merger that raises the HHI by more than 50 is challenged.

Antitrust Law Figure 17.6(b) shows how these guidelines were applied to the carbonated soft drink industry in 1986 to deny mergers between Pepsi/7-Up and Coke/Dr. Pepper.

Antitrust Law Social or Special Interest?
The intent of antitrust law has been to protect consumers and pursue efficiency, but at times the court interpretation of these laws has favored the interests of producers. On balance, the overall thrust seems to have been toward efficiency.

THE END

14 REGULATION AND ANTITRUST LAW CHAPTER.

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