Antitrust, Regulation, and Deregulation Chapter 13 Antitrust, Regulation, and Deregulation

Chapter Objectives The goals of U.S. regulatory and antitrust policies The legal framework for U.S. antitrust policy How governments enforce antitrust policy How the government gauges the effect of mergers on competition How antitrust laws are interpreted and enforced Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The Government’s Role in Promoting Efficiency Up to this point, we have studied the effects of the various market structures and government policy (taxes, price controls) on economy efficiency (deadweight loss). Now, we turn to the role of government in promoting economic efficiency when there is market failure (the unregulated market is inefficient). Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Why the Government Might Intervene Three main reasons why the government would intervene in a market: To promote productive efficiency Resources are employed at the lowest cost. To promote innovation Creation and application of new technology To promote allocative efficiency Resources are distributed in the way that society values most. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Why the Government Might Intervene (cont’d) Most economists agree that the best way to achieve efficiency and promote innovation is through competition. However, competitive markets do not always arise naturally, and may even be undesirable in some cases. (market failure) Too few competitors / barriers to entry Externalities (costs/benefits not price in market) Assymetric information Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Natural and Optimal Market Structures The natural structure of a market is the degree of competition that would occur in the absence of government intervention. The optimal structure of a market is the degree of competition that maximizes allocative efficiency. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Natural and Optimal Market Structures (cont’d) The government will tend to intervene if the natural structure differs significantly from the optimal structure. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The Perfect Competition Benchmark The efficiency of a market is measured by comparing the existing price and output to the price and output that would result from marginal cost pricing in a perfectly competitive market. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Figure 13.1 Consumer and Producer Surplus With Competitive and Monopoly Pricing Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

U.S. Antitrust Policy Legal Framework The history of U.S. antitrust policy dates back to the mid-1860s, when a few very large firms came to dominate the steel, railroad, and oil industries. These trusts came under fire for unethical business practices that drove competitors out of business. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

3 Major Pieces of Legislation to address Anti-Competitive Markets Sherman Anti-trust Act (1890) Anti-competitive behavior, mergers Clayton Act (1914) Price discrimination (simple) Tie-in sales Robinson-Putman (1936) More detailed/complex definition of price discrimination Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Sherman Anti-trust Act As explained by the U.S. Supreme Court in Spectrum Sports, Inc. v. McQuillan, “ The purpose of the [Sherman] Act is not to protect businesses from the working of the market; it is to protect the public from the failure of the market. The law directs itself not against conduct which is competitive, even severely so, but against conduct which unfairly tends to destroy competition itself The law attempts to prevent the artificial raising of prices by restriction of trade or supply.[4] Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The Sherman Antitrust Act of 1890 The basis of much of U.S. antitrust policy, the Sherman Act outlaws: Trusts and restraint of trade Trusts allowed 1 company to own shares in another; thus getting around prohibition of collusive agreements Monopolies or attempts to monopolize an industry Standard Oil: Predatory Pricing Dropping price < ATC to drive out competitors McGee: found SO offered P = P(monopoly) (higher than competitive value) Mergers that are anti-competive Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Sherman Anti-Trust Act Divided into three sections. Sec 1 delineates and prohibits specific means of anticompetitive conduct, (e.g., contracts/agreements) Sec 2 deals with end results that are anticompetitive in nature. (actual pricing tactics, or non-compete) Sec 3 simply extends the provisions of Section 1 to U.S. territories and the District of Columbia. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Section 1: "Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is declared to be illegal."[13] Section 2: "Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony [. . . ]"[14 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The Sherman Antitrust Act of 1890 Trusts and restraint of trade Trust: ownership of another company’s stock Marketing agreements/non-compete Monopolies or attempts to monopolize an industry Standard Oil: Predatory Pricing Dropping price < ATC to drive out competitors See McGee’s correction Mergers that are anti-competive Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The Sherman Antitrust Act of 1890 (cont’d) Under the Sherman Act, courts may: Break monopolies up into smaller firms Divestiture – divest the company of its smaller firms 1980 – AT&T break-up Prohibit certain business practices Predatory pricing: P < min ATC to drive competitors out Supposedly Standard Oil in the 30’s Price fixing: setting P > MC and agreeing not to compete Eastern/American Airlines Not compete: geographic/product lines Impose fines on firms Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The Clayton Act of 1914 The Clayton Act prohibits: Price discrimination that reduces competition Product tie-ins Required purchase of another more elastic good to be able to purchase monopoly good IBM and computer cards The purchase of stock issued by competing companies Serving on the board of directors of a competing company Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The Clayton Act of 1914 (cont’d) Established treble damages Plaintiffs can recover three times the actual damage. Exempted labor unions from antitrust law Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The Federal Trade Commission Act of 1914 Created the Federal Trade Commission (FTC), the agency that identifies and pursues antitrust cases Department of Justice (DOJ), agency for attorneys that prosecute the cases Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The Robinson-Patman Act of 1936 Clarified the definition of price discrimination discrimination in price; on at least 2 consummated sales; from the same seller; to 2 different purchasers; of "commodities" of like grade and quality; the effect may be "substantially to lessen competition or tend to create a monopoly in any line of commerce." Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Enforcement of Antitrust Policy The Department of Justice (DOJ) and the Federal Trade Commission (FTC) have the power to sue firms in order to: Force violators to stop anticompetitive practices Break up existing firms into smaller ones Prevent the formation of very large firms Impose fines on firms that violate antitrust legislation Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Changes in Enforcement Since the Sherman Act of 1890, enforcement of antitrust legislation has become less stringent. Technological change and globalization have lead to increased competition. (contestable markets) Telecomm – wireless and landlines Music – record manufacturers and ITunes Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Mergers In addition to enforcing antitrust laws, the FTC may try to block or alter a merger. A merger occurs when two firms combine to form a single firm. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Types of Mergers Conglomerate Merger Vertical Merger Horizontal Merger Firms in unrelated industries merge. Vertical Merger A firm buys another firm that is either above it or below it in the supply chain. Horizontal Merger A combination of two firms that are in the same industry Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The Government’s Position on Mergers The government’s position on mergers has changed over the years, from preventing the merger of relatively small firms to allowing the merger of large companies. Bush(43) – focused only on horizontal mergers Obama – returned to review both horizontal and vertical mergers (Ticketmaster) In general, a merger that results in a Herfindahl-Hirschman Index of less than 1800 will not be challenged. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Natural Monopolies And Regulation Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Natural Monopolies Economies of Scale continue to occur at so large a scale that is it is “productively efficient” (least cost) to have only 1 provider Natural state and optimal state is a monopoly typically high fixed costs and low variable costs electric, natural gas, water, telecommunications (land) and tv cable Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Regulation If a natural monopoly arises due to scale economies, the government may prefer to regulate the monopoly. Breaking the firm up may reduce efficiency Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Figure 13.2 Natural Monopoly in the Telecommunications Industry Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Government Regulation of Price and Output The government cannot require that a natural monopolist set price equal to marginal cost. Because marginal cost is less than average cost, two options: 1. Government subsidizes the loss (Euro approach) No deadweight loss, but requires taxes on other goods 2. Average Cost Pricing (or Rate of Return (ROR)): government sets price equal to average total cost. (US solution) Leads to some deadweight loss, but less than a monopoly Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Figure 13.3 Choosing a Price for a Natural Monopolist US French Economic Loss or Subsidy Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Government Regulation of Price and Output Two methods of regulating price and output: Rate of Return Regulation—the firm is allowed to earn a pre-specified amount of profit in a given time period. Set prices to recover average cost + normal rate of return How do you determine normal ROR? Incentive for regulated firm to “pad” its costs (Averech-Johnson effect) Price Cap—government sets the maximum price or the maximum rate of price increase. After rate setting process: future rates can be raised by rate of inflation – industry’s average productivity (incentive for tech. iinnov.) Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Deregulation The current trend is for the government to remove regulation and allow market forces to determine prices, output, profits, and industry structure. Factors favoring deregulation: Difficulty in determining a regulatory strategy Advances in technology that have lead to increased competition Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Life Lessons Two wrongs don’t make a right. In the 1930s many states passed “Fair Trade” laws that effectively outlawed low prices. Fair trade – same price in each market Doesn’t reflect different supply/costs (or demand) As a result, consumers faced higher prices and retail stores were protected from bankruptcy. These laws were eliminated in 1975. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Reasons For Deregulation In deciding to deregulate an industry, the government must be confident that private market outcomes will be more efficient than regulated outcomes. Will deregulation affect product safety or reliability? Will deregulation eliminate service for some customers? Will the benefits of deregulation accrue to only a few customers? Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Application: Deregulation of the Airline Industry In 1978, the U.S. Airline Deregulation Act removed regulations on prices, the number of carriers and route assignments. (some) Passengers have benefited from the resulting price competition among air carriers. FAA set similar rates for flights of similar difference, regardless of destination (and demand in large/small cities) “legacy” losses and gains Smaller cities saw higher prices and fewer flight Larger cities: lower prices, more flights Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Application: Deregulation of theTelecommunications In 1980, AT&T and the “Baby Bells” were broken up into 8 different companies AT&T could offer only long distance service and had to compete with MCI and Sprint (no longer a monopoly) Baby Bells’ customer could choose their LD provider Took several years for AT&T market share to drop below 80% Colbert video – “it’s all back together again” FCC missed that there were economies of scale – led to mergers to reduce costs 1996 Congress passed the Telecommunications Act Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Application: Deregulation of theTelecommunications 1996 Congress passed the Telecommunications Act Required Baby Bells and GTE to open their local markets to all competitors Established prices that Bells could charge competitors for “renting” their lines and switching equipment Prices were set below incurred (or historical) costs Decreased incentive to maintain and update existing equipment Previously business line rates set higher than costs to subsidize residential phone service New entrants targeted business customers and high long distance usage customers (winners) Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Strategy and Policy The Department of Justice takes on Cingular–AT&T Wireless merger In 2004, Cingular agree to buy AT&T Wireless, creating a company with an HHI of 8,000 in some markets. In 2005, the firm was required to divest the entire AT&T Wireless network in the 13 markets where concentration was highest. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Summary The U.S. government may intervene in the private sector to promote productive efficiency, innovation, or allocative efficiency. U.S. antitrust policy is based on: The Sherman Act, which forbids monopolies The Clayton Act, which prohibits price discrimination The Federal Trade Commission Act, which established the FTC Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Summary (cont’d) Some actions are per se illegal; simply engaging in them is enough to establish guilt. Conglomerate mergers are not usually challenged. Vertical and horizontal mergers may be challenged if they reduce competition. In the case of a natural monopoly, it may be preferable for the government to regulate the firm. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Summary (cont’d) Deregulation of an industry may be appropriate because of changes in technology and globalization. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Table 13.1 Excerpts From Section 1 and 2 of the Sherman Antitrust Act Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Table 13.2 Summary of Key U.S. Antitrust Legislation Copyright © 2006 Pearson Addison-Wesley. All rights reserved.