2After studying this chapter you will be able to Explain the economic theory of government and how government activity arises from market failure and redistributionDefine regulation and antitrust law and distinguish between the social interest and capture theories of regulationExplain how regulation and deregulation affect prices, outputs, profits, and the distribution of the gains from tradeDescribe the antitrust laws and review three of today’s antitrust policy debates
3Social 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?
4The 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:1. To establish property rights and set the rules for the redistribution of income and wealth.2. To provide a nonmarket mechanism for allocating scarce resources when the market economy results in inefficiency—a situation called a market failure.
5The Economic Theory of Government Governments and public choices deal with five economic problems:Monopoly and oligopoly regulationExternalities regulationThe provision of public goodsThe use of common resourcesIncome redistribution
6The Economic Theory of Government Monopoly and Oligopoly RegulationMonopoly 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.Governments regulate monopoly and oligopoly and enact antitrust laws that prevent cartels and other restriction on competition.
7The Economic Theory of Government Externalities RegulationExternal costs and external 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 external benefits prevent the market allocation of resources from being efficient.
8The Economic Theory of Government Provision of Public GoodsA public good is a good that is consumed by everyone and from which no one can be excludedExamples are national defense, law and order, and sewage and waste disposal services.The market economy underproduces these goods because it is impossible to exclude those who choose not to pay from enjoying them—called the free-rider problem.
9The Economic Theory of Government The Use of Common ResourcesSome resources are owned by no one and used by everyone.Examples are fish in the ocean and the lakes and rivers.The market economy overuses these resources because no one has an incentive to conserve them—called the tragedy of the commons.
10The Economic Theory of Government Income RedistributionThe market economy delivers an unequal distribution of income and wealth.Progressive income taxes pay for public goods and redistribute income.
11The Economic Theory of Government Public Choice and the Political MarketplacePublic 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 areVotersFirmsPoliticiansBureaucrats
12The Economic Theory of Government 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.
13The Economic Theory of Government 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.
14The Economic Theory of Government 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.
15The Economic Theory of Government Political EquilibriumA political equilibrium is the outcome of the choices of voters, firms, 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.
16Monopoly 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:RegulationAntitrust laws
17Monopoly and Oligopoly Regulation 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.
18Monopoly and Oligopoly Regulation The Economic Theory of RegulationThe economic theory of regulation of monopoly and oligopoly is an application of the general theory of public choice that we’ve just reviewed.There is a demand for regulation, a supply of regulation, and an equilibrium amount of regulation.
19Monopoly and Oligopoly Regulation The Demand for RegulationPeople and firms demand the regulation that makes them better off and they express their demand through political activity and making campaign contributions.The greater the potential benefit (consumer surplus per voter and producer surplus per firm) from regulation, the greater is the demand for the regulation.But numbers alone don’t translate to demand. Small well-organized groups can be more effective than large unorganized groups.
20Monopoly and Oligopoly Regulation The Supply of RegulationPoliticians supply the regulations that increase their campaign funds and that gets enough votes to achieve and maintain office.Politicians choose policies that appeal to a majority of voters.Bureaucrats support the policies that maximize their budgets.
21Monopoly and Oligopoly Regulation If a regulation benefits a large number of people by enough for it to be noticed, the regulation will appeal to politicians and it will be supplied.If a regulation benefits a small number of people by a large amount per person, the regulation will appeal to politicians because it will help them to get campaign funds from those who gain.
22Monopoly and Oligopoly Regulation Equilibrium RegulationIn a political equilibrium, no interest group finds it worthwhile to use additional resources to press for changes.And no group of politicians or bureaucrats wants to offer different regulations.The political equilibrium might be in the public interest or private interest.
23Monopoly and Oligopoly Regulation 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.
24Monopoly and Oligopoly Regulation Because the social interest and the self-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.
25Regulation and Deregulation The Scope of RegulationSome of the main agencies areInterstate Commerce CommissionFederal Trade CommissionFederal Power CommissionFederal Communications CommissionSecurities and Exchange CommissionFederal Maritime CommissionFederal Deposit Insurance CorporationCivil Aeronautical BoardCopyright Royalty TribunalFederal Energy Regulatory Commission
26Regulation and Deregulation Activities regulated have included:Interstate railroads, trucking, buses, water, oil, and gas pipelines, airlines, electricity, natural gas, broadcasting, telecommunications, and banking and finance.Regulation reached its peak in the mid-1970s when almost one quarter of the economy was subject to some type of regulation.During the 1980s and 1990s, a deregulation process stimulated competition in:Broadcasting, telecommunications, banking and finance, and all forms of transportation (both passengers and freight via air, rail, and road).
27Regulation and Deregulation The Regulatory ProcessRegulatory agencies differ in many detailed ways, but all have features in common:First, 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.Second, 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.
28Regulation and Deregulation In a regulated industry, firms are generally free to determine the technology to use and quantities of inputs.But firms are not free to set their own prices and sometimes, they are regulated in the quantities they can produce and sell or the markets they can serve.
29Regulation and Deregulation Natural MonopolyNatural monopoly is a firm with economies of scale that enable it to supply the entire market at the lowest possible price.Figure 14.2 illustrates the demand for the good produced, the natural monopoly’s marginal cost and average cost.
30Regulation and Deregulation Regulation in the Social InterestRegulation in the social interest is achieved by using the marginal cost pricing rule, which sets price equal to marginal cost: P = MC.Total surplus (the sum of consumer surplus and producer surplus) is maximized.
31Regulation and Deregulation With marginal cost pricing, the firm incurs an economic loss.
32Regulation and Deregulation The firm might be able to cover its economic loss:By price discrimination. An example is the hook-up fee that 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.The government might adopt a regulation that allows the firm to break even.That is, allow the firm to use the average cost pricing rule, which sets price equal to average total cost.
33Regulation and Deregulation Figure 14.3 illustrates the average cost pricing rule.Price is set equal to average cost.The firm breaks even, but total surplus is reduced.A deadweight loss arises, but it is minimized.
34Regulation and Deregulation 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 areRate of return regulationPrice cap regulation
35Regulation and Deregulation Rate of Return RegulationUnder 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.Managers also have an incentive to inflate depreciation charges and other costs and deflate reported profits.
36Regulation and Deregulation Figure 14.4 shows the firm’s economic profit under rate of return regulation when managers inflate capital costs.The firm persuades the regulator that the inflated costs are genuine costs.The “breakeven” price rises but the firm makes an economic profit.
37Regulation and Deregulation Price Cap RegulationA 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.
38Regulation and Deregulation 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 make only zero economic profit.
39Regulation and Deregulation The price cap lowers the price and increases output.In unregulated monopoly, the profit-maximizing quantity is less than the efficient quantity.The price cap provides an incentive to keep costs as low as possible and it delivers average cost pricing.
40Regulation and Deregulation 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.
41Regulation and Deregulation Higher rates of return are evidence in support of capture theory of regulation.Table 14.1 (p. 332) 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, the rates of return achieved by regulated natural monopolies were not very different from those in the rest of the economy.
42Regulation and Deregulation Another test is to study changes in the levels of producer and consumer surplus following deregulation.Table 14.2 (p. 332) 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 hurt only the consumer.
43Regulation and Deregulation Cartel RegulationA 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.
44Regulation and Deregulation Figure 14.6 shows two possible outcomes of cartel regulation.If the regulation is in the social interest, price and quantity will equal their competitive levels and the outcome will be efficient.
45Regulation and Deregulation If the cartel captures the regulator,it uses regulation to prevent cheating and to produce the monopoly profit-maximizing quantity and price.The outcome is inefficient and in the producer interest.
46Regulation and Deregulation Social Interest or Capture in Cartel Regulation?Table 14.3 (p. 333) 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.
47Regulation and Deregulation Table 14.4 (p. 334) shows the change in consumer surplus, producer surplus, and total 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. Total surplus increased in both industries.This evidence implies that regulation on the trucking industry benefited producers by restricting competition.
48Regulation and Deregulation Making PredictionsDeregulation of many industries began in the late 1970s and arose from three main influences:1. Economists have become more confident and vocal in predicting the gains from deregulation.2. The significant hike in energy prices of the 1970s increased the cost of regulation borne by consumers.3. Technological progress has ended many natural monopolies through increased competition, especially in the telecommunications industry.
49Antitrust LawAntitrust law provides an alternative way in which the government may influence the marketplace.The Antitrust LawsThe 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.
50Antitrust Law The Clayton Act was passed in 1914. The Clayton Act 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 (p. 335) 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.”
51Antitrust 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 areResale price maintenanceTying arrangementsPredatory pricing
52Antitrust 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.
53Antitrust 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.
54Antitrust 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.
55Antitrust LawA Recent Antitrust Showcase: The United States Versus MicrosoftThe 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.
56Antitrust Law The Case Against Microsoft Microsoft Possessed monopoly power—it had 80 percent of the PC marketUsed predatory pricing and tying arrangements—offering its browser with Windows for a zero price was viewed as illegal predatory pricing and an tying arrangementUsed other anticompetitive practices—network economies and economies of scale created barriers to entry.
57Antitrust Law Microsoft’s Response Microsoft countered that although the firm enjoys monopoly today, it is vulnerable to competition from other operating systems such as Linux and Apple’s Mac OS and there is a permanent threat of competition from new entrants.Microsoft claimed that integrating Internet Explorer with Windows provided a single, unified product of greater consumer value.
58Antitrust Law The Outcome The courts agreed that Microsoft was in violation of the Sherman Act and ordered that it be broken into two firms: an operating systems producer and an applications producer.Microsoft successfully appealed this order.But in the final judgment, Microsoft was ordered to disclose details about how its operating system works to other software developers so that they can compete effectively with Microsoft.
59Antitrust Law Merger Rules The Federal Trade Commission (FTC) 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).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.
60Antitrust 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 achieving efficiency and therefor to serving the social interest.