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.

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

The Economic Theory of Government 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.

The Economic Theory of Government 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 Economic Theory of Government 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.

The Economic Theory of Government 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.

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

The Economic Theory of Government 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 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.

The 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.

The 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.

The Economic Theory of Government 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

Monopoly 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.

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

Monopoly and Oligopoly Regulation 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.

Monopoly and Oligopoly Regulation 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.

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

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

Monopoly and Oligopoly Regulation 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.

Monopoly 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.

Monopoly and Oligopoly Regulation 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 and Deregulation 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.

Regulation and Deregulation 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.

Regulation and Deregulation 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.

Regulation and Deregulation 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.

Regulation and Deregulation 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.

Regulation and Deregulation 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.

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

Regulation and Deregulation 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.

Regulation and Deregulation 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.

Regulation 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 are: Rate of return regulation Price cap regulation.

Regulation and Deregulation 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.

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

Regulation and Deregulation 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.

Regulation 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 earn zero economic profit.

Regulation and Deregulation 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.

Regulation 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.

Regulation and Deregulation 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.

Regulation and Deregulation 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.

Regulation and Deregulation 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.

Regulation and Deregulation 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.

Regulation and Deregulation 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.

Regulation and Deregulation 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.

Regulation and Deregulation 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.

Regulation and Deregulation 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 1890. 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.

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 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.

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.

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 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.

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